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One question investors should be asking about new dividend-focused E&P companies in the Canadian oil patch is: How will they pay their taxes?

Deferring income tax payments is a major part of the business strategy for most junior E&Ps -- one that investors don't realize. Investors have become so used to junior producers (almost) never paying taxes, it's hard to imagine how paying taxes could affect valuations (read: stock prices).

Oil and gas companies typically build up "tax pools" -- credits that can be claimed against income -- as a result of their capital spending programs, on drilling wells and building facilities.

But income-focused E&Ps are today slowing their capital spending programs, choosing to divert more cash flow into dividends and less into drilling. Whitecap Resources (OTC:SPGYF) for example, announced it will reduce capital spending to approximately 63% of cash flow.

Lower capital spending means these companies generate fewer tax pools. Companies pay more tax, sooner-reducing cash flow. Valuations -- as a multiple of cash flow, and net present value of in-ground oil and gas reserves -- then decline, meaning lower share prices.

A hypothetical example goes like this: ABC Oil cash-flows $100 million per year -- entirely tax-sheltered by its tax pools. It trades at a five-times multiple valuation of $500 million. The company has 100 million shares out, so enjoys a $5 stock price.

But now drilling slows, and tax pools are used up. ABC's $100 million cash flow now becomes taxable -- $25 million is lost to the government (Alberta's all-in corporate tax is about 25%). Earnings drop to $75 million yearly, and the valuation slides to $375 million. The share price falls to $3.75.

This is potentially a big deal, especially for smaller companies: many E&Ps have avoided paying taxes completely over the last several years because of their spending-driven tax credits.

Whitecap stated in its last annual information form that management did not expect the company to be taxable until 2015. Renegade Petroleum (OTC:RPTTF) -- also announced converter to the income model -- estimated it wouldn't become taxable until late 2013 or early 2014.

Deferring taxes helps these companies in a few ways. First and foremost, it boosts their available cash flow, giving them greater scope for exploration work, and property or corporate acquisitions.

Deferred taxes also affect the net present value for an E&P's in-ground oil and gas reserves as reported every year. Companies show values for their un-pumped petroleum in two ways: the before-tax value and the after-tax value.

Deducting cash flow for taxes reduces the after-tax NPV (the number most analysts look at) -- all the more so on a percentage basis, when taxes kick in during nearer years that carry higher, less-discounted values.

Some analysts even believe that small E&Ps are unviable after they become taxable -- as a start-up, you need that extra oomph in cash flow in order to establish company-building fields.

The drive to stay sheltered from taxes even led to a movement (largely done with now) to re-structure failed technology companies into junior E&Ps in order to take advantage of huge, transferable R&D tax credits racked up by these companies. Trafalgar Energy, which later became Midway Energy -- which was acquired last year by Whitecap -- was one such restructured "tax-loss" company.

Exploration Versus Development

Tax credits applicable to E&Ps come in several forms. The most important are:

• Canadian Exploration Expenses - costs associated with drilling and completing wells on unproven exploration targets (100% deductible annually)

• Canadian Development Expenses - expenses on infill or enhancement drilling at established fields (30% deductible annually)

• Undepreciated capital costs - deductible at around 25% annually for most companies

• Canadian oil and gas property expenses - deductible at 10% annually

Drilling represents the major portion of capital expenditures for most junior E&Ps, who tend to spend less money on pipelines and major facilities. Start-up companies usually generate drilling-related annual tax pools quickly in the beginning, as they drill exploration wells that carry 100% annual write-offs.

Once companies make discoveries, they drill fewer exploration holes. Drilling now focuses on development wells that carry only 30% write-offs. This usually leads to slower generation of tax pools -- although development drilling tax credits are still significant because development programs are carried out on a larger scale. Meaning higher overall costs, compared to exploration drilling.

During this critical shift from exploration to development, changes in capital spending greatly affect tax pools.

Compare Renegade Petroleum -- which announced a switch to the dividend model early in 2012 -- with Whitecap Resources, which remained in spend-and-grow mode during most of the year.

In 2011, both companies were in growth mode. Renegade's Canadian development tax pools grew by 109%, with Whitecap's increasing by an even-larger 185%.

But in 2012 (up to last financials in Q3), Renegade's shifting strategy saw its development tax pool growth slowed to 41%. A natural consequence of the income-and-growth model, because the company claimed some of its existing tax pools against cash flow. But Whitecap's tax pool growth continued apace, up 186%.

Whitecap will now cut spending as it switches to the income model. Drilling will slow, and so will tax pool growth. Like Renegade, WCP will have fewer tax credits to claim.

The Taxman Cometh

The question is: how soon will these companies have to start paying tax?

As of the end of Q3 2012, Whitecap held up to $195 million in tax pools available for the current year. The company cash-flowed approximately $130 million through the first three quarters of 2012 -- meaning its annualized funds from operations should come in lower than its available tax pools, sheltering all this money.

Renegade is in a similar boat, with up to $59 million in tax pools available for use this year (as of the end of Q3 2012), against cash flow so far in 2012 of just over $44 million. They too should come in un-taxable.

But there's not a lot of room to breathe. When companies spend less, they generate tax pools slower. They become taxable sooner.

That's exactly what's happening. Renegade announced mid-January that its capital spending for 2013 will drop to just under $80 million -- 27% less than the $110 million RPL spent in the first nine months of 2012. Both companies look like they could come up against taxability in 2013 or 2014.

For Renegade, that's in line with management announcements. For Whitecap, it would be sooner than the company forecast last year (management will put out updated estimates in the next few months).

Earlier tax would obviously pinch cash flow…meaning a lower stock price and after-tax value of reserves.

Tax-Driven Consolidation And M&A

Investors need to look for management teams that recognize the tax issue. Ones prepared to deal with it. "We discuss it for sure," says Renegade Controller Mark Lobello.

What can companies do? One solution could be increased M&A. Acquiring not only production and reserves, but also tax pools from companies that have spent large amounts on drilling.

Whitecap, for example, gained tax pools when it acquired Midway Energy in the second quarter of 2012. During that quarter -- largely as a result of the acquisition -- Whitecap's tax pools grew by $318 million…including over $143 million in critical Canadian Development Expenses.

This adds as much as $75 million in pools applicable this year -- helping to shelter about 50% of WCP's cash flow.

Renegade also looks at M&A with tax pool-rich companies as an answer, according to Lobello. "We're always looking at tax-loss acquisitions," he notes.

E&Ps staring down taxability may look to acquire or merge with firms holding significant tax pools. Ironically, the preferred targets would be companies that have under-performed: those that drilled a lot, but failed to cash flow enough to eat up tax pools. Such companies often trade at reduced multiples, making them even more attractive as targets.

Whitecap's acquisition of Midway is a good example. Without Midway's tax pools, WCP would have been close to taxable in 2012. That would have meant a sudden, unexpected fall in cash flow -- the kind that causes analysts and investors to lower target prices and sell off a stock.

Such negative revisions will be reality in the new income-focused E&P sector. Investors need to check tax pools against cash flow to see who is safe and who is in danger of an unexpected tax-driven bite out of profits.

Source: Sizing Up Today's Dividend Paying Exploration & Production Companies