Five bad signs for junior producers
Many are wishing for a reason to be festive as we enter the holiday season, especially the oil and gas companies and their investors.
Commodity prices have been halved, bank lines are being slashed with corresponding writedowns, millions of dollars of share options are now worthless, and there have been large capital curtailments and tens of thousands of layoffs. The bad news appears to be gaining momentum rather than slowing down.
Should the lower-for-longer commodity price environment play out, it could mean a dramatically different landscape ahead with once-in-adecade opportunities for those able to take advantage of the upcoming consolidation.
Unfortunately, it’s a different story for many of the smaller junior producers, both private and public, and many may not survive the upcoming challenge.
In particular, we see five key developments that could bring an end to the junior producer as we know it, especially should low oil and gas prices persist.
Higher well costs
New horizontal fracking technology has been a godsend, unlocking billions of barrels of oil once thought unrecoverable, but it has also changed the nature of exploration. Well costs have exploded higher, resulting in a much higher well concentration for the new junior startups and, as a result, a lot more risk.
Despite the higher production rates, companies need a lot more size, scale and, most importantly, capital with their programs. Juniors were once able to participate, but have since lost their banker friends and investors have no interest in funding marginally economic, highrisk, single-well programs.
Less flow-through shares
Flow-through shares are a financing tool that allows an oil and gas company to renounce the exploration expenses it incurs to purchasers of certain qualifying shares that it issues. We were never a big fan of investing in these issues due to the large premiums being charged and lack of liquidity, but they have been a lifeline for many to the junior producers that often spend multiples of their cash flow.
This is potentially about to change though.
Prime Minister Justin Trudeau’s campaign proposed to restrict the use of Canadian exploration expens- es on those in the fossil fuels business.
The plan would disallow the use of CEE on successful finds, therefore limiting deductions only to unsuccessful ones.
This plan has yet to be enacted so the ultimate impact to the structure and terms of flow-through shares is unknown, but it certainly is a potential headwind underpinning the junior E&P sector.
Higher taxes on options
The birth of a junior producer has historically come from well-experienced individuals or teams leaving high salary positions at large E&Ps to create their own new startup. Many invest a lot of their own net worth alongside outside investors, but they also sacrifice the security of a large monthly paycheque in exchange for stock options in their new venture.
This is also about to change with the federal government proposing to tax stock options at the full 100 per cent rate instead of the current 50 per cent.
Bigger liability bonds
To prevent unfunded abandonment liabilities, especially in the event of receivership, we’re starting to see regulators auditing more producers and requesting sizable abandonment liability bonds.
We’re in favour of such bonds in order to prevent taxpayers from being on the hook, but they still represent another capital burden for junior producers at a time when they need every penny they have.
More going to the Crown
The Alberta government recently implemented a new carbon-tax scheme and is currently reviewing existing royalty rates.
As cited in the Calgary Herald, one of the panelists on the royalty review committee recently said that not every Alberta oil and gas company will be able to compete with U.S. shale under the recommended changes to the royalty regime. In addition, only “segments” of the industry will remain competitive.
Our take is that this is most likely not good news for junior producers, since many of them are operating at the margin and highly dependent on every dollar of cash flow being generated.
In the end, all of this may mean bigger is not only better, but also the safer way to invest in the sector — at least for the time being.