Strathcona Resources Ltd. (SCR) Earnings Call Transcript & Summary

Good morning, and welcome to the Pipestone Energy Corp. and Strathcona Resources Ltd. Strategic Combination Conference Call. [Operator Instructions] As a reminder, this call may be recorded. I will now pass the call over to Dan van Kessel, Vice President, Corporate Development, to introduce the call participants.

Thank you very much. We are incredibly excited to discuss the transaction. With me this morning for Pipestone Energy, I have our COO and Interim CEO, Dustin Hoffman; as well as our CFO, Craig Nieboer. From Strathcona Resources, we have the Executive Chairman; Adam Waterous; President and CEO, Rob Morgan; as well as the CFO, Connor Waterous. From Pipestone, Dustin will begin by outlining the rationale and key benefits of this transaction for Pipestone shareholders. Craig will follow with an overview of process, shareholder vote mechanics and time lines. Afterwards, the Strathcona team, including Adam, Rob and Connor, will review the strategic financial and operating highlights of the pro forma company. I will now pass the call over to Dustin Hoffman, COO and Interim CEO of Pipestone Energy.

Good morning, everyone, and thank you for joining today's conference call. We are pleased to announce that Pipestone has agreed to be acquired by Strathcona Resources, creating one of the largest oil and gas companies in Canada. This business combination creates a new publicly-traded large-scale, long-life oil-focused company with a strategic direction centered on combining production growth with significant free cash flow generation. The combined company will have three core areas, each with meaningful scale and inventory in aggregate, a balance of heavy oil, condensate, NGL and natural gas production. The combined company will be well positioned against other large oil-weighted Canadian producers in terms of production growth rate, operating netbacks and reserve life. This transaction represents the culmination of an ongoing effort by the Pipestone management and Board to uncover the optimal strategic and financial direction for our shareholders. We, as a management team, along with our Board, are fully supportive of this transaction, which will see Pipestone shareholders with a continued ownership stake in a highly differentiated oil and gas producer. Now I'll turn it over to Craig Nieboer, our CFO for Pipestone.

Thanks, Dustin. In terms of the combination structure detail Strathcona and Pipestone have entered into a definitive agreement to effect the combination through a planned arrangement under the Business Corporations Act of Alberta. Under the terms of the combination, Strathcona will acquire all of the issued and outstanding shares of Pipestone with all share -- with an all-share consideration transaction. Pipestone shareholders will receive 0.067967 shares in Strathcona for each Pipestone share owned. Such that immediately following the completion of the combination, Pipestone shareholders will own approximately 9% and Strathcona shareholders will own approximately 91% of the pro forma company. Upon closing the combination, Strathcona will become a reporting issuer in all of the provinces of Canada, and Strathcona shares will be listed and posted for trading on the Toronto Stock Exchange. Combination required of approval by 66 2/3% of the votes cast by Pipestone shareholders present or in person or represented by proxy and a special meeting of Pipestone shareholders to be held in late September, with the closing of the combination expected to occur in early October. It should be noted that as of signing of the arrangement, approximately 39% of shareholders have entered into lockup agreements to support the transaction, including the Board and management of Pipestone. The agreement further provides the completion of the combination is subject to certain other customary conditions, including the receipt of all required regulatory approvals, the approval of the TSX and approval of the Court of King's Bench of Alberta. BMO Capital Markets, who also acted as financial adviser to Pipestone, and Raymond James Ltd. have each provided an oral opinion to the Pipestone Special Committee and the Board of Directors. That as of the date thereof, and subject to the assumptions, limitations and qualifications set therein, the transaction is fair from a financial point of view to the holders of Pipestone shares. I will now pass it over to the Strathcona team to provide Pipestone shareholders and listeners an overview of the pro forma business.

Good morning. This is Adam Waterous speaking. We'll start with just a quick introduction on our side and try to give everyone on the call some perspective on Strathcona and its current business and what the business will look like on a pro forma basis. But before we get into those details, for those folks who are not familiar with the management team, starting with myself, I've spent most of my career in the energy business. For about 15 years, we had an oil and gas merger and acquisition advisory firm called Waterous & Co., which we built up into the largest oil and gas M&A firm in the world. We then sold it to Scotiabank in 2005. I then stayed and ran Scotiabank's global investment bank for about 10 years. And then in January of 2017, left to start Waterous Energy Fund, who's whole portfolio company is Strathcona Resources, and we'll talk about Strathcona. Rob?

Thank you, Adam. So my name is Rob Morgan. I'm President and CEO of Strathcona Resources. I am an engineer by training. I have a background over my entire career in the oil and gas industry, both the heavy oil and in the Montney with a number of publicly traded companies and joined this team, Strathcona, in about 2017 legacy companies and have been through the whole building of the business from that point in time. Connor, over to you.

Great. Thanks, Rob. This is Connor Waterous speaking. I've been a partner and cofounder of Waterous Energy Fund since day 1. Prior to that, kind of a number of years in the oil and gas private equity business with KKR and Blackstone. And over the last couple of months, has taken over as the CFO of Strathcona going forward.

So what we're going to do is just give you some background on Strathcona, its operations and its financial position. For those who have a presentation, which is currently on Strathcona Resources website, we'll use this as a speaking guide. And for those who do not have the presentation, we will try to make sure that we highlight all of the key points on each slide. Those with the deck, I will just turn to Slide 6. I will just give a quick sense on the pro forma business overview. The business will be producing at closing approximately 185,000 BOEs a day, with an ultra-long reserve life index of 53 years across three core areas: the Montney, Lloydminster Heavy Oil and Cold Lake Thermal. This is a liquids-dominated business, about 78% liquids. To give a good sense on reserves and therefore, associated reserve life index. On a 1P basis, the performance will have 1.5 billion barrels. On a 2P basis, about 2.6 billion barrels. On a 2P plus 2C basis, about 3.5 billion barrels. The associated reserve life indexes of each is on a 1P basis, 22 years; on a 2P basis, 38 years; and on a 2P, 2C basis, 53 year. The associated engineered value with those reserves is on a 1P PV 10 basis, approximately 16 billion; on a 2P basis, approximately 23 billion; and on a 2P, 2C PV 10 basis, 24 billion. Now how we have built that business, moving on to Slide 7, is that, we have invested $2 billion in cash equity, in addition to the equity at Pipestone is now receiving and we have about $2.9 billion at closing. The -- now we have -- and just to give a quick finger math on yesterday's close. The equity value is approximately $8.6 billion, the -- a $2.9 billion increase of $11.5 billion enterprise value. Now how we have built that business or what have been the strategic imperatives, is that, #1, we have focused on compounding long-term intrinsic value on a per share basis. This differs from many oil and gas companies who often focus on operating metrics. We think it's more important in terms of trading shareholder wealth to focus on compounding long-term intrinsic value per share. Secondly, we have focused on margin of safety buyouts, I mean, acquiring top quality properties. And the nice thing about the oil and gas industry, quality is not subjective, it's objective. It lends itself to being easily quantified. And in our view, there's only really two metrics that are really most important, and that is the reserve price index and operating margin of the business, both end up being extremely important in generating sustainable free cash flow. A low reserve price index is important because with a low reserve price index, inevitably, comes a low decline rate. A low decline rate reduces, generally speaking, the capital required to be able to hold production flat. Therefore, the margin relative to EBITDA on a low decline business is much, much higher. We'll give you a sense on that in just a few minutes. The other important thing about a low reserve price index is the opportunity to grow the business, while still having substantial remaining reserves. Now with those two core ideals, compounding per share growth and a margin of safety, we have executed the strategy by what we can call a core area consolidation strategy, where we went into three core areas, [indiscernible] in an initial acquisition and then acquired adjacent complementary assets. And Pipestone fits with that strategy and a lot more, and we'll go through that in greater detail in just a moment. The other thing that distinguishes Strathcona is how we manage the business by encouraging management to focus on controllable items being: operating costs, finding development cost to help safety in the environment as opposed to things that they can control, like commodity prices or the capital markets. As a consequence, managements are compensated through cash salaries, cash bonuses and then can acquire stock at the prevailing price. With that said, not surprisingly, does is a similar process that some of you may recognize from a compensation system well-known used by Berkshire Hathway. So that's just sort of the guiding principles in terms of how we built the business. Now what does that resulted in relative to the rest of the market? So turning to Slide 8, we're going to just -- at the moment, comparing Strathcona and its performance over the last 6.5 years relative to the rest of the sector. And on the upper left quadrant, what you'll see is on a growing production reserves, on a per share basis, the industry has had little to no growth over the last 6.5 years. Conversely Strathcona has grown production of 34% on a compound annual basis per share and reserves on a 26% compound annually per share. What that has led to is growth in net asset value in that time for Strathcona. And if you look at relative to the rest of the industry, the smaller caps and the mid-caps had almost no growth on a per share net asset value basis. The seniors have had some, but not very much, on a comparative basis. On a 1P basis, Strathcona has grown its net asset value per share on a 31% compound annual basis on a 1P basis. On a 2P basis, 27%. Doing that they have to growing net asset value per share is internal rate of return. And if you look at the annualized rate of return for the sector, over the last 6.5 years, it's extremely modest to negative. We have compounded internal rate of return on a 35% basis during that time. If you look at on a cash flow per share basis, the industry has done better than reserve or net asset value. [ Certainly ] speaking, because there has been some improvement in commodity prices. In that time, since the last 6.5 years we have grown cash flow per share on a 44% compound annually. Importantly, since that time, we have kept our leverage in check. On a trailing 12-month basis, we have averaged 1.8x debt-to-EBITDA. Now what has that led to in terms of what positions for the future, let's just turn to Slide 9. While we have been growing quickly in the past, we have the opportunity to be able to continue to grow quickly and specifically, grow production of about 185,000 barrels a day to about 325,000 barrels a day over an 8-year period, which is a compounding growth at about 8% per year. Now we look at that total amount of growth of about 140,000 barrels a day in three different buckets. The first bucket is just filling existing capacity, and we think we can grow to about 220,000 barrels a day by doing that. And that's importantly, when we think about growth [ activity ], what's the return and under what price scenario. So the hurdle that we're using is a 20% return on assets. And to achieve that 20% return of assets, selling this capacity, we think that will require $50 WTI. The next bucket is debottlenecking and some brownfield expansion, which would take us to 285,000 barrels a day. To achieve that same 20% return on assets, we need $60 WTI. The last component of growth is greenfield, it was about 40,000 barrels a day to 325,000 barrels a day to achieve that same 20% return on assets, would require $70 barrel. Now at the end of all that growth, we are still up with the 24-year reserve life index, extremely long. Now why is it being extremely important is that we generally are big fans of the nerve in the industry of returning capital to investors. And because, on average, the industry -- and this is [ cyclical ] across North America and certainly, just on something in companies, as they compare to the short reserve life index, and therefore, it's appropriate to focus on returning capital and not growing. And you have a short reserve life index because ours is ultra-long. And when I say ultra-long, it's the longest 2P reserve base in Canada for a scaled business greater than 150,000 barrels a day. We have presented a different suite of opportunities, and that we are able to grow, and still at the end of it, have an extremely long term -- extremely long reserve life index. Moving on to Slide 10. And we've been asked by a lot of folks, why go public? Because not surprisingly when you're private, it's a much simpler life, [ in such an important ] environment, et cetera. And we're showing [indiscernible] for that not surprisingly. But -- and I also would say is that our view of actually being public is that the sector, in general, is undervalued. So we're not going public because we think, "Wow, look, how great prices are." In fact, quite the opposite. We think that the sector, generally speaking, presents multiple attractive acquisition opportunities for Strathcona. But what we have seen is that as you consolidate the sector, we have seen that there are several targets who have been happy just to take cash, that's currency, which is our only form of currency today, but there are others who are -- who'd be interested in potentially partnering with Strathcona and delaying our shareholder base, but want to take shares in a public traded company. Hence, our desire to become publicly traded. But it's -- as part of this transaction, Waterous Energy Fund has no intention of selling any of its shares. But instead, over time, we're going to increase the size of the float by issuing shares to the potential acquisition targets and therefore, increase the -- the overall percentage ownership by Waterous Energy Fund. That's a quick background on just what we've done in building the business. I'll now turn it over to Rob Morgan, who will detail more about our existing profile of the business.

Thanks, Adam. And just as a reminder, the presentation we are referring to is available on the Pipestone website as well as the strathconaresources.com website. So in terms of the business itself, on a pro forma basis, we -- as Adam mentioned, we have three core areas. The first core area is Lloydminster Heavy Oil. This is heavy oil assets in Saskatchewan, largely under some form of enhanced oil recovery. That includes waterflood, polymer flood and small-scale SAGD. It's one of our largest margin assets in the portfolio, largely due to the quality of the oil in the area, but also in addition to shipping oil on the pipeline system in the area through the Enbridge, we blend condensate with the heavy oil. We also have owned and operated 50,000 barrel per day rail terminal that allows us to rail those barrels to the U.S Gulf Coast and achieved the premium pricing available on the Gulf Coast versus pricing that may be achieved at Hardisty -- the WCS market in Hardisty. So that is our Lloydminster Heavy Oil, long-life assets, a very low decline, low sustaining CapEx. Our second core area is the Cold Lake Thermal area. The majority of the Canadian -- Canada's oil sands production is from the Athabasca region, in the southern area near Cold Lake is where our three assets are located. Again, through our consolidation strategy, we acquired these assets over the last number of years. We prefer the Cold Lake region simply because the quality of the oil is better as you move to the southern end of the oil sands region. You have closer proximity to the takeaway pipelines in the area, and the oil has a lower viscosity and requires less condensate to blend. So we believe it gives us about a $10 a barrel improved margin over the Athabasca region. Again, a very low base decline rate of around 10% and fairly low sustaining CapEx. The Cold Lake Thermal region is where we have our largest reserve life index and our largest growth opportunity through the existing infrastructure we acquired with the three transactions we ended up over the years. Our third core area is Montney, and this is where the Pipestone assets are very complementary. When we look at the Montney, our previous core area was in the [ Calgary ] region, focused on liquids-rich natural gas, very much like the Pipestone assets. The Montney to us is a natural hedge against the oil side of our business, both from a perspective of our thermal business, in both Lloydminster and Cold Lake consume natural gas. And both areas consumed condensate, and the condensate that was produced from the Montney region as well as the natural gas provides that natural hedge across the business. Connor will outline that as we go forward. And just in terms of that low base decline across the asset base, it translates, on a go-forward basis, to what we believe a sustaining CapEx level of about $800 million, and we'll provide context of what that means with regards to cash flow generation going forward. The remaining portions of the presentation, again, highlight the profitability and the long reserve life of the assets, the opportunities within the portfolio. So I would encourage you to take some time to walk through the presentation and as well highlighting the very low full cycle breakeven cost of the business, built up from the sustaining capital through the cost structure, to essentially demonstrate a less than USD 40 WTI breakeven on the business, including sustaining CapEx. Now I'll pass it over to Connor to talk about the capital structure.

Perfect. Thanks, Rob. So folks who are following along, can turn to Slide 17 of the presentation. This provides a brief overview of the debt portion of our balance sheet. Pro forma after closing of the transaction with Pipestone, we expect to be approximately $1.7 billion drawn on our $2.3 billion bank facility, with a $525 million first lien bank term loan outstanding and our USD 500 million notes due 2026. When we think about the long-term debt target for the business, our plan over the next couple of quarters is to use free cash flow that the business generates to repay the $525 million term loan, leaving us with approximately $2.4 billion of debt, which leaves you as a prudent long-term target. That view, on a prudent long-term target, is informed by roughly $2.4 billion being the amount of EBITDA of the finished business generates at a flat $70 price deck on a run rate basis. Medium-term, our leverage target is based on net debt-to-EBITDA at mid-cycle pricing of about $70. For some further sensitivity to that cash flow guidance, each USD 10 move in WTI equates to roughly $300 million move in cash flow. So at current prices of roughly $80, that would mean approximately $2.7 billion in run rate EBITDA. When you couple that with current maintenance capital levels, as Rob outlined, of $750 million to $800 million, this translates into a little less than $2 billion of free cash flow post-maintenance capital on an unlevered basis at current prices. With that, a little less than $2 billion of excess free cash flow, this gives us quite a bit of flexibility in terms of investing in our future growth in the business or paying out capital to our shareholders. As previously outlined, we -- our plan is to grow production on a compound annual basis of roughly 8% per year, which would translate into meaningful growth in production and associated free cash flow after maintenance capital in the 2024 calendar year. On Slide 18, we give a brief overview of the hedge composition of the business. While we are well hedged over the balance of the year in both WTI and our national hedges with gas and condensate, we are largely unhedged for the 2024 calendar year as we pay down debt and move past the repayment of our term loan. On Page 19, we point out that unlike all of our peers in the space of the same or larger size, we are the only noncash taxpayer, which further increases the conversion of the unlevered cash flow into the net excess free cash flow that the business can use for growth and/or paying out to shareholders. And then finally, on Page 20, what we're proud to highlight is the long-term carbon capture strategy for the business, which is to take advantage of the fact that Strathcona's thermal properties, which account for the majority of its CO2 as of right now, both create a concentrate point source of CO2 and are at placed directly on top of that [indiscernible] storage reservoirs, which are ideally suited to carbon capture and storage, which gives us both a head start from a timing perspective in terms of doing major carbon capture and a cost benefit as well versus our peers furthermore.

So in summary, the business pro forma will have a 53-year reserve life index for long, a very low breakeven, $38 per barrel on a sustained basis. That's after having spent the capital to hold production flat, has the option of growing to add another up to 140,000 BOEs a day over what could be just 8 years is naturally hedged with both natural gas and condensate and is in a tax-efficient position as we were not expected to pay taxes for several more years. With that, we'd like to open the floor for questions. Thank you.

[Operator Instructions] Our first question comes from the line of Jason Mandel with RBC Capital Markets.

Congrats on this acquisition. If I could ask one question on another piece of news that just came out now from S&P, which actually moved to a negative outlook. I guess, a little hot on that, largely pointing to the term loan that remains outstanding. So can you just update us on the expectation for that term loan, i.e., full repayment by maturity, refinancing, et cetera?

That's -- our plan is the same as it's been for some time now, which is to repay the bank term loan using the free cash flow of the business generates over the next couple of quarters. And day 1, upon closing, we will also have approximately $600 million of availability under our main bank line. That can also be used to repay.

[Operator Instructions] And I would now like to hand the call back over to Pipestone CEO, Dustin Hoffman, for any closing remarks.

Thank you, operator, and thank you, everybody, for attending the call this morning. And any follow-up questions, you can surely reach out to the associated parties, that's Strathcona or Pipestone. Have a good morning, everyone.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect.