Canadian Energy Trust Revival

Monetizing assets by creating a master limited partnership (MLP) is a tried-and-true approach to unlocking the economic value of appropriate upstream and midstream assets. Yet some operators do not have a conventional-producing asset profile that fits the MLP structure. What about the horizontal driller with a large inventory of infill locations? Or the South Texas conventional producer with vast Eagle Ford potential?

In comes the Canadian Energy Trust. This emerging investment vehicle with its flexible criteria, flow-through tax benefits and 2P (proved and probable) market valuation provides a monetization alternative to the development-stage assets that do not fit the MLP structure.

Non-Canadian properties

In 2006, the Canadian government enacted the SIFT (Specified Investment Flow-Through) rules to level the tax-revenue playing field between tax-advantaged income trusts (similar to the U.S. MLP structure) and corporations. By 2010, most Canadian oil and gas income trusts were effectively eliminated. This generation of Canadian Income Trusts diminished from 256 funds in 2006 ($225 billion) to just 60 today ($64 billion).

A Canadian lawyer, however, realized that putting non-Canadian assets into a Foreign Asset Income Trust (FAIT) would avoid the SIFT taxes.

In 2010, a management team in Texas hired Scotiabank to sell certain Central Texas oil assets. The MLP structure would have been ideal for a competitive valuation, but the minimal proved developed producing (PDP) component was a no-go for the MLP market despite low-risk development potential in this long-lived, producing oil field.

Scotiabank introduced the Texas management team to this new structure, known simply as a “second generation Canadian Energy Trust.” The outcome was the Eagle Energy Trust which successfully raised an initial public offering (IPO) of $150 million at a 10.5% yield.

CETs take hold

Six months later, Parallel Energy Trust went public for $393 million and a 9% yield. The company was formed through the acquisition of a 59% interest in assets held by Natural Gas Partners-backed Bravo Natural Resources LLC. Later, in March 2012, Parallel acquired the remaining interest in Bravo, earning NGP the highest return ever posted from its portfolio companies.

The most recent CET, Argent Energy Trust, closed last August. Argent raised $244 million at a 10.5% yield to acquire Austin Chalk and Eagle Ford assets from Denali Oil & Gas. In October, Argent did a follow-on acquisition of producing Texas and Oklahoma assets for $133 million. Denali was another private-equity-backed team that recognized the friendlier environment of the Canadian Energy Trust market, and they stayed on to manage the new company.

Although it is still early in the life cycle of Canadian energy trusts, for the most part share performance-to-date has been going according to plan.

For Eagle, its trading price over the last 12 months has tracked quarterly operating performance and commodity prices. Dividend yield is currently trading in line with IPO yield of 10.5%. Argent has traded at a slight premium since its August 10 close, with the Greenshoe exercised on August 28. Parallel, however, has been impacted by operational issues, which have been addressed by management, with the goal of achieving near-term production targets.

Best assets

The type of assets that fit the CET structure should have a 2P production profile that can sustain distributions over a five-year period. This is measured by a “sustainability ratio ” which is the sum of monthly distribution and capex as a percentage of cash flow. If the ratio is over 100%, the company will need to draw on its revolver to pay distributions. Investors will not want to see higher than 100% sustainability for very long.

The ideal CET asset will be in a low-risk oil or gas reservoir with an identifiable and repeatable drilling program. The idea is to keep a low decline rate and generate enough cash flow for a five-year distribution profile. Bolt-on acquisitions and a growing asset portfolio are other ways to maintain required production volumes.

In addition, CET assets typically have PDP in the range of 25% to 50% of 2P reserves, with R/P (reserves-to-production) ratios under 15 years. This is a key distinction from the more restrictive criteria for MLP assets, which typically prefers assets with a high PDP component and R/P ratios greater than 15 years.

Many U.S. companies are in a position to take advantage of the CET solution. Private-equity portfolio companies with a “prove up and sell” model can monetize their assets via CET earlier in an asset’s development cycle than in an MLP. Small and mid-sized independents can use the CET to sell off substantially all assets in a company. Public companies can use the CET to divest assets at a competitive valuation, and reinvest in higher-return opportunities.

Although the MLP will continue to be a popular monetization solution for energy companies, especially in the midstream space, the Canadian Energy Trust is emerging as a strong contender for holders of upstream assets due to less restrictive asset profile requirements and an expedited filing process.

MLP vs. CET