PrairieSky Stock: This Royalty Company Just Doubled Dividend

Author’s Note: All figures in Canadian currency unless otherwise noted.

The Royal Oil Trio

PrairieSky Royalty Ltd. (OTCPK:PREKF) (TSX:PSK:CA) along with Topaz Energy Corp (TPZ:CA) and Freehold Royalties Ltd. (FRU:CA) are the three large publicly traded royalty companies in Canada. A royalty owner is entitled to the commercial benefit of production and upside potential from a property without the obligation of operating costs, capital costs or environmental liabilities. Typically, the land rights acquired are mineral and not surface rights.

It is important to understand that these companies are not oil and gas E&P firms. They do none of their own drilling or production. Capital expenditures take the form of land acquisitions. The royalty income is perpetual and does not require maintenance capital dollars for it to continue producing revenue. The types of royalties earned typically fall into two main categories, fee simple and Gross Overriding Royalty (GORR).

A fee simple interest is the highest form of rights associated with land ownership. Fee simple mineral title ownership is not subject to expiration and is effectively forever. This operating model allows for the company’s fee lands to be continually recycled, providing the opportunity for recurring revenue. The other major royalty type is (GORR), which is similar to fee simple, but with a fixed duration tied to the length of the lease.

Company Profile

PrairieSky Royalty is a pure play royalty company with the largest portfolio of fee simple mineral title and oil and gas royalty properties in Canada. The company has 18.4 million acres of royalty land across Alberta and Saskatchewan, British Columbia and Manitoba, including 9.7 million acres of fee land and 8.7 million acres of GORR lands.

PrairieSky receives royalty revenue based on production from wells on its land. These royalties are based in part on the market price of crude oil and natural gas. The company leases land in 1-5 year terms, with the mineral rights returning to PrairieSky after the lease term.

Headquartered in Calgary, Alberta, PrairieSky was created out of a spin-off of Encana’s, now Cenovus’s (CVE) royalty lands in 2014. Company insiders have invested about $80M since the IPO (about half of which was at the $28/share IPO) which creates good alignment between management and shareholders. Shares held by insiders account for about 1.14% of float, which is higher than Freehold Royalty, but well behind Topaz Energy.

Leverage to the Clearwater Play

The Clearwater resource play centred on the Marten Hills and Nipisi positions contain an estimated 4.96 billion barrels of oil in place. This play is among the best in class, fastest growing oil play in the Western Canadian sedimentary basin. Clearwater is especially attractive to producers due to its relatively shallow drilling depths and its low cost of development. Technological advancements in recent years have enabled new drilling and recovery opportunities. Production has grown from 4,311 bbls/d in 2018 to over 60,000 bbls/d in 2021.

Source: Daily Oil Bulletin

Topaz and PrairieSky currently have the most leverage to this play. PrairieSky in particular has a significant asset base in this play, with over 1.3 million acres in the play. The company started building up a large and early land base in this region in 2016 and 2017. In 2021, PrairieSky purchased 76,000 acres from Spur Petroleum Ltd. for $155M. These early investments in this area are showing significant growth, with the company forecasting year-over-year growth of in the 50% range over the next 12 months. PrairieSky’s foresight and concentration in the Clearwater play will be a significant driver of revenue growth.

Source: RBC Capital Markets

Dividend Profile

At current levels, PrairieSky has a dividend yield of 4.2%, ahead of its 5-year average yield of 3.7%. Competitors, Topaz Energy and Freehold Royalty have yields of 5.5% and 6.29% respectively.

PrairieSky’s free cash flow has grown from $273.4M in 2021 to over $500M in 2022 (est.). This increase resulting from strong drilling activity and high commodity prices has led the company to announce a doubling of the dividend from $0.12 quarterly to $0.24 for the dividend payable for the first quarter of 2023. The 100% increase is welcome, but it also signals the firm is trying to “catch up” to where its dividend should be.

According to Andrew Phillips, PrairieSky’s, President and Chief Executive Officer on the company’s Q3 2022 earnings call:

Given our continued low payout ratio and our organic growth opportunities, investors can expect ratable annual dividend increases in future years. This low payout ratio will allow us to retire the current debt and have significant liquidity available for opportunistic acquisitions or share repurchases, which ever provides the best long-term return for shareholders.

Phillips goes on to say that investors can expect annual increases going forward to be announced in February of each year.

After a challenging few years for oil and gas investors, many producers have been prioritizing returning cash to shareholders over investing capital in new production. As these firms pay down debt, they are able to increase dividends, which have led to many energy firms offering attractive yields at current levels. No doubt, this trend along with rising interest rates has pushed royalty companies to consider the attractiveness of their own dividend yields. With a TTM payout ratio of 36.29%, PrairieSky has room to increase its dividend in the coming years.

The magnitude of these increases will depend on commodity prices, which are the main driver of PrairieSky’s free cash flow. The linkage of the company’s dividend to realized oil prices may be a tailwind at the moment, but it has led to painful dividend cuts in the past. PrairieSky cut its dividend in 2016 and again in 2020 during low points in commodity price cycles. On the most recent earnings call, CEO Andrew Phillips stated that the current dividend is supported at $40 to $50/bbl oil prices and is not dependent on natural gas pricing.

Data Source: Morningstar

The company is also considering returning cash to shareholders through buybacks. In April 2022, PrairieSky announced its intention to seek to renew its normal course issuer bid (NCIB) for an additional one-year period. The NCIB allows for the purchase of up to 16,963,000 common shares, which represents 7.1% of the common shares outstanding and 10% of the public float. The company did some buying around the $14 level, however at the current $22 share price, it is likely the company will prioritize debt repayment.

Performance

Despite not being responsible for locating, producing and marketing oil, PrairieSky’s performance has largely tracked the S&P/TSX Capped Energy Index (XEG:CA), comprised largely of E&P and integrated oil and gas companies.

Source: Yahoo Finance

Some of PrairieSky’s weak performance is due to the lofty expectations and valuation the company had at its IPO. The company debuted in its listed form in June 2014, the height of the oil and gas cycle. By January of 2015, seven months later, the price of oil had collapsed almost 60%. There couldn’t have been many worse times to go public.

Risk Analysis

While detached from the operational risks of oil production, PrairieSky’s cash flow is still directly tied to commodity prices. At current production levels, a $10/bbl change in WTI prices has a $400-$500M impact on cash flow over ten years. The company is much less levered to natural gas prices, with a $0.50/Mcf increase in AECO impacting FFO by $100M over the same period.

Source: PrairieSky

The firm’s royalty revenue can be threatened by a slow-down in drilling activity as well as declining well productivity. As the rate of new drilling is closely tied to commodity prices, weak pricing can also exacerbate volumetric risk. Drilling activity and production can be impacted by the WCS/WTI differential, which tends to reflect egress limitations out of western Canada.

PrairieSky competes with Crown and other private landowners to attract drillers. Should government or competitor incentives change, PrairieSky could see margins shrink as it would need to adjust its leasing rates accordingly. The company’s current leasing model is attractive relative to Crown leases. PrairieSky’s standard leasing rates on fee lands are 17.5% for oil and 15% for natural gas, about half of what Crown leases can go for. The company has limited counterparty risk, as no one single client accounts for more than $45M in revenue.

PrairieSky has a business model that supports high margins, so when revenue growth is good, the balance sheet improvement is quick. The company’s net debt at September 30, 2022 was $364M, which is a 43% reduction from the $635M outstanding as of December 31, 2021.

Bottom Line

PrairieSky is entering a long awaited dividend growth phase that investors have been patiently waiting for. The company’s leverage to the Clearwater play will be a tailwind for revenue growth in the coming years. Should commodity prices stay reasonably strong, the company should be debt free by 2025 and well positioned to prioritize returning cash to shareholders.

Despite being able to earn cash flow without the challenges and capital spend required by E&P firms, PrairieSky’s share price and ability to grow its dividend have demonstrated a trend of tracking the S&P/TSX Capped Energy Index.

I tend to prefer businesses that can maintain and grow dividends in all economic conditions. I like to see steady incremental dividend growth based on visible free cash flow growth. PrairieSky’s dividend history over it 9 years as a public company has been erratic. While I see upside from here, I prefer long-term dividend growth profiles that are not as closely linked to energy prices. A bullish outlook on commodity prices is a prerequisite for owing PrairieSky. Investors with less conviction in continued high commodity prices may consider owning here for a “good time, not a long time”.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.