Saturday, April 05, 2008

Last of a Breed

This article first appeared in the April 2008 issue of Oilweek.
By Peter McKenzie-Brown Jim Kinnear makes it sound compelling. During the last couple of decades, “the trust took over the mid-cap end of the market. The junior companies are the explorers. The independents are doing the large projects – EnCana and CNRL (Canadian Natural Resources). Then there are the super majors. This type of vehicle (the trust) is ideal to fit that part of the market. It’s a difficult business model – how much should we reinvest, how much should we distribute to our unit holders. (The trust) is a very efficient way to reallocate capital. If you acquire an interest in an oil and gas asset, there’s good margins and good cash flow. You’re buying a good income stream. Our concept was to buy a cash flow stream. I’m a financial analyst. BSc – very general degree – then became a financial analyst. These assets provide cash flow, part of which is depletion of assets. You put up $100, get $20 back per year for five years, say, then you own the property. You can get a 15-20 per cent rate of return each year.” These notes give you an idea of the depth, intensity and direction of Kinnear’s thinking. Trusts evolved out of managed limited partnership (MLPs) for the wealthy and professionals. They are a financial vehicle developed to answer the question, “Can we expand the closed-end trust?” Trusts and MLPs combine the cash flow business model with a tax ruling that exempts them from tax. Pengrowth: Kinnear’s Pengrowth was the third trust; the first two were Enerplus and Royal Trust Energy. Kinnear remembers when Marcel Tremblay started up Enerplus in the mid-1980s. “He started his first fund with less than $10 million,” Kinnear says. “He got a comfort letter saying that he could distribute all this cash to his unit holders without paying tax. His unit holders would pay the tax on all the net revenue, not the trust. If unit holders lived in another jurisdiction, like the United States, they would pay tax in that jurisdiction.” Companies and corporations pay tax, but royalty trusts do not. They began as vehicles which pass oil and gas cash flow through to investors, and they still serve this purpose. Pulling out a writing pad, Kinnear draws a graphic showing how trusts work. With an expensive-looking fountain pen he draws a graphic showing cash flow coming from operations and being dispersed to individual investors. “You’re buying a cash flow stream,” he says. “We called it financial engineering. It’s like a REIT, except instead of owning buildings we owned revenue-generating oil and gas properties.” Taxes would be paid by investors, who could purchase trust units through stock exchanges. This very clever model enabled taxpayers to defer and avoid taxes – for example, by holding their trust in RSPs. The trust/RSP combination postpones taxes, sometimes almost endlessly. During a shift as an oil and gas analyst in Calgary, Kinnear acquired some petroleum interests. He incorporated Pengrowth in 1987. The year was significant because, in the dramatic first two months of 1986, oil prices had dropped precipitously from $26 per barrel to ten dollars. The drilling industry was flat on its back. Large projects were being cancelled and postponed. Oil and gas companies were earning negative rates of return. In Alberta, housing prices crashed. Yet the larger Canadian economy was doing well. “I felt like a turd in the fruit bowl” said the president of a major Calgary-based oil company (not Pengrowth) after addressing a business conference in Toronto in 1987. There seemed to be rising prosperity almost everywhere else – partly because energy prices were so much lower. Lower prices benefitted most of the country, but Alberta suffered. In those days, the late 1980s, oil and gas properties were there, in the gloom, for the asking, and that’s when Kinnear began to buy properties for Pengrowth. Pengrowth is one of the largest and most profitable energy trusts in Canada. Now 20 years old, the trust is worth about $5 billion (total assets). Enerplus and Pengrowth have both become major players in the energy trust business, and they are close in size. In 2006 Enerplus had $2.7 billion in net equity on the balance sheet, compared to Pengrowth’s $3 billion. Marcel Tremblay left Enerplus quite abruptly in 2001. Pengrowth Manager: Kinnear has created an organization on which, to a much greater degree than is common, he leaves indelible marks – especially in the area of corporate branding. Pengrowth is one of a declining number of income trusts which still has a one-person manager – essentially, a management contract with the founder and CEO of the company. Pengrowth Management Ltd. is owned 100% by Jim Kinnear, and it puts millions of dollars into not-for-profit events and charities each year. This arrangement means that Jim Kinnear’s management fees and bonus include millions of dollars for philanthropic sponsorship. Pengrowth’s major sponsorships tend to be high-profile events: The Pengrowth Saddledome, the Duke of Edinburgh Awards and the Canadian Open – the world’s third oldest open golf tournament. “For all (Pengrowth’s) community endeavours the money comes from the manager,” Kinnear explains, “and I am 100% owner of that.” Since the trust’s purpose is to pass cash flow on to investors, as a trust Pengrowth can’t sponsor charitable events directly. “When we invest in these programs, we don’t just give money, though. We get involved. We help make these organizations better. We really feel we can make a difference.” Kinnear has an encyclopaedic knowledge of the business and of the energy industry as a whole, especially from the perspective of a dealmaker and a salesman. He brings an analyst’s mind, a quick tongue and a great deal of charm to an interview. How has the report of Alberta’s Royalty Review Panel affected his trust? “We don’t have all the details, but it seems to be only 4-5 per cent. What is really important for us is the maintenance of credits for EOR (enhanced oil recovery).” Of more concern to him was Jim Flaherty's Scary Halloween Trick. Also known as the Halloween Massacre, federal finance minister Flaherty announced this new tax on October 31, 2006, and it will start taxing trusts in 2011. The tax, which will impose a 31.5% duty on the net income of energy trusts, has a catchy acronym, SIFT. The word stands for “specified investment flow-through tax”. As a result, the price of Pengrowth units “has declined by about 20 per cent on the markets and (the new rules have) made it more challenging to do our business.” Besides SIFT, Kinnear gives a litany of problems facing the Canadian industry. “The high dollar has affected costs and adversely affected margins. Over the last two years costs have really skyrocketed. They are now twice what they were in 2001. Globally, everything is way up, construction costs, drilling costs, everything. The cost chart in the last two years has become parabolic. Then there was the royalty review in Alberta. The gas market in North America has had major problems and there’s talk of recession. Stock markets around the world are volatile. We call it piling on. What more can happen?” Outlook: Given all that piling on, Kinnear seems sanguine about Pengrowth’s future. “We have a number of potential development projects down the road that can offset our depletion over the years,” he says. And “we have a huge accumulation of tax pools, we have about $2.5 billion in tax pools, and we can use those to offset this new tax. We continue to be a high-yielding Canadian energy trust. We want to deliver as much cash as we can to our unit holders before we become taxable.” He argues that a flight to quality in the industry has driven a lot of investors to Pengrowth. “We have a lot of heritage assets. Judy Creek, Sable Island, Swan Hills and the Weyburn field in Saskatchewan. Weyburn,” he adds parenthetically, “is currently the world's largest carbon capture and storage project.” Producing these assets during this period of high-priced oil means high rates of return. “In 2006 we were among the top ten oil and gas property acquisitors in North America. We can double the size of our assets under the SIFT rules.” He also notes with satisfaction that the federal government expects to have Canada’s tax rates at the lowest level in the G-8 by 2012. Asked about the price outlook, he says “We’re not very good at calling prices. We think there will be recovering gas prices over the next year or so. Storage in Canada is closer to the five-year average than it was, and gas drilling is down” both in Canada and, recently, the US. Will oil prices climb or collapse? Kinnear is just back from a CERA (Cambridge Energy Research Associates) conference in Houston. One speaker was Matt Simons – author of Twilight in the Desert, and a fierce sceptic of Saudi Arabia’s ability to increase or even maintain oil production capacity beyond the next few years. In a recent pronouncement, Simons proposed that the world reached maximum production two years ago. The apparent increase in supply since that time has been essentially a drawdown in global inventory. The interview turned to a discussion of peak oil. Peak Oil: Peak oil is the notion that the world has produced about half its producible reserves, and that implied demand will soon outpace available supply. Kinnear begins in a humourous way. “You usually see a peak in oil prices in the spring, and the low point for oil demand is usually in December.” It is not clear whether he understood the question until he adds this: “In the second half of last year something very interesting happened. Look: we have $90 oil, and most companies are still missing their production targets. Maybe the oil just isn’t there.” He warms up to the topic. “It took about 250 million years to create all this oil, and we have used about half of it in the last three generations. It’s amazing. Whether you do or don’t believe in peak oil, there just hasn’t been sufficient reinvestment in the business. There’s been a classic cycle of underinvestment. What are the major companies doing with their cash flow? Spending some of their cash on new development and buying back stock to increase shareholder value. Some major companies are replacing as little as 15% of their reserves.” This underinvestment has several causes. For one, 80% of the world’s reserves are national oil – owned by countries where alien companies can’t invest directly. These countries are mostly not known for their efficient use of capital: Venezuela, Sudan, Saudi Arabia. Other known reserves and resources are located in places that are difficult and undesirable to explore, like the Arctic. Kinnear echoes a century-old refrain: “It’s a capital-intensive business. You’ve got to keep offsetting depletion and there’s a massive amount of capital required just to maintain production. And suppose there’s not enough investment to both offset the decline and grow production in the near term. What’s going to happen if India and China continue to boom and expand their requirements for energy?” That is a good question. After listing a number of large producing basins and giant fields in decline, Kinnear points out that “the only country that has the potential to grow production over the next 5-10 years is Canada, because of the oil sands.” He returns to his central theme: “Whether you believe in peak oil or not, there is not enough money going back into the oil industry to offset production. It’s a huge issue.” There is an irony in this. Trusts like Pengrowth do not take large exploration risks or develop such megaprojects as oil sand plants. Instead, they acquire producing assets from other firms, and often operate them directly. For firms with that business model, the risk of peak oil can create an ideal business environment. Under peak oil, energy trusts would generate increasing cash flow as a result of rising energy prices. Those funds would come from existing operations, and they would fund future distributions and expansion. While not involved much in the hunt for new fields, trusts like Pengrowth provide an efficient way to harvest known reserves. This is a profitable business model.

1 comment:

Fred P. said...

Very good article! The only question that I was left with was exactly how much less will payouts be (assuming they still use that model) once Pengrowth has used their tax credits and are feeling the full brunt of the "SIFT" tax.