By GABRIEL LOWENBERG. Special to The Globe and Mail, Published Wednesday, November 5th, 2014
There are generally two types of companies in the oil patch – suppliers, who provide exploration services, and owners, who own the oil and gas reserves, but not the land. But there’s a third, often overlooked category: the entity that owns the land.
It is hard to make serious money in land ownership because, 90 per cent of the time, the Crown owns the mineral rights in perpetuity. But at least one Canadian company aims to prove that supplying land can be at least as profitable as supplying drill rigs. PrairieSky Royalty Ltd. owns more than five million acres of land in Alberta – and the mineral rights to that land. Its holdings, leased to companies hoping to find and develop petroleum and natural gas, are located in some of the most prolific fields in Canada. The company negotiates royalties on future production on the leased land.
Its properties are part of a 948-million-acre expanse deeded by King Charles II in the late 1600s to the Hudson’s Bay Company. HBC later ceded its holdings to the Dominion of Canada. PrairieSky’s inventory is part of the land granted in 1881 to Canadian Pacific Railway. It included all mineral and mine rights to a 38.6-kilometre-wide belt on either side of the railway’s right-of-way.
Why have I been accumulating PrairieSky shares for clients?
First, its managers and directors, including CEO Andrew Phillips, have invested $40-million in it. Voting with their wallets means management is focused on increasing the share price, not just working for a paycheque. I like that.
Second, management has a history of making money. Mr. Phillips recently completed the sale of his prior company, Home Quarter Resources Ltd., to Whitecap Resources Inc. for more than $300-million. I like that, too.
Third, as I learned during my gold investing days, the best place to find new gold deposits is near existing gold mines. PrairieSky’s acreage lies in the heart of some of the most fruitful land in Alberta for oil and gas exploration.
Fourth – and this is the best part – PrairieSky does no drilling. It has no equipment or pipelines to build and maintain, and thus avoids the entire infrastructure burden of traditional oil and gas firms. It confronts no horizontal drilling issues, no environmental pressures, and boasts the some of the highest netbacks in the industry.
Need more? Because PrairieSky owns the mineral rights in perpetuity, it can lease the land again and again when new seismic data or techniques for exploiting liquids become available. The company incurs no costs of operation other than the cost of leasing, pens and paper clips.
Oh, and one more thing, as Columbo used to say. When Encana owned this land, it was kept in reserve. Thus, while the adjacent lands are rich in oil and gas, these five million acres have never been exploited to their full potential.
The naysayers will argue that PrairieSky is expensive when compared using price-to-free-cash-flow multiples, forward price-to-earnings ratios, and dividend yields. Others will cite the declining price of oil and uncertainty surrounding pipelines to get oil out of Alberta.
PrairieSky carries a premium valuation and is absolutely expensive – deservedly so, in my opinion. It is true: If oil and gas prices continue to decline, PrairieSky will receive lower royalty revenue. But PrairieSky can increase its free cash flow more easily than any other company that I follow in the space. The existing acreage yielded just shy of $200-million of free cash flow in 2013. During the period from 2009 to 2013, only 534 oil wells were drilled, in a feeble effort to find new and replace production. So there were 10 new oil wells drilled per 100,000 acres.
Compare that to the adjacent 1.4 million acres, developed by private companies. During the same period, there were 765 oil wells drilled, or 55 wells per 100,000 acres. If PrairieSky’s assets were drilled to the same level, I cannot believe that they would not find a multiple more in reserves and producible oil and gas liquids. The company would then have materially increased its cash flow, making the existing valuation metrics irrelevant. More pens and paper clips will, of course, be required.
Yes, the oil price has softened. In this environment, I am content to play contrarian and to invest in companies with 90-per-cent operating margins. Providing that the underlying businesses maintain asset values, this down phase will not last. Sometimes, providing you are investing in quality, it is often best to buy when others are selling.
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