Syntroleum Gas To Liquids Economics

| About: Syntroleum Corporation (SYNM)

(Editors' Note: This article covers a micro-cap stock. Please be aware of the ricks associated with these stocks.)

Syntroleum (NASDAQ:SYNM) just signed a "memorandom of understanding" or "MOU" with a US based oil and gas production and exploration company to explore the feasibility of a 4 to 5,000 thousand barrel per day gas-to-liquids or GTL plant. That works out to be about 1.4 and 1.8 million barrels per year, or about 60 to 75 million gallons per year. MOUs are analogous to 8th graders going steady. It is a little more serious than being just friends, but it isn't as serious as a formal acknowledgement of the relationship like an adult giving a wedding ring. In baseball terms, the batter is at the plate. He still has to hit the ball and round the bases before he scores. The key is that MOUs are nice, but I've seen many in the past entered into by other firms that go absolutely nowhere. That may explain why the price of SYNM is up only 3% on the news. By the way, SYNM signed an MOU with Sinopec in 2007, which has yet to really pan out, but at least SYNM is in the game.

That being said, however, this MOU could dramatically change SYNM's outlook and prospects. With a GTL plant, SYNM will no longer be a "one trick pony." Currently, it's only semi-producing asset of any scale is the 50% ownership in the Dynamic Fuels Plant, a joint venture SYNM has with Tyson Foods (NYSE:TSN). They have had and extremely difficult and costly time getting the plant up and running. The plant has been operational for over 2 years and has yet to hit a profitable production run for any extended period of time, and remains shuttered as I write this. Re-start is planned for mid to late July, so that may change in the near future.

The Dynamic Fuels plant is also a biofuels/renewable diesel plant that is heavily impacted by EPA regulations, blender tax credits and an inelastic feedstock. While the economics for the plant are extremely favorable right now, there is always the political risk that an election could greatly alter those economics. A GTL plant would be a nice diversification asset to the SYNM portfolio and allow it to focus on what its main body of patents covers, the Fischer Tropsch process (FT). SYNM also has coal-to-liquids CTL technology as well. Clearly, exposure to GTL and biofuels is a nice way to diversify the political risks inherent in these industries. Right now, biofuels are favored in Washington, but a single election could just as easily put coal and natural gas into the driver's seat.

Fortunately for SYNM, even with the hostility towards carbon dioxide, fossil fuels and fracking in Washington, the GTL economics are extremely compelling. SYNM has a presentation available on their website that covers the economics supporting the GTL plant that I will use in this article.

The first supporting factor is the fracking revolution that is happening in the US and elsewhere that has sent the price of natural gas plummeting. According to the EIA, wellhead prices of natural gas have fallen from over $10.00 in 2008, to under $2.00 in 2012, and are currently around $3.66.

While natural gas prices have been increasing lately, prices are still well off their highs and the potential for future supplies is enormous as this SYNM slide highlights.

The gas conversion rate is 11 million cubic feet (MCF) of natural gas to 1 barrel (BBL) of oil. That puts the break even ratio at about 11mcf/1bbl. Right now 1 mcf of natural gas goes for $3.74 (Note: the conversion factor of 1 mmBTU to mcf is 1.023), and a 1 bbl of crude goes for $106, for a ratio of $106/$3.74 = 28, which is far in excess of the break even ratio of 11/1. There are also operating costs of about $15 per bbl, but that is for a plant 2x the size SYNM mentioned in the MOU. Additionally, the FT process produces fuel, not oil, which produces 18% more in revenues.

Using current market prices for oil plus 18% and natural gas, and assuming a $25 in operating expenses for the smaller plant, the current margin would be:

Oil $ 125.08
Feedstock $ 41.19
OPEX $ 25.00
Margin/bbl $ 58.89
Per Gal $ 1.40

Assuming that SYNM would enter into a 50/50 ownership agreement representing approximately 30 to 37.5 million gallons per year and a margin of $1.40, the plant could provide SYNM with $42 to $52.5 million in EBITDA per year. By the way, that $183 million annual EBITDA mentioned in the slide above represents about 1.5 x SYNM's entire capitalization if the plant was 50% owned by SYNM. That is why I say the economics of the various SYNM processes are so compelling.

The GTL and CTL options are also why I believe SYNM is a better long-term investment than firms like Renewable Energy Group (NASDAQ:REGI). SYNM has a diversified portfolio, and the renewable diesel that SYNM produces is of a higher quality and demands a premium price to the multi-feedstock biodiesel that REGI produces. SYNM's process also uses fewer lbs of feedstock per gallon, and currently has a higher margin according to my internal calculations.

Natural gas and coal are abundant resources with highly elastic supplies, whereas the feedstocks both SYNM and REGI use for their biofuels are highly inelastic, and whose price can vary wildly, as do their margins. The biofuels industry based upon waste oils has a capacity limited by the availability of waste oils, which is relatively small and relatively expensive. The biofuels industry relies on regulatory instruments called RINs to make it profitable. If the presentation slides from SYNM are accurate, GLT doesn't need any subsidies to make it profitable.

SYNM is also involved in a patent dispute with Neste (OTC:NTOIF), which has put a cloud over SYNM while it works its way through the courts. While it recently recieved good news on that front, there are still more disputes to get settled. The Neste patent claim covers both animal fat and vegetable oil, so an unfavorable ruling could be very detrimental to SYNM. A GTL plant would help diversify away some of its legal risk as well.

Lastly, one of the byproducts of the FT process is hydrogen. Hydrogen is a main ingredient of the SYNM Synfining process used at the Dynamic Fuels plant. The Dynamic Fuels plant has also had costly hydrogen supply disruptions in the past, so if the GTL plant is built close to the Dynamic Fuels plant, SYNM may be able to ensure hydrogen supplies as well as create another revenue source, further widening its margins, improving efficiency and diversifying and securing supply chains.

In conclusion; while a MOU is only a first step, it is a step in the right direction for SYNM. A GTL would help SYNM diversify its portfolio, reduce its political risk, greatly increase its profit potential and possibly provide a new revenue source more secure and reliable supply with the FT generated hydrogen. In my opinion, the greatest risk to SYNM right now is cash flow risk associated with getting the Dynamic Fuels plant started, second is the Neste lawsuit and third would be the political/regulatory risk. A GTL plant, assuming that it runs well, would help diversify all those risks. Diversification is one of the advantages that leads me to favor SYNM over firms like REGI that don't have the diverse patent portfolio that SYNM does. By the way, while the MOU didn't mention what oil company SYNM is dealing with, many of the FT patents SYNM uses are owned by Exxon/Mobile. Just something to think about.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I am long SYNM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.