Maple Leaf Memo
Oil is in a severe correction, the unit prices of oil and gas producing trusts are languishing, and your portfolio doesn’t look as strong as it did just a few short weeks ago.
Let’s start by admitting that, and then try to find out the reasons why these things are happening now. We’ve long believed that only some combination of four factors could bring about an end to the current energy bull market: a significant discovery of new reserves, changes in consumption, adoption of alternative fuels on a mass scale and a demand-killing recession.
We’re not there.
The increased commodity and oil-related stock trading activity suggests institutions are making strategic adjustments. Hedge funds are unwinding profitable positions, but it’s too early for mutual funds to be rotating into bets on a year-end rally that boosts performance numbers. Hedge-fund managers and other large speculators cut their long positions–their bets that prices will rise–by 39 percent in the week ended September 19, according to the US Commodity Futures Trading Commission. And it’s also likely that strategists are adjusting to a coming economic slowdown.
We’re debating now only the breadth and depth of such a slowdown, but most commentators project that 2007 growth will be well above demand-killing recession levels. According to the International Monetary Fund’s (IMF) World Economic Outlook, Canada’s economy is poised to grow by 3 percent next year, giving it the fastest growth among the Group of 7 (G-7) countries. Canada’s status as a major net exporter of energy will likely be enough to insulate it from the slowdowns that the IMF is forecasting for the US and Europe.
US growth is expected to slow from 3.4 percent this year to 2.9 percent in 2007. Citing strong growth in China, the IMF raised its global growth forecast a quarter of a percentage point to 5.1 percent this year and 4.9 percent in 2007. Japan, the world’s second-largest economy, will likely grow 2.7 percent this year on the back of solid domestic demand, but should ease next year to 2.1 percent. In the euro area, stronger corporate growth should moderate to 2 percent in 2007.
China’s economy will probably steam ahead with 10 percent growth this year and next, propelled by surging exports. India, Asia’s “other” major engine, should slow to a still-robust 7.3 percent next year.
Latin American economies would continue to lag, although growth
prospects have increased in the region, with expansion expected at 4.25
percent in 2007.
Significant New Discovery?
The story broke the morning after Labor Day, when the Wall Street Journal ran a front-page piece reporting that Chevron, Statoil and Devon Energy had announced the results of a major oil production test in the Gulf of Mexico. The partners ran the test on a well known as Jack No. 2 that was drilled last year in the Lower Tertiary zone of the Gulf. This zone is about 80 miles wide, 300 miles long and is located about 175 miles offshore. The well was unusual in that it went to a depth of 28,000 feet and the drilling began under 7,000 feet of water.
This isn’t the new North Sea.
Although no formal estimate as to the size of this particular find was announced, background briefers spoke of the possibility that the zone could contain between 3 billion to 15 billion barrels of oil in scattered deposits. If this speculation were to prove true, it would put the Lower Tertiary in a class with Alaska’s Prudhoe Bay and increase domestic US oil reserves by 50 percent.
The news of this great discovery naturally was replayed by nearly every newspaper and TV network in the country. Katie Couric ran a segment about the discovery on her first evening news show. Most reporting emphasized the possibility that the US might have found another 15 billion barrels of oil in its own backyard, but tempered the jubilation with the news that the find would have no immediate impact on gasoline prices.
Knowledgeable geologists and petroleum engineers began to question all the euphoria. First, they noted that the Jack No. 2 test wasn’t conducted on a single oil field that might contain 15 billion barrels oil. Rather, it was one test of a well in a zone that extends for hundreds of miles under the Gulf of Mexico. Whatever producible oil the zone contains will likely be found in numerous smaller deposits.
To extract oil from 20,000 feet below the surface is going to be a major technical challenge. Wells drilled to these depths will cost in the range of $100 million each. To drill and set in place the production equipment for one of these fields may cost on the order of $1.5 billion or more, as the cost of oil production equipment is inflating rapidly.
Although there are no geopolitical problems or nationalistic governments involved in producing oil from the Gulf of Mexico, the fields are right in its center–out where the Category 4 and 5 hurricanes really get wound up. On top of this, there are questions of how much oil can be extracted from an ultra-deep field with extreme pressures.
Assuming that producing oil from the Lower Tertiary turns out to be economically and technically feasible, will new production from the region fundamentally alter the prevailing supply/demand profile? Knowledgeable observers agree that even if all goes well, it’s unlikely that more than 300,000 to 500,000 barrels per day of production could come into production from all the possible fields in the Lower Tertiary during the next five to seven years. In the meantime, the world will have burned another 150 billion to 200 billion barrels of oil, and US production from existing fields will decline from the current 5 million barrels per day to somewhere around 4 million.
World oil consumption rose by about 1.2 million barrels per day in 2005, after an increase of 2.6 million barrels per day in 2004. The non-Organization for Economic Cooperation and Development (OECD) countries accounted for 1.1 million barrels per day of the 2005 increase, and the OECD as a whole accounted for 0.1 million barrels per day.
Unlike in 2004, when China’s oil usage increased by 0.9 million barrels per day, its demand rose by only 0.4 million barrels per day in 2005, despite continued strong economic growth. In the US, a 0.4 percent decline in oil demand in 2005 resulted from a combination of high prices, hurricane-related disruptions and a mild winter. It was the first decline in US demand since 2001.
World oil production growth trends, in the short term, have been decreasing during the last 18 months. Average yearly gains in world oil production from 1987 to 2005 were 1.2 million barrels per day (MB/day), or 1.7 percent. Global production averaged 84.4 MB/day in 2005, up only 0.2 MB/day (0.2 percent) from 84.2 MB/day in the fourth quarter of 2004.
Production in the second quarter of 2006 was 85.1 MB/day, up 0.4 MB/day (0.47 percent) from the same period a year earlier. Yearly gains in the last eight years ranged from -1.4 MB/day (-1.9 percent; 1998-99) to 3.3 MB/day (4.1 percent; 2003-04).
It will take some spectacular gains from new production to offset the natural decline currently underway in the US. The world continues to consume about 80 billion barrels of oil a year, and there’s still nothing in sight that can alter the supply/demand profile on a large scale.
The Roundup
The Canadian income and royalty trust market–namely, the S&P/TSX Income Trust Index–still rises and falls with oil and gas. It is, after all, a resource economy.
Though the last several weeks have been unkind to trust investors, the factors shaping a long-term energy bull market are still in place.
Here’s the roundup.
Oil & Gas
Shiningbank Energy Income Fund (TSX: SHN.UN, OTC: SBKEF) has agreed to buy most of Rider Resources Ltd’s oil and natural gas assets for CD404 million, giving Calgary-based Shiningbank more properties in Alberta. The income trust will assume CD92 million in debt and working capital deficiency. Shiningbank will buy most of Rider’s properties in west central Alberta. The balance of the producing assets and most of the exploratory lands will be transferred to a new publicly traded exploration company that will be managed by Calgary-based Rider. The move should add about 8,800 barrels of oil equivalent per day of production and increase Shiningbank’s cash flow per unit and production per unit. It will also give the income trust a market value of about CD2.4 billion. Under terms of the deal, Rider shareholders will receive 0.4659 of a Shiningbank trust unit along with ownership in the shares of the new exploration company and warrants for participation in its private placement. Both boards have approved the deal. Shiningbank remains a hold.
Gas & Propane
AltaGas Income Trust (TSX: ALA.UN, OTC: ATGFF) has closed the previously announced acquisition of the Clear Hills sour gas-processing facility and an associated 16 kilometer sour gas gathering line in Northwest Alberta for a total of approximately CD15 million. The pipeline will connect a number of existing producer wells east of the plant in what is expected to be an active drilling area. AltaGas will own 100 percent of the Clear Hills Gas Plant, which will consist of gathering pipelines, inlet separation, compression, refrigeration, amine sweetening and acid gas flaring facilities. AltaGas will also operate the plant, which began commercial operation last week. AltaGas also acquired an increased interest in the Pouce Coupe processing plant and related assets for approximately CD1 million. Buy AltaGas up to USD26.
Trinidad Energy Services (TSX: TDG.UN, OTC: TDGNF), well ahead of the game, has clarified for US unitholders the status of their 2006 distributions from Trinidad. In consultation with its US tax advisors, the company believes that its trust units should be properly classified as equity in a corporation and that dividends paid to individual US unitholders should be “qualified dividends” for US federal income tax purposes. As such, the portion of the distributions made during 2006 that are considered dividends for US federal income tax purposes should qualify for the reduced rate of tax applicable to capital gains. The split of distributions between qualified dividends and return of capital will be announced subsequent to the completion of the 2006 fiscal year. Trinidad hasn’t received an IRS letter ruling on this matter. Trinidad Energy Services is a buy up to USD16.
Business Trusts
ACS Media Income Fund (TSX: AYP.UN, OTC: AMOMF) and Caribe Acquisition Holdings announced that Caribe has entered into a definitive agreement to acquire ACS Media LLC, the income fund’s operating business. Under the agreement, Caribe will acquire ACS Media Canada, which holds a 99.9 percent interest in ACS Media, for CD188 million (USD168 million) in cash. Caribe will also repay USD35 million of ACS Media debt upon the closing of the transaction. The proceeds of the sale equate to CD9.40 per unit of the fund. ACS Media Income Fund will be wound up following redemption. ACS Media managers are expected to remain with the combined company following the transaction. The transaction, subject to approval by the fund’s unitholders, regulatory approval and other closing conditions, is expected to close in the fourth quarter of 2006. ACS Media noted that, although the business is located entirely in Alaska and distributable cash is generated in US dollars, distributions to its unitholders are paid in Canadian dollars. The weakening of the US dollar against the Canadian dollar impacted the fund’s ability to sustain its Canadian dollar distributions at the rate established at the time of its initial public offering. Those who currently own units of ACS Media Income Fund should hold through completion of the acquisition.
Sleep Country Canada (TSX: Z.UN, OTC: SLPCF) reported that revenues increased 42.3 percent in the second quarter as net earnings leaped nearly 45 percent. Sales in the quarter were CD74.6 million, compared with CD52.5 million in the comparable 2005 quarter. Net earnings came to CD6.8 million, or 48 cents Canadian per trust unit, compared with CD4.7 million, or 34 cents Canadian per unit, last year. Sleep Country’s earnings before interest, taxes, depreciation and amortization fell 6.2 percent to CD7.4 million in the latest quarter. Sales for the 116-unit Sleep Country Canada brand were up 17.4 percent quarter-over-quarter, with same-store sales up 6.4 percent. Sales by the Dormez-vous brand in Quebec rose 4.5 percent, while Sleep America in Arizona recorded a 20.1 percent sales increase. Sleep Country Canada acquired both regional chains earlier this year. At the end of the quarter, Sleep Country Canada Income Fund operated a total of 162 stores, compared to 101 last year. Sleep Country Canada is a hold.
Natural Resource Trusts
Fording Canadian Coal (TSX: FDG.UN, NYSE: FDG) cut its quarterly cash distributions for the fifth time in a row and announced it would reduce capital spending this year by 20 percent. Fording lowered its distributions to 80 cents a unit, and announced it would reduce capital spending to USD40 million. Fording is a buy up to USD35.