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  • Investment In Renewables Generates Illuminating Dividends: John McIlveen

    Renewable energy's days as the industry's disruptive stepchild are nearly over, says John McIlveen, senior vice president of Jacob Securities. Costs have fallen in recent years, making wind and solar competitive in a growing number of markets. In this interview with The Energy Report, McIlveen explains that 20-year take-or-pay contracts are turning renewable energy developers into steady, dividend-paying power producers, and he names the companies making the most of their opportunities.

    The Energy Report: John, how has the renewable space changed in the last five years?

    John McIlveen: Cost. The cost of standardized technologies for wind and solar have fallen by at least a half in five years, to just below $2 million per rated megawatt [$2M/rated MW], versus the same cost for a coal plant. That coal plant may deliver two to three times the power at that all-in cost, but the costs are about the same because wind and solar do not have fuel and heavy maintenance costs. Fossil fuel plants deliver much more power, but because they pay for their fuel, the overall cost is about the same as for renewables.

    TER: Bloomberg Business recently wrote that fossil fuels have lost the race with renewables, and Vox responded with some cogent counterarguments. Which is correct?

    JM: I think Vox. Bloomberg measured the growth of the power grid only. If you include all sources, especially transportation, fossil fuel is still the leader. Vox is also right in that fossil fuels deliver two to three times the power per rated megawatt as renewables such as wind and solar. However, I believe renewable growth will surpass fossil fuel growth within 20 years.

    TER: Besides wind and solar, do any other renewable technologies approach competitiveness?

    JM: Geothermal and also small hydro. Small hydro is totally dependent upon its distance from the road. It can cost $2M/MW if it's right beside a road, but if you have to go deep into the woods and create a base camp, roads and a lot of infrastructure, then the cost could rise as high as $4M/MW.

    Geothermal can be competitive too-if all goes right, and that's difficult for geothermal. After all, there's drilling risk, and a dry hole will cost you about $5M. If you get too many of those, you'll end up with a price for power that's higher. But if it's done right, geothermal can also be cost-competitive with fossil fuels.

    TER: Can renewable energy compete without production tax credits, investment tax credits and the renewables portfolio standard [RPS]?

    JM: I think so. In the areas where renewables now have grid parity, they are already cost-competitive. I don't think you're going to need monetary incentives. It's always good to have targeted mandates in terms of how many megawatts you want by a given date. But I don't think the monetary incentives would be necessary for those renewables that have already achieved grid parity.

    TER: Some states in the U.S. have discarded the RPS because they've shot past the goal and don't need it anymore. In other states, the RPS is under attack. Is this a sign that the standard is no longer required?

    JM: No, I think you still need it. For all those renewables that are not cost-competitive, we still need some monetary incentives. I think it's always good to have a mandate, a measuring stick.

    Really, the evidence is that the RPS worked. Twelve years ago, solar cost 10 times what it does today. There are still a variety of technologies that could solve a lot of big problems, like municipal solid waste through to power. But this is not yet a standardized technology. When the technology becomes standardized, and you can get the General Electrics [GE:NYSE] and the Siemens AGs [SI:NYSE] of the world involved, that's when the costs come down. For those technologies, the focus should be on becoming standardized.

    TER: How do low oil and gas prices affect the investment attractiveness of renewable energy?

    JM: Low gas and oil prices only affect the renewable power prices for new projects. They don't change an existing project because these companies have 20-year take-or-pay contracts. So their price is set, and the grid must take all the power that they can produce. However, it does lower prices for new projects. It can put pressure on a new renewable energy project.

    In North America, the gas price sets the marginal price of power. In the rest of the Western Hemisphere, it's largely oil prices that set the marginal price of power. The fuel of necessity or choice in those two areas sets the price.

    TER: What trends in the power industry are boosting the prospects for renewable energy now?

    JM: I think the trends are all favorable here. If we want to talk about distributed power, utilities actually like renewables. They don't have to build transmission. They don't have to build transformers. What's needed, from a regulatory point of view, is for states to allow for individual residences to sell power back into the grid if they're producing more, say with rooftop solar, than they actually consume in a particular afternoon. Quite a few jurisdictions already allow this, but not all of them do.

    What's really holding back a lot of these systems is battery, or storage, technology. For solar to make a residence independent of the grid, we would need to be able to store power for a few days and release it as needed. This battery would have to fit into an existing home. You shouldn't need to renovate your basement to put in a battery that's as large as an automobile to hold power for a few days. It needs to get down to the size of a water heater or something similar. Right now, you have to consume the power as it's produced. It can't be feasibly stored, and that holds back a lot of different renewable power technologies.

    TER: Are conditions for renewable energy more favorable in Canada or in the U.S.?

    JM: Federally, the U.S. has more favorable conditions than Canada. However, in both countries, renewable policies are being initiated more at the state level and the provincial level. The larger Canadian provinces are on a level playing field with a lot of the states. But, of course, typically, the fossil fuel energy-producing states are resistant in Canada, just as they are in the U.S.

    TER: The prevalent renewable energy in Canada seems to be hydropower. Is that an accurate assessment?

    JM: It is likely the most popular. There are great hydro resources everywhere. Even the prairies in the northern parts have good hydropower resources. It's abundant. Wind is being built in large quantities now, so that would be second, I guess. Solar is being built in large quantities now, too.

    TER: Which companies are you talking about with investors now?

    JM: My top picks are Algonquin Power and Utilities Corp. (OTCPK:AQUNF) [AQN:TSX], Brookfield Renewable Energy Partners L.P. (NYSE:BEP) and EnerCare Inc. (OTCPK:CSUWF) [ECI:TSX]. Innergex Renewable Energy Inc. (OTC:INGXF) [INE:TSX] is ascending into that group in terms of its recent results.

    TER: What do you like about those companies?

    JM: It's all about the dividend. All of these companies pay a good dividend. They have demonstrated consistent dividend growth that's well above the inflation rate, some as high as 10% annually, all while maintaining a constant payout ratio, which is the key dividend sustainability risk measurement.

    TER: What earned EnerCare a Strong Buy rating?

    JM: It's not for any fundamental changes. That was simply because, for me at least, a dividend-paying independent power producer [IPP] rated a Buy should show more than a 10% potential return. A Strong Buy is more than 20%. EnerCare got into that zone; the return to our target plus its dividend was more than 20%. That doesn't happen very often with the IPPs because they're not rocket ships. They're Steady Eddie companies that pay you a good dividend, and a dividend that usually increases every year as well. I rarely have more than one Strong Buy at any given time.

    TER: How long has EnerCare been in that category?

    JM: Just a few months. It's probably below 20% return to my target now. It's behaved as I thought it should, and risen a bit more quickly than other IPPs because it seemed out of line with where its valuation should have been.

    TER: As a company that provides water heaters and other household equipment, it's different from the others in your portfolio. What makes EnerCare an especially interesting company?

    JM: EnerCare does not produce renewable energy, but it has the same contract structure as IPPs, in that contracts are very long term and highly predictable in nature. From a risk point of view, I think the company's profile is very similar to the IPPs.

    Another reason EnerCare is interesting is that in H2/14, it bought the home service business of Direct Energy. Direct Energy was its partner in the water heater business. The companies did complementary activities, but there was always the possibility that Direct Energy could compete with EnerCare and withdraw from the partnership. Buying Direct Energy removes that possibility, which was always a little bit of an overhang on the story. The acquisition added about $60M in EBITDA [earnings before interest, taxes, depreciation and amortization], which was a 40% increase, and brought control of the entire operation in house.

    TER: How did EnerCare finance that purchase?

    JM: It was a combination of debt and equity; almost 50/50. EnerCare is one of the most conservative companies in my group in terms of how it runs its balance sheet. It has the highest bond rating in the group. It does everything on a very conservative basis.

    TER: So the financing is not likely to hurt its balance sheet.

    JM: Right. I think it issued something in the neighborhood of $300M in equity, and the balance was debt.

    TER: What was the catalyst for Brookfield Renewable Energy beginning operations in Europe last year?

    JM: There were two reasons. Here in North America, opportunities were becoming too pricey. The cost of assets, whether preconstruction assets or online assets, have gotten quite pricey. So Brookfield is looking beyond North America to find more opportunities. Before the Ireland acquisition, it was a big operator in Brazil. Now, it is ready to look elsewhere. Europe is a mature market. The resale of individual projects is going on there, so there is much more opportunity in Europe versus North America right now.

    Second, the assets were large enough to be meaningful. You can't have very good feet on the ground with new opportunities if you're buying something small. This was 463 MW, and that's about a 7% increase in the company's total megawatts, so it's not insignificant. Now Brookfield has feet on the ground in Europe.

    TER: Is Europe more hospitable to renewable energy development than North America?

    JM: Each country has its own regulations, of course. For the longest time, Germany was perhaps the most favorable market in the world. However, we've seen other countries, like Italy and Spain, try to roll back their contracts, meaning the prices they pay for the power once it has already been built. There's a real hodgepodge of both the attractiveness of renewable incentives as well as confidence that they'll be maintained.

    Germany is now peeling down its renewable incentives. It is not changing existing contracts, but new ones are relatively less attractive than they were, say, five or 10 years ago. But, again, that's because the cost of wind, solar and other technologies has come down so much. The country recognizes that it doesn't have to give as large an incentive. It's become a bit more directed.

    Offshore wind is doing great in Europe, particularly in the North Sea and around Britain. In fact, Northland Power Inc. (OTCPK:NPIFF) [NPI:TSX], another company in our group, is one of the biggest developers of wind in the North Sea. It plans to spend $3 billion on two individual projects, which are almost 1,000 MW in total. That's the next wave.

    TER: What do you like about Algonquin Power?

    JM: In the last few years, Algonquin Power has averaged about a 10% increase in its dividend. It has one of the lowest payout ratios, which is one of my key risk measurements. It's below 50%. It is now balanced about 50/50 in terms of free cash flow coming from renewable energy and water, gas and electric utilities.

    Utilities are a great investment in terms of the predictability of their cash flows. They're slightly more predictable than the long-term take-or-pay contracts of the IPPs. The company buys well. Algonquin's utility assets are already existing, and they're all in the U.S. Its renewable assets are largely in Canada and the U.S. It's got a well-managed balance sheet. Good execution. It's just a solid company.

    TER: What are the risks for a pure-play renewable energy provider like Innergex?

    JM: The overwhelming risk to all of these IPPs and, in fact, all dividend-paying companies, is the interest rate risk. The IPPs are most highly correlated with the five-year Treasury bond, which in Canada stands at 90 basis points, and in the U.S. at 135 basis points. That's near all-time lows. But nothing stays that low forever. Historically in Canada, the average spread is about 400 basis points over the five-year Canada bond. If rates rise, so will yields on the IPPs, which in turn means the stock price falls.

    Individual IPPs may have specific yield risk. A dividend yield of 8% and higher means the market fears a dividend cut, so do not buy these companies. You're better off with a lower yield, which means lower risk coupled with a steady track record of increasing dividends. The increasing dividend will mitigate rising interest rates over time and, eventually, skate you back onside. [Please excuse the hockey metaphor, but the playoffs are on.]

    TER: What kind of merger and acquisition [M&A] activity would you expect to see in this space?

    JM: We don't see much at the corporate level. The IPPs like to buy individual projects so they can fit the technology in the right location with their existing infrastructure. When you buy corporate, you're getting all sorts of extra assets and other items you don't want. I don't expect to see much M&A on the corporate level, but on a project level, that's where the market is.

    A few of the smaller IPPs, like Boralex Inc. (OTC:BRLXF) [BLX:TSX] and Capstone Infrastructure Corp. (OTCPK:MCQPF) [CSE:TSX], might be likely targets on the corporate level. However, anyone looking at these companies will be making sure all the assets are in the right locations, and that the technologies fit in well with their present mix. EnerCare has been the target of a couple of board takeover attempts over the last few years, but the acquisition of Direct Energy's home service business seems to have quieted down that noise. Atlantic Power Corp. (AT) is busy selling assets to get back onside with its lenders' covenants, but I have not heard of any interest at corporate level.

    I think, eventually, the large U.S. utilities could become interested. Utilities hate risk, but they do have mandates to fulfill. They own coal and gas, so why would they want to buy power from wind and solar that they don't own? They want to own it instead, but the last thing a utility can do is build wind or solar, because its engineers are fossil fuel engineers. Utilities have to acquire the expertise as well as the assets. There may be a possibility down the road to buy some of the larger IPPs, but I'm not hearing about that right now.

    TER: Given the low price of fossil fuels and the political resistance to decarbonization of the power industry, how should investors in this space proceed?

    JM: The price of fossil fuels only impacts new or aspiring power price contracts. These contracts are set at 20-year take-or-pay, so the IPP sells all it can produce at a known price for 20 years. I would say buy the IPPs with yields in the 4-6% range and a steady track record of increasing dividends. If you want to look deeper, look at the payout ratio-I would say a maximum of 75%. A payout ratio below 60% usually means that a dividend increase is coming. It's better for sleeping at night to have a well-run stock with a dividend that rises, as opposed to a dividend at 8% that you might find cut in half next week.

    TER: John, thank you for sharing your insights.

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

    Senior vice president for research John McIlveen has been with Jacob Securities in Toronto, an investment bank focused on renewable power and cleantech, for eight years. He is a published business professor with a bachelor of commerce degree and a master's degree in business administration. He has 28 years' experience in public equities research, private equity and term lending. McIlveen was the first sellside analyst in Canada to focus solely on renewable power, and is consistently ranked a top performer by Bloomberg on accuracy of estimates and returns.

    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 ofThe 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.
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  • Three Upstream MLPs With The Discipline To Succeed In The Coming Recovery: RBC Analyst John Ragozzino

    Are you ready for $74 per barrel oil? In this interview with The Energy Report, RBC's John Ragozzino tells us he's anticipating a V-shaped oil price recovery that could bode well for upstream master limited partnerships, the companies that invest in oil and gas assets and have been hit hard by lower prices. He has followed MLPs through the highs and lows, and he knows which had the strength to hedge at the right times and which are liquid enough to take advantage of growth opportunities that could be right around the corner.

    The Energy Report: John, oil and gas prices have rallied a bit recently. Have we established a bottom?

    John Ragozzino: Yes. In our recently published Global Energy Research "Commodity Price Revisions" report, we are calling for a meaningful V-shaped recovery beginning in the back half of 2015 and into 2016. This is not significantly different from our prior forecasts, as we adjusted our price forecasts to $54 per barrel [$54/bbl] from $53/bbl in 2015, and from $77/bbl to $74/bbl in 2016.

    Our thesis on crude oil is largely predicated upon a deceleration of non-OPEC supply growth, as we've seen the U.S. onshore rig count drop by more than half over the last five or six months. Additionally, we are seeing a growing inventory of uncompleted unconventional wells, as operators defer completions to an environment of better pricing and higher returns. When you combine these two factors with a global demand picture that calls for roughly 1.0-1.1 million barrels [1.0-1.1 MMbbl] of annual demand growth over the 2015-2016 time frame, it doesn't take long before the global oversupply situation is largely eroded and we find ourselves back in a state of equilibrium. I think that will be the meaningful catalyst that gets us to higher prices in 2016. Our long-term deck remains unchanged at $84/bbl West Texas Intermediate [WTI] and $90/bbl Brent.

    On the gas side, I wouldn't say that statement holds quite as well, because we continue to see new lows on Henry Hub natural gas prices. We can probably expect a continuation of anemic demand growth until the middle 2015, at the very least. That should mark the beginning of a phase of meaningful coal generation retirement, which could result in 2-3 billion cubic feet per day of additional demand. It's not until 2017 and beyond that we begin to see some meaningful changes on the gas demand side, with liquefied natural gas exports ramping up.

    TER: Based on your new commodity price forecasts, what's the risk profile of upstream master limited partnerships [MLPs]?

    JR: The upstream MLPs are at an elevated risk profile relative to historical levels. At the end of 2014, we believe the upstream MLPs were at a peak risk profile, as prices had been rapidly cut in half immediately after 18 months or so of market backwardation, when many management teams got ahead of themselves and veered off the well-beaten strategy path of robust hedging and price risk aversion measures. Most upstream MLPs typically follow a rolling three- to five-year commodity price risk-aversion strategy that includes the use of fixed price swaps and costless collars to mitigate exposure to price volatility. Many upstream MLPs today are well below their preferred hedge levels due to the temptation to wait for better pricing during that long period of backwardation.

    Management teams reluctant to take a $15-$20/bbl discount for their production volumes two to three years out held off on hedging at the worst possible time, as they saw prices cut in half as opposed to the forward curve simply returning to a normal state of contango. When the price continued to fall, a lot of companies that were crude oil-weighted effectively became victims of their own temptations.

    Today, upstream MLPs are looking healthier after cutting distributions and making meaningful reductions in spending plans for 2015. Capital preservation is the main theme. The passage of the spring redetermination period also lifts a material overhang on the group in general. Everyone has sobered up mighty quick in light of reduced oil prices. The outlook for distributions and spending profiles is far more sustainable than what it looked like going into 2015, which goes a long way to reducing risk compared to levels seen in late December and early January.

    TER: How do you identify an upstream MLP that meets your investment goals?

    JR: It's really pretty simple. A lot of naysayers argue that producing assets in the upstream model don't fit into the MLP structure, because the MLP holds a declining asset that must support a distribution profile that is steady in the worst-case scenario, and ideally growing over the long term. Those two things inherently don't match. But when an MLP employs a disciplined hedging strategy that mitigates commodity price risk, and follows a simple strategy of minimal spending on organic project development while using the cost of capital benefits that the MLP structure potentially affords to grow the business via accretive acquisitions, there is absolutely a place for upstream companies in the MLP structure.

    Longer term, I believe that the maturation of the resource base in the U.S., concurrent with a period of such vast discovery on the unconventional side, has led to a thirst for capital by the exploration and production [E&P] C corporations. This has facilitated a symbiotic relationship between the upstream MLPs and the E&Ps, and resulted in widespread divestitures of many mature, shallow decline-type assets that were likely not getting much appreciation from C-corp investors. Those are the ideal assets for an upstream MLP because they have very low decline rates, low capital intensity levels and, ultimately, they're far more suited to sustaining a distribution in the long term.

    As far as what we look for in specific companies, balance sheet health and liquidity position are at the top of the list. I also look carefully at the asset profile. Ideally it should be a diverse mixture of commodity products. You don't want to be overly levered to oil or gas. There was a time when it was cool to be 100% crude oil-weighted, but you can see how quickly that turns when prices are cut in half. So a diverse production profile is important. A quality asset base, meaning low decline rates [10-12%], and low capital intensity, are also important. Finally, I look for a strong management team, one that is well aligned with unit-holder interests.

    TER: What is an example of a company that meets your criteria?

    JR: Linn Energy LLC (NASDAQ:LINE) is a turnaround story that, 18 months ago, was probably dealing with upward of a 23% annual production decline rate on a year-over-year basis. Through a series of large divestitures and asset acquisitions, Linn has been able to wear that down to something more along the lines of 15% or so. Something in the 10-12% range would be ideal, but the company is moving in the right direction.

    Management has also strategically positioned itself to take advantage of both organic development opportunities and potential acquisition & development [A&D] opportunities by partnering with large private equity partners such as GSO Capital Partners [Blackstone Group L.P.] and Quantum Energy Partners.

    The bottom line is that this company should be able to continue to grow production and, ultimately, cash flow, without being so heavily reliant upon the traditional public debt and equity markets. Once Linn's balance sheet is de-levered to a more comfortable level and distribution growth is able to resume, the stock will be more attractive to investors. A healthy balance sheet and sustainable distribution growth is ideally what investors are looking for, and this should drive capital appreciation through yield compression.

    TER: Linn made almost half of all the acquisitions made by upstream MLPs since 2008. How is it finding synergies, cutting costs and integrating all those companies?

    JR: On the operations side, Linn's operations and asset integration team is second to none. The team has effectively created an acquisition machine. Over the last 18 months, the company significantly turned the asset base over, taking a high-decline asset base with a lot of production and undeveloped acreage in unconventional plays such as the Granite Wash and the "Hogshooter" and, through a series of asset swaps and divestitures, moved out of these plays and into plays like the Hugoton Basin. These plays are far less sexy and fun to watch, but they make a lot more sense for the upstream MLP model. For a company its size, Linn is actually quite nimble.

    TER: You aren't worried about the cut to its shareholder distribution?

    JR: Only a handful of companies in the group have not cut their distributions at this point. In light of the sector-wide lack of hedging, I see cutting distributions as a sign of being proactive and realistic about the world we now live in, rather than of weakness. Linn was the first to cut its distribution in January. It may have been a bit early, but it was the right decision. Others followed suit soon thereafter.

    TER: What other upstream MLPs are you following?

    JR: Another name we like is Memorial Production Partners LP (NASDAQ:MEMP). The thesis is pretty simple. It is one of the only names that remained disciplined throughout this period of volatility and falling commodity prices. On top of that, the company has had a good run in the acquisition market, growing quickly and efficiently. It has taken its largely natural gas-weighted production profile and turned it into a much more diversified product split. Most importantly, Memorial is one of the most aggressive hedgers of the group, managing a hedge book that extends well into 2019. Management stuck to the script: It removed all the emotion from the decision-making process and followed the playbook as it was written. That is paying off in the stock price, compared to a lot of its peers.

    TER: Memorial just did a redetermination and reduced the borrowing base by 9.7%. Is it still liquid enough to take advantage of acquisition opportunities?

    JR: The conservatism demonstrated in Memorial's hedging strategy has allowed the company to preserve a far healthier balance sheet and liquidity profile than a lot of its peers. Plus, the company was lucky enough to tap the equity markets right before the crack of the commodity and entered the redetermination season with close to $900 million [$900M] in liquidity. The expectation going into the redetermination was for a 10-15% reduction in the borrowing base. For a company of its size and with nearly $1 billion on hand, there is plenty of room for an adjustment of the borrowed base to the tune of about 9%. This move leaves Memorial well positioned to remain quite opportunistic for any emerging A&D opportunities.

    TER: Is there a third company you wanted to talk about?

    JR: The only other upstream MLP that we are currently recommending is EV Energy Partners L.P. (NASDAQ:EVEP). This name is largely natural gas-weighted, but the company recently announced the divestiture of its Utica East Ohio midstream project for $575M in cash to Williams Partners L.P. (NYSE:WPZ). That was a very attractive price in our opinion, providing the company with a meaningful booster shot of liquidity to the balance sheet. This cash is going to allow EV Energy to pay down all its revolving debt and ultimately emerge as one of the best-positioned upstream MLPs for future A&D.

    We are getting to a point where the bid-ask spread on producing assets is settling down and is likely to find some sort of equilibrium soon. I expect the acquisition activity to pick up in H2/15 and 2016. Those companies with additional dry powder to exploit A&D opportunities are going to be able to outperform their peers. EV Energy Partners will be sitting on $650M in cash. The addition of a mature, producing asset worth $500M or more could do a lot to reshape its current asset base, diversifying it into a more balanced product split, and ultimately yielding significant accretion to distributable cash flow per unit. This should help move the company back to its original strategy, which was a traditional, steady state of distribution growth. Following the path of most of its peers, EV Energy's early February distribution cut and reduced capital spending outlook leaves the company in a healthy position currently. I would like to see it get back to a sustainable 3-4% distribution growth number, and I think that this divestiture and reinvestment process is likely the catalyst to do that.

    TER: What about other parts of the MLP space? Do you have other companies we should be watching?

    JR: The one name that I follow in the refining and specialty products business is Calumet Specialty Products Partners, L.P. (NASDAQ:CLMT). This company is largely viewed as a refining name, which in the current environment is being helped by a favorable fundamental tailwind given the rally we've seen in crack spreads over the last couple of months.

    But if we go back to the end of 2014, it was a different story. The stock bottomed out at about $19-and-change/unit in late 2014, almost simultaneously with a bottom in crack spreads. Then crack spreads skyrocketed almost $10/bbl in less than a week, kicking off a strong rally in Calumet units. There has clearly been a lot of momentum behind units. I admit, we missed the opportunity to upgrade Calumet at its lows. However, following a secondary offering in mid-March, the stock pulled back over 14%, and we decided to get more aggressive on the premise that the fundamentals in the refining market were certainly reflective of better things to come on the refining side of the business.

    With Calumet, however, the most important thing to focus on is the specialty products side of the business, as opposed to the refining side. While the fuels business is in a good fundamental state right now, and the company does employ a risk mitigation strategy that uses hedges, similar to an upstream MLP, to lock in refining margin, it's a commoditized market and very volatile.

    On the specialty products side of things, Calumet produces some 5,000 different products and distributes to customers all over the world. These are very high-margin products with extremely sticky pricing. This means these products benefit when we see a reduction in crude oil prices-products like WD-40 or Royal Purple automotive lubricant. These products are ubiquitous and don't fluctuate with changes in oil prices. Just in Q4/14 alone, the company posted a record gross profit per barrel on the specialty products side of the business, a quarter during which we saw an average WTI crude price north of $70/bbl.

    The Street has largely put the company in the penalty box over the last two years, just because of weak operating performance on poorly timed maintenance downtimes for the refineries, digestion of acquisitions and cost overruns-things that were outside Calumet's control and one time in nature. Now that is cleared up, and we have a clear look at the business and what it can do going forward. I think that we're going to see Calumet outperform its historical levels of operating performance and exceed estimates.

    I think we are in the early innings of Calumet's upward trend and strong financial performance on the specialty products side of the business. Additionally, after the recent offering, the company has secured the necessary funding to complete its pipeline of organic growth projects, which should contribute nearly $140M in additional EBITDA [earnings before interest, taxes, depreciation and amortization] per year over the next 12 months or so. Once the remaining capex on these projects is completed, we expect the company to resume distribution growth.

    TER: What final words of wisdom do you have for investors already in the MLP space, or curious about getting into the space this year?

    JR: A fairly negative sentiment is still lingering around the upstream MLP space. I would say that there certainly is opportunity to be had in the sector right now, but given the underhedged profile of a lot of the upstream names-and the uncertainty that surrounds the commodity market-investors still need to be cautious about their investment decisions and can't be tempted by some of the attractive yields out there. They need to do their homework and make sure they're making prudent decisions and looking for the higher quality names. Selectivity will be key to picking winners versus losers over the next 12-18 months. Like I said earlier, it's going to come down to those companies that are well situated in terms of their liquidity position, balance sheet health, hedge profiles, production diversity and, ultimately, staying power.

    If we see our price deck come to fruition, and there is a meaningful V-shaped recovery, and we find ourselves back upward of $77-80/bbl by the end of 2016, then it's a bit of a different story. The situation would be more universally attractive. But until that happens, the best-of-breed investment strategy will ultimately win.

    TER: Thank you for your time.

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

    John Ragozzino, CFA, joined RBC Capital Markets in 2012, bringing with him more than nine years of experience in institutional equity research. He has followed a number of different sectors including media, entertainment, gaming, and most recently energy. Ragozzino has remained focused on the energy space through his coverage of various subsectors including oil and gas exploration & production, upstream master limited partnerships [MLPs] and oil and gas royalty trusts, the latter two of which he currently covers as one of RBC's three analysts dedicated to the broader MLP space. Before joining RBC, he worked in institutional equity research for a number of large and mid-size investment banks, including Robert W. Baird, Stifel Nicolaus Weisel, Wells Fargo and BMO. He holds a bachelor's degree in business administration [finance] from the University of Colorado at Boulder. 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 Interviews page.Top of Form

    Bottom of Form

    DISCLOSURE:
    1) JT Long 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 employee. She or her family own 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) John Ragozzino: 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: A member company of RBC Capital Markets or one of its affiliates managed or co-managed a public offering of securities for Calumet Specialty Product Partners LP in the past 12 months. A member company of RBC Capital Markets or one of its affiliates received compensation for investment banking services from Calumet Specialty Product Partners LP in the past 12 months. RBC Capital Markets is currently providing Calumet Specialty Product Partners LP with investment banking services. RBC Capital Markets has provided Calumet Specialty Product Partners LP with investment banking services in the past 12 months. A member company of RBC Capital Markets or one of its affiliates expects to receive or intends to seek compensation for investment banking services from Calumet Specialty Product Partners LP in the next three months. RBC Capital Markets is currently providing Linn Energy LLC with non-securities services. RBC Capital Markets has provided Linn Energy LLC with investment banking services in the past 12 months. A member company of RBC Capital Markets or one of its affiliates received compensation for investment banking services from Linn Energy LLC in the past 12 months. A member company of RBC Capital Markets or one of its affiliates managed or comanaged a public offering of securities for Linn Energy LLC in the past 12 months. A member company of RBC Capital Markets or one of its affiliates managed or comanaged a public offering of securities for Memorial Production Partners LP in the past 12 months. A member company of RBC Capital Markets or one of its affiliates received compensation for investment banking services from Memorial Production Partners LP in the past 12 months. RBC Capital Markets is currently providing Memorial Production Partners LP with non-securities services. RBC Capital Markets has provided Memorial Production Partners LP with investment banking services in the past 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 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

    Apr 29 5:38 PM | Link | Comment!
  • The Three Principles That Guide Randall Abramson's Oil & Gas Investment Strategy

    The market analysis tools used by Randall Abramson of Trapeze Asset Management Inc., suggest that the broad market has been fairly valued for about a year. But by applying apples-to-apples metrics to companies in the energy sector, Abramson has found specific equities trading well below their estimated appraised values. By the end of 2015, Abramson predicts oil prices will rise back to $70 per barrel or more, and undervalued energy equities should propel toward fair value. In this interview with The Energy Report, Abramson pinpoints some unloved energy companies poised for the rebound.

    The Energy Report: In a recent research report, you looked at the macroeconomic picture through the lens of value investing. You call the macro view "complex" and "historically unusual." In the context of certain uncertainty, could you please provide us with three principles that guide your investment decisions in today's market?

    Randall Abramson: The reality of the day is that we have historically low interest rates and a number of crosscurrents moving through the economy. At Trapeze Asset Management we've developed tools, some of which we have systematized since the big downturn in 2008-2009, to cope with periods like this. We use our valuation model from a bottom-up perspective to tell us where the individual bargains are, and from a top-down perspective to tell us, in general, whether the markets or sectors are overvalued, undervalued or fairly valued. Today, our work tells us that the market has been hugging fair value pretty closely for about a year, which is unusual. That one tool helps us establish where the markets are and where they ought to be heading.

    The second thing that guides us is the macroeconomic overlay. We have an economic composite and a momentum indicator, both of which are designed to predict whether there is a recession coming and/or a market debacle-not a typical correction but one of those 20% or more doozies. At the moment, our economic composite is showing smooth sailing, not just in the U.S. but also in other global economies. Our momentum indicators show relatively smooth sailing too, though a few countries, including Russia, Brazil and Peru, have negatively triggered.

    And, finally, we try to determine which way the world is going. Disinflationary pressures and the ascent of the U.S. dollar have pushed down the resource sector, and most commodity prices have been badly hurt. The stagnation in many economies around the world has resulted in highly accommodative monetary policies. That's a reason we like the resource sector: We think that reflation is around the corner.

    TER: Fair value would suggest that we're not in a bear market for energy stocks, but clearly we are.

    RA: There's no question that the sector has been in a bear market because we define, like most people, any drop greater than 20% as a bear market. Yet it's the most unusual energy bear market I've witnessed in my 25 years in the business. It's rare to get a selloff like this that is not precipitated by a recession. The demand for oil is ever growing. It normally rises even in a recession.

    The decline started after Brent crude went to $120/barrel [$120/bbl]. It was too far above the marginal cost of production, which is usually what holds the price in check. Then you had the serious rise in the U.S. dollar, which started bringing down most commodity prices because they're priced in U.S. dollars. At the same time you had excess supply driven by the U.S. shale boom. Then, in November 2014, OPEC said that it would not curtail oil production, knowing that would drive oil prices even lower to force production cutbacks around the world. That was probably the right thing to do, but I don't think even OPEC expected to see oil at $40/bbl.

    TER: What are your near-term and medium-term forecasts for oil and gas?

    RA: It's always hard to tell where things are going in the near term. But when you look out, say, six to nine months, you're likely to see a substantially higher oil price. That's because it's unbelievably rare to be trading below the average all-in cost of production. The all-in cost of production is in the $55-60/bbl range. While Brent has gone back above those levels, WTI [West Texas Intermediate] is still below. It's not sustainable.

    Case in point: We have seen the number of U.S. drilling rigs collapse from more than 1,900 to just over 1,000 since last fall. That hasn't translated to lower U.S. oil production yet, but it's coming. If you're not out there finding more oil, and you have abnormally high decline rates-U.S. shale oil wells tend to decline much faster than conventional oil wells-you're setting up for a decent production decline in the next 12-18 months. And, even if U.S. production were to merely flatline, the global supply/demand equation is tight enough that the ever-growing demand should quickly create a supply deficit.

    TER: You still like some energy names, even with oil at around $50/bbl. Is it about finding specific narratives with catalysts in a bear market?

    RA: First of all, you have to have a forecast that the bear market is going to end, which we do. As I said, the price for oil has overshot to the downside, below the average all-in cost of production. There's an adage in economics: Gluts beget shortages and shortages beget gluts. Clearly, we had a "mini-glut" because of the U.S. shale overhang, but we can end up in a shortage position rather quickly.

    Globally, supply amounts to 94 million barrels per day [94 MMbbl/d] versus demand of about 93.5 MMbbl/d. Demand has been growing smartly, thanks to countries like China and India. But the problem for the oil market is that U.S. supplies went from 6 MMbbl/d of supply to 9 MMbbl/d in three years. That has now flatlined just above the 9 MMbbl/day mark and I suspect it will drop. In Q1/15, global oil demand rose by 2 MMbbl/d year-over-year. So U.S. production doesn't have to drop far before overall demand outstrips supply again. That will, at the margin, quickly bring prices back up.

    TER: So even though U.S. oil inventories are at their highest point since 2001, you see that changing quickly?

    RA: Yes, because global inventories are relatively normal. It's only U.S. inventories that are bloated. Some people believe refineries are intentionally building supply because they see problems ahead. Refiners are known for being pretty adept. There has been commentary about the amount of heavy oil that is needed to import for refining. Heavy oil imports have been jacking up and leading to some strange inventory levels in the U.S.

    TER: In the report I referenced earlier, you aptly noted that investors are often giving up returns in the rush to safe investments, like government bonds or slow-growth blue-chip equities. How do you and your team balance risk versus reward?

    RA: A number of ways. I'll divide it between bottom up and top down. From a bottom-up perspective, we look for a margin of safety. That means if the price is trading at or above our appraisal, using our discounted cash flow models as fair value, we're not interested. A stock needs to be trading at a discount to fair value, because if something goes wrong we want to make sure there's a margin of safety. To make a sufficient return that beats your hurdle rate, you want something to go from at least $0.80 on the dollar back up to a dollar, and collect the dividends and growth in the company on top of that. We screen more than 1,200 large-cap stocks-the largest in the world, and a number of medium- and small-size companies, too-looking for those that are trading at less than $0.80 on the dollar. That's one piece of the puzzle.

    Then you want to do your due diligence, to make sure that you understand the businesses you're buying. They shouldn't be subject to regulatory issues that could alter the entire business, or leveraged to a point where the business could be in peril. At the same time, you want to avoid what we call "value traps," where the stock might be cheap, but it's cheap for a reason. Therefore, you want to focus on earnings revisions and near-term happenings in the business.

    From a top-down perspective, you want to monitor not for your typical 3-6% corrections, but for those 20% or more drawdowns in the market. Those usually arrive when recessions come.

    TER: What are some other names that you have positions in?

    RA: One that is farther afield is Orca Exploration Group Inc. (OTCPK:ORXGF)[ORC-A:TSX.V; ORC-B:TSX.V]. The company produces more than 90% of Tanzania's natural gas, about half of which is used to produce power. The stock has been stuck in the CA$3/share range for the longest time as Tanzania struggles with corruption issues. And the national utility, TANESCO [Tanzania Electric Supply Co. Ltd.], has not been meeting its obligations to Orca and other companies on a timely basis, even though things have improved since the World Bank got involved more than a year ago.

    Orca is also not producing at the levels the market expected by now, but a pipeline slated for completion years ago is finally going to be commissioned in a few months. Hopefully, that pipeline will deliver enough Orca natural gas to help alleviate the severe brownouts Tanzania has experienced for many years. In the meantime, Orca is remarkably cheap. The company has more than US$60M cash and is owed more than US$60M by TANESCO and has no debt-there's about CA$2.50/share of net working capital, including amounts we expect Orca to ultimately collect from TANESCO. You're nearly getting all the reserves for free. And the 2P reserves are worth in excess of CA$11/share according to the company's third-party engineers.

    TER: Is the company's move into Italy an attempt to mitigate risk in the stock?

    RA: It's an attempt to diversify, and management liked what it saw there.

    TER: Tell us about Orca management and some of its key people.

    RA: Chairman and CEO David Lyons has had a large ownership stake for many years. He spun out Orca from PanOcean Energy Corp., a successful company that ran for many years. Its primary investment was in Gabon, so he knows what it takes to operate in Africa. Lyons ultimately sold PanOcean to Addax Petroleum [AXC:TSX] in 2006. I think that Orca will get sold, too. In November 2014, the company announced that there were unsolicited expressions of interest, either in the entire company or its assets. Something may already be afoot.

    TER: Why hasn't that created more of a run on the stock?

    RA: People are simply scared of Tanzania. A country that does not pay its bills on a timely basis does not sit well with most investors. People pay a premium for safety, and they discount things that they're concerned about. Our job is to determine whether those risks are real. While we don't believe there are material risks here, resolving Orca's issues has taken way longer than we'd thought.

    TER: Are there any other equity stories you'd like to tell us about?

    RA: We like the oil and gas service space as well. One name in that space is Paris-based Technip S.A. (OTCPK:TNHPF) [TEC:EP; TKPPY:OTC]. Technip is one of the leading oil and gas service companies, offering both subsea and onshore/offshore services, everything from soup to nuts in the business. The stock has been knocked down, along with the whole energy space, to the point where it's trading at about 4.7 times EV:EBITDA versus about 7 times for the group and 10 times for names like Halliburton Co. [HAL:NYS]. We think it's a serious bargain. It's just a lesser-known name.

    TER: What's the next catalyst for Technip?

    RA: It's just about the oil price recovering. The service sector tends to be higher beta, and moves more dramatically. We need to see higher oil prices. When we wake up toward the end of the year, you should see a significant recovery of most players in energy services.

    TER: Are there any other stories you'd like to share with us?

    RA: I'll give you one more: Weatherford International Ltd. (NYSE:WFT), which is also in the oil and gas service space. Weatherford has been in turnaround mode after it added too much debt. But it sold divisions, cut costs and de-levered. Like Technip, once the price of oil and gas recovers, you could see a material recovery in the price of Weatherford.

    TER: What has the macro picture of the last five or six years taught you as an investor on a micro level?

    RA: In general, we've learned from our macro tools that when they are not giving us red flags to remain fully invested, the market will continue to climb the wall of worry. While it's doing that, until there is something to actually worry about, you need to be fully invested, assuming you can find bargains. Otherwise, cash becomes a significant drag to your portfolio.

    TER: Thank you for talking with us, Randall.

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

    Randall Abramson, CFA, is CEO and portfolio manager of Trapeze Asset Management Inc., a firm he cofounded in 1999 shortly after founding its affiliate broker dealer, Trapeze Capital Corp. Abramson was named one of Canada's 'Stock Market Superstars' in Bob Thompson's Stock Market Superstars: Secrets of Canada's Top Stock Pickers (Insomniac Press, 2008). Trapeze's separately managed accounts are long/short or long only, and have either an all-cap orientation or large cap-only mandate via the company's Global Insight model. Abramson graduated with a bachelor's degree in commerce from the University of Toronto in 1989, and his career has spanned investment banking, investment analysis and portfolio management.

    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) Brian Sylvester conducted this interview for Streetwise Reports LLC, publisher ofThe 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) Randall Abramson: I own, or my family owns, shares of the following companies mentioned in this interview: Orca Exploration Group 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.
    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

    Apr 23 5:41 PM | Link | Comment!
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