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PrairieSky: Highly Valued Canadian Oil And Gas Trust Faces Potential Distribution Cut
Dec. 17, 2014 5:00 AM ET | About: Prairiesky Royalty Ltd. (PREKF), Includes: DMLP, FRHLF, VNOM Subscribers to SA PRO had an early look at this article. Learn more about PRO »

Disclosure: The author is short PREKF. (More...)
Summary

Unhedged Canadian royalty trust trading at +30x my estimate of 2015 cash flows.
Barring a significant rally in oil and Canadian NGL prices, I believe PrairieSky will need to cut its distribution by +40%.
Exposure to high-cost Canadian oil and gas plays may result in asset impairment in the "new oil" environment.

(Editors' Note: PrairieSky trades on the Toronto Stock Exchange under the ticker symbol PSK.TO, with ~$CAD 23M average daily volume).
Thesis

PrairieSky (OTC:PREKF) is an unhedged, low-growth Canadian oil and gas royalty trust trading at +30x my estimate of 2015 cash flow. Given its concentration in low-return Canadian oil acreage, I think there is a serious possibility that most of its assets will be permanently impaired. I believe PrairieSky is a compelling short, with 50% potential downside and minimal upside.

At current strip prices and my estimate of potential 2015 production declines, PrairieSky should generate around $0.94/share in cash flow. With a current dividend of $1.30/share, I think there is a very strong chance that the dividend gets cut 40% to +50% in the next three to six months. Considering the fact that the stock is trading at a 4.4% yield, which is already far more expensive than peers, I conclude the market is expecting high growth rates from PrairieSky. I expect that a distribution cut would cause the market to revalue PrairieSky, leading to a very severe price decline.

I am short PrairieSky stock because it is one of the most - if not the most - expensive energy stocks in the market, and I think the investing community has fundamentally misunderstood the volatility in its cash flow and the limited growth profile going forward, even in a more robust commodity price environment.
Background

PrairieSky is the largest oil and gas royalty trust in North America. It was spun out of Encana in May 2014 through an IPO. The stock priced above its $23-$26 range at $28 (6% below today's price), and quickly rose to +$40. The motivations for Encana's pursuit of the spin-out are very clear - it needed liquidity to pursue its push into US shale, and selling the royalty rights for the lands it no longer planned on drilling was an ideal funding source. After selling a 45% interest in the IPO, Encana made a beeline for the exit, and sold its remaining 55% interest in a secondary less than four months later. Except for being PrairieSky's largest source of royalty revenues, Encana has no remaining relationship with the company.
Company Overview

Following its recent acquisition of Range Royalty, PrairieSky owns over 5 million acres of mineral interests across Alberta and Saskatchewan. Pro forma for the recent acquisition, PrairieSky receives royalty fees for 18,365 boe/d of net production. Over the past few years, oil and natural gas liquid (NGL) production increased at a mid-teens rate per year, while dry gas production declined at a low-double digits rate. The decline in gas production is largely attributed to the fall in natural gas prices that has rendered most Canadian dry gas plays non-economic. The majority of the company's production growth has come from a liquids-rich play called the Glauconite, which is located just southwest of Edmonton. Additional growth has come from the Halkirk Viking, Lochend Cardium, Ellerslie and a Canadian extension of the Bakken formation called Ferguson Bakken. These plays are generally not economic at current prices, and even in a higher commodity price environment, their economics rank well behind the high-quality shale plays in the US.
Production Growth Trends

While the liquids growth rate from 2011 through early 2014 was impressive, it has since slowed so much that we are now seeing sequential production declines. From Q1 2013 to Q1 2014, oil and liquids production grew over 40% as drillers such as Bonavista, the largest producer in the Glauconite, poured capex dollars into the play. However, from Q1 2014 to Q3 2014, oil and liquids production actually declined almost six percent. How does such strong growth reverse so quickly, you ask? Well, these liquids plays have really high decline rates. A typical Glauconite well's initial production (IP) is generally around 550 boe/d. At six months, production falls to around 200 boe/d. After a year, production is less than 150 boe/d. That's a +70% decline in the first year of production. While these decline rates are by no means out of the norm for hydraulically fractured wells, they point to a very important consideration when thinking about PrairieSky's revenue stream. Producers have to spend a lot of money to keep production flat, much less grow it. They need robust cash flow, projects that can be drilled economically and healthy balance sheets to fund this growth - something that is tough to come by in today's oil price environment.

Even before the recent oil sell-off, producers on PrairieSky's acreage were planning on spending less money drilling new wells. In 2013, Encana drilled 283 wells on PrairieSky's lands. Year-to-date, Encana has only drilled 66 wells, and zero since Q1. While Bonavista's 2014 well drilling activity in the Glauconite increased from 2013, the company's most recent plans called for drilling 62 wells in 2015, down from 69 this year. This plan was articulated in mid-November. Since then, Canadian liquids pricing has declined anywhere from 25% to 60%. Bonavista is levered +3.5x debt-to-cash flow at strip pricing, well above its stated goal of 2x. It is very likely that its cap ex budget will get revised downward.

PrairieSky's existing production is declining +20% per year. Prior to the acquisition of Range Royalty, the company estimated that it needs $300MM in cap ex to be spent on its land to keep production flat. Per the prospectus, in 2013, producers spent $368.7MM in connection with development activities on company lands. We don't know how much cap ex has been spent in 2014, but we can observe that production has declined over the course of the year. With oil prices down +45% year-to-date, 2015 cap ex budgets will likely be significantly lower. And with that, I think it is reasonable to expect mid-to-high single digit production declines. But wait, there's more.

Canadian oil and gas leases are frequently structured based on a sliding-scale royalty, whereby royalty rates increase as prices rise and vice versa. As of the third quarter, around 30% of PrairieSky's production was tied to sliding royalty rates. Again referencing the prospectus, these sliding royalty scales are based on two government-established structures - "The New Royalty Framework" from 2008 and the "Alberta Royalty Framework" from 2010. Royalty rates for these types of leases range from a minimum of 25% at a <$55 oil and 40% max when oil prices exceed $120. During the third quarter, oil prices averaged just over $100 (in Canadian dollars). Today, they are just under $57. At a $100 oil price, the average royalty for sliding scale leases is around 35%; at $57, the royalty falls to under 26%. This suggests that in addition to receiving lower proceeds due to falling commodity prices, PrairieSky is also experiencing a declining royalty rate that would result in around 7% lower production. Combined with the effect of natural decline rates at the wellhead, PrairieSky could see low-to-mid double digit production declines in 2015. So what might the distributable cash flow look like in 2015?
Cash Flow Estimate

Since PrairieSky's royalty revenues are a function of spot commodity prices and drilling activity from over 300 third-parties, estimating revenues and cash flow is, well, an estimate. Nonetheless, using a range of assumptions, I think you can get a reasonable sense for cash flow at various commodity prices and production levels.

Assuming fixed inputs for natural gas prices (current strip), NGL prices (60% of Edmonton par), Edmonton basis differentials ($5 per barrel, versus near-$7 today) and a USD/CAD conversion rate of 1.16, I get the following range of cash flow per share:

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