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Nickle's Daily Oil Bulletin -- 3 March 2006

COSCO Returns With Calgary Private Capital Conference

COSCO Capital Management LLC is bringing its Private Capital for Energy Forum (www.coscocap.com) to the Westin on Tuesday, March 7. The Bulletin conducted an e-mail interview with COSCO founder Cameron O. Smith, a long-time fixture on the Calgary energy scene, from his Park Avenue office to discuss the role of private investment in Canadian oil and gas companies.

DOB: You’re bringing your annual conference back to Calgary after skipping last year, what gives?

COS: As to our missing last year, we made a strategic decision to switch to a bi-annual format for the Forum, rather than annual, because, frankly, we were exhausted. We have been incredibly busy, in both the U.S. and Canada, over the past 18 months, closing 16 financings for over $600 million (U.S.), roughly half the financings and a third of the capital dedicated to Canadian companies. It also takes far greater effort in Calgary than in the U.S. to carry off a successful Forum on this subject, partly due to their respective positions in the evolution of private capital and partly due in Canada to your institutional indoctrination that the public market is the sole legitimate source of growth capital. We decided that the better response would be simply to do as many successful private equity financings as we could, and then come back every other year with a growing cadre of successful examples on which to draw.

DOB: What can attendees expect?

COS: On Tuesday, we have arranged for 14 private capital sources (four from Calgary) and four juniors who have raised $130 million from one or more of them to assemble on various panels to discuss what private capital is all about, what it looks for in a candidate, what it’s like to live with in terms of governance and operational interference, and how it rewards management, all with an implicit contrast to the public markets. All told, these sources have available approximately $12 billion to invest in the energy business, most in the form of “lines of equity,” which are drawn down, if and when needed and as approved by the companies’ boards of directors. In 2005, these sources reported investing over $3 billion in 150+ financings.

DOB: How is the private capital scene in Canada different that is was 12 or even 18 months ago?

COS: There are many new sources of private capital that have been founded in Calgary over this period, and the couple that were active before then have far more capital available today than ever before. This is also true of the U.S. private capital community. The closed-end capital funds have doubled in number and size over the past couple years, and they are seeing ever greater competition from each other and from open-end (hedge and mutual fund) sources, which have discovered energy with a vengeance. As a consequence, the managers of all these funds are receptive to expanding their search and investment options into Canada, giving COSCO with its cross-border presence real opportunity to match appropriate capital with worthy opportunity.

And speaking of opportunity, the rise in commodity prices has ramped up M&A activity, with many managers of successful companies, public and private, alike, electing to sell. These managers often then restart as heads of their own companies, which, for various reasons, they frequently want to keep private, thus constantly creating attractive new investment opportunities for the professional Private Capital investor.

DOB: Is there such a thing as a "secular bull market" and are we in it?

COS: There seems to be pretty strong consensus we are in a secular bull market and that the only way it would likely be interrupted, like at the end of 1997, would be by a recession leading to demand destruction, which would be tough on all asset classes - not just oil and gas. So, on a relative basis, oil and gas investments might still be the best place to be, even in a cyclical bear market, assuming one did not have to sell. This is, however, one of the greatest distinctions between the private and public investing communities: the public investor flees the market as soon as prices (or any news, fact of fiction) turn contrary. The private investor, on the other hand, sees contrary news, particularly in the macros, as opportunity, giving him the chance to get far greater advantage for his dollars by buying low, building, and then selling during the next bull cycle.

DOB: How will we know we’re at the peak?

COS: The last two cycles I picked by watching when the airlines scheduled non-stop round-trip flights from New York to Calgary. The local Ferrari dealerships are also pretty strong lead indicators.

DOB: With public markets up something like 100% last year (Canadian oils were some of the best performers on the planet), how does private capital compete when stock markets are giving away free money?

COS: Private capital doesn't compete with the public markets when they're in full run. It takes advantage of "free money" by exiting into it or leveraging with it. Free money, if and when it ever exists, doesn't stay that way for long. Witness the current state of public financings in Canada. Entrepreneurs may get one or two shots at raising capital in a hot public market, but where does that leave them? They then have to perform, and when capital is turned into production and revenues, reality returns to the market and prices trend to standard measures, with investors increasingly disillusioned and cranky. The only time that the price of one's stock counts is when one sells. If managers can't sell their founders' or optioned stock, why feel good about it? They can't bring in new managers, because the price of new options so far exceeds value that anyone with sense recognizes the charade. It's a cruel treadmill the public manager is on, and his only hope is that someone will run him down before the treadmill stops. Private capital, on the other hand, takes responsibility for its decision to invest. It recognizes the time frame required to achieve whatever business plan it has bought into, and it is alert to take advantage of temporary anomalies and/or has the capacity to wait them out. Finally, managers in private equity financed companies are compensated through participation in the profits recognized at the end of the day, when it counts, and the more of their investors' capital they use well, the greater is their personal payday.

DOB: How does private capital identify opportunities in a high market cycle?

COS: Private capital invests whether prices and public markets are up or down. In periods of strong prices and bull public markets, it tends concentrate somewhat more on selling its portfolio companies than when the prices are low, and, conversely, when prices are low, it tends to be far more focused on putting capital into the hands of its existing or new portfolio managers, recognizing that's when it can get greatest "bang" for its buck. In bull markets, private capital looks for entrepreneurs with strong track records creating value, particularly with the drill bit, rather than acquisitions, and backs start-ups rather than growth opportunities, both so that a significant amount of its capital is not exposed to price risk. That said, given the growth of hedging, even acquisitions can be justified, if appropriate precautions have been taken into consideration to protect an adequate return. And, finally, this marriage of private capital and start-up is particularly fortuitous, as the time frames tend to be longer and the road bumpier and less obvious, than the public markets find comfortable, unless they are so blinded by star quality that the initial financing can provide all the funding required for a start-up to reach its maturity.

DOB: Any examples specific to Canada?

COS: There are many examples of private equity activity in Canada over the past couple years. In terms of investment, COSCO, alone, has arranged financing for Stratagem, Ausam, Bunker, Energy 51, Onefour, and Action Energy, to name a few. In almost every case, the use of capital has been to drill out development locations and prospects, many of which included significant risk. On the sell side, both U.S. purchases by EnerPlus of Breitburn and Sleeping Giant/Lyco were private capital exits, as was Stratagem's sale to Sabretooth. Deer Creek's IPO and then its sale to Total and MEG's sale of a partial interest to CNOOC are also great examples of private capital taking advantage of the public markets and strategic buyers to monetize or reduce their average costs of capital.

DOB: What are the advantages of going the private capital route as opposed to public equity or even debt (assuming interest rates stay low)?

COS: Private capital is far better suited to start-ups than the public markets because start-ups, far more than established companies, experience surprises and require time to mature, which private capital, having made an active decision to invest, based on full investigation of the people and the plan, is far better positioned to weather, even to support, than the public, which has no conviction in the macros, let alone a specific company. Furthermore, most start-ups are long on science and thin in business experience. This, by definition, is an important value-add of private capital. Lastly, most start-ups fail, not due to a dry hole or a poor business decision, but due to being undercapitalized to reach a size that can sustain internal growth. The public markets, when they're hot, will often overpay for an opportunity to invest, but if a management does not get enough capital right then to provide for its full needs and relies on returning to the markets for follow-on financings (the norm), their capital plans are fraught with uncertainty over which they have no control, which adds immeasurably to the risk of the enterprise. Once private capital buys in, on the other hand, it is virtually impossible to exhaust its willingness to support a positive plan, and, as indicated above, reversals in the macros are only invitations to accelerate investment. Which type of capital would you choose to partner with?

DOB: American companies still seem quite open to private capital compared to their Canadian counterparts - why? What are some of the similarities and differences between the two countries?

COS: The public markets in the U.S. progressively over the past decade have become accessible only to companies that, particularly by Canadian terms, are quite large ($500+ million), whereas in Canada, assuming it is open, the public market is remarkably efficient at raising large numbers of (very small) financings, making the public market hugely accessible to almost everyone with a friend in the brokerage community. In the U.S., perhaps as a consequence, private capital has grown up as an investment class to satisfy the needs of the start-up and smaller companies that can't reach to the public markets. With this growth has come specialization, which in the case of energy, is all the more important to permit professional investors to understand and become comfortable with Energy’s inherent risks. Thus, private capital for over two decades has matured in the U.S. as an experienced, sophisticated, therefore ever-more viable, even attractive source for financing of the energy business.

In Canada, on the other hand, only the rising cost, regulatory complexity, and fickleness of an increasingly less sophisticated investing public have started to turn the confident manager away from the Public trough. Furthermore, only just in the last couple years has Private Capital started to develop a meaningful local presence, making it more competitive and ostensibly more compatible than US Private Capital. As consequence, while public financing in Canada will hardly disappear, we do see Private Capital becoming ever more important to local entrepreneurs, particularly those for whom scale is manageable and who are not concerned with their ability to persuade knowledgeable investors, whose success is tied to theirs, to accept and support their own insights on how best to reap value from the extraordinary opportunity that Canada still affords those confident of their talents.