Canadian royalty trusts in the oil and gas sector had a decade-long bull run until the Canadian government mounted a plan to strip them of their favorable tax status for distributions (see Daily GPI, Nov. 2). The plan to tax the trusts could very well spark a movement of investment dollars southward and American exploration and production (E&P) activity northward, said David Marcell, TriStone Capital managing director, acquisitions and divestitures.
Marcell recounted the royalty trusts' history for attendees at the Platts Oil & Gas Acquisition & Divestiture conference in Houston Wednesday. Over the last decade or so the trusts grew in number to about 33 last year and grew their share of the Western Canadian Sedimentary Basin to about 20% from a mere 2% in 1996, he said. The trusts had a captive market among Canadian 401(k)s and pension funds prohibited from investing outside Canada and for a time enjoyed an "incredibly low" cost of capital, according to Marcell.
With the entrance of the Royal Canadian Mounted Tax Man the trusts' advantages are gone. The effective tax rate for Canadian investors will go from 0 to 31 1/2% and from 15 to 41 1/2% for foreign (read American) investors.
"It's been an amazing trip for them," Marcell said of the trusts.
In trading Wednesday the Toronto Stock Exchange energy trust index gained 6% to close at 166.98 points. And trusts at large -- not just energy -- staged a comeback following the rout sparked by the tax news. The Toronto Exchange's income trust index, which includes the units of 72 trusts in a variety of sectors, including energy, jumped more than 4% to 141.3 points.
During their heyday the trusts dominated the Canadian mid-cap sector and kept other players out. By virtue of their low cost of capital others, like Anadarko Canada (see Daily GPI, Sept. 15), couldn't compete, said Marcell.
Without the favorable tax treatment the trusts' cost of capital rises about 15%, maybe more, said Marcell, who suggested the trusts' ability to raise equity "has really been hindered" and that they're going to have "a terrible time retaining talent." He predicted the number of trusts in the oil patch will decline to about 10. "Their ability to raise capital was legendary. That's gone away."
One fallout of the taxing of the trusts will likely be a migration of investment dollars to U.S. master limited partnerships (MLP). In the case of some trusts, 83% of their investors were American, said Marcell.
He said TriStone thinks the market overreacted to the trusts' tax setback and that there are many Canadian opportunities for investors willing to focus on issues other than tax advantages, such as company management teams. Additionally, the tax change opens the door to Canada for cash-rich U.S. and other E&P players from around the globe.
"We can see U.S. companies reentering as they certainly have the ability to," Marcell said. "I know it's been a long time since anybody's looked at it, but I think that's the direction. It's not only the U.S. but it's going to be people from all over the world who are going to take another look at Canada and see what the opportunities are."
The decision to tax the trusts followed a realization by the Canadian government that it was leaving a lot of money on the table. "If the government needs tax revenues, they're going to find ways to get it," warned Marcell. "And you'd better remember that with the new change of government here in the U.S."
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