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The lost boys of oil and gas are back

NORVAL SCOTT

Friday, April 18, 2008

CALGARY — — David Johnson remembers the dark days of last winter, when interest in small oil and natural gas companies like his was so low that investors in Toronto wouldn't even bother meeting with juniors seeking to raise money.

His company, ProEx Energy Ltd., has been chasing gas in unconventional plays in northeastern British Columbia since 2002, and has built up an attractive collection of prospects and healthy and growing production. He had enough money to operate, but investors had lost interest and the stock had fallen to a three-year low.

What a difference a winter — and a big leap in natural gas prices — makes. Since December, ProEx's stock is up 50 per cent, money managers are clamouring to get into its Montney play and Mr. Johnson can finally afford to sneak away to his boat off the Gulf Coast of Florida for a respite from the renewed energy rush.

"From an investor perspective, what's changed is the fundamental rejuvenation of the industry," he said this week from the deck of his boat.

"When you have one breakthrough it really sparks a whole series of incremental advances that are revitalizing the Western Canadian basin. It's got everyone pumped up, myself included."

Oil hit new records this week — including a record trade of $117 (U.S.) a barrel yesterday afternoon. That's created anxiety among motorists and economists but put the bloom back on the rose of Alberta's junior oil and natural gas industry and its increasingly unconventional resource plays.

The share prices of companies with exposure to those potentially lucrative areas are through the roof and interest in providing financing to them is returning in tandem, with a spate of major deals seen this month alone. (Measuring a cross-section of more than 100 companies, ARC Financial's Junior Producers Equity Index has risen by about 20 per cent in 2008. The TSX composite is up 2.9 per cent.)

While high oil and gas prices play a huge part in the turnaround, they're not the only factor. Investors, fleeing the carnage of the financial sector, are seeking a safe haven for their cash — and they appear to be attracted to the promise of new technology that is taking companies like ProEx and Birchcliff Energy Ltd. to new frontiers. Another unconventional gas player, Birchcliff's stock has more than doubled since December, prompting the company to launch a new equity issue in February that was oversubscribed by at least twofold.

It's a dramatic shift in sentiment. The junior sector had been wallowing in misery for nearly two years, a slump that started with the implosion of the country's energy trusts in 2006, when Ottawa took away the popular option that had created a wealth of buyers for the growing assets of junior companies.

A cocktail of other factors — disappointing gas prices, higher costs, and changes to Alberta's royalty regime — had driven investors further away from the sector. Share prices bottomed out in December and January. Lines of credit ran dry. The outlook was bleak.

What changed wasn't just perceptions of where commodity prices were headed, although that didn't hurt. Instead, there was a realization that junior companies are mastering the exploitation of unconventional resources at a time when demand for oil and gas looks to be stronger than ever — a heady combination of factors that, to many investors, smells of substantial long-term gains.

"The basin is changing, and the business model is changing too. Conventional firms can still be successful, but the economics are getting more difficult, in Alberta especially," said John Chambers, president of Calgary-based First Energy Capital Corp. "Resource plays — with their longer reserve lives — are the focus."

NEW FRONTIE RS

For Canada, the sea change is not the return of juniors but the fact that their hottest fields aren't necessarily in Alberta, the country's traditional oil and gas home. Companies are looking to the booming Bakken and Shaunavon oil fields in Saskatchewan, and even to the possibility of producing gas from shale rock in Quebec.

The greatest excitement, however, is in the Montney play, located mostly in northeastern British Columbia, although it extends into Alberta. (It gets its name from a B.C. town close to the Alberta border, northwest of Fort St. John.)

Montney is estimated to hold as much as 50 trillion cubic feet of gas (tcf), more than the proven reserves for all of Alberta (41 tcf). The challenge: How to profitably extract the resource at current prices.

The development of new fracturing techniques — in effect, setting off underground explosions to free the gas — has made that possible, so much so that Montney is now seen as viable. Companies don't have to do much more there than dig another well next to the one that's already working, rinse and repeat, and watch the money roll in.

Doing just that, Duvernay Oil Corp. is also feeling the Montney love. The large Calgary-based junior produces more than 20,000 barrels of oil equivalent a day. Its stock has almost doubled in value since December to all-time highs, as dramatic successes at Montney helped boost both production and estimates of its oil and gas reserves.

Earlier this week, Duvernay launched a $77.4-million (Canadian) bought-deal financing — a deal in which a broker buys new shares in a company in exchange for guaranteed cash, before selling on the equity to buyers — in order to fund an expanded drilling program. The move, coming at a time of relative drought for such arrangements, raised an eyebrow.

"We wouldn't have done the deal four months ago. We certainly wouldn't have got this price," Mike Rose, Duvernay's chief executive officer, said in an interview. "But our share price had had a nice appreciation from its lows and commodity prices are strong … and we had a fair idea it would be favourably received."

It was. Not only did brokerage Peters & Co. sell the new Duvernay stock almost instantly, but it felt it could have sold three times as much as was on the table.

"Montney is such a hot play right now, there's substantial activity there and the companies are having no problems making money," said David Doig, a Calgary-based analyst at Union Securities Ltd. "It's going to be a very successful play, so people are throwing cash at it."

Among juniors with Canadian oil and gas production, the only bigger financing this year than Duvernay's was one by Birchcliff Energy, which secured $130-million from investors in February. The carrot, again, is Birchcliff's vast exposure to unconventional gas; the company has as much as $1.5-billion worth of drilling opportunities in Alberta, much of it in the Montney play.

"The institutions are very focused on these large resource plays where you can do significant development work, and they'll finance repeatable, sustainable drilling," said Birchcliff chief executive officer Jeffrey Tonken, speaking from Toronto's airport after a hectic three-day tour meeting U.S. and Canadian investors.

According to Mr. Tonken, the company could have sold two or three times as much equity to institutions, but decided to raise only as much as it needed to pay off a bridging loan and finance some drilling.

"We had significant support because of our results and commodity prices, so we went to the market," he said. "Rule number one in this business is take the money when you can get it."

Almost 18 per cent of Birchcliff's stock — worth $230 million — is held by one investor: Seymour Schulich, the billionaire philanthropist with a reputation for investing in only a few companies, but regularly backing the right horse.

Mr. Schulich bought another 1.2 million shares in Birchcliff in the February financing deal; he believes that the stock could climb to $50 a share in the next three years from more than $11 a share today, as long as natural gas prices hold up.

"I really like them, and the play has a lot of potential," he said in an interview. "But the management has had some great success in the past and they run the company as it should be run, which is very attractive. You can't pay too much for good management or too little for bad management." HOW TO BE JUNIOR

While the management teams that run Canada's juniors vary wildly, from slick money makers to cowboy wildcatters, their business plans have never wavered far from a simple template.

They aim to find an asset, prove it has some decent reserves, get production to about 1,000 barrels of oil equivalent a day, and sell out to an energy trust with deep pockets that's aiming to boost its resources. If successful, the company management does the same thing all over again, but with greater backing from investors who now trust that the team knows how to create big returns.

It's a strategy that has served the country well, creating a thriving market for junior oil and gas companies, the likes of which doesn't exist anywhere else in the world. However, the rug was pulled out from the sector's feet in October, 2006, when Finance Minister Jim Flaherty pulled out his Halloween surprise — that income trusts would have to pay tax like normal corporations in the future.

As well as crippling the trusts, the decision effectively removed juniors' planned exit routes in one fell swoop, leaving their business plans in tatters. Several body blows followed; natural gas prices — so strong in 2005 because of hurricanes Katrina and Rita — stagnated, as mild North American summers and winters left demand flat.

Costs of manpower and materials continued to rise because of the oil sands boom, while the knockout punch was delivered last October, when the Alberta government introduced a new royalty structure on gas and oil production. Producers will have to pay the government more when prices are high.

Last winter, matters came to a head; all companies, not just juniors, slashed their drilling plans in Alberta, either turning turtle altogether or redeploying capital to B.C. or Saskatchewan. Drilling in Alberta fell to five-year lows.

Since then, drilling firms have cut prices for rigs, some by as much as 25 per cent from last year.

For Jennifer Stevenson, managing director at Qwest Energy Investment Management Corp., that means busy times. Her equity fund subscribed to all three April bought-deal financings — Crew Energy Inc., Celtic Exploration and Duvernay — and expects to be involved when new offerings take place.

Her rationale for the purchases is that she believes the junior market has bottomed out and is on the way up. Cost structures are much improved, and companies are making money again.

"In the last eighteen months, these companies have largely not been able to access the equity market for hard dollars, but now the positive tone is back," she said. "The strong companies have survived the downturn and now they're beginning to prosper."

For Ms. Stevenson, one big change is in natural gas. Usually, North American prices for the commodity dip in April — the so-called "shoulder season" — as demand for heating gas falls. Equally, summer demand (for electricity generation, to power air conditioners) hasn't yet kicked in.

This April, gas prices are above $10 a million British thermal units — a figure that's historically high by any measure, let alone for the time of year. They're a strong indication that North America has worked through the overhang in inventories seen in 2006 and 2007.

"The markets are starting to appreciate that the price is here to stay," she said. And for Ms. Stevenson, comparing the futures market for gas to the valuations of natural gas juniors, there's only one conclusion: Companies are substantially undervalued. She wants to get hold of as much equity as possible in gas-weighted names, particularly those with exposure to big unconventional plays.

THE NEW HIGH TECH

The shift to unconventional supplies is a direct result of the maturing Western Canada Sedimentary Basin, where much of the easily accessible oil and gas reserves have been used up. That's pushing firms into developing so-called unconventional supplies — natural gas found in tight shale formations or in coal beds. Or, of course, the mix of grit and crude that comprises Alberta's oil sands.

The problem with unconventional resources is that the oil or gas is difficult to get out, so companies have to throw science and money at it.

Even with better cost structures and prices, attacking unconventional resources might still seem a bit of a stretch for junior firms that don't have the capital base — and room to play — as, say, an EnCana Corp., the leader in developing unconventional gas resources.

Quietly, that picture changed last year. People started to notice that Petrobank Oil and Gas Resources Ltd., a junior oil and gas company with a reputation for trying out new technology, was getting remarkable results from the Bakken oil field.

Most firms saw Bakken, where light oil is trapped in very tight formations of shale, as being too tricky and expensive to develop. While there was clearly oil there, it was trapped in non-porous rock formations that kept it from flowing out into wells in any great volume. Essentially, the play was seen as being uneconomic.

Petrobank turned the conventional wisdom on its head by using a system that was developed by Packers Plus Energy Services, a closely held company whose technology had attracted attention for opening up tight gas plays in the United States, but hadn't yet gained traction north of the border.

"We knew we had to do something different to get the oil out of there, and our technical guys basically tore the whole [play] apart trying to work out what the best solution was," said Petrobank vice-president Chris Bloomer. "It turned out the fracturing technology was the key."

The system works by creating a series of explosions along the length of a horizontal well, literally breaking apart the rock formations and opening up fissures in the shale. Vast amounts of sand — as much as 75 tons — are pumped down the well, keeping the cracks open and allowing oil or gas to flow out at volumes far more comparable to a conventional well.

Effectively, multifracturing allows a company to replace as many as 10 vertical wells with one single horizontal well, greatly reducing the costs of developing unconventional plays like Bakken or Montney, while producing five times as much oil or gas. Not bad for a system that Dan Themig, Packers Plus's chief executive, first came up with when doodling on an airline napkin.

After Petrobank reported its Bakken production figures last year, Mr. Themig's phone started ringing "off the hook" as companies called up to use Packers Plus's technology, he said in an interview at the firm's head office in Calgary.

"We couldn't get any momentum until Bakken hit, but then company after company started to call and say that they wanted to use this system," he said. "It was the quickest adaptation of technology I've ever seen."

As a result of its success in the U.S. and now Canada, Packers Plus's rise has been meteoric. Mr. Themig says the firm has doubled in size every year since 2005, and is on course to do again in 2008, while the number of employees has soared from 30 to 240. The company expects to fracture as many as 1,000 wells this year worldwide. OLD FEARS

For Art Korpach, head of global oil and gas at CIBC World Markets, the mood is one of excitement that juniors are once again a viable business in which to invest. But there is also caution, and investors are focusing solely on firms' long-term strategies.

"The primary reason for the renewed interest is that companies have found some exciting things to pursue," he said. "But the market is distinguishing far more today between firms than it did in the past. Interest depends on the company's strategy, how it's going to use its money, and the reputation of its management. For firms trying to get capital for a marginal story, it's more difficult."

As a result, the juniors sector is set to be bifurcated between the haves, who got into resource plays early and are poised to make big profits, and the have-nots. The consequences will be that the strong companies will buy out the weak ones, Mr. Korpach said, leading to a situation where juniors get substantially bigger, effectively becoming intermediate players with a greater ability to more capably take on expensive, yet profitable, plays like Montney and Bakken.

"The junior space will consolidate to create a set of larger entities that have the ability to play in some of these trends," he said. "People are very much focused on getting into a longer-term game."

ProEx's Mr. Johnson has come to a similar conclusion. He expects juniors to attempt to copy the success of firms like his own by chasing unconventional plays elsewhere, in order to achieve success.

"Everyone in this business is smart, and people are going to look at what assets are doing well and say that they should get hold of some of those," he said. "They're going to have to go out and find something that's more appealing to investors or die on the vine."

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