The Energy Report's  Instablog

Source: Peter Byrne of The Energy Report (5/9/13)

http://www.theenergyreport.com/pub/na/15246

Shale oil has been North America's great experiment, says Oil & Gas Investments Bulletin Editor Keith Schaefer. But in this interview with The Energy Report, he questions the experiment's success and predicts steep declines ahead, with just a few formations left to supply the market. The question is what shale play will last the longest? Read on to find out how-and when-to get positioned for the end of the shale revolution.

The Energy Report: A number of experts say North American gas supply is peaking. Where do you weigh in?

Keith Schaefer: During the last three years, the mantra has been, "Drill, baby, drill," for a number of reasons. The price of gas was never one of those reasons. Companies drilled because the technology kept improving. They drilled because they were able to get cheap foreign capital to partner in joint ventures. The market situation was not based upon economic "truth." It was based on securing the land position and, "Economics be damned, let's go!" But we are now returning to a real gas market based upon economic fundamentals. Where that's going to shake out, nobody knows; the market is betting on higher prices.

"We are now returning to a real gas market based upon economic fundamentals. Where that's going to shake out, nobody knows; the market is betting on higher prices."

The reality is, Peter, there is only one true gas formation in the U.S. that is increasing production, and that's the Marcellus. Every other single shale gas play is now in decline. The industry is now much more disciplined in producing gas, as the rig count has gone way down. But I suggest that the price rise is a year or two away because there is so much gas drilling going on in the Marcellus and Eagle Ford. These two formations are making up the shortfall in other regions. At some point in time-nobody really knows when-the scales are going to tip: Gas production in North America will seriously decline. The gas bulls think it's going to happen quickly, because the hydraulic fracking wells come in like gangbusters and then rapidly decline. An overall decline in supply could drive up the price.

TER: Are there undeveloped or undiscovered shale gas plays still out there?

KS: The short answer is that we do not know. Explorers are testing new areas. Just outside the Bakken, there is activity in Bowman County. There is play in the Heath Shale. It looks like the Utica will be mostly gas, not oil. But I don't see any more Marcellus Shales out there.

TER: Is there a limit to exploration?

KS: All of the easy fruit has been picked. Remember, most of the shale plays were already well known geology, so everybody knew where the oil and gas was. We just did not have the technology to get the stuff out of the ground. As the technology has improved, bit by bit, and the politics has improved, bit by bit, the known shale plays are being developed to capacity. Is there another undiscovered giant like the Marcellus lurking somewhere? Realistically, I doubt it. The industry has very good tools for looking underground. A big monster shale play that would keep the gas glut going for another two or three years is a bit of a stretch.

TER: Will we go back to importing gas?

KS: I do not see the U.S. importing much gas for at least three years, and maybe longer, depending on existing wells' decline rates. Right now, drillers are doing maybe four wells per square mile. With downspacing, they can get down to 8, 16 or even 32 wells per square mile. There is still a lot more domestic gas to be pumped before we need to import a lot of gas again.

TER: Let's talk about the role of Canadian penny stocks in your portfolio. How is the shale experiment with the oil juniors going in Canada?

"All across North America and especially in Canada, the rush into shale oil has been a great experiment."

KS: All across North America and especially in Canada, the rush into shale oil has been a great experiment. But it really doesn't work in a junior company. The place for juniors in an investor's portfolio right now is getting smaller and smaller. The shale, or tight wells cost a lot of money to drill, and the juniors just do not possess the capital necessary to develop many of these plays. The wells will pay out in 12-24 months, and that is simply not fast enough for the junior companies to recycle the cash and drill another well. A junior might have a big land position, but it cannot develop it, particularly on the gas side, without continually raising equity. Many of these companies have stopped or dramatically reduced drilling. It's a bad spiral: You drill less, you produce less and your declines are high. These smaller energy firms are in a really tough spot-for oil or gas.

TER: Is it reasonable for the management of these struggling companies to hope the price will go up and make staying the course worthwhile?

KS: Well, yes, they have no choice other than shutting down all of their production. It's just a question of how long the wait is. I was talking with a producer the other day, and he indicated that there will be no new capital available for pure dry gas until it is hedged at $4.50/thousand cubic feet ($4.50/Mcf). Gas has to be at $5/Mcf for a couple of weeks for them to do that. So gas prices have to be $5/Mcf for the market to realistically think about putting more money into dry gas wells.

Could that happen this year? It could, but the Marcellus is still coming on strong. Next year is quite possible. The other thing is that the gas wells with lots of natural gas liquids (NGL) like condensate, propane, butane and ethane have better economics than simple dry gas wells. With NGLs, more production can come on-line at $3.50/Mcf. There is hope; prices are moving higher than most people expected at this time of year, thanks to a very cold early spring. But to say that prices will go much higher from here would be a bit of a stretch.

TER: Which junior names are doing well in Canada?

KS: In no particular order, NuVista Energy Ltd. (NVA:TSX), Advantage Oil and Gas Ltd. (AAV:NYSE; AAV:TSX) and Delphi Energy Corp. (DEE:TSX) are doing well. The market is watching these companies to see which has leverage to gas, and which can really show a huge improvement in its numbers if gas does go up. These companies are heavily gas weighted. So, if gas does turn and stay higher, they have the most torque.

TER: What about old school oil and gas production? Not everybody is fracking-how are the standard vertical wells doing?

KS: That industry has been on hold for three years while the market experimented with the shale plays. On the junior side, it's very rare to find conventional plays. The one that I like the most on the conventional side is a company called Manitok Energy Inc. (MEI:TSX). It has done a great job of putting together a land package in the Cardium Formation in the Alberta foothills and hitting on all its wells for both gas and oil in regular conventional formations. So the old-style industry is still alive. . .a bit.

TER: Is it more efficacious to do vertical wells in the Cardium than to frack?

"When you hit a regular, old-style conventional pool with a vertical well, you can book a lot of reserves."

KS: Well, where Manitok is, yes. The old-style pools are not in shale, tight rock or tight sandstone, so you can put a regular, old-style vertical hole down. If you hit the pool, splash! That's a great well. Manitok hit a monster well two years ago and it did 5 million cubic feet per day (5 MMcf/d) gas. Two years later, it's still doing over 3 MMcf/d. The well has declined less than 40% in two years. A lot of producers would give their eye-teeth for a well like that. The unconventional wells typically deplete 65-85% in the first year, and another 20% during the next couple of years. When you hit a regular, old-style conventional pool with a vertical well, you can book a lot of reserves.

TER: Is the Street being realistic about the depletion rate of the unconventional wells, or do people believe the reserves will last forever?

KS: The Street is acutely aware of what the decline rates are now. At the same time, some of these plays take a long time to peak, and some of them do not. The Haynesville peaked quickly, but plays like the Barnett took more than 10 years to peak. The Marcellus is still growing, with lots of new wells coming onstream. The Street is very aware of the decline rates, and I think that's why natural gas prices have doubled in a year despite production not going down. But I think the Street is also aware of the amount of wells that can still come on in these plays, and it is sitting back and waiting to see some kind of supply drop before bidding gas up any higher.

TER: What is the science behind the rapid depletion rate with the hydraulic fracking?

KS: Basically, with fracking, once you pump the water, steam, or sand into the formation, only the oil and gas that is sitting right inside those particular fracks surfaces. The shale formation is super oil charged, so there are still huge amounts of oil and gas left in the rock after the first go-round. One can either refrack it multiple times, or perform a water flood to liberate a little bit more oil and gas. But drillers have to be close to the fracks to get the product out. The trick is to plan the optimal size and strength of the initial frack. After the well has depleted for two to three years it might be worthwhile to refrack.

TER: Is it more expensive to frack the second time around?

KS: Remember, the well has already been drilled. If the company has drilled a $3 million (M) well, probably $1M of that is the frack. You don't have to spend $3M again-only $1M. If the well is doing 10 barrels per day (10 bbl/d), and a refrack gets it back up to 30 bbl/d for a while, there can be substantial payback.

TER: How important is jurisdiction in assessing what companies to buy?

KS: It is very important because prior to the shale revolution, the market searched the world for new sources of oil and gas. We were getting deeper and more remote with all of our exploratory work. We had to; the thinking was that all the easy pickings in North America were long gone. Then along came the shale revolution. Everybody refocused their budgets on North America. And there have been so many discoveries in the last three or four years. Enough to keep the market excited, enough that it has not bothered going back to the international locations. The Street is saying, "Why would I take any political risks when we're getting great discoveries with fantastic returns in the Texas, North Dakota and Alberta shale plays?"

"Investors are paying more attention to the international plays even though there are some drawbacks, such as the rise of resource nationalism."

But now investors are paying more attention to the international plays even though there are some drawbacks, such as the rise of resource nationalism. It's becoming more difficult for free enterprise to get business done in the rest of the world. All the big discoveries are now in gas. That's why the majors likeRoyal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) andExxon Mobil Corp. (XOM:NYSE) are moving toward gas. They report in barrels of oil equivalents (boe), as opposed to barrels of oil (bbl), because to keep up their reserve base, they have to book gas reserves. Given the situation, it is very difficult for a junior to enter a new jurisdiction. Two things have to happen. A firm has to a) make sure that the geology is good; and then, b) hit a good well; and c) get the market to realize that. However, in Africa for example, a lot of juniors are having fantastic success, such as Africa Oil Corp. (AOI:TSX.V). There are a lot of ongoing junior African plays that are very high-risk, high-reward plays that can see big lifts with a discovery.

TER: Is North Africa a safe place to do business?

KS: It depends where you are in North Africa. The Street tends to wipe an entire area with one brush, and sometimes that's justified. There are pockets in North Africa that one can operate in, though. Tunisia seems to be fairly safe for business. Obviously, Libya and Algeria are currently fraught with danger, and the Street does not want to go there. Morocco looks relatively safe. Despite the political disruptions, however, some business is done.

TER: Are there juniors in North Africa that investors should look at?

KS: The satellite juniors in the African risk play- Taipan Resources Inc. (TPN:TSX.V) and Vanoil Energy Ltd. (VEL:TSX.V) -are both funded and set to start drilling in the next six months. In Tunisia, there isAfrica Hydrocarbons Inc. (NFK:TSX.V) as well as DualEx Energy International Inc. (DXE:TSX.V), which is going to be drilling its big well within 30-60 days. In Angola, there are a couple of drill plays getting funded.

TER: Are North American investors funding African plays?

KS: Most of the money comes from London. The Europeans are much more comfortable drilling in Africa than North Americans are. North Americans are very risk averse on the international scene. They are myopic, in fact.

TER: You also follow refinery stocks. Are the risks lower there than for the producers?

"For refinery stocks to move higher, we'll to need to see the WTI-Brent spread widen again. And that could happen."

KS: The refinery stocks had a great run over the last year. But in early March, they started to run into a bit of trouble. The stock charts are now consolidating. Even though the refiners are showing great earnings for the last quarter, the market looks forward. And the Street sees a very tight West Texas Intermediate (WTI)-Brent spread. So the refiner stocks are now in full retrenchment mode and not moving forward. They are consolidating the gains they've had over the last 9-12 months. For those stocks to move higher, we're going to need to see the WTI-Brent spread widen again. And that could happen. As light oil production in the U.S. continues to increase, it will overwhelm the refinery complex on light oil, and we will see a drop in light oil prices here in North America.

TER: Are there any companies that you like in that space?

KS: I am watching Valero Energy Corp. (VLO:NYSE) because it has so many refineries. It has a lot of torque to any turnaround. It exports a lot of product, which is very important, and it's the largest independent refiner.

The other refiner that I follow quite closely is called Northern Tier Energy LP (NTI:NYSE). It has been hit, like everybody else, pretty hard on the tight spreads. So I am watching it from the sidelines as the whole refinery game shakes out. But the sector certainly did give investors a great run for 9-15 months.

TER: What advice do you have for new and veteran investors in the oil and gas space?

KS: Investors need to be very patient. There are lots of good stories out there that are starting to look very cheap. But, it is not wise to run out and buy stuff just because it's cheap, particularly in Q2/13. The second quarter is generally the weakest for the industry. As we get close to June, there's a very good chance industry share prices will go lower. The Street wants to see if the rally in natural gas is real. If it is, and we start to see production decline, then making money in this sector should be quite easy, because there are lots of gas stocks with good teams and good assets that are trading dirt cheap. But we are at the seasonal high for gas now. So be careful. Come June and July, though, everybody wants to have their checkbooks open and take another good look at the overall scene.

TER: I appreciate your time.

KS: Thank you, Peter.

Keith Schaefer is editor and publisher of Oil & Gas Investments Bulletin, which finds, researches and profiles growing oil and gas companies that Schaefer buys himself, so subscribers know he has his own money on the line. He identifies oil and gas companies that have high or potentially high growth rates and that are covered by several research analysts. He has a degree in journalism and has worked for several Canadian dailies but has spent over 15 years assisting public resource companies in raising exploration and expansion capital. Schaefer will be speaking at the upcoming World Resource Investment Conference 2013.

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DISCLOSURE:
1) Peter Byrne conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Royal Dutch Shell Plc. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Keith Schaeffer: I or my family own shares of the following companies mentioned in this interview: Vanoil Energy Ltd. I personally am or my family is paid by the following companies mentioned in this interview: Taipan Resources Inc. and African Hydrocarbons Inc. 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.
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Source: Tom Armistead of The Energy Report (5/7/13)

http://www.theenergyreport.com/pub/na/15242

Energy pundits sing natural gas' praises, but Bill Powers, author of "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth," isn't buying it. He sees serious flaws in how reserves are reported, and his own research shows steep, across-the-board production declines in the near future. Nonetheless, he expects a multiyear bull run for the resource, and recommends investors get positioned before scarcity hits-just five to seven years from now. Find out which companies Powers is betting on in this interview with The Energy Report.

The Energy Report: Numerous experts, including T. Boone Pickens and Porter Stansberry, have said that, thanks to natural gas shale recovery technology, the U.S. is set to become energy independent. In your new book, "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth," you say that the U.S. has only a five- to seven-year supply of shale gas rather than the 100 years estimated by the U.S. Energy Information Administration (EIA). What data are you consulting, and why are your conclusions so different from what the EIA projects?

Bill Powers: First of all, the EIA has since backtracked on its estimates of shale gas recoveries. At one time it was over 800 trillion cubic feet (800 Tcf), which is approximately a 40-year supply at current consumption rates. Due to reductions in estimated future recoveries in the Marcellus Shale and elsewhere, EIA estimates are now down to 400-500 Tcf, which is closer to a 20-year supply.

"T. Boone Pickens and Porter Stansberry provide very few facts to support their statements."

T. Boone Pickens and Porter Stansberry provide very few facts to support their statements. I use production history from shale plays that are currently in production. For the Barnett Shale, I use production history from the Texas Railroad Commission. For the Fayetteville Shale, I use production history from the Arkansas Oil and Gas Commission. I have examined the Department of Natural Resources' production reports for the Haynesville Shale. While there has been a big ramp-up in shale gas production, the evidence indicates that current production levels are not sustainable. In my book, I give substantial evidence that there may be 125-150 Tcf gas produced from shales in the future. That is a far cry from a 100-year supply.

TER: If the EIA's data are inaccurate, what information sources can investors turn to for reliable data?

BP: That's a tough question because it is very difficult to find independent information sources. The oil and gas industry funds a lot of these studies. MIT received money from Hess Corp.; Penn State has had controversy over its support from industry; Navigant Consulting has put out an industry-funded study. The Potential Gas Committee is also funded by the industry. Petroleum Geologist Art Berman has done some of the best work on shale gas productivity and decline curves-I cite him in my book. There are other sources out there, but they're relatively few.

Also, I document how the EIA has changed its methodology for collecting production data. The EIA has been substantially wrong-it has admitted this in the past. Last, I document the fundamental flaws in a widely cited report the EIA put out in July 2011 that went field by field through the shale gas and shale oil fields. There were numerous mistakes in that report.

TER: Your book starts with a warning that we're being set up for a replay of the 1970s gas crisis, but when we interviewed you in November 2012, readers commented on the perceived price manipulation that contributed to gas shortages 40 years ago. Is there more transparency now in reserve numbers and thus less chance of price manipulation?

BP: About 40 years ago, prices were set by the Federal Power Commission (FPC), which was the predecessor to the Department of Energy. Prices were not deregulated at the wellhead until the Wellhead Decontrol Act of 1989 accelerated the deregulation process that began in 1978. It is unlikely that there was price manipulation by producers. However, the SEC did not begin requiring publicly traded producers to put reserve numbers on their financial statements until 1978, so there was a lot of confusion and opaqueness surrounding industry reserve numbers. There is evidence that the American Gas Association (AGA), which supplied the FPC with the industry's reserve numbers at the time, would underestimate supply numbers. The FPC used the AGA's reserve data to set rates. That was quite a conflict of interest. Now, companies put out their reserve numbers on their financial statements and prices are deregulated.

"Investors should be aware that reserve numbers are estimates. . .They can be wildly off the mark."

Investors should be aware that reserve numbers areestimates made with incomplete knowledge by humans, and sometimes these reserves can be wildly off the mark. Numerous shale gas companies have taken significant write-downs over the last two years. For example, we saw Chesapeake Energy Corp. (CHK:NYSE) write down 4.6 Tcf of gas in Q2/12. That's over 20% of all of its reserves at the beginning of 2012. Other companies, such as BP Plc (BP:NYSE; BP:LSE), BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), Exco Resources Inc. (EXCO:NYSE) and Range Resources Corp. (RRC:NYSE), all have taken write-downs.

The timeframe over which reserves are expected to be produced is rarely discussed. One of the big surprises to me in researching this book was that companies often book shale gas reserves over a 40-65-year period. Production history does not support this assumption that shale gas wells will produce for multiple decades. In fact, most shale gas wells will produce the majority of their reserves within their first five years of production. Expectations for multi-decade reserve life are just unrealistic for shale gas wells.

TER: Then what metrics should investors seek to get more accurate production projections?

"Be skeptical of companies that have a high ratio of proven undeveloped as a percentage of their total proven."

BP: The amount of a company's reserves in its "proven undeveloped" category is important. Here's why: A few years ago, the SEC dramatically increased the ability of companies to book proven undeveloped reserves. This is the result of a change to the Oil and Gas Modernization Act in 2009, which assumed there was homogeneity across shale gas fields, meaning that future wells would be similar to producing wells. The act allowed for multiple offsets from a producing well, which in turn allowed for many companies to increase their proven undeveloped reserves. However, the proven undeveloped reserves are the ones that are most likely to be written down. Be skeptical of companies that have a high ratio of proven undeveloped as a percentage of their total proven. This is the riskiest category of proven reserves. That's a good place for investors to start.

Next, look at a company's cash flow statements. See how much it is spending and what it is getting for that spending. For example, how much is it able to grow production? Can it grow with its existing cash flow, or does it have to sell assets, issue new shares or take on debt? These are important indicators that will help you determine if a company's production is sustainable or if it can grow organically.

One of the best tools for investors is to see how competitors in the areas where it operates are doing, and therefore how realistic a company's projections are.

TER: Other experts, including Bob Moriarty and Marin Katusa, have talked about the end of cheap oil and the opportunities for companies to use technology like fracking to access new sources, even if it's going to cost more. But one of the arguments you make in your book is that higher prices will not trigger increased production. Can you elaborate?

BP: It's a question of the hard geological limits. From 1973-1984, the price of gas went up twelvefold, yet production went down more than 15%. This was not due to lack of trying; the number of rigs drilling in the United States increased substantially. Also, from 2001-2007, natural gas prices increased by 50%, and production went down. Throughout the long history of oil and gas production we've seen many fields decline despite high prices.

If we look at just oil fields, many have had increases in production from the application of technology. For example, when natural gas was injected into Prudhoe Bay, production went up briefly before going back down. When nitrogen was injected into the Cantarell Field in Mexico, production went up substantially before falling. In Kern River, California, when steam was injected into the field, production went up and it's now falling. There are hard limits to what extraction technologies can do.

While I do think that higher prices will bring out marginal production, today's level of shale gas production is unsustainable. Several shale gas fields are peaking or are very close to peaking, such as the Barnett, the Fayetteville, the Haynesville, the Arkoma Woodford. All of those fields will probably see production declines even in an environment of rising prices. Rising prices will certainly lead to increased production in younger fields, such as the Marcellus, but in other fields they're not going to make a difference.

TER: You talk about the improvements in technology that lead to renewed production in aging fields. Is there any reason to believe that we have exhausted our progress in technology?

"Technology advances are not linear. They come in clumps and they come unpredictably."

BP: Absolutely not. There is a lot of technology that can be applied. However, technology advances are not linear. They come in clumps and they come unpredictably. For example, there is potentially a lot of gas underneath the salt weld in the Gulf of Mexico. As of now there are zero wells in the Gulf of Mexico that produce from below the salt weld. Next week, trillions of cubic feet may be unlocked from beneath the salt weld, but it also may be decades before these resources are actually produced. We have just come through a period of very rapid advances in horizontal drilling and fracture technology, and the next phase of that may come a year from now, but it may come decades from now. That's why I'm very skeptical that technology advances will just happen to appear at the next price spike or that the next time we have a shortage of natural gas, technology will come to the rescue.

TER: Both hedging and production are falling because natural gas prices are below the cost of drilling and operating new wells. Will that lead to higher natural gas prices by the end of 2013?

BP: I believe so. Gas has been the best performing commodity in 2013 so far. I believe declining production in some of the bigger producing areas, such as Texas, Louisiana, Wyoming or the Gulf of Mexico, will lead to tightening supplies as well as higher prices later this year. We could easily see prices between $5-7 per thousand cubic feet ($5-7/Mcf) before the end of this year, given current storage levels and the demand we continue to see from the electrical power industry. A lot of this will have to do with the weather as well as economic activity, but gas prices have bottomed and they are now in the very early stages of what I believe will be a multi-year bull run that will take prices much higher than many people believe.

TER: In your January 2012 interview, you told The Energy Report that you expected gas prices to increase substantially. The price then was between $2.50-3 per million British thermal units ($2.50-3/MMBtu), and it has just recently broken $4/MMBtu. Is this the rate of increase you expected?

BP: I would expect prices to continue to go up, but the rate of their rising is unknowable because so much depends on market perception rather than the availability of supply. The market continues to believe that there will be relatively cheap gas for several more years. This belief is slowly eroding, and the rate at which this erodes will be reflected in the upward movement of gas prices. But the trend is very clear.

TER: If increased prices don't make for increased production, how relevant is the natural gas price for investors in the space?

BP: It's still very relevant because rising gas prices increase the cash flow gas companies can generate, especially low-cost producers. A number of companies are very cheap, some are richly priced. But there are many companies, both Canadian and American, that have good projects that are very cheap on almost every metric by historical standards. These are low-cost producers, well managed. There's a great opportunity for investors who believe that gas prices are going to rise.

TER: Will large or small companies be better able to make a profit in the future? Do you see any particular companies that are well positioned?

BP: It's difficult for companies in the junior space in Canada to profit from some of the rise in gas prices, simply because of the high cost of drilling new wells. Advantage Oil and Gas Ltd. (AAV:NYSE; AAV:TSX)has a great project and it looks like the company may be doubling its Montney production by 2015.Bellatrix Exploration Ltd. (BXE:TSX) has good gas production and some interesting projects that it's moving forward. In the United States, Southwestern Energy Co. (SWN:NYSE) has had good success in the Fayetteville and now is having success in the Marcellus. It is a low-cost producer that has been able to fund most of its growth through cash flow. Ultra Petroleum Corp. (UPL:NYSE) is cheap by historical standards, and it's a low-cost producer. It has good assets in Wyoming as well as in the Marcellus. All four of those companies are big enough to attract institutional investors once the market is confident the price of natural gas will continue its upward movement. Those are at the top of my mind as companies that are best positioned.

TER: You warn of a coming a natural gas deliverability crisis and the impact that will have on the economy, leaving people cold, hungry, unemployed and in the dark. How can investors participate in the upside of a possible solution?

BP: One of the best ways for investors to mitigate what I believe will be a 1970s-style natural gas crisis that will occur sometime in the next few years is to consider companies that have leverage to rising gas prices, and I have mentioned some of those. There also are a number of companies that will profit as the rebound in alternative energy really hits home. There's a cascading effect from higher natural gas prices. Higher prices will raise the cost of electricity and lead to higher home heating bills. Increased gas prices will also lead to higher food prices because of the amount of gas that's used in fertilizers.

"We will see a rebound in alternative energy companies."

We will see a rebound in alternative energy companies. People will reconsider nuclear power, especially smaller nuclear plants that can be built modularly and have less safety risk. We will see further gains in solar and in wind. Solar power is coming close to grid parity in areas like California. Even though alternative energy companies have had a very difficult time over the last few years, for investors that really want to dig in, this is an area that is going to rebound and I think the worst is behind it. There's been a big shakeout. For investors who can take a longer-term horizon, I think there are some fantastic companies that are very attractively priced.

TER: Can you name some companies that you think that could be part of this solution?

BP: Babcock & Wilcox Co. (BWC:NYSE) is the leader in smaller nuclear plants. It's had extensive experience in building nuclear plants over the years. In the solar space, given the carnage that has occurred, it's still difficult to see which companies are going to profit, but First Solar Inc. (FSLR:NYSE)has survived. Others will make it through to the next boom in the solar industry, but there are not going to be as many competitors the next time around. I think that keeping an eye on those companies that are likely to survive is a great start for right now.

TER: Are some of these solutions riskier than others?

BP: Absolutely. Technology is changing very quickly and the price point at which some of these solutions are going to work varies. With that being said, this is what leads to opportunities for investors-finding the companies that have the best technology and that are well funded. Those are the companies that will flourish as electricity prices rise and home heating prices rise. But there's still a lot of uncertainty in the alternative energy space as far as who the big winners are going to be the next time around.

TER: Bill, I appreciate your time.

BP: Thank you very much. It was a pleasure speaking with you.

Bill Powers is an independent analyst, private investor and author of the book "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth." Bill is the former editor of the Powers Energy Investor, Canadian Energy Viewpoint and U.S. Energy Investor. He has published investment research on the oil and gas industry since 2002 and sits on the Board of Directors of Calgary-based Arsenal Energy. An active investor for over 25 years, Powers has devoted the last 15 years to studying and analyzing the energy sector, driven by his desire to uncover superior investment opportunities.

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DISCLOSURE:

1) Tom Armistead conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report:Chesapeake Energy Corp. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Bill Powers: I or my family own 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: 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 and may make purchases and/or sales of those securities in the open market or otherwise.

Streetwise - The Energy Report is Copyright © 2013 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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Source: Peter Byrne of The Energy Report (5/2/13)

http://www.theenergyreport.com/pub/na/15226

Energy tech companies have a business model that's closer to Apple Inc. than Apache Corp. In other words, it's all about the new product. The products Dominick & Dominick Analyst James McIlree is excited about offer major benefits like improved geological mapping for oil and gas explorers, or electric grid safety for energy utilities. In an interview with The Energy Report, McIlree talks about his favorite companies in the energy tech space and how understanding product cycles can help investors time their buys.

The Energy Report: Your investment firm, Dominick & Dominick, keeps a sharp eye out for companies that back up electrical grid operations. Are the ongoing battles over President Obama's proposed budget likely to impact small companies in this space?

James McIlree: We focus on companies with new products that have the ability to grow even in a sluggish economic environment. Companies that are looking for federal subsidies, or that rely upon the U.S. government as a customer, should re-think those business plans. Although the overall shape of economy is important, the product cycles of the companies we invest in are much more important to determining their success than the macro-economic scene.

TER: What are product cycles and why do you focus on them?

JM: In the technology markets, product cycles are the most important determinant of success. Companies with strong, new product cycles are successful; those without it are not. Look at a company like Apple Inc. (AAPL:NASDAQ). When Apple introduced the iPhone, then the iPad, then the iPad Mini and then the next version of the iPhone, those product cycles drove extremely rapid revenue and earnings growth. Without a new product, Apple's stock falls.

Here are concrete examples of product cycles with three energy technology companies that I follow:Acorn Energy Inc. (ACFN:NASDAQ) is the majority owner of US Seismic Systems Inc. It manufactures a device called a fiber optic geophone, which maps geological formations using seismic waves. US Seismic's new geophone delivers a much greater sensitivity for detecting seismic activity, and at a much lower price than the existing technology. For this reason, this new product is expected to replace the geophone products oil and gas companies currently use. The product is still in the development stage, but assuming that it gets successful results from a series of upcoming tests, the company will increase its revenue via the successful launching of a new product cycle.

Active Power (ACPW:NASDAQ) has just introduced a new flywheel that is used for backing up power, primarily in data centers. It is bigger than the firm's previous flywheel, and it's cheaper on a per-unit of power backed up than the previous device. Because of its greater size, it can target a bigger market with a new product cycle.

Hydrogenics Corp. (HYG:TSX; HYGS:NASDAQ) makes utility-scale electrolysers that convert excess electricity into hydrogen. The gas can be stored and used to recreate electricity in place, or transported as a gas to a different part of the grid and re-electrified.

In each case, the new products address an existing need, have a clear return on investment for customers and can have a significant impact on the company's revenue, earnings and cash flow growth.

TER: A product cycle has a downturn built into it by definition. In July 2011, Acorn's stock was $4, rising to $12 last May, and now it is around $7. Why the volatility?

JM: Acorn's stock was affected because it took longer than expected for its new fiber optic geophone to be accepted by customers. Instead of starting six months ago, the product cycle has been pushed into the future. That drove the stock price down. But what drove the stock price up last year was the expectation that the new product cycle would start relatively soon. The market expected the product cycle to begin earlier and is now pricing a new expectation of when that cycle will begin into the stock.

TER: When will Acorn deploy the new geophone?

JM: Acorn delivered the geophone to an unnamed super major for testing. This is a global oil and gas company with assets in exploration, production, refining, marketing and chemicals. The super major will be testing the geophone side by side with other products. That test should begin in May. At that point, there are several future paths for the company. The most bullish path is that the super major says, "We love this geophone, and we are going to buy a whole bunch of them!" And then US Seismic obtains significant revenues in H2/13. Or, the customer says, "I like it, but I'm not going to start buying it until next year." Revenues will appear then. Or, the customer says, "We don't like this, and we are never buying it." Revenues will disappoint in that scenario. But that is not the scenario I am betting on!

TER: Does US Seismic have sufficient cash reserves to survive until the geophone takes off?

JM: At the end of 2012, the company was sitting on about $27 million ($27M) in cash and burning upwards of $5M/quarter. The cash burn can be reduced relatively quickly if necessary. Acorn has six quarters of cash at current burn levels, assuming no change in its product cycle prospects.

TER: Is this cash from investors, debt or a combination thereof?

JM: The most proximate source of the cash came from the sale of an Acorn subsidiary called CoaLogix in 2011. CoaLogix makes selective catalytic reduction systems for the coal-fired electric utility industry. The business sold for about $101M. Acorn collected about $60M cash, and that funded the reserve; debt is only about $150 thousand ($150K).

TER: What about Acorn's other properties, GridSense Inc. and OMNIMETRIX LLC?

JM: GridSense makes a device that monitors the performance of the electrical transformers that are ubiquitous throughout the electric utility network. It can predict breakdowns. That allows a utility to do preventative maintenance, rather than waiting for an outage and deploying a truck to fix a broken part of the grid. Unfortunately, it is difficult to sell this type of product directly to an electric utility. The firm needs to target system integrators, such as Silver Spring Networks (SSNI:NYSE), or Landis+Gyr (owned by Toshiba Corp. [6502:TSE]). The product is very relevant, but its sale cycle is quite long.

I am very optimistic about the prospects for OMNIMETRIX. It produces a monitoring service for backup power. It has just transitioned to a new business model, and did about $1M in revenues in 2012. It can do $2M this year, and maybe $7M in 2014. The nice part about this business is that most of its infrastructure has been built, so the extra dollar of sales has a high incremental margin attached to it. OMNIMETRIX should see subscribers, revenue and cash flow all grow rapidly over the next few years. It's in a hot space called M2M, or machine-to-machine communications. Other firms in the M2M space include Orbcomm Inc. (ORBC:NASDAQ), Numerex (NMRX:NASDAQ) and Fleetmatics (FLTX:NYSE), which has a very high multiple. In short, OMNIMETRIX is poised to create a lot of value. It's still a bit early for it, though.

TER: Do the three companies that Acorn holds all have separate management teams?

JM: Yes, each unit has its own management team. The corporate level of Acorn is very close to the teams at each of its subsidiaries. It does exert some authority and control over what the subsidiaries do, but it is not micromanaging them. Acorn strikes a very reasonable balance with its portfolio companies.

TER: Do you have a target price for Acorn?

JM: It's $14.

TER: You expect it to double?

JM: Right. We expect the company to grow its subsidiaries and sell one or two of them at valuations around $75-100M. That will get us to the $14 target.

TER: How does Active Power's product work?

JM: If, for some reason, there is a power outage, Active Power's interruptible power system kicks on and provides electricity until either power returns, or a diesel generator plugs the energy hole. Active Power's UPS (uninterruptible power system) is based on flywheel technology. The UPS is green because it stores energy snatched from the grid itself. And when the grid goes down, it does not fire up a gas or oil-powered generator. Instead, it delivers previously stored energy to the data center until, again, a more permanent fix appears. It's a short-term solution, but it's not a fossil fuel-based solution. This is important, because a smart phone stores applications that seek data in the internet cloud. The telecom companies want the data centers to be physically close to where you are, because that reduces the amount of time it takes to transmit data to your phone. The data centers are very valuable assets that must be powered 24 hours a day.

TER: How does the flywheel work?

JM: Electricity generated by the grid spins the flywheel. When the electricity stops, the flywheel keeps spinning. The spinning motion creates electricity. It will stay on for nine to 10 seconds, which is generally the amount of time needed to fire up a backup generator. Most of grid outages are of very short duration. The flywheel itself is actually relatively small, but it is housed in a cabinet that is 6 feet tall, 3 feet wide and 3 feet deep.

TER: And this is deployed at the site of a factory that is connected to the grid? It is not designed to be inserted into a major node of the grid?

JM: Correct, it would be on an end-user's site, rather than at the electric utility's site.

TER: Let's take a deeper look at Hydrogenics, which is based in Toronto. What makes it attractive?

JM: It sells a device that makes hydrogen gas from water using electricity. Hydrogen is used in a variety of industrial applications. In North America, it's usually provided by Air Products and Chemicals Inc., or Linde Industrial Gases, or Air Liquide. In international markets where there is not a robust distribution network for industrial gases, Hydrogenics markets a fuel cell that produces hydrogen onsite for use in industrial processes. Simply put: the device splits a water molecule (H₂O) into its component atoms: hydrogen and oxygen.

TER: By heating?

JM: No, it's an electrolysis-based solution. The electricity separates the hydrogen and the oxygen molecules. This is not about boiling the water, because all that does is create steam, where the H₂O is still combined, but in a different form. In the electrolysis process, the oxygen and the hydrogen atoms are split apart from each other. It's very old technology. It's been around for 100 years. Hydrogenics has worked very hard to commercialize it. In large-scale applications, the hydrogen gas can be inserted into a natural gas pipeline and transformed back into electricity many miles away.

This utility-scale electrolyser for the "power-to-gas" application is the real key for the company's success. A utility that generates a lot of electricity from wind, solar or hydro-electricity often has a timing problem. What happens when the wind is blowing, the sun is shining, and the hydro is going, but there is not enough consumer demand to use the electricity at the time of generation? This is a problem in many countries that have mandated renewable sources of energy, such as Germany. It's a problem in Canada. It's a problem in California. It's going to be a problem in a lot of states across the U.S. where renewable fuel standards have mandated that between 20-30% of electricity be generated from wind, solar or hydro. What do you do with the excess electricity? Hydrogenics has a solution.

TER: That's quite interesting. Thanks.

JM: Thank you.

James McIlree has 25 years of experience in the investment business as a sell-side research analyst and buy-side analyst and portfolio manager. He focuses on emerging growth companies in the technology, telecom, energy and defense electronics markets. Prior to joining Dominick & Dominick in October of 2011, Mr. McIlree was a Managing Director and research analyst at Merriman Capital covering firms at the intersection of satellite communications and defense electronics. Prior to Merriman Capital, McIlree was with Collins Stewart and its predecessor firm, C. E. Unterberg, Towbin, where he covered the defense electronics/communications sector and was Director of Research. McIlree holds a Bachelor of Arts in economics from the University of Chicago and a Master of Business Administration from the University of Colorado. He is a CFA charterholder.

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 a list of recent interviews with industry analysts and commentators, visit our Streetwise Interviews page.

DISCLOSURE:
1) Peter Byrne conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Acorn Energy. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) James McIlree: I or my family own 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: Dominick & Dominick LLC expects to receive or intends to seek compensation for investment banking activities from Acorn Energy Inc., Active Power Inc., Hydrogenics Corp. and ORBCOMM Inc. in the next three months. Dominick & Dominick LLC has received compensation for investment banking services from Acorn Energy Inc. and Hydrogenics Corp. in the last 12 months. 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 and may make purchases and/or sales of those securities in the open market or otherwise.

Streetwise - The Energy Report is Copyright © 2013 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