A new trust tax plan announced in Canada in October brought the normally bustling M&A activity of the energy trusts to a halt, even causing some to cancel acquisitions that were under way.

"The advantages the trust buyer group had in the marketplace were effectively taken away from them as their unit values fell in the last quarter of 2006," says Mark McMurray, managing director, corporate development, of Calgary-based divestment services firm Rundle Energy Partners, formerly Kobayashi Partners Ltd.

"Without equity support above their asset values, the majority can't do transactions at the kind of premium values they had been able to finance with paper in the market previously. Before, a good number of trusts could pay C$80,000 or C$90,000 per flowing barrel and still defend accretion in the market value of their units. Now, their units have peeled back and it puts them either on par with or at a disadvantage relative to other buyers."

At the same time, oil and gas prices have declined, making buyers nervous. "We're definitely in an era of uncertainty, and we've even noticed it in some of the processes we've been executing," says John Koyanagi, managing director of Calgary-based M&A advisor Canaccord Enermarket. "Bidders have been reluctant to get aggressive because they don't really know where commodity prices are going."

These two issues will affect the Canadian M&A marketplace for the rest of 2007.

"Both of those issues-a fewer number of competitive buyers and accretion thresholds-affect transaction values, but they also introduce new deal opportunities into the market," McMurray says. "The past two years have been the years of the advantaged buyer and seller. We're now into a market where it's just the inverse."

Meanwhile, producers whose business model has been to build assets the trusts would be interested in are now forced to re-think their plan. "Prior to the announcement changing the tax rules relating to trusts, the thinking was, 'If you want to sell an asset or if you want to sell your company, just sell it to a trust,'" says Brad Hurtubise, managing director, investment banking, with Tristone Capital's Calgary-based divestment services practice.

"They have always been the buyers with the greatest compulsion to grow through acquisition and the lowest cost of capital and best access to capital to fund those transactions.

"There were a bunch of people in the practice of starting up a company, growing it from production of under 200 barrels of oil per day to anything over 1,000 barrels and the trusts would be the buyers. With this announcement, that game is over."

Forecasts vary for how the trusts will transform as a result of the new tax rules. Some Canadian M&A advisors expect the smaller trusts to combine, continuing a trend that began in mid-2006.

"It depends on the size," says Martin Peters, a managing director of Canaccord Enermarket. "The larger trusts are well-positioned and have cost-of-capital advantages over the smaller trusts. They have a lot more flexibility to choose how they plan to go forward. The smaller trusts, because they don't have that depth to change their model, will probably resort to consolidation."

The new tax law takes effect in 2011; some trusts may stay the course until forced to change their business plan. "It will depend on the nature of the trust," says Alan Tambosso, president of Calgary-based divestment advisor Sayer Energy Advisors. "Those that are taxable can continue to run with tax-free status for four years, so they would be foolish to convert right now. Some are converting as we speak to take advantage of the corporate structure benefits, and you'll probably see some further consolidation of trusts."

McMurray expects the trusts to evolve to remain viable. "Part of that evolution could include combinations with other trusts," McMurray says. "It could include conversions back into an intermediate E&P model. Or it could include another financial transaction with a buyer who has another tax advantage. The buyer group in Canada that would have that tax advantage would be pension fund groups through direct ownership."

Koyanagi says a whole new set of issues arise for trusts that choose to transform into E&P companies. "In the past, they've just been an acquire/exploit model, and now they'll actually have to build some capabilities to do some exploration in addition to acquiring and exploiting," he says. "No question, their model is going to have to change. But they don't have the people to do that, and that raises a bunch of other issues."

Meanwhile, Hurtubise expects the Canadian M&A space will see fewer transactions, and likely at lower valuations, now that the big-spender trusts are benched, and junior start-ups have fewer potential buyers to pitch their assets.

"Trusts were trading at much higher multiples than E&P companies, so E&P companies could merge to get big enough to convert into a trust," he says. "Now the quick exit through a sale is much less available because the hungry buyer isn't there with his bag of money anymore."

Larger, traditional Canadian E&P companies will likely step up activity. "You're going to see the rebirth of the intermediate sector, which was basically replaced by the trusts when they bought out all of the intermediates," Hurtubise says.

"The juniors are going to be allowed to grow up now because they're not going to be sold to the trusts and they're not going to merge and convert to trusts. They will still merge, but they will merge with a view to becoming an intermediate and get the advantages that increased scale provides."

The junior sector is expected have a better chance at acquisitions. Koyanagi says, "They're starting to think about acquisitions. Not only do they feel they can be more competitive, but they feel they're going to have to do some acquisitions to stay around for more than two or three years."

As the low-capital-cost trusts were outbidding traditional E&P companies for assets, most non-Canada-based producers also left the field. "I wouldn't expect them to be back, unless there is some really compelling value," Koyanagi says. "A lot of the American and other foreign companies left Western Canada because they saw that prices being paid for oil and gas properties in Canada were the highest in the world.

"Given the maturity of the space, it kind of made sense to sell out. We'll see where the prices settle out, but I'm not seeing a big rush of foreign investment into Canada."

A large purchase will be needed to make it worthwhile to enter or re-enter the Canadian marketplace, Hurtubise says. "To make sense to come back to Canada, they would need a very large acquisition, and what are they going to buy? Given the pool sizes, cost structure and tight land situation, it's pretty tough to make a meaningful enough investment to make it worth your while."

McMurray still sees benefits for a foreign company to invest there. "It is one of the higher-cost environments, but it's also one of the lower-risk environments," he says. "It's high-cost from a finding-and-development point of view, but the individual investment dollar at risk is usually of a smaller scale than it is in the deep Gulf of Mexico or in West Africa, where you get one shot and you spend tens of millions of dollars.

"Here, you can still spend under a million dollars to test a concept and get gas moving through the sales meter in short order."



Commodity prices

Also pushing Canadian asset prices down is declining oil and gas prices. The Canadian rig count fell some 25% to 580 in early 2007 from early 2006. Koyanagi says, "It's causing some companies to have to reconsider capital programs and think through what they're going to do with their asset base going forward."

Peters says, "Because of prices, capital markets are tighter, which affects companies' ability to raise equity."

And, junior E&P companies' access to capital has been adversely affected, McMurray says. "Last year the junior marketplace was definitely advantaged and enjoyed a significant premium to their net asset value when it came to raising new equity to do acquisitions and exploration."

But there was more capital available than opportunities to chase. "As a result, the juniors leveraged their paper to raise capital but weren't able to add the volumes and reserves for a competitive cost or at a pace their shareholders required to achieve a high rate of return," McMurray says.

Lower commodity prices have caused a dip in equity values for all producers, making it harder to close deals. "Share price goes down, cash flow goes down and bank borrowing bases go down, and buyers are reluctant to do the deal because they don't have the currency," Hurtubise says.

"They still see the value of the asset because they can look past the short-term commodity-price fluctuation, but they can't pay the price of the asset because their shares used to be C$6 and they have dropped to C$4, for example, so it's more expensive to issue equity."

Many deals are not closing. Koyanagi says, "The sellers are just not getting acceptable offers. People aren't being as aggressive in terms of bidding and, though we've seen falling commodity prices, sellers are still holding onto the expectation that they can get the same dollar value as when prices were high."

McMurray says a retreat in M&A activity is also due to the conservatism of capital providers. "The capital providers will be here when the bulls are running and they'll hide in the shadow of a bear," he says. "The sellers have come off frothy transaction metrics with expectations that don't correct as quickly as the capital markets correct. The gap that results stretches many deals out."

Divestments that are under way include those of the financially disadvantaged to raise cash for re-investment or pay debt. "People are selling assets and companies now from positions of relative weakness," McMurray says. "If they can't go to the capital market to raise equity to fund growth, they'll raise more debt, or sell assets in the marketplace and redeploy the proceeds of those assets into their growth plan."

In this quarter, the gridlock should loosen. "We are going to see the floodgates for asset divestments and disadvantaged public corporate sales open up in the second quarter like we haven't seen in a number of years," McMurray says.

Peters says the slower pace of 2006 was actually an indication of the overall health of the industry. "If you're making a lot of money and you can execute on your programs, then there's really no reason to sell, and there's really no reason to go out and buy," Peters says.

"You need a bit of a spark or something that will cause transaction activity. Going forward, if commodity prices can level out and reduce the volatility a little bit, that will facilitate more transactions as buyers and sellers narrow in a little more as to what their price expectations are."

McMurray says 2007 will be a year to catch up on portfolio management, something producers were not compelled to do when commodity prices were higher.

"During high prices, the production and reserves booked on those interests were more valuable than the cash in their jeans," he says. "Now, the cash in their jeans is king. Some will now be pushed into divestment. Companies that remain strong in the long run know that portfolio management is just good business."

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