The search for yield started the day after the 2006 Halloween massacre, when Ottawa blocked income trusts.
Now one of the best-known faces in Calgary's oil patch believes he might have the next big thing. Over the past few months, Jim Kinnear, founder of Pengrowth Energy Trust, has appeared before money managers to sell a new financial instrument, called a gross overriding royalty interest, which promises many of the attributes of a trust: fresh cash flow for energy companies, and strong returns for investors.
“This could be one of the new models post the trust era,” said Mr. Kinnear, who stepped down as chairman of Pengrowth in September and now heads a small private firm, Kinnear Financial Ltd.
The financial structure is used frequently in mining and, in fact, was used decades ago by energy companies when they bought subsurface rights from railroad companies.
But though some doubt that the structure will gain much traction, selling a royalty interest on oil and gas is both novel, because the mechanism is rarely used today, and intriguing, because it replaces some of the functions that income trusts played before they were crushed by the federal government: a source of capital for cash-starved companies, and a source of low-tax profit for yield-starved pension funds.
“Smaller and medium-sized companies are always looking for capital. And then you've got investors who have capital they would like to invest. What I'm saying is, what's the conduit?” Mr. Kinnear said. “This could be a new source of capital for the energy sector.”
Perhaps the best way to understand how this works is to look at the first deal made by Caledonian Royalty Corp., a private energy financing concern in which Mr. Kinnear has a substantial investment. Caledonian's deal was with Calgary's Compton Petroleum Corp.
Compton, which pumps just over 30,000 barrels of oil equivalent per day, was facing a huge debt load and went looking for ways to reduce its leverage. It agreed to sell up to a 5-per-cent royalty interest in all of its production to Caledonian for about $100-million.
The deal, reached in September, gives Caledonian 5 per cent of Compton's cash flow; the only expenses subtracted before the royalty is calculated are transportation and marketing.
The agreement is struck in perpetuity, meaning Compton has to finance the capital costs of expanding its production, but will still have to pay the royalty, a fact that limits its upside. But company executives agreed to the deal because it worked out to about $85,000 per barrel of current daily production. That's more than double what Compton could have obtained by selling its assets.
“What we need is capital. So it served our needs,” said Tim Granger, Compton's chief executive officer.
Caledonian, meanwhile, gets a steady return of between 12 per cent and 14 per cent – more if natural gas prices spike, less if they drop – and can write off most of its tax bill under Canadian oil-and-gas property expenses rules.
“Particularly for taxable Canadian investors, this is very attractive,” Caledonian president Charles Selvy said.
At least one other small Calgary company, WCSB Royalty Income Investments, is using a similar royalty model to finance drilling of low-risk wells.
“Operators are embracing the capital,” said WCSB chairman Bill Bonner, who said his company's model can help significantly boost a company's rate of return, and provide financing for solid projects where banks have been reticent to lend.
But how many companies will be willing to sell a percentage of their future revenues? Could royalties take the place of trusts, the previously favoured instrument for high-yield energy investments?
The man considered one of the godfathers of the trust model doubts it.
“It won't replace the trust model. I think it'll be a bit of a specialized product,” said John Brussa, a tax lawyer and partner with Burnet, Duckworth & Palmer LLP in Calgary. “Having said all that, the trusts were a specialized product in the early days.”
There is also skepticism in the investment community.
“For investors, I think it probably makes sense. The question is, will companies really want to do this in a very meaningful way?” said Mike Tims, chairman of Calgary investment dealer Peters & Co. Ltd.
“I think a lot of the issuing companies will prefer to use debt and conventional equity.”
Still, there is no question that the demise of income trusts has created a yield vacuum that the financial community is scrambling to fill. Mr. Brussa thinks that, ultimately, the replacement will come in more than one form. But, he said, it's likely to favour convertible debentures and junk bonds, which are already gaining in popularity, over royalties.
“Unless you get paid a huge dollar up front, there's more economic ways of financing your business,” he said.
