Tak­ing Risk Out of the Bar­rel

Land roy­alty firms are pick­ing up non-core as­sets while avoid­ing cap­i­tal or op­er­a­tional ex­pen­di­tures to de-risk the oil in­dus­try for their in­vestors

Alberta Oil - - CONTENTS -

How land roy­alty firms are pick­ing up non-core as­sets and dodg­ing cap­i­tal ex­pen­di­tures to de-risk the oil in­dus­try for their in­vestors

FEW WOULD RE­GARD A

a jour­ney to the depths of Hell as risk-free. But when, in 2014, En­cana spun off its roy­al­ties into PrairieSky Roy­alty for $1.46 bil­lion, the new kid on the block in­her­ited min­eral rights go­ing back to the build­ing of the Cana­dian Pa­cific Rail­way, whose land was cov­ered by the Latin le­gal phrase “usque ad coelum et ad in­feros”—up to Heaven, and down to Hell. This free­hold land was orig­i­nally do­nated by the govern­ment as a sweet­ener to get the na­tion-build­ing rail­way built. Fast-for­ward a cen­tury and it made En­cana’s land dif­fer­ent. The Crown owns about 90 per­cent of roy­al­ties in Canada. But PrairieSky now holds a crown jewel of real es­tate with all the sub­sur­face rights, while Queen El­iz­a­beth II’s govern­ment has none.

Since the land deal, PrairieSky has been busy. “In late 2014, we started see­ing some op­por­tu­ni­ties to ex­pand our as­set port­fo­lio into other at­trac­tive ar­eas and plays, par­tic­u­larly in Saskatchewan and also the Deep Basin area of north­east B.C. and northwest Al­berta,” says COO Cam Proc­tor. “This was partly due to early weak­ness in com­mod­ity prices, but also the suc­cess of our IPO draw­ing more at­ten­tion to the roy­alty space in gen­eral.”

Canada’s big­gest roy­al­ties firm has also been ac­tively leas­ing land since 2014. “So far in 2016 we’ve en­tered into over 80 leas­ing ar­range­ments with 57 dif­fer­ent coun­ter­par­ties, es­tab­lish­ing the foun­da­tion for fu­ture drilling ac­tiv­ity on ex­ist­ing plays, as well as ex­plo­ration tar­gets with new dis­cov­ery po­ten­tial,” Proc­tor says.

While most other Western Cana­dian lands aren’t as at­trac­tive as these, they cer­tainly glit­ter enough to at­tract the at­ten­tion of Toronto-based Franco-Ne­vada—the world’s 10th-largest gold com­pany. The risk-averse firm doesn’t pro­duce an ounce of gold, pre­fer­ring to in­vest in roy­al­ties. It is now eye­ing the re­ces­sion-beaten North Amer­i­can oil patch to boost its hy­dro­car­bon di­vi­sion—roy­al­ties be­ing counter-cycli­cal in terms of pur­chas­ing. It ex­pects to close a deal by year-end to pur­chase roy­al­ties in the Stack shale play in Ok­la­homa’s Anadarko basin for US$100 mil­lion from a pri­vate U.S. seller.

Ja­son O’Con­nell, VP of Oil and Gas at Franco-Ne­vada, says, “We try to ac­quire roy­al­ties in the trough when prices are low and val­u­a­tions are down. But our main strat­egy is to ac­quire qual­ity as­sets no mat­ter where we are in the cy­cle—we don’t believe you can al­ways pick the bot­tom.” The key is as­set qual­ity, and good as­sets of­ten of­fer ex­po­sure to mul­ti­ple price cy­cles.

“We re­ally ramped up our ef­fort in 2016 in oil and gas. We are bid­ding on things [in Canada], although we haven’t landed any­thing yet. We’re well-po­si­tioned to get things done, but we try to stay dis­ci­plined on how we price as­sets and have yet to beat out the com­pe­ti­tion,” he says.

This isn’t the only money com­ing from the east. In 2015, the On­tario Teach­ers’ Pen­sion Plan spent $3.3 bil­lion buy­ing Cen­ovus En­ergy’s wholly owned sub­sidiary, Her­itage Roy­alty Lim­ited Part­ner­ship (HRP), which held Western Cana­dian oil and gas roy­al­ties. In June the fol­low­ing year, the Toron­to­based Canada Pen­sion Plan In­vest­ment Board in­vested US$450 mil­lion in LongPoint Min­er­als, a Den­ver-based com­pany that in­vests in U.S. oil and gas roy­al­ties. The pen­sion fund man­ager says it will ac­quire a ma­jor­ity stake in LongPoint within two to three years.

It was fall­out from PrairieSky’s IPO that fo­cused at­ten­tion on roy­al­ties. In the big deals of 2015 and 2016, peo­ple paid full value for as­sets dur­ing a $35-per-bar­rel en­vi­ron­ment, as­sum­ing prices would rise again to $60 or $70. Since then, the mar­ket has

been get­ting more cre­ative. Penn West Pe­tro­leum, for ex­am­ple, last May cre­ated an 8.5 per­cent roy­alty on top of a lower Crown roy­alty to al­le­vi­ate its debt is­sues. This was af­ter its 2015 sale of roy­alty in­ter­ests in Western Canada to Free­hold Roy­al­ties for $321 mil­lion to cut debt and ride out the oil price mael­strom. They in­cluded Saskatchewan’s Vik­ing oil field and lands in Al­berta and Man­i­toba. Penn West’s shares had plunged 72 per­cent and the sale met nearly half of the $650 mil­lion debt due.

In May this year, Free­hold Roy­al­ties also agreed to ac­quire $165 mil­lion of roy­alty pro­duc­tion and lands from Husky En­ergy. Matt Dono­hue, Free­hold Roy­al­ties’ in­vest­ment re­la­tions man­ager says Husky sold its as­sets to stream­line its operations to­wards longer-life projects—its roy­al­ties were non-core. And Free­hold sees “lots of up­side in land, low de­cline—[the deal] fur­ther di­ver­si­fies our roy­alty port­fo­lio,” Dono­hue says.

An­other way that roy­al­ties firms spread their risk is by in­vest­ing across the spec­trum of con­ven­tional and un­con­ven­tional gas and oil fields. Free­hold Roy­al­ties gets roy­al­ties from 300plus op­er­a­tors—about 44,000 wells, with only 9 to 10 per­cent of rev­enue com­ing from any one com­pany. “Roy­al­ties are a great busi­ness I am sure they will stand the test of time, re­gard­less of the com­mod­ity price out­look,” Don­ahue says.

From the pro­ducer’s per­spec­tive, Richard Lew, Pen­growth En­ergy’s roy­al­ties man­ager, says, “Com­pa­nies can sell roy­al­ties to cre­ate cap­i­tal funds for strate­gic rea­sons, such as in­vest­ing in pro­duc­tion projects when oil prices are high. This de­pends on the size of a project and where its fund­ing comes from. But at $100 a bar­rel the rev­enue stream from roy­al­ties is higher than dur­ing a slump, so firms may wish to hold on to them. It de­pends on in­di­vid­ual firms, their strate­gies, debt and bal­ance sheets.”

CNRL has ben­e­fited too, in a cre­ative move. In Novem­ber 2015, CNRL, the largest oil and gas pro­ducer in the coun­try by vol­ume, be­came the largest share­holder in PrairieSky in a $1.8 bil­lion cash-and-share deal. Proc­tor says, “When we part­nered with CNRL in De­cem­ber 2015 they took back to $1.1 bil­lion of stock, half of which they re­turned to their share­hold­ers. I think this was a very thought­ful way for CNRL to un­lock value for its roy­alty port­fo­lio, while giv­ing share­hold­ers the abil­ity to di­rectly par­tic­i­pate in the up­side of a pure play roy­alty busi­ness like PrairieSky.”

“We try to ac­quire roy­al­ties in the trough when prices are low and val­u­a­tions are down. But our main strat­egy is to ac­quire qual­ity as­sets no mat­ter where we are in the cy­cle—we don’t believe you can al­ways pick the bot­tom.” – JA­SON O’CON­NELL, VP OF OIL AND GAS AT FRANCONEVADA

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