Alternative Energy Gambles for 2008- Part III

by: Tom Konrad, CFA

This article is a continuation of my Ten Alternative Energy Speculations for 2008, with picks #8, 9, and10 published last Thursday. If you haven't already, please read the introduction to that article before buying any of the stock picks that follow. These companies are likely to be highly volatile, and large positions are not appropriate for many investors. My least risky picks are part of that same article linked to above; the moderately risky picks are here. This article contains the most speculative three picks.

#3 Nevada Geothermal Power (OTCPK:NGLPF)

Geothermal first started catching investors' attention about six months ago. I went into detail as to the reasons for its appeal, and the factors bringing it to investors' attention in this profile of geothermal power in October.

Since then, we have been given an added reason to appreciate geothermal in the United States. While the recent energy bill did not contain a national RPS, nor tax credits for renewables, it did give the geothermal community much of what they were asking for since it contained the "Advanced Geothermal Energy Research and Development Act of 2007."

There are three ways to invest in geothermal power: through the technology, through existing plant operators, and through resource explorers and developers. The provisions relating to enhanced geothermal power and co-production in oil fields should help technology and service providers such as Ormat (NYSE:ORA) and United Technologies (NYSE:UTX) over the long term, since they will help open up new opportunities for geothermal. Over the short term, which is what this article is about, I expect the "Industry-coupled drilling" provision will be most important, and help explorers and developers of conventional geothermal resources.

According to the Geothermal Energy Association, the Industry-coupled drilling provision "pairs the federal government with geothermal developers to reduce drilling risks and improve drilling precision." Geothermal exploration and development is a very risky process, so government risk-sharing should greatly increase the value of geothermal prospects by lowering the effective discount rate at which they are valued.

Coming as it does early in the development process, a reduction in risk could easily be worth more to a company which owns the rights to develop an undeveloped geothermal resource than the later boost to income that would come from a Production Tax Credit, even though the industry-coupled drilling provision is likely to cost the government far less than a Geothermal Production Tax Credit.

US-based geothermal developers are most likely to benefit from this provision. These include US Geothermal (UGTH.OB), Sierra Geothermal [SRAGF.PK], Raser Technologies, (RZ), and Nevada Geothermal. US Geothermal and Raser Tech are up over 3x from their 52 week lows, while Sierra and Nevada Geothermal are each up about 2x, although the Nevada Geothermal share price was stagnant for the previous two years, while Sierra Geothermal has been following a steady uptrend.

Comparing these last two with the least recent appreciation, Sierra Geothermal has many more early stage projects, while Nevada Geothermal has just four high quality projects nearer to production. In fact, Nevada Geothermal owns Sierra Geothermal's most advanced project (Pumpernickel), and Sierra's exploration and development efforts will earn them at most a 50% share of the project.

This is only Nevada Geothermal's second most advanced project, after their wholly owned Blue Mountain project which is on track to begin producing electricity in 2009, and for which they have already completed a Power Purchase Agreement and an interconnection agreement with local utilities. Nevada Geothermal is currently funding development of its projects with loans from the likes of geothermal specialist Glitner Bank and Morgan Stanley(NYSE:MS), while Sierra Geothermal is financing its exploration needs with dilutive private placements.

Because of the relatively small recent run-up for Nevada Geothermal, its strong financial position, and ownership of a late-stage project (as well as sufficient promising projects to keep them busy with development for many years to come), I see the most potential for robust returns in Nevada Geothermal among geothermal developers.

#2 Finavera Renewables [FNVRF.PK]

I chose to include Finavera in my Top Ten Speculations for 2008 for my own reasons, but Editor Charles Morand has been following the company longer and more closely than I have myself, so I asked him to profile it. You can read what he has to say about Finavera Renewables here or simply scroll down to the post below.

#1 First Solar (NASDAQ:FSLR)

When I disclosed that I was short First Solar in the first installment of this series, I received an incredulous comment soon after the article was syndicated on Seeking Alpha: "OUCH!! You have a short position in FSLR? I hope it doesn't come back and bite you!" I'm sure the commenter is not alone in his conviction that First Solar's rise will continue. The fact that First Solar has risen so far so fast is only because people like the commenter have been purchasing the shares like hotcakes all year.

Shorting is inherently more dangerous than being long, because in a long position you can not lose more than your initial investment. Shorting a momentum stock, even when it is overvalued, can be especially risky, because momentum tends to be a self-fulfilling prophecy, with more investors becoming interested and driving the price up as they try to buy the stock. For all those reasons, shorting First Solar deserves to be the #1 riskiest of my 10 speculations for 2008.

Why did I decide to short at all? What makes me think that 2008 will be the year that First Solar's bubble pops?

First Solar's valuation seems out of line because of an inherent limitation on their profitability. Their solar panels are based on Cadmium-Telluride [CdTe] thin film technology, and Tellurium [Te] is one of the scarcest elements in the Earth's crust. In 2006, First Solar's 60MW of production consumed 4% of the world's annual supply of the metal. In 2008, analysts expect revenues of approximately 4x the 2006 number, meaning they will need approximately 16% of new annual Tellurium supplies.

PrimeStar Solar, a private company is using a recent infusion of capital from General Electric (NYSE:GE) to quickly begin production of their own CdTe modules. They do not disclose the timing of production "for competitive reasons," but their hiring and equipment orders speak of an aggressive schedule; I expect they will begin production in 2008.

With this much demand on short-term Tellurium supplies, we can expect continued price increases. First Solar cannot set the price of their product in the market, because they will be in direct competition with conventional solar modules as will as thin film modules based on CIGS and amorphous silicon technologies. With the failure of the US Congress to extend tax incentives for solar or to pass a renewable electricity standard, demand for solar panels may not continue to grow as robustly as it has in recent years. If anything, this should cause prices per watt to fall somewhat in 2008.

Ethanol producers were caught in a commodity squeeze this year by using 25% of the United States corn supply. In contrast to First Solar, ethanol production has only been growing 20-25% a year, much slower than the demand for Tellurium from CdTe cells, and corn production was artificially sustained at an uneconomically high level before the advent of corn ethanol by farm subsidies.

Hence, I would expect a commodity squeeze for CdTe producers at a lower percentage of supply. My 16% projection for 2008 does not seem out of line to trigger a commodity squeeze, which could cause First Solar to miss (or at least cease to beat) earnings estimates in the coming year. Missing or just failing to exceed earnings estimates almost always leads to quick price drops for high multiple companies. According to Yahoo!, First Solar's trailing P/E is about 195.

If First Solar produces 240MW of panels in 2008, and Te prices remain at $100/lb, as they were in 2006, Tellurium cost alone would be $87 million, compared to First Call average estimated Revenues of $800M, and $146M estimated earnings.

I don't know what Tellurium prices were used in those estimated earnings, although I expect it was over $100/lb. Whatever those estimates were, a $200/lb underestimate would completely wipe out earnings for 2008, and, as the oil price has shown us, even moderate increases in demand for a commodity with inelastic supply can create massive price rises. What will new demand for Te rising from 4% of supply to 16% of supply in two years do to the price?

The other reason to believe that First Solar's meteoric rise might halt in 2008 has to do with investor sentiment. An unscientific survey of sentiment among Seeking Alpha bloggers (myself excluded) has turned negative (as far as I can tell, only Andrew Ling is still writing positively about the stock), and the Tellurium problem is getting wide attention. How long will it take the mainstream press to latch on to the Tellurium story? It's impossible to say, and another run like last quarter could easily squeeze out the shorts.

Taking this all into account, my short position is only about 0.1% of my portfolio, more of an intellectual experiment than a real bet. As Keynes said, "The market can remain irrational longer than you can remain solvent." I wouldn't advise anyone to take a short position in FSLR so large that they could not sleep through another doubling of the stock price.

If any play is for gamblers, this is it. But cards are stacking up against First Solar.

Links: Picks #10,9,8; Picks #7,6,5,4.

DISCLOSURE: Tom Konrad and/or his clients have long positions in (UGTH.OB), (OTC:SRAGF), (RZ),(OTCPK:NGLPF),(ORA), (UTX), [FNVRF.PK], (GE), and a short position in (FSLR).