The Energy Report: Brian, is there a production cost for
North American oil and gas producers at which most juniors can no longer
afford to operate?
Brian Bagnell: When you're losing money-and at these prices, most
companies are-the balance sheet becomes the most important asset you have. We
have a number of producers that have balance sheets that are looking
stretched on the current strip, but there are also a number that are doing
fine, either through a combination of hedging in 2016 or conservative capital
budgets in 2015 and 2016, which has left them in relatively good shape
looking forward into 2016.
We did a study last month looking at break-even costs for all of our North
American producers. We looked at 57 covered companies between Canada and the
U.S. When the 2016 strip was hovering around $41 per barrel ($41/bbl), we
found that the vast majority of companies were able to cover production
costs. However, once you consider maintenance capital, which is money that
needs to be spent by the company to hold production at current levels, only 9
out of 57 had excess cash flow. Once we factored in dividends, that number
dipped to just three companies.
TER: How do you identify a junior company with staying power in
this price environment?
BB: Again, the focus should be on the balance sheet because if a
company is losing money the key plank to staying power will be its access to
liquidity. So it just becomes a matter of how long a company is able to
sustain this current downturn. The strength of the balance sheet is going to
determine whether a company is able to hold on long enough to take part in a
gradual increase in pricing.
TER: What will stabilize the market?
BB: It's a matter of supply coming offline. There are data points
that help us to believe that demand for crude will continue to grow, but the
key plank is going to be a reduction in supply. There are too many companies
in the world right now losing money. Not all of them are going to make it.
Not all of them are going to be able to sustain their current levels of
production, which means production gets shut in or is allowed to decline.
That also contributes to shrinking the gap between supply and demand. Our
team thinks that the global supply/demand equation will start to come back
into balance later this year.
TER: What would trigger a gradual price rise toward the end of this
year?
BB: Aside from some event such as increasing tension in the Middle
East or an emergency OPEC meeting resulting in an agreement to reduce production,
it's just going to be a matter of supply declining or being shut in. It's not
something that's going to happen all at once. It's going to be a slow
response in companies shutting in wells or letting production decline.
TER: Are companies still shutting in?
BB: There hasn't been much shut-in activity in North America to
date, even with the prices of crude where they are. You get into a bit of a
tough situation with deciding to shut in production. If you shut in
production, your cash flow will decline. As your cash flow declines, you're
less able to maintain even a lower level of production and your costs per
unit of production can increase. So it can become a bit of a downward spiral,
though this is a bigger issue for companies with higher-than-average
leverage.
We haven't seen much of that happen to date, although there is one event
that I would point to that does give me cause for optimism: Whitecap
Resources Inc. (WCP:TSX) recently announced that it would not be drilling
any more wells through 2016. It has spent what it's going to spend on
drilling for the year, and until prices improve, it doesn't see any reason
why it should spend capital on wells that don't provide an adequate return.
It is the first company to announce such a dramatic strategy. It is not a
small company either. It has about 40,000 barrels of oil equivalent per day
of production in Canada and has been a market darling. For a company like
that to come out and make such an announcement took a lot of guts. It was the
first mover. I think if we get enough companies that follow suit, that could
help to get the market back in balance.
TER: How will that affect Whitecap's production?
BB: Its corporate decline rate is just north of 20%, so we could
see production fall by about 20% over a year's time. This is fairly unique
for the North American oil and gas space so far. Few other producers with
strong balance sheets are allowing production to decline so materially. One of
the benefits of doing that is its pro forma decline rate will be lower, which
means that it will have to spend less capital to maintain a lower level of
production, all else equal, which actually improves longer-term
sustainability.
TER: What are oil and gas juniors doing now to retain and attract
investors?
BB: Generally speaking, investors are very apprehensive about the
energy space, especially about the junior space. Prices have fallen so far so
fast that it will take quite a shot of confidence to get a lot of interest
back into the sector. But as I said, balance sheet strength is top of mind
for investors right now. There are certain companies that are able to offer
some strength in that regard and are able to keep investors interested.
TER: What are the juniors doing to strengthen their balance sheets?
BB: Most of the companies with stronger balance sheets have them
because of actions that they took when prices were higher and access to
capital markets was there. Right now, very little is going on in the way of
equity financings. Not a lot of investors are willing to put new capital to
work in the junior oil and gas market. At the same time, banks are conducting
reviews of credit facilities, and we have seen some companies announce
reductions to those credit facilities, which makes access to capital even
more challenging.
Some producers are trying to sell assets in an effort to strengthen their
balance sheets, but commodity price volatility has been an impediment. So I'd
say there is not a lot that they can do right now. They are where they are,
and hopefully prices improve and confidence returns to the sector.
TER: Are you anticipating further mergers or bankruptcies in the
sector?
BB: Absolutely. That will definitely accelerate in 2016 if prices stay
around the current strip. We have seen some bankruptcies announced already
since crude prices started diving. I think we will see merger and acquisition
activity pick up as well, as the relatively strong acquire the relatively
weak and make their own businesses stronger for the longer term.
TER: How deep will the price dive? As low as $20/bbl?
BB: I think anything could happen down here. We are at the margin
at this point, and the price swings have been very wild. So it could happen.
I just don't think it could stay there for any period of time because
essentially nobody in the world would be making money at $20/bbl crude. That
is just not sustainable.
TER: Let's take a look at some of the companies in your coverage
universe. Why are you rating Advantage
Oil and Gas Ltd. (AAV:TSX; AAV:NYSE) Outperform?
BB: Advantage has many of the characteristics that we just spoke
about. The company has one of the better balance sheets in our North American
coverage. The valuation is attractive relative to the North American space on
strip pricing. It is still growing production and cash flow with internally
generated cash flow. That means Advantage doesn't have to issue equity or
take on new debt to grow production, even with current commodity prices. It
was able to defer capital in 2016 to 2017 without affecting its growth plans
in any material way. It's strong all around. On virtually every metric that
we value Advantage on, it screens at the better end of our entire North
American coverage.
TER: What is Advantage's hedging strategy?
BB: Advantage is hedged on roughly 52% of its net production in
2016 at prices higher than $3.50/thousand cubic feet, which is very, very
attractive given that AECO prices are hovering at or below $2.25 today.
TER: Freehold Royalties Ltd. (FRU:TSX) has no employees or
operations. It subsists on royalties alone. Why is it rated Outperform?
BB: The royalty space can be relatively strong in a sustained
downturn. There could be opportunities for Freehold to acquire royalty
packages from struggling producers in the oil and gas space. One potential
source of financing for conventional exploration and production companies
could be the sale of royalty assets. Some of those could be at attractive
prices to Freehold in the current market.
On top of that, Freehold's balance sheet is relatively strong. It can
sustain a dividend at far lower commodity prices than most nonroyalty
producers just given that its costs are low and it doesn't have to spend much
capital of its own. Freehold faces the same challenges that other royalty
producers have resulting from lower drilling activity, but it's revised its capital
and dividend plans down multiple times throughout the year to adjust to those
challenges and avoid leaning on its balance sheet.
TER: Is Spartan Energy Corp. (SPE:TSX) prepared to weather the
low price commodity storm? What is its strategy for the coming year?
BB: Spartan is relatively well positioned for low commodity prices.
It has some of the lower supply costs of our North American producers. The
wells it is drilling in southeast Saskatchewan are very cheap to drill and
complete, and results have been tracking well above our regional type curves.
As a result, it should have an easier time sustaining production than many of
its peers. Spartan also has a pretty strong balance sheet on the current
strip. It's one of the few producers that can maintain production in the
$40/bbl WTI range without leaning on its balance sheet.
TER: How are the low prices affecting PrairieSky
Royalty Ltd. (PSK:TSX)?
BB: Drilling activity is down at least 50% in Western Canada over
last year. Licensing activity, which is an indication of future drilling
activity, is also down very materially. That is going to result in lower
production on PrairieSky land, which results in lower cash flow. PrairieSky
can do little to control that. It doesn't drill wells itself, so it's at the
mercy of producers, though it does have some long-term drilling commitments
that help protect it. While it does still have some pretty attractive land
for development at the low end of the supply cost curve in Canada, royalties
on PrairieSky's land are generally higher than they are on Crown land for
similar prospects, which makes us think that it could have a hard time
attracting capital in this environment. We think 2016 is going to be a
challenging year. We think a dividend cut is quite likely coming up in
February. It could be somewhere in the 30-40% range.
TER: Is that a greater dividend cut than other royalty companies
are making?
BB: No. Freehold has already cut its dividend twice, whereas
PrairieSky has not. It only sets its dividend policy once per year, so I
would expect a cut in February. Its payout, which is a measurement of capital
expenditures plus dividends divided by cash flow, is over 150% on strip
pricing, which is higher than it should be for a company structured like
PrairieSky. That said, it does have one of the stronger balance sheets in the
Canadian oil and gas space, so people still see it as a name that provides
some relative safety. We would agree with that. The royalty space is a
reasonably safe place to hide in a low commodity price environment within the
energy space.
TER: What is Toro Oil & Gas Ltd.'s (TOO:TSX.V) outlook for the
coming year?
BB: It hasn't actually released a budget yet for 2016. It is still
trying to decide how it will tackle the current environment. However, it has
no debt right now, which gives it a position of relative strength in the
junior market, although it will be trying to figure out the best way to
finance a reduced capital program in 2016.
TER: Given all the unknowns and uncertainty, what would be your
advice to investors in the junior oil and gas sector right now?
BB: Right now, the junior oil and gas market is facing a lot of
stress. Your best strategy is to stick with companies that have better
balance sheets that can withstand commodity prices staying at low levels
through 2016 and can offer you upside when commodity prices start to improve.
Stay away from the companies with the highest amounts of leverage just in
case commodity prices stay lower for longer than you expect. Stick with the
survivors. If you're looking to make a new investment in junior oil and gas
markets, I would hold off until you see some signs of definitive improvement
in the crude supply/demand balance that can give some visibility for
sustained higher prices, because at $30/bbl WTI, it's very difficult for junior
oil and gas companies to have any profitability.
TER: Thank you very much for taking the time to share your thoughts
with us.
Brian Bagnell, CFA, is a research analyst in Canadian oil
and gas company analysis for Macquarie Capital Markets in Calgary. He was
formerly an investment associate at the NB Investment Management Corp. He
holds a bachelor's degree in business administration (finance and accounting)
from the University of New Brunswick.
