How to play energy in a down cycle

Commodities, especially oil, have had a rough go of it this year. In summer 2014, Brent crude went north of US$110 per barrel; in October 2015, it was less than US$50. Not a good time to buy into energy, right?

Wrong.

Despite the low-price environment, oil and gas exposure can still make clients money. And it’s possible to do so without the hand-wringing volatility that usually comes with energy investing, says Stephen Johnston, co-founder of Enercapita in Calgary. Its strategy focuses on directly purchasing what energy experts call low-decline production assets from producers that, due to financial distress, are selling the assets at discounts.

The decline rate refers to the amount of production that’s lost every year if the asset’s owner doesn’t invest in upkeep. An oil well, for instance, will produce less every year if it’s not maintained. Another key metric is the cost associated with upkeep, or the asset’s capital intensity, says Johnston.

Over the last eight to 10 years, the energy industry’s primary focus has been less on investing in low-decline assets and more on acquiring assets with potential for significant reserve value increases. Reserve value is an estimate of the value of future (potential) production. Fracking, for instance, tends to yield impressive reserve values, but has high decline rates and high capital intensity.

Hedging isn’t a perfect risk-mitigation tool for a long-term decline in oil prices.

“The model is not to focus exclusively on reserve value expansion,” says Johnston. “It’s to buy low-decline assets at competitive cash-flow multiples—around 4 times. What comes out of that is a steady stream of cash that doesn’t require a lot of subsequent capex to maintain it.” That cash comes from selling the oil these assets generate.

To protect against oil price volatility, Enercapita implements a hedging program. When the fund buys a production asset, the asset’s cash flow is hedged up to five years to the price of oil as of the asset purchase date. So, the fund doesn’t make bets on which way oil prices will go; instead, it locks in future cash flow based on current prices.

The hedge involves “a forward sale of oil to a major bank [Enercapita’s counterparty]. There’s cash settled on sale.”

Investing in low-decline assets and hedging future cash flows are the first two pillars of the strategy; these cover distribution obligations. The distributions are made to unitholders of the mutual fund trust.

Client investments are effectively illiquid for 5 years.

The units carry a five-year term. Sitting beneath the mutual fund structure is a limited partnership that investors also sign on to. The limited partnership houses the third component of the strategy: equity participation.

Johnston says the equity piece allows unitholders to participate in any future upswing in oil and gas prices. Price increases generate more cash from production, which in turn increases the value of the equity. That equity gets sold off as part of the fund’s exit strategy. “A steady stream of cash in a low-decline asset package [is] appealing to bigger oil and gas companies looking for ways to maintain their distributions.”

An important feature of this strategy is that it’s both hedged and unlevered. “Bank leverage can be fatal in natural resource production because the underlying commodity price is volatile. If you get over-levered and there’s a downswing, the bank liquidates you.” The key, says Johnston, is to avoid leverage as the primary return driver (i.e., levered beta). A good use of leverage is as an interim financing tool for acquisitions of assets. “Leverage should always be used in moderation.”

The fund has a priority distribution of 8% to unitholders and a management fee of 2%. This is separate from any potential upside from the equity component. Since it’s partly a mutual fund trust, the fund is RRSP-eligible. But don’t assume clients can come and go as they please; only a negligible amount ($10,000 for the entire fund) can be redeemed per month to meet regulatory requirements. So, if a client invests $100,000, she should view it as though it’s an illiquid private equity style investment.

Fund Stats

Advisors get a 5% placement fee from the fund.

The minimum’s $5,000. “But the average investment is much larger,” says Johnston. The strategy has a “strong appeal to ultra-high net worth investors, who tend to be contrarian. They’re saying, ‘I’ve been through these [down] cycles before; now’s the time to invest in this space.’”

Dean DiSpalatro is a Toronto-based financial writer.