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With oil and gas prices surging this year, cash flows have roared back – and so, too, has demand for tax pools, which are deducted from operating income.Jeff McIntosh/The Canadian Press

After a long drought, Canadian oil and gas producers are hungry for tax pools again, putting them on the prowl for acquisitions that lower the amounts they owe the government every year.

On Monday, PrairieSky Royalty Ltd. announced a $728-million acquisition of royalty assets in Western Canada. To justify the deal, PrairieSky said the transaction will increase its exposure to oil assets, as well as provide $728-million in acquired tax pools that will immediately reduce its cash taxes by over $20-million this year.

Such pools are federally permitted accounting deductions awarded for capital investment and oil and gas exploration. Before the 2014 energy market crash, producers consistently hunted for these pools to offset their strong cash flows. But in recent years the pools fell off the radar because many companies simply tried to survive and focused on other pressing issues, such as debt repayment.

With oil and gas prices surging this year, cash flows have roared back – and so, too, has demand for tax pools, which are deducted from operating income.

At the moment, many producers still have ample tax pool coverage. In July, analysts at RBC Dominion Securities noted the energy companies they cover still had, on average, seven years’ worth of tax pools to use up.

The long runway partly stems from the accounting rules, which group the deductions into five classifications and dictate that a different deduction weight applies to each group. Some pools can be used at a rate of 30-per-cent rate per annum, while others can only have 10 per cent of their total value applied each year.

Still, the analysts anticipated “taxation to become a consideration as it relates to levels of activity and M&A transactions” should free cash flow remain robust – and it has.

Energy producers have also held the line on capital investments by refusing to drill more or to explore for new resources. This is largely because of investors growing tired of the sector’s boom and bust cycles. Whenever oil and gas prices used to jump, energy companies would boost supply and oversaturate the market, causing commodity prices to crash.

This time around, instead of pouring money into expansion, energy companies are returning it to their shareholders. After third-quarter earnings were reported this month, RBC’s analysts noted the majority of top-performing energy companies either increased their dividends, boosted the pace of their share buybacks or kept their capital investment budgets unchanged, “clearly conveying investors’ preference for capital discipline and returns of capital to shareholders.”

By showing such discipline, energy companies aren’t creating as many new deductions for future use – which makes existing pools all the more valuable.

For this reason, Bank of Nova Scotia analyst Jason Bouvier recently noted that MEG Energy could be an attractive takeover target, because it has tax pools worth $7.4-billion. After crunching the numbers, he found the value of these pools to an acquirer such as Suncor would be worth, on average, $1.6-billion.

Tax pools have already accrued to some large buyers in the past 18 months. In August, 2020, Canadian Natural Resources Ltd. purchased Painted Pony Energy Ltd. for $461-million, which included a tax pool balance of $1.4-billion. Six months later, in February, ARC Resources bought Seven Generations Energy for $2.7-billion, a deal that included tax pool balances worth $5.5-billion.

PrairieSky’s latest acquisition, meanwhile, will transfer $728-million in tax pools and also reunite two businesses. PrairieSky was spun out of Encana in 2014 to create a standalone royalty company that collects rent from producers who drill on its land; meanwhile some of the Western Canadian assets it has acquired were previously sold off by Cenovus. Cenovus used to be part of Encana until the two split in 2009.

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