The intermediates return

March 21st, 2011
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My “Letter from Calgary” column from the February 2011 issue of the Investment Executive newspaper of Toronto:

Intermediate exploration and production companies dangle the promise of cash yield with capital appreciation

It was barely five years ago that royalty trusts dominated the energy industry and the consciousness of energy-focused investors. The trusts’ tax-free yield had made them a category killer — literally — as they consumed junior exploration and production (E&P) companies like Skittles while, thanks to the trusts’ lower cost of capital, the markets drove the larger “intermediate” E&P class virtually to extinction. Some trusts even acquired their way to senior-sized status.

In their heyday, the 30 or so energy trusts produced considerably more than one million barrels of oil equivalent (BOE) a day — one-quarter of Canada’s combined oil and natural gas production. These trusts traded at double or triple the valuations of typical E&Ps. There was no end in sight to their success. But when the end did come, in the form of the federal government’s removal of the trusts’ tax advantage, it hit the trusts like the asteroids that wiped out the dinosaurs. By January, the last of the energy trusts had either converted to corporations or were continuing as trusts in name only, providing cash distributions taxable much like dividends.

Filling the void is a category that had been written off: the intermediate E&P. These are firms with production of 30,000 BOE or so a day and/or a market cap of around $500 million. Intermediates had been considered too big to deliver the 50%-100% annual growth investors had expected of juniors, but too small to raise the capital and take on the risks of really big, capital-intensive, high-risk, long-term projects such as the oilsands. The intermediates’ overheads were far higher than those of the juniors, but the former still lacked the technical and managerial depth of the majors. Intermediates were big enough to grow by acquiring a junior, but routinely disappeared into the maws of acquisition-hungry seniors. For a time, Calgary’s several hundred-strong E&P sector was down to one or two true intermediates.

Suddenly, everything about the intermediates seems just right. Today’s capital, resources and growth parameters fit the intermediates like a well-tailored suit. The most powerful parameter is the state of play out in the field. The focus is on “unconventional” reservoirs — gas-bearing shale, so-called “tight” sandstone and previously overlooked oil reservoirs, all of which are being developed using horizontal wells and hydraulic fracturing. This process requires a major capital investment of $3 million-$10 million per well and the ability to drive a multi-well program on a broad land base that itself costs millions to acquire.

This capital commitment, plus the longer time horizon required, is too much for most juniors. At the same time, some of Calgary’s seniors still don’t seem to get it, taking years to decide whether to drill a horizontal well. The intermediates are agile enough to recognize opportunity, yet big enough to get the job done. Many of today’s signature unconventional plays — the Bakken oilfield in Saskatchewan, the new Wilrich gas play in Alberta’s Deep Basin — are being driven by intermediates.

Meanwhile, investors have ratcheted down their growth expectations to a level the intermediates can fulfil quite nicely. Some are even dangling the promise of cash yield alongside capital appreciation. It’s just what investors are hankering for these days — and what trusts no longer provide.

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By George Koch