Energy Recovery CEO Joel Gay On VorTeq And Fracking

| About: Energy Recovery, (ERII)

Summary

Joel Gay discusses details of the Vorteq agreement with Schlumberger.

Another, less known agreement is also detailed.

General comments on the current state of affairs maybe be of keen interest to anyone tracking or predicting the oil market.

Energy Recovery (NASDAQ:ERII) recently reached out to me to conduct an interview with Joel Gay, the company's CEO. What follows is the edited (for readability) transcript from that session. A few links have also been added to provide what I believe to be relevant supporting information.

The first published part of the interview discussed general corporate actions and strategy for the company, and may be of interest to those concerned about ongoing litigation. The second discussed desalination. This section of the interview adds detail on the company's disruptive VorTeq technology and the associated agreements. Mr. Gay's comments on the general state of and outlook for North American onshore oil producers may also be great interest to investors in that market. The final part of the interview will discuss Energy Recovery's emerging oil & gas processing businesses.

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Esekla: Although you have an exclusive agreement with Schlumberger (NYSE:SLB), Liberty is grandfathered in, from my reading of the 10-K, for up to 20 VorTeqs for 5 years, with no extension. So, could you comment on the # of VorTeq cartridges per fleet?

Joel Gay: Ok, number of VorTeq cartridges per fleet... So each VorTeq Missle contains anywhere from 10 to 12 cartridges. It depends upon the design. That's one of the beauties of the pressure exchanger is that it is fully scalable and modular. If road weight restrictions were not a limiting factor we could put 200 cartridges on a missile to pump 500 to 750 barrels a minute, but there are weight restrictions, there are logistics restrictions. So 10 to 12 cartridges per missile.

E: On Liberty can you disclose if you'll be receiving any additional revenue from that use?

JG: Oh, absolutely. Why don't I just give you some background on that relationship. I believe I closed that deal in July of 2014. At that time we had been working with Liberty in evaluating the potential of the VorTeq and they were the earliest adopter of the technology and frankly our earliest supporters. So we consummated an agreement with them in the summer of 2014 with a very simple quid pro quo. If you take our technology once the prototype is developed and manufactured into your fleet and allow us to undergo rigorous testing at your R&D facilities and at your yard, and ultimately at the wellhead. We will enter into a preferred pricing agreement in which we will in essence lease you up to 20 VorTeqs at any given point in time, for a five year period. So that's the nature of the agreement.

E: Yes, I was actually at your Analyst Day and covered that. So there would be additional revenue for them using it over the next 5 years.

JG: Yes, the way we structured it is that we would be receiving a premium above our weighted average cost of capital, or really it's just our cost of equity. So we're getting a premium, that we are not disclosing, above our cost of equity and then service and maintenance will be billed on a time and materials basis at a pre-determined rate. We've guided appropriately for this. Our investors should not expect 65 to 75% gross margins on the lease or rental income that we will be generating through the Liberty arrangement as compared to the 65 or 75% target that we've established against the royalty income that we will be receiving from Schlumberger.

E: Can you give any color on the pace at which you manufacture VorTeqs and the extent to which we could expect to see CapEx increases in advance of their deployment?

JG: Our supply chain is more than adequate to meet Schlumberger's historical and current pressure pumping capacity levels. The deal was explicitly engineered to be CapEx-light given that Schlumberger is responsible for the manufacturing of the actual missile. Our CapEx will manifest in the form of cartridges that cost $500K - $600K per missile depreciated over a 2-year period and mobile reconditioning units at $750K with a 7-year life expectancy. Each mobile reconditioning unit services 10 - 12 VorTeqs. Other than intra-quarter escalation, we do not expect heavy CapEx mobilization. At some point in the future, we may fully reverse-integrate into Tungsten Carbide manufacturing, thereby building-out a standalone plant, which cost up to $60M.

E: Is there any codified prioritization for supplying of VorTeqs to Liberty vs Schlumberger? Codified or not, comments on any required decision-making there would be appreciated.

JG: We have not and will not subordinate one partner to the next. The gating item to supplying both SLB and Liberty is of course commercialization, which begins with achieving M1 and M2. We have the financial wherewithal and supply chain capacity to outfit both partners simultaneously.

E: Right, so moving on to that agreement. It specifies a monthly revenue stream starting in 2017, which scales linearly with the number of fleets that use your VorTeq technology. To get there you need to complete 5 and 20 stage tests with them as milestones.

JG: Yes...

E: Which should generate your additional $50M in payments. In the most recent conference call you expressed confidence that those milestones could be completed this year, but prior calls made it seem a little more like they might slip to early 2017. So is your best guess for the milestone completion in 2016 now, just to make sure, or could it be one or the other?

JG: Well, I would disagree with your interpretation that prior commentary suggested that there was a risk that they could slip into 2017. We remain confident that, at least as it stands today, both milestones will be achieved in 2016. We're just not providing quarterly guidance on that. There are too many variables that are outside of our control, but between now and December 31st, we expect to have both milestones done.

E: Excellent. Presumably, once you're past that you'll have information on Schlumberger's applicable fleet count, once the VorTeq starts going into them. However, I'm just curious is Schlumberger providing you with any plans or information that you can share in the interim?

JG: No, of course we know exactly what their fleet count is. Let me rephrase that, yes, but we're not disclosing that. It has been readily published previously. Prior to the dislocation that we're currently suffering in oil and gas, Schlumberger had approximately 120 fleets. As you know, there is a high correlation between rig count and fleet count. And so, you can appreciate what the active rig count has become, and therefore, what the actual capacity utilization of all pressure pumpers is.

The way that contract is structured is such that we too share in the systematic risk of that market. At the beginning of every quarter we peg what the active fleet count forecast should be, and then at the end of the quarter we reconcile active vs forecasted fleet counts and we are paid the greater of the two in the form of royalty income. That's the way the contract works.

E: Ok, interesting. Although at the end of 2015 they disclosed that North American rigs were down 68%. So, that's expected to rebound in 2017... I take it that you are standing by your $80-200M annualized long-term revenue projection?

JG: Long-term, exactly. Steady state, $80-200M is what we believe we will ramp to over a 5 year period beginning in 2017, assuming of course that we achieve milestones 1 and 2 this year. Now, that $80-200M is basically 50-130 fleets.

E: Right.

JG: Ultimately our steady state royalty income against that contract is going to be a function of the health of that market, which is to say alternative hydrocarbons. You know, E&Ps... Our view is a bit different on the market... when it will rebound... I think that we are in for a medium for longer environment as it relates to pricing. Certainly crude has rallied over the last 60 days, from the doldrums that it was in. But, if you look at it from a fundamental supply and demand perspective, there is still almost 2M barrels per day of excess supply or excess capacity.

The contributors to that remain here in North America, which is to say North American E&Ps and pressure pumping companies. Balance sheet rescues have been all the rage over the last 6 to 8 months, specifically within the upstream. The high yield debt markets shut down, which was good, but the equity markets are still allowing massive recaps. They are issuing equity to pay down debt, and that allows them to complete wells in a negative profit regime. And so, what I am ultimately getting at is that the market needs to rebalance, it has not rebalanced, as evidenced by, again, almost 2M barrels of excess supply.

The only way the market will rebalance is if the rate of attrition increases, and that applies to both E&Ps and pressure pumpers. Whether that occurs in Q1 2017, Q2 2017, I can't tell you, but if I were on the buy side predicting these market, I would look to the equity markets and the level of forgiveness therein as the best leading indicator as to when crude is going to return to a healthier pricing point.

E: Sure, makes a lot of sense to me, and I've even gone so far as to point out that the kind of middle-ground of hydrocarbon pricing is potentially a positive for you since it makes the cost of oil recovery very price sensitive, and you are reducing the price of production.

JG: You are absolutely right. I think the term that I've used in prior commentary is "omni-cyclical." Our value proposition resonates at almost all points of the cycle. Now it could trend down to 5 to 10 dollars... no one is going to be fracking, we will be putting any VorTeqs into service and I think the world is going to have much greater problems, at that point, than tracking Energy Recovery's progress. <laughter>

But you are absolutely right, that when you are in a sub $50 pricing regime, upon initial implementation utilizing the VorTeq with existing pumps, $3-4M per year per fleet is a tremendous amount of savings and allows Schlumberger to continue to be competitive. Then when you re-capitalize the fleets and migrate to the centrifugal pumping model, potentially unlocking up to $4-5 dollars per barrel, that is a step change in pricing power.

Now, what strategy Schlumberger will use with respect to the VorTeq, I won't speculate on that. I can tell you that there are really only two options:

  1. You can price to win and cost to lease, which is a market share capture strategy.
  2. You can harvest the margins.

The problem with harvesting the margins is, as you know, pressure pumping is an all but perfectly competitive market. Ultimately that value is going to propagate throughout the stream, most specifically upstream to the E&Ps. But yeah, our value proposition resonates quite nicely in a depressed market.

E: Yes, well I think that speaks to some of the other Schlumberger acquisitions and why they wanted to be exclusive with your technology.

JG: Yes

E: Moving on to the last question for fracking... The Schlumberger agreement specifies 100% usage by 2022, but the actual terms of the adoption are redacted. Can you at least give some color as to whether the actual terms of adoption are linear or curved, or anything like that?

JG: No, we have not done that. You know, what we tell our investors is that making a linear assumption would not skew your models.

E: Ok, I'll accept that that is as close as I am going to get.

Disclosure: I am/we are long ERII.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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