High commodity prices, strong balance sheets and a lack of large-scale organic growth opportunities led to several huge consolidation deals within the U.S. energy sector in the past year, but comparatively fewer transactions were announced by its neighbor to the north. That could be about to change, UBS energy analysts said last week.
With the exception of Canadian Natural Resources’ recent acquisition of Anadarko Canada (see NGI, Sept. 18), Canadian merger and acquisition (M&A) activity has been “very quiet” for the past year, noted UBS analysts Memet Kont and Andrew Potter. However, several big-name Canadian exploration and production (E&P) companies, including Talisman Energy Inc., Canadian Natural Resources, EnCana Corp., Husky Energy and Nexen Inc. “all make compelling targets for various reasons” to either merge or acquire more companies, or by using energy trusts to gain some attractive tax breaks.
“From a strictly financial standpoint, we believe Talisman remains the most likely target, given that it is trading at the lowest multiples within the Canadian E&P space.” Nexen also “would be among the more likely to be acquired” because of its smaller size (attractive to more buyers) and its strategic positioning in all of the major growth areas of the North American energy industry: oil sands, the deepwater Gulf of Mexico and its large stake in coalbed methane in Alberta.
From a consolidation standpoint, the analysts believe that for the first time since EnCana began its buying spree in the U.S. Rocky Mountains (see NGI, April 22, 2002), “we could see Canadian large caps target U.S. acquisition opportunities — particularly smaller U.S. refiners.” This type of acquisition would be appealing because of a combination of a strong Canadian dollar and the “massive discrepancy” of what U.S. refiners are trading at versus the high costs of building an oil sands upgrader, said the analysts.
Larger Canadian E&Ps also may be considering implementing the popular energy trusts, which provide “significantly” higher valuations and tax savings.
“The majority of the growth in oil and gas income trusts has been fueled by small/mid-cap producers converting to trusts to capitalize on the tax advantages and favorable valuations granted to maturing assets. However, we believe we will see this trend migrate from solely being a small/mid cap phenomenon to being a large-cap monetization strategy.”
The analysts questioned why large-cap E&Ps had not considered energy trusts before.
“We believe the reluctance of large caps to pursue a trust-type monetization has been due to a combination of: 1) concerns regarding size (can the market absorb super large E&P trusts?); 2) lack of limited liability legislation in many jurisdictions; and, 3) exclusion from indices. With the majority of these issues now resolved, or partially resolved, we believe the time is ripe for large cap trust monetizations.”
Energy trusts may appear to be a better investment opportunity “because of the increasingly mature production base in the Western Canadian Sedimentary Basin sector, as well as the attractive valuation of trusts relative to their corporate peers.” The average Canadian energy trust is currently trading at a 76% premium to the average large-cap and 42% premium to the average small/mid-cap.
“While the majority of the large caps in our coverage universe could receive a valuation bump as a result of restructuring in some form, we believe Talisman, EnCana and Suncor are the most likely candidates” for restructuring some assets into energy trusts. More than 16% of Canada’s oil and gas production now originates from energy trusts, which produced about 988,000 boe/d in 2Q2006, up more than 800% from 122,000 boe/d in 1996. As of June, income trusts contributed 10% of the quoted market value of the Toronto Stock Exchange.
EnCana could see “one easy value gain” by spinning off “its southern Alberta shallow gas assets into a Canadian royalty trust. Given that these assets would be an ideal trust because of the high-quality, low-decline and predictable nature of the assets, we believe it would trade at a premium to the trust average and in line with other large gas-producing trusts.”
Talisman makes the list because “year to date, the company has sold C$830 million of assets and we believe it will dispose of an additional C$2.9 billion (UBS estimates), including oil sands, and noncore conventional assets in Western Canada and the North Sea. We believe this restructuring makes sense in order to take advantage of valuation arbitrage and to streamline the asset base after years of consolidation.
“By our estimates, the upcoming Talisman asset sales could result in a valuation gain of approximately 11%. In addition to the announced asset sales, we believe there is a good chance Talisman will evaluate monetizing its midstream assets with the most likely option being a spin-out into a trust.”
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