Adam Waterous unscripted
Strathcona Resources: Capital Allocation Champions? Examining the CMD and older founder interviews.
A year ago, smart investors recommended me to look at Strathcona Resources because of the astute capital allocation track record and cheapness. Fairfax Financial is also an investor in the Waterous Energy Fund 'WEF' (Strathcona Resources is the main holding of WEF).
I wanted to share the evidence I found from the materials. The following post is mostly a compilation of a fanboy (2024 Capital Markets Day, some very old podcast interviews with the founder, and also notable tidbits from the company materials). Warning: this post is just philosophy, no numbers. For entertainment purposes only. I have been long $SCR.TO since last fall.
General intro to Strathcona and its founder
As a general intro, I'd like the company itself speak for itself and its founder. The WEF website has the following to say:
We’re Not Venture Capitalists, We’re Value Investors
Founded in 2017, Waterous Energy Fund (WEF) is a Calgary-based private equity firm pursuing investments in the Canadian oil and gas sector. WEF has closed on over $3 billion in capital commitments across five distinct fundraises since its inception, positioning WEF as Canada’s largest oil and gas private equity manager.
In contrast to the traditional growth equity and venture capital approach towards investing in oil and gas private equity, WEF pursues a value-based investment strategy, seeking to invest in established businesses with top-quality assets that ‘work’ today. Rather than having a large portfolio of smaller companies, we believe a highly concentrated portfolio of scaled businesses enhances the margin of safety in investing in the Canadian oil and gas sector.
On its founder, Adam Waterous, this is detailed on the same website (emphasis is mine):
Prior to founding Waterous Energy Fund in January, 2017, Adam served as Global Head of Investment Banking and Head of Energy and Power, North America at Scotiabank, where he was responsible for all of Scotiabank's global Equity and Advisory activities and Scotia Waterous.
Under Adam’s leadership from 2005 to 2016, Scotia Waterous was among the most active advisors in the oil and gas acquisition and divestiture market with transactions roughly evenly split between Canada, the United States and other countries.
Adam co-founded Waterous & Co., a predecessor firm to Scotia Waterous, in September 1991 where he was a member of the firm's Executive Committee and the head of the firm. Scotia Capital acquired Waterous & Co. in 2005.
Before co-founding Waterous & Co., Adam worked in the Mergers and Acquisitions department with First Boston Corporation in New York and in management consulting with McKinsey & Company in Toronto.
Adam holds an Honours Business Administration degree from the University of Western Ontario and a MBA from Harvard Business School. Being in the top five percent of his class at Harvard, he was designated a Baker Scholar.
The CEO Series with McGill's Karl Moore - Adam Waterous interview (2024)
Energy Council - Adam Waterous interview (April 2020)
The Minerals and Royalties Podcast - Adam Waterous interview (April 2020)
First thing Adam Waterous did after McKinsey was work in real estate. Shortly after working at a large firm, he became a real estate developer for a few years. I'm guessing this is where Mr. Waterous grew his appreciation for trophy assets. The next step was entrepreneurial:
"I then founded a large M&A advisory firm Waterous & co with my brother in 1991 for the oil & gas business with offices in Houston, Denver, London, Singapore, and Buenos Aires. When we sold it in 2005, it was the largest O&G M&A firm in the world."
Interestingly, when he got asked the simple question "What is the state of the oil market today?" on the McGill CEO series podcast, Waterous dove into 10 year history (paraphrasing and summarizing):
Generally speaking in the Oil & Gas industry "buying the dip" was a good strategy. In 2015 I had a very different view. A lot of people got vaporized by buying the dip through M&A. We ran a lot of auctions in the M&A business. We saw volumes fall instead of rise when prices went down during the shale revolution, this actually started already in 2013. The industry moved from drilling locations poor - from 2-3 years - to 10+ years as a result of the multi-stage fracking technological revolution. That made companies move to grow through the (organic) drill-bit instead of buy more drilling locations. We wanted to create a business to take advantage of that new dynamic. We did not want to get involved in the portfolio approach of backing many small technical teams: the market for small companies completely dried up. We wanted to build an operational company buying high quality tier one acreage, highly cash generative.
On the C.O.B podcast something similar happened:
Maynard: You spent almost 30 years helping companies merge. Now you’re integrating them yourself. What are your takeaways from going from advisor to implementer?
Adam: Here’s how I’d answer, Maynard: what drove us to integrate those businesses and do something different from a successful strategy? Look back at the North American industry. From 1973 to 2012, a 40-year run, we’d call it an age of scarcity. Since the Arab oil embargo, oil and gas were hard to find—companies were drilling-location poor, exploration success was rare.
The assumption was that oil’s value would rise over time—lots of volatility, but it’s hard to find, so it should be worth more later. That biased the industry toward growth: success meant growing reserves and production across all sizes of companies, spending capital through M&A or drilling. A 40-year dynamic shaped industry psychology—financing, life cycles, everything.
But around 2012, we saw a structural change: an age of abundance from horizontal multistage fracking. In two, three, four years, companies went from growth-challenged to growth-rich—50 drilling locations to a thousand, two-year inventories to 12 years. It was seismic, positive for production and US energy independence.
We saw this shift hurting the growth focus, causing dislocation—often technology-driven, like this was—creating opportunity. Around 2014, oil prices fell from $100 to $50. Many saw it as cyclical, not structural—industries cycle, like in 2008 or 1986, and they’re short-lived.
That view was “buy the dip” in 2015, expecting commodity prices to rebound. But those with a cyclical view got hurt—experienced executives vaporized because they misread a structural change. We saw it in 2012 because we pioneered the oil and gas auction market since 1991.
For years, auctions were robust—10 bids on average, six or seven for low quality, 20 for high quality. In 2012, bids started falling. We asked buyers why: “I used to be drilling-location poor; now I’m rich. I’ll drill, not buy.” That was a 40-year first, collapsing M&A.
Everyone saw transactions drop, but many thought it was just a cycle—prices and M&A would return. We didn’t. This 10-year age of abundance meant poor M&A demand, which goes hand-in-hand with value investing. You don’t want a robust M&A environment as a value investor—that informed our strategy.
I like a company backed by people who have an informed investment thesis for what they are doing. Too many managements don't know what they are doing (except trying to make their jobs more cushy).
This is how Waterous is positioning himself in this industry backdrop of abundance of mediocre oil opportunity (from the Mineral & Royalties podcast episode; emphasis mine):
Adam Waterous: So, what our firm, Waterous Energy Fund, does is we describe ourselves as a deep-value, special-situations investor. What we mean by that is we’re buying established businesses with reserves, production, and cash flow—but, importantly, businesses that have top-quality assets. Those are trophy assets, top-decile assets.
The reason we want to buy trophies is that you have the ability to do two things. Number one: be able to get equity payouts to investors. What I mean by equity payout is how we look at an investment—we assume that the M&A market, which I’ve said has collapsed, never comes back. Now, that doesn’t mean we don’t ever think we’ll have a chance of selling our businesses—we might end up selling our businesses. I would quickly say that if you have a top-tier asset, you’ve got a chance of selling your business because your asset might compete for capital relative to potential buyers, but we don’t count on it. That was the vast majority—95% plus—of all private equity on a historic basis over the last three decades: they exited through a corporate transaction.
Tim Powell: What do you classify as a trophy asset? Can you go into that? Because I think the last 10 years have been about core rock and shale plays, but Pengrowth, which you just closed on via Cona Resources in Canada, is heavy oil, water floods.
Adam Waterous: Sure. Essentially, “trophy” sounds somewhat subjective—like you’re talking about a painting, where what’s a trophy painting is in the eye of the beholder. But you can actually do it just through arithmetic, and essentially, you need three things to have a trophy asset.
The first is you need a very large resource base—a long reserve life. The reason you need a long reserve life is that this is a volatile industry, and if you have a short reserve life index, during a period of low commodity prices, you may be selling off a substantial portion of your asset at low prices. With a long reserve life, you protect yourself against that volatility.
The second thing you need is high margins. By high margins, I mean after royalties and operating costs—what are your netbacks?
And then the third thing you need is an attractive sustaining capital base. A key way of evidencing a trophy asset is: what percent of your cash flow do you have to spend to hold the asset flat? I would quickly say that this criterion is where a very high percentage—but not all—of shale oil assets really fall down: they require $55 oil, and a very high percentage of their cash flow is devoted just to holding the asset flat because of the rapid declines in the business.
So, when we put those three things together, we’re looking for a business that provides substantial free cash flow after holding production flat. Why that’s important is we’re looking for a suite of assets that have those characteristics that allow us to effectively dividend out our investments. To give you a sense, it’s partially tied to the reserve life index, but we want to be able to—when we make an investment—dividend out our equity, assuming we have modest leverage, entirely in a reasonable period of time, and then effectively, we’re just playing with the profits.
Now, that is not historically how the business has financed itself or the investing approach. Instead, it’s been entirely capital gains-driven, where 100%—or more than 100%—of the cash flow has been reinvested to grow reserves and production on the expectation of a capital gain. But for that to work, you need a robust M&A market, and we don’t think that M&A market is coming back anytime soon. So, that’s how we’re approaching it.
Now, the trick in investing in trophies in the oil and gas business—like it is in any industry—is that the trophies tend to be very expensive. Top-decile, the best assets—everybody wants those. So, the art, so to speak, is how to get them at a good deal. That’s why we focus on what are generally described as special situations—which is kind of fancy finance talk for “something has gone wrong with the business.” Often, it’s because there’s been too much leverage in the business, but that’s not always the case. The business has to be recapitalized, restructured, repositioned.
These are complex situations—complex shareholdings, too much leverage, non-core assets—but they have to have a lot of hand-holding and simplifying to make them more attractive. So, that’s the niche that we’re focused on. And not surprisingly, given the volatility that we’ve just experienced, we see that the number of special situations out there is growing. The target market that we’re focused on is increasing, frankly, on a daily basis.
Let's now move on to some interesting tidbits in the capital markets day. I recommend everyone to watch it in full. It's not often you see a stock jump around 10% just for the investor day. Indeed, the slide deck and explanations were impressive.
Capital Markets Day: packed with thoughtful numbers
Strathcona released a big slide deck which was very interesting. I encourage everyone to watch the first half hour introduction with Adam Waterous.
One of the metrics I think show their thoughtfulness for being quality investors is the PIR PV10. This is a modified recycle ratio, but discounted to reflect the time value of money. The traditional (undiscounted) recycle ratio divides the total profit of new barrels by the total capex to find and develop those barrels. Seasoned O&G investors always appreciate recycle ratios: in an industry with tremendous uncertainty in terms of operational issues, pricing, it's important to budget for a multiple of profit compared to the capex you are putting in. However, this is not good enough. Given the tremendous industry uncertainty (in particular in the last decade from recent investor doubts about the economical viability of the industry a decade out), the cost of capital or discount factor has gone up. Therefore, using recycle ratios flat out is simply not enough. I like the fact Strathcona presents their investment hurdle as the discounted recycle ratio (PIR PV10) exceeding 2.0X (which most all of their "quality" organic inventory satisfy).
On the topic of climate change, Adam is a realist. He prefers the more ethical and clean Canadian production over OPEC production. He believes it is imperative to reduce energy poverty in the world and provide affordable energy. Strathcona closed a 2 BUSD JV Carbon Capture deal last summer. When you drill into the details, you will see that almost no upfront capital is required from Strathcona (after accounting for grants, tax credits and the Canadian Growth Fund upfront investment). Operational risk is also with its JV partner. Instead, Strathcona will buy all carbon credits from the JV at a fixed price (taking on "the price risk" of future carbon credit pricing). But since Strathcona's main business is short carbon credits, this is not a risk in the traditional sense but rather a natural regulatory hedge financed by the government. Talking about the government, Mark Carney has now met three times - in a short period of time - with Mr. Waterous. Probably a good sign.
At Strathcona, Reserves Reports are Shareholder Letters
Every year, E&P's publish their reserve reports. In the case of Strathcona this is a shareholder letter with thoughtful discussion of the movements therein and their economic rationale. See here for the 2024 edition.
Summary & Investment Case
An investment case with specific numbers is beyond the scope of this article. Yet the very general investment case is as follows.
You've got a world class value creator from the sector. You've got a valuation at a fraction of 1P NPV10 that has compounded above 20% CAGR per share, mostly because of a low float, as Strathcona went public through reverse merger, and most of the equity is still held by the limited partners of Mr. Waterous Private Equity fund. The assets are low cost in nature.
Strathcona Resources is a trifecta stock: Cheap, Sound and Rewarding (for reasons why these elements are important, see my first post). My conviction of each element being present is high, though the magnitude of the trifecta elements vary. In a world obsessed with perfection*, I prefer a stock that scores good on each Trifecta element over a stock that reaches perfection on just one element. Judging from Mr. Waterous “special situation value investing” (see above), I believe he does too.
*In the last decade, stocks with extraordinarily high ROICs and low revenue/earnings volatility (think SaaS, Fundsmith) got way overpriced. In a world obsessed with perfection (Compounding Quality™) the highest TSR might be mediocre/good assets with good managements and good capital allocation.