Sunday, September 06, 2015

Venture Capital

By Peter McKenzie-Brown
It’s hard to forget the 2008 financial crisis, when the economies of North America and Europe went into freefall. 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 four small private companies. Starting in October 2008, during periods when the petroleum industry as a whole was nervous about the future, they were seemingly the only bidders on many parcels, at many Crown land sales – the bi-weekly auctions at which Alberta sells mineral rights to the highest bidders. The informal consortium reached an agreement by handshake.

One of the partners explained the outcome of their acquisitions, but for “competitive reasons” insisted on anonymity. “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,” he said. “Excluding lands in which others hold minor royalty interests, we acquired more than 60,000 hectares of mineral rights.” That was a small fraction 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 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 decades 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 skills. It is a management city, and its seasoned executives continually make high-stakes decisions.

A unique mix of characteristics have set Calgary up for growth and increasing strategic importance in the energy world. Within the city’s ten blocks – the business part of downtown – is an extraordinary concentration of expertise – the largest concentration of geological talent in the world, for example. Alberta’s petroleum industry has traditionally produced from conventional oil and gas formations that on a world scale are relatively modest. The industry developed strong drilling, engineering and technical skills at least partly in response.

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

“What makes Alberta special is its great investment environment,” according to Malcolm Adams, a senior VP at Annapolis Capital. “There’s a fantastic entrepreneurial spirit in Western Canada, and good royalty structures. In the Western Canada 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 oil sands. We do put investment money into companies that are doing unconventional tight oil and shale gas, the Bakken – that kind of thing.”

“The best investments you can find are companies capitalized in the $50 million-$150 million range, according to Adams. “As an investor we can help those companies grow, and might have somewhere in the range of $150-$400 million in value some years down the road.” There’s a big market for the “de-risked assets” that result. “To achieve an annual 20% rate of return for our investors, we take a bit more risk at the front end than those bigger organizations are willing to take.”

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 unique in the world. That is its approach to greenhouse gases – an inevitable by-product of oil and gas production.

By no means are the 105 largest CO2 emitters in the province all oil sands operations. As North America’s main energy producer, Alberta’s largest emitters include, for example, petrochemical plants at Joffre and Fort Saskatchewan, and large coal-fired power generating facilities. The quasi-independent Climate Change and Emissions Corporation (CCEMC) – established by the Alberta government but funded by imposing a $15 per tonne charge on the 105 largest CO2 emitters in the province – came up with the idea of having a global competition to see who could come up with the best ideas for turning emissions into products that benefit society. It doesn’t take long to recognize that as a transformative investment idea.

This extraordinary competition – nothing like it has ever been tried – has as its aim to develop businesses in Alberta which control CO2 emissions by using them as a feedstock. In a competition one-third through its five-year cycle, CCEMC created a global challenge to turn greenhouse gas emissions (mostly CO2) into a profitable resource.

To find ways to commercially use carbon dioxide as a resource, the agency is funding a global competition to look for answers. A not-for-profit with a mandate to reduce greenhouse gas emissions, the agency provided financial incentives for competitors – they ranged from university professors to multi-national corporations – to come up with “bright ideas” that, if initiated in Alberta, could help the province turn carbon dioxide into a useful resource – for example, methanol, which can be used directly as a fuel, or as a petrochemical feedstock.

According to CCEMC’s managing director, Kirk Andries, “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.” Emitters have a number of compliance options. They can reduce greenhouse gases by continuous improvement, they can buy offsets or emission performance credits from other emitters, or they can pay into the fund. “Or they can do all of these things; it is up to them to decide how they want to pay the bill.” Such a funding arrangement is possible because the large emitters are responsible for 70% of the Alberta’s emissions.

A “virtual organization” without offices, CCEMC has 90 projects on the books. “We have invested about $230 million in those 90 projects, yet their total value is about $1.6 billion. 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,” Andries continues. “We support transformative technologies that can deliver meaningful greenhouse gas 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.”

Oil Price Collapse? As this article went to press, 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’s 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 West Texas Intermediate, the most important North American benchmark.

These prices made heavy oil and oil sands projects quite profitable, but they also made tight oil production – a relatively new technology – profitable and competitive. Fracking projects were releasing natural gas and condensate in large volumes, profitably, and the oil sands 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 needed to find ways to export petroleum and its products, and did so. This led to a rapid decline in oil prices, beginning in October. How significant was that?

According to Ziff Energy’s Bill Gwozd, “The current price is irrelevant. What is really important is the price over the next several decades.” His company, which is active in most of the world’s petroleum basins, helps E&P firms by forecasting energy prices to the year 2050. “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.”

Not so, said an executive from Cenovus, who wished to remain anonymous. “We’re almost halfway through our Foster Creek project’s lifecycle, for example. Our steam/oil ratios aren’t quite as good as they were, and the price drop does have an impact on our ability to invest.”

According to executive VP Dan Allan of the Canadian Society of Unconventional Resources, the resources in the province are such that, although these price declines will not seriously affect long-term development, they will affect capital markets. “Rates of return dictate the business; if margins start to thin out, capital goes elsewhere. That is reality in the financial sector.” he says. “Certain projects being considered for mezzanine financing, for example, are now going to be marginal or at least less attractive.”

Then his infectious optimism 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.”

Many service companies are headquartered in Alberta. Operational services are generally in Edmonton, Red Deer, Fort McMurray and Lloydminster. Corporate headquarters are mostly in Calgary, and many of those companies do international work.

To cite one example, Ziff Energy – the company Bill Gwozd works for – does “two things for a living. We have an E&P 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,” he says. “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 in 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. 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 forecasting tools to forecast energy prices to the year 2050 – a 35-year timeframe. “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 2020-2050. That is how you build your economics.” He returns to the question of recent price declines. “Today’s price has no relevance for big, mammoth projects.”

What Malcolm Adams called Alberta’s “fantastic entrepreneurial spirit” is a spirit that runs deep.
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