It’s generally agreed that 2012 was a difficult year for the oil and gas industry in Canada. No part of the industry was spared from challenging times. Indications of these difficulties included:
- Persistent wide differentials in prices for Canadian oil and gas production compared to North American and international benchmarks;
- Decreases in capital spending by producers; and
- Declines in Alberta land sale bonuses and aggregate drilling days from 2011 levels.
At the same time, the industry’s initiatives to increase oil pipeline and refinery capacity and to develop alternatives to the US market for the oil and natural gas produced in Canada were frustrated by organized and effective opposition from First Nations, environmental and other special interest groups and by the reactions of governments to those political pressures.
In this difficult environment, the share prices of oil and gas companies declined during the year. The average for small and mid-cap companies was down 19% in 2012. In some cases, lower share prices can result in increased M&A activity as opportunistic acquirors look for bargains. However, in 2012 the number of acquisitions of oil and gas producers actually dropped compared to 2011 activity levels. There were some very large deals, but fewer other transactions. The drop in 2012 continued a three year trend of reduced numbers of M&A transactions in the Canadian oil and gas industry.
Will M&A activity improve in 2013?
The following are ten trends that will have an impact on the answer to that question.
1. Foreign Investment is Going to Continue, With Some Limitations on State-Owned Enterprises
2012 was a huge year for foreign investment in Canada, particularly in the oil and gas industry. The most significant foreign investment transactions of last year were:
- China’s CNOOC Limited’s agreement to acquire Nexen for $20 billion (including the assumption of debt); and
- Malaysia’s PETRONAS’s $6 billion acquisition of Progress Energy.
The Canadian government’s approvals of these two deals on December 7, 2012 sent a clear message that Canada is open to foreign investment—but with a caveat in the form of updated guidelines in respect of investments in Canada by state-owned enterprises (SOEs).
Highlights from the new SOE guidelines include the following points:
- A broader definition of SOEs to include enterprises “owned, controlled or influenced directly or indirectly by a foreign government”.
- SOEs are expected to demonstrate a strong commitment to transparent and commercial operations.
- The burden of proof is on the SOE to demonstrate that the proposed investment is likely to be of net benefit to Canada.
- The Minister of Industry’s assessment of net benefit takes into account the degree to which the conduct and operations of the SOE are influenced by the foreign government, as well as the degree of existing foreign ownership in the sector in which the Canadian business operates.
Prime Minister Harper further stated that future acquisitions of control by SOEs of oil sands interests will be approved only on an exceptional basis. While this “exceptional basis” caveat explicitly applies only to the oil sands, the government has also adopted a more wary attitude toward SOEs generally, and has indicated that it will closely monitor investments by SOEs in all sectors of the Canadian economy. To this extent, the changes in Investment Canada’s review thresholds for non-cultural transactions involving a party from a WTO member state from a “book value” test (currently set at $344 million) to an “enterprise value” test (to start at $600 million) will not apply to investments by SOEs.
Accordingly, we can expect to see a refocusing of investments by foreign entities in Canadian resource plays in 2013. There will not be many transactions where SOEs acquire control of Canadian oil and gas producers, and almost certainly none of those kinds of transactions will occur in the oil sands sector. However, investments by SOEs as minority shareholders such as:
- China Investment Corporation’s acquisition of a minority shareholding in Teck Resources; and
- CNOOC’s acquisition of a 14% stake of MEG Energy,
and SOEs taking minority positions in joint ventures and other similar arrangements—including in the oil sands—should continue to occur. Evidence of this trend occurred quickly after the Nexen and Progress Energy deals were approved. On December 13, 2012, Encana and PetroChina announced the formation of a $2.2 billion joint venture to develop Encana’s natural gas assets in the Duvernay region of Alberta. That deal will not be subject to Investment Canada approval because PetroChina will own 49% of the assets and Encana will remain in control. We expect to see similar arrangements in 2013 and beyond.
Foreign investment in the oil and gas industry by non-SOEs will not be significantly impacted by the new SOE guidelines. Accordingly, transactions like ExxonMobil’s $3.1 billion acquisition of Celtic Exploration that was announced in October 2012, at the height of the media speculation surrounding whether the government would approve the Nexen and Progress Energy transactions, should continue to occur in 2013.
2. M&A Activity Involving Shale Gas Plays May Pick Up
The larger M&A transactions in the oil and gas industry have tended to focus on the oil sands, the Cardium and on liquids rich shale gas plays such as Alberta’s Duvernay and the Montney in British Columbia. M&A activity involving these kinds of shale gas plays may pick up this year as:
- Investment Canada’s SOE guidelines do not directly restrict national oil companies from acquiring shale gas properties;
- Participants in the development of liquefied natural gas (LNG) facilities will be looking to secure feed stock for their export projects; and
- Land rich, but cash poor companies with positions in these plays will seek to partner with flush national oil companies to provide the billions in capital that will be required to develop their projects.
Expect more transactions like the Encana/PetroChina and ExxonMobil/Celtic deals.
3. Size Will Matter in LNG Export Projects
The impact of the increasing supply from US shale gas reserves and other factors has depressed prices for Canadian natural gas for the past few years. This situation has caused natural gas producers to focus capital spending on liquids rich gas plays and to look for other markets for their gas production including exporting LNG to overseas markets.
The significant amounts of capital required to develop LNG export projects, the large quantities of natural gas required to support them and the difficulty of securing long term commitments to purchase exported LNG make these projects difficult for anyone to execute other than the largest oil and gas companies.
Some of the M&A activity in 2012 reflected transitions of sponsors of LNG projects into these larger entities with the balance sheets and natural gas reserves required to advance development:
- PETRONAS’s acquisition of Progress Energy came after PETRONAS had announced a partnership with Progress for an LNG export plant in British Columbia and for the development of some of Progress’s gas properties to provide feedstock for the export facility. In 2012, in the lead up to the final approvals of that transaction that were received in mid-December, PETRONAS announced that if its acquisition of Progress proceeded, the size of its proposed LNG project could be increased by 60% as PETRONAS would then have access to all, and not just a part of, the gas properties of Progress.
- Following ExxonMobil’s agreement to acquire Celtic Exploration, ExxonMobil announced that it was entering the race to export LNG from Canada’s West Coast to markets in Asia. Its project is to be supported by the Celtic reserves as well as Imperial Oil’s gas holdings in Western Canada and in the Horn River area of British Columbia.
- In December 2012 Encana and EOG Resources agreed to sell to Chevron Canada their interests in the Kitimat LNG project and corresponding interests in the Pacific Trail Pipeline that will deliver natural gas to that project. Chevron Canada in turn agreed to equalize interests with the remaining existing owner, Apache Canada, to result in a 50/50 joint ownership of the project and the pipeline. In addition, Chevron Canada acquired a 50% interest in upstream assets from Apache, EOG and Encana in the Horn River area and Liard Basin.
M&A and joint venture activity should continue around LNG projects in 2013 as the evolution of the ownership of these projects and related infrastructure continues and companies position themselves to take advantage of opportunities to diversify markets for their natural gas production.
Evidence of this trend is the recent announcement by AltaGas and Idemitsu of Japan that they have formed a joint venture to pursue the export of LNG to Asian markets.
4. Continued Crude Oil Price Differentials May Discourage Acquisitions
Accessing markets outside of the US for Canadian crude oil is becoming increasingly important.
Differentials in the prices paid for Canadian crude oil (particularly heavy oil) in North America compared to West Texas Intermediate (WTI) and Brent bench marks are reducing cash flows for producers. Those reduced cash flows are constraining the development and expansion of oil projects.
These price differentials are the result of:
- Increased crude oil production in Canada and the US – as of September 2012 up 13% on a year over year basis;
- Limited or constrained North American pipeline capacity to transport this oil production to refineries and markets; and
- Reduced access to US refineries during periods of shut downs for maintenance and repairs.
Until new pipeline capacity is in service, particularly to the West Coast of British Columbia for access to Asian markets, the price of Canadian crude oil will continue to suffer significant discounts against WTI which in turn trades at a discount to Brent. Oil sands production has been particularly hard hit with discounts between $35 and $40 a barrel, spiking at times to over $65 a barrel. The Canadian Energy Research Institute has warned that these crude oil price discounts could cost Canada a $1.3 trillion loss of GDP and a $276 billion loss in tax revenue over the next 20 years.
Producers are not the only ones affected by price differentials. The Province of Alberta has announced that it is budgeting for $6 billion less in revenues from royalties on crude oil as a result of these discounts.
Solutions to this problem potentially include:
Shipping oil by rail: By the end of 2012 approximately 110,000 barrels of crude oil per day were being transported by rail to refineries in North America. But this solution has limits. The lead time to secure rail cars is now as long as 24 months and the cost of transporting crude by rail is up to three times more than the cost of transporting it by pipeline.
Completing TransCanada’s Keystone XL project that would ship up to 590,000 BPD to refineries in the US: Prior to the recent US presidential election, President Obama denied the presidential permit required for the Keystone XL pipeline project, which had previously been approved by Canada’s National Energy Board. In response to that decision, TransCanada split the project into parts. The southern part, between Cushing, Oklahoma and the Gulf Coast refinery market, became the Gulf Coast Project. That part has an anticipated mid- to late- 2013 in‑service date. The northern part of Keystone XL, running from Hardisty, Alberta to Steele City, Nebraska, was the subject of a new presidential permit application in May 2012. In an important related development, a realignment of the pipeline’s proposed route through Nebraska, which had been a major source of opposition to the project, has now been approved by officials of that state, paving the way for a decision on the presidential permit, expected in the first quarter of 2013. If approved, the facilities from Hardisty to Steele City could be in service and connected to the southern facilities by early 2015. However, President Obama stated in his 2013 inaugural address that climate change will be a top priority of his second term, a statement that may encourage environmental groups, who are likely to continue to voice objections to Keystone XL and to Alberta oil sands projects generally.
Reversing the flow of Enbridge’s Line 9 and expanding the capacity of that pipeline: These changes would allow western Canadian oil producers to displace up to 300,000 BPD of crude oil from the North Sea, West Africa and Middle East currently being delivered to eastern Canadian refineries.
Allowing Enbridge’s proposed Northern Gateway Pipeline to proceed: That pipeline is being designed to carry up to 525,000 BPD of crude from Alberta to the Pacific Ocean port of Prince Rupert, British Columbia. If Northern Gateway is approved by the regulators, construction could be completed by the end of 2017 or the first half of 2018. However, there has been significant opposition to the project from First Nations and special interest groups, as well as from the Government of British Columbia. Accordingly, whether Northern Gateway will be approved is an open question. Even if it is approved, litigation may ensue that could further slow or even stop its progress.
Increasing the capacity of the Trans Mountain Pipeline between Edmonton and Vancouver to up to 890,000 BPD: Unlike Northern Gateway, the Trans Mountain expansion can be constructed on its existing right of way. However, significant opposition from environmental, First Nations and land owner groups is also expected in respect of this project. Kinder Morgan has forecast an in-service date for the expansion of 2017, assuming that regulatory approvals can be obtained.
Using TransCanada’s mainline: Using part of TransCanada’s mainline to pipe oil to the East.
In addition, a number of positive initiatives are currently underway in the US, including new pipeline systems and expanded rail and coking capacity, that when completed will reduce the differential spread.
However, none of these projects are expected to have any effect until mid-2014 at the earliest. As a result, crude oil differentials are expected to continue throughout 2013.
The continued impact of these differentials on commodity prices for Canadian crude oil may discourage investment in Canadian oil producers notwithstanding share prices that have factored in these depressed oil prices.
5. Expect Increased Merger Activity Involving Junior and Intermediate Companies
The junior and intermediate sized Canadian oil and gas companies are caught between two difficult trends:
- The first is the decline in available financing. In 2010, oil and gas issuers listed on the TSX raised a total of $11.2 billion of equity. In 2011 the amounts raised by this group fell to $10.1 billion. In 2012 only $8.9 billion was raised, a 20% decline from 2010.
- The second is low prices for natural gas production and the persistent wide differentials between North American and international commodity prices. The differentials for Canadian crude are previously noted. Regarding natural gas, LNG sells at a US$10 premium in Asia compared to Canadian gas prices.
These trends are occurring at a time when the new opportunities that these companies would like to pursue, such as shale gas plays, require significant capital to assemble and expensive new technologies to exploit.
The dilemma that results is the need for greater amounts of capital at a time of reduced interest from investors.
Companies that stagnate in this environment may look to sell themselves or their assets. Interested buyers may include well capitalized competitors. Even in this market, experienced management teams with track records of proven success are able to attract investment—and private equity and other funds have money for acquisitions. However, uncertainties regarding commodity pricing and whether and when better markets for Canadian oil and gas production can be accessed may discourage these kinds of transactions.
The result may be continued consolidation among junior and intermediate producers with the objective of increasing the merged entity’s size, reducing General & Administrative expenses and hopefully attracting capital. Recent activity in this regard among producers with interests in the Cardium and Bakken will continue.
6. Private Equity Funds Will Look For Opportunities in the Oil and Gas Sector
Given the substantial amounts of uncommitted capital in resource-focused private equity and other funds, we expect continued investment in Canadian oil and gas sector from these funds on two fronts:
- First, acquisitions. These funds are able to make opportunistic acquisitions quickly and are known to be bargain hunters with the patience to wait out dips in commodity prices. In an uncertain stock market, “cash is king” and will be preferred over stock as a form of consideration. Depressed natural gas prices and a lack of capital among juniors may create conditions that are ripe for acquisitions at sale prices below net asset values. It is estimated that over half of the resource issuers listed on the TSX Venture Exchange have less than $200,000 in working capital available to them.
- Second, these funds may continue to provide funding for new ventures in the right circumstances, including where experienced and highly regarded management teams have compelling business plans. Private equity funds may also be a viable source of recapitalization financing for existing companies.
7. More Producers Will Become Dividend Payors
In 2012 a number of oil and gas companies converted themselves into an income and growth model by instituting dividend payments with the objective of attracting investment. These dividend payors included Whitecap Resources, Renegade Petroleum and Twin Butte Energy.
This trend could benefit junior producers by giving them the option of selling themselves to these dividend paying entities rather than pursuing continued growth. These kinds of exits would be similar to the acquisitions of juniors by royalty trusts that occurred in the period prior to 2011. Déjà vu all over again.
8. The Market for Foreign Trusts Will Continue to be Selective
Canada’s Department of Finance decided to tax income trusts at the same rates as corporations effective January 1, 2011. The SIFT Rules that provided for these changes effectively signalled the end of business and resource income trusts that until that time had been treated for Canadian tax purposes as flow through entities not subject to taxation. The SIFT Rules did not, however, apply to REITs or to foreign sourced income. As a result, since 2011 some income trust offerings have been made in Canada through which investors were given exposure to US oil and gas and other asset classes.
While a number of new foreign asset trusts are in various stages of development, the market has been taking a cautious approach to these offerings. Only the highest quality assets with reliable prospects for production growth, high netbacks and attractive but sustainable yields will appeal to investors.
There are asset packages available to roll into these foreign asset trusts. However, given the relatively long and uncertain route to market, the failures of the North American Oil Trust offering in 2011, the Meranex offering in 2012 and of other offerings that were abandoned before filing preliminary prospectuses, there is some concern that the expected relatively fast exit for US asset owners is anything but. It remains to be seen whether asset packages of sufficiently high quality will continue to be available to potential new entrants to the foreign asset trust market.
9. There Will be More Changes of Leadership
A significant transition of the oil and gas industry’s leadership occurred in 2012. In some cases these changes marked the end of brilliant careers, such as Rick George’s retirement from Suncor and Pat Daniel’s retirement from Enbridge. In other cases these changes occurred amid investor impatience with underperforming share prices and the need to revise strategic plans to respond to challenges.
Turmoil at the top has continued in 2013 with Randy Eresman’s sudden retirement from Encana. This trend will continue throughout 2013 as energy companies’ financial performance comes under even greater scrutiny. The success of Pershing Square Capital Management in replacing the board of Canadian Pacific Railway and pending changes to Canadian governance regulations are signs that shareholder activism is rising.
These kinds of leadership changes frequently signal impending M&A transactions either involving the energy company where the change is occurring, as was the case with CNOOC’s agreement to acquire Nexen, or dispositions by that company of non-core assets as it refocuses its corporate objectives.
10. Aggressive Competition Regulation Will Continue
In 2012, the Competition Bureau—Canada’s antitrust regulator—continued to aggressively assert itself on a number of important fronts. The Bureau continued to make full use of the powers accorded to it by the 2009 amendments to Canada’s Competition Act, which included enhanced information-gathering powers, longer merger review periods, and greater penalties for anti-competitive conduct. The most notable competition law developments of 2012 in the mergers context included:
- The Bureau published new Merger Review Process Guidelines.
- The Bureau’s application to block Air Canada’s proposed joint venture with United Continental was settled under a consent agreement in October.
- The Competition Tribunal ruled in May against a merger between two landfill companies and ordered divestitures.
- The Bureau did not oppose the Maple Group/TMX transaction.
The Bureau has increased the pre-merger notification transaction threshold from $77 million in 2012 to $80 million for 2013. The new threshold is now in effect.
On September 21, 2012, Commissioner Melanie Aitken stepped down from her role as Competition Commissioner. During her tenure, Ms. Aitken oversaw the implementation of the 2009 amendments to the Competition Act, setting a forceful new tone to antitrust oversight in Canada. She has been succeeded by Interim Commissioner John Pecman. We expect that the Bureau’s aggressive antitrust enforcement will continue in 2013 under Mr. Pecman, who has 28 years of experience at the Bureau and headed the Criminal Matters Branch during Ms. Aitken’s tenure.