It took almost a month, but Ottawa delivered a credit support package for small and mid-sized energy producers. While it may serve to bridge the immediate liquidity crunch, now is the time to make necessary structural changes to the industry such that it comes out of this cycle with strong credits, fully covering these taxpayer loan guarantees. Otherwise, we are undoubtedly kicking the can down the road to a more severe credit crisis.
This crucial part of the industry, which differs from the oil sands by applying horizontal drilling and completion techniques to produce clean, light oil and natural gas, is on life support and requires a structural reboot via re-establishing two equity classes: energy trusts and entrepreneurial growth stocks. The flow through entity (FTE) trust structure would align the maturity of the basin with a yield vehicle that can invest in optimizing mature production, bolster the financial wherewithal to fund environmental liabilities and reinvigorate small producer entrepreneurship.
The trust structure aligns environmental, employment, tax and royalty revenue objectives, but above all is the catalyst to reverse the fortune of an engine that drives one in every 10 dollars of Canadian economic output and fills the pipeline of net transfer payments eastbound.
The Canadian oil patch has a long history of fiscal instability and policy indecision, a turnoff for long-only investors who avoid uncertainty. In less than 15 years, Ottawa eliminated income trusts, Alberta launched two disruptive royalty regime reviews, Ottawa pushed through Bill C-69 (the “pipeline killer”) and nationalized Trans Mountain. For almost a year and a half, Alberta oil production has been curtailed by insufficient pipeline capacity.
This is an unenviable track record and has unfortunately only served to provide short-sellers an opportunity to profit from our made-in-Canada secular demise. It has been framed an Alberta problem, but the adage “as goes the energy trade surplus in Canada, so goes the Canadian economy” shouldn’t be lost on anyone. It’s a self-inflicted big short of the Canadian oil patch and, by extension, Canadian prosperity.
Reinstating the FTE status would serve to pivot the industry from secular decline to expanding its economic and environmental contributions to the country.
Confining the trusts to traditional production would appropriately ring-fence this asset class from the larger companies, which enjoy scale and lower cost of capital. In their previous incarnation, the trusts balanced income distributed to unit holders with investment to sustain their income stream. Demand for this risk-managed yield lowered their cost of capital as they filled the same void that exists in Canadian income markets today: low interest rates and an immature high-yield debt market.
The income trusts were eliminated by Ottawa in 2006 because of what was deemed tax leakage. While the government of the day never disclosed its tax leakage math, independent research quickly concluded that a holistic take on tax revenue from the energy trusts was positive for fiscal coffers; energy trusts actually paid more cash taxes than their corporate counterparts, and even the withholding tax rate on income to foreign investors exceeded the effective corporate cash tax rate. Moreover, tax-sheltered RRSPs yielded net outflows taxed at a higher individual tax rate, and their compounded growth creates an annuity for government tax collections.
This structure would reinvigorate junior entrepreneurship, which is at the most supressed state I have seen in 24 years. Political uncertainty has stymied funding for a segment so critical to driving employment and fuelling the growth multiplier of the energy economy. Importantly, this would be a boon to oil field services and would be felt from rural communities to fabricators in Eastern Canada equally damaged by our energy demise.
Restructuring the industry with better capitalized trusts would assure abandonment and reclamation liabilities are funded. Today these reside on the weakest balance sheets, and herein lies the moral hazard in Prime Minister Justin Trudeau’s climate ideology. Ottawa has a golden opportunity to staple a sustainable green mandate onto the trusts via a minimum annual reclamation spend.
We can no longer ignore the disturbing reality that policy makers, by action or inaction, own Canada’s long-standing energy crisis. We now measure this opportunity cost in decades, and beyond this pandemic, there is no vision for our energy economy, even as federal leaders posit an albeit longer-dated shift to green energy on today’s deficit dollars. The time to make structural changes for the prosperity of the sector, the environment and the Canadian economy is now. Mr. Trudeau, this is the pragmatic path.
Chris Theal, CFA, CIM, is the chief financial officer of Velvet Energy Ltd. He was formerly the head of energy research at Tristone Capital and an energy hedge fund manager.
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