Written by Michael Waring
Monday, 28 February 2005

As we discussed in our first letter, we believe that a significant evolution is underway in the Canadian oil and gas industry. We would like to re-emphasize our thoughts on this subject as they form the cornerstone of our portfolio.

Investors have long worried that oil and gas royalty trusts simply represented a return of one’s own capital and that the business model was unsustainable. Some day the ‘well’ would run dry. As professional investors, we agreed. With payouts that exceeded 100%, we felt the business model was unsustainable and accordingly, we avoided them in the early years when trusts were cobbled together by financial ‘engineers’.

In the nineties, oil and gas exploration companies typically possessed a life cycle of 4-7 years. These companies were seldom profitable. Individual company production could get to approximately 15,000 barrels of oil equivalent per day (boepd) and then seemed to hit a ceiling where upon the company was typically sold. A number of well run companies managed to break through this ceiling with production eventually topping out between 25,000-30,000 boepd at which point, they were sold.

Much has changed since the beginning of the new millennium. To begin with, thanks to higher commodity prices and more astute management, many E & P companies have turned very profitable. Second, due to the maturing nature of the Western Canadian Sedimentary Basin (WCSB), the corporate life cycle has shortened dramatically to 2-4 years from the prior 4-7 years. This is because production ceilings have dropped significantly for smaller companies to 5,000-8,000 boepd from 15,000 boepd. In the midst of all these changes and recognizing the looming tax liabilities, operating oil and gas companies began to adopt the royalty structure as a means to become more tax efficient and at the same time, maximize shareholder value at the end of the corporate life cycle.

A trust could be created that encompassed approximately 90% of the company’s maturing assets while 10% could be spun-out as a new ‘exploreco’. We like to think of these spin-outs as little Indy Race cars starting with a small production base and a great growth profile. The oil and gas trusts that are converting today are vastly different from those of just a few years ago. Trusts such as Bonavista, Ketch, Progress, Peyto and Zargon employ a vastly different business model than their predecessors. They are run by highly qualified management teams who’s interests are typically closely aligned with unitholders. These trusts typically have high levels of property ownership and operatorship. And in addition, many of these trusts possess large amounts of net acreage upon which to drill. Curiously, some of the trusts that we hold in the highest regard tend to have the shortest reserve life index (RLI). As we learned, this is because they possess the technical talent and net acreage to keep extending their RLI without having to rely on acquisitions and financings (read dilution) to extend production life.

And perhaps most importantly, this new generation of trusts recognizes the need to restrain payout ratios in order to retain enough capital to re-invest so as to minimize production declines. Meeting the monthly payment imposes significant discipline on management. Capital expenditures are carefully scrutinized resulting in a high grading of reinvestment. This will lead to greater capital efficiency going forward and ultimately, a higher return on capital employed.

The financial press has totally ignored this aspect of the oil and gas royalty trust market. They have simply lumped all trusts together in the same basket. We strongly believe that it is wrong to do so. All trusts are NOT created equal.

We believe that this new generation of so-called ‘hybrid-trusts’ represents quite a shift from the trusts of the past. The business model and hence the payout yields are more sustainable. And the dilution to unitholders is reduced.

Today the oil and gas industry in Canada no longer has an intermediate sector. There are large caps, small exploration companies and a host of mid-cap royalty trusts. We believe that institutional investors will have to increasingly consider these mid-cap trusts. The returns are simply too attractive to ignore. And it is these very hybrid trusts that form the cornerstone of our portfolio and serve to differentiate Energy Plus from the pack.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

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