The little engine that could is back on the main line, pulling the heavy load at the bottom end of Canada’s petroleum industry after two years of wheel-spinning in the wilderness.
Derailed by the collapse of the income trust sector, a cold shoulder from investors, changes in government climate-change and royalty regulations and a shortage of organic growth prospects, the junior players were driven into a prolonged slump.
The economics for companies that rely on conventional oil and natural gas for a future in the Western Canada Sedimentary basin are daunting.
What has changed is a dramatic shift from the traditional base to the unconventional plays that have made EnCana a raging success and attracted a full array of other players from senior producers to those smart enough to gain a foothold in northeastern British Columbia, northern Alberta and southern Saskatchewan.
With gas prices racing above $10 per thousand cubic feet, after floundering around $4-$6 for two years, and oil prices holding their breathtaking levels, a turnaround is under way.
But the same old rules apply for the little guys. Those who lack credible managements and have failed to lay out convincing long-term strategies are as much out of favor as ever.
The general assumption among analysts is that M&A activity will come back to life in the second half of 2008 after languishing in recent months.
No one is suggesting that the value of deal-making will come anywhere close to last year’s record C$49.8 billion, which was up C$20 billion from 2006.
Plenty believe strong Canadian M&A deal making will revive
Even so, there are plenty who believe Canada will retain its lead position in the global M&A marketplace.
In recent years, Canada has seen 8 percent of its oil and gas properties turn over annually, compared with 5 percent in the United States, 2-3 percent in the North Sea and 1 percent in the rest of the world.
Although the major integrated companies and the large U.S.-based companies that have unloaded most of the Canadian properties acquired in the 1990s and early 2000s are expected to remain on the sidelines, large independents are poised to plunge back into the marketplace for the first time in many years, David Vetters, managing director of Tristone Capital — underwriter for seven deals worth almost C$200 million in 2007 — told the Financial Post.
Arthur Korpach, head of global oil and gas at CIBC World Markets, told reporters there is a renewed mood of excitement that juniors are again a viable business for investors.
But he cautions that there is a divide between those who took early stakes in the unconventional plays — notably tight and shale oil and gas in British Columbia and Saskatchewan — and are positioned to reap the rewards and those who have been unable to present credible long-term plans for using their money and creating value for their shareholders.
He said the companies that have “found some exciting things to pursue” and can raise the necessary capital will be poised to buy out their weaker peers.
Don Greenfield, a partner in the Bennett Jones law firm in Calgary, told the Financial Post that more M&A activity is evident “because some of the gas producers are strapped for cash or unable to continue their growth curve.”
Despite the firming of prices, some companies are putting themselves in play “because of both gas prices and the impact of royalty rates,” he said.
Meanwhile, a lot of juniors simply haven’t figured out what to do, regardless of healthy commodity prices.
Optimism rebuildingBut there is a rebuilding sense of optimism.
Ross Freeman, finance committee chairman of the Small Explorers and Producers Association of Canada, told an investors conference “there’s a buzz again in the junior sector — people are raising money, mergers are happening and shares prices are starting to come back to where companies are actively interested in raising money.”
Regardless of what has happened to Alberta royalties, he said many companies say the impact is “not overly significant, particularly in the current price environment.”
But there is still the unknown of government climate-change regulations, Freeman said, adding SEPAC will try to ensure the burden on juniors is not too onerous.
He argued that junior producers should not have to monitor and compile information on their greenhouse gas emissions at the same level as large producers and plant operators because their emissions are so insignificant.
If the upper tier of juniors can grow substantially, turning themselves into intermediate players, they will be able to tackle the more expensive, more rewarding plays in British Columbia’s Montney region and Saskatchewan’s Bakken formation, Korpach said.
He said consolidation in the junior sector will create larger entities with the ability to succeed in the unconventional trends.
Even so, Korphach concedes that figuring out the best strategies to generate the best returns is as “tough or tougher today as it has ever been,” with the challenge of raiding debt or equity capital presenting an obstacle to M&A transactions.
The longer gas prices hold on to their current groups, companies pumping less than 15,000 boe per day and with market-caps under C$1 billion, are starting to see hope of a return to the days when they could reach a production threshold and sell out to eager buyers, especially in the trust sector.
Trusts no longer dominantWhile the trusts are no longer the dominant players in the M&A market there is a growing belief in a revival of deal making that could see Canada rebuild an intermediate tier in the 15,000-200,000 boe-per-day range.
Following a sluggish start to 2008, Sayer Energy Advisors counts on the pace picking up, so long as commodity prices stay robust and sharpen the appeal of fringe resource plays in British Columbia and Saskatchewan where a host of juniors have cornered sizeable chunks of property.
Although still struggling to raise equity and debt capital to pursue organic growth in a high-cost, limited-scope exploration environment in Western Canada, smaller companies with solid long-term strategies and strong asset portfolios are coming back to life.
If they can benefit from a building tidal wave of cash flow they can resume their traditional role, building enough reserves to get production to even 1,000 boe per day, then sell out and start the process anew. It’s the best chance of drawing investors back to the junior sector.
The most buoyant assessments of the investment outlook for junior companies are tied to companies that are backed by proven management teams and that have credible plans to return value to their shareholders.
Those that haven’t figured out what they are going to do got no help from the Alberta government when it modified the proposed royalty structure in a way that satisfied only those engaged in deep oil and gas activity.