By Claus Vistesen, on March 11th, 2011
I recently asked the opnion of my readers regarding the question of whether the global economy is in for inflation, deflation, or stagflation. Given the obvious issue that it may be all three at different points in time it seems as if recent market action suggests that we should be looking at the d-word.
QE1 + QE2 +…+QEn = Deflation?
Even if macro soothsayer’s favorite comparison between Japan and the US is misleading because the former has decidedly more miserable demographics than the former, it is clear that US policy makers are steering into largely uncharted waters.
Consider then Atlanta Fed President Dennis Lockhart’s recent comments before the National Association of Business Economics that the Fed would contemplate cueing in QE3 in the event that the current oil price shock proved to be more severe. On the face of it this makes sense in so far as goes the idea that the main effect from sharply rising oil price is a relapse into recession and thus deflation. Indeed, the Fed can hardly be blamed for acting in the context of events which are essentially geo-political in nature.
Yet, it is much more complicated than that.
It then stands to reason that while the Fed should certainly be forward looking in conducting policy the primary effect of ongoing measures of quantitative easing is exactly to put pressures on headline inflation and commodities in general. As I noted recently at this space;
Given that we seem to be looking at a re-run of 2008 it must be factored in that the volatility and speed (and subsequent decline) of commodity prices are a problem in itself. The famous loss function which must then be metaphorically minimised is the one which plots the trade-off between the cost of recurrent flares of commodity prices and the need to act as a counter trend to the destructive forces of a balance sheet recession. Here, it becomes a rather serious issue if one of the main collateral effects of providing buckets of liquidity is to engender strong commodity melt-ups with a subsequent deflationary outcome.
And perhaps this is what is running through the mind of Dallas Fed President Richard Fisher who, in the same picece as linked above, is quoted of voicing oppositon towards QE3 and indeed that he would like QE2 to be phased out sooner rather than later.
Which way the tide will turn at the Fed is not a trivial question. There are plenty of signs that after the SP500 having tested the 1350 level, and failed, the market is running on the evaporating fumes of QE2. As one of my many market spies noted today:
(…) it is definitely possible that the market will discount the end of QE2 ahead of time this time around. This is what happened in Japan too – the market began to rally as soon as their QE2 was announced (since it had rallied smartly on QE1) , but halfway through the implementation the Nikkei began to fall, ultimately losing 45% from the interim peak and ending below the level of the day QE2 was announced. Mind, I’m not saying it will play out in the exact same manner, this is just to point out that there can be leads and lags between QE and its effect on the stock market – the QE1 experience is not necessarily a road map that needs to be repeated.
Again, we have that comparison with Japan which is then only to say that repetitions in the market rarely occur the way you expect them to, but there is definitely an unwinding narrative emerging. Team Macro Man gives their list of bearish omens today and I find it difficult disagreeing with them on the general idea that the reflation trade might be in for a stutter; at least until the next round of QE.
To their list I would add that another favorite punt of the reflationistas, gold, is finding it mightly difficult to reach new highs above the 1420s (today, Thursday, getting a right beating back to 1405ish). Now, we should always remember that the market can move three ways, where sideways is the third. Yet, the fundamentals of the gold trade kind of black or write so the ongoing difficulty reaching new highs will be rightly worrying the g-bugs.
More generally however the SP500 is only now coming down to the 50dma (at pixel time) and I would wait to see whether it forcefully breaches that level before putting on the tin foil hat.
(click image for better viewing)
As you can see dear reader, the chart is telling you to buy the dip, but chartism on such short time scales can make plenty of widows too, so be careful out there.
Looking into the rearview mirror at the ECB
I wasn’t really sure whether to cry or laugh last week when Trichet mounted himself in front of the microphones to deliver an almost sure signal of future rate increases by invoking the idea of strong vigilance. Indeed, the ECB let it be known that it was perfectly possible that their April meeting would be accompanied by a rate increase. Game set and match then!
As I have noted before at this space, stranger things have happened than the ECB raising rates just before a global slowdown. I even ventured to call it a leading indicator. Soc Gen’s always enjoyable Albert Edwards dryly noted recently (HT: FT Alphaville); “all we need now to push the world back into the recession is an ECB rate rise.”
This seems an apt take on the situation and my good friend Edward Hugh similarly notes that all this has an alltogether well expected outcome invoking the idea of the Chronicle of a Policy Error Foretold.
Now the problem with this latest policy initiative is not only that it represents something akin to the chronicle of an early death foretold for a much troubled and highly fragile Spanish economy, where around 90 percent of mortgages are variable rate ones.
It also draws attention to an area which it would be much better for the ECB not to draw attention to at this delicate moment in its history: the convenience of having a single-size monetary policy applied to such a diverse group of economies.
I heartily agree that it is due time that we, yet again, try to evaluate what it means to have a single interest policy in the eurozone. More specifically, there is the question of divergence of fortunes when it comes to deflation and inflation;
Inflation on the periphery has much more to do with rising commodity prices and the application of a misguided policy of consumption tax increases as a way of reducing fiscal deficits than ever it has to do with economic overheating.
I think it is pretty obvious that there will be no second round effects in the eurozone periphery and if the ECB is seriously suggesting this to be the case, I would dearly like to see the empirical evidence for such a claim (even a theoretical would do actually!).
Finally, we should never neglect to mention that all this might be a bluff and that the ECB like most other rational institutions can change direction based on the evidence before them. Yet, herein also lies the rub because the current vigilance comes on a backdrop which smells a lot like the last time the ECB raised only to see the deck of cards fold before their eyes. Perhaps they ought to look closer into the rear view mirror.
Random Shots indeed
The immediate conclusion here would seem to be that Trichet should get on a plane and relieve Bernanke of his post in Washington and leave the tower of Frankfurt to Benny. As FT Alphaville (see link above) quotes from Gavekal;
Since its inception, the ECB has typically been slow to cut rates (famously rising them in July 2008!) and slow to raise them. So is the fact that the ECB is now considering a tighter monetary policy before the Fed a sign that the ECB is making a mistake? Or a sign that the Fed is starting to really fall behind the curve?
I am not sure that it is either really. Core inflation in the US is still nudging down but I think that ongoing loose monetary policy will run the risk of replicating the UK more than Japan. Put differently, I think the US economy is in a position where inflation expectations might take hold which is not the case in the Eurozone periphery at large.
At the time of writing it seems an awful lot as it the deflation trade is back and thus that the market has already sucked QE2 dry and now awaits the third version. A spike in oil prices helps no-one too, but oil at current levels is not the problem, but a quick zoom to 150ish and we would have grave problems. This would then be ample catalyst for QE3 and even if this would not prevent the correction which seems evident now, it would setup another meltup in all things unprintable and risky.
We can only hope then that central banks, on either side of the pond, are taking more than random shots at our current problems.
By The Energy Report, on March 11th, 2011
 As an investment option, uranium glows brightly for Siddharth Rajeev, vice president and head of research at Fundamental Research Corp. He also favors coal and explains why size matters when it comes to potash in this exclusive interview with The Energy Report.
The Energy Report: When you last talked with The Energy Report, you were more bullish on the uranium price than any other commodity. Since then, the price of yellowcake has gone from about $50/lb. to just under $70/lb. Is there much upward momentum left in uranium?
Siddharth Rajeev: Yes, we continue to believe in the uranium story. You’re right, uranium prices have gone up significantly in the last six to eight months. But we still think there’s upside potential, mainly because the fundamentals remain very strong.
There are four reasons we believe in the uranium story: 1) Nuclear energy is a dependable and clean power source; 2) There is no direct substitute for uranium in nuclear power plants; 3) On the supply side, the primary production of uranium must increase significantly from current levels to keep up with long-term demand because the current supply deficit is met by stockpiles; and 4) Most of the new projects that we see out there are of much lower grade than the majority mines operating currently. Lower grades imply higher operating costs.
Our research indicates that the operating cost of new projects in development stages could be about $55–$60/lb. This implies that uranium prices must be significantly higher than those levels in order for the new projects to be feasible.
TER: Do you think we could see another 2007 when prices reached the $130/lb. area?
SR: We believe the market overreacted in 2007. We don’t expect prices to go that high, but we definitely see significant upside from the current price.
TER: Can you put that into more specific terms?
SR: We use a long-term price of US$80/lb. in our valuation models.
TER: What is the investment thesis for uranium juniors in light of that price environment?
SR: When uranium prices hit record highs a few years ago, most junior exploration companies raised a significant amount of capital. A lot of them cut down their spending to preserve cash when uranium prices collapsed. So, when uranium prices recovered, we started seeing many juniors with quality assets in a strong cash position. Those are the kind of companies we like.
TER: Can you give us a handful of uranium juniors with upside that you’re currently covering?
SR: Our top three favorites in the uranium sector are Strathmore Minerals Corp. (TSX:STM; OTCQX:STHJF), Mawson Resources Ltd. (TSX:MAW; OTCPK:MWSNF; Fkft:MRY) and Fission Energy Corp. (TSX.V:FIS).
Let’s start with Strathmore. The company’s advanced-stage Roca Honda project in New Mexico has a measured and indicated (M&I) and inferred resource of 33–34 million pounds (Mlb.) of uranium. And STM has a strong partner—Roca Honda is held 60% by Strathmore and 40% by Sumitomo Corp. (TKY:8053; OTCPK:SSUMF) of Japan. Management expects to put the project into production in the next two to three years. The company recently completed an internal Phase 1 feasibility study on Roca Honda. This project is considered one of the largest planned underground mines in the U.S. in 30 years. We definitely think Strathmore has a lot of upside potential from this project.
The company also has several other projects with NI 43-101-compliant and historic resource estimates. It’s in a strong cash position, with more than $20 million in working capital and has a solid management team. We have a BUY rating on STM with a fair value estimate of $2.26/share.
TER: You mentioned an internal feasibility study. Does that mean we won’t be able to see it?
SR: We might not get to see it. Feasibility is typically done by a third party. Companies generally start with an internal study and depending on those results, hire a third-party consultant to do a formal feasibility study that can be disclosed to the public.
TER: Strathmore also has the Gas Hills project in Wyoming. What is its status?
SR: STM commenced a development-drilling program at its Gas Hills project in central Wyoming with the objective to complete an NI 43-101-compliant resource, confirm and expand known areas of mineralization and advance its permit application, which is expected to be submitted in Q211.
TER: Do you think Strathmore may thin out some of those other projects?
SR: Yes, that’s highly likely. Last year, the company sold its Pine Tree-Reno Creek properties in Wyoming to Bayswater Uranium (TSX.V:BYU) for US$17.5 million (cash) and US$2.5 million (shares). In November 2010, Strathmore announced plans to sell its Juniper Ridge property in Wyoming to Crosshair Exploration & Mining Corp. (TSX:CXX). And STM has definite plans to spin out its non-core projects. We think that’s the best strategy because it gives the company more time to focus on and monetize its core projects.
TER: What do you think of the combination of STM CEO David Miller and President Steven Khan, in terms of uranium juniors?
SR: We’ve been following the STM team for several years and the management team has a great track record.
TER: You also mentioned Fission Energy, which has projects in Saskatchewan, Quebec and Peru. What’s the next step for Fission?
SR: So far, results from the Waterbury Lake project in Saskatchewan have been extremely impressive. The stock has tripled since last May, and Fission recently completed a $7.5M financing.
TER: Some of the drill results at Waterbury have hit 5%–6% uranium, which is really quite high.
SR: They are exceptionally impressive. Drilling on the J-Zone uranium discovery has continued to turn up significant intersections of high-grade uranium. The main thing we see in this project is that high-grade uranium mineralization continues to be intersected at the unconformity. That’s encouraging because mineralization at many of the major deposits in the Athabasca Basin, like Cigar Lake and McArthur River, occurs at the unconformity.
TER: The last of your top-three was Mawson Resources, which has projects in Finland, Peru and Sweden.
SR: Mawson’s main project is the Rompas Gold-Uranium project in Finland. The preliminary exploration program completed by Mawson returned extremely positive results on the grab and channel samples. Just to give you an idea, channel samples collected on the property during last year’s field exploration program gave grades of 1,424 g/t gold and 1.3% uranium over 0.95 meters, and 191 g/t gold and 0.44% of uranium over 2.05 meters. These are tremendously high numbers. From initial results, we believe Rompas has some of the highest upside potential of any early stage project under our coverage.
TER: Mawson is trading at about $1.75 right now, a bit off some price spikes as a result of those bonanza-grade samples. What’s the next step for the company? Will it be drilling soon?
SR: Mawson recently applied for a winter ground-access permit for a shallow grid-diamond drilling program.
TER: Coal is another commodity that interests you. Despite growing concerns about pollution, prices continue to climb, mostly due to increasing demand from steel plants in places like China and Korea. We’ve even seen some recent takeovers, including Walter Energy, Inc.’s (NYSE:WLT) proposed acquisition of Western Coal Corp. (TSX:WTN). What should our readers expect from the coal market through the rest of 2011?
SR: We’ve always been bullish on coal because it remains the cheapest and most-abundant fossil fuel out there, accounting for 40% of global electricity supply. Despite the move toward cleaner energy, we believe it is tough to replace coal; consequently, we do not think coal will lose its significance in the energy sector at least for the next decade or so.
TER: What’s your coal price range per ton?
SR: We use $140/ton for long-term metallurgical coal—well below the current price of $175–$180/ton.
TER: What are some small-cap, under-the-radar names in coal?
SR: One of our favorite stories is Compliance Energy Corporation (TSX.V:CEC), which is developing the Raven Coal Deposit 80 km. northwest of Nanaimo, BC. It has more than 130 million tons (Mt.) of M&I and inferred semisoft met coal. Its focus is on metallurgical coal, which has a higher value than thermal coal.
The company has very strong partners in LG and ITOCHU, which indicates that it has solid access to capital. Compliance issued a very positive prefeasibility study (PFS) in October 2010. Our valuation on the stock is $2/share; the current price is $0.35. The main reason we like this stock as an investment is because cash and marketable securities alone account for $0.25–$0.30/share. This indicates that the market value of the company’s project is just $0.05–$0.10/share, which is extremely low for an advanced-stage project like Raven.
TER: Do you mean $0.05 per ton?
SR: No. The current share price is $0.35. Cash and marketable securities alone account for $0.25–$0.30/share, which means the remaining share price of $0.05–$0.10 is the value that the market assigns to the project.
TER: Could some of that low valuation be due to development risk?
SR: Generally, projects in BC have high permitting risk. Despite the risks associated with the project, we believe a market value of $0.05–$0.10/share is extremely low for a project with positive PFS results and an expected mine life of at least 16 years.
TER: What about some other coal names?
SR: The next one I want to talk about is 49 North Resources Inc. (TSX.V:FNR). It’s Saskatchewan’s first publicly traded resource investment company, with close to $65 million in assets under management. FNR invests in early stage resource projects, including minerals, oil and gas, and its portfolio also has coal projects.
One of its top-five holdings is a coal company called Westcore Energy Ltd. (TSX.V:WTR), which is a junior explorer focused on coal in Saskatchewan and Manitoba, where it has interest in over 95,000 hectares of land. Westcore’s Black Diamond property has had four discoveries recently. FNR owns 30% of WTR’s outstanding shares. The winter drilling program that commenced in January has thus far shown encouraging results.
TER: Another major commodity in Saskatchewan is potash, which is mostly used in fertilizer and prices show no signs of retreating any time soon. Why is potash so hot right now?
SR: Obviously, with high demand for food comes high demand for fertilizers. In addition to demand, the supply side of potash is very important to look at when forecasting potash prices. Most potash deposits are highly capital intensive and need billions of dollars to be put into production. As a result, new potash supply is hard to come by. Increasing demand and the bottleneck on the supply side are the primary reasons why we like potash.
TER: Last year, BHP Billiton Ltd. (NYSE:BHP; OTCPK:BHPLF) made a bid for PotashCorp (TSX:POT; NYSE:POT) in an effort to get a stable potash supply in an increasing price environment. Potash One Inc. (TSX:KCL) was acquired by the German company, K+S Aktiengesellschaft (Fkft:SDFG.F). In the last year, some potash juniors shot up as a result of this renewed interest. What are some names you cover?
SR: Our favorite potash story is a company called Western Potash Corp. (TSX.V:WPX), based here in Vancouver. Its main project is the Milestone Project in Saskatchewan, 30 km. from Regina. The company’s exploring the potential of hosting a solution potash mine. Solution mines are significantly cheaper to develop and have lower operating costs than underground potash mines. Western Potash has a pretty advanced-stage project that turned up a positive scoping study in the second half of 2010 that suggested WPX can produce potash for at least 40 years at a rate of 2.5 Mt./year. That’s a good source of supply for any major company or country looking for a stable source of potash.
As potash projects are capital intensive, the exit strategy of most potash juniors is either to joint venture (JV) or get acquired by a major (with access to capital). The acquisitions you mentioned, made in the last year, were mainly companies with producing or advanced-stage projects. Potash juniors typically tend to be acquired when they reach the point that the economics of their projects are known. We think Western Potash is an ideal acquisition target, particularly because it is Canada’s most advanced-stage junior that has yet to be acquired.
TER: Do you have some parting thoughts on the energy markets or on the markets for energy-related commodities?
SR: We continue to have a positive outlook on uranium. We believe there are lots of opportunities in the sector—companies with quality assets and a good cash position. We are also bullish on potash. However, investors should be extra cautious when it comes to investing in very early stage potash juniors as companies have to delineate large resource estimates to cover the huge capital cost and make their projects economically feasible. Companies with advanced-stage projects and known economics have significantly lower risk.
TER: Does that wisdom stand for uranium and coal projects alike?
SR: It is more relevant for potash projects. Uranium projects are capital intensive but not nearly as much as potash projects. Coal projects are less capital intensive compared to both uranium and potash.
TER: That’s good to know, Sid. Thank you for your time.
Siddharth Rajeev joined Fundamental Research Corp. in April 2006. At FRC, he oversees the research department and also covers a broad array of companies, primarily in the energy, mining and technology sectors. Prior to FRC, Siddarth had a mix of engineering and finance experience, including corporate finance experience, at a leading investment bank in Kuwait. Sid has ranked as a four-star analyst in the energy and mining sectors by Deutsche Asset Management, a division of Deutsche Bank. Sid holds a bachelor of technology degree in electronics engineering from Cochin University of Science & Technology and an MBA in finance from The University of British Columbia. He is a CFA Charterholder and has completed studies in exploration and prospecting at the British Columbia Institute of Technology. Sid is sought by the media for commentary on the valuation of small-cap stocks and industries he covers and is a speaker at various investment conferences.
By B.P.T., on March 11th, 2011
At 8:30 AM EST, the Retail Sales report for February will be released. The consensus is that retail sales increased 1.0% from January, after a 0.3% increase last month.
At 9:55 AM EST, Consumer Sentiment for the first half of March will be announced. The consensus is that the index will be at 76.5, which would be a decline of 1 point from the level reported in the second half of last month.
At 10:00 AM EST, the Business Inventories report for January will be released. The consensus is that inventories increased 0.8% from the previous month.
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By Thomas Knapp, on March 10th, 2011
… and personally I think some corporate fortunes are going to fall hard as this “$800 tablet” trend comes to a screeching halt before it really gets started.
I almost certainly wasn’t the first blogger to discover that you can get into a decent Android tablet for less than $200, but I caught on before blowing big money, anyway.
Today, the Wall Street Journal’s Brett Arends takes notice:
A lot of people are likely to stand in line to pay $500 or more for Apple’s iPad 2 when it goes on sale Friday.
I didn’t want to spend $500 for a tablet computer. I didn’t even want to spend $400.
So instead I went online and bought a brand-new tablet for a bit less.
The cost? Less than $200 … and about 20 minutes of my time.
No kidding.
I don’t think Apple itself will come to grief. Their business model has always centered around being the fashionable high end in hardware. But Motorola and Samsung (to name two) are probably going to take big hits to their bottom lines if they’re betting big on selling tablets in the $500+ range.
A few weeks ago, I was at my local Micro Center. The managers there all recognize my family, because we’re always in there buying something (not always something new or expensive, but something). One of the managers came over to chat me up, and we talked tablets. I told him that I was waiting to see an e-reader/low-end tablet in the $100 price range, and that I expected to see truckloads of them at Micro Center when the bottom fell out.
He got a little cagey with me, and told me (quote as best I can remember) “at this point, there’s really no way of predicting Micro Center’s future with tablets.”
That statement was what motivated me, a few days later, to go ahead and jump on the Velocity Micro Cruz Reader for $120 elsewhere. And naturally, within two weeks, what do I see at Micro Center? One of my other top picks … priced to sell at $109, with an “open box” return for less than $90 (when Micro Center sees me coming, they sigh and start clearing a path to the “open box” returns area).
I suspect some corporate policy prevented that manager from giving me a wink and a nudge and saying “wait a couple of weeks and we’ll have a deal for you.” His job was to interest me in what they had in stock, at the current pricing. He didn’t push that too hard, because he’s dealt with me enough times to know I don’t work that way. Unfortunately, it probably cost him a sale.
Anyway, whether or not you heard it here first, you are hearing it here: Unless you’re an Apple cultist (NTTAWWT), don’t blow $800, or even $500, on a tablet. Chances are you can find one that does everything you really want to do for less than $200, maybe even less than $100.
By Doug Gentry, on March 10th, 2011
Today, in a setting entirely removed from my economics class, I used the phrase, “there’s no such thing as a free lunch.” Someone called me on it, and – full confession – I was sloppy in invoking it. That said, the rest of the challenge got me to thinking about the phrase and its application.
 photo credit to Xavier Encinas on Flickr Milton Friedman used it as the title of a book. Wikipedia reports a varied and uncertain past for the phrase. As economists we look at the statement as rather obvious – converting negatives to positives – everything has a cost. Classical economics begins with the idea that there are scarce resources that help improve our lives or our country or the globe and that those resources are insufficient to meet all of our needs – hence the adjective scarce. There are fresh, new discussions on the possible inadequacies of this foundation principle in classical economics, but I believe it serves us well.
My challenger listed several examples of “free lunch”, including open source software and Google services. So do these examples provide a robust exception to the No Free Lunch proposal? I say “no.”
Every choice we make involves opportunity cost. When I choose an object or an activity that has no monetary price I am still choosing it over something else. If I choose to download OpenOffice, supported now by the Oracle Corporation, I devote some additional room on my hard drive to the application, which could have been used for something else. I start using this to compose or read documents, instead of using a commercial product like Microsoft Office. Choosing OpenOffice means giving up some features or other characteristics of Microsoft Office that I might value.
Signing up for a Gmail account is also free – price wise. Still I devote precious time to setting it up – time I could have used for other pursuits. And I adapt to the idiosyncrasies of Gmail, giving up features I might have enjoyed with my Mac Mail application or features that Yahoo provides.
So, yes, daggummit, everything has a cost and there is no free lunch. The moral of the story is to remember that costs involve more than money or prices, and that opportunity costs are often the most important costs to consider.
By B.P.T., on March 10th, 2011
At 8:30 AM EST, the U.S. government will release its weekly Jobless Claims report. The consensus is that there were 385,000 new jobless claims last week, which would would be 17,000 more than the number released last week.
Also at 8:30 AM EST, the International Trade report for January will be released. The consensus is a deficit of $41.0 billion, which would be $0.4 billion more than December.
At 10:00 AM EST, the Quarterly Services Survey will be released, showing the status of the information and technology-related service industries.
At 10:30 AM EST, the weekly Energy Information Administration Natural Gas Report will be released, giving an update on natural gas inventories in the United States.
At 2:00 PM EST, the Treasury budget for February will be released. The consensus is a deficit of $60 billion, which is larger than the historical average, and about $17.4 billion more than last February .
At 4:30 PM EST, the Federal Reserve will release its Money Supply report, showing the amount of liquidity available in the U.S. economy.
Also at 4:30 PM EST, the Federal Reserve will release its Balance Sheet report, showing the amount of liquidity the Fed has injected into the economy by adding or removing reserves.
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By Christopher Briem, on March 9th, 2011
Local government wonks should not miss the NY Times magazine’s ominous look at the fiscal crisis going on in governments across the nation: Broke Town, USA.
There is an obligatory mention of pseudo-bankrupt Harrisburg in there, but the more explicit talk over what the continuing Chapter 9 bankruptcy of Vallejo, California means. The scary thing remains that no matter how we want to look at it, the fiscal state of the city of Pittsburgh is far worse off than Vallejo ever was, is, or will be well into the immediate future.
But on the topic of local governments everywhere, and while we are awaiting the deluge of census data for Pennsylvania to be dumped.. here is something fun. Analogous to the graphic I did for Pennsylvania, below is what the same thing looks for the entire nation. All the governments in the United States. Roughly 90,000 in all. Again scaled by the number of full time workers employed by each. The low res version below can’t begin to come across; you can download the full PDF file which has much better resolution. Warning it’s a 50mb file in itself.
By The Energy Report, on March 9th, 2011
Over the last decade, more and more North American onshore oil and gas (O&G) production has come from past-producing deposits and shale. In this exclusive interview with The Energy Report, Wellington West Capital Oil and Gas Analyst Kevin Shaw talks about the technology behind this shift and how it’s affecting sector plays domestically. He also discusses what’s happening on the international circuit as North American E&P companies take their newfound know-how and multistage horizontal fracing expertise to new oil and gas hotspots in places like Argentina, Europe and New Zealand.
The Energy Report: Technology is changing the exploration landscape. It has enabled companies to reach untapped oil and gas in what were previously considered non-economical parts of many conventional producing reservoirs and to enter into many unconventional shale plays. How is this changing the game for North American exploration and production (E&P) companies?
Kevin Shaw: What’s old is new in terms of those existing pools, especially in the Western Canadian Basin. It’s all about going into poor-quality rock, which over the last 30 years typically would have been uneconomic to drill vertically. Horizontal drilling can open up more reservoir rock, connect the wellbore to more reservoirs, go into tighter sands with multistage fracture completions and increase recovery factors to increase reserves and production within the Western Canadian Basin. With multistage fracs, what was old once is now new, and it’s really revitalized the industry.
The use of horizontals started largely in the southeast Saskatchewan Bakken play, which translated down to North Dakota, and also moved into the U.S. shale plays (Marcellus, Eagle Ford, etc.) and the Canadian Montney formations on the gas side. Now horizontal multistage fracs are being utilized in a big way in both the Cardium and the Viking oil resource plays. The Beaverhill Lake is another zone coming into play, and there are several other zones of interest. In the Cardium, for example, they’re now extending lateral lengths of horizontals, putting in more fracs and getting better production and well results month-to-month out of the gate, as well as getting more reserves booked to each well they drill. This has changed rapidly over the last 12 months.
So it’s game on in a big way for technology; it’s game on for many of the older pools that had been considered depleted. And it’s an evolving space, with a lot of technology that keeps changing all the time. Companies are even starting to use horizontal frac technology with conventional pools to increase recovery factors and production reserves. The game has changed in a big way over the last few years. It’s great for service companies as well as E&Ps. Well by well, pool by pool, production rates are being enhanced in most new plays.
TER: Competition for drilling-related services drove costs up about 16% in 2010, and costs are expected to continue rising at least through the first half of 2011. How is this affecting these companies?
KS: As you say, the market for drilling rigs is tighter, but the big bottleneck is fracing, due to the boom in the application of the technology. A lot of the frac systems and fracing units need a lot of equipment and a lot of horsepower for big multistage fracs. The competition for that is intense, with waiting lists on both sides of the border in most key plays. That definitely gives the service companies pricing power. In fact, service costs are likely to continue to trend higher, which will lower netbacks unless oil prices continue to rise alongside increased development costs.
TER: So are you looking at companies with higher margins to compensate for rising costs?
KS: I like to look for companies that can put drilling programs together for an “assembly-line” approach to drilling horizontals in relatively close proximity to one another. These companies would have large acreage positions concentrated in the right neighborhoods. Bellatrix Exploration Ltd. (TSX:BXE), for example, which is an emerging mid-cap producer in and around 10,000 to 11,000 barrels of oil equivalent (BOE)-per-day, has a dominant position in the Cardium oil fairway.
It’s been hugely successful over the last year-plus with a focused effort on both the Cardium and the Notikewin resource plays. Its acreage is such that it has about six rigs running currently—four operated and two non-operated—and Bellatrix is able to repeat by drilling horizontal after horizontal from a combination of pads, or close proximity rig moves. Even with increasing service company prices, Bellatrix is able to lower costs by being more efficient at shorter rig moves, building efficiencies into facilities or pipeline infrastructure and being strategic in planning its program. Not all companies can do this because they don’t necessarily have large acreage blocks in the areas where they need to be drilling. Bellatrix is definitely one that can do that and is expected to continue to perform well throughout 2011.
TER: As of early January, you had a target price of $6.50 on Bellatrix.
KS: We have a $7.50 target and a Strong Buy rating, with Bellatrix a continued 2011 “Domestic E&P” top pick.
TER: Is that based on oil prices?
KS: Our recent target shift upwards was based on Bellatrix’s latest reserves report. We were modeling proven and probable (2P) reserves of 31 million BOE. They hit 40 million-plus BOE, definitely driven by the Cardium and the Notikewin Zone horizontal development plays. Bellatrix posted great results, one of the best domestic energy companies in the business today in terms of investing in both the near and long term, and arguably in two of the hottest plays in western Canada. As the company continues to invest capital into horizontal “manufacturing” in the Cardium and Notikewin, there is solid upside year over year.
TER: Any others?
KS: SkyWest Energy Corp. (TSX.V:SKW) is a pure-play Cardium small cap, 100% focused in the Cardium, and it hit an exit rate of 2,000 BOE-per-day last December. This company has been around only for a short time, inside a year.
TER: Not bad production for a start-up.
KS: It’s ramped up very quickly. Starting at around 350 BOE-per-day, it’s built its Cardium acreage from about 11 to 40-plus net sections. SkyWest is drilling with one rig, horizontal after horizontal, and has been successful out of the gate. It’s in one of the sweet spots in the play, alongside Bellatrix and others in the Williston Green and South Pembina areas. It’s definitely one of the top-performing areas in the Cardium, with wells that have anywhere between 300 to 3,000 BOE-per-day in terms of initial production rates.
The nice thing about SkyWest’s valuation is that it’s reasonably priced on a flowing BOE and in my opinion, continues to be a favorable “takeout” candidate in the near term. Depending on the timing, with every well they drill, they get more expensive to take out. In the meantime, it’s a nice pure play call if you want exposure to the Cardium.
TER: In addition to all of the action in Canada, one of your research reports compared Argentina favorably with Colombia and stated that Argentina could be the next hot market for oil and gas. Can you tell us about that?
KS: Yes. Argentina is one of the next potential hot beds on the international circuit right now, sitting on a huge untapped conventional reservoirs and massive upside potential in unconventional shale plays for both gas and oil. It’s really largely been underexploited, and the large companies—the majors around the world—have not really gone after them as of yet until now.
Historically, foreign direct investment in Argentina had been suppressed by government-controlled pricing caps in a lot of the gas production agreements. Of late, a couple of noteworthy things are happening on the macro side in Argentina, which is a net importer of gas. In the last several years, Argentina has sold gas domestically anywhere from $0.50 to $2 per million cubic feet (MCF), yet paying about $9 per MCF to import LNG from places like Bolivia. It’s an unsustainable situation.
And Argentina controlled oil pricing, too. Those controls have been easing, and we’re now seeing some higher realized sale prices on oil of $52/barrel and more. In addition, the government now gives exporters that are currently in the country an incentive tax credit that tacks another $5 to $11/barrel on top of those prices. So netbacks on Argentina’s oil are now on par with the average in Canada. Some of the other operating costs in the country are low, and royalties are also low compared to other countries.
A lot of positive things are happening in Argentina. For example, they used to sell all their gas at around $2 per MCF. They have now approved contracts for unconventional and tight gas plays to go to $5 and $6 and more per MCF, which is huge. As a net importer, they have a situation they’re trying to address; they have to spark more foreign direct investment, which also involves encouraging companies that are already in-country to ramp up activities. It’s a win-win for Argentina, for the government and for the operators.
TER: What are some companies with favorable gas and oil exploration blocks there?
KS: Over the last three or four months, Apache Corporation (NYSE:APA) has ramped up activities in a big way. Repsol-YPF S.A. (OTCPK:REPYY) and Pan American Energy [privately owned] are big players in Argentina but of late, Exxon Mobil Corp. (NYSE:XOM) and Total (NYSE:TOT) have entered the space along with Petrobras (NYSE:PBR). They’re not only focusing on conventional O&G exploration and development but also heavily on the unconventional side for both gas and oil, and starting to apply horizontal multistage frac technology through Halliburton Co. (NYSE:HAL), the BJ Services Company, which is now part of Baker Hughes Inc. (NYSE:BHI), and others. Unconventional shale plays in Argentina have the potential for 200+ trillion cubic feet (TCF) on the gas side alone and are just starting to be tested with horizontal technology.
YPF, for example, announced in December a new shale gas discovery of approximately 4.5 TCF in one of the big predominant zones of interest, the Vaca Muerta Shale zone. That was just one discovery YPF has delineated and announced; many others throughout the Argentina basins could be brought to light through exploration and delineation of this widespread shale. A second potential prolific shale zone is the Molles Formation, which has huge potential like the Vaca Muerta in Argentina.
The majors are going there for a reason. They can make an awful lot of money at $5 to $6 per MCF—actually, there’s more money in gas in Argentina than in North America currently.
TER: How about some smaller players?
KS: One of the small caps is Madalena Ventures Inc. (TSX.V:MVN), which is partnered with Apache drilling an unconventional play on one block. In partnership with another key company, Apco Oil & Gas International Inc. (NASDAQ:APAGF), Madalena will be drilling some unconventional shale oil and gas. As well, Madalena is drilling a number of high-impact targets with potential recovery of 60 million to 70 million barrels on the conventional oil side. Madalena will be doing three to four potentially game-changing wells over the next two or three months. One of those has to hit to drive the company forward, but it has enough optionality to make a very interesting story. So, lots going on with Madalena.
TER: Any others you’d like to talk about?
KS: Crown Point Ventures Ltd. (TSX.V:CWV) has just come to the table over the last 12 months in Argentina. It has a market cap of just over $75 million. In a very short period of time, Crown Point has put together four key blocks and is spudding a drilling program within a week or so, focused on low- to medium-risk conventional oil development to ramp production and cashflow.
Crown Point also has solid management, similar to Madalena. Based in Calgary, Crown Point is headed by Murray McCartney, who has teamed up with Mateo Turic in Argentina to run the operations there. Mateo Turic headed YPF’s exploration and production department in Argentina, so he’s very well connected, knows everyone in Argentina, and is a key strength for the company to go forward.
Crown Point is a very cheap stock currently. It is producing about 400 to 500 barrels of oil a day and has two low-to-medium risk development blocks in conventional oil, multizone type targets. It’s recently cashed up, with about $30 million in its jeans and no debt to drill probably 15 to 16 wells over the next 12 or so months. Crown Point also plans to drill some high-impact exploration wells, probably later this year. They’re talking three to four potentially game-changing exploration wells, the same type of stuff Madalena is drilling now. So, Crown Point is one to definitely watch, and it’s just coming out of the gates in Argentina.
TER: That’s a great story.
KS: There’s a third company in the space that I’m not officially covering, Americas Petrogas Inc. (TSX.V:BOE). Seeing the huge potential in the oil and gas side, over the last five years this team strategically assembled 16 blocks in the Neuquen Basin. That makes Americas Petrogas the second-largest landholder in the Neuquen Basin, next only to YPF. The company’s key attraction consists of two things they’re doing in Argentina. One, they’re ramping up conventional oil production on a play they’ve had some success on of late, drilling 200- to 600-barrel-a-day wells. Second, they’re partnered with Apache, again, for unconventional gas or oil potential in one of their blocks, similar to what Madalena’s done. They’re also surrounded by a lot of the majors. Exxon, for example, bought some lands that surrounds Americas Petrogas. They’re chasing the unconventional side of the business as well.
At this point, a significant number of Americas Petrogas’s blocks are expected to be in the unconventional, deep-basin part of the Argentina fairway. The key for Americas Petrogas to go forward is to find a way to unlock the value of their assets on the unconventional sides, because there are huge potential, multiple blocks in the unconventional sides where there could be TCFs of net recoverable reserves.
There are also a number of other small cap companies starting to emerge in the Argentina E&P space, so this is a country to watch over the coming months and years (i.e. much like Colombia evolved six to seven years ago).
TER: Will the time come when the unconventional plays provide the majority of onshore oil production?
KS: In specific areas around the world, you can see a significant amount of capital spending over the next 10 years go into unconventional plays, but will it drive global production and supply? An awful lot of conventional reserves still supply the market, so I wouldn’t go so far as to say unconventional plays will be the key driver. Still, it’s going to be a key part of the evolution of gas and oil in a lot of places, not just in North America but internationally as well.
Right now, there’s an effort to prove up European shale gas in multiple areas. You’re seeing what’s happening in Poland with ConocoPhillips (NYSE:COP), BNK Petroleum Inc. (TSX:BKX) and others. That could potentially change the game for the European gas market over the next 10 years. It’s not going to happen right away, because it will take time to build the infrastructure to put discoveries into production, but in the 5– to 10-year window, it could change the European gas market in terms of the amount of supply that can be made available from unconventional plays.
So, in select areas I think unconventional plays will become more of a focus. It’s a risk-reward trade-off. Once you find the unconventional plays, the risk level on manufacturing the oil or gas is very low. It comes down to whether you get the economic production rates well by well to continue to invest capital. That’s why the North Dakota Bakkens, the southeast Saskatchewan Bakkens, the Cardium, the Vikings, the Montneys that are coming to light today have been a huge success in North America. Once the technology is demonstrated to work, a lot of recoverable barrels can be realized by continuing to put significant capital into those plays, which are relatively low risk compared to taking exploration shots looking for new conventional hydrocarbon pools worldwide.
That’s part of what’s happening in other places, taking Argentina as one example. A lot of the historically conventional wells have been drilled through shale in Argentina, such as the Vaca Muerta, and the oil companies, big and small, see the potential that is in the shale. There’s a reason why Total, Apache, Petrobras, Exxon and smaller companies such as Americas Petrogas, Madalena, Crown Point, etc. are there for both the conventional and unconventional upside. Their risk centers on how the technology works in the play and whether it results in economic rates to manufacture.
If they find the areas in the plays that work—at which the industry is fairly efficient—it will drive huge development and billions of dollars in countries that have huge unconventional potential. Argentina is definitely one of those places.
TER: You’ve talked about Argentina, and a little bit about Poland. Anywhere else?
KS: Sure. It’s even in places such as the Paris Basin Shale oil, where the French government is currently looking at the regulations associated with industry fracing practices and in onshore Romania where there is shale gas potential much like is seen in Poland today. The Paris Basin Shale has huge potential. It’s a North Dakota Bakken look-alike area, and companies such as Sterling Resources Ltd. (TSX.V:SLG) have a huge position with potential of ~1 billion bbls of oil in place net to SLG. Sterling also has 400,000 net acres of onshore shale gas potential in onshore Romania next to Chevron who recently entered the space for the unconventional shale upside. If this Paris Basin shale oil and/or the Romanian shale gas potential proves up, it’s nowhere in Sterling’s stock price today and both plays are considered “game-changers.”
TER: Could you tell us more about the Paris Basin?
KS: The Paris Basin is an onshore shale oil deposit, very similar to the North Dakota Bakken. A lot of vertical wells have been drilled through conventional producing basins. There’s a lot of activity with Hess Corp. (NYSE:HES), Toreador Resources Corporation (NASDAQ:TRGL) and several other major companies who have acquired land positions in the play and preparations for several key wells could go down later this year.
TER: Are there other places that have that kind of potential in terms of exporting North American horizontal multistage frac technology into other parts of the globe?
KS: Definitely, there’s a lot of excitement around Tag Oil Ltd. (TSX.V:TAO), which has a big unconventional shale play in New Zealand’s East Coast Basin. TAG Oil will be drilling its first vertical wells to try to delineate the play late this year or early in 2012. There are billions of barrels in place if that play tests to be commercial. TAG already has executed the first horizontal multistage frac in New Zealand in a conventional oil reservoir to ramp some production and test technology. Then they’re going to apply it to the shale oil in the next 12 to 15 months. This again is an example of North American-based technology—proved in the Bakkens, the Cardiums, the Montneys, etc.—finding its way around the world. It’s evolving. Frankly, some of the international sites have more potential in unconventional plays than does Canada because they have been less depleted.
TER: Kevin, thanks very much for your time.
Wellington West Analyst Kevin Shaw, P.Eng, MBA, has extensive industry experience, including in engineering, operations and management positions with Imperial Oil Resources, junior small-cap E&Ps, large energy consulting firms and capital markets. Kevin is a professional engineer with a B.Sc. in mechanical engineering with a minor in petroleum and an MBA from the Haskayne School of Business at the University of Calgary.
By B.P.T., on March 9th, 2011
The Mortgage Bankers’ Association purchase index was released at 7:00 AM EST, and there was a week to week increase of 12.5% in the Purchase Index and a week to week increase of 17.2% in the Refinance Index.
At 10:00 AM EST, the Wholesale Trade report will be released for January, showing inventory levels for wholesalers in the United States.
At 10:30 AM EST, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.
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By B.P.T., on March 8th, 2011
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