PanCanadian Petroleum Ltd. has near-legendary origins, but the company's challenge now is to ensure that its future is as storied as its past. One of Canada's top energy firms, PanCanadian will become a leading North American independent producer later this month when parent company Canadian Pacific Ltd. spins out its 85% interest as part of a massive restructuring of the holding company. After 30 years as a publicly traded, but conglomerate-controlled, producer, PanCanadian is getting ready to fly solo. Its low debt, lack of a controlling shareholder and attractive mix of Canadian and international assets could lead to a takeover bid, setting up the chance that PanCanadian might more resemble the tale of Icarus than the phoenix. David Tuer, president and chief executive officer, says the impending breakup is both challenging and exciting. "It's surprising how little the (U.S.) investment community knows PanCanadian. Unless they have been following the company for some reason, most analysts don't know it at all," he told us in an interview from the top floor of the 28-story skyscraper the firm had built in 1982. "As a result, when we spin out, they have no idea the company is as big as it is." So, just how big is it? The firm will spend at least C$1.5 billion and drill more than 2,000 wells this year, with about 77% of those targeting natural gas beneath Alberta's prairies. It hopes to boost output by 15% this year to about 1.1 billion cubic feet per day. Its oil and gas liquids output will average between 115,00 and 120,000 barrels per day this year, compared with 124,000 per day in 2000 Some 256 million shares will be outstanding when the stock begins trading on the New York Stock Exchange, in addition to its current listing on the Toronto Stock Exchange (as PCP) later this month or in early October. Its market capitalization of roughly C$11.5 billion puts it into the top tier of independents, trailing Anadarko Petroleum Corp., Burlington Resources Inc. and Canadian Natural Resources. In addition to its capex devoted to drilling activity, PanCanadian will pay approximately C$1.18 billion-to be funded from a combination of cash on hand, medium-term notes and lines of credit-as a special dividend to Canadian Pacific as part of the reorganization. Despite the hefty expenditures, the company's debt to total capitalization will be less than 0.2. On a 12-month trailing basis from annualized first-quarter cash flow, debt will be less than 0.5. The company will stack up well against its rivals, says Duncan Mathieson, a Toronto analyst with Scotia Capital who rates it a Buy. "It is going to command respect simply by its sheer size," he says. "I think it's going to stack up pretty well against Canadian and U.S. independents, particularly as its exploration program starts to come into focus in the Gulf of Mexico and the North Sea." Like Burlington Resources and Union Pacific Resources (now a part of Anadarko Petroleum) in the U.S., the company is the result of its railroad past and the lands given it by the federal government. Intimately linked with Canada's history, Canadian Pacific was founded in 1881 to fulfill a national dream of connecting widely separated provinces with a ribbon of steel. Canadian Pacific received 25 million acres of land, including mineral rights, as part of an incentive package to build the railway. It set up an energy company in 1958 to develop its underground wealth, and this oil and gas division went public through a merger with another producer in late 1971. This legacy is still the backbone of the firm. But Tuer, a mechanical engineer who worked for a bank and as assistant deputy minister in Alberta's energy department before joining PanCanadian in 1990, says there are myths about the potential of the nearly 6 million gross acres of so-called fee lands. Mostly held in perpetuity, the lands include a mineral tax of 5% to 7%, compared with royalties of about 23% for most Crown land, where the provincial governments own the mineral rights and lease them to private firms in return for a bigger share of the output. "There is a perception that these freehold lands that we received through the railway land grant are maturing...and so this is a company that has to move off those lands to grow. That's a long way from the truth," he says. "If you take off the top 700 meters (2,300 feet) from those lands, we've hardly scratched the surface of the exploitation side. "It's an engine of growth that is going to fuel this company for a long, long time." PanCanadian has developed proprietary technology to tap cheaply both the deep and shallow formations from the same wellbore. The technique is opening up large possibilities for adding gas from Lower Cretaceous zones on its historic lands, in addition to the usual uphole formations such as the Belly River, Second White Specks and Cardium. (See "Canadian Gas," Oil and Gas Investor, October 1999). Buyer or seller? Good assets and low debt don't automatically mean the company carries a bull's eye on its back, says Terry Peters, vice president of energy with HSBC Securities (Canada) Inc. PanCanadian is more likely to buy than be bought because of the nature of its assets, says the Toronto-based analyst, who has a Buy recommendation on the firm. "Unless somebody is interested or committed to drilling 2,500 wells in western Canada every year like PanCanadian does, I'm not quite sure most of the larger players who could actually buy PanCanadian would want to do that," Peters explains. "PanCanadian does it very well but it's another thing for a competitor to step in and assume they can continue PanCanadian's success. That's probably a higher-risk proposition." Mathieson says the company's strong western Canadian base, plus its exposure to East Coast gas, heavy oil and the Gulf of Mexico, does make PanCanadian a target, especially in light of U.S. President George W. Bush's proposed energy plan that emphasizes Canada as a supply source. Tuer acknowledges his firm is underleveraged, especially compared with its U.S. peers, but he says PanCanadian will not make an acquisition strictly for defensive purposes. Brian Prokop, an analyst with Calgary brokerage Peters & Co., says how PanCanadian uses its balance sheet will be an important test. He says the fee lands give the company a considerable advantage over rivals such as Alberta Energy Co. and Canadian Natural Resources Ltd., fellow Calgary firms. He rates the stock a Hold because it already trades at a premium to Canadian firms, and other companies, such as Canadian Natural and Talisman Energy Inc., offer better upside potential for investors. At recent prices, PanCanadian's stock trades at 4.5 times 2001 debt-adjusted cash flow, making it comparable to U.S. producers rather than Canadian peers, who are averaging 3.7, Prokop says. "It's trading at a premium and my sense is that it's for the assets, because the management team, although very competent, I wouldn't call them exciting," he says. "Any investor, conglomerate or otherwise, looks for returns and growth. PanCanadian has provided returns but let's see if the growth comes." Growth prospects Oil volumes will grow over time, from areas such as the Gulf of Mexico, where PanCanadian has a 20% interest in the deep Llano discovery operated by EEX Corp., but that growth will be less predictable and come in lumpy increments, Tuer says. Prokop says overall production growth for the company will be about 3% in 2001, lagging behind double-digit targets of others such as Canadian Natural. Despite the mixed views by analysts, whopper quarterly profits and a buzz surrounding Canadian Pacific's breakup have made investors as keen on PanCanadian's stock as Olympians enjoyed ambrosia. PanCanadian shares rose 11% in the first half, compared with a 1.7% gain by the Toronto Stock Exchange's oil and gas group. The broader TSE 300 composite index was down 13.4% in the same period. The firm's performance also looks good in comparison with U.S. benchmarks. The Nasdaq composite dropped 12.2% in the first half, Standard & Poor's 500 index declined 7.2% and the Dow Jones industrials slipped 2.7%. Building on its western focus, PanCanadian has made a concerted push into the U.S. in the past 12 months. It purchased the oil and gas division of Montana Power Co. for C$708 million in October 2000 and this summer bought Causeway Energy Corp for C$69 million. Both firms have underexploited land holdings in the U.S., particularly Montana Power, says Tuer. The executive seems to be a cautious interviewee who prefers to let the company's record speak for itself. That record includes having the second-highest return among North American independents (trailing only EOG Resources Inc.) on average capital employed between 1996-2000. PanCanadian predicts compounded annual production growth of 15% between 2001-05, mostly from gas. The executive declines to offer earnings or cash flow goals other than to say the numbers "will be very impressive." Peters' model predicts PanCanadian will generate earnings of C$5.24 per fully diluted share this year and C$4.49 in 2002, with declining commodity prices pulling down profits next year. Some of that rising volume will come from the firm's Deep Panuke discovery, 1 trillion cubic feet of recoverable reserves found beneath an old oil field off Nova Scotia. (See "Canadian Maritimes," OGI, October 2000.) The firm expects to spend about C$1 billion to develop the gas located about 10,000 feet underground in the Jurassic Abenaki formation. It recently signed a 10-year agreement with Maritimes & Northeast Pipeline, the consortium that links the Sable gas project with U.S. Northeastern markets. Deliveries of 400 million cubic feet per day of Panuke gas to the same consumers are expected to begin in late 2004 or early 2005. With leases covering 4.4 million gross acres offshore Nova Scotia, PanCanadian has a firm toehold in one of the most exciting gas plays on the continent. Tuer says the East Coast project is typical of the strategy the firm employs. It wants to get in early and assemble a land position giving the potential for significant impact. The rationale helps explains why PanCanadian is not joining the latter-day rush for Arctic gas in Alaska or the Northwest Territories. "We looked at where the potential basis to supply the natural gas demand in North America might be and we realized that we had a much larger opportunity on the East Coast of Canada, where we could control the play," he says. "In a sense it was late in the day for us in the Canadian North, but that doesn't mean we won't get there. I think it will be a long time before gas starts to flow from the Canadian North, and between now and then there will likely be some companies that can't afford the game. We intend to have a balance sheet which will hopefully allow us to ease their pain." Another emerging core area for the firm is the U.K. North Sea, where it established a presence in 1999 with the C$255-million purchase of the Scott and Telford fields from BP. The business unit received a boost in July when PanCanadian announced a sidetrack well extended the reservoir of its Buzzard oil project, which is 60 miles northeast of Aberdeen, Scotland. The firm predicts the field, in which it owns a 45% interest, contains 200- to 300 million barrels of recoverable oil. HSBC's Peters points to Buzzard as an example of PanCanadian's technical competence and a sign the firm is starting to hits it stride in international activities after little success in the early 1990s. "They can take their technical competence anywhere and I think that gives them the opportunity to do what they did in the North Sea," he says. "They've opened a whole new play with their Buzzard discovery, which is probably the largest U.K. discovery in a decade." Midstream and power The company also has a growing midstream business and an increasing number of power plants in Alberta as part of a drive to integrate market knowledge and production assets for higher profits. While conducting roadshows in the months leading up to independence day, Tuer has been highlighting the knowledge and skills of PanCanadian's 2,000 employees. The company, named one of the top employers in Canada in a recent survey, deliberately strives to improve its intellectual capital. Oil and gas are fungible commodities with largely transparent prices but companies, which sometimes share interests in the same fields, deliver significantly different financial results. "The only reason for that difference is because of people," the president says earnestly, one of the few times where passion enters his voice. "It's increasingly apparent to the investment community that the biggest choke point in our industry is people. A year ago people's eyes glazed over on this issue, but we're long past that. There is real value in our people strategy." Not surprisingly, others are less convinced. Prokop of Peters says nearly every company claims to have the best workers and he's seen little evidence that investors are willing to pay a premium for staff. He says PanCanadian has a reputation in Calgary for spending an excessive amount of time on analysis before making a decision. "One would expect a fully public company to have to react more quickly, to make decisions more crisply, and I think that's going to be part of the learning curve for PanCanadian." Mathieson of Scotia adds that management remains a bit of a wildcard for investors. PanCanadian executives might respond differently as part of an independent firm than with the holding company, he says. "Going forward, I think we're going to watch how good they are at disclosure, how good they are at meeting their targets and how flexible they prove to be in the public markets." For his part, Tuer believes the company has a big advantage in being set free by Canadian Pacific, even as consolidation drastically reduces the number of energy firms in North America. As part of a conglomerate with interests in rail, coals, ships and hotels, PanCanadian had to compete for capital and so, is used to viewing every move through the prism of increasing shareholder value. "If there is a consolidation going forward, the players still on their feet at the end of that process are really value-driven players. They are players who have been supported by and rewarded by their shareholders because they have been creating value," he says. Like Pandora's box, there is no going back for PanCanadian. The big question is whether its hope of flourishing as a true independent is real-or doomed to fail because of market conditions, including a stronger dollar and higher trading multiples, that favor U.S. buyers in a takeover. The ending to this Canadian legend has yet to be written.