Turning to an energy royalty company, describe the upside you see in PrairieSky Royalty [Toronto: PSK].
JD: PrairieSky owns an enormous oil and gas royalty portfolio that spans 18.3 million acres in Western Canada with a reserve life of 50-plus years. As I mentioned before, these types of companies don’t produce the commodities directly or bear any development and operating costs, but they do participate in the revenue generated from the sales volume and prices of the reference resources. Because the reserve life is so long, PrairieSky doesn’t have to constantly be in the market replacing reserves – unlike many royalty companies – which is a tremendous advantage when oil and gas prices are at or near seven-year highs and buying reserves is increasingly expensive.
We’d argue that there’s an overall lack of appreciation for energy royalty streams. Part of that is investors fleeing the energy sector in general, due to years of bad returns and increasing focus on ESG criteria. Investors are also preconditioned to focus on current cash flows and growth, but the value in these companies predominantly resides in dormant or non-producing assets.
We also think in PrairieSky’s case that there is a misperception of the quality of Canadian oil and gas. Most investors assume the reserves in Canada are tar-sands and sulfur heavy, very expensive to extract and the least ESG friendly. But there actually are a number of light-oil fields in the Western Canadian Sedimentary Basin – which is where the company’s reserves are located – that are comparable to the best fields in the U.S.’s Permian basin. The oil produced generates high internal rates of return and is in higher demand, particularly from U.S. refiners.
Another differentiating factor here is that PrairieSky retains a lot of control over the use of its land. As a result, it’s pursuing a number of carbon-capture initiatives as well as alternative-energy projects like wind and solar. Once the investing world gets more comfortable with the fact that conventional fossil fuels are necessary for the energy transition and are going to be around for decades, we think the company’s flexibility to play as well in alternative energy makes it much more investable.
The last thing I’d say about what distinguishes the company is the quality of its corporate governance. Top executives are significant shareholders and their pay, which is modest relative to U.S. companies, is based intelligently on the performance of the company and the stock. The royalty playbook on the website details every asset they own. Their latest Investor Day presentation runs 200 pages, again with excellent detail on the entire portfolio. There’s just a very high level of transparency and accountability.
How are you looking at upside from today’s C$17.60 share price?
JD: Assuming energy prices 10-15% below where they are today and some small increases in production, we think the company can earn its entire market cap in free cash flow over the next seven to 10 years. More importantly, they’ll still at that point have at least 75% of their existing portfolio to exploit. That means I’m earning a double-digit free cash flow yield and there’s still an embedded call option on the large reserve base. That to us is a compelling value opportunity.
PrairieSky Royalty is the largest Canadian oil and gas royalty company. An oil and gas royalty company receives cash payments based on the produced volume and price from the oil and gas producers on land covered by the royalties. Unlike oil and gas producers it has virtually no input cost inflation and very little capex to maintain cash flow. With around 60 employees, it generated more than USD 400 million in revenue in the twelve months ended September 30, 2022, with 70% EBIT and 52% net profit margins. PSK has used its high operating cash flow to acquire royalties, almost doubling the land per share covered by royalties since its IPO in 2014. The company is valued at an EV / operating cash flow multiple of less than 11x.
Prairie Sky Royalty (PREKF, PSK.TO) is a pure-play royalty company, generating royalty revenues as petroleum and natural gas are produced from their 18.2 million acres of royalty properties spanning Western Canada from Northeast British Columbia to Western Manitoba. They have the largest independently owned portfolio of fee simple mineral title and oil and gas royalty interests in Canada.
The land that they own came from Canadian Pacific Railways, which was given a checkerboard pattern of land along its railway right-of-way from Winnipeg to British Columbia. They were granted 25 million acres of land, including mineral rights, in exchange for building the road. Later, the railway created Canadian Pacific Oil and Gas Limited, which became PanCanadian Petroleum Limited through a merger with Central Del Rio Oils Limited, and then Encana when PanCanadian merged with Alberta Energy Company. In 2014, Encana divested Prairie Sky Royalty, which grew even further in 2015 when it acquired a substantial portion of Canadian Natural's royalty assets.
The IPO price of Prairie Sky was $28, and it now trades at $14 (figures in USD), having paid $5.85 of dividends to shareholders along the way. However, management has made repurchases, with the result that acreage per share has grown since the IPO. This is a metric that management includes in its investor presentations, and it has grown from 0.04 acre/share at IPO to about 0.07 acre/share today, an 80% increase in acreage per share. That means that an investor is paying about $200 per mineral acre. Here is how the company describes its reserves replacement since the IPO:
The investor presentations of Prairie Sky are high-class, exactly what you would want to know as a shareholder. They actually include a chart showing their FCF multiple compared to Texas Pacific Land over time. And here is another stunning slide:
Their projection in February 2022 (above) was that if they can get 23,000 BOE/d of production at $75 WTI over the next decade, they would be able to reduce their share count by 90% over the next ten years if the share price remained at $13.50 (near the current level).
The market capitalization of Prairie Sky (at $14 per share for the U.S. ADR) is $3.3 billion. During Q4 2021, the company had funds from operations of $102 million. That was with an average WTI price of $77 per barrel and a $14.64 discount to WTI for Western Candian Select crude oil. The president Andrew Philips had this to say about the 2021 annual results:
Strong commodity pricing drove increased third-party operator activity on PrairieSky’s Royalty Properties in the second half of 2021, with 193 wells spud in Q3 2021 and 166 wells spud in Q4 2021. The increase in activity on our lands is starting to be reflected in PrairieSky’s Q4 2021 royalty production volumes which increased to 20,340 BOE per day, with oil royalty production volumes increasing to 8,311 barrels per day, a 10% increase over Q3 2021. Royalty production growth coupled with strong benchmark pricing for both oil and natural gas generated record funds from operations of $101.8 million in Q4 2021, a 148% increase over Q4 2020 and a 54% increase over Q3 2021.
PrairieSky added approximately 3.0 million acres of incremental royalty lands and associated production in 2021, including closing the acquisition of 1.9 million acres of royalty lands and complementary seismic from Heritage Royalty for cash consideration of $728 million (the “Heritage Acquisition“). The Heritage Acquisition was effective December 31, 2021 and therefore the production and revenue information for Q4 2021 and annual 2021 only includes one day of contribution from the acquired assets. At the time of announcement of the Heritage Acquisition on November 29, 2021, PrairieSky estimated current royalty production of 2,700 BOE per day (92% liquids), from which PrairieSky expected to generate approximately $65 million of royalty revenue in 2022 (assuming a West Texas Intermediate (“WTI“) price of US$68 per barrel compared to current prices of over US$80 per barrel). Since closing of the Heritage Acquisition, PrairieSky has been actively leasing undeveloped land in multiple oil weighted plays. While the full benefit of the incremental production volumes, associated revenues and any other revenues from the Heritage Acquisition will first be included in the Q1 2022 results, PrairieSky’s 2021 annual current income tax expense was reduced through the use of the acquired income tax pool deductions resulting in a current income tax recovery of $12.4 million in Q4 2021.
Our Q4 2021 and 2021 annual results demonstrate the benefits of our high margin business model. We anticipate 2022 will be an active year in Canadian energy including drilling on PrairieSky’s Royalty Properties. We expect to benefit from this activity through strong royalty production volumes without any incremental capital investment. Effective for the March 31, 2022 record date, PrairieSky will pay an annualized dividend of $0.48 per common share ($0.12 per common share per quarter), an increase of 33% from the current dividend. Under strip commodity price assumptions, PrairieSky expects to accelerate debt repayment including retiring all of the debt used for the Heritage Acquisition over the next 24 months.
Prairie Sky just reported results for Q1 2022. Some highlights:
"Royalty production averaged 23,892 BOE per day, representing a 17% increase over Q4 2021 and a 23% increase over Q1 2021."
"Achieved record quarterly funds from operations of $105.0 million ($0.44 per common share basic and diluted), a 3% increase over Q4 2021 and a 115% increase over Q1 2021 driven by a combination of royalty production growth, 2021 acquisitions and strong commodity pricing."
"Declared a first quarter dividend of $28.7 million ($0.12 per common share), representing a payout ratio of 27%, with remaining cash flow allocated to $6.3 million of royalty acquisitions and the balance to retiring bank debt."
"The differentiation of our business model is evident in an accelerating capital environment as we lease our vast underdeveloped land base to qualified, well-capitalized industry partners. PrairieSky believes leasing is a leading indicator of future third-party drilling activity on our lands and organic per share growth in royalty production. During Q1 2022, PrairieSky generated $3.5 million in bonus consideration by entering into 52 distinct leasing arrangements with 43 different counterparties. Following a busy second half of 2021 when 359 wells were spud on PrairieSky’s royalty properties, Q1 2022 was another active quarter with 194 wells spud, including 168 oil wells and 26 natural gas wells, almost double the 100 wells spud in Q1 2021."
"Our record Q1 2022 funds from operations of $105.0 million reflects the benefits of our high margin business as PrairieSky remains insulated from direct cost inflation in the upstream sector. Our unhedged royalty production received strong netbacks including $4.20 per MMcf for natural gas, $97.99 per barrel for crude oil and $55.66 per barrel for natural gas liquids ("NGL") which drove record quarterly royalty production revenue of $134.7 million."
"Cash administrative expenses totaled $10.3 million or $4.79 per BOE and included the annual cash payment of long-term incentives for staff and executives of $5.0 million (2021 annual LTI payment - $0.7 million for staff and $nil for executives as performance share units expired unvested due to share price performance). PrairieSky expects cash administrative expense per BOE to be below $3.00 per BOE for 2022."
Prairie Sky has net debt of $450 million, so the market capitalization (at $14 per share for the U.S. ADR) is $3.3 billion and the enterprise value is $3.75 billion. The earnings yield, based on Q1 2022 income annualized, is 7.7%.
Earnings include a big charge for depletion. More interesting is to look at funds from operations of $105 million, which adds that back, and gives an 11.2% FFO/EV yield.
It is quite impressive, considering how much of Prairie Sky's acreage is still undeveloped, and how good the capital allocation and corporate governance is.
Prairie Sky has 18.3 million acres of mineral rights in Western Canada, which means an enterprise value of $200 per acre. Acres per share have grown to almost 0.08. The latest investor presentation has a good chart of production per share:
Proved and probable reserves leapt by 37% over year-end 2020 because of more acreage and higher commodity prices.
Since the current earnings and FFO/EV yield are attractive enough to justify the current price, you are getting quite a lot of future production "for free". Stacking barrels.
It seems like the big question for the "dying industry" value strategy right now is: how much of the tobacco stocks (i.e. Altria and Philip Morris) are optimal to given the higher valuations than the oil and gas investments?
It probably depends on how confident you are that oil will be $100/bbl, not $50 or $75, over the coming years. The tobacco companies may be a good portfolio diversifier as well, in that lower oil prices would increase consumers' discretionary spending ability, and probably help sales.
