Companies that supply and service Canada’s oil and gas industry are watching carefully how conversions of explorers and producers (E&Ps) into acquisition-driven royalty trusts will affect their bottom line.
“We want to look ahead to see just how this trend will affect our industry,” says Roger Soucy, president and CEO of the Petroleum Services Association of Canada (PSAC).
Soucy says he wants to track developments so that service companies won’t be caught off guard by changing industry conditions. PSAC plans to put the issue on the agenda at a conference scheduled for late October.
In a royalty trust, investors supply capital by purchasing trust units. The trust then uses investors’ funds to buy an interest in an operating company, and distributes the company’s cash flow from operations to investors.
Traditionally, royalty trusts pay out high returns to unitholders while pumping as little as possible back into producing fields. Growth, meanwhile, has generally been achieved through acquisitions rather than the drillbit.
In recent years, several E&Ps have turned themselves into royalty trusts.
Today, roughly 30 trusts dot Canada’s oil and gas roadmap, and it’s likely more will follow, says Peters & Co. Ltd. analyst Brian Prokop.
“If I’m running an E&P and getting a four-times cash multiple, I turn into a trust and I get an eight-times,” Prokop says. “That’s a huge value enhancement, and it suddenly gives me paper that I can go out and buy things with.”
On August 20, Penn West Petroleum Ltd. became the latest, and one of Canada’s largest, oil and gas companies to announce it intended to recast itself as a royalty trust.
When energy trusts began to emerge in the late 1990s, it was believed that drilling would drop off, thereby hurting the service and supply sector. But some observers say reports of the trusts’ inactivity are exaggerated.
While cautious about what this new trend may bring, many in the oilfield service industry say they prefer to don their entrepreneurial caps and look for new prospects rather than problems.
“I think that in the real world this kind of thing provides opportunities for new service companies to come onboard,” says Al Schreiner, president of Stream-Flo Industries Ltd., an Edmonton-headquartered company that manufactures wellhead equipment as well as valves for drilling operations.
Bonnyville-based Heat Seekers Ltd., which offers a variety of downhole services, believes that both E&Ps and royalty trusts have little choice but to drill to replace reserves.
“When the folks down in Calgary come to the realization that to continue on you’re going to have to drill, then they will,” says president Ned Brand. “So there might be slowdown at first, but the oil is there in the ground, and how do you get it? You’ve got to drill it.”
Schreiner agrees, noting that Stream-Flo, which does business with both the E&Ps and royalty trusts, is experiencing one of its busiest years ever.
“There are all sorts of income trusts coming out of nowhere, yet we’re seeing record drilling levels and record levels of overall industry activity,” he says.
The Canadian Association of Oilwell Drilling Contractors reported that, to the end of July, 10,185 wells had been drilled in Western Canada, compared to 9,374 for the same period in 2003. Most expect 2005 to be another robust year.
Miles Lich, who follows the service sector for Peters & Co., says that the “big boys” – EnCana, Husky, Talisman, Burlington, Apache and Petro-Canada – are the most active drillers, and that the majority of royalty trust conversions have involved small- and mid-size E&Ps not known for being prolific explorers.
Even so, he says a new generation of energy trusts is emerging.
“What you’re seeing today are trusts that are more active, paying out less to unitholders and reinvesting that money into development drilling and even lower-risk exploration activity,” Lich says.
Created in 2001 by the merger of Danoil Energy Ltd. and Western Facilities Fund, Acclaim Energy Trust is more in line with the new generation. In the first half of 2004 it drilled 26 wells and plans to sink another 65 in the latter half of the year. In fact, the trust claims it is only becoming more active as time goes on.
“This is the busiest we’ve ever been,” says Kerk Hilton, manager of investor relations. “In addition to the drilling, we did 65 well workovers in the first half, and we’re spending about $75 million this year, which is up from about $40 million last year.”
He notes that Acclaim payout ratios to unitholders are falling from around 90 per cent to 80 per cent, in order to reinvest and grow its production.
What could trigger a crunch, says Peters & Co., is a tumble in oil and gas prices, which would squeeze the trusts’ distributions to unitholders.
“Cashflow comes down, distributions come down, unit process come down, suddenly the valuation will not be at a premium and they’re not going to have the capacity to go out and raise money to do acquisitions,” Prokop says. “I think we’ll see consolidation in the sector where we have trust-eat-trust.”
