How Royalty Firms Take the Risk Out of the Barrel

Land royalty firms are picking up non-core assets while avoiding capital or operational expenditures to de-risk the oil industry for their investors

December 12, 2016

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Few would regard a a journey to the depths of Hell as risk-free. But when, in 2014, Encana spun off its royalties into PrairieSky Royalty for $1.46 billion, the new kid on the block inherited mineral rights going back to the building of the Canadian Pacific Railway, whose land was covered by the Latin legal phrase “usque ad coelum et ad inferos”—up to Heaven, and down to Hell. This freehold land was originally donated by the government as a sweetener to get the nation-building railway built. Fast-forward a century and it made Encana’s land different. The Crown owns about 90 percent of royalties in Canada. But PrairieSky now holds a crown jewel of real estate with all the subsurface rights, while Queen Elizabeth II’s government has none.

“We try to acquire royalties in the trough when prices are low and valuations are down. But our main strategy is to acquire quality assets no matter where we are in the cycle—we don’t believe you can always pick the bottom.”
– Jason O’Connell, VP of Oil and Gas at Franco-Nevada

Since the land deal, PrairieSky has been busy. “In late 2014, we started seeing some opportunities to expand our asset portfolio into other attractive areas and plays, particularly in Saskatchewan and also the Deep Basin area of northeast B.C. and northwest Alberta,” says COO Cam Proctor. “This was partly due to early weakness in commodity prices, but also the success of our IPO drawing more attention to the royalty space in general.”

Canada’s biggest royalties firm has also been actively leasing land since 2014. “So far in 2016 we’ve entered into over 80 leasing arrangements with 57 different counterparties, establishing the foundation for future drilling activity on existing plays, as well as exploration targets with new discovery potential,” Proctor says.

While most other Western Canadian lands aren’t as attractive as these, they certainly glitter enough to attract the attention of Toronto-based Franco-Nevada—the world’s 10th-largest gold company. The risk-averse firm doesn’t produce an ounce of gold, preferring to invest in royalties. It is now eyeing the recession-beaten North American oil patch to boost its hydrocarbon division—royalties being counter-cyclical in terms of purchasing. It expects to close a deal by year-end to purchase royalties in the Stack shale play in Oklahoma’s Anadarko basin for US$100 million from a private U.S. seller.

Jason O’Connell, VP of Oil and Gas at Franco-Nevada, says, “We try to acquire royalties in the trough when prices are low and valuations are down. But our main strategy is to acquire quality assets no matter where we are in the cycle—we don’t believe you can always pick the bottom.” The key is asset quality, and good assets often offer exposure to multiple price cycles.

“We really ramped up our effort in 2016 in oil and gas. We are bidding on things [in Canada], although we haven’t landed anything yet. We’re well-positioned to get things done, but we try to stay disciplined on how we price assets and have yet to beat out the competition,” he says.

This isn’t the only money coming from the east. In 2015, the Ontario Teachers’ Pension Plan spent $3.3 billion buying Cenovus Energy’s wholly owned subsidiary, Heritage Royalty Limited Partnership (HRP), which held Western Canadian oil and gas royalties. In June the following year, the Toronto-based Canada Pension Plan Investment Board invested US$450 million in LongPoint Minerals, a Denver-based company that invests in U.S. oil and gas royalties. The pension fund manager says it will acquire a majority stake in LongPoint within two to three years.

It was fallout from PrairieSky’s IPO that focused attention on royalties. In the big deals of 2015 and 2016, people paid full value for assets during a $35-per-barrel environment, assuming prices would rise again to $60 or $70. Since then, the market has been getting more creative. Penn West Petroleum, for example, last May created an 8.5 percent royalty on top of a lower Crown royalty to alleviate its debt issues. This was after its 2015 sale of royalty interests in Western Canada to Freehold Royalties for $321 million to cut debt and ride out the oil price maelstrom. They included Saskatchewan’s Viking oil field and lands in Alberta and Manitoba. Penn West’s shares had plunged 72 percent and the sale met nearly half of the $650 million debt due.

In May this year, Freehold Royalties also agreed to acquire $165 million of royalty production and lands from Husky Energy. Matt Donohue, Freehold Royalties’ investment relations manager says Husky sold its assets to streamline its operations towards longer-life projects—its royalties were non-core. And Freehold sees “lots of upside in land, low decline—[the deal] further diversifies our royalty portfolio,” Donohue says.

Another way that royalties firms spread their risk is by investing across the spectrum of conventional and unconventional gas and oil fields. Freehold Royalties gets royalties from 300-plus operators—about 44,000 wells, with only 9 to 10 percent of revenue coming from any one company. “Royalties are a great business I am sure they will stand the test of time, regardless of the commodity price outlook,” Donahue says.

From the producer’s perspective, Richard Lew, Pengrowth Energy’s royalties manager, says, “Companies can sell royalties to create capital funds for strategic reasons, such as investing in production projects when oil prices are high. This depends on the size of a project and where its funding comes from. But at $100 a barrel the revenue stream from royalties is higher than during a slump, so firms may wish to hold on to them. It depends on individual firms, their strategies, debt and balance sheets.”

CNRL has benefited too, in a creative move. In November 2015, CNRL, the largest oil and gas producer in the country by volume, became the largest shareholder in PrairieSky in a $1.8 billion cash-and-share deal. Proctor says, “When we partnered with CNRL in December 2015 they took back to $1.1 billion of stock, half of which they returned to their shareholders. I think this was a very thoughtful way for

CNRL to unlock value for its royalty portfolio, while giving shareholders the ability to directly participate in the upside of a pure play royalty business like PrairieSky.”

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