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  • How To Ride The Lithium Battery Boom: JGL Partners' Jonathan Lee

    Tesla's Gigafactory and Powerwall, plus other proposed battery plants and uses, are sparking a surge in demand for lithium, says Jonathan Lee of JGL Partners. Lee tells The Energy Report that he expects double-digit compound annual growth rates over the next few years as battery prices continue to fall and demand rises. The lithium space is small and entrenched, but the widening gap between supply and demand is prying an opening for new entrants, which Lee believes provide the best investment opportunities in the sector.

    The Energy Report: Jonathan, what is the condition of the lithium space today?

    Jonathan Lee: The lithium space today is an oligopoly; there are only four major mines owned by four companies. Over the past three years, the space has actually consolidated with the largest mine, Greenbushes, owned by two companies through a joint venture agreement. From that perspective, price increases have occurred over the past three years, just because of the concentration of the mine operators.

    TER: What are the greatest challenges for the space?

    JL: The hardest challenge is that lithium is not really a mining sector investment; it's a specialty chemicals investment. A lot of the products that lithium miners or producers sell are specialty chemicals, and there is somewhat of a competitive moat around these products because many are specialized to the customer. Lithium is not a commoditized product. The incumbents have both the premier assets globally in terms of low-cost operation, and also a knowledge base of who the customers are, what they're looking for and what specifications they require. Those are some of the challenges faced by any new entrant to the space. From the investor perspective, there are limited opportunities for pure play lithium exposure since three of the four existing producers are part of larger conglomerates with other business lines, Sichuan Tianqi Lithium Industries Ltd. [002466:SHE] being the exception.

    TER: What are the greatest opportunities here?

    JL: While the premier assets are taken or being almost fully utilized, demand is outstripping supply. The compound annual growth rate [CAGR] for demand is over 10%, while the supply expansion from Chile is limited in the near term because of permitting and lifetime production quotas. Another factor limiting supply is the fact that FMC Lithium Corp. [FMC:NYSE] continues to have technical problems expanding its production in Argentina. Expansion potential in the short term is limited, while demand is still growing at double digits. There is a dislocation, and that creates the biggest opportunity today.

    TER: Do the lithium producers have either the investment ability or the resources to scale up to meet the demand?

    JL: That's a good question. Their resources and reserves are substantial enough for them to expand. However, there have been some limiting factors in Chile. Sociedad Química y Minera de Chile S.A. [SQM:NYSE; SQM-B:SSX; SQM-A:SSX] has been dealing with issues on the political front, as well as its lifetime production quotas, which could be reached as early as 2021. Production expansion would pull forward that quota data without negotiating an extension of the production permit. So the company has halted on its expansion plans.

    Albemarle Corp. [ALB:NYSE] has experienced delays in its expansion goals in Chile as well. FMC has dealt with supply issues and production in Argentina over the past four years. When you look at the whole scheme, the one producer that expanded capacity has been the Greenbushes mine in Australia, which is a joint venture between Sichuan Tianqi Lithium Industries and Albemarle. It has been supplying the additional demand over the past three years. Additionally, the lithium coming out of the Greenbushes has had annual price increases over that same time.

    TER: How is the lithium market responding to the construction of the Tesla Motors Inc. (NASDAQ:TSLA) Gigafactory and Powerwall?

    JL: Tesla's developments are positive because they are an additional source of demand for Tesla's lithium products. The announcement of the Powerwall gives us confidence that, at $350 per kilowatt hour [$350/kWh] demand will be there. Lithium production at the Gigafactory will now have two avenues to be sold into; the electric vehicle market or the Powerwall energy storage units. This gives us greater confidence that capacity utilization will be full once the Gigafactory does get up into full production in 2017.

    At $350/kWh, the price will bring in the economic buyer in certain areas, as opposed to just the fashionable buyer. By that I mean it actually brings in customers who could buy Powerwalls because it makes economic sense. This customer set is a much larger consumer base.

    TER: Are you anticipating a surge in demand for lithium as a result of this?

    JL: Yes. If you look at what the Gigafactory will be by 2020, I believe it will have a 50-megawatt-hour [50MWh] capacity, and that will require roughly 40 million tons [40 Mt] of lithium carbonate equivalent. That's 20% of today's global lithium demand. This is just one of many battery plants being built today. There will definitely be a surge in lithium demand. That's why I'm pretty confident that double-digit CAGRs are on the pathway for the next three to five years.

    TER: Besides this surge, what other developments are having an impact on lithium today?

    JL: The other development is that lithium's use in the glass and ceramics business, and in the construction business, has been growing at a gross domestic product [GDP] growth rate. With some applications, lithium is a better additive relative to sodium- and potassium-based greases and lubricants. We are seeing a switch over to lithium because of the better performance. But the real growth over the next 10 years is going to be demand from lithium-ion batteries.

    TER: Is the cost of manufacturing those batteries rising or falling?

    JL: It is definitely falling, and quickly. The fact that Tesla is going to sell at $350/kWh, with the potential of the cost going down to $200/kWh, is a huge and dramatic decrease from five years ago. Some companies were producing batteries at anywhere from $800-1,000/kWh a few years ago. This huge decline in manufacturing costs for batteries has correlated with the decline in the cost of the batteries on a dollar-per-kilowatt-hour basis, which then, in turn, allows for more economic applications.

    TER: What does the falling cost of manufacturing mean for the lithium producers?

    JL: When we think about lower battery costs, and lower battery prices, we get into more applications for the batteries. Once you get more applications that are economical, you see the huge amount of energy storage potential. The use of lithium-ion batteries becomes more prevalent. That increases demand for lithium and is obviously beneficial for lithium producers.

    TER: Where are the most promising lithium deposits? What companies are mining them?

    JL: There are three major deposits globally, where the vast majority of lithium is mined today. One is in Chile, at the Salar de Atacama, where SQM and Albemarle produce lithium. The second is Salar del Hombre Muerto in northwest Argentina, in the Lithium Triangle, and FMC produces there. The third resource is the Greenbushes mine in western Australia. Albemarle and Tianqi have a joint venture there, where they produce lithium concentrate, a precursor to lithium chemicals.

    TER: What are your thoughts on some of the near-term producers?

    JL: The existing producers have the premier assets, and have consolidated over the past three years on a very high EBITDA [earnings before interest, taxes, depreciation and amortization] multiple relative to other specialty chemicals business. We've seen that consolidation, but there continues to be no pure way of playing the lithium theme inside the current producers.

    But some other companies have started production and built mines. Orocobre Ltd. (OTCPK:OROCF) [ORL:TSX; ORE:ASX] has built a mine in Argentina, and is commissioning its plant now. RB Energy Inc. [RBI:TSX], formerly known as Canada Lithium, has built a mine in Québec and is going through a restructuring and bankruptcy process. It will come out of bankruptcy with a clean balance sheet, which may enable the company to get back up and running. Those two major mines have been built over the past five years.

    TER: What's the significance of the Olaroz project for Orocobre?

    JL: The opening of the Olaroz project has been a huge construction success. It is behind schedule, but recently produced its first batches of lithium carbonate. It will be interesting to see how it goes forward in terms of ramping up to the 17,500 tons per annum nameplate capacity, which is planned to be achieved by the end of 2015.

    TER: Is the project meeting goals?

    JL: Orocobre has had some delays in the ramp-up phase. It will be interesting to see how it progresses over the next six months. As of Dec. 31, 2014, the joint venture that holds the Olaroz lithium project, which Orocobre owns 72.7% of, had AU$247 million [$AU247M] in long-term borrowings and AU$43M in current liabilities. On a corporate level, AU$55M was raised, so it will also be interesting to see whether Orocobre can meet production and cost goals to service its loans and borrowings over the next 12 to 18 months. If the company can ramp up production quickly, that would alleviate some of the potential short-term pressures with respect to the project loan obligations.

    TER: Overall, how are you advising investors to proceed in lithium right now?

    JL: It's very difficult to gain exposure through any of the existing specialty producers of lithium. For example, with FMC, lithium is a very small portion of its business. Albemarle's lithium operation is a very small portion of its business. For the asset in Greenbushes, Tianqi Lithium is listed on the Shenzhen Stock Exchange, and for U.S.-based investors, sometimes it's difficult to invest on the Chinese exchanges.

    The only way to get exposure to the lithium space going forward, and the only investable ideas, are really with the emerging miners, whether they be miners that have failed and restarted, like RB Energy with the Québec Lithium mine, or new producers that are in the process of getting project financing. I believe that's where you have to invest to gain exposure on the lithium side.

    TER: Jonathan, thank you very much for your thoughts.

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

    Jonathan Lee is the president of JGL Partners LLC, a consulting firm based in New York that consults to investment firms and corporate clients.

    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 Interviews page.

    Bottom of Form

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

    Streetwise - The Energy Report is Copyright © 2014 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (NYSE: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
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    Email: jluther@streetwisereports.com

    Jun 02 2:13 PM | Link | Comment!
  • U.S. Global's Brian Hicks Shares His Summer Plans For Creating The Ultimate Resource Fund

    You may want to rethink those tickets to Hawaii, and instead spend the summer basking in the opportunities developing in three different sectors of the oil market. In this interview with The Energy Report, U.S. Global Resources Fund Manager Brian Hicks shares the names of the juniors that could benefit from the current volatility. Plus, he reveals the dramatic shift he made in the fund this year that allows him to get paid to wait for the market to catch fire.

    The Energy Report: Summer means driving season, which is good news for oil and gas prices. U.S. Global Investors recently published an article that says Americans are driving and flying more than ever. Will energy investors who "sell in May and go away" kick themselves later, when they look at the stock charts for their favorite companies?

    Brian Hicks: The summer driving season is a supportive time for crude oil. Refineries are at very high utilization levels, ramping up production of gasoline, and that creates extra demand for crude oil. We have begun to see inventories come down, which creates physical demand in the marketplace and helps offset high domestic inventories. This is a seasonally strong period for oil, which should alleviate the storage overhang heading into the summer months.

    TER: Oil has been above $60/barrel [$60/bbl] recently. Do you believe we've hit a bottom in oil prices? What can we expect going forward if history is a guide?

    BH: I think we have hit a bottom. Clearly, oil prices below $50/bbl are not sustainable. We simply can't replace global production at that price. It is way below the marginal cost of production, which we think on a long-term basis is somewhere around $75/bbl. Even at $60/bbl, we have more upside to go to reach an equilibrium price. We have come up a ways since the lows set earlier this year. Perhaps we are entering a holding pattern before the next leg up in the back half of the year. But who knows? We are starting to see production growth decline and inventory levels receding, so we could see prices maintain these levels, or get even stronger, if declines accelerate into the summer.

    TER: What are rig counts telling you?

    BH: Rig counts coming down over 50% bodes very well for the price of crude oil. The resetting of global crude oil prices resulted in less drilling, particularly in the U.S. That's why we are starting to see a production response.

    From a historical standpoint, this is the point in the cycle when you want to look at energy stocks. We believe we are in a trough, and heading into 2016 we are going to need to see the rig count come back up-certainly not to the peaks that we had previously, but higher than current levels. As we see production growth decline and demand pick up, inventory levels are going to head down further.

    TER: Are you buying and selling based on Q1/15 results, or are you looking out at Q2/15 or Q3/15 expectations and beyond?

    BH: We're trying to look forward. Obviously, some useful data can be gleaned from current financials, but we're trying to look ahead of the noise and over the horizon to see where oil prices will settle out and the prices that energy stocks are discounting in their valuations. We feel good that energy stocks have found a bottom and have started to come up. We think there is more upside as we get closer to 2016.

    TER: How are you protecting the fund from volatility?

    BH: We are a diversified, long-only mutual fund, so it's not a core strategy for us to short crude oil or energy stocks. But we do try to mitigate volatility through diversification. That means holding companies across the market cap spectrum, in different geographies and with different commodity exposure, to derive a portfolio that is not highly correlated.

    TER: I understand you started investing in some larger caps this year. What prompted that?

    BH: As part of that diversification, and because there was heightened volatility coming into the year, we were trying to find value in stocks that paid a dividend and offered lower volatility.

    In a new energy cycle, the stocks that typically move first out of the trough are the larger caps. We made investments in some major integrated oil stocks, some of which were paying dividend yields as high as 6%, which really helped buffer the portfolio from excess volatility. We were able to pick up some income in the meantime. Historically, when you can buy large companies with high dividend yields, that's a signal of the value to be had.

    One of the companies we added to the portfolio is Royal Dutch Shell Plc (NYSE:RDS.A). When we purchased the stock, it was yielding over a 6% dividend, and the acquisition of BG Group Plc [BRGYY:OTCQX; BG:LSE] was a nice bonus. We're very encouraged by that acquisition. We feel it strategically places the company very well. BG Group puts Shell in regions of the world that look interesting from a growth standpoint, namely in Brazil and Australia. We feel like that's going to be a good platform for Shell, and for a company of its size, to get more growth.

    TER: Are you expecting more merger and acquisition [M&A] activity as we move through this phase of the cycle?

    BH: I think we are going to see the cream rise to the top, and companies that have high quality assets or are strapped with excess debt will become targets. In many cases, at this time in the cycle, you can buy oil reserves in the ground for less than the price of drilling for new reserves. Many market upswings begin with an M&A cycle, similar to the late '90s, when Exxon's $80 billion acquisition of Mobil Oil marked a bottom in the energy cycle.

    We recently saw Noble Energy Inc. (NYSE:NBL) buy Rosetta Resources Inc. [ROSE:NASDAQ]. That gives Noble exposure to new, prolific oil and gas basins of the Eagle Ford Shale and the Permian Basin. I think this is a trend that will continue, as companies look to reduce costs and for strategic bargains. I think we'll see more M&A activity into the summer-perhaps a takeout of a larger independent by a major oil company-which would highlight the long-term value embedded in energy shares at this point in the cycle.

    TER: Your fund's sweet spot has always been the juniors. Are you finding bargains in the junior space? What are you adding to the portfolio right now?

    BH: That has been our core historically. The junior names that look interesting to us are those that, despite cutting capex, are still managing to grow through the drill bit. Other names look attractive simply because their assets are burdened by debt or undercapitalized. On the whole, we're seeing very attractive valuations on a full-cycle basis, which make us quite optimistic.

    TER: Can you name some of the companies that you're optimistic about?

    BH: They are primarily in Canada. The first name is Legacy Oil + Gas Inc. (OTCPK:LEGPF) [LEG:TSX]. This company has significant value. It's not a name that most folks are looking at because it has excessive debt on the balance sheet and is actively trying to manage that debt and still grow production. But it has high-quality oil assets, and a lot of operational and financial leverage to the price of crude oil.

    We think, on a sum-of-the-parts basis, Legacy looks very interesting at current prices. If you look at the proven reserves in the ground and you discount them over the reserve life, and then net out the value of long-term debt, the stock could double from current levels based on a normal full-cycle oil price.

    In addition, it looks as though there are some large institutional shareholders that are trying to unlock more immediate value by breaking up the company, divesting assets or perhaps even replacing management. That could offer additional catalysts.

    TER: Is there another company that reported Q1/15 results you like?

    BH: We're always intrigued by companies that are able to grow through the drill bit with low capex spending. One name we like is RMP Energy Inc. (OTCPK:OEXFF) [RMP:TSX], also in Canada. It has very interesting oil assets and plans to grow production 10-15% this year despite a capital cutback. At current oil prices, the company should be generating some free cash flow, which could be used to lower its debt, although its balance sheet is relatively strong. There are a lot of options for the company and we expect to hear further good news on improved well completion techniques that could unlock further value. We also are encouraged by the robust wells being drilled at its Ante Creek project. When we come out of this low period, it's this type of company that will thrive. It's a company that can increase shareholder value above and beyond just an increase in crude oil prices.

    TER: What will it take for the market to recognize the potential and rerate RMP?

    BH: I think execution is the main thing. The company recently issued a production report that showed it is on the right track. In fact, the estimates seemed fairly conservative given where RMP is producing right now. It is experimenting with some new completion techniques that look like they're enhancing the productivity of the new wells. We think there is positive operational and drilling momentum for the company. It looks as though production estimates are more than achievable. Companies that execute are the names that should outperform.

    TER: How about a dividend-paying Canadian explorer and producer?

    BH: We have been involved in royalty trust companies for some time. It's a model that works well with the right kind of company. Whitecap Resources Inc. (OTC:SPGYF) [WCP:TSX.V] is a bellwether name with high-quality assets and a strong management team. It recently made an acquisition, which further increases its overall growth profile. It pays a dividend of around 5%, so you get paid to own this name as oil prices begin to recover. This is another company that has historically executed on its drilling plan and should continue to offer value for shareholders.

    TER: How, specifically, would Whitecap's acquisition of Beaumont Energy Inc. help to create value?

    BH: This is a textbook acquisition for Whitecap. It is going in when there are difficult times and making an acquisition in a core area in West-Central Saskatchewan. It gives the company upside via some basic water flood developments, helps enhance its overall core area as well as its growth profile, and helps offset declines.

    This type of acquisition is probably something we'll continue to see with Whitecap Resources, especially since the company has the financial firepower to look for strategic opportunities. This is the time in the cycle when Whitecap can enhance its overall platform and increase its production on a per share basis, while others in the industry are starved for capital. It's an opportune time for shareholders in Whitecap Resources to create some value, and in the meantime there is an attractive dividend yield.

    TER: We have talked before about opportunities in service companies. Are you still finding that they are profitable in this environment? Are there some that really stand out to you?

    BH: Some investors would think it's a little early to look at service stocks. We would probably agree when it comes to fracking companies and some of the other service providers, but we think it may be an interesting time to look at drilling companies. We are starting to see market share being overtaken by higher-quality, higher-horsepower rigs that can drill multiple wells per pad, as well as rigs that can move much more quickly to different drilling locations. Their drilling days are shorter, which creates a tremendous amount of efficiency and lowers costs for operators. These are the kinds of drilling rigs that operators are looking for, especially in a low commodity price environment.

    Patterson-UTI Energy Inc. (NASDAQ:PTEN) is starting to garner market share in this space. We think over the next 12-24 months, this market share will continue to grow. The utilization of higher-end rigs should be well over 90%-maybe even sold out in this particular category over the next 24 months-which implies higher day rates for these higher spec rigs. The three or four companies with this capability should do well and should be buffered by any weakness in the oil services space. Then, as oil prices begin to recover and move back up, operators will increase their capital budgets, and they're going to want these premium rigs. The companies we're looking at, such as Patterson, should thrive.

    TER: What advice do you have for investors looking to take advantage of opportunities over the summer without getting burned?

    BH: Investors need to focus on the long term. I know it's difficult to think that way when we're bombarded with negative short-term data points. But current crude oil prices are not sustainable at these levels. We cannot replace global production. Demand continues to grow outside of the developed markets in the emerging world. That does not appear to be changing. If we do not see a higher oil price, we're not going to be able to offset the global decline rate in current production or meet future demand.

    We believe that we are in the early innings of a recovery in this energy cycle. The companies that are able to withstand the volatility are going to do quite well, and get bigger. There's a tremendous amount of opportunity in the energy space right now. We're very encouraged. It's not to say that we couldn't see more volatility, but I would look at that volatility as an opportunity to add to positions because, over the long run, we will see higher commodity prices and higher share prices within the energy patch.

    TER: Thank you for sharing your insights. Have a great summer.

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

    Brian Hicks joined U.S. Global Investors Inc. in 2004 as a co-manager of the company's Global Resources Fund [PSPFX]. He is responsible for portfolio allocation, stock selection and research coverage for the energy and basic materials sectors. Prior to joining U.S. Global Investors, Hicks was an associate oil and gas analyst for A.G. Edwards Inc. He also worked previously as an institutional equity/options trader and liaison to the foreign equity desk at Charles Schwab & Co., and at Invesco Funds Group as an industry research and product development analyst. Hicks holds a master's degree in finance and a bachelor's degree in business administration from the University of Colorado.

    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) JT Long conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report and The Life Sciences Report, and provides services to Streetwise Reports as an independent contractor. She owns, or her 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: Royal Dutch Shell Plc. The companies mentioned in this interview were not involved in any aspect of the interview preparation or post-interview editing so the expert could speak independently about the sector. Streetwise Reports does not accept stock in exchange for its services.
    3) Brian Hicks: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: All companies mentioned are owned by the fund. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I determined and had final say over which companies would be included in the interview based on my research, understanding of the sector and interview theme. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
    4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
    5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports' terms of use and full legal disclaimer.
    6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews on the site, may have a long or short position in securities mentioned. Directors, officers, employees or members of their families are prohibited from making purchases and/or sales of those securities in the open market or otherwise during the up-to-four-week interval from the time of the interview until after it publishes.

    Streetwise - The Energy Report is Copyright © 2014 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (NYSE: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

    May 26 4:54 PM | Link | Comment!
  • Now Is The Time To Own The Oil & Gas Leaders: Keith Schaefer

    U.S. shale oil producers have responded to the oil price collapse so quickly, and with such discipline, that they've shown they are able to turn production on and off as if with a light switch. As Keith Schaefer tells The Energy Report, that means it's time to be nimble, and to keep small positions until oil finds a stable new price level.

    The Energy Report: Keith, the first U.S. grassroots refinery in nearly 40 years just began operation in North Dakota. Is the growth in U.S. oil production going to catalyze refinery construction?

    Keith Schaefer: I'm going to say no. U.S. production has peaked and we're doing just fine, so I don't see any great need for more refineries right now.

    There was talk a couple of years ago, particularly in 2012-2013, that with unbridled shale oil growth we would need more refineries. But the producers have been more disciplined than anybody expected in the last three months, with the rig count declining sharply and then staying down. I think we're going to see a drop in U.S. production, so I don't see the need for any new refineries right now. The only thing that could change would be even more demand growth, which we're seeing because of lower prices. Somebody might get the idea that we need another refinery to meet that demand.

    Right now, refinery crack spreads are actually very good. They're $20-25 per barrel [$20-25/bbl], which for this time of year is fantastic. But I don't know if that's good enough to warrant somebody spending tens of billions of dollars to build something new. The other thing is that the refinery industry has been pretty good at incrementally adding light oil capacity around the country. A thousand barrels a day [1 Mbbl/d] here, 2 Mbbl/d there-that has added up over the last two or three years. I don't know what the exact number is, but certainly there's been no problem in getting gasoline to market, as you can tell by the big drop we've had in gasoline prices over the last six months.

    TER: Is the gasoline price going lower?

    KS: No, I don't think the price is going lower. We've had a nice little rally in the last month, with oil prices back to about $60/bbl on the WTI [West Texas Intermediate] and almost $70/bbl on Brent.

    I think it's important that investors realize the gasoline price is based on Brent pricing, not on WTI. We're exporting more gasoline-refined products out of the U.S., so we're competing with foreign buyers for our own energy. I think that's why gas prices are a bit higher than people think they should be; they keep thinking about WTI, not Brent.

    TER: The new U.S. production is lighter than what U.S. refineries were designed for. Are the U.S. refiners retooling?

    KS: Well, a bit. Like I said, you're getting 1 Mbbl/d here, 1 Mbbl/d there, of light oil capacity. Refiners are also trying to increase the amount of distillates they produce, because generally that's a more profitable product-jet fuel and diesel fuel, which is what Asia uses. Asia runs on diesel. That's definitely Brent pricing, so there's more margin in that. Everybody's been trying to reduce heavy oil. The big exception would be BP Plc's [BP:NYSE; BP:LSE] Whiting, Indiana, refinery, which just went from mostly light oil to mostly heavy oil.

    TER: How has the delay in approval of the Keystone XL pipeline and resistance to Canadian pipelines going both east and west affected Canadian oil sands producers?

    KS: So far there is not much impact. The heavy oil discount is quite tight right now because the Gulf Coast is getting a lot of Canadian oil that it never used to get. Enbridge Inc. [ENB:NYSE] has got the Flanagan South Pipeline moving, so it's able to bring 300-350 Mbbl/d more Canadian crude straight to the Gulf Coast than it used to. That's not quite as big as Keystone, but between what rail has done in the last two years, going from zero to just under 200 Mbbl/d, the incremental oil sands production has been able to find a way down to the Gulf Coast. There's actually more Canadian oil now going to the U.S. than ever before. That's great news for Canadian producers.

    As you said, most of the refineries down there are geared toward heavy oil. Keystone probably will start to be important next year or the year after. Rail and the Enbridge Flanagan South line bought Canadian producers one to two years' grace on their growth in production. It's going to hit the wall again very quickly because oil sands production is going to rise anywhere between 50 Mbbl/d and 120 Mbbl/d every year for the next five or six years. Keystone will come back into importance fairly quickly.

    TER: Is refinery construction on the table in Canada?

    KS: Oh yes. The Alberta government is building a refinery, the North West Upgrader. I think it's relatively small-somewhere around 75 Mbbl/d. But from private industry, there is just no appetite for a refinery in Canada. You need a big petrochemical complex surrounding your refinery complex, and you just don't have that in Canada. The refineries are either in Edmonton, Alberta, or in Sarnia, Ontario. Sarnia has a petrochemical complex, but with the government there now, you're never going to see another refinery in Ontario. You might see one in Alberta, but, again, it's not going be as economic because it would just be producing gasoline, and not as many petrochemical products.

    TER: Speaking of Alberta, how will the election results there affect refiners and oil sands producers?

    KS: I don't know if it's going to affect oil sands or refineries that much. Because of the dirty oil moniker, if there's one thing the New Democratic Party [NDP] government might go after, it's trying to get the image of the oil sands in better shape. I think stronger environmental rules could really help the industry in the long run. That's going to cost some money, and potentially put a crimp into some cash flows. The producers don't want to disturb their tailings; they just want to plant poplar trees over them and let them go back to nature. I don't know if the NDP is going to allow that.

    From a tax point of view, I don't think the elections are going to make much difference. There is talk about raising corporate income taxes, but the reality is that most, if not all, the producers lose money every year on an accounting basis. There's not going to be much impact for the oil patch. Royalties could go a little higher, but I don't see them going much higher. Honestly, the fear is greater than what the reality will be. The bark is worse than the bite.

    TER: Has the price of oil found its new level?

    KS: I think there's a strong argument the price is going to actually pick up over the next eight weeks. The harsh drop in the rig count in the U.S. should now translate into a pretty significant drop in U.S. production, which we'll see each Wednesday when the U.S. Energy Information Administration [EIA] numbers come out. The EIA numbers for the next 6-10 weeks have the potential to drop quite a bit. The Street is very short-term-oriented right now. I think the market could take oil a lot higher than people would suspect because of the emotion that will follow the drop in U.S. oil production in the next 6-10 weeks.

    Here's what I tell my subscribers: Right now there are many crosscurrents in the market, but two things have happened that were a bit of a surprise to the market so far this calendar this year, and both of them were bullish.

    One was that demand has picked up way more than anybody expected, way sooner than anybody expected. Before the oil price crash in late 2014, the market was seeing lots of stories about how oil demand was inelastic to price. It didn't matter what the price of oil was, demand didn't change much at all. You can throw that idea out the window. Even by January that had been completely debunked, and we were seeing 300-500 Mbbl/d or more increase in demand in the States. Right now, we are seeing 700-800 Mbbl/d more demand in the U.S. over last year. When you consider that production is up 1 MMbbl/d, the surplus doesn't look like such a big deal anymore.

    Internationally, we're starting to see some big stats as well. China's up 250 Mbbl/d. Japan's up. Korea's up 110 Mbbl/d. They haven't been able to see the same benefit in the drop of oil that we have because the rising U.S. dollar has taken a lot of that away. Demand has been a big surprise.

    Second, as I said, nobody thought the U.S. producers would have the level of discipline that they've had in dropping the rig counts through this calendar year. The market has been stunned that we're continuing to see rig drops week after week. We had that one big month-February-with 90 rigs a week getting dropped. Even now, it's at least 20 rigs. In Canada, for example, there are only 16 oil rigs working-in all of Canada! That's stunning to me.

    So when we talk about where the oil price is going, nobody knows. When you canvass the analysts, the smartest guys on the Street, the numbers are all over the map. The oil price has jumped 50%, from $40/bbl to $60/bbl. Is it over? I don't know, but I would say that demand's been higher, and it looks like supply is going to be a little bit lower than what everybody thought in January.

    I think we're going to have relatively bullish production numbers and inventory numbers in the States by the end of Q2/15. The numbers could be bullish enough that companies might start to bring rigs back. It's only going to take one or two weeks of the U.S. adding 30 to 50 rigs to put a big stop in the oil price rise.

    I think in the short term-really short term, toward the end of Q2/15 and in early Q3/15-oil can go higher. The U.S. industry has shown that it is so flexible and so adaptable it can bring rigs off and on like flipping a light switch. It's just amazing. Any opportunity these guys have to lock in good margins on their hedging programs at $65-70/bbl oil-if it gets that high-they're going to do it, and rigs are going to come out.

    TER: What are you forecasting on the oil price for this year?

    KS: This is going to be one of the choppiest years for oil we've seen in a long time. Everyone had such confidence in the Saudis' massaging and managing the oil price for the last four years, and the Saudis did do that. We had a very, very tight range for oil from 2010 through to the end of 2014. That's out the window now. It's going to be a lot more volatile.

    I think you're going to see a lot of head fakes, both bullish and bearish, this year. If you talk about whether the price could find a level late this year, I'm going to guess that's somewhere between $60 and $65 per barrel WTI. At that price the big guys have the scale-they can make money. And little guys can't. The high producing core areas of the big plays make money, and the fringe areas don't, so these prices don't warrant spending a lot of money on the fringe.

    TER: Let's talk about some of the companies that you are most familiar with.

    KS: Rock Energy Inc. (OTCPK:RENFF) [RE:TSX] had a great year last year because of its big light oil discovery. The only problem was that the company spent a lot of money in Q4/14 drilling that up as the oil price was collapsing, so its debt levels got pretty high. But it has just figured out a key component to increasing production out of its wells. The company has been adding a lot more sand and getting much better results.

    Rock had to raise money at the bottom, but it still only has 50 million [50M] shares out. You know you're investing in a company that has lots of leverage when it has 50M shares out. The company has been able to hold production steady at 5 Mbbl/d, and actually makes good positive cash flow on that. With Rock, you've got great positive cash flow at these prices, and a real turbo charge in its light oil play if oil prices come back up.

    TER: Can you mention another company?

    KS: This is a year for small bets. With the uncertainty and volatility around commodity prices, there's no point in making any big bets this year. Legacy Oil + Gas Inc. (OTCPK:LEGPF) [LEG:TSX] is a Tier 2 producer in Canada that has just enough debt to be outside the market's comfort zone, but if oil goes back to $80/bbl, its debt levels actually come in line. In addition, the company has an activist investor group with quite a track record of creating value.

    TER: FrontFour Master Fund Ltd. is nominating a slate of directors for Legacy. Is that something that investors should be worried about?

    KS: No, they should be excited about it. Last year, this investor group ousted the Renegade Petroleum board, sold Renegade to Spartan Energy Corp. [SPE:TSX], and Spartan took that asset and improved production so fast its stock doubled in about three months.

    The team at Legacy has lost the Street a bit. For a couple of years, Legacy's reserve reports didn't keep up with spending, and so the Street has slowly abandoned the team. The straw that broke the camel's back for FrontFour, and a few of the other investors in the company, was when the board decided to guarantee CEO Trent Yanko's personal loan for some stock.

    Would the company be able to perform better with a different management team? I don't know. But I would say that the market has great respect for the asset base, particularly in Saskatchewan. Even the Turner Valley asset in Alberta is a very low-decline asset, which is what the Street likes right now. I think it's a case where the sum of the parts is greater than the whole. Because of the anticipation of what FrontFour and the other investors might be able to do with the company, Legacy should have an extra bid under it this year.

    TER: With the uncertainty in renewable fuel policy and the question of using a food crop for energy, is ethanol a smart investment?

    KS: The reality is that ethanol right now makes sense. Even if the renewable fuel standard [RFS] didn't exist, there would still be an ethanol industry. It might not be quite as big as we've got right now, but there would definitely still be an industry, because ethanol produces octane cheaper than anything else.

    Valero Energy Corp. (NYSE:VLO) is invested in corn ethanol in 11 plants. Ethanol didn't make any money for Valero last quarter, and the stock still had a fantastic run-up to pretty much all-time highs. The crush spread for ethanol through the rest of this year is actually pretty good. It's in the mid-$0.40 per gallon range. Valero produces more than 1 billion [1B] gallons of ethanol per year. Going forward, ethanol should actually be quite a positive contributor to Valero's top line, and especially to the bottom line. Not only that, Valero has shown that it actually gets better margins and pricing than most of the pure ethanol producers. It's a pretty smart cookie in that division. I think ethanol is going to be a big positive for Valero for the next three quarters.

    TER: Can ethanol compete with crude at current prices without mandates?

    KS: It absolutely can. But the reality is that it's a political issue. If the renewable portfolio standard were withdrawn, there would be a large contingent that would just stop using ethanol altogether. Certainly the integrated refinery companies would have no incentive to use it; they should use their own oil. But groups like Valero, which aren't as integrated, or the independents, like Marathon Oil Corp. [MRO:NYSE], Northern Tier Energy LP (NYSE:NTI) or Alon USA [ALJ:NYSE], would continue to use ethanol as much as possible because it makes economic sense right now. If we ever went back to a situation like 2012, where there was a drought, corn prices spiked, and it made no economic sense to use ethanol, these companies would drop ethanol like a dirty shirt and go straight with oil. That would absolutely have a big impact on the industry. The RFS really only kicks in when corn prices are high. The ethanol market works on market-based economics when corn is this low in price.

    TER: Valero's share price since February has been at its highest 52-week level. What's driven that performance?

    KS: A couple of things. Ethanol last year did great. And now Valero and all the other refiners are seeing the pipeline stocks in the last 3-4 years do really well. Those stocks have the best charts in the industry. And there's almost no volatility in them. They have been the best-performing stocks you could ask for in an energy portfolio. The multiples are very high because the Street likes a steady tolling charge. It doesn't like revenue based on commodity risk.

    What we're seeing now is refiners saying, "Hey, we want to have those bigger cash flow multiples, like the pipeline stocks. They're stealing our lunch. We're going to integrate our own logistics into a separate company. We're going to take every bit of revenue we get that's not commodity-related and put it into a master limited partnership [MLP] structure, which gets a much higher multiple like midstream or pipeline companies."

    Valero, in particular, has a lot of assets. It's one of the biggest refineries in the States. It figures it's going to be able to add almost $1B/year in assets in the next five years to put into these higher-multiple MLPs, where the cashflow multiple is going to be a lot greater. That's a great extra uplift underneath the stock for the next three or four years.

    TER: Has Northern Tier Energy done better or worse since Western Refining Inc. [WNR:NYSE] bought out its managing partner share?

    KS: In some ways, better. Fundamentally, the company has outperformed. Northern Tier is a one-refinery company in Minnesota. Before Western Refining took it over, it always underperformed financially against the bigger industry benchmark for that area, which is called PADD 2. Since the Western Refining guys have taken it over, the company has done a much better job at running the business and has been able to outperform the benchmark. I say kudos, because the stock value increase for Western Refining over the last five years is $5/share to $45/share. I'm so excited to have that team at the helm of Northern Tier. I think it's going to do fantastic.

    TER: What is the major trend in your advice to your newsletter subscribers now?

    KS: Caution and small positions. Pretty much everything we bought in 2015 is up, simply because the commodity prices have done better than I expected on both the oil and gas. Now is a time when I think we need to be very cautious, stay in lots of cash. A fat pitch, as Warren Buffett says, will come into the market that we should be able to latch onto. Right now that's hard to see. Just stay in cash. Stay in small positions, and only own the leaders. They always have a higher valuation, but you always buy up in a down market. Buy the leaders and have patience.

    TER: Thank you very much for your time.

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

    Keith Schaefer is editor and publisher of the Oil & Gas Investments Bulletin, which finds, researches and profiles the growing oil and gas companies that Schaefer buys himself, so Bulletin 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 for more than 15 years has assisted public resource companies in raising exploration and expansion capital.

    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 Interviews page.

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    DISCLOSURE:
    1] Tom Armistead conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
    2] The following companies mentioned in the interview are sponsors of Streetwise Reports: None. The companies mentioned in this interview were not involved in any aspect of the interview preparation or post-interview editing so the expert could speak independently about the sector. Streetwise Reports does not accept stock in exchange for its services.
    3] Keith Schaefer: I own, or my family owns, shares of the following companies mentioned in this interview: Rock Energy Inc., Legacy Oil + Gas Inc. 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 determined and had final say over which companies would be included in the interview based on my research, understanding of the sector and interview theme. 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.
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