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The Squeeze is On

Peter McKenzie-Brown
November 22, 2008

This article appears in the December 2008 issue of Oilweek.

“I’d rather you didn’t mention the company by name. In fact, better not mention my name, either, because the story is a disaster. We don’t want (the information) out yet.”

From an officer in a small oilsands company – call him Don Fischer, – that comment sums things up for many juniors. Fischer argues, however, that the recent meltdown in global financial markets is only the killer blow in a credit squeeze within Canada’s petroleum sector that has been developing for three years.

A credit squeeze occurs when interest rates rise and new credit is difficult to access. At such times marginal borrowers, or those who have borrowed at the end of any debt-induced asset bubble, get squeezed out of further borrowing. A contraction in the growth of money supply occurs, triggering a slow-down in the growth of previously inflated assets purchased with debt.

Such a squeeze is a natural part of the economic cycle. This time, however, it has taken the form of a whirlwind that threatens to leave behind an astonishing combination of devastation, cataclysmic change and opportunity.

For some of those who anticipated the problem, there were ways to protect themselves. For example, Pennwest Energy – Canada’s largest conventional energy trust, with anticipated cash flow this year of $2.8-$3 billion – saw a year ago that something was happening, and restructured its debt in response. According to president and COO Murray Nunns, “We termed out a portion of our debt into private long-term notes and Pennwest isn’t drawing on the full extent of its bank lines. We thought that was prudent given the conditions that might arise in the banking sector.” Of course, many companies did not have the foresight or the financial resources to protect themselves.

Triple whammies: According to Fischer, even before the global crisis hit many companies in the sector were having credit problems. “We faced a triple whammy – maybe more whammies than that.”

One whammy has been high exchange rates. The loonie has risen during this decade from just over 60 cents per US dollar (when an American business magazine famously dubbed it the “northern peso”) to $1.10 last year. As a result, American oil companies benefitted far more Canada. Since the Canadian sector profited much less from oil price increases than those in the States, for example, its access to capital for exploration and development tightened. It was one of a number of factors (including labour shortages and rising environmental costs) contributing to high operating inflation in the oil patch.

Another whammy has been Canadian natural gas production, which now seems in terminal decline. Export markets in the US are well supplied and they are also far from Canadian supply. This means transportation costs take a big bite out of producer revenues. At this writing, the price of gas at Alberta’s AECO Hub was more than a dollar cheaper than gas at Louisiana’s Henry Hub –$6 and change per thousand cubic feet. According to market analyst Martin King of FirstEnergy Capital, “at current prices, little in the way of new natural gas production is economic in Western Canada.”

Until recently, however, the greatest whammies have come from government. Ottawa’s decision to tax trusts – the SIFT, or “specified investment flow-through tax”, will impose a 31.5% duty on the net income of energy trusts starting in 2011 – has made trusts unattractive as exit strategies for junior producers. It has also taken money out of the hands of investors. The Alberta government’s decision to increase royalties is also cutting into the industry’s available capital. It will significantly cut net income when it goes into effect in January – not a good thing when energy prices are in decline. This development has already affected drilling, which has been dropping from a peak for three years.

The hottest resource plays tend to be at either side of the basin, in BC and Saskatchewan. That’s partly because of Alberta’s new royalty framework. According to landman Bob James, who is president of privately held Tiger Moth Energy, “The most plentiful hydrocarbon that remains to be found in this province is natural gas, but it’s prohibitive to explore for it because of the upcoming royalty structure. That really needs to be looked at, because it means in a couple of years this province will be ‘way behind where we should be in terms of drilling and production. And that will ripple across the country.”

And now, the perfect storm: These and other factors had been offsetting the higher oil prices of the last year. New projects had become harder to fund. Leveraged companies and those without cash flow were shedding assets. Despite a pickup last summer, drilling has been in decline for three years. The environment was not good, but disguised by higher oil prices – and, during spring and summer, higher gas prices too.

But when the financial crisis roared out of Wall Street and the City of London in September, it created a whole new environment. The global financial crisis unfolded at warp speed, and the full fury of its power will take months to unfold. When this article is in your hands, no doubt the situation will still be changing rapidly. Like the 100-year rogue wave the Hibernia production platform was designed to withstand, it hit during what had seemed to be a rough but not overwhelming storm. The TSE’s index of larger energy stocks lost 50% of its value in little over a month, and the juniors fared far worse.

After the big wave hit, Jeffery Tonken (CEO of junior producer Birchcliff Energy) famously said “It’s Armageddon out there. I’ve lost millions. Everyone has.” He was referring primarily to the collapse in share prices – especially for junior companies.

Already hit by poor gas prices, the lot of most juniors became far worse after the world saw trillions of dollars vapourize in weeks. Investors are worried that banks will reduce or even refuse to renew their revolving lines of credit. This will stymie their ability to expand, since they won’t be able to invest much more than cash flow. According to Murray Nunns, president and COO of Pennwest Energy, “The vast bulk of the junior market is going to be left floating on an ocean of limited access to capital.”

There are exceptions, of course. According to Tiger Moth Energy’s Bob James, “Adversity breeds opportunity. As things turn down land becomes cheaper, properties come up for sale that would ordinarily not be up for sale and prices go down. It’s harder to take advantage of these opportunities, though, because capital freezes up and courage freezes up. So you have to recognize these opportunities and pursue them with conviction. Just now you have to be sure you aren’t exploring and drilling for gas, though.” As if to emphasize the point, when contacted for an interview he was putting in a bid at an Alberta land sale.

James stresses that a credit crisis for an enormously capital intensive industry will have huge repercussions for producers.

Keith Macdonald agrees. He is president of another privately held company, Country Rock Resources, serves on the boards of half a dozen oil and gas companies and is also a director of the Small Explorers and Producers Association of Canada (SEPAC). “The cost of borrowing for juniors is going up, and this reduces your flexibility. Right now we also have the backdrop of lower gas and oil prices. The A-teams of the oil and gas world are going to be able to get capital, but the rest are going to have to scrape and scrap for every dollar that they raise.”

“Already a lot of those companies are trading at deep discounts to their net asset value,” he adds. “We’re already seeing companies with good development projects that simply can’t raise the funds they need. Ordinarily that isn’t a problem. Now the junior sector has to stay within its cash flow and consolidate for survival until they reach the size where they can conduct meaningful drilling programs. I think that means 2,000 to 3,000 barrels per day.”

“In terms of planning, you have to plan for the longer term. A lot of things have to be worked through, including the steps governments have taken to help resolve the crisis. I think companies have to be planning for maybe an 18-month time frame.”

The impact of the financial crisis on service companies may be equally profound. “Any time there is uncertainty, companies are going to budget less,” said Nunns. “We’re coming into the budget cycle right now and most companies are going to be cautionary simply because of uncertainty. The juniors aren’t going to get much capital and there’s limited access to further capital from other players. So drilling has to slow, (this crisis) has to feed through to the service industry within the next six months.”

The silver lining: In a nutshell, small service companies carrying debt will struggle. Mid-cap companies and minnows will take sometimes desperate measures to fund core projects that need more money than cash flow can provide. Exploration will tail off. Distress sales and mergers and takeovers will occur.

According to Nunns, “The acquisition market should improve. People will be chopping off arms and legs so they can continue with projects they really like, and as a result there should be an active acquisition market. Keeping an eye on this market for the next six months to a year will be a very handy thing to do in (the world of royalty trusts).”

“Living in Calgary is really good when hydrocarbon prices are through the roof,” he adds, “but the lows are when you can create value. The credit crunch presents that kind of opportunity for the right companies in the right situations. We think opportunities will present themselves, including the ability to buy hydrocarbons at more reasonable costs, and that can be a good thing for the long run.”

According to Gwyn Morgan, retired CEO of EnCana, there are other good reasons to welcome the change in commodity prices. “A lower dollar will make Canadian manufactured products more competitive. Lower oil prices will be good for Canadian businesses and families, yet they are still high enough for oil companies to profit from quality projects. Farmers will welcome lower fuel and fertilizer costs.” But how long will these benefits last?

Murray Nunns, for one, thinks the dip in hydrocarbon pricing will be relatively short-term. “There has been an immediate reaction in the futures market of lowering commodity pricing in anticipation of a recession which will lessen demand for six months to two years. ,” he said. “In conjunction with limited access to capital and project funding being tougher to find, supply additions are going to slide. Because of the limited supply adds during this time period, we should begin to see some distinctive upward pressure on price in the mid-term.”

“If you look at the history of oil,” he continues, “there was only one year in the last fifty in which (global) oil demand declined; 2008 might be the second.” As president of a large, well-capitalized company, he can take the long view of developments.

China syndrome: China has spent millennia taking a long view of developments, and is sitting on more than a trillion dollars in cash. Twelve to 18 months ago the country was trying to buy world resources everywhere. Nunns asks, “How active are the Chinese going to be in the resource acquisition market?” He thinks the answer is obvious, but after being pressed offers these comments. “The Chinese economy is not going to grow at quite the same rate it has over the last decade. It is probably going to focus more on internal growth. There will likely be continued internal economic development, and this will generate significant demand for key commodities and resources. I’m not an expert in the area, but they may see the credit crunch as the ultimate buying opportunity.”

In a recent article on Chinese energy policy, Oilweek noted that the Middle Kingdom has proclaimed its intention to “promote the common development of energy around the world, expand the global market, and make positive contributions to the world’s energy security and stability.” In a world of extreme instability in global energy markets, perhaps those ideas will translate into takeovers of bigger companies with cash flow or debt problems. Thus, perhaps, could China and other countries sitting on piles of foreign currency recycle their US dollars.

If so, which well-known Canadian companies would be most likely to become takeover targets?

Peter McKenzie-Brown
November 22, 2008

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