Junior oil sector hit hardest amid downturn

First published on April 7.

A little more than a year ago, Darryl Metcalfe sold his junior energy company, Artek Exploration, for $307 million. It was a time when the entire oilpatch was waiting for a rush of takeovers in the aftermath of very low energy prices

"I thought we were the front end of a wave," said Metcalfe.

While Metcalfe got a pretty good price for his shareholders, his deal was one of the few that took place last year. That wave of takeovers never happened for reasons that aren't entirely clear, but probably had a lot to do with the hope that prices wouldn't be in the cellar for too long.

'There's a dung beetle component to the junior energy sector.'- Darryl Metcalfe

Well, we all know how that bet turned out.

Now nearly two years into the oil price downdraft, there's talk of another kind of wave — that of bankruptcies. A report from the accounting firm Deloitte in February suggested that a third of energy companies around the world carried a high risk of going bankrupt.

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In Alberta, Terra Energy was pushed into bankruptcy by its bankers last month, following Spyglass Resources, Exall Energy, Redwater Energy, Shoreline Energy and Southern Pacific. All juniors, all carrying too much debt.

In Alberta, juniors are the entrepreneurial heart of the industry. It's where the creative and the hungry make their mark. The question is whether they have a future.

High risks and potential returns

The path to the junior energy sector is well trod. An engineer or geologist will start his or her career in a larger company like Imperial or Encana, learning the ropes before venturing out with a team of people.

You use some of your own money and get some funding from the market, start prospecting, buying properties, maybe some cast-offs from larger energy companies. You build it with sweat equity. And often you flip it and start over again.

There's risk here, of course, and bankruptcies are common among the juniors. But there's also real money — third house and a polo pony kind of money. Buy your own hockey team kind of money. And that's why the market has traditionally been willing to fund these kinds of risky startups. The carrot is very large.

Fracking expensive

But the times are changing.

Capital has become focused on the oilsands. About half of the province's oil production comes from the oilsands, and the juniors that that looked so promising are getting slaughtered right now. It has become an investment for deep pockets.

And outside the oilsands, the cost of entry is also going up.

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"The first sign was really shale gas," said Martin Pelletier, a portfolio manager with Trivest Wealth Counsel.

"Before fracking, the average conventional well cost $250,000 to $500,000 to drill and complete, but can now cost anywhere from three to ten million dollars. This changes the risk profile significantly, and a lot of guys didn't manage this appropriately, by taking on way too much debt to finance overly expensive drilling programs.

"The problem was just masked for a long time by high commodity prices and easy access to equity and debt markets."

Another issue at play is that of well reclamation. A court case is currently being decided in Calgary that may lead to companies needing to put more security down when drilling a well in the first place.

Pelletier feels that the days of easy startups are over.

"I think those days have come and gone, because investors aren't willing to put capital with an unproven team, even if they've established a track record in a large company, and that's unfortunate."

Junior oil as 'dung beetle'

After selling Artek to Kelt Energy, Metcalfe and his team of seven moved on to a new project with funding from private equity. That's an option available to him because he does have a track record. He's made money for investors and shareholders in the past. But he has no interest in running a public company right now.

"Teams like us are very much going to the private equity sector," said Metcalfe. "It's longer money, it's more patient money and appreciates the value creation that can happen with good technical, risk-taking teams in a long cycle."

But Metcalfe still thinks that this is a loss to Alberta.

"There's a dung beetle component to the junior sector. What's someone else's dung is pretty nutritious and nourishing for the dung beetle."

Metcalfe said that private equity funds in Canada and the United States are more patient because they are looking for bigger payoffs. "Private equity are looking for $100-million to $500-million projects, they're not looking for that 1,000 barrels a day."

Is there a future for the little guys?

Metcalfe said that it is harder to be creative in a huge oil company, and without a vibrant junior sector, some of that creative spark will be lost

"There is less of an environment for original thought. Juniors are where the explorers, discoverers, technology testers go to ply their trade. It used to be a very fertile environment for them."

Oilpatch historian David Finch agrees that juniors are important to the industry and to Alberta as a whole, but said right now, history is just repeating itself.

"This is all normal, this has happened many, many times before. There's been a boom and bust cycle in the industry almost once a decade for the whole century it's been around. The juniors have always been the slack in the industry."

Calgary at a Crossroads is CBC Calgary's special focus on life in our city during the downturn. A look at Calgary's culture, identity and what it means to be Calgarian. Read more stories from the series at Calgary at a Crossroads.