Special Episode | Adam Waterous with Alvarez & Marsal | PRAGMA New York Energy Investment Series

Speaker A: Foreign. Good morning and it's great to be here. I'm Avendeep Singh. I'm managing director with Alvarez and muscle in Canada. We work with energy companies and investors. Range of business improvement and um, optimization objectives. So the topic is quite timely and uh, follows well from the previous discussion. On one hand we have the US Shale assets that are getting from growth to a more mature phase, which means production is slowing moving up the cost curve. And the premium tier 1 inventories are less harder to find the states much more work to sustain that production. And on the other hand, in contrast Canada offers a different proposition. Its assets at scale, competitive breakevens, uh, but a long, very uh, long results and inventory life. So that creates, you know, opportunities both organically but also inorganically in Canada. And I think there are few people who are better placed to talk about it than Adam Waters. Adam has a, uh, long history of career in the energy business. In 1991 formed the Water Silco, uh leading uh, investment advisory and firm in Canada. Later combined with Scotiabank and he ran the uh, investment banking and energy business for Scotiabank. In 2017, Adam formed the Waters Energy Fund and subsequently created Strathcona Resources, uh, which they grew From I think 4 or 5,000 barrels for a series of consolidations to today $140,000, 130,000 production, about $10 billion market cap and you know, reserve lives of uh, about 50 years. Investors have done phenomenally well, received five times their investor capital. So that's been quite a success. So with that, uh, Adam, welcome. Um, and maybe we begin right there, uh, in, in 2017, what did you see different? And now with markets and in the Canadian versus US assets and that's a tourist still, all that led to this success with trapping resources.

Speaker B: Sure. Uh, sponsor this on the uh, m. She's spelling. Let me just. Anyway, thanks a lot Aditi. Uh, so Tom was really about, you know, Canada versus US and maybe everyone's got biases. It's really good to understand your biases. So if I've ended up investing all my money in Canada, then I'm not biased. Okay. Uh, I do think it is helpful though to have a perspective. In 2017, um, uh, the uh, three of our founders came from KPR here in the United States. And we looked around and we said, where's a better place to invest Canada in the United States? So we didn't. It wasn't just, hey, we're always going to invest in Canada. You know, we looked, we made a determination that the uh, ras was reentered In Canada. Why was that? Well, it was because, uh, we approached the uh, investing opportunity, uh, as value investors and we thought it was a much lower risk opportunity to be able to invest in Canada. And value investing is kind of a. Sometimes sounds kind of fancy, but it's just really focusing on margin, safe safety, focusing on not losing money, not bought. Now, uh, as Mandy just graciously said in my introduction, um, our investors have made five times their money. Uh, so it's kind of like $10 profit. Um, and so usually it's like, well, geez, that's. Usually there's a lot of risk associated if you have this, you know, big score, so speak. And usually if there's been, you know, this really big outsized rate of return in the oil and gas business, usually it's been, uh. One of. A couple of things happened. Um, uh, one is, um, the company found a huge resource, uh, that uh, had obviously not been uh, discovered by others. Uh, we didn't find any. We didn't find any oil and gas. Um, the second way there's been a big pass made in the sector is market timing. Oh, there was a big downdraft in the uh, oil and gas business and uh, put all their money in, you know, counter st all the money in the depths of co. We didn't do that. In fact, uh, on average, um, since we started 2017, spot price of oil has been basically in the low 70s, uh, where we're at today. So our current accounting has been uh, unremarkable, uh, online. So geez, what happened? How did we. What was the. What was the sear sauce, so to speak? Well, um, we had a different view of how to approach risk in the business. And uh, essentially what we wanted to focus on is what is the absolute lowest possible way of investing in the sector. And if we did that, um, we thought that we wouldn't lose light. And we had a second operating strategy which was through core area consolidation, which I talked about. But what this first one is, what I think is the most important when you think about Canada versus the United States is how not to lose money. And uh, sometimes, um, approaching risk in the sector. Uh, often investors get a little fuzzy about how to think about risk in, in the sector. And um, the first, there's four big risks in the business and we try to attack each one of the risks. And the first big risk in the business, um, is technical risk in that when you go into a new area and you try and uh, make it work, it usually fails. Um, and uh, sometimes you don't have great teams. That's just extremely hard to do. And of course most of most private equity funds deal with that is through portfolio diversification. They both back we multiple teams hoping you know uh one or two of them and it be uh, successful. Uh and uh, so we said we don't want to take that to the risk. So we wanted to uh, acquire uh, things that were on stream currently, uh, that were very well developed, sort of minimal capital risk. Uh the second big risk, and this is the one I think is most poorly understood in the sector is price risk. And how most people deal with price risk is through hedging. Uh, and we uh, don't hedge it too. But we think the real way of dealing with price risk is by buying top quality assets. And uh, the challenge in this industry, or what often gets kind of fuzzy is what is quality? And quality is actually super easy to define. There's a lot of things that confuse people. So two things you have to think about. Um, the first which is most obvious is what is your sustainable break even and that is at what price do you cover all your costs including the capital whole production flat A lot of people get. The second piece we focus on ebitda, um, and not no gets word sustainable free cash flow. The second of course the lower that number is less pressure. The second which is critically important is your Reserve Life index. And so fundamentally the uh, longer your reserve life index the less price risk you take. And they take less price risk for two reasons. The first is when prices fall and they always fall. Um, if you have long Reserve Life index you're not going to run out of reserves in this low price environment. But the second thing you get with the Long Reserve Life index is a lower decline rate. And so uh, and so if you have say a 20 decline rate versus a 40% decline rate and prices fall and you have to cut capital, you're not working yourself into a big hole. Now this set, this uh, element of Long Reserve Life Index has been a critical success factor in us uh at building our business. And the difference between the U.S. industry and Canadian industry or the Canadian industry has a much longer term of index. I have a lot of detail about that and that and that's why we went to Canada to take less risk.

Speaker A: Okay, great. So um, on that note and on the contrarian approach and from the previous panel discussion we talked about the interest in South Canadian assets. Montney is a uh, premium large uh, liquid rich gas resource in Canada with a lot of uh, investor interest. But you took an opposite move in 2025 because you exited Montney and we are in fact seeing more m and a interest into Montney. Can you unpack that a little bit? Why that Montgomery?

Speaker B: Sure. Uh, I would observe as I'm always a big fan, pay attention to what people do, not what they say. Um, and we actually think you know us actually the model was uh, quite a big card turned up in Canada in that we had a very successful business. We grew from 5,000 bue stay to uh 75,000 bue today over an eight year period. Uh, we were very profitably sold for twice what we had into it went to cash. Um, sold to the three biggest gas producers in town. Um, which uh, I think those three gas producers which k Natural Arc Resources and Terminally would they would say what we sold them would compete with top hotel Permian. So why don't we sell? So it's really a function that uh, we had an alternative um, which is thermal oil which has fundamentally superior uh, economics uh, to the shale business. And going back to this reserve life index is you need to be thinking about as an investor two things. What is your reserve life but also um, what kind of free cash flow you get. And uh, that really focuses on margin and margin is, it's always varies by price. But to give you some quick, uh, a typical profile of um, a quality Permian asset might be at $70. So it's functional price. Um, you might have a uh, reserve life index of say 10 years. Sometimes M it's shorter but let's say it's 10 years and at $70 you might be spending 80% of your cash flow to low production flat. Uh, so you have a 20% margin. Now also I compare that to the thermal oil business in Canada. Thermal oil business in Canada is probably going to have a 40 year reserve life index, uh, or slower. But let's say it's a 40 year reserve life index and at $uh 70 the sustainable the capex of oil production flat might be the 30 to 40% range double. So that's where I was like go do deals in my head. Can't do a deal in your head. I usually don't like to do it. So what that means is you have uh, double the margin in thermal oil and four times the Reserve Life Index. So you get eight times the sustainable free cash flow per dollar of EBITDA. Eight times is dramatic. So 10% better, 4% better. It is an order of magnitude better. And so, and uh, we thought she's young. So by the way, quick to Say is that doesn't mean you can't make any money in permanent. It doesn't mean you can't make any money in the mon. There's lots of opportunities, but for what we want to do, um, we must for law, business.

Speaker A: Okay, wait, let me, let me change track a little bit with the interest of time. Canadian and the American energy systems are extremely integrated. A lot of the refineries of Canadian.

Speaker B: Thank you.

Speaker A: Thanks. Um, there's also a lot happening both in the macro political and, and also the US Canadian relationship. How do you, how do you see the impact of either Canadian supply or the geopolitics or vice versa? Geopolitical impact on Canadian value of Canadian supplies.

Speaker B: So super topical. Uh, so interesting. So our firm, we have uh, the term, we call it down five, up five. And essentially what that means is, um, the down five is we think roughly over the next 10 years the United States is probably going to lose about 5 million barrels a day of production. So it's running from about 13 million barrels a day and change to about 8 million barrels a day and change. Uh, our previous panelists talk a little bit about inventory. What's going to happen? Uh, and uh, essentially the math, uh, probably the rough, rough number is that uh, um, for perspective, the last time the US declined was between 86 and 2005. Over a 20 year period, the United States went from 9 million barrels a day to 5 million barrels a day, lost 4 million barrels a day. By the way, uh, there's always this great thing, oh, don't ever underestimate the ingenuity of an American engineer. Well, there were a lot of American engineers in that 20 year period too. And when you're running out of oil, you're running out of oil. It's tough. Okay. Anyway, from that, in that 20 year period, 86, 2005, uh, Decatur, which is compound annual decline rate was 2.7%. That's how they lost 4 million barrels today. Um, uh, of course then share came along. It went from 5 to 13 in 2019. It's basically bumped around 13 million change for the last seven years. And we think it's uh, it's not exactly a minority report. Um, it's very long in the truth at this point. It's not a question of if it's declines, what's it going to start and what's the rate of decline going to be. And going back to the Most recent decline, 86, 2005, as you all know in the room, those were vertical wells. Of course the vertical wells are Quite prolific, uh, but they don't decline as fast of course. Now what we're going to be facing is horizontals, bigger productivity, faster climates. So the question is, okay if it was in the 86 to 2005 time period it was 2.7%, what's the cater going to be off of horizontals? Well even just some math on that, let's say it's double, let's say it's 5.4%. I'll take the over on that. But it's good to just at least follow where this is going to go. Uh, at a 5.4% uh, cater combination rate, uh, the US over 10 year period goes from about 13 and a half million to about 8.2. Uh, but one, uh, and I can say that doesn't mean you can't make any money in the US oil industry while it's declining. There was money made when the US oil industry declined from nine to five. But uh, uh, make no mistake, we could have a debate about is it 5%, is it a 6% climate, is it higher? What's the number that going to be? Now this is the neighborhood of what's going to happen. So the U.S. loses 5 million barrels a day over 10 years. Rough. And again I'm quite fond of the Warren Buffett, uh, I'd rather be generally correct and precisely wrong. You know, uh, this is the neighborhood what's going to happen over 12 years is over nine years. This is what's going to need to be facing uh now at the same time in Canada. Sort of the big card that turned up, and this is a little bit talked about briefly on the last panel, is that ah, uh, the new federal government um, has embraced the uh, Alberta provincial goal of being what they call an energy superpower. And what an energy superpower according to the province of Alberta, uh, is uh, the goal of doubling oil and gas production over the next 10 years. Uh, Canada uh, currently produces 5 million barrels a liquids. Uh, its goal over the next 10 years is to double and go to 10 million barrels a day. Uh now obviously there's some real symmetry there. Down five, up five. Now that's a uh, really good thing now I would say it's going to be quite remarkable. Again we does Canada get to 8, 9 and 10 or it's going to 12? What's the exact number? But these are the direction where this is heading now ah, if that happens it's going to be quite remarkable what the dynamic is going to be beat because uh, Canada's around 10 say let's say directionally, right, the US is at 8. My guess is that Russia's at 8. So then at that point, 10 years from now, Canada is going to be arm wrestling with Saudi Arabia as, uh, who's going to be the largest oil producer in the world. Now, this is tremendously good news for the United States to have what is probably going to be, you know, the first, or is it the second largest oil producer in the world right next door in the United States, declining. And I would say this is really good news whether, you know, it's Kamala Harris, Gamma Newsom, um, Marco Rubio, J.D. vance. I don't care who the president of the United States is. When the United States is losing a million barrels a day or so every other year of production, uh, it's going to be enormously positive for the relationship between the two countries. Good.

Speaker A: Do we, do we have time for a couple of great audience questions? Okay.