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So maybe I need to get into a daily digit type of routine. Of late there is a round of news around the state how municipalities are going to use their shale gas impact fee windfall. Here is the Inky’s version: PA towns savor drilling impact-fee checks
How much of a windfall is it? According to the news, a total of $204 million is being distributed to local governments across the commonwealth. A big number yes?
For perspective the revenue for local governments alone across Pennsylvania amounted to $63 billion in 2010 alone. So the ratio of the new windfall to that revenue base gives me……..
update: I overestimated. So only 60% of the 204 million goes to local governments. So it is $122 million being distributed to local governments. The ratio works out to be: 0.19%.
If you really want to play with numbers, that $ amount is equivalent to the fines from just 10 red light cameras like this one in DC.
AP is running a look at the history of fracking and all of that: Decades of federal dollars helped fuel gas boom
But what I think the story misses, and pointed out here in the past, is the long history of Federal research into that which is known as fracturing including the attempts to use atomic detonations to tease the natural gas from the shale. Read up on:
So if you are a relativist, it sure makes anything happening these days appear a bit tame.
Fracking in the U.S. is here to stay, affirms Keith Schaefer, editor of the Oil & Gas Investments Bulletin. North American business is dependent on cheap energy, and even energy utilities are switching from coal to natural gas. Although environmental concerns remain, the industry has incentive to do the right thing, says Schaefer. In this exclusive interview with The Energy Report, Schaefer profiles service companies that are using cutting-edge technology to make fracking safer, greener and cheaper.
The Energy Report: Keith, considering that natural gas prices are still near all-time lows, can you still argue that fracking has improved North American energy markets?
Keith Schaefer: In just a few short years, fracking grew the supply of natural gas way ahead of demand. The price of natural gas fell from $8–9/thousand cubic feet (Mcf) to $2/Mcf! Natural gas is the low-hanging fruit for the energy sector and for consumers. Cheapened feedstock provides a huge boom for American business.
TER: Have fracked oil prices kept pace with falling natural gas prices?
KS: It has not declined by the same degree, but it has lowered the cost of North American oil. West Texas Intermediate (WTI) used to be the major benchmark for oil around the world. Now, WTI is only a benchmark for a small area of the United States and Canada. In addition, the flood of supply coming out of new shale oil wells in North Dakota and Texas is overwhelming the refinery complex in the Gulf Coast, which is about 50% of North America’s refinery capacity.
TER: Is there a glut of gasoline? Prices for consumers are certainly high.
KS: That’s a great question. The short answer is no. But the long-term answer is yes. People are saying, OK, how come gas prices at the pump are so high when we’ve got all this oil? What’s going on? Here is how the game works: the refineries are moving their production flows to produce the least amount of driving gasoline possible, and the most amount of other refined products, like home heating oil fuel, diesel, kerosene and jet fuel. These are products they can export, in which case they get to use the Brent prices, which are 15% higher than WTI prices. These refineries generally operate on skinny-to-average margins, so 15 points is huge for them. That is why the price of retail gasoline for driving is 50% higher than it was in 2008.
Let me give you an example. I’m in Vancouver. We sell gas by the liter, not the gallon. Back in 2008, we had an uncanny relationship where if oil was $100 a barrel (bbl), gasoline was $1 a liter (L) at the pump. If it was $110/bbl, it was $1.10/L. If it was $1.35/L in Vancouver, oil was $135/bbl. Now, gasoline is $1.35/L, but oil is only $96/bbl. Why? Because the refineries are producing the least amount of gasoline, and the most amount of other refined products.
TER: Does fracking lower oil production costs?
KS: As a rule of thumb, the cost of production for most shale plays in North America is $40–45/bbl, which is not that much different from costs using conventional methods. It is above-ground logistics that cause lower prices for fracked oil. We don’t have enough pipelines to efficiently transport the fracked oil to the refineries. Consequently, supply backs up at the hubs, creating big discounts. For example, in late June, Canadian oil and Bakken oil were at huge discounts, almost $20/bbl to WTI. Because of pipeline disruptions and refinery downtime, Canadian producers were receiving under $70/bbl for their oil. But only 2½ months later, the logistics are running smoothly and Bakken oil is now selling at only a $3/bbl discount to WTI.
TER: Why do we see regional price differentials at the pump?
KS: Logistics. Here is an example. Recently, BP Plc’s (BP:NYSE; BP:LSE) Cherry Point refinery, which is just south of the Canadian border, went down. The next day, gas prices jumped $0.30 per gallon from Seattle to San Diego.
It’s not like we have no new refining capacity. Even though no new refineries have been built since ‘76 in the U.S., refineries have been expanding. Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and Saudi Aramco have spent $10 billion during the last few years, doubling the size of their Motiva refinery in Texas from 300,000/bbl per day (bblpd) to 600,000/bblpd. It immediately ran at full capacity. But, then, an industrial accident took the new expansion offline for nearly a year, which boosted the retail price.
TER: Why is fracking politically controversial?
KS: Scientific studies have shown that fracking is not an environmental issue. It does not contaminate the ground water. There is usually more than a mile of granite between where the fracking takes place and the water table. On the other hand, the government of British Columbia has released a study finding that fracking causes earthquakes. And there is seismic activity associated with fracking and saltwater disposal wells, but that takes place in the formation where the fracking is occurring. The quakes are no different than any of the millions of micro seismic events that happen around the world every day. Of course, there is an impact. Blasting for mining creates seismic events. Building a dam creates seismic events. Filling a large manmade lake creates seismic events, because water is heavy. Fracking is no different.
It is the fierceness of emotion that is the big issue here. People get nervous about the safety of their water supplies and say, “Hey, prove to me that fracking is really safe!” Industry has responded by saying, “Look, here’s the science. We’ve been doing this for 50 years. No need to worry, it’s all good.” But that’s not what people need to hear. People need to hear, “Hey, we hear that you’re really concerned about this, that it’s a big issue for you. Let us come together at a community hall and talk about it.” That would be more effective than just taking out ads that say, (a) we bring so many jobs to the area, why are you bugging us? and (b) we’ve done this for decades, why are you bugging us? That kind of attitude is not going to win any arguments.
TER: Are drought conditions in the Southwest and Midwest affecting the availability of water for fracking?
KS: Due to drought, the price of water for oil and gas companies has more than doubled in the Midwest and Texas. Some of the oil and gas companies are not drilling as much as they said they would this year because they need to figure out where to get the water and how much they want to pay for it. Even though the amount of water used by the industry isn’t huge compared to irrigation, there are areas where the oil industry is bidding for water rights against farmers. The industry needs to be very careful about public relations. Otherwise it becomes a case of the big guy against the little guy.
TER: Are there any technological fixes to that issue?
KS: Yes. Firms involved in the fracking supply chain are figuring out how to source, treat, recycle and dispose of water efficiently. One company that comes to mind is Ridgeline Energy Services Inc. (RLE:TSX.V). It has a proprietary water recycling technology. EOG Resources Inc. (NYSE: EOG) is a Ridgeline client, as is Pure Energy Services Ltd. (TSX:PSV). These companies are starting to recycle their fracking water, which is great.
Other companies doing water management include GreenHunter Energy (GRH:NYSE:MKT). That’s Mark Evans’ deal from Magnum Hunter (MHR: NYSE.A). This company is determined to use saltwater disposal wells as its entrée into the water management sector. Another company is Poseidon Concepts Corp. (PSN:TSX). It has a water storage product and is branching out into more vertically integrated work in the water sector. There are lots of companies experimenting with this, and for good reason—there are very big margins, 50–85% gross margin. That’s fantastic. It beats the pants off any other service in the oil patch. Investors should be taking a strong look at fluid and water service companies.
TER: Aside from the Bakken shale, what are the most exciting international sources of shale oil and gas?
KS: The only other notable proven deposit of size is the Vaca Muerta shale in Argentina. There are a few Canadian juniors down there, but the Argentine government has started to nationalize part of YPF SA (NYSE: YPF). Plus, some permits were pulled from juniors by provincial regulators. That put a huge chill in the market for these stocks. They are well funded and cashed up, but the market’s just not going to care about them until there’s real production growth.
European shales have been fairly slow to take off. Poland’s been on the hot list for a while, but nothing’s happened. During the next two to three quarters, we could see a few wells get plunked down in New Zealand. That looks like a fairly thick formation. If it gets going, it could be a big win for investors next year.
TER: What about the oil and gas shale near Paris, France?
KS: Fracking is still banned in France. ZaZa Energy Corp. (ZAZA:NASDAQ) dropped its French play and is now focused on the Eagle Ford shale and the Eaglebine in Texas.
TER: Could fracking be banned in the U.S., either in certain areas or in its entirety?
KS: Fracking will never be banned in the U.S. But if it did happen, businesses would go bankrupt left, right and center. Many companies are hooked on cheap gas. There would be widespread bankruptcies and unemployment. Power companies are using cheap gas instead of coal. The U.S. reduced its greenhouse gas emissions more than any other country in the world over the last two to three years because of shale gas.
TER: What technological changes will keep fracking profitable, while reducing its environmental footprint?
KS: A company called GasFrac Energy Services Inc. (GFS:TSX) has been trying to get the industry to start using liquid petroleum gas (LPG) for fracking, instead of injecting water into the ground. LPG is propane, which is a naturally occurring substance in the formation, so it doesn’t damage the formation, as water can. Unfortunately, the company is not having very much success. But the industry is doing a lot of research into food-grade fracking fluid. The idea is to make fracking fluid as green and environmentally friendly as possible. That’s a couple of years away, but it’s only a matter of time.
TER: Any other names on the cutting edge of fracking technology?
KS: Raging River Exploration Inc. (RRX:TSX) has a big play in the Viking formation in Saskatchewan that is very profitable. Its water flood technique is returning incredibly cheap oil. It got the first half million barrels of oil out at about $30–35/bbl, and the last half million barrels at $5–10/bbl. It is at the forefront of recovery technology. Normally, a firm is lucky if fracking returns 10–15% oil. But with the water floods, the recovery factor can go way up. That is great news for Raging River stockholders.
Renegade Petroleum Ltd. (RPL:TSX.V) is also working in the Viking formation, and it has two other upcoming plays worth watching. One is the Slave Point play in Red Earth, which is north of Edmonton. Pinecrest Energy Inc. (PRY:TSX.V) has been involved. Renegade will drill the first well later this year. If it can prove up one or two wells, it has a big enough land package to allow a lot of new locations to open up. Renegade also has a really interesting conventional play in southern Saskatchewan called Souris Valley. It’s turning out to be a lot more profitable than the company had originally thought it would be.
TER: What is your bottom-line message on the future of fracking?
KS: Mainstream public attention on water management isn’t a bad thing. It makes the industry do things that should get done. Fracking water should be food grade. The market rewards stocks for doing the right thing. There’s nothing that the market hates more than uncertainty. If the industry starts to lose what I call its “social license” in the United States, that loss will have a very big impact on valuations. Companies are incentivized to do the right thing, to do it well—and to do it fast. That’s why we will soon see a resolution to the fracking issue.
TER: Thank you for chatting with us today.
KS: A pleasure as always.
Keith Schaefer of the Oil & Gas Investments Bulletin writes on oil and natural gas markets. His newsletter outlines which TSX-listed energy companies have the ability to grow and bring shareholders prosperity. Keith has a degree in journalism and has worked for several dailies in Canada but has spent the last 15 years assisting public resource companies in raising exploration and expansion capital.
Fossil fuels have to be transported and stored. This is the classic midstream industry that resides between the producers and the marketers and that generally makes money regardless of the price of oil, natural gas or natural gas liquids (NGLs). Now, with the boom in production coming from unconventional oil and gas shales and the enhanced technologies that produce fuels in areas where it was once impossible, the demand for midstream oil and gas infrastructure is growing. In this exclusive interview with The Energy Report, Morgan Stanley Managing Director and Master Limited Partnership (MLP) Analyst Stephen Marsesca makes his case for a handful of MLP and common stocks that will generate increasing cash flow and dividend payouts.
The Energy Report: In your last interview, you told The Energy Report it was a good time to be involved in midstream plays. What about now?
Stephen Maresca: It’s still a good time to be involved in midstream stocks. A lot of unconventional oil and gas shale plays are increasing production and require new infrastructure to bring their supply to market. The growth outlook is still as strong as it was a year ago, even though recent commodity price weakness has created some investor concern.
We are now adding duration to this growth story: Midstream companies are adding projects not for just this year, but as far as three years out. When those projects are completed, they will add incremental cash flows for these companies. Over the next few years, we estimate about $60 billion ($60B) in growth capital is going to be spent among our companies under coverage, and we believe a lot of that has been derisked. Many new projects are coming on line with volume commitments from producers and many of these long-term contracts are not tied to commodity prices. It is becoming a more visible story.
TER: The midstream industry seems very unusual given current market conditions.
SM: That is largely because the energy landscape has improved so much over the past five years, with advancements in oil and gas technology, horizontal drilling and lower drilling costs. The technological improvements have really been a game changer for the energy industry, and that is why this story is so visible. There have been remarkable supply shifts and production growth from areas that did not previously have infrastructure or end-demand markets. For example, the oil being found up in North Dakota needs to be moved out into end markets where it can be used by refiners (like the Gulf Coast or Northeast). This is where the midstream companies play a critical role in building the interconnects to bring the new oil supply to end-use markets.
“It’s still a good time to be involved in midstream stocks.”
Specifically, we think the midstream group of MLPs is attractive on a value basis with yields where they are now. The median yield in our coverage universe is currently 6.5%, and we think distribution growth over the next couple of years is likely to be 7% on average. Year-to-date MLP stocks have experienced modest share appreciation, about 1%, but with where things stand right now we see average potential total stock returns at 13–14% for the group.
TER: If you could put your theme in a nutshell, how would you describe it?
SM: Building critical North American energy highways. This is an organic building story. This type of opportunity did not exist before because we did not have this type of supply shift and production growth, and now we do. These are still-in-the-ground, non-discretionary, essential energy assets that are helping to advance energy independence for the U.S. We now have increasing oil production in addition to the increasing gas production that we have had for several years. The gas derivatives, the NGLs—ethane, propane and butane—are also increasing in volume and need to be handled. End users like utility companies, petrochemical companies and refiners are going to benefit from this new and increasingly abundant supply of oil and gas.
TER: What does this increasing production portend for capacity? Can fees rise?
SM: We believe revenues are going to rise handsomely over the next three or four years because of the $60B in spending that I mentioned. We see cash flows for these companies, in many cases, rising 11–12% per year over this time period because of the buildout.
There are many asset locations where we are constrained in capacity, so we need to build more. We are constrained in areas like the Eagle Ford shale in South Texas, North Dakota and the Marcellus and Utica shales. Increasing volumes in these areas are creating the need for new building.
TER: Are you seeing net inflows of funds into these instruments?
SM: We are seeing money flow into the sector. I think the MLPs have become more of a mainstream sector with more investors participating. Larger companies, market caps and daily trading volumes are attracting broader participation across all types of funds—institutional funds, mutual funds, closed-end funds and hedge funds. This is an important and growing part of the energy industry and it is likely to stay that way.
TER: Is the midstream industry healthy today, and does it represent value for investors?
SM: Balance sheets are, for the most part, quite healthy given lower levels of debt to cash flow and recent equity raises. Distribution payout coverage is higher today than it was four years ago. The amount of commodity sensitivity, in general, is declining for the industry as more fees and volumes come on line that are not directly tied to commodity prices. So, bottom line, I would say the sector is healthy in terms of the financial structure and fundamentals.
“The energy landscape has improved so much over the past five years, with advancements in oil and gas technology, horizontal drilling and lower drilling costs.”
Yields still trade wider on a spread to 10-year bonds than they have in the past, which is one metric we review. They are about 70 basis points wider than historical norms. With interest rates overall looking to stay low and growth rates sustainable for the next year or two, the risk-reward opportunity for the long term is attractive.
TER: Some of the MLPs in your coverage universe are up double digits over the past month. Is a good earnings season upon us?
SM: Not necessarily. I think some of the stock rebound recently was reflective of an oversold sector and an increase in recent fund flows. Investors have concerns about commodities pulling back and some of those concerns are valid, as it can impact a portion of cash flows and longer term could impact volumes. Now, we have recently gotten some support in commodity prices. West Texas Intermediate (WTI) oil price has moved back up from below $80/barrel to nearly $90/barrel. NGL prices have gone from $0.80/gallon up to $0.90/gallon. Things have calmed with support for the commodity.
I think second quarter earnings will be weak in certain spots. You have some companies that will see subdued results because of the lower commodities during the quarter. I do not think this changes the forward forecast for volumes and project growth, hence our positive longer-term view.
TER: What MLPs and C-corps do you recommend for your clients?
SM: One of the names that we’ve been recommending is Kinder Morgan Inc. (KMI:NYSE). We think this is one of the lower-risk growth names in our coverage universe. It’s trading at a 4% current yield, and we think you’ll see 16% dividend growth in the next 12 months.
“The sector is healthy in terms of the financial structure and fundamentals.”
It just recently purchased El Paso Corp., and that closed about six weeks ago. We think this was a very good purchase, and it helps to lower Kinder’s risk profile because the assets are essentially long-haul, eight-year weighted average contracted natural gas pipelines with 93% of the capacity under contract. There’s not a lot of variability associated with the assets purchased.
Kinder is poised to expand on what we think is one of the better footprints in North America in terms of expansion of pipelines because of a growing volume story. It’s working on a large oil pipeline up in western Canada called Trans Mountain that could be more than a $4B investment. And it clearly has a lot of opportunities now with the El Paso assets that it can drop down into its MLPs, both Kinder Morgan Energy Partners L.P. (KMP:NYSE) and El Paso Pipeline Partners L.P. (EPB:NYSE), which will help funnel cash back up to Kinder Morgan Energy Inc. to help grow its dividend. It’s a well-run company with one of the better management teams in the space, and there are a lot of synergies from buying El Paso. Kinder Morgan originally talked about $350M in synergies, and now it’s gone up to $400M.
TER: Kinder Morgan Energy is a C-corp, not an MLP. Is there any advantage to the C-corp?
SM: Not particularly. They own a lot of similar assets compared to MLPs, such as pipelines, terminals, gathering and processing plants. The big difference about a C-corp common stock is that it is a taxable entity, and it’s a common stock, so you get qualified dividend tax treatment. Being a C-corp doesn’t really offer many advantages other than possibly more trading liquidity, depending on the size of the company.
TER: What’s your next promising name?
SM: We like Williams Companies Inc. (WMB:NYSE). The current dividend yield is over 4%. We expect dividend growth over the next 12 months of about 22%, and our target price is $37. I think the interesting thing about Williams is that it has really set up a promising footprint in the Northeast. We feel it is going to become one of the dominant players in the Marcellus and possibly Utica shale plays. It has a great set of pipeline assets in that region, as well as in western Canada. It has one of the best balance sheets and we think the company will see continued volume increases in the Northeast from gas and liquids production.
Williams’ Transco pipeline goes from the Gulf Coast up to the Northeast, and I think it is one of the better pipelines in the U.S. It is close to the Eastern Seaboard, and there will be a lot of expansion because of increases in demand from utility companies. There could be upward of a couple billion dollars of expansion projects on that pipeline alone because of increases in power generation and ongoing abundant gas supplies.
TER: Who else stands out in this space?
SM: I would say another one right now would be Atlas Energy L.P. (ATLS:NYSE). This is more of a small-cap name. The current yield is about 3.3%, but it has the highest distribution growth of any company that we cover right now. The distribution is currently $1 per unit, and we see it growing to $1.87 per unit for the full year 2013. Atlas is unique in that it owns the general partner of two separate companies. One company is Atlas Resource Partners L.P. (ARP:NYSE) and the other is Atlas Pipeline Partners L.P. (APL:NYSE). The Atlas Pipeline assets are in some of the best basins—Oklahoma, Mississippi and West Texas—where there is a tremendous amount of expansion opportunities. We believe Atlas Pipeline will be growing cash flow by 10% or so over the next year. Atlas Resource Partners is a unique exploration and production (E&P) company with very little debt on its balance sheet that has been out buying assets from distressed E&P companies. The combination of the organic build at Atlas Pipeline Partners and the acquisition and production growth story at Atlas Resource Partners is fueling Atlas Energy L.P. Our target for Atlas Energy L.P. is $48. We see a lot of upside there.
TER: Stephen, is there one more you can mention?
SM: One last one I would mention is Energy Transfer Equity L.P. (ETE:NYSE), which has a current 6% yield. We have the distribution growing 10% next year. Energy Transfer Equity recently purchased Southern Union Co., and its subsidiary, Energy Transfer Partners L.P. (ETP:NYSE), is now in the process of acquiring Sunoco Inc. (SUN:NYSE), which owns an interest in Sunoco Logistics Partners L.P. (SXL:NYSE). I think the purchase of Sunoco is an important step for Energy Transfer as it adds an oil pipeline, storage and refined product business that it didn’t have before. This will help diversify Energy Transfer. Sunoco Logistics already had strong excess cash flow, a good balance sheet and a unique footprint with over 5,000 miles of oil pipelines in the Midwest, as well as a sizeable oil storage position along the Gulf Coast and some refined product terminals in the Northeast. It’s very well positioned for the increasing oil production flows in the United States, and I don’t think Energy Transfer Equity is getting full credit for the Sunoco purchase yet.
TER: Thank you, Stephen.
SM: Thank you.
Stephen Maresca is a managing director of Morgan Stanley covering energy Master Limited Partnerships (MLPs) and diversified natural gas companies. Prior to joining Morgan Stanley in 2008, Maresca spent 10 years at UBS focused largely on the energy sector. From 2001 to 2008 he was a director in UBS’ equity research division covering energy MLPs. From 1998 to 2001 he was an associate director in UBS’ investment banking energy group and from 1997 to 1998 he was in PaineWebber’s fixed income department. Maresca holds a Bachelor of Science degree in accounting from Providence College and the Chartered Financial Analyst designation. He is a member of the New York Society of Security Analysts.
Examining the macro-economic environment is how Jim Letourneau, publisher of the Big Picture Speculator, likes to begin his stock-picking process. However, his understanding goes beyond headline news to reveal surprising investment themes with profit potential. In this exclusive interview with The Energy Report, Letourneau talks about the hype and commodity investment cycles and where to dig for blue-sky stocks.
The Energy Report: You publish the Big Picture Speculator. What does that title imply?
Jim Letourneau: I believe the macro context is often more important than the details about an individual company. I read a broad range of material every day that helps me form my views, and one of my best skills is putting together the big picture and connecting the dots for audiences. A recent example of my method is my coverage of the natural gas sector, which focused on how the abundant supply of natural gas has led to a complete shift in the types of companies that people should be following. Rather than natural gas producers, investors should find companies that are consuming natural gas, like Methanex Corp. (MEOH:NASDAQ; MX:TSX; METHANEX:SSE), Westport Innovations Inc. (WPT:TSX) or Energy Fuels Inc. (EFR:TSX). These companies are in great shape because their costs are significantly lower. That’s a huge big-picture shift, but people get bogged down in all of the debates about fracking and other controversies.
The bottom line is the U.S. now has the cheapest natural gas in the world, and that’s not a horrible problem to have. When I talk to technical people, we just look at each other and think this is a miracle. No one saw this coming.
TER: As a geologist, how does your technical knowledge shape your investment decisions? What do you look for in potential investment opportunities?
JL: Technical knowledge includes pluses and minuses. In general, the types of companies I look for are usually going to have a market cap of under $100 million (M) and for me to get excited about them, they have to have the potential to surmount that $1 billion (B) market cap. So there’s a potential tenbagger upside in them, if everything pans out. That potential could be in the form of a new technology backed by a critical management team or a higher-quality mineral property. Either way, management teams are critical for these types of things to play out.
TER: How far down in market cap do you go when considering investments?
JL: Sometimes I go down too far, but I think $50M is better than $5M. While you can argue that it’s easier for a $5M market-cap company to go to $50M, your odds start to dwindle. It’s a matter of finding that balance point. Obviously, it’s nicer to buy a company cheap and have it grow into something bigger, but the company is usually cheap for a reason. I don’t want to have to write about 50 companies a year that didn’t quite make it. I’d rather go up the food chain a little bit and follow ones that are going to survive, and whose progress we can track year by year.
TER: You spoke at the Cambridge House Energy and Resource Investment Conference in Calgary on March 30 and 31. What subjects did you cover?
JL: My keynote talk was called “Making Money Using Commodity and Hype Cycles.” I overlayed two kinds of cycles: The commodity cycle is a longer cycle that we’ve been in for over 10 years now. Hype cycles refer to heightened public awareness of a new technology or a particular element on the periodic table that hasn’t been speculated on yet. A recent example would be graphite. Uranium is another really good example of a hype cycle; there was a huge amount of interest about eight years ago and hundreds of companies were formed. Investors were making lots of money with uranium stocks. Then it all withered away. There is still opportunity because some of those companies are still around and advancing their businesses.
I also did a workshop called “How to Find Billion-Dollar Companies,” where I mentioned some of the companies I like that have market caps near $100M with the blue-sky potential to get up to the $1B level.
TER: What do you think the potential is on a percentage-wise basis of finding billion-dollar companies?
JL: The odds are challenging. This is more speculative and it’s much higher risk than a nice dividend-paying stock with cash flow. These companies have lower market caps for a reason; there is either skepticism about the technology or a lot of competition. We don’t need 100 new rare earth mines, but maybe we have 100 rare earth companies. So which companies are going to win that race? It’s a bit like horse racing; you pick your favorites. The odds are you’re not going to win on every one of them.
TER: For a company to get to a $1B market cap these days is probably going to involve some acquisitions and consolidations, unless it really has some amazing property or technology.
JL: That’s very true. Sometimes companies just lay it out and if you can see that it can get the sales and the trajectory, it is certainly possible, and it does happen. It’s a challenge, and that’s what we’re looking for.
The other important part of the stock-picking process is the timeframe. The commodity cycle has a long-term timeframe, whereas the hype cycles can be pretty brief. Eventually, the market turns and the interest goes away. The challenge for these companies, if they have something real, is to keep moving the project forward until the next hype cycle comes around, when people get really interested again. If you’re investing in equities related to commodities, you’re speculating both in the market and on commodities. Sometimes you can have the right commodity, but the company you pick doesn’t follow that commodity’s price performance very well.
TER: Can you point to any companies you’ve seen in the last few years that have turned out that way?
JL: There are a few. To be honest, the other part of this strategy is that for every company that I talk about and like, there are probably 100 that I don’t. There’s a lot of screening and filtering to get rid of the ones that don’t have the potential. One company that I like right now is a biotech that I think we’re at a triple on right now called biOasis Technologies Inc. (BTI:TSX.V). It has a protein that can cross the blood-brain barrier. Therapeutic molecules can be conjugated to this protein, allowing it to cross the blood-brain barrier. This can dramatically increase an existing drug’s effectiveness. That’s one. We found it under $0.50, and now it’s in the $1.40–1.50 range.
DNI Metals Inc. (DNI:TSX.V; DG7:FSE) has also performed really well. While it’s down now, it had gone from around $0.20 to more than $0.60. I like it because it’s pushing the frontiers a little bit. It has a very large, black shale metal deposit in northeastern Alberta, a bit north of the oil sands. Historically, very few geologists studied shales, but they’ve become more popular now because of shale oil and gas. The Alberta Geological Survey has done numerous studies going back to the early 1990s that mention an anomalous metal content in the Second White Speckled Shale. The grades are really low, but the deposits are very extensive. There are huge resources in place containing a whole cocktail of meterials, including rare earths, nickel, iron, vanadium, uranium, zinc, copper, cobalt and molybdenum. It’s almost a conceptual play in some ways. Although the grades are not stellar, they are a little bit higher than we’d expect anywhere else.
So it’s a resource-in-place story, but it’s also a technology story because we’ve seen other industries dealing with a low-grade resource that suddenly become economic plays because of technological breakthroughs. The best example of that is probably shale gas, where people knew for a long time that there was gas in these shales, but nobody was really making any money from them. New technology comes along, and suddenly these shale deposits are worth a lot of money.
For DNI Metals, the challenge is how to get the metals out and make money doing it. The best method to extract these metals is pointing to a technology called bioleaching, which is being used by a company called Talvivaara Mining Co. Plc. (TALV:LSE) in Finland. That’s the exciting part that’s pushing the frontiers.
TER: Are these metals pretty much disseminated throughout this whole deposit, or are certain metals concentrated in certain areas?
JL: The metals are widely disseminated within a fairly uniform and consistent material. That makes it similar to coal or potash mining, where the ore bodies are tabular in shape. They may not be exciting, but at least you know what to expect and you can plan very large operations around that.
TER: With bioleaching, is in situ recovery (ISR) an option?
JL: There may be some way to use ISR, but the bioleaching at Talvivaara involves actually digging it up, piling it onto pads and leaching it by letting the bugs do their work and make acid. But there may be a way to apply in-situ technology in the upper zone. Bioleaching in heaps seems to be the approach with the most potential at the moment.
The value of the minerals in this shale is probably $40 per ton (/t). Extracting the metals for less than $30/t is the challenge. No one’s done it before, so there’s a lot of skepticism. I think a really big mining company would eventually take interest in this because it’s the kind of project that, if it can get up and running, has a life-of-mine potential of over 100 years.
TER: You mentioned uranium earlier. Despite Fukushima, people are realizing that nuclear is here to stay and one of our best sources of energy generation for the foreseeable future. Is there still life after its hype cycle has ended?
JL: I think uranium’s future is very bright and it is a critical part of the world’s energy matrix. We can’t really afford to just turn it off. There actually are a lot of benefits to using it. In terms of the actual price of uranium, the market may not be as excited about it yet, but Russia said it will not renew its supply agreement with the U.S. so analysts are anticipating shortages starting in 2013, which isn’t that far away.
TER: What other companies would you like to comment on?
JL: I like the uranium companies that use ISR technology. The main plays I’ve been considering are either in Wyoming or Texas, where you don’t get the really high grades that you find in the Athabasca Basin. There were hundreds of uranium explorers in the Athabasca Basin and the only one that’s really been successful for investors was Hathor Exploration Ltd., which was recently acquired by Rio Tinto (RIO:NYSE; RIO:ASX). With an ISR uranium project, you have a degree of certainty that a company will actually be able to build the mine and get it into production.
There are three companies in that space that I like. Going from the smallest market cap to the biggest, there is Ur-Energy Inc. (URE:TSX; URG:NYSE.A), in Wyoming. It’s on track to be a producer very soon with expected permitting for its Lost Creek mine early this summer. Then it will be able to get its mine into production probably within six months.
Uranerz Energy Corp. (URZ:TSX; URZ:NYSE.A) is a similar company in Wyoming. It has actually started its mine construction and is looking to start producing 600–800 thousand pounds (Klb) uranium/year very shortly. Both are very near-term production stories.
The last one, Uranium Energy Corp. (UEC:NYSE.A), is currently producing in Texas. It has an inventory of projects coming online and the company announced property acquisitions in Paraguay and Arizona earlier this year. These are all companies with uranium resources that, once their facilities are built, enable extremely long production runs. Typically, they’ll have a centralized uranium processing plant and all of the mines around it will be satellite projects.
The challenge for all of these companies has been permitting. The various U.S. government regulatory bodies didn’t really have anyone qualified to evaluate ISR projects because there haven’t been any new ones developed for decades. The absence of a competent regulatory structure has slowed down progress on getting these mines built. These companies have typically spent a year or two longer than they expected on the regulatory process; it’s not a reflection of any gaps in the quality of their projects.
TER: At least the regulators are willing to permit these operations, which apparently was quite a problem for a while.
JL: That’s a very good point. These are viable, useful industries with quite good safety records and low environmental impact. Again, I like to talk about the big picture.
TER: What sort of capital costs do these uranium ISR projects have?
JL: There’s a range, but the costs are usually $20–30/lb. But these companies are pretty comfortable that they can eke out a living at the current uranium price, which is not going to encourage a whole bunch of new projects to come along. They’re anticipating higher longer-term prices, which should make them quite profitable.
TER: Do you have any thoughts on the current gold market?
JL: I just tell people to look at a 12-year gold chart. Gold is probably the best-performing investment product over that timeframe. I personally don’t think gold has that critical a role in the monetary supply, but it is a place to preserve wealth and look for protection. This recent consolidation pullback is probably an opportunity, but people need to remember that bull markets don’t last forever. However, gold still has legs right now, and the trend is your friend.
TER: Looking at the “big picture,” what do you suggest people do to figure out how they should invest their money these days?
JL: Investors have to do their research and be informed. We are in dangerous times. A lot of assets are correlated so it’s hard to find safety. Sometimes maybe the best safety is not even being in the market, which I hate to say. I like finding good companies that are going to grow into viable businesses. But the markets are not kind, and we’ve seen what can happen when the flow of capital gets turned off. The valuations of publicly traded companies, big and small, in all sectors, tend to drop in unison, even precious metals prices. It’s important to be mindful of the downside. I look for upside opportunities because I’m an optimist and I assume that life will go on.
We do have some structural issues in the financial system. If that breaks down, you really don’t want to own anything that’s not tangible. That’s the strongest investment thesis for owning hard assets. That doesn’t mean owning shares in a hard asset company; that means owning the physical hard asset. If you own a car, a house or some gold, those things will still be around no matter what happens to the money supply and currency valuations. The monetary system is a wild card, and that’s the thing that keeps everybody nervous. We can make informed guesses, but nobody really knows how that’s going to play out.
TER: We appreciate your time and input today.
JL: My pleasure.
Jim Letourneau is the founder and editor of the Big Picture Speculator and is a professional registered geologist living in Calgary, Alberta. He has over 20 years of experience in the oil and gas sector.
With energy prices flat to down in a murky global economy, MKM Partners Managing Director Curtis Trimble says investor agility is essential. In this exclusive interview with The Energy Report, Trimble talks about his favorite names and some of the fuel-rich plays that make them interesting.
The Energy Report: Curtis, what is your overall theme right now?
Curtis Trimble: Agility is probably the best theme I could come up with for the current environment. The debt overhang and political gridlock in the U.S. combined with similar events coming out of the European Union around the viability of Greece, Italy, Ireland, Spain, Portugal, et cetera have been unnerving. In the energy market, and crude oil in particular, China remains the 800-pound gorilla with somewhere between 40–50% of world crude oil demand stemming from its growth expectations.
TER: Clearly the global economic outlook is not optimistic for the near- or even the mid-term. What does that mean for energy prices?
CT: While we have seen some substantial discoveries off the coasts of West Africa, Brazil and even the U.S.—off the Gulf of Mexico along with crude oil coming out of the Bakken and Canadian Oil Sands.—there is nothing in the next three-year landscape even close to the level of discovery successes we’ve seen over the past three years. I will use Will Rogers’ adage to buy land because they are not making any more of it, and for all intents and purposes that is going to apply to crude oil as well.
I think you are going to have a much wider trading range than what we have seen in the last year with West Texas Intermediate (WTI) lows in the mid- to high-$70s per barrel (/bbl) and highs in the $120/bbl range. A lot of that is going to center on expectations not only for current economic conditions, but probably more importantly over an 18-month out view for future economic growth. Again, China will remain amongst the most important drivers for those crude oil price expectations.
TER: Do you have a timeframe for reentry into economic growth?
CT: I think it is probably going to take 12–18 months to get some solid insight into U.S. policy and the other developed markets I just mentioned. Most likely we won’t gain any clarity until we work our way through the election season, and that is still a year off. We will continue to see gridlock as a policy response here. Without U.S. leadership, it is going to be very difficult for the balance of the world to step up and make adequate policy decisions to rectify their economic shortcomings.
TER: Will energy prices lead or lag economic growth?
CT: I think one of the more interesting phenomena we have seen over the last 12 months is crude oil as a store of value. My guess is that we are seeing some trickle-over from gold prices, which have historically been an inflation hedge. Gold prices have become quite heavy over the past few years, and some of that is expectation for hard assets, which is propping up crude oil prices. I would expect more of that based, again, on the scarcity argument. Over this next 12–18-month period we will likely see crude oil prices lead and prepare for reinvigoration of economic growth.
TER: Do you have a near- and mid-term forecast for oil and gas?
CT: Sure. For 2012, our estimate for WTI is at $90/bbl, and our estimate for natural gas is $4.16 per million British thermal units (MMBtu). Certainly if we continue to see what I deem a store of value phenomenon for crude oil, that $90/bbl level likely will prove conservative. But, in terms of generating valuation estimates for equities, I would rather be conservative than not, especially given the backdrop of volatility that will likely continue into the foreseeable future. As we look further out, we’ve got a 2013 estimate of $100/bbl. We see recovery in natural gas prices to $4.75/MMBtu as we move toward that 2013 timeframe.
TER: How does an MMBtu correlate to an Mcf (thousand cubic feet) for natural gas?
CT: It’s basically a 9% differential in the conversion. It’s going to end up being a rounding error in terms of generating valuation estimates for equities.
TER: Do you use them interchangeably?
CT: Yes, I generally use them interchangeably.
TER: Are energy equities a value now?
CT: I generally break up the various cohorts into micro-, small-, mid- and large-caps. I think the mid- and large-caps are reflecting fair value right now. The smaller guys, where we generally anticipate outsize growth and merger and acquisition premiums occurring, are probably a little ahead of their value, given near- to medium-term crude oil and natural gas price expectations.
TER: Do you expect to see value created before we emerge from these flat to downward trending energy prices?
CT: Given the overall backdrop of questionable economic conditions, flat to rising service costs and transportation issues concerning some of the quickly emerging shale basins, such as the Eagle Ford and the Marcellus, I think value creation in equities is likely going to be a function of takeout premiums and/or the actual realization of those takeouts. I think it is going to be difficult for the small-caps through micro-caps to post the outsize growth and value realization over the next 12–18 months. That’s not to say that reserve values in 2013, ‘14, ‘15 and beyond aren’t significant for these guys; I just think they are probably ahead of themselves.
TER: You speak about rising costs and transportation constraints that are a negative for small-cap companies, but I’m noting that at least two of your three top picks are small-cap energy companies.
CT: Generally, you see a pretty significant disconnect between small- and micro-cap companies’ ability to develop and bring their reserves on and realize that significant growth. The factors that discount future cash flows include constrained credit, access to capital markets and the headwinds of a higher-cost environment. It takes these guys a little bit longer to put the pieces of the puzzle together and bring those reserves to production. Nevertheless there are a couple of guys out there such as Gastar Exploration Ltd. (GST:NYSE) and Energy XXI (EXXI:NASDAQ) that we think are on the cusp of being able to realize significant production ramps. But truthfully for many small companies, it’s going to end up being a function of near-term oil performance.
TER: Do you expect smaller-caps to outperform in 2012?
CT: I think it’s going to be difficult for them next year. I would expect credit conditions to remain tight and natural gas prices to remain low compared to the 10-year historical price average. And even though many of the micro-cap and small-cap companies have a fairly substantial legacy base of natural gas reserves and production, I think it will be difficult for the average company to see significant reserve value expansion, and therefore their access to credit facilities is going to be difficult. I think it’s going to be difficult for the average company to do much better than it may have done in 2010 and 2011.
TER: Curtis, what are Q3 earnings telling you? Did you note any trends from earnings calls?
CT: One overarching trend you will see time and again is that investors will continue to latch on to outside positive news, and certain stocks will continue to benefit from incrementally beneficial news flow. For example, we have seen stocks like Rex Energy Corp. (REXX:NASDAQ) with significant exposure to the Utica Shale and upside from a Utica well bid up substantially in the context of a down-trending market. The counterpoint is GMX Resources Inc. (GMXR:NYSE), which produced a marginal initial well at its Bakken program and traded down significantly. So we see many illogical moves in the market in response to news flow.
Another overarching trend is the market’s ability to extrapolate companies’ positive results, such as the Wolfcamp results from EOG Resources, Inc. (EOG:NYSE) and Pioneer Natural Resources Co. (PXD:NYSE) across a wider base of companies, such as Concho Resources Inc. (CXO:NYSE), Approach Resources Inc. (AREX:NASDAQ) and Clayton Williams Energy Inc. (CWEI:NASDAQ). We are seeing some return to logic and the desire to extrapolate reserve value across equities out of third quarter earnings, which is interesting in the backdrop of a flat overall market.
TER: I believe you have about 18 companies in your coverage universe. What are your top picks?
CT: Chesapeake Energy Corp. (CHK:NYSE) has been one of our top picks for the mid- and large-cap space. It recently announced a substantial joint venture for its Utica Shale position, which is on the magnitude of 1.5 million acres. Shares actually traded down on the heels of that announcement, and I think that has more to do with investors’ distrust of management’s ability to constrain capital expenditures for incremental acreage acquisitions than it does for anything operationally with the company. That’s unfortunate, in my opinion, because I think its convergence to substantial liquids production from an extremely large base in natural gas production has gone extremely well. Management has basically grown its liquids production to the size of a Continental Resources Inc. (CLR:NYSE) in a matter of 18 months. Yet we don’t see that reflected in the share price.
As we look to some of the smaller companies, Gastar Exploration is a micro-cap company that I expect good-to-very good things out of in terms of reserve and production growth. I think the Marcellus program has been extremely aggressive for a company its size and is going to be the primary catalyst for that growth. Gastar should have upwards of 14 wells drilled and completed with potential for production over the next two quarters. For a company that is basically at 20 million barrels per day (bbl/d) of production ending Q3, that prolific basin should be a distinct and substantial equity value driver in a fairly compressed period of time.
TER: Do you expect to hear market-moving information on Gastar’s Marcellus play by the end of the year?
CT: I do. It has a handful of wells that are in various stages of completion that should turn to production between now and year end.
TER: You recently raised your target price on Energy XXI from $32 to $36. It’s a mid-cap at $2.3B. Why do you like it?
CT: Energy XXI has a number of tailwinds at its back right now. A significant premium is being paid for Louisiana Light Sweet crude oil, which is likely going to add somewhere between 10–15% to its cash-flow. Also, it has an extremely deep bench of potential drilling projects, including what appears to be an absolute homerun acquisition of some legacy Exxon Mobil Corporation (XOM:NYSE) properties contiguous to its shallow-water Gulf of Mexico core operations. Then there is its ultra-deep exploration portfolio in which it is participating with McMoRan Exploration Co. (MMR:NYSE) and several other partners. The Davy Jones, Blackbeard East and Blackbeard West wells are going down 36,000 feet deep or deeper. Initially, at least, the company is finding absolutely monstrous structures that appear to be a continuation of the extremely large structure found onshore in the transition zones of Louisiana that define some of the most prolific crude oil and natural gas fields in the history of that state.
TER: Energy XXI shares have performed quite well over the past 12 weeks, even with some weather-related issues during Q3. It was the best-performing stock in your coverage during that period. Why has it performed so well?
CT: First, most of that weather issue was related to tropical storm Lee, and that was fairly well known. It is really more of a production deferral than a production loss. Second, the upside performance is related to higher crude oil price realizations than what a lot of folks, including me, expected. And, again, that’s the tie-in to Louisiana Light Sweet crude. And, third, I think its building expectations for a Davy Jones production test sometime mid-December followed by first production shortly thereafter.
TER: Were there some small caps that you could talk about?
CT: A number of small caps looked comparably attractive in the long-term. One name worth some attention is Goodrich Petroleum Corp. (GDP:NYSE), which has become quite active in the Eagle Ford Shale and was among the first to investigate the Buda Lime Shale. This is another company transitioning out of lower value legacy natural gas assets to more liquid-rich crude oil driven areas like the Eagle Ford. The company has to work its way through some liquidity issues, and questions still remain to some degree about funding the 2012 capital budget. But, I think if it continues to post Eagle Ford results like it has the past few quarters, those liquidity concerns will give way to enthusiasm for growth in the crude oil volume.
TER: Are you implying that the Eagle Ford play has not been discounted into the stock price?
CT: Not anywhere close by my estimates. And, in a number of instances we see capital flowing disproportionately into larger players like Petrohawk Energy prior to its acquisition by BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK). EOG Resources continues to be on a very nice run in the Eagle Ford. Pioneer Natural Resources is also realizing some benefits there. But, I think the smaller-cap players have been disproportionately affected by transportation issues and have yet to fully realize the same degree of value as have the larger players such as Swift Energy Company (SFY:NYSE).
TER: Was there one more small cap?
CT: A large one that I would point to is SandRidge Energy Inc. (SD:NYSE). I’ll call it a Chesapeake junior, if you will. I say that because Chairman and CEO Tom Ward was one of the co-founders, president and CEO of Chesapeake before leaving that company and striking out on his own to build SandRidge. In terms of investor sentiment, SandRidge is quite striking in similarity to Chesapeake as well. The thesis of asset quality has been working for me over the past 5-7 years and ultimately it wins out. I believe SandRidge will continue to put points on the board with its oily growth out of the horizontal Mississippian and, certainly, as it continues to bring growth to the forefront of its Central Basin Platform property.
TER: Will SandRidge be able to fund its greater capex requirements associated with other projects?
CT: It will, and 2012 should not be at all problematic for SandRidge.
TER: A while back you said that small-cap GMX Resources Inc. was your top pick. How do you feel about it now?
CT: We maintain a Buy rating on it, and I think the shares are worth $5 as our estimates stand now. But, largely that is going to be predicated on the balance of the near-term well results. If we see further evidence of marginal performance out of the Bakken program it’s going to be very difficult to remain bullish on GMX without some substantial step-up in well performance.
TER: You have ATP Oil and Gas Corp. (ATPG:NASDAQ) rated as a Buy. It has had good relative strength over the past 12 weeks. You have a $16 price target on the stock, and that implies a substantial return of more than 100%. What is your thesis here?
CT: Our thesis remains intact. By my estimates, ATP was probably the most negatively affected by the federal government drilling moratorium after the Macondo oil spill tragedy, largely because it carries a substantial amount of leverage with about $2 billion of debt outstanding. Its largest development program, Telemark, was on the cusp of first production when that drilling moratorium was handed down. That put the company’s ability to pay down its debt load in a significant lurch. The forecast for Telemark was to have peak production of 30 thousand bbl/d, which would have more than doubled the company’s existing base of production. In a very recent conference call, the company noted that the production rate on one of the three wells in production has been lowered, which should act as a production deferral rather than a production loss. But investors have reacted negatively.
TER: Thank you very much for the time.
CT: I appreciate your time as well.
Curtis Trimble joined MKM Partners in August 2010 as an analyst covering the oil and gas exploration and production (E&P) sector. Mr. Trimble previously covered the U.S. E&P sector for Natixis Bleichroeder, ranking second in the 2010 Wall Street Journal analyst survey for that sector. He also followed the oilfield services sector for Canaccord Adams and Sterne Agee, ranking fourth in that space in 2006. Mr. Trimble holds a Bachelor of Arts in economics from Swarthmore College and a Master of Business Administration with a focus in finance from Rice University.
After nearly 30 years as an investment banker and another 20 years providing consulting to small companies, Newport Capital Consultants Founder and President Gary Bryant knows all the ins, outs, risks and rewards of small-cap investment. In this exclusive interview with The Energy Report, he shares his knowledge on what factors push small- and mid-cap growth, as well as some surprising new business models changing the dynamics of shale drilling.
The Energy Report: Gary, can you tell us about your background in small- and micro-cap stocks? You have a special interest in these.
Gary Bryant: I do. The microcaps and smallcaps have been my expertise for a number of years. I got in the business in the ’60s, and in December 1963 I got a securities license. In 1965 I was fortunate enough to start my own brokerage firm, Anderson, Bryant & Company with my partner Anderson, and we did a lot of small-cap deals through the years. I was lucky enough to be one of the founders of the Regional Investment Bankers Syndicate, which was the forerunner to the National Investment Bankers Association. That began in response to deregulation in securities markets in ‘78, which made it difficult for small-cap brokers to operate because the large-cap brokers could no longer do business with them on those syndications. It worked really well, and we were able to syndicate a lot of offerings that way.
TER: You have said that the small- and micro-caps are key to a vital economy. Can you elaborate on that?
GB: In the United States of America, it’s the real way to employ people in the absence of large-scale manufacturing. But small companies need funding, and it’s been a lot harder since September 11 to get anything done. Some of the small-cap companies that I have helped fund went from zero employees to 1,200 in a matter of three years.
TER: Aside from obvious liquidity issues, what are some dangers of investing in small- and micro-cap stocks?
GB: Let’s say you buy an SEC Rule 506 private placement, and you put $25,000 into it. These have to be accredited investors, meaning sophisticated, high net worth corporate or institutional investors. Thus, most of the time companies do get pretty good amounts of money. But what happens if they sell to only five or 10 investors and raise a quarter of a million dollars when the business plan calls for $1 million (M) or $2M? If you’re stuck in a company that didn’t get enough funding, you stand a good chance of losing your money.
Another problem is that even after they’ve raised capital, a lot of small companies don’t have sales to justify being public. It happens all the time. However, there are many counter-examples that do get enough funding to successfully go public.
TER: Gary, what do you do for companies today?
GB: I consult for these companies and introduce them to investment bankers and capital markets. I was an investment banker all my life, and I know that business very well. I have strong relationships with broker dealers around the country.
TER: When you take a micro-cap deal to an investment bank, what’s the first question they want to ask you?
GB: The first question is always, “What are their sales?” Most investment bankers qualify companies based on their sales. If your company has $1M or less in sales, then it’s definitely a startup. If you’re anywhere from $2M to $10M in sales, you’re barely getting started. They can work with you a lot better at $50M or $75M in sales.
TER: Does the investment banker want to know how much of this stock you are going to buy, and how long you will hold it?
GB: Not really. I often put my own capital into companies. And if I do, I’m sure to tell them about it. But they would rather I own stock than not.
TER: Aside from lack of sales, what conditions would prompt you to advise a company to wait six months or a year to go public?
GB: Sometimes companies want to go public, but they frankly just don’t need to be public. The management doesn’t have the experience to be in a public arena. Sometimes companies go public too soon. For example, a fast-growing company may only have $2M or $3M in sales, but its product is good and it is likely to increase sales to $10M the next year or $20M the next. It would behoove the company to hold off until bigger brokerage firms are considering underwriting the company, and when it could get a bigger offering and a much higher market cap.
TER: Does the investment bank want to see that management has mortgaged their houses and gone to their family and friends first?
GB: Sure. That’s usually the way it starts out. I’ll just give you an example: The founders of the company sometimes put their money in before going to friends and family. The friends and family are usually accredited investors, and will invest half a million or $1M. That will be enough to push the company to the next stage, where they can do another larger private placement and later go public.
TER: What’s the sweet spot in market cap size where a company is small enough to give investors huge gains but large enough so that mutual funds can own it?
GB: It’s different with almost every company. Generally, companies under a $75M market cap sometimes have mutual funds and hedge funds investing, but not often.
TER: I think you were the lead consultant on Petro Resources, which was later taken out by Magnum Hunter Resources Corp. (MHR:NYSE.A).
GB: That’s true. The other day I had the pleasure of talking with Brad Davis, senior vice president of capital markets at Magnum Hunter. The stock came down considerably from $8 to around $4. He said the company was three times better off than it was at $8, yet the general public is not paying the price for the stock. Sometimes stocks trade in a certain range.
Magnum Hunter bought three companies in the past two or three years that had sellers in them, and all of a sudden they get the benefits of a New York Stock Exchange company with a lot of liquidity. I think this is one factor that has caused the company to sell off. You never know.
TER: You’re interested in shale-fracking technology. Will this become the new conventional technology as low-hanging fruit dries up?
GB: Absolutely. Hydraulic fracking on shale plays is a tremendous invention. Ten years ago this technology was not developed. As a young man going to high school, I worked on some drilling rigs just to make enough money to buy a car. But when we hit shale, it was a really bad situation. Today they’ve learned how to go down to depth and then go two miles horizontally. I saw them fracking one of the Barnett Shale wells the other day. It is definitely the new-and-improved process with horizontal drilling.
TER: Do you have any favorite shale-fracking companies?
GB: Certainly. I like the major players, such as Continental Resources Inc. (CLR:NYSE), Devon Energy Corp. (DVN:NYSE) and Williams Companies (WMB:NYSE). They have been doing a lot with these particular formations. Now Magnum Hunter has interesting plays in the three big shale formations: the Eagle Ford, the Marcellus and the Bakken. Of course, there are a lot of other shale players too, like GMX Resources Inc. (GMXR:NYSE) on the border of Texas and Louisiana. It’s a gas play, and it’s doing pretty well.
TER: Are there any small- or micro-caps you have good feelings about right now?
GB: There’s one called Eagleford Oil & Gas Corp. (ECCE:OTCBB) and another called U.S. Energy Corp. (USEG:NYSE), which is run by the Larsen Family. U.S. Energy appears to be doing very well in the Bakken formation in addition to having success in its Wyoming production. I like Lucas Energy Inc. (LEI:NYSE.A). I like CAVU Resources Inc. (CAVR:OTCPK). Billy (William C.) Robinson is the CEO. He’s kind of changing his tune on how he’s doing business, as are others who are discovering opportunities in the sector beyond oil itself. For example, Xtreme Oil & Gas Inc. (XTOG:OTCBB) and CAVU are both drilling water disposal wells and making quite a bit of money by charging producers for water disposal services. Shale drilling involves getting rid of a tremendous amount of water, which has become a big problem over the last 10 years. For every barrel of oil recovered, some water is also extracted, and it’s not like drinking or ocean water. It’s more of a brine—twice as heavy and loaded with salt and chemicals.
TER: Do water disposal services de-risk these plays?
GB: They do, because the process alleviates an environmental problem by putting water back in the right sand. Companies build what are called saltwater disposal wells, and drill 4,000–5,000 feet, similar to an oil well. They reach a deeper, different type of sand in which they deposit the water, so it won’t touch drinking water sources.
TER: Gary, Xtreme Oil & Gas has been hurt pretty badly over the past 12 months. It’s down about 76% over that period, and it has a market cap of under $14M. Why have investors forgotten it?
GB: Knowing this company as well as I do, I know that it was a Gray Sheet company for years, and there was hardly any market in the stock. So when they registered on the Bulletin Board, it was trading around $1, but lightly. Market breaks have suddenly come in and driven the stock down. I’ve talked to CEO Will McAndrew about this, and the company has earned money two quarters in a row. Its disposal well business should help provide more sales and earnings. It’s one of those situations where the company has been improving but the stock has been going the wrong way.
TER: What do you think would get investors’ attention here?
GB: Making money three quarters in a row would probably do the trick. It needs to attract more institutional buyers and get the word out. I’m a believer in the value of attending conferences. The company has to do more PR and get some publicity from companies like The Energy Report.
TER: That micro-cap size is just a tough nut to overcome.
GB: It’s a very tough nut to overcome. No one has the solution to that. But Will McAndrew can get them out of the ditch. I see it every day. Before the Magnum deal, Petro Resources was a Pink Sheet-type of company, but it went out and raised a lot of money, so it was able to go from Pink Sheets to the American Stock Exchange. A large brokerage firm jumped on them and loaned them $75M to acquire properties up in North Dakota in the Williston Basin. Once companies get the ball rolling, doors open, but that first push is tough sometimes.
TER: Gary, it’s been a pleasure meeting you.
GB: My pleasure. Thank you.
Gary Bryant is the current president and founder of Newport Capital Consultants, Inc., an Orange County, California-based firm that has been providing consulting services to private and public companies since 1991. Since gaining his securities license in 1963, he has gained over 40 years of experience in the investment banking services industry, and was recently involved as a co-founder of the Southern California Investment Association (SCIA), which offers select small-cap companies a venue to present to investment professionals. In December of 2006, Gary received the prestigious “Founders Award” from the National Investment Banking Association, and in October of this year he was honored with a lifetime achievement award from the West Coast Wall Street Conference.
Over the next two decades, liquid and natural gas shales could release a treasure trove of new energy production. But even given this extraordinary new resource, FBR Capital Markets Head of Energy and Natural Resources Research Rehan Rashid expects demand to stay ahead of supply. Rehans’s long-term bullish scenario favors a few select names that he shares with The Energy Report in this exclusive interview.
The Energy Report: Your coverage universe is mid-cap to very large, and I even see a couple of companies under a billion dollars in market cap. Could you tell me your basic investment theory?
Rehan Rashid: We believe an energy supercycle is redefining how we look for oil and gas, thus driving reserve and production growth the likes of which we have already seen in natural gas and are now seeing unfold on the liquids and oil side. And yes, this is applicable to small cap names, perhaps sometimes more dramatically like we’re seeing in Rosetta Resources Inc. (NASDAQ:ROSE) today.
TER: Your list looks to be largely tied to commodity price and perhaps M&A activity.
RR: I’m kind of a commodity agnostic. Instead, we are margin-driven. It’s all about margins and what’s currently priced into the stock. It could be oil, gas or something in between. We are more focused on the platform—the acreage position or the capital structure that goes into a good bottom up thought process.
TER: You just mentioned your supercycle thesis. We’ve already gotten the low-hanging fruit from conventional drilling, but you believe we’re getting this new supercycle of energy from the shales? Is that correct?
RR: Yes. U.S. natural gas production quadrupled from 15 billion cubic feet per day (Bcf/d) in 1950 to more than 60 Bcf/d of dry gas by 1970. That’s kind of when the last paradigm shift finally played itself out and we discovered a lot of what was then known as conventional gas. So, it’s our estimation that yes, history is repeating itself under a different name.
TER: And this momentum is driven by new technology.
RR: Absolutely. The question in the investor’s mind is no longer whether this new reserve or production growth is really happening, but rather what is its magnitude and what is the path that it might take? Also, how fast will this technology facilitate the harder stuff, such as oil shales or liquids development, including processing and all the other above ground infrastructure issues?
TER: How long can this supercycle last?
RR: The answer to that question is probably two-fold. First, we need to know how long it will take for growth to play out. Second, we need to know how quickly the market will recognize the value. Natural gas production took 20 years to quadruple from 15 Bcf/d to 60 Bcf/d in the last go-round, right? So, physically speaking, it may take a long time—a decade, two decades—to get the appropriate volume of oil and gas out of the ground. But the market will stay multiple years in front of that. The market typically likes to stay 6–12 months ahead, but in a growth cycle, it probably goes out 24–36 months. So, in my opinion, the overall evolution of the trajectory of the growth is going to peak 10–15 years from now, and the stocks will price in 12–36 months going forward at any given time.
TER: Okay, in light of that, you’ve lowered your full-year price forecast on natural gas from $5/mcf to $4.80/mcf, but you’re maintaining your 2012 forecast at $5.50/mcf. Why wouldn’t this price drop?
RR: I presume you’re alluding to the idea that the existing supply of natural gas may result in pressures at these levels or even lower?
TER: That’s my question, yes.
RR: That’s a complicated question with a lot of inputs that will drive gas prices higher going forward. In the middle of 2008 and early 2009, we were the first ones to lower the long-term price to $4.50/mcf. We saw what was happening two years ago and said that gas prices would have to correct to these levels before we can talk about any change in direction. We saw that two years ago, but now we’re trying to look further out.
What we’re seeing slowly but steadily now is that the market is responding. Chemical companies are coming back and power generation companies are favoring more and more natural gas. Plus, environmental regulations are making it more difficult to burn coal. So, consumption factors are shifting to favor more demand. In addition, what people forget is that yes, while shale is going through a massive growth cycle, almost 40 Bcf/d of existing supply is old, conventional assets that are seeing no capital investment and is going to decline. I think between improving demand, continued shale growth and declining conventional supply, we will see a balance of supply and demand leading $5.50/mcf gas.
TER: What is your oil forecast?
RR: Well, oil is a much tougher beast because of global drivers. It’s not lost on us that global spare productive capacity is too low. We also see that global geopolitics are for real and manifest themselves in a whole host of different ways. The future of the dollar is under question. So, we will let the broader futures market aggregate all that and come up with a pricing forecast. We will take a 10% haircut off that and build it into our models. In other words, we don’t actively forecast oil prices, but we understand the broader dynamics, and that’s why we’re okay with letting the market set the direction.
TER: From your perspective, is the price of oil U.S. dollar-dependent?
RR: It is dependent on the U.S. dollar, geopolitics, tight spare capacity and, of course, the continued globalization and urbanization growth stories that come of out of China, India and BRIC countries [Brazil, Russia, India, China] in general. It’s dollar; it’s geopolitics; and it’s economy.
TER: We’ve seen some recent pull back in nearly all commodities. Could this be a trend, or is it a normal part of the cycle?
RR: Well, we went from $85/bbl oil to $112/bbl or so. At $4-plus a gallon gasoline at the retail level, demand could be affected. The market is going to react with a correction. The direction of the price will be dependent upon the ability of the world to absorb the higher oil prices, and the U.S. dollar.
TER: Rehan, you have said that the primary risk in investing in oil and gas producing companies is depressed commodity prices. How does the investor manage these risks?
RR: It may be difficult in the near term to be agnostic to commodity prices, but over time, margins, asset growth and production growth should really drive value creation. If oil prices drop, cost structures will also come down and margins will improve again. But you have to endure that yin and yang over time.
TER: Should investors be adding more exploration and development to their portfolio weightings?
RR: Yes, they should because in our opinion at the beginning stages of this supercycle, the risk-adjusted returns are much higher.
TER: How should the companies protect themselves? Is this the time to have capital structure fixed for the future?
RR: It is always prudent to have a reasonable portion of your commodity portfolio hedged in the financial markets. The value proposition for companies is not simply in commodity exposure, but also in value creation from their technical competence. So, yes, we like companies that have cash flows to execute the program.
TER: For equity investors, where are you telling them they should be today?
RR: To be name-specific, we like Pioneer Natural Resources Co. (NYSE:PXD) quite a bit. We like Newfield Exploration Co. (NYSE:NFX). We like Southwestern Energy Co. (NYSE:SWN). We like Endeavour International Corp. (NYSE.A:END). All these companies offer some margin of valuation or asset growth, or they’re not fully appreciated in terms of their platform.
TER: You have Pioneer rated outperform and you said earlier in the spring that the flow rates from its horizontal Wolfcamp drilling would set the price direction for the rest of this year. How is that looking?
RR: Well, the results are mixed so far, but I am probably repeating what the market is thinking. Our opinion is that it’s just the beginning, but there’s so much oil in place and technology will ultimately resolve the gap of where their productivity is today and where it’s going to go tomorrow. EOG Resources Inc. (NYSE:EOG) validated that recently in its earnings call that Wolfcamp and Permian horizontals looked good, and they’ll get better. So initially, Pioneer may be mixed, but the industry’s saying this will get tremendously better.
TER: You mentioned Newfield; your target price is $85, which is an implied return of 20% from current levels. I realize you don’t worry about commodity prices too much, but this is an oil-driven play. If oil settles at current prices, can Newfield achieve your target price?
RR: Yes, we use $90/bbl oil long term in our metrics and we have not adjusted the numbers higher for $110/bbl or anything like that. Our underlying presumption right now is $90/bbl oil long term and Newfield can very well achieve those objectives.
TER: You mentioned Southwestern. What’s the long-term driver here?
RR: Transition to liquids and how successful it will be.
TER: Is there any news on the company’s new stealth play?
RR: Not yet, but we’re expecting it in the third quarter.
TER: You also threw in a small-cap, Endeavour International. Your target price implies a 50% upside. Are there any misconceptions about the risk in this play?
RR: Well, yeah, we think so. We think that the production of the company from its discovered projects alone could be up seven- or eight-fold in the next two years. But the asset base is in the U.K., and the market for small-cap reasons and international-asset reasons has chosen not to give it the appropriate credit. It’s also pursuing a central-Montana heat oil shale play and an Alabama shale play that the company believes looks like the Marcellus. So, yes, to us the risk/reward profile is very attractive given the material development-driven growth and a domestic program that could be a game changer with very minimal capital required.
TER: At current levels, do you think of Endeavour as being value priced?
RR: Yes, very much so.
TER: Okay, so those are your four favorite plays. Did you recommend any others?
RR: No, these are our top four names to think about along with a lot of different things that can happen in the sector at any given day, but we are focused on these four.
TER: I enjoyed meeting you very much.
RR: Thank you.
Rehan Rashid is managing director and head of energy and natural resources research at FBR Capital Markets. He joined FBR in September 1998 as a vice president, covering the oil and gas E&P sector and most recently initiated coverage of the liquefied natural gas (LNG) sector. Prior to joining FBR, he was an associate analyst at PaineWebber, covering E&P and spent two years at Jefferies Inc. He received his BS in accounting and an MBA in finance and accounting from the University of Houston.