By The Energy Report, on February 10th, 2012
 Major potash stocks are beginning to raise eyebrows with impressive profit margins. But as this developing market expands, industry giants will face competition from greenfield and brownfield projects in the works. In this exclusive interview with The Energy Report, Mackie Research Capital Analyst Jaret Anderson debriefs us on some fascinating development stories that are poised to change where and how the most successful potash producers operate.
The Energy Report: You last spoke with The Energy Report in June 2011. What has transpired in the fertilizer and potash business since then, both in Canada and in Brazil’s emerging market?
Jaret Anderson: The tail end of 2011 saw a period of weak demand for Canadian potash. Fourth-quarter shipments at Potash Corp. (POT:TSX; POT:NYSE) dropped by about one-third year over year (YOY). General concern over the economy gave dealers an incentive to avoid stocking up their warehouses, resulting in soft shipments, higher unit operating costs and quarterly earnings below expectations. However, Potash Corp. posted a 68% gross margin in its potash segment during the quarter, making it one of the most profitable publicly-traded businesses of this scale.
Meanwhile, Brazil overtook India as the top global importer of potash in 2011, with imports of about 7.5 million tons (Mt) KCl. This figure was up 21% YOY, drawing even more attention to the country’s chronic domestic potash deficit.
TER: What should fertilizer producers expect in the next few years?
JA: We’re going to see bullish prospects for fertilizer producers over the next 12–18 months. Demand for fertilizer products is likely to remain soft in Q112, but as the spring planting season in the northern hemisphere kicks into gear in Q212, we expect markets to tighten.
TER: You put out a report last December showing a fairly large global number of both new and expansion projects in the works. How will these projects affect the supply and demand equation over the next five years?
JA: We actively track 19 different brownfield expansion projects and 26 different greenfield projects around the world, totaling ~67 Mt of planned capacity. If all of those projects were built on the timelines put forward by their respective owners, we would see a massive glut of capacity in the back half of this decade. The reality, though, is that only the best of these projects are going to be built, and those are likely to experience significant delays compared to their projected timelines. Potash demand in 2011 was about 55 Mt. If we assume demand growth of 3%/year for the remainder of the decade, that implies we’ll need an incremental 17 Mt of supply by 2020 in order to maintain operating rates at 2011 levels. That is pretty close to the 20 Mt of brownfield projects currently on the drawing board. Any demand growth beyond this 3% level or further delays of brownfield projects would tighten markets further.
TER: You don’t expect an oversupply or downward price pressure?
JA: In any commodity, things don’t go up forever. At some point, the supply-demand balance is going to shift in favor of the buyers. The next several years however, look very positive for potash producers.
TER: Saskatchewan is the potash capital of North America, and although it’s a major supplier to other parts of the world, the North American market is relatively mature. What North American potash companies are still attractive buys at this time?
JA: In my view, the most attractive greenfield potash project in Saskatchewan is Milestone, which is being developed by a company called Western Potash Corp. (WPX:TSX.V). The company has a very large in situ resource of about 3.5 billion tons (Bt) KCl and has the highest grade of any existing solution-potash mine in Saskatchewan. Milestone looks very similar to the former Legacy project of Potash One Inc., which was purchased by K+S Potash Canada (SDFG:FKFT) in November 2010 for $434 million (M). At a market cap of $200M today, we believe Western Potash represents the lowest-risk greenfield potash company in the world, with a very attractive valuation.
TER: Another Saskatchewan company you’ve discussed in the past is Karnalyte Resources Inc. (KRN:TSX). It is developing a relatively low-cost, solution-mining project. What are your thoughts on the company’s risk-reward ratio?
JA: Karnalyte is focused on a different type of project that will seek to extract carnallite mineralization at its Wynyard property. While its carnallite mineralization is only about half the grade of a project like Milestone, Karnalyte’s engineers have designed a plant that can be built in stages, which offers some advantages in terms of capital expenditures. Karnalyte’s shares suffered a significant decline in December after the company pulled a $115M financing. We upgraded the shares from “Hold” to “Buy” during December and believe that below $10/share, the company represents good value. However, it may be difficult to see performance for Karnalyte until it successfully raises capital to begin construction at its Wynyard project in the spring.
TER: Are its prospects reasonable for the company as long as the market holds up?
JA: Its shares now represent good value. That said, I believe Western has a more attractive valuation and project than Karnalyte. But there is a difference between a good project and a good stock. Because Karnalyte has taken a large hit of late, it has some decent upside, especially below $10/share.
TER: You recently visited Brazil to get a little better picture of the country’s fertilizer business. That’s a very large, growing market. Tell us what you learned.
JA: Each time I visit Brazil, I come away with more anecdotes that convince me of the need to find ways to invest in Brazil’s agricultural future. Brazil has over 400 million hectares of arable land, but uses less than 15% of it today for agricultural purposes. It is the largest global exporter of beef, poultry, sugar, coffee and orange juice, and that production should grow for many decades. The problem is that its Cerrado region is generally nutrient-poor and requires significant quantities of fertilizer. Brazil has only one operating potash mine and imports more than 90% of the potash it consumes. In 2011, Brazil was the world’s largest importer of potash, at about 7.5 Mt. The Brazilian government has set a goal of becoming fertilizer independent by the end of this decade and we believe investors should be looking for ways to gain exposure to Brazilian agriculture and fertilizer markets.
To that end, two companies we’ve focused on are Verde Potash (NPK:TSX.V) and Rio Verde Minerals Development Corp. (RVD:TSX). Verde Potash controls the Cerrado Verde project in Minas Gerais state, which contains a large, at-surface deposit of potash-rich verdete slate. The company has developed and patented a process to convert verdete slate into KCl, the same standardized product that’s produced in Saskatchewan and Russia today. This is known as the Cambridge process. It’s very exciting, as it could allow for large-scale potash production in Brazil from an open-pit operation—something that hasn’t been done anywhere in the world.
Verde Potash recently published a Preliminary Economic Analysis that indicated an operating cost of US$274/t during the early years of production, ramping up to $291/t over the 30 year life of mine as the stripping ratio increases. That would give Verde Potash the lowest delivered cash costs to Brazil of any large-scale competitor globally. The potash producers in Canada and Russia have lower operating costs, but face very large transportation costs to deliver product to farmers in Brazil. Capital costs for Verde Potash’s project are estimated at US$800/t, which is about 25% below a typical greenfield solution mining project in Saskatchewan. Based on these attractive economics, we recently increased our 12-month target to $19.00/share. With the stock trading at about $7.00/share today, this is a very interesting story.
Another name we believe offers good exposure to Brazil is Rio Verde Minerals, which controls a land package near Aracaju in Northern Brazil. It is located adjacent to Taquari-Vassouras, the only operating potash mine in Brazil. Rio Verde is still at an early stage of development, having completed drilling on its first drill hole in November. We visited the site a couple of months ago and inspected the core. We await assay results from that hole. Rio Verde plans to drill three holes at its Sergipe potash property and to publish an NI 43-101 resource during Q212. Given the strong outlook for good potash grades on the property and the company’s ideal location in Brazil, with nearby access to a port, roads, power and natural gas, Rio Verde looks to us to offer excellent risk-reward at current levels. Based on our target of $1.30/share, Rio Verde offers more upside to our target than any other company in our coverage universe.
TER: Can you elaborate on the Cambridge process you mentioned?
JA: In December 2010, Verde announced that it had patented a process to convert its verdete slate into KCl. This process was developed by Dr. Derek Fray at Cambridge University in the United Kingdom. This process was tested and optimized by Hazen Research in Denver, CO, and by FLSmidth in Allentown, PA, and SRK Consulting, which resulted in the publication of a Preliminary Economic Assesment in late January. We visited FLSmidth’s facilities in Pennsylvania last week and observed the process in operation. The process is relatively simple and bears many similarities to the cement production process. It employs a rotary kiln, like cement, but uses different inputs, namely Verde Potash’s verdete slate rock, limestone and salt. The Verde Potash KCL production process takes place at lower temperatures than that of cement, about 900C vs. cement at about 1,450C.
TER: Do you expect the Cambridge process to work on a commercial scale?
JA: It’s moved from a bench scale at a university to a pilot plant. To move to a commercial scale is another jump. Staff at FLSmidth and SRK have indicated to us that they typically see fewer problems with commercial scale facilities than they do with pilot plants. Every indication we have points to the commercial scale kiln as being well within the technical ability and experience of the teams at FLSmidth and SRK.
TER: There’s also been some development on the African continent, and a couple of Canadian juniors are working on projects there that are projected to go online in about five years. How are they progressing?
JA: Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX) and Ethiopian Potash Corp (FED:TSX.V; FED.WT:TSX.V) are both working to develop greenfield potash projects in the Danakil depression in Northern Ethiopia. Allana is the much better capitalized of the two companies. It has published a large NI 43-101 resource based on its successful drill program over the last couple of years. The projects in Ethiopia are interesting in that the high year-round temperatures in the Danakil may allow for solar evaporation, thereby materially lowering energy costs in the solution-mining process. Ethiopia is also located relatively close to China and India, two important potash consumers.
Ethiopian projects face a major challenge, however, in that the logistics of moving thousands of tons of potash per day from the project site to the port at Djibouti some 600 kilometers (km) away over roads of varying quality may be a significant hurdle. We believe the transportation costs will end up being materially higher than current estimates.
Both Allana and Ethiopian Potash have seen their share prices languish over recent months and are both near 52-week lows. We believe both stocks have room to move up as the projects are derisked and as Allana moves toward a feasibility study in August of this year. While Ethiopian Potash has more leverage to positive developments given its smaller enterprise value, it is a much riskier investment given its very low cash levels. Allana, on the other hand, has more than $65M in cash on its balance sheet, providing it with a lot of time and resources to derisk its project and make it more attractive to potential suitors.
TER: Will Allana rely on a rail link to be built in order to get its product to market?
JA: There are plans in Ethiopia to build a rail network in the country, and that rail network is planned to approach Allana’s project site. We’ve met with the minister of transportation in Ethiopia on this topic. That project is probably a number of years away from completion, and for at least the first several years of production, Allana is going to need to find a way to transport its product by road via truck. You can’t assume the rail network is going to be ready in the next few years, in our view.
TER: What effect will trucking the material have on the project economics?
JA: Trucking will be much less economic than a rail network. Allana has published its own cost estimates for transporting the product from its project site to the port at Djibouti. We find its estimate of $12/t to be very low. We see a number closer to $50/t, based on the figures we’ve seen at other operations in existence today, such as those in Saskatchewan.
TER: Do you have any other interesting stories that our readers might find useful?
JA: The potash industry today is generating very high cash flow and strong returns on capital for incumbent producers. Potash Corp. generated a gross margin in its potash business last year of 68%. Apple Computer, by comparison, posted a gross margin of 41% in its fiscal 2011. The levels of free cash flow generated by this business and the strong secular trends in agriculture are going to attract capital and will ultimately lead to new greenfield production. With so many companies chasing so few quality projects though, we would caution investors to think carefully about the merits of each individual project. The size and grade of the deposit, the infrastructure in place, the proximity to major potash-consuming countries and the geopolitical risk are all critical drivers of value.
TER: Do you see any further consolidation in this business at this point? Or is it still too early?
JA: We’ve had a lot of consolidation in this business. The successful business strategy that greenfield potash companies have employed in the past has been to identify a good project; then derisk it by defining the resource through engineering and feasibility studies to make it more attractive to well-capitalized companies. A number of greenfield potash companies have had success with that strategy by ultimately selling to large mining companies like BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), Vale S.A. (VALE:NYSE) and Rio Tinto (RIO:NYSE; RIO:ASX). I think this process makes sense and is going to continue.
TER: What are your top picks at this point?
JA: Our top picks in the sector for 2012 are Verde Potash and Rio Verde Minerals. Both companies offer good leverage to the Brazilian fertilizer market and have the potential to generate meaningful returns to equity investors. By their nature, development-stage resource companies involve much more risk than an operating company. We believe, though, that 2012 is likely to see very strong results for the greenfield companies with the best-quality assets, in the right locations, with attractive valuations. In our view, Verde Potash and Rio Verde check all of those boxes.
TER: Thank you for your time.
JA: Thank you.
Jaret Anderson is a research analyst covering agriculture and fertilizer at Mackie Research Capital. Anderson has 13 years of experience in the investment industry and was rated #1 for earnings estimate accuracy by Starmine in 2006 and #2 for the quality of his reports in 2005. Prior to joining the firm in July 2011 Anderson worked at UBS Securities Canada where he covered Canadian paper and forest companies, as well as chemical and fertilizer industries. Most recently Anderson covered Canadian fertilizer and chemical companies for Salman Partners. He received a Bachelor of Commerce, with honours (Finance) from the University of British Columbia, and was awarded the CFA designation in 2000.
By The Energy Report, on February 8th, 2012
 Despite depressed natural gas prices, investors in master limited partnerships (MLPs) leveraged to natural gas liquids can expect both excellent income and share price appreciation, says Credit Suisse Senior Analyst Yves Siegel. In this exclusive interview with The Energy Report, Siegel discusses his favorite MLPs and their winning formula for double-digit returns.
The Energy Report: Yves, what can investors expect out of MLPs between now and the end of 2013?
Yves Siegel: Steady as she goes. The yields for our group now are around 6%, and we expect distribution growth to be about 7%. If Fed Chairman Ben Bernanke is true to his word, we’ll continue to expect an environment of low interest rates for the next two years. So if you combine the yield and the distribution growth, we think investors could see low double-digit returns.
TER: How do distributions grow?
YS: When contracts roll over on terminal assets, they typically roll over at higher rates because they’re competing with new facilities. In order for companies to get a return on their facilities, they need a certain price. Storage at Cushing, Oklahoma, for example, is relatively expensive to build. When contracts roll over for those existing storage assets, typically those rates can move up to the prevailing rate for new construction. Distribution growth results not only from contract rollover but largely from new builds and investments that come online, either through greenfield projects or through acquisitions. The MLPs as a group have been able to grow distributions by investing capital in excess of the cost of capital. That’s been a winning formula for quite some time.
TER: Do you see real estate partnership investors shifting their attention to energy MLPs?
YS: I would suggest that retail investors who are searching for yield and invested in real estate investment trusts (REITs) are now looking at MLPs. I would also include investors who have historically invested in utilities. I think MLPs have been around long enough now that investors are feeling more comfortable with investing in the security.
TER: Returns on your MLPs coverage universe have been excellent in recent months, some experiencing double-digital total returns. With more demand and buying, do you expect yields to grow in addition to distributions?
YS: No; I think yields will compress. The current average yield is around 6%. I wouldn’t be surprised to see that reduced to 5.5%, the rationale being that stock prices move higher once the market sees healthy returns. Demand for income-oriented securities remains pretty robust. In a low interest rate environment, people continue to look for places where they can safely park cash as opposed to keeping it under their mattresses. I expect a combination of increased distributions and continued higher stock prices. The result would probably be net-net compressed yields.
TER: Do you expect to see initial public offerings (IPOs) for these types of MLPs this year?
YS: Yes, I expect to see new MLPs come to the market.
TER: Everything you’ve covered suggests good health in this sector. What is your investment thesis right now?
YS: The themes have been threefold: One, invest in MLPs that are well situated to participate in burgeoning shale plays, because as producers pursue these plays, they need the infrastructure to support further production.
Two, we think natural gas liquids (NGL) fundamentals are strong and will remain strong for the foreseeable future because NGL prices correlate with crude oil prices. NGLs are a byproduct of a natural gas production, and current low prices for natural gas are part of the cost of producing NGL. But crude oil prices are high, and that determines the revenue stream NGLs will produce. This all speaks to a very favorable margin opportunity. We would suggest that MLPs that have exposure to NGL fundamentals should continue to do well.
Three, we like this notion that MLPs can buy assets from their sponsors at attractive valuations that enable them to grow distributions. These dropdown stories will continue to perform well over the next couple years.
TER: Are extraction products from natural gas the most profitable part of natural gas production?
YS: Yes. As we speak, natural gas prices have fallen below $2.50/thousand cubic feet (Mcf). Natural gas is very depressed, but what’s keeping the economics favorable is the fact that some of these plays, such as the Marcellus shale play, produce NGLs along with the gas. The NGLs triple the actual realization on the commodity because of the liquids content. So that is a very, very powerful thematic right now.
TER: What are your preferred standards for MLP growth and income?
YS: Our approach focuses more on total return. Simplistically, an investor can buy a stock that’s yielding 8% but has 3–4% distribution growth, and he or she would probably have an 11–12% return. Conversely, an investor could buy a stock that’s yielding 5% and is growing 7–8%, and wind up with a 12–13% total return. Balancing total return with calibrated risk is the right approach. Don’t try to capture total return and take undue risk. Overall, the market pays for growth.
MLPs with more growth typically have much lower yields, so it’s not inconsistent for us to recommend Western Gas Partners, L.P. (WES:NYSE), for example, which is yielding below 5% but which we think will have double-digit distribution growth over the next couple of years. At the same time, we could recommend Boardwalk Pipeline Partners, L.P. (BWP:NYSE), which is yielding around 8% and is going to have much more modest distribution growth of 3–4%.
TER: Let’s segue into your top MLP picks.
YS: Well, what we like about Boardwalk Pipeline Partners is that it has a very steady revenue stream tied to its interstate pipelines. With new management in place, we think 2011 was perhaps an inflection point for the company to try to focus more on growth. It has done so by buying storage assets from Enterprise Products Partners, L.P. (EPD:NYSE) and signing a gathering agreement with Southwestern Energy Co. (SWN:NYSE) in the Marcellus. We think there is an opportunity to accelerate the growth in distributions if management is successful. If management falls short of that goal, I think investors would still be happy with the safety of the yield.
The other company that’s within that interstate pipeline business model is El Paso Pipeline Partners, L.P. (EPB:NYSE). That stock came under a little pressure when Kinder Morgan Energy Partners, L.P. (KMP:NYSE) announced that it was buying El Paso Corporation (EP:NYSE) last year. I think El Paso Pipeline Partners was unduly punished because investors felt the distribution growth would slow. It is going to slow, because instead of having all of El Paso’s pipeline assets migrate into the MLP, now some of those assets will be migrating into Kinder Morgan. It’s almost a truism that the growth at El Paso Pipeline Partners is not going to be as robust because those pipelines will be moving into a different entity. However, we still think El Paso Pipeline Partners will be able to grow its distributions at 9%, and in fact, Kinder suggested as much. So we think a 5.5% yield and 9% distribution growth over the next couple of years is a good formula for success and a good formula for total return potential.
When you think about the other theme we spoke about, the strength of the NGLs, Targa Resources Partners, L.P. (NGLS:NYSE) fits into that. We like Targa because of the investment opportunities, the integrated model it’s pursuing within its midstream business and its very good management team.
We also like DCP Midstream Partners, L.P. (DPM:NYSE), which is another NGL story, but it’s also a dropdown story. There is the MLP, DCP Midstream Partners, and its sponsor, DCP Midstream LLC (DPM:NYSE), which is 50% owned by Spectra Energy Corp. (SE:NYSE) and 50% owned by ConocoPhillips (COP:NYSE). DCP Midstream Partners will continue to see assets migrate to it from DCP Midstream, helping to finance its growth while it pursues its own organic growth.
Then, within the dropdown stories and also in the midstream space, it’s hard not to mention Chesapeake Midstream Partners, L.P. (CHKM:NYSE) and Western Gas Partners, which I mentioned earlier. Both of these MLPs are owned by exploration and production (E&P) companies—Chesapeake Energy Corp. (CHK:NYSE) for Chesapeake and Anadarko Petroleum Corp. (APC:NYSE) for Western. The upstream parents are investing millions of dollars on building infrastructure to connect their wells, and the MLPs are helping to finance that via the dropdown. In the case of Western, it is having some good organic growth in the DJ Basin on top of what it can expect to acquire from its parent. We think Western and Chesapeake give investors nice, double-digit growth.
For investors who are looking for more safety, or simply more mature MLPs, Enterprise Products Partners LP probably represents the best in class, being the largest MLP and having a vast footprint within the U.S. spanning NGL, crude oil and refined petroleum products. It covers the whole spectrum, and it has an excellent management team. It has an excellent balance sheet and a great formula for 5% steady distribution growth as far as the eye can see. Enterprise is a real core holding and one that we would like to have in any MLP portfolio.
TER: Over the past 52 weeks Enterprise is up 15%, and it’s up 2% over the past four weeks. With a $43B market cap, what are its growth prospects?
YS: Well, it is investing $3–4B annually in organic growth projects. Let’s not forget that it will cost billions of dollars to build U.S. energy infrastructure that supports shale play development. We think that a majority of that spending is being done by MLPs and Enterprise is a good case in point. That runway is probably pretty long, meaning infrastructure spending should last several years. That bodes well for the MLPs that are investing the capital and should be generating returns that support distribution growth.
It’s not only the size of the company that matters, but the ability to execute projects efficiently and cost effectively, using existing assets in some cases that provide leverage. For example, Enterprise will be using some of its existing pipeline and its right-of-way in order to realize its planned ethane line, stretching from the Marcellus to the Gulf Coast. The joint venture crude pipeline that it is doing with Enbridge Energy Partners, L.P. (EEP:NYSE) from Cushing to the Gulf Coast makes use of an existing pipeline there. It is reversing the Seaway pipeline at an extremely reasonable cost, which speaks to your point that there are not many companies out there that have the infrastructure or the entrepreneurial spirit to go after these projects.
TER: Are there any other companies that exhibit this entrepreneurial spirit?
YS: ONEOK Partners, L.P. (OKS:NYSE) has an excellent management team, and it is also a play on the burgeoning NGL market. I would also mention Magellan Midstream Partners, L.P. (MMP:NYSE), which is focused on crude and refined products pipelines.
TER: Both of those companies have had tremendous runs recently; ONEOK is up 39% over the past 52 weeks, while Magellan is up 21% or so.
YS: Both of those stocks have good growth characteristics and excellent management teams, but investors might want to wait for a better entry point before buying. They’ve certainly had really terrific runs.
Sunoco Logistics Partners, L.P. (SXL:NYSE) is also doing its bit to take advantage of getting ethane out of the Marcellus. It is also helping to de-bottleneck the amount of crude oil that’s trapped at Cushing by moving crude production from the Permian Basin down to the Gulf Coast instead of north to Cushing. I put it in the same sort of category, as it has a good management team, strong balance sheet and very good growth prospects. All those good things are reflected in the stock price, so a better entry point might be worth waiting for.
TER: Sunoco Logistics has pulled back a bit over the past four weeks, but not much.
YS: I’d just like to stress the fact that the companies in the MLP class are very transparent because of cash flow. It’s a very good pass-through structure for getting cash back to shareholders in a tax-efficient manner.
TER: If you had to pick one of these MLPs as a very favorite, what would it be? Or should investors choose a basket of MLPs?
YS: My thought is that investors are best served by diversifying within a basket of MLPs. I don’t think MLPs are mispriced securities, so you’re not necessarily going to have outsized returns, nor do I think investors who are looking at the bond and stock markets could really expect outsized returns. For the equity market, if investors could see a 6–8% type of total return, they should be pretty happy.
TER: Yves, we haven’t seen any large gains in the price of crude over the past six months, and we have certainly seen the price of gas depressed. If energy commodities began to strengthen, what kind of an effect would that have on these MLPs?
YS: It would affect different sectors in different ways. With the gathering and processing companies, most of the contracts are for a percentage of proceeds. The MLPs do a pretty good job of hedging their commodity risk out one to three years. But in a strong NGL- and crude oil-pricing environment, net-net they would benefit. Low natural gas prices are positive for gas processing margins. However, some intrastate pipelines would see diminished volumes if drilling slows down in dry gas areas. If crude and gasoline prices were to get too high and gasoline prices get too high, refined petroleum product pipelines might experience some negative pushback because of declining volumes in their pipelines.
TER: Thank you for sharing your knowledge and time today.
YS: You bet. Thank you.
Yves Siegel joined the Credit Suisse Energy Research Team in June 2009 to cover the MLP and natural gas pipeline sectors. Immediately prior to joining Credit Suisse, Siegel was a senior portfolio manager at a New York hedge fund focused on MLPs. Prior to his buyside experience, Siegel had established a leading sellside MLP franchise, having spent more than 10 years at Wachovia Securities after prior sellside engagements at Smith Barney and Lehman Brothers. He has received both a BA and an MBA from New York University and is a CFA charterholder.
By The Energy Report, on February 3rd, 2012
With the winter warmer and drier than previous years, natural gas companies are suffering from depressed prices. However, Raymond James Analyst Luc Mageau identifies liquids-rich companies that can create profits with or without a natural gas price rally. In this exclusive interview with The Energy Report, Mageau explains how to use well payout rates to evaluate a company’s longer-term cash flow.
The Energy Report: With Brent Crude trading at about US$110 per barrel (bbl) and natural gas futures trading at 10-year lows, are you leaning more heavily toward oily names than you did in 2011?
Luc Mageau: Absolutely. In fact, although gas prices have been reduced to around the $2.50 level, it still seems like the picture could get worse before it gets better. Current natural gas storage is at ~3.5 trillion cubic feet (Tcf); that’s a full 0.4 Tcf fuller than an average winter. The reason we have such a glut of gas is the winter has not been co-operating. Basically, we rely on winter to post the bulk of the withdrawals throughout any given year—in the last few years, we have truly been relying on a cold winter to bail us out of the storage glut and we’ve been lucky. On average we normally see ~150-200 billion cubic feet (Bcf) of gas withdrawn per week. With the warm weather we’ve been getting, our average withdrawals from storage have been closer to 80-100 Bcf during the 2011/2012 winter season—that translates to a lot of excess gas. Making matters worse, the weather is not expected to get colder. This means we could be in store for several more weeks of warmer-than-average winter, and given we only have a handful of weeks left in the official “withdrawal season,” we’re running out of time to get back to normal storage.
Historically, when weather fails to bail us out of the glut we have seen production shut-ins to curtail the problem. This time, I think we could be in a slightly different boat—and we can blame the price of oil for that. You see, over the last several years, low natural gas prices have forced gas producers to derive cash flow from other sources. One major source has been incremental extraction of natural gas liquids (NGLs). NGLs are heavier hydrocarbons that are produced in conjunction with natural gas. These products typically trade closer to the oil price. Given the wide discrepancy of oil:gas pricing, NGLs can account for a good chunk of the effective price a gas producer receives. What this means is that even when gas prices are below $2.50, the NGL component now being realized from produced gas is allowing a lot of gas that would have historically been shut in to remain marginally economic, and as such, still on production. So we are seeing less shut-in production than historically, and even if we were to begin shutting in production now we would need nearly 6 Bcf/d to be shut-in for the bulk of 2012 just to get back to normal storage levels—a situation that seems unlikely.
The bottom line is that we continue to expect gas prices will stay depressed and oil prices to continue to thrive and as a result, oil stocks should continue to outperform in general.
TER: Should investors stay away from the gas-heavy names or simply gas-heavy names with liquids-poor content?
LM: Some companies are certainly offering good value today and just because gas prices are low right now doesn’t mean that there are no investable ideas. This being said, dry gas companies (i.e. those with liquids infused plays below 20 bbl/MMcf) are really having their cash flows squeezed right now. Netbacks for companies in this camp have been compressed to mid-single digits and even keeping production levels flat without adding a significant amount of debt is hard. On the other hand, companies with liquids rich gas plays that generate 50 bbl/MMcf or more can boost the realized price of their gas by $4.00/mcf. In fact, given the price of liquids, these companies were already generating in excess of 80% of cash flow from the liquids anyway, so the price of gas does not make that much of an impact on the overall value of the company. So if you are looking for gas exposure, it would probably be safer to look at companies that have exposure to these types of plays. In our coverage universe, Crocotta Energy Inc. (CTA:TSX) is probably the best positioned in this camp.
TER: Let’s talk some more about your coverage universe. Crocotta Energy relies heavily on its liquids-rich assets. Please tell us about how one of those assets, Edson Bluesky, is insulating Crocotta from low gas prices.
LM: Crocotta has been working this asset up for the bulk of 2011 and it has been having very good success. In all it holds ~36,000 acres of land here and the key play so far has been the Bluesky formation. The reason that this play is exciting is because it truly is liquids rich—getting anywhere from 50-100 bbl/MMcf of NGLs. What this means is that even though Crocotta is a gas-weighted producer, at $2.00/mcf gas prices the company can generate netbacks in the mid-$20/barrel oil equivalent (boe) range (compared to low- to mid-single digits for most gas companies). The wells typically cost ~$5.8M, so they are expensive, but considering the amount of wells already drilled on the land base, they are low risk and generate an NPV of over $4M even at $2.00/mcf gas (compared to drier gas wells that would be posting closer to $0-1M NPVs). So the company is still making plenty of money even at these gas prices and it still offers the option on gas prices for the future.
TER: Crocotta exited 2011 with production of about 6,500 boe/day, well ahead of both the company’s exit guidance range and your expectation of about 6,000 boe/day. In fact, those fourth-quarter results brought Crocotta’s 2011 average production up to 3,725 boe/day. What sort of production are you expecting in 2012? And will that be enough to reach your 12-month target of $4.75?
LM: Our numbers have the company exiting 2012 north of 8,000 boe/d—one-third of that production is expected to be oil and liquids. The growth is primarily expected to come from Bluesky liquids rich wells, but we’ve also built in some wells for the company’s Cardium lands at Edson. Late in 2011 the company announced its first Cardium well in the Edson area had an initial production rate of 1,000 boe/d (60% oil). This was previously a formation that we were not anticipating much growth from so there is a significant opportunity for the company to build an oil-weighted portfolio of wells if it can show that this is repeatable—and based on what we’ve seen, we think that’s possible. So our $4.75 target price is premised on the production profile through 2012 and 2013. In fact, for 2013, even at $2.00/mcf gas the company could post cash flow of $0.90/share so it is currently trading at just 3.8x, lower than its gas-weighted peers.
TER: You cover Cequence Energy Ltd. (CQE:TSX), which recently conducted some tests on several new wells at Simonette, Alberta, which is part of the Montney Shale play. One new well tested at 4.8 MMcf/d and 216 bbl/day of condensate over 15 days, which would correspond to a liquids yield of about 45 bbl/MMcf. That means that these wells would be economic even at $2.50 natural gas. What’s your outlook for Cequence given these testing results versus lower than expected oil-equivalent production in 2011?
LM: We believe the recent Montney well results continue to prove that the Simonette area is highly prospective for natural gas production growth. This combined with the additional take-away capacity from the pending Alliance Pipeline connection adds comfort that growth will continue through 2012. You are certainly correct; at 45 bbl/MMcf the company’s Montney wells continue to be economic at $2.50/mcf gas. The unfortunate take-away, however, is that the payout ratios on these wells are expected to be approaching three years. This means that it essentially takes three years for the company to re-coup the money it put into the ground to drill the well, and for a junior company, this makes sustained growth at current prices difficult.
TER: Cequence says that once it connects to the Alliance Pipeline and the Aux Sables liquids extraction facility, which is slated to happen in April 2012, its operating netbacks from Simonette production would reach $30.31/boe. Do those numbers line up with yours and, if so, do you expect that to significantly move the share price?
LM: It all comes down to your view of natural gas prices. We are currently forecasting $3.25/mcf gas for 2012—which sounds more bullish than it actually is. Based on that, we have netbacks in the $18/boe range. If current prices were used instead, i.e. $2.25/mcf gas, netbacks would go to $10/boe.
TER: What’s your 12-month target on Cequence?
LM: We are at $3.50—but again that is premised on $3.25/mcf gas for 2012.
TER: A smaller name that you cover is Renegade Petroleum Ltd. (RPL:TSX.V). Renegade exited 2011 with higher-than-expected average production of 3,625 boe/day, which resulted in year over year growth of 73%. Renegade has set its 2012 production guidance at between 4,000 and 4,200 boe/day and that should result in another year of significant growth. Please tell our readers about why you believe Renegade will reach its production guidance and why you raised your 12-month target to $5.00.
LM: Renegade certainly did have a great year in 2011. After it rolled up its JV partner in the Viking (Petro Uno), it went to work post-breakup and its production growth number definitely reflects that. For 2012 we expect the company is going to put a bit more emphasis on southeast Saskatchewan, though, and we had previously been a bit more conservative on our view of the potential there. We were previously forecasting another break-up season similar to what we saw in 2011—wet and prolonged. But the very unseasonably warm summer, combined with the almost nil snow accumulation in the region is making things look much better than originally expected. Now anything can change—especially the weather—but with a slightly longer drilling season than originally expected, we were able to bring up our production estimate a bit to an average of 4,070 boe/d for 2012, about the midpoint of guidance. With our oil price deck at $100 WTI for 2012, our cash flow estimates and target followed suit.
TER: Things don’t look quite so rosy for Open Range Energy Corp. (ONR:TSX). Most of Open Range’s production base is from natural gas and its production is slated to contract in 2012. Nonetheless, you still have a C$2.00 target on that name. Tell us about that one.
LM: Open Range is coming off of a stellar year in 2011. It successfully launched the spin-out of its Poseidon division, which continues to be a strong performer. However, with that division gone, the bulk of the company’s opportunities are in dry gas, meaning NGLs under 20 bbl/MMcf. The company also has ~$50M of debt on a $75M line and is planning six gross wells for this year. So facing the current commodity price environment, the company is really in cash-conservation mode and as a result has forecasted production to shrink through this year—a stark contrast to the massive growth it was leading investors to believe for most of 2011 (its presentation projected a 2012 exit rate of ~10,000 boe/d). Now the assets that the company has are actually quite good—as far as gas assets go. The company has primarily one consolidated land block in the deep basin, an area that characteristically has large gas reserves and low operating costs, but it also has very low liquids yields so the netbacks are at $2.25/mcf gas. Our $2.00 target is premised on a $3.25/mcf gas price and to be fair, for gas investors looking at options on the commodity, Open Range is certainly a good candidate, however we believe gas markets will remain weak for some time, likely putting more near-term pressure on the name—we’ve had the company rated market perform since the spin-out, which really reflects our neutral-to-negative outlook on natural gas prices.
TER: And, finally, Strategic Oil & Gas Ltd. (SOG:TSX), which completed a $40M equity financing in December to give the junior a total of C$42 million in the bank. How is Strategic planning to use that cash?
LM: Strategic has two core light oil assets; the Maxhamish Chinkeh sand horizontal play in northeast BC, where Legacy is the operator, and its Steen River lands in northern Alberta. At Steen River, the company is the operator and has a 100% working interest in 70,000 net acres, so it has a lot of flexibility to accelerate the program here as well as a significant amount of running room for future drilling. There are at least three different oil-prone zones being targeted at Steen, so this is where we see the company getting the leverage for growing production in 2012. With that in mind, the company has provided a $60M capital program for 2012 that focuses on Steen. It has two rigs running there now, and plans to drill 20 (17 net) wells in 2012. Although the focus is still on the high-impact vertical Keg River wells, which get initial production rates of about 200 bbl/d for $1.5M, the company is also going to continue to advance its more “resource-style” horizontal play in the Sulphur point formation, and test out some new zones and play concepts in the area. Given that this program is pretty front-end weighted (there are nine wells planned for Q112), we think the company could use its balance sheet to expand this program through the back half of the year if it continues to achieve results like it has been.
TER: Despite the equity dilution in December, over the course of 2012 you expect Strategic’s share price to almost double to C$1.50. How is that going to happen?
LM: Strategic spent a lot of time on its Steen River assets in 2011. A lot of this was laying the technical foundation on which to build a strong portfolio of oil drill prospects. It successfully tested the horizontal Sulphur Point oil play, and it built out and de-risked its Keg River locations. With its balance sheet now all cashed up, we see 2012 really as a year where it focuses on aggressive drilling at Steen River. Since these wells can get IP rates of 100—200 bbl/d of oil and the capital costs of drilling them are low, it is able to really step on the accelerator pedal quickly. So we think that both cash flow and production will grow substantially through the year and into 2013. Right now we have it spending its guidance of $60M in 2012 and exiting the year with production of ~3,000 boe/d, a pretty strong growth profile when you compare it to 2011 exit production of 1,880 boe/d.
TER: Do you have some parting wisdom to impart to investors looking to enter this space for the first time in 2012?
LM: We are still constructive on oil prices, and with our view on NGL pricing and yields, we remain very cautious on the outlook for gas prices, so obviously we would overweight oil-focused names. That said, there are gas-weighted names that have currently good liquids yields with the ability to weather low gas prices and reallocate capital away from dry gas. Crocotta Energy is an exceptional example of this—the company is getting a liquids yield of 50-80 bbl/MMcf, which means that not only can it weather low natural gas prices, the bulk of cash flow is already coming from the liquids so the wells are very economic even at gas prices with a $1-handle. Second, we would certainly look to invest in companies that have the financial resources (balance sheet and cash flow) to fund an oil- or liquids-focused drilling program in order to take advantage of current oil prices. To put this in perspective—a typical oil well will pay-out in ~1.5 years, which means that all the money a producer puts in the ground they get back in 1.5 years—everything else after that is profit. Gas wells on the flip side can have pay-outs longer than three years. For a junior company, the ability to recycle cash by putting it in the ground, getting it out and repeating the process is paramount—particularly given that the amount they have is very limited. So to that end, junior companies with high oil weightings that we especially like include companies like Renegade Petroleum, Strategic, and Twin Butte Energy for their growth profiles and valuation. However, the top pick in our space right now is Twin Butte Energy, which recently closed the acquisition of Emerge. It pays a healthy dividend of 7%, has the potential to outperform its guidance, and has a very conservative payout ratio for 2012 if light-heavy differentials and oil prices remain within reason of current levels.
TER: Thanks for sharing your insights with us.
LM: My pleasure.
Luc Mageau joined Raymond James in March 2006. He is responsible for covering junior and intermediate oil and gas producers. Prior to joining the firm, Luc was employed as a commercial lender at a major bank and as a research analyst at a U.S.-based equity research firm. He has a bachelor of commerce degree from the University of Alberta (2001) and holds the CFA designation.
By The Energy Report, on February 1st, 2012
 Powers Energy Investor Editor Bill Powers doesn’t shy away from microcaps; he embraces them. In this exclusive interview with The Energy Report, he explains why triple-digit oil is here to stay and how the best-positioned companies will be sitting pretty when natural gas prices rise—as will investors who time the rebound right.
The Energy Report: Is it fair to say that you are a value investor?
Bill Powers: Absolutely. I’m very much a value investor focused on fundamentals and finding companies that can grow reserves, production and cash flow without taking on too much debt and/or diluting shares. Those are the companies that can have very strong long-term outperformance. That is my theme, and I think it is really powerful right now. The companies I’ve identified do not currently reflect future prices that their stocks will be receiving.
TER: Clean balance sheets, steady cash flow and a depressed market price: would that sum it up?
BP: Yes. The Canadian junior market has changed in the last 10 years markedly. It’s matured greatly. Many companies have proven management teams and very good cash flow but are trading below their net asset value.
TER: Do you try to stay away from micro-cap stocks?
BP: Absolutely not; I very much embrace micro-cap stocks. As a newsletter writer, my commentary is largely directed at investors who want information on companies that are below Wall Street or Bay Street’s radar screen. I try to find the company that I feel is best positioned in a certain play and that have the chance for the best share price appreciation. Usually, it’s not the large-cap producers who have acreage in the play.
TER: How do you define a micro-cap?
BP: I consider a micro-cap as $250 million (M) on down.
TER: You recently wrote in the Powers Energy Investor that foreign investors are paying too much for joint venture (JV) agreements with large North American companies. If foreign companies are overpaying, why is that depressing the price of gas?
BP: I’ll give an example: Chesapeake Energy Corp. (CHK:NYSE) made a deal with Total Energy Services (TOT:TSX) to farm out its Utica shale acreage in Ohio. To put this into perspective, there have only been a handful of wells drilled in Ohio into the Utica shale, primarily within one county. This is a speculative play and I am very skeptical of how productive the Utica shale could really be.
That being said, the way these deals are structured is that Total, the foreign company in this case, pays $600M up front to Chesapeake, which will be drilling wells funded completely by Total. So between now and the end of 2014, it will be spending $1.5B on drilling. There are other companies that have done similar deals totaling maybe $20B from largely foreign companies farming into U.S. acreage. This is important because the foreign company will fund drilling for usually two years irrespective of gas price, and when companies drill with somebody else’s money, they are not sensitive to the fact that gas right now is under $2.50/thousand cubic feet (Mcf). It’s a good deal for the American companies, but it’s usually a very, very poor deal for the foreign firms.
TER: Classic economic theory says that if you keep producing like this and prices get very low, people will quit producing. Then, eventually, prices will go back up. When does that happen?
BP: I think it’s going to be happening fairly soon. Right now we have a glut of gas. Part of this is due to Haynesville and Marcellus operators’ drilling acreage to keep leases from expiring. The rig count is really starting to fall, especially in the Haynesville, which is producing 6 billion cubic feet (Bcf)/day right now and is the largest-producing field in the U.S. But that rate has already flattened out, and production will probably start to fall as rigs continue to get dropped. These are very high-decline wells. Texas production is beginning to decrease because the Eagle Ford is not offsetting production declines elsewhere in Texas. Gulf of Mexico production continues to go down. Basically, with gas under $3/Mcf, virtually every field in North America is uneconomic, and we will see a big slowdown in drilling. Very few companies have attractive hedges in place because we’ve had low gas prices for a couple of years. We will see a rebound in gas prices, and it will be quite violent. The challenge is finding the right timing of it. It is not so much a function of when the economics make sense as it is about when other people’s money runs out. We’re seeing that happen right now.
TER: Have we reached the point of maximum pessimism yet?
BP: That’s hard to say. I do think there is a lot of pessimism, but that doesn’t mean a reversal is imminent. I do think that at some time in 2012 we will see that reverse itself, and when that happens we will see gas prices increase substantially.
TER: It sounds like you are playing a very bullish scenario for natural gas. One of the first things I noted in your model portfolio from your Powers Energy Investor is that you have significant personal exposure to natural gas.
BP: Yes, absolutely. From an investor’s standpoint, being a contrarian is easy when your stocks are going up or when your ideas are being recognized by other market participants. What I’m doing in my newsletter is finding gas producers that have been beaten bloody by the marketplace but are low-cost producers that will make it to the other side to see the rebound in gas prices. I’ve identified about five companies that are leaders in certain plays or that have very good leverage to what I think are some of the best North American unconventional resource plays. Those are all places that will continue to produce into the future because they have the better acreage that will become economic once gas prices go back to $4/Mcf. Right now, you’re getting a lot of upside for free because the marketplace doesn’t believe that gas prices will eventually rebound.
TER: Could you talk about those companies you just referenced?
BP: Sure. One of the companies is Ultra Petroleum Corp. (UPL:NYSE), which is a slightly bigger company than I usually cover. It is very active in Wyoming on the Pinedale Anticline, and it’s also very active in the Marcellus. It is a very low-cost producer. This company was a penny stock about a decade ago.
Another I really like, a smaller company, is Advantage Oil and Gas Ltd. (AAV:NYSE; AAV:TSX). It has a great project in the Montney in Canada. It is an extremely well-run company that I think is doing very good work up there.
There are other companies that offer a lot of value and have seen their share prices decline, such as Fairborne Energy Ltd. (FEL:TSX) in the Willrich. It’s a very exciting play in Alberta’s Deep Basin.
This is just a preview of companies that I think have good acreage and that are very leveraged to rising gas prices.
TER: Those were three of your five favored gas companies. What were the other two?
BP: One is Quicksilver Resources Inc. (KWK:NYSE). It’s a U.S.-based company that has a fair amount of debt on its balance sheet. However, for a small-cap company, it has fantastic acreage in the Horn River Basin, where it is very early stage, but this may turn out to be the best shale gas play in North America. Time will tell. This company has been around for more than 50 years, and it has a very good management team. It has been a leader in a number of shale plays. It had the Antrim shale in Michigan and the Barnett shale in Texas. It was one of the early players in those plays.
The other one I like is a bigger company that continues to produce very good results, and that is Southwestern Energy Co. (SWN:NYSE) in the Fayetteville shale as well as in the Marcellus. The company has a dominant acreage position in the Fayetteville and has really been able to grow its production quickly in the Marcellus. It is a very well-run company by Steve Mueller.
So those are just some companies that I try to find. Each is unique. Each of them has different catalysts that will help its share prices more than double once gas prices start to move up. I think these stocks could go up three- or four-fold from here without any problem.
TER: Ok, you love natural gas. What about oil?
BP: I’m very bullish on oil. I think there are some very good factors that will keep the price of oil over $100/barrel (bbl) almost irrespective of how the economy does. With the natural declines from the Gulf of Mexico and the North Sea as well as Venezuela and Mexico, a lot of countries are struggling to keep up production. I think the U.S. has been able to increase its production materially over the last five or six years due to breakthroughs in technology, but that does not change the long-term trajectory of oil production in the U.S. We will see declines from California and the Gulf of Mexico, and we will see further production declines in Alaska, which will largely offset some of the very exciting production growth in unconventional plays, such as the Bakken in North Dakota or the Permian Basin in Texas. I do think triple-digit oil prices are here to stay, and I think we could see $150/bbl before too long, especially if there is a disruption in the Middle East. I think the leverage available to investors with small-cap companies is really mindboggling when you look at what oil prices mean to these companies.
TER: What oil-based companies are we looking at?
BP: Arsenal Energy Inc. (AEI:TSX), a very exciting play in the Bakken. It also has acreage in the Willrich and a very good management team. It is growing its production, and it just did an acquisition that grew its production to around 4 thousand barrels (Mbbl)/day. It has a very strong future as far as production growth that’s high net back, high cash flow and reasonable balance sheets. That’s one company that I am very high on. It has a market cap of only about $109M. It is one of my favorites.
As far as other companies that have great leverage that will go up, I’m becoming very keen on oil sands companies. I think companies like Connacher Oil & Gas (CLL:TSX) are going to rebound and continue to rebound. PetroBakken Energy Ltd. (PBN:TSX), Petrobank Energy & Resources Ltd. (PBG:TSX) and Petrominerales Ltd. (PMG:TSE) are all very oil-weighted companies that will be able to really ramp up cash flow in 2012 as oil prices maintain the $100-level.
Then we do see some U.S.-based companies like SM Energy Co. (SM:NYSE) in the Eagle Ford. This is along my theme of trying to find companies with the best leverage to a certain play. I think SM Energy has the best acreage in the Eagle Ford.
A couple of companies are involved in secondary oil recovery are Evolution Petroleum Corporation (EPM:NYSE) and Denbury Resources Inc. (DNR:NYSE). I think both of those companies are very well-leveraged to oil prices.
So those are some ideas that I think will provide shareholders great returns in the next two years.
TER: Speaking of oil sands, the Obama Administration nixed, at least temporarily, the Keystone XL Pipeline from Canada down to the Gulf Coast. Are the concerns valid? Aside from the developer TransCanada Corp. (TRP:TSX), who does this hurt?
BP: I think this really hurts American consumers. I don’t believe the concerns over the environmental aspects of the XL Pipeline were valid whatsoever. I think this was almost entirely a political maneuver. Right now, the U.S. still imports a substantial amount of production from overseas, and I don’t think some of these overseas suppliers are nearly as reliable as Canada. We import a lot from countries such as Venezuela and Mexico, which are struggling to maintain their production levels and are increasing internal consumption. So I think it is unlikely we will see material imports from either of those countries 10 years from now. Given the growth profiles of many Canadian oil sands producers such as Imperial Oil (IMO:TSX; IMO:NYSE.A) and Cenovus Energy Inc. (CVE:TSX; CVE:NYSE), I think we will see material growth in the Canadian oil sands from about 1.2 million barrels (MMbbl)/day to maybe 4 MMbbl by 2022, obviously depending on permitting issues and the price of oil. I think the Keystone would have been a very good supply. Eventually, I think the Canadians will get fed up and build a pipeline to Port Rupert and send the oil sands production to Asia if the U.S. cannot find some solution to get the XL Pipeline moving forward.
TER: The differential in price for what Asians are paying could pay for shipping that oil to Asia.
BP: Yes, absolutely. And one of the things we’re seeing in Asia is that some of the biggest producers such as Indonesia are seeing flat to declining production. And China has really struggled to keep its production flat. There have been some very good offshore finds in Malaysia and Vietnam that will replace some of the declines from places like Indonesia, but on an overall basis, those are not keeping up with the growing regional demand. Numerous Asian countries, especially China, would love to tap into the Canadian oil sands. A pipeline will get built. It’s just a matter of whether it leads to the U.S. or to the west coast of Canada.
TER: You have reviewed Energy XXI (EXXI:NASDAQ) recently.
BP: It’s not in my model portfolio right now, but I was very impressed that it has been able to grow production and that the company has a material oil weighting. It has a very good mix of exploration prospects as well as development prospects. Right now, the market has really turned its back on the Gulf of Mexico producers such as Energy XXI, and it is trading at lower valuations than its onshore peers, but it is able to generate material cash flow. In the case of Energy XXI’s balance sheet, I think some investors were a little scared off by its debt levels, which I see as very manageable given the cash flows it will be receiving over the next two years and its significant material reserves that it can borrow against. I think Energy XXI has a pretty bright future. I’m going to continue to monitor the company and see how it continues to execute over the next six months or so. It has a very good mix of high-impact exploration and lower-risk development.
TER: Bill, you are writing a book now?
BP: I’m currently working on a book that looks at shale gas and what I consider to be the myth of a 100-year supply. While there is a significant amount of shale gas that will be recovered in the next decade, it is nowhere close to a 100-year supply. Shale gas is not the game changer that a lot of people think it is.
TER: What thought would you leave us with?
BP: I think the perceived risks in energy investing have been somewhat overblown given where oil prices are. The space is very volatile, but for investors who can take a longer-term approach and who can identify companies that are well-run and that have legitimate projects, there are fantastic returns available. The energy sector has been out of favor, but the fundamentals are very strong. I think investors who can position themselves in gas-weighted firms ahead of the coming rebound will be richly rewarded, but there are also fantastic returns in oil-weighted companies that will benefit mightily from triple-digit oil prices.
TER: Bill, I’ve enjoyed speaking with you.
BP: Thank you for having me.
Bill Powers is the editor of Powers Energy Investor and previously the editor of the Canadian Energy Viewpoint and US Energy Investor. He is a former money manager and has been an active investor for over 25 years. Powers has devoted the last 15 years to studying and analyzing the energy sector, driven by his desire to uncover unrecognized trends in the industry and identify outstanding opportunities for retail and institutional investors.
By The Energy Report, on January 27th, 2012
 The lithium market is currently dominated by a handful of major producers, but investors naturally look to smaller junior exploration and production (E&P) companies for the real growth. Economist Daniela Desormeaux of Santiago, Chile-based signumBOX takes a global macroeconomic view of the lithium industry and concludes that supply will meet demand, but if the adoption of vehicular lithium ion batteries occurs sooner than the market expects, demand could overtake supply. In this exclusive interview with The Energy Report, Desormeaux discusses some of the juniors that could ultimately add some energy to portfolios.
The Energy Report: Daniela, over the past three months the small-cap lithium developers have on the whole been in positive territory. Are we at the beginning of a
long-overdue bull market in lithium equities?
Daniela Desormeaux: Most of the smaller-scale suppliers trading in the open market are young, junior mining companies. The stock price fluctuations observed during recent months reflect the market’s sensitivity to the companies’ announcements and news.
TER: What is currently driving lithium demand? What will drive it in the future?
DD: Lithium demand has a promising future. Rechargeable batteries are the largest application, accounting for about 30% of the lithium demand. This is also the segment with the highest growth rate for the next 10–15 years, by which point we believe batteries will represent more than 50% of demand. The main driver is the automotive industry. Electrification of transportation is now driving the use of lithium in energy storage devices for hybrid and electric cars. The amounts of lithium required in these batteries are significant, from between 5–60kg lithium carbonate equivalent (LCE) depending on the battery type and specification. When compared with the lithium required for mobile phone batteries, for example, the difference is huge. A mobile phone battery device requires less than 5g LCE. Other battery applications will also show very interesting growth rates in the coming years. These include smartphones, tablets, power tools and batteries for grid storage, among others. Other current lithium applications include glass and ceramics as well as lubricating greases. Considering all of its applications, we estimate lithium’s average demand will grow around 10%/year, which is greater than the growth of the economy.
TER: How are lithium prices holding up currently?
DD: In the last few months we have seen lithium prices going up in response to announcements made by FMC Lithium Corporation (FMC:NYSE) and Chemetall (a unit of Rockwood Holdings Inc. (ROC:NYSE)). Both companies announced price increases of around 20% on all of their lithium products last year. According to the companies, the main reason behind the rise in prices was higher raw material costs. So, we might be seeing an inflation phenomenon in this industry. In real terms, prices have remained stable, and probably will go down since new capacity is being added. Talison Lithium Ltd. (TLH:TSX) is expanding capacity in Western Australia, and Chemetall is also expanding in the U.S. Other new projects are in the pipeline coming from Galaxy Resources Ltd. (GXY:ASX) in Australia and from other projects in Argentina and Canada.
TER: So, for the moment there is currently some pricing power in the market?
DD: In general terms, prices are driven by the balance between production capacity and demand. If the market is tight, prices go up. Nevertheless, this industry has been, and still is, very concentrated and the largest, lowest-cost lithium chemicals producers drive prices. However, we have seen more competition in the market. Chinese lithium hydroxide producers have entered with an aggressive price strategy in order to gain market share from the other producers.
TER: But not all the large producers are raising prices, right?
DD: So far, Sociedad Química y Minera de Chile S.A. (SQM:NYSE; SQM-B:SSX; SQM-A) has kept prices stable. It hasn’t announced any price increase the way FMC or Chemetall have. The company probably wants to give a signal to the new competitors that they can “afford” higher costs. Most of the Chinese lithium hydroxide is produced from lithium concentrate, which is obtained mainly from spodumene. Producing lithium hydroxide from hard rock pegmatites has competitive advantages compared with producing from the lithium carbonate like Sociedad Química y Minera de Chile does, and so the Chinese can compete better in this field.
TER: Here in the U.S. we are seeing proliferation of TV ads for hybrid and electric cars (EVs). Manufactures are beginning to advertise these cars with some zing. Will this jump start hybrid and EV sales?
DD: It is difficult to know because these are still considered “luxury” cars because of their high price. We have tested a statistical model on how hybrid car sales in the U.S. responded to changes in the economic cycle and changes in gasoline prices. Conclusions are very interesting. We found some price elasticity with gasoline prices, as higher gasoline prices incentivize decisions to buy more efficient cars. But income elasticity is huge, which means these cars are very sensitive to the economic cycle. Of course these conclusions will change in the future when these cars become more affordable.
TER: Investors need to see double-digit sales and real increases in cash flow, and small companies have the tremendous advantage of not having the law of large numbers work against them. Can any of the companies you follow begin to double production and revenue and create exciting bottom lines?
DD: In the short term I don’t think so, but it’s likely in a future. Main sources of uncertainty are how fast/slow hybrid and electric cars will enter into the market in a massive way (at lower prices), and how fast/slow producers will respond to the demand. In the last years we have seen that in more than 90 projects under evaluation. We believe that 4–5 projects have chances to become part of the lithium supply very soon. That means that more competition will be added in the market.
TER: I’m recalling the way the mobile phone industry took off in less-developed countries in Asia and elsewhere because there was no pre-existing buildout of copper wire infrastructure. Mobile phones were an instant success in those areas. Why then are we not seeing large lithium ion storage batteries powering neighborhoods in the developing world where power grids have not been developed?
DD: Well, the thing is that batteries are expensive. The technology has only been in development since the early 90s. It took 30 years to make progress in developing batteries for mobile phones and electronic devices, and these are small batteries and less costly than larger batteries. This is where the industry has been focused, and now we are seeing a shift from batteries for cell phones and electronic devices to electric cars.
The requirement in terms of energy storage capacity is huge, and so the cost so far is also huge. That’s why we haven’t seen implementation of these batteries in neighborhoods and in small towns. There are also some projects that try to store energy for the grid, but in order to make these projects profitable, you have to store an important amount of energy. For a power grid, the main issue is cost.
TER: With a lot of new lithium supply coming onto the market over the next few years, will supply overpower demand, or will it be the other way around?
DD: Again, while demand is growing, so is supply. Talison Lithium Ltd. in Australia, for example, is performing a very aggressive expansion plan. We see expansions in Argentina and in the U.S., and the Chinese are also expanding capacity. The main question mark is how fast or slow electric cars will come into the market. But without subsidies and without incentives from the government, it’s very difficult to enter the market because the electric and hybrid vehicles are expensive right now. If demand for lithium grows sooner than expected, we might see a delay if supply is unable to meet demand, but I don’t think this is going to happen. In short, I think supply will meet demand.
TER: Which types of projects do you favor?
DD: There are projects based on pegmatites and projects based on brines. These are two completely different worlds. I think projects based on lower-cost brine have better chances to compete with current low-cost producers.
TER: What companies are interesting to you?
DD: Australian company Galaxy Resources Ltd. extracts lithium from pegmatite and has already started producing. Apparently, the company is competitive, and it has started to ship concentrated spodumene to its lithium carbonate plant in China.
Other pegmatite projects include Canada Lithium Corp. (CLQ:TSX; CLQMF:OTCQX) and Nemaska Lithium Inc. (NMX:TSX.V; NMKEF:OTCQX). All of these projects have a chance to become part of the lithium supply. In Argentina there’s Lithium Americas Corp. (LAC:TSX; LHMAF:OTCQX), Lithium One Inc. (LI:TSX.V) and Orocobre Ltd. (ORL:TSX; ORE:ASX). These and the previous ones I mentioned have the highest project ranking by our methodology and have more chances to become part of the lithium supply.
TER: What about Li3 Energy Inc. (LIEG:OTCBB)? Back in December, it executed a letter of intent to acquire a 100% mining interest in one of the biggest assets to be had near the Maricunga Salar in Northern Chile. That makes Li3 Energy a potential major player in Chile and one of the few developers inside of Maricunga. What does this mean to the company, particularly with regard to the ban?
DD: Li3 is developing a project in the Salar de Maricunga, the second-best salar after Atacama in Chile. The company has a project and has a strategic partner (POSCAN), but current Chilean regulation does not allow newcomers to exploit lithium. We have a ban that only allows lithium extraction from those mining concessions that were assessed before 1984, which is the case of most of the mining concessions at Atacama. I think that the ban will be removed this year, but we really can’t yet know the formula that the government will use.
TER: Lithium One is close to production, and it has established a good relationship and a joint venture with Korea Resources Corp. I believe the stock has been supported by this relationship. What are the prospects here?
DD: Lithium One is in a very advanced stage of development, and it is very well ranked in our signumBOX ranking. One of its upsides is that it is located in Salar del Hombre Muerto. It’s the only startup that actually is operating in Argentina. So it has really good prospects for the future.
TER: Back in November, Rodinia Lithium Inc. (RM:TSX.V; RDNAF:OTCQX) delivered results of a preliminary economic assessment (PEA) for the Salar de Diablillos lithium brine deposit. There are estimates of 15 kilotons (kt)/year production of lithium carbonate and 51 kt/year of potash. This implies a 34% internal rate of return (IRR), which is excellent. Is this a viable project?
DD: I think it can work, but Rodinia faces huge competition. The company estimates costs will be in the range of $1,500/t lithium carbonate. But I think that it is very different to have an estimated cost before starting production than when you’ve already started producing. I think that Rodinia can be a player in the lithium industry, but like other players in Argentina it will face huge competition. It will have to be competitive because new production is coming from China and Australia. And if Chile removes the ban, they will have to deal also with that.
TER: Talison Lithium is the leading global producer of lithium, and it’s a pure play. It’s a mature company. How much can it grow?
DD: Yes, Talison is the largest lithium concentrate producer, but it’s not the lowest-cost producer. It produces lithium concentrate in Australia and most of its product is shipped to China, where it’s converted into chemicals. I think Talison will face more competition, and that’s why it has expanded production capacity. It has performed a very aggressive expansion plan at its Greenbushes project in Australia. Nevertheless, its deposit has a short mining life; that’s why it is looking for other sources of lithium and performing an evaluation project in Chile.
TER: Daniela, thank you very much for your time.
DD: Thanks to you.
Daniela Desormeaux is an economist and an expert in industrial chemicals and natural resources. She runs signumBOX, a Chilean-based company with extensive experience in the lithium industry. signumBOX has issued several reports regarding the use of lithium in batteries and vehicles and its prospects and trends.
By The Energy Report, on January 25th, 2012
 Last year marked the third-largest growth in the potash industry, but hesitancy from India and China may put things on hold in 2012. However, MGI Securities Analyst Corey Dias still expects to see a lot of positive news coming out of the junior potash space. In an exclusive interview with The Energy Report, Dias specifies which companies he’ll be following for progress.
The Energy Report: Total potash demand in 2011 was estimated at 56 million tons (Mt), and the market has traditionally grown at a rate of about 3.5%/year. Do you believe we’ll see a similar increase in 2012?
Corey Dias: I think 3.5% could be at the high end of growth for 2012. I would expect slightly lower growth this year given that India is delaying its potash purchases until the end of Q112. China is also determining its exact needs, and there are rumors that it may reduce its imports this year versus 2011. Everything tends to depend on price. Canpotex (the marketing company for Saskatchewan potash producers) and its Belarusian counterpart are holding out for higher prices than India and the China currently seems willing to pay. With those delays, demand will probably be slightly below the historical 3.5% growth rate.
TER: Potash Corp. (POT:TSX; POT:NYSE) of Canada has shut down two mines in that country, and The Mosaic Company (MOS:NYSE) says potash buying is slow right now as buyers are taking a wait-and-see approach. What do you make of Potash Corp shutting down those two mines?
CD: It is a prudent approach. The company doesn’t want to flood the market with product as it would like to sustain a reasonable potash price that could provide a reasonably profitable return. By shutting down these mines, it’s limiting the output and that should keep the price at a fairly stable level. It’s not a question of shutting down so much capacity that prices are going to spike; it’s simply a way to keep potash prices relatively stable until the moment when a larger buyer comes back into the market, whether it’s India or China.
TER: In 2011, potash had the third-largest price increase among the 32 commodities ranked by the Scotiabank Commodity Index and, over the span of 2011, potash rose about 32%. The leading indicator of potash prices is often the price for corn, which is down significantly after some bumper corn crops in Eastern Europe, Russia, and Australia. What do you believe will be the average price per ton (t) for potash in 2012?
CD: Potash prices seem to be ranging between $450 and $550/t at the moment, depending on the port of delivery. It will probably stabilize around the $500/t level in the short term. I don’t see any reason for a significant spike in the price at this point. Although the corn price has recently seen a dip, it still remains above its historical average. Moreover, given the fact that the U.S. Department of Agriculture said that its stocks-to-use ratio is still well below the historical average, it would take a significant amount of corn production to reach the normal level of 15–20% in terms of that ratio, and reaching that level of production to meet this ratio could be a real challenge, especially when corn demand continues to grow. Therefore, while corn is slightly down, I don’t think there is going to be a downward trend in the corn price, or a complementary downward trend in potash.
TER: You don’t believe that potash will be in the top 10 performing commodities in 2012?
CD: I think it will have a fairly average year. I don’t think it will repeat its price performance in 2012 as it had a relatively low price point from which to start in 2011. It will probably stay somewhere in the middle of the park vis-à-vis other commodities.
TER: In an interview with The Energy Report in May 2011, Dundee Securities’ senior analyst Richard Kelertas predicted that we would see $750/t potash at some point before May 2013. What’s your perspective?
CD: As you said, that was in May 2011. The market looks a little different now than it did then. The fact that India is pushing back on pricing and delaying its purchases and China is reassessing are going to mitigate the potential upside of the potash pricing. Probably $600–650 is a reasonable price going to 2013, but there are a number of different factors that come into play in addition to India and China, whether it is production capacity being added to the market via brownfield or greenfield projects, whether or not there is a recovery in the European market, or whether or not the U.S. recovery continues. The fact that farmers seem to have a lot of money coming out of 2011 could, at worst, bode well for holding a pricing floor on potash at current levels and could potentially even support a higher price. I think that $600–650/t is reasonable.
TER: Tell us about your coverage universe and the types of companies you cover.
CD: I’m now ramping up coverage in the potash space. My first report was about Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX), a name that I’ve followed since early 2011 when I was working in an institutional equity sales capacity at MGI. I really like this story and the fact that it’s in a safe, mining-friendly jurisdiction. An opportunity to build a mine in a potash-rich region—the Holbrook Basin—with only two competitors in the Basin could provide an opportunity for consolidation. It is a story with a great deal of appeal.
Generally, I’m looking at small-cap developers and am not restricted to North America. There are developers in Africa and South America that could be appealing in the same way. It will be up to clients to decide whether or not they have the risk tolerance for assets outside North America.
TER: Is that typically the type of company that MGI covers even in the other sectors?
CD: We tend to cover smaller-cap names. Large-cap names would be a bit more difficult for us to champion in a lot of ways because we wouldn’t necessarily get the mind space from clients for large-cap ideas because clients are well covered by banks and bulge bracket firms that are looking at the Potash Corps of the world, companies like Agrium Inc. (AGU:NYSE; AGU:TSX) and Mosaic.
TER: Passport Potash’s share price took a beating in 2011. It’s currently developing the Holbrook Basin potash project in Nevada. Why do you believe that junior is going to rebound this year?
CD: Part of Passport’s problem this past year was based on the market itself being quite volatile, especially toward the end of the year. In general, small-cap names tend to suffer the most in those circumstances. But management made a few promises to the market that it was unable to keep and probably didn’t realize the extent to which it would be punished by the market by having missed deadlines. However, I believe that the company is starting to right itself. It is in the process of putting together an NI 43-101-compliant resource estimate, which we expect to be released by the end of Q112. Following that, we should see a preliminary economic assessment or scoping study and, further, a prefeasibility study from Passport in order to show the economic viability of its project. In addition, there was an announcement on January 18th that Passport has brought on a new chairman who has significant operational experience gained during his time with Rio Tinto (RIO:NYSE; RIO:ASX). It also has added Ali Rahimtula, who has experience in India, which is key in this type of business because there is the potential for an offtake agreement with an Indian partner. Passport has acknowledged the fact that it needs more relevant experience on the board, and has clearly begun to address this shortfall.
Like most of the names in the junior developer space, there tends to be a rerating—in terms of valuation—of these types of businesses once milestones are met along the road to production. As Passport meets its milestones, the market will likely provide the company with a more positive valuation via a re-rating of its stock. The company’s stock price hit bottom at $0.17 toward the end of last year. Since then, it has been able to at least project to the market that it does have some deadlines, which it intends to meet. Passport has engaged the engineering firm ERCOSPLAN to complete its NI 43-101. ERCOSPLAN has a really good reputation in the marketplace and has done a lot of work for developers in the potash space worldwide. The market now understands that the company is working very hard to meet its current deadline and, once met, Passport will have a potash resource estimate to put to the market. The market at that point will respond favorably, in my opinion.
TER: A competitor operating in the same basin that Passport is operating in, the Holbrook Basin, already has an NI 43-101 resource of 125 Mt potassium chloride (KCl). How large do you expect Passport’s resource to be once it’s published?
CD: The competitor has about 94,000 acres of land, while Passport has about 81,000 acres. If we were to use a ratio of acres to contained tons of KCl for the competitor and apply it to what Passport has, Passport would probably come in somewhere about 100–101Mt of contained KCl. Remember, this is in no way a forecast that I am making as to the size of Passport’s resource. Even if Passport has something like 80% of that number, I think it’s still a decent-sized resource. In my report, I am forecasting that Passport will produce about 1Mt/year over 40 years. That implies about 40Mt of in situ KCl. If we’re talking somewhere between 80–100Mt of contained KCl, there is significant opportunity for Passport to increase the size of production on an annual basis, or it gives a bit more leeway in terms of what the potential resource size could be, on a contained-ton basis.
TER: You have a Speculative Buy on that particular equity. What is your 12-month target?
CD: My 12-month target for Passport is $0.75.
TER: Another junior in that space, Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX), jumped out of the gate in 2011 and slipped above $2 in June 2011 before spending the rest of the year retreating from that benchmark. It now sits well below $1. Will that junior rebound this year? If so, what are the catalysts that are going to make that happen?
CD: I think so. Allana probably jumped up based on speculation more than anything else, but as the actual resource-related numbers come in, then it tends to start trading at some kind of multiple based on its enterprise value (EV), whether it’s EV:resource or EV:ton KCl, et cetera. When the market sees that it’s getting closer and closer to production, that’s when the valuation will start to improve. I think that is something that could happen this year. When one has an asset that doesn’t have any economic information tied to it, it’s very easy to speculate as to what you think the value should be. Obviously, the closer one gets to production, then there are hard and fast numbers that one can start applying some kind of multiple to in order to value a company like Allana Potash. That’s probably why it’s now down below $1. It’s probably more reasonably priced here and as more news comes out that’s favorable to the company, then you should start seeing the stock move back up.
TER: What are your thoughts on the Danakil potash project in Ethiopia?
CD: The Danakil project is interesting because it’s a near-surface project, which means the capex should be low. I think that it will have a fast track to production, which is another positive. And the fact that it’s probably selling to India, and perhaps China, is another positive because there is a quicker trade route to those countries when compared to North American or South American potash producers.
That said, there is no domestic demand for the product in Ethiopia. The companies that I believe have an advantage are those that have domestic demand or significant domestic demand, whether it’s a place like the U.S., which imports most of its potash needs, or South America—Brazil in particular—where 90% of its potash needs are imported. Ethiopia is also landlocked, that is, it has to go through another country in order to reach the port. Moreover, there is a greater possibility of political risk in Africa than in the U.S. or in Brazil. However, if everything remains stable, I think there could be a big opportunity for Allana, especially given its low operational cost base.
TER: What are some other small-cap potash plays that you expect will outperform in 2012?
CD: Verde Potash (NPK:TSX.V) is planning to produce a unique product called Thermopotash. Thermopotash, derived from the combination of glauconite and limestone, is a slow-release potash product with no chloride, which is great for crops like tobacco, coffee and oranges. In addition, the company is exploring the use of a new technology—the Cambridge process—which could potentially convert Verde’s potassium-rich rock to regular KCl. This would be a massive opportunity in Brazil. In terms of available infrastructure, Brazil falls behind North America but is certainly ahead of Africa.
Rio Verde Minerals Development Corp. (RVD:TSX) is another small company operating in Brazil that recently confirmed that it has potash on its property. The stock has moved up a little bit on the back of that news. Once an NI 43-101 resource estimate is released for Rio Verde Potash’s potash asset, we should see another re-rating of the stock.
Karnalyte Resources Inc. (KRN:TSX) is another one. Once again, I tend to favor the junior potash developers that have a bit of a unique element or bring something a little bit different to the table. Karnalyte is focusing on extracting potash from the potash-bearing carnallite layer, which is unusual for Saskatchewan because other producers and developers target the sylvinite layer that is usually closest to the surface. Karnalyte’s deposit is based on an anomaly where there is a significant carnallite layer that is relatively near-surface vis-à-vis the sylvinite layer. The technology that it is planning to use also could provide a magnesium byproduct and sodium chloride byproduct, both of which the Company could potentially market and sell in the future. Karnalyte has a number of things going for it; I think management is very strong. The fact that it has four patents pending for its technology could mean that what it ends up with is going to be very unique. It has a massive land holding and has only conducted advanced exploration on 20% of it. Fnially, it plans to expand its plant by using cash flow generated from its initial buildout.
TER: It has done a nice job of managing its share flow, too, with only about 21M shares outstanding vs. something far greater for a company like Allana.
CD: Yes.
TER: Or do you prefer a larger share count, such as Allana, with its 193M shares verus 20M for Karnalyte?
CD: When you’re in the small-cap space—and especially if your float is small—it becomes a bit riskier for clients to hold when the markets are a bit more volatile. It’s one thing to get into a stock, but when the market is volatile and a client is looking to exit a position, it’s very difficult to do if the trade volumes aren’t there. That’s the risk with Karnalyte. The average trade volume is 34,000 shares a day. So if you have a position that’s 100,000 shares, it’s going to take you roughly three days to get out of that position, and that assumes that you can be 100% of the trading volume over those days. And you could end up driving its price down significantly while you’re trying to exit your position. Having a more liquid position in a stock like Allana that you can get in and out of a lot more easily would likely appeal to portfolio managers.
TER: Could you give our readers an outline of what to look for in the small-cap potash space over the next year or so?
CD: You’ll see a number of companies starting to reach the prefeasibility and feasibility stages. At that point, these companies will start to look for strategic partners, whether it’s to fund the buildout of the products or secure an offtake agreement for the product that’s going to be produced a few years out. At that point, we’ll start to see which projects are going to be viewed as more viable. There probably won’t be enough demand to drive a need for every single junior potash developer that is currently out there to actually move into production. That said, there is also the possibility that some of these companies will be absorbed by larger entities that are looking to enter the potash space given the future, positive fundamentals for potash or those that are currently in the market and are looking to increase potential capacity moving forward. I expect to see a lot of positive news coming out of the junior potash space, especially as a few of these companies meet milestones in order to get a little bit closer to production and production becomes more of a reality.
Corey Dias has worked in the capital markets industry since 2003 and has spent eight years in institutional equity research and institutional equity sales. In addition, he has worked for a U.S. hedge fund, where he shared responsibility for the running of a $400M portfolio and sought out assets for private equity investment on behalf of the fund. Mr. Dias holds a Master of Business Administration from the Richard Ivey School of Business at the University of Western Ontario.
By Christopher Briem, on January 24th, 2012
My inner energy futures trader is mesmerized by what is happening in the natural gas markets of late. If you do not wake up at night wondering if natural gas will flip from contango to backwardation then I will make it simple.. the price of natural gas is plummeting faster than anyone predicted.
A little over 3 years ago, right around when a lot of folks were signing a lot of their Marcellus Shale leases, the benchmark price for natural gas peaked at over $14 per million British thermal units. The benchmark is for the gas at the Henry Hub pricing point. As of Friday that price had dropped to around $2.34. So for now a decline of 80+% from it’s recent peak, but nobody seems to know where the trend ends. Some describe it as a 10 year low in natural gas prices, but that is in nominal prices. Adjusted for inflation I wonder what prices would be described as? I only know what I read, and it seems to me that industry folks, or at least the traders, are beginning to contemplate a near term future where there isn’t enough storage capacity to hold the gas being produced. Then what?
Remember the glow of steel mills along the rivers? There may be a new glow forming across the Pennsylvania countryside.
But it means more than the potential artificial twilight that may be on the horizon. Most landowners signed leases with upfront hand money as a bonus to entice signing development rights to one of the drillers out there, but also with guarantees of royalties against future production usually around 12.5% as per state law setting the minimum royalty payments, though many may have negotiated higher shares.
But not all minimums are a minimum. Some may remember that the drillers won a court case against landowners that the royalty payment was only due on the price NET of a cost to get gas to market. How much that isI do not know, but if there are any folks out there in receipt of royalities it would be of interest (at least to me). The only number in the record I see is from this old blog post which says Range Resources is deducting 72 cents or 80 cents, mer MMBtu, for dry and wet gas respectively.
So just for sake of argument, assume the selling price for gas is the benchmark price. Yes, some may be getting more, but hold the thought and lets assume a dry gas example for moment. If you net out 80 cents from the peak and current prices it works out to $13.28 back in 2008 and $1.62 on Friday, it then works out to a royalty decline of over 88%.
Seems to me there are some latent stories out there of individual landowners seeing their royalty checks dropping precipitously? Though I have no idea what the time lag is between production and check which may have a lot to do with it. The biggest drops in gas prices have been very recent, and certainly to recent to have been reflected in checks yet.
The bigger question is just where the stability returns to the market. Are current price levels enough. Some industry folks say clearly yes and that profit can be made even as low as $2.50, likely because of the other ‘wet’ products in the gas here. But we are not even at that level right now.
By The Energy Report, on January 20th, 2012
 With oil reserves less and less accessible to western majors, producer stocks can carry significant geopolitical risk. In this exclusive interview with The Energy Report, First Asset Investment Management Inc. Senior Vice President John Stephenson explains why service-oriented companies are smart selections for risk-averse energy investors. No matter what happens in the oil and gas business, the companies doing the drilling have solid prospects in this market environment.
The Energy Report: 2011 was a pretty exciting year with oil prices all over the map, largely fueled by the European debt crisis. What do you expect are going to be the hot topics affecting energy commodities in 2012?
John Stephenson: The spread between Brent and West Texas Intermediate (WTI) prices, which was a big story in 2011, will continue to play a role. I expect a lot of talk about how WTI has once again resumed its place as the global benchmark. Another big topic, as it always is, will be the continuing geopolitics of oil, be it a possible Arab spring in Saudi Arabia or Iran’s nuclear program and how that impacts the world. In terms of possible black swan events, the Environmental Protection Agency (EPA) or other regulators could limit horizontal drilling and fracking. However, that could be very positive in the short run for natural gas prices.
TER: What caused the big spread between the WTI and the Brent prices?
JS: Everyone used to look at WTI as the main global benchmark for crude oil prices, and Brent historically traded at a slight discount. Then, over time, Brent started trading at a premium to WTI. What people have to understand is that these benchmark contracts specify grade and location. The delivery location of the WTI crude contact is Cushing, Oklahoma. Because it’s landlocked, you can’t get crude in from the Gulf region, which actually traded in line with Brent. There also wasn’t enough pipeline capacity to get the large inventories of crude that had built up in Cushing out to other global markets. So it really was an infrastructure issue that caused the price spread. Now, various companies have gotten together and proposed pipeline alternatives that would alleviate this glut of oil at Cushing. Therefore, you’ve seen the spread go from $25 to about $11.40, where it is today.
TER: Your management company, First Asset Investment Management Inc., manages a variety of different commodity-focused funds. What is your 2012 energy outlook?
JS: Our outlook is very supportive and positive for oil. One of the interesting things about oil is that despite the dire headlines, mainly out of Europe, oil has held in as well as it has. In fact, it’s been hitting eight-month highs recently. Why is that? Partly because demand is so strong. We saw record demand globally in August and near-record demand in October and November and continuing strong demand despite the fact that Europe appears to be dipping into recession and growth is potentially slowing a little in Asia. This is why I’m very positive on this and expect to see oil go higher.
Natural gas, on the other hand, is very weak. It’s sub-$3/million cubic feet (MMcf) right now, and I think it will continue to be weak. Historically the period between December and March is when natural gas trades at a premium to its summer prices. This is actually the first winter I can recall seeing it trading at a discount.
TER: Weak natural gas prices are a result of increased shale gas production through fracking, which has created a significant oversupply in the last year or so. Is this going to continue, do you think?
JS: Yes, the U.S. has 200–250 years of reserves of shale gas at current production rates. I don’t see any reason at all for it to change unless, of course, the EPA or someone else were to rule that fracking was detrimental to the environment and there was a moratorium placed on drilling. That could be a black swan event and could change things. If things continue the way they are, there’s no doubt that prices will stay low. Now, clearly, there is some opportunity to export this, but that means building a liquefaction terminal, probably on the Gulf Coast or some other part of the country where people are willing to have a liquefaction facility. That would turn natural gas into a liquid to be transported to Asia or potentially to Europe, where the prices are much higher than they are in North America.
TER: So even though we may have hit peak oil, we certainly haven’t hit peak gas.
JS: No, I don’t think we’ve hit peak gas. Four years ago, the talk was that we were running out. They were going to build terminals on the Gulf Coast to take liquefied natural gas from Trinidad and other places, gasify it and put it in the U.S. pipeline system and supply the northeast in particular with natural gas. Now we’re finding we have so much of this stuff in various shale deposits that we have the potential to become a huge energy exporter. Hopefully that will be the case, but for now we don’t have the infrastructure in place to make that happen.
TER: In some respects it’s a happy turn of events compared to previous supply concerns.
JS: Not if you’re a producer of natural gas, but if you’re a producer of oil, it’s great. If you’re a consumer of electricity, then it’s great.
TER: As far as your portfolio selections and your outlook for this year, you’re clearly leaning much more toward oil and gas liquids. What other factors do you think are going to be affecting prices this year and into the future?
JS: What impacts prices for commodities is supply and demand. I think you’re going to see that demand continues to grow. The reality of why we’ve hit record world demand is not because consumers in the U.S. are doing so much driving. It’s rather because consumers in Asia are doing so much driving. China is now the number-one car market in the world. Who would have thought? If you look at total energy consumption, including coal and other sources, China has overtaken the U.S as the number-one consumer of energy in the world. That trend will continue and put upward pressure on oil prices over time.
The other theme that I think is important for investors to understand is that most of the majors have had real trouble finding replacement reserves to keep producing at the same level. Most of the industry has run from one country to another, where they’ve been kicked out. When Lee Raymond was running Exxon, he ran over to Russia, then to Nigeria, then Venezuela. The settlement that Venezuela was willing to offer Exxon for its assets was a pittance. This is typical of what we’re starting to see around the world. It’s very hard for most of the majors to find new reserves and to continue to produce at the same levels because most of the world that has energy is not open or friendly to the West. This creates a huge problem for these companies.
Given that backdrop, investors need to find companies with reserves in geopolitically stable locations, or where companies are not in the business of generating the reserves; they’re in the business of helping oil companies produce those reserves. That leads you to the service sector, which I think is a lower-risk area. Investors can stay in North America and invest in companies they know and understand without worrying about geopolitics.
TER: What are some of the names that you like in the service sector?
JS: I think if Saudi Aramco, the largest oil company in the world, is going to do a job and it’s going to produce a new field, it will call in Halliburton Co. (HAL:NYSE) or Schlumberger Ltd. (SLB:NYSE). It’s not going to call in Exxon Mobil Corp. (XOM:NYSE). It doesn’t need Exxon’s expertise or capital. But it does need Halliburton’s or Schlumberger’s expertise. These global majors are going to do well on the service side. In the last 25–30 years, the industry has gone from positive bullish cycles to bearish cycles. The people who had the expertise in down-hole seismic techniques, who understood how to operate drill bits at various angles and how to cement and case wells and all of these other things became outsourced to the service industry. The true oil business expertise is in the service industry; that’s why I see it as a sound investment.
TER: So if I may make a mining metaphor, it’s the guys that supply the shovels to the miners that are going to make the money, not necessarily the miners.
JS: Absolutely. It’s the California Gold Rush all over again, except it’s the global energy rush, and you want to be in the picks and shovels business, not necessarily in the prospecting business laying claims. If you’re a Western company and you’re laying claims, chances are you’re laying claims in some part of the world that doesn’t want you there and that may kick you out down the road. Then what do you have?
TER: What are some other companies in your portfolio holdings that you particularly like at this point?
JS: One area to look at is the smaller energy service companies, like Calfrac Well Services Ltd. (CFW:TSX) and Trican Well Service Ltd. (TCW:TSX). Again, there is an increasing amount of drilling that’s happening, even on the gas side. It’s just happening with these new horizontal drilling and fracking techniques. These are the guys who supply this equipment. That’s very strong.
I also think you want to look at the oil companies that don’t have problems with reserves and short reserve life, including some of the Canadian oil sands producers. I would recommend Suncor Energy Inc. (SU:TSX; SU:NYSE) and Canadian Natural Resources (CNQ:NYSE; CNQ:TSX). These stocks are cheap. They’re trading as if oil were $55 or $60/barrel (bbl) when it’s over $100/bbl. These low valuations offer a great opportunity.
TER: Looking at your portfolio in your First Asset Energy and Resource fund back at the end of last quarter, Sept. 30, you were about 78% in cash. Was that a strategic decision? Have you changed that cash into equities at this point?
JS: No. We were very defensive at that time, and I think the reason was pretty simple: Europe was blowing up and when any major economic zone is blowing up, I don’t think you want to be in commodities or commodity producers. Now we’re seeing that the market has stabilized, and you’re going see growth going forward. Valuations certainly never got ahead of themselves in either individual stocks or in any energy sector, so I expect valuations to move higher at this point.
We’re no longer at that same cash level. Our position at that time reflected an overall nervousness about the world. When you have these dominant issues, you need to take your money off the table, which we did. Ultimately, the trade was to the downside, and we preserved value by doing that. I’m very proud that we were able to raise so much cash and be truly defensive at a time when the market was dropping quite substantially.
TER: Are there any of your other attractive portfolio holdings that you’d like to discuss at this point?
JS: I think in terms of other commodity themes that are working well, certainly Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE) would be a great name—that’s on the copper side; it is the largest pure copper producer out there. On a similar vein with a little bit better growth and a little bit more sensitivity to the market—meaning it will move a little more dramatically than the market itself—would be First Quantum Minerals Ltd. (FM:TSX). That’s another name that I think does very well.
We haven’t talked a lot about the agricultural names. If we’re talking about the broad resource base, it’s been a tough time in the agricultural space, particularly for the fertilizer companies. But I continue to think Potash Corp. (POT:TSX; POT:NYSE) looks attractive, especially at this level. Agrium Inc. (AGU:NYSE; AGU:TSX) looks attractive at this level. It’s a little more defensive than Potash. The Mosaic Company (MOS:NYSE) has struggled. I would probably recommend CF Industries Holdings Inc. (CF:NYSE) over Mosaic. Those are the areas that I would look to.
Also, in terms of other oil and gas producers, Canyon Services Group Inc. (FRC:TSX) does well. Transocean Ltd. (RIG:NYSE; RIGN:SIX), a big supplier of offshore platforms, will do well in this environment. Even Baker Hughes Inc. (BHI:NYSE) is transitioning its fleet to more horizontal drilling from straight vertical drilling. Those are all names that we have held and will continue to hold in the future and expect to do well.
TER: To sum things up as far as the energy outlook for 2012, what would you like to tell us?
JS: I would say that energy remains the most important of all the commodities. It will be the most important in 2012 and likely in 2020. Even though we’re over 100 years into the energy era, we are still very much dependent on oil. While it may seem expensive when we’re filling up at the pump or when we look at the futures prices, it’s still cheaper than orange juice on a volumetric basis. There is no substitute for oil, at least no good substitute. There is no technology right now that is commercially viable enough that could change the industry in the way that horizontal drilling and fracking changed the natural gas world. So I think you’re going to see oil prices move considerably higher.
Demand no longer is being driven by America; it’s being driven by Asia and predominantly by China. That trend will continue. In many parts of the world where demand is growing the fastest, namely the Middle East as well as some parts of South America and Asia, fuel prices are subsidized. In an environment where gasoline prices are subsidized, the consumer isn’t feeling the full impact that we feel here in North America. So for those reasons, I think we’ll see oil prices move higher, stay higher and exit 2012 at least $130/bbl. Natural gas prices, on the other hand, will remain range-bound in the $2.50–3, maybe $4, range. It’s very hard to see a successful investment strategy for investors there, other than with the service companies that are going to be the beneficiaries from all of that drilling.
TER: I think that pretty well sums it up. We appreciate your thoughts and input today.
JS: My pleasure.
John Stephenson is a senior vice president and portfolio manager with First Asset Investment Management Inc., where he is responsible for a wide range of equity mandates with a particular focus on energy and resource investing. He has been recognized by Brendan Wood International (BWI) as one of Canada’s 50 best portfolio managers for the past three years. He is the author of The Little Book of Commodity Investing (John Wiley & Sons, 2010), which has been translated into five languages and Shell Shocked: How Canadians Can Invest After the Collapse (John Wiley & Sons, 2009), and writes a free bi-weekly investment newsletter, Money Focus, which reaches a global audience of more than 125,000 (www.reportonmoney.com).
Stephenson is regularly quoted by Bloomberg News, Reuters, The Associated Press, The Wall Street Journal and The Globe and Mail and is a frequent guest on Bloomberg TV, CNBC, CNN, Fox Business and Canada’s Business News Network (BNN), Sun TV and the CBC. He is frequently the keynote speaker at investment conferences throughout North America. Stephenson holds a degree in mechanical engineering from the University of Waterloo, an MBA from INSEAD, as well as the Chartered Financial Analyst (CFA) and Financial Risk Manager (FRM) designations. He lives in Toronto.
By The Energy Report, on January 13th, 2012
 Retail and institutional traders invested record amounts in renewable energy producers in 2011, but separating the wheat from the chaff can be challenging. In this exclusive interview with The Energy Report, Jacob Securities’ Senior Vice President for Research John McIlveen shares how to pick and choose. For steady dividends, high-yield Independent Power Producers deliver shareholder value, while renewable projects in the developing world offer incredible potential returns. Whatever the project, it’s the internal rates of return that matter.
The Energy Report: John, what is your current investment thesis?
John McIlveen: Safety is still the dominant concern with small-cap companies, which are high-risk by definition. I mostly stick with power generators. High-yield Independent Power Producers (IPPs) returned over 20% in 2011, whereas manufacturing was slammed as many sectors entered cyclical lows. The generators have 20-year contracts, which provide highly predictable cash flow. To buy the manufacturers, you really have to understand the cycles.
TER: What’s the relationship between conventional energy prices and renewable energy stocks? Do higher conventional energy prices trigger a bounce in renewables?
JM: Optimally, it would be better for renewables if conventional energy prices were higher. However, the reality is that renewable prices do not fluctuate with conventional energy prices because renewable power generators operate on long-term contracts with fixed prices. In the power business it is natural gas, not oil that sets the marginal price of power in the developed world. Low gas prices actually reduce prices on new renewable power contracts, but they do not affect an existing contract. Oil and diesel dominate power prices in the developing world, and because of this, power prices are two to four times the developed world prices. This is why we’re seeing generators rush to the developing world. The generator can get twice the power price there and yet still save the host country 50%. There are much higher prices to be had for power in the developing world right now.
TER: Where would that be?
JM: Anywhere where oil or diesel are generating power. That would include most of the Caribbean and the Pacific islands. Even Hawaii is mostly on diesel.
TER: What’s the most workable alternative energy technology right now that can deliver for investors?
JM: I don’t see a surefire rocket ship growth story right now, but two technologies worth watching are algae and power storage. Algae consuming carbon dioxide (CO2) could be turned into a biofuel or a biomass, and it has the potential to be turned into human-grade protein. It has not been demonstrated on a large scale yet but if it works, it could supply us with clean fuel and power while consuming CO2.
Also, the lack of good power storage has held back many technologies for decades. A power storage system that could be sized to fit into a residential home and capable of storing a few kilowatts would enable a nationwide roof-top solar power system without new transmission lines.
TER: That sounds like the kind of thing that could take off in the developing world much the same way cellular telephone technology did in countries where there was no huge copper wire infrastructure in place. Is that fair to say?
JM: Yes, that would be completely applicable to the developing world as well.
TER: Which renewable energy technology could be the most profitable for investors and which the least?
JM: Once online, the generation method really does not matter. It’s the project’s internal rates of return (IRRs) that matter. Generally, investors should look for 10% or better unlevered IRR on a particular project. If investors are buying developers with little to no assets already online, then geothermal carries the most risk due to drilling, whereas solar carries the least risk due to its higher predictability and short installation time. However, having said that, geothermal stocks have been beaten up the worst of all these junior developers and may represent good value buys.
The biofuel area has some favorable political winds in its sails, as the biofuel volumes are mandated and increasing by 20% a year. However, there is still the double-ended commodity price risk, as you do not have the long-term contracts as you do in power production.
TER: I’m looking at an unweighted basket of conventional exploration and production (E&P) mid caps that were up nearly 19% over the last 52 weeks. I’m also looking at a basket of alternative energy stocks that were down 43% during the same period. What catalyst might induce a secular, upward movement in alternative energy shares?
JM: I think it’s more broad-market based as opposed to being simply about alternative energy. The non-yielding IPPs were down 40% in 2011. Only one of them had a positive return, that one being Western Wind Energy Corp. (WND:TSX.V), which was up 24%. However, most of these have bounced off their one-year lows, and the market now looks like it is anticipating the resumption of upward movement in the small-cap sector. The market must come to believe large-cap stocks are fully valued, and there are signs now that this is happening, and some investors are now looking for bargains in small caps.
TER: You mentioned that Western Wind was up 24% in 2011. It’s up more than 5% in just the first few days of 2012.
JM: Western Wind has been a unique story. It has brought 130 megawatts (MW) of wind online in 2011 without any equity dilution by using the investment tax credit (ITC) cash grants to secure bridge loans. It expects to add another 30 MW of solar the same way in 2012. There was also a $2.50/share takeover offer, which was withdrawn by the bidder after the huge stink that Western Wind put up. Now, there’s a possible proxy battle looming by disgruntled shareholders who would’ve preferred to see the bid entertained further.
TER: Solar is a new business for Western Wind, isn’t it?
JM: Yes. Up to this point, it had only 0.5 MW in operation. This new 30-MW project will be in Puerto Rico and should be online toward the end of 2012.
TER: Do you feel that’s a good fit for the company to be in both solar and wind?
JM: Yes, I do. You could even put solar and geothermal on the same site, thereby saving on a lot of infrastructure and transmission costs.
TER: What other companies are you talking to investors about today?
JM: I like Ram Power Corp. (RPG:TSX), and we are rating it Speculative Buy with a $0.74 target price. It’s just coming online with 36 MW of geothermal in Nicaragua. It will have another 36 MW in a year on the same site and could pay a dividend in 2013. So I think there is some good near-term potential to that one.
TER: Your implied return is more than 100%. After a tough year, the stock is up about 14% over the past four weeks. Are we looking at a turnaround?
JM: I think so, because all these junior developers now are show-me stocks. The market wants to see their projects come online on time, on budget and with cash flow. Once you see that, these values are going to move into these stocks very quickly.
Another is Etrion Corporation (ETX:TSX), which has 60 MW of ground-mount solar in Italy. However, it cannot pay a dividend now because its projects were 100% debt-financed. The stock is still too low to recapitalize, so I think what I’d like to see there is that it sell some assets at a good gain so that it can restart its growth.
TER: In your reports you refer to Etrion as a project company. Tell me more about that.
JM: It has about 10 different solar ground-mount projects, all of which it built over a two-year period. The company financed it all with debt; it didn’t raise any equity. Because it has such a high-interest and debt-repayment schedule, it will not be able to pay a dividend, and I don’t think it generates enough cash flow on its own to continue to grow. With the stock half what it was a year ago, I’m sure management doesn’t want to issue any equity to fund growth. A good alternative for Etrion would probably be to sell one or some of its projects in order to finance growth.
We like Ormat Technologies Inc. (ORA:NYSE), a solid company with free cash flow to grow its megawatts by about 20%/year. But without a significant dividend, the market punished it in 2011. I expect the company to beat the Street in 2012.
TER: You reduced your target price on Ormat from $34 to $24. What was going on there?
JM: It had nothing to do with Ormat. I had actually increased my estimates a little bit at the same time when I did that. Essentially I’m going from a 15x enterprise value/earnings before interest, taxes, depreciation and amortization (EV/EBITDA) multiple, which was what a bull market pays for a high-growth power company, down to 12x EV/EBITDA, which is more of what a slow-growth or bear market would pay.
Another is Alterra Power Corp. (AXY:TSX). It is a solid company with geothermal, wind and hydro assets. It would benefit the most if small caps return to favor, but it will not be able to pay a dividend for a few years given its current expansion program.
TER: Back in November, you raised your rating on Alterra from a Hold to a Buy. What was the catalyst for that?
JM: Two things: the company had turned cash-flow-positive with the consolidation and acquisition of Plutonic Power Corp. just as the general market began to move the stock. Eventually, with their declines, they all move into a Buy-position. Our criterion for a small-cap stock is it has to have a 25% potential return to the target price to be a Buy.
I might also mention U.S. Geothermal Inc. (GTH:TSX; HTM:NYSE), the only geothermal company not to have stumbled over drill results in 2011. Progress has been plodding but mistake-free. I think U.S. Geothermal is a good value, and unlike the other geothermals, it has not yet bounced off its one-year low.
TER: You also follow Just Energy Group Inc. (JE:TSX) and you have a $15 target price on it, which represents about 40% upside potential from here. This company has a significant market cap compared to most of your coverage universe, and it has a very different business model as well.
JM: Just Energy Inc. is essentially a reseller of gas and electricity, but the company has a small and growing renewable energy component to its business such that when it resells electricity, you can buy green power and buy green credits. This small part of its business is growing quite rapidly.
In its gas markets, it has a very high turnover in its contracts because that market is very fear-driven. End-users are only likely to lock into a five-year gas contract if they fear gas prices are going to be rising, but that’s certainly not the buzz we hear every time we read a newspaper. That part of the business is a little challenging.
Their electricity market is a little bit better because there is still upward pressure on electricity prices, and people are thus willing to lock into contracts. The company has made three good-sized acquisitions in the last few years and has levered up the balance sheet on the high side. The dividend here is yielding 11% in the market, but the market is worried that there might be a dividend cut.
TER: You have had some concerns about BIOX Corp. (BX:TSX), but the stock is up 120% over the past six months.
JM: I have some short-term concerns because the U.S. $1/gallon tax credit has expired. I think this is going to cause some short-term downward pressure on biofuel prices; however, because the volume mandates remain, it should correct later on in the year. I’d suggest watching for a technical bottom for an entry point.
TER: Do you think the U.S. tax credit could be renewed?
JM: I don’t think the tax credit will be renewed. Given the current budget-cutting Congress we have, perhaps it will just be allowed to expire like so many other renewable incentives. As for the Environmental Protection Agency’s volume mandates, Congress would actually have to take action to rescind the mandates, whereas in the case of the tax credit, Congress doesn’t have to do anything, just let it expire. The volume mandates look to be here to stay.
TER: I have enjoyed speaking with you very much, John. JM: Thank you.
Jacob Securities Senior Vice President for Research John McIlveen has been with the firm five years and has a total of 26 years experience in special-situations research and merchant banking. In 2004, he became Canada’s first sell-side analyst to focus solely on renewable energy research and consistently has been ranked a top performer by Bloomberg on accuracy of estimates and returns. He is currently treasurer of the Canadian Geothermal Energy Association and a published academic with 15 papers, including his and coauthor Alan Rugman’s 1985 best Canadian book-nominated Megafirms: Strategies for Canada’s Multinationals.
By The Energy Report, on January 11th, 2012
 John Edwards, first vice president covering energy infrastructure master limited partnerships for Morgan Keegan, is bullish for 2012 and well beyond. In this exclusive interview with The Energy Report, Edwards highlights how this sector pairs a low-volatility asset class with stable, secure distributions—a rare combination in today’s markets.
The Energy Report: A year ago, you forecast average returns of 10% with the yield spread between master limited partnerships (MLPs) and 10-year U.S. treasuries at 290 basis points. How accurate did your forecast turn out to be?
John Edwards: It turned out fairly well. The actual performance for MLPs beat our original expectations by about 390 basis points. On the last trading day of 2011, we were looking at 13.9% total return.
We targeted yields on the sector between 6% and 6.5% and it ended near 6.1% at the lower end of our targeted range.
TER: What is the current yield spread?
JE: The current yield spread is approximately 4.2%, 420 basis points.
TER: Do you believe MLPs are valued fairly right now?
JE: We think fair value in the year ahead should be in the 5.75% to 6.25% range, which is where we are. In that regard, MLPs are fairly valued.
If you look at it from the standpoint of spreads against U.S. 10-year Treasuries, you can make the case that MLPs are undervalued. Over the last decade, the average yield spread between MLPs and the U.S. 10-year has been about 324 basis points. Over the last five years, it has been 385. Obviously, that was skewed by the financial crises in 2008 and 2009. The most commonly occurring yield spread is in the range of 200–250 basis points.
We prefer to be a little conservative. With respect to valuation, MLPs have averaged a 7% yield over the last 10 years, and about 7.4% over the last five years. Inevitably, we expect there will be some spread compression, more due to a rise in the yields on the U.S. 10-years than to drops in the yields on MLPs. But overall, looking at the sector’s history, we consider 6% or so to be a very commonly occurring yield.
TER: Will total returns nearing 12.5% in 2012 lead to a flight into MLPs by retail investors? After all, virtually nothing else out there is performing at a consistent level.
JE: On a risk-adjusted basis we think MLPs offer a very compelling opportunity. For 2011 we targeted 6–6.5% yield and a distribution growth of 4–6%. We believe distribution growth ended up at the high end or a bit above. For 2012, we think the growth will be a bit stronger. We recently raised our target to about 100 basis points, or 5–7% growth. We are now thinking it will be even stronger, maybe 6–8% for 2012, in which case, we would be looking at a total return expectation somewhere between 10–22% for 2012. That would put our mid-point expectations in the 15–16% range for 2012.
TER: As of mid-December the Alerian MLP Index, which is basically the industry benchmark, was down half a percent from an all-time high set earlier in December. Did that surprise you?
JE: That did not surprise us too much. The last three months have been surprisingly strong for the sector; it has been at or very near its all-time highs. The Alerian benchmark has recently surpassed its all-time high, set in April 2011 on a price basis, and of course has set an all-time high on a total return basis.
There are not many opportunities for investors where you can find a low-volatility asset class paired with stable, secure distributions. This is a sector with tremendous visibility in terms of growth over the next 20 years. It is very difficult for us to think of other asset classes available to investors that offer what MLPs offer right now.
TER: In 2011, gas processors and MLP general partners were the best-performing MLP subsectors, with total returns at about 18% for gas processors and 17% for general partners. Do you see that trend continuing for 2012?
JE: We do. The opportunity for gas processors remains very strong. A tremendous amount of opportunity remains in shale plays where there is a lack of infrastructure. There is a lot of wet gas out there, which creates demand for the services needed to separate the gas from the liquids.
It is also important to note that fractionation capacity is also in short supply. We expect the capacity of raw liquids pipeline to be much greater than the fractionation capacity additions over the next few years. Consequently, we think companies involved in those businesses should do very well.
The one risk we are always mindful of and that is difficult to diversify away is commodity exposure in gas processing that arises from difficulties in the financial sector. Whenever there is trouble in the financial sector, it tends to create headwinds in gas processing, as natural gas liquids (NGLs) that are produced tend to tie more closely with oil, which in turn could face downside, should we see contagion from the European banking and the financial sector. NGL prices are important to natural gas processing/fractionation margins. We saw this in 2008 and 2009. But assuming the financial sector stays relatively healthy, gas processers should do very well in 2012.
TER: Conversely, it was a rough year for propane and shipping MLPs. Propane MLPs were down around 6%. Do you expect this subsector to rebound?
JE: This was a challenging year for propane MLPs. There is ongoing conservation in that subsector, and as a result, there is no organic volumetric growth at the retail level. Rising propane exports have kept wholesale propane prices relatively strong, which cuts into margins for the propane companies.
We expect the challenges for propane to continue. The subsector is ripe for consolidation. The irony is that, should there be difficulties in the financial area, propane companies would likely do well because wholesale propane prices would probably fall. But barring that scenario, we think propane companies are more likely to lag.
TER: Your recent Morgan Keegan MLP Top 10 list carries the caveat that those names are not necessarily the best fit for all accounts and are not necessarily how you would build an MLP portfolio. How would you build an MLP portfolio?
JE: In building an MLP portfolio our bias is to protect investors’ interests, to protect against downside risk. Thus, although we believe gas processors have perhaps the best upside potential, there also is more downside exposure to difficulties in the financial sector. With that in mind, we tend to overweight the larger-cap MLP names. But we would certainly want to continue to have exposure to that area.
TER: EV Energy Partners, L.P. (EVEP:NASDAQ) holds the top spot in the Morgan Keegan MLP Top Ten, largely due to its exposure to the Utica Shale. Please tell us about that play and how EV Energy is leveraging it.
JE: EV Energy Partners is an unusual MLP, in that it is in the upstream area, meaning it is involved in oil, gas and liquids production. It has a very strong position in the Utica Shale, about 158,000 acres. A number of wells have been drilled there, and it is providing a lot of data points indicative of a play with very strong potential. Some reports liken its geologic characteristics to the Eagle Ford Shale, which has been a very, very strong play.
We need more data, but based on a number of announcements from other players that have signed up for takeaway pipeline capacity out of the Utica Shale, we believe there is tremendous potential, and that it is only a matter of time before EV Energy Partners is able to realize some of that upside. That is why we think it has one of the strongest total return potentials for the coming year. We also see that at current valuation levels investors are effectively valuing the Utica acreage at just $5,000-$7,500/acre compared to recent transactions that effectively valued the acreage at $10,000-$15,000/acre, again supportive of upside potential in the value of EV Energy Partner units, in our view.
TER: It performed remarkably well over 2011. At the beginning of December, its total return for 2011 was close to 80%. Do you expect similar performance in 2012?
JE: Not quite as strong as 80%—somewhere between 27–73%. A good midpoint would be ~50% total return over the next year.
TER: That is still impressive. In January 2011, you named MarkWest Energy Partners, L.P. (MWE:NYSE.A) as one of your top picks. This year it is in your top 10. Why?
JE: MarkWest Energy had a very strong 2011, with a total return exceeding 30%. It has a very well-positioned footprint in the Marcellus Shale. It continues to have very rapid growth, providing midstream assets and services. We also believe it will be very well positioned to take advantage of emerging demand for services in the Utica Shale. We expect MarkWest will be able to invest hundreds of millions of dollars in the Utica and Marcellus Shales each year over the next several years. With that kind of visibility and potential for tremendous distribution growth, we are looking at returns averaging at least in the mid-teens for the next several years, with strong balance sheets and strong distribution coverage. Most portfolios ought to have exposure to MarkWest Energy Partners, in our view.
TER: And, you recently raised your price target to $66.
JE: Yes, as a result of its decision to buy into a joint venture with the Energy & Minerals Group for $1.8 billion (B). The two will be forming a subsequent joint venture to take advantage of the Utica Shale. We expect an announcement in January about additional plans to serve producers in the Utica Shale play.
TER: In a recent description of your investment thesis for the next few months, you included “exposure on liquids and storage” among the attributes you are looking for. Which midsize names in the liquids camp do you favor?
JE: One of the names we believe has very strong potential over the next year is Enbridge Energy Partners, L.P. (EEP/EEQ:NYSE). The partnership itself is based in Houston, but the parent is up in Calgary.
TER: What sort of distribution growth is Enbridge targeting in 2012?
JE: Enbridge’s target is in the 2–5% range, a very conservative target. We believe that given its position, recent performance and opportunities, Enbridge is more likely to be in the 5% range, giving the units some upside potential from a valuation perspective.
TER: Canadian regulators recently approved Enbridge’s Bakken pipeline project to carry oil from the Bakken into Canada, where it would connect with Enbridge’s main line in Manitoba. Is that a significant catalyst?
JE: That is just one project among many. Enbridge has $1–1.2B in projects on the drawing board over the next year. We believe all of those will contribute to Enbridge’s longer-range growth prospects.
We also like Plains All American Pipeline, L.P. (PAA:NYSE) over the next year. It has had a very strong run recently, but we think it is well positioned for the long term.
TER: Plains All American is a large-cap MLP. It made a number of acquisitions last year, including buying BP’s Canadian NGL and liquefied petroleum gas businesses. Which of Plains’ acquisitions are you most excited about?
JE: The one that you just mentioned. We think Plains was able to acquire the BP assets at a very attractive multiple and that it will be immediately accretive. Because the guidance on that contribution was very conservative, the distribution growth rate was raised recently. We anticipate it will be in the 9% range next year. Now a large part of that has been captured recently in its valuation. But, given the conservatism embedded in the guidance, we see a potential for more upside.
TER: You have an outperform rating on LINN Energy LLC (LINE:NASDAQ). Why do you believe Linn will outperform the S&P 500 in 2012?
JE: We think Linn has good distribution growth prospects. We also think it is pretty attractive valuation-wise. We are looking at somewhere in the neighborhood of 6–8% growth and distribution over the next couple of years. You combine that with its ability to make accretive acquisitions and its robust development program, and we think Linn should continue to do well with a roughly 18–20% total return prospect over the next 12 months.
TER: Do you have any parting thoughts for us today?
JE: We continue to be bullish on MLPs for the next several years at least. And we think MLPs should have a place in almost every investor’s overall portfolio.
TER: John, thank you for your time and your insights.
John D. Edwards, CFA, joined Morgan Keegan in October 2006 as a vice president, covering energy infrastructure master limited partnerships. Prior to joining Morgan Keegan, Edwards was a managing partner of Vektor Investment Group, LLC, where he consulted on energy infrastructure projects and real estate development. Edwards also worked with Deutsche Bank Securities as a vice president and senior analyst covering natural gas pipelines and as an associate analyst covering automotive suppliers. Edwards began his career in the energy industry with Edison International where he worked in regulatory finance, M&A, project finance, and business development. He received his Bachelor of Arts from Occidental College in Los Angeles, California and a Masters in Business Administration from California State University, Fullerton, and he holds the Chartered Financial Analyst designation. He is also a member of the Financial Analysts Society of Houston, Texas.
|
|
Most Popular Posts