NAL Energy's cash flow sealed deal for Pengrowth

The combination of two mid-sized Canadian energy companies comes as smaller players of the oil patch increasingly look for cash to fund expensive work in the oil sands.

On Friday, Pengrowth Energy Corp. announced a $1.3-billion all-share takeover of NAL Energy Corp., a transaction that will transform Pengrowth into a large-sized producer of 100,000 barrels of oil equivalent a day.

The takeover must be approved by NAL shareholders, who must decide whether to accept a modest 10-per-cent premium. It comes as smaller echelons of the energy industry seek the scale it takes to compete in a fast-changing energy space. Single oil wells that once cost $1-million to drill now routinely cost $5-million – and triple that in some places – as companies use sophisticated techniques to free oil from tough rock reservoirs.

That has dramatically increased the size and scale of companies needed to operate in today's environment, a consideration that is accentuated for Pengrowth, which is also looking to expand in the capital-intensive oil sands.

In fact, the Pengrowth deal has shades of the Suncor Energy Inc. takeover of Petro-Canada, writ small. Suncor coveted Petrocan's cash-minting offshore operations to fuel its oil sands growth. Pengrowth felt the same about NAL's portfolio of assets, which spin off cash the company can use to build a new $450-million oil sands plant, expected to start pumping 12,500 barrels a day of oil by 2015.

NAL will add about $75-million to Pengrowth's annual cash flow, enough to boost its ability to self-fund development of that oil sands plant, at a location called Lindbergh.

"A bigger cash flow base allows us to not only high-grade the opportunities inside of the asset base where we're going to put capital to work, but it allows us to shove more cash flow at our [oil sands]project," Pengrowth chief executive officer Derek Evans said in an interview.

Operating in the new oil patch environment is "not for the weak of mind, soul or those with shallow pocketbooks," Mr. Evans said.

For some investors, however, the transaction signals another sign of things to come: anemic values for stumbling companies.

"The broader trend is, if a company is not executing on their plan, i.e. the growth rates the market wants, then they're going to be forced to sell," said Rob Lauzon, managing director for Western Canada with Middlefield Group. "And don't expect big premiums. Expect the 10- to 15-per-cent premiums."

Mr. Evans acknowledged the small size of the premium. But, he said, "let's bear in mind that NAL shareholders are getting a 20.4-per-cent lift in their dividend, their leverage is coming down, and they're getting a slice of the Lindbergh [oil sands]project."

The deal, subject to a $45-million break fee, needs two-thirds approval of NAL shareholders to proceed, and some investors say they hope a better offer will materialize. NAL is, however, prevented from pursuing other suitors, and Pengrowth has a right to match another offer.

Mr. Evans said Pengrowth expects to save $10-million to $20-million in expenses a year through the combination. Much of that will come from stripping away NAL's management team, which operated as a separate entity paid $21-million in 2010.

There may be some difficulties in merging the companies, however. Laura Lau, senior portfolio manager with Brompton Group, pointed out that the two have geographically dispersed assets that aren't likely to weave together especially well. Pengrowth will also have to work with Manulife Financial Corp., which has a financial stake in a number of the NAL assets.

"When I looked at it [the deal,] I was very confused," she said.

Pengrowth has one important advantage, however: It already employs Marlon McDougall, the former chief operating officer at NAL. That should do much to smooth the merger of the two companies, Ms. Lau said.

"He knows the assets inside and out," she said.

Pengrowth (PGF)

Close: $9.78, down 17¢

NAL Energy (NAE)

Close: $8.26, up 46¢