Canadian junior oil and gas companies are exciting to watch, and even more exciting to participate in. Investors who do their homework by researching company fundamentals, growth prospects and the caliber of management can make money in this sector. More than 70 publicly listed juniors are focused on exploration and production in western Canada, mostly from a base in Calgary. This year some of them will see their share price double, triple and do better. There will also be some disappointments. A number of companies will be acquired or reorganized, and a new crop will continue to take their place. This thriving sector runs in cycles driven by commodity prices, but its fate is also connected with exit strategies and management teams that keep returning under new company names. These teams don't just enjoy the game of building small oil and gas companies to a point where they can sell them; they can also make a significant amount of money doing so. Fortunately, so can shareholders. We define juniors as those with production averaging between 500 and 15,000 barrels of oil equivalent (BOE) per day. Although a number of companies in this range are private, the majority trade on the Toronto Stock Exchange (TSX) or the Toronto Venture Exchange (TSXV). Market capitalization of each of the 71 public juniors ranges from C$15- to C$600 million. The whole junior sector has an aggregate market cap of approximately C$9 billion. Companies with less than 500 BOE per day of production are called emerging, and larger companies are referred to as either intermediates or seniors. But in the past three years, the intermediate sector has evolved to a point where it is almost exclusively populated by royalty trusts. Because they continually distribute a large percentage of their cash flow to unit-holders, they are much less active as explorers and aggressive drillers than intermediate companies have been in the past. This has helped the juniors rediscover their niche as they have been picking up the slack. They have also become feedstock for the trusts that use their tremendous access to capital to buy up junior companies at a rate of five to 10 per quarter. As a group, the juniors seem to favor gas production over crude oil. Gas can be produced with comparably lower operating costs, while the prices received are often relatively higher than those received for oil. Some of the companies that had the highest proportion of their fourth-quarter 2003 production weighted to gas include Hawker Resources (Toronto: HKR) at 100%, Ketch Resources (Toronto: KER) at 94% and Diaz Resources (Toronto: DZR.A) at 88%. One company that has found success while bucking this trend is Blackrock Resources (Toronto: BVI) with 100% of production made up of heavy oil. An extended period of high commodity prices has benefited the Canadian juniors and their investors. During 2003, juniors showed an average return of 63.5%. Only 15% experienced a share-price decrease, while one in four saw its share price rise 100%. By comparison, the 17 Canadian energy trusts that make up the intermediate sector had total returns, including distributions, averaging 49% for 2003. That included an 18% average return from distributions paid during the year as well as a 31% average gain in unit prices. In the first four months of 2004, the market for juniors appeared to be catching its breath, with only a 2% average share-price increase during this period. Valuations, key metrics Investors in junior companies, and often the executives of these companies themselves, frequently compare companies' financial and operating results against each other to make more informed investment decisions. However, in a recent survey Iradesso Communications found that the quality of the management team is the most important factor for investment decisions. Of course, this is impossible to objectify, although a past record of success or failure is as close as one can come. Another key factor that cannot be found in the comparison of investment ratios or multiples is the quality of future growth prospects. This means some companies end up trading at much higher multiples because future growth is already factored into their share price. Reserves volumes and present values are evaluated by third-party engineering firms and reported by Canadian juniors on an annual basis. However, some companies are starting to report reserves quarterly to recognize growth and lower the chance of any surprises. Starting with year-end 2003 reporting, the Canadian Securities Administrators implemented National Instrument 51-101 to ensure consistent reserve definitions are used across the board by public Canadian oil and gas companies, while attempting to enhance investor confidence in Canadian capital markets. Under the definitions of reserves set out by NI 51-101, a company's reserves should have a 90% probability of being greater than the proved reserves assigned to the company, and a 50% probability of being greater than the proved plus probable reserves assigned. Of the 71 juniors currently operating, 55 had released their year-end 2003 results at press time. For those 55 companies we were able to calculate a blow-down net asset value by taking the 10% discounted net present value of reserves, adding C$100 per acre for undeveloped land, adding working capital and subtracting debt. After dividing this by the number of shares outstanding, we found that as of April 30, 2004, 80% of companies were trading at a premium to our blow-down net asset value (NAV) calculation. This high percentage could be a result of conservative pricing forecasts used to calculate the present value of reserves. It could also be a result of investors attributing value to strong management teams and post-2003 growth prospects. Using the year-end reserve reports, we can compare the enterprise value (market cap plus net debt) less undeveloped land value, attributed to each BOE of reserves. This calculation gives us an average value of C$24.45 per BOE of proved reserves and C$17.53 per BOE of proved plus probable reserves. Companies that appeared to offer good value using this measure include Ranchgate Energy (Toronto: ROG) at C$7.52 per BOE, Purcell Energy (Toronto: PEL) at C$8.39 and Connacher at C$8.43 (all on a proved-plus-probable basis). Cash flow multiples are also a favorite valuation tool. Rather than use a straight share price, or market cap multiple of cash flow, it is more effective to use enterprise value multiples, which incorporate net debt. Otherwise a company that carries a comparably large amount of debt could appear falsely undervalued to potential investors. Cash flow multiples can be monitored quarterly and also be projected into the future with a forecast of cash flow. On a historical basis, by the end of April, companies were trading with an average enterprise value 14.3 times their 2003 cash flow. A more valuable measure will be the enterprise multiple of cash flow for first-quarter 2004 annualized. It is likely that companies that had a low enterprise multiple of cash flow for 2003 will continue to report this in 2004 and therefore will look like a strong potential investment. These companies include Devlan Exploration (Toronto: DXI) at 4.7 times, Case Resources (Toronto: CAZ) at 5.4 and Energy North (Toronto: ENI) at 5.8. Debt levels are monitored by investors as another multiple of cash flow. Most companies strive to have net debt of less than 1.5 times annualized cash flow, and companies carrying higher debt than this are often penalized by the market. Among the cycles experienced by the sector is availability of capital. The past year has been good for access to capital, as many junior companies have been able to successfully conduct secondary share offerings. Exit strategies Iradesso's quarterly report on Canadian junior companies attempts to compare all companies that meet the criteria. The last report, issued at the beginning of December 2003, included 68 companies. In the last four months, 13 of these companies have disappeared or are in the process of disappearing, while at least 15 new companies have filled the void. This translates into a turnover rate of approximately 20% in less than half a year. The 13 companies that most recently disappeared have all been acquired, mostly in friendly takeovers by royalty trusts, or they have converted to a royalty trust. The usual life-cycle of a junior in western Canada is three to five years, with production growth from zero to 1,000 or 2,000 BOE per day. After this time, the company is often acquired or merged with another. The management normally parachutes out of the transaction and starts again. In recent years, this has been done through a spin-off company that takes some of the more growth-oriented assets as a starter kit. The spin-off transaction seems to have been mastered by the management team led by Paul Colborne. This team began this type of transaction when Startech Energy was sold to ARC Energy Trust in early 2001 and spun off Impact Energy. Most recently, when Crescent Point Energy merged with Tappit Resources to form Crescent Point Energy Trust (Toronto: CPG.UN), shareholders received shares in a new spin-off, Starpoint Energy (Toronto: SPN). Selling the company to a royalty trust hasn't always been the most common exit strategy for juniors. During 2000, there was a cycle involving U.S. exploration and production companies acquiring Canadian companies with a focus on securing access to junior oil and gas reserves. In 2001, when gas prices declined, many of these acquisitions started looking expensive, so U.S. companaies have shied away from acquiring Canadian juniors since. What's next? As any investor in the oil and gas sector should know, the next phase of the cycle is often determined by what happens to commodity prices. The fate of the junior sector will also be tied to the intermediate royalty trust sector. If oil and gas prices continue to stay at historically high levels, these trusts will continue to enjoy exceptional access to capital and will use that to buy up juniors to replace their reserves and production. Conversely, if commodity prices were to weaken for a sustained period, the royalty trusts would need to deal with lower distributions to unit-holders and lower cash flow. This could lead to a period of consolidation within the royalty trust sector, while junior oil and gas companies maintain themselves on their own cash flow. A shake-out of the junior and intermediate sectors could be healthy, and those that make it through a lower-price cycle will be much stronger coming out the other side. Another possibility presumes American companies once again make their presence felt by acquiring Canadian companies. This has happened approximately every few years in the past, and the time may be due for this trend to emerge once again. The model for building a junior oil and gas company will undoubtedly continue to evolve. It may do so to take advantage of new technologies available to smaller companies such as those involved in producing coalbed methane or shallow oil sands. They may also evolve to take advantage of new and improved financial structures, such as the case was for royalty trusts. Canada's junior sector is filled with growth stories and competent management teams, and will continue to be a fascinating (and hopefully profitable) sector to watch. Peter Knapp is president of Iradesso Communications Corp., a Calgary-based investment research, investor relations and corporate communications firm. The firm represents some of the companies mentioned in this article.