Chen Lin has gotten so much attention for his investment success, new subscribers to his newsletter, What Is Chen Buying? What Is Chen Selling?, have to line up on a waiting list. Luckily, he sat down with The Energy Report to share some of the investment ideas that helped his portfolio climb 63% in 2012. Learn how Lin played price differentials and dividends to create outstanding gains in a challenging year, and what his moves for 2013 may be.
The Energy Report: Chen, what’s your economic and market outlook for 2013?
Chen Lin: In the past few months, China seems to have turned the corner as its real estate market started to turn up, and so goes its economy. I believe the U.S. will likely do well. I don’t see the EU breaking up in 2013, and Japan is going to be printing a lot of money this year to try to jumpstart its economy. So although I see slow global economic growth, it’s still growing, especially in China and the U.S. I believe the stock market can do quite well as investors have been piling into bonds and cash in the past a few years.
TER: Oil prices have recovered from their lows of last year, but Brent is much stronger than West Texas Intermediate (WTI) and closer to its March peak than WTI. What’s your forecast at this point?
CL: I see relatively stable oil prices. There will be a lot more oil coming from U.S. shale plays. However, the pipeline to the Gulf will be limited and the United States has a ban on exporting oil. We are likely to see a lot of oil coming from Oklahoma to the Gulf Coast. However, the oil has to be refined at the Gulf Coast because it cannot be exported, so the new pipelines will likely push down Louisiana Light Sweet until it sells at a sizable discount to Brent, which could create some interesting opportunities for refiners on the Gulf.
TER: How do you view the domestic versus international production arenas in terms of investment potential? Where do you see the best investment opportunities in 2013?
CL: I’ve been really focusing on international onshore plays in the past few years and will continue to do that. International companies can get the Brent price. Domestic producers are usually shale or offshore plays with high capex. Capital is very hard to get, especially for small companies, so that’s why I’m focused on international onshore players. The geographic area I’m mainly looking at is Southeast Asia and onshore Africa, because those are areas in which China is likely to make more acquisitions.
Last year was very difficult and many juniors were hit very hard—it reminded me of 2008. I see potential on the other side of the trade, where most investors are going to cash and bonds and avoiding risk. Maybe investors are getting ready to take on more risk. That’s got me quite excited for 2013 and I’m continuing to watch the market for opportunities to arise.
TER: What are the global implications of China’s aggressive oil and gas acquisition plans?
CL: I think China’s acquisition strategy is twofold. One is its focus on North America, mostly in Canada, where the primary goal is to understand fracking technology and see if it can be applied in China or elsewhere. The other focus has been on Southeast Asia and Africa, which can be very beneficial to juniors. We’ve seen some M&A activity there and I expect to ride the wave and hopefully take advantage of that.
TER: Has your investment strategy changed at all as a result of developments over the past six months?
CL: Not much, but I have started to look a little at some more risky junior plays because investors have been extremely risk-averse. This is a good time to start looking at them more closely.
TER: You recently closed your newsletter to new subscribers. What was the reasoning behind that?
CL: My newsletter has been getting a lot more popular lately and I really hate to see stocks swing a lot on my recommendations. In an ideal world, stocks should only rise and fall on their own merits and not on my recommendation. So I decided to close it to new subscribers so our existing subscribers could have a better chance to make profitable trades. We are allowing people to go on a waiting list if people drop out.
TER: Do you feel that investors need to be more trading-oriented in order to profit in the energy market these days?
CL: Personally, I’m a pretty long-term oriented investor, but recently the market has been so rough I’ve been forced into taking more of a trader approach. I really enjoy working on long-term winners and energy companies that can be self-funded are extremely attractive. I have quite a few very long-term plays I’ve been in two or three years and still holding. I’m hoping the market will stabilize a little so we can have longer-term trades, but I do short-term as well.
TER: When you talked with us, midyear 2012, your portfolio was up somewhere between 40% and 50% for the first half of the year. How did you do overall for 2012?
CL: My partner, Jay Taylor, tracked it at about 63%. There’s a retirement account without any leverage or option trading, which was intentional. I was fortunate to do very well over three main areas in 2012: energy, mining and biotech. Actually, my biggest winner in 2012 was in biotech. Sarepta Therapeutics (SRPT:NASDAQ), which I discussed in The Life Sciences Report not long ago, has actually returned 15-fold in the call option trade. We also made a few very profitable trades in metals and mining; for example, we bought gold and silver stocks and ETF call options just weeks before QE3, which we sold on the QE3 news market swing. I also did quite well in the energy sector.
TER: What were your best performers last year in the energy sector and are you going to be sticking with them?
CL: I was heavily invested in Mart Resources Inc. (MMT:TSX.V) and Pan Orient Energy Corp. (POE:TSX.V) at the end of 2011. I will continue to be bullish on both stocks and those continue to be my heavy holdings. In terms of Mart Resources, we will likely see dramatic increases in its production when it finally builds out its pipeline. Oil production could easily double, if not triple, after the pipeline is built, so I expect the dividend increase to follow. Right now it’s paying about a 13% dividend. I would expect to see a much higher dividend after the new pipeline goes in.
TER: And when do you expect that will be built?
CL: The company guidance is for the second half of 2013.
TER: And where is Mart trading these days?
CL: It’s trading at $1.76 in Canada, $1.80 in the U.S. It paid $0.20 in total dividends in 2012 and it’s been a big winner. I started buying the stock at $0.15–0.16. I expect the dividend should be relatively stable because the cash flow is just incredible. The risk is that it’s in Nigeria and subject to some political risk. But if you can look beyond that, the stock has a very bright future. China recently made an acquisition in Nigeria paying about $23 per barrel (bbl) oil, so you can see that the upside is very significant. Most recently, Mart announced initial results for the UMU10 well. These new discoveries at deeper zones will not only increase the reserve and production, it may even carry an additional tax holiday that can be very beneficial to Mart shareholders.
TER: What’s going on with Pan Orient?
CL: This year will be the most exciting in the company’s history. It’s a producer in onshore Thailand. It has prepared for the past five years to explore some big targets in Indonesia as well as Thailand and will start drilling this month. There was an excellent article written by Malcolm Shaw, a retired Canadian fund manager. Seldom in my trading career have I seen this kind of risk/reward, and if you ask me which stock I think would have the greatest chance of becoming a tenbagger in 2013, I would say, without a doubt, it would be Pan Orient.
The beauty is it has so much cash on the balance sheet and no debt. It has fully funded all its exploration and doesn’t need to dilute shares. By the end of the year, it should still have a lot of cash left. Management consistently bought shares in the past. Even in the worst-case scenario, the downside is very limited and the upside is very big. Also, I want to say that the Chinese company, Hong Kong and China Gas Co. Ltd. (3: HK), bought the Pan Orient legacy oil field last year for $170 million ($170M), and has been looking for more assets. If Pan Orient makes new discoveries, we have a natural buyer right there to buy them and reward shareholders. That’s why I’m very excited about this one. I purchased the stock a year ago and it has much more room to run. I believe the run for Pan Orient has just started because it takes many years to prepare that groundwork, get approvals, do the seismic and then finally start drilling this year. I’m very excited about the stock.
TER: What other names have been good performers in the last year?
CL: Another stock with a nice return that is still undervalued is Coastal Energy Co. (CEN:TSX.V). It’s offshore Thailand so development is always slower than onshore; fortunately the wells are inexpensive to drill. I wouldn’t put it in the same category of Mart and Pan Orient. I’ve been trading it in and out since the stock was trading at a few dollars. Last year when an Indonesian company proposed to buy Coastal, I sold out all my shares. I told my shareholders to sell on the surge and then when the takeover failed, I bought back, at a much lower price. I’ve been trading in and out of this one.
Another stock I’ve been trading in and out of, so far successfully, is PetroBakken Energy Ltd. (PBN:TSX). It pays about a 10% dividend right now on its Bakken play. It’s quite undervalued if you compare it with its peers. I just bought it back recently after making a 50% return in the last round a year ago. Hopefully, it will rally from here. Many traders like to trade by the chart, which sometimes ignores the fundamentals. I often put “opposite trades” in place to take advantage of market swings.
TER: Do you have any sleeper names that are maybe due to take off?
CL: Porto Energy Corp. (PEC:TSX.V) was probably my major loser in the energy portfolio last year. Porto is an example of my risk-taking. When George Soros closed his position of Porto at $0.07 last summer, I decided to take advantage of it and told my subscribers that I became one of the largest shareholders. My calculations at that time were if its ALC-1 well were successful, the stock would be a tenbagger. If not, it’s still worth a lot of money. But the well was a failure. The stock is still trading at $0.06, so it’s really verified my calculation. You can see the risk/reward was in my favor and, in the future, if this kind of situation arises, I would do it again. But right now, looking at a $0.06 stock, I think it’s still very undervalued.
I had a long discussion with management not long ago. As a large shareholder, I proposed to management to take a look at the current tax-loss carryforward situation. Porto spent over $100M in Portugal and has over $100M in loss carryforward in Portugal. That could be worth a lot of money to its partner, like Galp Energia, which is a $10 billion Portuguese national oil company. Galp can take advantage of that loss and could translate easily to $0.20–0.30 per share. Management told me that they would take that into consideration and they are still in the middle of discussions with Porto to drill two or three wells this year. Those wells will be critical to the company’s future. The silver lining is that if all the wells fail this year, Porto may still have the option to sell to its partner, which may be able to use the loss carryforward on the balance sheet. I like this kind of a situation.
TER: So it may still be a winner for investors.
CL: Possibly. The risk/reward is in my favor, which also tells you how undervalued many resource plays are. The market has been in extreme conditions and Porto is just one example. There are so many undervalued plays out there that I am looking at right now.
TER: Does Porto have enough money to be able to do exploration work on its own?
CL: The two to three wells it plans to drill will be completely on the partner’s money, so it’s kind of a win-win situation for both.
TER: So it doesn’t have to go out and try to raise more money in the foreseeable future.
CL: Exactly. Management owns a lot of the stock and has been very careful about dilution.
TER: Do you have any other situations that look particularly attractive?
CL: A couple of weeks ago I took a position in a refinery play, which is a recent IPO called Alon USA Partners LP (ALDW:NYSE). Its parent is Alon USA Energy Inc. (ALJ:NYSE). Alon USA Partners is a master limited partnership that’s based on a single refinery in the Permian Basin. The Permian Basin right now has huge oil production and there’s a big spread between the local oil—West Texas Sweet—and Brent. Management is guiding about a $5.20 dividend for 2013. Right now the stock’s trading about $22. That means the dividend will be over 20% in 2013.
People wonder what happens if, in the long run we have all the pipelines built in the next 5-10 years. Alon USA Partners LP should still have an advantage because it would be more like a pipeline company. Why? Because it can take oil locally instead of piping all the way to the Gulf Coast and then it can refine that into gasoline and sell locally instead of piping the gasoline from the Gulf Coast. Basically, its margin will be the pipeline cost to pipe oil over and then pipe gasoline and diesel back. It should have a double-digit dividend, even after everything’s settled. Right now we’re looking at a huge dividend, more than the guidance by the company, which is $5.20 for 2013. It hasn’t announced yet, but some analysts are expecting over $2 in dividends for Q4/12—just in one quarter for a $22 stock.
TER: That’s pretty amazing.
CL: It’s a very nice dividend play. Also, Alon U.S.A. Energy owns about 82% of U.S.A. Partners. If you calculate the value of the shares it owns, it’s more than U.S.A. Partners’ whole market cap, which is absurd. Alon U.S.A. Energy also has another refinery in Louisiana that can take advantage of Louisiana Light Sweet, which will go down to the Gulf of Mexico later this year or next year, when the pipeline is built. So to value the rest of the assets to negative is really absurd. I own both companies.
TER: There’s hardly been any refinery capacity built in this country in many years so any company with a refinery is in a pretty good position.
CL: Plus, refineries are closing down on the East Coast and in California because they’re not making money because Brent is so high. The U.S. has the Jones Act, which forbids foreign tankers from shipping oil from one U.S. port to another. After Hurricane Sandy, they had to suspend the Jones Act. All the light sweet going to the Gulf of Mexico cannot go anywhere, which is just absurd under the existing laws.
TER: You’ve given us some really good ideas and follow-up, Chen. Thanks for joining us today.
CL: Thank you.
Chen Lin writes the popular stock newsletter What Is Chen Buying? What Is Chen Selling?, published and distributed by Taylor Hard Money Advisors, Inc. While a doctoral candidate in aeronautical engineering at Princeton, Chen found his investment strategies were so profitable that he put his Ph.D. on the back burner. He employs a value-oriented approach and often demonstrates excellent market timing due to his exceptional technical analysis.
Global population growth and escalating food demand underpins long-term upside for potash, phosphate and nitrogen producers, but fertilizer oligopolies may have jumped the gun last year with aggressive rates that priced farmers out of the market. As farmers expand acreage rather than boost yields in now-tired fields, grain prices have backed off recent highs. That’s why Robert Winslow, agriculture research analyst and director at National Bank Financial, is picking his stocks with care. In this interview with The Energy Report, he shares where he sees strengths and weaknesses in the industry and names some interesting contrarian plays.
The Energy Report: Your last interview took place in April of 2011. What have been the major developments on the agricultural front impacting the fertilizer markets since then?
Robert Winslow: Increased weather volatility, like last summer’s drought in the U.S., which led to modern-era highs in corn, wheat and soybean prices, have had a significant impact on the market. Although grain prices have softened of late, I believe you’re likely to see somewhat higher-than-usual grain prices through at least the first half of 2013, given the persistent dryness in the U.S. corn belt and wheat-growing regions. Grain prices drive farmer sentiment and buying, and therefore the price and the demand for fertilizer.
We’ve seen some disconnects when it comes to potash, such as in India: Because the rupee was devalued about 20% through 2012, Indian farmers can’t afford to pay the prices that the potash companies would charge, and this resulted in subdued demand. Chinese demand has been somewhat subdued as well. Globally, we’ve had this really interesting dichotomy with high grain prices buoying larger demand in places like North America and even Brazil, but softening demand in yet other parts of the world with country-specific issues. In total, we haven’t seen the demand strength in potash that you might have otherwise expected with this high grain-price environment.
Some would say it’s partly because grain prices are not sustainable at these high levels. We are actually of that view. Like any commodity, when the price gets too high, two very simple things play out: demand destruction and supply response. You’ve seen demand destruction over the last 3–6 months. For example, high-cost ethanol plants have been shuttering production. High-cost producers of cattle, pigs and chickens have been culling their herds because they can’t afford the feed costs unless meat prices rise in conjunction, which they have not.
Then there’s supply response. Farmers are expanding acreage by moving into marginal land. You may not get robust yield on that land, but you can still increase production, which we’re seeing play out now. Brazil is expected to increase soybean acreage by 8–10% this year. With these dynamics playing out, the grain prices are beginning to come down. We expect that by the second half of 2013 you should start to see lower fertilizer demand reflected in pricing, even in the U.S. and Brazil. That is why we maintain a fairly cautious view on the fertilizer sector at this stage.
TER: How might continuing climate change and severe weather affect grain prices and fertilizer demand?
RW: Nobody really knows the answer. I don’t pretend to, but I will say that the stocks-to-use ratio for grains right now, globally, is about 68–69 days of supply. It’s relatively tight compared to the last 30 years or so, and it doesn’t take much to tip over and get a real spike—or falloff—in grain prices. When you do get these supply shocks through floods or droughts, the relatively tight supply situation can move prices quite dramatically, which we saw just this past year.
Many investors don’t believe such price spikes are sustainable and they aren’t going to pay for them. We’re probably at least two years away from where we have a bit more of a buffer in the stocks-use ratio to get us away from this tightness that is causing more volatility in the grain price. In the meantime, we can expect continued volatility in both grains and fertilizer equities.
TER: How have the various segments of the fertilizer industry performed in the last year and a half?
RW: Potash has been the commodity with the most interest. We’ve been a bit of an outlier in the investment community, with a rather bearish view on both the commodity itself and on some of the senior potash producer equities. We are of the view that the potash oligopolies (and we all know who they are) have been rather aggressive with their pricing. In a perfect world, you might be able to raise your prices every year, but we don’t live in a perfect world. Places like India just couldn’t afford the higher prices, so they bought less. The oligopolies and agronomists are right in saying that parts of the world, like India and China, need more potash in the soil, but ultimately, demand is price dependent.
In 2012, global potash demand looked to be in the neighborhood of 50 million tonnes (50 Mmt), which is below the levels we saw back in 2004. Thus, the commodity usage has been basically flat to down over the last 7–8 years—not a compelling investment theme. But the potash price more than tripled over that period. This aggressive pricing has since come back to bite the oligopolies. I expect a demand recovery in 2013 because India has been under-applying fertilizer, and it will need to make up for that at some point. I doubt India would purchase its full allocation, which would be 6–7 Mmt, unless it can buy potash near or below $400/Mmt. And if it does buy the 6-7 Mmt, then there’s a good chance India might buy less again in 2014, with Indian farmers trying to mine the soil. Of course, if the rupee comes back with vigor, India would have more buying power.
On the supply side, there’s tremendous brownfield supply expected over the next three to four years. Most of it is coming from the oligopolies themselves. It looks like the global supply will be growing about 4% per year, on average, over the next four years. So if your demand is flat and supply is up 4% per year, it doesn’t bode well for potash prices. That doesn’t include the greenfield supply that could come on from BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), K+S Potash Canada (SDFG:FSE) or any of the juniors that are working to build mines. So the supply/demand dynamics are not, in our view, compelling for potash over the next two years, particularly if we get less volatile global weather patterns and grain prices trend down.
TER: How do the prospects look in the other fertilizer segments?
RW: Phosphate is looking rather interesting here. Not unlike potash, there’s a bit of an oligopoly situation, with Morocco controlling half or so of the global phosphate rock market. It appears that Moroccans really want to move more into the higher-margin business. Instead of just selling rock to the world, they figure they can make monoammonium phosphate and diammonium phosphate, which are finished fertilizer products. This will make it rather challenging for the non-integrated phosphate producers and/or companies that still rely on imported rock. U.S. phosphate producers like The Mosaic Co. (MOS:NYSE) and Agrium Inc. (AGU:NYSE; AGU:TSX), for example, rely or expect to rely to some extent on Moroccan rock.
On the other hand, that should provide some interesting opportunities for the greenfield phosphate companies, certainly in North America, that are developing phosphate deposits. There are a couple of companies in particular that you might want to keep an eye on. One is d’Arianne Resources Inc. (DAN:TSX.V; DRRSF:OTCBB; JE9N:FSE) and the other is Stonegate Agricom Ltd. (ST:TSX, SNRCF:OTCPK). Both are working on projects here in North America. The next few years could be interesting for them.
TER: Then how about the nitrogen products?
RW: Unlike potash and phosphate, nitrogen isn’t reliant on ore bodies. It’s produced all over the world, so you don’t get the sort of concentration you get in potash and phosphate. If you’re investing in that sector, you have to be a little careful, because we believe that nitrogen producers in North America, in particular, are near peak margins due to the low price of natural gas, which is a big input component. In our view, you shouldn’t generally buy equities that are about to post peak earnings and peak margins, especially when the market already expects those peak results.
Two companies in particular, Agrium Inc. (AGU:NYSE; AGU:TSX) and CF Industries Holdings Inc. (CF:NYSE), have share prices near their all-time highs, and the market’s already valuing some pretty robust results for them. We would be very cautious, and, in fact, we have an Underperform rating on Agrium. That stock’s trading a little over $102 today, and we have an $87.50 target on it.
TER: How are current commodity and financial market conditions affecting plans for junior mining companies in the project development stage?
RW: It’s a challenging time. Finance risk is the key challenge for a lot of these junior companies, whether it’s potash or phosphate. That means that if you have an ore body or an asset, it needs to have some competitive advantages, for example by being a low-cost operation either at the mine level or through low distribution costs. We look at projects like Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX) in Ethiopia, for example, which looks to be well positioned as a low-cost operation at the mine gate and could be one of the lowest-cost delivered potash suppliers into India, which has no domestic potash. Companies are better off when they have these types of strategic advantages, but at the end of the day, the finance risk is still an overwhelming one today.
There is one development stage fertilizer company that we’re most intrigued by, and that’s MBAC Fertilizer Corp. (MBC:TSX; MBCFFOTCQX), because its finance risk is now largely behind it—it is about to move into production in the next few months or so. It has a phase one phosphate project in Brazil called Itafos, right in the Cerrado, which is the breadbasket of Brazil. It also has another phosphate asset to the north of the Cerrado. This company has a logistic advantage because half of the phosphate fertilizer manufactured in Brazil uses imported rock from Africa. We are extremely interested in this stock and it has our Top Pick rating in the sector. We have a $5.25 target on the stock with an Outperform rating. Frankly, the company is a potential acquisition target because there are parties that appear to be aiming to consolidate the phosphate fertilizer sector in Brazil. We believe MBAC Fertilizer is one to own for 2013.
TER: It’s nice to see some blue sky on the horizon.
RW: I’m not a complete bear on the sector. There are some bright spots in my coverage list.
TER: Do you expect any other interesting M&A activity in this industry due to current market conditions?
RW: I don’t see much particularly different about 2013 versus 2012 as far as the macro call goes. There’s been expectation for some time that the Indians and/or Chinese would come in and buy up more of the junior fertilizer companies to help secure supply, particularly in the potash sector. That just hasn’t happened yet. One thing that’s different about 2013 is that there should be a number of bankable feasibility studies completed this year, which will help derisk a number of the early-stage projects. It looks like Allana Potash is expecting its bankable feasibility any day now and d’Arianne Resources is expecting a bankable feasibility mid-year. Elemental Minerals Ltd. (ELM:TSX; ELM:ASX; EMINF:OTCPK) has a bankable study expected in the second half of 2013 on its potash project in the Republic of the Congo. Even IC Potash Corp. (ICP:TSX; ICPTF:OTCQX), which is a company looking to develop a sulfate of potash fertilizer project in the U.S., expects a bankable study in mid- to late 2013 as well.
There are number of bankable feasibility studies coming, which will help derisk these projects and could spur some investment by the likes of the Indians, the Chinese and even the Brazilians as they look to secure fertilizer, but time will tell. Because finance risk is quite significant for these companies, they ultimately need strategic partnerships and/or offtake agreements to help mitigate that risk. So as these studies come out in the next 6–12 months, that could change the equation for many of them. We’ll have to wait and see how that plays out.
TER: You talked about MBAC, which you like. What’s the situation with PotashCorp. (POT:TSX; POT:NYSE)?
RW: We’re bearish on that one. I believe we have the only Sell rating for that stock on Bay Street and Wall Street. So if you like contrarian views, that’s us. The potash commodity supply/demand situation is not particularly compelling. In terms of valuation, we look at that company as having mid-cycle earnings around $3.05 a share in our 2014 estimate. A typical multiple on mid-cycle earnings tells us this stock is overvalued at $41–42. The Street and most analysts seem to love it. They believe it’s worth $50+. Considering the cyclical downside potential for grain, we’re not of that view. We had a sell on it for most of 2012 and it’s been the right call. We’ll have to see how 2013 plays out.
TER: What do you see ahead for fertilizer producers and how can investors position themselves in this industry, if they like the future prospects?
RW: It’s as simple as this: The correlation between grain prices and agricultural equities, particularly the fertilizers, is quite high. Grain prices have retreated of late but still appear to have more downside risk than upside and we would argue over the next year or so, barring unforeseen supply shocks, the trend for grain prices is for further downside. If you’re of that view, then the bias for the agricultural equities would be down as well. So we’re pretty cautious here. We’d be inclined to sell into strength, if these agricultural equities rally, and focus more on the supply/demand fundamentals for grains. With that view, we have only a select few buys and we’re more cautious with a number of sells in our universe.
TER: And there’s a little bit of news on the horizon for mid-year with some of the smaller companies if they can get their act together.
RW: That’s correct, on the bankable feasibility studies coming out.
TER: We greatly appreciate your time and input today, Robert.
RW: Thank you very much.
Robert Winslow is an agriculture research analyst and director at National Bank Financial (NBF). Prior to joining NBF, Robert was an analyst, managing director, and the head of research at Wellington West Capital Markets Inc. (WWCM). Prior to WWCM, Winslow was a special situations analyst at Orion Securities. Winslow began his career at Solar Turbines Inc. (a Caterpillar company) in Dallas, TX, where he was a senior product engineer. He has a Bachelor of Science in mechanical engineering from Queen’s University, a Master of Science in mechanical engineering from Texas A&M University, and a Master of Business Administration from Cornell University. He also holds the Chartered Financial Analyst (CFA) designation.
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From the coal beds of Indonesia to oil and gas fields throughout Europe, Sam Wahab of the London-based investment firm Seymour Pierce is a master at spotting investment opportunities in the topsy-turvy world of fluctuating energy prices. In this interview with The Energy Report, he deftly defines the structural problems affecting gas and coal markets, while identifying some plays that demonstrate the savvy to come out on top.
The Energy Report: Sam, with natural gas production stalling in North America, where can investors find good deals in the junior exploration space?
Sam Wahab: Gas exploration in the U.S., especially of the unconventional type, has resulted in diminishing Henry Hub spot prices. Nevertheless, gas exploration on a global scale remains strong. The key reason is that gas prices in Europe and Asia are underpinned by robust consumer demand and the need for energy security.
A clear example is in Central and Eastern Europe, where Gazprom (OGZD:LSE; GAZ:FSE; GAZP:MCX; GAZP:RTS; OGZPY:OTC) has a strong monopoly on gas supply despite a plethora of untapped resources. Many of the governments in these countries (Poland, Romania, Ukraine, etc.) are now incentivizing junior domestic players through undemanding fiscal terms to prove up these resources to secure energy self-sufficiency. In return, these junior companies enjoy gas prices far in excess of the Henry Hub, which is about $3 per thousand cubic feet (Mcf).
The Romanian gas market is slated to deregulate its gas prices next year. That should bring it inside the European average of $8–13/Mcf. We have a Buy recommendation on Hawkley Oil & Gas Ltd. (HOG:ASX), an Australia-listed company that owns and operates Ukrainian assets. It was getting $11.80/Mcf, which is a fourfold multiple to the Henry Hub. Our target price for Hawkley is $0.72/share. Other beneficiaries of this type of price movement in Europe include Zeta Petroleum Plc (ZTA:ASX), Aurelian Oil & Gas Plc (AUL:LSE) and San Leon Energy Plc (SLE:LSE; SLGYY:OTCBB), which is merging into Aurelian.
Another interesting proposition for investors, in my view, is the growing interest in the supply of regassified liquid natural gas (LNG) to gas-starved West African markets. To clarify, LNG is natural gas that has been converted to liquid form for ease of storage or transport. Regasification is the process of returning the LNG to natural gas prior to distribution.
London-listed Gasol Plc (GAS:LSE) is looking to service this growing demand by securing sales agreements with LNG suppliers and national governments for fixed periods. LNG cargoes will be delivered to a floating LNG regasification facility, which will then either pipe gas to nearby industry or power generation facilities.
TER: Are the explorers that you cover focused on finding and developing gas-producing properties that they can hold onto as income producers, or are they typically more interested in selling their properties to a major corporation once the resources are proved out?
SW: That’s a very good question and the answer will strongly depend on the individual management team, their strategy and the diversification of the company’s asset portfolio. It is extremely difficult for a junior gas explorer to prove up and commercialize an asset alone, given the significant financial and technical resource base necessary to do so. We often see juniors acquire an asset, shoot seismic and potentially drill one or two exploration wells, at which point they have sufficiently derisked the acreage to attract a partner to assist in bringing the asset through field development.
We’ve seen this strategy work recently with Tethys Petroleum Ltd. (TPL:TSX; TPL:LSE). Seymour Pierce has a Buy recommendation on Tethys and a target price of $0.72/share. Its most significant asset is the Bokhtar area in Tajikistan, with an estimated 27.5 billion barrels oil equivalent (Bboe). The company recently announced a farm out of this asset, bringing in Total S.A. and CNODC as equity partners.
We also have a Buy recommendation on CBM Asia Development Corp. (TCF:TSX.V), with a target of $0.54/share. CBM is acquiring high-quality cold bed methane (CBM) acreage in Indonesia. It plans to derisk the properties to about 80% certainty by drilling low-cost wells to reach early-stage production and generate cash flow. At that stage, the company will seek to sell the property to a major oil company to capture the valuation upside from the derisking process and unleash shareholder value.
TER: Indonesia is a microcosm of East Asian energy development. It is balancing its domestic needs against export demands and it enters into production-sharing contracts between the government and the CBM explorers that bear the burden of derisking the gas fields. Where is the margin in this type of public-private venture?
SW: The country’s natural gas market is characterized by a declining supply of conventional gas and a rapidly growing domestic market with a large export segment. A clear margin exists where the domestic gas price is between $5–11/Mcf, whereas the export prices go as high as $15/Mcf.
It turns out that 50% of Indonesia’s gas is exported to North Asian markets in the form of LNG—down from 62% during the past decade. So a declining conventional gas production combined with driving domestic gas consumption is crimping Indonesia’s ability to meet its own LNG export obligations and its ability to capitalize on the high gas prices in North Asia. Meanwhile, domestic consumption has risen over 100% during the last 10 years. That’s largely a function of Indonesia’s strong economic growth, which is headed toward a gross domestic product of $1 trillion this year.
Looming shortage of supply is causing the Indonesian government to support public-private CBM development projects with incentivized production-sharing contracts (PSCs). The terms allow contractors to take 40–45% on an after-tax basis—higher than the industry average. The capital requirements for CBM exploration, which is classed as unconventional, are low—between $2.5–3 million ($2.5–3M) to acquire a production-sharing agreement and up to $4–6M to complete the exploration phase. The risk and costs are low with the potential for high returns. The situation has set off a bit of a land grab in Indonesia.
TER: What other companies are focused on CBM exploration?
SW: In addition to CBM Asia, other companies active in CBM exploration in Indonesia include BP Plc (BP:NYSE; BP:LSE), Dart Energy Ltd. (DTE:ASX), Exxon Mobil Corp. (XOM:NYSE), Santos (STO:ASX) and Total. Whilst in our view CBM Asia and Dart Energy have the most compelling investment case at the moment, we would expect more entrants into this particular market given the low cost of drilling and access to existing infrastructure.
The Australian CBM industry is mature. Between 2003 and 2011, Australia’s CBM industry consolidated through 33 mergers of small, independent operators with a value of over 30 billion Aussie dollars. I believe a similar consolidation could occur in Indonesia as acquirers of Australian CBM assets such as Total and Santos, which are active in Indonesia, look to pick up small companies like CBM Asia.
TER: Let’s talk about CBM drilling for a moment. How does it differ from conventional gas drilling?
SW: Coal bed methane is a byproduct of the coal formation process. It’s chemically identical to other sources of natural gas, but it’s cleaner than hydrogen sulphide. In the reservoirs, the methane is absorbed into the coal surface—held tightly in place by a layer of water. Drilling a production well releases the water pressure in the coal stream, allowing the gas to float to the surface following the water. The wells are shallow, less than 1,000 meters down to the gas-rich stream. Remarkably, such a well can be drilled and completed in less than 48 hours.
TER: When a major is looking at CBM juniors, what metrics do they require?
SW: The effects of the U.S. shale boom on the Henry Hub have led many majors to deploy their technical resource base in extracting unconventional resources in high spot-price environments. They are constantly on the lookout for sufficiently derisked assets, made through a combination of seismic and drilling activity. They want to take a significant equity portion, and they want the asset to be located in geopolitically stable regions with a strong demand or sufficient infrastructure in place so that they can easily export the hydrocarbons. If most of these boxes are checked, there is a good chance that a major will show interest in a junior oil and gas company.
Recently, BP divested many of its non-operating gas interests in the North Sea, while increasing its presence in West Africa. It has just farmed in to Chariot Oil & Gas Ltd. (CHAR:LSX) block. Exxon exited many of its Polish shale concessions in favor of the reported interests in onshore United Kingdom shale by Egdon Resources Plc (EDR:AIM). The U.K. government has lifted a suspension on fracking in the U.K. Now Exxon is interested in some of the onshore U.K. assets. Egdon Resources could be a key benefactor.
TER: Nonetheless, share prices for many gas explorers are not very robust. Why?
SW: Historically, gas prices have been linked to oil prices. Starting with the U.S. shale boom, we have seen a divergence—oil prices have remained strong, while gas prices have generally fallen. However, contract prices for drilling infrastructure such as rig equipment and personnel continue to be linked to oil prices. The upshot is that gas exploration has become increasingly less viable.
There have also been a number of micro-economic events that affected individual companies and regions. The difficulty in employing extraction methods in Central Europe using similar techniques as those in North America arises from the significant differences in the geological makeup. This has led to disappointing exploration performance.
TER: Are there limits to the supply of natural gas that can be profitably brought to market?
SW: The movement of the gas market is largely randomized on a macro level. Shifts in supply and demand are being dictated by economic growth in emerging economies and continued productivity from existing and untapped resources. It’s fairly unpredictable.
But in the near term, gas prices will be dictated by the aggressive use of gas in China and India from their growing economies, which will push prices on a global scale. As will the discovery and utilization of gas resources in Latin America—an up-and-coming region with a huge, untapped potential for natural gas. There is a move away from nuclear power in Japan and some European countries in response to the nuclear incident in Fukushima. And Europe is continuing to process policies requiring greenhouse gas emissions reductions. That could hinder direct gas exploration there.
In Russia, however, people are slowly chipping away at Gazprom’s monopoly. In response, it is looking to regasify the Far Eastern region, which could also push prices. Generally, the ongoing search for shale and other unconventional gas will dictate the global gas price regime. In the U.S., though, the low Henry Hub price could result in a lot less drilling for gas and more of a focus toward oil production, which could drive gas prices back up.
TER: Thanks very much, Sam.
SW: Many thanks, Peter.
Sam Wahab began his career at PricewaterhouseCoopers (PwC), where he qualified as a prize-winning chartered accountant. On PwC’s energy team, he specialized in assurance and transaction advisory. His clients including Royal Dutch Shell and JKX Oil & Gas. Following a spell in the oil and gas research team at Arbuthnot Securities, Wahab joined Seymour Pierce in 2011. He heads up oil and gas equity research at the firm. His coverage includes companies with global operations on multiple stock exchanges.
In the midst of a global market lull, many companies are sitting on their hands, argues Mark Lackey of CHF Investor Relations. That’s why he’s scoping out smart management that’s keeping busy and making great progress—whether or not the markets are quick to notice. Learn who’s getting a running start in the uranium, oil and natural gas spaces in this Energy Report interview.
The Energy Report: It’s been a busy five months since your last interview in August. What’s your macro view on energy markets?
Mark Lackey: The problems in Europe were somewhat worse than most people anticipated regarding Greece and long-term bond rates in Portugal and Spain. Slower world economic growth wasn’t a disaster, but it was enough to knock the price of oil back down under $90 per barrel ($90/bbl). Natural gas had been climbing closer to $3.70–3.80/thousand cubic feet (Mcf), then retreated as well. And, of course, uranium got all the way down to $41.25 per pound ($41.25/lb). Part of the reason for that was that only two out of 56 reactors in Japan were actually operating, but I’m still bullish on uranium. The oil weakness experienced wasn’t terrible, but oil certainly went a little lower than I anticipated. Now that it’s back in that $88–89/bbl range, I’m anticipating somewhat stronger prices next year for oil, as well as for natural gas and uranium.
TER: Are you still expecting West Texas Intermediate (WTI) to average between $100 and $105/bbl next year, or has the supply/demand picture changed?
ML: I’ve lowered my expectation to more like $95–105, partly because the shale oil supply has been a little bit better than I expected with more Bakken production on-line. On the other hand, China, India, Indonesia, Japan and Brazil have all announced significant infrastructure spending programs for 2013, which will certainly increase the demand for energy.
TER: You talk with many people in the analyst community. What’s the current mood and outlook there?
ML: There’s a bit of a divergence. People on the street who agree with me believe that world growth will be fairly decent and that the five countries with the big infrastructure spending will, in fact, move the world forward. There are some who believe that both Europe and the U.S. will do better, and they’re seeing oil up in the $110–115/bbl range. Then, there’s a smaller group looking at an $85–90/bbl range because they think the U.S. economy will stagnate and the situation in Europe will continue to deteriorate. I would say that more analysts agree with where I am, but there’s more divergence in opinions out there than I have seen in the last few years.
TER: Natural gas prices have staged a strong comeback from last spring and now the main concern in the North American markets relates to winter weather usage. Any thoughts on that?
ML: Last spring, natural gas hit close to a 10-year low, under $2/Mcf. It bounced off of that to $3.90/Mcf largely due to increased industrial demand and gas substitution for coal in the electricity market. It’s since retracted a bit of that. In the very short run, if you’re looking solely at the winter, a cold winter could move the price higher.
Looking at fundamentals over the next year, I expect a better year for both the auto and chemical sectors. On the supply side, drilling activity for gas was down in November to a 16-year low in the U.S. but partially offset by horizontal drilling advancements. On balance I expect we’re going to see somewhat less gas than some people are anticipating, and I expect it to get back up to $4/Mcf by the end of 2013.
TER: Can you update us on some of the oil and gas plays you discussed in your last interview?
ML: We had mentioned Greenfields Petroleum Corp. (GNF:TSX.V), which operates in Azerbaijan. This is not wildcat drilling. Greenfields has been very successful reworking old wells and fields and finding oil and gas in established areas with past production. We see its production going up significantly this year. Being close to Europe, it gets a much higher price for natural gas as well—anywhere from $5–9/Mcf and also $15–20/bbl more for oil because it’s based on the Brent price, not the WTI price. Azerbaijan has had a lot of expertise in drilling and a good labor force going back to the Soviet Union days. It’s a very pro-oil and gas jurisdiction and clearly one of the best areas for that business.
TER: How’s the stock done since we last talked?
ML: It’s thinly traded and has gone down some, even though it beat expectations. With oil prices coming down somewhat, people were selling small- and mid-cap oil and gas stocks in the last three to six months of 2012. But I would suggest that people should now be looking at companies like this because of the lower entry point and better cash flow numbers in 2013.
TER: What about Primeline Energy Holdings Inc. (PEH:TSX.V)?
ML: Primeline Energy will have operations in the South China Sea and its partner is CNOOC Ltd. (CEO:NYSE), one of the largest oil and gas companies in the world. Production is expected late in 2013 and it has some significant upside in terms of cash flow and earnings, particularly into 2014. That’s when one analyst has forecast earnings of $0.24 and cash flow of $0.28 per share, which I agree with. An important point to remember about why it can see such good earnings is that it gets $15–16/Mcf for selling gas into China, or approximately four to five times what natural gas gets here.
TER: That’s definitely one to keep an eye on. You also talked about a company in the services business.
ML: Right. That’s Bri-Chem Corp. (BRY:TSX), which announced the takeover of Kemik Inc., a chemical blending and packaging niche company that will add to Bri-Chem’s cash flow and earnings. Bri-Chem has been very strong in the drilling fluids, cementing and steel pipe business sector, supplying the oil and natural gas service area. Now it will have even better earnings and cash flow in the next two years if U.S. gas drilling activity starts to turn up this year. And last week Bri-Chem closed another U.S. fluids wholesaler acquisition of General Supply Co. in Oklahoma. At this stock price level it’s certainly one that people should be looking at and expecting appreciation in 2013.
TER: Do you have any new names in the oil and gas sector that look interesting?
ML: We’ve started to follow a company called Strategic Oil & Gas Ltd. (SOG:TSX), which is a very interesting play in the Steen River area of western Canada. It has primarily light oil, which sells at a premium to WTI or Edmonton light. It’s done a great job of increasing production—more than doubling it in the last year. Another recent acquisition added approximately 10–12% to its production numbers. It’s well capitalized and with such a good balance sheet, we see it going forward in 2013 with work that can further increase its light oil production.
TER: So, where’s that one trading these days?
ML: It’s trading around $1.20 per share. When we first looked at it three or four months ago, it was trading at $0.70. It’s been a nice winner, given the performance of the rest of the TSX Venture market, which has gone from 2,450 in 2011 down to 1,200 at the end of 2012. Strategic Oil’s big increase in production and the fact it produces light oil has caught the attention of the marketplace.
TER: The other energy sector that seems to be coming back is nuclear. Prices had been pretty weak for several months and then suddenly jumped up to over $46/lb. Did the Japanese election have something to do with that? What’s the outlook from here?
ML: Yes, the Japanese election was the key factor in moving the price strongly in just a few days. Before that, people were only starting to wake up to the fact that the end of the Megatons to Megawatts program will take about 24 million pounds (Mlb) out of the marketplace by 2013 year-end. Clearly, the fact that the Japanese government won with a largely pro-nuclear position was a major catalyst. They need to stimulate the economy and will be facing potential electricity shortages if they don’t begin restarting more of their nuclear plants over the next year; mind you restarts require new environmental assessments that the government has now said will be done in June.
TER: So that’s expected to create enough demand to justify higher prices?
ML: That, and there are some other factors too. There are 66 reactors under construction worldwide as we speak. If the Japanese bring back even 20 of their 56 that are off-line in the next year and more new reactors built come onstream in the next one to two years, then you can see some significant demand increase for uranium. In addition to the Megatons to Megawatts program phaseout, Cameco Corp. (CCO:TSX; CCJ:NYSE) has deferred its Kintyre project in Australia and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) has deferred expansion of Olympic Dam. Then Uranium One Inc. (UUU:TSX) canceled its Zarechnoye project in Kazakhstan. Higher demand and lower supply lead us to expect significantly higher uranium prices in the next one to three years.
TER: Have there been any interesting developments with the uranium developers you talked about in August?
ML: Fission Energy Corp. (FIS:TSX.V; FSSIF:OTCQX) had some very good drill results in the Athabasca Basin, at Waterbury Lake and Patterson Lake South. This caused the stock price to almost double in about a week and remain close to that peak. One of its properties is very close to the Hathor property that was ultimately acquired by Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK), so we view Fission as a potential takeout candidate. It’s going to do more drilling to define additional resources, but it’s a company that has some pretty good potential.
TER: A lot of companies are working the Athabasca Basin, where most of the North American uranium development has taken place.
ML: Right. The two other big areas are Wyoming and New Mexico, where another company we mentioned and have followed for a number of years, Strathmore Minerals Corp. (STM:TSX; STHJF:OTCQX) has projects. Its Gas Hills project is in Wyoming and the Roca Honda project is in New Mexico. I’ve liked Strathmore over the years because, whenever management told me they were setting certain milestones, they met them. I’ve spent a number of years in the uranium business and always thought the Gas Hills project area was one of the best in the U.S., and it’s now owned by Strathmore. I also really like its New Mexico play, and the company has considerable depth in its property portfolio for a junior. Strathmore expects to see production in the next three or four years; that would make it a relatively low cost and fairly significant uranium producer in the U.S. If I’m right about uranium prices going a lot higher in the next three years, this stock will be trading at considerably higher than present levels.
TER: Do you have any new companies that look interesting?
ML: Forum Uranium Corp. (FDC:TSX.V) is one I’ve watched for a while. Its two main projects are in the Key Lake area of the eastern Athabasca Basin near Cameco’s Key Lake Mill. It’s also on-trend with Hathor’s Roughrider discovery and Forum has two plays in the western Athabasca. Its management team of President, CEO and Director Richard Mazur; Vice President of Exploration Ken Wheatley and Chief Geologist Dr. Boen Tan are three of the best guys that I’ve known in the whole Athabasca area. These guys have actually discovered over 300 Mlb of uranium throughout their careers.
The company also has a very interesting play in the North Thelon, in Nunavut. I think there’s some significant upside there, and it just announced some very good drill results. Many juniors aren’t doing much these days, but these guys are out there drilling, raising money and moving their projects forward. That’s important, because if we get the uranium prices I suggest, the markets are going to be looking at players who have been forging ahead.
TER: Does it have money in the till to be able to do more work?
ML: It has some money to do part of its next work program but will likely look to raise more. The company consolidated its shares Jan. 3. This is an interesting play also because of its partnerships with Rio Tinto and Cameco. I used to look at about 60 small uranium explorers and now I’m down to only about 10 that I think have a legitimate chance of doing something down the road. Forum is definitely one of them.
TER: Any other ones?
ML: There’s Purepoint Uranium Group Inc. (PTU:TSX.V), which is also a player in the Athabasca Basin and has done a lot of work this year. It signed a joint venture agreement with Cameco and AREVA (AREVA:EPA) on its Hook Lake uranium project and completed an NI 43-101-complaint technical report there and on its Red Willow project. Purepoint just raised some money and Chris Frostad, Purepoint’s president and CEO, is continuing to move it forward. He’ll be doing a lot more drilling over the next year with some big people behind him. Again, it’s a micro-cap company, but if you’re going to buy some micro-cap companies, buy the ones with active management, good properties, some money in the bank and good joint venture partners. Then you at least have a good chance of success down the road.
TER: These didn’t all start out being micro caps.
ML: No they didn’t, and that’s an interesting point. I can remember when it was trading at $1.60 back in the better uranium days. It’s way more advanced now at $0.07, which shows you what happens when you have such a bad market environment. The market doesn’t seem to differentiate, at this point, between uranium players that have stronger odds at being successful and those that don’t. They’re all in the same basket. Once we get better uranium prices, I think investors will start to focus on which companies actually have not been sitting on their hands.
TER: So what does the year ahead look like for energy stock investors and where do you feel they should be focusing their attention for maximum upside?
ML: I’m expecting a moderate upward movement in oil prices, but certainly not a boom. North American natural gas should move higher. Natural gas prices in Europe and China offer some pretty exceptional opportunities for companies selling into those markets. My three-year outlook on uranium is way above the consensus. I actually see uranium trading this time next year at $65/lb, compared to the current spot price of $44.75/lb. Then I see it at $80/lb at the end of 2014, and $90/lb in 2015, all based on the supply and demand factors I mentioned earlier.
TER: That would certainly bring life to a lot of these cheap uranium stocks. People are going to be all over uranium again if you get a double in the price.
ML: A lot of people may think I’m overly optimistic, but I would point out that when we first liked uranium at $10/lb in 2001, we thought there was some pretty good upside. I never expected it to go to $135, like it did in 2007. But, it does show you that when the uranium market starts to move, it usually moves fairly significantly and can create some definite investment opportunities.
TER: So there’s something that people certainly should focus on in the next few months to a year. We greatly appreciate your time and input today, Mark.
ML: Thank you.
Mark Lackey, executive vice president of CHF Investor Relations (Cavalcanti Hume Funfer Inc.), has 30 years of experience in the energy, mining, banking and investment research sectors. At CHF, Lackey involves himself with business development, client positioning, staff team coaching and education, market analysis and special projects to benefit client companies. He has worked as chief investment strategist at Pope & Company Ltd. and at the Bank of Canada, where he was responsible for U.S. economic forecasting. He was a senior manager of commodities at the Bank of Montreal. He also spent 10 years in the oil industry with Gulf Canada, Chevron Canada and Petro Canada.
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Energy investment is about more than just the commodities; it’s about growth. That’s why, for example, the emerging economies theme has been an important one for investors who know that every business and modern home in Brazil, Russia, China or on the African continent will need to keep the lights on somehow. But the next big thing for 2013 may be in our own backyards: the drive toward U.S. energy independence. How feasible is this goal, and how can investors profit from it? With this question in mind, The Energy Report looked back at some of the most memorable interviews of 2012 for expert advice on how to get positioned.
Oil and Gas
Here’s a little energy investment 101: when oil moves up, so does the dollar. Energy bulls bet on increasing momentum, whereas gold bugs amass hard assets for the day the dollar collapses. Well, that’s the way it used to be; global energy markets have become so schizophrenic that this once self-evident correlation is about as reliable as India’s power grid. But one indisputable fact remains, as Porter Stansberry pointed out in his Dec. 13 interview, “End the Ban on US Oil Exports“: “One of the biggest drags on the U.S. dollar over the last several decades has been the trade deficit resulting from petroleum imports.” Wacky oil and gas differentials aside, outsourcing energy production has taken its toll on the national budget and the dollar itself.
But if the U.S. doesn’t rely on international imports, could it make do with domestic supply? Potentially, argues Rick Rule in his Nov. 27 interview, “A Global Perspective on U.S. Energy Independence.” Responding to the I.E.A.’s predictions that the U.S. could reach self sufficiency by 2035, Rule responded, “We stand a very good chance. . .the U.S. is endowed with spectacular natural resources and we remain the epicenter for extractive and exploration technology. Our advantages in terms of the cost of capital, the application of technology and our legal apparatus are uniquely suited to unlocking the potential of our geology.” Even John Williams of Shadowstats.com sees some upside here: “If domestic oil production could replace foreign production, you could still have a positive domestic demand environment. I’d push for that as much as possible.”
So if we need the goods, and we have the goods, the next logical step would be to scout out the domestic producers who can come through with supply—at the highest margins possible, experts suggest. There’s no shortage of recommendations on mid-, micro- and large-cap producers who may fit that bill, and investors with a bullish outlook on domestic oil and gas would do well to keep checking in with The Energy Report to hear why Josh Young invests exclusively in mature oil fields (”There is an old adage: ‘The best place to find oil is an oil field.’”), why Darren Schuringa looks to MLPs to generate returns on investment in North American oil and gas infrastructure (”Consistency is very important for investors, especially for those who are looking for alternatives to fixed-income instruments.”) or how John Stephenson chose the energy stocks that yielded 30% growth for his portfolio year over year (”Look for producers who are good at managing the cost side of the business.”)
Fracking: Miracle or Mirage?
But the energy independence story doesn’t end here. Weaning the U.S. economy off petroleum imports doesn’t begin and end with domestic oil and gas production. For one thing, U.S. regulations haven’t exactly made for an open season on extraction (or transport). Stansberry commented: “We have archaic laws about oil because we had long believed that oil was a strategic resource and that the world was going to run out of it in the short term. Unless we change our laws to allow exports of crude oil, none of this magnificent new supply is going to aid our economy at all.”
One expert, Bill Powers, made waves in his Nov. 8 interview “U.S. Shale Gas Won’t Last 10 Years,” when he delivered a scathing critique of various public and private organizations that, he argues, drastically overstated the extent of U.S. reserves. (He nonetheless sees a bullish future for energy producers scraping the bottom of the barrel.) Powers represents a minorty voice in the shale debate, but even those who are bullish on North American reseves understand that the roads to returns include complications. How can investors plan for the detours?
The U.S. Energy Mix
One horizon we’ll continue to watch is the outlook for uranium producers. Nuclear power is still a controversial subject, but its proponents point out its ability to deliver low-emissions energy in vast quantities—cheaply. Germany may still be saying “Nein danke,” to the power source (although it’s fine with purchasing it from its neighbors) but sector analysts argue that Japan istelf is moving toward a broader restart, and China, Russia and emerging economies around the world are by no means turning their backs on the efficient energy source. Could the U.S. cover a greater share of its energy needs through nuclear power? Analysts David Talbot and Alka Singh see brighter times ahead in the space, both emphasizing the looming expiration of the U.S.-Russia Megatons to Megawatts program and the need for new producers to fill the supply gap. A number of U.S. producers have been getting their ducks in a row to commence with large-scale, low-cost uranium production.
Whether you believe in peak oil or simply the absence of cheap oil, diversifying your assets is a sound investment move—both from a public policy and private investment perspective. U.S. energy production is already a fairly diverse mix from state to state, as a quick glace at the Department of Energy’s interactive map shows. For this reason, The Energy Report will continue to deliver expert opinion on a spectrum of energy sectors, from oil and gas E&Ps to the service companies that keep them operating, to innovative players in the energy technology and alternative energy spaces and promising natural gas, uranium and coal producers ready to deliver to domestic utilities.
A number of our expert interviewees suggested that risk-hungry investors may want to place their bets further out on the energy supply horizon with alternative energy plays that could likewise reduce dependency on foreign oil. Biofuels have earned some support from energy investors, in part because they do not necessitate a nation-wide shift to electric vehicles. But it just may encourage the transition away from petrol imports. As analyst Ian Gilson commented in his June 12 interview, “Enzymes and Algae May Spur a Biofuel Boom,” “Biofuels are really many industries. . .but they share some common ground in that they could reduce our dependence on foreign fuels.”
Raymond James Analyst Pavel Molchanov echoed the multifaceted nature of alternative energy companies in his March 29 interview, “How to Play the Cleantech Energy Boom,” noting that many names in the space are very diversified, so it can be hard to find a pure-play investment. For potential investors, Molchanov emphasized that “Within every industry, there are companies that are in a better competitive position than others. So we have to look at everything case-by-case. It’s very hard to make a universal, far-reaching call regarding whether a particular subsector is now the right or wrong place to invest. For example, the solar industry is facing a lot of headwinds and yet there are still companies in that space that are quite profitable and successful.”
As we move into 2013, we’ll face the global economic forces that ultimately result in upside and downside momentum, continuing the conversation with the experts that share their wisdom with The Energy Report and its readers—you. Exciting, isn’t it? Many happy returns in 2013.
To find undervalued energy stocks that offer upside and stability, look for utilities with undervalued energy assets. That’s Ray Saleeby’s preferred method, and the experienced value investor has shared his top picks in this Energy Report interview, along with some research pointers. Read on to find spin-off pearls missed by overspecialized market analysts.
The Energy Report: Ray, your firm, Saleeby & Associates Inc., focuses on identifying companies with turnaround potential—good firms that trade at a discount, but enjoy a solid customer base in hard-to-enter industries. Why?
Ray Saleeby: I buy stock in companies that are discounted to the intrinsic value of their operations. This differs from growth investing, which focuses on companies that outpace their peers for earnings. It differs from momentum investing, which attempts to time stocks on a short-term basis. My philosophy of value is more long term and contrarian. I buy companies when they are out of favor.
“I buy a lot of utilities because there are tremendous barriers to entry to that sector.”
I handle $220 million ($220M) plus, of which about $100M is in the utility and energy industry. I buy a lot of utilities because there are tremendous barriers to entry to that sector. One does not find a gas utility popping up every other week! For the same reason, I like the construction aggregate business. And I absolutely love the water business. It’s a resource that we’re going to need forever. I also invest in defense electronics and oil and gas. There are also barriers to entry in the drugs and medical device space.
TER: Tell us about your research process.
RS: I have a library of 60,000 different research articles going back 20 years. I subscribe to about 60 different periodicals that provide financial reports and different types of information about various companies. I look at annual reports and presentations by companies. But before I buy a stock, I call up the management and ask detailed questions.
TER: How do junior gas and oil companies fit into this model?
“I like companies that have a first-mover advantage in acquiring developable property.”
RS: With the juniors, I take a very hard look at management. Does it have a track record of success? Are the managers personally invested in the firm? Second, I like companies that have a first-mover advantage in acquiring developable property. Clusters of wells provide economies of scale where drilling rigs can easily be moved around. Energy is a commodity business and access to capital is very important. And being a low-cost provider is crucial when dealing with commodities, as we never know when the market will fall. And, last but not least, I want companies that have a good hedging strategy. And for tax reasons, I look toward MLPs (master limited partnerships).
TER: Let’s talk about discounted utilities with exploration and development arms. Where are the undervalued opportunities in that space?
“The typical oil and gas analyst does not generally understand how to analyze utility operations, whereas the typical utility analyst does not understand how to value oil and gas assets.”
RS: One of the positives about operationally diversified utilities is that they can spin off resource development divisions. Now, a utility analyst is completely different than an oil and gas exploration analyst. With a spin-off, suddenly there are two different types of analysts following two related companies, and the new firm can get double coverage. Secondly, the new managers may have more incentive to produce than they did when they were operating under the parent company’s top management. Also, utilities are heavily regulated; spin-offs are usually nonregulated.
The negative aspect of a divestment is that utilities are generally financially stable and can provide a cushion for commodity capital into its development divisions through boom and bust times. And the flip side of a spin-off in the analytical marketplace is that the typical oil and gas analyst does not generally understand how to analyze utility operations, whereas the typical utility analyst does not understand how to value oil and gas assets. So the double coverage can turn into a negative, a discount of real existing value.
TER: What are some promising names in this space?
RS: Questar Corp. (STR:NYSE) is a perfect example. Originally, Questar was a utility that also had a gas exploration business. About two years ago, it spun it off as QEP Resources Inc. (QEP:NYSE), and it’s been very successful and is leveraging the resource needs of its parent. Questar supplies natural gas to a lot of customers. It is very competitive with electric and it steals customers that have a choice between electric or gas meters. It is well diversified; its Wexpro division also develops and produces gas for the utility and it is very attractive on its own merits. Another factor to consider is that a lot of natural gas companies are not able to make a profit in the current price environment, unless they are hedged. Some are starting to shift their exploration dollars toward oil, rather than gas, because oil is holding up relatively well relative to gas prices. QEP Resources is well positioned in gas but has recently made a couple of acquisitions in the oil business to help balance things out. It’s even buying back its own stock.
An example of a well-diversified company that has not split is National Fuel Gas Co. (NFG:NYSE). It is a combination of utility, pipeline, storage and explorer and producer (E&P) company with, I believe, some of the best assets in the U.S. It has 800,000+ acres in the Marcellus fields close to the New York consumer markets. It’s been around for 100 years, it has a good balance sheet, and it has a history of paying increasing dividends. Looking deeper, it had some problems with executing on oil-producing land it owns in California. And it was not able to get a joint partner for its Marcellus field after natural gas prices went down. If gas prices start popping up again, National Fuel could be a takeover target. The Marcellus acreage is extremely valuable and it can be better exploited if natural gas goes higher. Mario Gabelli has a position in the company, as do I.
TER: How hard is it for an exploration company to switch over from natural gas to oil?
RS: Some fields are more attuned to gas, some to oil. It is hard to get out of leases to switch over from one to the other resource. And drilling crews have to be shifted around, which is expensive. But there’s a glut of gas right now in a lot of different markets. And that’s one of the reasons why the MLP sector is a very attractive sector going forward.
TER: How do MLPs work?
RS: Master limited partnerships are structured so that income flows directly to the investors. It is not double taxed at the corporate level. Investors receive K-1 forms versus 1099 forms for their IRS tax returns. However, it is advisable that you really know what you’re doing before diving into a complicated MLP arrangement. MLPs may not be suitable for all investors.
TER: What other utility-centric natural gas companies provide good value for investors?
RS: Enbridge Energy Partners L.P. (EEP:NYSE) is an MLP. It operates one of the largest pipelines and brings Canadian tar sands oil into the United States. It enjoys great access to capital. It is a very well managed company. It has I-units, which allow investors to reinvest dividends and receive a 1099. It’s a unique investment for the long term.
Energen Corp. (EGN:NYSE) is a small utility in Alabama that runs a large exploration company in the Permian Basin. It is currently out of favor in the market—discounted to its asset value. It is very conservative. It hedges a lot, and has 30 years of dividend growth. It uses the dividend income from the utility to grow the oil and gas exploration and development business. It’s a good value find.
TER: Why is Energen discounted?
RS: As a combined utility and oil and gas exploration company, it is subject to the kind of analyst misdiagnosis I explained earlier. But Energen’s cash flow and its EBITDA are cheap comparable to its peers. It has proven reserves. Management is competent, even though it just reported a disappointing quarter: gas prices plummeted and the firm was not as well hedged as it had been previously due to expirations.
TER: Is there a limit on the supply of natural gas?
“Some say that the U.S. is the Saudi Arabia of natural gas. But the real question is: Is the existing supply an economic supply?”
RS: Some say that the U.S. is the Saudi Arabia of natural gas. But the real question is: Is the existing supply an economic supply? Companies simply cannot make money exploring for gas at the current price. Capital is moving into oil. Sufficient cash is not spent on the necessary infrastructure, such as storage and transportation, to take the gas to the domestic consumer and to international ports for export. The other problem is that it takes a while for utilities to shift over from coal to natural gas. Facilities are being built, but it takes time. On the upside, there are transportation uses for gas, especially for heavy trucks and commercial vehicles and government vehicles. Incentives are needed to support that transformation. The more these gas-dependent industries develop, the higher the price of gas will rise, providing more capital for more infrastructure and development. But a lot of E&P firms are keeping the gas in the ground for now.
TER: Are there any energy holding companies that reflect your investment model?
RS: MFC Industrial Ltd. (MIL:NYSE) is a company that has done phenomenally well. A $1 investment in MFC a little over 10 years ago is worth $6.50 today. It’s averaging a 20% compounded return. MFC is a true value investor. It turns energy and resource companies around and monetizes them. It recently bought Compton Petroleum. The management is very shareholder oriented; executives own a large stake in the company. It is a small firm, but it sources and delivers commodities and resources throughout the world.
South Jersey Industries Inc. (SJI:NYSE) is a utility in New Jersey. But probably 30% of their business is nonregulated. An investment of $6,000 in 1985—with reinvesting the dividends—would now be worth $720,000. Management has just been top notch in creating shareholder value.
TER: To conclude, are any of these firms looking at renewable energy development?
RS: South Jersey is involved in solar. But with the revolution in cheap natural gas, a lot of the solar and wind ventures have been put aside. A few decades down the line, solar is going to be the solution. The world has an abundance of sun! There are, however, cost and efficiency problems with solar and wind due to storage and transmission of power. Alternatives have a role in the future, but we have an abundance of natural gas at this time.
TER: Thanks for speaking with us, Ray.
Ray Saleeby formed Saleeby & Associates Inc. in 2001 after 15 years working with brokerage firms such as R. Rowland Co. and Forsyth Securities. Saleeby published a newsletter between December 1987 and May 1996 that received national attention. Articles written about him and his recommendations have been published in USA Today, The Wall Street Journal, St. Louis Post-Dispatch, St. Louis Business Journal and other periodicals.
Byron King, editor of the Outstanding Investments and Energy & Scarcity Investor newsletters, is expecting surprises in the energy sector in 2013. In this interview with The Energy Report, King discusses his forecasts for fracking’s impact on oil and gas prices, a worldwide uranium shortage and a possible change in the economics of alternative energy sources.
The Energy Report: Let’s start with a recent takeover deal that’s been getting a lot of criticism in recent weeks. Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE) made a $9 billion takeover offer for the oil and gas explorer McMoRan Exploration Co. (MMR:NYSE) and Houston-based Plains Exploration & Production (PXP:NYSE). Are you happy with this deal?
Byron King: It came as a surprise. I’ve held McMoRan Exploration in Energy & Scarcity for about two years. I like what McMoRan is working to do with deep gas in the Gulf of Mexico. Still, I recommended that readers take their money off the table with this deal. Sell the shares, take the cash and we’ll find other opportunities.
McMoRan Exploration nearly doubled after the Freeport announcement, going from $8 to $15 per share. You can’t walk away from that kind of potential gain. Take your money, pay your taxes at the lower 2012 rates and do something else with the money next year.
There’s another angle to this takeover. Freeport and Plains together already own about 36% of McMoRan. There are a lot of ties here, between key individuals. I think this deal was driven by the impending tax changes next year. Freeport, the copper play, is borrowing a lot of money to fund this whole process. Fortunately, interest rates are very low, so it’s borrowing cheap to do a big takeover, which will give a lot of people a really sweet payday, and they’ll get to pay capital gains taxes at much lower rates this year than if they wait until January 2013.
TER: James “Jim Bob” Moffett, who founded McMoRan, is also paying himself. He was a significant shareholder in McMoRan Exploration. He’s taking from his left pocket to put it in his right pocket.
BK: Wall Street hated this deal. Freeport’s share price dropped by about $6/share within a few minutes of the deal being announced.
TER: This whole deal really hinges on the Davy Jones well offshore of Louisiana and whether or not it can make that play. Can it turn this around? Can it make it a viable, producing well?
BK: Davy Jones is all about using new, deep-drilling and production technology to make this type of well work in the Gulf of Mexico, albeit in shallow water—20 feet or so. Sad to say, the Davy Jones well isn’t quite where it needs to be. But it’s coming, and likely sooner than most people believe.
“I’m forecasting that oil prices are going to rise.”
The components of the technology are all there, I’d say. I’ve seen super-strong well casing. I’ve seen advanced valve systems. I’ve seen blowout preventers that can handle the stresses. It’s just that I have seen these things in vendors’ offices and warehouses in Houston. Now the trick is to systematize it all, and make the Davy Jones concept work as a deep gas producer with economics that won’t break the bank.
The next question is what’s going to happen with natural gas prices in the U.S.? Whether it’s Davy Jones or a new well, companies are drilling wells that need $6, $8 and $10 per thousand cubic feet (Mcf) gas. Yet, on a good day, gas is selling at $3–3.50/Mcf. Are the economics going to work? That’s a whole other discussion.
TER: How does this change the landscape among the hard asset players? Are we returning to the 1970s, when mining companies and oil and gas companies were one and the same?
BK: Back in the 1970s, when oil prices went up and the economy realized that energy was a key component of everything, a lot of oil companies started to get into other resources. They did these types of rollups in the 1970s, and then they spent a big part of the 1980s divesting and spinning these things back out. Right now, in this era, McMoRan may be a one-off idea. It’s a unique play. It’s not quite time to break out your old 1970s leisure suits and hang the disco balls or anything.
TER: Let’s get to what you’re calling “taxageddon.” How will this affect investors?
BK: When the tax code changes dramatically on Jan. 1, a lot of people are going to feel the sting. We’ll get hit by that 2% increase in the FICA Social Security in every paycheck. The capital gains tax rates will effectively double on Jan. 1, including the Obamacare increase. The personal rates will go from 15% to the 30–35% range. It’s a big hit.
TER: Are you managing the Outstanding Investments portfolio differently than you were a year ago? Are there more yield-bearing stocks in that portfolio?
BK: In the last year, I’ve focused more on identifying yield-bearing stocks. I added one this fall called Linn Energy LLC (LINE:NASDAQ).
TER: In recent editions of Energy & Scarcity, you have discussed declining rates at fracking wells across the U.S. Do you believe this is an across-the-board problem or is it limited to certain plays or geology?
BK: It’s pretty much all of the shale gas wells. A fracked well that does not decline quickly is truly the exception. Last week, at a conference at the University of Texas, the overall decline rates that were tossed around were absolutely shocking. The decline rates on wells in their first year are in the range of 35–40%, and it is a similar number in the second year. By year two, a company will have produced perhaps 75% of the ultimate recoverable hydrocarbon out of a well.
It utterly wrecks the economics of a gas well to produce most of its output up front, during a low-price environment. These frack plays are astonishing wells, in a technical sense, but the economics are very problematic.
TER: If the production rates are rapidly declining and there is not as much natural gas as first thought, won’t that ultimately lead to higher natural gas prices?
BK: Natural gas prices are already starting to climb back up. About a year ago, the number of rigs devoted to drilling for gas fell off a cliff. I am bullish on natural gas in general. The natural gas price could double to the $7 range within the year.
TER: One of the companies in your Outstanding Investments portfolio is Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE), which is moving heavily into natural gas. Is that a smart move?
BK: Royal Dutch Shell is moving to gas. Exxon Mobil Corp. (XOM:NYSE) is moving to gas. Chevron Corp. (CVX:NYSE) bought Chief Oil and Gas LLC in western Pennsylvania to establish itself as a major player in the Marcellus region. However, the executives from these companies will tell you about the very tight economics of these projects. Actually, Rex Tillerson of Exxon said that up until now, Exxon has been losing its shirt on these things.
“I am bullish on natural gas in general.”
I’m not going to say that Royal Dutch Shell has done the wrong thing. It bears watching. These big companies have deep pockets, and will have to work their way through this storm the same as everyone else. The good news is that the big guys can afford to take risks that small companies, or even large independents, can’t take to drill gas plays and test new technology that might change those decline rates from being so steep.
TER: What are some other senior oil and gas producers in the Outstanding Investments portfolio?
BK: Over the years, I’ve focused more on international names. Statoil ASA (STO:NYSE; STL:OSE) of Norway is a large, well-run company. I like that the Norwegian government has a large stake because it seems to be mature enough to let Statoil operate as an oil company, collect the dividends and benefits, but not interfere in the day-to-day operations. Statoil has wonderful technical capabilities. It’s a nice dividend payer.
French company Total S.A. (TOT:NYSE) is also a large, global company that operates in a lot of jurisdictions that France has close ties with. It pays a nice dividend. Total has been good.
BP Plc (BP:NYSE; BP:LSE) has been in the portfolio for a while. I kept it through the Gulf of Mexico blowout. BP’s shares dropped terribly right after the blowout, although I told people to buy back in at $28/share, and it wound up going up to the $40s.
Yet BP has been a very frustrating company for a lot of reasons. Of course, there is the Gulf of Mexico disaster, but it has other issues related to people’s perception of its safety culture. Fair or not, people write books about it, like Drowning in Oil: BP and the Reckless Pursuit of Profit, by Loren Steffy of the Houston Chronicle. That hurts BP’s share value.
Plus, BP hasn’t done itself any favors with the confusion over its partnership with TNK-BP. I’m still thinking through what to do with BP. On the one hand, it has a lot of great people and assets. It has an aggressive aspect to its exploration and production in the future. On the other hand, there is informed speculation that BP could be worth more in a broken-up state. It’s going to be interesting to see how BP evolves over time.
TER: Most natural gas is used to heat homes and to create electricity at large utilities. Could declining output from fracked natural gas wells ultimately be a boon to green energy sectors like solar, geothermal or wind?
BK: Cheap natural gas has completely altered the economics of the electric utility system in North America. Natural gas base rates are now considered the number to beat, even when people are proposing nuclear power. That’s a very odd dichotomy because a natural gas well can be set up and generating electricity in a few years. With nuclear, it can be a 25-year process to acquire a site, get the permitting and navigate the maze of regulation and public acceptance for a reactor. What may be a temporary glut of natural gas is truly altering the long-term investment climate for nuclear power.
TER: Are you less bullish on uranium plays as a result?
BK: I’m bullish on uranium because there’s not going to be enough new uranium mined and milled to meet demand. China has an aggressive plant-building program. Every one of those plants needs to lock down a 20- to 30-year supply early in the development cycle. There are not enough new mining plays coming on to supply that.
An entire level of uranium supply is also going to go away in a year. Russia is not renewing its agreement with the Megatons to Megawatts program, which purchased nuclear reactor fuel that had been converted from enriched uranium in old nuclear weapons.
TER: Are there any particular uranium plays that you’re bullish on?
BK: Uranium Energy Corp. (UEC:NYSE.MKT) extracts uranium via in situ recovery, by washing the uranium out of sandstone using hydrogen peroxide in Texas. It is producing uranium yellowcake at an internal loaded cost of about $18–20/pound (lb), which sells into a spot market at $50/lb.
“These frack plays are astonishing wells, in a technical sense, but the economics are very problematic.”
UEC’s numbers are going up. It just had a brand new permitting approval at Goliad, Texas. It will be using a fairly simple technology, drilling wells that are less than 1,000 feet deep. It’s pumping the fairly benign substance hydrogen peroxide, along with a few other odds and ends, into the sandstones. It is pulling it out with resins and taking it to a fully licensed plant at Hobson, outside of San Antonio.
I’ve visited the facility. It’s all good: The people are good. The technology is good. The economics seem good. I like Uranium Energy as a long-term play. It will be very sensitive to rising uranium prices that I forecast in the next year or two.
TER: Any others?
BK: Over a longer time frame, there is a Canadian company operating in South America called U3O8 Corp. (UWE:TSX; OTCQX:UWEFF). U3O8 has very early-stage uranium deposits in Colombia, Guyana and Argentina. I’ve visited the Colombian play. It is polymetallic, which means that in the process of recovering the uranium, it is going to be able to pull out phosphate, silver and some intriguing quantities of rare earths. It’s very early stage. It is still doing the drilling out in the jungle. It is a speculative play for long-term investors who know how to ride these junior resource markets.
TER: The green energy sector is in the midst of hard times. It’s had more downs than ups during the past few years. How would you characterize alternative energies right now?
BK: The renewable energy space has been very frustrating for most investors. It’s not to say that you can’t produce energy using solar, wind or geothermal. Of course you can. But it gets back to that well-known critique about how, when the wind doesn’t blow, you have no power. When the sun doesn’t shine, you have no power. What’s the answer?
Europe has a lot of wind and solar power. It creates so much power during windy and sunny times that it actually disrupts the fossil fuel baseload within Europe. Yet, for every windmill and solar field, Europe still needs fossil fuel backups to kick on if the alternative source goes down. This kind of overdevelopment of so-called renewables may feel good to the green side, but it has completely disrupted the economics of a lot of utilities across Europe. Many European utilities have ceased being investment-grade assets.
“What may be a temporary glut of natural gas is truly altering the long-term investment climate for nuclear power.”
We haven’t built renewables to that scale in the U.S. If we do, we would have a similar problem. Rapid overbuilding of green power will degrade the investment quality of many public utilities, which are among the few things that pension funds and institutions can still count on. It’s something that investors need to keep an eye on. We blew up the stock market in 2008 with a housing meltdown. Do we want to risk blowing up the market again with a utility meltdown? We’re not there yet, but we could be on that track.
The Holy Grail for renewable energy is backup battery storage that charges up batteries for continued use after the wind or sun dies down. I’ve been focusing on American Vanadium Corp. (AVC:TSX.V), which is developing a vanadium redox battery that’s very intriguing and scalable. It’s capable of storing immense amounts of electricity.
TER: They’re only being used right now in Japan, right?
BK: The Japanese are leading the charge of commercializing it. The Chinese are close behind. In the U.S., it’s the typical story of caution and underinvestment, relating to the problem of industry working with public utility commissions (PUCs). Will the PUCs of America build this new tech into the rate base?
Nobody wants to be the first one to approve a vanadium redox battery system for a public utility. People don’t want to put their necks on the block. But I suspect that a lot of people would love to be the second players at bat. Unfortunately, we are very risk averse in the U.S., whereas Japan and China are charging ahead—if you’ll excuse the pun. Looking ahead, if we crack the code on reliable, large-scale storage, it could truly alter the economics of alternative energies.
TER: If you were to speculate on which one of those renewable energy sectors will be the first one to be commercially viable, where would your money be?
BK: Solar panels are becoming less costly, which is improving the economics for use on a much larger scale. It will be geography dependent. The sunny Southwest and West regions ought to see solar penetration the soonest and in the greatest degree. The idea that there could be a solar-powered Boston or Minneapolis is probably not as realistic.
TER: One issue with solar is the lack of baseload power. That’s a big advantage of geothermal over solar. However, if you want to talk about frustrated investors, look at geothermal energy.
BK: I started out Energy & Scarcity Investor with a number of geothermal ideas. I truly believed that these things were on the way up, but the technical problems and capital requirements have been absolutely overwhelming. The fact is that the largest geothermal power producer in the world is Chevron. It picked all that up when it bought Unocal. In 2005, Unocal had developed a lot of geothermal in Indonesia. A lot of green-power people hate it when I say that Chevron is the biggest geothermal player.
TER: Geothermal is working in Central America. Why isn’t it happening in the U.S.?
BK: It’s started to happen here in certain areas, such as Nevada. I drove by a geothermal facility on Interstate 80 when I was in Reno recently. Where it works, it works well. But it’s getting it to work that’s the hard part. The foremost reason is that there are few geologists and engineers who understand this space. It’s tough to build a technical team and keep the lights on long enough to make it all work. It’s been very frustrating.
“I’m bullish on uranium because there’s not going to be enough new uranium mined and milled to meet demand.”
Even more frustrating is that geothermal is struggling to spread in an environment that is supportive of renewable energy. California and Nevada state legislatures are telling the public utilities to have a certain percent of power coming from renewables by certain dates. The Obama administration and the Environmental Protection Agency are supportive at the regulatory level. There are tax benefits and low interest rates. Still, the geothermal space has not worked out.
TER: Have you stopped following geothermal companies?
BK: I haven’t stopped. I just don’t spend a lot of time on them. There are too many other ideas that offer a better return on investment.
TER: To conclude, what investable themes in energy should investors look for in 2013?
BK: In terms of oil and gas, people should look for surprises. I’m forecasting that oil prices are going to rise. There are conventional oil plays that still offer excellent returns to investors.
Natural gas prices are also going to drift up as the year goes on. The rapid depletion rates on fracked wells from the past two and three years are going to kick in, and probably with a vengeance.
There could be interesting breakthroughs in the alternative space. 2013 could be the year when investors start to better understand energy storage. This could be the year that the investing community is going to begin to realize it’s out there and that could lead to the beginning of a rebound in the solar and energy storage spaces.
TER: Will we see a dramatic rise in uranium prices in 2013?
BK: I think the spot price will start to drift up late in the year. People are going to have a lot more on their plates to worry about in the first six months of the year. For some strange reason, a lot of investors have allowed their investment horizons to shorten up. What people ought to be worried about now is that at the end of 2013, there is going to be a big uranium shortage worldwide. It will happen. I don’t think that it cannot happen.
Byron King writes for Agora Financial’s Daily Resource Hunter. He edits two newsletters: Energy & Scarcity Investor and Outstanding Investments. He studied geology and graduated with honors from Harvard University, and holds advanced degrees from the University of Pittsburgh School of Law and the U.S. Naval War College. He has advised the U.S. Department of Defense on national energy policy.
The results from Japan’s general election Sunday may be a bellwether event for nuclear power. In a landslide win, Japan’s Liberal Democratic Party (LDP) claimed 294 out of the 480 seats in the lower house of the Diet Sunday, defeating anti-nuclear opponents with a platform focused on economic issues and foreign policy. The Energy Report reached out to leading North American analysts for their take on Japan’s changing of the guard and its effect on uranium stocks.
Energy played an important role in this election, and as the National Journal reports, LDP Leader Shinzo Abe has criticized Democratic Party of Japan Leader Yoshihiko Noda’s goals to eliminate nuclear power from Japan’s energy mix as both “unrealistic” and “irresponsible.”
Federation of Electric Power Companies of Japan (FEPC) Chairman Makoto Yagi echoed this stance in his Dec. 17 statement, which declared the election a “breakthrough event in regenerating the nation” and called for a diverse energy portfolio that would allow Japan to “attain the three Es of energy security, environmental conservation and economy.”
Nuclear Restart Timing Remains Uncertain
Abe’s LDP plans to decide on a general nuclear reactor restart within three years, with a longer-term goal to determine the best overall energy mix for the country in the next ten years. As UPI reports, the LDP is expected to “approve the restarts one at a time, when the Nuclear Regulation Authority certifies them to be safe.” So far, just two of Japan’s 50 nuclear reactors have come back on-line following the Fukushima nuclear power plant disaster. Critics emphasize that the LDP will have to tread carefully on the still-controversial issue and contend with Japan’s regulatory and bureaucratic bodies in accomplishing a wider restart.
But the markets themselves were very quick to respond. World Nuclear News reported a 33% jump in Tokyo Electric Power Co. (9501:OSE; TKECF:OTCPK) shares and an 18% boost in share prices for Kansai Electric Power Co. (KEP:NYSE; 9503:OSE). Australian uranium producers Paladin Energy Ltd. (PDN:TSX; PDN:ASX) and Energy Resources of Australia Ltd. (ERA:ASX) rose 8.4% and 5%, respectively.
Although national polls have shown that 80% of Japanese favored a nuclear phaseout, the country’s election results told a different story and many commentators are expressing support of the LDP’s economy-focused agenda. Kazuhisa Kawakami, a political science professor at Meiji Gakuin University, argued that “we need to prioritize the economy, especially because we are an island nation,” he told the Associated Press. “We’re not like Germany. We can’t just get energy from other countries in a pinch.”
Across the Pacific, some North America-based analysts are decidedly bullish on a bright future for uranium producers.
Rob Chang of Cantor Fitzgerald Canada commented, “We view the Japanese election results as a catalyst for the uranium market because it is the strongest indication to date that Japan will return to meaningful nuclear electricity use. With the Russia-U.S. highly enriched uranium agreement drawing to a close at the end of 2013 and removing about 24 million pounds (Mlb) of uranium from the market, Cantor Research forecasts a continuous uranium supply deficit for many years.” [See chart.]
Source: Cantor Fitzgerald Research
Dundee Securities Analyst David Talbot agrees, commenting that “the LDP win may be a turning point for the nuclear sector and the catalyst many investors have waited for. Although we believe the uranium price may be the only catalyst some investors will consider, we expect that this news could accelerate the likelihood that at least part of the Japanese nuclear fleet gets back on-line, perhaps even earlier than mid-2013.”
Talbot went a step further, sharing his uranium producer picks on the back of Japan’s election results: “Energy Fuels Inc. (EFR:TSX) is a potential turnaround story—it has been punished the most of the uranium producers this year. But it is now focused on lower-cost, higher-grade production from its Arizona Strip breccia pipe mines, with its new Pinenut mine scheduled for startup shortly and its Canyon project in the pipeline. The company announced in September that it would close three higher-cost operations.
“This is a story has: 1) huge leverage to risking uranium prices; 2) a significant regional resource base; 3) the only conventional mill in operation in the U.S.; 4) no need to spend $150 million to construct a new mill despite receiving its Nuclear Regulatory Commission permits; and 5) vast potential to expand production. . .as uranium prices are expected to rise, given the company’s high leverage to prices, we would expect to see Energy Fuels shares to rise in tandem.”
Talbot has a relatively large coverage universe on uranium producers and explorers, and he shared a few more names on his short list in his ecstatic report published Monday:
“Ur-Energy Inc. (URE:TSX; URG:NYSE.MKT) is a top pick in the developer space; this is likely the first U.S. in-situ recovery producer to come on-line next year. Construction is on track and it plans to add recent acquisitions to its pipeline.
“Laramide Resources Ltd. (LAM:TSX) has also outperformed its peers this year as the Queensland uranium mining ban appears set to be overturned. Exploration at its 52-Mlb flagship project continues to deliver.
“Kivalliq Energy Corp. (KIV:TSX.V) is our top pick of the explorers. It has made six discoveries this year alone in Nunavut, and it moves closer to expanding resources toward that 40-Mlb milestone.
“Uranium Participation Corp. (U:TSX) is already on a hot streak, up 11% from last month. . .this is the smallest discount that Uranium Participation has traded since Fukushima, and given its hard assets, we don’t feel that it should be at a discount at all.”
Back on the Table
In a country that has just elected its seventh prime minister in six and a half years, winning a two-thirds majority is not a final victory; it’s an entrance into an ongoing political battle. Opinions are mixed as to how effectively the LDP can carry out its goals, but one thing is clear: Nuclear power is back on the table.
Porter Stansberry doesn’t mince words. Politicians? Scumbags. People in general? Lazy. Laws against oil exports? Disastrous. In this interview with The Energy Report, the Stansberry & Associates Investment Research founder argues that oil exports could usher in an era of unprecedented prosperity, if legislation would only allow it. However, he says there’s no holding back U.S. energy wealth; the profits will sprout up in oil- and gas-related industries like fertilizer, petrochemicals and shipping. Find out where Stansberry is putting his money. This time, it’s not on E&Ps.
The Energy Report: As a history enthusiast, Porter, to what extent do you believe technology has changed investing?
Porter Stansberry: The future will be unlike the past in every way related to technology, but it will be exactly like the past as it relates to people. Technology changes a great deal, but people don’t. You can count on politicians to be scumbags and most people to be lazy. But as for investing, technology gives far more people access to information. Only one person in the world knew the actual price of a high-yield bond 25 years ago—Michael Milken—and he made a fortune with that information advantage. Today, everybody has access to trading information. Everyone has access to price. In general, technology has made finance a smaller-margin business. It’s led to enormous scale in our financial institutions, which is the only way they can really survive. But fear and greed are still the underlying forces that drive the markets, and investors are just as subject to irrational emotional decisions as they’ve ever been. I don’t expect technology will ever change that.
TER: Getting specifically into energy, a few weeks ago the International Energy Agency World Energy Outlook (WEO) said the U.S. would become the world’s largest oil producer, overtaking Russia and Saudi Arabia, before 2020. Then Goldman Sachs said it would happen by 2017.
PS: They stole my thunder. I’ve been saying 2017 for maybe a year now. If Goldman is saying 2017 and IEA is saying 2020 it will probably happen in 2016.
TER: How will the geopolitical and socioeconomic landscape change when the U.S. becomes the largest oil producer?
PS: One of the biggest drags on the U.S. dollar over the last several decades has been the trade deficit resulting from petroleum imports. That’s going to largely disappear, though not completely because we’ll still need some petroleum imports for certain flavors of crude. As for exports, considerable legal hurdles remain. We have archaic laws about oil because we had long believed that oil was a strategic resource and that the world was going to run out of it in the short term. Unless we change our laws to allow exports of crude oil, none of this magnificent new supply is going to aid our economy at all. In fact, we’ll have a terrific glut of oil, and we’re already at record levels of storage. The price hasn’t collapsed yet because unrest in the Middle East is causing fear to inflate the market price, but the price will absolutely collapse if we don’t allow for oil exports. The entrepreneurs who brought us this incredible new supply would, in that scenario, suffer, and many companies would go bankrupt because the oil industry is not capitalized to survive $50/barrel (bbl) oil.
But to answer your question—how the geopolitical and socioeconomic landscape will change when the U.S. becomes the largest oil producer—I’d have to know the unknowable, which is how or if oil policy will adapt. So far, it doesn’t look good. So far, 12 companies have applied for licenses to export LNG, and only one license has been granted. I don’t think the Obama administration is ever going to do anything to help the domestic oil industry. And I think that the result will be a price collapse and an oil glut that will harm our economy.
TER: You mentioned one company has a license. Who is that?
PS: The Department of Energy granted a conditional permit to Cheniere Energy Inc. (LNG:NYSE.MKT). It’s an ironic story. For many years I was a short seller in the stock. In fact, I published an article in 2006 when the stock was trading between $30 and $40 per share. I wrote that this company’s business model was beyond stupid and had ventured into insane territory. Its plan was to import LNG into the United States and the company built a $6 billion ($6B) facility, the Sabine Pass LNG Terminal, to bring in natural gas from Qatar. I said it was insane because not only was the U.S. on the verge of a huge glut of natural gas, but for decades the U.S. had either the largest or second-largest reservoir of gas anywhere in the world. So the U.S. importing natural gas is like Saudi Arabia importing sand. It doesn’t make any sense.
Of course, natural gas prices collapsed and Cheniere almost went bankrupt. It saved itself by selling new equity to a very smart group in New York, Blackstone Group. With the money raised from Blackstone Group, Cheniere switched that facility from imports to exports and applied for an export license long before government officials thought any market for U.S. export gas would materialize. Cheniere got lucky.
TER: To what extent will manufacturing and petrochemical industries move to the U.S. to take advantage of cheap natural gas prices?
PS: There’s roughly $40B worth of construction going on in the chemical industry. You’ll see the same kind of growth in fertilizer. You’re also going to see huge growth, which hasn’t really started yet, in refined products. Imagine it this way: If the government won’t allow exporting energy in the form of crude oil, then you can damn well bet that entrepreneurs will find a way to export that energy in some other form. Fertilizer is energy rich and easy to ship, so we’ll have a huge boom in domestic fertilizer production. How about propane? There’s no law against exporting propane. Targa Resources Corp. (TRGP:NYSE), a company we recommend, is expanding its Mont Belvieu import/export complex to boost propane export capacity.
The funny thing is the energy will find a way out of the country. That’ll be good for our economy, but it’s so inefficient. We’ll have enormous investments in all these industries surrounding the energy complex that are much lower margin. It would make so much more sense to just export the oil.
TER: But wouldn’t bringing in more production manufacturing have the additional advantage of creating jobs?
PS: Yes, but it’s not the highest and best use of our time, our capital or our people. This is something important about economics that people do not understand at all—comparative advantage. The U.S. has enormous comparative advantage in lots of different industries. Manufacturing is not one of them. Neither are giant refineries. Yet that’s what we’ll be stuck with.
TER: What would change the equation?
PS: There’s really no easy answer. It’s mind-boggling. Imagine for a moment where Saudi Arabia would be today if it hadn’t exported its oil. It could have a huge petrochemical business and be the world’s leading producer of fertilizer and plastics. But guess what? The fact that Saudi Arabia put its resources to their highest and best use made it one of the richest countries in the world.
TER: So maybe we should export oil rather than gas.
PS: Absolutely. To make natural gas as our main export energy source would cost trillions to build enough of these terminals and it would take decades. Why not just hook up a pipeline of crude oil to a tanker and be done with it? Natural gas is so clearly better suited for domestic energy needs. We should export the crude and use the gas domestically, but that’s not what will happen. We’ll end up with higher prices on domestic crude with very little export and that’ll be disastrous.
TER: You’ve described shale oil and natural gas in North America as one of the biggest investment opportunities. How do you reconcile that outlook with depressed prices?
PS: You can be very bullish on production without being bullish on price. In fact, I think that’s the only logical position. When natural gas was at $4–5 per thousand cubic feet (Mcf), I said it would go below $3/Mcf and people thought I was out of my mind. It’s not only gone below $3/Mcf, it’s essentially stayed there since 2008 or 2009. As you drill more horizontal wells, as production in the Eagle Ford and the Bakken and other places soars—just look at oil storage. We’ve never seen this much oil in storage in the U.S. There’s no doubt the price will crack eventually, and when it does it will crack hard.
I’ve been telling my subscribers not to buy the exploration and production (E&P) companies but to buy the companies that are able to use lower energy prices to their advantage in their own markets, such as fertilizer companies and terminal and shipping stocks, such as Targa. You can find opportunities coming about in lots of little nooks and crannies because of the excess energy supply.
TER: What are some other examples of energy-related opportunities?
PS: The big way is to play lower energy cost in the U.S., or just to find any business that uses energy and can get a retail price for the product. Think about Calpine Corp. (CPN:NYSE), an unregulated producer that converts natural gas into electricity. The price of electricity in wholesale markets is dominated by coal-generated electricity, so Calpine stock price is essentially a way to arbitrage the price of natural gas and the price of coal. If gas remains cheaper than coal, Calpine’s earnings will go up—and that’s what I believe.
Another good example is fertilizer. About 75% of the cost of fertilizer is made up of natural gas but the price of fertilizer is based on supply and demand. Global demand for food, of course, continues to grow quite rapidly, and due to the inflation of the dollar, farm prices continue to rise, so there’s plenty of capital for buying fertilizer. This is another simple way to play and there are lots of good fertilizer stocks out there. The one we’ve recommended is called CF Industries Holdings Inc. (CF:NYSE).
And, then, of course, look for companies that are constructing the pipelines, making the steel for them, handling the storage, building the terminals. We’ve recommended lots of those companies.
TER: When you mentioned businesses that take advantage of lower energy costs, you mentioned those building terminals. Why would we want more terminals if the law won’t allow exporting oil?
PS: Terminals aren’t necessarily just for export, but also storage and distribution. We need huge new storage facilities, huge new pipelines and huge new terminals all across the country mostly to move gas but also NGLs and crude oil. Right now we’re using railroad cars to move crude out of the Bakken in North Dakota, which is very inefficient.
TER: Whereas producers need higher prices to sustain the production costs.
PS: Mostly, yes. Operating costs are actually very low once the wells are in place. To drill a well in the Eagle Ford, for example, costs about $7M, but you can make that back from production in 90 days. The problem these companies face is the cost of buying additional acreage. As soon as people know oil’s around, real estate prices go bananas and companies have to borrow tons of capital to buy the leases and drill before the leases expire. This puts tremendous capital pressure on their balance sheets.
The number-one thing to be careful of right now in this space is the oil companies that have been rewarded for building huge real estate portfolios but have done so with tons of borrowed money. That puts these companies in a precarious financial position if the price of oil falls. It’s not because they can’t produce oil for $35/bbl. They can. However, they wouldn’t be able to pay off the debt on their balance sheets.
TER: Considering the glut of natural gas, do you foresee changes in the way U.S. consumers use energy?
PS: We’ve already seen a huge shift in what I’ll call the robust transportation sector, the big trucks and the buses, moving into natural gas. That’s absolutely going to continue and it’s going to grow. However, to build these things in a way that’s safe requires a big, heavy vehicle, so I don’t think you’ll see that at the retail level.
Porter Stansberry is intense when it comes to investing and recreation. His Atlas 400 Club brings together intelligent, successful people from all over the world for adventures that last a lifetime. See a video from his travels, including a recent trip that included racing Porsches in Germany.
Most people in the U.S. don’t understand the role that energy plays in our economy. They don’t understand that the boom from 1900 to 1925 was fueled mostly by the oil found at Spindletop in Texas. They don’t understand that all the success we had in World War II and the boom that led to the1950s and 1960s came from east Texas. Literally the energy that drove all of that productive capacity came out of the ground with the east Texas discovery of 1930. The size of the discoveries found recently dwarf that. East Texas ended up being a 4B bbl field of oil. Every one of these new major shale plays contains 20B bbl of recoverable oil—all five times bigger than east Texas and more than 20 of them are currently being drilled. We’re sitting on the biggest economic and financial boom in the history of our country and we’re strangling it.
TER: If indeed we’re sitting on all this gas, why doesn’t the price of gasoline at the pumps go down? And if natural gas can create electricity, why aren’t we seeing more electric cars?
PS: Because electric cars don’t work. How many dead Fiskers do you need to see before you realize they’re not reliable? The hybrids are fine because they’re still using gasoline to drive them. If it makes it good for you to turn gasoline into electricity before it spins your wheels, it’s fine with me. But it’s completely unnecessary. In regard to electric power, we don’t have the battery technology yet to make this work. It’s not even close. That would be great but it’s naive to think we can plug all of our cars into the power grid. Can you imagine if everyone could overnight just plug all their cars into the power grid?
By the way, all those power plants would be coal or natural gas, so you’d still be consuming hydrocarbons. So electric cars are just fantasy devices. They don’t make sense technologically, economically or ecologically.
And as for prices at the pump, a very important thing that people don’t get at all is that gasoline isn’t oil. It’s a derivative of oil. The lower price of oil will increase the crack spread, which will make refiners more profitable. But gasoline comes from refineries, and no new refineries have been built in the United States since 1974. If you want cheaper gasoline, guess what you have to build.
TER: Refineries—but earlier you said that’s not a good use of capital.
PS: It is not a good use of capital for export but it’s incredibly important for the domestic market. And guess who sponsors the green politicians who don’t want any refineries built? The refining companies. They don’t want any more competition. People think the Keystone XL Pipeline didn’t get built from Canada to the U.S. because the Obama administration’s full of these ecologist folks. No. The pipeline didn’t get built because the E&P companies in America don’t want to compete with Canadian crude.
TER: Any other insights you’d like to give to readers of The Energy Report?
PS: Yes. If they want to know what’s ahead for the oil markets, study the natural gas markets from 2008 through 2010, because the same technologies are being used in the same fields and the result will be exactly the same. There’s going to be a glut of domestic oil, and the oil companies that have leveraged their balance sheets to buy lots of acreage will have a very hard time.
TER: Assuming of course that we don’t change some laws to allow exports.
PS: In that case, everything would change overnight. First of all, the global price of oil would equalize between West Texas Intermediate and Brent, at somewhere around $100/bbl. The profits these U.S. companies would make would be fantastic for our economy and it would be great for the shareholders. Unfortunately, the odds say that American politicians won’t make any kind of wise economic choice. That only happens by accident.
TER: Let’s keep our fingers crossed for a serendipitous accident, then. Thanks, Porter.
Porter Stansberry founded Stansberry & Associates Investment Research, a private publishing company based in Baltimore, Maryland, in 1999. His monthly newsletter, Stansberry’s Investment Advisory, deals with safe-value investments poised to give subscribers years of exceptional returns. Stansberry oversees a staff of investment analysts whose expertise ranges from value investing to insider trading to short selling. Together, Stansberry and his research team do exhaustive amounts of real-world independent research. They’ve visited more than 200 companies in order to find the best low-risk investments. Prior to launching Stansberry & Associates Research, Stansberry was the first American editor of the Fleet Street Letter, the oldest English-language financial newsletter. Read more Stansberry oil insights and Porter’s Atlas 400 Club.
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