Canada is estimated to be home to 45% of the world's oil and gas companies and the host to approximately half the world's privately accessible oil. Calgary is one of, if not the best, places in the world to run an oil and gas junior, and the TSX-V is one of, if not the best, exchanges on which to launch an oil and gas micro-cap.

The story of Primary Petroleum, a Canadian junior with large land holdings just south of the boarder in Montana, provides an interesting example of the difference between the Canadian and American capital markets.

"The investment stays very segregated because of the border, with Canadians staying on the Canadian side and Americans on the American side," observes Mike Marrandino, Primary's CEO. "For us, 2010 saw interest from the Canadian side but we were too small of a company on the market (capitalization) side for the American investors."

In 2010, Primary's neighbors started defining the Bakken around Primary's considerable landholdings and the company's stock soared. "Now we are a $100-million market-cap company and are getting stronger interest from the U.S. market. Canada was our stepping-stone, and now we're moving to the next level of investor... Institutional investors are now calling us and it's been a bit of a role reversal, which is very exciting on our part."

In the U.S., juniors tend to stay private until late in the game and onerous regulations make listing (and maintaining that listing) expensive. For the busy junior management team trying to build an investor following, raise capital, trade land and get on with the business of finding oil, dealing with reams of red tape and associated liabilities can be suffocating. In Canada they have more freedom.

Capital alternatives

In the U.K., the AIM provides a more risk-tolerant and globally aware investor base. However, investors tend to be looking for massive upside to accompany that risk and greater liquidity in the form of a larger market capitalization. European investors are rarely as in touch with the actual business of oil and gas as are their cousins in Calgary and Toronto, and they have been battered hard by the financial crisis.

Concerns about the performance of AIM-listed companies and an unease concerning the regulatory environment may be encouraging British investors to gain exposure to emerging oil and gas stocks through the TSX. According to Colombia-focused Bolivar Energy CEO John Moreland, who still retains a hint of his Scot's accent despite many years in Canada, "Most of the (investor) interest is coming through Toronto, but there's interest both in the U.S. and Europe, particularly through London. I think the AIM market hasn't been successful over the last few years, so the London investor is looking at Latin America through Toronto."

William H. (Bill) Smith, CEO at France- and Australia-focused junior Gallic Energy, says, "Most of the time even European projects get sent to Toronto and New York first. However, there clearly is appetite for oil and gas exploration and development projects (especially those located in Europe) across the pond. We spent one week in Paris and London (speaking to investors), and they were very appreciative of us starting in Europe."

Chayan Chakrabarty, of Bengal Energy, notes that CEOs of foreign-focused juniors may have to spend more time educating investors in North America than they might have to in other markets. "I find that it isn't just the diversity of our assets, but even the geographic location of those assets that often poses certain questions for the average North American investor.

"Yet when I go to London, there is a quick understanding of why we are in India and Australia. The questions seem to be much more targeted and informed, much like what we'd hear when taking a heavy oil story to Toronto. But we are hoping to see that change as more companies come into the areas (in which we operate)."

Bigger juniors

Has the ball game changed in the Canadian junior marketplace? In other sections of this report we have discussed the increased importance of multistage fracs in horizontal wells and the demise of the income trust model. The barrier to entry has risen for the junior and the classic exit route has been banished by the federal government.

Brickburn Asset Management's Martin Davis, who has long helped fund juniors, notes that the tide started turning against the smaller juniors five years ago. "Our focus has historically been small oil and gas businesses, but that's changed because the really small guys, sub-1,000 BOEs, have a much tougher go of it. The high point for the junior energy market was in 2005. It changed in 2006 when costs went through the roof and the industry was at full capacity. You couldn't get a drilling rig, you couldn't get a well serviced, and all the major companies dominated the space and pushed the little guys out of business.

"As that was unfolding, income trusts emerged (as players in the exploration and development space), then the government changed the taxation rules for those trusts and the junior market took another hit, because that was a liquidity option everyone was focused on."

Davis' partner Bill Bonner notes, "Today you have to start with a larger production base. The starting point for junior micro-caps is going to be 2,000- to 3,000 BOE per day and they're going to have to acquire it. It's going to become a different business."

Horizontal, multistage fracs are substantially more expensive than traditional vertical, unfraced wells. "The advent of horizontal, multifraced wells has forced a lot of micros like our company to really look at metrics that work and start to step out of North America," states Blackbird Energy CEO Garth Braun. "If you were not one of the companies that bought some of the Bakken when it was $100 an acre, then you can't participate. Horizontal wells are too expensive for exploration. When you include multiple fracs, the cost per well can be $4 million or $5 million—that could be all of a micro's exploration budget. One dry well, you're out of the game!"

Clearly, juniors will not be compelled to develop into midcaps. There is still an exit opportunity for those with the right assets, argues Steve Fitzmaurice, CEO and chairman of Hawk Exploration. "If you have good, high-quality assets, then there's always going to be a market for them. You may not get the premium prices that you saw in the heady days of the trusts, but if the assets are of a high-enough quality, then when the time to sell comes, there'll be suitors."

Post-income trust, the exit model has changed for most juniors, and management teams need to be mindful of this from the onset. "You have to be careful how you create your asset combinations today," says Larry Parks, CEO at Ironhorse Oil & Gas. "You have to deal with quality all the way through, so you need to develop a core area, a focus area, a high-enough working interest and then decide how far you want to develop it. If it's fully developed, then there's no more upside and it's going to be hard to find a purchaser. The trusts used not to be in the drilling game, but now they have converted back and have an appetite for value addition through the drillbit. Now you have to get bigger to get better and the game has changed."

There can be little doubt that in this new world of multimillion-dollar wells, there will be substantially fewer micro-cap oil and gas companies. However, veteran junior builders, who can hunt out the right land and know how to get profitable hydrocarbons out of smaller asset bases, still attract a loyal investor following.

Kelly Ogle, CEO of Trafina Energy, has this advice for the budding junior builder trying to raise funds: "Use your Rolodex to phone everyone you know and try to raise money. Then people make the next step to the flow-through funds. Once you've raised about $5- to $10 million, you have to make the next step to the institutions in Toronto, New York, and Boston. You're probably not big enough to get attention. But you have to have something unique to show them, like the Bakken or Cardium or heavy oil."

Ogle was able to call on relationships built from a lifetime in the oil and gas game to recapitalize Trafina when he took the company over. "I went to a person I know who was a founder of one of the top oil and gas investment banks in Calgary and now runs his own fund. He put a million into Trafina and found other guys to put another million in it. I doubled my capitalization in order to buy the land that we acquired. I know that if we deliver and continue to show results for this fund then they'll be the lead order in any financing that I do... If you've got a lead order, someone believes in your story and others will follow."

Financial services

Calgary, the hub of Canada's oil and gas industry, is also a superb place to raise capital, particularly for the junior. Mike Tims is co-chairman of Peters & Co., the boutique investment house where many of the city's bankers learned their trade.

"The Calgary market for investment banking is one of the most competitive anywhere, because everybody's in it: large global firms, large U.S. firms, the Canadian banks and the independent firms," he says.

Why has Calgary become such a financial center? After all, the town is only the fourth city in Canada, a relatively small economy when compared to Europe or the U.S. Clearly, the relationship between E&P companies and the financial service sector is symbiotic; the more clients, the more banks; the more capital, the easier it becomes to launch a junior. The state's determination to leave hydrocarbon exploration in private hands, the city's pioneer-inspired entrepreneurial spirit and the success of the TSX-V have all played a vital role as well.

Adam Waterous, head of global investment banking and president of Scotia Waterous, says, "The investor base (in Calgary) has been educated through past successes and knows to come to Calgary as a center for excellence. While the regulatory environment here is helpful, I don't think it's the driving force. It is certainly less bureaucratic and onerous, but that is only one of many reasons as to why there is so much success in Calgary."

Bruce McDonald, managing director and global head of energy at Canaccord Genuity, believes that Calgary's success is based on "knowledge, the sophistication of investors and the research community and the quality of the consultants."

High standards of governance make Canada a safe harbor for globally mobile capital. Says McDonald, "We have a very strong sense of corporate governance and structure. A lot of our investors look to the quality of the board as well as the management when making investment decisions. We've done a good job of putting together boards that create confidence and global credibility with investors. Also, there's less confusion about the exchange. Foreign investors know to look to the TSX and the TSX-V for energy and mining companies.

"We do business on several different exchanges [since] energy financing is becoming very global in nature. If we were to put up a transaction that's large and international, most of the investors would be from outside of Canada, so the global markets are very important to our business. The global markets are very comfortable with the TSX," he concludes.

While Canadians have a reputation for being financially conservative, Phil Taylor, head of Union Bank's Canadian operations, notes that the reputation is only partially founded: "People tend to think that Canadians are conservative and risk-averse. ...but in the oil patch, Canadian companies are very aggressive and take risks on things such as looking for and adopting new technologies. They tend to do that with risk capital instead of bank debt. They'll fund the initial stages with equity, prove that it works, and then put layers of debt in to support the ongoing expansion of those activities."

"Most companies are public and try to manage debt-to-cash-flow ratios of around 1- to 1.5 times," says Taylor. "The expectation and the reality have proven that if you start to approach higher levels [of debt], the market expects you to have to issue equity in order to solve your debt problem, and your equity gets depressed in price. This is a different model than in the U.S., where 2 to 2.5 ratios of leverage levels tend to be common. I think that, in Canada, borrowers tend to hedge less than in the U.S. In Canada, we typically see companies hedging 40% to 50% of their production, while in the U.S., companies are hedging 80% to 90% of their production because they need to support a higher debt level and need more surety to their cash flow."

There can be little doubt that Canada has come out of the global economic crisis stronger. Indeed, the only sector to benefit more than the country's energy and minerals sectors is the nation's financial services industry. Derek Neldner, managing director of RBC Capital Markets, says, "When it comes to energy, Canadian banks are now among the world's leaders. The Canadian banking system has won accolades in terms of our regulatory oversight and how the industry fared [throughout the crisis]."

For RBC, "It's worked out exceptionally well that an ambitious international growth strategy put in place before the crisis has been rapidly accelerated," continues Neldner. "We went from being the 35th-largest bank in the world to the 15th. Because of the stability shown in our results, we've been able to attract a phenomenal group of people. It's moved us ahead by a number of years in terms of our build-out in the U.S. and London."

2010 was marked by a flurry of IPOs and further public offerings as companies took advantage of the first benign markets in two years. While capitalization and re-capitalization activity is set to continue through 2011, the year may be better remembered for its M&A and JV activity instead.

"Where we've really seen it pick up in Calgary is in M&A," says Timothy Watson, head and managing director of energy and power, Canada, for Bank of America Merrill Lynch. "Within this [broader M&A trend], the cross-border flow of capital is the most eye-catching feature. Over the last two years, joint ventures have been very popular in the U.S., many of which have been done with foreign capital. We are now just starting to see that in Canada, but I anticipate we'll be seeing a lot more.

"To secure the sort of capital required for the new breed of JVs you really do have to be able to reach capital internationally, into Asia, India, and even the Middle East to find buyers," notes Watson. "Buyers are becoming more and more saturated with these joint-venture transactions and yet they keep happening and we keep doing them. These joint ventures have to be strategic because you are choosing a partner for the next 20 or 30 years, so it fits very well with what we look to do."

Private equity

The Canadian E&P sphere has traditionally been dominated by publicly listed companies. The importance of public capital in Canada stands in marked contrast to the financing environment in the U.S., where private equity reigns supreme in the world of juniors. Given the ever-increasing cost of exploration and development, the need to assemble large land holdings in order to pursue resource plays and the longer time frames required to fully explore them, it remains to be seen whether private equity will become a greater force in the Canadian E&P world.

Private equity has its attractions for both the investor and management teams, argues Pentti Karkkainen, general partner at PE fund Kern Partners. "If you're a public market participant and you're going to buy Encana, for example, you're exposed to all of the drivers of public market volatility which are well beyond your control.

"With private equity, you're moving away from those things that are out of your control and towards higher risk from a resource perspective. It's all about managing risk; both the components you can't do anything about and those that you have the power to do something about.

"The Canadian advantage used to be the free access to information, but if you're good at what you do it can be a disadvantage. If you're public you have to give full disclosure in order to get a higher share price. If you're private you don't have to talk at all. The evolution of public markets with their legal, regulatory, and reporting issues are driving the top deciles away. High share prices might look good, but they can trap you," says Karkkainen.

Private equity may be the best way to finance today's costly and time-consuming plays, notes Karkkainen: "Everything is taking a little bit longer now and requiring more capital, so you have to ask if it all fits into [the sphere of the] public market."

End of the trust era

In 2007, when Global Business Reports last undertook a comprehensive review of Canadian oil and gas for Oil and Gas Investor, the mood was dampened by the federal government's decision to end the beneficial tax status enjoyed by income trusts. The industry fought the decision tooth and nail but, in the end, failed to change the government's mind. The "Halloween Massacre," as it was to become known, has had a wide ranging and profound effect on the oil and gas sector in Canada.

The income trusts, tax-efficient vehicles focused on return over capital appreciation, shaped how the oil and gas sector developed in Canada. "In the WCSB, over the period from 1995 to 2005, a lot of the conventional assets were sold by the large companies to the trusts, or the large companies converted wholesale into trusts," explains one of Calgary's longest-serving and most successful oil and gas CEOs, William Andrew of PennWest Energy Exploration.

"As trusts, we were looking for properties with shallower declines and good, stable long-term production, and we ended up with a lot of the old legacy oil and gas fields in the conventional basin."

The trusts' mandate of providing high and steady yields to their holders came at the expense of increased production in those legacy fields. "We were distributing a large portion of our funds flow so we were starving these properties [of investment]," says Andrew.

The trusts were sitting on exactly the sort of assets which, today, are the very profitable purview of horizontal, multistage-fraced wells; large and well-defined reservoirs from which very few further hydrocarbons could be extracted using primary recovery methods.

Now that the former trusts are free to determine their own exploration and development budgets, they are utilizing horizontal multistage fracs to increase both the production and the capital values of their large land positions.

"The horizontal drilling technology has helped production rates and has transformed areas where we could not drill before into areas that we are able to drill," says Andrew. "Due to their nature, a lot of the fields were utilizing vertical technology and had very low productivity. That is why the decline was so flat, which meant a long payout time and a low payout on investment.

"The conventional E&P model works when you go out and acquire a land position and drill some exploratory wells and then push the play forward. This did not happen with the trust, as there was not a lot of risk capital or development capital [around]," he adds. With the forced conversion to conventional corporation status, Canada's mid- and large-cap E&Ps are once again starting to drive exploration and development in the basin.

Peyto Energy Trust was one of the highest-yielding trusts from its original conversion in 2003 through to its reconversion back to corporation in 2011. Peyto's president and CEO, Darren Gee, explains that, back in 2003, the company pioneered a hybrid strategy that became commonplace. "When the trust structure was popular in the market (in 2003), we looked at the trusts but didn't like the way the model was set up. Because we are not an acquisition company the model didn't fit," he recalls.

"We had to retain more of our cash flow to drill, so instead we came up with a hybrid trust model with a 50% payout ratio and 50% retained cash flow. The plan was met with skepticism early on, but we proved it was the better model and it has now been widely accepted as a viable option, with most trusts now routinely paying out less money and retaining more. The hybrid model is now the one many companies use, largely because it is more balanced than the pure trusts."

As Peyto reverts back to a corporation, Gee argues that the hybrid model, and the mentality imbued in it, positioned the company well. "We're retaining, like the others, a dividend or some source of income flow to the shareholder. The demand for yield today is very high and so there is a great deal of demand from investors abroad looking for something more from their investments."

The mass re-emergence of the mid- and large caps as a force to be reckoned with in the exploration sector may come at the expense of Canada's celebrated juniors. The federal government's decision to tax trusts "hurt juniors more than it hurt the trusts themselves," says Brian McLachlan, president and CEO of Yoho Resources.

Whereas the junior economic model used to rely on trusts to buy them out once they reached a certain size, these changes meant that the access to capital diminished. "Combine that with the collapse of the worldwide economy, and it's been an interesting time for juniors," says McLachlan.

Dec. 31, 2010, effectively marked the end of the income trust era as big names such as Baytex and PennWest converted to conventional corporations.

After trusts, a marketplace gap?

Does the demise of the income trusts leave a gap in the investment product marketplace and, if so, will anything be able to fill that niche?

In answer to the first question, Shane Fildes, executive managing director and global head of energy at BMO, says, "There is a big difference between the business model and the legal structure, and while the legal structure is gone, the business model continues. So a lot of trusts converted without changing their payout policy.

"Yielding return of capital to investors made sense in our mature basin. There's still a large conventional asset portfolio that lends itself to a dividend-paying, payout model and that will continue. In 2009-2010 there was a massive shift in portfolios, as conventional assets were being shed to raise capital for unconventional, resource-based assets."

One investment model that is evolving to satisfy investors' desire for income is royalty partnerships. Royalty partnerships are not a new idea, but they have been uncommon in Canada in recent years. Brickburn Asset Management launched the WCSB series of partnerships in 2008 because, "We noticed that there was a large component of proven, undeveloped reserves on companies' balance sheets, which needed capital to develop and turn that reserve into cash flow," says Brickburn's president, Bill Bonner.

The benefits for investors are multiple, according to Brickburn's managing director, Martin Davis. "First, they get cash flow off the wells as well as a tax reduction; they also get Canadian development expense write-offs, which take some capital risks out of the equation for the investor. Over a period of time they'll recover about 40 cents on their dollar investment in tax savings.

"As we gather royalty revenue, we pay it out every month to the investors. When interest rates collapsed after the credit crises, it exposed strong cash-flow streams as being quite desirable. So even though we're hugging the lowest-risk and lowest-rate returns in the energy business, they're still very compelling.

"A lot of operators were able to fund their capital budgets by selling flow-through shares where they were obliged to do an exploration event. As a result, there was lots of capital for exploration but none for development opportunities," continues Bonner. "Another complication was that the cost of wells went through the roof because of new technology. A well that used to cost $1 million now costs between $3- and $4 million. We found a real niche because we don't want an operator's equity."

One area where the federal government has been applauded is the Flow Through Shares program, which is designed to help resource companies, including oil and gas juniors, finance their exploration and development activities. Juniors "flow through" to their investors their exploration and development activities, thus providing investors the tax deductions that would normally be available to the company. The program is an important advocacy topic on the agenda for federal meetings, according to SEPAC executive director Gary Leach.

Asian money

Canada, like many a resource-rich country, has witnessed a wave of Asian investment in recent years. Some Asian investors have chosen to buy companies and assets outright, for instance Korean national oil company KNOC's 2009 purchase of Harvest Operations Corp. for $4 billion. Still, the larger proportion of capital has been invested through joint ventures with Canadian partners.

In part, the trend is driven by Asian governments' desire to achieve a return on their foreign currency positions in the face of low interest rates. CIBC's vice chairman and global head of oil and gas, Art Korpach, says, "Many Asian sovereign funds have large dollar positions and investing in North American energy assets gives them a place to park that capital, generating a higher return and providing a hedge against energy prices."

Korpach argues that Asian investors' appetite for foreign energy assets is more than a mere part of a wider foreign currency strategy. "I think Asian investment is a long-term trend, which is driven by a massive and sustained need for energy. The Chinese need and want lots of energy, and technology is making it more available. They want gas, and improved LNG capability makes it viable for them to own foreign assets and import the gas.

"We believe China is now in its third phase of investment," says Adam Waterous. "The first phase was to get physical barrels of oil for their domestic market, which continues today, and the second phase was to invest in natural gas and export it back to China. The third phase has just started, and it is seeing Asian companies investing where there's no potential to export the commodity, but where they still see an attractive investment. There has been a real move from resource capture and export towards more financial investments."

"Asian NOCs have really moved up the learning curve on deal acumen and the speed and sophistication of transactions that they put forward has changed a great deal over time," observes Waterous. "They are highly experienced, sophisticated and capable buyers, which has helped them in becoming major competitors in acquisitions. Their mandate is to grow, so they're looking to buy."

China might be a major oil producer in its own right, but the industry there has a lot to learn from the Canadians.

"We've seen these pools of capital do joint ventures in Canada as more of an intellectual capital capture strategy," says BMO's Fields. "At the end of the day, they don't want the physical molecules of gas to go back to their local markets, but rather the intellectual capital of how you drill shale-gas wells, how do you complete them, and how you manage those operations.

"That trend started in U.S. shale gas, but it's coming now to Canada. They are genuinely interested in setting up management teams on the assets they invest in on a joint-venture basis where there is an opportunity for an intellectual capital transfer."

Not only is it important for Canada to attract investment from a variety of sources; the country should be looking to diversify its customer base as well. In the words of Fildes, who is echoed by many in the industry: "As a resource seller it's in our best interest as a nation to have more than one customer."

Canadians: As friendly as they claim?

Canadian attitudes toward foreign investment have been called into question following Investment Canada's recent decision to turn down Anglo-Australian BHP Billiton's hostile takeover of Potash Corp. following intense lobbying by the Saskatchewan provincial government and the Canadian company's management.

The ramifications of the ruling for the oil and gas investor are hard to determine, according to Mike Tims at Peters & Co. "The Potash ruling is causing international companies to realize that they may have difficulty getting approval and a public license to do something that's too big. As a result, joint-venture deals continue to be well received, since smaller companies are easier to acquire because they don't cause much public concern.

"But these smaller companies don't necessarily have the assets that are attractive to international players. They're looking for something with more scale and that has a highly concentrated asset base so that they aren't spreading managerial resources over a large area. There has been money going to the oil sands because these projects provide that sort of scale and represent value for the kind of capital international investors can provide."

John Zahary, CEO of Harvest Energy, says, "Canada has a 'net benefits' test and the government has a responsibility to approve or disapprove acquisitions. There needs to be a benefit to the country and, if there isn't, then they should choose not to approve it. However, I don't think that changes anything.

"The openness to foreign investment is obvious here," adds Zahary, who remained in place as CEO after KNOC's acquisition of Harvest. "Relatively speaking, Canada is the most open country in the world. There are specific hurdles to overcome in all countries, but one ruling should not make people think that Canada is biased against foreign companies."

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