Want to Start a Junior Oil Company? It’ll Cost You $100 Million

Juniors are getting larger, better capitalized and will soon only work in the very best production areas

BY MARKHAM HISLOP

Like everyone else in the global oil patch, Canadian junior oil and gas companies have had a rough time of it. The oil price rout engineered by the Saudis and OPEC that began in the second half of 2014 left a trail of failed juniors in its wake. But not often discussed is the additional pressure of low natural gas prices caused by the “shale gale”—as industry veterans call it—out of the U.S. With few exceptions for the best-managed firms, those juniors clinging to life after two years of bust are suffering battered and bruised balance sheets. And when the inevitable upturn arrives, juniors may be confronted with a transformed industry that is not as hospitable as in years past.

“I think the juniors and intermediates will reflect a smaller group of companies that have survived and thrived through this difficult period and come out stronger on the other side”
– Gary Leach

Most Canadians think of 2014 as the start of the downturn in the energy sector. But Gary Leach, CEO of the Explorers and Producers Association of Canada, says natural gas-weighted juniors were already suffering since prices dropped in response to the flood of cheap gas unleashed by U.S. shale producers. After peaking at almost US$14 per Mbtu in 2008, prices plummeted and today they remain under $3. Canadian exports to the U.S. peaked in 2007 at well over 4,500 Bcf and last year were under 3,000 Bcf, according to the U.S. Energy Information Administration. “The entire business model for Canadian natural gas producers, especially those weighted more toward gas, was in trouble,” says Leach.

Juniors adapted by switching to more liquids-rich natural gas because propane, butane, ethane, and condensate were priced off oil benchmarks, which were much more robust. And as the gap between gas and oil prices widened, investors pressured management teams to chase more oil. “The initial wave of transition was through the natural gas side of the business and it forced a lot of companies to change their business model,” says Leach. “The world we had five years ago was marked by a big difference between those fortunate enough or clever enough to be liquids and oil-weighted and those that were dry gas-weighted.”

Another change that marked the new business model for juniors was a shift away from raising capital on public markets and, instead, tapping private equity. “A point of departure between the Canadian oil patch and other countries has been the heavy reliance by Canadian companies on public capital markets,” says Leach. Even less than a decade ago the TSX and TSX Venture exchanges were full of micro-caps and juniors. All that changed after the financial collapse of 2008 dragged on for two years and sent investors fleeing into T-bills and bonds. After the carnage stopped, investors’ appetite for scrappy management teams with an inside play or a technological advantage rapidly diminished. Only 20 publicly traded juniors remain, says Patrick O’Rourke, an analyst with AltaCorp Capital, who follows junior and mid-cap producers. Fortunately, private equity stepped up. Managers recognized the opportunity to build value, especially after oil prices took off after 2011. “A lot of Canadians don’t realize it but the Canadian Pension Plan, the Ontario Municipal Employee’s Pension Plan, the Ontario Teacher’s Pension Plan, all of these big government and union pension plans are big investors in the Canadian oil patch,” says Leach.

And then the second shoe dropped in the fall of 2014. Saudi Arabia opened the taps wide, flooding global oil markets and sending prices into free fall. West Texas Intermediate briefly dipped below $30 at one point last winter—with Western Canadian Select languishing in the lower $20s—sending a chill over an already struggling junior sector. Junior companies began failing left and right. By the summer of 2016, the Land Integrity Foundation estimated as many as 230 juniors were teetering on the brink of bankruptcy. Companies shifted to survival mode, sometimes ripping up service contracts and asking vendors to rebid, or even using reverse auction websites to drive suppliers to the lowest possible price, says Mark Salkeld, CEO of the Petroleum Service Association of Canada.

The upturn isn’t far off, as oil markets slowly rebalance during the fall of this year and appear poised to test $60 per barrel—or perhaps much higher, according to some economists—sometime in 2017, and gas looks to be headed north of $3 per Mbtu based on supply concerns. What might the Canadian junior oil and gas sector look like in a revitalized oil patch? Much different, according to Leach, Salkeld and O’Rourke.

For starters, companies will likely be much bigger. No one agrees on a precise definition of the proper size of a junior, but 500 to 10,000 boe/d is a common yardstick, which will likely become quite a bit longer in the next five to 10 years. “I think the juniors and intermediates will reflect a smaller group of companies that have survived and thrived through this difficult period and come out stronger on the other side,” says Leach. “They’ll be larger, better capitalized, and probably only working in the very best production areas because marginal production areas with high costs just won’t be economic.”

One of the reasons for higher costs will be government regulations. The election of the NDP in Alberta and the Liberals nationally has dealt industry a double-whammy, according to Leach. Canada has always been a high-cost place for the oil and gas industry to do business, he argues, but the past 18 months have compounded the problem. The Alberta carbon tax, with perhaps a national version tacked on for good measure; fugitive methane emission reduction; the cost of addressing abandoned wells…the list goes on. Add to it delay—or even non-approval—for new pipeline projects and the prospects look daunting. “The cost of doing business in Western Canada is very high, and I’ve worked all over the world,” says Leach. “Canada and provincial governments have got to provide investment and regulatory certainty.”

Change is certainly coming to the Canadian oil and gas services sector, which could be both good and bad for juniors, says Salkeld. Good because as producers shed staff and expertise, service providers are expanding their technical offerings, allowing customers to remain lean and competitive with less overhead. “The service providers took on more and more of the technology to deliver successful wells,” he says. “Now, producers are looking to the service companies for their hydraulic fracturing or cementing or well completion or optimization expertise. The relationship between small producer and service company is going to be different coming out the other side of this downturn.” But Salkeld also worries that juniors that burned bridges with service companies to drive down costs and survive may not be the highest priority when good times return. “If the small guys ripped up contracts or wheedled us down to nothing, but bigger customers didn’t, our members are going to stick with the customers that stuck with them,” he says.

Even if a service company is willing to forgive a junior’s survival tactics, it may not have enough trained workers to provide the services. Salkeld and Leach warn that oil and gas lost tens of thousands of trained and skilled workers over the past two years, many of whom have left the industry; quite a few won’t be coming back. “It’s going to take a long time to ramp back up. We’ve passed the point of rebounding quickly. It’ll be a while now, we just lost too many people,” says Salkeld, who notes that the West drilled 10,000 to 12,000 new wells annually before the downturn, but current levels are only a quarter of the peak. Ramping up, he says, will be a “long, slow process.”

One bright spot in the near-term is the role new technologies and techniques have played since 2014 in driving down costs. U.S. shale producers have been particularly aggressive given their steep decline rates, but the flow of expertise across the border is pretty much seamless, says Leach. Producers are refracking wells, experimenting with fewer and more strategically placed frack stages, lowering the number of days required to drill, adopting Big Data/analytics strategies, and managing supply chains better, to name a few approaches. “The technologies that we’re using in the oilfield services for drilling, completions, hydraulic fracturing, multi-well pads, economies of scale—that’s all grown significantly in the past four or five years,” says Salkeld. Juniors can expect to benefit from the innovations, but some take a less technology-intensive approach, according to O’Rourke: “For the companies that are exploring, they’re taking exploratory risks and in some cases want to minimize technology risk.”

O’Rourke adds that going forward, investors will support juniors that have the same ingredients they’ve always looked for: a high quality management team, “good rock,” and a strong balance sheet. But there is no denying juniors will face headwinds. “You’re no longer doing the friends and family round and raising a million or two. At the very low end I’d say you need $50 [million] to $100 million, maybe even more than that,” he said.

The days of plucky upstart Canadian juniors starting with a shoestring budget and a smart management team, then selling out to a larger company or maybe growing to be a thriving mid-cap, appear to be over. The “lower for longer” price environment coupled with much higher capital requirements and the need for ever more technology favor bigger players. Not that there won’t always be dozens of juniors trying, say experts, but the odds are getting longer and longer that they will be successful.

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