Calgary is Deal City for the global energy industry, accounting for fully one-quarter of the value of all oil and gas mergers and acquisitions worldwide between 2010 and 2014. According to Calgary Economic Development there are more than 960 oil and gas companies headquartered in the city — in a constant state of forming, exploring, producing, acquiring each other and being acquired.
But with oil prices cut by more than half in the past 15 months, the pace of deal making has slowed significantly as conventional debt and equity funding have become scarce. Now, private-equity firms that came to town in better times are seeing reduced competition. Flush with cash from investors seeking to outperform public markets, corporate lawyers say, private equities are directing increased attention to Calgary in the wake of the reset on commodity prices.
Derek Flaman of Torys LLP says deal making was slowed in the first half of 2015 by a significant gap between bid and ask prices for energy assets. But prolonged price weakness has softened asking prices in recent weeks. He adds that private equities are particularly suited to tough times in the oil patch because of their ability to conduct intensive analysis before taking controlling positions in carefully chosen companies.
“Since June, the dial has really been turned up,” says Neville Jugnauth, Flaman’s partner at Torys in Calgary. “Private equity fits the Calgary model and currently it’s driving the model.”
The long-established Calgary model is for a young engineer or geo-scientist to work 10 to 20 years learning the ropes at a major oil company before forming a group of similarly expert, middle-aged tyros to go forth and conquer the energy world.
A leading example is the team led by energy accountant Mike Culbert, who remains president and CEO of Progress Energy after selling the company to Petronas of Malaysia for $5.5 billion in 2012. But the acknowledged archetype is geologist Mike Rose, who worked 14 years for Shell Canada before striking out with a few friends in the early 1990s. In 2001, they sold their first vehicle, Berkley Petroleum, for $777 million, and in 2008 they sold Duvernay Oil Corp. to Shell for $5.25 billion. Rose’s latest effort, Tourmaline Oil Corp., now has a market capitalization of about $7 billion. And, while his is the name to conjure with, there are hundreds of others engaged in the business of making themselves and others rich through the trade in hydrocarbon assets. While some crash and burn, others go on to glory.
“It’s a very entrepreneurial culture,” says Janice Buckingham, energy lawyer with Osler, Hoskin & Harcourt LLP. Neal Ross, Buckingham’s colleague at Osler, puts it another way: “No one is getting into this so they can be here 20 years later.” He says exceptions to the rule are MEG Energy, Seven Generations Energy, Northern Blizzard and Gibson Energy, where PE backers elected to retain their investments after initial public offerings (IPOs). But the vast majority of those 960 oil companies are born to be sold off or consolidated once they’ve built up sufficient value.
Trouble is, oil and gas prices are in the dumps. And that makes it harder to sell companies or to assemble the funding to build companies. Making it harder still, Buckingham says, is the trend toward increasingly complex and expensive drilling and fracking technologies needed to extract previously inaccessible reserves. A decade ago, Ross says, a start-up company needed to raise about $25 million to drill perhaps two dozen conventional wells and work up enough oil and gas production to support further exploration.
“Now,” he says, “you’re betting on far fewer wells for the same amount of money, so you need a much bigger capital pool” to drill more wells and reduce the risk of failure. “Now you need $120 million for a five-year runway,” and, he says, repeated private placements of $20 million to $30 million aren’t realistic.
All this is why private equity is becoming a larger factor in the Canadian energy sector, according to the lawyers who write the deals.
“It’s a very capital-intensive and transaction-intensive environment,” says Darrell Peterson, with the Calgary head office of Bennett Jones LLP. He says it’s a hot-house deal environment, in part, because the headquarters of the entire Canadian oil and gas sector are concentrated in a ten-square-block area of office towers and “you can literally just walk around” to meet with all the potential players. The resulting deal velocity, he says, is part of the attraction for private equities.
“The demise of the income trust sector really was the kick-off for private equities,” says John Mercury, co-head of Bennett Jones’s PE practice.
Osler’s Ross says that, until the federal government killed energy income trusts in 2006, “the natural buyers of small- and mid-sized oil and gas companies were the trusts and when they disappeared they left a significant gap.”
Torys’s Neville Jugnauth says income trusts were a “made-for-Calgary kind of model” that bought producing assets away from exploration companies. Trust investors got quarterly cash distributions from the income trusts, while exploration companies got the money they needed to prove up more reserves.
The trusts were succeeded by state-owned enterprises (SOEs), such as Petronas of Malaysia and several Chinese companies. SOEs made multi-billion-dollar investments in Calgary producers until Ottawa banned them from buying controlling interests in oil sands companies after December of 2012 as a matter of national security. The federal government said it would be wary of controlling acquisitions of a leading Canadian company in any industry by an SOE, and that this policy would extend to any individual or entity deemed to be influenced by a foreign government.
More recently, the formation and consolidation of oil companies has been further slowed by lower commodity prices that have constricted the flow of conventional debt and equity to the sector, Ross says.
“With low prices, you’ve got a less robust mergers-and-acquisitions environment,” Ross says. “Larger companies want to hold onto their cash and they can afford to wait for the gap to narrow between bid and ask prices. They aren’t rushing out to buy more things that they then have to spend more money on.”
In the mergers and acquisitions (M&A) hiatus, lawyers say, there’s room for patient money prepared to wait out the price slump. With their five- to seven-year time horizons and a propensity for investing in tranches of $100 million to $500 million, private equity (PE) funds are capable of funding start-ups, recapitalizations and consolidations. But lawyers agree it would be wrong to assume PEs are simply rushing in to acquire assets at fire-sale prices.
“They’re investing in expert management teams,” Ross says. “This type of capital isn’t available to everyone. Only those with outstanding track records and meaningful business plans are going to attract PE funding,” he says.
It’s the local management teams that develop the exploration plays — and scope out potential acquisition targets. PE investors supply the money and install board members who are experts in assessing potential acquisitions and structuring deals that pass the investment test.
Bennett Jones’s Peterson says accepting PE money typically means giving the new investors a majority of board positions and fledgling oil companies need experienced CEOs to manage expectations. “A PE might give you a fair bit of money but they’re in your face and they’ve got control.” Still, he says, many managers of small companies and start-ups prefer this prospect to the vicissitudes of public markets.
Alicia Quesnel, of Calgary-based Burnet, Duckworth & Palmer LLP (BDP), says the uncertainty created by low prices has slowed all deal making — but if oil prices stay low that’s likely to change. Quesnel says banks have held off calling loans of troubled companies while they wait to see whether private equity will step in to recapitalize companies or buy assets. She says she expects PEs to play that role because, “Who doesn’t like a sale?”
BDP’s Kelsey Clark says the pace of deals will quicken when there’s a consensus that prices have bottomed out. At that point, PEs are likely to provide substantial amounts of capital for consolidations.
Most lawyers agree the PEs tend to have a long-term view that prices will recover, adding potential upside to their investments. But they say PE timing is as much about a dearth of competing investors as a bet on commodity prices rebounding, and the key to private-equity commitment is a perception of management talent.
“When (PEs) hear about assets in distress, that may all be quite interesting, but without the right management team it means very little,” says Bennett Jones’s Mercury. “These investors will put $300 to $400 million behind a management team with no assets.”
As examples of PE funding based on management track records, Mercury cites PTW Energy Services, led by Don Basnet; and CanEra Inc., led by Paul Charron. US-based private-equity firms Metalmark Capital and NCA Partners announced a deal in April 2014 to fund the merger of three energy service companies to create PTW Energy Services, with a total of 5,000 employees and Basnet as CEO. And last January, Riverstone Holdings and NGP Energy Capital Management, both of the US, signed their third investment deal with Charron, providing up to $465 million for the acquisition of oil and gas properties in Canada. That deal closely followed the sale of Charron’s previous company, CanEra Energy, to Crescent Point Energy for $1.1 billion and, presumably, a tidy return for Riverstone and NGP. In both PTW and CanEra cases, Mercury says, the key to PE investment decisions was confidence in a proven manager.
Mercury says a major impetus for PE funds investing in the energy sector has come from pension funds seeking to outperform public markets by investing either directly in private-equity funds or by acting as partners on specific energy deals.
“That’s maybe the biggest driving force of this whole game. The biggest investors in the [Warburg Pincus LLC] and KKRs of the world are the pensions,” Mercury says, referring to big private equities from the US now active in Calgary.
Ontario Teachers’ Pension Plan invested as a partner with ARC Financial to create Aspenleaf Energy, a portfolio company that is now acquiring oil and gas properties. Another case in point is Black Swan Energy, which announced in June it would acquire Carmel Bay Exploration for about $200 million, with the backing of Warburg Pincus, Canada Pension Plan Investment Board and KERN.
Bennett Jones’s Calgary managing partner, Perry Spitznagel, says a new attraction for PEs, and particularly for the pension funds, is the trend by certain oil companies to raise needed cash by spinning off royalty freehold assets into separate subsidiaries.
While the Alberta Government owns oil and gas rights on 81 per cent of the land in the province, the remaining 19 per cent is freehold land with mineral rights included. Leading examples are Cenovus Energy Inc. and Encana Corp., heirs of Canadian Pacific Railway, which was given huge tracts of freehold land in payment for construction of the transcontinental railway. Both Cenovus Energy Inc. and Encana Corp. recently created subsidiaries with mandates to generate revenue streams by leasing out largely untapped freehold lands to exploration companies in return for royalties on any subsequent hydrocarbon production on the land.
Newly formed Cenovus subsidiary Heritage Royalty LP was in the business of leasing some 4.8 million acres of freehold lands when Ontario Teachers’ Pension Plan surprised the markets in June by announcing a deal to buy Heritage for $3.3 billion. Mercury says the deal gives Cenovus a very large cash infusion, while Teachers’ gets an immediate revenue stream from royalties on production.
Industry observers have also suggested there’s potential for Teachers’ to profit further from an eventual Heritage IPO, likely when oil prices recover. They say large pension funds have a longer investment horizon than other sources of private equity, so they can wait longer on a price rebound, especially when they’re receiving royalties in the interim.
BDP’s Quesnel says another way for oil companies to attract PE investment is to offer gross overriding royalties on production from crown lands. The oil company pays the normal crown royalty to the province, plus an overriding royalty to a lender such as a PE fund. The oil producer gets cash to fund exploration, while the PE investor gets an immediate revenue stream, derived from production volumes covered by the agreement. “We’re just seeing those types of deals in the last year or so,” she says.
“We’re also starting to see private equity coming from China,” Quesnel adds. If Chinese PEs seek to invest in the Canadian energy sector, she says, it could raise national security concerns and “it’s going to be interesting to see how Investment Canada is going to handle that.”
Torys’s Jugnauth says another variant on pension fund investment is a “platform” investment company, such as the one created by the Ontario Municipal Employees’ Retirement System (OMERS). As an alternative to investing in individual energy companies, OMERS moved in 2009 to create its own in-house energy company by acquiring Guard Resources Ltd. and its management contracts. Under the name of OMERS Energy Services it then backed its newly acquired management team with an additional $600 million to pursue oil and gas acquisitions.
Mercury says 2014 was a “banner year” for PE fundraising and industry players are now waiting to see how much of that cash will be ploughed into the sector. Indeed, Clark says, one of the challenges for the larger PE players will be finding management teams with business plans of sufficient scale. “One of their big questions is, do we have a team that can profitably deploy the amount of capital we want to invest?”