Eagle Energy Trust recalls an era of ‘economic cocaine’

Once relegated to the dustbin, a prized investment vehicle returns

November 21, 2011

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Illustration by Dushan Milic

When Richard Clark hit the road in an effort to scrape together the seed money to launch an energy company, investors weren’t sure what to make of him. At the time, oil and gas producers were converting en masse from income trusts to corporations as a result of changes in how the federal government planned to tax the trusts through the new Specified Investment Flow-Through (SIFT) rules unleashed in 2006. Yet here was Clark – a recently retired lawyer – standing in front of bankers, retail brokers and institutional investors asking for money to jumpstart an energy income trust.

The people in Clark’s audience may have had different occupations, but they were all skeptics. After all, Eagle Energy was the first oil and gas trust to go public in nearly five years. Clark started off his presentations for Eagle Energy Trust the same way: “Yes, we’re an income trust; yes, it’s our initial public offering; yes, we’re doing this on purpose; and no, we’re not going to convert to a corporation in two months.”

Clark put on more than 85 presentations in a two-and-a-half week span. He spent about 90 per cent of the time talking about income trusts, the new tax regulations and addressing concerns that the two didn’t mix well anymore. Very little time was spent discussing the assets Eagle Energy was targeting. Despite the trepidation, Clark’s road show paid off. Eagle Energy Trust raised $170 million for its initial public offering at $10 per unit in November 2010 – including an over-allotment of $20 million.

Just one year later, Clark found himself on the road raising money again, speaking to investors across Canada. This time, however, 90 per cent of the discussion focused on Eagle’s asset base and considerably less time was dedicated to discussing the income trust structure. By then another firm, fellow Calgary-based junior Parallel Energy Trust, had completed its initial public offering. Investors seemed less leery of Clark’s strategy. “Our structure was validated by Parallel,” Clark says.

Another firm – Argent Energy Trust – recently joined the ranks of Eagle and Parallel, and rumors of more energy trusts entering the re-emerging sector are starting to surface. The new SIFT rules, however, place limitations on how these new income trusts can operate, and the story might play out differently in the oil patch than it did before the new rules came into play. But the income trust business model, which was left for dead, is coming back to life and a few juniors are leading the charge.

 

At the peak of the income trust market in market in 2006, there were 256 income funds operating in Canada with a total market capitalization of $226 billion. The investment structure was created in the oil patch – where it remained especially popular – when Enerplus launched as a royalty trust in 1986. A couple of other energy trusts quickly followed suit and the funds paid distributions to their unit holders from revenue derived from mature, producing oil and gas assets.

But it took almost a decade for the movement to really gain momentum. Opportunity spurred innovation and by the turn of the century, income funds were being created, not just as royalty trusts, but as exploration and production companies looking for growth. “It evolved fairly rapidly to the model we know today,” says Murray Lee, partner, U.S. corporate tax services with PricewaterhouseCoopers (PwC) in Calgary. “They would plow money back in, grow the asset and grow the distribution, then it became really popular.”

Income trusts were popular structures because companies were not required to pay corporate tax on money paid out in distributions to unit holders. They were also popular with investors who collected revenue, while still retaining their ownership position. “It was a win-win situation between the people that had the money and the people that wanted the money,” says Cam Crawford, managing partner of Catalyst, a Calgary-based business advisory firm. “These distributions were economic cocaine for investors.”

By 2006, energy trusts accounted for $98 billion of the income fund sector, but other industries were starting to see an influx of trusts. “It transcended a lot of industries,” Crawford says – “any operating business that had good cash flow to distribute to their investors or who were seeking growth capital to expand.” Organizations in the real estate sector, utilities, retail and the hospitality industry had begun adopting the trust structure as a way to seem more attractive for capital investment dollars.

Income trusts, however, weren’t as popular with the Department of Finance in Ottawa. When some of the country’s largest corporations – among them Bell, Telus and Royal Bank of Canada – started openly musing about converting into trusts, the federal government stepped in. “They didn’t like what was happening because trusts didn’t pay tax, the unit holders did,” Lee says. “But a lot of the distributions were going to tax exempt pension funds, RRSPs or foreigner investors. The [federal government] saw its tax base significantly eroding and said ‘we’re losing too many tax dollars, we’re going to shut this down.’”

On Oct. 31, 2006, Finance Minister Jim Flaherty dropped the hammer. He revealed Canada’s new SIFT rules as part of the Tax Fairness Plan that would amend the Income Tax Act. The new regulations were enacted in June 2007 and would be implemented on Jan. 1, 2011. Under the new system, income funds would be required to pay tax on their distributions, which, according to the federal government, would create “a level playing field between income trusts and corporations.”

With the tax advantage of operating as an income trust removed, many organizations began converting back into corporations because the structure had less onerous governance requirements. After five years in operation, Peyto Exploration and Development Corp. made the switch to a royalty trust in 2003. Prior to that, the company could take profits and reinvest in operations or pay tax on them. But as a trust, Peyto also had the option of flowing profits out to unit holders. This gave Peyto and other producers a capital outlet, rather than investing in exploratory or high-risk wells in an effort to avoid paying taxes.

Peyto reverted back to a corporation last December. In an effort to hang on to investors looking for a revenue stream, Peyto – along with several other oil and gas corporations – still pay a yield out to shareholders, although at a much smaller percentage than during the income trust heyday. As a trust in October 2006, Peyto’s shares were trading at about $22 and with a $0.14 monthly distribution, yielded 7.6 per cent for unit holders. As a corporation in September 2011, Peyto’s shares were still trading at about $22 and the company paid a monthly dividend of $0.06 a month to shareholders, about a three per cent yield.

 

As energy trusts continued transitioning into corporations after the SIFT rules were put in place, Richard Clark had a feeling there was still an appetite for high-yield paying funds among investors. By Jan. 1, 2011, when the new tax regulations for income trusts took effect, the total income trust market in Canada had shrunk from 256 funds worth $226 billion to 50 funds worth $44 billion. And 75 per cent of the market capitalization was made up of real estate investment trusts (REITs), which were excluded from the SIFT rules. “If we got 10 per cent of that, it’d be great,” Clark says. “In response to the government announcement in 2006, I started working on a way to create an energy-weighted yield product for Canadian energy investors.”

It was a slow process.

Clark worked on a few different strategies that ultimately went nowhere. But as details of the new SIFT rules began to filter out from the federal government, something started to become clear to Clark – the new rules only applied to trusts operating Canadian assets, so a Canadian-based company holding nothing but foreign assets did not fall under the SIFT rules. During his law career, Clark had worked with a couple of U.S.-based Master Limited Partnerships – which served as the blueprint for the trust structure – and spent time working in the States. He enlisted the help of PwC’s Lee and Bob McCue, a partner with Bennett Jones LLP, and they spent the next eight months building the structure for the new income fund and business strategy.

Essentially, the trio revived the old income trust model, only they had the trust pay corporate tax in the U.S., while Canadian investors pay personal income tax on the distributions they receive. With the structure in place, Clark went looking for capital. The funds raised by Eagle Energy Trust’s IPO were used to purchase light oil assets in the Salt Flat Field in Texas – its only assets so far. The company has drilled and completed more than 40 horizontal wells on the property, and production from the play in 2010 was about 1,200 barrels per day.

Almost one year after Eagle Energy bought into the property, the trust’s shares are up to $10.70 – a high of about $12 was achieved earlier in the year – and paying a monthly distribution of $0.0875 per unit or roughly 10 per cent. Clark says his reincarnation isn’t exactly the same as the old income funds. “The payout rates were probably too high and were ultimately 100 per cent of cash flow. For the most part they were not growth vehicles, just revenue,” he says. “Our approach is to target 50 per cent payout of cash flow and reinvest the rest into assets.” Clark plans on acquiring mostly producing assets but will look at properties with undeveloped upside.

As the first organization venturing into this new income trust market, Clark figured Eagle would remain a novelty for six to 12 months. It didn’t work out that way. Parallel Energy president and CEO Dennis Feuchuk is an oil and gas industry veteran, including senior management roles with both Athabasca Oil Sands Trust and PrimeWest Energy Trust. He was keeping a close eye on Eagle Energy’s progress and six months after Eagle Energy was launched, Parallel Energy Trust completed its initial public offering. “Eagle came out last fall and we saw there was an appetite and market demand for this product, if you have the right assets,” Feuchuk says.

Parallel followed Eagle’s blueprint of investing only in assets outside of Canada and raised nearly $400 million – including an over-allotment of about $50 million – with its IPO in April 2011. The company purchased natural gas assets in the West Panhandle Field of Texas. Production at the liquids-rich property is currently about 4,000 barrels of oil equivalent per day. Half a year after launching, Parallel’s share price sits just under $10 with a monthly distribution of $0.075 per unit or roughly 10 per cent.

While Eagle and Parallel have been able to create double-digit yield distributions similar to former income trusts, Feuchuk says it’s not because they have found a loophole in the SIFT rules. The companies are not eliminating tax payments; they just manage it and mitigate it according to U.S. regulations. “We’re just operating with the rules that exist,” he says. Those rules, Feuchuk says, put a lot of onus on income trusts to toe the line south of the border. “We have U.S. directors, management in the U.S. and have to demonstrate that operations exist in the U.S.,” he says. “There’s probably more corporate governance and accountability than a typical corporation.”

Although Parallel and Eagle operate their trusts under the same structure, the companies operate with slightly different philosophies. While Eagle plans to reinvest some of its revenue back into operations and achieve growth from developing proven reserves, Parallel’s focus is on long-life assets in the late stages of production. “Our philosophy is a sustainable distribution model. We will keep distribution and maintenance capital, not growth,” Feuchuk says. “It will be interesting to see how the market pans out.”

 

Murray Lee with PWC figures the emergence of the income trust model in Canada will benefit not only investors and energy firms, but other industries as well. “A large void in yield products has been created and demand has gone up since 2006, not down,” Lee says. “It was designed with the U.S. in mind, but when you step back it works in any country with any asset. Some Calgary boys created it, so it starts in oil and gas, but other industries are looking at it. At the end of the day, the key is that the trust is not carrying on business in Canada.”

Lee notes that the biggest concern in the business community with income trusts is the legislative risk. Could the federal government change Canadian tax rules again to the detriment of energy income trusts? “We think it’s pretty small,” he says. “What they were trying to stop was Canadian tax leakage. Energy income was being distributed so no tax was paid. Under this structure the income is coming into Canada. I think the government understood that, which is why they came out with this in the first place.”

Not everyone is convinced the move back into energy trusts will have a happy ending. Catalyst’s Crawford thinks in this case, history is bound to repeat itself. “I think it’s unique and interesting that businesses have found a way to survive and prosper with the SIFT rules,” Crawford says. “I would think the Department of Finance would move quickly to block benefits being enjoyed by the trust structure.” Other industry experts take a less pessimistic view, stating that as long as the income trusts remain a niche market and are limited to a few small juniors, the government won’t bother interfering this time.

But Clark doesn’t seem interested in a future where energy income trusts in Canada wallow in obscurity. By taking the energy trust model global, Clark sees potential for the new income fund sector to reach the same heights it did in 2006. “It’s totally capable of getting that big,” he says. “The first time there were restrictions on non-Canadian shareholders, but that doesn’t exist because there are no foreign investment restrictions.”

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