How does a company become the fastest growing oil and gas firm in Canadian history – currently the fifth largest in Canada – throughout a time period rife with headwinds in its sector? How does it grow from 5,000 bpd to almost 200,000 bpd in just eight years, achieving spectacular financial results despite volatile and historically low energy prices?
If you’re thinking it’s by doing things in a profoundly different way, you are correct.
This according to Adam Waterous, Managing Partner and CEO of Waterous Energy Fund and Executive Chairman of Strathcona Resources Ltd., said fastest growing Canadian oil and gas firm. The architect of Strathcona, Waterous leveraged his decades as a student of the oil and gas industry to do private equity in a completely new – and highly successful – way.
“We reached $4 billion in revenue faster than any company in Canadian history, in any sector,” Waterous says of Strathcona from his office in downtown Calgary. “We invested $1.9 billion in equity that today is worth around $6 billion.” Facts to no doubt be proud of, though Waterous is careful not to boast.
Rather, in masterclass fashion he freely explains his strategy and why it worked.
“You don’t get these kinds of results by being smarter or working harder,” he says, “you have to have a completely different approach to the sector. We had a different investing strategy, a different operating strategy and a different management strategy.”
Waterous is quite familiar with the older, traditional way of doing things. In 1991 he co-founded Waterous & Co., an oil and gas mergers and acquisitions advisory firm. He spent 15 years building it into the largest oil and gas merger advisory firm in the world before it was sold to Scotia Capital in 2005. Waterous stayed at Scotia Waterous and ran their global investment bank for about 10 years. He left in 2017 to form his Fund.
“Single play companies were in very high demand in the acquisition market for more than 30 years,” he reminisces, “because the industry was drilling location poor, all across North America. But in the middle of the 2000s, two new technologies came around. One was horizontal multistage fracks, and the second was SAGD. And in a very short period of time, the industry went from being drilling location poor to drilling location rich.”
“That collapsed demand for these small companies,” he continues. “I saw that collapse in 2012 because I had a very large sell side business. I was auctioning off a lot of single play oil and gas companies that had become illiquid. That’s what inspired me to leave Scotia and start the Fund.”
Waterous started with three other people, formerly from KKR, a large private equity fund in New York, including his son Connor. “They’re all still with me today,” he says proudly. “I’ve also had two more sons join the firm.” Notably, all three of Waterous’ sons are Harvard graduates (like their father) with degrees in economics.
Strathcona was the Fund’s first investment.
With respect to the Fund’s investing strategy, Waterous notes the historical strategy is growth equity – focus on organically growing production and reserves by de-risking tier two and tier three assets.
“That’s not what we did,” he notes. “We did something totally different. Our investing strategy was value investing. [The most well-known practitioner of value investing is Warren Buffet.] We really just focus on two things: evaluating current cash flows and creating a margin of safety.”
The goal is to protect principal and try to avoid losing money, Waterous explains: “Historic growth equities is ‘swing for the fences.’ Try for a homerun but have lots of strikeouts. This is much more ‘bunting to get on base.’ Low risk. When you’re creating a margin of safety, you’re really focusing on what’s the lowest risk method of investing in the sector. And to do that, we invested our capital trying to address the four big risks in the sector.”
That first risk is technical. Rather than buying into new areas, which is very risky, the strategy was to buy assets that were already on stream and had well-established production histories.
The second risk – price – is typically dealt with through hedging, but again, Waterous’ strategy was different. “The primary way of dealing with price risk is to buy top quality assets,” he says. “There’s only two metrics to look at. One is your sustainable breakeven price: the lower that number, the less price risk. The second metric to look for is a long reserve life index: the longer the reserve life index, the less price risk.”
Sometimes that which seems obvious, is not: “The first two technical and price risk-reducing strategies – buying top quality assets that were already on stream – had never been combined before,” Waterous marvels.
The third risk is leverage: “We generally kept leverage down between one- and two-times EBITDA the entire time we built our business.”
The final risk is exit risk – how to get out of the investment. Typically, private equity in small juniors exits through a corporate sale. “But that’s very risky because you can’t control that,” Waterous points out. “We want to control our exit by getting big enough to go public.”
“With those four strategies to reduce risk, we went and did something that had never been done before: we raised private equity capital, and instead of putting it into a portfolio of 10 or 20 businesses, we put all our money into one single business: Strathcona,” he continues.
“We went against the old saying ‘don’t put all your eggs in one basket.’ Instead, we put all our eggs in one basket and then we watched the basket very carefully. A private equity firm had never been done like this before.”
A novel operating strategy was also employed at Strathcona. Core area consolidation – going into an area to make an initial acquisition and then purchasing several properties nearby with the same oil and gas recovery process – was employed to take advantage of operating synergies and economies of scale. “The real estate analogy is: we go into a nice neighbourhood, find a good street, buy a house and then buy up the whole block,” Waterous explains. “We focused on very tightly focused core areas.”
Strathcona’s team built four operating areas in this way. “We bought five SAGD businesses,” Waterous says. “We’ve bought all the SAGD businesses sold in Canada that didn’t have a right of first refusal in the last six years.” In total, Strathcona has made 10 major acquisitions.
The management strategy employed at Strathcona was likewise very different. Intended to avoid accumulating a large bureaucracy and layers of management, the management structure is based on highly decentralized operating units.
“Strathcona has an Executive Chairman – that’s me, then three C-suite executives – a Chief Operating Officer, Chief Commercial Officer and Chief Financial Officer,” Waterous notes. “Then it has four Presidents and reporting to each President are our managers. So between me and a manager is only two levels. It’s highly decentralized and each President has the authority, responsibility and accountability of running his business unit.”
“By pushing authority, responsibility and accountability down, it becomes very conducive to attracting high performing people,” he continues. “I want to attract the elite, the high performers.”
It’s this mix of value investing, consolidation of the operating strategy and a decentralized management strategy that have led to Strathcona’s stellar performance over the last eight years.
Recently, the company made news with the sale of its Montney assets for $2.84 billion. “We grew that business from 5,000 to 75,000 barrels per day,” Waterous says proudly. “We sold it in three packages to three of the largest natural gas producers in Canada. We concluded that ultimately, in each of those three areas, we were subscale in being able to optimize development.”
Now producing 120,000 barrels per day with a 50-year reserve life index, Strathcona is a pure play company – all oil – and debt free. The plan is to grow organically to 195,000 barrels per day by 2030, mostly through drilling.
The day after it announced the sale of its assets, Strathcona announced its offer to purchase MEG Energy. “The money was burning a hole in our pocket,” Waterous jokes. “The reason we’d like to buy MEG is it’s a continuation of our core area consolidation strategy. MEG is an almost identical twin to Strathcona. It’s a bit smaller and has slightly lower margins. So our ability to extract value through economies of scale and operating synergies is very high.”
Strathcona approached the board of MEG (a publicly traded company) which responded it wasn’t interested. Strathcona subsequently disclosed publicly it owns 9.9 per cent of the shares of MEG and made its offer directly to shareholders. That offer is outstanding for 105 days, and its success won’t be known until September.
“We think our offer to MEG is win-win. MEG shareholders get an immediate premium and per share accretion on cash flow and net asset value. Strathcona shareholders benefit as Strathcona proforma will be large enough to be upgraded to investment grade and have increased liquidity,” Waterous remarks. “It’s all about synergies. With MEG, Strathcona will be drilling about a quarter of all the SAGD wells in Canada, so we can take advantage of economies of scale.”
“And if we don’t by MEG Energy, we’ll probably pay a very large dividend,” he adds. With very low debt the dividend would be about $10 per share (the stock currently trades around $30 per share).
To eventually exit Strathcona, Waterous’ team is unwinding a series of partnerships to then distribute the shares directly to its investors. Over time, the Fund will own less in Strathcona while the Fund’s investors will own the shares directly.
About eight months ago, the Fund made its first non-Strathcona investment in publicly traded Greenfire Resources. “We now own 56 per cent of that,” Waterous says. “It’s a smaller producer but we hope to emulate what we did with Strathcona: build it both organically and through acquisitions.”
A loud and proud advocate for doubling oil and gas production in Canada as a moral obligation to address the energy poverty emergency, Waterous and his family have also partnered with the federal government on two major initiatives to reduce carbon emissions.
The first is a partnership with the Canada Infrastructure Bank to build the Calgary Airport to Banff Rail (CABR) project. “It’s a $2 billion plus project that will be hydrogen powered and zero emissions,” Waterous explains. “My wife and I have worked on this for 10 years and we’ve made a huge amount of progress on it. It will be transformational in terms of consumer emissions.”
The second partnership is with the Canada Growth Fund to develop the first carbon capture and sequestration project for an oil sands company. “It’s another $2 billion project,” Waterous says.
“Somewhat unusually, I straddle two worlds,” Waterous reflects. “We’re putting our money where our mouth is on reducing emissions, both consumer and industrial, but at the same time calling for Canada to double oil and gas production – we believe it’s our moral obligation. It’s a very dual view of the world.”
Waterous and his Fund have broken the mold for building an oil and gas business in spectacular fashion. Only time will tell whether the new mold becomes the norm.
