?While the total number of Canadian transactions in 2008 is tracking that of 2007, the total deal value is significantly less—even more so when discounting one deal that equals 60% of the year’s value.

W?hile the M&A landscape in Canada during 2007 was active and efficient, 2008 has proven to be one of caution and discipline. Uncertainty surrounding commodity prices, retracting capital markets and a shifting regulatory framework among other drivers has motivated buyers to take a more pragmatic approach and sellers to often wait on the sidelines.


“Nobody moves; nobody gets hurt,” says Mark McMurray, managing director with M&A advisory firm Rundle Energy Partners in Calgary, summing up the attitude of many Canadian players of the past few months. “That’s not a bad strategy when assets are cash flowing as strongly as they are today.”


In total deal value, the statistics bear him out. According to M&A advisor Scotia Waterous, the total deal value of Canadian transactions (not including oil sands) in 2007 was approximately C$27 billion, compared with approximately C$10 billion in 2008 year to date—of which approximately C$6 billion is attributable to Shell Canada Ltd.’s July announcement of its pending acquisition of Duvernay Oil Corp.


In total number of transactions, however, 2007 produced 98 total deals, while 2008 has registered 45 through July, or about par.


Tom MacInnis, managing director for M&A advisor Tristone Capital Inc. in Calgary, says 2008 is shaping up to be just as active in terms of the number of transactions, but significantly lower in dollar value. But it’s still early, he says. “Part of that is driven by commodity-price volatility slowing down some of those transactions, and some of it is the natural consolidations that happened in 2007.”


When evaluated on total production changing hands, “we’re more than halfway through the year at about a quarter of 2007 volumes,” says Derek Wheatley, associate director for Scotia Waterous in Calgary. Last year, daily production of more than 400,000 barrels equivalent was exchanged; through July 2008, less than 100,000.

Price points
Unpredictable—and commonly believed to be unsustainable—commodity prices have been the elephant in the data room, causing a distinct pause in M&A activity through the first half of the year. Buyers are uncertain as to what price deck to use and seller expectations have been moving upward, creating a gap. And more often than not, seller expectations have exceeded buyers’ willingness to pay.


“That has been far and away the biggest driver we’ve seen in the M&A market in the last calendar year,” says MacInnis. “Any time you see commodity volatility, you’re going to have buyers and sellers separate.”


Transaction activity has been steady, but deals are smaller in size this year, he says, and generally taking longer to get done. “Those transactions are more complicated than they have been in recent years.


“When commodities move that significantly, it’s difficult to have buyers and sellers agree on the proper price deck, so you see a slowdown in transactions getting done while these commodities are moving.”


Rundle’s McMurray sees the same difference between value expectations. “Because we’ve had rising commodity prices, these gaps have evolved and a lot of the deals that have been in the market have been stretched out.”


Buyers are cautious and selective, he says. “People that could have done deals were reluctant because of the expectations of sellers.”

Tight markets
When capital markets retracted in midyear 2007, a flurry of assets hit the marketplace toward year-end as Canadian junior E&Ps sought to raise capital to fund winter and spring drilling campaigns.


“Previously, a lot of the juniors had been able to go to the capital markets and raise equity to be able to fund their programs,” McMurray says. “When they were trading at a discount there was less ambition to do that, which resulted in a flurry of small asset transactions in the marketplace,” typically deals of under C$50 million, he says.


The recovery in gas prices at the beginning of 2008 and expanding oil prices added “quite a bit of relief” to the balance sheets of Canadian juniors and intermediate-size producers, lessening the need to raise cash and thus lessening the quantity of assets on the market.
“We thought we were going to see a lot of distressed-sale situations in the first quarter of this year, but the high prices provided a ‘stay of execution’ for a lot of companies,” he says.


Yet the lack of liquidity has had another effect: smaller E&Ps consolidating to be in a better position to tap the equity markets.


Companies with market caps below C$250 million are feeling the illiquidity pinch, a lack of trading activity, and their cost of and access to capital getting squeezed, MacInnis says. “It’s causing a pause in that group’s ability to attract capital to acquire assets and companies at attractive valuations.”


While the number of corporate and asset transactions has been essentially balanced for the past year and a half, the difference in deal value for the two is significant. In 2007, 87% of the deal value was due to corporate transactions, and year-to-date deals teeter at 90% corporate in terms of value, according to Scotia Waterous.


Capital markets prefer large-cap companies with liquidity, and larger juniors trading at premium valuations are able to complete more transactions. Examples are NuVista Energy Ltd. buying Rider Resources Ltd., and Iteration Energy Ltd. acquiring Cyries Energy Inc.


“There’s a view that, at lower commodity prices, the smaller companies are just unprofitable and can’t survive the G&A (general and administrative) burn that they naturally have,” MacInnis says. “Today, that is less of an issue, given where commodity prices have gone, but the capital markets have not gone back and traded those smaller companies at the same multiples some of the bigger companies are getting.”

Royalty trusts
The Canadian market backdrop continues to be driven by shifting regulatory regimes. Though it has been two years since announced, the impending changes set forth for royalty trusts in the federal Tax Fairness Plan loom ahead, affecting M&A now as these trusts attempt to decipher how their present and future business models—and thus portfolios—will be affected. The legislation effectively forces Canadian royalty trusts to convert to a traditional corporate structure between 2011 and 2013—and pay corporate taxes.


“The trusts used to accumulate just about anything that moved,” McMurray says. “They were building barrels of reserves on their balance sheets. They didn’t care about the asset quality too much. Now they are looking at the quality of those assets and their ability to perform, and making disciplined decisions around how they value them and whether they fit their portfolios.”


Since the federal announcement in late 2006, MacInnis notes that larger-cap trusts have been absent from making transactions.


“They are focused on upgrading their average asset quality as they prepare for the future. Transactions that made sense in the past were accretive transactions that increased their size profitably, but now—when they have to pay attention to how they spend their growth dollar—they’re being picky.”


Sayer Energy Advisors president Alan Tambosso says M&A activity is picking up, involving trusts attempting to buy conventional E&P companies holding development potential and income-tax pools in preparation for a conversion to a more normal corporate structure. “That’s affecting M&A activity right now. You’re definitely seeing trusts do those kinds of deals.”


He says activity bottomed out after the announcement, as trusts stopped buying juniors, but now the trusts are picking up activity as they prepare to change their corporate structure. “They’re learning to live with it,” he says.


He counters the perception that trusts have been absent from the acquisition market. “That’s a misunderstanding. Prices have come down a bit and they were a little more quiet, but they never left. They continue to be active, but—instead of seeing asset acquisitions—you’re seeing corporate acquisitions, especially where the vendor has significant tax pools.”


One significant change as a result of the Tax Fairness Plan involves a limit in the amount of equity that trusts can issue for funding cash transactions, or “safe harbor.” Historically, royalty trusts were the most active buyers, but have now become more selective in their cash acquisitions, which were previously their “power alley,” Wheatley notes.


“Royalty trusts in the oil and gas sector were purchasing 80% or more of the asset deals and 60% of the corporate deals,” he says. “Many of these deals were cash transactions.”


Since that time, cash acquisitions by trusts have decreased, dampening the movement of asset packages. Cash deals have dropped from C$13 billion in 2007 to C$7 billion in 2008—or C$1 billion not factoring the single C$6-billion deal by Shell for Duvernay. The result is a shift to smaller asset packages, typically those producing fewer than 1,000 barrels a day, to target a broader universe of potential buyers.


Conversely, noncash trust-on-trust transactions have blossomed as trust consolidation has no effect on the Tax Fairness Plan’s safe-harbor limits. Examples of this are the merger of Penn West Energy Trust and Canetic Resources Trust, and Enerplus Resources Fund’s acquisition of Focus Energy Trust.


And junior oil and gas companies are left holding assets, as the trusts were a critical exit strategy for this sector. As trusts become more selective, junior assets are now potentially undervalued in the marketplace and are not garnering the premiums as are highly focused companies.


Says MacInnis, “It’s raised the bar on the quality of company you build to attract high-value buyers.”

Alberta blues
The decision by Alberta’s government in October 2007 to increase provincial royalty rates is another regulatory driver shifting Canadian M&A patterns.


“We’ve definitely seen people re-allocate capital outside of Alberta,” Wheatley notes. “Alberta’s transaction activity has declined as a result of buyers being less interested in deploying capital into the relatively higher royalty regime and the relatively lower-return environment that Alberta now offers. It’s taken away some of the upside as investors and buyers are concerned.”


That’s led to more capital being deployed into British Columbia and Saskatchewan. “There are still deals happening in Alberta; they’re just not the premium transaction deals.”


McMurray agrees. “Alberta has fallen out of favor. Companies looking to build growth are weighted in (British Columbia and Saskatchewan) where they’re treated with a more favorable royalty structure, so the rate of return on the capital they invest is higher and affords them more scale in the types of positions they can get into.”


Even so, Alberta’s bread and butter is its conventional oil, where M&A is ongoing. In an era of high commodity prices, “there’s still a lot of capital that can go chase conventional oil plays.”


Tambosso says the Alberta royalty tax affects producers drilling for new reserves more, and acquirers of assets will simply factor in the economics of the royalty in valuations. “It doesn’t mean there’s more or less activity; it just changes your valuation.”


“M&A in Alberta is not dead,” MacInnis emphasizes. From a risk perspective, the royalty “just made it more of a big-company game.”

Up with unconventional
On the upside, M&A activity has heated up over Canadian resource plays, particularly the Montney gas formation in northeastern British Columbia and the Bakken oil play in southeastern Saskatchewan, where land prices and metrics have risen significantly.


“The flavor of 2008 has been all about the Montney and some of the other gas plays such as shale gas,” says McMurray. “Shale gas has come into vogue and people are interested in establishing footholds in those plays.”


Shell’s pending acquisition of Duvernay defines a new high-water mark in transaction metrics for the play, he says—some C$200,000 per flowing barrel equivalent. “Shell has defined what it costs to play.”


The Bakken oil play is experiencing heightened M&A activity as well, largely consolidations by a handful of key players, such as Crescent Point Energy Trust, Tri­Star Oil & Gas Ltd. and Petrobank Energy and Resources Ltd., buying private junior E&Ps. “All of those deals were done at a premium to what conventional assets would have historically sold for in western Canada,” Wheatley says.


While one is gas and the other is oil, the Montney and Bakken are similar in that activity in each is driven by commodity prices and technological advancement. Says MacInnis, “It is remarkable that the valuation of those assets is significantly different today than a year or two ago.”


And where there would have been government land available a year ago, “there aren’t too many wide open spaces on land maps anymore.”

The road beyond
Canadian M&A is in transition. Stable commodity prices is “No. 1 by a mile” the biggest factor to jump-starting transaction activity, says MacInnis. “The biggest driver is commodity stability so buyers and sellers are not debating the commodity forecast.”


Confidence in capital markets will return when balance sheets strengthen, says McMurray, and this will loosen equity funding for cash transactions. He expects positive corporate reports in the second half of 2008 to shore up investor confidence and stimulate returns.


“We’ll see corporate valuations go up and more public-market support for M&A,” he says.


Small junior companies—those with market caps below C$300 million and trading at a discount to larger peers—will experience pressure to “grow or go” in the coming year, Wheatley anticipates. “If they can manage to grow their assets to a larger size, they expect to get a premium valuation. If they don’t, they may be acquired by larger companies or trusts.”


But the 2011 deadline for royalty trusts is the only certain driver of transaction activity for the coming years as trusts convert. Says McMurray, “That is the one trend we have confidence in for introducing deal flow into the marketplace.
“There is going to be a lot of reorganization of assets around the industry.”

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