The collapse in energy prices since fall 2014 has exacerbated a number of long-term issues facing the industry in Alberta, particularly its smallest producers.
The regulations that protect Albertans from having to pick up the tab for long-term abandonment and reclamation are making it particularly difficult for smaller producers to compete and grow.
These companies are facing combined headwinds of increased compliance costs, higher well costs and lower prices for their product, raising questions about their future.
Through the Alberta Energy Regulator (AER), Alberta has an impressive and flexible program for evaluating companies that want to do business in the oil patch: the Licensee Liability Rating (LLR) program.
The style of the program allowed the AER to respond quickly to limit the potential damage from the recent Court of Queen’s Bench decision in the RedWater case that allowed companies to renounce assets in an insolvency process. The unique way in which LLR judges companies enables its flexibility.
Under the LLR program, the AER calculates a Liability Management Rating (LMR) expressed as a ratio of deemed assets to deemed liabilities. The deemed asset number is derived from a company’s production, multiplying it by an industry average netback based on a three-year rolling average of prices. Deemed liabilities are established based on the average cost to abandon a well in different states of completion in differing regions of the province (shallow gas wells in the southeast are cheap; deep multi-zone wells in the foothills are expensive).
The outcome of this approach to evaluating licensees is a bias (not a bad thing) that favours companies with fewer, highly productive assets. It is not a surprise that three of the companies with the highest LMR ratings are Peyto (13.75), Tourmaline (15.99) and Seven Generations (31.79) which are all taking a concentrated and intensive approach to development.
The corollary to this is that companies with many wells that are not particularly productive have high deemed-liabilities, which pushes their LMR rating down. When one considers the companies with an LMR below two (the newly established threshold to transfer well licences that was put in place after the RedWater decision) one finds 531 entities, many of which are junior/micro-cap producers and generally privately-held firms.
An interesting result of this production-based approach to evaluating assets is that it takes the strength of the company’s balance sheet out of the picture; Lightstream Resources, a company that has been struggling under a substantial debt load for some time and has now entered CCAA protection, still has a LMR rating of 4.08.
This is mostly because despite having been born with way too much debt, the company did in fact drill some pretty decent wells. The beauty of the system is that despite Lightstream’s balance sheet being a mess, the AER has not presented a significant challenge as it restructures because no matter what happens, its assets have value and that value will not be left to waste away.
This provides a uniquely level playing field.
If a company is cash-rich it can fix its LMR problems by posting collateral with the AER to buy itself some time to turn around its assets. This is a reasonable system, despite the howls of some smaller producers that feel put upon because they tend to collect the least productive assets which tends to give them higher deemed liabilities.
This is the point of the system: if a company wants to lower its LMR, it should abandon the assets that are producing the liabilities.
This shift in the market has already had and will continue to have interesting effects on divestment and asset spin-off activity.
Traditionally, active growing companies have disposed of established assets to help fund exploration and development of newer – potentially higher growth – properties. This is in part why Paramount has conducted so many spin-off and asset restructurings over the years, creating more focused companies along the way.
With fewer companies spinning off assets and the cost of drilling the new, highly productive wells that help a company’s production profile, it seems that the story of a small producer is becoming an anachronism, a throwback to a simpler time.
The most dynamic companies operating in the Western Canada Sedimentary Basin that seem to be rapidly growing are usually private equity backed (Canadian International Oil Operating Corp.) or private equity backed that have gone public (Seven Generations).
This is illustrative of the changing way in which companies will develop in this new world. It is now much harder to bootstrap a company by buying a few wells using cash flow and debt to drill a few more and repeat, because now to drill wells that have a substantive payout company must devote at least a million dollars to drilling—even for the least expensive shallow Mannville oil wells.
The confluence of these forces is putting substantial pressure on the smallest producers. However, this only brings into stark relief the consequences of the long time trend of the least productive assets migrating into the hands of the companies least able to abandon and reclaim them.
It is clear that the energy industry is becoming more capital intensive and unfortunately that does not leave much for small independent operators without substantial financial backing.