Capital Starting To Redeploy To The U.S. Six Weeks After The Federal Liberal Feb 27 Budget
Apr 5, 2018
No one should be surprised to see the start of US companies selling Cdn assets to redeploy the cash into US operations. On Monday, NextEra announced the US$582.3 million sale of its Cdn wind and solar assets to CPP Investment Board, a sale driven by NextEra’s desire to redeploy capital to the US to take advantage of US tax reform bringing lower corporate taxes and significantly better write off rates for capital expenditures. Why now? Prior to the federal Liberal Feb 27 budget, companies had two months to analyze the advantages of US tax reform. With no changes in the Feb 27 budget and no indication if any changes would be forthcoming, companies can’t wait any longer to take action on capital allocation. Capital allocation is one of the most important board decisions, and these decisions are now being done on the basis of improved economic returns for US capital opportunities vs unchanged economic returns for Cdn capital opportunities. Its why we expect to see more of these sales and also for capital spending being shifted to the US over Canada. US tax reform advantages will impact capital allocation decisions in all sectors, but not necessarily as much as might be expected in the Cdn oil and gas sector. The top Cdn oil and gas plays have economics as good if not better than the top US plays and therefore relative capital allocation shouldn’t suffer. In fact, this was proven this week with ConocoPhillips stepping up to expand its liquids rich Montney land position. And well funded Cdn companies will be able to buy more quality Cdn assets that wouldn’t be available prior to US tax reform. Unfortunately, most investors will not look thru to see that these top Cdn oil and gas plays (and the top Cdn oil and gas companies) have as good or better economics than the top US plays even after US tax reform. Rather, they see the narrative of improving US fiscal regime and lack of response from Canada and move more capital to US opportunities keeping the top Cdn oil and gas companies trading at low multiples.
NextEra’s US$582.3 million sale of its Cdn solar/wind assets was driven by US tax reform advantages to reallocate capital to US. On Monday morning, NextEra Energy Partners announced it was selling its wind/solar assets in Ontario CPP Investment Board for US$582.3 million. This transaction went under the radar until Claudia Cattaneo’s Financial Post story “Lack of Canadian tax competitiveness discourages even renewable energy – The NextEra sale is seen in the energy sector as being specifically related to taxation. It’s likely the first of many such deals” [LINK]. The Financial Post noted how the transaction was linked to US tax reform, and included NextEra CEO’s comments “As discussed during our earnings call in January, we expect the sale of the Canadian portfolio to enable us to recycle capital back into U.S. assets, which benefit from a longer federal income tax shield and a lower effective corporate tax rate, allowing NextEra Energy Partners to retain more CAFD in the future for every $1 invested.” He made it clear – it all about capital allocation. We had the opportunity to speak with her on the story and wanted to expand on our views and the implications for the sector.
Its all about capital allocation decisions – NextEra said in Jan that US tax reform changes meant that NextEra wants to redeploy capital from Canada to the US. Our Jan 28, 2018 Energy Tidbits memo highlighted NextEra’s Q4 earnings call, wherein NextEra clearly warned that US tax reform was the motivating factor for looking to sell its Cdn wind and solar projects. At that time, we wrote “(ii) US tax reform is creating an opportunity to sell its Cdn operations. Pg 11 and 12, Q&A “Yes. We are looking at – as a result of tax reform, Stephen, we are looking at some optimization opportunities around our international portfolio. There is a difference between the federal income tax shield in the U.S. and in Canada after the results of tax reform have come through. So this has pinpointed a potential capital recycling opportunity, where we may be able to sell the assets in the Canadian portfolio and then use those proceeds to reinvest either in third-party M&A opportunities or acquisitions from Energy Resources or to support our organic growth program. And by reinvesting those proceeds in the U.S., what that does is it has the effect of actually creating more CAFD for every dollar invested. And because of that, it puts us in a position where we could extend our runway, our financial expectations and extend the need for common equity. So it’s kind of a very interesting opportunity that we continue to evaluate here internally.”
No one should be surprised with more transactions of US companies selling Cdn assets. Lets not forget its only been six weeks since the Liberal federal budget on Feb 27, which is when the federal Liberal govt decided to not take any near term action to counter the benefits from US tax reform. US companies with Cdn operations and Cdn companies with US operations had two months prior to the Feb 27 budget to analyze the US tax reform advantages (in particular lower tax rate and faster writeoffs for capital spending) and compare against the then current Cdn fiscal regime. The Feb 27 budget did not include any specific items to offset the benefits of US tax reform. Prior to the budget, Finance Minister Bill Morneau was asked about how the budget would counter US tax reform and was widely quoted “We are doing our analysis to make sure that we understand the impact of any changes … to make sure we get it right and not to act in an impulsive way”. Since the Feb 27 budget, Morneau has not give any specific timing for when he will complete his analysis or if there will be any actions therefrom. It is why no one should be surprised that we are starting to see transactions that will allow for capital to be deployed out of Canada and into the US. Its all about capital allocation. This is exactly in line with NextEra’s Q4 call comments – they were evaluating internally in Jan/Feb, but took action after the Feb 27 budget. This is not just oil and gas, it will be for any sector.
Perhaps more importantly, companies will shift capital spending from Canada to the US. Its not just M&A and the ownership of assets that is being impacted, it will be capital allocation in the near term (ie. 2018 and 2019) between capex opportunities in Canada vs the US for companies that operate on both sides of the border. In fact, it is even more important for the economy when capital spending gets reallocated out of Canada and into the US. We wrote in our Feb 11, 2018 Energy Tidbits “We also believe US tax reform sets up more potential Cdn asset sales, and sets up more capital allocation to US plays by Cdn producers that also have US operations, and also some companies looking to move domiciles to the US.” Most oil and gas companies set 2018 capex budgets before US tax reform and would have allocated capital based on the relative economics of US vs Canada at that time. If that capital allocation analysis was redone after Feb 27, the US capital opportunities (ie. US oil or gas plays economics) would have increased economic returns and the Cdn capital opportunities would have unchanged economic returns. The better economics should have moved some US wells higher in the ranking priority for capital allocation. Capital allocation decisions are among the most important stewardship decisions by boards, which is why we believe the increased relative economic returns for US capital opportunities has to result in a shifting of the 2018 capex budgets where possible to the US. The level of the shifting will depend on the relative quality of the Cdn assets vs the US assets ie some plays like the condensate rich Montney would still rank at or near the top and not be bumped off their top economic ranking. But it would be difficult for a company to defend why they aren’t allocating more capex to the US in light of improved economics post US tax reform compared to unchanged Cdn economics post the Feb 27 budget.
Canada’s top oil and gas plays will still win a relative capital allocation decision – Conoco’s Montney expansion reminded of this, even post US tax reform. The good news for the Cdn oil and gas sector is the top Cdn oil and gas plays have as good or better economics than the top US plays. This means that the shifting of capex shouldn’t really impact these top Cdn oil and gas plays. There was proof of this view this week with the ConocoPhillips April 2 release [LINK] “ConocoPhillips Provides Update on Disposition Program and Recent Acreage Additions” that updated capital allocation on disposing of non-core and “adding high-value resource opportunities for future investment”. COP is completing its non-core dispositions in Q2/18 that included Q1/18 sale of ~US$250 million of “several small packages in the Permian Basin” and the expected closing of a “package of largely undeveloped acreage in South Texas”. The release noted the two areas of adding high-value future opportunities – one was an undisclosed price for its “acquired 245 thousand net acres of early life-cycle unconventional acreage in the Lower 48 for very low entry cost”, now named as Austin Chalk play in central Louisiana. The other was liquids rich Montney. COP said “The company also announced it recently acquired about 35 thousand net acres in the Montney play in Canada for approximately $120 million. This additional acreage is adjacent to the company’s existing position in the liquids-rich portion of the Montney. The company now holds approximately 140 thousand net acres in the liquids-rich Montney play, with appraisal underway. Exploration and appraisal activity in the Montney will also be funded within the existing exploration budget. “We have been laser focused on strengthening our portfolio by divesting non-core properties, while adding high-value resource opportunities for future investment,” said Matt Fox, executive vice president, Strategy, Exploration and Technology. “The acreage we’ve acquired in Louisiana and the Montney has the potential to add to our low cost of supply resource base without requiring significant near-term capital commitments.”
The winners will be well funded Cdn companies buying quality assets. It is important to remember the economics of the Cdn opportunities are unchanged for now. Its that Cdn opportunities have lost ground to US opportunities that have improved economics post US tax reform. And as seen by the NextEra/CPP deal, US tax reform brought quality Cdn assets for sale. This should also provide the opportunity for well funded Cdn companies, including the oil and gas , to buy quality Cdn assets with unchanged economics that are now available for sale and likely for a slightly more attractive (lower) price. We expect this redeployment of capital activity to increase as US companies move to bring capital back to the US in 2018. And who knows, maybe Morneau’s analysis will lead to some action to make the Cdn economics a little better and not just unchanged.
Unfortunately, most investors don’t look thru to see that the top Cdn oil and gas plays and companies still have as good or better economics than the US peers even after US tax reform. One of the market disappointments remains how the top Cdn oil and gas companies continue to significantly underperform the US peers, even in a world of $60 oil. This is especially puzzling for the top Cdn light oil producers and condensate rich Montney producers who aren’t impacted by wider Cdn heavy oil or AECO differentials. The ConocoPhillips expansion of its liquid rich Montney this week reinforces that the top Cdn plays compete against the top US plays. Unfortunately, most investors do not look thru to see that these top Cdn oil and gas plays (and the top oil and gas companies) have as good or better economics than the top US plays even after US tax reform. Rather, most investors continue to see the narrative of improving US fiscal regime and lack of response from Canada and move more investor capital to US opportunities.