CANADIAN CAPITAL

Consider this anomaly: West Texas Intermediate (WTI) crude oil prices have been trading in the US$25 to $26 range; natural gas prices, above US$3. Meanwhile, the stocks of many Canadian producers listed on the Toronto Stock Exchange (TSE) have been trading at only two to four times cash flow-the lowest multiples seen in the Maple Leaf oil and gas sector in the past 20 years. Why the alarming market disconnect? Institutional investors generally believe they have to own momentum stocks like the dot-coms and biotechs. It's hard to blame them: until recently, some of these stocks have yielded 100% returns in a matter of days or weeks. No wonder a huge amount of capital has been siphoned away from the North American energy industry and other "old economy" sectors. Still other factors are at work. "There's a new investor focus on returns on capital employed and shareholder equity, which the Canadian energy sector hasn't delivered on for much of the last decade," says one Calgary investment banker. "In addition, many high-flying operators have disappointed the market, in terms of not meeting their reserve, production and cash flow targets. So it's not hard to see why there's such a dichotomy today between energy share prices and commodity prices-and why the Canadian oil and gas equity markets have been so quiet over the past year." Quiet indeed. In 1999, equity financings for the Canadian oil and gas industry totaled only $2 billion, versus $4- to $8 billion in prior years. For 2000, the consensus is that, with continued investor fixation on high-tech stocks-until there's a whole bunch of dot-bombs-and the persistence of low energy stock valuations, the pace of energy equity deals will again be slack. How then does the Canadian energy industry rekindle buysider interest? With the pressure on operators to improve their returns on capital and equity, many leading Calgary market-makers see the need for increased consolidation in the Maple Leaf Patch, either through domestic or cross-border deals. As this Patch-pruning occurs, and investors are presented with fewer, but more profitable choices for their energy portfolios, the equity markets will rebound, as will the debt markets. "More and more, you'll see bridge financing by banks for those types of transactions," says one Canadian lender. Arthur N. Korpach, managing director of energy investment banking for CIBC World Markets in Calgary, couldn't agree more. "At last count, there were some 180 publicly traded producers listed on the Toronto Stock Exchange. If you look at the U.S. or U.K., there are substantially fewer E&P companies operating in those environments. So a serious argument can be made that we don't need 180 investment choices in the Canadian oil and gas industry. Therefore, we expect to see a lot of consolidation in 2000." Vincent L. Chahley, managing director and co-head of global energy origination for RBC Dominion Securities in Calgary, also sees energy M&A activity taking off this year, and with it, a quickened pace in both equity and debt financings. Says the banker, "We're entering a period where investors are going to want fewer, better oil and gas companies in their portfolios-companies in which they can have greater confidence." Korpach believes that U.S. producers seeking exposure to larger North American natural gas supply will drive much of this merger mania. If past is prologue, he's right on target. During the past two years, U.S. independents triggered $12 billion of the $15 billion worth of M&A deals done in Canada. Capitalizing on this trend, as well as its U.S. presence, CIBC World Markets last year advised Richmond, Virginia-based energy giant Dominion Resources on its $430-million buy of Calgary producer Remington Energy, and Unocal on its $250-million investment in Northrock Resources. Seizing upon another type of opportunity-senior Canadian oils looking to expand internationally-in 1999 the investment banker counseled Alberta Energy on its $1.1-billion acquisition of Pacalta Resources, and Talisman Energy on its $1.1-billion purchase of Rigel Energy. The Pacalta buy gave AEC an immediate oil-production base in Ecuador, while the Rigel transaction expanded Talisman's asset base in the North Sea. Korpach, whose firm was involved in more than $3 billion worth of energy M&A deals last year, observes: "The best value for would-be acquisitors in North America today is to target midsize Canadian E&P companies, which are trading at a discount on a corporate basis. "Recently, we've seen such Calgary producers as Newport Petroleum Corp. reviewing strategic alternatives. Simply put, the alternative of selling out for a premium is becoming more attractive in many cases than running your own business." David J. Swain, managing director of Canadian credit capital markets for CIBC in Calgary, stresses that rising M&A activity also means more opportunities for his firm to provide financial one-stop-shopping for energy clients. Case in point: Last fall, when Penn West Petroleum sought to bid on BP Amoco's Canadian oil assets, the bank underwrote and syndicated an $800-million bridge financing so that Penn West could make an offer. When that offer was successful, CIBC, through Korpach's group, then comanaged a $154.5-million equity offering enabling the producer to reload its balance sheet. "You're going to see this theme repeated throughout the year," says Swain. "Banks are willing to use their balance sheets in large amounts for such transactions, knowing that they're going to have the opportunity to play other roles in a producer's financing needs." Overall, CIBC was involved in about $1.3 billion of energy equity financings last year. This past April, it led the largest ever, bought-deal equity in the Canadian oil and gas sector when it distributed $618 million of Canadian Hunter Exploration common shares on behalf of Edper Brascan Corp., which held a 40% stake in that Calgary producer. On the lending side, the firm's total commitments to the North American oil and gas sector are in excess of $8 billion; its outstandings, more than $3 billion. Its stance on future commodity prices? Conservative. CIBC's price deck for WTI crude this year is US$19, dropping to $18 for 2001; it's using an average Henry Hub gas price of US$2.45 for 2000 and $2.30 for 2001. Interestingly, Canadian lenders can offer more attractive reserve-based or production-loan pricing than many of their U.S. brethren. "In the U.S., it's very normal to see loan pricing for triple-B-rated credits in the range of 125 to 150 basis points above Libor [the London Interbank Offered Rate]," says Swain. "In Canada, many triple-B-rated producers still enjoy pricing in the range of 75 to 100 basis above Libor, even though spreads are slowing trending upward." RBC Dominion Securities knows a thing or two about upstream consolidation in North America. Last year, it advised Calgary's Poco Petroleums on its $3.1-billion sale to Houston's Burlington Resources. "Our presence in Houston helped us materially in understanding the acquisitor and structuring the deal," says Chahley. "Moreover, that presence allowed us to build on our relationship with Burlington." Explains Chris L. Fong, managing director and head of global debt markets for RBC Dominion in Calgary: "Following the Poco acquisition, we and Chase advised Burlington on how best to refinance the existing $1 billion in debt that Poco had on its books. As a result, Burlington is now putting in place in Canada a roughly $500-million commercial paper back-up program and a similar-sized medium-term-note program, which is being led by both banks." An even more dramatic display of RBC Dominion's capabilities occurred last August. "When BP Amoco announced plans to sell its Canadian heavy oil properties, Murray Edwards-a director of Canadian Natural Resources and Penn West Petroleum-wanted to make a preemptive bid for those assets on behalf of Canadian Natural," says Chahley. "So he called us on a Friday afternoon to explain that he needed a lot of money-$1 billion to be exact-to show BP Amoco that he had an offer with teeth." Beginning at dawn the next morning, Chahley and Fong-representing both the capital markets and corporate banking sides of RBC Dominion-sat down with Edwards near a Calgary airport. What Edwards needed was an integrated financing solution that included an up-front commitment of $1 billion, a bank debt syndication plan, an equity financing plan to take out part of that bank debt, and a follow-up capital markets debt plan. The outcome? "By Monday morning-three days later-we confirmed with BP Amoco that Canadian Natural had a $1-billion commitment from us to move ahead with the purchase," says Chahley. "We then executed a $339-million equity offering, arranged a $125-million public offering of seven-year, medium-term notes, and put in place a three-year-term, $550-million credit facility that was syndicated among 11 banks," says Fong. Currently, the bank has commitments to the North American oil and gas sector totaling more than $10 billion, with outstandings one-third of that. More merger deals are likely. "We're working right now on three transactions involving U.S. operators looking at Canadian opportunities, as well as a couple of others involving Canadian producers looking south at U.S. independents," says John Sinders, managing director and co-head of global energy origination for RBC Dominion in Houston. Canadians looking south? "Sure, it makes perfect sense," responds Sinders. "We're entering a very integrated hydrocarbon market in North America, especially on the natural gas side. Also, there's plenty of access in the U.S. to the capital markets for Canadian E&P companies which is, in part, what this office provides." This focus on consolidation doesn't imply that RBC Dominion is ignoring the equity markets. On the contrary, the firm, which participated in more than $900 million worth of equity deals in 1999, is stepping up its focus on emerging junior oils in Canada-helmed by managements that were former bank clients at successful intermediate and senior oils. "Our strategy is to maximize the value of those relationships," says Chahley. John F. Abbott, executive managing director, energy group, for BMO (Bank of Montreal) Nesbitt Burns in Calgary, sees very few energy equity deals being completed in the Canadian market over the next six to 12 months. "I don't think investors are prepared to give more equity to oil and gas companies simply to allow those operators to increase their capital expenditure programs-not when those investors believe they can make money faster in high-tech issues, such as those on the Nasdaq. "However, to the extent that we see reduced equity financings, this will lead to further consolidation within the Canadian oil and gas industry. Over time, that should lead to higher returns for those companies left standing. In turn, that should bring institutional and retail investors back into the industry." In particular, Abbott sees more and more U.S. independents coming into Canada, with a view toward making attractive acquisitions, notably on the natural gas side. During the past two years, BMO Nesbitt Burns has advised on $26 billion worth of mergers. It advised Union Pacific Resources-now being acquired by Anadarko Petroleum-on its $3.7-billion acquisition of Norcen Energy Resources. The firm also advised Tarragon Oil & Gas on its $1.1-billion sale to Marathon Oil. It also counseled Seagull Energy, Ocean Energy and Wainoco Oil on the sale of their Canadian subsidiaries or assets. Meanwhile, it advised TransCanada PipeLines on its $15-billion merger with Nova Corp.-the largest M&A transaction in Canadian history. Last year, BMO Nesbitt Burns participated in nearly $765 million worth of public equity offerings. On the lending side, its commitments to the North American oil and gas industry were $11.2 billion. Combining its expertise in both areas, it provided in 1999 credit facilities for Startech Energy and Compton Petroleum while participating in respective equity offerings of $30.7 million and $10 million for the two producers. Abbott's advice to this year's attendees at the Canadian Association of Petroleum Producers (CAPP) conference in Calgary: "Don't wait for somebody to jump on your company with either a hostile or friendly bid. Instead, be proactive. Think about what you want your company to become over the next five or 10 years. Then look for the right partner to accomplish your strategy for growth." Adds the banker, "If we continue to have an industry that has marginal players, with low profitability and low returns, then at some point the whole Canadian oil and gas industry will either be taken over by multinational oils or wind up as an industry that's unable to compete long term with other market sectors." Karl B. Staddon, managing director of energy investment banking for Scotia Capital in Calgary, observes that the availability of equity to the E&P sector has been shrinking, as well as equity values in the sector-with the TSE Oil & Gas Producer Index off about 25% from its late-1997 peak. "That has created an opportunity for U.S. oil and gas companies looking for attractive acquisition opportunities in Canada." There are, however, other factors driving this cross-border interest. The terms of trade on the Canadian dollar are about 7% more favorable than they were in October 1997, the Western Canadian Sedimentary Basin is less mature, access to technical data is better, and the land title system is more efficient than in the U.S. Says Mike Jackson, managing director and industry head, oil and gas pipelines, for Scotia Capital in Calgary, "For the balance of 2000, we see continued investor apathy toward Canadian oil and gas stocks-unless there's a further major correction in the dot-com phenomenon. But even if that happens, there's still going to be market pressure on producers to improve their return on capital. Very simply, the investment community is demanding consolidation within the Canadian oil and gas industry." Last year, Scotia Capital participated in every major energy equity deal in Canada. Meanwhile, on the lending side, its commitments to the Canadian oil and gas sector totaled $4.5 billion-a 50% increase over 1997's level-with outstandings of about $2.3 billion. "During the 1998-99 period, we added 18 new Canadian oil and gas credit relationships," explains Jackson. "Moreover, our energy credit portfolio is clean. There are no troubled loans." That's because Scotia Capital chose a few years ago not to participate in bank financings that it thought were sheer insanity, says Mark A. Ammerman, managing director, U.S. energy M&A, for Scotia Capital in Houston. "In the Northwest Territories, there's a saying: 'When you're dancing with a bear, you hope the music doesn't stop.' Unfortunately for a number of banks during the 1997-98 period, the music stopped shortly after their oil and gas deals were done, and they got trapped holding large debt positions because there was no equity or high-yield take-out available." Staddon adds that during the next six months, consolidation activity in the Canadian Patch will be largely driven by U.S. producers looking for a slice of the Maple Leaf E&P pie-on a corporate or asset basis. "Given this outlook, equity prices could turn around quickly, resulting in increased equity issuance this fall." U.S. producer interest in Canada is strong. One of Ammerman's clients, a publicly traded Houston producer, indicated to him one day last summer that it wanted to grow its heavy-oil portfolio internationally. "I immediately got on the phone with Karl, and he told me that on the previous day, he had talked with a Canadian producer looking for a joint-venture partner to develop a heavy-oil prospect in Alberta," says Ammerman. "The next day, we approached the U.S. client with this opportunity. A day later, that producer told us that it wanted to get into the Canadian prospect in a big way. Shortly thereafter, we put the two producers together for a $100-million transaction that gave the U.S. operator an interest in the Canadian oil prospect." Warren G. Holmes, managing director, corporate finance, for FirstEnergy Capital Corp. in Calgary, is used to doing equity transactions-lots of them. In fact, according to Sayers Securities-an independent tracker of Canadian capital markets transactions-FirstEnergy Capital led all other Maple Leaf market-makers last year in the dollar volume of energy equity deals completed. Overall, it participated in 36 such offerings worth $1.8 billion, leading 55% of them. More recently, however, FirstEnergy has seen its oil and gas equity deal flow slow to a crawl. "It has been extraordinarily difficult of late to raise capital for Canadian energy companies, despite the fact that we're at a 10-year high for oil prices," says Holmes. "The big problem: rates of return within the industry versus other sectors. We might think, for instance, that a 30% annual rate of return on an oil and gas stock makes it very attractive. But buysiders today are likely to respond, 'That's nice, but I can get that in one or two days by picking the right e-commerce stock.'" The investment banker observes that it's ironic that investors-discontent with what they see as inadequate returns in the oil and gas sector-are so eager to embrace Internet stocks, many of which won't generate positive earnings for years, let alone adequate returns on investment. Given this shift in market sentiment, FirstEnergy's primary focus during first-half 2000 has been its energy M&A practice. "We've been assisting several Canadian producers in cross-border negotiations with U.S. operators interested in acquiring those companies, in whole or in part," says Holmes. "The aggregate value of these potential mergers or minority-stake positions is in excess of $1 billion." Last year, FirstEnergy advised Pacalta Resources in its defense against Alberta Energy's hostile bid for the company-a bid which was ultimately raised-and Northrock Resources on Unocal's equity investment in that company. He notes that as more mergers take place-bringing with them operating synergies and cost reductions-better returns are going to be generated by the newly combined entities. "When that happens, value-oriented investors, who are becoming nervous about participating in dot-com stocks, will start coming back into this sector, particularly if commodity prices remain high. Then we should begin to see a rebound in equity financings-probably in the latter part of this year." Emphasizing the current low market valuations within the energy sector, the banker points out that the shares of Canadian Natural Resources have been recently trading at nine to 10 times estimated 2000 earnings. In a healthier market environment, they would be trading at 15 to 20 times earnings. Also, CNQ has been trading at less than four times estimated 2000 cash flow versus an historical multiple of five to seven. Says Holmes, "Those kinds of low valuations, by themselves, should be drawing investors back to the sector." But as Michael J. Tims, president and chief executive officer of Peters & Co. in Calgary, notes, energy investors these days are scarce, and the Canadian equity markets, lackluster. "At the market peak in 1997, we saw about $8 billion of overall equity financing in the Canadian Patch; last year and this year, share issuance has been running at about 25% of that peak level," he says. Why? "With the rebound in commodity prices, operators don't need equity as much as before, plus investor capital, up until a few months ago, has drifted steadily into the higher-return, high-tech sectors of the economy. On the bright side, however, oil and gas is still an essential business and its fundamentals have never looked better. The challenge is finding investors who care." Ian D. Bruce, vice chairman of Peters & Co., notes-as other have-that the offset to the bad energy equity market has been the continuing consolidation wave. "That has created an enormous flow of M&A business for us-so much so that, in any given week, our people are working most nights." Last year, Peters & Co. participated in energy equity transactions totaling $1.1 billion and completed $421 million worth of M&A advisories; this year thus far, stock offerings have been few and far between, but the firm has counseled on $1.7 billion worth of oil and gas mergers. Petrorep Resources, Pursuit Resources and Newport Petroleum retained Peters & Co. earlier this year for advice on strategic alternatives. "In many cases, Canadian producers have become frustrated with the low market valuations being accorded their stocks," explains Tims. "So they're beginning to explore the options of either selling outright or merging into another company in order to get a better valuation." On the other side are opportunistic acquisitors, says Bruce. "Their thinking is that if they can buy oil on Toronto's Bay Street for $7 per barrel versus spending $12 per barrel to find and develop it, then they're better off taking out a competitor. And they're doing it with cash and debt instead of stock, given the low market valuations in the Canadian energy sector." Bruce advised an independent committee of Canadian Occidental Petroleum directors on the sale of California-based Occidental's 29% equity stake in CanOxy. The shares were sold to CanOxy and to the Ontario Teachers Pension Plan Board. In other cross-border dealings, Peters & Co. is talking to 150 to 200 potential U.S. buyers of Canadian oil and gas companies or properties. "They like the gas-prone nature of Canada's western basin and the fact that it's less mature than basins in the U.S.," says Bruce. "They also like the current strength of the U.S. dollar versus the Canadian 'dollarettes.'" Can an "old-economy" sector like energy again curry favor with Bay Street's buysiders? "Clearly, as industry consolidation proceeds and returns improve, this sector will come back into favor-it's only a question of when," says Tims. "After all, people still have to put gas in their cars and heat their homes and businesses." Thomas A. Budd, president of Griffiths McBurney & Partners in Calgary, has a reputation for getting equity deals done-even small ones-in a tough market. And last year, his institutional boutique investment firm did just that, participating in more than $1 billion worth of Canadian oil and gas stock transactions, ranging from $1 million to $339 million. But even he believes it's going to be tough sledding for would-be issuers in the Maple Leaf equity markets for the balance of 2000. "There has been major investor disappointment with many oil and gas companies that haven't delivered on their production and cash flow targets," says Budd. "Meanwhile, other sectors of the economy-notably high-tech and biotech issues-have until recently shown greater returns. So there has been very little interest on the part of institutions to provide new capital to this industry. The only interest they've shown is a willingness to buy energy shares on the secondary market as takeover activity highlights the low valuations that have been accorded most oil and gas stocks." However, Budd points out that if commodity prices stay where they are, the Canadian oil and gas industry isn't going to need to raise new equity from outside sources. Instead, operators will be able to use their excess cash flows to not only explore, but also to pay down bank lines and fund share buybacks. "Moreover, this industry is going to be so financially healthy that hostile bids for companies with low market valuations will become a real threat-such that merger activity will increase significantly from 1999 levels." That should sit well with portfolio managers. They think they own too many oil and gas stocks and find it difficult to monitor their performance. They'd rather own fewer, larger, safer names in the energy sector and get rid of their illiquid positions. "So the desire to see industry consolidation will continue, and during this summer and fall, Calgary will likely witness more takeover fever among smaller Canadian independents than we've seen before." However, consolidation won't necessarily bring more liquidity to the energy sector, Budd contends. That's because there's very little legitimate investor interest in the sector at this time, except for guessing who will be the next take-out target. "Until recently, buysiders wanted out of energy so that they could put their money into dot-com issues. When you think about it, it's the same investor mentality we saw during the 1991-93 period. Then, startup junior oils were trading the way dot-coms did during the first four months of this year." Budd concedes that investors may be disenchanted with the Canadian energy industry right now because a lot of investments made back in the early 1990s didn't work out. "However, they're eventually going to be just as mad at many of the dot-coms that can't deliver self-funding cash flow or eventually, earnings. At that point, they'll hopefully refocus on the stocks of Canadian oil and gas companies with good managements and good growth prospects." Which operators fit that bill? Budd cites such emerging producers as Startech Energy, Compton Petroleum, Vermilion Resources, Cypress Energy, Edge Energy and Ventus Energy; among larger-cap names, he cites Rio Alto Exploration, Penn West Petroleum, Canadian Hunter Exploration and Anderson Exploration. (At press time, the latter acquired Ulster Petroleums for $647 million.) "With stocks like these, I'm confident that over the next year or two, I'm going to double my money on many of them-barring a major downturn in commodity prices." NEW DOORS TO DOLLARS U.S. oil and gas companies aren't the only energy players being drawn to the Canadian Patch these days. Hopeful of opening the doors to the U.S. capital markets for Maple Leaf producers and service companies, stateside investment banking firms are establishing a presence in western Canada. One of them is Raymond James & Associates Inc., whose Calgary corporate finance office is headed by Glenn N. Huber. "If one looks at how the Canadian energy sector has been financed historically, the capital formation process has been essentially driven by about 15 to 20 institutions on Bay Street in Toronto," explains Huber. "Such a concentrated source of capital has its limitations, especially when the energy sector falls out of favor with those institutions, as it has recently." Says the native Calgarian, "What we're trying to do is create a gateway for Canadian E&P and oilfield service companies to the U.S. capital markets, where there are 300 to 500 institutions active in energy at any given point in the oil and gas cycle. Also, we want to be the bird dog for U.S. private and public capital seeking Canadian energy investment opportunities, as well as for U.S. industry players seeking to establish a presence in Canada." Since opening its Calgary office in January 1998, Raymond James' 40-member North American energy team-which is also based in Dallas and Houston-has been actively educating Canadian producers and service companies on the merits of positioning themselves in the U.S. private and public capital markets. In addition, it has facilitated some initial private placements and cross-border M&A deals. In mid-1999, it advised Destiny Resource Services on a $20-million private placement of equity and debt with First Reserve Corp. of Greenwich, Connecticut. Earlier, in the fall of 1998, its dual relationships with San Antonio-based Abraxas Petroleum and Calgary's New Cache Petroleum resulted in Abraxas' Canadian subsidiary acquiring New Cache. "This year, we co-sponsored a Calgary conference attended by 175 local oil and gas companies," says Huber. "On the panel were 16 U.S. private energy equity providers that represented $10 billion worth of uninvested capital. Additionally, we've initiated research coverage-for U.S. investor consumption-on 12 Canadian oil and gas companies looking for a more diversified shareholder base, access to broader capital markets sources and premium market valuations." PRIVATE POCKETS Institutional capital flowing into the Maple Leaf oil and gas industry may be scarce these days. But ARC Financial Corp., a Calgary investment management and merchant banking company focused on the Canadian Patch, believes that this is a great time to be plowing capital into this beleaguered sector. In fact, the firm, by its own account, is the dominant private energy equity investor in Canada today. "We're currently managing about $400 million of primarily institutional capital directed toward investments in the Canadian energy business," says Mac H. Van Wielingen, ARC's chairman and chief executive officer. This is being done through three funds: the private ARC Canadian Energy Venture funds I and II-which focus on equity investments in "early-stage" junior oil and gas and oilfield service companies-and the ARC Strategic Energy Fund, a publicly traded, closed-end fund on the TSE that makes equity investments across the entire Canadian oil and gas sector. In addition, ARC Financial acquires and manages production-currently about 22,000 equivalent barrels of oil per day-for ARC Energy Trust, a TSE-listed royalty trust with a total market capitalization of about $750 million. Recently, this trust completed a $135-million acquisition of additional oil properties, primarily in west-central Alberta, not far from its core holdings in Pembina-Canada's largest conventional oil field. "There's generally very little support for oil and gas equities in the capital markets right now," says Van Wielingen. "But if your annual returns to investors are good-and our target for our private equity funds is 20% to 25%-then investors will be receptive to pursuing such investments. In fact, virtually all the investors that were in our first private equity fund have come back into the second one that just closed. As for our royalty trust, annual returns have averaged 16% to 18% over the past few years." Says Kevin J. Brown, managing director and president of the ARC Strategic Energy Fund, "The outlook for the Canadian oil and gas sector is the best we've ever seen, in terms of profitability and cash-flow generation, and that's being completely ignored by the market. However, a year or two from now, we see the smart money rotating out of the speculative, overvalued sectors of the market back into the sounder, more profitable, growth-industry sectors such as energy. We therefore view the current low trading multiples for the oil and gas group as an extraordinary buying opportunity." What does ARC look for in making private equity investments in producers or oilfield service companies? "A strong, top-quartile management team with a proven record and a clear, sound vision of how it plans to grow," says Van Wielingen. "Ideally, we also want to see existing quality assets with upside. Then we want to be able to assist that company with our expertise, as it relates to financing, M&A transactions, corporate strategy and market access."