The Energy Report: Chen, what’s your economic and market outlook for 2013?

Chen Lin: In the past few months, China seems to have turned the corner as its real estate market started to turn up, and so goes its economy. I believe the U.S. will likely do well. I don’t see the EU breaking up in 2013, and Japan is going to be printing a lot of money this year to try to jumpstart its economy. So although I see slow global economic growth, it’s still growing, especially in China and the U.S. I believe the stock market can do quite well as investors have been piling into bonds and cash in the past a few years.

TER: Oil prices have recovered from their lows of last year, but Brent is much stronger than West Texas Intermediate (WTI) and closer to its March peak than WTI. What’s your forecast at this point?

CL: I see relatively stable oil prices. There will be a lot more oil coming from U.S. shale plays. However, the pipeline to the Gulf will be limited and the United States has a ban on exporting oil. We are likely to see a lot of oil coming from Oklahoma to the Gulf Coast. However, the oil has to be refined at the Gulf Coast because it cannot be exported, so the new pipelines will likely push down Louisiana Light Sweet until it sells at a sizable discount to Brent, which could create some interesting opportunities for refiners on the Gulf.

TER: How do you view the domestic versus international production arenas in terms of investment potential? Where do you see the best investment opportunities in 2013?

CL: I’ve been really focusing on international onshore plays in the past few years and will continue to do that. International companies can get the Brent price. Domestic producers are usually shale or offshore plays with high capex. Capital is very hard to get, especially for small companies, so that’s why I’m focused on international onshore players. The geographic area I’m mainly looking at is Southeast Asia and onshore Africa, because those are areas in which China is likely to make more acquisitions.

Last year was very difficult and many juniors were hit very hard—it reminded me of 2008. I see potential on the other side of the trade, where most investors are going to cash and bonds and avoiding risk. Maybe investors are getting ready to take on more risk. That’s got me quite excited for 2013 and I’m continuing to watch the market for opportunities to arise.

TER: What are the global implications of China’s aggressive oil and gas acquisition plans?

CL: I think China’s acquisition strategy is twofold. One is its focus on North America, mostly in Canada, where the primary goal is to understand fracking technology and see if it can be applied in China or elsewhere. The other focus has been on Southeast Asia and Africa, which can be very beneficial to juniors. We’ve seen some M&A activity there and I expect to ride the wave and hopefully take advantage of that.

TER: Has your investment strategy changed at all as a result of developments over the past six months?

CL: Not much, but I have started to look a little at some more risky junior plays because investors have been extremely risk-averse. This is a good time to start looking at them more closely.

TER: You recently closed your newsletter to new subscribers. What was the reasoning behind that?

CL: My newsletter has been getting a lot more popular lately and I really hate to see stocks swing a lot on my recommendations. In an ideal world, stocks should only rise and fall on their own merits and not on my recommendation. So I decided to close it to new subscribers so our existing subscribers could have a better chance to make profitable trades. We are allowing people to go on a waiting list if people drop out.

TER: Do you feel that investors need to be more trading-oriented in order to profit in the energy market these days?

CL: Personally, I’m a pretty long-term oriented investor, but recently the market has been so rough I’ve been forced into taking more of a trader approach. I really enjoy working on long-term winners and energy companies that can be self-funded are extremely attractive. I have quite a few very long-term plays I’ve been in two or three years and still holding. I’m hoping the market will stabilize a little so we can have longer-term trades, but I do short-term as well.

TER: When you talked with us, midyear 2012, your portfolio was up somewhere between 40% and 50% for the first half of the year. How did you do overall for 2012?

CL: My partner, Jay Taylor, tracked it at about 63%. There’s a retirement account without any leverage or option trading, which was intentional. I was fortunate to do very well over three main areas in 2012: energy, mining and biotech. Actually, my biggest winner in 2012 was in biotech. Sarepta Therapeutics (SRPT:NASDAQ), which I discussed in The Life Sciences Report not long ago, has actually returned 15-fold in the call option trade. We also made a few very profitable trades in metals and mining; for example, we bought gold and silver stocks and ETF call options just weeks before QE3, which we sold on the QE3 news market swing. I also did quite well in the energy sector.

TER: What were your best performers last year in the energy sector and are you going to be sticking with them?

CL: I was heavily invested in Mart Resources Inc. (MMT:TSX.V) and Pan Orient Energy Corp. (POE:TSX.V) at the end of 2011. I will continue to be bullish on both stocks and those continue to be my heavy holdings. In terms of Mart Resources, we will likely see dramatic increases in its production when it finally builds out its pipeline. Oil production could easily double, if not triple, after the pipeline is built, so I expect the dividend increase to follow. Right now it’s paying about a 13% dividend. I would expect to see a much higher dividend after the new pipeline goes in.

TER: And when do you expect that will be built?

CL: The company guidance is for the second half of 2013.

TER: And where is Mart trading these days?

CL: It’s trading at $1.76 in Canada, $1.80 in the U.S. It paid $0.20 in total dividends in 2012 and it’s been a big winner. I started buying the stock at $0.15–0.16. I expect the dividend should be relatively stable because the cash flow is just incredible. The risk is that it’s in Nigeria and subject to some political risk. But if you can look beyond that, the stock has a very bright future. China recently made an acquisition in Nigeria paying about $23 per barrel (bbl) oil, so you can see that the upside is very significant. Most recently, Mart announced initial results for the UMU10 well. These new discoveries at deeper zones will not only increase the reserve and production, it may even carry an additional tax holiday that can be very beneficial to Mart shareholders.

TER: What’s going on with Pan Orient?

CL: This year will be the most exciting in the company’s history. It’s a producer in onshore Thailand. It has prepared for the past five years to explore some big targets in Indonesia as well as Thailand and will start drilling this month. There was an excellent article written by Malcolm Shaw, a retired Canadian fund manager. Seldom in my trading career have I seen this kind of risk/reward, and if you ask me which stock I think would have the greatest chance of becoming a tenbagger in 2013, I would say, without a doubt, it would be Pan Orient.

The beauty is it has so much cash on the balance sheet and no debt. It has fully funded all its exploration and doesn’t need to dilute shares. By the end of the year, it should still have a lot of cash left. Management consistently bought shares in the past. Even in the worst-case scenario, the downside is very limited and the upside is very big. Also, I want to say that the Chinese company, Hong Kong and China Gas Co. Ltd. (3: HK), bought the Pan Orient legacy oil field last year for $170 million ($170M), and has been looking for more assets. If Pan Orient makes new discoveries, we have a natural buyer right there to buy them and reward shareholders. That’s why I’m very excited about this one. I purchased the stock a year ago and it has much more room to run. I believe the run for Pan Orient has just started because it takes many years to prepare that groundwork, get approvals, do the seismic and then finally start drilling this year. I’m very excited about the stock.

TER: What other names have been good performers in the last year?

CL: Another stock with a nice return that is still undervalued is Coastal Energy Co. (CEN:TSX.V). It’s offshore Thailand so development is always slower than onshore; fortunately the wells are inexpensive to drill. I wouldn’t put it in the same category of Mart and Pan Orient. I’ve been trading it in and out since the stock was trading at a few dollars. Last year when an Indonesian company proposed to buy Coastal, I sold out all my shares. I told my shareholders to sell on the surge and then when the takeover failed, I bought back, at a much lower price. I’ve been trading in and out of this one.

Another stock I’ve been trading in and out of, so far successfully, is PetroBakken Energy Ltd. (PBN:TSX). It pays about a 10% dividend right now on its Bakken play. It’s quite undervalued if you compare it with its peers. I just bought it back recently after making a 50% return in the last round a year ago. Hopefully, it will rally from here. Many traders like to trade by the chart, which sometimes ignores the fundamentals. I often put “opposite trades” in place to take advantage of market swings.

TER: Do you have any sleeper names that are maybe due to take off?

CL: Porto Energy Corp. (PEC:TSX.V) was probably my major loser in the energy portfolio last year. Porto is an example of my risk-taking. When George Soros closed his position of Porto at $0.07 last summer, I decided to take advantage of it and told my subscribers that I became one of the largest shareholders. My calculations at that time were if its ALC-1 well were successful, the stock would be a tenbagger. If not, it’s still worth a lot of money. But the well was a failure. The stock is still trading at $0.06, so it’s really verified my calculation. You can see the risk/reward was in my favor and, in the future, if this kind of situation arises, I would do it again. But right now, looking at a $0.06 stock, I think it’s still very undervalued.

I had a long discussion with management not long ago. As a large shareholder, I proposed to management to take a look at the current tax-loss carryforward situation. Porto spent over $100M in Portugal and has over $100M in loss carryforward in Portugal. That could be worth a lot of money to its partner, like Galp Energia, which is a $10 billion Portuguese national oil company. Galp can take advantage of that loss and could translate easily to $0.20–0.30 per share. Management told me that they would take that into consideration and they are still in the middle of discussions with Porto to drill two or three wells this year. Those wells will be critical to the company’s future. The silver lining is that if all the wells fail this year, Porto may still have the option to sell to its partner, which may be able to use the loss carryforward on the balance sheet. I like this kind of a situation.

TER: So it may still be a winner for investors.

CL: Possibly. The risk/reward is in my favor, which also tells you how undervalued many resource plays are. The market has been in extreme conditions and Porto is just one example. There are so many undervalued plays out there that I am looking at right now.

TER: Does Porto have enough money to be able to do exploration work on its own?

CL: The two to three wells it plans to drill will be completely on the partner’s money, so it’s kind of a win-win situation for both.

TER: So it doesn’t have to go out and try to raise more money in the foreseeable future.

CL: Exactly. Management owns a lot of the stock and has been very careful about dilution.

TER: Do you have any other situations that look particularly attractive?

CL: A couple of weeks ago I took a position in a refinery play, which is a recent IPO called Alon USA Partners LP (ALDW:NYSE). Its parent is Alon USA Energy Inc. (ALJ:NYSE). Alon USA Partners is a master limited partnership that’s based on a single refinery in the Permian Basin. The Permian Basin right now has huge oil production and there’s a big spread between the local oil—West Texas Sweet—and Brent. Management is guiding about a $5.20 dividend for 2013. Right now the stock’s trading about $22. That means the dividend will be over 20% in 2013.

People wonder what happens if, in the long run we have all the pipelines built in the next 5-10 years. Alon USA Partners LP should still have an advantage because it would be more like a pipeline company. Why? Because it can take oil locally instead of piping all the way to the Gulf Coast and then it can refine that into gasoline and sell locally instead of piping the gasoline from the Gulf Coast. Basically, its margin will be the pipeline cost to pipe oil over and then pipe gasoline and diesel back. It should have a double-digit dividend, even after everything’s settled. Right now we’re looking at a huge dividend, more than the guidance by the company, which is $5.20 for 2013. It hasn’t announced yet, but some analysts are expecting over $2 in dividends for Q4/12—just in one quarter for a $22 stock.

TER: That’s pretty amazing.

CL: It’s a very nice dividend play. Also, Alon U.S.A. Energy owns about 82% of U.S.A. Partners. If you calculate the value of the shares it owns, it’s more than U.S.A. Partners’ whole market cap, which is absurd. Alon U.S.A. Energy also has another refinery in Louisiana that can take advantage of Louisiana Light Sweet, which will go down to the Gulf of Mexico later this year or next year, when the pipeline is built. So to value the rest of the assets to negative is really absurd. I own both companies.

TER: There’s hardly been any refinery capacity built in this country in many years so any company with a refinery is in a pretty good position.

CL: Plus, refineries are closing down on the East Coast and in California because they’re not making money because Brent is so high. The U.S. has the Jones Act, which forbids foreign tankers from shipping oil from one U.S. port to another. After Hurricane Sandy, they had to suspend the Jones Act. All the light sweet going to the Gulf of Mexico cannot go anywhere, which is just absurd under the existing laws.

TER: You’ve given us some really good ideas and follow-up, Chen. Thanks for joining us today.

CL: Thank you.

Chen Lin writes the popular stock newsletter What Is Chen Buying? What Is Chen Selling?, published and distributed by Taylor Hard Money Advisors, Inc. While a doctoral candidate in aeronautical engineering at Princeton, Chen found his investment strategies were so profitable that he put his Ph.D. on the back burner. He employs a value-oriented approach and often demonstrates excellent market timing due to his exceptional technical analysis.

The Energy Report: It’s been a busy five months since your last interview in August. What’s your macro view on energy markets?

Mark Lackey: The problems in Europe were somewhat worse than most people anticipated regarding Greece and long-term bond rates in Portugal and Spain. Slower world economic growth wasn’t a disaster, but it was enough to knock the price of oil back down under $90 per barrel ($90/bbl). Natural gas had been climbing closer to $3.70–3.80/thousand cubic feet (Mcf), then retreated as well. And, of course, uranium got all the way down to $41.25 per pound ($41.25/lb). Part of the reason for that was that only two out of 56 reactors in Japan were actually operating, but I’m still bullish on uranium. The oil weakness experienced wasn’t terrible, but oil certainly went a little lower than I anticipated. Now that it’s back in that $88–89/bbl range, I’m anticipating somewhat stronger prices next year for oil, as well as for natural gas and uranium.

TER: Are you still expecting West Texas Intermediate (WTI) to average between $100 and $105/bbl next year, or has the supply/demand picture changed?

ML: I’ve lowered my expectation to more like $95–105, partly because the shale oil supply has been a little bit better than I expected with more Bakken production on-line. On the other hand, China, India, Indonesia, Japan and Brazil have all announced significant infrastructure spending programs for 2013, which will certainly increase the demand for energy.

TER: You talk with many people in the analyst community. What’s the current mood and outlook there?

ML: There’s a bit of a divergence. People on the street who agree with me believe that world growth will be fairly decent and that the five countries with the big infrastructure spending will, in fact, move the world forward. There are some who believe that both Europe and the U.S. will do better, and they’re seeing oil up in the $110–115/bbl range. Then, there’s a smaller group looking at an $85–90/bbl range because they think the U.S. economy will stagnate and the situation in Europe will continue to deteriorate. I would say that more analysts agree with where I am, but there’s more divergence in opinions out there than I have seen in the last few years.

TER: Natural gas prices have staged a strong comeback from last spring and now the main concern in the North American markets relates to winter weather usage. Any thoughts on that?

ML: Last spring, natural gas hit close to a 10-year low, under $2/Mcf. It bounced off of that to $3.90/Mcf largely due to increased industrial demand and gas substitution for coal in the electricity market. It’s since retracted a bit of that. In the very short run, if you’re looking solely at the winter, a cold winter could move the price higher.

Looking at fundamentals over the next year, I expect a better year for both the auto and chemical sectors. On the supply side, drilling activity for gas was down in November to a 16-year low in the U.S. but partially offset by horizontal drilling advancements. On balance I expect we’re going to see somewhat less gas than some people are anticipating, and I expect it to get back up to $4/Mcf by the end of 2013.

TER: Can you update us on some of the oil and gas plays you discussed in your last interview?

ML: We had mentioned Greenfields Petroleum Corp. (GNF:TSX.V), which operates in Azerbaijan. This is not wildcat drilling. Greenfields has been very successful reworking old wells and fields and finding oil and gas in established areas with past production. We see its production going up significantly this year. Being close to Europe, it gets a much higher price for natural gas as well—anywhere from $5–9/Mcf and also $15–20/bbl more for oil because it’s based on the Brent price, not the WTI price. Azerbaijan has had a lot of expertise in drilling and a good labor force going back to the Soviet Union days. It’s a very pro-oil and gas jurisdiction and clearly one of the best areas for that business.

TER: How’s the stock done since we last talked?

ML: It’s thinly traded and has gone down some, even though it beat expectations. With oil prices coming down somewhat, people were selling small- and mid-cap oil and gas stocks in the last three to six months of 2012. But I would suggest that people should now be looking at companies like this because of the lower entry point and better cash flow numbers in 2013.

TER: What about Primeline Energy Holdings Inc. (PEH:TSX.V)?

ML: Primeline Energy will have operations in the South China Sea and its partner is CNOOC Ltd. (CEO:NYSE), one of the largest oil and gas companies in the world. Production is expected late in 2013 and it has some significant upside in terms of cash flow and earnings, particularly into 2014. That’s when one analyst has forecast earnings of $0.24 and cash flow of $0.28 per share, which I agree with. An important point to remember about why it can see such good earnings is that it gets $15–16/Mcf for selling gas into China, or approximately four to five times what natural gas gets here.

TER: That’s definitely one to keep an eye on. You also talked about a company in the services business.

ML: Right. That’s Bri-Chem Corp. (BRY:TSX), which announced the takeover of Kemik Inc., a chemical blending and packaging niche company that will add to Bri-Chem’s cash flow and earnings. Bri-Chem has been very strong in the drilling fluids, cementing and steel pipe business sector, supplying the oil and natural gas service area. Now it will have even better earnings and cash flow in the next two years if U.S. gas drilling activity starts to turn up this year. And last week Bri-Chem closed another U.S. fluids wholesaler acquisition of General Supply Co. in Oklahoma. At this stock price level it’s certainly one that people should be looking at and expecting appreciation in 2013.

TER: Do you have any new names in the oil and gas sector that look interesting?

ML: We’ve started to follow a company called Strategic Oil & Gas Ltd. (SOG:TSX), which is a very interesting play in the Steen River area of western Canada. It has primarily light oil, which sells at a premium to WTI or Edmonton light. It’s done a great job of increasing production—more than doubling it in the last year. Another recent acquisition added approximately 10–12% to its production numbers. It’s well capitalized and with such a good balance sheet, we see it going forward in 2013 with work that can further increase its light oil production.

TER: So, where’s that one trading these days?

ML: It’s trading around $1.20 per share. When we first looked at it three or four months ago, it was trading at $0.70. It’s been a nice winner, given the performance of the rest of the TSX Venture market, which has gone from 2,450 in 2011 down to 1,200 at the end of 2012. Strategic Oil’s big increase in production and the fact it produces light oil has caught the attention of the marketplace.

TER: The other energy sector that seems to be coming back is nuclear. Prices had been pretty weak for several months and then suddenly jumped up to over $46/lb. Did the Japanese election have something to do with that? What’s the outlook from here?

ML: Yes, the Japanese election was the key factor in moving the price strongly in just a few days. Before that, people were only starting to wake up to the fact that the end of the Megatons to Megawatts program will take about 24 million pounds (Mlb) out of the marketplace by 2013 year-end. Clearly, the fact that the Japanese government won with a largely pro-nuclear position was a major catalyst. They need to stimulate the economy and will be facing potential electricity shortages if they don’t begin restarting more of their nuclear plants over the next year; mind you restarts require new environmental assessments that the government has now said will be done in June.

TER: So that’s expected to create enough demand to justify higher prices?

ML: That, and there are some other factors too. There are 66 reactors under construction worldwide as we speak. If the Japanese bring back even 20 of their 56 that are off-line in the next year and more new reactors built come onstream in the next one to two years, then you can see some significant demand increase for uranium. In addition to the Megatons to Megawatts program phaseout, Cameco Corp. (CCO:TSX; CCJ:NYSE) has deferred its Kintyre project in Australia and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) has deferred expansion of Olympic Dam. Then Uranium One Inc. (UUU:TSX) canceled its Zarechnoye project in Kazakhstan. Higher demand and lower supply lead us to expect significantly higher uranium prices in the next one to three years.

TER: Have there been any interesting developments with the uranium developers you talked about in August?

ML: Fission Energy Corp. (FIS:TSX.V; FSSIF:OTCQX) had some very good drill results in the Athabasca Basin, at Waterbury Lake and Patterson Lake South. This caused the stock price to almost double in about a week and remain close to that peak. One of its properties is very close to the Hathor property that was ultimately acquired by Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK), so we view Fission as a potential takeout candidate. It’s going to do more drilling to define additional resources, but it’s a company that has some pretty good potential.

TER: A lot of companies are working the Athabasca Basin, where most of the North American uranium development has taken place.

ML: Right. The two other big areas are Wyoming and New Mexico, where another company we mentioned and have followed for a number of years, Strathmore Minerals Corp. (STM:TSX; STHJF:OTCQX) has projects. Its Gas Hills project is in Wyoming and the Roca Honda project is in New Mexico. I’ve liked Strathmore over the years because, whenever management told me they were setting certain milestones, they met them. I’ve spent a number of years in the uranium business and always thought the Gas Hills project area was one of the best in the U.S., and it’s now owned by Strathmore. I also really like its New Mexico play, and the company has considerable depth in its property portfolio for a junior. Strathmore expects to see production in the next three or four years; that would make it a relatively low cost and fairly significant uranium producer in the U.S. If I’m right about uranium prices going a lot higher in the next three years, this stock will be trading at considerably higher than present levels.

TER: Do you have any new companies that look interesting?

ML: Forum Uranium Corp. (FDC:TSX.V) is one I’ve watched for a while. Its two main projects are in the Key Lake area of the eastern Athabasca Basin near Cameco’s Key Lake Mill. It’s also on-trend with Hathor’s Roughrider discovery and Forum has two plays in the western Athabasca. Its management team of President, CEO and Director Richard Mazur; Vice President of Exploration Ken Wheatley and Chief Geologist Dr. Boen Tan are three of the best guys that I’ve known in the whole Athabasca area. These guys have actually discovered over 300 Mlb of uranium throughout their careers.

The company also has a very interesting play in the North Thelon, in Nunavut. I think there’s some significant upside there, and it just announced some very good drill results. Many juniors aren’t doing much these days, but these guys are out there drilling, raising money and moving their projects forward. That’s important, because if we get the uranium prices I suggest, the markets are going to be looking at players who have been forging ahead.

TER: Does it have money in the till to be able to do more work?

ML: It has some money to do part of its next work program but will likely look to raise more. The company consolidated its shares Jan. 3. This is an interesting play also because of its partnerships with Rio Tinto and Cameco. I used to look at about 60 small uranium explorers and now I’m down to only about 10 that I think have a legitimate chance of doing something down the road. Forum is definitely one of them.

TER: Any other ones?

ML: There’s Purepoint Uranium Group Inc. (PTU:TSX.V), which is also a player in the Athabasca Basin and has done a lot of work this year. It signed a joint venture agreement with Cameco and AREVA (AREVA:EPA) on its Hook Lake uranium project and completed an NI 43-101-complaint technical report there and on its Red Willow project. Purepoint just raised some money and Chris Frostad, Purepoint’s president and CEO, is continuing to move it forward. He’ll be doing a lot more drilling over the next year with some big people behind him. Again, it’s a micro-cap company, but if you’re going to buy some micro-cap companies, buy the ones with active management, good properties, some money in the bank and good joint venture partners. Then you at least have a good chance of success down the road.

TER: These didn’t all start out being micro caps.

ML: No they didn’t, and that’s an interesting point. I can remember when it was trading at $1.60 back in the better uranium days. It’s way more advanced now at $0.07, which shows you what happens when you have such a bad market environment. The market doesn’t seem to differentiate, at this point, between uranium players that have stronger odds at being successful and those that don’t. They’re all in the same basket. Once we get better uranium prices, I think investors will start to focus on which companies actually have not been sitting on their hands.

TER: So what does the year ahead look like for energy stock investors and where do you feel they should be focusing their attention for maximum upside?

ML: I’m expecting a moderate upward movement in oil prices, but certainly not a boom. North American natural gas should move higher. Natural gas prices in Europe and China offer some pretty exceptional opportunities for companies selling into those markets. My three-year outlook on uranium is way above the consensus. I actually see uranium trading this time next year at $65/lb, compared to the current spot price of $44.75/lb. Then I see it at $80/lb at the end of 2014, and $90/lb in 2015, all based on the supply and demand factors I mentioned earlier.

TER: That would certainly bring life to a lot of these cheap uranium stocks. People are going to be all over uranium again if you get a double in the price.

ML: A lot of people may think I’m overly optimistic, but I would point out that when we first liked uranium at $10/lb in 2001, we thought there was some pretty good upside. I never expected it to go to $135, like it did in 2007. But, it does show you that when the uranium market starts to move, it usually moves fairly significantly and can create some definite investment opportunities.

TER: So there’s something that people certainly should focus on in the next few months to a year. We greatly appreciate your time and input today, Mark.

ML: Thank you.

Mark Lackey, executive vice president of CHF Investor Relations (Cavalcanti Hume Funfer Inc.), has 30 years of experience in the energy, mining, banking and investment research sectors. At CHF, Lackey involves himself with business development, client positioning, staff team coaching and education, market analysis and special projects to benefit client companies. He has worked as chief investment strategist at Pope & Company Ltd. and at the Bank of Canada, where he was responsible for U.S. economic forecasting. He was a senior manager of commodities at the Bank of Montreal. He also spent 10 years in the oil industry with Gulf Canada, Chevron Canada and Petro Canada.

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Oil and Gas

Here’s a little energy investment 101: when oil moves up, so does the dollar. Energy bulls bet on increasing momentum, whereas gold bugs amass hard assets for the day the dollar collapses. Well, that’s the way it used to be; global energy markets have become so schizophrenic that this once self-evident correlation is about as reliable as India’s power grid. But one indisputable fact remains, as Porter Stansberry pointed out in his Dec. 13 interview, “End the Ban on US Oil Exports“: “One of the biggest drags on the U.S. dollar over the last several decades has been the trade deficit resulting from petroleum imports.” Wacky oil and gas differentials aside, outsourcing energy production has taken its toll on the national budget and the dollar itself.

But if the U.S. doesn’t rely on international imports, could it make do with domestic supply? Potentially, argues Rick Rule in his Nov. 27 interview, “A Global Perspective on U.S. Energy Independence.” Responding to the I.E.A.’s predictions that the U.S. could reach self sufficiency by 2035, Rule responded, “We stand a very good chance. . .the U.S. is endowed with spectacular natural resources and we remain the epicenter for extractive and exploration technology. Our advantages in terms of the cost of capital, the application of technology and our legal apparatus are uniquely suited to unlocking the potential of our geology.” Even John Williams of Shadowstats.com sees some upside here: “If domestic oil production could replace foreign production, you could still have a positive domestic demand environment. I’d push for that as much as possible.”

So if we need the goods, and we have the goods, the next logical step would be to scout out the domestic producers who can come through with supply—at the highest margins possible, experts suggest. There’s no shortage of recommendations on mid-, micro- and large-cap producers who may fit that bill, and investors with a bullish outlook on domestic oil and gas would do well to keep checking in with The Energy Report to hear why Josh Young invests exclusively in mature oil fields (”There is an old adage: ‘The best place to find oil is an oil field.’”), why Darren Schuringa looks to MLPs to generate returns on investment in North American oil and gas infrastructure (”Consistency is very important for investors, especially for those who are looking for alternatives to fixed-income instruments.”) or how John Stephenson chose the energy stocks that yielded 30% growth for his portfolio year over year (”Look for producers who are good at managing the cost side of the business.”)

Fracking: Miracle or Mirage?

But the energy independence story doesn’t end here. Weaning the U.S. economy off petroleum imports doesn’t begin and end with domestic oil and gas production. For one thing, U.S. regulations haven’t exactly made for an open season on extraction (or transport). Stansberry commented: “We have archaic laws about oil because we had long believed that oil was a strategic resource and that the world was going to run out of it in the short term. Unless we change our laws to allow exports of crude oil, none of this magnificent new supply is going to aid our economy at all.”

One expert, Bill Powers, made waves in his Nov. 8 interview “U.S. Shale Gas Won’t Last 10 Years,” when he delivered a scathing critique of various public and private organizations that, he argues, drastically overstated the extent of U.S. reserves. (He nonetheless sees a bullish future for energy producers scraping the bottom of the barrel.) Powers represents a minorty voice in the shale debate, but even those who are bullish on North American reseves understand that the roads to returns include complications. How can investors plan for the detours?

The U.S. Energy Mix

One horizon we’ll continue to watch is the outlook for uranium producers. Nuclear power is still a controversial subject, but its proponents point out its ability to deliver low-emissions energy in vast quantities—cheaply. Germany may still be saying “Nein danke,” to the power source (although it’s fine with purchasing it from its neighbors) but sector analysts argue that Japan istelf is moving toward a broader restart, and China, Russia and emerging economies around the world are by no means turning their backs on the efficient energy source. Could the U.S. cover a greater share of its energy needs through nuclear power? Analysts David Talbot and Alka Singh see brighter times ahead in the space, both emphasizing the looming expiration of the U.S.-Russia Megatons to Megawatts program and the need for new producers to fill the supply gap. A number of U.S. producers have been getting their ducks in a row to commence with large-scale, low-cost uranium production.

Whether you believe in peak oil or simply the absence of cheap oil, diversifying your assets is a sound investment move—both from a public policy and private investment perspective. U.S. energy production is already a fairly diverse mix from state to state, as a quick glace at the Department of Energy’s interactive map shows. For this reason, The Energy Report will continue to deliver expert opinion on a spectrum of energy sectors, from oil and gas E&Ps to the service companies that keep them operating, to innovative players in the energy technology and alternative energy spaces and promising natural gas, uranium and coal producers ready to deliver to domestic utilities.

A number of our expert interviewees suggested that risk-hungry investors may want to place their bets further out on the energy supply horizon with alternative energy plays that could likewise reduce dependency on foreign oil. Biofuels have earned some support from energy investors, in part because they do not necessitate a nation-wide shift to electric vehicles. But it just may encourage the transition away from petrol imports. As analyst Ian Gilson commented in his June 12 interview, “Enzymes and Algae May Spur a Biofuel Boom,” “Biofuels are really many industries. . .but they share some common ground in that they could reduce our dependence on foreign fuels.”

Raymond James Analyst Pavel Molchanov echoed the multifaceted nature of alternative energy companies in his March 29 interview, “How to Play the Cleantech Energy Boom,” noting that many names in the space are very diversified, so it can be hard to find a pure-play investment. For potential investors, Molchanov emphasized that “Within every industry, there are companies that are in a better competitive position than others. So we have to look at everything case-by-case. It’s very hard to make a universal, far-reaching call regarding whether a particular subsector is now the right or wrong place to invest. For example, the solar industry is facing a lot of headwinds and yet there are still companies in that space that are quite profitable and successful.”

As we move into 2013, we’ll face the global economic forces that ultimately result in upside and downside momentum, continuing the conversation with the experts that share their wisdom with The Energy Report and its readers—you. Exciting, isn’t it? Many happy returns in 2013.

The Energy Report: Ray, your firm, Saleeby & Associates Inc., focuses on identifying companies with turnaround potential—good firms that trade at a discount, but enjoy a solid customer base in hard-to-enter industries. Why?

Ray Saleeby: I buy stock in companies that are discounted to the intrinsic value of their operations. This differs from growth investing, which focuses on companies that outpace their peers for earnings. It differs from momentum investing, which attempts to time stocks on a short-term basis. My philosophy of value is more long term and contrarian. I buy companies when they are out of favor.

“I buy a lot of utilities because there are tremendous barriers to entry to that sector.”

I handle $220 million ($220M) plus, of which about $100M is in the utility and energy industry. I buy a lot of utilities because there are tremendous barriers to entry to that sector. One does not find a gas utility popping up every other week! For the same reason, I like the construction aggregate business. And I absolutely love the water business. It’s a resource that we’re going to need forever. I also invest in defense electronics and oil and gas. There are also barriers to entry in the drugs and medical device space.

TER: Tell us about your research process.

RS: I have a library of 60,000 different research articles going back 20 years. I subscribe to about 60 different periodicals that provide financial reports and different types of information about various companies. I look at annual reports and presentations by companies. But before I buy a stock, I call up the management and ask detailed questions.

TER: How do junior gas and oil companies fit into this model?

“I like companies that have a first-mover advantage in acquiring developable property.”

RS: With the juniors, I take a very hard look at management. Does it have a track record of success? Are the managers personally invested in the firm? Second, I like companies that have a first-mover advantage in acquiring developable property. Clusters of wells provide economies of scale where drilling rigs can easily be moved around. Energy is a commodity business and access to capital is very important. And being a low-cost provider is crucial when dealing with commodities, as we never know when the market will fall. And, last but not least, I want companies that have a good hedging strategy. And for tax reasons, I look toward MLPs (master limited partnerships).

TER: Let’s talk about discounted utilities with exploration and development arms. Where are the undervalued opportunities in that space?

“The typical oil and gas analyst does not generally understand how to analyze utility operations, whereas the typical utility analyst does not understand how to value oil and gas assets.”

RS: One of the positives about operationally diversified utilities is that they can spin off resource development divisions. Now, a utility analyst is completely different than an oil and gas exploration analyst. With a spin-off, suddenly there are two different types of analysts following two related companies, and the new firm can get double coverage. Secondly, the new managers may have more incentive to produce than they did when they were operating under the parent company’s top management. Also, utilities are heavily regulated; spin-offs are usually nonregulated.

The negative aspect of a divestment is that utilities are generally financially stable and can provide a cushion for commodity capital into its development divisions through boom and bust times. And the flip side of a spin-off in the analytical marketplace is that the typical oil and gas analyst does not generally understand how to analyze utility operations, whereas the typical utility analyst does not understand how to value oil and gas assets. So the double coverage can turn into a negative, a discount of real existing value.

TER: What are some promising names in this space?

RS: Questar Corp. (STR:NYSE) is a perfect example. Originally, Questar was a utility that also had a gas exploration business. About two years ago, it spun it off as QEP Resources Inc. (QEP:NYSE), and it’s been very successful and is leveraging the resource needs of its parent. Questar supplies natural gas to a lot of customers. It is very competitive with electric and it steals customers that have a choice between electric or gas meters. It is well diversified; its Wexpro division also develops and produces gas for the utility and it is very attractive on its own merits. Another factor to consider is that a lot of natural gas companies are not able to make a profit in the current price environment, unless they are hedged. Some are starting to shift their exploration dollars toward oil, rather than gas, because oil is holding up relatively well relative to gas prices. QEP Resources is well positioned in gas but has recently made a couple of acquisitions in the oil business to help balance things out. It’s even buying back its own stock.

An example of a well-diversified company that has not split is National Fuel Gas Co. (NFG:NYSE). It is a combination of utility, pipeline, storage and explorer and producer (E&P) company with, I believe, some of the best assets in the U.S. It has 800,000+ acres in the Marcellus fields close to the New York consumer markets. It’s been around for 100 years, it has a good balance sheet, and it has a history of paying increasing dividends. Looking deeper, it had some problems with executing on oil-producing land it owns in California. And it was not able to get a joint partner for its Marcellus field after natural gas prices went down. If gas prices start popping up again, National Fuel could be a takeover target. The Marcellus acreage is extremely valuable and it can be better exploited if natural gas goes higher. Mario Gabelli has a position in the company, as do I.

TER: How hard is it for an exploration company to switch over from natural gas to oil?

RS: Some fields are more attuned to gas, some to oil. It is hard to get out of leases to switch over from one to the other resource. And drilling crews have to be shifted around, which is expensive. But there’s a glut of gas right now in a lot of different markets. And that’s one of the reasons why the MLP sector is a very attractive sector going forward.

TER: How do MLPs work?

RS: Master limited partnerships are structured so that income flows directly to the investors. It is not double taxed at the corporate level. Investors receive K-1 forms versus 1099 forms for their IRS tax returns. However, it is advisable that you really know what you’re doing before diving into a complicated MLP arrangement. MLPs may not be suitable for all investors.

TER: What other utility-centric natural gas companies provide good value for investors?

RS: Enbridge Energy Partners L.P. (EEP:NYSE) is an MLP. It operates one of the largest pipelines and brings Canadian tar sands oil into the United States. It enjoys great access to capital. It is a very well managed company. It has I-units, which allow investors to reinvest dividends and receive a 1099. It’s a unique investment for the long term.

Energen Corp. (EGN:NYSE) is a small utility in Alabama that runs a large exploration company in the Permian Basin. It is currently out of favor in the market—discounted to its asset value. It is very conservative. It hedges a lot, and has 30 years of dividend growth. It uses the dividend income from the utility to grow the oil and gas exploration and development business. It’s a good value find.

TER: Why is Energen discounted?

RS: As a combined utility and oil and gas exploration company, it is subject to the kind of analyst misdiagnosis I explained earlier. But Energen’s cash flow and its EBITDA are cheap comparable to its peers. It has proven reserves. Management is competent, even though it just reported a disappointing quarter: gas prices plummeted and the firm was not as well hedged as it had been previously due to expirations.

TER: Is there a limit on the supply of natural gas?

“Some say that the U.S. is the Saudi Arabia of natural gas. But the real question is: Is the existing supply an economic supply?”

RS: Some say that the U.S. is the Saudi Arabia of natural gas. But the real question is: Is the existing supply an economic supply? Companies simply cannot make money exploring for gas at the current price. Capital is moving into oil. Sufficient cash is not spent on the necessary infrastructure, such as storage and transportation, to take the gas to the domestic consumer and to international ports for export. The other problem is that it takes a while for utilities to shift over from coal to natural gas. Facilities are being built, but it takes time. On the upside, there are transportation uses for gas, especially for heavy trucks and commercial vehicles and government vehicles. Incentives are needed to support that transformation. The more these gas-dependent industries develop, the higher the price of gas will rise, providing more capital for more infrastructure and development. But a lot of E&P firms are keeping the gas in the ground for now.

TER: Are there any energy holding companies that reflect your investment model?

RS: MFC Industrial Ltd. (MIL:NYSE) is a company that has done phenomenally well. A $1 investment in MFC a little over 10 years ago is worth $6.50 today. It’s averaging a 20% compounded return. MFC is a true value investor. It turns energy and resource companies around and monetizes them. It recently bought Compton Petroleum. The management is very shareholder oriented; executives own a large stake in the company. It is a small firm, but it sources and delivers commodities and resources throughout the world.

South Jersey Industries Inc. (SJI:NYSE) is a utility in New Jersey. But probably 30% of their business is nonregulated. An investment of $6,000 in 1985—with reinvesting the dividends—would now be worth $720,000. Management has just been top notch in creating shareholder value.

TER: To conclude, are any of these firms looking at renewable energy development?

RS: South Jersey is involved in solar. But with the revolution in cheap natural gas, a lot of the solar and wind ventures have been put aside. A few decades down the line, solar is going to be the solution. The world has an abundance of sun! There are, however, cost and efficiency problems with solar and wind due to storage and transmission of power. Alternatives have a role in the future, but we have an abundance of natural gas at this time.

TER: Thanks for speaking with us, Ray.

RS: Likewise.

Ray Saleeby formed Saleeby & Associates Inc. in 2001 after 15 years working with brokerage firms such as R. Rowland Co. and Forsyth Securities. Saleeby published a newsletter between December 1987 and May 1996 that received national attention. Articles written about him and his recommendations have been published in USA Today, The Wall Street Journal, St. Louis Post-Dispatch, St. Louis Business Journal and other periodicals.

The Energy Report: Let’s start with a recent takeover deal that’s been getting a lot of criticism in recent weeks. Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE) made a $9 billion takeover offer for the oil and gas explorer McMoRan Exploration Co. (MMR:NYSE) and Houston-based Plains Exploration & Production (PXP:NYSE). Are you happy with this deal?

Byron King: It came as a surprise. I’ve held McMoRan Exploration in Energy & Scarcity for about two years. I like what McMoRan is working to do with deep gas in the Gulf of Mexico. Still, I recommended that readers take their money off the table with this deal. Sell the shares, take the cash and we’ll find other opportunities.

McMoRan Exploration nearly doubled after the Freeport announcement, going from $8 to $15 per share. You can’t walk away from that kind of potential gain. Take your money, pay your taxes at the lower 2012 rates and do something else with the money next year.

There’s another angle to this takeover. Freeport and Plains together already own about 36% of McMoRan. There are a lot of ties here, between key individuals. I think this deal was driven by the impending tax changes next year. Freeport, the copper play, is borrowing a lot of money to fund this whole process. Fortunately, interest rates are very low, so it’s borrowing cheap to do a big takeover, which will give a lot of people a really sweet payday, and they’ll get to pay capital gains taxes at much lower rates this year than if they wait until January 2013.

TER: James “Jim Bob” Moffett, who founded McMoRan, is also paying himself. He was a significant shareholder in McMoRan Exploration. He’s taking from his left pocket to put it in his right pocket.

BK: Wall Street hated this deal. Freeport’s share price dropped by about $6/share within a few minutes of the deal being announced.

TER: This whole deal really hinges on the Davy Jones well offshore of Louisiana and whether or not it can make that play. Can it turn this around? Can it make it a viable, producing well?

BK: Davy Jones is all about using new, deep-drilling and production technology to make this type of well work in the Gulf of Mexico, albeit in shallow water—20 feet or so. Sad to say, the Davy Jones well isn’t quite where it needs to be. But it’s coming, and likely sooner than most people believe.

“I’m forecasting that oil prices are going to rise.”

The components of the technology are all there, I’d say. I’ve seen super-strong well casing. I’ve seen advanced valve systems. I’ve seen blowout preventers that can handle the stresses. It’s just that I have seen these things in vendors’ offices and warehouses in Houston. Now the trick is to systematize it all, and make the Davy Jones concept work as a deep gas producer with economics that won’t break the bank.

The next question is what’s going to happen with natural gas prices in the U.S.? Whether it’s Davy Jones or a new well, companies are drilling wells that need $6, $8 and $10 per thousand cubic feet (Mcf) gas. Yet, on a good day, gas is selling at $3–3.50/Mcf. Are the economics going to work? That’s a whole other discussion.

TER: How does this change the landscape among the hard asset players? Are we returning to the 1970s, when mining companies and oil and gas companies were one and the same?

BK: Back in the 1970s, when oil prices went up and the economy realized that energy was a key component of everything, a lot of oil companies started to get into other resources. They did these types of rollups in the 1970s, and then they spent a big part of the 1980s divesting and spinning these things back out. Right now, in this era, McMoRan may be a one-off idea. It’s a unique play. It’s not quite time to break out your old 1970s leisure suits and hang the disco balls or anything.

TER: Let’s get to what you’re calling “taxageddon.” How will this affect investors?

BK: When the tax code changes dramatically on Jan. 1, a lot of people are going to feel the sting. We’ll get hit by that 2% increase in the FICA Social Security in every paycheck. The capital gains tax rates will effectively double on Jan. 1, including the Obamacare increase. The personal rates will go from 15% to the 30–35% range. It’s a big hit.

TER: Are you managing the Outstanding Investments portfolio differently than you were a year ago? Are there more yield-bearing stocks in that portfolio?

BK: In the last year, I’ve focused more on identifying yield-bearing stocks. I added one this fall called Linn Energy LLC (LINE:NASDAQ).

TER: In recent editions of Energy & Scarcity, you have discussed declining rates at fracking wells across the U.S. Do you believe this is an across-the-board problem or is it limited to certain plays or geology?

BK: It’s pretty much all of the shale gas wells. A fracked well that does not decline quickly is truly the exception. Last week, at a conference at the University of Texas, the overall decline rates that were tossed around were absolutely shocking. The decline rates on wells in their first year are in the range of 35–40%, and it is a similar number in the second year. By year two, a company will have produced perhaps 75% of the ultimate recoverable hydrocarbon out of a well.

It utterly wrecks the economics of a gas well to produce most of its output up front, during a low-price environment. These frack plays are astonishing wells, in a technical sense, but the economics are very problematic.

TER: If the production rates are rapidly declining and there is not as much natural gas as first thought, won’t that ultimately lead to higher natural gas prices?

BK: Natural gas prices are already starting to climb back up. About a year ago, the number of rigs devoted to drilling for gas fell off a cliff. I am bullish on natural gas in general. The natural gas price could double to the $7 range within the year.

TER: One of the companies in your Outstanding Investments portfolio is Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE), which is moving heavily into natural gas. Is that a smart move?

BK: Royal Dutch Shell is moving to gas. Exxon Mobil Corp. (XOM:NYSE) is moving to gas. Chevron Corp. (CVX:NYSE) bought Chief Oil and Gas LLC in western Pennsylvania to establish itself as a major player in the Marcellus region. However, the executives from these companies will tell you about the very tight economics of these projects. Actually, Rex Tillerson of Exxon said that up until now, Exxon has been losing its shirt on these things.

“I am bullish on natural gas in general.”

I’m not going to say that Royal Dutch Shell has done the wrong thing. It bears watching. These big companies have deep pockets, and will have to work their way through this storm the same as everyone else. The good news is that the big guys can afford to take risks that small companies, or even large independents, can’t take to drill gas plays and test new technology that might change those decline rates from being so steep.

TER: What are some other senior oil and gas producers in the Outstanding Investments portfolio?

BK: Over the years, I’ve focused more on international names. Statoil ASA (STO:NYSE; STL:OSE) of Norway is a large, well-run company. I like that the Norwegian government has a large stake because it seems to be mature enough to let Statoil operate as an oil company, collect the dividends and benefits, but not interfere in the day-to-day operations. Statoil has wonderful technical capabilities. It’s a nice dividend payer.

French company Total S.A. (TOT:NYSE) is also a large, global company that operates in a lot of jurisdictions that France has close ties with. It pays a nice dividend. Total has been good.

BP Plc (BP:NYSE; BP:LSE) has been in the portfolio for a while. I kept it through the Gulf of Mexico blowout. BP’s shares dropped terribly right after the blowout, although I told people to buy back in at $28/share, and it wound up going up to the $40s.

Yet BP has been a very frustrating company for a lot of reasons. Of course, there is the Gulf of Mexico disaster, but it has other issues related to people’s perception of its safety culture. Fair or not, people write books about it, like Drowning in Oil: BP and the Reckless Pursuit of Profit, by Loren Steffy of the Houston Chronicle. That hurts BP’s share value.

Plus, BP hasn’t done itself any favors with the confusion over its partnership with TNK-BP. I’m still thinking through what to do with BP. On the one hand, it has a lot of great people and assets. It has an aggressive aspect to its exploration and production in the future. On the other hand, there is informed speculation that BP could be worth more in a broken-up state. It’s going to be interesting to see how BP evolves over time.

TER: Most natural gas is used to heat homes and to create electricity at large utilities. Could declining output from fracked natural gas wells ultimately be a boon to green energy sectors like solar, geothermal or wind?

BK: Cheap natural gas has completely altered the economics of the electric utility system in North America. Natural gas base rates are now considered the number to beat, even when people are proposing nuclear power. That’s a very odd dichotomy because a natural gas well can be set up and generating electricity in a few years. With nuclear, it can be a 25-year process to acquire a site, get the permitting and navigate the maze of regulation and public acceptance for a reactor. What may be a temporary glut of natural gas is truly altering the long-term investment climate for nuclear power.

TER: Are you less bullish on uranium plays as a result?

BK: I’m bullish on uranium because there’s not going to be enough new uranium mined and milled to meet demand. China has an aggressive plant-building program. Every one of those plants needs to lock down a 20- to 30-year supply early in the development cycle. There are not enough new mining plays coming on to supply that.

An entire level of uranium supply is also going to go away in a year. Russia is not renewing its agreement with the Megatons to Megawatts program, which purchased nuclear reactor fuel that had been converted from enriched uranium in old nuclear weapons.

TER: Are there any particular uranium plays that you’re bullish on?

BK: Uranium Energy Corp. (UEC:NYSE.MKT) extracts uranium via in situ recovery, by washing the uranium out of sandstone using hydrogen peroxide in Texas. It is producing uranium yellowcake at an internal loaded cost of about $18–20/pound (lb), which sells into a spot market at $50/lb.

“These frack plays are astonishing wells, in a technical sense, but the economics are very problematic.”

UEC’s numbers are going up. It just had a brand new permitting approval at Goliad, Texas. It will be using a fairly simple technology, drilling wells that are less than 1,000 feet deep. It’s pumping the fairly benign substance hydrogen peroxide, along with a few other odds and ends, into the sandstones. It is pulling it out with resins and taking it to a fully licensed plant at Hobson, outside of San Antonio.

I’ve visited the facility. It’s all good: The people are good. The technology is good. The economics seem good. I like Uranium Energy as a long-term play. It will be very sensitive to rising uranium prices that I forecast in the next year or two.

TER: Any others?

BK: Over a longer time frame, there is a Canadian company operating in South America called U3O8 Corp. (UWE:TSX; OTCQX:UWEFF). U3O8 has very early-stage uranium deposits in Colombia, Guyana and Argentina. I’ve visited the Colombian play. It is polymetallic, which means that in the process of recovering the uranium, it is going to be able to pull out phosphate, silver and some intriguing quantities of rare earths. It’s very early stage. It is still doing the drilling out in the jungle. It is a speculative play for long-term investors who know how to ride these junior resource markets.

TER: The green energy sector is in the midst of hard times. It’s had more downs than ups during the past few years. How would you characterize alternative energies right now?

BK: The renewable energy space has been very frustrating for most investors. It’s not to say that you can’t produce energy using solar, wind or geothermal. Of course you can. But it gets back to that well-known critique about how, when the wind doesn’t blow, you have no power. When the sun doesn’t shine, you have no power. What’s the answer?

Europe has a lot of wind and solar power. It creates so much power during windy and sunny times that it actually disrupts the fossil fuel baseload within Europe. Yet, for every windmill and solar field, Europe still needs fossil fuel backups to kick on if the alternative source goes down. This kind of overdevelopment of so-called renewables may feel good to the green side, but it has completely disrupted the economics of a lot of utilities across Europe. Many European utilities have ceased being investment-grade assets.

“What may be a temporary glut of natural gas is truly altering the long-term investment climate for nuclear power.”

We haven’t built renewables to that scale in the U.S. If we do, we would have a similar problem. Rapid overbuilding of green power will degrade the investment quality of many public utilities, which are among the few things that pension funds and institutions can still count on. It’s something that investors need to keep an eye on. We blew up the stock market in 2008 with a housing meltdown. Do we want to risk blowing up the market again with a utility meltdown? We’re not there yet, but we could be on that track.

The Holy Grail for renewable energy is backup battery storage that charges up batteries for continued use after the wind or sun dies down. I’ve been focusing on American Vanadium Corp. (AVC:TSX.V), which is developing a vanadium redox battery that’s very intriguing and scalable. It’s capable of storing immense amounts of electricity.

TER: They’re only being used right now in Japan, right?

BK: The Japanese are leading the charge of commercializing it. The Chinese are close behind. In the U.S., it’s the typical story of caution and underinvestment, relating to the problem of industry working with public utility commissions (PUCs). Will the PUCs of America build this new tech into the rate base?

Nobody wants to be the first one to approve a vanadium redox battery system for a public utility. People don’t want to put their necks on the block. But I suspect that a lot of people would love to be the second players at bat. Unfortunately, we are very risk averse in the U.S., whereas Japan and China are charging ahead—if you’ll excuse the pun. Looking ahead, if we crack the code on reliable, large-scale storage, it could truly alter the economics of alternative energies.

TER: If you were to speculate on which one of those renewable energy sectors will be the first one to be commercially viable, where would your money be?

BK: Solar panels are becoming less costly, which is improving the economics for use on a much larger scale. It will be geography dependent. The sunny Southwest and West regions ought to see solar penetration the soonest and in the greatest degree. The idea that there could be a solar-powered Boston or Minneapolis is probably not as realistic.

TER: One issue with solar is the lack of baseload power. That’s a big advantage of geothermal over solar. However, if you want to talk about frustrated investors, look at geothermal energy.

BK: I started out Energy & Scarcity Investor with a number of geothermal ideas. I truly believed that these things were on the way up, but the technical problems and capital requirements have been absolutely overwhelming. The fact is that the largest geothermal power producer in the world is Chevron. It picked all that up when it bought Unocal. In 2005, Unocal had developed a lot of geothermal in Indonesia. A lot of green-power people hate it when I say that Chevron is the biggest geothermal player.

TER: Geothermal is working in Central America. Why isn’t it happening in the U.S.?

BK: It’s started to happen here in certain areas, such as Nevada. I drove by a geothermal facility on Interstate 80 when I was in Reno recently. Where it works, it works well. But it’s getting it to work that’s the hard part. The foremost reason is that there are few geologists and engineers who understand this space. It’s tough to build a technical team and keep the lights on long enough to make it all work. It’s been very frustrating.

“I’m bullish on uranium because there’s not going to be enough new uranium mined and milled to meet demand.”

Even more frustrating is that geothermal is struggling to spread in an environment that is supportive of renewable energy. California and Nevada state legislatures are telling the public utilities to have a certain percent of power coming from renewables by certain dates. The Obama administration and the Environmental Protection Agency are supportive at the regulatory level. There are tax benefits and low interest rates. Still, the geothermal space has not worked out.

TER: Have you stopped following geothermal companies?

BK: I haven’t stopped. I just don’t spend a lot of time on them. There are too many other ideas that offer a better return on investment.

TER: To conclude, what investable themes in energy should investors look for in 2013?

BK: In terms of oil and gas, people should look for surprises. I’m forecasting that oil prices are going to rise. There are conventional oil plays that still offer excellent returns to investors.

Natural gas prices are also going to drift up as the year goes on. The rapid depletion rates on fracked wells from the past two and three years are going to kick in, and probably with a vengeance.

There could be interesting breakthroughs in the alternative space. 2013 could be the year when investors start to better understand energy storage. This could be the year that the investing community is going to begin to realize it’s out there and that could lead to the beginning of a rebound in the solar and energy storage spaces.

TER: Will we see a dramatic rise in uranium prices in 2013?

BK: I think the spot price will start to drift up late in the year. People are going to have a lot more on their plates to worry about in the first six months of the year. For some strange reason, a lot of investors have allowed their investment horizons to shorten up. What people ought to be worried about now is that at the end of 2013, there is going to be a big uranium shortage worldwide. It will happen. I don’t think that it cannot happen.

Byron King writes for Agora Financial’s Daily Resource Hunter. He edits two newsletters: Energy & Scarcity Investor and Outstanding Investments. He studied geology and graduated with honors from Harvard University, and holds advanced degrees from the University of Pittsburgh School of Law and the U.S. Naval War College. He has advised the U.S. Department of Defense on national energy policy.

The Energy Report: As a history enthusiast, Porter, to what extent do you believe technology has changed investing?

Porter Stansberry: The future will be unlike the past in every way related to technology, but it will be exactly like the past as it relates to people. Technology changes a great deal, but people don’t. You can count on politicians to be scumbags and most people to be lazy. But as for investing, technology gives far more people access to information. Only one person in the world knew the actual price of a high-yield bond 25 years ago—Michael Milken—and he made a fortune with that information advantage. Today, everybody has access to trading information. Everyone has access to price. In general, technology has made finance a smaller-margin business. It’s led to enormous scale in our financial institutions, which is the only way they can really survive. But fear and greed are still the underlying forces that drive the markets, and investors are just as subject to irrational emotional decisions as they’ve ever been. I don’t expect technology will ever change that.

TER: Getting specifically into energy, a few weeks ago the International Energy Agency World Energy Outlook (WEO) said the U.S. would become the world’s largest oil producer, overtaking Russia and Saudi Arabia, before 2020. Then Goldman Sachs said it would happen by 2017.

PS: They stole my thunder. I’ve been saying 2017 for maybe a year now. If Goldman is saying 2017 and IEA is saying 2020 it will probably happen in 2016.

TER: How will the geopolitical and socioeconomic landscape change when the U.S. becomes the largest oil producer?

PS: One of the biggest drags on the U.S. dollar over the last several decades has been the trade deficit resulting from petroleum imports. That’s going to largely disappear, though not completely because we’ll still need some petroleum imports for certain flavors of crude. As for exports, considerable legal hurdles remain. We have archaic laws about oil because we had long believed that oil was a strategic resource and that the world was going to run out of it in the short term. Unless we change our laws to allow exports of crude oil, none of this magnificent new supply is going to aid our economy at all. In fact, we’ll have a terrific glut of oil, and we’re already at record levels of storage. The price hasn’t collapsed yet because unrest in the Middle East is causing fear to inflate the market price, but the price will absolutely collapse if we don’t allow for oil exports. The entrepreneurs who brought us this incredible new supply would, in that scenario, suffer, and many companies would go bankrupt because the oil industry is not capitalized to survive $50/barrel (bbl) oil.

But to answer your question—how the geopolitical and socioeconomic landscape will change when the U.S. becomes the largest oil producer—I’d have to know the unknowable, which is how or if oil policy will adapt. So far, it doesn’t look good. So far, 12 companies have applied for licenses to export LNG, and only one license has been granted. I don’t think the Obama administration is ever going to do anything to help the domestic oil industry. And I think that the result will be a price collapse and an oil glut that will harm our economy.

TER: You mentioned one company has a license. Who is that?

PS: The Department of Energy granted a conditional permit to Cheniere Energy Inc. (LNG:NYSE.MKT). It’s an ironic story. For many years I was a short seller in the stock. In fact, I published an article in 2006 when the stock was trading between $30 and $40 per share. I wrote that this company’s business model was beyond stupid and had ventured into insane territory. Its plan was to import LNG into the United States and the company built a $6 billion ($6B) facility, the Sabine Pass LNG Terminal, to bring in natural gas from Qatar. I said it was insane because not only was the U.S. on the verge of a huge glut of natural gas, but for decades the U.S. had either the largest or second-largest reservoir of gas anywhere in the world. So the U.S. importing natural gas is like Saudi Arabia importing sand. It doesn’t make any sense.

Of course, natural gas prices collapsed and Cheniere almost went bankrupt. It saved itself by selling new equity to a very smart group in New York, Blackstone Group. With the money raised from Blackstone Group, Cheniere switched that facility from imports to exports and applied for an export license long before government officials thought any market for U.S. export gas would materialize. Cheniere got lucky.

TER: To what extent will manufacturing and petrochemical industries move to the U.S. to take advantage of cheap natural gas prices?

PS: There’s roughly $40B worth of construction going on in the chemical industry. You’ll see the same kind of growth in fertilizer. You’re also going to see huge growth, which hasn’t really started yet, in refined products. Imagine it this way: If the government won’t allow exporting energy in the form of crude oil, then you can damn well bet that entrepreneurs will find a way to export that energy in some other form. Fertilizer is energy rich and easy to ship, so we’ll have a huge boom in domestic fertilizer production. How about propane? There’s no law against exporting propane. Targa Resources Corp. (TRGP:NYSE), a company we recommend, is expanding its Mont Belvieu import/export complex to boost propane export capacity.

The funny thing is the energy will find a way out of the country. That’ll be good for our economy, but it’s so inefficient. We’ll have enormous investments in all these industries surrounding the energy complex that are much lower margin. It would make so much more sense to just export the oil.

TER: But wouldn’t bringing in more production manufacturing have the additional advantage of creating jobs?

PS: Yes, but it’s not the highest and best use of our time, our capital or our people. This is something important about economics that people do not understand at all—comparative advantage. The U.S. has enormous comparative advantage in lots of different industries. Manufacturing is not one of them. Neither are giant refineries. Yet that’s what we’ll be stuck with.

TER: What would change the equation?

PS: There’s really no easy answer. It’s mind-boggling. Imagine for a moment where Saudi Arabia would be today if it hadn’t exported its oil. It could have a huge petrochemical business and be the world’s leading producer of fertilizer and plastics. But guess what? The fact that Saudi Arabia put its resources to their highest and best use made it one of the richest countries in the world.

TER: So maybe we should export oil rather than gas.

PS: Absolutely. To make natural gas as our main export energy source would cost trillions to build enough of these terminals and it would take decades. Why not just hook up a pipeline of crude oil to a tanker and be done with it? Natural gas is so clearly better suited for domestic energy needs. We should export the crude and use the gas domestically, but that’s not what will happen. We’ll end up with higher prices on domestic crude with very little export and that’ll be disastrous.

TER: You’ve described shale oil and natural gas in North America as one of the biggest investment opportunities. How do you reconcile that outlook with depressed prices?

PS: You can be very bullish on production without being bullish on price. In fact, I think that’s the only logical position. When natural gas was at $4–5 per thousand cubic feet (Mcf), I said it would go below $3/Mcf and people thought I was out of my mind. It’s not only gone below $3/Mcf, it’s essentially stayed there since 2008 or 2009. As you drill more horizontal wells, as production in the Eagle Ford and the Bakken and other places soars—just look at oil storage. We’ve never seen this much oil in storage in the U.S. There’s no doubt the price will crack eventually, and when it does it will crack hard.

I’ve been telling my subscribers not to buy the exploration and production (E&P) companies but to buy the companies that are able to use lower energy prices to their advantage in their own markets, such as fertilizer companies and terminal and shipping stocks, such as Targa. You can find opportunities coming about in lots of little nooks and crannies because of the excess energy supply.

TER: What are some other examples of energy-related opportunities?

PS: The big way is to play lower energy cost in the U.S., or just to find any business that uses energy and can get a retail price for the product. Think about Calpine Corp. (CPN:NYSE), an unregulated producer that converts natural gas into electricity. The price of electricity in wholesale markets is dominated by coal-generated electricity, so Calpine stock price is essentially a way to arbitrage the price of natural gas and the price of coal. If gas remains cheaper than coal, Calpine’s earnings will go up—and that’s what I believe.

Another good example is fertilizer. About 75% of the cost of fertilizer is made up of natural gas but the price of fertilizer is based on supply and demand. Global demand for food, of course, continues to grow quite rapidly, and due to the inflation of the dollar, farm prices continue to rise, so there’s plenty of capital for buying fertilizer. This is another simple way to play and there are lots of good fertilizer stocks out there. The one we’ve recommended is called CF Industries Holdings Inc. (CF:NYSE).

And, then, of course, look for companies that are constructing the pipelines, making the steel for them, handling the storage, building the terminals. We’ve recommended lots of those companies.

TER: When you mentioned businesses that take advantage of lower energy costs, you mentioned those building terminals. Why would we want more terminals if the law won’t allow exporting oil?

PS: Terminals aren’t necessarily just for export, but also storage and distribution. We need huge new storage facilities, huge new pipelines and huge new terminals all across the country mostly to move gas but also NGLs and crude oil. Right now we’re using railroad cars to move crude out of the Bakken in North Dakota, which is very inefficient.

TER: Whereas producers need higher prices to sustain the production costs.

PS: Mostly, yes. Operating costs are actually very low once the wells are in place. To drill a well in the Eagle Ford, for example, costs about $7M, but you can make that back from production in 90 days. The problem these companies face is the cost of buying additional acreage. As soon as people know oil’s around, real estate prices go bananas and companies have to borrow tons of capital to buy the leases and drill before the leases expire. This puts tremendous capital pressure on their balance sheets.

The number-one thing to be careful of right now in this space is the oil companies that have been rewarded for building huge real estate portfolios but have done so with tons of borrowed money. That puts these companies in a precarious financial position if the price of oil falls. It’s not because they can’t produce oil for $35/bbl. They can. However, they wouldn’t be able to pay off the debt on their balance sheets.

TER: Considering the glut of natural gas, do you foresee changes in the way U.S. consumers use energy?

PS: We’ve already seen a huge shift in what I’ll call the robust transportation sector, the big trucks and the buses, moving into natural gas. That’s absolutely going to continue and it’s going to grow. However, to build these things in a way that’s safe requires a big, heavy vehicle, so I don’t think you’ll see that at the retail level.

Porter Stansberry is intense when it comes to investing and recreation. His Atlas 400 Club brings together intelligent, successful people from all over the world for adventures that last a lifetime. See a video from his travels, including a recent trip that included racing Porsches in Germany.

Most people in the U.S. don’t understand the role that energy plays in our economy. They don’t understand that the boom from 1900 to 1925 was fueled mostly by the oil found at Spindletop in Texas. They don’t understand that all the success we had in World War II and the boom that led to the1950s and 1960s came from east Texas. Literally the energy that drove all of that productive capacity came out of the ground with the east Texas discovery of 1930. The size of the discoveries found recently dwarf that. East Texas ended up being a 4B bbl field of oil. Every one of these new major shale plays contains 20B bbl of recoverable oil—all five times bigger than east Texas and more than 20 of them are currently being drilled. We’re sitting on the biggest economic and financial boom in the history of our country and we’re strangling it.

TER: If indeed we’re sitting on all this gas, why doesn’t the price of gasoline at the pumps go down? And if natural gas can create electricity, why aren’t we seeing more electric cars?

PS: Because electric cars don’t work. How many dead Fiskers do you need to see before you realize they’re not reliable? The hybrids are fine because they’re still using gasoline to drive them. If it makes it good for you to turn gasoline into electricity before it spins your wheels, it’s fine with me. But it’s completely unnecessary. In regard to electric power, we don’t have the battery technology yet to make this work. It’s not even close. That would be great but it’s naive to think we can plug all of our cars into the power grid. Can you imagine if everyone could overnight just plug all their cars into the power grid?

By the way, all those power plants would be coal or natural gas, so you’d still be consuming hydrocarbons. So electric cars are just fantasy devices. They don’t make sense technologically, economically or ecologically.

And as for prices at the pump, a very important thing that people don’t get at all is that gasoline isn’t oil. It’s a derivative of oil. The lower price of oil will increase the crack spread, which will make refiners more profitable. But gasoline comes from refineries, and no new refineries have been built in the United States since 1974. If you want cheaper gasoline, guess what you have to build.

TER: Refineries—but earlier you said that’s not a good use of capital.

PS: It is not a good use of capital for export but it’s incredibly important for the domestic market. And guess who sponsors the green politicians who don’t want any refineries built? The refining companies. They don’t want any more competition. People think the Keystone XL Pipeline didn’t get built from Canada to the U.S. because the Obama administration’s full of these ecologist folks. No. The pipeline didn’t get built because the E&P companies in America don’t want to compete with Canadian crude.

TER: Any other insights you’d like to give to readers of The Energy Report?

PS: Yes. If they want to know what’s ahead for the oil markets, study the natural gas markets from 2008 through 2010, because the same technologies are being used in the same fields and the result will be exactly the same. There’s going to be a glut of domestic oil, and the oil companies that have leveraged their balance sheets to buy lots of acreage will have a very hard time.

TER: Assuming of course that we don’t change some laws to allow exports.

PS: In that case, everything would change overnight. First of all, the global price of oil would equalize between West Texas Intermediate and Brent, at somewhere around $100/bbl. The profits these U.S. companies would make would be fantastic for our economy and it would be great for the shareholders. Unfortunately, the odds say that American politicians won’t make any kind of wise economic choice. That only happens by accident.

TER: Let’s keep our fingers crossed for a serendipitous accident, then. Thanks, Porter.

Porter Stansberry founded Stansberry & Associates Investment Research, a private publishing company based in Baltimore, Maryland, in 1999. His monthly newsletter, Stansberry’s Investment Advisory, deals with safe-value investments poised to give subscribers years of exceptional returns. Stansberry oversees a staff of investment analysts whose expertise ranges from value investing to insider trading to short selling. Together, Stansberry and his research team do exhaustive amounts of real-world independent research. They’ve visited more than 200 companies in order to find the best low-risk investments. Prior to launching Stansberry & Associates Research, Stansberry was the first American editor of the Fleet Street Letter, the oldest English-language financial newsletter. Read more Stansberry oil insights and Porter’s Atlas 400 Club.

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The Energy Report: Much has happened on the economic, political and financial fronts since your last interview in February 2011. Obama has been reelected, oil is now at $87 a barrel (bbl) and quantitative easing is the new normal. Have any of these developments changed your investment perspective?

Kevin Bambrough: They haven’t changed our perspective because we’ve been prepared for these events for some time. We view this as a 15- to 20-year trend where runaway deficits and printing money is the chosen solution central bankers will provide to the markets. It will ultimately result in the U.S. dollar losing its reserve currency status and paper money, as we know it, becoming essentially worthless over time. Real businesses and real assets are what you should own.

We focus solely on resources at Sprott Resource Corp. (SCP:TSX) and Sprott Inc. (SII:TSX) focuses primarily on resource-related investments. Our long-term strategy is to sell businesses with strong margins in fairly buoyant sectors that could become unsustainable and depressed in value over time. We then recycle those investments into areas of the resource sector that are quite depressed and have an upside in valuation and margins. At the same time, we focus on building solid businesses in jurisdictions where we can develop our assets and create value.

Paul Dimitriadis: We started out in September 2007 with roughly $70 million ($70M) of capital with the idea of building a publicly traded private equity firm. Over five years, we’ve compounded capital, net of fees, at roughly 28% annually, growing the net assets to over $450M during a period when the resource sector has been extremely volatile and most resource stocks and the major indexes are down. We’re quite proud of that record. We’ve also been very active in buying back our shares to increase the net asset value per share, and have bought back a little over $70M worth over the last five years, which we’re committed to continue doing.

TER: In the broad economic/financial picture, how far down the road can governments keep kicking this can?

KB: I think the printing is going to continue out of necessity because governments need to provide funding for their operations. When governments issue bonds, central banks are the ultimate backstop for buying them. This process will continue on until investors around the world stop holding onto bonds or currency as a store of value and decide to own something more concrete than a promise from a bank or a government institution.

PD: To follow up on that, over the past 5–10 years, there’s been a lifestyle adjustment taking place globally that’s being reflected in the price of real assets. The emerging markets are getting wealthier and competing for real assets with the developed economies. We’re going to continue seeing the pressure on the EU and North American economies as the middle class gets squeezed further, while the emerging economies continue to progress and consume more, putting additional pressure on the resource pricing.

TER: Maybe we can talk about the individual resource segments you’re interested in at Sprott, starting with the oil market.

KB: In 2007, when everybody was loving oil at $140/bbl and gas at $10 per thousand cubic feet (Mcf), most resource funds were very heavy in oil and gas. We went to investing in coal, phosphate and potash. Nobody was really even looking at phosphate and potash at that time and the coal market was facing bankruptcy. Sprott Resource stepped in and gave capital to a company called PBS Coals Ltd. during a very weak time in the market when we saw a rebound coming. When that rebound came with very high coal prices in 2008, we took the company public and ultimately sold it. It’s now fully owned by Severstal Russian Steel (SVST:LSE).

Similarly, we monetized some of our potash and phosphate investments during a lofty period in that sector during 2009 and reloaded most of our capital into oil and gas.

TER: What’s your view of the oil market now, considering all the development going on all over the world with new offshore reserves that are fairly substantial?

PD: There’s been a lot of development in unconventional drilling and development of offshore reserves that were previously difficult to produce economically. Much of this new production is relatively short life and expensive, and is putting us on a treadmill just to maintain current global production rates. Bakken marginal production is over $80/bbl. Offshore is very expensive, so we’re putting a floor under oil prices at around $80/bbl West Texas Intermediate. It’s going to be difficult to sustain production with these unconventional barrels that have steep decline rates.

KB: To continue on Paul’s point, when the marginal price goes below that $80/bbl, we’ll be buyers because that price is unsustainable and oftentimes companies will be trading at very low values to a low oil price. When the price gets high and multiples tend to expand on optimism, we’ll be looking to monetize again. We’ve been continually adding to our oil and gas position. We’ve managed to merge Orion Oil & Gas Corp. with a company called WestFire Energy Ltd., and another company we invested in called Galleon Energy Inc., which became Guide Exploration Inc. They all came together and now it’s called Long Run Exploration Ltd. (LRE:TSX). It’s a very large oil and gas producer with significant upside.

PD: Long Run is currently producing around 23,000 barrels of oil equivalent per day, at a roughly 50/50 ratio of oil to gas. It has an incredible land package of around 600,000 net acres in northern Alberta and over a billion dollars in tax pools. We’re excited about this because it’s incredibly undervalued relative to its peers—probably 30–50% lower than companies of its size. Also, with its huge land package, we think that the company will be able to grow successfully over the next few years, principally in the Viking and the Montney. We’re buying the cheap of the cheap and it’s a core holding for us.

TER: Are you going to continue to grow Long Run or is it going to be taken out at some point by somebody larger?

PD: With sovereign funds and state oil companies, you never know where a bid might come from. But our focus is on building the company and developing its land position.

KB: An asset needs to be fully valued before we even consider parting with it because we’re very patient, long-term oriented investors and we can afford to take our time to advance it.

TER: What are your thoughts on natural gas?

KB: The conventional wisdom in 2007 was that the gas price was going to stay above $10/Mcf. That winter everyone was concerned that we’d run out of natural gas. Fast-forward to 2011, when natural gas plummeted to $2/Mcf, and people were saying it was going to zero because the storage was going to fill and we wouldn’t be able to deal with it. Finally, we had a big rinse-out in the sector. We continued to invest capital to build a bigger, stronger company that would be positioned for the rebound. Now we have a more positive market, and we think it’s going to continue to improve. In 2007, the question was whether we could build enough terminals to import enough gas quickly enough. Now everyone’s talking about exporting it—it’s a complete mirror opposite.

TER: What are your expectations for the coal market?

KB: The coal sector is looking a lot like it did in 2007, when we were buying PBS Coals. It’s a very depressed sector and we haven’t begun to see a strong rebound yet. Almost every coal stock has been crushed back to lows they hadn’t seen in years, and we’re looking to put capital to work. We’re trying to find the right opportunity, although it may still be a little early. We’re focusing on emerging markets, where we would like to make long-term investments, buy assets or partner with foreign entities that want to access fuel sources for their own country. The main key is to be in a country where we don’t have to worry about expropriation or excessive taxation. That’s becoming more difficult, considering all of the government budget problems all over the world.

TER: Uranium appears to be coming out of the doldrums. What’s your take on the sector?

KB: Despite Fukushima, many large utilities are seeking to build new nuclear facilities, especially in emerging markets and the Middle East. It’s becoming increasingly evident that there’s going to be a shortfall of uranium production in the coming years as some of the old mines are depleted. The depressed price doesn’t make most new mines attractive investments, so the sector has been starved for capital for a few years now. We expect that higher prices will inevitably attract capital to the sector. The new facilities under construction are going to have to pay up to secure supply and they’re going to have to fund mining projects, which is something we’re actually looking at. We’re working with some parties now that want to fund development projects in order to get offtake agreements in place.

TER: What uranium price would make uranium mining projects more economic?

KB: Investment would be much more attractive with uranium nearer the $75 per pound level. It may take a couple of years to get there.

TER: How are you playing that market?

PD: Our principal investment in the uranium sector right now is Virginia Energy Resources Inc. (VUI:TSX.V), which owns the Coles Hill deposit in Virginia. It’s the largest untapped deposit in the U.S. and it would be an economic boon to the area, if developed. The big issue is the moratorium on uranium mining in Virginia, which explains why the stock is so cheap relative to the project size and economic value. The legislature is going to consider a new mining law in the near future and we’re hopeful it will pass. If it does, that would obviously revalue this investment, probably making it worth multiples of what it is right now.

TER: When do you expect to see a legislative decision on this?

PD: The matter should be examined in the 2013 legislative session.

TER: Are there any private equity deals you’re involved in that will soon be going public?

PD: We don’t have any that we’re going to be taking public soon. We just monetized an oil and gas investment called Waseca Energy for a large win. We’re sitting at roughly $115M in gold bullion and $25M in cash.

KB: Right now we’re very focused on getting Sprott Resource’s stock trading much closer to its net asset value. It traded at two times net asset value when we first started the business, and as low as $0.50 on the dollar during bad times in early 2009. We’ve been buying back stock aggressively. We just announced a four million-share block purchase. We’re going to keep doing whatever it takes to tell our story and attract investors that are interested in sticking with us for the long run.

TER: What do you see ahead in 2013, and how can investors profit or protect their assets?

KB: I see more of the same—more deficits, more printing, more bailing and more volatility. We think that precious metals are going to do very well in this environment and that investment demand is going to eventually overwhelm the paper market. In the 1970s, gold went from around $35 per ounce (oz) up to $850/oz in 1980. That was a 25-fold increase within 10 years. This gold bull market started at around $250/oz in 2002 and I’m convinced that this run will carry a larger magnitude at a higher multiple because there isn’t as much physical gold held by central banks.

The seventies boom was ended in part by central banks dumping gold onto the market and leasing out their gold to bullion banks to flood the market in order to regain stability in the currencies, versus gold. That took interest rates to double digits all around the world. Now, no government can afford to raise interest rates because they’re already at huge deficits and raising them would make deficits even larger. Gold’s been up every year for the last 10 years but, at some point the doors are going to blow open.

TER: When do you expect mining stocks to perform more in step with the metals themselves?

KB: I think there’s going to be a continued separation between quality stocks and the more speculative ones. In the early boom in the gold stocks, almost any stock went up 10- to 20-fold over a period of 10 years. Some of the bigger ones that had hedges didn’t. The unhedged gold juniors and the exploration companies were awarded capital with very little discrimination by the investment community. Now we’re starting to see more emphasis on the companies that could actually produce gold profitably and be free cash flow generators that become dividend-payers. They make money the old-fashioned way—they mine it.

TER: Let’s end on that positive note. Thanks for speaking with us today.

KB: Thanks for having us.

PD: Thanks for the opportunity.

Kevin Bambrough founded Sprott Resource Corp. in September 2007. He is a seasoned financial executive with more than a decade of investment industry experience and is a recognized leader in the commodity investing space. Since 2009, he also has served as president of Sprott Inc., one of Canada’s leading asset managers, which has more than $8 billion in assets under management. Between 2003 and 2009, he held a number of positions with Sprott Asset Management, including market strategist, a role in which he devoted a significant portion of his time to examining global economic activity, geopolitics and commodity markets in order to identify new trends and investment opportunities for Sprott Asset Management’s team of portfolio managers.

Paul Dimitriadis is Chief Operating Officer for Sprott Consulting and Sprott Resource Corp. He has been with Sprott since 2007. Dimitriadis evaluates and structures transactions, coordinates and conducts due diligence and is involved in the oversight of subsidiaries and managed companies. He serves on the board of directors of two of Sprott Resource Corp.’s subsidiaries, Stonegate Agricom Ltd. and Long Run Exploration Ltd. Prior to joining the Sprott group of companies, he practiced law at Blake, Cassels & Graydon LLP. Dimitriadis holds a Bachelor of Laws degree from the University of British Columbia and a Bachelor of Arts degree from Concordia University.

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The Energy Report: Amin, you started your career in the consumer credit industry, where you were involved in risk management at a major bank. How does that translate to the securities industry?

Amin Haque: The company I worked for was MasterCard International Inc., and as director of risk management, my focus was on macroeconomic risk management in international jurisdictions. That gave me a very good foundation for evaluating sovereign, political and currency risks. In my four-year career with MasterCard, I focused on countries in Africa, the Middle East, South America, the Caribbean and the Asia Pacific. These are the same regions where many of the exploration and production (E&P) companies I’m interested in operate. My previous experience is proving quite useful as an oil and gas analyst.

TER: When you look at a company, do you consider the jurisdictional risk first?

AH: Jurisdictional risk differentiates a company focused in North America from one that operates internationally. For the latter, geology, exploration history and reserves matter as much as they do for a North American company, but equally important considerations are geopolitical or currency risks. These issues affect operations as well as profit repatriation.

TER: Do you focus on the downside?

“If management addresses the risks and has a program to meet and mitigate them, I feel more confident. But if they paint too rosy a picture and gloss over the risks, I try to steer away from that company.”

AH: No, I try to look at the company as a whole. In the oil and gas business, one has to be an optimist. As an analyst, I try to be a rational optimist. I use risk as a tool to screen management. I make a list of all the jurisdictional risks as I understand them. If management addresses the risks I have identified and they have a program to meet and mitigate those risks, then I feel more confident about the quality of the management.

But if the management paints too rosy a picture and glosses over the risks, which seems unrealistic for even a layman like me, then I try to steer away from that company and its team. But I don’t always start with the downside.

TER: You seem to be concentrating on a theme of oilfield redevelopment.

AH: Yes. Of the six companies, four are focused on redevelopment.

TER: Do redevelopment projects inherently carry less risk, because reserves in the ground are already established?

AH: That would be a fair statement. I play to my strength. I do not have a background in geology or petroleum engineering. I’m trained as an electrical engineer. I can relate to the basics of oil and gas science, but I am not an expert.

But if you start with a proven reserve that has not been extracted for various reasons, then you have a head start on the companies with exploration risks, where the outcome could be binary. You either find oil or you drill a dry hole for up to $50 million ($50M) per well.

“If you start with a proven reserve that has not been extracted, you have a head start on companies with exploration risks that will either find oil or drill a dry hole for up to $50M per well.”

If you have a proven reserve, then the outcome is not binary. There are risks. There are challenges in extracting the resources, both operational and geopolitical. But if you have competent management in place, then you have the confidence that they’ll find ways to meet those challenges, mitigate those risks, extract that oil and find a way to sell it.

TER: Is this redevelopment theme dependent on technology that we didn’t have a decade ago?

AH: That’s an absolutely fair statement. With most of these old fields, development success is predicated on applying new technologies and new ideas. We take new technology for granted in North America, but not so in these international jurisdictions.

Let me start with examples. Two of my Nigeria-focused companies, Oando Energy Resources Inc. (OER:TSX) and Mart Resources Inc. (MMT:TSX.V), are working mostly on oilfields that were discovered some time ago but have not been fully exploited. Mart has been in West Africa for quite some time, but its latest success was due to its use of three-dimensional (3-D) seismic data that was acquired some 15 years ago. It then used new technology to reinterpret it and the company found success. Oando is on the same path, and so are many other Nigeria-focused independent E&Ps.

A company in another part of the world, Azerbaijan, is Greenfields Petroleum Corp. (GNF:TSX.V). Azerbaijan has been producing oil and gas for at least 100 years. The field Greenfields focuses on has been producing at a very marginal level for the last 30 years because operators were still using Soviet-era drilling rigs and completion technologies. Greenfields acquired new two- and 3-D seismic data and new ways to model the reservoir. It is also using new drilling technologies. That’s how it hopes to find success.

TER: Define “marginal field” for me.

AH: Different countries have slightly different definitions. Generally, it is a field that has been discovered years ago and may have been producing for some time. But the initial leaseholder, which in most cases is an international oil company of substantial size, does not find it economic for continued development.

“Marginal fields are economic for smaller E&Ps because they operate with a shoestring budget and often introduce new technology.”

Therefore, these fields get marginalized and do not receive any new capital expenditure. That’s what’s happening right now for many fields in Nigeria, for example. Fields are declared marginal under new laws and regulations, and the original discoverer farms it out to, in most cases, a smaller outfit. That smaller company puts in new resources to start producing from it. Marginal fields are economic for smaller E&Ps because they operate with a shoestring budget and often introduce new technology. The government gets royalties and taxes, and the original operator gets some farm-out royalties. So it’s a win-win for everyone.

TER: It sounds like once the low-hanging fruit is gone, it’s necessarily going to cost more to drill these wells. Is that fair?

AH: It could go both ways. There are many marginal field opportunities like that. If a marginal field is large enough, then from the first well drilled to the, say, fifth or 10th well, the development cost actually declines over time. But when people start hearing about these new, unexplored opportunities, new companies come in and bid up the price for assets.

Even if not a marginal field story, let us think about Colombia, for example. About five years ago, Canadian energy companies went into Colombia and found success. More and more companies began flocking in, bidding up the price for new fields. That adds to the cost. That makes it more expensive for even established companies to expand and obtain access to new assets. So that’s a challenge.

TER: You follow junior E&P companies, where investors can hopefully get a large return on their money. Can you give us some of your favorites?

AH: Yes. Let me start with Mart Resources. Only recently, the institutional investors have been paying some attention to Mart. In June, the company declared a very generous dividend payment to its shareholders of $0.05 per quarter.

TER: Even after the dividend was paid on July 19, the stock still behaved quite well. At times, after a one-time dividend, shares fall. But investors have favorably viewed this stock.

AH: You’re correct. I’d like to note that when management declared this dividend, it made a strong statement about its commitment to return of capital to the shareholders. Although it was a one-time special dividend, management spoke of continuing special dividends in times of good cash flow.

TER: Can the regular $0.05/quarter dividend be sustained?

AH: I believe so, despite some of the risks the company faces. Since the end of October, Mart has not been able to produce and pump oil because of pipeline disruption as well as flooding in the Niger Delta area. Losing 15–20 days of production from its only producing field made for a challenging quarter. But Mart has a large stash of cash it can use to pay the dividend as well as continue its development program. In the future, it expects to increase oil sales with the help of a second pipeline, at which point a $0.05 quarterly dividend should not be a big challenge.

TER: Does Mart have prospects for increasing its reserves and production?

AH: Let me address the production issue first. The field is averaging about 12,500 barrels per day (bbl/d). Depending on Mart’s entitlement production, the production allocation to Mart goes between 50% and 82% but averages about 65%. It has drilled 10 wells so far, but the problem is that the field cannot produce to its maximum capacity.

The field has pipeline constraints. Five different producers in the area share the same pipeline, so there is a rationing of pipeline capacity. Unless that restraint is removed, Mart cannot produce to its maximum capacity, which I believe to be on the order of 15,000 barrels per day (15 Mbbl/d).

The company’s management is working on two things to remove the constraints. First, it is negotiating with the pipeline company that it uses right now to expand the capacity. In addition, Mart and its partners, along with other E&P companies in the area, are building a second pipeline that will connect to a Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) facility. A second pipeline should do two things—provide the company with redundancy and excess capacity, as well as giving it access to a second export terminal. That should allow Mart to significantly increase its production, which I expect to be achieved gradually between the beginning of 2013 through the end of the year.

TER: What is it about Mart’s management team that impresses you?

AH: First, they have done a good job of building relationships in Nigeria. Mart’s two partners for the Umusadege field proved to be sound partners. In Nigeria, many joint ventures by international junior and intermediate E&Ps have failed because of partnership issues. Secondly, the Umusadege field is one of the few marginal fields that have succeeded. Mart’s management has shown that the marginal field is a viable concept and it works.

“Nigeria is making progress in building a corporate culture, and it has created a middle class that’s generating its own energy demand.”

I’d also like to make one other point about Nigeria. The country is making some tangible progress in building a corporate culture, in building a civil society. It has created a middle class that’s generating its own energy demand, which is good for natural gas production in Nigeria. With increasing demand for electricity, entrepreneurs are looking at natural gas as a source for electricity generation. If smaller E&Ps get a chance to sell their natural gas, that’s a separate and new revenue stream for them. So the timing is also good for Mart, Oando and other independent junior E&Ps.

TER: Mart’s market cap is now just over $600M. At that market cap, this is a company that now can be owned by mutual funds. Do you expect to see this transition from it being a retail story to an institutional story?

AH: Yes. Institutions expect to buy a sizable chunk of shares and the market cap is getting to that level. Also, Mart did not have any institutional coverage before. Institutional investors expect some institutional broker support while they take an interest in a company.

TER: Could you talk about another story that you like?

AH: Sure. A similar story to Mart, also in Nigeria, is Oando Energy Resources. One risk about Mart is that its production is from a single asset. For Oando, the picture is different. It has interests in nine different blocks. It produces from two. So it’s not that dependent on a single field or a couple of fields. It has production and cash flow. At the same time, it has some very lucrative exploration blocks. Its management has worked for Schlumberger Ltd. (SLB:NYSE) and other international companies. But at the same time, it’s a Nigeria-based company, so the management team has more appreciation of the issues on the ground.

TER: You have a really nice target price with over 100% implied upside from current levels. But I see that 95% of outstanding shares are held by one entity, its parent, Oando Plc (OANDO:NSE; OAO:JSE).

AH: You are correct. But other than Mart, there are not many opportunities to get exposure in Nigeria. Oando will need additional capital to develop these assets. My belief is that it will come to the capital markets, and that will create an opportunity for investors who have interest in Nigeria.

TER: As an investor, you’re not concerned that 95% of these shares are owned by one entity?

AH: I think that should change over the short term. Oando Energy Resources came into being as a spinoff of the upstream assets of the parent company, Oando Plc. The current shareholding structure is a result of how this company became public, through a reverse takeover and through a spinoff of assets. But my strong belief is that that’s not the ideal situation for any of the parties involved and that situation is going to change.

TER: Is there another story you’d like to talk about?

AH: I mentioned Greenfields Petroleum earlier. It has assets in Azerbaijan, the Bahar project, where it has a one-third interest. An Azerbaijani company holds the remaining two-thirds. Azerbaijan is a country that has the longest history of producing oil and gas. But in the middle of the last century, when Azerbaijan was part of the Soviet Union, all the capital was shifted from Azerbaijan to Western Siberia, so it did not receive any new capital, new ideas, technology, focus or interest.

But the resources are there. It was very astute on the part of the Greenfields management to find this particular asset. Greenfields’ management team is trying to prove what can be done in an old field using new technology. When you are operating in a country that has not seen the introduction of new energy technologies for over a half a century, you face challenges—getting trained people, moving equipment, procuring supplies, etc.

The project has been delayed by a year or so, but it looks as if everything is lined up and drilling should start within a couple of weeks. Greenfields should be able to get some good results out of its current drilling program.

I would also like to mention that several key people in the management team of Greenfields have worked in Central Asia—in Azerbaijan and some of the neighboring countries—for over a decade. So management has connections there. They know the country and the people. I would say those relationships and that knowledge are extremely important for any junior E&P getting into a lesser-known international jurisdiction such as Azerbaijan.

TER: Another you might mention if you wish?

AH: The last one I’d like to mention is Touchstone Exploration Inc. (TAB:TSX.V; TCHSF; OTCPK). It is located in Trinidad and Tobago, which is a country with a very long history of petroleum production. Again, it’s a redevelopment story, where production went down in some fields because there was no infusion of new technology or capital.

The state oil and gas company, Petroleum Company of Trinidad and Tobago Ltd. (Petrotrin), owns this concession. Touchstone went into an arrangement called a lease operatorship agreement whereby Petrotrin would still hold the concession but Touchstone would get a percentage of the production when it brings in new capital and increases production. But one major challenge in Trinidad and Tobago is its vast bureaucracy.

What I like about Touchstone is its dogged persistence. In the last year, it has faced many challenges. But it still has been able to increase production from 500 bbl/d to about 2 Mbbl/d currently. Consider that there are thousands of old wells that can be recompleted and brought into production. Even if they contribute 15–20 bbl/d, you are talking about a very large level of incremental production at a low cost. That’s what Touchstone is targeting.

TER: Did you want to mention one more?

AH: Another company on my list is New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX). For Canadian companies, New Zealand is a comparatively new jurisdiction. There are a couple of Canadian companies active there. New Zealand Energy had some impressive initial successes. It has a large land position right now. The thesis is that it can replicate the initial success in the remaining land base.

TER: The stock has suffered over the past six months. It’s down about a little bit more than one-third. What were the issues that contributed to that?

AH: The first three wells were quite successful, but the decline rates were high. So current production has come down. I guess the market is waiting for new wells to start augmenting production.

TER: It’s been a pleasure. I thank you for taking the time.

AH: Thank you. It’s been a great pleasure talking to you.

Amin Haque joined Stonecap Securities’ oil and gas research team in Calgary in October 2011. He provides research coverage of international explorers, producers and oilfield service companies. Haque brings 14 years of financial market experience, seven of which have been devoted to equity research analysis. He worked as an analyst both on the buy and sell side, focusing on energy and other resource sectors. Prior to joining Stonecap, he provided independent valuation services to oilfield services, logistics and related companies.

The Energy Report: James, with the U.S. election behind us, we are currently looking at a couple of looming and significant issues. One of these is QE3. You’re not a fan of easing; tell me why.

James West: Quantitative easing is just the issuance of more money. Since the onset of the crisis, two episodes of stimulus/quantitative easing injected $2.3 trillion into the economy between 2008 and 2011. Real gross domestic product (GDP) numbers in that timeframe show GDP grew by roughly a net of $2.3 trillion, demonstrating that the “recovery” GDP growth rate of 1.2% was not in fact growth at all, but was merely the addition of 2.3 trillion newly fabricated dollars to the weak and stagnant GDP number. By distributing free money to the top layer of the financial food chain, Obama and Bernanke get healthy numbers. In other words, they are focused most intently on maintaining a delusion, and expend no effort on tackling the real problem, which is income and opportunity disparity.

TER: You have cited the practice of dividend recapitalization as a consequence of near-zero rates. You’ve written that it leads to a doubled rate of bankruptcies in companies undertaking that strategy. But shouldn’t easing promote higher rates?

JW: Dividend recaps are the exclusive domain of private equity-owned corporations. The private equity owner causes the company to borrow so that the owners can be paid a dividend by the company. With such low interest rates, they can completely destroy the company over time, while paying themselves large dividends until the company goes bankrupt, and then they just walk away. They know that the United States can absolutely not withstand a rise in interest rates, or else it would have to declare bankruptcy as the cost of servicing debt would then rise to truly unsustainable levels. Super-low interest rates create the illusion of sustainable debt service levels to persist.

TER: Do you see this practice of dividend recap occurring in energy companies?

JW: Not necessarily. For private equity-owned energy companies, it’s possible. But that would only happen if the earnings from energy sales were insufficient to provide income to the private equity owner. If the board of a public company tried that, they would be voted out, as the self-destructive nature of dividend recaps is obvious. The key requirement that makes a dividend recap possible is a strong balance sheet that throws enough cash flow to service a debt, which disqualifies 99% of the juniors. And again, it’s not an option for a public company.

TER: Let me ask this counterintuitive question: Do you believe higher rates are important to the health of the economy?

JW: Interest rates are essentially the value of money. If you have interest rates at zero, and money is being created arbitrarily, then what does that tell you about the value of money? Zero interest rates mean banks don’t make anything lending or investing money, so why should they? Meaningful and stable interest rates are absolutely characteristics of a robust and healthy economy. Zero interest rates are likely signals of impending economic collapse.

TER: The other major issue looming over the U.S. right now is a threatening fiscal cliff. What could be the upshot of this issue if it is not resolved between the president and Congress?

JW: There’s all kinds of posturing by both sides to suggest there won’t be a problem resolving the issue, and there won’t be! It will likely go to the eleventh hour of course, as each side tries to exact concessions from the other, but at the end of the day, there’s no choice. The bigger issue ahead of the fiscal cliff is the debt ceiling. Watch how quickly that gets raised. The U.S. can’t afford another ratings downgrade.

TER: How do investors play your general economic theory? Back in the summer you told us you favored energy over gold. Is that still the case? Why?

JW: I don’t think individual investors play economic theories so much. I don’t think there are anywhere near the number of investors right now that there were in 2007. Yes, I favor the energy sector over the precious metals sector generally because it’s easier to understand the market catalysts, which in energy are a little less controlled than in precious metals. The precious metals markets make no sense, unless you subscribe to the theory that the U.S. cannot permit higher gold prices, because a suppressed gold price is critical for maintaining the illusion that all is well in the United States Treasury and Federal Reserve.

The huge disparity in gas prices between east and west hemispheres is creating massive opportunity, and the rapid increase in North American shale-borne production is changing world energy dynamics by the day. In precious metals, you’ve got all the same fundamentals, but they’re castrated by government-sponsored price suppression in futures markets.

TER: What about junior companies?

JW: Junior explorers are divided into two camps, as far as I’m concerned. Two years of severe underperformance have capped any possible upside in a lot of these older companies. They’re practically pariahs, just waiting for the inevitable day when they run right out of money, and can’t raise it at any price. There are many such “zombie” companies out there, but there will be a lot fewer this time next year.

Still viable are companies that match strong management with solid structures where the share price can still respond to success without battling through a wall of cheap paper from past financings. These are generally newer companies.

For specific ideas in junior explorers, my favorite companies now are Atico Mining Corp. (ATY:TSX.V), which we own in the fund. The Ganoza family is essentially recreating the winning recipe that they applied to Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE), though this time in Colombia. The company is acquiring a producing mine with plenty of exploration upside, and so you’re buying into cash flow.

Mason Graphite (LLG:TSX.V) is a new graphite deal in which I own shares. I’ve been familiar with its graphite project for many years and I’ve spent time traipsing all over it. It’s called Lac Guéret, and this was a hot graphite property in 2006, when it was owned by Quinto Mining, which was sold to Consolidated Thompson Iron Mines Ltd., which then was bought by Cliffs Natural Resources Inc. (CLF:NYSE). More importantly in the graphite game, however, is not so much grade and purity, both of which you need, but end users. Who are you going to sell it to? Graphite is not scarce. It’s common. But CEO Benoit Gascon built the entire graphite sales channel at his former employer, Stratmin Graphite, from nothing to the point where it was bought by Imerys (NK:PA), one of the world’s largest graphite vendors. In my mind, that is a critical differentiator that will make Mason Graphite one of, if not the graphite company of this cycle.

For lithium, I like Critical Elements Corp. (CRE:TSX.V), again not so much because it’s the biggest lithium deposit, but because management is making all the right moves to put the deposit into production on a fast track. Ron MacDonald, the company’s executive chairman, has a high profile within the alternative energy materials space, and serves several companies among whom synergies exist. Critical Elements is working to secure non-dilutive, commodity-based financing that could see it leapfrog ahead of other, more apparently advanced companies. Production I think will happen as soon as the company can find a buyer who wants to secure a supply of lithium, and will advance the funds to go to production on that basis. I know discussions are under way with a few groups, though nothing concrete has emerged yet.

TER: Do you have some other ideas you could share?

JW: I own the most shares in a stock I think is a billion-dollar company in the making. It’s an OTC-traded company called Abakan Inc. (ABKI:OTCQB). It has now filed for a NASDAQ listing, and it has received investment from and is working with Petrobras, the world’s fifth-largest petroleum producer, to supply Petrobras with a continuous supply of its nano-composite coatings for pipelines. Petrobras is producing highly corrosive oil from very deep fields, which creates stress for pipes gathering and transporting oil from offshore Brazil. Without Abakan’s pipeline coating, much of the oil that Petrobras owns would be uneconomical to produce. And Petrobras is the tip of the iceberg for Abakan. Seventy percent of the world’s remaining oil and gas supplies are “sour,” meaning highly corrosive, and so that means demand for Abakan’s MesoCoat pipelines should keep ramping up for decades to come. The company is looking at building plants in Indonesia, Bahrain, Brazil and Canada, besides its first plant, which comes onstream soon in Euclid, Ohio. The company recently won the Wall Street Journal’s Technology Innovation Award in the manufacturing category.

TER: James, I’d like to get some updates on some of your picks from past interviews with us. To start, Aroway Energy Inc. (ARW:TSX.V; ARWJF:OTCQX) announced that it had acquired an additional 265 barrels per day (bbl/d) of immediate production. That’s a runrate of about $1.3M per year just on this addition. The company has now increased production six fold this fiscal year. Shouldn’t these additions be significant for a $27M cap company? When is this company going to get noticed?

JW: All the junior producers in the patch are in a state of suspension pending the outcome of Industry Canada’s rulings on the two big mergers currently underway, yet not yet done deals. I’m referring to China National Offshore Oil Corp.’s (883:HKSE; CEO:NYSE) acquisition of Nexen Inc. (NXY:TSX; NXY:NYSE), and Petronas (PETRONAS) acquisition of Progress Energy (PGN:NYSE), which was initially turned down. This arbitrary move has put a big question mark over the valuations of the whole patch, from seniors to juniors, because the possibility of a buyout from a bigger company is one of the key price drivers in the sector. With the denial of the Petronas-Progress deal, global investors don’t know who qualifies and who doesn’t as far as purchasers go.

As that story starts to resolve itself, I think Aroway will start to see more of a lift in its share price. These days, if you don’t produce 1,000 bbl/d, you’re not even on the radar. So the company is technically already over that hurdle because it will exit 2012 with 1,200 bbl/d.

TER: EFLO Energy Inc. (EFLO:OTCQB) has recoverable access to 1.8–3.3 trillion cubic feet of natural gas. Gas may be cheap, but this stock is cheaper. Clearly the company suffers from being so small in market valuation where small-cap funds can’t participate. But is it just a matter of time before the company is discovered by small hedge funds and investors? What catalyst can we anticipate?

JW: EFLO is owned by the Midas Letter Opportunity Fund, and has already been a double and then some for us. That’s certainly one to watch, though it’s early days for the company at this point. The big picture for EFLO is the development of pipeline capacity and a liquefied natural gas (LNG) plant on the west coast, which still has a lot of hurdles to clear. But it’s going to happen. Canada needs the addition to the GDP. When the company starts drilling and bringing wells onstream, it will be able to move its gas to market—that’s going to be the ongoing catalyzing event for the company’s shares. That and getting a listing on a senior exchange, which I understand is in process.

TER: Prophecy Coal Corp. (PCY:TSX; PRPCF:OTCQX; 1P2:FSE) shares have had a rough time. It seems like the stock began to turn south when the company announced it was going into the power generation business in Mongolia. Did investors hate this deal because it took focus off of its core business?

JW: Not at all. Its horrible share price performance is attributable exclusively, I would say, to the political situation in Mongolia, which is still uncertain, especially with the passage of the Strategic Entities Foreign Investment Law, passed in May 2012. This document has created more uncertainty than it has assuaged, and that’s why Prophecy shareholders are suffering right now. Unofficially, there is basically a sense of optimism for the long term, and pessimism for the short term.

Just look at Oyu Tolgoi—no investment hesitation there on the part of Rio Tinto. Obviously, Prophecy Coal isn’t Rio Tinto, and that’s probably the main roadblock to reversing the share price performance. When it becomes apparent that Mongolia is not going to make a grab for the power plant, and clear investment and power offtake agreements are in place, the share price should start to appreciate. At this level, I think it’s attractive.

TER: Recently the company announced a preliminary economic assessment on its Chandgana Tal coal mining licenses in central Mongolia, reporting 124 million metric tons of measured coal with a mine life of 30 years. How significant will this be?

JW: Well this was a big cloud put over the company by the Ontario Securities Commission, which has now been quite thoroughly addressed. In any other market, that should have been sufficient to attract buyers in the company’s shares, but there just aren’t a lot of those around right now, thanks to the overall weakness in mining companies for the last two years. Add to that a dose of political uncertainty, and you get the share price Prophecy has right now. But there’s certainly no longer any question of there being sufficient coal to supply the power plant.

TER: James, thank you for your time today.

JW: My pleasure.

James West is publisher and editor of The Midas Letter, an independent capital markets entrepreneur and investor. He has spent more than 20 years working as a corporate finance advisor, corporate development officer, investor relations officer, and media relations and business development officer for companies involved in mining, oil and gas, alternative fuels, healthcare, Internet technology, transportation, manufacturing and housing construction.

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The Energy Report: It’s been about one year since we last spoke, Robert. What do you think have been the most significant developments in the North American oil and gas industry since then?

Robert Cooper: It’s a dynamic business, and a number of changes have occurred. First, the macroeconomic backdrop remains murky, resulting in persistent volatility in equity and commodity markets. Investors remain wary of putting on riskier trades because the visibility simply isn’t there. The fear that some Monday morning we’ll wake up with a negative surprise is inhibiting risk taking and impacting small-cap growth equities, particularly.

“The winners tend to be experienced managers with proven track records.”

Second, the rapid increase in U.S. oil production has negatively impacted Canadian producer net-backs. The spread between Canadian light oil prices and the U.S. equivalent has been much more volatile than historical rates. The lack of pipeline capacity has exacerbated this trend and given rise to alternative methods of transportation, such as oil-by-rail. But overall, the “differential risk” has been added to the list of risk factors investors assume when investing in the oil and gas sector.

Finally, the natural gas market, after a period of massive oversupply, has, in our view, self-corrected and appears to have returned to balance.

TER: In terms of pipeline capacity and building potentially new pipelines and better distribution, do you have any further thoughts on where you think that might be headed at this point—or is it all regulatory?

RC: There is a juicy arbitrage between waterborne markets and domestic markets. There are a lot of smart companies and individuals looking at ways to solve that, but in the end, these things sometimes have political masters who need to be appeased. The current president has indicated he’s not amenable to it. We’ll see what happens.

TER: In your last interview, you were seeing a potential downside in oil prices in the $60–70 range, if the economy took a turn for the worse. Things now seem to be slowly improving in North America. Oil has been up and down, but it’s still kind of weak. Some analysts are thinking we could still see lower prices. What’s your thinking?

RC: Higher or at least stable prices are primarily a function of the global economy continuing to muddle through with positive, but not thrilling, economic growth. We’ve seen a lot of competing evidence on this, but on the whole, the global economy is doing just that. Conversely, I am still of the view that global shocks, such as sovereign default or a hard landing in China, would likely deflate the oil market. We saw the impact of economic concerns in Q2/12, when crude tumbled from over $100 per barrel (bbl) to about $76/bbl at the end of June. That downside risk remains. That’s not our base-case forecast, but we’re certainly cognizant of the potential for black swan events that can really deflate the equity and commodity markets.

TER: Is the new trading range somewhere between $80–90/bbl, or is this just a temporary setback?

RC: The oil market is highly volatile, so you could probably make a case for somewhere between $75–100/bbl. The longer it’s at $75/bbl, the more likely it is to move higher. Alternatively, if it hovers in the $100/bbl range, the more likely it is to move lower. The sweet spot is somewhere in between, and that’s what we’ve seen on the whole in the last several quarters.

TER: Natural gas is a different story. We’ve bottomed out already. Where is it headed from here?

RC: The gas market is very similar today to what it was a year ago, and yet different in a number of respects. Last year, the market knew that production from shale gas reservoirs, particularly in the U.S., was rapidly increasing, and had taken the step change down to the $4 per thousand cubic feet (Mcf) range as a result. But the winter was one of the warmest on record. Consequently, gas collapsed along with demand.

The difference between this year’s storage overhang in April versus normal was basically equal to the lost heating demand over the winter. In other words, we can retrospectively demonstrate that the market was balanced a year ago. Between October of last year and April of this year, it went from balanced to well oversupplied. What changed in the summer was what we refer to as the power burn rally, in that utilities switched from coal to gas en masse. In the span of three or four months, that phenomenon has returned the market to essentially the same place it was this time last year. In fact, prices are approximately equal to last year, as are storage levels.

The difference now, however, is that there are other positive factors at work. One, the number of gas-directed drilling rigs have fallen from the 800s into the low-400s. Second, producers have pivoted to liquids-rich gas and/or oil. Natural gas liquids (NGL) prices have declined precipitously year over year (YOY). The average weighted NGL barrel as a percentage of crude oil is down 25% YOY. This change still results in economic, liquids-rich gas projects, but it reduces the cash flow associated with them. With lower cash flow comes lower reinvestment and less drilling, and then you should see a further cannibalization of the gas rig count. Finally, gas supply has stopped increasing. After several years of higher production, it looks like exit 2011 to average 2012 production is basically flat. All of those, in aggregate, are good signs.

TER: What happens if we have another warmer-than-normal winter?

RC: My view now is that the gas market is balanced. Whether or not it goes higher or lower in the near term is largely a function of winter weather. You give me normal weather, and I can probably give you $4/Mcf gas. If you don’t, then it’s history repeating.

TER: Have the prices over the last six months to a year had any significant impact on the way that oil and gas companies are planning their future operations, based on what’s visible to them at this point?

RC: Speaking about Canada, the small- and mid-cap Canadian producers have embraced hedging to a greater degree than I can recall. Generally speaking, pre-2008, the prevailing view of exploration and production (E&P) managers was that companies existed to provide investors beta to commodity prices. In other words, they were unhedged. Since then, we’ve noticed a distinct trend toward risk management, which means greater and more consistent hedging among the producers. This has been driven by a number of factors, including more challenging equity markets in which raising capital is much more difficult. It’s a function of highly volatile commodity prices and, on average, larger capital budgets that require some certainty in the cash flow. E&Ps have attempted to take some risk out of the business plan by providing a degree of cash-flow certainty via hedging.

Second, E&Ps have become much more focused on cost control. One manifestation of this is that, in Canada, a number of producers have made conscious decisions to avoid drilling during peak seasons. The goal is to utilize the best rigs and services at off-peak times. A number of them have had success, which has made a positive impact on capital costs and returns. The downside is that drilling in Canada remains seasonal, and spring breakup remains an impediment for many companies. But, overall, I think the theme is toward risk management, simply because the equity markets of late have been rather unforgiving of mistakes.

TER: Everybody has to adapt to changes, and it’s a fluid market. You joined Haywood Securities since we last spoke. Has that had any impact on the way you approach your investment selections and general analysis?

RC: No. Nothing has changed in how I evaluate equities, although I’ve added an international dimension to my coverage universe.

TER: Maybe you can bring us up-to-date on developments with some of the companies we talked about last year and how they look now.

RC: Let’s start off with Open Range Energy Corp. (ONR:TSX). Open Range was a huge win. We said then that once the E&P was split, the tank business had a significant growth runway and that the company was likely to get acquired. We got both of those right. The tank business is now called Poseidon Concepts Corp. (PSN:TSX). It’s taken off, paying a dividend and trading at about $15/share. Growth in the U.S. has accelerated. We were predicting at that time, $130 million ($130M) in 2012 earnings before interest, taxes, depreciation and amortization (EBITDA). Management guidance for 2012 is now $210M in EBITDA. The E&P spinout was acquired by top-tier producer Peyto Exploration & Development Corp. (PEY:TSX).

Crocotta Energy Inc. (CTA:TSX) was another one. It has performed as I expected. We said then that there was $4/share upside, and it got there in January. It has since pulled back some, but the business is further advanced now at a lower stock price than it was then. Crocotta has proven its Edson liquids-rich gas asset and has added an emerging Cardium oil play as well. With gas strip prices as they are now, we’re likely to see further development in the Montney play in northeast British Columbia. All the while, Crocotta management has maintained a sterling balance sheet, so we like this story a lot. Right now, it’s about $3.20. In October of last year, it was around $2.60.

Yoho Resources Inc. (YO:TSX.V) is the final one. I said last year that I liked Yoho because it had the most resource exposure of any junior company I knew of combined in the Duvernay and the Montney. That is still the case, and it remains one of my favorite stories. What’s changed is that Yoho has drilled some Duvernay shale wells. The development of any shale basin tends toward lower productivity and higher well costs at the outset, and as the plays mature, production increases and costs decrease. Yoho is following that in the Duvernay. What’s most interesting is that Exxon Mobil Corp. (XOM:NYSE) recently paid $2.6 billion for Yoho’s partner in the Duvernay, Celtic Exploration Ltd. (CLT:TSX). This shows you that the Duvernay is the real deal, and that large companies want exposure here. The thesis remains the same on Yoho as it was 13 months ago.

TER: Do you expect it to be taken out, at some point?

RC: If you look at where Yoho is and its Duvernay acreage, it is surrounded by the majors—Chevron Corp. (CVX:NYSE), Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE), Exxon, Talisman Energy Inc. (TLM:TSX), Encana Corp. (ECA:TSX; ECA:NYSE) and Husky Energy Inc. (HSE:TSX). And then there’s Yoho. So chances are Yoho will not be around in 12–18 months. That would be my guess. It’s been our Top Pick this year on the basis that resource exposure is an investable theme among the juniors. And we still feel that way today.

TER: Do you have any new names that you’d like to talk about at this point that look interesting?

RC: I do. One is called Tamarack Valley Energy Ltd. (TVE:TSX.V). Tamarack has emerged as a very well run junior light oil producer. The company is active in Alberta’s Cardium light oil trend as well as Alberta’s Viking light oil trend. It produces about 2,550 barrels of oil equivalent per day (boe/d) currently. The company is led by the former CEO of Apache Canada (APA:NYSE). We like the company for a number of reasons. First, Tamarack has a number of oil projects that have payouts in about a year. This is an attractive attribute because it means that the company is able to self-fund under reasonable commodity price assumptions. Second, Tamarack has demonstrated that it has been able to reduce costs and increase productivity in both the Viking and Cardium formations. Obviously, decreased costs and increased productivity drop right down to the bottom line in improved economics. Third, we really like management. They work hard. They take a risk-managed approach to their business, and they tend to meet or exceed expectations. Finally, we like the risk-reward profile of attractive valuation coupled with a number of near-term drilling catalysts.

TER: That’s certainly one to keep an eye on. How about any others that look interesting?

RC: The second company is called Novus Energy Inc. (NVS:TSX.V). Novus is also a Viking producer but in west-central Saskatchewan. We like the Viking generally, for a number of reasons, especially for a junior producer. The Viking in west-central Saskatchewan is well defined geologically. It’s low risk, low capital cost and repeatable. The key to success is having scale, because the initial well productivity is lower than some of the deeper, tight oil plays in Alberta. Novus has the dominant land package in the area and is growing production. It is guiding to 4,400 boe/d at year-end. We have written that we think Novus’ asset base could ultimately support a dividend. Based on the comparables, this should result in some value creation. Alternatively, it’s our view that the west-central Dodsland area is going to be the domain of larger producers, and that consolidation is likely. In either scenario, we see Novus benefiting.

TER: Could Tamarack and Novus get taken out?

RC: I think Tamarack is earlier in its life cycle than Novus is. Larger companies need scale and scope and a number of them have indicated that west-central Saskatchewan is going to be a focus for them. If you want scale and scope in west-central Saskatchewan, you pretty much have to go through Novus.

TER: So it’s pretty well-situated there as far as its land position.

RC: Yes, it is.

TER: Generally speaking, what do you think the focus should be for our readers and people interested in playing the energy markets in North America at this time?

RC: I think volatility creates winners and losers. The winners tend to be experienced managers with proven track records. In times of stress, proven managers tend to retain their multiples relative to their peers and are able to raise capital, if required. This enables them to grow, either organically or through mergers and acquisitions. And in the worst of times, they survive. When the rising tide isn’t lifting all boats, investors should gravitate toward the best-in-class.

TER: That’s a good closing thought. Thank you, Robert.

RC: I said this last time, and I’ll say it again this year: I hope I’m right.

TER: As does everybody. We appreciate your time today.

Robert Cooper, CFA, is Senior Oil & Gas Analyst at Haywood Securities in Calgary. He has a diverse background including commodity trading and merchant banking. Cooper has spent the past six years in equity research focused on high-growth energy equities both in Canada and across the world and is regularly called upon for insight on the oil and gas industry by various local and national media. He is a CFA charter holder and is a past president of the Calgary CFA Society.

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