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  • Quality Oil And Gas Stocks Are On Sale: Joel Musante

    Quality Oil and Gas Stocks Are On Sale: Joel Musante

    Source: Zig Lambo of The Energy Report (6/14/12)

    http://www.theenergyreport.com/pub/na/13611

    The pullback in oil prices has created some attractive buying opportunities in both developing and established oil and gas companies, even if oil prices settle in the $80-90/bbl range. In this exclusive interview with The Energy Report, Joel Musante, senior analyst with C. K. Cooper & Co., gives us his insights into current energy markets and talks about several of his favorite names that may reward investors with an appetite for risk.

    The Energy Report: We've had some pretty interesting ups and downs since your last interview with us in September of 2010. What's your assessment of the current situation in the oil market?

    Joel Musante: Most of the focus is now on whether the European Union is going to hold together. This could cause the European economy to weaken and the dollar to strengthen against the euro, sending oil prices lower. At this point, we really don't see any resolution in sight. So there's still risk that oil prices could continue lower.

    TER: What portion of the decrease is attributable to a stronger U.S. dollar?

    JM: It's hard to separate all that out. Oil went up to $109/bbl when there was fear the U.S. or Israel might attack Iran's nuclear facilities. Now, this Eurozone crisis seems to be dominant in the market. Oil prices are very volatile, and they tend to trade on investor sentiment over political and economic risk rather than just supply and demand fundamentals of the commodity itself.

    TER: Could we be headed down to $60/bbl oil as an ultimate downside?

    JM: That price level is pretty low and not very sustainable. It could reach that, but I don't think it would stay there for any length of time. Saudi Arabia and some of the bigger Organization of the Petroleum Exporting Countries (OPEC) members need $80+/bbl oil to pay for their fiscal budgets. Outside of OPEC, $90/bbl oil is necessary for many commercial development projects or to maintain drilling at the current pace.

    TER: In the short term, there is obviously going to be some effect on earnings of companies that are currently in production. How do you assess the impact of that?

    JM: I still think it's going to be short lived, but if prices stay low for an extended period, it could have some negative impacts for companies. Drilling for oil is a very capital-intensive business. These companies depend on cash flow. When prices fall, they have to cut back on their development programs. The alternative is to take on more debt or issue equity at not-so-attractive terms, which most companies will try to avoid. Most companies will cut back on spending and accept lower growth. This will ultimately lead to lower valuations.

    TER: The other side of the picture is the natural gas markets, which have been pretty sick for quite a while. Are you expecting anything to turn around there?

    JM: We are starting to see the initial signs of a turnaround in natural gas, but it is still difficult to put a timeframe on it. The natural gas drill rig count has fallen significantly and dry gas production is starting to decline. But there is still a large storage surplus, and production is still outpacing demand by a pretty large margin, so we have a long way to go before supply and demand comes back in line. The interesting thing about this natural gas supply-demand cycle is that the oversupply was driven by aggressive development in shale gas areas. These wells come on at very high rates, which would account for the steep supply increase. But they also decline very quickly, which could mean we are in for a rapid correction. So far, the production data is not showing a fast correction, but it is still early in the cycle.

    TER: Is the worst behind us as far as declining prices?

    JM: Not necessarily, gas storage is at record-high levels. If the gas buildup during the summer months is similar to what it has been in the past, then we may see full storage by the end of the summer. With nowhere to store the gas, we could see the gas price fall very steeply. This would be temporary, as gas is depleted from storage during the winter months.

    TER: Let's talk about some of the companies you cover. In your last interview, you discussed Evolution Petroleum Corp.'s (EPM:NYSE) artificial lift technology. What's developed with that? Has it been able to implement that more to its advantage?

    JM: Yes. Tests on Evolution's artificial lift technology are ongoing. Early results look pretty promising. In one instance, the company increased production from a nonproducing well to 11 barrels oil equivalent per day (boe/d), consisting of about 60% oil and 40% gas. It's only been on-line for a short period, but the company is estimating that it could increase the reserves of the well by 50 thousand barrels oil equivalent (Mboe), though more testing is needed to better estimate the reserve increase.

    TER: That's significant if the cost to do that isn't very great.

    JM: It's actually fairly cheap-a couple hundred thousand dollars to implement the equipment in the well and it looks like you could get quite a bit of oil and gas out of it. So far, there are not a lot of results, but when you get these kinds of numbers, it looks very promising.

    TER: Fifty thousand barrels at $80/bbl is $4 million (NYSE:M). If it only costs a couple hundred thousand to do it and ongoing expenses aren't that great-that's found money.

    JM: Yes. The company is not saying it can definitely get 50 Mbbl; it said it can get up to 50 Mbbl. Even with 40% of the production being natural gas, that's still an attractive proposition. The company's main asset is the Delhi Field in Louisiana, which another company operates. A carbon dioxide (CO2) flood is being applied to this old oil field and production has responded better than the company had originally anticipated.

    TER: Can that production stay up at a reasonable level or is it going to fall off quickly?

    JM: The CO2 that's pumped into the formation gets into the oil, lowers its viscosity and surface tension, releasing it from the pore spaces of the rock. The pressure from the CO2 helps mobilize the oil, and move it to an extraction well. Success of these kinds of operations depends on a number of factors, but in this case it is working exceptionally well, certainly better than expected. The field development is going to take place in phases. The company is in the third phase of five and is producing between 5-6 Mbbl/d. The whole field should get up to 12-14 Mbbl/d over time. Evolution's interest in the field will increase significantly after the operator recovers its initial development cost, per the agreement between the two companies. I have an $11 target, which is pretty conservative. The stock is trading at $7.90. All the company is doing now is converting proven undeveloped reserves to proven developed, so the market should recognize it.

    TER: Last September you resumed coverage on FX Energy Inc. (FXEN:NASDAQ) That company is operating in Poland, which most people don't even consider as an area for oil and gas production. What's the story there?

    JM: FX is unique because it operates almost exclusively in Poland. It targets high-risk, high-potential-return exploration prospects in contrast with most oil and gas companies in the U.S. that focus more on lower-risk resource plays. For investors who can tolerate the risk of an exploration-oriented company, FX may be attractive. Some of the drilling prospects the company is testing have the potential to double or triple its reserves, if successful. Some discoveries it has made are quite large and some not so large, but when it does hit a prospect, it's usually very economically attractive.

    TER: Is Poland interested in developing gas reserves, rather than importing from Russia?

    JM: Yes. There isn't a lot of gas production in Poland, so it does import a lot from Russia, which pegs the price of its gas to oil prices. But Poland is trying to develop its own resources, rather than depending on Russia, which has used its gas supplies as a political weapon against neighboring European countries.

    TER: What caused you to resume coverage on FX?

    JM: I thought it was an interesting story. It wasn't well covered at the time. In the past, FX was only drilling about one exploration well a year, and when it made a discovery it took a while to bring the well on-line and establish commercial production. Through the accumulation of its past discoveries, it has brought on a lot of production recently. Now, it's using its cash flow and reserves as a funding source and drilling quite a few exploration wells. Some prospects are small and others are quite large, so there is a lot more going on now than in the past.

    TER: What is your target on FX and where is it now?

    JM: I have a $9 price target on it. It's at $4.80. In an exploration-oriented company, valuation is tricky because you have to assume that it's going to make a discovery, and there's no guarantee that will happen. The only way that you can get ahead of this is if you buy it before it makes a discovery. If you don't, as soon as it makes one and announces it, the stock is going to appreciate, and you're going to miss out.

    TER: So you are betting on a hit rather than just a somewhat predictable earnings stream.

    JM: Exactly. In research reports, I try to make clear that my target price and rating really depend on a discovery, which is hard to predict, to say the least.

    TER: Another one on your coverage list is PDC Energy (PETD:NASDAQ), which has been around for many years. That's a higher-priced stock, but it's become more of a bargain recently. What's the story on that one?

    JM: The stock has fallen recently, mainly due to lower commodity prices. Some of the decline may have been due to lower expectations in the Utica Shale, which is a relatively new oil and gas play where the company has established an acreage position. Some recent well results have raised concerns that the Utica shale may be gassier than previously thought. We saw a pullback in the share price of several other companies that held Utica acreage around the same time the well data was made public.

    I still like the story and its position in the Wattenberg field, which is one of the oilier regions to drill in North America. The Wattenberg has evolved over time. More recently, companies have tried horizontal drilling and hydraulic fracking in some of the formations there, and the field has responded pretty well to that new technology.

    TER: So this company has somewhat more of a history, with hopefully more predictable cash flow and earnings. Is that right?

    JM: That's correct. It's a much more established company with production and reserves comprised of a lot of natural gas. But most of its drilling is oriented toward oil and liquid-rich gas.

    TER: What's your target on that one?

    JM: I recently upped my price target. It's $45 now. It pulled back quite a bit recently with all of the economic turmoil in Europe. It got pretty close a short time ago, when macroeconomic fears were less of an issue.

    TER: Where is it trading these days?

    JM: $22.68.

    TER: There's some pretty decent upside there if the market turns and oil prices strengthen. Are there any other companies you think are interesting that you'd like to mention?

    JM: I just initiated coverage on Bonanza Creek Energy Inc. (BCEI:NYSE). Like PDC Energy, the company operates in the Wattenberg field. It has a strong management team and a lot of very attractive, oily prospects.

    TER: So where is that one trading now and where do you think it's going?

    JM: I have a $27 price target, and it's trading at $16. It IPOed in December, so it's a relatively new entrant to the public market.

    TER: Do you have some closing thoughts on the energy markets and how people can best play things under current circumstances?

    JM: I would suggest that investors focus on the quality names. In a broad market pullback like what we are seeing in the market today, there is an opportunity to buy quality names at discounted prices, providing you can stick it out and weather the storm.

    TER: Thanks a lot for joining us today.

    Joel Musante, CFA, is a senior analyst in the Research Group for C. K. Cooper & Co., a full-service investment bank. In 1998, he began his career with W.R. Huff Asset Management; in 2000, he joined the E&P team at Wasserstein Perella Inc. He has also worked with Ferris, Baker Watts Inc., Zacks Investment Research and John S. Herold Inc. He has a Master of Business Administration from the University of Rochester and a Bachelor of Science in geology and geophysics from the University of Connecticut.

    Want to read more exclusive 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 Exclusive Interviews page.

    DISCLOSURE:

    1) Zig Lambo of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.

    2) The following companies mentioned in the interview are sponsors of The Energy Report: FX Energy Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.

    3) Joel Musante: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.

    Streetwise - The Energy Report is Copyright © 2012 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.

    The Energy Report does not render general or specific investment advice and does not endorse or recommend the business, products, services or securities of any industry or company mentioned in this report.

    From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

    Streetwise 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

    Jun 18 5:31 PM | Link | Comment!
  • Enzymes And Algae May Spur A Biofuel Boom: Ian Gilson

    Enzymes and Algae May Spur a Biofuel Boom: Ian Gilson

    Source: George S. Mack of The Energy Report (6/12/12)

    http://www.theenergyreport.com/pub/na/13602

    What is the most viable form of alternative energy? For the oil-centric infrastructure of North America, biofuels make for strong contenders. The challenge facing the sector today concerns low-cost mass production, and researchers are already showing significant progress. In this exclusive interview with The Energy Report, Senior Technology Analyst Ian Gilson of Zacks Investment Research shares select undervalued companies that stand out for their long-term profit potential.

    The Energy Report: With so many types of products, can biofuels be considered a single industry?

    Ian Gilson: Biofuels is a name we give to many products from several processes that produce fuels based on sources other than coal and oil. As such, biofuels are really many industries. The two major industries are ethanol and biodiesel. Others include fuel from algae and alternative cellulosic materials. Ethanol and biodiesel are sold into two different industries and serve different markets. Ethanol is mixed with gasoline and biodiesel is mixed with diesel fuel. However, biofuels in general share some common ground in that they could reduce our dependence on foreign fuels.

    TER: How efficient is biofuel production? Is there a real value proposition without tax credits?

    IG: That depends largely on the size of the manufacturing plant, which impacts the cost of production for both ethanol and biodiesel companies. In the case of biodiesel, there are many small plants that were built to capture the blending credits in local markets or to use excess soy oil from beans grown by farmers. The cost of biodiesel also depends on the feedstock used. The Environmental Protection Agency (EPA) has estimated that biodiesel production costs for soybeans was close to $2.75 per gallon (/gal) in 2010. The large ethanol and biodiesel plants are still profitable without tax credits while the small plants are not. In many cases, they were built to capture the credits. It has been reported that of approximately 150 biodiesel plants in the U.S., only 40 were still operating at the end of April. A statement by the U.S. Navy quoted costs of $15.25/gal in late 2011. This seems rather high to me.

    The lack of profits in both areas will probably reduce the number of productive plants-those with cash flow above the cost of capital-below the number needed to meet the mandated levels. This is particularly so with biodiesel. Without profits, plants will close and no new plants would be built, no matter what the mandates are. The government is faced with reinstating the subsidies, as it did in 2010 after ending them in December 2009. Some state subsidies still exist, but they are small and only apply to limited quantities and small plants.

    TER: How do U.S. subsidies compare with Brazil and other countries?

    IG: Most European countries subsidize biodiesel through lower taxes, and tax relief varies by country. Brazil produces ethanol from excess sugar, with spent sugar cane used as a fuel. However, in recent years the sugar plantations have not been replanting with new cane. Because new cane produces more sugar than older canes, the yield has declined, and Brazil now imports ethanol from the U.S. Europe has been reducing its subsidies on biofuels over the past few years. At this time in the U.S., there are agricultural subsidies, but not fuel subsidies.

    TER: Conservative governments are generally against mandates. Is this year's election particularly important for biofuel industries' outlook?

    IG: First of all, the mandates have been in place for some time. A large number of government employees are involved in governing those mandates within the EPA. I doubt very much whether any future president would do away with the EPA.

    As far as the renewable-fuel mandates are concerned, I think that appeals both to Republicans and Democrats. The fact that we can reduce our dependence on imported oil is good politically and economically. Although the price of oil goes up and down, it's ultimately going to go up because there's going to be less of it, and it gets harder and harder to find. Building an infrastructure with mandates would appeal to both parties, in my opinion.

    TER: Do biofuels put demand pressure on food production? Is there risk of overusing land, fertilizer and labor for energy production?

    IG: Even food has an energy component in its cost of production. In the case of ethanol, the corn used is feed corn, not food corn. Yes, it takes energy to grow corn, but that energy is partially recaptured. Ethanol production also produces an animal food supplement that partially offsets the food value of the corn.

    TER: There has been significant pressure on these stocks, and valuations are certainly lower over the past year. Is it because of the expired tax credits?

    IG: Not only that, but lack of profits due to a variety of factors have impacted both ethanol and biodiesel stocks. However, there are growth opportunities in biofuels. The use of alternative feedstocks for ethanol and biodiesel production is a major research area.

    TER: The consensus opinion holds that the price of oil will ultimately increase. But does more costly oil make for higher ethanol and biodiesel prices?

    IG: To a certain extent. If the cost of oil increases, then the production cost of biofuels would also go up. Fertilizers are made from products that come out of the oil industry. Methane, nitrogen and hydrogen come from oil. Growing crops requires fuel. But will costs go up at the same rate? Probably not.

    TER: Ian, you mentioned that alternative feedstock for both ethanol and biodiesel were major areas of research. What new industries or improvements to existing industries could emerge from this kind of research?

    IG: Let's take two cases: Making ethanol from starch-corn starch, potato starch, wheat starch-has been going on since antiquity. In doing so, we have tailored the enzymes and the yeasts that are required to be highly specific and very productive. When it comes to other cellulosic materials that are not like starch in their chemical structure, we have to develop the enzymes that will convert those into the sugars at the rate necessary for profitability . There's a research effort by a number of research companies to find better enzymes to produce sugar and better yeasts to make ethanol. When somebody finds one of those, it would be extremely profitable.

    We're talking about something that could utilize wood celluloses, like barks or grasses. I believe cattle have four stomachs that are highly specialized to convert grass into energy. What we need is one of those stomachs, a relatively inexpensive one, to convert waste celluloses like grass into starch or sugar that can be converted by yeast into alcohol.

    The other major research focus is to find a cheaper source material, and that brings me to the topic of algae, which are specialized and relatively easy to grow. They do require some energy, but they can consume waste carbon dioxide and waste heat. They are cheap in many ways but are currently expensive in their use of land. If we can develop a cheaper way of farming the algae, then it would be a low-cost, raw material source and therefore a low-cost diesel fuel. Both enzyme- and source material-focused research present major opportunities in ethanol and diesel fuel, which could lead to productivity improvements that would make somebody a lot of money.

    TER: On that note, you follow OriginOil Inc. (OOIL:OTC), a licensing- and royalty-based research company. How is the company contributing to biofuel-related research?

    IG: OriginOil has developed a unique, patent-pending process for separating oil from the water and biomass produced from growing algae. The company has recently demonstrated that this technology can be used to separate the oil, water and solids in the water used for fracking. The oil separates from the water, and the sediment sinks to the bottom. That water can then be reused. That increased oil recovery has an economic value far in excess of the cost of the process. The technology that can be licensed on a fee or royalty basis, and infrastructure doesn't have to be built. This could be a major win for OriginOil. This is a potential gold mine.

    TER: You've got it rated Outperform with a target price of $6, which represents something like a 400% implied upside from current levels.

    IG: A 1% or 2% royalty on the fracking process could generate $1 per share or more in the next three to four years.

    TER: This is a micro-cap company, and the first thing I noticed was that it has lost 76% of its market value in the past year, and this was a very small company to begin with. Yet insiders own only 21% of the company.

    IG: Well, somebody had to finance the R&D.

    TER: So, the financiers diluted out the original owners then.

    IG: Yes.

    TER: At this low market cap it just seems that insiders should own more.

    IG: They have put a considerable amount of their own money into this. It's not like they have just gone out and floated stock and sold it and then printed shares for themselves. They have employed and continued to employ a significant number of research people. And, they have come up with products that have a market, which will generate income in the future with very little in the way of a cost structure because the costs are being absorbed now. When the revenue comes in, the cost based on that revenue will be very small. So you're looking at a tremendous increase in gross margins and in profits.

    The reason the stock has gone down is because the market at the moment is not paying very much for micro-cap stocks. It's not just OriginOil. Many other very small companies have lost market value due to the fact they're considered to be high risk, and the market is moving away from risk at this point.

    TER: You are following Pacific Ethanol Inc. (PEIX:NASDAQ). What is your thesis for this company?

    IG: Transportation costs are significant in the total production cost of ethanol. The closer you are to corn production, silos and the farmers who grow it, the lower your incidental costs. It so happens that Pacific Ethanol's plants are in the western United States, where the company has a very strong marketing position.

    TER: Its geography gives it the edge?

    IG: Yes. That's the benefit, in addition to the fact that Pacific Ethanol has a subsidiary, Kinergy Marketing, which is also in a good position, marketing ethanol that others produce for a fee. It gives the company a major advantage over its competitors, and it's probably the most important aspect of the company. Ethanol is a commodity. You can't distinguish one producer's ethanol from anybody else's. To be able to market it is worth something, in my opinion.

    TER: You are following FutureFuel Corp. (FF:NYSE), which has a rather nice market cap of around $387 million ($387M). It has two major customers in its chemical division that have reduced orders.

    IG: Well, it's interesting that customers have decided for one reason or another to reduce their purchases of two of the products that the company makes on the chemical side of the business. The market dynamics have changed. In one case, the generic competition for the company's post-emergent herbicide made for Arysta LifeScience North America has come under significant pressure. In the other case, it's the bleach activator, the little blue specks that you see in Tide powder detergent. The market has been moving away from powders to liquids for years now, and so the customer, Procter & Gamble Co. (PG:NYSE), doesn't need as much.

    However, the company is still making a fair amount of money, and there is not as much of a decline in profits as one would have thought. The importance of those products and the cash flow from the chemicals side is positive. You don't take profits to the bank. You take cash flow to the bank. I'm talking about net-free cash after capital expenditure.

    FutureFuel is also a distributor of diesel fuel. It has a transportation complex that it built in the last few years for distribution of diesel fuel and blended diesel fuel at a relatively low cost. So it got a blender's credit. When blenders' credits were eliminated in December 2009 and more than half of the industry shut up shop, the government realized that without those credits there wouldn't be any biodiesel produced. So at the end of 2010, the credit was reinstated for a full year and the plants opened up again. The situation now is very similar. If the government wants its mandate to be met, it has to provide economic incentives to produce the fuel, be it ethanol or biodiesel. In my opinion, when push comes to shove, there will be some credits available to bring capacity back on-line.

    TER: You upgraded FutureFuel back on February 23 from Neutral to Outperform. What was the reason for that? Was it oversold at that point?

    IG: Yes, plus the fact that the company makes a graphite product that was designed to be used in hybrid and electric car batteries. That's a good business, ultimately. And the company pays a 4% dividend and has the cash flow to support that dividend. The plant is still trying to optimize its biodiesel production process, and the company is doing that. Basically, this is a value that is well in excess of the current stock price.

    TER: It's very interesting to see a stock with a market cap of under $400M paying a dividend. Do you expect it to continue with that after this year?

    IG: The dividend started out as a special dividend, and then it was made a regular dividend. Companies don't do that unless they expect to generate the cash from operations to support that dividend and possibly increase it. Net-free cash flow is positive and there is no reason to cut or eliminate the dividend.

    TER: Many thanks to you, Ian.

    IG: Thank you.

    Ian Gilson, PhD, MBA, CFA joined Zacks in 2006 as a senior analyst covering the graphics display industry as well as some special situations. His current coverage includes several micro-cap companies in the technology sector. He has 20 years of experience as a sell-side analyst covering small- and micro-cap companies. His buy-side experience includes three years as a money manager with Manning & Napier and 13 years with the Harris Trust and Savings Bank as an analyst and money manager.

    Want to read more exclusive 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 Exclusive Interviews page.

    DISCLOSURE:

    1) George S. Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.

    2) The following companies mentioned in the interview are sponsors of The Energy Report: None. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.

    3) Ian Gilson: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family is paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.

    Streetwise - The Energy Report is Copyright © 2012 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.

    The Energy Report does not render general or specific investment advice and does not endorse or recommend the business, products, services or securities of any industry or company mentioned in this report.

    From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

    Streetwise 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

    Jun 14 5:40 PM | Link | Comment!
  • A Major Uranium Supply Gap Is Looming: Ed Sterck

    A Major Uranium Supply Gap Is Looming: Ed Sterck

    Source: Padma Nagappan of The Energy Report (6/7/12)

    http://www.theenergyreport.com/pub/na/13562

    With Japan set to restart reactors and Russia's Megatons to Megawatts program near its expiration date, Analyst Edward Sterck thinks uranium stocks could pick up momentum, even if uranium prices show no inclination of heading north. In this exclusive interview with The Energy Report, Sterck warns of a supply-demand gap that could hit the world as early as 2015. In the meantime, consolidation is the name of the game.

    The Energy Report: Why is the uranium market still down more than a year after the Fukushima accident?

    Edward Sterck: While the uranium price is lower than it was immediately prior to Fukushima, it's important to remember that it is at a higher level than we saw in mid-2010, which was only six months before Fukushima. At that time, the uranium price was in the mid- to low-$40s, and we're now in the mid- to low $50s. From that perspective, I think the market is looking more robust than it did in 2010 despite the impact of Fukushima.

    Uranium prices appear to have established a base in the mid- to low-$50s, but are now drifting along without any particular inclination to head higher. The main things keeping a brake on uranium prices are the current supply-demand balance and also some residual uncertainty regarding Japanese reactor restarts and the issuance of new reactor licenses in China, which were suspended after the Fukushima accident. I think we could see some positive news on both fronts in the not-too-distant future.

    It looks increasingly likely that Japan will begin to restart reactors. Local opposition to reactor restarts was overcome last week, and the government appears to be getting closer to a definite restart decision, although the exact timeframe remains unknown.

    In China, some nuclear regulators have come out publicly over the course of the last few months, saying that they will begin to issue new reactor licenses again, potentially as early as June. We could possibly see those licenses issued fairly shortly. In addition, at the beginning of June, the Chinese cabinet reportedly reconfirmed the country's commitment to its nuclear program, although exact details are yet to be released.

    In summary, Japan and China's unfolding nuclear policies are potential catalysts we may see in the near future. These two short-term catalysts may not necessarily result in an increase in the uranium price, but I view them as being potentially positive for uranium stocks. Such events may derisk the outlook for the nuclear industry in the investment community, and therefore for uranium demand. This could draw capital back into uranium stocks and potentially result in a rerating of the market valuation multiples applied to them.

    TER: Could a catalyst like the end of the reprocessing program in Russia turn the prices up again?

    ES: The downblending of Russia's highly enriched uranium, derived from decommissioned Russian nuclear weapons, ends at the end of 2013. The so-called Megatons to Megawatts program currently produces the equivalent of about 23 million pounds (Mlb) per year. Although it's possible Russia may continue to downblend some material for internal purposes or sell its reactor technology to third-party countries, the resulting production will be greatly reduced. Even in 2013, the last year of the current deal, the quantity of material available to the market is expected be somewhat lower, at around 16 Mlb. However, the impact of that is somewhat difficult to ascertain with absolute certainty.

    The program's output does represent a fairly large part of the market-around 12% of annual uranium demand. As such, one would expect some price appreciation after that material is no longer available to utilities. However, when you look at the procurement process for nuclear fuel, the utilities typically look at supply levels 18+ months ahead. So we're actually already coming into the timeframe where the Russian material is all spoken for, and the utilities should need additional sources of material from 2014 onward. But we haven't really seen a huge price movement to reflect any supply-demand shortfall there.

    It's probably fair to assume that the increase in production from various parts of the world, particularly Kazakhstan, has been sufficient to offset the Russian material, at least for the time being, although we could see a supply-demand deficit opening up in the years after 2014.

    TER: Given what you've said about China and Japan, will things pick up in the market over the summer? Or is it going to take a little longer than that to bounce back?

    ES: The summer is traditionally a very quiet time in the nuclear space, as it is in capital markets in general. It's possible we could see some movement toward the end of the summer, but I think the world is still somewhat fixated on the uncertainty surrounding the Eurozone and the broader macroeconomic impact that any continued problems with the Eurozone might have. Until those are resolved, it's very difficult to make absolute calls on these sorts of things.

    TER: Quite a few of the uranium stocks are down right now. Is this going to make them ripe for acquisitions?

    ES: I think it's possible we could see a period of consolidation. There have been some transactions over the last year or so. ARMZ Uranium Holding Co. and Uranium One Inc. (UUU:TSX) bought Mantra Resources Ltd. (MRU:TSX) a little over a year ago. Extract Resources Ltd. (EXT:TSX; EXT:ASX) has been bought by China Guangdong Nuclear Power Group and another Chinese investor. In addition to that, Hathor Exploration Ltd. was purchased by Rio Tinto (RIO:NYSE; RIO:ASX) in December 2011. Given the current valuations, it's possible we could see some consolidation.

    Most of the current producers are already currently spoken for, with the exception of Paladin Energy Ltd. (PDN:TSX; PDN:ASX). The other major listed producers have significant shareholders who can block any takeover acquisition, whereas Paladin has a broad shareholder base. In addition, its balance sheet is looking a little bit stretched at the moment and this could make the company vulnerable.

    There are a couple of others out there that could be of interest. Denison Mines Corp. (DML:TSX; DNN:NYSE.A) is one. It has a couple of interesting projects, one in the Athabasca area with the Wheeler River project, on which it has a joint venture with Cameco Corp. (CCO:TSX; CCJ:NYSE). Cameco owns about 30% of that joint venture. Denison also has the Mutanga project in Zambia, which already has its mining license but probably needs to undergo some further exploration to develop critical mass. In addition, Denison has a 22.5% interest in the McLean Lake mill operated by AREVA (AREVA:EPA) at present.

    TER: What about Bannerman Resources Ltd. (BAN:TSX; BMN:ASX)? It backed away from a cash offer from China's Sichuan Hanlong last year, but in your January interview, you told us it was still talking to some other potential buyers. Has the feasibility study that it has completed for Etango in Namibia changed things? Could these talks send the price up?

    ES: We haven't really heard anything more on the talks from them. Bannerman has completed all of its technical and environmental studies. I suspect the company is probably in the process of consulting with various parties and seeing what interest there might be out there, but there is nothing specific in the market.

    TER: Did that feasibility study show it would be viable?

    ES: The feasibility study showed that the project is economic, but that it probably needs higher uranium prices, upwards of $70/lb, for it to be a viable stand-alone entity in current market conditions. Bannerman's primary project is the Etango project in Namibia. Its metallurgy is similar to Rio Tinto's Rössing operation, which is not too far to the north, and also similar to what was Extract Resources' Husab. The problem that Bannerman faces is that it appears to be just a little bit too low grade at current uranium prices.

    For its share price to appreciate, Bannerman probably needs to see an element of merger and acquisition (M&A) interest. One of the interesting things about the Etango project is that although it's low grade and doesn't appear to be economic at least on my current estimates at existing uranium prices, it could be of interest to a strategic parastatal (quasi government-owned) organization. I think this is one of the reasons that the company has had discussions with various Chinese and other Asian groups in the past, the reason being that if you're a parastatal organization, possibly out of China, with a low cost to capital, then obviously the economics of the project are quite different. It has a very large resource base. So from a strategic perspective, it could be interesting.

    TER: Which companies do you think will be hunting for bargains with the stocks down? Cameco plans to raise some money, so is it on the prowl right now? Which companies may be of interest?

    ES: Cameco has just filed a short-form shelf prospectus. That doesn't necessarily mean it's actually going to raise money. I think it is just putting things in place to give itself some flexibility if it does decide to make a move. Cameco also has a strategy to double uranium production organically by 2018, for which it will need a certain amount of capital. But it should be able to fund the bulk of its needs from operational cash flow. The shelf prospectus just gives it some flexibility if there are any capex overruns or if it does want to consider making acquisitions.

    Paladin may be of interest to Cameco, because it has two projects that are mostly technically derisked. It offers about 8 Mlb/year in production straight off the bat. Given the fact that its balance sheet is a bit stretched at the moment, it's possible that it could be vulnerable. The enterprise value is about $1.7 billion, so it would definitely be at the top end of what Cameco may be able to afford. Beyond Paladin, Denison, as I mentioned earlier, could also be of interest. Additionally, it is worth highlighting that while Paladin may demonstrate M&A appeal, the stretched balance sheet also means that potential investors could be faced with a liquidity event at some point in the future.

    TER: Paladin experienced a labor strike in Kayelekera. Production was back up again in May, but could the strike further impact the company?

    ES: I don't think it's going to have a significant impact. Paladin experienced around five days of reduced production at about 65% of normal capacity, so I don't expect the strike to significantly dent output unless there have been further issues that have not yet been publicly reported. However, Paladin has been fairly upfront about all of this, so I'm not really expecting any significant surprises there.

    TER: In FYQ3, Paladin had a loss of $18 million. How is it going to do in Q4?

    ES: We are expecting it to achieve breakeven in Q4. Looking into next year, I'm expecting it to move into a very modest profit over the course of the subsequent four quarters of the next year.

    TER: What will propel Paladin's climb back into the black?

    ES: Reducing operating costs at Kayelekera and perhaps tweaking the operating costs at Langer Heinrich may become a focus. However, the principal problem that Paladin faces is servicing its debt, because it's quite leveraged. The interest payments are pretty much offsetting the profitability from the mining assets at present, so restructuring its balance sheet is probably a priority for it to move toward sustained profitability.

    TER: Aside from Cameco, are there other companies looking for bargains to pick up?

    ES: If we look at the list of uranium producers, Uranium One has the option to buy the Mkuju River project off ARMZ, so I think from its perspective, it already has a fairly comprehensive pipeline of potential projects it could develop. I'm not necessarily sure that it would be going after or making any major acquisitions. Paladin's balance sheet probably couldn't support an acquisition currently, so I think that it will be focusing on its existing portfolio of projects and trying to pay down its debt position, perhaps focusing on reducing costs at Kayelekera. Then, if we look at Energy Resources of Australia Ltd. (ERA:ASX), a one-asset company majority owned by Rio Tinto, I think it's unlikely that it would be out making acquisitions. Cameco is really the most likely consolidator as I see it.

    TER: Where will Cameco look to expand capacity?

    ES: Its plan is to double production from around 20-40+ Mlb by 2018. The biggest component of that is Cigar Lake, which is gradually coming close to first production. Cameco's target is first production in mid-2013. I think the first tangible commercial production will probably take place in 2014. That should provide about 9 Mlb/year for Cameco on an attributable basis. Cigar Lake is largely funded already, although there is some capex still to be spent over the course of the next couple of years. For the remaining 11+ Mlb that Cameco would be looking to grow, Inkai in Kazakhstan is one possibility. It has the potential for production to be doubled there, but that depends on whether the company obtains the various licenses from regulators in Kazakhstan. Then Cameco also has the Kintyre project in Australia, for which it completed a prefeasibility study, but it hasn't released very many details as yet.

    TER: Thank you for your time, Ed.

    Edward Sterck covers uranium, diamond and platinum group metal mining companies for BMO Capital Markets. He joined BMO in 2007, prior to which he was a mining analyst at Hargreave Hale. Before working in mining research, he spent more than four years trading government bond futures on a proprietary basis. Sterck holds a Bachelor of Science in geology with honors from the Royal School of Mines, Imperial College London.

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    DISCLOSURE:

    1) Padma Nagappan of The Energy Report conducted this interview. She personally and/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 The Energy Report: Bannerman Resources. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.

    3) Edward Sterck: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.

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