Tax loss carryforwards are important

They comprise an underalued asset of some energy companies

I am thankful to Burnsco@garquake for posting this chart which sets out the magnitude of the tax losses carried forward by key Canadian Exploration and Development companies. What is clear is that ARC Resources (ARX.TO), Tourmaline Oil (TOU.TO), Whitecap (WCP.TO) , Crescent Point (CPG.TO) , MEG Energy (MEG.TO) and Athabasca (ATH.TO) have tax losses that are material assets in that they can not only be used to defray future tax exposure but also may be assets valued by taxable oil & gas companies who look to mergers or acquisitions to acquire tax losses while expanding their own operating base.

Source: Twitter burnsco@garquake

Taxable oil & gas companies can acquire other oil & gas companies with tax losses and may be able to apply the tax losses to their own operations gaining an immediate benefit equal to the taxes avoided or recovered. Take Cenovus (CVE.TO) for example, a currently taxable company. In 2021, the company paid CAD$728 million of taxes on income of CAD$1.3 billion. Athabasca (ATH.TO) has tax pools of ~CAD$3 billion and a market capitalization of about CAD$1.2 billion. If Cenovus were to bid CAD$4.00 per share for Athabasca they are likely to succeed and would have to pay just over CAD$2 billion for the company, but get an immediate benefit of ~$1 billion from the tax benefit of the Athabasca tax pools, effectively buying the company for less than its current trading value. The trading value of CAD$1.2 billion is well supported by Athabasca assets which are generating cash flow of an estimated CAD$300 million and free cash flow for 2022 of ~CAD$180 million, according to the company. The market seems to place no value on Athabasca’s tax pools.

MEG Energy is similarly trading as if the CAD$6.5 billion of tax pools had no value. MEG cash flow for 2022 is projected at CAD$2 billion (Q1 cash flow was CAD$587 million) and the market values the company at an enterprise value of ~CAD$6.5 billion (308 million shares at CAD$15 plus net debt of CAD$2 billion). If Suncor were to bid CAD$20 a share for MEG stock they might be successful and for CAD$8 billion (including acquired debt) get an immediate benefit of CAD$1.4 billion in tax recoveries (the amount they paid in 2021) and ongoing tax avoidance of at least another CAD$1 billion, effectively adding 100,000 barrels a day of production currently generating CAD$2 billion of annual cash flow (CAD$1.6 billion of free cash flow) for a net economic cost of CAD$5.6 billion or 2.8 times current levels of cash flow. The market seems to place no value on MEG’s tax pools.

Similar logic supports other M&A ideas. What about Tourmaline acquiring ARC on a share exchange? Canadian Natural Resources acquiring either Whitecap or Crescent Point on a share exchange?

I think M&A activity will continue to consolidate activities in the Canadian oil patch. A portfolio of target companies may outperform a similar portfolio of logical acquirers but both are sensible holdings.

Canadian tax laws are complex and professional tax advice would be essential to any acquirer hoping to make use of acquired tax losses. Here is a summary of the rules by a Canadian law firm. No one should assume the summary will apply to the particulars of any two entities contemplating a merger or other business combination, but investors should appreciate that the tax losses on the books of some E&P’s are nonetheless valuable assets typically ignored by the market.