Thursday, February 10, 2011

Tell Your Banker to Buzz Off!

As lines of bank credit grow increasingly restrictive, royalty financing offers new options for operators. This article appears in the February issue of Oilweek
By Peter McKenzie-Brown and Richard Graham

Especially if you’re a natural gas producer, it can be tough to get credit these days. What are you going to do?

One possibility is to do what Compton Petroleum did last spring. Primarily a gas producer, the company sold a 5% royalty interest in 19,000 barrels of oil equivalent (BOEs) production per day, plus a 5% interest in 600,000 undeveloped acres to Caledonian Royalty Corporation, a company founded and managed by oil and gas financier Jim Kinnear.

In a way, royalty financing is filling a gap created by the elimination of energy trusts – at least, that’s what conventional wisdom would like you to think. However, as we researched this story, it became increasingly clear that royalty financing not only meets the needs of investors (especially heavy hitters), but it is also an excellent tool to meet the industry’s needs – natural gas companies like Compton Petroleum, for example, but other companies as well. While the industry traditionally associates the idea of royalties with government take, the new players in this area are promoting it as an effective alternative financing tool. While the jury is still out on whether it will be a preferred form of funding during the next boom, right now it has a lot of merit.

The Olden Days
Royalty funding is not new in Canada’s oil and gas sector, but the industry has to a large extent lost its collective memory of royalty financing. The founder of royalty financing in Canada was R.A. (Bob) Brown who, with his son – also named Bob Brown – later turned Home Oil into a major independent oil company.

During the Great Depression royalty financing played a critical role in the development of Turner Valley – at the time “the biggest oilfield in the British Empire.” On June 16, 1936, Brown senior’s Turner Valley Royalties #1 well began flowing 850 barrels of crude oil per day. Funded by royalty financing which guaranteed investors a percentage production from successful wells, Royalties #1 found Turner Valley’s oil formation two decades after earlier producers began stripping naphtha from wet gas discoveries there. This meant the first generation of producers had wasted much of the pressure needed to produce light oil from the reservoir.

Royalties financed 69 other wells in Turner Valley in the two years following Brown’s discovery. Since only two of those wells were dry, the primary constraint on new investment was the rapid saturation of local crude oil markets.

Royalties financing didn’t last, however. In 1938 the federal government decreed that income from oil production was taxable as profits in the hands of the producing company. In the investor’s hands it was taxed again as income, rather than return of capital. Although a producing company appealed this decision successfully, the incident shook confidence in the system. Indeed, in 1942 Ottawa amended the Income Tax Act to tax oil income from royalty trusts at wartime rates. Although the federal government repealed this provision in 1950, it was 70 years before petroleum royalties again became a significant alternative to traditional debt and equity.

Teams at Play
In recent years, at least four teams have suited up for the royalty game. Each team has its own style of play and a strategy that sounds like a winner. Brickburn Asset Management has the most passive style of play. Range Royalty Management is the brainchild of Clayton Woitas, founder of Renaissance Energy, and effectively combines royalty financing with E&P. Caledonian, founded and controlled by Jim Kinnear, is new while the fourth, Freehold Royalties Ltd. has roots going back to the creation of Canada.

Until it converted to a dividend-paying corporation at the beginning of 2011, Freehold was a publicly listed trust that issued distributions based on a large number of diverse royalty-generating properties (mineral rights and gross overriding royalties) and working interest properties. Its income comes from oil, gas, liquids and potash. Many of its properties are legacy assets – royalty rights which Ottawa granted to railroads and the Hudson’s Bay Company as part of the national effort to secure Western Canada. Freehold has interests in more than two million gross acres of land and 23,000 wells.

In a statement, the company’s president and chief executive officer, Bill Ingram, said that most “of our oil and gas production comes from mineral title lands and gross overriding royalties, which have no associated capital or operating costs; thus we have relatively low capital expenditure requirements. The strength of our royalties has allowed us to preserve a high payout ratio historically and should allow us to maintain a high dividend payout.”

The newest team is that of financier Jim Kinnear, who sees royalty financing as an extension of a common practice in Canada’s mining sector. When he started out in the securities business, says Kinnear, “we invested in small mining syndicates that had acquired claims – money returned plus a carried interest. I learned about returning capital to investors. People liked to see a return of cash or cash flow, and they still do.”

Last year, after retiring from Pengrowth Energy Trust – a business he founded and managed for over 20 years – Kinnear began applying this lesson in finance to oil and gas in an innovative way. So far he and his investors have placed $100 million in Caledonian Royalty Corporation. Their royalty investments – which represent registered interests in land and rank ahead of banks and other creditors – allow qualified investors to participate in cash flow based on production. Caledonian’s royalty interests include current production and potential future production from a large undeveloped land base in Alberta. At present, those assets are heavily weighted towards natural gas.

Range Royalty Management operates rather more like a traditional oil company, but also does financing through the issuance of royalties. The company was not willing to be interviewed for this story, but a source who asked to remain anonymous describes the firm as having “a great technical team. While they always want an overriding royalty, they get at it in a different way. They begin at the grassroots level” – by going to land sales, drilling and frequently operating oil and gas properties. Issuing royalties effectively gives the company financing that bears no interest, doesn’t need to be repaid and is free of commodity price risk.

The Problem with PUDs
Another newcomer to royalty financing is Bill Bonner, president of Brickburn Asset Management. Brickburn manages four partnership funds that invest in royalty interests under the WCSB brand name.

Although he has had a long career in oil and gas financing, Bonner only added royalty financing to his company’s portfolio in 2008. His system is both conservative and traditional. “We raise capital through prospectus,” he explains, “then make that capital available to experienced operators for the completion of development wells. In return, we earn a gross overriding royalty. One way to think about this is that we rent the operator’s wellbores. We are not concerned with any of the traditional costs, including the well’s ultimate abandonment.” He adds, “The sanctity of the royalty position is a very special place to get to.”

Bonner is adamant that royalty financing in its own right is an effective and robust form of finance rather than a replacement for the energy trust. When the oil industry goes into boom mode again, “we think there will still be opportunities for this kind of instrument, although candidly we don’t know for sure.”

He adds that “the main link between us and income trusts is that we pay out capital as we receive it. We provide a stream of income which the investor really likes. We are very much a distribution model as opposed to a model where you retain capital and grow. One of the advantages we have is that our investors get a tax write-off – a 30% Canadian Development Expense, which enables them to write off all of the money they have invested. It just takes time.”

He adds, “We have completed five partnerships totalling $82 million. We only take the money for three years. At that point our prospectuses say we will offer a ‘liquidity event’ to return the capital investment back to the investor. Our game plan is to somehow monetize the property after our investments have gone through a period of flush production – either by selling it outright or by somehow putting it into a going-concern business.”

Brickburn’s first royalty partnership came about in 2008. After the 2006 Halloween Massacre imposed a new tax on energy trusts, he says “it became increasingly difficult for smaller energy businesses to finance growth because for them the liquidation opportunity (selling their assets to energy trusts) had disappeared. So we moved in with this royalty instrument.” Complicating the tax problem was the financial crisis. Traditional sources of equity and debt financing for junior oil and gas companies seemed to have disappeared. Part of the solution was royalty financing.

Brickburn royalty partnerships have participated in more than 70 wells, 95% of which used horizontal multi-frac technology. “One of the reasons operators like us,” according to Bonner, “is that we extend their budgets. If we provide one and a half million dollars for a horizontal well, it frees up that much money for them to go do something else.” Royalties can add to the companies’ bottom lines in other ways, too. One of the main reasons is that operators tend to carry inventories of “proven undeveloped reserves,” or PUDs.

“The problem with PUDs,” says Bonner, “is that you get credit on your balance sheet for them as a proven resource, but now you have to throw a lot of money at them to turn them into developed resource. What we did was to come along and offer operators the opportunity to develop those PUDs in a way that was not dilutive to equity” since royalty interest investments equate to non-repayable loans. “Even though interest rates for the last couple of years have been close to zero, royalty financing is attractive because you don’t have to pay back the principle. When operators began to see this, they quickly realized that taking our capital was very accretive to the capital they had to spend themselves.”

Through its family of funds, Brickburn has acquired royalty interests through 11 operating companies, but is bound by agreement not to mention names. However, Delphi Energy and Bellatrix Exploration have both publically acknowledged that they use royalty financing from Brickburn.
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