Every year, several junior oil and gas companies in the Canadian oilpatch are successful enough that they get bought out by intermediate producers, making their long term shareholders much wealthier in the process. Depending on what stage of the market we’re at, premiums can be 40%-50% on top of the value the management team had created.
And then some of the intermediates get bought out by even larger (and often American) energy companies, creating even more value for investors.
It’s a continuous cycle. Management teams build up companies, sell them, and start over. Sometimes it only takes a couple years, sometimes it’s a five to seven year process. But for the investors who know the teams that have the track record, investing in that teams’ next deal from the beginning is a winning recipe.
In my latest issue for subscribers, I outlined three management teams in the oilpatch – two Canadian and one international – who have made their investors a lot of money this decade. And then I gave a small synopsis on each of their brand new ventures that are just getting off the ground.
Like the mutual fund disclaimer says, past results is no guarantee of future performance. But getting in close to the ground floor of a successful management team’s new deal is often a good place to start.
The junior and intermediate oil and gas producers are now in the hangover period of a big buyout cycle.
It has been exactly three years since the Canadian government flip-flopped on their promise not to tax the energy trusts. The trusts’ business model was to pay out their profits to dividends to investors, and not as income taxes to the federal government. The government promised not to tax them during the election, but changed their mind afterwards.
Not only had they become a key staple in investor’s income portfolio, during a time of low interest rates, but their business model made millions for energy investors.
Investors can tell if a stock is a trust or not because they have “.un” at the end of their stock symbol. As energy prices – especially natural gas, (most Canadian producers are heavily gas weighted, vs. oil) soared upwards, junior companies loaded up on debt to increase production as fast as they could. They knew that the trusts would buy them out at a certain production level, as the trusts needed to keep replenishing their production to keep up their monthly distribution payouts. It was like engorging yourself at a buffet.
But then the Canadian government’s “Hallowe’en Massacre” of Oct 31 2006, where they said would now tax the trusts, was the beginning of the end of the huge gravy train the junior and intermediate producers were on. Without the trust structure’s tax advantage, these companies would/will now revert to regular corporations, and they will create shareholder wealth through less expensive organic growth, not acquisitions designed to keep up distributions.
The junior and intermediate producers continued to add debt to speed up growth, however, because gas prices steadied around $8/mcf for much of 2007, and spiked to $12+/mcf in 2008, providing enough cash flow to cover increased debt and see their valuations increase. At the same time, the new technologies of horizontal drilling and multi-stage fracing were also opening up new fields and helping to increase cash flows, profits and multiples.
And then came the crash of 2008. Demand dried up with the global economic collapse just as these twin technologies brought huge new sources of cheaper supply on stream.
So what is happening now is that all that debt was piled on to grow production in a completely different price environment. And many – I would even say most if not almost all – producers were highly levered. Their debt levels were very close to their limits back when gas was $12/mcf.
Lenders are now tightening their lines of credit. Companies are being forced to sell off assets (actual bankruptcies have been few) and for the gas weighted producers, cash flows remain low.
This situation has handicapped even some of the most respected management teams in the business. The good ones have been able to raise equity – and truly, at much less dilutive prices than I would have thought – but few have yet been able to crawl out from under their mountain of debt.
That’s why I like these new ventures by proven teams – they are not saddled with old debt. Their debt structure fits the new cash flow reality, and the business – along with my investment in it – can grow much more freely.
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