Maple Leaf Memo
Energy trust executives will meet Tuesday with Canadian Federal Finance Minister Jim Flaherty to argue that the oil patch shouldn’t face the same tax hit as other income trusts.
No, the Coalition of Canadian Energy Trusts (CCET) doesn’t expect any great progress to be made, but it’s happy for the opportunity to be heard. The government has said it won’t back down from its proposal to eliminate the tax-free status of trusts; the CCET maintains that the oil and gas sector’s tax-free status allows it to play a vital role in developing lower production fields that are avoided by larger energy companies.
Trusts produce about 20 percent of Canada’s oil and gas, the equivalent of roughly 1 million barrels of oil a day.
The government’s current plans will hurt energy trusts’ ability to raise international capital; RBC Capital Markets estimates that international investors hold 22 percent of the income trust funds, which have a market value of more than CD200 billion. Rebecca Patterson, a senior currency strategist at JP Morgan in New York, said her proprietary data showed that outflows from the Canadian equity market were noticeably higher in the wake of the trust tax announcement.
And if nothing else, the heads of 42 energy-related trusts have an opportunity to rebut conclusions the finance ministry has cited as fact in support of its position. Issue No. 1: clearing up Ottawa’s misunderstanding of US treatment of flow through entities. The Finance Ministry has said that the US eliminated royalty trusts for energy–that’s not true.
The US government carved out an exemption for resource-based Master Limited Partnerships (MLPs), the US flow-through equivalent of Canadian trusts, when it similarly constricted tax-efficient structures in 1987. US MLPs are alive and well, enjoying a lower cost of capital than the Canadian energy trusts, even before Halloween.
If the American change was a key factor in Ottawa’s decision, the coalition believes Flaherty must take another look at how trusts are treated in the integrated North American energy market.
Where It All Begins Again
It lacks the jarring eloquence of the Declaration of Independence and the Lebowskian scope of the Port Huron Statement.
It may not be a mind-changing instrument on the scale those other documents are (Jefferson’s) or would like to have been (Hayden’s), but the first issue of Roger Conrad’s Canadian Edge spelled out clearly the approach to energy trusts (see Canadian Edge, July 2004, Feature Article: High Energy Income):
In short, as in any other sector, oil and gas royalty trusts will react to many of the same market and economic events in the short run. But selective buying and selling within the sector is the key to long-run investment success.
Jim Flaherty used “a blow torch to kill a fly” in taxing income trusts, in the words of one prominent Canada-based mutual fund manager. He evened up the cost of capital for corporations and income trusts at the expense of middle-class retirees.
Now what?
Let’s say one potential scenario–that trusts could be forced to adopt riskier capital structures through additional debt because interest on debt is deductible–plays out. A high-yield debt market could emerge. At that point, you’ll have to ask yourself whether to add those securities to your portfolio.
Here’s one way to approach the issue: By owning the equity and the debt, you effectively own the original entity that was formerly represented by the income trust units. The debt may increase volatility in the portfolio, but the underlying entity will still be worth owning.
Here’s where the new landscape requires old tools. From the beginning, Canadian Edge
emphasized stability and sustainability. This meant and means owning
the highest-quality companies and their underlying cash flow growth.
The CE Portfolios have been and will continue to be built
around good businesses with a safety net and the ability to adjust to
changing circumstances.
If you focus on companies that have excess distribution coverage and
strong balance sheets, you’re biasing yourself toward companies that
have the best ability to deal with extraneous events.
The Roundup
The initial reaction to the income trust tax proposal was devastating, as trusts across the board plunged 15 to 25 percent on November 1 and continued to retreat in the days that followed. The move was well deserved for weaker trusts, many of which had no business operating as big dividend payers. But it was a mighty overreaction on the part of owners of stronger trusts that do represent solid businesses.
One of these is Yellow Pages Income Fund (TSX: YLO.UN, OTC: YLWPF), which owns and operates essentially all of Canada’s print yellow pages and has a thriving business on the Internet as well. The trust announced last week that it’s maintaining its trust structure past 2011 and anticipates that it will generate enough cash flow to both pay a generous dividend and meet its new tax obligations. Moreover, it put its money where its mouth is by increasing its distribution 6 percent.
In the coming months, some trusts will no doubt elect to pull in their horns, convert to corporations and even cut dividends. Other weaker ones will perish entirely. But Yellow Pages’ example clearly indicates one size does not fit all in this sector.
Oil & Gas
Canadian Oil Sands Trust (TSX: COS.UN, OTC: COSWF) said repairs to a heavy oil upgrader at Syncrude Canada have been extended because of bitter winter weather at the northern Alberta site. Daily output will be as much as 100,000 barrels below capacity for another day. Full production at Syncrude’s Coker 8-2 isn’t expected to return until Tuesday because of weather delays. Coker 8-2, which normally processes between 85,000 and 100,000 barrels a day, was shut down for repairs after a leak was spotted in an overhead line on November 18. A cold snap has pushed Fort McMurray’s temperatures to minus 30 degrees Celsius (minus 22 degrees Fahrenheit), 13 degrees Celsius below seasonal norms. The Syncrude joint venture normally produces about 350,000 barrels a day. Hold Canadian Oil Sands.
Crescent Point Energy Trust (TSX: CPG.UN, OTC: CPGCF) and Mission Oil & Gas will delay a shareholder vote on their proposed merger, and Crescent’s bid for Mission will be sweetened. The two companies will seek an adjournment of the special shareholder meeting set for November 30 that was to consider the combination. Mission‘s management now wants to hold the meeting December 18 to give the companies and their shareholders more time to consider the new trust rules. Crescent has offered to pay 0.695 of a unit for each Mission share and assume about CD28 million of net debt, valuing Mission at about CD534 million at Monday’s unit price on the Toronto Stock Exchange. In addition, Crescent is now offering 13.9 cents Canadian per share of Mission, or CD5.9 million, to provide its shareholders with cash equal to the distribution they would have received for December if the deal had closed when originally anticipated. “The adjournment of the meeting would provide Mission and Crescent Point additional time to attempt to obtain the necessary assurances from Ministry of Finance officials,” the companies said in a statement. “In addition, the Minister of Finance has been quoted in the press recently as having suggested that guidelines setting out the application of the proposals will be released in the coming weeks. If such guidelines are released prior to the reconvening of the meeting, Mission and Crescent Point will be in a better position to accurately assess the impact of the proposals on the arrangement.” Should the merger go ahead, it will close in January. The transaction would give Crescent Point 5,500 barrels of oil equivalent per day of light oil and natural gas, as well as about 550 square kilometers of undeveloped land in southeast Saskatchewan and northwest Alberta. Crescent Point was already a major Mission stakeholder, owning nearly 9 percent, or 3.8 million, of the junior producer’s shares. Most of Mission’s current production is in the Bakken light sweet oil pool in southeast Saskatchewan, located “adjacent to and contiguous with” Crescent Point’s core properties. Crescent Point is a hold.
Daylight Resources Trust (TSX: DAY.UN, OTC: DAYYF), the successor firm to <i>Daylight Energy Trust</i>, reported a third quarter loss of CD2.14 million, versus a year-earlier profit of CD20.5 million, on a drop in natural gas prices. The loss amounted to 5 cents Canadian per diluted unit and compared with a year-earlier profit of 38 cents Canadian per unit. The gas-weighted energy trust said its revenues dropped to CD69.9 million from CD76.4 million in the comparable period of 2005. Production during the quarter averaged 16,342 barrels of oil equivalent per day, compared to last year’s 14,424 barrels. Sell Daylight Resources.
Shiningbank Energy Income Fund (TSX: SHN.UN, OTC: SBKEF) and Rider Resources have delayed a special meeting of Rider shareholders to consider the companies’ merger plan so they can evaluate the impact of proposed federal taxes on income trusts. The two energy producers will reschedule the meeting to December 15 from November 27 to allow more time to review Ottawa’s proposal. Much of the attention following the October 31 announcement has focused on eliminating the tax-free status of existing trusts in 2011. But rules and regulations regarding new restrictions on “undue expansion” haven’t been quantified, leaving companies in limbo as they plan their operations. Shiningbank is a hold.
Trilogy Energy Trust (TSX: TET.UN, OTC: TETFF) has made the necessary filings and received the necessary approvals to make a normal course issuer bid through the facilities of the Toronto Stock Exchange. Trilogy may purchase up to 4,624,801 of its trust units, representing approximately 5 percent of the 92,566,681 units outstanding as of November 15, for cancellation under the bid. Purchases under the bid may be made during the period beginning on Nov. 24, 2006, and ending on Nov. 23, 2007, or on such earlier date as Trilogy may complete its purchases under the bid. The price Trilogy will pay for any units purchased under the bid will be the market price at the time of purchase. Sell Trilogy Energy.
Business Trusts
KCP Income Fund (TSX: KCP.UN, OTC: KCPIF) announced that its board of trustees has engaged TD Securities and Genuity Capital Markets
to assist in the ongoing process of identifying and considering
strategic alternatives available to KCP to enhance unitholder value.
The fund has created a special committee consisting of all independent
trustees to oversee the strategic review process. KCP further stated
that while the trustees, together with management, have been
periodically reviewing strategic value enhancement initiatives for some
time, the trustees have decided to accelerate and now formalize the
process in response to the October 31 announcement by the Canadian
federal government of its intention to tax income trusts. KCP
emphasized that the strategic review process is intended to consider a
range of value enhancement alternatives in light of the “new reality”
for income trusts, and there can be no assurance that the evaluation
process will result in any transaction. KCP is a hold.
Real Estate Trusts
H&R Real Estate Investment Trust (TSX: HR.UN, OTC: HRREF) completed the acquisition of a second major retail property portfolio this quarter. The real estate investment trust (REIT) closed an USD88 million deal involving the purchase of eight retail stores comprising 489,000 square feet in Indiana. The stores are leased for 20 years to the 75-year-old grocery chain Marsh Supermarkets, with contractual rent escalations every five years. The properties are secured with 10-year, non-recourse, mortgage financing in the amount of USD65 million. On November 10, H&R announced it had completed the USD242 million acquisition of 33 retail properties comprising 1.5 million square feet in 25 cities across Ontario and one in Laval, Québec. The properties are leased primarily to established mass merchandisers Sobeys, A&P Canada, Zellers and Shoppers Drug Mart, with rental income from these retailers representing approximately 84 percent of the portfolio’s current annual base rent. The average lease term to maturity for the portfolio is 13 years, and the properties are secured with mortgages totaling USD149 million (of which USD36 million is non-recourse) with an average term to maturity of nine years. For both portfolios combined, the average debt leverage is approximately 65 percent, the weighted average interest rate of property financing is approximately 5.6 percent, and the average return is anticipated to be approximately 9 percent. Buy H&R REIT up to USD22.
Natural Resources Trusts
SFK Pulp Fund (TSX: SFK.UN, OTC: SFKUF) has increased its distribution from 2 cents Canadian to 3 cents, beginning with the December 15 payment to unitholders of record as of November 30. Good market conditions and the recent addition of the Menominee and Fairmont RBK pulp mill assets contributed to an increase SFK Pulp’s distributable cash. Buy SFK Pulp up to USD4.