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.”

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