Well-funded energy royalty trusts continue to put pressure on the Canadian asset marketplace as they remain somewhat restricted to the area by a tax-related hurdle. And, their cousins-traditional E&P companies-are just as hungry for growth in the region, leaving almost no type of asset immune from bid. "The demand is so high, we have a number of purchasers regularly making preemptive bids," says Ross Kobayashi, president of Calgary-based M&A firm Kobayashi Partners Ltd. "It's a very competitive environment here." Midyear 2004, Canadian A&D professionals reported that the marketplace was its most active ever. (For more on this, see "Fire!," Oil and Gas Investor, September 2004.) Kobayashi says it has become yet busier. "There is still significantly more demand for opportunities than supply." The trusts and junior exploration companies have unprecedented buying power. The average trust is trading at C$60,000 per flowing barrel of oil equivalent of daily production, Kobayashi adds. Currency-exchange rates are key to the current Canadian A&D environment, too, but are contributing to the supply of assets for sale. U.S. companies ran north of the border for growth in the second half of the 1990s in part because of a weak Canadian dollar. Contributing to U.S. companies' divestments in Canada today is the weakening U.S. dollar, combined with growing Canadian F&D costs. U.S. and other non-Canadian asset-owners must decide: continue to include Canada as a core area or profit now by selling. Many are selling. Among them in 2004 were Anadarko Petroleum Corp., Murphy Oil Corp., ChevronTexaco, Vintage Petroleum Inc., Calpine Corp. and The Wiser Oil Co. These sales-some of them whole exits-followed divestments by El Paso Corp. and Marathon Oil Co. in 2003. Already in 2005, U.S.-based Dominion and Exco Resources have been sellers, and Pioneer Natural Resources and Devon Energy Corp. have divestments under way. Senior Canadian producers are taking the bait too. The offers can be hard to refuse. Houston-based Randall & Dewey Inc., which has a Calgary practice, reports that Midnight Oil paid US$14.60 per proved barrel of oil equivalent (BOE) for Vintage Petroleum's Canadian assets and Advantage Energy paid US$14.34 per proved BOE for a package from Anadarko. Its review of third-quarter Canadian deal-making turned up US$1.9 billion in transactions at an average implied value of US$15.11 per proved BOE and a median US$21.39. In the first nine months of 2004, there were 131 Canadian deals totaling C$6.7 billion and having an average implied value of US$13.17 per proved BOE and median US$19.59. By comparison, divestments of U.S. assets in the third quarter had an implied value of US$9.61 per proved BOE, Randall & Dewey reports. In effect, an owner of Canadian assets could sell these for some US$15 per proved BOE and use the proceeds to buy 1.5 times as many proved reserves in the U.S., assuming the divestment proceeds are tax-free. Or, the seller could buy 12 times as much proved reserves outside North America. According to Randall & Dewey, third-quarter 2004 deals for assets abroad had an implied average value of US$1.21 per proved BOE. EnCana Corp. is a Calgary company that is buying in the U.S. and selling in Canada. It bought Denver-based Tom Brown Inc. in 2004 and has a large indigenous asset-divestment plan under way. An energy trust, Provident, found a way to beat the tax hurdle. It leaped across the border last summer to buy Los Angeles-based BreitBurn Energy LLC, whose long-lived, low-cost assets are expected to throw off enough cash flow that Provident can pay U.S. taxes on the revenue and still manage a profit margin comparable to that of its Canadian production. "A huge M&A sector is coming to the U.S.-the trusts," says George Gosbee, who recently merged his Calgary-based M&A firm Tristone Capital Inc. with that of Denver-based Petroleum Place Energy Advisors. "In the next 18 months, C$5- to C$6 billion of corporate activity will be done in the U.S. by Canadian trusts. The first one was Provident-BreitBurn." FirstEnergy Capital Corp. analysts Jill Angevine and William Lacey estimate that the 20 trusts they cover will produce 550,000 BOE per day in 2005. The largest, Enerplus, will produce nearly 80,000 per day, and Pengrowth, ARC and Bonavista will each produce some 50,000 per day. Gosbee says, "The energy trusts are a C$50-billion industry now that has to buy 160,000 barrels a day. Where are they going to buy it? They used to be able to buy a 10,000-barrel-a-day junior, but juniors can convert themselves into a trust now. So the opportunities for growth for the larger trusts are in the U.S." Smaller Canadian E&P companies are merging with each other, forming a trust and an exploration company, and distributing shares of the exploration company to existing unit-holders. "The trend now is for a junior to hit 10,000 barrels a day or hit 5,000 and merge with someone else with 5,000, and form a trust," Gosbee says. Kobayashi notes that juniors that are built to sell are exiting within a much shorter time frame, sometimes as short as two or three years. "The trusts offer a liquidity event to private-company shareholders," he says. Also pushing trusts across the border is their need for larger and larger amounts of equity to fund increasingly larger deals, Gosbee says. Creating a U.S. subsidiary that is traded on a U.S. exchange is one solution to tapping into a bigger capital market. "That's the beauty of it," Gosbee says. "Let's say I'm XYZ Trust and I need to replace my 20% declines every year and I can only raise C$300 million at a shot. Well, I'm going to have a hard time doing that. So, go to the U.S., buy $500 million of assets, turn yourself into a North American energy trust, so you will be raising more out of the U.S. and be able to do billion-dollar financings without even touching the institutions." Trusts are limited by Canadian law to having 50% of their asset value in Canada. Few have assets outside Canada currently, so they could shop outside the border for some time before hitting that threshold. The Canadian marketplace could also get busier with a new divestment vehicle. The combination of Tristone and Petroleum Place will result in the launch, probably this fall, of a Canadian oil and gas asset auction business by its U.S.-based The Oil & Gas Asset Clearinghouse, Gosbee says. FirstEnergy's Angevine and Lacey say the trusts are pressed to keep distributions strong. The 24 companies in their oil and gas trust index had 2004 shareholder returns-improved stock price plus distributions to shareholders-of 26%, slightly less than traditional producers' 29%. "Years of steadily compressing yields, a broadening of the peer group, a declining yield curve, and healthy commodity prices have resulted in overall returns beginning to moderate somewhat...," they report. Adam Waterous, senior managing director and a principal of M&A firm Waterous & Co., says the trusts have been actively seeking U.S. assets but have been unsuccessful bidders to date except for Provident. Waterous cites the relatively low cost of U.S. assets, compared with Canadian assets, as among reasons Canadian trusts are looking south. "While there is some tax leakage, the U.S. market is, on average, less expensive than the Canadian market, so the Canadian trusts believe they can net similar returns," he says. Also, trusts have developed a substantial investor base in the U.S., so unit-holders are comfortable with investments in U.S. assets. And, the U.S. holds the type of assets trusts are seeking: long-lived, low-cost, operated with a predictable decline rate and non-complex geology. "Some want to partner with management teams that are selling but want management to stay on with the assets, while they have some time to get their feet wet." Asian companies are actively seeking assets in Canada, as well as in the U.S., but they are looking at nonconventional plays and have yet to place a winning bid, Waterous says. Oil-sands operations in western Canada have piqued their interest. "Outside onshore North America, the most important buyers today are Asian," Waterous adds. "They've already been very active. But for onshore assets, they're looking for oil assets, not gas, and they want large reserve plays, such as oil sands. Don't expect Asian companies to be the new buyers of conventional North American production." FirstEnergy's Angevine and Lacey expect the trusts to be most affected going forward by commodity prices, limitations on foreign ownership and the recent decision by Standard & Poor's and the Toronto Stock Exchange to include them in the S&P/TSE composite index. As for non-Canadian ownership of trust units, the rule had been that it was limited to no more than 50% but the Canadian government has lifted that for now. It's a positive development, but "this issue is not closed and will be the subject of continued discussions throughout the year," Angevine and Lacey report. Waterous expects continued consolidation of E&P companies in 2005. There are 797 U.S. and Canadian publicly and privately held producers with output of between 1,000 and 100,000 BOE per day. They have a combined market value of US$182 billion. Among them, 167 are based in Canada; 630, in the U.S. "That highly fragmented market will continue to drive consolidation," Waterous says. Also, the top 30 North American asset-owners' bottom 10% of production totals 1.7 million BOE per day with an estimated market value of some US$50 billion. "There is a large amount of noncore assets left to be sold." And, there is the simple math: it continues to be cheaper to buy North American assets than to find them. The 2003 average Canadian F&D cost was US$8.40 per BOE of proved reserves, compared with an average acquisition price of US$5.95. In the U.S., it cost an average US$9.70 to find and prove a BOE in 2003, versus US$6.20 to buy it. "In 2004, acquisition costs went up, but F&D costs also went up," Waterous notes.