Is Harvest Energy Trust's Premium Valuation Justified?
by: One Blog March 04, 2008
Harvest Trust Energy (HTE), a Canadian Oil and Natural Gas royalty trust formed in 2002, had its initial public offering [IPO] on December 5, 2002. It raised $34.5M at $8 per share then and a secondary offering in February 2003 raised another $15M at $10 per share. The trust also initiated its monthly dividend distribution immediately after the IPO. The distribution started at 20c per share and progressively went up to 38c per share and remained at that level for a couple of years before the recent slash to 30c per share.
The business plan at IPO was to acquire mature properties and eke out additional value by using production enhancement and optimization efforts. The initial acquisitions were mature oil producing properties in Eastern Alberta. Since then, the company diversified into natural gas properties although production is weighted 70% in favor to oil. In October 2006, they acquired North Atlantic refinery for C$1.6B.
HTE is structured as a Canadian Royalty Trust (CanRoy) and has a monthly dividend distribution policy. CanRoys have certain tax advantages that are set to expire by 2011. The company announced a 20% dividend cut in mid-November, which prompted an immediate sell off. The yield is now close to 15%.
Business Issues
Harvest Trust Energy classifies itself as an integrated energy company reflecting their presence in both the upstream and downstream businesses. This is a moot point though, as logistical issues prevent them from using the oil produced in their refinery. The refinery needs around 110,0000 bbls per day while upstream production is only about half of that. Further, the feedstock requirement is medium sour crude oil while the production is spread-out over light, medium, heavy oil, and natural gases.
Considering the refinery output to be around 115,000 bbls per day, the acquisition price for North Atlantic Refinery can be broken down to be around 14000 per flowing barrel. This price was at the upper end for refineries at the time. The rest of the business is valued at about $3.6B.
The company also employs an extensive hedging strategy. It is planned such that there is only minimal or no cost in a low price environment, when Harvest would otherwise be less able to afford the cost of such ‘insurance’.
The three types of hedging in place are:
Crude Oil Hedges for Upstream,
Refined Product Hedges for Downstream, and
Currency Exchange Rate Hedges.
Currency hedging is essential to mitigate the operational risk of costs being in the local currency (Canadian dollars) while the revenue is in US dollars. The complex nature of the remaining hedging types indicates more of a throwback to hedging strategies employed by the acquired companies rather than an optimized strategy allowing for the business risks. Specifically, a much simpler strategy should be worked out, which takes into account the fact that roughly half of the feedstock requirements for the refinery need not be hedged since production is in that range.
Harvest along with other Canadian royalty trusts is negatively affected by a Canadian tax law change that comes into effect in the 2011 timeframe for existing trusts. When the tax-exempt status on distributions expires, the trusts will pay taxes like other regular corporations. The probable scenario then is for Harvest to act like a regular corporation with the lion share of its cash flow going for capital expenditures to fund future growth as opposed to distributions. Similarly the shareholder base will also experience a shift from income-oriented investors to growth-oriented investors prior to that timeframe.
Provincial royalties also has an impact on Harvest. Specifically, Alberta recently unveiled plans for increased royalties in the 2010 timeframe and Harvest has a major portion of its upstream business in the area. The counter measure from the company was to reduce capital expenditures in the area. While this can help send a message to regulators, the company needs to organize itself better for a high-tax scenario.
Outlook
Harvest’s upstream oil and gas production is weighted approximately 73% in crude oil and liquids and 27% in natural gas, and is complemented by its long-life refining and marketing business. The company’s current focus is on sustainability. Weak natural gas, high cost in western Canada upstream business, royalty framework increases in Alberta, and the strength of the Canadian dollar are the current challenges facing the Harvest. The company’s course is to adapt by implementing a growth strategy using very selective capex investments.
HTE’s sustainable growth strategy in its upstream business is dependent on its access to over 2B BOE of reserve. The recovery is less than 30% and the contention is that 20M will be added to its Proven and Probable [P&P] reserves for every one-percentage increase in recovery using technological advancements. Since that amounts to 10% of the existing P&P reserves the potential is huge. The execution of this strategy requires high oil prices, as its OOIP reserves are either mature properties or oil sands, both of which are capital intensive. The downstream business is by nature highly cyclical as indicated by the crack spread.
The company is valued in the high end of CanRoys. This premium valuation is somewhat justified, given its oil weighting and refinery diversification. The dependency of the company’s prospects on the highly cyclical refinery crack spreads and uncertainties surrounding the royalty and tax effects should together keep the shares volatile for the foreseeable future. It should act as a good trading stock in diversified stock portfolios.
