ENERGY TRUSTS -- KEY TO WESTERN PROSPERITY

Canadian Energy Trusts:
An Integral Component of the Canadian Oil and Gas Industry

Excerpted from CCET Report

Executive Summary

This report summarizes the perspective of the Coalition of Canadian Energy
Trusts (“CCET”) regarding the Government of Canada’s announcement of
October 31, 2006 with respect to energy trusts. The CCET also fully supports
the initiatives of the Canadian Association of Income Funds (“CAIF”) in regard
to reconsideration of the tax proposals made by the Minister of Finance.
Do Energy Trusts Cause Federal Tax Leakage?

No. Federal and provincial government revenues are actually enhanced by the
energy trust structure. During the past five years, CCET member trusts have
generated greater taxes both provincially and federally than would have
occurred had they been structured as corporations.

In 2005, the oil and gas trust sector generated over 30 percent of the tax
revenue collected from publicly-traded Canadian entities in the oil and gas
sector while representing only 16 percent of the revenue. Oil and gas royalty
trusts have also generated over 40 percent more taxes than Canadian publiclytraded
senior independent producers on a unit-of-production basis.

The capital intensity of oil and gas exploration and production generates
significant tax pools. As a result, oil and gas exploration and production
corporations have historically paid minimal corporate taxes. In contrast,
distributions from energy trusts generate:
• current personal income taxes from Canadians;
• additional tax from compounding investment in tax-deferred accounts; and
• a 15 to 25 percent withholding tax from foreign investors.

Because most CCET unitholders live outside Alberta, where all energy trusts
are based, Canadians throughout the country share in the distributions paid and
their provinces of residence benefit through hundreds of millions of dollars of
increased tax revenues. Alberta, in turn, receives the benefit of additional
royalties on mature oil and gas producing assets, spending on goods and
services in the province, employment and associated taxes, and all of the
ancillary economic spin-offs associated with increased activity.

Other Tax Considerations

• As long as there is no reduction in total tax paid, sources should be
irrelevant to the government, especially given that the government is
currently experiencing surpluses from its tax revenue collections.

• The federal government surplus is supported by taxes being collected
directly on distributions and from taxes being paid on retirement plan
withdrawals.

• Canadians’ retirement plans are “tax-deferred”, not “tax exempt”.

• Trust distributions in tax-deferred accounts act as huge savings accounts for
the government and serve to increase government tax revenues because:
- there is a gain to government revenues when trusts or other securities
are held inside tax-deferred accounts; and
- the tax cost of the contributions in any given year is offset by taxes
collected on the withdrawals in any given year.

• The existing 15 to 25 percent withholding tax on distributions to foreign
investors generates substantial revenues to the government, without any
corresponding use of services or infrastructure.

• Should a significant portion of the trust’s assets revert to foreign ownership,
tax value will most likely leave the country in the form of deductible interest
in Canada which will be subject to only 0 to 10 percent withholding tax and
from taxation of capital gains in foreign jurisdictions and not taxed in
Canada.

Do Energy Trusts Threaten Canada’s Long-term Economic Growth?

On the contrary, energy trusts are the ideal model for Canada’s mature
hydrocarbon basins. Since their introduction in 1986, they have played a unique
role in maximizing oil and gas production and reserve recovery and providing
essential capital to Canada’s energy industry.

The Western Canada Sedimentary Basin (“WCSB”) has matured rapidly in the
past twenty years. Despite record levels of drilling activity and capital spending:

• Canadian conventional light oil production has entered a decline phase with
production dropping at 3.4 percent per year since 1997; and

• Canadian natural gas production has only remained flat since 2000.

Other evidence of the maturation of Canada’s most prolific hydrocarbon basin is
as follows:

• capital spending in conventional assets, excluding oil sands, has doubled
since 2002;

• annual drilling activity has increased 500 percent since 1992;

• the cumulative number of wells drilled in the WCSB has more than doubled
in the last 13 years, but with ever-diminishing returns as production per well
continues to fall;

• limited incremental conventional oil opportunities exist as annual oil drilling
activities have remained flat since 2002 despite significant increases in
commodity prices and capital spending in the WCSB;

• with the producing well count increasing, the average per well oil productivity
has declined at 4.6 percent per year since 1994;

• the basin’s conventional prospects are now predominately natural gas pools,
with over 70 percent of conventional wells drilled in the WCSB targeting gas
in 2005; and

• natural gas production has reached a plateau as average natural gas per
well productivity has declined 9.2 percent per year since 1996.

Investors expect oil and gas producers organized as corporations to grow
production. Growth is increasingly difficult in the WCSB, where new gas well
production can decline as much as 30 percent in the first year. This is the socalled
“treadmill” effect as oil and gas producers have to reinvest much of their
cash flow just to keep production flat.

Oil and gas royalty trusts have a sustainability mandate. With a successful
history of optimizing assets and increasing productivity, this model has
demonstrated improved capital efficiencies over exploration and production
corporations with conventional WCSB operations.

For oil and gas trusts, there is an urgent requirement to reinvest cash flow to
maintain production. This is one of the major differentiators of royalty trusts from
business trusts.

Energy trusts have an important symbiotic relationship within the energy
industry. The oil and gas royalty trusts:

• buy and enhance mature assets from senior producers;

• are the logical buyers of juniors’ assets once they have proven up new
reserves and seek to monetize value, often providing a catalyst for
successful junior management teams to re-capitalize new companies,
creating more economic activity;

• have injected over $17 billion of new capital into the energy sector in the last
five years, much of which has been redistributed to the other producer subgroups
in the sector;

• have themselves invested over $15 billion in the last five years into lower
risk / lower return projects aligned with the objectives of the trust’s incomeoriented
investor base to optimize mature fields, enhancing the ultimate
recovery of Canada’s oil and gas resources; and

• have repatriated approximately $10 billion of assets from foreign control
during the past ten years. Many of these assets are being aggressively
optimized by the energy trusts, providing additional production and reserves
with minimal impact to the environment.

The government’s proposed tax changes would force trusts back into a
corporate structure that is less efficient for mature oil and gas assets, reducing
tax revenue for both provincial and federal governments.

Evolution of Canada’s Energy Industry

Conventional finding and development costs are up substantially in the last five
years, while unit operating costs have more than doubled. The combination of
higher costs and lower production and reserve expectations has made it more
difficult for energy producers to invest profitably in the WCSB. Those factors
have driven senior producers to seek their growth opportunities outside
Canada, to reduce their production growth expectations in the WCSB and to
pursue development of Alberta’s oil sands.

Senior producers and their peers have been selling their mature WCSB
properties to energy trusts, which have become expert at maximizing the
resource recovery out of these mature reservoirs. With the lower cost structure
and lower cost of capital that results from the alignment of unitholder objectives
to the asset base and the business plan, energy trusts are able to exploit and
extend mature property opportunities that would be uneconomic to other
producers.

This provides more oil and natural gas from existing pools without
intensive capital and infrastructure development of the type required for oil
sands development. From an environmental point of view, a considerable
number of these mature properties conserve waste gases, utilize efficient power
sources and have significant potential for greenhouse gas sequestration.

Although newer Canadian conventional hydrocarbon basins outside the WCSB
are promising, they remain underexploited due to a number of factors. These
include remoteness from markets, lack of infrastructure or unsettled land
claims, such as is the case with the Mackenzie Valley and Delta; a lack of new
discoveries, such as in offshore Newfoundland; and moratoriums on exploration
such as offshore BC. Optimal recovery from the WCSB remains critical to
Canada’s conventional oil and gas industry.

Environmental Considerations

Perhaps the most significant unintended consequence of the government’s
proposed tax changes relates to the environment, which is important to all
Canadians. Canada’s greenhouse gas (“GHG”) challenges are well
documented. As the WCSB has matured, ownership and control of the vast
majority of Canada’s legacy conventional oil reservoirs has transferred to the oil
and gas trust sector. The large corporations chose not to retain control of these
properties and pursue enhanced oil recovery (“EOR”) activities through CO2
injection, instead selling the majority of these large ‘in-place’ oil reserve assets
to the trusts.

The oil and gas trust sector’s low cost of capital and business model has
allowed these projects to become more attractive economically such that trusts
are now at the forefront of CO2 sequestration initiatives. In two large fields
alone, Pembina and Redwater, CO2 EOR projects could reduce emissions of
GHG to the atmosphere by 30,000 tonnes per day, or 11 million tonnes
annually. These projects represent the only truly meaningful opportunities to
dramatically reduce Canada’s GHG emissions in the near term.

Unfortunately these projects would be targeted to come on stream around
2011, just as the government’s revised tax treatment for trusts would come into
effect. The proposed changes will drive energy trusts back into a corporate
model.

As history has shown, this business model and a growth-oriented investor base
is not aligned with the pursuit of CO2 EOR projects in Alberta. At the very least
these projects will be delayed but more likely many may not proceed at all.

Social Considerations

Canadian energy trusts focus on optimizing existing conventional oil and gas
pools. This focus on optimization extends the effective working life of mature oil
and gas fields, providing continued direct and indirect economic benefits,
including future employment opportunities and municipal and county taxes, to
the many Western Canadian communities where trusts operate as well as to
the provincial treasuries. Additionally it creates new productivity in areas with
infrastructure, gas conservation and future potential for greenhouse gas
sequestration.

Other Unintended Consequences

Whenever major changes are made to government policies without consultation
of affected parties, unintended consequences result. In this case, these include:

• massive capital losses to millions of individual investors, on the order of $14
billion, and the associated lost tax revenue;

• reduced or lost income for millions of investors, many of whom depend on
this income to live;

• a ripple effect of reduced income for economic spending and lost investment
value for millions of Canadians, including charitable organizations;

• exposing Canadian corporations to leveraged buy-out groups seeking to
acquire intermediate-sized corporations;

• loss of head office jobs as management control leaves the country;

• a shifting of focus from implementing improved, energy-efficient optimization
methods on existing developed pools to less energy-efficient, grassroots
mega projects. This in turn imposes tremendous strain on infrastructure,
available labour and project costs; and

• ultimately reduced production and lower recovery of Canada’s oil and gas
reserves.

Without the trust structure companies will be forced to choose higher return
grassroots mega projects over lower return optimization of mature fields. With
the trust structure both types of projects can exist in harmony, ultimately
maximizing the recovery of Canada’s hydrocarbon resources.

Did Canada Stand Alone in its Treatment of Trusts Before These
Changes?

No. The U.S. did eliminate flow-through entities (“FTEs”) in 1987 but provided a
ten-year transition period, plus life thereafter upon electing to pay a 3.5 gross
income tax. This to be compared with the four years proposed in the “Tax
Fairness Plan”.

Further, the U.S. excluded Real Estate Investment Trusts (“REITs”) and explicitly exempted resource industries from the measures.

Ironically, the government’s proposed new tax will effectively eliminate the trust
structure in Canada’s resource sector just as that structure expands in the U.S.
Acting consistently with the U.S. would mean exempting the resource sector
and providing other trusts with a ten year transition period.

Conclusions

Energy trusts are different from other trusts by virtue of their very high
reinvestment requirements and their role in maintaining Canadian oil and
gas production. The proposed changes will have many unintended
effects, including the diminution of Canada’s energy supply.
Exempting energy trusts from the proposed tax changes is the only
sensible course of action for this government. Failure to do so will be
counter-productive to the government’s own stated reasons for acting.

Excerpted from: A Report By The Canadian Coalition Of Energy Trusts