Who's next in oil and gas consolidation? - Capital Ideas

With the recent oil and gas takeover announcements in Western Canada, one must wonder whether Calgary is up for sale.

Since April of last year there have been almost 20 significant transactions in the oilpatch, ranging from the $186 million takeover of Ionic by the oil and gas royalty trust Shiningbank Energy Income Fund to the $3.4 billion Canadian Hunter-Burlington deal.

More than $20 billion in merger and acquisition activity has been completed as U.S. firms buy Canadian companies.

Several observations can be made to explain the consolidation:

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Using the usual basic yardsticks, such as price-to-cash flow, cash flow-to-debt and market price related to net asset value, Canadian stocks generally are still not that expensive. When anything is cheap, it attracts takeover activity.
Why take the risk if you can buy the whole company? The view seems to be that it can be cheaper and less risky to buy on Bay Street and integrate operations than it is to drill in Alberta.
Gas stocks, such as Anderson Exploration and Canadian Hunter, and oil stocks, such as Gulf Canada, have been bought. What are being sought are energy reserves.

The strong U.S. dollar has mighty buying power. Nothing beats buying a dollar of assets with 64 cents.
Interest rates are low, and lots of buyers are using leverage to buy rather than diluting themselves through share offerings, because the cost to carry the loan is low.
Oil and gas, like grain and livestock commodities, fluctuate in price, causing energy stocks to go up and down.

I believe that in the future, the United States will be willing to pay a premium to obtain energy from a “friendly and stable” source like Canada.

As a result, we believe more takeovers are coming. Who’s next?

Speculation abounds, but here are the names most frequently mentioned.

Rio Alto is at the top of the list.

Trading volumes have been well above average, suggesting that where there’s smoke, there could be fire.

Analysts on the street have targets exceeding $28 per share.

Fundamentally, Rio Alto is not the quality of some of the other names in the market.

At its $24.77 closing price on Oct. 29, it looks a little late to play this one because the stock has run up from a 52-week low of $16.97 in early October.

Husky Oil finally confessed that it was in play, then almost immediately said talks had broken down.

Analysts have been frustrated with this company. Consequently, its valuation has tended to lag behind the other integrated oil companies.

Hong Kong-based billionaire Li Ka- Shing is the major shareholder and has been rumoured to be a willing seller.

At current levels, the downside appears limited and the company pays a dividend for a two percent yield.

I would consider this stock on weakness.

Pan Canadian Petroleum is regarded as one of Canada’s gems in the oilpatch.

This $10 billion market capital company has one of the best land banks in the country and is set to significantly increase its gas production over the next several years.

With control out of Canadian Pacific’s hands, it’s now vulnerable to a takeover, despite its premium valuation of 5.6 times estimated cash flow in 2002.

I would look at Pan Canadian as a core position based on fundamentals, with the potential of a takeover as a sweetener.

Others mentioned from time to time as potential takeover candidates include Alberta Energy, Penn West Petroleum and junior companies such as Vermilion and Storm Energy.

The bottom line when considering the activity taking place in the oilpatch is that although current economic conditions are putting a damper on energy demands, energy drives North America and will turn when the economy turns.

Long-term strategic buyers will continue to look for ways to acquire energy reserves to fuel this demand.

Ian Morrison is a financial consultant with Wood Gundy Private Client Investments in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. This article is for information only. Morrison can be reached at 800-332-1407 or by e-mail at ian.morrison@cibc.ca.