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  • Musings On The Second Great Recovery Experiment And The Promise Of Natural Gas: Ron Muhlenkamp

    Like the economy as a whole, the Muhlenkamp Fund is still struggling to extricate itself from the morass of the Great Recession. Ron Muhlenkamp, founder of Muhlenkamp & Co. Inc., sees a forerunner to this downturn in the 1980-82 recession. In this interview, he tells The Energy Report how good policy ended the earlier slowdown and set the stage for two decades of prosperity. He also explains why bad policy is hampering recovery now, and what this means for investors.

    The Energy Report: Ron, in an online seminar in June, you compared the government's response to the 2008 financial panic and recession with its response to the recession of 1980-82. How are those recessions comparable?

    Ronald Muhlenkamp: We've had 12 recessions since World War II. We had a serious recession in 1973-74, and I've done a lot of work on recessions ever since. The 2008 recession shared a distinction with the 1980-82 recession: Each, at the time, was the most serious recession since the Great Depression of the 1930s. Each was preceded by conscious government policies that were meant to improve the economy. In the 1970s, we printed money in an attempt to negate periodic recession. We got inflation. In the early 2000s, we encouraged-mandated-the writing of mortgages to people with low incomes. We got a housing bubble. We then responded to these two recessions with very different policies, and the policies have produced different results. It is important for us to learn from that.

    The 1980-82 recession followed a decade of high inflation during which an accommodative Federal Reserve was printing money. By 1979 inflation had reached 13%, and most economists believed it was intractable, that it was going to be 10% or more going forward.

    Jimmy Carter appointed Paul Volcker chairman of the Federal Reserve, and Volcker said he was going to break the back of inflation by printing money at a 6% rate. Conventional economists responded by saying, "If inflation is 10% and you print money at only 6%, you'll have a minus-4% real gross domestic product, and you'll have a very serious recession bordering on depression." Volcker said, "I'm going to do it anyway." Within three years, inflation went from 13% to 3%.

    Many economists argued at the time that the U.S. was a slow-growing economy; that the economy was mature, and the like. What Volcker and, later, Ronald Reagan, proved is that bad policy caused the distortion. The first part of the solution was Volcker saying, "I'm going to restrict the growth of the money supply." The dollar was weak, which is why Carter appointed him. What Volcker proved is that real growth under proper policies is stronger than inflation; that you could, in fact, lick inflation by restricting the growth of the money supply.

    When Reagan was elected, we were in recession. To get the economy going again, he removed some of the burden from the employers and the general public by cutting tax rates and regulations. He essentially viewed the employer as a partner with government in getting people back to work. I refer to this period as the first great economic experiment of my adult lifetime.

    The economic forecasts from the 1970s all predicted continued low growth and high inflation. Reagan and Volcker changed policies, and what we got was low inflation and high growth through the 1980s and the 1990s. That was the first great experiment: These two men led a change in monetary policy and fiscal policy that gave us good growth for a generation.

    I think the reason the 2008 recession was so serious was that in 2005 and 2006, the Fed was raising interest rates and tightening monetary policy a little bit, but stopped short of triggering a recession. Every recession since World War II has been triggered by-not necessarily caused by-the Fed raising interest rates. This time, it raised the rates but stopped at 5.25%, trying to get a soft landing.

    Behind that, it was mandated that if you wanted to be in the mortgage brokerage business, you had to make more loans to people with low incomes. The Fed accommodated this with monetary policy, and accountants instituted a mark-to-market rule on asset holdings, including for regulatory purposes, banks and insurance companies. In 2007 and 2008, as the price of bonds came down, banks and insurance companies, by regulation, had to either raise more equity capital or sell off their bonds. Of course, in selling their bonds, they drove the prices even lower.

    We think the recession ended up being deeper and longer than it would have been without these two changes. In the middle of the 2008 recession, and coming out of it, the Fed continued to print money. The government also told employers that regulations were going up, their taxes were going up, and that they were going to have to pay for increased prices on healthcare.

    In our latest newsletter [Muhlenkamp Memorandum #111], we show what employment costs have done. In January of every year, every one of our employees gets a W-2 form that shows that employee's gross pay, deductions, and net pay. We also give them a statement showing the employee cost to the company, including FICA and health insurance. Ignoring pension and profit sharing, in 1996, just the mandated taxes and contributions to Social Security, plus healthcare insurance for employees, cost the employer $1.53 for every $1 an employee took home. In 2014, that ratio is $1.94 to the employer per take-home $1. Employer costs have gone up $0.41 [which is 27%]. Most of that has been in healthcare costs, but the point is that it's there.

    It's far more expensive to hire someone today than it was back in 1996, or in 2006. We believe that is why employment growth in the latest expansion has been so slow. As employers, we know healthcare costs are going up and insurance costs are going up, but we don't know by how much. We've been promised that our taxes are going up. The same is absolutely true of regulation. Half of the Dodd-Frank rules haven't been published yet. We know there are more rules coming.

    The 1980-82 recession was the first great economic experiment; I call 2008 the second great economic experiment. We are seeing what happens when, coming out of a recession, you flood the economy with money and promise employers that their costs are going up. What we've seen is a subpar response. We have seen about 2% growth coming out of this recession. There was never really a catch-up. Of course, the population grows about 1%, and, historically, we've gotten about 2% productivity. This time, we're getting about 1% productivity. The data is out there for those who choose to look.

    Our company just got the bill for our health insurance for next year, and the quote is up 19%. Our taxes are going up and we know more Dodd-Frank regulations are coming. As a businessman and an employer, it's very hard for me to justify hiring people or putting money out for capital expenditures when these increasing costs have been promised.

    TER: Which specific metrics in the two recessions are directly comparable?

    RM: Many recessions aren't visible in consumer spending. The consumer cuts back on long-term stuff, like housing and autos; those are cyclical purchases. But people don't cut back on food. They don't cut back on what they spend for utilities; they still heat their houses.

    Most recessions are inventory and capital expenditure recessions. Industrial production always cuts back. These factors are common to all recessions, though each recession had certain characteristics that have allowed us to do pretty well in the investing market place for 30 years. Each looks just different enough that people can say it's different this time. But the underlying pattern looks pretty much the same.

    What made 1980 look different was the backdrop of high inflation. What made 2008 look different was the focus on encouraging people to borrow money and buy houses. The public made the house prices go up, while the Federal Reserve was keeping interest rates low. The Department of Housing and Urban Development mandated more mortgages to people in low-income brackets. What we found was that if people bought a house with no money down, they had no stake in it, and they were willing to default and walk away. People didn't do that when to buy a house they had to put 10-20% down. They had a stake in it.

    We used to believe that recessions occurred every three to five years, because in the 1950s and 1970s, they did. When John Kennedy lowered taxes in the 1960s, we got nearly a decade between recessions. Then, in the 1980s and 1990s, we went a longer period of time without a downturn, which I think was due to the success of the response to 1980 policy changes.

    TER: How is the Muhlenkamp Fund doing this year?

    RM: Through June we were up about 5%. We're just a bit behind the Standard & Poor's 500 Index.

    We got hit in 2008. I misjudged the amount of damage that mark-to-market and other changes would bring. I expected the Fed to act differently than it did. We went back and took a look at what happened, and as a result we've added "who might have to sell and how much" to our checklist.

    Normally, hedge funds have to sell any time the market comes down, because they're on leverage. What we got in 2008 were banks and insurance companies that were forced to sell bonds because of the mark-to-market standard of accounting-which, incidentally, the Financial Accounting Standards Board [FASB] quit enforcing in March 2009. I don't know if the rules have been taken off the books yet, but the FASB said, in response to a congressional committee, that it was not going to enforce these rules, and that became the bottom of the market.

    TER: What is the Fed's retreat from quantitative easing [QE] doing to your investment strategy?

    RM: We think that's a move toward normal, which is always good. As a country, we've tried to adjust for poor fiscal policy with monetary policy. The biggest bubble out there is in low-level, short-term interest rates. The Fed says it sees no bubble, but the Fed's causing a major one. The premise was that low interest rates would help people buy houses and encourage companies to build factories. Neither of those is happening, even at normal levels.

    What has happened is retirees trying to live on interest are getting no income. Retirees and pension funds are being squeezed big time. And the reason people aren't buying houses is that they overbought 10 years ago, and they no longer believe housing always goes up. The fact that they can get a cheaper interest rate is not enough, because their perception of the asset has changed. Companies aren't building plants either. They don't know what the rules are. Even if you can borrow money at 3% instead of 6%, if you don't see demand for the plant and don't know what the rules will be, you're not going to build it.

    The Fed set out to get employment up and the economy going. That hasn't happened-but it did help get the stock market up. If the Fed had said four years ago its goal was to get the stock market up, it would have been shot down politically. What [Fed chairwoman] Janet Yellen basically said a couple weeks ago was that the Fed would continue to keep interest rates low because it hasn't worked. She would say it hasn't worked yet, but I would say it hasn't worked.

    Ending QE3 is a move toward normalcy, but it's simply not enough. The best thing you can do for retirees is to allow the return on their savings to go from zero in treasuries or less than 1% on a certificate of deposit back to 2-3%. If that happened, retirees would be more confident, and it would also take some of the pressure off the pension funds.

    TER: You have only a couple of energy companies in your Top 20. Are you planning to keep that ratio?

    RM: Our Top 20 are the companies that have done well for us. In energy we have one foot in a half-dozen different places. We own a couple of exploration and production companies but are not concentrated on any given one. We own some service companies. Halliburton Co. (NYSE:HAL) shows up in our Top 20. We own a number of companies that we think benefit from cheap energy.

    Natural gas now sells for less than half, on a British thermal unit [Btu] basis, of what crude oil sells for. That's going to draw people to use natural gas. We own stock in companies that convert engines from diesel to natural gas, for both the original equipment manufacturers [OEM] and the aftermarket.

    I believe the big driver is the relative cost of energy. We have investments in a number of companies that, individually, look fairly small. But in the aggregate we have a pretty good bet on the amount of energy used.

    We're betting that people will use more natural gas. At $3/thousand cubic feet [$3/Mcf] for gas, it becomes competitive with coal. So we don't think the price will go much below $3/Mcf, because at that point people who now use coal will convert to natural gas. We don't think the gas price will get much above $5/Mcf because a whole lot of gas is profitable to drill at $5.

    I live north of Pittsburgh in Butler County, Pennsylvania, which sits on top of the Marcellus Shale. Right now, the spot price on Marcellus is well below $3/Mcf. For the next year or two, we think the price will be on the low side of $4/Mcf. But what we're trying to bet on are the people who will end up using more gas and the people who facilitate that as the price stays well below crude oil.

    TER: The forward price for natural gas, at least on the NYMEX, is below $4/million Btu [$4/MMBtu; equivalent to $4/Mcf].

    RM: But that's a nationwide price. Some of the quotes on the spot price in the Marcellus are $1.50/Mcf. That makes sense as a spot price, but in Massachusetts, we're seeing spot prices of $7-8/Mcf. It's cheap in Pennsylvania and expensive in Massachusetts, because there isn't enough pipeline to meet demand between the two. Of course, they're still flaring gas in Williston, North Dakota, in the Bakken field, which basically means that it's free, because there isn't enough pipeline to ship the gas even to places like Minneapolis, St. Paul or Chicago.

    Nationwide in the U.S., the price is about $4/Mcf. In Europe, it's $12/Mcf and in Japan, it's $16/Mcf, which is driving the move toward liquefied natural gas [LNG] terminals and LNG tankers. We've been asking people for years what it costs to take natural gas, compress it, liquefy it, ship it and then regasify it. That number has been about $6/Mcf. It may, over time, work its way down to $5/Mcf. But if we have gas at $4/Mcf and Japan is paying $16/Mcf, that's what is driving the LNG focus.

    TER: Is the gas in storage being replenished fast enough to restrain the price spikes coming next winter?

    RM: We can get numbers on this weekly. We're still running below normal in storage, and we're not gaining much. If nothing else hits the fan, it looks like we might just make it.

    Two years ago, when we had a warm winter, gas fell to $2/Mcf in April 2012. This last year we had a cold winter, and fuels like propane were on allocation in Ohio, Indiana and various places. If we have a normal winter, we may get through it OK, but we don't have a cushion. There are a lot of moving parts here. It's going to be interesting to see how all this shakes out.

    TER: You mentioned Halliburton, which reported great results for Q2/14. What sparked that growth?

    RM: Part of it is the return to demand for fracking. The drillers are telling us that to the extent they can put more sand into the formation-and they usually do that by shortening the segments when they frack it-if a given well is fracked in a few more stages, and more sand is put into each, it more than pays in terms of the amount of gas that comes out of the well. This year has been a very good year for the fracking companies. Halliburton is the biggest but, of course, it does a lot of other things as well. The company is a class act in many ways, but we think it has been helped this year by the increased demand for fracking.

    TER: Any other energy companies on your Top 20 list that you want to talk about?

    RM: Rex Energy Corp. (NASDAQ:REXX) is also in our Top 20. I have two farms in Butler County that the company has leased to drill. Rex just brought on a processing plant, which allows it to up volume significantly this year, on the order of 40-50%. The company continues to improve its economics in the drilling of wells. Most of the drilling stocks have come down in the last month or so, as the spot price of gas has come down. That makes sense, but the spot price for gas is getting low enough. At these levels, Rex is a great play.

    TER: It looks like Rex is very near its 52-week low. Is that a bargain or is that a warning?

    RM: I think it's a bargain. The stock has come down as the spot price for gas in Appalachia, in the Marcellus, has come down. We've seen daily spot prices at $1.50/Mcf. I don't think spot prices will stay low very long. The Environmental Protection Agency continues to put pressure on electric utilities to switch from coal to something cleaner, like gas. I think gas is the best alternative. And we think Rex is at a bargain price.

    TER: Is there another company you'd like to mention?

    RM: Westport Innovations Inc. (NASDAQ:WPRT) has a joint venture with Cummins Inc. to make diesel engines, primarily for OEM. We think the next big thing is conversion of over-the-road diesel trucks to natural gas. It's taken a little longer than we thought, but providing natural gas at stations nationwide is the next logical step. Clean Energy Fuels Corp. (NASDAQ:CLNE) is the 800-pound gorilla in terms of the service stations.

    Cummins Westport is the big guy in terms of converting OEM trucks. The service stations weren't in place a year ago; they now are. The 12-liter truck engines weren't available a year ago; they now are. We're sizable investors in what we think will be a changeover. It won't be 100%, but it will be significant.

    You may recall that in the 1950s, nearly all over-the-road trucks burned gasoline because diesel engines were hard to start. The same was true for farm tractors. But once people figured out how to make diesel engines easy to start, over-the-road trucks switched from gasoline to diesel in less than a decade. A similar changeover is happening with railroads. The head of Burlington Northern Santa Fe LLC has said that the company is testing switching from diesel to natural gas. He was quoted as saying that it might be the biggest change in railroading since the switch from steam to diesel. Frankly, I don't think it will be quite that big, but the largest single user of diesel fuel in the country is Burlington Northern.

    We believe we're in the process of cutting the cost of energy in this country in half in the current decade. It's already happened for consumers who heat with natural gas, but almost no one is aware of it. When you cut the cost of energy in half, amazing things happen in an economy. We're still only beginning to see the effects of cheap natural gas on the U.S. economy. We're trying to find different ways to play that, because we're not quite sure which companies will be the winners.

    TER: Do you issue ratings for your companies?

    RM: As investors, we don't publish research. We do our own research for our own purposes. In fact, if we think we have an edge, we don't talk about it until we're done buying it. At current prices, my appetite is bigger than it was six months ago. We think having energy priced at two different levels, crude oil being over twice the price of natural gas, has created too wide a spread for energy consumers not to try to shift from one to the other. We're trying to play every which way we can to benefit from the shift from crude oil to natural gas.

    TER: I appreciate your time.

    RM: It's been a pleasure.

    This interview was conducted by Tom Armistead of The Energy Report and can be read in its entirety here.

    Ron Muhlenkamp is the founder and portfolio manager of Muhlenkamp & Co. Inc., established in 1977 to manage private accounts for individuals and institutions. In 1988, the company launched a no-load mutual fund as an investment vehicle for all investors, large or small. Muhlenkamp is an award-winning investment manager, frequent guest of the media, and featured speaker at investment shows nationwide. His work since 1968 has been focused on extensive studies of investment management philosophies, both fundamental and technical. In addition to publishing his quarterly newsletter,Muhlenkamp Memorandum, he is the author of "Ron's Road to Wealth: Insights for the Curious Investor." Muhlenkamp received a bachelor's degree in engineering from M.I.T. in 1966, and a master's degree in business administration from the Harvard Business School in 1968. He holds a Chartered Financial Analyst [CFA] designation.

    Want to read more Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see recent interviews with industry analysts and commentators, visit our Streetwise Interviews page.

    DISCLOSURE:
    1) Tom Armistead conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
    2) The following companies mentioned in the interview are sponsors of Streetwise Reports: None. Streetwise Reports does not accept stock in exchange for its services.
    3) Ronald Muhlenkamp: I own, or my family owns, shares of the following companies mentioned in this interview: Halliburton Co., Rex Energy Corp., Westport Innovations Inc., and Clean Energy Fuels Corp. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
    4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
    5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports' terms of use and full legal disclaimer.
    6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned. Directors, officers, employees or members of their families are prohibited from making purchases and/or sales of those securities in the open market or otherwise during the up-to-four-week interval from the time of the interview until after it publishes.

    Aug 21 4:01 PM | Link | Comment!
  • Natural Resource Surprises Galore: PeterEpstein

    The natural resources space has been difficult in recent years. Potash prices collapsed, uranium spot prices hit a nine-year low, the gas market was in glut. Only oil has stayed strong. But Peter Epstein of MockingJay Inc. has found some gems in the resource rubble, and foresees better times ahead. In this interview, Epstein tells The Energy Report who stands to capture the graphite market, how to catch the next wave in potash, and offers his thoughts on when investors might catch a break in the uranium market.

    The Energy Report: Why are you excited about the oil and gas space right now?

    Peter Epstein: Oil and gas is unique in that it hasn't budged when so many commodities have fallen precipitously in price. Coking coal prices, for example, are at multiyear lows. The iron ore price has fallen below $100/metric ton. The uranium spot price has fallen to a nine-year low. But oil prices have held in the $90-100/barrel [$90-100/bbl] range on West Texas Intermediate crude for three or four years, steady and strong. Natural gas prices collapsed in 2012 but have come back fairly strong, only recently giving back a bit of the gains. That's why I like oil and gas. It's a strong commodity. Even with all this talk about a slowdown in China, which causes lots of commodities to fall, oil and gas sticks in there.

    TER: Oil, gas and mining industries are tarred with the same brush by environmental advocates, who describe them as dirty, polluting and environmentally destructive. Can these industries be made attractive to investors who put a premium on environmental considerations?

    PE: Companies are learning the hard way that they have to have a social license to operate, as well as address the increasingly long list of permitting and environmental hurdles. Extractive industries that are dirty and polluting have to clean up their acts. But this is not a new problem; it's been going on for years-or even decades-depending on the jurisdiction.

    Another negative impact for such companies is the longer time frame to production, created by a myriad of factors above and beyond environmental considerations. A longer time frame means more difficulty funding projects, and therefore a lower net present value. Project hurdle rates have to rise to account for the higher risks and longer time frames. This means that industry-wide cost curve increases and commodity prices have to rise in response. Margins will be squeezed somewhat, even if companies enjoy higher commodity prices in the long term.

    TER: What do companies have to sacrifice to achieve environmental goals?

    PE: Companies have to give up profits to meet these new realities. But companies that approach dirty and polluting industries in innovative ways, frequently with the use of technological advances, will be rewarded.

    TER: When uranium's price stalled around $35/pound [$35/lb], everyone bet it was about to rise again, because it couldn't go any lower. Then it stalled again, at about $28.50/lb. What will make uranium mining profitable and attractive again?

    PE: For the first time since April, the spot price has a $3 handle on it, with Ux Consulting quoting it at $30/lb on Aug. 11. It appears that spot uranium may have bottomed at about $28/lb. If the spot price rebounds to even just $35/lb, that could be bullish for the sentiment of uranium juniors.

    Let me point out that the spot price is not the same as the long-term price that most utilities contract at. Make no mistake, $28.50/lb was a nine-year low and a depressed price. Most uranium mines around the world can't do business at $28.50/lb-or at $35/lb. Many analysts believe the price at which new greenfield projects would get the green light is $60-75/lb. That might sound high, but in the months leading up to the terrible Fukushima disaster in March 2011, the long-term uranium price was steady at around $70/lb.

    Globally, the cost per pound to produce uranium has not gone down over the past three years. All mining costs are generally increasing because of the factors we've discussed: permitting costs and time frames, environmental concerns, etc. The market needs a higher uranium price, and we will see a higher uranium price. It's a question of when, not if. Many pundits point to the restart of some Japanese reactors, all of which are currently offline. I agree that this will be a positive sentiment booster, but that alone will not be enough to move uranium prices by all that much, in my opinion.

    Instead of focusing on Japan, the market should be watching China and India, both of which only generate 2-3% of their electricity from nuclear power. That has to change-and it will. Given their severe air pollution problems, the Chinese are going to build new reactors as fast as they can. They will also continue ramping up hydropower, wind, solar-you name it. But nuclear power generation in China is going to be a larger part of a growing pie. China is sitting on $2-3 trillion [$2-3T] in U.S. Treasuries, and it will happily buy hard assets in the form of uranium or uranium enrichment facilities. The Chinese are very active, up to a state-owned entity level, in terms of building nuclear power stations.

    Some analysts point to in-situ recovery operations as potentially profitable. These have low costs and can be profitable at a uranium price of, say, $40-45/lb. But the size of these projects is typically too small to move the needle globally.

    Finally, I would point out that utilities have not been contracting for long-term supplies of uranium since they feel no urgency to do so. That will have to change. Utilities can't wait until 2017 to contract 2018-2023 uranium supplies. As soon as next year, utilities will be back in the market and the long-term price of $45/lb will rise.

    As a commodity that's hit a nine-year low, uranium is out of favor. A lot of the uranium stocks are oversold. But I think there are opportunities in small names.

    TER: Some projections for nuclear power plant construction in China suggest that even with as much construction as it wants to do, the country still won't exceed 10% of its total power needs. Is that going to greatly increase uranium demand?

    PE: China expects to start building something like six new reactors every year for the next five years, and that's going to keep ramping up. If your question is how long will it take to get 10% of its electricity from nuclear power, it could take 10-15 years. China thinks long term, and has a lot of U.S. dollars that it would like to transform into hard assets. And it's not just the Chinese who are actively going after uranium and nuclear power. It's Russia as well, and India.

    By the way, both China and India are very active in building hydroelectric dams. But that kind of construction gets an unbelievable amount of scrutiny in terms of the environment, and the fact that tens or hundreds of thousands of people must be moved out of villages to build these dams. Hydroelectric development in China and India may come to a quicker end than people realize. Then, of course, you have coal. The World Bank, the International Monetary Fund, the U.S. and some other major international bodies are saying they're not going to fund Third World coal power plants anymore. Those factors all lead to more nuclear power development.

    TER: Is there another company you'd like to mention?

    PE: CBD Energy Ltd. (OTC:CBDE) is interesting because, in addition to being a solar stock, the company also works with wind and energy management systems. It has over 17,000 [17K] installations, mostly in Australia, and is moving into the U.S. In Australia, 15% of homes have solar. In the U.S., it's estimated that 1% have solar. Even though it's extremely competitive in the U.S. for companies installing rooftop solar panels, the penetration of solar on rooftops of individual homes is still quite low.

    CBD Energy is well funded. It has a strong management team and a long track record. In fact, it has licensed the "Westinghouse Solar" trademark to tell people who it is. It's a real brand name.

    The exciting part of the story is that solar companies can trade at 10-30x revenues. But it's a very competitive, crowded space, and it's hard to tell if those kinds of multiples are fair, or if it's a bubble. In the case of CBD, however, you have a geographically diversified, fast-growing, small company that's trading at a 1x multiple of 2015 revenue.

    TER: The potash space was shaken up in the last year by the collapse of the cartel in Russia. How is that affecting the potash space in North America today?

    PE: Potash is a generic term that refers to a group of potassium-bearing minerals, naturally occurring potassium salts and the products produced from those salts. Potash is a plant's main source of potassium, and is used in fertilizers. For muriate of potash [MOP], prices collapsed after that event. It took a couple of months, but the potash price fell from more than $400/metric ton down to about $300/metric ton. Prices differ around the world, so I'm using a benchmark price that a lot of people refer to.

    MOP is widely used in all types of farming, but it contains a chloride ion that can be detrimental to plant growth, especially fruits and vegetables. Sulfate of potash [SOP] is different. SOP improves yield, quality, taste and shelf life. These attributes are valuable to farmers, so SOP trades at a premium price to MOP.

    SOP prices barely moved at all. It's almost like they're two different products. SOP is a specialty product with one-tenth the market of MOP. A third-party study suggests that demand for SOP would be 2-3 times greater if existing users could ensure security of supply, and if new users were introduced to SOP versus MOP. The premium of SOP over MOP has moved quite a bit because SOP prices were virtually unchanged during the Russian cartel turmoil, while MOP prices fell 25%.

    You can make SOP, but you need MOP as a feedstock to start with. If you have to start with MOP and spend money to process it, the margin is not going to be that strong. Since it is an expensive process, not many companies do it. That's why the MOP market is 50M metric tons/year, and the SOP market is about 5 million tons.

    For MOP, in Saskatchewan alone, there's a huge amount of production. Plus, a number of juniors and both BHP Billiton Ltd. (NYSE:BHP) and Rio Tinto Plc (NYSE:RIO) have projects they could bring online.

    TER: You have an extremely diverse portfolio of companies that you follow. Can you offer some advice for investors looking to build that kind of a portfolio for themselves?

    PE: Investors in natural resources have not been happy campers for the last two or three years. I think it's important to stick with companies that have cash on their balance sheets. Stick to companies already in your portfolio, even if they're down 60-70%, with good management teams that are 100% committed to the company, not management teams involved with five different companies at once. And watch out for the cash burn of companies. You want the cash burn to be minimal, so that your companies can live to fight another day.

    TER: Peter, I appreciate your time and your insights.

    This interview was conducted by Tom Armistead of The Energy Report and can be read in its entirety here.

    In 2011, CFA Peter Epstein left his senior analyst position at a $3B hedge fund and formed MockingJay Inc., a consultancy for companies in the natural resources space and an informal investment adviser to high-net-worth investors, family offices and funds. The company's mission is to increase awareness of select natural resource companies. Epstein's areas of expertise include uranium, coal, potash, gold and oil & gas. He has published hundreds of articles on investment sites such as Seeking Alpha, The Motley Fool and Au-Wire.com.

    Want to read more Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see recent interviews with industry analysts and commentators, visit our Streetwise Interviews page.

    DISCLOSURE:
    1) Tom Armistead conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
    2) The following companies mentioned in the interview are sponsors of Streetwise Reports: None. Streetwise Reports does not accept stock in exchange for its services.
    3) Peter Epstein: I own, or my family owns, shares of the following companies mentioned in this interview: CBD Energy Ltd. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
    4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
    5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports' terms of use and full legal disclaimer.
    6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned. Directors, officers, employees or members of their families are prohibited from making purchases and/or sales of those securities in the open market or otherwise during the up-to-four-week interval from the time of the interview until after it publishes.

    Streetwise - The Energy Report is Copyright © 2014 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part.

    Streetwise Reports LLC does not guarantee the accuracy or thoroughness of the information reported.

    Streetwise Reports LLC receives a fee from companies that are listed on the home page in the In This Issue section. Their sponsor pages may be considered advertising for the purposes of 18 U.S.C. 1734.

    Participating companies provide the logos used in The Energy Report. These logos are trademarks and are the property of the individual companies.

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    Aug 14 3:00 PM | Link | 1 Comment
  • Looking For The Next Big Thing? Jason Sawatzky Has A Suggestion

    For Jason Sawatzky, the word is "oilfield services." They are not glamorous, but they are necessary, and Canada's explorers and producers need oilfield services as they prepare to fill pipelines with natural gas to be liquefied and exported. AltaCorp Capital's director of institutional equity research tells The Energy Report that Canada is pushing hard to approve liquefied natural gas plants, and Canada's proximity to Asian markets gives it an edge. A whole portfolio of companies is poised to support and profit from the business opportunities that will come with that industry.

    The Energy Report: Jason, what is your outlook for oilfield services industry in Canada for the second half of 2014?

    Jason Sawatzky: We are very bullish on Canadian oilfield services heading into H2/14 and 2015. The only thing that may throw a monkey wrench into the positive view in the short term would be the recent pullback in natural gas prices. We have seen the oilfield services index pull back a bit over the past couple of months. If we see natural gas prices pull back even more, we could see a similar pullback in the oilfield services index and in share prices. Other than that possibility, we remain bullish on the sector.

    TER: Do you think there's more to the pullback in natural gas prices than seasonal fluctuation?

    JS: We've recently had some large injections into the gas storage levels down in the U.S. That's been the reason for the more recent pullback in gas prices. But we are heading into the winter season, and typically gas prices strengthen as we head into winter, as heating-degree days tend to increase and gas usage increases. Even though we've seen a pullback, we expect gas prices shouldn't pull back much more from where they're at today.

    TER: How strong is foreign market demand for Canadian liquefied natural gas [LNG]? Eight or nine Canadian LNG targets are proposed. Can demand support all of them?

    JS: We believe one to three projects will eventually go ahead. The Canadian market would have a hard time handling eight to nine projects just from a labor and infrastructure perspective.

    TER: Are any of the projects in progress right now?

    JS: Not really. A lot of the developers have applied for initial approvals. Many projects are waiting on the British Columbia [B.C.] government's LNG tax package, which is expected in the fall. Companies will decide whether they'll go ahead after that. Petronas (OTC:PNADF) [PETRONAS]/Progress Energy Canada Ltd. has started delineation drilling. It's operating between 25 and 30 rigs right now, and that's the predevelopment phase of delineation drilling in preparation for eventual approval-if that happens.

    TER: There are a lot of LNG projects in the U.S. that have a head start. Can the Canadian projects compete?

    JS: U.S. LNG projects do have a head start, as the U.S. already has infrastructure in place for imports on the LNG side. They're now converting these plants to export. That said, we believe the Canadian projects will definitely be able to compete in building out LNG plants and infrastructure. Just considering Canada's proximity to Asian markets, it can compete. It's all about proximity to the Asian markets.

    TER: What about the petrochemical industry? Natural gas is a feedstock for that industry. Would that be an equally good market for western Canadian gas?

    JS: We think it will also be a good market. The petrochemical industry already exists in Canada, with plants in Edmonton, Alberta, and Red Deer, Alberta. The industry would definitely be a good market for western Canadian gas, but it would be a much smaller market as compared to LNG, given the global demand for LNG.

    TER: Are the First Nations on board with the pipelines that will be necessary to get Canadian LNG to the coast?

    JS: The largest pushback from the First Nations is actually around oil pipelines, due to the potential for spills and the environmental impacts around that issue. Their opposition has been mainly to the Northern Gateway Pipeline, an oil pipeline. Natural gas is a much cleaner energy; the B.C. government and First Nations are on board with LNG and the gas pipelines that would be built around that production.

    TER: What does Canada want from a tax package on LNG, in terms of policy goals and revenue goals?

    JS: Regarding a tax package on LNG, the B.C. government has said it is definitely pro-LNG, given the potential economic benefits for the province if a number of these projects go through-and the economic benefits for Canada as a whole, for that matter. We would expect a tax package in or around the September time frame. We think it's going to be favorable for the industry and for producers.

    The B.C. government is looking to change its provincial tax model, which is currently based on the federal model. The new provincial tax model would be based on a cost recovery system [i.e., less tax would be paid overall, but there would be a higher net present value on taxes].

    TER: You predict one to three LNG projects, out of eight or nine proposed, are going to go forward. Will the successful ones be those making progress now? Or might one of the late starters have a better chance?

    JS: With Petronas/Progress already doing a lot of development drilling, we think that's a pretty positive sign. If the tax package is relatively favorable, we think that Petronas/Progress is prepared to move ahead with its project. Then some of the other larger players, like Chevron Corp. (NYSE:CVX), will be willing to move ahead relatively quickly.

    TER: Would you talk about companies operating in the LNG space? Which companies are of interest, and what is driving their growth?

    JS: Sure. Canadian Energy Services and Technology Corp. (OTCQX:CESDF) [CEU:TSX] is one of our top investment ideas. It's one of the largest drilling fluids providers in western Canada. It currently has roughly 34% market share in Canada, and is growing its drilling fluids business in both Canada and in the U.S. The company is operating in the Permian Basin down in the U.S., which is a large growth area for the company.

    What's driving growth in the drilling fluids business for Canadian Energy Services is demand for more complex drilling fluids. That market is growing in both Canada and the U.S., as wells are drilled longer horizontally. The company offers its customers drilling fluids products that actually lower the total cost of a well, and that can raise overall productivity of a well, which ultimately increases the return for exploration and production [E&P] companies. Canadian Energy Services also has good exposure to the LNG build-out in Canada, and good exposure in the U.S. to increasing activity in plays like the Permian.

    TER: Canadian Energy Services acquires a lot of its technology in mergers and acquisitions [M&A]. Does it do its own research and development too?

    JS: It does. When this company first started out, it very quickly became a market leader on the drilling fluids side in Canada. A lot of that was through its own research and development, and through providing proprietary drilling fluids products. But it has done a lot of M&A as well.

    Canadian Energy Services has acquired a company called JACAM Chemical Co. Inc. down in the U.S.-a $240 million [$240M] acquisition. That acquisition transformed the company, and gave it another growth area in terms of production chemicals. It was a very positive transaction, and the stock has reacted accordingly.

    TER: What was Canadian Energy Services looking for in the JACAM acquisition?

    JS: It was looking to diversify its operations. The company's main operation is drilling fluids, which is tied heavily to the drill bit. You can have a lot of volatility in that business when commodity prices fluctuate. Production chemicals are a lot more stable in terms of business, as they are used on wells that are already producing. You have more stability and are less tied to the drill bit on the production chemical side, so it evens out the revenue stream.

    TER: How does the company fund its M&A?

    JS: It funds the M&A through debt, through equity financings and through cash flow from the business. On the equity financing side, Canadian Energy Services recently did a $75M equity financing and issued some debt as well-about $75m in debt.

    TER: How extensively is the management invested in the company?

    JS: The management team is heavily invested, and has been since the start of the company. Management and directors currently own 18% of the stock. They have skin in the game, and that's been reflected in how well the company's done over the past number of years.

    TER: Is there another company that might benefit from LNG development?

    JS: Newalta (OTCPK:NWLTF) [NAL:TSX] is one of the three largest oilfield waste providers in Canada. The other two are Secure Energy Services (OTC:SECYF) [SES:TSX], which is a public company, and a private company called Tervita Corporation.

    If LNG goes through in Canada and one to three projects go ahead, that will create a lot of activity in western Canada, which in turn will generate a lot of oilfield waste for companies like Newalta to handle on the back end. Newalta wouldn't be on the front end of the LNG development-that would be the drillers and the frackers. It would be on the back end, handling the oilfield waste generated from the increased LNG-related activity.

    TER: Newalta's industrial division has underperformed recently. Now the company is talking about selling it. Where does that stand right now?

    JS: The company engaged an advisor a few months ago to conduct a strategic review of its industrial assets, and it's working through that right now. We believe that we could see either a sale of a portion of the division or sale of the entire division by the end of this year. We think that will be positive for the company, given that the industrial business for Newalta is a lower-margin business compared to its higher-margin oilfield waste business. When Newalta does eventually sell off its industrial assets, it will take those proceeds and reinvest them into the higher-margin oilfield waste business.

    TER: Will that materially change the way Newalta operates?

    JS: It provides the company with more capital to invest in some of its higher growth areas. For Newalta, that would be its heavy oil business, which is centered on waste processing for steam-assisted gravity drainage [SAGD] and mining operations through onsite locations and fixed facilities. Another growth area for Newalta would be U.S. expansion. It's growing in the U.S., providing onsite and satellite oilfield waste services. Those would be the two main growth areas where it could redeploy capital.

    TER: This is a pretty diversified operation. Do you see one of the units as representing the core business, and the others just supporting that?

    JS: Once Newalta sells its industrial position, it becomes a pure-play oilfield waste provider in Canada and the U.S. We think that's going to be the focus for the company. Wells are aging in western Canada, produced water is increasing every year, and the amount of waste is increasing as horizontal wells are being drilled longer. We think these are all positive drivers for Newalta's core business of oilfield waste management.

    TER: Do you foresee any other sales or acquisitions?

    JS: Other than the industrial assets, no. And in terms of acquisitions, not anything in the near term. Over the longer term, if Newalta were to do any acquisitions, it may be in the U.S., buying smaller oilfield waste providers in certain plays. That would be the only potential acquisition.

    TER: Speaking of acquisitions, Canyon Services Group Inc. (OTC:CYSVF) [FRC:TSX] purchased Fraction Energy Services. How did the market respond to that?

    JS: The market responded favorably to that acquisition, which was about 8-10% accretive. It allows Canyon to develop a more comprehensive fracking fluid management solution, offering both fracking and water frack fluid management services. Eventually, the goal for Canyon is to offer frack water recycling services. When the frack water is taken from the well, the company would be able to recycle it and frack with the same water. Down the road, that's what Canyon is looking to do.

    TER: Any other companies that you're excited about at this moment?

    JS: Generally, around LNG development in Canada, I would note some of the companies that we believe are on the front lines, or who will benefit from LNG development. That would include some of the largest drillers in Canada. Some of the smaller drillers, like Western Energy Services Corp. (OTC:WEEEF) [WRG:TSX] or CanElson Drilling Inc. (OTC:CDLRF) [CDI:TSX.V], will benefit from the LNG build-out on the front lines.

    Some of the fracking companies will benefit as well, such as Canyon Services Group, Trican Well Service Ltd. (OTCPK:TOLWF) [TCW:TSX] and Calfrac Well Services Ltd. (OTCPK:CFWFF) [CFW:TSX].

    Another big area that will benefit from LNG build-out is camp accommodations, so we would highlight companies such as Horizon North Logistics (OTC:HZNOF) [HNL:TSX] and Black Diamond Group Ltd. (OTC:BDIMF) [BDI:TSX] as being able to provide pipeline and LNG-related accommodations on the west coast.

    TER: You threw a number of companies into that basket. Is there anything particularly outstanding about any one of them?

    JS: Certain companies within the Canadian oilfield services space are going to benefit more than others. Frackers and the drillers will benefit the most initially, and then the accommodations segment. Generally, if we do get one to three LNG projects approved and we look at the amount of capital coming into the basin, we think that oilfield services in Canada is the way to play the LNG theme.

    TER: Thank you very much for your time today.

    This interview was conducted by Tom Armistead of The Energy Report and can be read in its entirety here.

    Jason Sawatzky is director of institutional equity research at AltaCorp Capital Inc., where he focuses on oilfield services. Prior to joining AltaCorp, Sawatzky was an associate analyst covering oilfield services at Stifel Nicolaus. Prior thereto, he worked at Cormark Securities, covering oilfield services and E&P companies for four years. Sawatzky holds a bachelor of commerce degree in finance from the University of Alberta, and a bachelor of arts degree in sociology/psychology from the University of Calgary.

    Want to read more Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see recent interviews with industry analysts and commentators, visit our Streetwise Interviews page.

    DISCLOSURE:
    1) Tom Armistead conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
    2) The following companies mentioned in the interview are sponsors of Streetwise Reports: None. Streetwise Reports does not accept stock in exchange for its services.
    3) Jason Sawatzky: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: CanElson Drilling Inc., Canadian Energy Services and Technology Corp. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
    4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
    5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports' terms of use and full legal disclaimer.
    6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned. Directors, officers, employees or members of their families are prohibited from making purchases and/or sales of those securities in the open market or otherwise during the up-to-four-week interval from the time of the interview until after it publishes.

    Streetwise - The Energy Report is Copyright © 2014 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part.

    Streetwise Reports LLC does not guarantee the accuracy or thoroughness of the information reported.

    Streetwise Reports LLC receives a fee from companies that are listed on the home page in the In This Issue section. Their sponsor pages may be considered advertising for the purposes of 18 U.S.C. 1734.

    Participating companies provide the logos used in The Energy Report. These logos are trademarks and are the property of the individual companies.

    101 Second St., Suite 110
    Petaluma, CA 94952

    Tel.: (707) 981-8204
    Fax: (707) 981-8998
    Email: jluther@streetwisereports.com

    Aug 07 3:37 PM | Link | Comment!
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