A Controversial Prediction For U.S. Oil And Gas
I’m going to say something a lot of petro-people will object to.
The oil and gas industry is about to see a revolution in project finance. Particularly in the unconventional plays of North America that have emerged as such strong producers globally over the last five years.
I know, I know — that assertion in itself sounds pretty benign. After all, why wouldn’t mega-plays like the Eagle Ford, the Marcellus, and the Montney continue to attract capital, right?
But here’s the controversial part. The way in which development cash is going to be deployed for drilling in these parts of the world.
Namely — through a kind of financial engineering known as “streaming”.
Let me back up for a moment — and tell you why I think the stage has been set for this subtle, but ground-breaking revolution in project finance.
That’s because of a couple of trends that have emerged in the E&P industry during the most recent boom — and most especially during the subsequent bust that’s hit the industry the last couple years. A tide that’s exposed a lot of people swimming naked as it’s gone out.
One big thing we’ve learned is — there’s a limited amount of real management talent in the junior E&P sector. There are a handful of technical and business teams that do oil and gas development well. And it mainly comes down to capital management and sound forecasting.
This has become glaring apparent over the past 12 months. As many “all star” juniors have gone the way of Chapter 11. In some cases, these former market darlings were victims of marginal project selection. But in a surprising number of cases, they actually held great assets — but were destroyed by poor decisions on the capital front, most often over-leveraging with debt.
Second critical trend: the divergence of commodity prices in North America.
Remember the old 6-to-1 rule for natural gas-to-oil prices? For a long time this was considered gospel — so much so that it was ensconced in official SEC rulemaking.
Now look where we’re at. Henry Hub natgas is $2/Mcf — while WTI crude is over $45. That’s a ratio of 22.5-to-1. So much for the old rules.
Here’s why this is important. Because there’s still a tremendous amount of capital looking to invest in the North American E&P space. Just last week it emerged that private equity firm Stonepeak is putting forward a hefty $500 million for investment in the Texas oil and gas sector. And there are tens of billions of dollars more watching from the sidelines.
Smart investors who’ve watched the Chapter 11 trainwrecks this year are increasingly going to focus on a small group of proven and prudent management teams. Not everyone will get the message — there are always going to be risk-takers who step out to the B-teams — but the recent carnage has been a pretty stark reminder to stick with quality.
But how much cash can those few A-class management teams take directly? Remember, private equity analysts Preqin estimate there wasnearly $40 billion raised for energy last year alone. That’s a lot more than E&P juniors could use productively.
And that’s where the streaming concept comes in.
Streaming companies have become fairly common in the mining business the last ten years. They function by providing development capital to build mines — in exchange for a share of the future production streams from these operations. A streaming company might advance $500 million to a mining company to build a gold mine. In exchange, the streaming firm would own, say, 20% of the revenues that come from selling this gold.
The important point is that the streaming company itself doesn’t need detailed technical knowledge. Because the mining company is still in charge of designing, building and operating the mine.
The streaming firm simply receives checks from its ownership interest. Mining streamers like Silver Wheaton built hundreds of millions in revenues with an office staff that could fit in two rooms.
Now, theoretically, the streaming model could easily be applied to oil and gas too. An investor could contribute development capital to a company with a big land position — in exchange for a share of the revenues that come once this property is drilled and producing.
But this model has never really gained prominence in the oil and gas sector — mainly being confined to the realm of dodgy limited partnerships that, more often than not, have been scams to fleece unsophisticated retail investors.
That’s why a lot of oil and gas pros are going to cringe at my suggestion that now could be the time for streaming. But there’s one big reason I believe it could work.
Price divergence.
One of the main reasons that a streaming firm like Silver Wheaton worked in mining is because they were very selective in what they funded. Basically, they bought high-quality silver streams produced as by-product at gold mines — and in effect, created a pure play on silver, where there hadn’t been one before.
Investors who wanted exposure to silver jumped all over it. Driving up Silver Wheaton’s valuation, and pushing down the company’s cost of capital — allowing them to do more deals at favorable terms.
So what if we used today’s topsy-turvy oil and gas pricing to do the same?
I got thinking about this opportunity earlier this week, looking at the chart below from RBN Energy (if you don’t already read RBN’s daily blog on the U.S. oil and gas space, it’s one of the most detailed and insightful publications in the industry — and it’s free).
Source: RBN Energy
The chart uses a lot of big words — but basically what it’s showing is a big rise in U.S. demand coming for one petroleum commodity. Propane. With propane use for new petrochemical plants — mostly on the Gulf Coast — expected to nearly triple over the next two years.
At the same time, U.S exports of propane are surging — with export capacity up 250% over the last 3 years, and expected to double again this year alone. And with both exports and domestic demand going through the roof, a lot of observers in this space are quietly starting to forecast a big crunch in supply.
And a potentially explosive rise in prices.
As an investor that’s exciting. But how do you play it? After all, there aren’t any pure play propane producers. Propane is a natural gas liquid (NGL), that’s usually produced alongside significant amounts of natural gas itself — so most E&Ps that produce propane are also strongly linked to the natgas price, which isn’t looking so good right now.
Enter the streaming model. What if an investor gave an E&P firm in the Eagle Ford (a place where there’s a lot of NGLs production) development capital to drill wells that produce natgas and NGLs like propane. But in exchange for that capital, the investor only bought the rights to the produced propane (and perhaps butane, which is often sold with propane)?
Financial engineering could thus create a pure play on the potentially-rising propane market. A story big insider investors in the oilpatch could get on board with — the same way silver investors did with Silver Wheaton.
How much capital could be put to use with such a strategy? Quite a bit. As a quick example, consider an E&P firm like Leucrotta Exploration (TSX: LXE).
Leucrotta holds a very big land position in Canada’s Montney unconventional play — an area that produces both natural gas and a lot of associated liquids. The company reported this past week that it holds 177 net sections of land (113,280 acres) here. But it has only booked reserves on six sections — or 3.4% of its total land position — because of limited development capital available during the current downturn.
This is exactly the sort of situation where a streaming partner could get involved — paying for drilling in exchange for rights to the liquids. Potentially creating a win-win for the E&P management and investors — who get development cash — and the backers of the streaming firm, who get exposure to a high-upside commodity without having to put a whole new technical team in place.
There are plenty of other property packages like this out there in the E&P world today. And combined with other prevailing industry trends, that could be a major opportunity for investors willing to think outside the box. (There’s a similar opportunity shaping up in petroleum coke — but that’s a letter for another day.)
As always look forward to your comments, suggestions, and — I’m sure– a “you’re out of your mind” email or few. Have a great weekend — all the best till next week.
Here’s to sweet lady propane,
