Two For The Price Of One

In the bull market of the 1990s, investors greeted each new corporate merger with breathless excitement. The typical reaction today, in contrast, is a collective yawn (at best) or a major selloff of the joining parties’ shares (at worst).

That makes the proposed marriage between oil and gas producer trusts Harvest Energy (HTE.UN, NYSE: HTE) and Viking Energy (VKR.UN, OTC: VKERF) unique. Since the two trusts announced they were joining forces on November 28, their units have tacked on substantial gains. That’s even factoring in the favorable impact of the Canadian government’s decision not to change the tax treatment of trusts.

The credit markets have been even more effusive in their praise of the deal. The Dominion Bond Rating Service has put stability ratings of both trusts under review for a potential upgrade. Both currently merit a rating of STA-6. An upgrade would put the combined entity on a par with the stronger players in the industry.

It’s not hard to see the appeal of the deal. On their own, Harvest and Viking were fast-growing trusts but also relatively small. With oil and natural gas prices at today’s lofty levels, small--and large--players can thrive. But the further industry cost pressures build, the less competitive they become for acquiring and developing new resources, as well as dealing with the inevitable ups and downs of a volatile commodity market like energy.

Unfortunately, cost pressures look almost certain to increase in the coming months. Aggressive drilling plans by producers have increased demand for rigs and oilfield services, hence their cost. And there’s increasingly a shortage of qualified workers in the industry, which forces producers to pay higher salaries and bonuses.

With an initial enterprise value of CD4 billion, the larger trust will have a much easier time meeting these demands than the two trusts ever could individually. By creating the fourth largest oil and gas trust—which will keep the Harvest name and TSX/NYSE trading symbols—this deal should do that for these trusts. The combination will have daily production of 64,000 barrels of oil equivalent. About 75 percent of output will come from oil and gas liquids (about half valuable “light” oil) and the balance from natural gas output.

The new trust will also enjoy much improved access to capital in the equity and debt market than either trust had individually, particularly if DBRS raises ratings. Most, if not all, capital spending is expected to be met from cash flow in 2006 and very likely for at least two more years after that. Debt at 1.1 times cash flow is higher than some trusts, but still quite manageable. And it won’t rise appreciably on the merger given its stock-for-stock basis.

The payout ratio—dividends as a percentage of distributable cash flow—is anticipated to be 65 to 70 percent in the merger’s first year, based on the current commodity price environment. That’s a bit above the payout ratios of both trusts based on third quarter earnings. But it provides a great deal of flexibility for the much larger trust they’ll form, which has targeted a payout of 55 to 80 percent during the long term. It’s also competitive with other solid trusts, and it builds in some protection against a drop in energy prices, particularly light oil.

The merger will also present numerous cost-cutting and joint development opportunities. That’s in large part because the two trusts have overlapping properties in Alberta. The combination will also have a hefty underdeveloped land base (estimated 760,000 acres) and drilling inventory, along with proven reserves (90 percent or better odds of development) estimated at 7.2 years at current output levels. In addition, operatorship of properties is high at 85 percent, giving management the ability to slash costs where needed.

Under the terms of the deal, Harvest shareholders will see no real changes to their holdings, as shares will be exchanged on a 1-1 basis. In fact, the only real difference will be an increase in the monthly dividend to 38 cents Canadian from the prior 35 cents Canadian. That will happen as soon as the deal can win needed regulatory approvals and close, which is expected by March 2006.

If there's a drawback to this deal, it concerns Viking investors. Under the merger’s terms, each Viking share will receive 0.25 Harvest shares. As a result, the effective dividend per Viking share will drop from a current level of around 48 cents Canadian per share. Given the trust’s pre-deal yield of some 16 percent, however, that was certainly priced in. Moreover, as a prospective part of Harvest, the shares are already earning a better yield multiple than they were previously.

From now until this deal closes, these two oil and gas trusts are going to be affected by two major forces. First, both will gain ground if oil and gas prices rise further from here and will give it up if energy prices slip. Second, as the merger nears consummation—seemingly almost a sure thing—both trusts’ shares should gain ground, particularly if energy prices stay strong.

Harvest's and Viking's taxation situation appears secure, with the Canadian government electing to leave the industry alone and their home province of Alberta abstaining from imposing a new tax on US investors, at least for now. Here in the US, dividends on both trusts are considered qualified for tax purposes, taxable at a maximum rate of 15 percent.

There is a 15 percent withholding by Canadian authorities for both trusts’ dividends, and will presumably remain after the trusts combine. As is the case with all trusts, this can be reclaimed when you file your US taxes, if you hold them outside an IRA. If you hold them inside an IRA or other tax-deferred account, you’ll have to eat the withholding. But you won’t owe any US tax.

For investors who hold both Harvest and Viking—which have been periodically recommended in Canadian Edge—there’s nothing wrong with holding onto all your shares until the deal is completed. If the combination is an inordinately large part of your portfolio, take some money off the table.

For someone looking to buy into the deal now, the best bet is Harvest for no other reason than that it trades NYSE and is easier to trade. Even the most Neanderthal of brokerages should be able to buy shares with low commissions and no additional fees. And it should get the tax situation straight. Both trusts, however, remain solid buys at current prices and an adept broker should have no problem getting Viking shares for you economically. Buy Harvest up to USD33 and Viking up to USD9.