The earthquake of consolidation continued to topple household names in the Canadian oil patch in the second half of 2001 and first quarter of this year, with the latest shakeout including the proposed C$27-billion merger of PanCanadian Energy Corp. with Alberta Energy Co. Ltd. The aftershocks rippling through Canada include the creation of numerous private firms led by experienced managers displaced by the ferocious pace of takeovers that has occurred during the past two years. During the next five years, these companies-which have raised several hundred million dollars from North American fund managers and wealthy investors-will fuel the growth of royalty trusts or rebuild the decimated ranks of public junior and intermediate producers. "If you've structured it right, this is the best time in the past 10 years to start a private company," says George Gosbee, managing director of Tristone Capital Advisors Inc. The Calgary-based financial firm helped launch seven private producers in the last year. "There is a tremendous supply of properties because of consolidation, and buyers are going to be able to access a lot of great property deals at attractive prices because of the declining commodity environment." He believes there hasn't been a better time to invest in an oil and gas start-up than right now. "We've never been able to back so many good management teams and they just don't have the competition when they go in to buy these oil and gas properties." The pace of takeovers in the Canadian energy industry slowed markedly in the second half of last year, with slumping commodity prices and rising debt levels dousing the once-roaring flame. However, some of the completed deals were huge and will continue to send out tremblers for years to come. The most notable was the late January PanCanadian-AEC engagement announcement. The union creates a powerhouse with size, financial might and international exploration opportunities equal to some of the largest U.S. independents, such as Anadarko Petroleum Corp. and Burlington Resources Inc. Other megadeals in the past several months include Burlington's US$2.1-billion takeover of Canadian Hunter Exploration Ltd.; Devon Energy Corp.'s US$3.4-billion acquisition of Anderson Exploration Ltd.; and Phillips Petroleum Co.'s proposed US$15.4-billion merger with Conoco Inc. The lattermost has Canadian implications because Conoco, until displaced by the PanCanadian-AEC transaction, scored the largest deal in the Canuck producer patch with its US$4.3-billion takeover of Gulf Canada Resources Ltd. last year. The headline-hogging mergers, including Burlington's 36% premium for Canadian Hunter's stock, are having a less-publicized effect of spinning out a tier of new producers. A raft of private companies, many raising C$10- to C$30 million to fund their initial efforts, is being led by relatively young executives with proven teams and chemistry. The head honchos at these firms comprise a Who's Who of the Canadian energy industry. Barry Jackson, the former boss of Crestar Energy Inc., and Randall Pardy, the founder of Tethys Energy Inc., are piloting Resolute Energy Corp.; Doug Kay, the ex-chief executive officer of Cabre Exploration Ltd., is heading Segue Energy Corp.; Berkley Petroleum Corp. founder Mike Rose is leading Duvernay Oil Corp.; and Clayton Woitas, former head of Renaissance Energy Ltd., is calling the shots at Profico Energy Management Ltd. The list goes on and on. Much of the money was raised locally, sometimes on little more than the executives' reputations and connections. "We went through a window where it appeared that private capital was receptive to backing management teams that have grown businesses before on a blind-pool basis, and that's a big difference," says Kay, whose firm raised C$19.3 million in April 2001. "I'd say overall it's easier to raise money than it has been in times of the past." While Tristone connects experienced executives with patient money, it does not participate in financing the new players. Some of the key Calgary companies occupying this space include ARC Financial Corp., Longbow Capital Ltd. and Network Capital Inc., along with brokerages Peters & Co. Ltd. and FirstEnergy Capital Corp. The hot market for experienced executives is one reason why Rose immediately formed Duvernay (named after the sourcerock for most oil and gas pools in the Devonian) after leaving Berkley last summer. "What gets you respect is what you did before, and I believe people do have respect for what Berkley did," says the 44-year-old geologist, who says he is too young and too passionate about his work to consider retiring. "Do I and the staff in here want another Berkley right away? The answer would be no. We are having fun with the smaller staff, more flexibility and more focus on the things we're good at, but that doesn't mean we don't want to be a larger company in three or four years." Founded by Rose in 1993, Berkley developed a solid reputation for exploration after finding oil in Saskatchewan and gas in Alberta, British Columbia and the Northwest Territories. After a hostile bid was initiated by Hunt Oil Ltd. of Dallas, Berkley was acquired by white knight Anadarko for US$777 million last spring. The 10 Berkley veterans at Duvernay raised C$81 million, including C$28 million from their own pockets, making it the largest private energy firm started to date in Canada. While Duvernay wasn't trying to set a record, it wanted a big war chest to enhance its credibility and take advantage of the opportunities created by soft commodity prices. "There is a very strong and exciting exploration deal flow out there in which we're in the middle," Rose says. "I'm surprised at the opportunities that are available. We're going to end up doing more, and more quickly, than I originally thought." While Rose is new to private financing, former Anderson executives Larry Macdonald and Alan Archibald have already ridden the pony. They sold gas-focused Westpoint Energy Inc. in the spring of 2000 to Alberta Energy for C$8 per share, giving their backers a sevenfold return on their investment. Shortly before the sale, the company talked to brokers about a financing that would have netted C$3 per share, amply demonstrating the significant difference between the two markets. "It was much better to sell the company but, at the same time, it's tough to sell a company because you fall in love with the assets," says Macdonald. "The assets have to some upside-otherwise, why else would somebody be interested in buying them?" After taking time off to enjoy golf, the duo raised C$26 million a year ago for Pointwest Energy Inc., currently producing about 500 barrels of oil equivalent per day. Not everyone is going private. Dave Johnson and several key members of Encal Energy Ltd.-bought for US$870 million in early 2001 by Calpine Corp.-have taken the reins at Progress Energy Ltd. Don Archibald and other Cypress Energy Inc. veterans are running Argonauts Group Ltd. The company in late January bought Chain Energy Corp. for about C$25 million. Cypress was acquired just over a year ago by PrimeWest Energy Trust for US$419 million. Private v. public An attitude of "been there, done that, got the T-shirt" might best describe the reluctance of many experienced executives to return to the public arena. "On balance, I'd personally say I'm having more fun," Kay says. "We have more control and we're not subject to the whims of capital markets on a day-to-day basis. The last number of years it hasn't been fun to be a junior Canadian public energy company because many companies below the senior level attracted very low trading multiples, hence low share prices, which made it difficult to grow the business." Less disclosure, for competitive and cost reasons, is a key advantage of staying out of the public eye, several officials say. Tougher accounting and disclosure regulations sure to follow Enron's debacle will only increase these reasons, says Macdonald, Pointwest chief executive. Stress is less because Street expectations no longer drive decisions. "We don't worry about the market. We don't know what the spot price of gas was today, but if you're a CEO of a public company you'd better know because analysts are going to be phoning to talk about it," he says. "Mother Nature can be very mean, but we don't need to worry about keeping the Street happy." Bill Davis, former chief executive of Search Energy Inc., says he won't miss some aspects of his previous experience. There's no going on the road to meet with investors and analysts, less time is spent on annual reports and there is less worry about saying something that might violate fair disclosure laws. "The nature of my job as a chief executive officer of a private company is distinctly different from the nature of my job as a CEO of a public company," he says. "The nature of my business now will be closer to the things that I do enjoy, although I enjoyed some of the other work. But because those tasks aren't required of me, I will be devoting more of myself to the basic parts of the business." He also thinks he'll be able to generate better returns by being able to make countercyclical deals, such as selling assets when prices are high, without worrying about being punished by the investing public. The downside of avoiding an exchange listing could come in the war for midlevel professional talent, where the liquidity of stock options for public companies may be a recruiting and retention advantage. Davis, who formed Sine Energy Inc. in late December after raising C$21 million, says operating in the private sphere requires some adjustments to attitudes and business practices. "I keep a little note in my desk so that when I open the drawer it says: 'Behave like a private company,'" he explains. "I look at it to remind myself that I don't need to overcapitalize my projects just to grow cash flow. It's just a tweak rather than a major change." Others intend to apply different lessons from their time at public firms. Duvernay insiders, for example, control more than 50% of the firm's shares as a result of their experience at Berkley. Many of the new private producers use outside auditors and engineers to produce financial and reserve reports. Archibald, the president of Pointwest, says the need for capital discipline, such as daily updates on spending, remains constant for small firms regardless of their financial background. "If you're relying on your accounting systems, then you're going to be three or four months behind your actual expenditures. If you're drilling a dozen wells over the winter, you can get your spending well ahead of yourself especially if prices drop. We've seen a lot of public companies, and I'm sure there are a lot of private companies in the same situation, where all of sudden their debt-to-cash-flow ratios are quite large." Private money The stampede to private money reflects a major shift in capital markets, says Tristone's Gosbee. During 1993-97, a heady time when dozens of juniors went public in Canada, a company could get six or seven times cash flow for its assets with an IPO. Well-publicized flameouts of once-respected juniors, such as Blue Range Resource Corp., Merit Energy Ltd. and Probe Exploration Inc., in the late 1990s and a flight by investors to larger stocks compressed the cash flow multiple to less than three. "The cost of capital actually got cheaper last year for private companies for the first time," he says. "And you also had a willingness and tremendous amount of good management teams willing to go into private companies. It was a complete synchronicity of events." The explosion in private companies partially results from an increased level of wealth and sophistication in Calgary. Many people in Cowtown did well speculating which firm would be taken over, giving them the wherewithal to back teams that made money for them in the past. Another change is increased alignment between founders and investors. A decade ago, Gosbee explains, founding executives might be given shares for 10 cents while the initial public offering was priced at $1. The situation rewarded a successful IPO and negated pressure to generate good earnings for investors. "Management now is willing to go shoulder-to-shoulder with institutional capital, earning on the back end through performance shares," he says. "This way they can get four or five key institutions with big, deep pockets so it's a very strategic shareholder base and [executives] are focusing on rates of return for the first time in the oil and gas business, not quarter-over-quarter cash flow growth." Pointwest's Archibald says private companies can pick their shareholders to ensure shared vision, eliminating conflict that sometimes arises when investors in public producers have different agendas. "I think they are a lot more forgiving if you stub your toe. If you're a public company, you keep the Street happy. If you're a private company, you keep your shareholders happy." Sine's Davis says a small but supportive group of shareholders lets a company be more strategic, like buying land in Alberta when it is cheap, since there is less pressure to constantly grow daily production and cash flow. It can also lead to another advantage, speed, since just a few calls can line up funds for an unexpected acquisition or joint-drilling venture. Private investors expect compounded annual returns of 15% to 35%. The hurdle initially seems high, Davis says, but analysis of financial results shows the teams attracting funding have cleared similar benchmarks in the past. However, the money won't come unless the firm has strong directors. Executives also need to have a significant portion of their own net worth tied up in the venture, many players say. "They're looking for everyone to be pulling on the oars together," says Kay of Segue. "They want people to be meaningfully invested, that means it's going to hurt you if you mess up. We don't get rich on the salaries here. We're working hard to add value to the shares to create wealth." Estimates of the number of new private companies vary, but most observers peg it at about 25. Most believe the wave has crested and few other private producers will be created. "There have been a lot of deals done but I think they will be increasingly hard to do," says Kay, whose firm employs 10 people. "I think most of the management teams that were bought out are back now from summer vacation and have done their deals so there is less to do in that regard." The future of the new private companies is a big unknown. While private money is patient, just about everyone has an exit strategy as part of the business plan. The idea of building a company from scratch into a major producer, perhaps emulating the success of Canadian Natural Resources Ltd., is almost as dead as Enron's good reputation. The change results from several factors. • Increased maturity of the Western Canada Sedimentary Basin means less opportunity for growth than in previous decades. Trying to expand output, especially with annual decline rates for new wells averaging at least 20%, past 10,000 barrels of oil equivalent per day, is becoming more difficult. • Higher recognition by investors of where true value is created is another part of the evolution, Gosbee says. "When you start small, growing production from zero to 5,000 barrels of oil equivalent per day, that is where there are the most lucrative rates of return in the Canadian oil and gas business." Selling assets or the whole company to the growing royalty-trust sector is one potential exit strategy. Royalty trusts have been eager acquirers of entire companies during the past two years. Cabre, for example, was purchased for C$310 million in late 2000 by EnerMark Income Fund, which has since been folded into Enerplus Resources Fund. With a tax-advantaged structure and a wide popularity with retail investors, Canadian royalty trusts have been willing to pay up for long-lived producing assets. They often spin out higher-risk properties to a new company run by the target's former management. "It is somewhat comforting to know that there is a vibrant, growing trust market out there which will always be driven to acquire good-quality assets," Kay says. But Gosbee predicts many of the private firms will eventually go public, via IPOs or by mergers and takeovers of existing companies. He believes public markets will start to pony up for growing producers, partially because Canadian law limits foreign investments by pension and mutual funds to 30%. This means institutional money managers have to play Canadian energy stocks. The risk of owning just a couple of producers, raising the potential for poor portfolio performance if one stumbles (painfully demonstrated by the crash of Canadian IT giant Nortel Networks Corp.) gives investment professionals incentive to look for new juniors and intermediates. With billions of producing properties in Canada on the auction block as acquisitors try to cut bloated debt levels, well-capitalized, smaller companies-public and private-are ideally positioned to grow. "There is going to be a great return to the junior oil and gas sector in Canada," Gosbee says. "I think we'll see it once we start inching up and see an expansion in the trading multiple to five or six times current year's cash flow." Kay believes five years, about enough time to go through two commodity cycles, will likely be the lifespan of many of the private companies. Davis has a slightly different view on how to accomplish the "liquidity event" private investors demand. "I think it's more of a cycle-time thing," he says. "When the cycle is showing it's frothy and buyers are very enthusiastic, that's a good time to sell whether you've reached a numerical objective or not." For his part, Rose of Duvernay does not rule out a return to the more familiar side of the energy industry. He says the size of capital pools available to private companies in Canada remains a big unknown, meaning the next round of the company's growth may depend on public support. Rose points to the Ladyfern gas field in northeastern British Columbia as an example of the potential for big finds held by deeper formations such as the Slave Point. Such discoveries will help pique interest in smaller companies. "Being private is especially conducive to exploration-focused companies like Duvernay. It gives you the time-frame you need to pursue the areas you want, build your inventory patiently and make the best deals you can. While you're always concerned about performance, getting that two- or three-year front end means you don't have to answer to a quarterly production volume." Duvernay currently produces about 1,100 barrels of oil equivalent per day after swapping some of its equity for producing assets and land in British Columbia. While Rose, Kay and others are heading young companies, private companies are not new in Canada. Calgary's wealthy Mannix family, for example, owned Pembina Corp. It produced about 11,500 barrels of oil and 100 million cubic feet of gas per day just before it was sold to Talisman Energy Inc. in 1997 for C$501 million. However, this cycle is allowing more people, either directly or through managed funds, to participate in the game. If even half of the 25 companies eventually go public, there will be a much-needed restocking of the junior and intermediate ranks in Canada. The ability of private firms to focus on exploration projects with longer lead times could also result in new fields, helping maintain the productivity of the western Canadian petroleum industry.