Despite uncertainty and slow growth in the US and Europe, Canada has continued, for the most part, to post impressive economic results. One reason for this has been the unceasing demand for Canadian natural resources including oil and gas. In addition, Canada’s stable majority government is a significant factor. In recognition of this economic strength, Forbes recently ranked Canada as the best country in the world in which to do business. It is the only country of the 134 surveyed that reached the top 20 in ten separate metrics. Consequently, we expect M&A activity in Canada will increase in 2012, particularly in the energy sector.
The following outlines ten trends that will impact M&A activity in the energy sector in the coming year.
1. Foreign Investment is Going to Continue
The year 2012 will most certainly experience continuing demand by foreign investors for Canadian energy plays, especially from China, India, Korea, Japan and India. In addition to going-private transactions in the form of takeover bids or plans of arrangement, this sector will also see creative and strategically oriented investment structures.
Significant transactions involving foreign investment in Canada’s energy sector that occurred in 2011 include:
- the acquisition by Petronas (Malaysia) of a 50% interest in Progress Energy’s North Montney, British Columbia natural gas properties;
- Korea Investment Corporation’s $251 million acquisition of Hunt Oil Company’s oil and gas properties and its investments in Alberta’s oil sands through shareholdings in OSUM and Laricina;
- the acquisition by the INPEX (Japan) led consortium of a 40% interest in Nexen’s Horn River, Cordova and Laird shale gas plays;
- Chinese National Offshore Oil Corp.’s acquisition of a 35% interest in the Long Lake oil sands project through its transaction involving OPTI Canada; and
- Sinopec’s $2.1 billion acquisition of Daylight Energy.
Through transactions like these, foreign investors have acquired interests in some of Canada’s most significant oil and gas projects, securing long-term supply that is very important in the Asia Pacific region. In addition, those investors have gained experience in managing and developing unconventional oil and gas plays which they can apply to similar projects in their home countries.
In exchange, the counterparties to these transactions with foreign investors have gained needed access to significant amounts of capital investment, in order to accelerate the development of their unconventional projects.
Early indications are that foreign investment in Canada’s oil and gas sector will continue in 2012. Transactions already announced this year include:
- PetroChina’s purchase of Athabasca Oil Sands’ remaining 40% interest in the undeveloped MacKay River oil sands project;
- PetroChina’s agreement to acquire a 20% stake in Shell Canada’s Groundbirch shale gas project in north eastern British Columbia; and
- Grizzly Oil Sands’ (US) $225 million agreement to acquire Petrobank Energy Resources’ undeveloped May River oil sands project.
Including the two PetroChina investments above, China will have spent more than $15 billion in Alberta’s oil patch alone. Additionally, the Canadian government is encouraging more of these investments. In February, Prime Minister Stephen Harper led a Canadian trade visit to China to attract further investment in the Canadian resource sector and to diversify markets for Canada’s energy, mining and forestry exports.
Investments by foreign entities have tended to focus on either acquisitions of interests in oil and gas properties concurrently with entering into partnerships or joint ventures for the exploration and development of those properties, or on investments in existing enterprises. However, the recent CNOOC/OPTI and the Sinopec/Daylight transactions were corporate acquisitions. These acquisitions may be indicative of the next stage of foreign investment in Canada’s oil and gas sector. If so, larger Canadian companies may become targets for foreign investors, although the Prime Minister signaled in February that hostile takeovers of key Canadian businesses could receive heightened scrutiny by Investment Canada.
2. Companies Will Position Themselves to Participate in Export Markets
President Obama’s rejection of the Keystone XL pipeline project has strengthened Canada’s resolve to expand the markets for its oil and gas away from the US. Prime Minister Harper told the World Economic Forum in Davos, Switzerland in January that:
… we will make it a national priority to ensure we have the capacity to export our energy products beyond the US and specifically to Asia.
This aim was repeated during the recent China trade mission.
Consistent with this objective, the Federal government made its intentions clear that it expects expeditious regulatory approvals of the proposed infrastructure required to diversify markets for Canadian energy. Natural Resources Minister Joe Oliver recently said in this regard that there is a need to make regulatory reviews of new projects less time consuming if Canada is keen to reach out to new markets.
This is a strong statement to the regulators currently reviewing Enbridge’s Northern Gateway project, which is proposed to ship 525,000 barrels per day of bitumen from Alberta’s oil sands to Kitimat, British Columbia for export to Asian markets. A decision on that project is expected to take over 18 months.
British Columbia also wants access to Asian markets for its natural gas industry. On February 3, 2012 the Province announced its Natural Gas Strategy, with LNG exports being a cornerstone of the plan.
Several LNG export projects based in Kitimat are at various stages of development.
A number of M&A transactions in 2011 focused on positioning companies to participate in energy exports from Kitimat. These included:
- EnCana acquiring a 30% interest in the Kitimat LNG Project with Apache and EOG Canada;
- the Kitimat LNG Project acquiring the remaining 50% of the Pacific Trails Pipeline system in order to control the delivery of natural gas from northeastern British Columbia across the province to Kitimat; and
- Shell Canada and its partners, Mitsubishi, China National Petroleum Corp. and Korea Gas acquiring Cenovus’ marine terminal site at Kitimat.
More transactions of this nature are expected to occur in 2012. As an example of this continuing trend, BG Group PLC (UK) has just secured an agreement with the Prince Rupert Port Authority to study an LNG terminal on port lands. It is anticipated that companies participating in proposed LNG facilities will look for natural gas reserves to ensure supply for those facilities, which will lead to investments in producing oil and gas properties by some foreign investors as part of their integrated export strategy. Partnerships like Nexen and INPEX and PennWest and Mitsubishi are examples of this strategy. More recently, PetroChina’s motive for its purchase of a 20% interest in Shell Canada’s Groundbirch shale gas project in British Columbia may well be to source the LNG that PetroChina plans to buy from the Shell Canada consortium’s LNG project.
Japan’s ongoing shut-down of its nuclear plant infrastructure highlights the importance of long-term supply development.
3. Size Will Matter for Midstream Companies
There was significant M&A activity among owners of midstream facilities in 2011. These transactions included:
- Kinder Morgan’s US$38 billion acquisition of El Paso Corp. Kinder Morgan’s properties include the TransMountain Pipeline System that transports oil from Alberta to ports and refineries in Vancouver and the Express Pipeline System that transports bitumen from Alberta to Casper, Wyoming and beyond;
- Plains All American’s US$1.67 billion acquisition of BP’s natural gas liquids and liquefied petroleum gas businesses and related assets; and
- AltaGas’ $230 million acquisition of Pacific Northern Gas and its natural gas distribution business in British Columbia.
Not only were midstream companies getting bigger, but they were expanding their properties and operations throughout North America.
Early indications are that these trends will continue in 2012. Recently:
- AltaGas announced an agreement to acquire SEMCO Holding Corporation for US$1.14 billion. SEMCO owns natural gas distribution businesses in Alaska and Michigan;
- Pembina agreed to acquire Provident to create a company with a combined enterprise value of $10 billion in energy infrastructure assets; and
- Keyera acquired the isooctane manufacturing business of EnviroFuels and its related facilities and equipment in a US$237 million transaction.
The turn to liquids production in Canada, the demand for more complex processing arising from the oil sands and the very competitive cost of capital in the mid-stream sector have helped shape an active M&A climate in midstream. These trends will remain intact.
4. Natural Gas Producers Will Face Challenges
Unexpectedly low prices for natural gas over the winter heating season and unrelenting US production growth will put pressure on natural gas producers to manage through reduced cash flows and limited access to capital markets. Prices for Canadian natural gas have recently been lower than $2.00 per gigajoule, less than half of what prices were expected to be at this time of year. These low prices resulted from mild winter weather in North America and correspondingly less than usual demand. Low gas prices also occurred because of significant new gas supply being produced from previously untapped shale gas reserves.
The immediate consequence of weak pricing has been for several gas-weighted producers to announce reductions in their 2012 capital budgets to align their spending programs to available capital.
Annual borrowing base re-calculations and resulting reductions of lines of credit may further restrict the ability of gas producers to implement capital programs. As hedged production comes off in 2013, cash flow and covenant issues loom unless prices stabilize.
Shutting-in gas production has also been proposed, with some producers already taking this step.
Within a short time, consolidations of natural gas producers may occur. If prices remain weak, we also expect that assets or entire companies will be offered up for sale or become takeover targets as their market values decline.
Energy-focused and other private equity funds will be among the buyers of these assets. These funds are known to be bargain hunters with the patience to wait out dips in commodity prices. Velvet Energy’s $209 million acquisition of Alberta natural gas assets from Vero Energy is an example of what may become a growing trend. Velvet is backed by a US private equity fund.
Other gas-weighted producers with depressed market values will also be potential targets for private equity funds, participants in export projects looking to secure energy supplies and other strategic investors. Interestingly, pricing drives much of this activity towards asset packages. The weakness in gas prices and the concurrent downturn in the gas-weighted Canadian equity market has slowed corporate M&A in this space. Management teams will be looking to preserve battered option and incentive structures from the reality that the market will not quickly welcome a start-up transaction after the sale. It may make sense to eliminate G&A, but teams are avoiding that result in order to wait for the turn-around. At some point this trend will turn, but low prices aren’t leading to much corporate change. Dissidents have made noises, and have enjoyed some success, but there isn’t much concerted action in this regard.
5. There Will be More Aggressive Competition Regulation
Last year Canada’s antitrust regulator, the Competition Bureau, aggressively asserted itself on a number of important fronts. These included high-profile, ongoing M&A matters including an application to block Air Canada’s proposed joint venture with United Continental and the investigation of the Maple/TMX transaction. Many trace the more vigorous enforcement of Canada’s competition laws to amendments in 2009 that gave the Bureau enhanced information-gathering powers, longer periods of time to investigate mergers and greater penalties for anti- competitive conduct.
We expect this trend to continue in 2012.
6. Investment Canada Will Continue to Approve Foreign Investments, But …
Following the Minister of Industry’s rejection in late 2010 of BHP Billiton’s hostile bid for Potash Corporation of Saskatchewan, it appeared to be a return to “business as usual” under the Investment Canada Act, as the federal government reviewed and approved some 13 applications for review in 2011, apparently without incident.
Most of those reviews related to investments in Canada’s energy sector, including CNOOC’s acquisition of OPTI Canada, Sinopec’s $2.1 billion acquisition of Daylight Energy, and Korea Investment Corporation’s acquisition of Hunt Oil’s oil and gas assets for $251 million.
However the anticipated guidelines on Investment Canada’s approach to the “net benefit to Canada” test have not materialized. Those guidelines were promised with the minority government, in response to criticisms that the process was opaque following the Potash decision. Now that the government has a majority in Parliament, no such guidelines are expected. Prime Minister Harper commented in a February 2012 interview with Reuters news agency that Canada is open for foreign investment. However, he cautioned that not every foreign bid is good for Canada, singling out hostile takeovers of key Canadian businesses, and takeovers of critical technology companies as being of doubtful benefit to Canada. Hostile takeovers of some of the largest Canadian energy companies may accordingly not be approved.
We do not expect any material legislative changes to occur in 2012 in relation to the ICA as it pertains to its reviews of foreign investment in the energy sector.
The annual change to the review threshold under the ICA for direct acquisitions by WTO investors in non-cultural businesses has been set at $330 million for 2012 (book value of assets of the Canadian business – wherever located).
The government’s court action against U.S. Steel Corporation seeking penalties for breach of its undertakings in the wake of plant closures in the 2009 recession was settled in late 2011, with U.S. Steel providing new undertakings following a court ruling that the government’s action was not unconstitutional.
7. Cross Border Income Trusts Will Continue to be Offered, Cautiously
Rumours of the demise of the income trust may have been premature. That is positive news for M&A participants looking for “made in Canada” liquidity alternatives. By way of background, in 2006, the Department of Finance unexpectedly announced proposed changes to Canadian tax rules under which the same taxes imposed on corporations would also be imposed on publicly-traded trusts and partnerships. While these “SIFT Rules” did not become fully effective until January 1, 2011 (and do not affect REITs), the 2006 announcement largely signaled the end of business and resource income trusts. Up until 2011, these entities had effectively been treated for tax purposes as flow-through vehicles not subject to taxation. Needless to say, this characteristic made them very popular with Canadian tax-exempts, non-residents and even Canadian taxpayers who could earn business income through a public vehicle on a more tax-efficient basis than income earned through a public corporation. However, the SIFT rules do not apply to foreign source income, and in 2011 we began to see a few income trust offerings in Canada through which investors were given exposure to US resource-based assets (among others). Eagle Energy Trust and Parallel Energy Trust are examples of this. Argent Energy Trust launched in August 2011 but had to pull back. Look for others to try in 2012, with offerings providing Canadian yield-seeking investors with exposure to other foreign-based asset classes.
8. Cross Border Acquisitions Will Continue to be Structured Through Intermediary Jurisdictions
US buyers in cross-border M&A transactions into Canada will continue to utilize creative acquisition structures, including the continued use of Luxembourg companies and unlimited liability companies (ULCs) created under certain Canadian provincial jurisdictions. Due to the changes in the Canada-US tax treaty which can impact dividends received from a ULC, ownership of the ULCs is more frequently being structured such that there is an intermediary jurisdiction between Canada and the US.
9. Poison Pills May be More Effective as Defensive Tactics
For many years, the view of Canadian securities regulators on shareholder rights plans (commonly referred to as “poison pills”) was that poison pills were strictly limited to the single purpose of helping the board buy time to seek out improved or alternative offers. As a result, in contrast to US practice, poison pills could not be used by a board of directors in Canada as part of a “just say no” defence.
Over the past few years, a series of developments suggested that securities regulators were becoming more flexible in assessing the allowable purposes of poison pills, and that the conventional view that “eventually a pill must go” may be an overstatement, at least where securityholders had given a strong and recent endorsement to the pill or where a bid appeared to be an opportunistic attempt to wrest away control of the company during a difficult economic period.
Although rulings in 2010 and 2011 reversed this trend by reaffirming the traditional view of poison pills, the appropriate role of poison pills as a defensive measure continues to be debated by regulators and market participants. In late 2011, at a public roundtable discussion, the OSC revealed that it is currently reconsidering its historical approach to shareholder rights plans. New proposals being considered include allowing shareholder rights plans to remain outstanding if approved by shareholders, subject to the ongoing rights of shareholders to remove the plan on a “majority of the minority” vote (requiring a bidder to launch a proxy battle or proceed with a permitted bid). The purpose of the rule would be to provide more consistency and certainty in the context of defensive tactics and decrease the need for regulatory intervention. The progress of this proposal will almost certainly be among the most closely-watched developments in Canadian M&A in 2012.
10. Controlled Auctions Will Remain Important
As the M&A market continues to improve, we anticipate that controlled auctions will remain a preferred route for many sellers, particularly in the energy sector where they have been quite common. Because controlled auction transactions have been a major bright spot in the post-2008 Canadian marketplace, particularly in the mid-market, US firms looking for acquisitions north of the border will generally want to remain open to such a transaction as a means of entry into Canada. In its broad outlines, a controlled auction is similar in Canada and the US – however, there are important differences. For example, the Supreme Court of Canada’s 2008 BCE v. 1976 Debentureholders ruling established that Canada does not recognize a strict “Revlon” duty to maximize shareholder value in the context of change-of-control transactions. Instead, a director’s fiduciary duty is defined with respect to longer-term interests of the company and can include consideration of the interests of non-shareholder stakeholders (e.g. creditors or employees). It is not clear how broadly this concept will be applied.
With respect to the procedural aspects of controlled auctions, there is no reason to expect any change to Canada’s tradition of judicial deference to seller-established auction rules.
Finally, since Canada’s recent abolition of withholding tax on interest payments to foreign lenders, we are seeing more private equity and other financial buyers rely on their US-relationship banks for committed financing (often without commitment fees) at early stages of auction processes when success is still uncertain. This is often advisable because Canadian acquisition financing markets are generally more limited than their US counterparts.