Are capital markets truly inefficient for oil and gas?

It has been a complaint for the last several years that the capital markets have become inefficient for oil and gas companies, particularly in Canada. We can see how this could happen, as interference in any sector from stakeholders and governments is bound to result in less than efficient markets. We don’t need to look further than large institutions with mandates not to invest in the sector, or banks that specifically state they will not provide capital to certain oil and gas activities. These trends seem to be good indicators that capital is likely not getting to where it needs to be. But how do we actually quantify that the assets that could provide the world with the energy it needs are not getting capitalized appropriately?

One clear indication of the above can be seen by analyzing future development capital (“FDC”) for reserves vs. capital guidance. We like this because FDC is from an independent third party and capital guidance is also public and agreed on. There are several nuances to this analysis that we have included in the notes section following the post.

Future development capital is what reserve engineers quantify as the capital required to develop the reserves they attribute to a company. These capital cost estimates typically don’t extend too far out. For example, assets that would require twenty years of capital to extract would no longer be classified as reserves. A general rule of thumb has been that you can take 2P future development capital and it will represent approximately five years of capital. There are slightly different reserve approaches between the US and Canada, and certain regulations that drive this, but historically this number has remained in this range. Interestingly, you can now see a significant disconnect from this average even across companies that focus on the exact same resource play. In the graph below we have tracked this ratio for several Canadian producers targeting the Montney.

The above companies all target the same highly economic and repeatable resource, often right beside each other. Despite these tremendous assets you can see that many of the companies are not able to run a capital budget that would be appropriate to this resource.

It would be expected that they would accelerate the development of these economic reserves. Or alternatively, one would assume that the company next door would buy these assets. Neither is occuring. These companies are constrained, without access to the capital markets, and good assets are going undercapitalized.  

Notes:

  • The argument could also be made that reserves are simply overbooked. This sometimes occurs in the industry but rarely occurs for repeatable resource plays like the Montney, where many reserves are well proven through significant area development.
  • By using 2019 guidance it could be argued that this number is not indicative of capital over the next five years. This is a fair argument, but we cross-checked guidance vs. street research, which has estimates a few years out, and it tracks very closely for plays like this. The contrast would be where it differs significantly year-over-year if you look at offshore or oil sands projects, where the spending follows the typical fluctuations of mega-projects.
  • Another factor to consider is perhaps that the asset isn’t capitalized due to political risk. Another fair argument but political risk in a region like Canada will manifest itself in differentials which are included in reserve reports. For example, pipeline constraints in certain basins result in differentials on product pricing vs. major pricing hubs, and these differentials are used to assess the economics that classify a product as economic reserves or not.
  • One item we have seen a lot of press around is whether capital markets simply won’t provide a company with capital if it is spending beyond cash flow, a long-standing critique of the energy industry. In this instance, it wouldn’t matter if the company has good reserves as the market still wouldn’t provide capital. We would argue that you should still see M&A of the smaller players, many of which would be accretive to cash flow per share, which should be exactly what cash flow focused markets want.  
Mark Le Dain

Mark Le Dain

Mark Le Dain currently runs strategy for Validere and previously worked as an energy investment banker. Mark has significant experience advising energy and infrastructure companies, successfully completing over $18 billion of M&A transactions and $5 billion of capital markets transactions.
Mark Le Dain