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Sun may not always be shining over PrairieSky

As corporate names go, it's tough to beat PrairieSky Royalty Ltd. and the image it conjures up of cloudless blue heavens stretching as far as the eye can see.

Of course, as any Albertan will tell you, prairie weather can change in a flash. Investors who are thinking about taking a flyer on PrairieSky's soaring stock may want to keep that fact in mind.

The new company is a repackaging of massive swathes of royalty land owned by Encana Corp. and its predecessors since the 1880s. After being treated as a humdrum asset for more than a century, the land is now being touted as a rare opportunity – and the market seems to agree.

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Investors propelled PrairieSky shares 30 per cent higher after the stock's initial public offering last week. This week, underwriters decided to exercise their overallotment option and take another $218-million of shares, bringing total proceeds from the IPO to almost $1.7-billion, nearly double the original target.

All of which raises the question: What do buyers see in this deal – the biggest in the Canadian market since 2000 – to send PrairieSky into the, um, stratosphere?

The company owns mineral rights to about two million hectares of land in Alberta. It makes money by leasing land to oil-and-gas drillers and collecting royalties on their output.

The operation has historically produced a decent return as a side venture for Encana. But investors gobbled up the PrairieSky IPO because they believe there's enormous potential to further develop the business now that the royalty lands are the sole focus of a standalone company.

Rafi Tahmazian, partner and senior portfolio manager at Canoe Financial, says he "aggressively pursued" the IPO last week, convinced that many analysts didn't understand PrairieSky's potential.

The business produced just over 14,000 barrels of oil equivalent a day during 2013. Mr. Tahmazian figures production could easily expand by 4,000 to 6,000 barrels a day over the next year as PrairieSky strikes a flurry of new deals with producers that want to drill on its land.

Making this projected increase even sweeter, PrairieSky doesn't have to put up its own money to develop its properties – that's the responsibility of the driller or producer. PrairieSky simply signs a contract, then sits back and collects royalties. With no expenses other than administration, it's free to pay out nearly all of its cash flow to yield-hungry investors.

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It sounds ideal – except that it does raise the question of why investment bankers, normally an optimistic breed intent on getting the best possible deal for their clients, would price the PrairieSky issue at $28 a share. The stock nearly immediately jumped to $36, meaning that Encana left a lot of money on the table.

The underwriters may have been looking at many of the same factors as Sam La Bell did when he wrote a report in early May assigning the company a fair value of around $25 a share.

Mr. La Bell, an analyst with Veritas Investment Research, said in an interview that he is concerned about the business's lacklustre history of growth and its lack of control over its own future. Essentially, PrairieSky needs other companies to be willing to drill on its land – and that willingness hinges on the price of oil and natural gas as well as the attractiveness of competing opportunities.

If prices for oil and gas drop, PrairieSky will get hit with a double whammy, Mr. La Bell says. It will make less money on what it produces and it will become harder for it to attract new drillers. "This is still a cyclical business trying to fold itself into a royalty income model," he says.

Investors who are buying the stock for its dividend yield could prove particularly fickle if there are any hiccups. Even assuming a big increase in production, PrairieSky will produce a yield of around 4 per cent at its current price of just over $36 a share, Mr. La Bell estimates.

Compared with BCE, which offers a 4.9-per-cent yield with no commodity risk, PrairieSky looks less than compelling. The market's hottest new stock will have to find ways to keep boosting its production if it wants to avoid some cooler weather ahead.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More


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