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  • Play Defense And Offense With MLPs: John Edward

    Play Defense and Offense with MLPs: John Edwards

    Source: George S. Mack of The Energy Report (6/21/12)

    http://www.theenergyreport.com/pub/na/13698

    Where does an investor go for income in an environment where interest rates are in the pits? Credit Suisse Senior Analyst and Director John Edwards follows a sector encompassing what he believes is the purest form of capitalism, the midstream oil and gas master limited partnerships (MLPs). He has staked out a short list of highly defensive plays that are less sensitive to commodity price fluctuations even as they grow income and weather the effects of economic catastrophe. In this exclusive interview with The Energy Report, Edwards brings his best names to the forefront.

    The Energy Report: John, falling commodity prices are a symptom of our ailing macroeconomic health today, but master limited partnerships (MLPs) are supposed to be defensive vehicles. Do they still offer protection in these tough markets?

    John Edwards: They are still defensive vehicles. But, to be clear, while MLPs generally do not have direct commodity exposure, there are some subsectors that do have direct commodity exposure.

    TER: You must be talking about the upstream partners, which have direct commodity-price exposure.

    JE: You have the upstream partners, and you have some gas processors that have direct commodity exposure. The propane providers and suppliers have commodity exposure. The defensive MLPs are in what I would call in the main fairway-contracted pipelines and storage in the areas of crude oil, refined products and natural gas.

    TER: That's the classic midstream.

    JE: Yes, the classic midstream. They have indirect commodity exposure.

    TER: What has been driving a lot of the growth in the MLP sector over the last few years?

    JE: The shale revolution on the natural gas-, natural gas liquids- (NGLs) and oil-side has resulted in very strong demand for midstream infrastructure. However, a sustained collapse in commodity prices would start to reduce demand for infrastructure because the upstream producers would not be able to make the rate of return on their efforts to extract product out of the ground. From that standpoint, the growth rates are very much affected over the longer term by the behavior of commodity prices. Clearly, we've been in an environment where oil and liquids have been strong relative to dry gas. There have also been a lot of bottlenecks in the United States' plumbing, and that has put pressure on the midstream segment to address those bottlenecks.

    TER: What shifts have you seen in the midstream?

    JE: Because of low natural gas prices, we're seeing producers pull rigs out of the dry gas areas and redeploy them in the wet gas and oily areas. That has generated a lot of demand for storage and other midstream services on the wet gas and oily side. We've had a tremendous increase in the demand for the liquids side of the business.

    TER: We've seen some significant weakness in MLP unit prices. Shouldn't we be seeing more consolidation now with these weak prices?

    JE: That's a good question. If you look back to 2008-2009, we saw what amounted to a collapse in unit prices at that time. There were a number of companies that could have been acquired for what would amount to a bargain by today's standards. But the reality is that because of the MLP structure, it's more difficult to get mergers and acquisitions done because of the fact that you have to get approvals from both the general partner and limited partner boards, in addition to going through a review from the conflicts of interests committees, which becomes rather cumbersome with MLPs. More parties are involved, which makes it more complicated. That said, we have had a number of transactions here recently-more than what we've had in quite some time.

    TER: Because some of these companies in your coverage universe are rated Outperform, I'm assuming that you believe that income-seeking investors should be in MLPs. Why?

    JE: There are a couple of points I think investors should keep in mind. One is that from a valuation standpoint, we now view this sector as quite attractive. We base that valuation on the yield spread between the sector and the U.S. 10-year Treasury. When the spread is above 400 basis points (or 4 percentage points), the sector has a history of delivering above-average returns in the ensuring 12 months. In fact, it's on average over 40%. Right now, we're above 500 basis points in terms of yield spread, and we've never had a losing 12 months when the yield spread has exceeded 465 basis points. When the spread has been between 500 and 549 basis points, returns have averaged 40%. But that's an average, and you also have to take existing conditions into account. For example, the U.S. 10-year Treasury is obviously near record lows. It closed recently around 1.5-1.6%. This very low number contributes to the very wide yield spread. What's embedded in our assumption is that you're going to have a narrowing of that yield spread, ultimately because the U.S. 10-year yield is going to have to rise at some point, which dampens our expectations for returns matching their past history.

    With that in mind, I would suggest that the total return outlook for the next 12 months is somewhere in the 18-32% range, which assumes somewhere in the neighborhood of a 5-8% distribution (MLP payout) growth over the next 12-months. If you want to take a more conservative view, your returns would still be in the mid-teens over the next 12-months.

    TER: What index are you using to determine the MLP yield?

    JE: We use the Alerian MLP Index (AMZ:NYSE), which is a market-weighted index. If you looked at a simple index average, it would be higher, but the main point we wanted to get across here is we have a yield target for the sector of 5.75-6.25%, with a yield of 1.5-1.6%-for the U.S. 10-year Treasury, the targeted yield spread is still extraordinarily high. Historically, the most commonly occurring yield spread is in the 200-250 basis point range with an average of approximately 300 basis points.

    TER: John, what are the risks now?

    JE: Given the current environment we're in, some of the risks are macroeconomic and therefore non-diversifiable risks. Investors are generally pretty well aware of these, but I think it bears getting them out there on paper so we're all on the same page. There's clearly the European situation, and there are sovereign debt risks. There's been a lot of talk about Greece, and now Spain is in the headlines. Growth has been slowing in China and there is the fiscal cliff in the U.S. All of these issues are likely to weigh on economic growth and in turn on the demand for commodities like oil and NGLs. This in turn can weigh on demand for the mid-stream energy infrastructure provided by MLPs, thereby resulting in a slowing of the distribution growth outlook.

    TER: What are the features that make an MLP less risky? What are the best defenses an MLP can offer?

    JE: Great question. What makes these more defensive names within a sector that's already defensive is that if the majority of revenue is from fixed-fee contracted assets, then you have much less vulnerability and exposure to these non-diversifiable macro events. The reality is that even in the financial crisis of 2008-2009, people still heated their homes if it was cold, took showers and cooked meals, and electric utilities still used natural gas for electric power generation, so natural gas use was relatively stable. Petroleum use is relatively stable. People may not drive quite as much, but even during those challenging times, the drop in refined products volumes was relatively low, all things considered. And with drops in demand with FERC-regulated assets, owners can request rate adjustments to keep whole on operations, though as a practical matter we did not see much in the way of rate applications from operators of refined product pipelines that were experiencing some single-digit volume falls. Contracts on pipelines are often largely capacity charges, and so there's not a whole lot of volumetric risk associated with these contracted pipelines. That means you have very stable and predictable cash flows from the assets that some of these companies own and operate.

    TER: So, does this contracted, fixed-fee structure mean revenue visibility?

    JE: Yes. That's right. You have highly visible growth opportunities. But by "fixed fees," what I mean is we're looking for those companies that have the large majority of their cash flow coming from fixed-fee contracted assets.

    TER: So, fixed-fee assets are the prime directives for investors. Is that right?

    JE: Yes. Protecting your downside is principle number one. Principle number two is that while protecting your downside, look for names that also have a degree of visible growth. In effect, you are supporting a team that has first and foremost a strong defense, but that also has a reasonably strong offense.

    TER: It doesn't sound like we're talking about small-cap companies here.

    JE: We are not focused on small-cap companies right now. We think the overweight positions in an MLP portfolio should be among the larger caps.

    TER: Can you find all these defensive characteristics in single companies, or do you have to diversify among companies to find them all?

    JE: You can find it all in some of the companies, but you're better off putting together a portfolio of companies so that you have a greater chance of achieving a reliable cash-flow stream over the long term.

    TER: What companies fit these stats?

    JE: Given the macro backdrop that we've been talking about, one of the companies that we think should be on investors' radar screens would be in the Kinder Morgan family. There are three tickers associated, and they are Kinder Morgan Management, LLC (KMR:NYSE), Kinder Morgan Energy Partners L.P. (KMP:NYSE) and Kinder Morgan Inc. (KMI:NYSE). Kinder Morgan Energy Partners LP has a very large and diversified set of businesses, with approximately 80% of its cash flows based on stable contracted assets. To the extent that there is commodity exposure in one of its business units, that commodity exposure is substantially hedged. Kinder Morgan Energy Partners LP and Kinder Morgan Management LLC are economically equivalent, except that Kinder Morgan Management LLC pays its distributions in the form of more stock and not in cash and investors receive a 1099 instead of a K-1. Kinder Morgan Energy Partners LP pays the distributions in cash, but Kinder Morgan Management LLC trades at a substantial discount to Kinder Morgan Energy Partners LP. Recently, Kinder Morgan Management LLC was trading at over $5 per unit discount to Kinder Morgan Energy Partners LP, even though it shouldn't make any difference from an economic standpoint. They ought to be roughly equivalent. Kinder Morgan Inc. is a C-Corp, not an MLP, but it owns the general partner to Kinder Morgan Energy Partners LP. We are looking for substantial dividend growth from Kinder Morgan Inc. in the low- to mid-teens going forward.

    We also like Enterprise Products Partners L.P. (EPD:NYSE) because of its large size, balance sheet strength, large asset footprint, visible growth opportunities, solid distribution growth opportunities and high percentage of fee-based cash flows in its asset mix. About 78% of its business is fee-based, and that's growing to about 80% by next year.

    TER: That sounds like the kind of limited commodity risk you were just addressing.

    JE: Yes, that helps insulate it from commodity price swings. It is our belief that that this growth will be sustainable through difficult macroeconomic conditions. It proved its mettle during the 2008 financial crisis.

    TER: Another one?

    JE: There's also Plains All American Pipeline L.P. (PAA:NYSE). It's involved in oil transportation and storage. It has similar characteristics to Enterprise Products Partners, although it's on the higher-end for its distributions growth outlook. It's a smaller market cap of about $12 billion ($12B), versus Enterprise at about $43B. Plains All America was recently trading at a yield of 5.4%. It has very visible growth prospects, but it is also very defensive in nature. It held up quite well during the financial crisis. Its balance sheet is actually as strong as it's ever been, so it's well positioned to withstand difficult market conditions.

    TER: John, your defensive theme is really interesting given current global conditions. There are clearly not a lot of companies that can meet the criteria.

    JE: You know, there are some of the other names that may not necessarily be Outperform-rated, but they're very defensive and provide substantial downside protection to investors.

    TER: Go ahead. I'd like to hear them.

    JE: For example, Magellan Midstream Partners L.P. (MMP:NYSE). It's trading at about a 5% yield, and we're looking for about a 9% distribution growth outlook with a mid- to high-teens total return outlook, which is perhaps on the lower end of the sector. But if things really get difficult, it's good to know that Magellan had very limited downside during 2008. Again, it's very defensive, but with a good offense as well.

    Let me mention one more, Outperform-rated ONEOK Partners L.P. (OKS:NYSE). While it has some exposure to commodity prices, the majority of its cash flows is fixed-fee. It also has very visible growth prospects. Management has issued guidance for a mid-teens distribution growth outlook over the next year. Considering the difficult macroeconomic environment, that certainly gives a solid degree of downside protection.

    TER: Thank you for sharing your strategies.

    JE: My pleasure.

    John Edwards joined Credit Suisse in April 2012 as a director and senior equity research analyst covering publicly traded MLPs involved in energy and energy infrastructure along with pipeline companies and companies that own the general partners to energy MLPs. Prior to joining Credit Suisse, Edwards was senior vice president and senior equity research analyst for Morgan Keegan & Company Inc. Edwards also worked in equities research with Deutsche Bank securities as a vice president and senior analyst covering natural gas pipelines. He received his Bachelor of Arts in economics from Occidental College and a Master of Business Administration from California State University, Fullerton. He is a member of the Financial Analysts Society of Houston, Texas.

    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) John Edwards: 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 25 5:13 PM | Link | Comment!
  • Get More For Your Money With Fiber-Optic Fracking: James McIlree

    Get More for Your Money with Fiber-Optic Fracking: James McIlree

    Source: Peter Byrne of The Energy Report (6/19/12)

    http://www.theenergyreport.com/pub/na/13657

    Fracking technology is giving a new face to the oil and gas industry, says James McIlree, managing director of Dominick & Dominick. In this exclusive interview with The Energy Report, McIlree zeroes in on a small holding company, Acorn Energy Inc., whose line of fiber-optic sensors makes oil exploration faster, safer and more economic.

    The Energy Report: Dominick & Dominick is looking at small high-tech companies serving energy exploration and related enterprises. Why?

    James McIlree: We are looking for micro-cap firms that apply advanced technology to developing traditional sources of energy-natural gas, coal and oil. We focus on companies intent upon making fossil fuels more efficient, cleaner and cheaper to produce.

    TER: What companies meet those standards?

    JM: We're in print right now on a holding company called Acorn Energy Inc. (ACFN:NASDAQ). Acorn owns several subsidiaries that meet these standards. One of its holdings is U.S. Seismic Systems Inc. U.S. Seismic has developed a fiber-optic sensor with applications in oil and gas exploration, as well as in reservoir management. Its fiber-optic sensors have much greater sensitivity than traditional geophones do, and that capability can be important to the hydraulic fracturing market.

    TER: How do fiber optics improve geophone technology?

    JM: A traditional geophone converts seismic energy into an electrical signal, which is measured and used to create maps, or representations of geologic formations. The seismic event can be created with explosives or vibrating plates. Seismic events are also created when a well is hydraulically fractured. The seismic event creates sound waves that travel through the earth and are "heard" by the geophone. The sound wave is modified as it travels through formations.

    When an energy company is looking for oil and gas, it does a seismic survey. It then interprets the data to determine whether or not there is oil and gas in the area of interest. The traditional geophone converts seismic energy to electrical signals. The advantage of a fiber-optic geophone is that it is much more sensitive than the traditional geophone; the fiber-optic geophone is capable of "hearing" more.

    This is advantageous in the exploration market, where greater accuracy helps determine the size of reservoirs. And it is advantageous in the hydraulic fracturing market as well, by assisting the gas company in siting its wells in the most efficient locale.

    TER: Can you be more specific about how this technology works?

    JM: The fiber-optic geophone is a spring with fiber wrapped around it. Sound waves generated by a seismic event cause the spring to change shape. And when the spring changes shape, the fiber that's wrapped around it expands or contracts. The engineers shoot a "reference" light through the fiber. The light's return signature is different than the reference signature. The differences are compared and used to create a database of how the sound wave changed as it traveled through a formation. The fiber-optic geophone U.S. Seismic has developed has been shown to be much more sensitive-that is, it can hear better than a traditional geophone.

    An interrogator, or the electronics of the system, is housed in a trailer some distance away. The interrogator is the electronic device that compares the reference signal and return signal and creates the database that is used by the exploration company or the oil and gas company. This is a critical aspect of the system that U.S. Seismic recently licensed from Northrop Grumman.

    TER: How new is this fiber-optic technology?

    JM: The technology has been pursued for many years, but Acorn has overcome some of its limitations.

    TER: Is this fiber-optic geophone a proprietary product?

    JM: Yes, it is proprietary; there are patents and some trade secrets surrounding it. There are two basic seismic products sold by Acorn's U.S. Seismic. The fiber-optic geophone is placed either on the ground or down a hole, and the interrogator interprets the signal changes.

    TER: Acorn is engaged in a number of different types of technological ventures geared toward energy exploration. Can you talk about its scope of operations?

    JM: Acorn addresses the entire food chain of energy production-from exploration through distribution. It has a unit called GridSense, which serves the electrical utility. GridSense has developed a line of transformer monitors that help electric utilities predict where transformers are likely to fail and, based on that information, do preventative maintenance. In the United States, the transformer fleet is relatively old and, consequently, transformers are a significant point of failure. GridSense has developed a low-cost way to monitor transformers and replace them before they fail.

    TER: Does Acorn have competitors in the grid-monitoring space?

    JM: Of course. There is General Electric Co. (GE:NYSE), Siemens AG (SI:NYSE) and a variety of smaller competitors.

    TER: Let's talk about the environmental concerns around fracking. How do these types of high-tech products address those issues?

    JM: There are four major environmental concerns about fracking. The first is water supply, and to what extent fracking fluids and gas can infiltrate the water supply. The second is disposal of the fracking fluids once fracking has taken place. The third concern is earthquakes, which can occur if fracking creates a large enough seismic event. The fourth concern is greenhouse gas emissions, to which natural gas contributes. U.S. Seismic's technology targets the first and perhaps biggest cause of concern, that is, will fracking contaminate the water supply? U.S. Seismic's fiber-optic geophones can show that the seismic events are limited to certain areas, and generate a high degree of confidence that the fracking is not contaminating any of the water supply in that area. Regulators are trying to understand exactly what environmental risks are involved in fracking. U.S. Seismic's ultra-sensitive instruments can alleviate these fears.

    TER: And conversely, the sensors could determine that such-and-such an area should be off limits.

    JM: Yes, exactly.

    TER: This sounds like a growing field. Does this type of technology apply to solar, wind or geothermal energy?

    JM: There are opportunities there, but we are currently focused on the traditional sources of energy, not the alternative sources.

    TER: Pipeline corrosion is a problem in the aging energy grids. Who is looking at that issue?

    JM: Acorn has two products applicable to that problem. One is produced by U.S. Seismic. It's a fiber-optic sensor that could be used to monitor pipelines. And Acorn recently acquired a company called OmniMetrix LLC, which also has a product used for pipeline monitoring.

    TER: Let's talk about what you look for in management. What is the situation with Acorn?

    JM: Acorn is a holding company. Its CEO is John Moore. John has a very good track record of identifying companies with emerging technologies in the energy industry. He invests in companies with proven management teams, such as U.S. Seismic, GridSense and OmniMetrix. Acorn offers these companies relative autonomy and financial resouces. As companies grow and mature, John Moore typically sells them. Over its history, Acorn has executed a couple of successful sales, including a company called Comverge and another called CoaLogix Inc., which does pollution-control technology for the coal-fired electric industry.

    TER: What is it about the recent trajectory of Acorn's stock price that attracts you?

    JM: The stock started the year close to $4-5/share and ran to about $13/share. It rose based upon expectations for good news coming out of its U.S. Seismic business. There has been increased focus on that business as oil prices have moved up. But Acorn had a rough May, like the rest of the market, and so the current $8/share level looks fairly attractive. We have a target of $14/share, and that's based upon our belief that, over time, the divisions that Acorn owns will mature and become increasingly attractive to potential buyers.

    TER: Is Acorn's price tied to the ups and downs of the energy sector in general?

    JM: Yes. But what we like about the Acorn stock movement is that it's not just driven by the price of oil or gas. The company's products enable energy companies to reduce their costs and to improve output. There is a viable market there, even with fluctuating resource prices. The viability is tied to the necessity of the oil and gas companies to lower costs and improve the quality of production.

    TER: Does Acorn have its eyes on international business, or is it purely domestic, to the United States?

    JM: Initially, the Acorn products will be proven in the North American markets, and then migrate to international markets. The energy industry is an international industry. But a lot of high technology is originally developed in North America, proven in North America and then sold to the rest of the world. I envision that the same type of progression will occur with Acorn's products.

    TER: Do you view Acorn itself as a company that has acquisition potential down the road, or a company that will grow and maintain itself on its own steam?

    JM: The reality of the small-cap market is that the successful ones have a higher likelihood of being acquired. But it would be difficult for one company to buy the whole portfolio of companies that Acorn owns. Energy service companies like Baker Hughes Inc. (BHI:NYSE), Halliburton Co. (HAL:NYSE) or FTS International (FTSI) are potential candidates to buy U.S. Seismic. Different sets of companies would be interested in GridSense and OmniMetrix.

    TER: Well, Acorn is a holding company at this point, right? So companies can come and go and it can maintain its structure if it wants to.

    JM: Right. And that is what has happened. Acorn sold Comverge, took the proceeds and found other companies that it thought were interesting. It sold CoaLogix, took the proceeds, and purchased companies that it thought were interesting. I think that's the more likely scenario: that somebody comes along and offers an attractive price for an Acorn property. Moore says "Sold," takes the proceeds and finds something else to develop.

    TER: Do you have an approximate dollar figure that you could attach to what Acorn earned from those sales and were able to put back into their companies?

    JM: Acorn's Comverge subsidiary went public in 2007 at a $250 million (NYSE:M) valuation and Acorn sold its entire position later in the year for $50M. In 2011, Acorn sold CoaLogix at a $101M valuation and banked close to $60M, after taxes, for its share.

    TER: Let's go back to the theme of Acorn making energy cleaner, cheaper, safer, and more reliable. Can you sum up how Acorn is approaching those goals?

    JM: The strategic philosophy behind Acorn's investments is that the traditional energy industries are going to be with us for a very long period of time. Acorn is looking for companies that can help those traditional sources of energy operate more efficiently. John Moore wants firms that have already had the initial round of investments-he is not a venture capitalist. He looks at companies that are either on the verge of product development, or that have a product but need help bringing it to market. Acorn is not going to be the first investor. It will be the second or the third investor. Many companies go through a lifecycle of the venture capital where it's founders have a great idea, but they run out of cash or expertise, and that's when Acorn can assist these companies.

    TER: Is Acorn returning a dividend at this time?

    JM: Yes, it returns a small dividend, at an annual rate of $0.14 per share.

    TER: Thank you for your time.

    JM: Thank you for having me.

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

    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) Peter Byrne 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: Acorn Energy Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.

    3) James McIlree: I have not, nor has my family, been compensated by any companies mentioned in this interview. Neither I, nor my family, own shares in any company mentioned in this interview. I was not paid by Streetwise Reports for participating in this story.

    4) The following disclosures are applicable to Acorn Energy Inc.: The research analyst responsible for preparing reports on Acorn Energy Inc. has received compensation based upon various factors including the firm's total revenues, a portion of which is generated by investment banking activities.

    Dominick & Dominick LLC expects to receive or intends to seek compensation for investment banking activities from Acorn Energy Inc. in the next three months.

    Dominick & Dominick LLC has received compensation for investment banking services from Acorn Energy, Inc. in the last 12 months.

    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 21 6:55 PM | Link | Comment!
  • 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.

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    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.

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