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  • Chris Berry Identifies Commodity Companies With The Disruptive Advantage

    Globetrotting Chris Berry, founder of House Mountain Partners, finds most retail and institutional investors sitting on the sidelines waiting to see where the energy sector is headed before jumping back into the game. Game-changing disruptive technologies or sustainable end-user agreements are what companies need to succeed and he shares some likely names in the cobalt, lithium, nickel, graphite-even uranium-spaces in this interview with The Mining Report.

    The Mining Report: Chris, on your travels, what are you seeing in Europe and Asia regarding supply and demand in the commodity markets?

    Chris Berry: Sentiment varies depending on location. In Hong Kong the institutional community is generally optimistic and really favored gold, nickel, and aluminum heading into 2015, with a more bearish stance on coal and iron ore. While there are serious structural headwinds facing the global economy including the threat of deflation and a slowing China, the general consensus was that we're at the bottom of the cycle.

    In Germany and Switzerland, the outlook is much more somber. In Germany, the call for higher gold prices based on market manipulation was in full force as it perpetually seems to be. The failure of gold to increase in price in the wake of the end of quantitative easing in the U.S. and the almost immediate continuation on the part of the Bank of Japan has many people scratching their heads. Clearly, the lack of inflationary pressure has stunted gains in gold or gold shares.

    Switzerland was an interesting place to be, as I was there two weeks before the referendum voting on whether or not the Swiss National Bank would be required to hold 20% of its reserves in gold. Most people I asked had no opinion or didn't think the referendum would pass, but the fact that over 75% of voters voted against it was a real surprise. That the Swiss would rather have their national bank hold fiat currency in reserve rather than gold says a great deal about how gold is viewed in the financial markets these days.

    My message to the institutional groups I spoke with was simple: If all you do is turn on the TV and listen to commentators rail about the falling price of gold and oil and you think that all commodities are faring the same, you're going to miss out on a host of opportunities. Not all commodities are in trouble. The outlook for lithium, cobalt or aluminum, for example, is positive, and this is where I see a number of opportunities going forward.

    TMR: What is the collective opinion on the price of oil and what roles are Russia, OPEC and the U.S. playing in the era of fracking?

    CB: With the price of a barrel of oil down close to 50% this year from its highs, I think everyone is in a collective state of shock. Fracking in the U.S. has led to a glut of oil on global markets. That and soft global aggregate demand are the primary forces responsible for the collapse in the oil market. The implications are positive or negative depending on which side of the investing coin you're on.

    Consumers in the U.S. will presumably benefit as low oil prices give them a giant tax cut. What they choose to do with this-pay bills or spend on goods-is another story. I filled up my car yesterday for just $38. I cannot remember the last time I did that for less than $50.

    Ultimately, low oil prices could end up hurting the mining industry in the near term as cheaper energy encourages increased production into many oversupplied markets. This remains to be seen, however.

    TMR: What is your prediction for the price of oil going into 2015?

    CB: It's not my area of expertise but it seems that the price of oil will continue to fall and may not bottom until mid-2015. In June 2014, West Texas Intermediate oil [WTI] was $108/barrel [$108/bbl]. Today it's near $56/bbl. Wells that are currently producing oil can continue to do so until they run dry, as the costs are largely sunk. We're likely looking at another six months of oil prices in the current range.

    Longer term, my sense is that the equilibrium price for WTI crude oil will be $70-80/bbl. That level still hurts a number of OPEC members and Russia; they need a higher oil price to balance their budgets. It would appear that OPEC is backed into a corner and will continue to suffer regardless of the final new equilibrium for oil prices.

    In the U.S., we're reading a lot about how the fracking industry is exposed to high-yield debt. The Saudi Arabians know this and it's one of the main reasons they won't allow OPEC to cut production to support the price of oil. The goal is to push the marginal players in the U.S. shale industry out of business.

    TMR: With such low prices, are energy investors doubling down and investing in companies while they're at their historic lows or are they waiting to see what comes next?

    CB: Almost universally, in both the institutional and retail sectors, energy investors are waiting and are pursuing higher returns elsewhere. This is a classic falling knife scenario where many commodities have fallen hard consistently and nobody wants to be the first person back in the market for fear of incurring additional losses. It seems that this is a market where you find out if you're a true contrarian or not.

    Instances like this strengthen my belief that deflation, rather than inflation, is the more pressing economic issue to tackle.

    TMR: Let's talk about some of those other commodities. You've written a lot about the impact of increasing battery demand on commodities. What's your outlook for lithium?

    CB: Lithium is one of my top picks going forward. Despite the large amount of press lithium receives, it really is a small industry. The combined market capitalization of all lithium mining companies I'm tracking amounts to about US$18 billion [US$18B]. When you strip out the established lithium producers, that market cap number plummets to about $550 million [$550M]. For the sake of comparison, Apple, a major lithium-ion battery customer, has a market cap of $653B, over 36 times larger than the entire lithium industry.

    Currently, just about all metals are suffering from excess capacity that built up during the first leg of the commodity super cycle between 2002 and 2011. Lithium is no exception. That said, there are two primary reasons I'm optimistic about lithium in the coming years.

    First, overall demand for lithium is growing at about 8% annually. I can't think of another metal I'm tracking with that same growth trajectory. Compare that to global GDP growth at about 3%. Even if lithium demand falls to 6%, it's still growing at double global GDP. This provides some insulation.

    Second, lithium has multiple avenues of demand. "Current day" uses include ceramics or pharmaceuticals. The next generation of use is the battery business, which is growing at healthy double digit rates. Vehicle electrification and energy storage are key drivers for lithium going forward. Almost any major auto manufacturer is either producing or working on some sort of a vehicle with an electric drive train, and with so much R&D funding focused on building more powerful and cheaper lithium-ion batteries, I'm confident that breakthroughs with energy density can occur, but will take time to be commercialized.

    I'm paying particular attention to how companies like Panasonic, LG Chem, or Sumitomo are positioning themselves in the industry.

    TMR: You also need cobalt to make batteries. What is its supply and demand picture?

    CB: If there is a pain point where the grandiose plans for North America-based lithium-ion battery supply chains could come unraveled, it would be with cobalt procurement. Battery chemistries can differ but cobalt is typically the most expensive raw material or component in the batteries. It also originates from challenging investment locales such as the Democratic Republic of Congo or Russia, with much of the refining taking place in China. The cobalt price on the London Metals Exchange is up about 8% in 2014, in stark contrast to just about all other metals, indicating that demand is healthy. The overall demand picture looks reasonably strong, with a 6-7% annual growth rate, primarily coming from the battery and aerospace industries.

    The challenge with cobalt is the lack of near-term production stories in reliable geopolitical jurisdictions. End users trying to find sustainable, secure sources of cobalt have a real problem. I'm not sure what the answer is, but it's a real potential flashpoint for the supply chains.

    TMR: What about nickel and graphite?

    CB: Nickel has been hogging the headlines lately and rightfully so.

    A lot of the interest in nickel was due to the Indonesian government's actions shutting off exports of raw nickel ore. The goal of the government is to build its domestic supply chains and export higher-value products. I think the real keys to watch regarding nickel in 2015 are the inventory levels on the London Metals Exchange [LME], nickel production in the Philippines, and also nickel stocks in China.

    As for graphite, it has a different story. Of the metals and minerals I cover, graphite is among the most difficult to reliably forecast. The market is incredibly fragmented and there are dozens of end products, making an overall forecast challenging, to say the least. China's relative dominance in the market is another factor adding a layer of opacity to the supply and demand picture.

    A main difference between graphite and other metals and minerals is that graphite has a substitute in synthetic graphite. This product is also already integrated into global supply chains. Even though synthetic graphite is more expensive to produce than natural graphite, end users know exactly how it will fit into their supply chains.

    Substituting natural graphite for synthetic is a sizable risk. That said, with so many potential uses for graphite being discovered in labs, the future for graphite, both synthetic and natural, remains positive. I think the optimal junior mining graphite opportunities going forward will be those that have worked to establish their own supply chains, or have established patented production technologies. In an era of excess supply and muted demand, increased productivity is crucial for sustainability.

    TMR: What other commodities are playing disruptive roles right now?

    CB: It's less about the commodities and more about which companies are employing unique technologies to reduce costs and compete in oligopolistic markets with high barriers to entry. An example is the titanium dioxide market, which is currently well-supplied. Titanium dioxide is a $15B per year market and is mainly used in the paint business. Recent production figures peg the size of the market at 5 million tons. It's dominated by the Chinese and by companies like DuPont.

    TMR: Let's move on to the last commodity, uranium. Rick Rule calls it one of the most hated materials and therefore one of his favorite investments. What role does uranium play in the changing energy landscape and which companies could capitalize on that?

    CB: Uranium is definitely hated. It's still my top contrarian pick. It's indispensable in our global energy nexus. Nuclear energy supplies about 20% of global electricity today, and will arguably provide about 20% into the future as the overall size of the energy "pie" grows. Nuclear infrastructure is in place and, of course, growing in countries like China and a lot of R&D is underway to make nuclear power safer and more effective.

    It's been encouraging to see the uranium price increase this year. It was up about 50% off its lows this year, although it has backed off some.

    Again, the key is finding the lowest-cost near-term producers. I am still tracking Uranerz Energy Corp. (NYSEMKT:URZ), as an example. The company recently achieved commercial production from its in situ projects in Wyoming and is one of the few companies that can operate in the current low uranium price environment.

    With a great deal of uranium production not economic at current prices and the long-awaited restart of Japanese reactors looming, finding low-cost production stories is the most realistic way to play the uranium market. Exploration isn't getting rewarded, so I would argue that the greatest leverage can be had by finding near-term production stories. I don't think you'll see new supply incentivized until uranium reaches $70 per pound.

    TMR: Any final advice for taking advantage of disruptive technologies looking forward?

    CB: One of the more powerful lessons I've learned in investing is that when you hear people say, "This time it's different," remember that it's never different. Disruption and innovation are certainly clichés, but given that we are dealing not only with cyclical challenges but structural challenges as well, including excess capacity, structural challenges can be mitigated through applying technology that can lower costs in a mining operation. Structural challenges take much longer to work through before we can begin a new commodity cycle.

    Technologies, relationships and intangibles like those I described above can help companies achieve low production costs.

    I think energy metals are set to outperform during the next metals cycle as technology and higher living standards converge to demand a sustainable path of growth going forward.

    TMR: Chris, thank you for your time and your insights.

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

    Chris Berry is a well-known writer, speaker and analyst. He focuses much of his time on energy metals-those metals or minerals used in the generation or storage of energy. He is a student of the theory of Convergence emanating from the Emerging World and believes it will have profound effects across the globe in the coming years. Active on the speaking circuit throughout the world and frequently quoted in the press, Berry spent 15 years working across various roles in sales and brokerage on Wall Street before shifting focus and taking control of his financial destiny. He is the co-author of The Disruptive Discoveries Journal. Berry holds a Master of Business Administration in finance with an international focus from Fordham University, and a Bachelor of Art in International Studies from The Virginia Military Institute.

    Want to read more Mining Report articles 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 The Mining Report home page.

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

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

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

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

    101 Second St., Suite 110
    Petaluma, CA 94952

    Tel.: (707) 981-8999
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    Dec 30 4:23 PM | Link | Comment!
  • 8 Billion Reasons To Invest In Potash: Paradigm's Spencer Churchill

    Potash producers have 8 billion reasons why demand for the minerals that increase food production will grow in the coming decades. Plus, a sinkhole emerging under a Russian mine is raising questions about the ability to produce enough fertilizer to feed what is projected to be an even larger and more demanding global population. The right companies could reap the benefits of exposure to the agricultural market. In this interview with The Mining Report, Paradigm Capital Analyst Spencer Churchill shares some of his favorites and talks about a unique streaming model that benefits from immediate upside.

    The Mining Report: The United Nations recently raised population projections based on increased births in industrialized nations, and has said that it expects 8 billion people to be on the planet by 2050. Is this good news for agriculture and fertilizer companies?

    Spencer Churchill: Population growth is a positive long-term driver for agriculture and fertilizer companies, and this has been one of the key arguments for many years in favor of investing in these stocks. That said, the market is more concerned with changes in the near-term fundamentals [grain and fertilizer prices, inventories, geo-political events, macro-economic factors etc.] and we believe the long-term argument has lost some weight in the minds of investors, partly because it is repeated so many times and referred to during periods of underperformance.

    TMR: Will some types of companies in some places do better than others? What is your litmus test for picking companies?

    SC: Our litmus test for picking companies is a combination of financial health [solid balance sheet, track record of profitability in different environments], strong management, positive macro trends and valuation [trading in line or at a discount to peers/historical average].

    More people eating more and eating better should lift all boats in the space, but there are definitely times in the cycle when some will outperform others. A good example of this is the current situation in the agricultural equipment market. While sales of big ticket items like tractors and combines have been hit hard with the drop in grain prices and decline in farmer sentiment and spending, some companies in the equipment space have prospered. For example, Ag Growth International Inc. (OTCPK:AGGZF) [AFN:TSX] sells lower-ticket equipment that is essential to farm operations and that must be replaced regularly. One of the primary drivers for the company is corn volumes in the U.S., which have reached record levels two years straight. Lower corn prices have resulted, but this is a positive for Ag Growth. Farmers are more reluctant to sell at depressed prices, which increases the need for on-farm storage capacity. Ag Growth is a player in that space as well, and will be a much larger one with the proposed acquisition of Vicwest's Westeel division.

    TMR: Could reports of a giant sinkhole under a potash mine in Russia bring potash commodity prices up, at least short term?

    SC: While there is still uncertainty around the final outcome of this event, Uralkali [URKA: LSE] recently indicated that the sink hole has increased in size to 50-80 meters [from 30-40 meters] and that there is a high probability the mine could be a complete loss [according to the director of the Mining Institute of the Urals Branch of the Russian Academy of Science]. Given the size of the mine [~3.5% of global capacity], the increased likelihood it will be at least shut down for many months and the potential the flooding spreads to the second mine [~1.5% of global capacity], we believe the event should support potash prices in the near term.

    TMR: What potash companies could be poised to take advantage of future price increases?

    SC: Those with the greatest exposure to potash would benefit most: 50% of PotashCorp.'s (NYSE:POT) gross margin is generated from potash, Intrepid Potash Inc. (NYSE:IPI) has 100% exposure to potash in the U.S., The Mosaic Co. (NYSE:MOS) revenue is derived from around 40% potash and Agrium Inc. (NYSE:AGU) is the lowest with around 5% potash.

    TMR: Funding is always a challenge for juniors. You follow Input Capital Corp. (OTC:INPCF) [INP:TSX.V], which is a unique agricultural streaming company. Can you explain the value proposition for investors?

    SC: Input Capital is a small cap in the space, but not a junior. The company is not exploring or developing a fertilizer deposit. Input provides capital to canola farmers in Canada in exchange for a stream of canola production, which Input then sells into the market.

    Like other royalty companies, the attraction is the very high earnings leverage these companies can produce [EBITDA margins of 90%+], given the relatively low headcount required and the growing recurring revenue base generated as capital is deployed. Input is unique in that it generates revenue from its contracts in year one, with no waiting for a mine to be built, concerns about capital expenditure, mineralogy etc. like with the precious metal streamers. There is much less concentration risk; the company already has 20 customers and is growing. And by reinvesting the cash flow from current contracts, Input can grow the business 25-35% a year without having to raise new capital. Input is the first company to attempt this business model in the agricultural space and the founders have a great pedigree. They founded and grew Assiniboia Farmland LP, which sold for $128M in December 2013.

    The biggest risks are with the commodity price [the company does not hedge] and Input's ability to continue to deploy more capital to meet the market's expectations for growth. Input is one of our favorite names in the space.

    TMR: Thank you, Spencer.

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

    Spencer Churchill has been working in the investment industry for 15 years. Prior to joining Paradigm, Churchill worked as a sellside research analyst at CIBC and Clarus Securities, with coverage areas including agriculture, clean technology, special situations, software and wireless technology. Churchill also spent two years working as an associate portfolio manager at a hedge fund in Toronto.

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

    DISCLOSURE:
    1) 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 independent contractor. She owns, or her family owns, shares of the following companies mentioned in this interview: None.
    2) Spencer Churchill: 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: Input Capital Corp. and Ag Growth International Inc. 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. Paradigm Capital Inc.'s disclosure policies and research distribution procedures can be found on our website at: www.paradigmcapinc.com/documents/show.ph...
    3) The following companies mentioned in the interview are sponsors of Streetwise Reports: Input Capital Corp. 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.
    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 Mining Report is Copyright © 2014 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part.

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

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

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

    101 Second St., Suite 110
    Petaluma, CA 94952

    Tel.: (707) 981-8999
    Fax: (707) 981-8998
    Email: jluther@streetwisereports.com

    Dec 23 2:38 PM | Link | Comment!
  • Turbulent Times Call For Insulated Investments: Steven Salz

    Turbulence and volatility are in Steven Salz's forecast for the energy market. The special situations analyst at M Partners tells The Energy Report that falling oil prices are hurting oil field services companies in different measures depending on their specialties, but that all are taking hits. A sign of the times: He thinks the Halliburton/Baker Hughes merger may be the first of a series of consolidations in the space.

    The Energy Report: Steven, is the price of oil nearing the point where North American exploration and production companies [E&Ps] will have to curtail production?

    Steven Salz: Yes. We're already starting to see hints of a pullback in drilling activity, with the Baker Hughes Inc. (NYSE:BHI) rig count showing a slight decline on a forward basis. In the Q3/14 earnings of major E&Ps, we saw language suggesting more modest plans for 2015 than previously anticipated. We're expecting around a 10%-20% drop off previous expectations in capex for 2015. That translates into a near equivalent drop in the well count year over year [YOY], which has a direct impact on the energy service space.

    If oil prices continue to decline, or even hold steady at $65-70 per barrel [$65-70/bbl], it's going to be important for investors to position themselves with companies exposed to basins that have low breakeven oil prices per barrel.

    TER: Do you think the Baker Hughes/Halliburton Co. (NYSE:HAL) deal is partially a result of this fall in price?

    SS: I do. Thoughts on that deal originally fell into two polarized camps. Some thought maybe this was a bottom, and we were going to see a recovery. That's the immediate reaction when investors see deals with such large majors. But I thought-and we now see-the deal was more about Baker Hughes thinking that tougher times were ahead, and Halliburton wanting to be opportunistic. That's consistent with the recent moves in oil prices. When you have a massive drop in the commodity price, it's expected that companies with a comfortable balance sheet are going to be opportunistic.

    TER: Are unconventional and conventional E&Ps equally affected by this price situation?

    SS: You would get hurt more on the unconventional side. Both have their advantages, with conventional arguably being lower beta in a falling oil price environment because there's typically a lower cost of production, thus a lower breakeven price per barrel. It's going to depend on which plays you're exposed to. Generally though, unconventional, on average, would need more capital to sustain production given higher costs and quicker declines.

    TER: Natural gas prices have been stable and are actually rising again. Is this causing E&Ps to shift their focus to gas production now?

    SS: Not at a level that has become apparent. These things have a lagging effect. Oil's really only come off the past few months, so you wouldn't see any material shift in the production profile over less than a quarter's time of decline. We're not seeing a shift yet, but it's possible.

    TER: Has the price of natural gas liquids [NGLs] tracked the fall in oil prices?

    SS: We are seeing some price compression in NGLs. Crude oil prices impact the price ceilings for propane and butane because they compete with oil-based products, like heating oil and gas oil. That being said, the move has not been as volatile or significant, and that's due to the fact that NGLs don't have the same export restrictions in the U.S. as crude oil exports.

    TER: Does that mean dry gas is becoming more highly valued now than it was?

    SS: It does. Dry gas wells have a lower cost of production than wet gas. In an environment where the oil price is low, there is compression in NGLs, which reduces the wet gas well netbacks because it can be sold at lower prices. The cost of production is the same, so you get a compressed netback. With stable natural gas prices, or an increase in natural gas prices, you get deeper value in a dry gas play.

    TER: How are oil field services companies responding to the price situation in oil and gas?

    SS: Many have sold off. Energy service companies are impacted by E&P capex. When the oil price falls and capital programs are at risk to be cut or moderated, the pie gets smaller for service companies to fight over. Declines vary by subsector within the energy service space: Drillers and pumpers get hit a bit harder. Those are down 35-45% year-to-date. Field service and infrastructure companies are down 15-25% year-to-date. I'd say the latter would be considered more maintenance and sustaining services versus exploration spend for the drillers and pumpers.

    If you're an energy company facing lower oil prices, you're going to cut new production; you're going to cut your capex programs on new exploration and new projects. You'd rather deploy capital into maximizing existing resources and existing wells. That results in more pain for the exploration service companies, versus companies working in maintenance and sustaining.

    TER: How is the situation affecting the companies you cover?

    SS: Among the companies we cover, there's Xtreme Coil Drilling Corp. (OTC:XTMCF) [XDC:TSX], a drilling and coil operator. This company has been hit quite hard. It was up 30-40% year-to-date in August, and once oil rolled over, Xtreme sold off, now down about 60% year-to-date. The impact and effect was almost immediate on that side.

    TER: Your $6/share target for Xtreme Drilling looks like a moon shot given its decline since the summer. How do you justify your Buy rating?

    SS: In July, the stock was well above $5. Now we're talking about $2/share, with the only fundamental change at the company level being higher day rates on its coil units and an up-and-running, two-rig Indian program, both of which are positive events. I think this shows just how levered driller names are to the oil price.

    Our Buy rating is still justified by a few things. The company has just over 7,000 contracted days on its XDR rigs, representing revenue of about CA$225-235M. That's 75% of 2015 contracted days already locked in, which provides a lot of cash flow certainty-much more than Canadian drillers can say for themselves. In Canada, Xtreme is going to get hit a little harder simply as a function of the fact that the seasonality is very different, with spring break-up, and the fact that the company operates on a well-to-well contract versus long-term contracts, which Xtreme can achieve in the U.S.

    Also, a foundational component of Xtreme is its coil unit business. It's seeing day rates actually increase as oil prices decline. Producers are increasingly cognizant that they need to optimize well productivity and achieve the netbacks to stay profitable in a declining oil price. Xtreme has consistently demonstrated that its coil is the most efficient, and its rates are competitive. Recent rig data shows that Xtreme's U.S. fleet drilled the most footage per month per rig in the U.S. It was at almost two times the average. That substantial efficiency increases profitability for the producer. Should there be long-term concern on rigs the company has in more exposed basins, Xtreme has noted it has optionality to move rigs to India and other international markets, where the company garners more premium day rates.

    When oil comes off, usually the shallow-depth rigs get hit first. That class of rigs has been more commoditized, and they're more replaceable. Xtreme has only a couple of shallow-depth rigs in its fleet, which we expect will get hit as oil prices come off. Those are the ones that it can easily move internationally.

    TER: What effect will the Halliburton/Baker Hughes deal have on these companies, if it goes through?

    SS: Baker Hughes and Halliburton have minimal presence in Canada. Xtreme, which primarily operates in the U.S., could feel the impact of their operations. It's important to say at the outset that Xtreme already works for both Baker Hughes and Halliburton. The company recently deployed two rigs to India; those are actually working through Halliburton.

    Xtreme has a stronger relationship with Halliburton's groups than with Baker Hughes. In the event of an acquisition closing between those two parties, should the project management groups consolidate and the right people from Halliburton step into the roles of the combined entity-which we see as highly likely given that Halliburton's group is substantially larger, is more effective, and has a much greater scope, not to mention that Halliburton is acquiring Baker-that would bode well for Xtreme in terms of the amount of work that it is awarded. Either way, Xtreme's work through Baker and Halliburton is not substantial. Any material change would be incremental.

    TER: Let's move on to something entirely different. Can you tell us about another company you have under coverage in a different sector?

    SS: Yes. We cover Input Capital Corp. (OTC:INPCF) [INP:TSX.V], the first and currently only agricultural streaming company in the world.

    TER: Your target price of $5 per share for Input sets the bar pretty high for a stock that has been nowhere near that for the last year. But your Buy rating indicates your faith in the company. Can you explain your thinking on that?

    SS: For the investor community and analyst, it's the first time we've ever had to determine the potential of a company like this. We see Input as a classic take on textbook compounding of capital. The company deploys capital into canola contracts at a 20% internal rate of return [IRR]. It receives cash on the sale of canola on those contracts as early as a few months later, then redeploys that cash into new contracts, and so on. Input has already demonstrated its ability to deploy capital and sell canola. Should it continue at pace, we think the compounding potential-just the organic cash deployment, let alone further equity raises-should catalyze the stock and justify our $5 target price and Buy rating.

    TER: The company was exposed to falling canola prices. Are you concerned about that?

    SS: I'm not concerned that the canola price has come off. Our valuation is slightly different from other analysts. We value the company not just on a forward cash flow basis, but also on a net asset value [NAV]. The reason is the company contracts on a six-year basis, and just has to achieve an average $400-425 per metric ton canola price to get the IRRs it's looking for. On top of that, Input, on average, has been selling its canola at an 11.2% premium to spot. That's a function of its effective marketing program.

    The company also has significant cash on the balance sheet, which allows it to shift the sale of canola in and out of quarters to more favorably approach the market. Additionally, in a weaker canola price environment, the company can actually lock in lower all-in costs per metric ton on its contracts. It can then have an IRR of 20% at, say, $380/metric ton canola versus the $425/metric ton that it was locking into at a higher canola price. There's a lot of flexibility.

    The model is fluid. The company is very insulated, and the market needs to be thinking about this over a six-year timeline, not in terms of a two- to three-month move in the canola price. We're not concerned.

    TER: Are you anticipating a new wave of mergers and acquisitions in energy?

    SS: I can only speak to what we can see in services. Again, when a sector collapses under commodity price pressure, it's expected that companies with comfortable balance sheets will be opportunistic, and that's what we saw with Halliburton. You could start to see a ripple as Halliburton, because of antitrust concerns, may have to shed and divest up to 7.5% in revenue. We're looking to see what happens with Halliburton, what the divested shares are going to look like, and who will target those. People are going to look for opportunities there. Buyers with cash are seeing the cheapest valuations in years.

    The entire services sector has massively sold off. People are going to get squeezed. The million-dollar question right now is: Who's next? You do get industry consolidation when oil prices come off and the survival-of-the-fittest mentality comes in.

    Everyone's speculating, from the top down, about which majors will consolidate next, who's looking to pick up tuck-ins, which companies are most exposed to the downswing, and who's going to need to sell themselves or divest noncore assets. We already saw that with Precision Drilling Corp., which divested its coil tubing assets earlier this month.

    It's only been a few months of weak oil prices, but we're already seeing some companies looking for an exit opportunity. I think Halliburton sets a precedent, and now we must wait to see what the windfall is.

    TER: What are you anticipating for the oil price next year?

    SS: The Organization of the Petroleum Exporting Countries [OPEC] decision on Nov. 27 should not have surprised anyone. There was no political incentive for OPEC to cut its own production to support the U.S. I think we're going to see $55-65/bbl for a little while as a result. The market seems pretty comfortable with that level.

    TER: Any final thoughts? Is this a good time to get into the services?

    SS: What investors want to do now is have the right names on their radars. In these selloffs, it becomes extremely important to position in the right basins. That's the only way to survive a turbulent energy market. For us there are core areas-the Bakken, the Eagle Ford, Niobrara-that are consistently rated best for returns in capital spend.

    Beyond basin positioning, it's a matter of holding companies with right technology and efficiency. That's going to come increasingly into focus as operators need to put great emphasis on cost per barrel. We look to Xtreme Drilling as a name that fits that criteria-a defensive driller you could say-and that's why we picked up coverage on it in the first place.

    Generally, in the services space, I think there's going to be significant near-term volatility. Services are high-beta names and highly correlated to the oil price. Stepping in now could be like catching a falling knife until the dust settles in oil prices. We are cautious until a base builds.

    TER: Steven, thank you very much for your time today.

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

    Steven Salz is an event-driven and special situations analyst at M Partners. Before joining M Partners he worked in a generalist equity research role at a major Canadian bank, in its internal retail asset management group. Prior to that Salz worked as a private Canadian defense contractor, and has held a variety of roles at major Canadian banks since 2010. Salz has a bachelor's degree from the University of Western Ontario.

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

    DISCLOSURE:
    1) 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.
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    3) Steven Salz: 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.
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