One Man, Immeasurable Impact

How J. Howard Pew's intense and unwavering belief in the oil sands created an industry.

This article appears in the August issue of Oilsands Review 

By Peter McKenzie-Brown

If he is remembered at all, Americans interested in business history think of J. Howard Pew as an industrialist who created what was once one of the world’s largest energy companies. For Canadians, though, he was the legendary force behind the harnessing of the oilsands. Though his efforts in the oilsands sector were a cash drain for his company – at the time, one of the 20 largest in the United States – for this country he created an industry.

The thumbnail sketch of his life is this: Born in 1882, J. Howard Pew graduated from high school at age 14, from university at 18 and became president of Sun Oil at age 30. With his brother Joseph he transformed Sun (founded by his father; now called Sunoco) by introducing new refining, marketing, and distribution techniques. He was astute. During the First World War he responded to the war-time demand for crude by building a navy of tankers. That fleet became one of Sun’s most profitable businesses.

A publication celebrating Sun Oil’s centenary in 1986 described the man, who had died in 1971. “Tall and broad-shouldered, with bushy eyebrows, he was often seen clutching an enormous cigar in his fingers as he moved about Sun’s corridors. He was intense, sure of himself and deliberate in his speech even in old age.”

The Venerable Pew: An extreme conservative in his religious and political views, Pew was passionate about his work. “Working for Sun Company these years has been not merely a job,” he said in 1956. “It has been participation in an exciting adventure – a way of life providing satisfaction in the accomplishment of our goals. So our people have become a great team, welded together by great ideals and purposes accepted by each of us.”

In the 1940s the venerable Pew took a serious interest in the oilsands, in part because of an investigation of potential crude oil sources Sun undertook during the Second World War. In the early 1950s, George Dunlap had a remarkable interview with Pew before moving to Calgary to set up Sun’s Canadian exploration and production operations.

“I have one area that I am interested in and would like to share with you my interest,” Pew told him. He went to a cabinet to pull out a thick file marked “Athabasca Tar Sands,” then shared his vision of the future importance of the oilsands. He told Dunlap to ensure that “Sun Oil always has a ‘significant position’ in the Athabasca Tar Sands area!”

The venture was called Great Canadian Oil Sands Limited (now the Suncor plant), and in 1962 the Oil and Gas Conservation Board (today the ERCB) granted approval for the company to proceed with a 31,500 barrel-per-day, $122 million plant, but imposed severe environmental restrictions on the plant. The partners had serious concerns about economies of scale for such a small project. Costs began to rise and financial difficulties ensued. By 1964 it was clear that a company with deep pockets – not Canadian Oil Sands Ltd. – was needed to lead GCOS. Sun took on that responsibility. The capacity of the proposed plant increased to 45,000 barrels per day and the cost escalated from $122 to $190 million.

The larger plant received approval in 1964, partly because Pew wrote a letter to the Petroleum Resources Conservation Board (now the ERCB) saying “I believe in the future of this project and I will put up my own money without reservations if the permit is approved.” Read aloud at a meeting of the Conservation Board, that letter carried the day. By the time GCOS reached completion in 1967, costs had risen to $235 million.

Building the Plant: The contractor for the project was Bechtel of Canada, and the engineer representing Sun during construction was Robert (Bob) McClements, Jr., who later became chairman and CEO of Sun Oil. McClements described Pew as “one of the strongest influences on my life.”

Pew would visit the construction site and “we would have engineering (and other) discussions. He would ask ‘How much does it cost to feed a man an average twelve hours on a shift?’ He was very, very detailed. I still remember: it was six to eight pounds of food per person per day and a little less than $2.00 per person to feed a construction worker… Anyway, there was a side of J. Howard that I don’t think has really been widely recognized. I think many people would describe him first perhaps as an industrialist. He was certainly known as the leader of a large corporation. Sun was always in the top 20 of the Forbes list of companies. It was a huge company. But there was also a spiritual side to him. He was a very religious individual. His conversations often included two words: faith and freedom, and they were welded together….”

The Sun Company McClements joined in the 1960s was much different from those in today’s oilpatch. “There was no retirement plan, there was no healthcare plan, there was no sick plan. When you were sick, you took your own time off….You would pay for that time. When you retired – and nobody quit and nobody was ever fired at the Sun Company – you retired at 50% of your pay. There were no documents explaining this in those days.”

McClements described the only meeting he attended between Pew and Premier Ernest Manning. “I’m telling you I’ve never been in a business meeting in my life like that. It was like you and me sitting here talking. There were no hard specifics. (There) was a feeling of absolute trust between the two of them. And I remember when I went back to the plant, somebody asked me about it. Without thinking, I said ‘Those two men just reeked with honesty.’ The relationship they had was unbelievable, exactly the same wavelength.”

McClements served as master of ceremonies at the official GCOS opening. A Sun Company publication commemorating the event quoted him as saying “synthetic crude is a natural for petrochemicals. I see no reason why the stretch along the Athabasca (river) cannot become an industrial valley in time.”

McClements vividly remembered the official opening. “It was the end of September in 1967 at the dedication of the plant. Pouring rain, not a very good day at all.” Premier Ernest Manning and Pew (then 85 years old) both addressed the audience of about 200.

According to Manning, “no other event in Canada’s centennial year is more important or significant.… It is fitting that we are gathered here today to dedicate this plant not merely to the production of oil but to the continual progress and enrichment of mankind.” For his part, Pew told the assembly that “No nation can long be secure in this atomic age unless it be amply supplied with petroleum. It is the considered opinion of our group that if the North American continent is to produce the oil to meet its requirements in the years ahead, oil from the Athabasca area must of necessity play an important role.”

McClements, who was the first plant manager for GCOS, recalled a tour he gave Pew once production had begun. “We had visited the mine and were in the refining section of the plant (when he) asked to see a sample of what we were running and I asked an engineer to pull a sample of the product we were making at the moment. Mr. Pew took the bottle and held it up to the light. It was water white. He unscrewed the cap, held one nostril and sniffed the oil again. Finally, he stuck his finger in the bottle and tasted the oil. When he did, you could just see his face beam.”

A broad view of the GCOS story comes from Paul Chastko, a renowned oilsands historian. “When Great Canadian Oil Sands began production in 1968, it represented a remarkable achievement,” he wrote: “a Canadian company, backed by the investment capital of a U.S. multinational corporation, used a separation process researched and developed by scientists funded by the governments of Canada and Alberta to produce a synthetic oil capable of competing against conventional Saudi crude in world oil markets.” All true, but the energy behind this effort was the vision of J. Howard Pew. The impact on the oilsands of this one man has been immeasurable.

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.