By The Energy Report, on February 3rd, 2012
With the winter warmer and drier than previous years, natural gas companies are suffering from depressed prices. However, Raymond James Analyst Luc Mageau identifies liquids-rich companies that can create profits with or without a natural gas price rally. In this exclusive interview with The Energy Report, Mageau explains how to use well payout rates to evaluate a company’s longer-term cash flow.
The Energy Report: With Brent Crude trading at about US$110 per barrel (bbl) and natural gas futures trading at 10-year lows, are you leaning more heavily toward oily names than you did in 2011?
Luc Mageau: Absolutely. In fact, although gas prices have been reduced to around the $2.50 level, it still seems like the picture could get worse before it gets better. Current natural gas storage is at ~3.5 trillion cubic feet (Tcf); that’s a full 0.4 Tcf fuller than an average winter. The reason we have such a glut of gas is the winter has not been co-operating. Basically, we rely on winter to post the bulk of the withdrawals throughout any given year—in the last few years, we have truly been relying on a cold winter to bail us out of the storage glut and we’ve been lucky. On average we normally see ~150-200 billion cubic feet (Bcf) of gas withdrawn per week. With the warm weather we’ve been getting, our average withdrawals from storage have been closer to 80-100 Bcf during the 2011/2012 winter season—that translates to a lot of excess gas. Making matters worse, the weather is not expected to get colder. This means we could be in store for several more weeks of warmer-than-average winter, and given we only have a handful of weeks left in the official “withdrawal season,” we’re running out of time to get back to normal storage.
Historically, when weather fails to bail us out of the glut we have seen production shut-ins to curtail the problem. This time, I think we could be in a slightly different boat—and we can blame the price of oil for that. You see, over the last several years, low natural gas prices have forced gas producers to derive cash flow from other sources. One major source has been incremental extraction of natural gas liquids (NGLs). NGLs are heavier hydrocarbons that are produced in conjunction with natural gas. These products typically trade closer to the oil price. Given the wide discrepancy of oil:gas pricing, NGLs can account for a good chunk of the effective price a gas producer receives. What this means is that even when gas prices are below $2.50, the NGL component now being realized from produced gas is allowing a lot of gas that would have historically been shut in to remain marginally economic, and as such, still on production. So we are seeing less shut-in production than historically, and even if we were to begin shutting in production now we would need nearly 6 Bcf/d to be shut-in for the bulk of 2012 just to get back to normal storage levels—a situation that seems unlikely.
The bottom line is that we continue to expect gas prices will stay depressed and oil prices to continue to thrive and as a result, oil stocks should continue to outperform in general.
TER: Should investors stay away from the gas-heavy names or simply gas-heavy names with liquids-poor content?
LM: Some companies are certainly offering good value today and just because gas prices are low right now doesn’t mean that there are no investable ideas. This being said, dry gas companies (i.e. those with liquids infused plays below 20 bbl/MMcf) are really having their cash flows squeezed right now. Netbacks for companies in this camp have been compressed to mid-single digits and even keeping production levels flat without adding a significant amount of debt is hard. On the other hand, companies with liquids rich gas plays that generate 50 bbl/MMcf or more can boost the realized price of their gas by $4.00/mcf. In fact, given the price of liquids, these companies were already generating in excess of 80% of cash flow from the liquids anyway, so the price of gas does not make that much of an impact on the overall value of the company. So if you are looking for gas exposure, it would probably be safer to look at companies that have exposure to these types of plays. In our coverage universe, Crocotta Energy Inc. (CTA:TSX) is probably the best positioned in this camp.
TER: Let’s talk some more about your coverage universe. Crocotta Energy relies heavily on its liquids-rich assets. Please tell us about how one of those assets, Edson Bluesky, is insulating Crocotta from low gas prices.
LM: Crocotta has been working this asset up for the bulk of 2011 and it has been having very good success. In all it holds ~36,000 acres of land here and the key play so far has been the Bluesky formation. The reason that this play is exciting is because it truly is liquids rich—getting anywhere from 50-100 bbl/MMcf of NGLs. What this means is that even though Crocotta is a gas-weighted producer, at $2.00/mcf gas prices the company can generate netbacks in the mid-$20/barrel oil equivalent (boe) range (compared to low- to mid-single digits for most gas companies). The wells typically cost ~$5.8M, so they are expensive, but considering the amount of wells already drilled on the land base, they are low risk and generate an NPV of over $4M even at $2.00/mcf gas (compared to drier gas wells that would be posting closer to $0-1M NPVs). So the company is still making plenty of money even at these gas prices and it still offers the option on gas prices for the future.
TER: Crocotta exited 2011 with production of about 6,500 boe/day, well ahead of both the company’s exit guidance range and your expectation of about 6,000 boe/day. In fact, those fourth-quarter results brought Crocotta’s 2011 average production up to 3,725 boe/day. What sort of production are you expecting in 2012? And will that be enough to reach your 12-month target of $4.75?
LM: Our numbers have the company exiting 2012 north of 8,000 boe/d—one-third of that production is expected to be oil and liquids. The growth is primarily expected to come from Bluesky liquids rich wells, but we’ve also built in some wells for the company’s Cardium lands at Edson. Late in 2011 the company announced its first Cardium well in the Edson area had an initial production rate of 1,000 boe/d (60% oil). This was previously a formation that we were not anticipating much growth from so there is a significant opportunity for the company to build an oil-weighted portfolio of wells if it can show that this is repeatable—and based on what we’ve seen, we think that’s possible. So our $4.75 target price is premised on the production profile through 2012 and 2013. In fact, for 2013, even at $2.00/mcf gas the company could post cash flow of $0.90/share so it is currently trading at just 3.8x, lower than its gas-weighted peers.
TER: You cover Cequence Energy Ltd. (CQE:TSX), which recently conducted some tests on several new wells at Simonette, Alberta, which is part of the Montney Shale play. One new well tested at 4.8 MMcf/d and 216 bbl/day of condensate over 15 days, which would correspond to a liquids yield of about 45 bbl/MMcf. That means that these wells would be economic even at $2.50 natural gas. What’s your outlook for Cequence given these testing results versus lower than expected oil-equivalent production in 2011?
LM: We believe the recent Montney well results continue to prove that the Simonette area is highly prospective for natural gas production growth. This combined with the additional take-away capacity from the pending Alliance Pipeline connection adds comfort that growth will continue through 2012. You are certainly correct; at 45 bbl/MMcf the company’s Montney wells continue to be economic at $2.50/mcf gas. The unfortunate take-away, however, is that the payout ratios on these wells are expected to be approaching three years. This means that it essentially takes three years for the company to re-coup the money it put into the ground to drill the well, and for a junior company, this makes sustained growth at current prices difficult.
TER: Cequence says that once it connects to the Alliance Pipeline and the Aux Sables liquids extraction facility, which is slated to happen in April 2012, its operating netbacks from Simonette production would reach $30.31/boe. Do those numbers line up with yours and, if so, do you expect that to significantly move the share price?
LM: It all comes down to your view of natural gas prices. We are currently forecasting $3.25/mcf gas for 2012—which sounds more bullish than it actually is. Based on that, we have netbacks in the $18/boe range. If current prices were used instead, i.e. $2.25/mcf gas, netbacks would go to $10/boe.
TER: What’s your 12-month target on Cequence?
LM: We are at $3.50—but again that is premised on $3.25/mcf gas for 2012.
TER: A smaller name that you cover is Renegade Petroleum Ltd. (RPL:TSX.V). Renegade exited 2011 with higher-than-expected average production of 3,625 boe/day, which resulted in year over year growth of 73%. Renegade has set its 2012 production guidance at between 4,000 and 4,200 boe/day and that should result in another year of significant growth. Please tell our readers about why you believe Renegade will reach its production guidance and why you raised your 12-month target to $5.00.
LM: Renegade certainly did have a great year in 2011. After it rolled up its JV partner in the Viking (Petro Uno), it went to work post-breakup and its production growth number definitely reflects that. For 2012 we expect the company is going to put a bit more emphasis on southeast Saskatchewan, though, and we had previously been a bit more conservative on our view of the potential there. We were previously forecasting another break-up season similar to what we saw in 2011—wet and prolonged. But the very unseasonably warm summer, combined with the almost nil snow accumulation in the region is making things look much better than originally expected. Now anything can change—especially the weather—but with a slightly longer drilling season than originally expected, we were able to bring up our production estimate a bit to an average of 4,070 boe/d for 2012, about the midpoint of guidance. With our oil price deck at $100 WTI for 2012, our cash flow estimates and target followed suit.
TER: Things don’t look quite so rosy for Open Range Energy Corp. (ONR:TSX). Most of Open Range’s production base is from natural gas and its production is slated to contract in 2012. Nonetheless, you still have a C$2.00 target on that name. Tell us about that one.
LM: Open Range is coming off of a stellar year in 2011. It successfully launched the spin-out of its Poseidon division, which continues to be a strong performer. However, with that division gone, the bulk of the company’s opportunities are in dry gas, meaning NGLs under 20 bbl/MMcf. The company also has ~$50M of debt on a $75M line and is planning six gross wells for this year. So facing the current commodity price environment, the company is really in cash-conservation mode and as a result has forecasted production to shrink through this year—a stark contrast to the massive growth it was leading investors to believe for most of 2011 (its presentation projected a 2012 exit rate of ~10,000 boe/d). Now the assets that the company has are actually quite good—as far as gas assets go. The company has primarily one consolidated land block in the deep basin, an area that characteristically has large gas reserves and low operating costs, but it also has very low liquids yields so the netbacks are at $2.25/mcf gas. Our $2.00 target is premised on a $3.25/mcf gas price and to be fair, for gas investors looking at options on the commodity, Open Range is certainly a good candidate, however we believe gas markets will remain weak for some time, likely putting more near-term pressure on the name—we’ve had the company rated market perform since the spin-out, which really reflects our neutral-to-negative outlook on natural gas prices.
TER: And, finally, Strategic Oil & Gas Ltd. (SOG:TSX), which completed a $40M equity financing in December to give the junior a total of C$42 million in the bank. How is Strategic planning to use that cash?
LM: Strategic has two core light oil assets; the Maxhamish Chinkeh sand horizontal play in northeast BC, where Legacy is the operator, and its Steen River lands in northern Alberta. At Steen River, the company is the operator and has a 100% working interest in 70,000 net acres, so it has a lot of flexibility to accelerate the program here as well as a significant amount of running room for future drilling. There are at least three different oil-prone zones being targeted at Steen, so this is where we see the company getting the leverage for growing production in 2012. With that in mind, the company has provided a $60M capital program for 2012 that focuses on Steen. It has two rigs running there now, and plans to drill 20 (17 net) wells in 2012. Although the focus is still on the high-impact vertical Keg River wells, which get initial production rates of about 200 bbl/d for $1.5M, the company is also going to continue to advance its more “resource-style” horizontal play in the Sulphur point formation, and test out some new zones and play concepts in the area. Given that this program is pretty front-end weighted (there are nine wells planned for Q112), we think the company could use its balance sheet to expand this program through the back half of the year if it continues to achieve results like it has been.
TER: Despite the equity dilution in December, over the course of 2012 you expect Strategic’s share price to almost double to C$1.50. How is that going to happen?
LM: Strategic spent a lot of time on its Steen River assets in 2011. A lot of this was laying the technical foundation on which to build a strong portfolio of oil drill prospects. It successfully tested the horizontal Sulphur Point oil play, and it built out and de-risked its Keg River locations. With its balance sheet now all cashed up, we see 2012 really as a year where it focuses on aggressive drilling at Steen River. Since these wells can get IP rates of 100—200 bbl/d of oil and the capital costs of drilling them are low, it is able to really step on the accelerator pedal quickly. So we think that both cash flow and production will grow substantially through the year and into 2013. Right now we have it spending its guidance of $60M in 2012 and exiting the year with production of ~3,000 boe/d, a pretty strong growth profile when you compare it to 2011 exit production of 1,880 boe/d.
TER: Do you have some parting wisdom to impart to investors looking to enter this space for the first time in 2012?
LM: We are still constructive on oil prices, and with our view on NGL pricing and yields, we remain very cautious on the outlook for gas prices, so obviously we would overweight oil-focused names. That said, there are gas-weighted names that have currently good liquids yields with the ability to weather low gas prices and reallocate capital away from dry gas. Crocotta Energy is an exceptional example of this—the company is getting a liquids yield of 50-80 bbl/MMcf, which means that not only can it weather low natural gas prices, the bulk of cash flow is already coming from the liquids so the wells are very economic even at gas prices with a $1-handle. Second, we would certainly look to invest in companies that have the financial resources (balance sheet and cash flow) to fund an oil- or liquids-focused drilling program in order to take advantage of current oil prices. To put this in perspective—a typical oil well will pay-out in ~1.5 years, which means that all the money a producer puts in the ground they get back in 1.5 years—everything else after that is profit. Gas wells on the flip side can have pay-outs longer than three years. For a junior company, the ability to recycle cash by putting it in the ground, getting it out and repeating the process is paramount—particularly given that the amount they have is very limited. So to that end, junior companies with high oil weightings that we especially like include companies like Renegade Petroleum, Strategic, and Twin Butte Energy for their growth profiles and valuation. However, the top pick in our space right now is Twin Butte Energy, which recently closed the acquisition of Emerge. It pays a healthy dividend of 7%, has the potential to outperform its guidance, and has a very conservative payout ratio for 2012 if light-heavy differentials and oil prices remain within reason of current levels.
TER: Thanks for sharing your insights with us.
LM: My pleasure.
Luc Mageau joined Raymond James in March 2006. He is responsible for covering junior and intermediate oil and gas producers. Prior to joining the firm, Luc was employed as a commercial lender at a major bank and as a research analyst at a U.S.-based equity research firm. He has a bachelor of commerce degree from the University of Alberta (2001) and holds the CFA designation.
By The Energy Report, on February 1st, 2012
 Powers Energy Investor Editor Bill Powers doesn’t shy away from microcaps; he embraces them. In this exclusive interview with The Energy Report, he explains why triple-digit oil is here to stay and how the best-positioned companies will be sitting pretty when natural gas prices rise—as will investors who time the rebound right.
The Energy Report: Is it fair to say that you are a value investor?
Bill Powers: Absolutely. I’m very much a value investor focused on fundamentals and finding companies that can grow reserves, production and cash flow without taking on too much debt and/or diluting shares. Those are the companies that can have very strong long-term outperformance. That is my theme, and I think it is really powerful right now. The companies I’ve identified do not currently reflect future prices that their stocks will be receiving.
TER: Clean balance sheets, steady cash flow and a depressed market price: would that sum it up?
BP: Yes. The Canadian junior market has changed in the last 10 years markedly. It’s matured greatly. Many companies have proven management teams and very good cash flow but are trading below their net asset value.
TER: Do you try to stay away from micro-cap stocks?
BP: Absolutely not; I very much embrace micro-cap stocks. As a newsletter writer, my commentary is largely directed at investors who want information on companies that are below Wall Street or Bay Street’s radar screen. I try to find the company that I feel is best positioned in a certain play and that have the chance for the best share price appreciation. Usually, it’s not the large-cap producers who have acreage in the play.
TER: How do you define a micro-cap?
BP: I consider a micro-cap as $250 million (M) on down.
TER: You recently wrote in the Powers Energy Investor that foreign investors are paying too much for joint venture (JV) agreements with large North American companies. If foreign companies are overpaying, why is that depressing the price of gas?
BP: I’ll give an example: Chesapeake Energy Corp. (CHK:NYSE) made a deal with Total Energy Services (TOT:TSX) to farm out its Utica shale acreage in Ohio. To put this into perspective, there have only been a handful of wells drilled in Ohio into the Utica shale, primarily within one county. This is a speculative play and I am very skeptical of how productive the Utica shale could really be.
That being said, the way these deals are structured is that Total, the foreign company in this case, pays $600M up front to Chesapeake, which will be drilling wells funded completely by Total. So between now and the end of 2014, it will be spending $1.5B on drilling. There are other companies that have done similar deals totaling maybe $20B from largely foreign companies farming into U.S. acreage. This is important because the foreign company will fund drilling for usually two years irrespective of gas price, and when companies drill with somebody else’s money, they are not sensitive to the fact that gas right now is under $2.50/thousand cubic feet (Mcf). It’s a good deal for the American companies, but it’s usually a very, very poor deal for the foreign firms.
TER: Classic economic theory says that if you keep producing like this and prices get very low, people will quit producing. Then, eventually, prices will go back up. When does that happen?
BP: I think it’s going to be happening fairly soon. Right now we have a glut of gas. Part of this is due to Haynesville and Marcellus operators’ drilling acreage to keep leases from expiring. The rig count is really starting to fall, especially in the Haynesville, which is producing 6 billion cubic feet (Bcf)/day right now and is the largest-producing field in the U.S. But that rate has already flattened out, and production will probably start to fall as rigs continue to get dropped. These are very high-decline wells. Texas production is beginning to decrease because the Eagle Ford is not offsetting production declines elsewhere in Texas. Gulf of Mexico production continues to go down. Basically, with gas under $3/Mcf, virtually every field in North America is uneconomic, and we will see a big slowdown in drilling. Very few companies have attractive hedges in place because we’ve had low gas prices for a couple of years. We will see a rebound in gas prices, and it will be quite violent. The challenge is finding the right timing of it. It is not so much a function of when the economics make sense as it is about when other people’s money runs out. We’re seeing that happen right now.
TER: Have we reached the point of maximum pessimism yet?
BP: That’s hard to say. I do think there is a lot of pessimism, but that doesn’t mean a reversal is imminent. I do think that at some time in 2012 we will see that reverse itself, and when that happens we will see gas prices increase substantially.
TER: It sounds like you are playing a very bullish scenario for natural gas. One of the first things I noted in your model portfolio from your Powers Energy Investor is that you have significant personal exposure to natural gas.
BP: Yes, absolutely. From an investor’s standpoint, being a contrarian is easy when your stocks are going up or when your ideas are being recognized by other market participants. What I’m doing in my newsletter is finding gas producers that have been beaten bloody by the marketplace but are low-cost producers that will make it to the other side to see the rebound in gas prices. I’ve identified about five companies that are leaders in certain plays or that have very good leverage to what I think are some of the best North American unconventional resource plays. Those are all places that will continue to produce into the future because they have the better acreage that will become economic once gas prices go back to $4/Mcf. Right now, you’re getting a lot of upside for free because the marketplace doesn’t believe that gas prices will eventually rebound.
TER: Could you talk about those companies you just referenced?
BP: Sure. One of the companies is Ultra Petroleum Corp. (UPL:NYSE), which is a slightly bigger company than I usually cover. It is very active in Wyoming on the Pinedale Anticline, and it’s also very active in the Marcellus. It is a very low-cost producer. This company was a penny stock about a decade ago.
Another I really like, a smaller company, is Advantage Oil and Gas Ltd. (AAV:NYSE; AAV:TSX). It has a great project in the Montney in Canada. It is an extremely well-run company that I think is doing very good work up there.
There are other companies that offer a lot of value and have seen their share prices decline, such as Fairborne Energy Ltd. (FEL:TSX) in the Willrich. It’s a very exciting play in Alberta’s Deep Basin.
This is just a preview of companies that I think have good acreage and that are very leveraged to rising gas prices.
TER: Those were three of your five favored gas companies. What were the other two?
BP: One is Quicksilver Resources Inc. (KWK:NYSE). It’s a U.S.-based company that has a fair amount of debt on its balance sheet. However, for a small-cap company, it has fantastic acreage in the Horn River Basin, where it is very early stage, but this may turn out to be the best shale gas play in North America. Time will tell. This company has been around for more than 50 years, and it has a very good management team. It has been a leader in a number of shale plays. It had the Antrim shale in Michigan and the Barnett shale in Texas. It was one of the early players in those plays.
The other one I like is a bigger company that continues to produce very good results, and that is Southwestern Energy Co. (SWN:NYSE) in the Fayetteville shale as well as in the Marcellus. The company has a dominant acreage position in the Fayetteville and has really been able to grow its production quickly in the Marcellus. It is a very well-run company by Steve Mueller.
So those are just some companies that I try to find. Each is unique. Each of them has different catalysts that will help its share prices more than double once gas prices start to move up. I think these stocks could go up three- or four-fold from here without any problem.
TER: Ok, you love natural gas. What about oil?
BP: I’m very bullish on oil. I think there are some very good factors that will keep the price of oil over $100/barrel (bbl) almost irrespective of how the economy does. With the natural declines from the Gulf of Mexico and the North Sea as well as Venezuela and Mexico, a lot of countries are struggling to keep up production. I think the U.S. has been able to increase its production materially over the last five or six years due to breakthroughs in technology, but that does not change the long-term trajectory of oil production in the U.S. We will see declines from California and the Gulf of Mexico, and we will see further production declines in Alaska, which will largely offset some of the very exciting production growth in unconventional plays, such as the Bakken in North Dakota or the Permian Basin in Texas. I do think triple-digit oil prices are here to stay, and I think we could see $150/bbl before too long, especially if there is a disruption in the Middle East. I think the leverage available to investors with small-cap companies is really mindboggling when you look at what oil prices mean to these companies.
TER: What oil-based companies are we looking at?
BP: Arsenal Energy Inc. (AEI:TSX), a very exciting play in the Bakken. It also has acreage in the Willrich and a very good management team. It is growing its production, and it just did an acquisition that grew its production to around 4 thousand barrels (Mbbl)/day. It has a very strong future as far as production growth that’s high net back, high cash flow and reasonable balance sheets. That’s one company that I am very high on. It has a market cap of only about $109M. It is one of my favorites.
As far as other companies that have great leverage that will go up, I’m becoming very keen on oil sands companies. I think companies like Connacher Oil & Gas (CLL:TSX) are going to rebound and continue to rebound. PetroBakken Energy Ltd. (PBN:TSX), Petrobank Energy & Resources Ltd. (PBG:TSX) and Petrominerales Ltd. (PMG:TSE) are all very oil-weighted companies that will be able to really ramp up cash flow in 2012 as oil prices maintain the $100-level.
Then we do see some U.S.-based companies like SM Energy Co. (SM:NYSE) in the Eagle Ford. This is along my theme of trying to find companies with the best leverage to a certain play. I think SM Energy has the best acreage in the Eagle Ford.
A couple of companies are involved in secondary oil recovery are Evolution Petroleum Corporation (EPM:NYSE) and Denbury Resources Inc. (DNR:NYSE). I think both of those companies are very well-leveraged to oil prices.
So those are some ideas that I think will provide shareholders great returns in the next two years.
TER: Speaking of oil sands, the Obama Administration nixed, at least temporarily, the Keystone XL Pipeline from Canada down to the Gulf Coast. Are the concerns valid? Aside from the developer TransCanada Corp. (TRP:TSX), who does this hurt?
BP: I think this really hurts American consumers. I don’t believe the concerns over the environmental aspects of the XL Pipeline were valid whatsoever. I think this was almost entirely a political maneuver. Right now, the U.S. still imports a substantial amount of production from overseas, and I don’t think some of these overseas suppliers are nearly as reliable as Canada. We import a lot from countries such as Venezuela and Mexico, which are struggling to maintain their production levels and are increasing internal consumption. So I think it is unlikely we will see material imports from either of those countries 10 years from now. Given the growth profiles of many Canadian oil sands producers such as Imperial Oil (IMO:TSX; IMO:NYSE.A) and Cenovus Energy Inc. (CVE:TSX; CVE:NYSE), I think we will see material growth in the Canadian oil sands from about 1.2 million barrels (MMbbl)/day to maybe 4 MMbbl by 2022, obviously depending on permitting issues and the price of oil. I think the Keystone would have been a very good supply. Eventually, I think the Canadians will get fed up and build a pipeline to Port Rupert and send the oil sands production to Asia if the U.S. cannot find some solution to get the XL Pipeline moving forward.
TER: The differential in price for what Asians are paying could pay for shipping that oil to Asia.
BP: Yes, absolutely. And one of the things we’re seeing in Asia is that some of the biggest producers such as Indonesia are seeing flat to declining production. And China has really struggled to keep its production flat. There have been some very good offshore finds in Malaysia and Vietnam that will replace some of the declines from places like Indonesia, but on an overall basis, those are not keeping up with the growing regional demand. Numerous Asian countries, especially China, would love to tap into the Canadian oil sands. A pipeline will get built. It’s just a matter of whether it leads to the U.S. or to the west coast of Canada.
TER: You have reviewed Energy XXI (EXXI:NASDAQ) recently.
BP: It’s not in my model portfolio right now, but I was very impressed that it has been able to grow production and that the company has a material oil weighting. It has a very good mix of exploration prospects as well as development prospects. Right now, the market has really turned its back on the Gulf of Mexico producers such as Energy XXI, and it is trading at lower valuations than its onshore peers, but it is able to generate material cash flow. In the case of Energy XXI’s balance sheet, I think some investors were a little scared off by its debt levels, which I see as very manageable given the cash flows it will be receiving over the next two years and its significant material reserves that it can borrow against. I think Energy XXI has a pretty bright future. I’m going to continue to monitor the company and see how it continues to execute over the next six months or so. It has a very good mix of high-impact exploration and lower-risk development.
TER: Bill, you are writing a book now?
BP: I’m currently working on a book that looks at shale gas and what I consider to be the myth of a 100-year supply. While there is a significant amount of shale gas that will be recovered in the next decade, it is nowhere close to a 100-year supply. Shale gas is not the game changer that a lot of people think it is.
TER: What thought would you leave us with?
BP: I think the perceived risks in energy investing have been somewhat overblown given where oil prices are. The space is very volatile, but for investors who can take a longer-term approach and who can identify companies that are well-run and that have legitimate projects, there are fantastic returns available. The energy sector has been out of favor, but the fundamentals are very strong. I think investors who can position themselves in gas-weighted firms ahead of the coming rebound will be richly rewarded, but there are also fantastic returns in oil-weighted companies that will benefit mightily from triple-digit oil prices.
TER: Bill, I’ve enjoyed speaking with you.
BP: Thank you for having me.
Bill Powers is the editor of Powers Energy Investor and previously the editor of the Canadian Energy Viewpoint and US Energy Investor. He is a former money manager and has been an active investor for over 25 years. Powers has devoted the last 15 years to studying and analyzing the energy sector, driven by his desire to uncover unrecognized trends in the industry and identify outstanding opportunities for retail and institutional investors.
By The Energy Report, on January 20th, 2012
 With oil reserves less and less accessible to western majors, producer stocks can carry significant geopolitical risk. In this exclusive interview with The Energy Report, First Asset Investment Management Inc. Senior Vice President John Stephenson explains why service-oriented companies are smart selections for risk-averse energy investors. No matter what happens in the oil and gas business, the companies doing the drilling have solid prospects in this market environment.
The Energy Report: 2011 was a pretty exciting year with oil prices all over the map, largely fueled by the European debt crisis. What do you expect are going to be the hot topics affecting energy commodities in 2012?
John Stephenson: The spread between Brent and West Texas Intermediate (WTI) prices, which was a big story in 2011, will continue to play a role. I expect a lot of talk about how WTI has once again resumed its place as the global benchmark. Another big topic, as it always is, will be the continuing geopolitics of oil, be it a possible Arab spring in Saudi Arabia or Iran’s nuclear program and how that impacts the world. In terms of possible black swan events, the Environmental Protection Agency (EPA) or other regulators could limit horizontal drilling and fracking. However, that could be very positive in the short run for natural gas prices.
TER: What caused the big spread between the WTI and the Brent prices?
JS: Everyone used to look at WTI as the main global benchmark for crude oil prices, and Brent historically traded at a slight discount. Then, over time, Brent started trading at a premium to WTI. What people have to understand is that these benchmark contracts specify grade and location. The delivery location of the WTI crude contact is Cushing, Oklahoma. Because it’s landlocked, you can’t get crude in from the Gulf region, which actually traded in line with Brent. There also wasn’t enough pipeline capacity to get the large inventories of crude that had built up in Cushing out to other global markets. So it really was an infrastructure issue that caused the price spread. Now, various companies have gotten together and proposed pipeline alternatives that would alleviate this glut of oil at Cushing. Therefore, you’ve seen the spread go from $25 to about $11.40, where it is today.
TER: Your management company, First Asset Investment Management Inc., manages a variety of different commodity-focused funds. What is your 2012 energy outlook?
JS: Our outlook is very supportive and positive for oil. One of the interesting things about oil is that despite the dire headlines, mainly out of Europe, oil has held in as well as it has. In fact, it’s been hitting eight-month highs recently. Why is that? Partly because demand is so strong. We saw record demand globally in August and near-record demand in October and November and continuing strong demand despite the fact that Europe appears to be dipping into recession and growth is potentially slowing a little in Asia. This is why I’m very positive on this and expect to see oil go higher.
Natural gas, on the other hand, is very weak. It’s sub-$3/million cubic feet (MMcf) right now, and I think it will continue to be weak. Historically the period between December and March is when natural gas trades at a premium to its summer prices. This is actually the first winter I can recall seeing it trading at a discount.
TER: Weak natural gas prices are a result of increased shale gas production through fracking, which has created a significant oversupply in the last year or so. Is this going to continue, do you think?
JS: Yes, the U.S. has 200–250 years of reserves of shale gas at current production rates. I don’t see any reason at all for it to change unless, of course, the EPA or someone else were to rule that fracking was detrimental to the environment and there was a moratorium placed on drilling. That could be a black swan event and could change things. If things continue the way they are, there’s no doubt that prices will stay low. Now, clearly, there is some opportunity to export this, but that means building a liquefaction terminal, probably on the Gulf Coast or some other part of the country where people are willing to have a liquefaction facility. That would turn natural gas into a liquid to be transported to Asia or potentially to Europe, where the prices are much higher than they are in North America.
TER: So even though we may have hit peak oil, we certainly haven’t hit peak gas.
JS: No, I don’t think we’ve hit peak gas. Four years ago, the talk was that we were running out. They were going to build terminals on the Gulf Coast to take liquefied natural gas from Trinidad and other places, gasify it and put it in the U.S. pipeline system and supply the northeast in particular with natural gas. Now we’re finding we have so much of this stuff in various shale deposits that we have the potential to become a huge energy exporter. Hopefully that will be the case, but for now we don’t have the infrastructure in place to make that happen.
TER: In some respects it’s a happy turn of events compared to previous supply concerns.
JS: Not if you’re a producer of natural gas, but if you’re a producer of oil, it’s great. If you’re a consumer of electricity, then it’s great.
TER: As far as your portfolio selections and your outlook for this year, you’re clearly leaning much more toward oil and gas liquids. What other factors do you think are going to be affecting prices this year and into the future?
JS: What impacts prices for commodities is supply and demand. I think you’re going to see that demand continues to grow. The reality of why we’ve hit record world demand is not because consumers in the U.S. are doing so much driving. It’s rather because consumers in Asia are doing so much driving. China is now the number-one car market in the world. Who would have thought? If you look at total energy consumption, including coal and other sources, China has overtaken the U.S as the number-one consumer of energy in the world. That trend will continue and put upward pressure on oil prices over time.
The other theme that I think is important for investors to understand is that most of the majors have had real trouble finding replacement reserves to keep producing at the same level. Most of the industry has run from one country to another, where they’ve been kicked out. When Lee Raymond was running Exxon, he ran over to Russia, then to Nigeria, then Venezuela. The settlement that Venezuela was willing to offer Exxon for its assets was a pittance. This is typical of what we’re starting to see around the world. It’s very hard for most of the majors to find new reserves and to continue to produce at the same levels because most of the world that has energy is not open or friendly to the West. This creates a huge problem for these companies.
Given that backdrop, investors need to find companies with reserves in geopolitically stable locations, or where companies are not in the business of generating the reserves; they’re in the business of helping oil companies produce those reserves. That leads you to the service sector, which I think is a lower-risk area. Investors can stay in North America and invest in companies they know and understand without worrying about geopolitics.
TER: What are some of the names that you like in the service sector?
JS: I think if Saudi Aramco, the largest oil company in the world, is going to do a job and it’s going to produce a new field, it will call in Halliburton Co. (HAL:NYSE) or Schlumberger Ltd. (SLB:NYSE). It’s not going to call in Exxon Mobil Corp. (XOM:NYSE). It doesn’t need Exxon’s expertise or capital. But it does need Halliburton’s or Schlumberger’s expertise. These global majors are going to do well on the service side. In the last 25–30 years, the industry has gone from positive bullish cycles to bearish cycles. The people who had the expertise in down-hole seismic techniques, who understood how to operate drill bits at various angles and how to cement and case wells and all of these other things became outsourced to the service industry. The true oil business expertise is in the service industry; that’s why I see it as a sound investment.
TER: So if I may make a mining metaphor, it’s the guys that supply the shovels to the miners that are going to make the money, not necessarily the miners.
JS: Absolutely. It’s the California Gold Rush all over again, except it’s the global energy rush, and you want to be in the picks and shovels business, not necessarily in the prospecting business laying claims. If you’re a Western company and you’re laying claims, chances are you’re laying claims in some part of the world that doesn’t want you there and that may kick you out down the road. Then what do you have?
TER: What are some other companies in your portfolio holdings that you particularly like at this point?
JS: One area to look at is the smaller energy service companies, like Calfrac Well Services Ltd. (CFW:TSX) and Trican Well Service Ltd. (TCW:TSX). Again, there is an increasing amount of drilling that’s happening, even on the gas side. It’s just happening with these new horizontal drilling and fracking techniques. These are the guys who supply this equipment. That’s very strong.
I also think you want to look at the oil companies that don’t have problems with reserves and short reserve life, including some of the Canadian oil sands producers. I would recommend Suncor Energy Inc. (SU:TSX; SU:NYSE) and Canadian Natural Resources (CNQ:NYSE; CNQ:TSX). These stocks are cheap. They’re trading as if oil were $55 or $60/barrel (bbl) when it’s over $100/bbl. These low valuations offer a great opportunity.
TER: Looking at your portfolio in your First Asset Energy and Resource fund back at the end of last quarter, Sept. 30, you were about 78% in cash. Was that a strategic decision? Have you changed that cash into equities at this point?
JS: No. We were very defensive at that time, and I think the reason was pretty simple: Europe was blowing up and when any major economic zone is blowing up, I don’t think you want to be in commodities or commodity producers. Now we’re seeing that the market has stabilized, and you’re going see growth going forward. Valuations certainly never got ahead of themselves in either individual stocks or in any energy sector, so I expect valuations to move higher at this point.
We’re no longer at that same cash level. Our position at that time reflected an overall nervousness about the world. When you have these dominant issues, you need to take your money off the table, which we did. Ultimately, the trade was to the downside, and we preserved value by doing that. I’m very proud that we were able to raise so much cash and be truly defensive at a time when the market was dropping quite substantially.
TER: Are there any of your other attractive portfolio holdings that you’d like to discuss at this point?
JS: I think in terms of other commodity themes that are working well, certainly Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE) would be a great name—that’s on the copper side; it is the largest pure copper producer out there. On a similar vein with a little bit better growth and a little bit more sensitivity to the market—meaning it will move a little more dramatically than the market itself—would be First Quantum Minerals Ltd. (FM:TSX). That’s another name that I think does very well.
We haven’t talked a lot about the agricultural names. If we’re talking about the broad resource base, it’s been a tough time in the agricultural space, particularly for the fertilizer companies. But I continue to think Potash Corp. (POT:TSX; POT:NYSE) looks attractive, especially at this level. Agrium Inc. (AGU:NYSE; AGU:TSX) looks attractive at this level. It’s a little more defensive than Potash. The Mosaic Company (MOS:NYSE) has struggled. I would probably recommend CF Industries Holdings Inc. (CF:NYSE) over Mosaic. Those are the areas that I would look to.
Also, in terms of other oil and gas producers, Canyon Services Group Inc. (FRC:TSX) does well. Transocean Ltd. (RIG:NYSE; RIGN:SIX), a big supplier of offshore platforms, will do well in this environment. Even Baker Hughes Inc. (BHI:NYSE) is transitioning its fleet to more horizontal drilling from straight vertical drilling. Those are all names that we have held and will continue to hold in the future and expect to do well.
TER: To sum things up as far as the energy outlook for 2012, what would you like to tell us?
JS: I would say that energy remains the most important of all the commodities. It will be the most important in 2012 and likely in 2020. Even though we’re over 100 years into the energy era, we are still very much dependent on oil. While it may seem expensive when we’re filling up at the pump or when we look at the futures prices, it’s still cheaper than orange juice on a volumetric basis. There is no substitute for oil, at least no good substitute. There is no technology right now that is commercially viable enough that could change the industry in the way that horizontal drilling and fracking changed the natural gas world. So I think you’re going to see oil prices move considerably higher.
Demand no longer is being driven by America; it’s being driven by Asia and predominantly by China. That trend will continue. In many parts of the world where demand is growing the fastest, namely the Middle East as well as some parts of South America and Asia, fuel prices are subsidized. In an environment where gasoline prices are subsidized, the consumer isn’t feeling the full impact that we feel here in North America. So for those reasons, I think we’ll see oil prices move higher, stay higher and exit 2012 at least $130/bbl. Natural gas prices, on the other hand, will remain range-bound in the $2.50–3, maybe $4, range. It’s very hard to see a successful investment strategy for investors there, other than with the service companies that are going to be the beneficiaries from all of that drilling.
TER: I think that pretty well sums it up. We appreciate your thoughts and input today.
JS: My pleasure.
John Stephenson is a senior vice president and portfolio manager with First Asset Investment Management Inc., where he is responsible for a wide range of equity mandates with a particular focus on energy and resource investing. He has been recognized by Brendan Wood International (BWI) as one of Canada’s 50 best portfolio managers for the past three years. He is the author of The Little Book of Commodity Investing (John Wiley & Sons, 2010), which has been translated into five languages and Shell Shocked: How Canadians Can Invest After the Collapse (John Wiley & Sons, 2009), and writes a free bi-weekly investment newsletter, Money Focus, which reaches a global audience of more than 125,000 (www.reportonmoney.com).
Stephenson is regularly quoted by Bloomberg News, Reuters, The Associated Press, The Wall Street Journal and The Globe and Mail and is a frequent guest on Bloomberg TV, CNBC, CNN, Fox Business and Canada’s Business News Network (BNN), Sun TV and the CBC. He is frequently the keynote speaker at investment conferences throughout North America. Stephenson holds a degree in mechanical engineering from the University of Waterloo, an MBA from INSEAD, as well as the Chartered Financial Analyst (CFA) and Financial Risk Manager (FRM) designations. He lives in Toronto.
By The Gold Report, on January 17th, 2012
When it comes to picking gold mining names in the current market environment, John Stephenson, author and portfolio fund manager at First Asset Investment Management, believes that buying the “best of breed” is the way to go. In this exclusive interview with The Gold Report, he explains his reasoning in light of how the current global economic environment is affecting prospects for the metals markets and valuations of mining company stocks. He also talks about his favorite picks in a range of three production classes and why he likes them.
The Gold Report: As a portfolio manager and an author of two books, The Little Book of Commodity Investing and Shell Shocked: How Canadians Can Invest After the Collapse, how do you see the prospects for the resource commodities in 2012?
John Stephenson: I think, in general, my prospects and outlook are very bullish. The story continues to be one of strong demand out of China. I don’t see that story changing. Obviously, there have been a lot of headlines and the Purchasing Managers’ Index data in China recently are not as robust as they were, but its economy is still going to grow at 8.5–9%. That’s pretty darn good. That’s really where demand for most of these commodities will come from. Certainly, any improvement in Europe and the U.S. will be good news for commodities.
TGR: Are there any specific ones you think will do better than others?
JS: I’d have to say that oil will do very well. I think we’ll see oil exit 2012 north of $130/barrel. Certainly, copper looks very strong. I could see that at $4.50/pound (lb) by the end of the year. Gold and precious metals will do well, also. Gold and precious metals are in a different category than the others, but, nonetheless, what I think is going to continue to drive that is Europe, and I think you’ll see $2,500/ounce (oz) gold.
TGR: So in that light, I guess $4.50/lb copper isn’t that far out of line, if you’re expecting gold in the $2,500/oz range.
JS: I think what you’re seeing across the board in commodities is very strong demand and weak supply. Nothing has happened that will improve that situation and the volatility we see daily has only made the situation worse. Suppliers have struggled to keep up. The smaller, more marginal players have had trouble getting financing as the volatility has increased. The eventual supply response, which would normally end a bull market, is going to be a long time coming.
TGR: In this recent semi-panic where gold dropped into the low $1,500/oz range and people were saying it was all over—you’re certainly not a believer in that if you’re predicting $2,500/oz gold.
JS: No. I’m not a believer in it. Gold shares some characteristics with other commodities in terms of supply and demand. Over the last 40 years, the average grade globally was around 9.6 grams/ton (g/t). It’s now around 1 g/t. So, we’re potentially facing a peak gold scenario as we may be in oil.
Look at Barrick Gold Corp. (ABX:TSX; ABX:NYSE). It recently acquired Equinox Minerals Ltd. (EQN:TSX; EQN:ASX), a copper miner. That’s how it’s struggling to find replacement gold reserves. It had no better idea than to buy a copper miner. This is typical across an industry facing very challenging supply conditions.
Gold is really taking on a different characteristic; it tends to be a commodity that is more of a currency than a commodity. I see it going higher ultimately because the solution to what ails Europe will be the need for the European Central Bank to step in line and start to print money. Once we have that, you’re going to see gold move higher. What’s kept gold down in the last few months has been that the U.S. dollar and U.S. Treasuries have become safe havens. But how much worse can things get in the world when you have the 10-year U.S. Treasury trading below 2%?
TGR:: So you’re pretty well convinced that we’ve seen the lows in the gold price?
JS: Yes. There were several reasons why the low price dropped recently. Fund managers facing redemption requests looked around and said, “Well, this has probably been the best-performing asset in my portfolio this year and maybe the last 11 years.” They felt that to meet these requests, they needed to sell. So there were a lot of things that were happening that weren’t really related to gold or to the bigger story of what was happening within Europe. We have an enormous amount of paper money out there being debased. And the solution for these debts really is to debase more of this paper money. In that environment, people around the world are saying, “I want something tangible. I want something real. I want something I can hold in my hand, store, put in the bank or under my mattress.” And the demand is going to remain very strong. I don’t see that changing.
TGR: So regardless of how all these problems evolve, as far as you’re concerned, gold is going higher, no matter what?
JS: No matter what!
TGR: Obviously, you’re a precious metals bull. What’s your preference among the equities, the physical metal and exchange-traded funds (ETFs)? Or is it a combination of all of them?
JS: A combination makes sense. The reason people have held the equities is because they get leverage to the gold price. So assuming that costs don’t increase at the same rate as the metal itself increases, you get increasing earnings and, therefore, on a consistent multiple basis, you get a higher share price and greater leverage to it.
The situation for gold miners has really changed over the last, say, four to five years. If we look back, 12 or even 15 years ago, we saw that for the first three or four years of that period, from early 2000–2004, the actual miners outpaced the metal by a three times multiple. Right now, evaluations have fallen so steadily for the miners that probably the smarter bet is to look at the equities. Certainly, the physical metal has some storage and handling costs associated with it. So I would say if you had to choose between the three, you would probably, at this point, look mainly to the miners, somewhat toward the ETFs and maybe hold a small amount physically for safekeeping.
TGR: In your portfolio management business, what criteria do you consider in selecting companies for your funds?
JS: Valuation is obviously one. We do a fair bit of work in terms of determining what we think the fair value is relative to what particular miners are trading at. We also look for reserve growth and the potential for production growth. Then I think a very important consideration is where in the world they are producing it, because geopolitical risk has taken on a whole new concern. As the traditional supply basins have started to run dry, companies have had to go further and further afield, creating additional problems. So we try to look at stable geopolitical jurisdictions that are attractive and mining friendly. We look for companies that have production histories that are strong and likely to continue, coupled with outstanding management.
TGR: Makes sense, although it is a moving target as things change, and what once appeared to be stable doesn’t look so stable anymore.
JS: That’s right. You can’t just buy and hold. You have to keep following up.
TGR: 2011 was a tough and disappointing year for a lot of investors considering what the metals did and the resource stocks didn’t do. What are you expecting to happen this year with the mining equities? Are they going to finally catch up with the commodities price?
JS: Yes. Our view is that mining equities will outperform the metals in 2012 and that now is a good time to be looking at the mining companies themselves. We think that the commodity itself will be very strong because the Europe situation is coming to a head and will be a catalyst to lift prices higher. The miners will play catch-up and multiples will go from compressing to expanding, or at least not compressing any further.
TGR: You do quite a bit of research and have become quite familiar with a broad range of companies in the mining development and production business. Can you talk about some of the ones you like, maybe starting with some of the seniors and working your way down?
JS: In terms of relative size and scale, you don’t get any bigger than Barrick. The stock is trading at less than 10x earnings, which in itself is phenomenal and less than 1x net asset value (NAV). It has better growth than Newmont Mining Corp. (NEM:NYSE), and it’s the largest producer in the world. It has struggled, there’s no question about it, but if you’re looking for a value play, something that is liquid, well managed and has very strong growth. Going with the largest in the industry at almost 9 million ounces (Moz) per year, you have to look at Barrick.
TGR: Barrick has gotten to be so big. Is it going to be able to grow internally or will it just have to continue making acquisitions?
JS: I think that’s the issue, and you have correctly identified why investors have been a little skeptical on the name. At some point, things get cheap enough that you have to look at it and give it some credit. Looking back over the history of Barrick, it had a hedge book and much of its upside was hedged. Then as gold took off, people said it wasn’t going to get credit for it if it had the hedge book on it. So the hedge book was taken off and unwound. Then people said it needed to show production growth, which it did. At some point, when the chips are down, people are going to say, “Here’s a company that’s delivered.” But, you’re right. It’s hard to see how it can become a 10–11 Moz producer from around 9 Moz and continue to replace reserves, particularly in a world of declining ore values. But, if you think that the world of investments is going to bounce all over the place as the headlines out of Europe dominate trading, then I think you need to be somewhere where they’re printing money, and this is what Barrick is doing.
The next senior I would highlight is Goldcorp Inc. (G:TSX; GG:NYSE). This is the third largest gold producer in North America. What’s unique about Goldcorp is that it offers a blend of things that are almost never found in one company. It has good growth and great production diversity—not just producing from a single mine. It’s the lowest cost major producer, with cash costs at roughly $550/oz. Typical industry average is closer to $875/oz. It has a strong balance sheet, and it’s operating in politically secure parts of the world. So the chance of expropriation is pretty low. And, it’s liquid. So we really like this.
TGR: How about Intermediates?
JS: On the intermediate producers, with production in the 800 thousand ounces (Koz) to 1–1.5 Moz per year range, we like IAMGOLD Corp. (IMG:TSX; IAG:NYSE). It has a number of mines around the world, largely in the Americas, but also in Africa. It has recently brought in a new management team, which is focused on really servicing value. It brought in someone who is not from the industry but a turnaround expert, and it’s looking at really harvesting this value. With its good mines and good operating profile plus a bent toward servicing value, this name should move higher.
Another intermediate that we like is Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE). It has a number of mines in Finland, Canada and Mexico. This was a company that was a Street darling for many, many years. It probably has the best management team out there. It has had a few stumbles lately. It actually closed one of its mines, Goldex in Quebec, and wrote off the asset, so the stock has fallen because people have probably lost a little confidence in management’s ability to deliver. It was essentially trying to bring on five mines in two years’ time, and that’s really just too high an expectation. But at this price level, it has excellent growth and still is a name to look at.
TGR: And then Juniors?
JS: In the junior producer category, there are two names I think are worth looking at. One is Osisko Mining Corp. (OSK:TSX), which is very quickly moving into the intermediates. Until we get robust global growth, a company that is going to make this transition very quickly is obviously desirable for that reason, if nothing else. Osisko is already producing from its Canadian Malartic gold deposit in Quebec even though it just finished the original mine plan. It’s already producing around 600 Koz/year and has some catalysts for growth. Once you start production, you see a re-rating in your shares. This is trading at a discount to its junior and intermediate peers in terms of a multiple basis, but we think that multiple will expand as it continues to produce. It also has another property that gives it some option value and some further upside.
Lastly, we like AuRico Gold Inc. (AUQ:TSX; AUQ:NYSE) with three operating mines in Mexico and two in Australia. It recently commissioned a new mine at the Young-Davidson project in Ontario. We think this is another company that has a very strong growth profile and has been a bit in the penalty box, but it’s really too cheap at this point not to be looked at. So we think this is a potential double in terms of per-share value over the course of the next year to year-and-a-half.
TGR: AuRico has somewhat come out of nowhere with a name change and then these acquisitions. It’s actually quite a diversified situation with these properties spread out all over.
JS: Yes, it is. It used to be called Gammon Gold and then bought Northgate. We think that this is a name that should do very well. Given that it’s trading below its NAV at this point, it’s just too cheap to be ignored. It has a heap leach at its Ocampo property that continues to struggle a little bit. But I think all these issues are well known. At this level, this name and really all the others, should be bought, if you believe that gold prices will move higher, which we certainly do.
TGR: You probably look at a lot of other little companies that maybe are not suitable for your portfolio. Do you have any you might like to mention that you think are good speculations but not necessarily investment quality?
JS: Yes. Obviously, lots of gold companies come along that we think are interesting. I’m skeptical to mention some of these names because I think that for most investors, they’re a binary outcome. They either make it or they don’t, and in more cases than not, they struggle. I think, certainly, you could make a case for Pan American Silver Corp. (PAA:TSX; PAAS: NASDAQ) and some of these other names that are smaller, but they’re really a beta play on gold because when you start looking at some of these silver names, they typically trade in a much more volatile pattern than the gold producers. I think for many investors, the volatility isn’t worth the ride.
TGR: What sort of strategy are you suggesting investors use this year for maximizing their gains or not having the same sort of performance we had last year?
JS: We’ve seen mining company valuations trend down for many years. Now is a good time to start building positions by buying the best of breed—the ones that will do well in an increasing gold scenario that have little or no operational risk and are larger-cap names. Besides Barrick and Goldcorp, certainly, Kinross Gold Corp. (K:TSX; KGC:NYSE) would be another name to look at. I think its growth comes a little further out, probably in 2013, but you can start to take a look at that. I think turnaround situations like Agnico-Eagle Mines might be very good to look at. Keep in mind, if you’re buying a mining company, it’s making lots of money at $1,500–1,600/oz gold, but if you buy an ETF or the physical metal, you’re hoping it goes from $1,600/oz to $2,000/oz or $2,500/oz in order to make a profit. In the case of a mining company, you don’t need it to go anywhere. All you need is some recognition that there is value today in these companies, and there will be value tomorrow, as they, it is hoped, find more reserves and produce them.
TGR: Are there any parting thoughts that you’d like to leave with our readers?
JS: I would advise people to keep in mind that if there ever was a time for an investment in gold and gold equities, it is now. We have a very unusual situation in the global economy, where there really isn’t any obvious exit path other than the monetization of the debts. Gold companies have suffered because people have flocked to other safe havens, namely the U.S. dollar, but the U.S. has its problems as well. In general, if you’re with a company that has more than one operating mine in geopolitically safe parts of the world and has a demonstrated track record of increasing reserves and production, then I think those are the things that will, in the longer run, reward you. Short run speculating may be exciting but I think most people need to invest in things that have the potential to be higher a year from now than they are today. I think, right now, this is gold equities.
TGR: Thank you for your thoughts, input and insights. I hope 2012 will be a better year for everyone. We look forward to seeing how all of this comes about.
JS: I hope so.
John Stephenson is a senior vice president and portfolio manager with First Asset Investment Management Inc., where he is responsible for a wide range of equity mandates with a particular focus on energy and resource investing. He has been recognized by Brendan Wood International (BWI) as one of Canada’s 50 best portfolio managers for the past three years. He is the author of The Little Book of Commodity Investing (John Wiley & Sons, 2010), which has been translated into five languages, and Shell Shocked: How Canadians Can Invest After the Collapse (John Wiley & Sons, 2009) and writes a free bi-weekly investment newsletter, Money Focus, which reaches a global audience of more than 125,000 (www.reportonmoney.com).
Stephenson is regularly quoted by Bloomberg News, Reuters, The Associated Press, The Wall Street Journal and The Globe and Mail and is a frequent guest on Bloomberg TV, CNBC, CNN, Fox Business and Canada’s Business News Network (BNN), Sun TV and the CBC. He is frequently the keynote speaker at investment conferences throughout North America. Stephenson holds a degree in mechanical engineering from the University of Waterloo, a Master of Business Administration from INSEAD, as well as the Chartered Financial Analyst (CFA) and Financial Risk Manager (FRM) designations.
By The Energy Report, on January 13th, 2012
 Retail and institutional traders invested record amounts in renewable energy producers in 2011, but separating the wheat from the chaff can be challenging. In this exclusive interview with The Energy Report, Jacob Securities’ Senior Vice President for Research John McIlveen shares how to pick and choose. For steady dividends, high-yield Independent Power Producers deliver shareholder value, while renewable projects in the developing world offer incredible potential returns. Whatever the project, it’s the internal rates of return that matter.
The Energy Report: John, what is your current investment thesis?
John McIlveen: Safety is still the dominant concern with small-cap companies, which are high-risk by definition. I mostly stick with power generators. High-yield Independent Power Producers (IPPs) returned over 20% in 2011, whereas manufacturing was slammed as many sectors entered cyclical lows. The generators have 20-year contracts, which provide highly predictable cash flow. To buy the manufacturers, you really have to understand the cycles.
TER: What’s the relationship between conventional energy prices and renewable energy stocks? Do higher conventional energy prices trigger a bounce in renewables?
JM: Optimally, it would be better for renewables if conventional energy prices were higher. However, the reality is that renewable prices do not fluctuate with conventional energy prices because renewable power generators operate on long-term contracts with fixed prices. In the power business it is natural gas, not oil that sets the marginal price of power in the developed world. Low gas prices actually reduce prices on new renewable power contracts, but they do not affect an existing contract. Oil and diesel dominate power prices in the developing world, and because of this, power prices are two to four times the developed world prices. This is why we’re seeing generators rush to the developing world. The generator can get twice the power price there and yet still save the host country 50%. There are much higher prices to be had for power in the developing world right now.
TER: Where would that be?
JM: Anywhere where oil or diesel are generating power. That would include most of the Caribbean and the Pacific islands. Even Hawaii is mostly on diesel.
TER: What’s the most workable alternative energy technology right now that can deliver for investors?
JM: I don’t see a surefire rocket ship growth story right now, but two technologies worth watching are algae and power storage. Algae consuming carbon dioxide (CO2) could be turned into a biofuel or a biomass, and it has the potential to be turned into human-grade protein. It has not been demonstrated on a large scale yet but if it works, it could supply us with clean fuel and power while consuming CO2.
Also, the lack of good power storage has held back many technologies for decades. A power storage system that could be sized to fit into a residential home and capable of storing a few kilowatts would enable a nationwide roof-top solar power system without new transmission lines.
TER: That sounds like the kind of thing that could take off in the developing world much the same way cellular telephone technology did in countries where there was no huge copper wire infrastructure in place. Is that fair to say?
JM: Yes, that would be completely applicable to the developing world as well.
TER: Which renewable energy technology could be the most profitable for investors and which the least?
JM: Once online, the generation method really does not matter. It’s the project’s internal rates of return (IRRs) that matter. Generally, investors should look for 10% or better unlevered IRR on a particular project. If investors are buying developers with little to no assets already online, then geothermal carries the most risk due to drilling, whereas solar carries the least risk due to its higher predictability and short installation time. However, having said that, geothermal stocks have been beaten up the worst of all these junior developers and may represent good value buys.
The biofuel area has some favorable political winds in its sails, as the biofuel volumes are mandated and increasing by 20% a year. However, there is still the double-ended commodity price risk, as you do not have the long-term contracts as you do in power production.
TER: I’m looking at an unweighted basket of conventional exploration and production (E&P) mid caps that were up nearly 19% over the last 52 weeks. I’m also looking at a basket of alternative energy stocks that were down 43% during the same period. What catalyst might induce a secular, upward movement in alternative energy shares?
JM: I think it’s more broad-market based as opposed to being simply about alternative energy. The non-yielding IPPs were down 40% in 2011. Only one of them had a positive return, that one being Western Wind Energy Corp. (WND:TSX.V), which was up 24%. However, most of these have bounced off their one-year lows, and the market now looks like it is anticipating the resumption of upward movement in the small-cap sector. The market must come to believe large-cap stocks are fully valued, and there are signs now that this is happening, and some investors are now looking for bargains in small caps.
TER: You mentioned that Western Wind was up 24% in 2011. It’s up more than 5% in just the first few days of 2012.
JM: Western Wind has been a unique story. It has brought 130 megawatts (MW) of wind online in 2011 without any equity dilution by using the investment tax credit (ITC) cash grants to secure bridge loans. It expects to add another 30 MW of solar the same way in 2012. There was also a $2.50/share takeover offer, which was withdrawn by the bidder after the huge stink that Western Wind put up. Now, there’s a possible proxy battle looming by disgruntled shareholders who would’ve preferred to see the bid entertained further.
TER: Solar is a new business for Western Wind, isn’t it?
JM: Yes. Up to this point, it had only 0.5 MW in operation. This new 30-MW project will be in Puerto Rico and should be online toward the end of 2012.
TER: Do you feel that’s a good fit for the company to be in both solar and wind?
JM: Yes, I do. You could even put solar and geothermal on the same site, thereby saving on a lot of infrastructure and transmission costs.
TER: What other companies are you talking to investors about today?
JM: I like Ram Power Corp. (RPG:TSX), and we are rating it Speculative Buy with a $0.74 target price. It’s just coming online with 36 MW of geothermal in Nicaragua. It will have another 36 MW in a year on the same site and could pay a dividend in 2013. So I think there is some good near-term potential to that one.
TER: Your implied return is more than 100%. After a tough year, the stock is up about 14% over the past four weeks. Are we looking at a turnaround?
JM: I think so, because all these junior developers now are show-me stocks. The market wants to see their projects come online on time, on budget and with cash flow. Once you see that, these values are going to move into these stocks very quickly.
Another is Etrion Corporation (ETX:TSX), which has 60 MW of ground-mount solar in Italy. However, it cannot pay a dividend now because its projects were 100% debt-financed. The stock is still too low to recapitalize, so I think what I’d like to see there is that it sell some assets at a good gain so that it can restart its growth.
TER: In your reports you refer to Etrion as a project company. Tell me more about that.
JM: It has about 10 different solar ground-mount projects, all of which it built over a two-year period. The company financed it all with debt; it didn’t raise any equity. Because it has such a high-interest and debt-repayment schedule, it will not be able to pay a dividend, and I don’t think it generates enough cash flow on its own to continue to grow. With the stock half what it was a year ago, I’m sure management doesn’t want to issue any equity to fund growth. A good alternative for Etrion would probably be to sell one or some of its projects in order to finance growth.
We like Ormat Technologies Inc. (ORA:NYSE), a solid company with free cash flow to grow its megawatts by about 20%/year. But without a significant dividend, the market punished it in 2011. I expect the company to beat the Street in 2012.
TER: You reduced your target price on Ormat from $34 to $24. What was going on there?
JM: It had nothing to do with Ormat. I had actually increased my estimates a little bit at the same time when I did that. Essentially I’m going from a 15x enterprise value/earnings before interest, taxes, depreciation and amortization (EV/EBITDA) multiple, which was what a bull market pays for a high-growth power company, down to 12x EV/EBITDA, which is more of what a slow-growth or bear market would pay.
Another is Alterra Power Corp. (AXY:TSX). It is a solid company with geothermal, wind and hydro assets. It would benefit the most if small caps return to favor, but it will not be able to pay a dividend for a few years given its current expansion program.
TER: Back in November, you raised your rating on Alterra from a Hold to a Buy. What was the catalyst for that?
JM: Two things: the company had turned cash-flow-positive with the consolidation and acquisition of Plutonic Power Corp. just as the general market began to move the stock. Eventually, with their declines, they all move into a Buy-position. Our criterion for a small-cap stock is it has to have a 25% potential return to the target price to be a Buy.
I might also mention U.S. Geothermal Inc. (GTH:TSX; HTM:NYSE), the only geothermal company not to have stumbled over drill results in 2011. Progress has been plodding but mistake-free. I think U.S. Geothermal is a good value, and unlike the other geothermals, it has not yet bounced off its one-year low.
TER: You also follow Just Energy Group Inc. (JE:TSX) and you have a $15 target price on it, which represents about 40% upside potential from here. This company has a significant market cap compared to most of your coverage universe, and it has a very different business model as well.
JM: Just Energy Inc. is essentially a reseller of gas and electricity, but the company has a small and growing renewable energy component to its business such that when it resells electricity, you can buy green power and buy green credits. This small part of its business is growing quite rapidly.
In its gas markets, it has a very high turnover in its contracts because that market is very fear-driven. End-users are only likely to lock into a five-year gas contract if they fear gas prices are going to be rising, but that’s certainly not the buzz we hear every time we read a newspaper. That part of the business is a little challenging.
Their electricity market is a little bit better because there is still upward pressure on electricity prices, and people are thus willing to lock into contracts. The company has made three good-sized acquisitions in the last few years and has levered up the balance sheet on the high side. The dividend here is yielding 11% in the market, but the market is worried that there might be a dividend cut.
TER: You have had some concerns about BIOX Corp. (BX:TSX), but the stock is up 120% over the past six months.
JM: I have some short-term concerns because the U.S. $1/gallon tax credit has expired. I think this is going to cause some short-term downward pressure on biofuel prices; however, because the volume mandates remain, it should correct later on in the year. I’d suggest watching for a technical bottom for an entry point.
TER: Do you think the U.S. tax credit could be renewed?
JM: I don’t think the tax credit will be renewed. Given the current budget-cutting Congress we have, perhaps it will just be allowed to expire like so many other renewable incentives. As for the Environmental Protection Agency’s volume mandates, Congress would actually have to take action to rescind the mandates, whereas in the case of the tax credit, Congress doesn’t have to do anything, just let it expire. The volume mandates look to be here to stay.
TER: I have enjoyed speaking with you very much, John. JM: Thank you.
Jacob Securities Senior Vice President for Research John McIlveen has been with the firm five years and has a total of 26 years experience in special-situations research and merchant banking. In 2004, he became Canada’s first sell-side analyst to focus solely on renewable energy research and consistently has been ranked a top performer by Bloomberg on accuracy of estimates and returns. He is currently treasurer of the Canadian Geothermal Energy Association and a published academic with 15 papers, including his and coauthor Alan Rugman’s 1985 best Canadian book-nominated Megafirms: Strategies for Canada’s Multinationals.
By The Energy Report, on January 6th, 2012
 Clean balance sheets, cash flow visibility and trading liquidity in oily stocks are the cornerstones of investment success in junior E&Ps, according to Oil and Gas Analyst Tim Murray of Desjardins Securities. In this exclusive interview with The Energy Report, Murray lays out his risk/reward proposition for his very favorite names.
The Energy Report: Tim, what is your investment thesis right now?
Tim Murray: It hasn’t changed since the last time we talked. We are biased towards oil plays. But we will look at selective natural gas players and we prefer the lowest-cost producers as well as the companies with a larger production base.
TER: Are you currently telling investors that they need to be patient?
TM: Yes. Most of the small/micro cap stories have seen a dramatic drop in share price over the last year; however, WTI (West Texas Intermediate) is hovering around $100/barrel (/bbl), and oil companies should be able to generate strong cash flow at these levels. The market has gone quieter on the smaller-cap companies as investors traditionally flock to larger, more liquid names in times of uncertainty. Once we see more general stability in the global market place we expect money to once again flow back into small/micro cap names.
TER: So, how does a micro-cap company get out of a hole like this? If its market cap has been knocked down so dramatically that the stock becomes hard for mutual funds to own, what must happen to get out of that situation?
TM: It usually comes down to market sentiment changing. Money managers will eventually start looking at the small caps again because those companies offer significant potential gains in a portfolio. You don’t buy small caps or micro caps for 20% returns; you buy them for 80% or 90% returns. Small cap names may currently be light in many portfolios, however we believe market participants will return to these names once general global market stability is demonstrated. The other option is to become an active acquirer in order to grow in size, however this can be a challenging goal for many small caps that have depressed valuations, unless you can purchase another small cap in the same situation.
TER: Do institutional E&P investors tend to think in terms of value, or are they looking for growth names?
TM: I think most institutional E&P investors are still looking for growth prospects. However, many of the small cap names are trading cheaply on a cash flow basis, so these growth stories can also be viewed as value plays. Most institutions are choosing companies with better balance sheets that don’t have to go to the market to raise money to move their drill programs forward. Companies that can show good visible organic growth from cash flow for the next two to three years seem to attract more attention. Institutions also seem to be most interested in liquid stocks.
TER: Gasoline prices in some regions have declined to the sub-$3/gal range, and this is right in front of a big holiday. Are we looking at continued weakness now in commodity oil?
TM: I don’t think so. We do like the commodity and prefer it to natural gas right now. As for natural gas, we are bearish in the short/medium term, and I don’t see any meaningful near-term catalyst to change that. We don’t see $50/bbl oil in the near term and we are thinking that anywhere between the $80–100/bbl bandwidth is a realistic range for WTI to trade over the next 12 months.
TER: What catalysts are needed to turn energy stocks around?
TM: Well, some equities have done well this year, and so it’s hard to paint a broad stroke across the board. We believe once general market stability has returned that market participants will return to the small/micro cap space. Looking more to a company-specific level, management teams that continue to deliver results will see stock prices that outperform their peers.
TER: When could we see some upward movement?
TM: There is lots of news flow operationally for the names I cover in January and February, so positive drilling results should help push individual stocks higher. On the commodity front it’s really hard to project what’s going to unfold in the next month and we prefer to look out over the next 12 months and believe a realistic trading level is between $80–100.
TER: What names are you talking to investors about today?
TM: The ones I’m talking about the most have strong management teams, good balance sheets, liquidity and visible cash-flow growth. My favorite name is Whitecap Resources Inc. (WCP:TSX.V), which has all those characteristics. Whitecap is run by Grant Fagerheim, who has led several other successful junior oil and gas companies. We believe Whitecap has a top-tier management team. This is the biggest company that I follow in terms of production and reserves, and it also has the best liquidity. It has a visible light oil growth profile for the next several years, offers a top-tier cash netback and a low relative corporate decline, which we believe positions them very well. We also like that Grant has traditionally been an active M&A player, which we think leads itself well to the current environment as we have mentioned previously many small/micro caps trade fairly cheap.
TER: What’s the story here? Is it about the Pembina Cardium and Valhalla Montney?
TM: Yes, and it is acquiring Compass Petroleum (CPO:TSX.V), which will give the company another core area targeting the Viking in the Dodsland region of Saskatchewan. So, it now has a fourth core oil area.
TER: Your target price was $11. Have you upped that?
TM: Yes, it’s $12.25 now.
TER: That represents 40% upside potential from here.
TM: Yes, and the upside may seem light for a small cap, however it carries considerably less risk than some of the other companies I cover. For instance, I have a target of $1.25 on Torquay Oil Corp. (TOC.A:TSX.V; TOC.B:TSX.V), which would be a much greater return, but there’s a lot more inherent risk in a Torquay then there is with Whitecap. So, on a risk/return basis, Whitecap is currently my top pick.
TER: You took Torquay down from a $2- to a $1.25-target, which is still better than a 200% implied return from current levels. What’s your investment thesis on the company?
TM: A larger portion of my $1.25 target hinges on the company’s key core property at Lake Alma. The company is basically trading at my base net asset value (NAV), which is essentially all the company’s other properties. Torquay has discovered oil at Lake Alma; however, it has not been extracted economically to date. Torquay’s management team believes they do have a viable play and that they can extract the oil economically. However, Torquay is not big enough in size to fund a meaningful drilling program from cash flow, and the company is going to have to go to the market to raise money if they would like to get aggressive again with Lake Alma. The large drop in share price and its marginal success at Lake Alma over the last 18 months could make raising money challenging. That’s why on paper it looks like a no-brainer to invest in because of the huge potential return, but there’s a lot of risk associated with the company from a market perspective (raising capital) and exploration risk at Lake Alma. If Torquay can’t succeed at Lake Alma, then I would have to remove the Lake Alma upside of approximately $0.75/share.
TER: Who is currently buying the stock? Is it the hedge fund community?
TM: Since November and December, Torquay has had relatively huge trading volume. Some investors picked it up in the $0.25–0.30 range because they thought it was so cheap that they couldn’t go wrong as it was trading below its base NAV. So they basically got exposure to Lake Alma for free. It’s hard to say who’s playing in this story right now. Some hedge funds may be looking to add this classic high-risk/high-reward play to their portfolios.
TER: What other companies do you like?
TM: It is not my top pick, but one of my other favorite names is Spartan Oil Corp. (STO:TSX). I think of it as a mini lookalike of Whitecap, however smaller in size. Spartan’s core property is located at East Pembina targeting the Cardium formation. Management is very familiar with the Cardium as its predecessor company showed terrific growth drilling the Cardium horizontally. The key asset for Spartan is the Keystone unit #2, which is a legacy oil pool that has been drilled vertically. Spartan believes it can substantially increase the recovery factors through the application of horizontal drilling. The #2 unit has never had a horizontal well drilled into the pool and Spartan has drilled three to date, and we’re waiting on results from these wells. Spartan also has a couple of exploratory plays in Saskatchewan, which is the torque in this story. Further positive drilling results could lead to another core area. We also would like to point out that the balance sheet is very strong and Spartan could announce a very aggressive 2012 capital program.
TER: This is the best-behaved stock in your universe. It’s had its head above water for an entire year.
TM: Right.
TER: Is your target still $4.75?
TM: My target is higher than that. It’s $5.25 now. Whitecap and Spartan are my two favorite names right now. I like both their balance sheets. I believe Whitecap can show organic growth in the 20% neighborhood from cash flow over the next several years, and Spartan should be able to demonstrate similar numbers over the next 12–18 months because its balance sheet is very strong.
TER: Tim, you follow Strategic Oil & Gas Ltd. (SOG:TSX). I saw that it had recently negotiated a $40M bought-equity deal. When a company can avoid the risk of going to the market by selling its equity directly to the investment banks, it sounds like a very positive development.
TM: I definitely agree with that as Strategic will have a very strong balance sheet entering 2012, which will allow it to have an aggressive 2012 drilling program. Strategic has two oil plays that are both very early stage and quite high risk. We can see growth prospects for the next 12–18 months if either one of the oil plays is deemed commercial. On a comparable basis, Strategic’s assets are much higher risk than Whitecap’s or Spartan’s. This stock could perform very well with good drilling results or very poorly with bad drilling results.
TER: I enjoyed speaking with you very much. Thank you.
TM: Cheers. Thank you.
Tim Murray joined Desjardins Securities in July 2011. Prior to this, he was an oil and gas analyst for almost six years at several investment boutiques covering junior and mid-cap companies. He also spent over a year at AltaGas Income Trust performing risk and credit analysis on natural gas and power assets for the company’s midstream business and served as an investment advisor for three years. Tim was awarded the CFA designation in 2003.
By The Energy Report, on January 4th, 2012
 Fishing for value is no easy task in a stormy economy, but investors can still come up with a profitable catch. Oil and gas analyst Nav Malik of Octagon Capital uses due diligence to identify select value plays with great growth potential. In this exclusive interview with The Energy Report, Malik discusses three cream-of-the-crop picks and a hot new play in the United Kingdom’s North Sea.
The Energy Report: Nav, what is your current investment thesis?
Nav Malik: Given the commodity price environment, we prefer oil and light-oil plays at the moment. The economics are much more favorable. We also like liquids-rich gas plays, which serve to boost project economics. Given natural gas prices, we’re not as favorable on dry gas plays at this point.
TER: You would think of the liquids as icing on the cake?
NM: Absolutely. Projects have better economics via more favorable pricing in the liquids. With dry gas around $3.50/thousand cubic feet (Mcf), it’s not as economic to drill purely for gas, but when you add a liquids component to it, that serves to boost the overall production revenue stream.
TER: What do you look for in small exploration and production (E&P) companies?
NM: For both explorers and producers, the first thing we look at is the management team. We look at management’s track record, how familiar they are with the assets and what their plans are for the assets going forward. That’s certainly a key part of it. For producing companies, we also look at growth potential, and that could be a function of the number of potential drilling locations and inventory that they can exploit. We look at the potential to boost operational efficiencies to lower operating costs. For developers, we look at the quality of the resource base, how much it has been derisked and what steps management has taken to derisk the project.
TER: When you’re looking at developers, does it make you more comfortable when you are able to see other producers in the vicinity?
NM: Yes, absolutely. That certainly is a key component of derisking, whether there’s some well control in the area surrounding a company. That is helpful and gives us more confidence.
TER: Are there certain channel checks that you perform?
NM: We talk to the energy services providers. Their relative level of optimism helps to put the puzzle together. We also look at available industry statistics, such as license data and land sale activity. There is a lot of information available in the oil and gas space, particularly in Western Canada, which helps us gain an understanding of how the future is going to unfold. We also talk with industry associations like the Canadian Association of Petroleum Producers (CAPP), and we attend conferences. There are all sorts of indicators that keep us in tune with industry sentiment regarding future plans.
TER: Do the service providers have pricing power?
NM: They do. It’s a very active drilling period at the moment and considering the extended spring breakup that we had earlier this year; the latter half of the year has been a very busy time for service providers. Most of them are guiding for continued strong activity right through into next spring and the next breakup period. Their capital expenditure (capex) budgets have been growth-oriented and higher than last year’s spending. That’s what we saw with Precision Drilling Corp. (PD:TSX) very recently, as well as several other smaller service providers. That general theme has been playing out even in this uncertain economic environment, and the feeling is still positive when it comes to drilling intentions.
TER: Can you be bullish on small E&Ps if commodity prices are in a trading range?
NM: Yes, absolutely. Many of the small E&Ps offer good growth potential. It comes down to their land base and drilling inventory. You can certainly see production and cash flow growth in a flat commodity price environment based on how active and how successful companies are at executing their drill programs. If a junior company has a solid inventory of potential targets and is able to execute on those, we do see production growth.
TER: Do you see investors flow funds in small E&Ps in a flat oil commodity market?
NM: Yes, and I think there are companies that offer good value and growth potential in this market. Those are the types of companies that investors should look for. Even if you assume commodity prices are going to be relatively flat, there is tremendous potential still remaining, and new technology is opening up further potential. Hydraulic multistage fracturing (fracking) and horizontal drilling have really opened up potential in many resource plays that were previously thought to be near the end of their lives. They’ve now been rejuvenated with the improved technology.
TER: Can investors make money in this environment?
NM: There are opportunities to profit. The economic environment is still uncertain, so if we saw a significant downdraft in economic growth followed by a corresponding decline in commodity prices, that would certainly be a risk for an investor. But we’re assuming relatively flat commodity prices going forward. We think the $90–110/barrel (bbl) for WTI (West Texas Intermediate) level is a very positive environment in which investors are able to make money. Opportunities are there as long as the economy doesn’t decline significantly.
TER: What is your forecast for oil and for gas?
NM: We forecast WTI at $90/bbl in 2012. For gas, we’re looking for about $3.50–3.75/Mcf for NYMEX.
TER: What companies do you currently like?
NM: Equal Energy Ltd. (EQU:TSX; EQU:NYSE) is one of the names that we like. This is a company that has about 9,500 barrels a day (bpd) of production. It’s in the liquids-rich Hunton play in Oklahoma. It also has an asset base in the Cardium and in the Viking in Canada. So it’s in some light oil-focused plays in Canada and a liquids-rich gas play in Oklahoma. The economics are very favorable, and it’s been executing very well on its plays.
It just recently sold some noncore assets and applied the proceeds to its debt. It also has potential upside from an area in Oklahoma where it has about 20 sections in the Mississippian formation, which has become a highly attractive light-oil play in the U.S. A lot of the major companies in the U.S. are drilling here, including SandRidge Energy Inc. (SD:NYSE), which has been very active in this play.
TER: Will Equal develop its Mississippian play in 2012?
NM: Yes, I think we’ll see some cash flow from Equal’s land base in the Mississippian next year. I think it’s looking for potential partners to keep its own capital costs low.
TER: Equal decreased its guidance down for 2012. You had expected it to produce 11,600 barrels oil equivalent per day (boepd) in 2012, but the company is now projecting 9,400–9,800 boepd with a lower percentage of oil as well. What are the issues that resulted in these revised expectations?
NM: Part of it was that it sold off some non-core assets recently, which lowered its production numbers. We also find management to be very conservative, which is a good thing. They want to ensure that they are putting out achievable numbers in the investment community, erring on the side of caution. Finally, the company is not including potential development of the Mississippian in its cash flow and production guidance. Thus, there is certainly more upside there.
TER: So, the Mississippian could be a key catalyst for upside?
NM: Yes, absolutely. However, the market isn’t giving Equal much credit for the potential growth its acreage suggests. I think once it announces development plans there, or when it has partnered with somebody in the area to develop that play, that should really be a catalyst for the stock to move higher. The current share price level does not reflect this value.
TER: Is paying down debt the best use of proceeds from Equal’s asset sale?
NM: For Equal Energy specifically, it is the best use of proceeds. Its debt level was more than 2.5x its debt-adjusted cash flow number. That’s on the higher end of the scale for most companies in the energy space. I would say around 1–1.5x is the level most energy companies probably strive to remain below. So its debt is slightly higher than the industry average, and I think for that reason, using these proceeds to bring down its debt was really prudent on management’s part.
TER: Because of Equal’s lowered production forecast, you reduced your target price from $11.20 to $9, which still represents an 80% implied return.
NM: Yes, exactly. It’s still trading at a relatively attractive valuation. On an enterprise value (EV) to debt-adjusted cash flow basis, it’s trading at less than 4.5x, which is at the lower end of the range. Most companies in the energy space are trading around the 4–6x multiple. It’s at the lower end of the range, so valuation is attractive. Even our $9 target price represents solid upside from current levels.
TER: Equal sounds like a classic value play.
NM: Absolutely. It’s a good value play with an attractive valuation, a strong set of assets and a very strong management team as well. I think it’s doing all the right things. As it continues to execute, it should be reflected in its valuation going forward. So it’s a good time to step into the stock, and I think you could certainly see the stock price get closer to our target price over the next year or so.
TER: If Equal is producing on its Mississippian play a year from now, would you consider this company a legitimate growth story?
NM: I think there is growth potential out of the Mississippian. Plus, it has a number of locations available to drill in all of its plays, in the Cardium, the Viking and in the Hunton formation. So there certainly is solid growth potential there. I think we will see that down the road.
TER: What else do you like?
NM: I also like Spartan Oil Corp. (STO:TSX), which is a junior company primarily focused on the Cardium play in Alberta. What we like here is that it’s an emerging growth story. By the end of this year, it should be producing about 1,500 bpd. It has a very contiguous land base and is very low risk in the sense that there’s a lot of historical production from its specific area of the Cardium in East Pembina. It is basically exploiting horizontal drilling and multistage fracking to further increase production from its land base. So we’re looking at production doubling from current levels by the end of next year. Spartan recently increased its guidance for 2011 from about 1,050 bpd to likely hitting 1,500 bpd by the beginning of 2012. It’s been getting good results from the wells it has been drilling, and I think we’ll see that continue. The other thing I like about Spartan is that it has been reducing its capital costs on well drilling. Originally, the company was expecting to spend about $3.3 million/well in the Cardium. The company reduced that figure to about $2.5M/well, and it will likely go even lower than that. I think it’s commendable to management on how they’ve been able to reduce capital costs.
TER: Spartan’s relative strength has been extremely high. It’s up 27% over the last six months and up 14% over the past month. It’s really a mirror image of many of its peers that have gone the other direction. Is it a legitimate growth story?
NM: Absolutely. I think it’s one of the best junior names in the industry at the moment based on the land base and potential for growth alone. It’s just a matter of getting the resource out of the ground. The company’s growth trajectory should continue to accelerate, given those characteristics.
TER: I guess this is a case that proves investors can make money in this kind of market.
NM: Exactly. Spartan Oil is a great example of a very solid, growth-oriented, junior oil and gas company.
TER: Any other promising value plays?
NM: Another company we like is Xcite Energy Ltd. (XEL:TSX.V). Xcite has a play in the United Kingdom’s North Sea called the Bentley Field, which it was awarded back in 2003. The field is located about 160km east of the Shetland Islands. It has derisked that field significantly by drilling some exploratory wells and some appraisal wells that have demonstrated commercial flow rates. Its most recent reserve report outlines about 28 million barrels (MMbbl) of proven and probable reserves, and it also has about 87 MMbbl of contingent resources that we think should be reclassified as reserves once the company actually starts developing the field and begins producing. There are about 115 MMbbl potentially recoverable from the Bentley Field, which we think is very valuable. Our target price of $5 is based on our net asset value (NAV) model for that field, and represents considerable upside compared with the current share price.
TER: Yes, an upside of about 250%.
NM: Given that Xcite is not producing at the moment, there is obviously a higher level of risk, but it offers a very compelling risk-reward opportunity, in our opinion. We expect solid production out of the Bentley Field, upwards of 40 thousand barrels per day (Mbblpd) in about Q414.
TER: That’s three years from now, which is a lifetime in the energy sector. But if this kind of production can be achieved, this is a multibillion-dollar market cap company.
NM: Just over a $1 billion is roughly where our valuation is on it currently.
TER: Shares of Xcite are down 74% from one year ago. Is this due to the play’s built-in risk, or is there something else that has caused such a brutal drop in its share price?
NM: In this case I think it’s more about the economic environment. Capital is required to execute on the Bentley Field development strategy. When the financial markets are uncertain, it may be more difficult to access or raise capital. That being said, Xcite actually does have enough capital available to begin the first step of the process. In my opinion, the company is not really constrained by any means, but some investors may feel that there is a high level of risk still involved. I think the other issue that may have brought the share price down slightly is that the company is awaiting Department of Energy and Climate Change (DECC) approval for its Bentley field development plan. Xcite recently revised those plans, which may have caused some uncertainty in the investment community. We think that it will receive DECC approval shortly, which should serve as a positive catalyst for the share price.
TER: Even though the company’s share price has been beaten down dramatically, it still has a $251M market cap, which means it could be owned by a lot of mutual funds. Sometimes a company’s market cap can drop so low that mutual funds can’t own them, but that’s not the case here.
NM: Absolutely. I think that speaks to the value of its asset in the Bentley Field, a very valuable resource. There are other large players in the North Sea, such as Statoil ASA (STO:NYSE: STL:OSLO) and Apache Corp. (APA:NYSE). There are a lot of companies in the North Sea that can appreciate the value in the Bentley Field. For those reasons, we also consider Xcite a potential takeout target down the road.
TER: This Bentley Field play is a huge and complex project.
NM: Yes, absolutely, but lots of potential, in our opinion.
TER: Many thanks to you, Nav.
NM: Thank you very much.
Nav Malik joined Octagon Capital Corporation in late 2010 as a research analyst covering the oil and gas sector. He has over 15 years of capital markets experience, primarily focused on companies in the energy, transportation and industrial/manufacturing industries. Mr. Malik was ranked as the number-one Business Trust Stock Picker in the 2009 StarMine Analyst Awards, and has also been highly ranked in other investment industry surveys. He has a Bachelor of Commerce degree from the University of Calgary and a Masters of Business Administration from the University of Western Ontario.
By The Energy Report, on December 28th, 2011
 According to Jim Letourneau, author of the Big Picture Speculator, oil and gas aren’t going away any time soon. Indeed, new technologies offer the industry and investors profitable opportunities. Read more about why Letourneau considers shale gas, shale oil and enhanced oil recovery “game changers” in this exclusive Energy Report interview.
The Energy Report: Jim, in a nutshell what is the big picture in the oil and gas space right now?
Jim Letourneau: Despite a big renewable trend, oil and gas are still critical to world energy markets. We will need both for the foreseeable future, at least the next decade.
TER: You recently wrote about fear paralyzing the market. What effect is fear having on you as a newsletter writer?
JL: When people are scared, they want dividends, U.S. dollars and precious metals. No matter how interesting or exciting the company is, in a really strong bear market it will not matter unless the assets are productive today. People will look at a mine that is in production and has cash flow. A project that involves lots of drilling to build out a deposit is a tougher sell.
Most newsletter writers, myself included, do not like talking about companies whose stocks do not appreciate. Fewer people want to be invested in the stock market because they don’t see why they should be. However, even that can be an opportunity. When people are fearful, sometimes the market can turn and have a really nice run. If we do not have new lows over the next couple of months and the trend changes, we would hypothetically be able to enjoy that for quite some time.
TER: Some oil and gas companies are boosting dividends in an effort to get attention in the market. Do you expect that to continue?
JL: That is a way of showing off, of saying “Look, we are so comfortable with our business model that we can afford to pay out dividends.” If there is a bull market in dividend-paying stocks, there also could be a time when that popularity will end. It could be just a passing phase.
TER: But it does provide a bit of flexibility: A company can increase or decrease its dividend. It is one of the cards a company can play if it has a lot of free cash flow.
JL: Exactly. Some of the major gold producers are increasing their dividends. Everything else being equal, I would rather have a dividend from a gold producer than from a financial institution. Banks will tell you everything is great until the day before they collapse. If people are looking for dividend-paying stocks, at least gold mines or oil and gas companies have productive assets; they produce something of value. That’s where I would concentrate.
TER: That seems to be where the Chinese are concentrating. Sinopec just bought Daylight Energy Ltd. (DAY:TSX) for a little more than $10 a share, more than double the closing price the day before the bid. Do you think China will continue to turn its dollars into hard assets while dollars still have value?
JL: The short answer to your question is yes. China is making acquisitions all over the world every day of anything that is productive.
It tells you something about the state of the market that Canadian investors thought Daylight was worth less than $5/share and China waltzed in and paid $10 without any haggling at all. This was an opportunistic move by Sinopec.
Chinese companies have taken the clever strategy of going for lesser-tier companies. If they go for a bigger one, they will take a minority interest so it is not seen as a takeover.
TER: What did Daylight have that the Chinese wanted?
JL: Daylight has oil, natural gas and high-content natural gas liquids in a few different plays in western Canada. The Chinese are buying companies with the potential for productive assets.
I think China also has a very long-term horizon concerning its energy policies. The country is willing to invest in the long term over a broad portfolio of energy sources. The Chinese know that all the investments may not all work out, but they can afford to do it.
We are still building out the capacity to export natural gas from North America. If that happens, our low-price North American natural gas will be very attractive to China.
TER: At a recent investment conference in Montreal, you told the audience about three “game changers” in the oil and gas space: shale oil, shale gas and enhanced oil recovery (EOR). Can you please give our readers the nuts and bolts of your presentation?
JL: All three of those things involve new technologies that are squeezing more oil out of the ground than we ever thought possible.
In terms of shale oil, the best example is the Bakken in North Dakota and Saskatchewan, and possibly Montana and Southern Alberta. The Bakken really changed the oil and gas landscape in North America to the point of using trains to transport gas from North Dakota to Texas. And there are a lot of other source rocks that have the same characteristics and will be developed over time.
Shale gas was actually the first big game changer. Five years ago we were building natural gas import terminals because we thought we would run out of domestic natural gas. Today, North America has the cheapest natural gas in the world and we are building export terminals. It started in Texas, in the Barnett Shale. For every argument that says shale gas will not work, there are arguments that say it will. A lot of the technical problems that exist today will be solved in the not-too-distant future. That is one of the reasons I am not a huge believer in peak oil; yes, you can extrapolate present-day trends, but you cannot predict what human innovation will come up with to increase supply.
That leads to the third category, which is enhanced oil recovery. Big picture, roughly a third of the oil that has been discovered has been produced. Getting the next third out will take some innovation. There are a lot of interesting technologies in EOR that make it quite likely that the next third will be produced. Recovery factors can move up from 33% to 50% or 60%.
TER: I see your point on shale oil and EOR. But gas prices on the NYMEX are at record lows. Very few companies can make money at that level. The only shale-gas companies seeing an uptick in their share price deal with natural gas storage, and they are running out of places to put it. How can an investor make money in shale gas?
JL: There are two sides to the story. First, abundant, cheap shale gas is good for consumers of natural gas. Second, all commodity bull markets end.
Natural gas is not the best place to invest, but, it does point to the opportunities. The service companies that unlock the shale gas are doing fairly well. I suggest that people look not so much at the producing side but more on natural gas being used as transportation fuel. Some petrochemical industries and the steel industry will benefit from cheap natural gas. So, you have to be a little bit nimble.
TER: Could you give our readers a name or two in the shale-oil space?
JL: I really like Shoal Point Energy Ltd. (SHP:CNSX) because not too many people pay attention to the company. It discovered Green Point, an oil-in-shale play in Port au Port Bay in western Newfoundland. The Green Point shale can be over 2,000m thick, compared to the Bakken, which is typically 30m thick. The extra thickness really changes the amount of oil per section. Shoal Point has an oil-in-place number of at least 100 billion barrels, calculated from volumetrics. Production will be the challenge, but that is just too big a resource to ignore.
TER: The company also has the Ptarmigan oil-in-shale play in Newfoundland and the South Stoney Creek gas play in New Brunswick. How is Green Point progressing?
JL: There was a delay for further testing and Shoal Point had to wait for permits. Investors got a little discouraged because everybody wants results right away, and the share price languished.
Now, the company has the permits and will deepen the well and test it soon.
TER: In other Newfoundland oil projects, the provincial government has wanted a piece of the action. Does the government have a piece of this?
JL: I’m not sure. But, I cannot imagine Newfoundland not having a royalty interest because that is typically how we do things.
TER: Are there other shale oil plays?
JL: There are a lot in the Alberta Bakken, in Montana and southern Alberta, where that play has yet to really ignite and catch on fire. Companies are also looking in the Duvernay in Alberta. That is a deeper, Devonian shale that sourced a lot of the Leduc oil.
TER: Do you have any names in the shale gas space?
JL: Given that the price of that commodity keeps dropping, one way to play shale gas is through service companies. GasFrac Energy Services Inc. (GFS:TSX) has gotten a lot of attention for using gelled propane as the carrier fluid instead of water.
There has been a lot of concern about the use of water in fracking. Very few people realize that most oil and gas production in North America involves about 10% oil and 90% water.
People like GasFrac because it does not use water. But more importantly, in certain types of formations having a liquid hydrocarbon that changes to the gas phase when the pressure drops helps avoid the formation damage and other problems that can happen when you use a massive water-based frack.
TER: In terms of enhanced oil recovery, what names are you following?
JL: There are very few specific companies; usually it is an oil company with a project. One that I have been following for a long time, and worked for, is Wavefront Technology Solutions Inc. (WEE:TSX.V).
All versions of EOR involve injecting a fluid. It could be water, CO2, chemicals or nutrients. The more uniform and evenly distributed those fluids are, the better the process will work. Wavefront has patented an injection process that provides that uniform fluid distribution.
The company is not quite profitable yet, but the growth will come quickly from its Powerwave application for EOR.
TER: Wavefront now has a market cap of around $68 million (M). It would not take long for a major producer to get older assets to market if this technology works as well as you suggest.
JL: The biggest upside for oil companies using the technology is that they can increase their reserves without infill drilling. The oil industry does not just jump and try new technology; it likes to see some proof. Wavefront now has proof. The longest Powerwave installation is over four years old. It has numerous case studies that document how the technology works and how it makes money for the client. It has made the transition from an unproven technology to a proven technology. It is now a commercial technology with a lot of upside.
Wavefront is essentially a technology company that licenses its technology to oil companies. Wavefront will not have a lot of additional expense to sell 100 tools or 150 or 200. The scalability is exciting.
TER: If a major can apply that technology in its old basins, it would not take long to reach perhaps, $70M worth of oil.
JL: Definitely. Of course it depends on the size of its fields, but increasing ultimate production by 5-10% provides some big numbers. More and more people are seeing exactly that. Wavefront could become a takeover target. The company has roughly $24M in cash. It has a lot of staying power.
TER: Jim, what should investors be keen on in the oil and gas space in 2012?
JL: I would still look to oil and gas service companies with the right technology. Shale gas fracking companies are interesting plays to look at.
I would not be too excited about natural gas producers. Those producers who are moving toward liquid rich natural gas are a little more interesting.
Overall in the oil space, the only thing that would move oil prices any higher would be severe geopolitical tension. And I wouldn’t be shocked to see some unpleasant geopolitical tension in 2012. Economic news is creating tension all over the world. When that happens it’s usually pretty bullish for energy prices.
TER: Jim, thank you for your time and insights.
Jim Letourneau is a public speaker, geologist, corporate evangelist, and investor in emerging technologies and discoveries.
By The Energy Report, on December 21st, 2011
 With resource stocks extraordinarily cheap, 321energy.com Founder Bob Moriarty calls them “an opportunity of a lifetime,” in this exclusive interview with The Energy Report. However, investors need to steer clear of the dangers of derivatives. Moriarty explains how the hypothecation hobgoblins associated with these instruments can sneak up on investors and zero out accounts in a flash.
The Energy Report: Peak oil has returned as a popular topic of conversation, and you’ve been talking about it for some time. Are we really in the era of peak oil, with oil production diminishing? Or do we just lack cheap oil?
Bob Moriarty: It’s both. We’ve reached the peak of oil production, which doesn’t mean we’re going to run out of oil, but we’ve run out of cheap oil. When the Saudi oil fields opened in the 1940s and 1950s, their return on investment was $350 per barrel. When OPEC formed in 1959, they were profitable selling Saudi oil at $0.10 a barrel. The cheap, high-grade, high-quality oil is all gone now, and the days of finding giant oil fields with high-grade oil that was relatively inexpensive —such as Ghawar in Saudi Arabia and the Cantarell off Mexico—are gone. They’re history.
With the resources in the tar sands of Canada, we’re going to have oil for another 100 years of production, but it’s very expensive. It’s very dirty, with a number of political issues in focus, such as the Keystone XL pipeline to the United States. Production will be problematic.
TER: Besides the tar sands, oil appears to be available offshore both in North and South America.
BM: Yes, but these projects carry ferociously expensive costs. Some of the wells BP was drilling a year and a half ago, going 25,000 feet (ft) deep, cost hundreds of millions of dollars each.
TER: You mentioned that the Canadian tar sands probably hold enough oil—albeit expensive to extract and dirty—to last 100 years. Meanwhile, the U.S. sits atop some major natural gas fields, and natural gas is unbelievably cheap right now. Why aren’t oil-powered vehicles and other machines being converted to run on natural gas?
BM: Natural gas is handy for some things. It’s used in a lot of power generation. It’s very valuable to replace heat or coal or diesel. But you couldn’t power an aircraft with natural gas under any circumstances; it simply wouldn’t work.
Gasoline and oil are very portable and very cheap. You can go to the hardware store, buy an inexpensive container and carry around five gallons of oil or gasoline. To get the same amount of energy from natural gas probably would cost $1,000 for a container. All kinds of technical and temperature issues make natural gas ineffective as a portable energy source.
TER: So if natural gas is not the solution, we’re stuck with the more expensive alternatives. And if it’s dirty and expensive, what are the economic implications of getting oil from the Canadian tar sands to the U.S.?
BM: Dirty is expensive. And when you start talking about getting the oils from the tar sands to the United States, which is the major market, you run into all kinds of issues. Politicians and lobbyists will spend years delaying the pipeline until their personal agendas are satisfied.
TER: Senator Mitch McConnell called the Keystone XL Pipeline, which is proposed to carry tar sands oil from Canada down through the U.S. to Texas for processing, the single greatest “shovel-ready” project in America. He said it’s ready to go, but Obama doesn’t want to deal with it until after the 2012 elections. In an era when we need oil and people need jobs so badly, why the political slowdown?
BM: Every organization and every government official has an agenda, and not necessarily your agenda. You and I may want the tar sands oil as soon as possible and as cheap as possible. Obama has his own agenda—to get reelected.
TER: There also have been discussions about building a pipeline across Canada to bring it to Vancouver and potentially ship it to China. In terms of an investment opportunity, what does that mean for the tar sands oil producers?
BM: There will be a lot of investment opportunities. The question is when. The longer the transportation issue—a pipeline—is delayed, the more expensive it will be to operate and lower the return on the investment will be. Ultimately, though, I think there’s a good chance that Canada will decide that China and Japan and Asia are better, more dependable markets than the United States.
TER: Over what timeframe do you suppose that pipeline will be built?
BM: We are facing some pretty serious economic issues right now. Should we go into a depression soon, which is my belief, the decrease in energy demand could kill this project and others for years.
TER: But your writings suggest that you’re interested in some Canada-based energy companies based on what you consider their good potential for return. Don’t these companies face the same margin squeeze with the prospect of higher transportation costs?
BM: Not at all. The tar sands are in a pretty inaccessible part of Canada. The junior companies I deal with have access to pipelines, refineries and major markets, so it’ won’t affect them.
TER: Would demand come to them first as lower-cost producers, and help their profit pictures?
BM: Of course. It would be a very good thing for them. Everything that’s bad for one group is good for another.
TER: What are some other companies with good prospects?
BM: Two juniors I’d like to talk about are doing a really excellent job. A few months ago the stock of Aroway Energy Inc. (ARW:CVE) was $0.32 a share. It’s doubled since then, and it’s another easy double from here. It “should” probably be worth $1–$1.20 a share right now. These guys have done a bang-up job. They’re producing 669 barrels a day at Peace River in Alberta.
TER: Is your analysis of what the stock should be worth just based on Aroway’s current production times the barrel of oil equivalent (boe) price in the marketplace?
BM: Yes. Oil fields are actually relatively homogeneous, so people can know on a daily basis what a barrel in the ground or barrel of production is worth.
TER: What’s the other company you wanted to mention?
BM: Blackdog Resources Ltd. (DOG:TSX.V) just finished a well within the past couple of weeks. Its stock is at $0.40 a share and the company has about 26 million shares, so market cap of about $10 million (M). Based in Calgary, Blackdog could be $1 a share easily.
TER: Aroway has projections to increase production over the next 12-months. Is Blackdog producing yet or just drilling and exploring?
BM: Blackdog is doing exactly the same thing as Aroway, producing and exploring. It’s just a little bit earlier stage. The company is producing something like 150 barrels a day now, but literally has wells coming into production as we speak.
Production is critical, because the world’s financial system is blowing up and counterparty risk is enormous. If you’re not invested in something real, you’re going to wake up and find yourself poor.
TER: Could you expand on that counterparty risk and the concept of investing in something real to minimize investors’ chances of waking up poor?
BM: With the collapse of the major global commodities broker MF Global at the end of October, up to $2.5 billion worth of its customers’ money evaporated. Investors as financially sophisticated as Trends Journal Publisher Gerald Celente went to bed rich and woke up to worthless accounts.
Some very important concepts, hypothecation and re-hypothecation, are involved when it comes to derivatives, which are financial instruments that gain their value from something else. Suppose that you open a commodities account because you expect the price of gold, silver or oil will go up. You deposit $100,000 margin and buy a contract for gold, silver or oil. Let’s say things go wrong because of hypothecation, re-hypothecation and counterparty risk.
Here’s what happens with hypothecation. The broker-dealer usually goes to a bank and borrows money to loan you. But in this scenario you put up twice as much as the margin required, so he doesn’t even loan money to you. Regardless, you are required to sign a statement saying you will allow the broker-dealer to hypothecate the account. This pledges everything in your account to the bank. Broker-dealers borrow money from the bank at, say, 3% and loan it to customers at maybe 6%. That’s how they make money. In this scenario, the problem is that the broker-dealer created a risk for you that never occurred to you. If the broker dealer reneges on the loan, the bank can demand all the assets you have deposited even if they are in your account and you don’t owe anyone anything.
With re-hypothecation, the broker-dealer can take money from a number of customers—let’s say $1B from 10,000 customers—and buy something like Greek one-year bonds that are paying 352% today. The broker-dealer pledges your assets against that bet. That gets really slick, because if the Greek bonds actually pay 352%, he or she pockets that money. But if the bonds blow up—which some people have been predicting for years—you lose all your money.
TER: Is this true on any bank account?
BM: It’s true of any margin account. If you open a margin account with Schwab, put up $1M and buy $500,000 worth of securities, you’re not using margin but you’ve still signed that agreement. You can wake up one morning and find all your money gone.
For years and years I’ve been saying that derivatives of this magnitude are not sustainable in a rational economic system. We have a $64 trillion (T) world economy, and we’re basically up to $708T in derivatives. You cannot have $708T in derivatives unless most of it is fraud.
MF Global was defrauding its customers and its customers didn’t even know it. There could be another 100 MF Globals out there. At the end of the day, a lot of brokerage accounts will blow up and people are going to go to bed rich and wake up poor. The danger today is not buying Aroway or Blackdog and seeing the value of your stock cut in half. The danger is that your broker will blow up.
TER: Is it fraud because investors don’t know about the hypothecation and re-hypothecation? That they don’t know what’s being done with their money?
BM: That’s correct. Literally until weeks before MF Global’s collapse, I think on the books they were showing $70M being used for re-hypothecation when in fact it was $6.5B.
TER: Why such a big gap?
BM: The way they do the books creates that gap. Greece and Italy and Spain got into the EU because JP Morgan and Sachs cooked the books by leaving their assets on the books and moving their liabilities off the books. Jon Corzine moved $6.5B in liabilities off the books and nobody realized they had enormous exposure, and when the financial system in the EU blew up it took $6.5B of MF Globals’ money with it. What’s really scary is that nobody’s in jail is because all of this is perfectly legal—a scam, but a legal scam. If they make money, they keep it; if they lose money, you pay.
TER: This is easy money with no risk for brokers.
BM: Exactly. And the danger is somebody at Schwab or E-Trade or Merrill Lynch or 100 other institutions can go out and do the same thing tomorrow. It’s just as legal. They can speculate on something like Greek bonds paying 352% and some fool will think that’s a good deal.
TER: Wow. That’s a very compelling argument and it certainly underscores your point of buying real assets.
BM: But if you go out and buy shares of Aroway or Blackdog, you may want to get a share certificate in your name in your hands because you can count on some stock brokerage accounts to disappear in the same way the Gerald Celente’s hundreds of thousands of dollars disappeared. You’re at enormous risk if you have a margin account with any kind of a broker.
TER: Do you run the same risk in a non-margined account?
BM: In theory, no; in practice, yes.
TER: And what’s the practice?
BM: The practice is that $708T in derivatives, probably 80% of which is fraud, and nobody but me, Jim Sinclair and maybe Jim Rogers understands the potential risk. In theory, there’s $210T in debt in the world and $150T in assets. I think in practice there’s up to $400T worth of debt and the system is going to blow sky-high. Our financial system is on the precipice of an absolute, total collapse. And it’s going to be catastrophic to the wealth of most people. This is the most serious I have ever been about anything. Derivatives are a giant casino. It’s a crap game. It’s all fraud.
Back in 1997 the head of the U.S. Commodity Futures Trading Commission (CFTC) was extremely concerned at the size of the derivatives market and battled to get regulations in place to control it. The head of JP Morgan, as well as Robert Rubin, who was Treasury Secretary and the head of Goldman Sachs, and Alan Greenspan, chairman of the Federal Reserve, all fought her. She lost. By 2002 derivatives had grown to $100T, and clearly were going to blow the system sky-high. Now—and these numbers are really staggering—the Bank for International Settlements reports that derivatives grew $107T between January and July of this year. That’s 18% in a six-month period, which means derivatives are growing about 40% a year.
TER: Now that you have everybody shaking in their boots, let’s shift gears a bit. One of your articles equated peak energy to peak food. Earlier you reminded us that we’re not about to run out of oil, but cheap oil is a different story. Is it the same with food? That we aren’t going to run out of food, but the days of cheap food are history?
BM: Exactly. And when the cost of food goes up the costs of the additives literally goes down in relative terms. Let me give you a perfect example. It takes 81,000 calories of energy to produce 75,000 calories of energy in the form of ethanol—for a net loss. It has to be subsidized. Regardless of the conditions, production of ethanol is a net loser. The U.S. government has literally been bribed by corn producers and big food companies, doling out subsidies for the production of ethanol that drove corn prices up literally all over the world.
I went to a vegetable market in Guyana, for instance, that was selling four really scrawny ears of corn for $5. That’s a result of these silly practices in the United States. Increases in the prices of corn and wheat throughout the Middle East triggered the Arab Spring. I think three billion people in the world survive on less than $2 a day, so when the cost of food goes up 50%—as it has in the last year—many of those who were marginal before are starving now. That leads to revolutions.
TER: You’ve been big on potash. Because potash in fertilizers helps increase food production per acre, do you think potash is due for another run-up in price?
BM: Potash is a form of energy. Food is a form of energy. To make more food you need more energy and you need more potash. There are enormous potash deposits, basins of sedimentary deposits—basically a variation of salt—that date back tens of millions of years. We know where they are. They’re easy to drill. A lot of people are going to make a lot of money in potash.
You can bet on some things in the short term and others in the long term. I don’t think anyone would conclude the cost of energy is going to go down over the long term, because there are no cheap energy sources. There is no magic bullet. So the cost of food is going to go up.
Real safe investments for 5, 10 or 15 years would be food, potash, water, oil and natural gas. Good shorter-term investments would be anything real—gold, silver, platinum and anything that you can actually hold in your hand.
TER: According to John Williams of ShadowStats, inflation is running around 11% if fuel and food are included. Where’s the upside if you’re looking at investments in potash, oil and such that could play out in five to 10 years and you’re dealing with double-digit inflation?
BM: I love it when something goes down in price. I love it when shoes or socks or coats or boats or airplanes go down in price. I don’t have any particular problem with it when a stock I really like goes down in price, either, because it makes it possible to buy more. So I think the fact that potash is down now in relative terms is wonderful.
TER: So suppose you buy potash on sale at today’s prices. It’s not worth anything unless you can sell it, so when would you expect a return on that investment? Five years?
BM: No, no, soon—three months, six months, a year.
TER: Because your underlying assumption is that the costs of energy and food will go up in the near term, how do you recommend playing the potash market dynamic?
BM: I think any potash company would be a good investment right now.
TER: When we chatted at the Hard Assets Conference in San Francisco you mentioned being intrigued by another potash company in addition to those you’ve been following for some time.
BM: Yes, North American Potash Developments Inc. (NPD:TSX.V; RNGTF:OTCQX; 3OZ:Fkft) just released drilling results this month. It had a 3,450-foot rotary drill and core hole on its Lisbon Valley property in Utah, and reported 15 ft total thickness and 10.4% potash at 2,600 ft deep, which is very good. There were two potash beds; one was 19 ft and one was 24 ft. Two different holes, one was 5 ft at 13%. Those are good results. That’s going to be an interesting story. Because the potash was laid down as water evaporated, it doesn’t take many holes of it to be good.
TER: So this company is basically going after a deep-shaft type of potash versus an open pit?
BM: No. Actually it’s in-situ leaching. The right kind of potash can be leached in place by pumping hot water down, bringing the brine to the surface, spreading it out in big pads to air-dry, and then just harvesting it with scoop loaders. It’s a very cheap way of doing it.
TER: How does that compare to the other companies?
BM: Well, Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX) has been doing a lot of drilling and is finally coming out with some results. The issue there is not technical; it’s management and communications. They simply have to release more information. Eventually they’ll start telling the story. I have discussions with management about what they do well and what they do poorly, and what Passport’s done poorly over the last year is communicate.
TER: You said that any potash company would be a good investment right now. What are some more names?
BM: They’re easy to find. Buy the potash companies because they’ve been hammered like gold stocks, silver stocks and other resource stocks. Buy resource stocks, anything in resources—water, energy, food and land. The resource stocks are cheaper in real terms now than they were at the bottoms of the market in both 2001 and 2008. They’re extraordinarily cheap. I think it’s an opportunity of a lifetime.
TER: You’re not the only one to say that. People are talking about precious metals and rare earth metal stocks all being on sale—large ones, juniors, pretty much the whole sector. Would you say the same thing of oil and gas?
BM: Yes. But here’s the deal in terms of the global economy: All these people are swinging at this giant piñata loaded with nitroglycerin. One day soon, somebody’s going to hit the piñata and when that happens, you want your finances under control. I would recommend against having a margin account with any broker under any circumstances right now unless you’re prepared to write off 100% of your investment.
TER: Any other thoughts you’d like to leave with our readers?
BM: We’re at the most dangerous time financially in the world’s history. There are enormous risks. A lot of people are going to lose a lot of money. This is not a time for speculation or borrowing. It’s time to head for the bunker. It’s time to be aware of what’s going on financially. And it’s time to be especially conservative.
Convinced that gold and silver were at their bottoms, and wanting to give others a foundation for investing in resource stocks, Bob and Barb Moriarty brought 321gold.com to the Internet 10 years ago, and later added 321energy.com to cover oil, natural gas, gasoline, coal, solar, wind and nuclear energy. Both sites feature articles, editorial opinions, pricing figures and updates on relevant current events. Before his Internet career, Moriarty was a Marine F 4B pilot and O 1C/G forward air controller with more than 820 missions in Vietnam. A captain at age 22, he was the youngest naval aviator in Vietnam and one of the war’s most highly decorated. He holds 14 international aviation records, and once flew an airplane through the Eiffel Tower’s pillars “just for fun.”
By Bron Suchecki, on December 19th, 2011
A reader, LS, asked for my thoughts on the following topics:
1) freegold
2) the gold for oil trade
3) the current price is not a real physical price of gold because of happenings in COMEX/LBMA
4) do you believe the current world affairs will resolve itself towards freegold or something similar?
Firstly, I haven’t had the time to read FOFOA in depth given the amount of material and thus give it justice. My comments here are therefore tentative thoughts.
Freegold is very interesting and I can see the logic of the idea of leaving fiat to perform the medium of exchange role and gold the wealth store role. I have a feeling free banking (see also) and a restriction on maturity transformation would need to be involved for it to work. There is a hell of a lot of discussion condensed in that sentence, more than I have time for at the moment.
I would also argue that Freegold needs to allow gold leasing but not gold lending. By “leasing” I mean as in leasing a car, ie physical asset rented (not borrowed and sold). Manufacturers of gold products like the Perth Mint could not operate without leasing because with Freegold’s ban on lending of gold and other financialisations it would be difficult (impossible?) to hedge against gold price movements.
This leads to my next point, which is that the gold price under Freegold would not be stable and still exhibit some volatility. This is because under Freegold people can save excess wealth either in gold or by investing in productive enterprises (ie true investment). Human nature being what it is we will still have overestimation of the success of productive enterprises, thus failures, thus business cycles, ths varying preferences to store wealth in gold versus investments.
On the Oil/Gold idea, I don’t have an option as this is not an area of FOFOA I’ve looked at much.
The current price is a real physical price as physical buyers and sellers of size (giants) are willing to exchange at that price. When aversion to counterparty risk really hits market players (MF Global you’d think should have been enough), then we will see a divergence between paper and physical.
As to the fourth question, well this is bound to my answer in the paragraph above, which is a necessary condition, but not sufficient, for Freegold to emerge. You would also need consensus that a gold standard is not the answer, and there are strong forces working towards that end. Possibly the biggest problem is getting people to understand the reason why financialisation of gold needs to be banned. How it will end is impossible to predict.
Either way it is going to be exciting to see how it plays out. 
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