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The Globe and Mail

A privileged trough of capital reflects change in oil and gas sector

They say, "You can lead a horse to water, but you can't make it drink."

There are exceptions to this proverb, notably for oil and gas companies. We know if you lead them to capital they will always drink. Unless the trough is dry.

Right now there is unprecedented scarcity of public capital available for oil and gas companies. Year-to-date Canadian financings for the industry are at a 10-year low, and probably at an all-time low if the data are adjusted to reflect a growth metric, for example dollars available per unit of output. The dearth of dollars is, in part, due to the mood of the capital markets, but mostly the situation speaks to the changing structure of the industry.

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After flipping the 2013 monthly calendar twice, year-over-year public company financings to date are tracking around 20 per cent of normal. As of early March, total equity raised is at $345-million, which is a mere trickle. Usually by this time of year new equity issues are indicating $1.5- to $2.0-billion, well on the way to the 10-year average of about $10-billion per year. Debt too is lagging: Only $275-million has been issued this year.

It's not unheard of for the debt and equity spigots to be shut. It happened in 2002 after Enron imploded. It also happened on rare occasions in the 1990s, but back then the industry was one-fifth the size that it is now on a cash flow basis. Also, since then, acute inflation in the mid-2000s devalued the purchasing power of an investment dollar.

Today the capital markets are demonstrating extreme discretion. Although broad equities have perked up recently, risk aversion is still top of mind among investors. In Canada, intertwined macro oil and gas issues such as price differentials, low prices and access to markets are also causing reticence to finance public companies in the industry.

While debt and equity are important lifelines, the dominant source of investment capital is cash flow. Unless dividends are being paid out, oil and gas companies typically reinvest every dollar of cash flow back into the ground. But on the natural gas side of the business, this source of capital is also scarce due to low continental commodity prices. On the oil side, cash flow is compromised due to deep price discounts. Historically, this three-way choking off of industry capital – equity, debt and cash flow –would reflect negatively on the industry, leading to a serious contraction of field activity and ultimately production declines.

Drilling activity is somewhat muted this year, but not proportionally to the dearth of public capital. Our estimates suggest that the industry will still spend $54-billion in 2013, this despite a forecast of only $36-billion from cash flow. How is this reconcilable – in other words, how can the industry as a whole be spending 1.5 times its cash flow without help from public capital markets?

The gap is explainable by prevailing structural changes. First, private equity capital has stepped in to fill in for some of the public market shortfall, but not all. Globally, the institutional investor's bias is leaning toward private company investment. Private equity has financed several hundred million dollars already in 2013, but this quieter source of capital is highly selective and doesn't serve up growth capital to the broader industry.

Selectivity and discretion is a big theme in today's investment landscape. Only a handful of high-growth, darling companies are able to raise money; for example, two-thirds of the $345-million in equity this year was raised by one public company – Tourmaline Oil Corp.

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The loudest statement about structural change comes from the patient and deep pockets of large multinational companies, where the bulk of the industry's growth capital is coming from right now. None of these participants need to depend on public market financings to further their interests. Shell, Chevron and Petronas are declared long-term players in the LNG game, spending money from wellheads to the coast, regardless of current market conditions. Overseas joint venture money targeting resource plays also continues to be an alternative source of capital. Notably, big oil sands companies are tracking spending levels in the low $20-billion level this year, with no hiccup relative to prior years.

Massive upfront investment into big resource development is how the industry will end up spending significantly more than its cash flow this year; the oil sands sector will spend 250 per cent more than it takes in, and conventional plays 120 per cent, for a weighted average 150 per cent as a whole.

Structurally, the selectivity of capital and shift in its sources means that the oil and gas industry has become a cloistered business that favours the few. In fact, there is lots of water at the trough. But for now only big, sophisticated or privileged horses are able to drink.

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