Recent launches of royalty trusts in Canada and the U.S. prove that when it comes to corporate finance, you can put a new spin on an old classic. Or in this case, E&P companies on both sides of the border can use the trust vehicle to access capital for growth.

When the Canadian government announced in 2006 its intent to eliminate the income tax exemption on Canadian royalty trusts' distribution payments, the market knew double-digit yields would soon be gone. Implementation finally happened in January 2011, though some trusts converted into corporations ahead of schedule. By the beginning of this year, all publicly traded Canadian trusts had converted to corporations, and an entire asset class was taken off the table for investors.

But this year, Canadian trusts may make a comeback—outside of Canada. Interestingly, the re-imagination of the Canadian royalty trust is happening just as royalty trusts formed by U.S. E&P companies such as Energy Corp. of America and Sand­Ridge Energy Inc. are starting to attract serious attention.

The most recent, ECA Marcellus Trust I, based on producing Marcellus shale acreage, was completed last July, garnering proceeds of $176 million. For its unique position in the marketplace as a way to finance upstream activity, this deal, led by Raymond James & Associates, has won the Oil and Gas Investor Excellence Award for Best Financing of 2010. (See Oil and Gas Investor, "Marcellus Royalty Trust," October 2010.)

The trusts coming out on both sides of the border are similar in only a handful of ways, but both offer compelling features for the right company, and the right investors. Investment bankers say that in particular, more U.S. royalty trusts could go public this year.

Richard W. Clark is chief executive officer and president of Eagle Energy Trust, a Calgary royalty trust launched last year that went public in November. In keeping with new laws governing trusts, it holds no assets in Canada.

Canadian content no more

Richard W. Clark is chief executive officer and president of Eagle Energy Trust, a Calgary royalty trust launched last year from scratch that went public in November. Its units are traded on the Toronto Stock Exchange and the trust pays no tax in Canada, because it distributes all of its income to its unit-holders. Eagle's distributions are taxable only in the hands of the unit-holders. While this might seem to directly contradict Canadian law, Eagle is actually making use of a provision in the legislation that required converting existing royalty trusts to corporations earlier this year.

Under the new laws governing public Canadian trusts, Eagle does not hold assets in Canada. This is a crucial legal distinction that allows it to achieve taxation closer to the regime seen in the golden days of the 2000s, yet its units still trade on the public market. If a publicly traded trust holds Canadian assets, it now falls under the new specified investment flow-through, or SIFT, regulations. For Clark, who intends to generate cash flow for unit-holders, these new regulations were less than ideal.

"We are in the business of paying distributions," he says. A veteran of the Canadian royalty trust model, he helped start Shiningbank Energy Income Fund in 1996. He is a former corporate finance attorney who has specialized in energy, and in particular the trust model, nearly his entire career.

All of the trusts extant at the time of conversion to corporation were free to either divest their Canadian assets, or opt to cease trading their units in public markets. Strategically, says Clark, changing horses in midstream to avoid the new tax treatment was not ideal for most of them. Reworking asset portfolios and shuffling teams to accommodate new areas of focus outside of Canada would have been difficult, and in the end, this strategy was not pursued by most.

"The Canadian oil and gas business and American oil and gas business are very different. You have to design your team specifically to function not only where the capital is raised, but where the assets are," he says. Existing staff expertise was likely a driver behind most Canadian trusts electing to hold Canadian assets, despite the tax ramifications, and convert to a corporate form, rather than have to switch to entirely new assets outside of Canada.

From the ground up

Clark thinks Eagle gained an advantage by starting from scratch, once all of the legal cards were on the table. Building a new entity meant designing it around tax treatment, with the explicit goal of paying bigger distributions to unit-holders than were likely possible in the long term from corporate dividends. Compared to the corporations, some of which expressed commitment to paying out income to shareholders even in the face of their conversion, Eagle's yield is favorable.

"The Canadian-listed, oil-weighted, yield-producing companies average about 6% yield, with a median of 5.6%," Clark says. That is a shadow of the double-digit yields seen in the trust heyday.

"There has been yield compression, and I think there is a bit to go yet, as well. We will settle in the 7% to 9% range, which frankly comes from our structural advantage," he says. Eagle is free to add and divest assets as it wishes in order to maintain its distribution level. Of course, in order to keep its tax treatment unchanged, any acquired assets must lie outside the Canadian provinces.

Because of this, he believes U.S. publicly traded master limited partnerships are closer in design and investment opportunity to the new international-asset-based Canadian trust.

"We are more like an upstream MLP, but there are a few important differences," he says. Among these are leverage, management fees, payout ratio, and hedging. Eagle's debt leverage is intended to remain under a range of 1.5 times cash flow, whereas the MLPs are typically three to four times more debt-levered.

"We don't have sidecar management fees. Our payout ratio is lower than most MLPs. It's in the 40% to 50% range, as opposed to the traditional upstream MLP model, in which all of net operating cash flow goes out in distri­butions."

Finally, notes Clark, MLPs also tend to hedge more than Eagle will. "Generally, the MLPs hedge all or more than all of their production. Because we don't use so much leverage, we hedge only 50%." Their hedging strategy is also somewhat in response to investor demands.

"Canadian trust investors are extremely sophisticated. They have had 20 years to watch this model develop. They want exposure to commodity prices in a gentle way: easy up and easy down. A 50% hedging strategy does that for them. Canadian trusts historically reward unit-holders with extra if commodity prices go up dramatically, and reduce distributions if prices go down dramatically," says Clark.

Coming to America

The asset profile for this new type of Canadian trust falls under two main constraints: it must hold developmental assets, and they must be outside of Canada. Cost of drilling is a key consideration beyond that. Clark says this was one of the main reasons the entity settled on the Salt Flat acreage in Caldwell County, Texas, for its first acquisition. Over 500 vertical wells had been drilled into the Edwards formation prior to the field being shut in around 1960, resulting in a well-defined formation.

A productive formation for years before it was shut in, this asset package was chosen by Eagle from 50 potential deals. Previous wells drilled in the field are shallow, conventional oil wells with low drilling costs. Eagle and its partner in the field have already drilled more than 36 wells in the field and plan on drilling another 13 in the remainder of this year. Clark says the analogous Darst Field lies to the south of the Salt Flat acreage. Continually productive since the 1950s, the area is an expansion target for Eagle.

Eagle plans to spend a net $23 million in the field in 2011, and has been booking average reserves of 130,000 barrels of oil per well.

"The decline rates on this field are comparable to a Cardium well in Canada," says Clark. Looking forward, Clark says the trust will actively pursue acquisitions, as the volume of opportunities in the U.S. is favorable.

"The deal flow is orders of magnitude greater here than it is in Canada. There are two basins in Canada. In the U.S., there are over 40," he says. The particulars of the land regime in Canada make it easy to assemble huge land positions well ahead of drilling. Most Canadian oil companies are publicly traded and have good access to capital. As well, in Canada, companies generally have five years to drill once they acquire a lease, although for some oil-sands and most heavy-oil leases, the time can be between 10 and 15 years. World-leading public data and good access to capital make Canada a very competitive environment, and the acreage is well trod. On the other hand, conditions in the U.S. have historically supported both an active industry of smaller, private operators as well as a much higher threshold for going public.

"More so than in Canada, assets held by small companies have often had less capital applied to them here," says Clark, who researched companies operating 30,000 barrels a day or less, and discovered that a material percentage were private. The assets held by these relatively smaller owners still hold some value that Clark aims to exploit. Knowing the U.S. operating environment is key to Canadian trust strategy.

Clark's goal is to grow the fledgling trust into a billion-dollar entity in 18 to 24 months. The trust will focus on assets in Texas, the Midcontinent, and the Bakken. Eagle has an $8-million credit facility with Scotiabank, and additional credit is available for the right project. Current debt costs are not overly burdensome, he adds.

The new trust structure targets a niche play, and Clark believes by making that choice, Eagle will put a lot of cash into unit-holders' hands. To advance its strategy, Eagle recently opened a Houston office and hired Robert Cunningham, formerly of Zone Energy LLC, as its vice president of business development, and Dusty Dumas, an experienced oil and gas finance executive, as its controller.

Born in the U.S.A.

Royalty trusts are not a new concept in the U.S., as domestic companies have been using them for years. The structure under U.S. law is slightly different, however, from either the old Canadian trust model or the new iteration represented by Eagle Energy Trust.

Once launched, a royalty trust under U.S. law is confined to the acreage declared at the initial offering, with only slight modifications possible, such as pooling, from that point forward. Properties cannot be added. The trust ends in 20 years, at which time the acreage reverts to the issuing E&P company.

John Mork is president and chief executive of Energy Corp. of America, a private independent oil and gas company that has launched three royalty trusts to date. The oldest, the Eastern American Natural Gas Trust, began 18 years ago and is still paying distributions to unit-holders.

"The irony of royalty trusts is they are essentially E&P companies without management, and they trade at higher multiples than companies. That lets you know what the market thinks of management," jokes Mork, who has enjoyed success with the royalty trust structure. He believes the U.S. royalty trust is going to see more use in the coming years.

"I think there will be broad use of this structure from E&P companies, outside of the bigger firms," says Mork.

For ECA, he says, the choice was calculated. The private independent has nearly 50 years of experience in the Appalachian Basin, and holds almost a million prospective Marcellus acres with conventional production. When the company found it required more capital to develop its position, Mork took stock of the options.

"Bank debt is retrospective. It looks at what you did last year, and loans to that. We'd always be behind that way. We looked at mezzanine, with rates in the mid- to high teens to low 20s. There wasn't a lot of claw-back. We could do pure equity in the form of selling leases, but the required return for them was 35% to 50%." ECA benchmarked its returns and felt the company's cost of capital would be PV-10, based on its ability to sell at PV-10, a task he was confident it could achieve.

"I believe that set a new tone for royalty trusts. In the unconventional plays, I think you will be able to do them with a much higher percentage of proven undeveloped reserves."

John Mork, president and chief executive of Energy Corp. of America, has launched three royalty trusts, the most recent based on producing Marcellus shale acreage.

Public access

Mork believes the real advantage of the U.S. royalty trust—and the thing that will likely drive more use of the device in the future—is access to public capital for private companies.

"Being a private company but having access to public capital is a huge advantage," he says. There is also a tax advantage, as taxes can be deferred with production over the 20-year life of the trust, though the cash proceeds are still collected up front. At the end of the life of the trust, the acreage reverts back to the company, in most cases.

"If all the acreage reverts to the company, the day before the last distribution, the value of the units is only the value of the final dividend," Mork says. As the production from the underlying assets drops off over time, the distributions, calculated on the royalty income less tax, dwindle. ECA opted to have half of its latest trust revert with the intention to sell the assets on the open market. The proceeds of that sale will go to unit-holders in one last big payment. Natural gas prices were low at launch, so Mork anticipates that a future lump payment could please unit-holders.

Even so, Mork thinks this tool is not for every company.

"If you are public and your cost of capital is different because you can issue stock, then maybe that is cheaper." Mork says investors sometimes question why he didn't go the master limited partnership route—which many have successfully done.

"I'll be interested to see how MLPs work for the unit-holders over time," he says. "Successful E&Ps don't pay dividends. They find and develop properties, and get value appreciation for shareholders. The exit strategy for shareholders is to sell the company to a larger entity." But Mork has reservations about splitting corporate resources between the two differing goals of asset growth and dividend payment.

"On a full-cycle basis, I am curious if there is enough cash available to maintain big dividends and grow assets simultaneously. If the cash is there, then investors might ask why E&Ps are not paying big dividends."

Everybody wins

As Mork points out, the pure U.S. royalty trust pays unit-holders the royalty after taxes—nothing else is subtracted. There are entities that charge the trust to drill wells, but for shareholders, Mork says, that is a bad deal. The challenge, then, is launching a public trust with a value that is appealing to potential unit-holders, but which still allows the sponsor company to expand drilling. Mork says the Marcellus itself played a part in solving that problem for ECA on the most recent trust.

"We recognized in a fabulous resource play like the Marcellus, there was great consistency in the wells. We convinced the market we could drill wells and results would be steady." In hindsight, Mork says ECA's results have been about 40% better than forecast, which is upside for unit-holders.

"They have exposure to natural gas price increases, because they bought in when prices were really low. That sets up an interesting possibility. Because the terminal decline rate on these wells is only about 4%, it is quite possible that natural gas prices might increase as fast as decline rates, and dividends might not see reductions at all." Even if prices do not climb in step with decline rates, Mork says the trust is still a compelling investment. ECA's first trust is trading around $24 per unit, 18 years later.

"The unit-holders were able to buy into a vehicle designed to get better than 10% IRR," says Mork about the entity. He says retail investors, for whom this is most attractive, would be hard-pressed to find returns like that in other conventional investment options. In Mork's opinion, half a billion dollars is probably the feasible upper limit for a U.S. royalty trust offering, though the number of those offerings the market could accept is large. As such, it is a niche retail product, not an institutional opportunity, which is another reason that larger E&P companies might not be interested in the model.

Mork advises E&P companies to try to retain some units if they end up creating a trust.

"We held half of the units from the Marcellus I trust. Not quite a year later, we did a secondary offering for a quarter of those we retained, and they traded up from $20 to $28. If you do a good job, the market rewards you nicely."

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