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Canadian Insanity--Week Three

By Tobin Smith

* Higher natural gas prices.
* Lower tax revenue collection.
* Higher unemployment.
* $20 billion of wealth dissolved.

Looks like the Canadian Finance Minister has had a GREAT month so far.

For those of you who missed the Halloween Income Trust Massacre, the short story is the Canadian government -- in probably the single most insane and illogical legislative move I can recall -- changed the rules of the energy income trust game in Canada and refused to grandfather existing energy trusts to boot.

This betrayal was Shakespearian in its cold-hearted cunning and contempt for rational thought.

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Now I distinguish "energy trusts" from "income trusts" because clearly having two different tax schemes for operating corporations was just as insane. They were worried that Canada was going to become an "income trust economy." Really?

If you had companies taxed two different ways -- with one method being significantly less-taxing for shareholders -- wouldn't you choose the low-tax (i.e. income trust) approach?

But energy trusts are the correct tax model for long-lived, high-cost energy reserves. They created a super-efficient model for increasing energy development in Canada and now they want to throw it away. They created an economic "Hamlet" and now they want to rewrite it?

Canadian energy trusts have created a market for energy exploration companies to convert older, low-risk, low-upside reserves into cash so they can use that money to fund greenfield exploration.

In other words, just like the billions of liquidity that was created in the real estate development business via sales of projects to real estate investment trusts, energy royalty trusts created a liquid market for long-lived mature energy reserves.

Energy trusts don't threaten Canada's economy -- actually, the opposite is true.

IN THEIR OWN WORDS ...

"We are supporters of income trusts and we oppose tax measures that would raise taxes on income trusts." -- Conservative finance critic Monte Solberg, Jan. 12, 2006

"A Conservative government will ... (s)top the Liberal attack on retirement savings and preserve income trusts by not imposing any new taxes on them." -- Conservative federal election platform, Jan. 13, 2006

"We're faced with a situation where Canada was moving to an income trust economy and is that a good thing for Canada? And the answer is no. It's a very bad thing for Canada." -- Finance Minister Jim Flaherty, Oct. 31, 2006

In short, by taxing energy trusts as corporations starting in 2011, pushing the legislation through their house and senate with an odd coalition of liberal parties and by NOT acknowledging that energy trusts are a unique business entity that creates jobs and wealth in Canada, they have screwed the economic pooch in a single mind-boggling move.

Let's explore the economics of this travesty.

Overall, the weighted-average cost-of-capital for energy trusts will go up at least 20% higher under the new tax, translating into an increase of at least two full percentage points in real (not nominal) financing costs.

That's the equivalent of arbitrarily raising interest rates for companies 20% by creating a "cost of capital tax."

A 20% HIGHER cost of capital? Somebody needs to explain the concept of "cost of capital" to the Tories. Evidently, they somehow think that when you raise the cost of capital in a capitalistic society that your economy does better?

Maybe we should just take over the Canadian business schools, eh?

BLAME CANADA! BLAME CANADA!

It was the low cost of capital that created $50 billion of liquidity for the Canadian energy industry -- duh!

The energy trust model takes revenue from predictable oil and gas production volumes, subtracts the cost of developing and producing these volumes (i.e. the "netback" net cash flow to the trust) and then subtracts the cost-of-capital for owning the reserves.

This formula has worked spectacularly -- more than $10 billion a year in oil and gas is owned and produced by energy trusts that sends most of it to the United States, by the way.

$3 billion to $5 billion is also reinvested into supplemental development of these older reserves with modern tertiary recovery methods and new drilling. All due to the economics inherent in the energy trust model.

Why on earth would you want to diminish the economics of a $15 billion industry by 20%, especially when net back percentages have been falling because of higher production and energy labor costs?

The 20% higher cost-of-capital raises the economic threshold of mature energy production by 20%, which means 20% MORE abandonment of marginal but previously acceptable fields in addition to 20% less investment in mature energy assets.

Twenty percent less production means 20% less employment, less merger and acquisition activity, and 20% fewer jobs in the sector.

And last, but not least, significantly less oil and gas production.

The trust tax plan guarantees significantly less activity in acquiring, developing and exploiting high-cost, mature fields.

Less capital from trusts means LESS new field exploration for E&P companies.

And for natural gas (where we see a rapid 30%-40% decline in the rates of production from initial new reserve finds) that means one thing ... HIGHER natural gas prices.

We get more than 10% of our natural gas from Canada -- that's certainly going to change.

So, not only does Alberta now lose BILLIONS in business investment and commerce, they will lose thousands of taxpayers. And natural gas prices will have to rise as production rates fall in Canada.

Now that makes terrific sense doesn't it?

THE GOOD NEWS?

Energy trusts are fighting back, and they are RIPE for

1) Stock buy backs
2) Private equity takeover moves
3) Changing domiciles out of Canada (too bad)

Stay tuned ... the energy trust industry has changed forever.

But what the economic dunces in Ottawa failed to realize is there are other options for the energy trust companies. That's very wrong.

And as Shakespeare taught us, revenge is one very-powerful motivation.

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Tobin Smith is the founder of ChangeWave Research, the editor of ChangeWave Investing and ChangeWave Microcap Investor and a contributing market analyst for Fox News Channel. His market commentary can be found twice weekly in the ChangeWave WaveWire and he provides more specific recommendations and advice through his ChangeWave Investing service. To learn more about ChangeWave Investing click here.