For an oil-sands company producing in the largest single deposit of crude oil in North America, MEG Energy Inc. has had, by some accounts, a uniquely successful run. And while it took 12 years and a bit of financial creativity to reach its current worth of nearly $10 billion, the Calgary-based company seems to have found its groove.

MEG has raised an impressive $3 billion of equity and $1 billion of debt in one of the larger private-equity financings in recent history. This is the result of good timing, improved oil-sands technology, a dedicated management team, and patient investors who stayed true to their thesis. MEG went public in 2010, and with its new access to capital is positioning to grow production from more than 25,000 barrels per day to more than 260,000 per day—and in less time than it took to reach that first 25,000-per-day mark.

Early private-equity investments by Warburg Pincus LLC and Chinese National Offshore Oil Co. (CNOOC) crystallized over the course of several years. Warburg Pincus’ investment of a combined $450 million over that time and CNOOC’s $150-million investment in 2005 made possible the company’s core project and ability to produce oil beyond nameplate capacity. As a result, MEG has been described as one of the biggest successes in the thermal oil-sands sector.

Chairman, president and chief executive William McCaffrey has maintained MEG Energy Inc.’s liquidity while using diverse sources to fund the oil-sands producer’s growth through the cycles.

Indeed, it has come a long way since 1999, when co-founders Bill McCaffrey, Steve Turner and Dave Wizinsky used their own capital to lease half of the Christina Lake area in northern Alberta’s oil-sands region. Oil was $12 a barrel at the time, and some economists suggested it could go lower. The group’s first raise, from friends and family, brought in a few million dollars for acquisitions and to delineate some of the resource with cores and seismic data. MEG now has a cadre of 30 high-quality investors.

“If we were doing this in the public market,” says chairman, president and chief executive McCaffrey, ”it would have been very difficult.” He credits private-equity investors for having the patience and temperament to remain involved over a long time frame and through the cycles. “All money is not created equal,” he says.

However, correctly aligned investors are not the only factor necessary for success.

Also key are a quality resource, a blue-chip investment group and strong management. Still, MEG’s case speaks volumes about the value that private equity provides.

SAGD arrives

Private-equity players like Warburg Pincus were watching oil-sands projects from afar at the time of MEG’s formation, waiting for a compelling development. Steam-assisted gravity drainage (SAGD) was beginning to be deployed, but as it was a relatively new process, time would pass before investors would be comfortable with it.

“We watched mining developments, but couldn’t find an attractive way to play,” says Peter Kagan, managing director of Warburg Pincus’ energy team in New York. “As technology advanced, we got comfortable with SAGD.”

Before SAGD, in-situ projects were based on cyclic steaming technology, which delivered less attractive results. An underground test facility ended up proving the newer SAGD technology was an effective and credible way to monetize oil sands. Also, SAGD had a more benign environmental impact than previous methods.

“Oil was at $21 per barrel at the time, and MEG showed returns all the way down to $18 per barrel” during its presentation, says David Krieger, a Warburg Pincus managing director.

The SAGD process involves drilling two horizontal wells into the resource, several meters apart. The upper bore is filled with steam, heating up the bitumen and causing the viscos- ity of the oil to drop, allowing it to flow into the lower bore. The lower well is the producer, bringing oil to the surface. The recovery factor is around 60% of oil in place, besting cyclic steaming by a wide margin in a well-suited formation.

Before the Warburg Pincus team committed funds to MEG, Kagan and his partners had been proactively thinking about SAGD. Also, they had worked alongside McCaffrey in the past.

In late 2003, McCaffrey again visited them, making a presentation that Kagan and fellow Warburg Pincus managing director David Krieger cite as one of the best and most complete they have ever seen. The two also point out that MEG’s strategy has remained consistent with that original presentation. Having studied oil sands, Kagan and Krieger were familiar with other early-stage mining projects developed in the mid- to late 1990s.

“It (MEG) is the first SAGD project to consistently produce above nameplate, in addition to being the fastest ramp-up of any SAGD project of any substantial size,” says Michael Dunn, an analyst with Canadian investment dealer FirstEnergy Capital Corp. MEG’s most recent quarterly report supports Dunn’s assertion: bitumen production is 27,826 barrels per day from a facility designed for 25,000. That is a feat, says Dunn, which puts MEG in a great position to continue expanding production.

Maturing technology

When Warburg Pincus began funding MEG, ConocoPhillips and Encana also had SAGD projects up and running. Seeing the industry’s progress with the technology steeled the Warburg Pincus team’s resolve.

“Oil was at $21 per barrel at the time,” says Krieger, “and MEG showed returns all the way down to $18 per barrel.” MEG’s first institutional backing came in 2003-2005, when Warburg Pincus and a Boston-based fund manager put in nearly $90 million. By 2006, Warburg Pincus and other private investors would invest another $190 million.

Additionally, CNOOC made a $150-million equity investment in MEG, the first by a Chinese institution in the Canadian oil sands. This equity jolt, which runs counter to the current joint-venture trend, made the Chinese national firm the second-largest investor in MEG behind Warburg Pincus. Their aggregate $340-million infusion funded the acquisition of more leasehold in the area and ongoing development of the 3,000-barrel-per-day Christina Lake pilot installation.

The Warburg Pincus energy team was watching mining developments, but until technology advanced and SAGD was proven, it couldn’t find an “attractive way to play,” says Peter Kagan, managing director in New York.

Two-thirds of the SAGD process’ cost structure is variable and related to commodity pricing. There are two major components. The first is diluent, which is typically one of several less-viscous hydrocarbons required to blend with bitumen to facilitate transport via pipeline. The second is natural gas, burned to make steam to heat the top wellbore of a SAGD pair of wells. As oil prices have moved, there has been some correlation between oil and diluent prices, says Kagan.

“The economics can compete at prices for West Texas Intermediate crude much lower than today,” he says. “When we first made the investment, the oil-to-gas ratio was 6- or 8-to-1. Now it is 18- or 20-to-1. That clearly benefits MEG, since gas is an input cost.” Kagan and Krieger both say the economics today are stronger than when they initially modeled the investment, but that if or when natural gas recovers, MEG and other SAGD operations should continue to generate reasonably attractive margins.

Though MEG is exposed to commodity prices in both directions, the company has not been an active hedger. Hedging is embedded in the business model, however.

“It’s something the board considers regularly. We make sure we aren’t taking on any unintended consequences or exacerbating risk by putting in hedges,” says Kagan, who is on MEG’s board, along with Krieger and a representative from CNOOC.

The company does not source its own natural gas to make steam; it relies on the well-established and proximate Western Canadian Sedimentary Basin production and infrastructure. Kagan says that market is fairly sizable and liquid, making it sufficient for MEG’s requirements. Instead, the company has mitigated energy costs by building power-cogeneration units with its facilities. Combining the generation of heat for steam and power generation offers efficiencies.

“At times during the first quarter of this year, power revenue exceeded natural gas costs,” says Dunn. He notes that power prices in Alberta have been working in MEG’s favor. In a tightening power market, some coal-fired generation has been taken off-line in the region, and energy price spikes have occurred.

Business expansion

As its pilot was being built, MEG was already thinking about the next phase of expansion. This time the company included debt funding in the mix. Prior to 2006, the Canadian debt market was lending to some projects at ratios near two times EBITDA. MEG undertook some innovative financing to secure a $750-million senior secured credit facility.

“MEG was early-stage at that time, and traditional covenants would not work,” says Kagan. Instead, what was typical of acquisition finance in March 2006 was applied to corporate finance for MEG. Some $350 million of this was a drawn seven-year term loan, but another $350 million was a delayed draw, which allowed MEG to pull funds as needed to optimize its cost of capital. The drawn and delayed-draw tranches were covenant-light, meaning MEG did not have to maintain particular financial ra- tios. The final piece was a $50-million revolver.

This debt financing was recognized by Project Finance International as North American upstream deal of the year in 2006. After the company completed the financing, it went on to raise $350 million in equity.

FirstEnergy’s Dunn notes that, even just four years ago, oil-sands projects—even SAGD—faced higher natural gas and lower oil prices. This yielded weaker netbacks.

“Suncor, PetroCanada and Encana (now Cenovus) brought on production that took capital and years to develop. They had their share of issues ramping up, and even then their net-backs didn’t look that great,” he says. But with higher oil prices and, more importantly, lower gas prices, MEG got closer to designed project capacity. That pushed the production price down and netbacks up, simultaneously.

Around the time of MEG’s pilot, the oil-sands resource play was gaining momentum. MEG recognized that there was a finite amount of quality land, and it would be advantageous to secure as much as possible to solidify its growth for the next several years. In mid-2006, the company revisited the market and raised $1.5 billion to finish construction of Phase 2, bring the nameplate capacity to 25,000 barrels per day and acquire growth areas west of Christina Lake.

“It’s just like any other E&P play; there are better spots and worse spots,” says Dunn. “MEG doesn’t have more land than most, but it does have high-quality resource—several billion barrels of it—that is economic even at today’s prices.”

Just another cycle

At the time of the global market crash in 2009, MEG was completing the start-up of Phase 2, and its management was contemplating Phase 2B—an additional 35,000 barrels per day of nameplate capacity. To do this, MEG would have to go to the market once again—this time under the worst market conditions in its history.

“In the depths of the crisis in 2009, MEG raised a billion dollars in private equity,” says Kagan. The raise was again led by Warburg Pincus. Had it not been for the capital injection that year, Kagan believes the project would have been delayed. Instead, MEG could head right into Phase 2B development.

“There will be cycles, and neither the high nor the low should create starts and stops,” says McCaffrey. “That generates huge cost exposures.“ He notes that although many private-equity firms are starting to understand this model, Warburg Pincus has earned respect for successfully investing in this fashion early on.

Canadian oil-sands producer MEG Energy Inc. has mitigated energy costs by building power-cogeneration units with its facilities.

MEG also reworked its debt agreements, levering up by $1 billion, and raising a total of just over $3 billion in private equity. With Phase 2 up and running, MEG was ready to access the public market in August 2010. The IPO on the Toronto Stock Exchange raised $750 million in gross proceeds at $35 per share. Less than a year later, the security is trading in the range of $45 to $50 per share. Post-IPO, Warburg Pincus is a 21% stakeholder in MEG, and Krieger says it is not atypical for the firm to remain invested in a venture like this for an extended period of time.

“It’s a bet on a management team’s ability to grow reserves and production better than most people. If you do that long enough, you can generate nice returns,” he says, citing the examples of Newfield Exploration Co. and Spinnaker Exploration Co., companies where Warburg Pincus has been a shareholder for as long as seven to 10 years.

In 2011, when MEG received investment-grade status, it refinanced the billion-dollar senior secured term loan, turned the $50-million revolver into an undrawn $500 million, and went to the bond market with $750 million in senior unsecured notes.

“The plan from here for the next 10 years is to grow tenfold,” Kagan says, noting that putting the foundation for the corporate financing structure in place was important to McCaffrey. “He’s managed to use leverage prudently and conservatively,” Kagan adds.

At the same time, McCaffrey has been aggressive in raising equity, which Kagan believes has been critical in de-risking the MEG story. Kagan also credits the CEO with maintaining liquidity and using diverse sources to fund growth projects.

“It’s a real success story,” says FirstEnergy’s Dunn. “Some investors think it is expensive, some think it’s a great long-term buy. We have a $55 price target on it.”

The stock has done very well year-to-date, Dunn says. “In our view, they have enough cash on the balance sheet to fully fund the next phase (2B), and they should have cash left over to fund even more expansion.” That would be Phase 3, which could also be funded through credit, and would move MEG even closer to its goal of producing 260,000 barrels per day.