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  • Where To Look For Yield During A Time Of Low Gas Prices: Elliott Gue

    With gas prices stuck at historic lows for the foreseeable future, bored investors can look toward master limited partnerships to increase profit yields on energy portfolios. Elliott Gue, energy investment strategist of Capitalist Times, spends his day finding great energy deals in the margins and curves. In this interview with The Energy Report, Gue does the dirty work and gives us his strategy so that investors can golf, yacht, and have fun without worrying about losing the value of their savings to inflation.

    The Energy Report: Elliott, you recently wrote in Capitalist Times that "unless last winter marked the onset of a new ice age, the underlying supply-and-demand trends that prevailed before the polar vortex are always going to win out." Based on the charts that accompany that article, what are those trends?

    Elliott Gue: Last winter was really cold and, as a result, natural gas demand was very high. Natural gas stores in the U.S. were drawn down much more rapidly than normal. At the same time, there were production disruptions. It was so cold in the Rocky Mountains that producers were not able to service their wells. Natural gas production plummeted and gas prices shot up.

    The underlying trend remains very bearish for gas prices, however. The demand for gas did ease after the winter heating season, lowering prices, but there has been resurgence in production, and storage levels are back up. The electric power utilities thrive on cheap gas, and production is growing even faster than rising demand. There are simply oceans of gas out there that we have not yet tapped, like the Haynesville Shale in Louisiana. I expect that gas prices in the U.S. will remain low, and, consequently, electricity prices will continue to hug the bottom relative to the rest of the world.

    TER: Given the situation, who will be the winners?

    EG: The biggest winners are going to be companies that consume gas, rather than companies that produce gas. A lot of energy companies are moving away from gas toward producing more oil and natural gas liquids. Electricity prices in China are twice what they are in the U.S. Reversing a long trend, Chinese companies are building out manufacturing capacity in the U.S. The aluminum smelting industry stands to benefit tremendously, because its manufacturing process is linked to the price of electricity.

    TER: Who do you like in aluminum?

    EG: We like Century Aluminum Co. (NASDAQ:CENX), which is an aluminum smelter. Century takes aluminum oxide and, using a process that requires a lot of power, turns the oxide into aluminum, which is then used in thousands of products. Century is buying power in the U.S. on the spot, which means that it pays prevailing market prices. As a result, it is buying power at a steep discount to what its European competitors are paying.

    Demand for aluminum by the automobile industry is expanding, because the federal government's Corporate Average Fuel Economy [CAFÉ] standards require automakers to boost the fuel efficiency of entire lines of cars and trucks. Ford is meeting the standard by increasing the amount of aluminum used in its vehicles. The 2015 Ford F-150 pickup truck is 750-1,000 pounds lighter than the 2014 model. It is expected to sport a fuel efficiency of 30 miles per gallon [30 mpg]. No standard-size pickup truck in the U.S. has ever achieved 30 mpg in terms of fuel efficiency. The low natural gas prices in the U.S. will continue to be a big boost for companies like Century Aluminum, which require an awful lot of power in their factories.

    TER: Are energy investors today looking for short-term profits in the hurly-burly of the stock market, or are they looking for steady income vehicles?

    EG: Steady income investments are in demand. Back in 1999-2000, you could put money into a certificate of deposit, a money-market account, or even a savings account and still get interest rates of 5-6%/year. Now, you can't even get 1%. Income-producing stock sectors, like utilities and real estate investment trusts [REITs], are yielding at near historic lows, under 3%. Investors are starved for steady-stream income vehicles. This highlights the attractiveness of master limited partnerships [MLPs], which are typically used by midstream energy companies. The MLPs own assets like pipelines and natural gas storage vehicles. They offer higher-than-average yields, which permits investors to earn better than average returns.

    TER: Are the best opportunities for steady income flow emerging from the established MLPs, or from those MLPs making initial public offerings [IPOs]?

    EG: We focus on MLP IPOs because the yields on many of the large, traditional MLPs have fallen-not because they have cut dividends or distributions, but because the MPL industry has rallied so much. I see a lot of value in new MLP listings-companies that have just gone public as MLPs. Exchange-traded funds [ETFs] and institutional money is strongly attracted to the largest and longest-standing MLPs, such as Enterprise Products Partners L.P. (NYSE:EPD). Buying MLPs en masse inevitably drives down the yield. Still, investors are so hungry for yield that they are piling into the traditional MLPs, which can increase the valuation of the larger, more established names.

    Oftentimes, if you search for a symbol for a new MLP, it will show that there is no yield. The reason is that the MLP has not yet paid its first quarterly distribution. It is a good strategy to jump in early on new MLPs, before they become too popular. Investors can get a good price until the MLP starts paying out distributions, and displays its income potential for all to see and grab.

    TER: What IPOs do you like in the MLP space?

    EG: One new IPO that we are looking at is Cypress Energy Partners LP (NYSE:CELP). It went public in January 2014. Cypress is in the wastewater business. Oil and gas fields produce large volumes of water that contains all kinds of contaminants, and that water must be disposed of in a regulated fashion. Cypress injects wastewater into disposal wells underneath the drinking water table.

    There is also a need for recycling fracking wastewater, so it can be used in another round of fracking. The technology to do that already exists, but it is more expensive than disposing of wastewater in an injection well. The future holds more recycling opportunities because reusing expensive water can cut costs. For instance, in Southern California, water prices are very high because there is a drought, so using recycled water makes sense. Cypress may enter that space as well.

    The second part of Cypress' business is pipeline integrity, monitoring pipelines for signs of weakness that might cause a spill. Obviously, with high-profile pipeline spills and reputation-damaging ruptures over the last five to 10 years, focus has shifted to this business. Companies are spending cash to make sure their pipelines are safe.

    Cypress yields about 6.5%. The average MLP yields about 5.5%, so Cypress delivers an above-average yield. It has a lot of growth potential because both of its businesses are necessary. I expect its distributions to grow at an annualized pace of 10-15%, plus the 6.5% yield.

    TER: Which other MLPs do you particularly like?

    EG: One of our favorites is Memorial Production Partners LP (NASDAQ:MEMP). It owns mature oil and gas fields in Texas and the Rockies, and an offshore field in California that went into production 70 years ago. Predictable rates of production from these fields back the company's strong, 9.6% yield. Of course, if oil and gas prices fall, Memorial would have to cut its distribution. To prevent that scenario, it hedges most of its production five years into the future-meaning that Memorial does not have any real exposure to the volatility of commodity prices.

    TER: Have you spotted any undervalued oil and gas production majors?

    EG: The problem with Exxon Mobil Corp. (NYSE:XOM) and Chevron Corp. (NYSE:CVX) is their slow production growth in recent years. These companies are overvalued by any metric-price:book value, price:cash flow, price:earnings. We look for smaller integrated names. These are still massive companies, but not as gargantuan as Exxon and Chevron.

    For instance, Eni S.p.A. (NYSE:E) is an integrated oil company that is partly owned by the Italian government. It trades at a discount to the big U.S. and northern European energy firms because it is based in Rome. The financial crisis in southern Europe has hit the Italian economy hard, and investors tend to shun firms listed in Rome. The reality is that most of Eni's assets are in Africa, where Italy had a longstanding colonial relationship. Eni's main products are natural gas and crude oil-priced in dollars, not euros. So Eni has had very little exposure to the risky Italian situation, yet it trades at about half the valuation of Exxon.

    TER: If the majors are experiencing a slowdown in production growth, how can the smaller firms do better?

    EG: Exxon has trouble growing because, for a field to move the company's stock needle, it has to be massive. Eni can exploit smaller projects in Africa and generate relatively greater production growth. It has a number of major finds in Mozambique that are due to come on-stream over the next few years. An additional benefit is that Eni yields about 5%, whereas Exxon yields around 2-3%. Eni is offering a much higher yield alongside production growth in the outlier regions.

    TER: Are there other large companies in that smaller space that you like?

    EG: Total S.A. (NYSE:TOT) is a French company. It trades at a discount because it is based in Europe. It offers a yield of about 5%. It is not quite as strong a production growth story as Eni, but it does have a number of interesting projects coming online in the Arctic, near Norway.

    TER: What junior explorers and producers do you have your eye on?

    EG: Noble Energy Inc. (NYSE:NBL) centers its production on the Niobrara Shale region in Colorado and Wyoming. The Niobrara is not as fully developed as the Bakken Shale, but the Niobrara's wells are among the most spectacular plays in the U.S., ranking only behind the Bakken in terms of profitability. Noble is one of the largest acreage holders in the Niobrara. It has set up a very aggressive drilling program for the next three to five years. As people become more aware of what is going on in the Niobrara, and as production expands, entrenched names like Noble will attract lots of attention and capital.

    TER: Is Noble international?

    EG: Three years ago, Noble discovered a massive gas field off the coast of Israel called the Leviathan. While natural gas prices in the U.S. are very low, that is certainly not the case in Europe and Israel. The massive Leviathan gas field is strategically important to Israel. Noble will be able to produce natural gas from this field, sell it domestically, and bring down the cost of natural gas in Israel. It will also be able to export liquefied natural gas [LNG] to Europe. Currently, Europe imports the majority of its natural gas from Russia. With the ongoing political turmoil in the Ukraine, the Europeans are keen to diversify their supply sources.

    TER: When will the Leviathan start producing?

    EG: Noble is drilling a number of delineation wells. These wells will evaluate the size and productivity of the play. The flow of news is good. I suspect the Leviathan will go into production in the next two to three years. It will ramp up in 2019, as the company's LNG plant goes live.

    TER: With the differential in natural gas prices, what's happening in the refining space? Where are the best buys?

    EG: The refining space is the biggest beneficiary of the surge in U.S. oil production. At the end of 2013, the U.S. overtook Saudi Arabia to become the world's largest oil producer. That is an amazing statistic when you consider that just 10 years ago, we were talking about how much more oil the U.S. was going to have to import from Saudi Arabia to meet domestic demands. And oil production in the U.S. continues to grow.

    But one of the side effects of that growth is that U.S. oil prices are far lower than in other parts of the world. The key international global oil benchmark is Brent crude. It is trading around $100-105/barrel [$100-105/bbl]. The key U.S. oil benchmark is West Texas Intermediate [WTI], and that is trading in the low-to-mid-$90s.

    In other parts of the U.S., oil prices are even lower. In Midland, Texas, in the heart of the Permian Basin play, oil prices are trading around $74/bbl, which is a massive discount to international oil prices. Due to the lack of pipeline capacity, there is a glut of crude oil in certain parts of the U.S., and that fact is depressing prices. Obviously, that is not good news for producers, but it is great news for refiners.

    TER: Why?

    EG: Refiners are manufacturers. A refiner's largest cost is the price of crude oil. If a refiner can buy oil at a deeply discounted price, that will enhance its profit margins. Refiners located near Midland purchase crude at a steep discount and sell gasoline and diesel fuel at high prices. Plus, the U.S. government does not allow the export of crude oil, but it does allow the export of refined products. And international prices for refined products are sky-high.

    TER: What refiners do you like?

    EG: Valero Energy Corp. (NYSE:VLO) is the largest independent refiner in the U.S., with refinery assets primarily located around the Gulf Coast area. A lot of production flows toward that region because pipelines in the U.S. are set up to transport oil to the Houston area, where the refining industry is strong.

    Looking at smaller refiners, we keep tabs on Alon USA Partners LP (NYSE:ALDW). This MLP has a refinery in Big Spring, Texas, near Midland. It benefits from the low Midland crude oil prices and selling its refined products at very high markups. It currently yields about 16%, and that is super.

    TER: Of the Big Four firms in the service sector, which ones are the best positioned in today's economic climate?

    EG: Four of the largest oil services firms in the world are Baker Hughes Inc. (NYSE:BHI), Halliburton Co. (NYSE:HAL), Schlumberger Ltd. (NYSE:SLB) and Weatherford International Ltd. (NYSE:WFT).

    Schlumberger is the largest. It is also the most respected and, technologically, the most advanced. People sometimes make the mistake of thinking that the energy business is not high tech. The energy business is one of the most high-tech industries. It is producing oil from deepwater plays, drilling in water that's 10,000 feet [10,000 ft] deep, with wells that can be 35,000 ft long. Bidding on big deepwater developments, and big onshore projects in the Middle East, is a very competitive business. These projects are so heavily bid that the pricing is not great, because companies are competing on price to win business.

    Schlumberger has developed certain unique technologies that the rest of the Big Four services firms don't have. These are typically techniques that allow companies to drill a well using less water, drill a well quicker than its competitors, and locate oil in underground rock formations with seismic waves that map the rock formations. As a result, Schlumberger is able to charge high prices for its unique services, and its margins are much higher than those of its competitors.

    Weatherford has been the worst of breed over the last five years. It had an accounting scandal-an irregularity in its international accounting for taxes. That matter has been settled, which means Weatherford's management team can return to focusing on operations. The company is spinning off noncore businesses that were not returning high margins. The $1 billion [$1B] from these spinoffs can be used to pay down Weatherford's debt load, which is a big positive.

    Operationally, Weatherford has artificial lift, a technology that can produce more oil from mature fields. That lifting ability is very much in demand, because there are a lot of mature fields around the world, and oil prices are high enough to make it profitable. Once Weatherford gets rid of the small businesses that have been acting as a headwind on profits over the last five years, its managers will be able to focus on the firm's competitive strengths, such as artificial lift.

    TER: What advice are you giving readers about adjusting portfolios for the fall?

    EG: Stocks have been steadily on the rise, and we have not seen very many corrections. The correction we saw this summer was on the order of 5% on the S&P. Be prepared for a 5-10% pullback in the broader market. We regard a pullback as a buying opportunity for a lot of the names that I have mentioned.

    Longer term, the economy is in good shape. Growth is accelerating after too many years of weak growth. Growth generates a big tailwind for stocks. We have been selling out of the names that have done very well for us, taking our profits off the table or reducing our exposure. It is all about having cash in reserve to take advantage of the lower prices when they come around, as they always do.

    TER: Thanks for talking to us, Elliott.

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

    Since earning his bachelor's and master's degrees from the University of London, Elliott Gue has dedicated himself to investment in the energy sector, and was been referred to in the official program of the 2008 G-8 Summit in Tokyo as "the world's leading energy strategist." He has also appeared on CNBC and Bloomberg TV and has been quoted in a number of major publications, including Barrons, Forbes and The Washington Post. Gue's expertise and track record of success have also made him a sought-after speaker at MoneyShows and events hosted by the Association of Individual Investors. Gue has contributed chapters on developments in global energy markets to two books published by the FT Press, "The Silk Road to Riches: How You Can Profit by Investing in Asia's Newfound Prosperity" and "Rise of the State: Profitable Investing and Geopolitics in the 21st Century." Prior to founding the Capitalist Times, Gue shared his expertise and stock-picking abilities with individual investors in two highly regarded research publications, MLP Profits and The Energy Strategist, as well as the long-running financial advisory Personal Finance. In October 2012, Gue launched the Energy & Income Advisor, a semimonthly online newsletter dedicated to uncovering the most profitable opportunities in the energy sector, from growth stocks to high-yielding utilities, royalty trusts and master limited partnerships.

    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) Peter Byrne 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) Elliott Gue: I own, or my family owns, shares of the following companies mentioned in this interview: Enterprise Products Partners L.P., Cypress Energy Partners L.P., Memorial Production Partners L.P., Exxon Mobil Corp., Chevron Corp., Eni S.p.A., Total S.A., Noble Energy Inc., Valero Energy Corp., Alon USA Partners L.P., Baker Hughes Inc., Halliburton Co., Schlumberger Ltd., Weatherford International 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.
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  • Malcolm Gissen And Marshall Berol: Welcome To The Golden Era Of Oil & Gas

    Few things in life are certain, but Encompass Fund managers Malcolm Gissen and Marshall Berol are convinced that the world needs much more energy, and that this is great news for oil and gas companies and their investors. In this interview with The Energy Report, Gissen and Berol discuss why their fund has shed much of its metals interests in favor of oil and gas producers and services and highlight their strategy for picking potential winners in an evolving energy market.

    The Energy Report: In your May 31 annual report, you wrote: "The most important change we have made to improve performance has been to increase the [Encompass] Fund's exposure to the energy sector, while reducing exposure to metals." Why have you done this?

    Malcolm Gissen: We believe that we are now living in a golden era of oil and gas. We believe that demand for oil and gas will continue to grow faster than supply. This provides a unique opportunity to invest in companies that do not have a great deal of risk, yet boast many attractive characteristics. They are expanding production. They are expanding cash flows. They are improving exploration technology. They are reducing expenses. Internal rates of return [IRRs] often go over 100%.

    TER: How are the investments in the Encompass Fund allocated by sector?

    MG: Oil and gas companies comprise about 20-25%. Oil and gas field services are 2.5-4%, and natural gas processing companies are about 2.7%. Precious metals are a little under 20%. We're not solely a commodity fund, however. We've also got technology and biotech companies, as well as homebuilding, healthcare, and real estate investment trust [REIT] companies, among other sectors, represented.

    TER: How much must oil and gas supply grow to meet demand?

    MG: In "The Outlook for Energy: A View to 2040," Exxon Mobil Corp. (NYSE:XOM), in its annual report for 2013, predicted that global energy demand will grow about 35%, driven by growth in developing nations. By 2040, Exxon expects nine of the world's 20 largest cities will be in India and China, and that these two nations alone will account for more than 50% of the increase in global energy demand. Even as fuel efficiency increases and technologies improve, oil will remain the No. 1 fuel type, with natural gas supplanting coal as No. 2.

    The International Energy Agency [IEA] published a special report in June on this subject. The IEA projects that spending to meet energy needs will increase from $1.6 trillion [$1.6T] in 2014 to $2T per year by 2035. The IEA report estimates that the total spent to meet the world's growing need for energy will be $48T by 2035. Less than half of that spending will be in developing new energy supply; most will be to replace declining production from existing oil and gas fields.

    This bolsters our belief that investment portfolios should increase exposure to oil and gas, and helps explains why the Encompass Fund produced a 17.4% return as of the end of August.

    TER: What will be the primary source of new supply?

    MG: The IEA forecasts that North America-the U.S. and Canada-will provide most of the new supply into the 2020s. After that, there will be more dependence on Middle Eastern oil and gas, according to the IEA.

    Marshall Berol: I would add that whatever your views about climate change, the fact of that matter is that governments around the world are moving away from coal. China, for instance, is moving toward more use of natural gas, particularly around Beijing, because of pollution. China has announced that it will be closing almost 2,000 small coal mines. And after the Fukushima earthquake, use of nuclear power to generate electricity has become politically troublesome.

    TER: Isn't an increased dependence on oil and gas from the Middle East troublesome? The Islamic State in Iraq and Syria [ISIS] army has already occupied much of Iraq and has moved into Kurdistan.

    MG: Middle Eastern politics have become increasingly volatile, violent and unpredictable. We think it unlikely the jihadists are going to disappear, no matter how strongly the West responds to them. They are active in Lebanon, Syria, Iraq, Pakistan, Yemen, Libya and Nigeria, among other oil-producing countries, and present a constant threat to oil supply in both the Middle East and Africa.

    TER: Even as the Middle East burns, the West and Russia are ramping up sanctions against each other.

    MG: Vladimir Putin seems intent on increasing instability in Eastern Europe, not just in Ukraine, and that impact is likely to grow. In 2013, the U.S. exported more than $1.5T of goods, and less than 10% of that was either crude oil or petroleum products. That same year, Russian exports of crude oil, petroleum products and natural gas amounted to more than two-thirds of total exports, and composed more than 50 percent of the Russian government's total revenue. Much of these exports go to Europe: 30% of Europe's natural gas comes from Russia. There is a real threat that this supply could disappear. If that happens, natural gas prices will likely rise, and we'll see pressure on North America to replace the Russians as suppliers of natural gas for Europe.

    TER: Do you believe in the peak oil theory?

    MG: No, for two basic reasons. First, we're finding more oil, and a number of those discoveries are of very large reserves, such as those off the coast of Brazil, Mexico, Russia and Australia, among other places. Oil is also being found in more remote places, often very deep in the ocean. But it is there, and it will be produced, particularly with oil selling at $90 to $110 a barrel [$90-110/bbl]. Right now West Texas Intermediate [WTI], at around $94/bbl, is very profitable for oil companies. We expect prices to remain in this range-perhaps even go higher-for some time.

    The second reason Marshall and I don't believe in peak oil is that technological advances are being made that are increasing production, as exploration companies capture oil and gas from existing reservoirs that had eluded them in the past. Horizontal drilling and fracking are making that possible. We're seeing more horizontal drilling than vertical drilling now in the U.S. and Canada.

    MB: That said, the technologies being utilized to increase production-horizontal drilling and hydraulic fracturing [fracking]-are more expensive than drilling was just 50 or 75 years ago, when you punched a hole in the ground and the oil came gushing out. These increased expenses, as well as a tightening of supply/demand, should result in a continued rise in oil and gas prices.

    TER: After the 2008 economic crisis, we saw a drop in energy demand and a concomitant drop in prices. Should economic growth stall or fall again, won't demand and prices fall with it?

    MG: There are two answers to this question. The first is that we're not traders. We're investors. We're looking at what will happen over the next 6 to 36 months. We also believe that the demand for energy in developing countries like China and India, and in Third World countries, assures that world demand will outstrip supply during any reasonable period over the next 5-10 years. There will, of course, be economic slowdowns, but we think they won't last more than a few quarters

    MB: Another factor that should be mentioned is the increasing size of the middle class worldwide. In China, we're watching 250-300 million [250-300M] people move from rural areas to cities, and consume more energy. They want dishwashers, refrigerators, washers and dryers, and cars. We're seeing the same in India, as it builds infrastructure. A number of African countries are also demonstrating improvements in living standards.

    TER: You have noted that because of increased horizontal drilling and fracking, the U.S. is importing less oil every year, and have argued that soon oil imports will be unnecessary. Are horizontal drilling and fracking a short-term boost to U.S. energy supply, or is this a bigger story?

    MG: Fracking is not a short-term solution, but a permanent one. It is here to stay. The technology gets better and better, increasing oil and gas production and having a smaller impact on the environment. Proper regulation should ensure against environmental concerns, such as oil getting into the water table.

    MB: Horizontal drilling and fracking are increasing production globally, not merely in the U.S. and Canada. We think this trend will continue. Further technological advances cannot be guaranteed, of course, but we certainly don't discount them.

    TER: How much of a premium do you award oil and gas companies already in production?

    MG: We look more favorably on investing in companies in production, as opposed to those still in the discovery, exploration and development stages. With regard to oil and gas companies, we like those that are increasing production, cash flow and profitability, whether due to acquisitions of new lands or companies, or both. We are looking for companies that are very profitable, that have access to all the capital they will need to continue fast-paced growth, that are applying newer technology to production of oil and gas, and that have experienced management teams with prior successes.

    TER: In the mining industry, junior explorers find the metals. To what extent is increased oil production driven by oil juniors?

    MG: Juniors drive production to a significant extent. Let me clarify. The large, integrated companies, such as Chevron Corp. (NYSE:CVX) or Exxon Mobil, produce enormous quantities of oil and gas, and are only interested in very large projects. In 2013, Exxon produced over 18 million barrels [18 MMbbl] of oil equivalent [oil, natural gas and natural gas liquids] per day, and had revenues of $438 billion. Exxon will only explore if the project has very large potential.

    The juniors produce less than 10,000 barrels of oil equivalent per day [10 Mboe/d], but the juniors in which we are invested have the potential to increase that by 20-35% per year. If they are successful-and most are-their stock prices should react accordingly. In some cases the juniors are exploring areas not known to have produced oil and gas. They can do this with greater dexterity and at far lower costs than the large companies. When the juniors find oil and gas in these areas, we often see larger companies come into those basins, buying companies and driving up valuations.

    In other cases, the majors sell junior companies properties that, to the majors, may seem marginal because they don't appear to have enormous resources at the time. If the junior companies prove the potential of these properties, the majors can always buy back the properties, or simply buy the juniors involved. Cash flows are so enormous in this industry, and bank lines so available, that it is not difficult for large companies to make these acquisitions.

    MB: Whether it's energy, mining or pharmaceuticals, the larger companies are less innovative, less creative, and more risk-averse. It is the smaller companies that are willing to take the risks.

    Some years ago, the oil majors in the U.S. and Canada sold many of their enormous land holdings and leases to smaller, more nimble companies. It is the latter that made the technological advances in exploration and development we've seen in the last 5-10 years. Now, the majors are coming back to the areas they had gotten out of.

    TER: Junior mining companies have been hobbled by funding shortages for more than three years. Does this situation pertain to junior oil companies?

    MG: Not to the same degree, by any means. The primary reason for the difference is that junior mining companies typically have no revenues, let alone profits. Junior oil and gas companies likely do have production-growing production. They have increasing cash flow, which gives them the ability to finance their own growth.

    TER: Which junior Canadian producers do you rate most highly, particularly with regard to potential expansion?

    MG: The question of potential expansion is easy to address: They're all expanding. The ones we prefer are expanding faster and more efficiently. In client accounts, we're invested in nine or 10 Canadian oil and gas companies, and in one very good company in the U.S. A number of these Canadian oil and gas companies pay very attractive dividends.

    A company we think should be in every investor's portfolio is DeeThree Exploration Ltd. (OTCQX:DTHRF) [DTX:TSX.V], an oil-weighted name in the Canadian mid-cap space that has grown production for 11 consecutive quarters. That derisks the investment, as skeptical investors see DeeThree's success. We just met with the company's CEO, and he confirmed that DeeThree intends to grow production by about 1 Mboe/d per quarter for the next few years. The company has the resources to accomplish this for a long period of time. DeeThree has been realizing exceptional results from its Belly River wells, which should continue to be the growth engine for the company. Growth should also come from its Alberta Bakken wells. The stock looks cheap when compared to its peers. It has some of the best wells and the biggest production from any initial well drilling in Canada this year.

    TER: Which other Canadian companies do you like?

    MG: When we look at energy companies, we examine their relative oil and gas production, the likely growth over the next one to two years, cost control and profitability.

    Natural gas prices have backed off a bit and are not particularly high, as production has increased significantly the last few years, largely due to increased fracking. We think that natural gas prices are likely to go higher in the longer term. Oil prices look very attractive now, and we think they will go higher as well.

    Tamarack Valley Energy Ltd. (OTC:TNEYF) [TVE:TSX.V] is a junior oil-focused exploration and production [E&P] company with exposure to two compelling plays in Canada. The company's production is expanding as it increases its capital budget. The company continues to outperform the expectations of analysts and investors, and has excellent management. We see the potential for growth in excess of 40% over the next 12 months.

    TER: Is there another company?

    MG: Bellatrix Exploration Ltd. (NYSEMKT:BXE) is a deeply discounted Canadian E&P that has been among the least expensive small/mid-cap Canadian E&Ps. The company has grown production significantly over the past few years [about 65% of production is natural gas], as it has attracted overseas partners to fund some of its exploration on very favorable terms. In raising money recently, Bellatrix received bad advice from its banks and had to cut back the size of the raise. It was punished for that, and the stock declined. With about 40 Mboe/d in production in 2014, and production increasing in 2015, we think that patient investors will be rewarded longer term.

    The four companies we've mentioned are all in client accounts, and we believe they are undervalued, even as they're expanding production and revenues while profitability grows. They have enormous resources and enough locations to drill for 10-20 more years. This is what makes the Canadian E&P subsector particularly attractive.

    TER: Could you explain the difference between development drilling and exploration drilling?

    MG: The four companies we've mentioned are developmental drillers. They drill where there are known pools of oil and/or gas, and hit close to 100% of the wells they drill. Thus there is not great risk of drilling a dry hole. Exploratory drilling is riskier because you are drilling where oil and gas has not been discovered, but it has much higher upside.

    TER: Aside from the U.S. and Canada, which region is most prospective?

    MB: South America has two very significant oil and gas basins. One is in the Colombia/Ecuador/Peru area, and the other is in Argentina. We have stayed away from Argentina because its government has been distinctly unfriendly to both the energy and mining industries.

    With the decline of the drug wars and a more business-friendly government, Colombia has greatly expanded its oil and gas production over the past dozen years. There's a lot of development going on there.

    TER: What's your favorite South American oil and gas producer?

    MB: One company that has done quite well for the Encompass Fund is Canacol Energy Ltd. (OTCQX:CNNEF). It now has 12 producing wells, and production is about two-thirds oil and one-third natural gas. Q2/14 showed a 47% production increase year-over-year [YOY].

    Canacol does a lot of drilling in its existing production areas, and a lot of exploration in adjoining areas. It has the financial and managerial ability to handle growth. It's a solid midsize now, with about a US$522M market cap, and it has some big partners, including Exxon and ConocoPhillips (NYSE:COP).

    TER: Oil and gas servicing is a rapidly growing sector. What other companies do you like?

    MB: Energy services are very attractive to us because, as oil and companies have increased production, they require increased services from the related industries: engineering, pipeline construction, maintenance, disposal, water handling, etc.

    Another good-size holding that we have in the Encompass Fund is GreenHunter Energy Inc. (NYSEMKT:GRH). It has also shifted its focus, in this case to the transportation, handling and disposal of the water and other fluids involved in fracking. Fracking pushes a lot of water into the ground. Most of that water comes back up, and needs treatment and disposal. GreenHunter's revenues increased 18% in the previous quarter year-over-year. The company is still not that large, but we think there's a lot of room for growth. GreenHunter operates primarily in the Appalachian region, in the Marcellus and Utica shale plays, and in the Bakken Shale of North Dakota.

    The company is in the final stages of permitting to barge liquids on the Ohio River system, which appears to be far more economically and environmentally beneficial than trucking these liquids up and down the roads.

    TER: Of the companies that we've discussed, which are your favorites?

    MG: Which of our children do we like the best? That's a very difficult question to answer. I can say that Canacol Energy is among our largest holdings, as is Magnum Hunter Resources Corp. (NYSE:MHR). Magnum is the largest individual holding in our mutual fund.

    Magnum had some property in Canada and in the Texas shale plays, which the company has sold off. It now concentrates on oil and gas production and exploration in the Marcellus and Utica areas, and has been very successful. The CEO, Gary Evans, previously built up another company also named Magnum Hunter. He sold that several years ago for about $1.2B, and started a new E&P company under the same name. He is an extremely knowledgeable oil and gas executive, with a very experienced and knowledgeable team around him.

    TER: How much consolidation in the oil and gas industry can we expect in the near future, and which companies do you see as possible takeover targets?

    MG: There are many companies with lots of cash, and with interest rates as low as they are, it is much easier than it has been for years for midsize and larger companies to make acquisitions. We have seen many acquisitions of companies and of land in 2014, and we should see a number of significant acquisitions over the next couple of years.

    One of the companies in some of our client accounts was Crocotta Energy Inc. (OTCPK:CRCTF) [CTA:TSX], which had very aggressively expanded production. As a result, it was just acquired at a very nice premium by Long Run Exploration Ltd. (OTCPK:WFREF) [LRE:TSX]. Several of the companies we've mentioned today are possible acquisition targets. Bellatrix could be acquired by one of the larger Canadian or American companies, because they have very attractive resources and have derisked their investments.

    MB: We don't think that a proper investment philosophy is buying a company because it's going to be acquired. Having said that, buyouts are an attractive way to go when all the metrics are there: properties, finances and good management teams.

    TER: Malcolm and Marshall, thank you for your time and your insights.

    This interview was conducted by Kevin Michael Grace of The Energy Report and can be read in its entirety here.

    Malcolm Gissen founded Malcolm H. Gissen & Associates Inc., an investment advisory services firm, in 1985. Whereas early in his career the firm specialized in financial planning and in funding private companies, it has, since 2000, focused on money management. Gissen received a bachelor's degree from Case Western Reserve University and a Juris Doctor degree from the University of Wisconsin. In 2006, Gissen and Berol cofounded the Encompass Fund, a no-load mutual fund, and are the portfolio comanagers.

    Since 2000, Marshall Berol has been the chief investment officer of Malcolm H. Gissen & Associates Inc. In addition, for more than 20 years, he has owned the investment firm BL/SH Financial. His investment management experience has focused primarily on investments in publicly traded companies. He did his undergraduate work at the University of California, Berkeley, and received a Juris Doctor degree from the University of San Francisco School of Law. He was in the private practice of law before entering the investment-management business.

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    DISCLOSURE:
    1) Kevin Michael Grace 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) Malcolm Gissen: I own, or my family owns, shares of the following companies mentioned in this interview: ExxonMobil, Long Run Exploration Ltd., Magnum Hunter Resources Inc., GreenHunter Energy Inc., Tamarack Valley Energy Ltd., DeeThree Exploration Ltd., Crocotta Energy Inc., Canacol Energy Ltd., Bellatrix Exploration 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) Marshall Berol: I own, or my family owns, shares of the following companies mentioned in this interview: GreenHunter Resources Inc., Magnum Hunter Resources Inc., Encompass Fund. 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.
    5) Encompass Fund owns Bellatrix Exploration Ltd., Tamarack Valley Energy Ltd., Canacol Energy Inc., GreenHunter Resources Inc., and Magnum Hunter Resources Inc. The fund is not paid by any company, and has no financial relationships, except as a security holder.
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    Sep 11 2:50 PM | Link | Comment!
  • Oil Field Services Surprise: Brandon Dobell On The Upstart That Could Compete With The Big Three

    Consolidation is coming to the oil and gas industry, says Brandon Dobell of William Blair & Co. As economic recovery takes root, oil prices will stabilize at current levels and interest rates will remain low, creating conditions for mergers and acquisitions among explorers and producers and, in a ripple effect, among the oil field service companies they employ. In this interview with The Energy Report, Dobell offers a surprising prediction for a service company he expects to see playing in the big leagues soon.

    The Energy Report: Brandon, oil prices are declining globally. Should investors be concerned about that?

    Brandon Dobell: There are a couple of angles to focus on here. Oil prices were strong in May, June and July, and geopolitical tensions in the Middle East, as well as Russia, put stress on expectations for supply. On the heels of that, in recent weeks relatively weak economic data points have come out-out of Europe, in particular.

    For investors in the U.S., let's call oil prices a mixed bag. After a run-up in both West Texas Intermediate [WTI] and Brent prices, recent economic data points have forced oil prices down a bit. They were high, so weaknesses off a high level are not too concerning. But investors, like explorers and producers [E&Ps], have to pay attention to the prices they can realize in the market. They must pay attention to the price level, but also to the trajectory or velocity of change in commodity prices.

    Most conventional basins are economical at current levels. Production costs, or break-even costs, are $60, $70, even $80/barrel [$80/bbl] in some of the unconventional basins and the offshore theaters. Weighing concerns for operators, price per barrel is a graduated scale. At $90/bbl, I don't think anybody is too concerned. At $80/bbl, you're going to have some concerns about production in some of the unconventional basins. Some of the shale basins in the U.S., for example, start to get a little wobbly. Operators get nervous about the prices they can realize in the global markets. As you track below WTI of $80/bbl, you start to impact activity levels a lot.

    The plus side is there's not an awful lot of spare capacity globally. The Middle East, in general, doesn't have the ability to flip a switch and pump more crude oil, like it had in the 1970s or 1980s. North American production has helped buffer some of the lack of spare capacity in the Middle East, but we can't turn that production on and off automatically-that's not the way unconventional shales work. Prices have more downside protection than in previous years given the lack of spare capacity and the types of basins generating oil and gas.

    But there is concern, of course, which has been reflected in energy services stocks and in oil and gas stocks in the last three or four weeks, post-Q2/14 earnings and performance reports. The weak performance since late July is a reflection of both high expectations going into Q2/14 earnings, and concern that oil prices below $90/bbl will get operators to think about how much money they deploy to drill and complete new wells.

    TER: Do you foresee any further slippage than what's already occurred?

    BD: It wouldn't surprise me, but I don't expect a major downtick. I would expect the geopolitical wrangling in the Middle East and Russia, which are about supplies of energy, to continue. Whether we've seen de-escalation of tensions in those regions is a tough question to answer. De-escalation would probably put pressure on oil prices because people would be less concerned about supply.

    It feels like the path of least resistance is for prices to move lower, but the lack of global spare capacity continues to be important to the overall commodity price. If capacity goes too low, supply starts to dry up. Projects on the verge of becoming economic get delayed. Any geopolitical shock could tighten up supplies quickly. Those factors would tend to put a higher floor on oil prices than we would have seen three or four years ago, when there was more spare capacity in the market.

    TER: You mentioned low prices in the shale market. Are there any signs of weakness in the U.S. unconventional oil sector?

    BD: Not really. We approach the shale market from equipment and services companies, so our perspective is a bit different than that of investors focused on producers. After a rough finish to 2013, when activity levels were down year-over-year, we have seen a decent rebound in activity levels for service companies like pressure pumpers. The equipment companies are talking about restocking inventory, and are back selling more into distribution channels.

    Initial production rates on a lot of the shales are quite good for new wells. Technology continues to improve, which means successive wells tend to generate better returns for E&Ps. There is more takeaway capacity in many of the unconventional basins, meaning you don't have huge gluts of oil and gas stuck in a particular part of the country because you can't get it out either by rail or by pipeline.

    The decision to widen the definition of what is OK to export from the U.S., with a couple of the E&Ps given the go-ahead to export condensate, or crude that has been distilled in condensate, has given E&Ps more confidence that, over the coming years, the definition of what is exportable from the U.S. will be expanded. If there's enough momentum to export natural gas and other types of products, companies won't get stuck with a lot of oil or gas sitting in storage in the U.S.

    At the same time, the E&Ps are getting better at driving down well costs. They drill wells faster and more cheaply than they could have two or three years ago. The technology is getting better, and so well completions are driven more by science and less by horsepower, which tends to generate better initial production or better decline rates.

    In general, the U.S. shale environment is in good shape. Of course, global prices could influence the E&Ps' confidence level. But if WTI prices are $90-110/bbl, which seems like a reasonable range for the foreseeable future, there's a good amount of confidence that E&Ps working in the shales can continue to employ capital and generate solid returns for the equity and debt investors.

    TER: Are you expecting oil prices to rise again anytime soon?

    BD: No. I think they were overdone on the high end because of geopolitical clashes. For prices to go back up, we're going to need geopolitical escalation-Russia pushing harder on the Ukraine, the Islamic State in Iraq and Syria [ISIS] pushing harder in the Middle East or, potentially, China doing something in the South China Sea to get Japan or the Philippines up in arms. China has been a big driver for the marginal price of oil, because it is the marginal buyer right now.

    As we get closer to year-end, you'll see some stronger economic data points, and that will bolster confidence around demand. Upward pressure on oil prices toward year-end wouldn't surprise me, as people think about economic growth and start gearing up for 2015.

    TER: There has been a lot of merger and acquisition [M&A] activity in the oil field services in North America recently. Is this level unusual?

    BD: There wasn't an awful lot of M&A coming out of the financial crisis and in the following periods of weak activity. M&A is difficult in a financial crisis because debt financing is hard to get. When there are inflections in activity, especially to the downside, companies in strong financial positions are not willing to take a risky bet on an acquisition because they have spare capacity, both in equipment and people. When the financial picture gets good, sellers want a premium price.

    On a longer-term basis, I'd expect more consolidation. The U.S. unconventionals require, or are necessitating, a different approach to development, completion and production.

    The term "manufacturing" has been thrown around in the oil field space. Rigs have gotten more efficient and more powerful. Drillers and E&Ps are able to drill wells in less time, and they're able to use processes that are repeatable across a basin and across wells. Efficiencies have been driven into the development process. Those efficiencies necessitate larger organizations that can deal with rapid turnarounds, tight supply chains, and serving a customer across multiple basins, even though those multiple basins have very different geologies.

    Also, given the duration of the shales-we're going to have a lot of oil and gas production for a long time-I think we will see a healthy amount of E&P consolidation, either within independents of decent size or with supermajors buying out independents to get bigger positions in the bigger basins, especially as larger E&Ps look at risk-adjusted capital returns.

    The Western Hemisphere has been, and will continue to be, an attractive place to deploy capital. The big oil companies have big balance sheets, and have to deploy capital in big ways. That will drive E&P consolidation. And E&P consolidation is going to drive service company consolidation, because the E&Ps won't want to deal with five or 10 different vendors.

    As long as credit markets and the oil prices remain solid, companies will bulk up both organically and through acquisitions. Current interest rates certainly make doing M&A in any sector an attractive proposition, especially in energy in the U.S., where you have a good horizon for growth and activity levels.

    TER: Are you excited about any particular companies in the oil field services sector?

    BD: C&J Energy Services Inc. (NYSE:CJES), which we've covered for a couple of years now. They are primarily a U.S.-focused services provider. I like their strategic positioning. I like the fact that the company is in North America, where I feel activity levels are going to be good for quite some time. They're also a company that has, for a variety of reasons, fallen between the cracks for investors. When you find a stock that hasn't been dug into by the institutions or other analysts, and if that company can execute on its strategy, that's an opportunity for outsized returns on investment.

    TER: The big news at C&J Energy Services is the acquisition of Nabors Industries Ltd.'s (NYSE:NBR)Completion and Production Services unit. How does that benefit C&J?

    BD: The thesis has a couple of different components. The acquisition gives C&J a broader list of services to sell to its existing customer base. The company is now also in a better position to go after some international opportunities over the next 10 years, in some unconventional basins in the Middle East in particular, but perhaps elsewhere.

    The part of the story that gets me most excited is that a lot of the equipment in the Nabors completion segment has been underutilized. C&J has been a metrics-driven, utilization-driven company. It has a sales force that finds opportunities to deploy the company's equipment, to keep utilization high. I don't think the same management or operational strategy was deployed on the Nabors side as well as it will be by C&J. C&J can put the Nabors equipment to work quickly, whether it's coiled tubing units, wireline units, pressure pumping fleets or all three. You'll see the evidence of how C&J plans to make more money, both on the top and bottom lines, after this deal closes and we move into 2015.

    With this acquisition, C&J will be a significant player in every service line necessary for completion services-pressure pumping in hydraulic fracturing, wireline, coiled tubing, cementing and workover rigs for down the line, when well intervention and recompletion opportunities abound. C&J is now much better able to compete with the likes of Schlumberger Ltd. (NYSE:SLB), Halliburton Co. (NYSE:HAL) and Baker Hughes Inc. (NYSE:BHI) in every basin and every service line, whereas previously it was viewed as a midtier player. It has the scale and capacity to serve the market better. That should afford the company opportunities to drive more benefits of scale than we've seen in the past.

    TER: Schlumberger and Halliburton? That's fast company. Is there any drawback?

    BD: Yes. There's the risk that C&J is now a bigger company but not necessarily a better company. M&A can work for you or against you. Getting bigger doesn't necessarily mean you're going to be better at what you do.

    But the big three-Schlumberger, Baker Hughes and Halliburton-dominate the market for pressure pumping and completion services. I think having an upstart-somebody new on the scene with a different approach-is nice positioning from a go-to-market strategy perspective.

    But, as I said, C&J has to execute-utilize the Nabors equipment better and convince customers that it can perform at a high level. If the company can do that, it has a good opportunity to move into the top echelon as a premier provider.

    I also think scale is going to afford C&J the opportunity to sit at the table for the Middle East unconventionals, as the large Middle Eastern national oil companies get more confident that C&J can execute in the Middle East like it can in North America. If you're really small, it's tough to convince big oil companies you can travel halfway across the globe and do the same kind of job you're doing in Wyoming or Texas.

    TER: Are there so few opportunities for a company like this in the U.S. that it would look offshore? That seems kind of risky.

    BD: C&J did a pilot project with Saudi Aramco in Q2/14. It was a coiled tubing pilot project. The company did a good job, so now it has a larger contract with Saudi.

    The reason to look overseas is that there's less competition for unconventional completion services outside the U.S., so the pricing and margins are better than in the U.S. If you have the capital to deploy, one could argue that you should deploy that capital against opportunity in the Middle East just as you would deploy it here in the U.S. C&J has an opportunity to use its experience with Saudi Aramco, along with its relationship with Nabors, to utilize its international equipment at higher rates.

    I wouldn't anticipate C&J taking equipment from the U.S. and putting it to work overseas. C&J sees a tremendous amount of opportunity to take market share in a growing market here in the U.S. But the two businesses are going to generate an awful lot of cash flow. If C&J can deploy its cash flow into two or three markets and generate good returns in those markets, no matter what theater we're talking about, the stock is going to benefit.

    TER: C&J has four big lines of business. Which lines contribute the most to its revenue, and which has the highest margin?

    BD: The biggest single piece of revenue is in pressure pumping or hydraulic fracturing, where C&J is doing the work for an E&P to fracture a well in the early part of the completion process. Within that segment is the coiled tubing business; coiled tubing has a lot of different applications. Coiled tubing is the highest-margin business for the company, although wireline is also quite profitable. The pressure pumping business can produce a very good margin.

    C&J has been impacted by pass-through costs for the last several quarters. The company will buy sand, or ceramic proppant, or resin-coated proppant, and then resell that as part of a package deal it gives to an E&P. That transaction usually comes at a low margin. So margins on the fracking business have fallen, whereas the wireline and coiled tubing margins remain quite strong. That's consistent across the space, where, coming out of three or four quarters of difficult pricing and activity levels for pressure pumping, operators are now starting to talk about stable prices or prices going up a bit.

    If prices increase, that falls right to the bottom line. The Nabors acquisition should allow C&J to generate better margins because there will be better utilization across the entire fleet, but I think you'll see growth first in the coiled tubing and wireline opportunities.

    TER: Are you excited about anybody else right now?

    BD: Yes. Shifting from North America and heading offshore, we've focused on RigNet Inc. (NASDAQ:RNET). Think of it as a telecommunications service provider for the oil and gas industry, primarily for offshore rigs, platforms and vessels, but also for the onshore markets. It installs and services equipment on rigs, like antennas and routers. It provides bandwidth from the big satellite companies, as well as microwave providers. It is one of the two companies-the other is Harris CapRock, a subsidiary of Harris Corp. (HRS:NYSE)-in the offshore space that connect rigs and production facilities back to headquarters, remote offices or other bases of operations. It provides these services for E&Ps leasing rigs to drill in the Gulf of Mexico or offshore Africa, and, on occasion, to service companies like Schlumberger, Halliburton, Baker Hughes and Weatherford International Ltd. (WFT:NYSE), which are on the rigs as well.

    RigNet does not own satellites or bandwidth. It's a bandwidth reseller. The business model looks more like that of a telecommunications service provider or a cell tower company. The company enters into multiyear contracts with good revenue visibility based on the amount of bandwidth provided, the location, and the breadth of services RigNet is offering.

    We think the growth rate opportunity over the next several years is strong, driven by site growth, meaning RigNet will continue to add offshore rigs, offshore vessels and production facilities to its network. There is big opportunity in the oil and gas space, both onshore and offshore, for more information, bandwidth, real-time video and similar services. Rigs, operators, E&Ps and service companies not only generate, but need to access more information. RigNet stands right in front of what we think is a good trend for the next several years.

    TER: If exploration and production in the Atlantic Ocean is approved, how will that affect RigNet's business?

    BD: It's a net positive. The more areas that open to exploration and development, the more opportunities E&Ps have to put capital to work. There are going to be rigs drilling wells and, eventually, there are going to be facilities producing oil and gas from those wells. This net positive number of rigs, vessels or production facilities operating globally gives RigNet opportunities for market share.

    I'll give you another example. Reforms in Mexico could open up deepwater Mexico on the Gulf of Mexico over the next five or 10 years. That should be a net positive as well, particularly because RigNet has a very good telecommunications network, as well as service capability, in the Gulf of Mexico. On the Atlantic, RigNet has good onshore and offshore presence, which it should be able to parlay into opportunities.

    TER: Are you expecting, then, that the Atlantic would draw entirely new rigs, and not just rigs moved from elsewhere?

    BD: That remains to be seen. Part of the volatility we've seen with RigNet's stock has been driven by uncertainty around rig utilization. Are there too many rigs out there? Are there not enough rigs out there?

    I think the general consensus is that there are too many midwater rigs, and too many low-specification rigs, and that's putting pressure on day rates for the rig operators. That's started to worry people looking at a stock like RigNet, or other stocks related to offshore drilling. If the initial move to the Atlantic does turn into an interesting opportunity for the E&Ps, you'd probably see low utilization rigs move that direction. Some might come from the Gulf, some might come from the Middle East. If there are too many rigs, and operators are worried about utilization, having the Atlantic or Mexico open up would take up some of the slack. That would be a good thing for RigNet. Fewer concerns about rig utilization or the number of rigs working in the Gulf, the Atlantic or globally, would mean fewer concerns for investors about RigNet's ability to grow revenues.

    TER: How is the Inmarsat Plc (OTCPK:IMASF) acquisition affecting RigNet's margins and its share price?

    BD: Initially, Inmarsat came in as a much lower margin business. The acquisition was quite dilutive to RigNet's overall operating margins and earnings before interest, taxes, depreciation and amortization [EBITDA] margins, after you take into account appreciation for the deal. Part of that is just scale. The Inmarsat energy business that RigNet acquired, which provides communications and project management services to the onshore and offshore oil and gas industry, similar to RigNet's business, was underscaled and probably undermanaged. RigNet has the opportunity to do things better, smarter, and on a larger scale; it could generate some better margins.

    Over the long run, the acquisition affords RigNet the opportunity to consolidate the number of bandwidth providers it uses, which should be a tailwind to gross margin. It's certainly afforded the company that opportunity in the Gulf of Mexico and onshore. It got a lot more scale in both those areas, so there should be better operational leverage with every dollar of revenue. But, as you look at our financial projections comparing 2015, 2014 and 2013, the margins we have in our model this year and next year are lower than they were in 2013. That's a direct reflection of RigNet's buying a lower-margin business.

    RigNet has said it thinks it can get the Inmarsat margins up to par with RigNet's core business over time, which would mean taking it from a 5% EBITDA level to something in the 25% range. RigNet made a smart acquisition because it puts the company in a much better strategic position with regard to technology and bandwidth access over a longer period of time.

    TER: Do you have any parting words of advice?

    BD: My big picture commentary is that North America is the right place to be. The activity levels in this sector will be good for a long time. From a research perspective, we're focused on finding ideas in energy that are off the beaten path. We also like to align ourselves with management teams that are thinking about customers first, and deploying capital in ways that generate good returns. The two companies we highlighted today line up well with that. It's been a hallmark of how William Blair looks at companies on the sell side. We try to find good growth businesses with good returns on capital that have management teams that can executive and are aligned with shareholders. C&J and RigNet are both good ideas in that regard.

    TER: Brandon, thank you for your insights.

    BD: My pleasure.

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

    Brandon Dobell, partner and group head, global services at William Blair & Co. LLC, specializes in the energy, real estate services and technology industries. Dobell was previously group head, global services research at Credit Suisse. He also worked in equity research at Bank of America Securities. Dobell has won two awards in the Financial Times/StarMine "World's Top Analysts" listing, including the No. 2 earnings estimator rank for 2008 in diversified consumer services, and the No. 1 earnings estimator rank for 2009 in real estate management and development. Dobell has a master's degree in business administration (finance) from the University of Southern California Marshall School of Business, and bachelor's degrees in history and political science from the University of California, San Diego.

    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.

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