Provident, Enerplus, and Canetic: Is it Time to Reconsider Canadian Energy Trusts?
This is a Seeking Alpha article, so take it for what it's worth.
posted on: October 01, 2007 | about stocks: CNE / PVX / ERF
I recently spent a couple weeks pondering over my opinions about Canadian trusts, and just as I'm finishing up a little post on them, boom, there goes my thunder. First, Abu Dhabi buys up PrimeWest (PWI) at a big premium and catches everyone's attention, and then, I hear Jim Cramer turned back to the trusts again last Wednesday on Mad Money.
Surprisingly enough, the PrimeWest buyout offer didn't really move the prices of most of the other trusts.
I've got some thoughts to share, so I'm going to share them anyway, even if Abu Dhabi and Jim Cramer get all the credit, well then they can have it. I won't be bitter or anything, honest.
So, much like other U.S. individual investors, I immediately dismissed investing in Canadian Royalty Trusts when they pushed through new legislation last year that will significantly change the tax landscape for these investments beginning in 2011. I only held one of the trusts at the time, Precision Drilling (PDS), and I sold it not too long after the shares collapsed by 25% or so, along with all other trust shares, in the wake of the new tax announcement.
But now, I've done a bit more reading, and I attended a presentation by a few representatives of some of the oil and gas trusts, and I'm starting to wonder whether the current (still depressed) prices represent a possible buying opportunity. I am definitely not interested in getting into any of the business trusts now - the ones, like Precision Drilling, that don't have energy assets. But the energy trusts, just maybe.
For those who don't know the current situation, it is essentially this: Canadian Royalty Trusts used to be sort of like U.S. REITs in terms of taxation. They were not taxed at the corporate level, as they distributed most of their cash flow to shareholders, and shareholders were on the hook for whatever taxes might be forthcoming.
This was such a popular sector as oil climbed from $20 to $60 in the early 2000s that the Canadian government gradually started to get a bit nervous. More and more non-Canadian investors jumped on board, and more non-energy companies started converting into trusts, or considered doing so, including some of Canada's largest companies.
The budget implications for Canada were significant, as they could get back a similar level of tax payments from individual taxable Canadian investors, but U.S. investors paid just the U.S. dividend tax or the Canadian withholding tax, both were 15%, and tax-exempt investors in Canada paid nothing. I imagine that trusts were very popular holdings in Canadian retirement accounts.
So the thought of much corporate tax money going the way of the dodo got everyone a little jittery, especially when the big firms like BCE (Canada's Bell telephone company) started toying with the idea of converting to trust status. So even though most politicians have historically promised not to touch the trust structure, which is very popular with income-oriented investors (like retirees) as well as with foreign investors from the U.S., and around the world, they reneged on their promise, and essentially determined that all current trusts would begin paying tax at the corporate rate at the end of a grace period of about four years. Trusts that haven't formed yet pay the new tax immediately upon formation, so you may have noticed that no one has started a new trust, or converted to a trust recently.
So essentially, it works out that most U.S. investors might have previously owed only a 15% tax, but in 2011 the effective tax could roughly triple to the 45% range. The actual numbers that any one stakeholder or company would pay are of course, highly varied, and it's a corporate tax so investors would never actually see the withholding. But this should mean a significant cut to the high yield distributions that CanRoy enthusiasts have enjoyed for so long.
In addition to the fact that some people (not I) think energy prices are peaking here and will decline, which would have a significant negative impact on nearly every trust, folks are looking at the existing distribution, cutting it in their minds by anywhere from 20-50%, and wondering whether these investments are still worth it at that new dividend rate.
That's what I was thinking, too, but, if you start to incorporate some other variables in your analysis, it's possible that this thinking is too black and white, then maybe there is still value, and a decent future, in some of the better Canadian trusts. Certainly, the folks who invested in PrimeWest are realizing this, after the buyout offer from Abu Dhabi sent their shares surging last Monday by close to 30%, which I expect probably brought the shares back to where they would have been without the new tax law.
The companies that I took some interest in were Enerplus (ERF), Provident (PVX), and Canetic (CNE), largely because they were all part of a panel at a recent investing conference, moderated by a newsletter editor who writes a letter that covers trusts. In case you haven't said it yourself in your mind yet, yes, that means information from these sources is a bit prejudiced. Still, I found it interesting. And I did own Enerplus several years ago, and it's the real big cap bellwether for this group, so I paid special attention to them.
Here's what essentially got my thoughts rolling in this direction. The following comments were taken all three of these companies:
There is virtually no chance that the big trusts will take the new law laying down, and just pay a high tax rate and cut their distributions. They will come up with some kind of plan or reorganization.
There are significant tax breaks available to energy producers in Canada, and it might be that there is potential for a year or few of using those tax breaks following the transition even if these companies remain as trusts, which would allow them to keep distributions high for at least a little while. ERF in particular noted that it thinks that the tax pools that it has available to it will probably dictate its initial reaction to the 2011 changeover, but that it might use up those tax pools quickly, and need to react further in the years following.
The likelihood of any of these companies actually paying the full corporate tax rate, regardless of their corporate structure, is remote. The average Canadian exploration and production company pays an effective tax rate of 6% (I haven't verified that, but that's what the ERF rep said), so many trusts believe that somehow they will be able to "hammer down" their tax rate to the single digits. also climbed, so the U.S. distribution already is more like 10%, so you can make your own adjustments from that).
So that's what got me started. All of the companies who spoke said that any hope of the tax law changing before 2011 is very faint, and such hope should not be the basis for investing in their companies. They also noted that the chance of their companies remaining in their current structure without any changes after 2011 is also quite faint, since all of the trusts currently have teams of tax lawyers looking at how they can reorganize, use tax credits, spin off units, or otherwise remain competitive income investments following the tax change.
For those of you who haven't fallen asleep yet, here are my notes about each of these companies, and, in particular, why each of these companies believes their shares are undervalued:
Provident (PVX)
This one is a little bit interesting, because it's already explored the step that several companies are considering. This is the conversion to a U.S. Master Limited Partnership (MLP) to keep its tax pass-through status. It only did it with a portion of the U.S.-based assets, but it still has that experience.
So what does it think is keeping its share price low?
Low natural gas prices (this is a constant, as most trusts produce more gas than oil, and even the ones that don't get lumped in with the gas producers much of the time. Sure, gas prices are still historically relatively high, but they're way down from last year.
Provident noted that it is hedged significantly from volatile prices (up or down), and it doesn't believe that investors are giving it credit for that.
The most significant part of that "hedge," in my opinion, is its upstream business. PVX says that its upstream is about 60% of income, and 40% is from midstream NG liquids production. The nice thing about that is that natural gas liquids such as butane, propane, etc., use natural gas as their feedstock but are priced against a crude oil benchmark, so that's a natural hedge against low gas prices at a time of high crude prices.
I appreciate PVX's long-lived assets, especially the midstream assets that require relatively little in capital investment yet throw off good cash flow. PVX is probably better suited to the MLP status than any other big trust, and of course it's already spun off some assets in to an MLP. Its representative thinks the one thing that remains as a catalyst for the shares, save for a big boost in gas prices, is recognition by the market that the sum of its parts is of a higher value than it's being granted at the current price.
Enerplus (ERF)
ERF was in my portfolio back in 2003 and 2004, and I still kick myself for selling it. I enjoyed a nice profit, but it has more than tripled since then even without the dividends. Apparently this is my day for being bitter.
It is about twice as big as PVX, although PVX is also one of the larger trusts.
So, what does it think will unlock the value of ERF shares?
It keeps debt below annual cash flow and have kept the distribution steady for a couple years -- they think they're not getting credit for their better-than-average balance sheet and stability (stability with a 10%+ yield is, I agree, pretty nice).
Enerplus noted that it also has significant U.S. operations, but that its U.S. operations (about 10-15% fo the company) are not really appropriate for an MLP spinoff (not long-lived enough. Even if it could spin them off, it needs the cash flow from these wells to help pay for its oil sands projects.
According to Enerplus, according to them, its hidden growth story is its oil sands leases, which it still has not even really begun to explore. It thinks the biggest catalyst in its near future will be the market recognizing the option value of its oil sands leases. According to its rep., it has 467 million barrels of contingent resources in Alberta that still haven't been turned into reserves.
Enerplus has paid an unchanging dividend for several years (about 10.5% today), so it looks to me like it's reinvesting in production, and is starting to explore its oil sands leases instead of raising distributions as income from higher realized prices climb.
As far as future, post-2011 plans, Enerplus, like the others, said that nothing is decided yet. But it went further, essentially guaranteeing that it would not just start paying the corporate tax rate when the ball falls on New Year's Eve, 2010.
So, Enerplus would like more credit for its oil sands projects, even though production is at least four years off, and it would really like higher gas prices, please.
Canetic (CNE)
This is one I hadn't ever really looked at before, because I thought the name was just too silly. But again, I heard some promising things:
CNE doesn't think they’re getting credit for its very profitable hedges, which might be a catalyst as soon as the next quarterly report. This was actually a pretty strongly worded hint from their representative, I don't know whether or not he was blowing smoke.
It has been brought down by the natural gas price like everyone else, but only 25% of its production is gas. Its oil production might not be getting the credit it deserves, especially with $80 oil.
Its gas projects are pretty high cost. When compared to other trusts, it needs $6.50-7 gas price to make many of its projects economical.
These three companies have somewhat different philosophies, as I read them (and I could be wrong). To me, this is what you get:
Canetic: This is a fairly aggressive exploration, and production company that happens to pay a big dividend. It seems focused on being a good producer and being profitable, not necessarily on the future yield as its core driving principle. If it produces well, the yield will take care of itself, maybe as just a regular corporate dividend. It's also more interested in oversease expansion than the others.
Enerplus: This one really feels like a financially-focused income investment to me. Its intent is very specifically to continue to be a high-yielding income investment that's based on energy production, and clearly the past tendency to keep the yield on the low side compared to some peers, even when cash flow is high, is designed to enable them to invest for the future of the stable dividend. When looking 5-10 years out, ERF strikes me as a big bet on oil sands, so you better believe that oil is going to remain above $40 (at least) to consider this one attractive in the long term.
Provident: This one seems to me to be among the more flexible trusts. It's got a very nice vertically integrated business, with parts that probably would be worth more as separate companies, but it has managed to keep dividends high even with the kind of midstream assets that, in the U.S., typically produce significantly smaller yields. To me, it seems to be quite open to some signficant spinoff/reorganization in a few years, at least more so than many of its compatriots (since it's already done a little spinning off of assets).
Again, that's my psychoanalyzing of their public statements, and some off the cuff chatter from their representatives It may be way off base.
So now that I've looked in some more detail at a few of these trusts, do I want to buy some? I must admit, I'm tempted. I see some significant appeal in all of these, and in a few of the other larger, high quality and long-life reserve trusts. In essence, this is because I'm starting to understand that, regardless of the tax law, these companies are focused on their work of developing and producing cost-effective oil and natural gas on the front porch of the world's largest consumer of both of those commodities.
Investing in CanRoys takes somewhat of a leap of faith now, and remains, even with Cramer's blessing, a little bit contrarian for the always tax-obsessed Wall Streeters among us - you have to assume not only that energy prices will remain at historically high levels, but also that these companies are really going to come up with a plan to manage effectively after 2011, whether that's through reorganizations, spinoffs, mergers, takeovers, or tax credits.
I think it's likely that they will develop some effective plans, and that they will pay more taxes but remain investments that pay a higher, and more consistent yield than any comparable U.S. company. And unfortunately, I also think it's quite likely that they won't share their specific plans with us - and with their competitors - until we are right on the cusp of the tax deadline, so it's certainly quite possible that prices will trend down significantly if investors grow nervous about the imminence of 2011 and haven't yet heard anything concrete or encouraging.
