Despite sustained enthusiasm in North American energy during recent months, as evidenced by rising indices and bolstered by unprecedented earnings and cash flow, many small-cap producers have yet to receive an invitation to the party. Some circles conclude the game is over for many companies, especially the juniors, exemplified by cash flow multiples that lag the usual measures of increased profitability, the rash of buybacks and recent M&A activity, which stand at unprecedented levels. Many juniors, defying all odds, have grown up to represent some of the industry's most successful companies, making superior returns on invested capital. So, what is different today? Many small-cap energy management teams say there is a lack of interest in junior oils from the public equity markets if the company can't deliver quarter-over-quarter growth in production and cash flow per share. It would appear that equity capital for these companies has dried up. Moreover, with banks becoming more and more selective in their lending practices, companies are faced with only one option, growth by cash flow. Compounding the situation is the perception that the opportunity basket for quality oil and gas assets is dwindling and for the assets that do exist, the competitive forces are heating up. Add to this the increasing competition for services and higher prices and you have enough reason to justify the lack of enthusiasm that normally prevails at this time of year. Making a strong case that opportunity does exist and the future is bright for juniors are two emerging Calgary-based producers, Rosetta Exploration Ltd. and TriQuest Energy Corp. Each sees opportunity from differing strategies: Rosetta is focused on pure exploration and TriQuest betting on development and exploitation. Both share common ground in their recognition of the importance of management and the need to raise equity capital, as two main ingredients to building a successful oil and gas company. Rosetta Exploration For start-ups like Rosetta and TriQuest, the challenges can be even greater. The "new kid on the block" syndrome is almost a complete barrier to entry into the industry. Management with an impeccable exploration track record obviously plays the main role in overcoming this barrier. Jim Malcolm, Rosetta president, and Glenn Gradeen, managing director, know all too well how important management is when it comes to raising capital and delivering management's vision. To this end, Rosetta has enlisted an impressive team of experienced explorationists. Malcolm and Gradeen describe their management team as unique. "Within our group, we have the visionaries-the guys who capture the larger picture and we have the technical experts able to ground these larger ideas," Gradeen explains. Vision plays an important roll in differentiating Rosetta's focus from other mainstream E&P companies. "We have a team of seasoned explorationists with plenty of ideas about how things might be if not constrained by conventional wisdom." Rosetta's utilization of a well-defined risk-managed exploration model is a significant departure from the "quarter-over-quarter growth of cash flow per share or else" formula followed by many companies working under the watchful eye of the investment community. Rosetta's management feels a vacuum has been left because of the majors pulling the plug on exploration and many other companies' focus on development and exploitation. Rosetta's risk-managed exploration model is buoyed by the fact that significant production exists in deeper Mississippian and Devonian structures, despite the limited drilling activity when compared with Cretaceous production. An industry study points out that the Devonian has produced approximately 50 trillion cubic feet (Tcf) of gas from approximately 27,000 wells, whereas Cretaceous production to date is roughly the same but comes from nearly 175,000 wells. Rosetta is further convinced that improved seismic and data acquisition and processing technologies will vastly improve exploration results. It has successfully raised more than C$25 million to fund its activities. "We were able to assemble a tremendous team, build a focused business plan and start a process of elephant hunting," Gradeen says. To date, Rosetta has assembled more than 100,000 acres of land (80% in Alberta, 20% in British Columbia,) reviewed approximately 3,000 miles of seismic and through 23 identified prospects, now has exposure to 3 Tcf of gas reserves. With this prospect inventory now in place, the only ingredient remaining on the wish list is an industry partner, preferably from the U.S., who shares the company's commitment to exploration in the Western Canadian Sedimentary Basin. For U.S. companies seeking a "window on Canada," Malcolm and Gradeen feel that Rosetta offers at least a two-year head start, given their achievements to date. TriQuest Energy Gordon Hoy, TriQuest president and chief executive officer, is also convinced that ample opportunity continues to exist for emerging juniors and brings a seasoned management team to the task. There is a declining opportunity base in western Canada but only for the very significant and risky prospects that the larger companies are forced to chase, he says. Meanwhile, ample opportunity exists for the smaller prospects that TriQuest chases. Yet, the limiting factor is not the reserve potential but access to capital. "If the emerging and junior companies aren't attempting to access these reserves, it will be the result of not being able to access equity capital," Hoy says. TriQuest is interesting in not just the amount of equity it has raised but also in the type of investor behind its capital. "When we completed our C$12-million equity financing in September 1999, we deliberately brought in two large sophisticated, patient investors. Having this type of shareholder base allows us to manage for the long term, rather than being forced to make short-term decisions to achieve quarter-to-quarter production and cash flow increases," Hoy explains. Currently, TriQuest produces 250 barrels of oil equivalent (BOE) per day, of which 66% is gas, and has 10 drillable prospects ready to go, with more on the horizon. All prospects target gas. The 2001 budget forecast is to spend C$9 million, essentially equal to the company's current working capital. Past is prologue So are junior oil and gas companies done? Veteran oilman James Gray, current nonexecutive chairman of Canadian Hunter Exploration , one of Canada's leading gas producers, says, "Put together a good technical team with a valid strategy and the money will come." Gray, who co-founded Canadian Hunter in the late 1970s, recalls all too vividly how difficult it was to raise capital for a start-up oil and gas company and now doesn't seem surprised with the lack of interest and money for junior E&P companies. "Historically, there was no equity capital," says Gray. However, he remains convinced that there is a strong future for juniors and the disappearance of the senior producers brings opportunity for juniors. "Today's junior producers are tomorrow's seniors." He also believes that there is ample opportunity remaining for junior oil and gas companies, as the smaller, average well size is no longer attractive to the senior producer. However, for all companies, it is difficult to create value at today's high prices. "The industry requires patient money and that is more likely to be privately sourced than public," he says. Bruce McIntyre, president of BXL Energy , a successful Calgary-based junior, says, "Avoid the strategy of speculation and depending on the one-well wonder. Building an oil company is a long-term commitment and the industry must return to this." Investment capital is available but for the most part it is private capital, he agrees. BXL's early strategy of first building a solid asset base evoked little interest from the investment community. "If you couldn't deliver significant production and cash flow numbers on a quarter-over-quarter basis, no one was interested," McIntyre explains. BXL now enjoys the luxury of financing operations from cash flow and proudly boasts a 400% increase in the company's share price, realized during the past 18 months, in response to operational successes. BXL represents a fair testimonial to a rather traditional approach to running an oil and gas company: the strategy may not burn barns in the public equity market but it creates value for the industry and shareholders alike. Hunting ground Evaluating the North American junior energy sector is an arduous endeavor. With research supplied by Calgary-based Benjamin Financial Solutions Inc., and using 1999 revenue and production data from a sample of 230 publicly traded North American E&P companies, it is readily apparent that the juniors are an active and dominant group (see chart). Companies generating under US$50 million make up approximately 67% of the industry sector and produce roughly 6% of the combined production. Companies generating more than US$1 billion in revenues from production make up 6% of the total population and contribute 40% of production. In the middle, companies generating US$100- to US$500 million in revenues make up 14% of the population and contribute 25% of production. These numbers may not inspire at first glance. But a disappearing middle class could pose some challenges for the industry, considering that this group is the current hunting ground for the large producers, particularly U.S.-based companies. Companies can acquire and merge only if the effort makes good business sense, and that ultimately means wealth creation. With many senior producers exiting via the M&A route, the feeding frenzy can only last so long. Of course, replacing the middle class will remain a challenge and herein lies the opportunity for juniors. (See "Got Canadian Gas?" Oil and Gas Investor, March 2001.) Andrew Boland, small-cap oil and gas analyst with Calgary-based Peters & Co. thinks there is patient risk capital for private, as well as public, juniors. Many small-cap producers have limited resources and the cost associated with being public is not conducive to creating shareholder value. The disappearance of many of the senior producers requires institutional investors to make a choice, he adds. At one end of the spectrum are the large producers and at the other end are the juniors. Even if the resources are split, one could conclude that significant capital might find its way to the junior sector. Caveats If there is one caveat in Boland's opinion, it is concerning junior companies trying to exceed production of 10,000 BOE per day. Historically few juniors achieve this and fewer exceed it without running into trouble. Additional caveats exist and won't disappear too soon. Higher oil and gas prices can create the proverbial double-edged sword for many juniors: coupled with increased competition for assets, opportunities decrease for many juniors. At today's spot gas price even marginal production capacity can be attractive to many companies. And, services that do become available are also expensive. On the reserve evaluation side, higher commodity prices rarely increase the value of reserves unless they are flowing through a pipeline generating cash flow. And in many cases, the price being paid for the cash flow can be a significant discount to the more established companies, if the companies are having a difficult time raising capital and meeting their operating commitments. So, at the end of the day, what does the future hold for junior producers? The general consensus seems to strongly support a bright future. However, more than ever, it appears that success will require a patient, long-term approach to realizing a return on invested capital. Most certainly the industry would welcome this as good news as it has proven to be a very difficult challenge, meeting the short-term growth expectations, typically set by the investment community. If there is a caveat, finding suitable small-cap investment candidates will remain the biggest challenge for all investors. Management will certainly remain a main ingredient as well as a well-defined and focused business strategy. Cash, already in the bank, speaks for itself. Robb Moss, CFA, is an equity research analyst, specializing in Canadian small-cap oil and gas producers. He is based in Calgary.