2006 Performance
2006 MESSAGE TO UNITHOLDERS | 2006 FINANCIAL AND OPERATING STATS
Message to Unitholders
During 2006, ARC celebrated its 10th anniversary and took time to reflect on its many accomplishments over the last 10 years. ARC has been a leader in the sector in many ways – we were the first to move to a lower payout model thereby preserving more cash for re-investment, the first to incorporate an “exploreco” as a spin out from an acquisition, the first conventional trust to internalize management and one of the first trusts to look solely to internal development to sustain production. One of the things we are the most proud of is our contribution to the communities that we live and work in and to the Canadian economy. To the end of 2006, our cumulative distributions now exceed $2 billion – a significant accomplishment for a trust whose initial public offering was just $180 million.
ARC is proud of its investment in the local economies in western Canada. Since inception, ARC’s cumulative capital spending in western Canada is $1.3 billion. ARC has distributed a total of $2.2 billion in cumulative distributions to its unitholders since 1996 out of $3.1 billion of cash flow. ARC has paid out $1.1 billion in royalties to the provinces it operates in since 1996 and contributed $932 million in operating costs to the economy. All of these contributions add positively to the Canadian economy at large through job creation both in small and large communities, money re-invested by unitholders into the purchase of goods and services and directed to other investments, and monies distributed to people across Canada in the form of distributions, which they in turn use to stimulate the economy in their provinces and communities.
Operationally and financially, 2006 was a record year. We successfully executed a $365 million capital program, drilled 294 gross wells (220 net wells) on our properties and brought 10,000 boes of production on stream. The success of the program was demonstrated by ARC raising its production guidance three times during 2006, with production averaging a record 63,056 boe per day. Continued high commodity prices in 2006 were reflected on ARC’s financial performance with revenue before hedging of $1.2 billion, cash flow of $760 million, distributions of $484 million and net income of $460 million – all new highs for the Trust. Despite all of this, 2006 was one of the most challenging years of our existence. While our business fundamentals remain strong, the Government’s decision to impose a punitive tax on trusts destroyed a billion dollars of value in the hands of our investors. Despite our strong operating results and record cash flow, total unitholder return for the year was a loss of eight per cent as our unit price plunged following the Government’s announcement. The Government’s decision was made without an in-depth understanding of the role that energy trusts play in the Canadian economy. When you look at the October 31st announcement and examine the reasons the Finance Minister provided for his actions, they do not apply to energy trusts:
• There is no firm evidence that tax leakage is occurring from energy trusts and in fact there is strong evidence that Federal and Provincial Government tax revenues are being enhanced by energy trusts. Oil and gas companies have historically paid little tax, but all trust investors pay tax (either now, or in the future in the case of units held in tax deferred accounts) on the distributions they receive. • There is irrefutable evidence that the energy trust sector has demonstrated enhanced productivity when managing mature assets. We believe that the energy trust sector is a major contributor to INCREASED productivity, as productivity is not measured by how much you spend, but how well you spend it. • The Federal Government stated that “Canada stands alone in its treatment of income trusts” – this is simply not true. The United States eliminated “flow-through entities” in 1987, but provided a ten year transition period and exempted resource industries from the measures. Today, there is a strong and growing energy MLP (“Master Limited Partnership”) sector in the United States that controls much of the United States’ energy infrastructure. Over the past two years, we have seen the birth in the United States of Energy LLC’s (“Limited Liability Corporations”), which have been designed to replicate the Canadian energy trust model and conform to United States tax law. • Trusts have played a significant role in bringing Canadian oil and gas reserves under Canadian management and ownership through the repatriation of $10 billion in previously foreign controlled assets.
ARC will continue its support for the Canadian Association of Income Funds and the Coalition of Canadian Energy Trusts as both organizations work to lobby for changes to the new legislation. We are also a founding member of the Canadian Association of Income Trust Investors (“CAITI”), which is an income trust investor advocacy group. We strongly encourage all of our unitholders to join this organization (www.caiti.info) so your voice on this issue can be heard.
Commodity prices remained volatile throughout 2006; reaching record highs on geopolitical instability but declining toward the end of 2006 and into January 2007, because of warm weather, elevated storage levels and an apparent abundance of spare capacity. AECO natural gas, in particular, started off strongly in 2006 and plunged to a low of $3.45 in September before recovering to end the year at $5.69. WTI oil prices were just as volatile, with oil reaching all time highs of $77.03 U.S. per barrel in July before falling off dramatically by year-end. ARC’s strategy of maintaining a balanced production portfolio between oil and natural gas again proved advantageous as strong summer oil prices offset the pain of weak natural gas prices. While commodity prices remain strong, the growth in prices experienced in 2005 and 2006 has dissipated so that many institutional investors have been pulling their money out of energy equities so as to invest in other areas where they believe the prospects may be more attractive for short-term growth. Activity levels in the western Canadian oil and gas sector continue to be high with 22,000 wells drilled. With the high activity levels, utilization rates were high for most of 2006 throughout the oil and gas industry, putting upward pressure on the cost of services and supplies. ARC’s operating costs rose to $8.49 per boe, a 23 per cent increase over 2005 with approximately half of the increase due to the acquisition of high operating cost properties in December 2005. Although operating costs for Redwater and NPCU averaged over $20 per boe in 2006, lower royalties and strong sales prices for the high-quality oil recovered on these properties offset the higher operating costs so that the netbacks from these properties were among our highest.
The continued increases in the cost of services and supplies are creating significant challenges for the industry as it struggles to ensure that returns from investing in western Canada remain competitive with opportunities elsewhere. The area where increased costs have had the most impact on ARC is in finding, development and acquisition [“FD&A”] costs. In 2006 ARC’s FD&A costs increased to $22.41 per boe ($27.20 including future development costs) bringing our three year average up to $15.59 ($18.99 including future development costs). While a portion of the cost increases can be attributed to a significant increase in non-reserve adding activities – such as buying land and the initial funding for several significant enhanced oil recovery projects – the increase in the costs of services and supplies to execute the development program was significant. For western Canada to remain a competitive place to deploy capital, the double digit cost increases need to stop. We are starting to see indications that costs have reached a peak and are heading back down. Rig utilization rates were 75 per cent at the beginning of 2007, sharply down from the 95 per cent utilization rates at the same time last year and we are starting to see a roll back of prices from many of our service providers.
Looking forward, I believe that 2007 will be seen as the start of a new era for ARC as we begin to deploy capital towards the utilization of CO2 for enhanced oil recovery (“EOR”).
ARC began preliminary work in 2006 on its CO2 program by evaluating the Redwater reservoir to better understand it geologically, and to identify areas best suited for CO2 flooding within the reservoir. ARC has performed detailed technical analysis of the Redwater reservoir and fluids and is developing preliminary designs for a CO2 pilot plan for the Redwater area. In the Pembina area, ARC began miscibility testing of the reservoir fluids to determine their response to CO2. While enhanced oil recovery utilizing CO2 shows great promise to increase the oil ultimately recovered from the reservoir and to increase production, there are significant technical risks and uncertainty. Successful CO2 projects in Canada are dependent on various factors including: a source of commercially viable CO2, government legislation on CO2 emissions, and the construction of infrastructure to transport the CO2. Over the long-term, I believe that these reservoirs will play an important role in helping Canada achieve its objectives of lowering CO2 emissions. We remain very optimistic about future value creation for our CO2 EOR activities, despite the significant capital required to make this a reality.
ARC views itself as being an oil and gas entity that is structured as a trust. While there are challenges ahead of us, we believe the oil and gas industry is fundamentally sound and that the companies or trusts that have the best assets and the best people will continue to outperform. ARC’s focus will continue to be on developing and acquiring high quality assets. What has changed as a result of the government announcement? Our cost of capital has gone up and our access to capital has gone down. Therefore we will have to carefully review any project that is particularly capital intensive and / or has a lower rate of return to ensure that they are still economic under the new regime.
The most important fact to keep in mind is that ARC is a disciplined oil and gas company, with high quality assets, a low cost structure and an organization that has consistently delivered results. We believe the combination of these three things will allow ARC to continue to provide strong returns to its investors now and in the future. ARC has a robust $360 million capital program planned for 2007 that is intended to maintain ARC’s production at 63,000 boe per day. It remains business-as-usual at ARC.
John P. Dielwart
President and Chief Executive Officer
• How do our 2006 numbers measure up? Click here to find out.