Wednesday, January 14, 2015

A fantastic entrepreneurial spirit

Albertans have a reputation for new investment opportunities
This article is published in the 2015 Investment Guide to Alberta's Energy Industry
By Peter McKenzie-Brown
It’s hard to forget the 2008 financial crisis, when the economies of North America and Europe went into free-fall. The world seemed to be teetering on the brink of a collapse like the one that followed Black Tuesday—the day in 1929 when a stock market crash triggered what became the Great Depression.

By contrast, the Great Recession that followed the 2008 event was a period in which, in Alberta, imaginative companies were able to find opportunity.

Take the case of a partnership of four small private companies. Starting in October 2008, during periods when the petroleum industry as a whole was nervous about the future, the companies were among the few bidders on parcels at many Crown land sales—the biweekly auctions at which Alberta sells mineral rights to the highest bidders. (The informal consortium reached an agreement by handshake.)

“For a collective payment of less than $1.4 million [including initial rentals and fees], we acquired mineral rights of different sizes, in a variety of geological horizons and in many parts of Alberta,” says one of the partners, who, for competitive reasons, does not want to be named. “Excluding lands in which others hold minor royalty interests, we acquired more than 60,000 hectares of mineral rights.”

That was a small amount of the mineral rights sold at auction, but he and his partners bought those lands at “a very small fraction of the average cost of lands sold within that time frame.”

The four companies were already moderately successful; their proprietors had been in business for 25 years or so each. But this deal—agreed to during a period of great uncertainty—took each player to another level. In the years following, they entered into deals where they sold or farmed out these lands and the plays they developed to a variety of other players, retaining residual interests when they cut the deals. By drilling and installing production equipment, “larger entities” successfully transformed that land into producing operations. The partners received production royalties and cash payments, and they have since gone on to other deals—sometimes together, sometimes solo. Of course, those partners were operators, whose ultimate goal was to develop their own companies. Other companies see asset sales in a different light.

Liquid assets For many years Calgary has been home to the largest number of major head offices in Canada outside the Toronto area, which has five times the population. Calgary is a corporate city, which arranges finance and makes business decisions. It is a technical centre, with an amazing array of scientific and technical

Albertans have a reputation for new investment opportunities. It is a management city, and its seasoned executives continually make high-stakes decisions.

A mix of characteristics have set Calgary up for growth and increasing strategic importance in the energy world. Within the 10 blocks that make up the business part of downtown is an extraordinary concentration of expertise—among the largest concentrations of geological talent in the world.

Other areas of expertise include management, legal and accounting skills; energy finance and economics; technological development and environmental innovation. These skills developed in an entrepreneurial climate that takes a competitive delight in financing, exploring, developing and overseeing production from the geologically complex Western Canadian Sedimentary Basin.

A vibrant business environment makes Calgary one of the most enviable cities in North America. In the past 10 to 15 years especially, there has been significant growth in the financial sector.

Because of the success of the energy sector, not only do most Canadian financial institutions and lenders have a presence in Calgary, but the number of foreign financial institutions has increased steadily in recent years. Since 2011, new members of Calgary’s financial community include KKR & Co., Bank of China, Industrial and Commercial Bank of China, Mizuho Bank and United Overseas Bank (UOB) of Singapore. In 2011, Calgary was added to the list of cities eligible to be recognized in the Global Financial Centres Index.

Economic growth in Alberta is on track to be the strongest in the country in 2014, according to the Conference Board of Canada, and its two largest cities are reaping the rewards.

Calgary’s real gross domestic product is forecast to reach 4 per cent in 2014. In Edmonton, the provincial capital, the economy is forecast to grow by a nation-leading 4.9 per cent in due to continued strength in the energy, construction and manufacturing, sectors. Edmonton is home to the Alberta Investment Management Corporation, one of Canada’s largest and most diversified institutional investment fund managers with an investment portfolio of approximately $80 billion (and a desired partner by many foreign institutional investors).

Alberta’s entrepreneurial spirit “What makes Alberta special is its great investment environment,” says Malcolm Adams, a senior vice-president at Annapolis Capital. “There’s a fantastic entrepreneurial spirit in western Canada, and good royalty structures. In the Western [Canadian] Sedimentary Basin, there are opportunities for all kinds and sizes of companies.”

Annapolis, which invests exclusively in Canadian energy, has a pragmatic approach to asset liquidity. “We don’t invest in service companies or the midstream, where we don’t have a lot of expertise, or in the capital intensive oilsands,” Adams says. “We do put investment money into companies that are doing unconventional tight oil and shale gas…that kind of thing. “The best investments you can find are companies capitalized in the $50 million to $150 million range. As an investor we can help those companies grow, and might have somewhere in the range of $150 [million] to $400 million in value some years down the road.”

There is also a big market for the “de-risked assets” that result. “To achieve an annual 20 per cent rate of return for our investors, we take a bit more risk at the front end than those bigger organizations are willing to take,” Adams says.

As the eight to 12 companies in a portfolio grow, Annapolis sells interests to bigger entities. Of course, the market for assets within Alberta “ebbs and flows,” according to Adams. “We had six realizations last summer. It was maybe 18 months since our previous realization.”

Waste to wealth In one investment area, Alberta is unequalled in the world. That is its approach to greenhouse gases (GHGs), the inevitable by-product of oil and gas production.

Alberta’s Specified Gas Emitters regulation identifies companies that emit more than 100,000 metric tonnes of carbon dioxide equivalent per year. Those companies are required to reduce their emissions below baseline levels, through continuous improvement, buying offsets or emission performance credits from other emitters, or by paying $15-per-tonne emitted into the Climate Change and Emissions Management fund. “Or they can do all of these things; it is up to them to decide how they want to pay the bill,” says Kirk Andries, managing director of the Climate Change and Emissions Management Corporation (CCEMC). Such a funding arrangement is possible because the large emitters are responsible for 70 per cent of Alberta’s emissions.

In turn, CCEMC runs global competitions to find and fund ideas that have the potential to make real reductions in carbon emissions for the benefit of all society. It doesn’t take long to recognize that as a transformative investment idea.

“We have invested about $230 million in 90 projects, yet their total value is about $1.6 billion,” Andries says. “Our money is leveraged; on average, for every dollar we spend we get $5–$6 of return. Ours is risk capital, and it is mostly put into projects that would not occur without our funding. We support transformative technologies that can deliver meaningful [GHG] reductions.”

“From the GHG perspective, the reduction potential from all the projects we have funded is more than 20 million tonnes by the year 2020,” he adds—a number he says, is generated at the project level. “When the technology itself is commercialized and then broadly deployed in Alberta and anywhere else, we expect a much greater reduction.”

 These numbers continue to grow with the issuing of annual Grand Challenges and bi-annual expressions of interest for funding of the next big GHG reduction idea. “Alberta isn’t the only jurisdiction with this kind of technology fund, but we are the only technology fund supported with these types of regulations,” Andries says.

Look at the long term In the fall of 2014, global oil prices had just gone through what the business press frequently called a “price collapse.” These price declines followed half a dozen years in which international oil prices averaged nearly $100 per barrel. In real terms, that is one of the longest periods of higher oil prices on record. Of particular interest, Brent crude—an international standard, based on oil production from Europe’s North Sea—was higher-priced than WTI, the most important North American benchmark.

These prices made heavy oil and oilsands projects quite profitable, but they also made tight oil production profitable and competitive. Fracking projects were releasing natural gas and condensate in large volumes, profitably, and the oilsands sector was providing the market with more complex hydrocarbons—resources with uses for both fuel and petrochemicals.

For the first time in many decades, North America had excess production and was looking for ways to export petroleum and its products on a large scale. However many factors led to a rapid decline in oil prices beginning in October 2014. How significant was that for continued project growth?

According to Ziff Energy’s Bill Gwozd, “What is really important is the price over the next several decades. Construction on the projects that we are working on won’t even start until 2019, say. They won’t be going on production until 2023, and then they’ll produce for maybe 40 years. What you care about is the median price, maybe three decades forward.” Of course, not everyone shares the same view: an executive from Cenovus, for example, says lower prices have an impact on a company’s ability to invest.

According to executive vice-president Dan Allan of the Canadian Society for Unconventional Resources, the resources in the province are such that, although price declines will not seriously affect long-term development, they can affect capital markets.

“Rates of return dictate the business,” he points out. “If margins start to thin out, capital goes elsewhere. That is reality in the financial sector. Certain projects being considered for mezzanine financing, for example, are now going to be marginal or at least less attractive.”

But then Allan’s infectious optimism—an optimism that is evident throughout Alberta—kicks in. “I have been around long enough to know that we always find a way,” he says. “We go somewhere else with a different product. It might be light tight oil; it might be liquids-rich gas. We go to the products that provide the highest rates of return, while we let other assets sit idle for a while until circumstances change. When it becomes difficult to attract capital on one side of the equation, an opportunity opens up on the other side. That is how markets correct themselves.”

As Allan observes, “it is the nature of markets to change.” For example, at the beginning of 2013, it was difficult for some companies to raise money. As the year progressed, however, that changed. “The right assets with the right management teams got in favour again because people were feeling more comfortable about the prospects for success in some of these projects; capital started to flow back in. Capital flows are robust, and that is a good thing.”

To cite one example, Ziff Energy—the company Gwozd works for—does “two things for a living. We have an E&P [exploration and production] services group, and we have a natural gas group. Our E&P services group has national oil companies as clients, intermediate oil companies, private companies, public companies, small producers, big producers, onshore producers, offshore producers” in 70 countries around the world.

“The most important thing we do is to benchmark operating costs. For example, when you are drilling an offshore well, you need materials and unique services. You may need chemicals such as glycol. For similar operations, the Gulf of Mexico versus Indonesia, for example, your annual glycol costs may represent $1 million in one area and $10 million in the other.” Because his firm has so many clients, its database enables it to quickly benchmark minute operating costs. “We help our customers understand that in some areas they are very efficient, while in others there is room for improvement,” he says. “By benchmarking you get best practices, and you drive your operating costs down.” That’s one part of Ziff’s business.

The other is its forecasting group, which uses sophisticated tools to forecast energy prices to the year 2050.“We forecast gas supply, gas demand, gas transportation, gas pricing, cost of gas. We forecast the decline rate of new shale gas plays in the Marcellus in the year 2029. We are interested in at least a 30-year spectrum—say, the price of oil from 2017 to 2047; 2032 is the midpoint. The same with LNG projects: the relevant time period is 2020-50. That is how you build your economics.” He returns to the question of price declines. “Today’s price has no relevance for big, mammoth projects.”

Sunday, January 11, 2015

They'll be back

Chinese SOE activity may have cooled, but that likely won’t last

This article appears in the January, 2015 issue of Oilweek 

By Peter McKenzie-Brown
Consider the record.

In 2007, when oil prices were on a tear, buyers spent $18.9 billion on oil sands assets. In 2010, companies poured $16.6 billion into oil sands acquisitions. The largest of the acquisitions that year was Chinese state-owned enterprise (SOE) Sinopec’s purchase of ConocoPhillips’s for 9 per cent interest in Syncrude Canada for $4.75 billion. A year later, Sinopec bought Calgary oil producer Daylight Energy Ltd. in a $2.1-billion deal. Then another Chinese SOE, PetroChina, bought Athabasca Oil Sands’ MacKay River project for $1.18 billion.

And in 2012 CNOOC – a “mixed-enterprise” company, which means it was not entirely owned by the Chinese government – acquired Nexen for $15.1-billion. Professor Gordon Houlden, director of the University of Alberta’s China Institute, says that “was the largest acquisition that China, in its 5,000-year history, has ever made.” It was also the culmination of a 7-year buying spree, during which China invested $30 billion in Canada’s energy sector, as part of a $100 billion splurge on global energy and mining assets.

Getting Tough with China: At least in theory, these efforts brought a firm response from Ottawa. “When we say that Canada is open for business, we do not mean that Canada is for sale to foreign governments,” said Prime Minister Stephen Harper as the Foreign Investment Review Agency let the deals go ahead. “Going forward, the [industry] minister will find the acquisition of control of a Canadian oilsands business by a state-owned enterprise to be of net benefit only in an exceptional circumstance.”

Harper toughened the rules on foreign ownership in Canada. Legislation proclaimed in 2013 broadens the definition of a state-owned enterprise. It now refers to an entity directly or indirectly controlled by a foreign government. Substantial investments in the oilsands are eligible for review, and in the case of the oilsands they must provide an “exceptional net benefit” if the acquisition means an SOE will control an operation. Also, the Minister of Industry has the discretion to accept or deny a deal.

Have these rules had an impact on investment in the oilsands? On the surface, that seems to be the case. Since the regulations became law, the number of SOE acquisitions of oilsands companies has declined steeply. As interestingly, merger and acquisition activity tied the lowest levels of the century: so far this year, there have been none.

However, it is important to put the federal government’s rules into context. China has not been buying, but neither has anyone else. Last year, bids for oil sands property sank from a gusher to a trickle. Transactions with oilsands content added up to only $770 million in 2013 and they have yet to recover. This year oilsands acquisitions have been higher – $1.8 billion – but nowhere near the highs of several years ago. And most of this year’s investment took the form of two deals. The larger one was a $751 million Exxon/Imperial acquisition of leases from ConocoPhillips. The other was Osum’s $325 million purchase of a project from Shell. Taken as a sector, the shares of oil sands producers are lower today than they were two years ago.

Lethargy: “Except for 2008-9, in recent years there been many acquisitions of oilsands companies in Canada,” said Professor Eugene Beaulieu of the University of Calgary’s School of Public Policy, “but this is in rapid decline.” Why did the oilsands suddenly sink into such a stupor? In a report available online, Beaulieu and his colleague, Matthew Saunders, show that in 2013 only a single SOE deal took place in Canada. It was worth a modest $320 million, compared to $28 billion the previous year, and it didn’t involve the oil sands.

Yet, according to Beaulieu, the recent changes in foreign investment have had at most a modest impact on foreign investment. “Ottawa’s Minister of Industry has a great deal of latitude at the political level,” he says, and “Canada has not been obstructive. We have been really open to foreign investment.” Except for the proposed $40 billion sale of Saskatchewan Potash Corporation to Australia’s BHP Billiton – a deal the Saskatchewan government opposed – and a $520-million offer for part of a Manitoba telecom, “we have been open to foreign investment. These new rules are not restrictive.”

In Beaulieu’s view, takeovers dried up because the oilsands industry faced internal problems. “The large companies have not been negatively affected as much as the little guys,” he says. Smaller oilsands companies are being disproportionately affected by a number of factors. “These include high extraction costs; changing regulations; such alternatives as tight oil; and problems with infrastructure and lack of access to markets. Those are the big four. Some people even say that China is experiencing buyer’s remorse because of all the properties” their SOEs bought at 2012 valuations.

In their report, Beaulieu and Saunders show that the oil companies suffering most from the decline in foreign investment were the juniors. Since Harper made his 2012 announcement about tightening SOE investment in the oilsands, share prices for the larger oilsands companies have risen slightly. By contrast, oil sands juniors had seen their prices decline by 40%. Calculated last May, these metrics did not reflect the steep declines in global oil prices since last summer’s highs.

Also, says investment banker Mike Jackson of Scotia Capital, not everyone sees Canada as a low-risk country. For example, there is “the regulatory process we have around pipelines, and Aboriginal issues,” he says. “People outside Canada scratch their heads when they consider how lengthy and convoluted it can be for us to get anything done.”

“Government-owned entities make Canadian acquisitions not only to acquire resource properties, but also for intellectual property and experienced staff,” said an executive – he requested anonymity – with a senior bitumen producer. “In at least one case, the Chinese acquirer used corporate acquisition in Canada as a means of training its own staff to the detriment of the business.” He shook his head. “With proper structuring, all the benefits they want could be obtained through a joint venture arrangement. For example, a Canadian entity could transfer an asset to a partnership or corporation. The foreign entity could acquire a non-controlling interest in that entity in return for funding all or part of the subsequent development costs.”

Another Bite: Chinese SOEs “will be back for another bite, “says the U of A’s Houlden. “They have powerful incentives to continue to buy Canadian oil assets. One of them is that they are sitting on $6 trillion worth of cash reserves, and they would rather have assets than paper. They can only put so much into T-bills.” As importantly, he says, “The bulk of the oil they import comes from unstable parts of the world, where they have been burned many times in the past. Many of those countries are remarkably unstable. They have had bad experiences in Libya, Sudan, and Iraq, for example. Canada is rock-solid.”

“I think their absence is temporary,” he says; China is out of the Canadian market because they binged at the beginning of the decade and now they are digesting what they bought. “They were attracted to the price of our assets, but now they need to develop the software, the skill sets needed to run a large corporation in a North American environment. They are used to operating in developing world environments, but in North America the rules are different. The labour regulations are different, and the transparency requirements are far different. It is in their strategic interests to learn some of that. Also, we have attractive technology – shale gas, for example. That will be a good fit over time.”

According to Houlden, three things are behind China’s absence, although “you can’t put an exact weight on each of those factors.” For one, Chinese investors “aren’t happy with the adjustments to the Canada investment act regulations, which made it difficult though not impossible for SOEs to invest in the oilsands,” he says. Another is that the acquisition doesn’t look as good as it did a couple of years ago, either. “Valuations are declining. In the long run, though, I think CNOOC’s acquisition will be just fine. Nexen had attractive assets.”

Finally, he says, “We’re in the second year of an anticorruption campaign in China, and the kingpin in that campaign is Zhou Yongkang.” Formerly a senior party official, Zhou became quite wealthy through his involvement with SOEs. There has been a great deal of examination of his business dealings, and this is affecting the operations of Chinese SOEs abroad, according to Houlden. In addition to the corruption issue, he says, “the consequences of making a really bad investment are much more serious in China than they are in Canada.”

It is because China is out of the market, that the asset buying spree makes sense. However, says Houlden, “The Chinese will be back. They have the deepest pockets of anybody, and they are the biggest importers of petroleum.”

Shortly after the interview with Houlden, a senior Chinese diplomat, Calgary based consul general Wang Xinping, told a newspaper that China’s state-controlled energy firms were struggling to turn a profit in Canada – in part because of Ottawa’s immigration laws. Mr. Wang said China’s SOEs want to bring in their own employees to reduce costs. Ottawa has been unwilling to issue the work permits the companies asked for; this made it harder for Chinese companies to develop their projects profitably.[

Bottom Line: Although M&A investment in the oilsands is down, investment in just about every other hydrocarbon asset in the WCSB is at historically remarkable levels. To a large degree, that is because Canadian oil and gas plays are more profitable than their American counterparts – especially given the recent decline in the loonie compared to the greenback. More importantly, petroleum properties in Western Canada are stable and offer better value. Of 31 North American plays that pay out in 2.5 years or less, 25 are Canadian. In addition, the Western provinces often provide royalty holidays as incentives to drill.

Also, of course, the WCSB is a huge geological basin with the most diverse resource base on the planet. This makes it a particularly attractive place to invest in oil and gas, and this year investors have placed large sums in the sector. The shares of Canada’s public oil companies are barely higher than they were two years ago. Fanned by the winds of historically low interest rates, they are using debt to acquire and develop attractive conventional assets. Not everyone is so optimistic, however. Citing lower oil prices and uncertainty around pipeline construction, the Canadian Association of Oilwell Drilling Contractors (CAODC) expects drilling in the basin to drop 10% next year.

Private investors are even more enthusiastic. If you prorate the numbers in the Annapolis report to the end of 2014, private interests are almost certain to invest more in the basin than the $3.8 billion they did during the 2008 economic crisis. Stories are still circulating about private investors who made killings by putting money into energy assets in those grim days. Will today’s private investors do the same? If so, it will be another enticement for China’s SOEs to come back to the table.

“You can’t ignore them,” Houlden says. “China will be back.”