Cheap money? Not if you’re a junior oil and gas company
With capital at a premium, junior energy companies are in for a rough ride
by Max Fawcett
The world is awash in cheap money. At least that’s the prevailing wisdom, and the credit – or blame, if you’re so inclined – belongs mostly to record-low interest rates and the central banks that are keeping them that way. But for the juniors in Alberta’s energy sector, it’s a completely different story. Take BlackPearl Resources, an Alberta junior heavy oil producer that announced this past June that it planned to raise US$350 million through a second-lien senior secured term loan to develop its Onion Lake property.
Illustration Dushan Milic
It was tapping the debt markets because, with its share price trading at a discount to its net asset value, issuing equity would have been dangerously – perhaps destructively – dilutive. But by the end of the month, faced with financing costs that were rumoured to be in the double digits, it abandoned the debt issuance. The next day, its shares plummeted almost 15 per cent to $1.36, the lowest level they’d traded at since July 2009 and a far cry from the $8 level they reached in 2011. So much for all that cheap money.
BlackPearl isn’t the only junior having a hard time finding the credit that it needs. Bruce Edgelow, the vice-president of energy for ATB Financial and a man with more than 20 years of experience in the industry, says it’s about as bad out there for juniors as he’s ever seen. “There have always been cycles, but this is one of the choppiest ones we’ve seen. The capital markets have gone to other avenues. They’ve left the juniors.” They’re not likely to come back any time soon, either, given that the most obvious draw – a rise in commodity prices – has already happened. “We’re at $100 oil, and natural gas prices are 86 per cent higher than they were a year ago,” Edgelow says. “This isn’t driven by low prices. This is simply driven by capital availability.”
For juniors, which typically need a multiple of cash flow to prove-up their properties and grow their production, that’s a problem. Worse still, it’s forced many of them to put assets up for sale, creating a buyer’s market. It’s the other golden rule in action, Edgelow says: The people with the gold get to make the rules. “You used to be able to sell reserves at total proven metrics, and you’d pay for the non-producing side of the reserves,” Edgelow says. “But the market is constricted, and the guys with the gold have said, ‘It’s my capital that’s going to bring those reserves on, so I don’t need to give you very much for those non-producing wells or the lands and licenses. I’m going to pay you maybe even a discounted rate on proven and producing.’ ”
Raging River Exploration is one of the few juniors that don’t have to sell assets to fund ongoing operations. Instead, president and CEO Neil Roszell says his company is one of the few “haves” in the patch, and that the privileged status is a function of the company’s track record of making good on its promises. “If you’ve delivered on what you said you would over the last 18 to 24 months, and you’ve given your investors a return – which is few and far between – then the access to capital is still very strong,” he says. But it’s a slippery slope out there for those that haven’t delivered. “If you’ve had some hiccups along the way – you’ve missed a couple production targets, you’ve overspent your capital – you’re in a penalty box, and it’s tough to get out.”
That hasn’t stopped a few companies from trying. Some have converted to dividend payers in the hope that attaching a yield to their business model would bring back investors. And while that’s worked for a few companies – Whitecap Resources, in particular, has managed to make the transition successfully – it’s hardly a panacea. “We were led to believe that there are these massive pools of dividend capital that would chase these things,” Roszell says. “But those funds are typically very large – in the billion or multibillion-dollar plus range – and if you don’t have market caps that are a billion-dollar plus, they won’t invest in you.”
So, what’s a junior to do? It’s simple, Roszell says – hit your marks, deliver on your promises and be careful how you deploy your capital. “Guys have missed their targets, and then start to use excess capital to chase that. And once they miss, the only way to come back is to get really lucky with the drill bit and have some phenomenal successes or to have patience, where they have to dig in, live within their means and deliver consistent quarters. Slowly, that market will come back to them. But there’s no magic bullet – it doesn’t fix itself in three months.”
And while Roszell sympathizes with some of his colleagues, he’s quick to point out that current market conditions may be more of a return to the norm than a deviation from it. “We went through this 10-year bull market where everyone could access capital and create value, and it didn’t create much differentiation between teams that were doing a great job versus those that were doing an OK job. Today, there are definitively haves and have-nots.”
In his keynote address at the Explorers and Producers Association’s Investor Showcase this past June, Josef Schachter, the president of Schachter Asset Management, suggested that a meaningful recovery – and a resulting rise in both oil and gas prices – may not happen until 2016 at the earliest. In light of that fact, and in view of the difficulty that juniors are already having in accessing either equity or debt capital at reasonable prices, he made a rather stark prediction. “It’s a question for the industry of surviving for the next few years,” he said, “which will be tough.”
A total collapse seems highly unlikely, to say the least. But a fundamental restructuring of the sector and what the companies in it look like is a much more realistic prediction. Both Roszell and Edgelow note that the costs associated with starting a junior exploration and development company – the table stakes, if you will – have gone way, way up. “When I first started with Jim Saunders when we were doing Great Northern and Prairie Schooner,” Roszell says, “with $10 million you could create a company and start snowballing it along the way. With these bigger wells and bigger well costs, you need $100 or $200 million to get started, which is a different game because it’s hard to do the doubles and triples from there.”
As a result, he says, the people from whom entrepreneurs get the money they need to create the business in the first place have changed. “You can no longer talk to the friends and family and a few small firms in town. Now you need to access the ARCs and the KERNs [two of Calgary’s biggest energy-focused private equity firms) and some of the bigger U.S. firms.” Edgelow agrees. “There will be fewer micros, plain and simple. The starter kit is bigger. You need a $3.5- to $5-million bucket every time you go out and do some work. In the past, $3.5 to $5 million got you 10 wells.”
If there’s a ray of light on the horizon for those in the junior space, it’s that valuations can’t get much cheaper than they are today. “We’re at the cheapest part of the cycle that we’ve seen since the ’08 downturn,” Roszell says. “Things got really, really dirt cheap then. Beyond that, you have to go back to ’02.” But he says waiting around for a macroeconomic catalyst, be it the approval of a particular pipeline project or an increase in the price of a certain commodity, is a losing strategy. “Returns,” Roszell says. “It’s just returns. If Bay Street starts generating good returns in the energy space, capital will flow back from guys putting money in those energy funds, which has to get redeployed.” The question in Calgary right now is which companies will be around to see that happen.
The debt and equity markets may be closed to some of Alberta’s juniors, but that doesn’t mean they’re dead in the water. Here are five strategies juniors can turn to for the capital they need.
The recent(ish) tie-up between Pace Oil and Gas, AvenEx Energy and Charger Energy that created Spyglass Resources is the highest profile example of this strategy, but Roszell says the mixed reviews it’s gotten from the markets underscores the fact that consolidations have to be accretive in order for them to work. “What we’ve seen is that’s not a fix in itself. You take the Spyglass merger, which was Pace, Charger and a whole myriad of companies that came into that before, and it still has no traction in the marketplace. Just putting stuff together doesn’t necessarily garner capital.”
This strategy has come back in vogue in recent years, such as in 2009 when an investor group led by Trent Yanko injected $15.6 million into Glamis Resources (and rebranded it as Legacy Oil and Gas). But, Roszell says, it’s one that isn’t universally accessible. “That’s a model that I think will be supported, but not en masse – it will be very team-specific.”
With the public markets turning their collective backs on the junior sector, many of the companies in it are turning to private equity for the capital they need. One of the most popular arrangements is a farm-in joint-venture, in which the equity fund provides money up front in exchange for a working interest in a particular play or set of wells. This past June, for example, Grafton Asset Management closed a deal with Bellatrix Exploration worth $122 million (with Grafton providing $100 million) that will allow the company to develop wells in the Cardium and Notikewin/Falher plays.
Ontario-based grocery chain Loblaws made big news earlier this year when it decided to spin off its real estate assets into a REIT – and, more importantly, saw its share price rally on the news. It was just the latest example of a company finding an innovative way to satisfy the market’s desire for yield, and monetize assets that may not have been being valued by the market correctly in the process. Well, it’s happening in the patch as well, as juniors sell their oil batteries, pipelines and other infrastructure assets to energy service conglomerates like Secure Energy Services and Inter Pipeline Fund. It’s a win-win scenario: the juniors get some much-needed cash, and the service companies build their asset base, their cash flows and their ability to pay out the dividends that have had investors bidding up their shares for years now.
Royalty streaming agreements are far more common in the precious metals space, but the basic premise – the forward sale of production in exchange for cash – could easily apply in the cash-starved junior oil and gas sector. “That pre-sale of your product is really a big forward hedge,” Roszell says. “I actually investigated that with a couple of capital markets guys a couple years ago, and it’s not being done but it definitely is another source of capital. I like it, and I don’t know why nobody has chosen to use it.”