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Where the Market is Going and What the Perfect Investment Looks Like

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RICK RULE INTERVIEW PART II

Keith:    Rick, in the first part of our interview we talked about the state of the energy market now, and what some of the opportunities are.

But let’s talk details for a second—you’re aiming to come in somewhat as a lender of last resort in a tough market; willing to take the Big Risks.

But I wouldn’t think that comes cheap to these companies.  What’s the art of getting a deal done in that environment?  Why wouldn’t they just stop drilling?

Rick:    Remember Keith, the decline curves on most people’s new production is steep enough that if they don’t drill their production credit facility cannibalizes all their existing cash flows anyway; any remaining value they have is in their PUD’s. A lot of these revolving credit facilities were set up in anticipation of the fact that the companies could become self funding in 2019.

Keith:    Right.

Rick:    If you’re drilling the types of plays that have driven the Canadian oil and gas industry for the last 10 years your hope is refracturing that is secondary stimulation and additional drilling. And for some of these companies not drilling given the level of revolving credit facility debt they have–it’s not an option.

Keith:    So really they have a choice of doing nothing and being caught in a slow death spiral or…

Rick:    Probably a fast death spiral Keith.

Keith:    Yeah a fast death spiral or they basically take your terms and…

Rick:    Yes, live to fight again!

Keith:    So now is there a sweet spot for you in terms of either size of producer, commodity, location…is there any trend there at all?

Rick:    We would want to go to companies that are in the best quartile in terms of fully loaded production costs. What we’ve noticed is the good companies and I’m talking about a sub $500 million market cap space, the good companies have been thrown out with the bad companies.

If you look at companies like Delphi that is an extraordinarily efficient little company and they’ve been savaged.

Keith:    Yeah.

Rick:    So we would look at companies to be completely frank that wouldn’t have talked to us 3 years ago because they wouldn’t have had to. We would look to show love to what I like to call the “bruised super stars.”

Keith:    Right it makes perfect sense. Now do these guys see you coming? Is there a difference between experienced teams and relatively new teams or by definition these are fairly experienced teams cause they are the low cost producers?

Rick:    We would look to both. We think this is going to be a wonderful period for recaps. We’re in discussion with a couple of groups in Calgary looking to put up $50 to $60 million of their own money and have $30 to $35 million in what are in effect revolving acquisition lines, bridge lines available from us. So we’d certainly look to back new teams that were comprised of people we’ve done business with successfully in the past.

Keith:    Right.

Rick:    Preferably you find a group that’s be intact for 8 or 10 years that has an asset they’ve been working on for 3 to 5 years that they’ve been successful with but have been set back by low energy prices and aggressive capital expenditure.Keith:    How do you structure a deal that works?

Rick:     What I see probably working differently in this market is a chance to do hybrid debt equity. An example would be where an issuer has 80 or 100 proved under developed locations and has the producing infrastructure in place and has some of the money but not sufficient money.

What Sprott proposes to do with those people is to say take 30% working interest in a well, drill the well, get a priority payout on the well and then drop back to royalty positions so the rest of the reserves in the well subject to the royalty accrue to the issuer and the issuer’s bank. We see a lot of potential for that.

So we see potential in 2 ways, one our working interest in the well would not, in that case, be subordinated to the issuer’s bank. Importantly for the issuer, at payout the issuer goes back up to 100% working interest and so he or she books the vast majority of the reserves.

For us, we get a relatively quick payout but we get a lower overall rate of return. It’s important to note, however, that after the hyperbolic declines the tails, the producing profile of the well after payout can be very, very long. And having, from Sprott’s viewpoint, a clear title overriding royalty position on a package of wells could be a very good thing for the Sprott shareholders simultaneously with it being a very good thing for the issuer’s shareholders, and the lenders .

So we see the ability to do more of these hybrid debt equity deals.

Keith:    For these companies that are a preferred payout and I don’t know if you consider that 100% or 80% of cash flow to payout or what but for most wells now; whereas you were talking before pay backs bounced so quickly, pay backs were sitting around for the really good plays 8 to 12 months and now the really good plays are 18 to 24 months.

Rick:    Yes we’re looking at 18 to 24 months and we’re looking at pay out with a return on capital employed, so we’re talking about 110% pay outs and then we’re backing off to a GORR (Gross OverRiding Royalty).

What we’re giving them is the ability to buy us back out the GORR. We want to be able to do a lot of these transactions, so we want to provide the issuers very attractive solutions.

Keith:    Right.

Rick:    We see a situation where the Market takes care of itself in 3 or 4 years. And a company that has a great land base–and a lot of the small Canadian companies have monstrously large and wonderful land bases—where the companies have an existing portfolio of proved producing reserves and if we can help them monetize enough of the PUD’s to service the underlying credit revolving facility they still have enormous optionality in the rest of their PUD’s and land base.

Keith:    Right.

Rick:    We see this as a classic bridging opportunity. We see this as an opportunity to help someone get through the next three years.

Certainly we’re not the Red Cross; we’re going to do extraordinarily well helping them through the next three years. But we see in the case of many companies with $300 million market cap that we’re the only players in the market trying to help them survive.

Keith:    OK. Go on.

Rick:    If my suspicions are correct about the 1st and 2nd quarter of next year and particularly the 2nd quarter where the annual reports come out and the new reserve evaluations come out and the analysts are able to look at the reserve evaluations relative to the revolving credit facility, I think by that point in time we might evolve back into the equity business because we may be the only players in the equity markets.

We basically try and compete with other players in the market by competing where they aren’t. Right now we don’t see a lot of people in hybrid debt equity or in subordinated bridge and mezzanine facilities and so we’re competing here. My suspicion is we may have a 2 or 3 year window in debt but we may only have a 1 year window in debt. It may be the window next year is in equity.

Keith:    OK…now in the last cycle, after the 2008 crash, oil prices rebounded more quickly than people thought they would.

Rick:    Yes!!

Keith:    Today I would suggest you’re looking or consensus anyway is that we’re looking at a much longer timeframe to get back to those levels. How does that impact your thinking this cycle vs. last cycle?

Rick:    I think it’s correct and we have more to fall in the oil and gas space. We had that little move in the oil price from 50 to 62 or 63 that gave people a lot of hope and a lot of guys came to market. The issuers probably had less hope than the investors because the issuers “monetized” that demand as fast as they could. I think that hope has been dashed and I think we’re in a position in the very, very near term and now I’m talking between now and the end of October where there’s no hope.

We see equities collapsing, oil and gas stocks are equities; and we see the energy price off, we see emerging and frontier markets collapsing, we see all peripheral equity markets (and the junior markets are certainly peripherals) collapsing and then we have the specter of the psychology of that great boogey bear month of October coming up. Bad things seem to happen in October and when you have a market that’s emotionally driven, things like “October” become relevant.

So my suspicion is between now and the end of October there’s no particular reason to take much equity risk because most of the visible factors that could move a market one way or the other seem to be there to move it negatively.

Keith:    Right okay. Again, like the fact that this is going to be a flatter market opposed to a stronger rebounding market how do you see that impacting strategy?

Rick:    For me, in the near term what I’m going to be is a lender and not an equity player.

Keith:    Right.

Rick:    I think we have lower to go on the equity side. The issuer suggests that they’re starved for capital but for some reason they can’t spell warrant. In other words, they aren’t willing to make equity deals that suggest they are actually starving for capital. I suspect that will take care of itself and there will come a time when the best equity players out there raise capital on terms that reflect it’s scarcity.

Keith:    Rick we are running out of time. You’re painting a bearish picture here…what hope is there for energy producers and their shareholders?

Rick:    I do feel hopeful although I don’t feel hopeful about the next 8 weeks. But the truth is that the natural resource business has been extraordinarily good to me over time.

But it has been good to me because I’ve maintained the cash and courage through the last down cycles. The money you have invested in bull markets that you don’t scrape off the table and put in the bank or somewhere sensible declines by 50% in the bear market. This particular bear market, of course, has been more vicious than that.

But in the ensuing bull market if you apply the time at the market bottom to rationalize the mistakes you made, kick out the terminal losers and re-deploy the money into things that will survive and thrive in the bull market, in the ensuing bull market you make 10 times your money.

And trough to peak is sort of a 10 year cycle, so if you think about something where every 10 years you lose half your money and then you take the half you have left and it increases in value 10 times, the aggregate arithmetic is pretty damn good.

Keith:    Yeah.

Rick:    I believe the aggregate arithmetic coming out of this market is not going to be pretty damn good, it’s going to be spectacular because the market as expressed by the TSXV hasn’t fallen by 50% it’s fallen by more like 80% or closer to 90%. And my own experience has been the bear markets are truly the authors of bull markets and while I can’t tell your listeners when—I definitely can tell you that it will occur.

Keith Schaefer

 



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