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James West, publisher of the Midas Letter, asks
himself three questions when considering energy investment opportunities: Who
is the management? What is the asset mix? Where is the project located? He
shares the names of companies in the oil, gas, uranium and lithium sectors
that have all the right answers in this exclusive interview with The Energy Report
The Energy Report: James, what
percentage of the Midas Letter model portfolio consists of
energy-related plays?
James West: Energy holdings represent 15% and I expect that to grow
closer to about 20–25%.
TER: Starting with oil and gas, which fundamentals are pushing you to
invest?
JW: I have to qualify that oil and gas no longer track each other in
prices. In fact, they are so widely divergent as to be almost opposing
markets. Gas in North America is much cheaper than gas in the Ukraine. In the
Ukraine, you are looking at $10/trillion cubic feet (Tcf)
at the wellhead; in Canada and the U.S. it is below $2/Tcf.
Oil and gas companies are valued on a premium depending on how much oil and
condensates they produce relative to gas.
In domestic Canadian plays, I look for a much higher oil:gas ratio, in excess of 70%. If the ratio is
reversed, I am not interested. However, for TSX-listed companies in Poland,
Germany or France, the oil:gas
ratio is not important. Large quantities of both are excellent, especially if
the companies are producing light, sweet crude and low-sulfur gas. That is
the best-case scenario.
Once I've evaluated a company's asset base, I look at the people behind the
project. I look at capitalization and management's fundraising abilities
because a lot of oil and gas plays are very expensive. If the company will be
an operator, does management have operating experience?
Next, I look at location. Is the project in a politically tricky
jurisdiction? The Niger Delta is somewhat of a hotspot now. Kurdistan is a
bit problematic; Uzbekistan, Afghanistan—the -stans
are always problematic. The elections in June make Mongolia a question mark
right now.
TER: Recently, Canada's National Post reported that oil majors
like Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and
Malaysia's Petronas Nasional
Bsd are evaluating plans to build terminals in the Kitimat, British Columbia area to export liquefied
natural gas (LNG) to Asia. The Post speculates that the need for more
natural gas could lead to a rash of takeovers with names like Talisman Energy Inc. (TLM:TSX), Painted Pony Petroleum Ltd.
(PPY.A:TSX.V), Progress Energy (PGN:NYSE) and
even Encana Corporation (ECA:TSX; ECA:NYSE).
What are your thoughts on that speculation?
JW: The oil majors are considering LNG terminals for export to Asia
because they get a better price in Asia, where there is a big and growing
market. A lot of fundamental market drivers support that idea.
Companies like Talisman, Progress and EnCana are looking down the road.
Building an LNG terminal can take up to 10 years from baseline environmental
studies to the time you turn on the tap and start loading ships. This talk
and activity is about capturing opportunities to move gas from its source to
where it is needed, and in anticipation of the time when the global inventory
diminishes.
Today, fracking and horizontal drilling have
created new opportunities and new reserves of oil and especially gas. Now,
you can drive a drill bit anywhere you want. Trillions of cubic feet of gas
are in the global inventory. The market—always
irrational—overreacted to that and now gas is at an all-time low. That
will not last.
There is increased resistance to hydraulic fracking
because blasting a toxic concoction of chemicals and fluids deep into the
ground undermines the competency of the rock structures, and causes both the
chemicals and natural gas to contaminate aquifers that supply drinking water.
That is not just radical environmentalism; it is a real concern. For example,
New York has banned fracking because of the
problems with drinking water in Pennsylvania and in other places.
But the environmental concerns are up against equally strong economic
concerns. With the economic weakness, the collective mindset is against
environmental interference that delays economic activity derived from
hydrocarbon exploration in the form of hydraulic fracking.
TER: What investment-worthy themes do you see playing out in the
energy space this year?
JW: I think uranium prices will recover. I am not a fan of nuclear
power, but as an investor, you cannot ignore the price movements of
commodities and the inherent opportunities. Very knowledgeable people tell me
there is demand for uranium in anticipation of a nuclear power construction
boom in China.
I think lithium prices will increase and we are already seeing higher
graphite prices.
Oil prices will continue to rise incrementally, with gas prices remaining
stable or even tipping a bit going into summer in the Western Hemisphere. The
Eastern Hemisphere is a different story. It will retain its higher gas
pricing premium, roughly five times that of the Western Hemisphere.
There are a couple of caveats regarding incremental price increases for oil.
If Iran, the second-largest OPEC producer, experiences a military regime
change, the price of oil could spike to $140/barrel (bbl).
The rise in sectarian Muslim violence in the Niger Delta, the largest African
producer of oil, has already caused disruption, including a pipeline
explosion.
TER: What about coal?
JW: Coal is like natural gas. I always ask: Where is it? What kind is
it? Who are you going to sell it to?
The best coal story in terms of near-term share price appreciation is Prophecy Coal Corp. (PCY:TSX; PRPCF:OTCQX; 1P2:FSE). It
has 1.4 billion tons at its Chandgana Ulaan Ovoo project. It has two
coal mines in Mongolia. One is immediately south of the capital, Ulan Bator,
where Prophecy has a permit to build a 600-megawatt power plant that will
consume more than 2 million tons (Mt) of its coal annually. Called the
Mine-Mouth Power Plant, it will be built right at the mine, and should be
operational by 2016. The company is negotiating the power offtake
agreement. According to its preliminary economic assessment (PEA), it has a
good internal rate of return, but the exact numbers depend on what the power
purchase agreement number is. It looks like it might be $0.06/kilowatt hour
(KWh). The financing will be 70% through debt, 30% equity. Now, 70% debt is
not what you'd call a done deal, but all of the Chinese and Mongolian players
are ready to write checks.
TER: Prophecy is already producing coal. Will all of its coal go to
the Mine-Mouth plant, or will it still export some?
JW: That is the beautiful thing about Prophecy, it has flexibility. It
has an immediate project that will consume 2 Mt/day. It has a great offtake partner in itself. Essentially, it will sell the
coal as electricity. It also has tons left over for export. It has exported
some coal from its mine in Northern Mongolia to Russia, and that will likely
increase in the future.
The company also owns 42% of Prophecy Platinum Corp. (NKL:TSX.V; PNIKD:OTCPK; P94P:FSE).
Prophecy Platinum is a very liquid stock, last trading at more than $4.
Basically, Prophecy Coal's entire market-cap value is in Prophecy Platinum
shares. It is as if the power plant and the coal operation are a bonus for
investors.
There is a discount because Mongolia is perceived as a bit flaky when it
comes to deciding what to do with its natural resources. The Mongolian
election in June adds some uncertainty. But the bottom line is that Mongolia
is growing and it needs electric power. No matter who is elected, this plant
will get built. The government will not steal it from Prophecy Coal because
the government does not know how to run it and it lacks access to capital.
China, its next-door neighbor, will make sure everything happens according to
plan.
TER: Are there any gas-heavy names you believe deserve attention?
JW: Let's look specifically at names that might benefit from
construction of LNG terminals in Canada. Although LNG terminals only process
large suppliers of gas, even small suppliers can benefit indirectly.
The majors are going to be looking for juniors like Aroway Energy Inc. (ARW:TSX.V; ARWJF:OTCQX), which has an
inventory of production and exploration targets in the form of lots of good
three-dimensional (3D) seismic data. Besides drilling nine new wells this
year, Aroway is shooting 3D seismic over 75% of its
101 sections on its 29K hectares. It is building itself into an attractive
takeover target.
Shell Canada Ltd. is just to the south of Aroway. Birchcliff Energy Ltd. (BIR:TSX) is immediately to the west, and
it has Crescent Point Energy Corp.
(CPG:TSX) on its northeastern border. Aroway
is essentially surrounded by billion-dollar plot companies, all of which will
be looking to supply those LNG plants.
TER: Where and how is Aroway drilling?
JW: It is drilling in a very prolific region, into the Peace River
Arch in the Leduc Formation. It's a traditional well with vertical and
horizontal wells.
TER: In its first year, Aroway's share price
went from $0.20 in July to the mid-$0.80s now. Can the company follow that
with another successful year?
JW: I believe its second year will be even better for a couple of
reasons. First, its joint venture partner controls the distribution and
gathering infrastructure for the oil and gas on its land. Second, the company
did a private placement at the end of 2010, which put some selling pressure
on its stock. That pressure is gone; the company is cash-flow positive and no
longer needs to raise money. At this point, there is no downward pressure on
the share price from previous financing.
In 2011, Aroway said it would exit with 600 barrels
per day (bbl/d). In fact, it exited with 670 bbl/d. Aroway
under-promised and over-delivered. That is a key driver to getting a
better share price valuation. But it remains under the 1,000 bbl/d mark. A company is not even considered a junior
producer of any substance until it produces over 1,000 bbl/d. This year, Aroway's
targeted exit production is 1,200 bbl/d.
That will put the company into a new category and more companies will be
looking at it as a takeover target and as a good, largely derisked
investment, one with long-life wells and a clear growth strategy for a land
package that could support average production of at least 100 bbl/d per well.
Its neighbor Birchcliff Energy is a billion-dollar
company, producing 17,000 barrels of oil equivalent per day (boe/d). The possibility for Aroway
to do that only grows with time. At the current price, it is still a fraction
of what I think it will be worth. And remember, that 670 bpd reported
production and its 1,200 bpd target for 2012, is only 50% of the oil being
produced from those wells. Aroway's joint venture
partner accounts for the remaining 50%. So, in essence, Aroway
exited 2011 with more than 1,200 bpd on its own balance sheet.
There will be a lot of compelling reasons for Aroway
and its joint venture partner to merge. At that point, it becomes a very
attractive takeover candidate for a large mining company. I think 2012 will
be even better than 2010 and 2011.
TER: Do you have another gas name?
JW: BNK Petroleum Inc. (BKX:TSX) is one of my favorites. The first
thing that attracted me to BNK Petroleum is its people. Ford Nicholson, the
chairman, was a board member of Bankers Petroleum Ltd. (BNK:TSX)
and InterOil Corp. (IOC:NYSE). He also was with
Tartan Energy Inc. (TEW:TSX.V). Bob Cross is another
marquee name in oil and gas investment, former chairman of Yorkton Securities
and of Northern Orion Resources Inc. (NNO:TSX) and non-executive chairman of
B2Gold Corp. (BTO:TSX; BGLPF:OTCQX) and co-founder and chairman of Petrodorado Energy Ltd. (PDQ:TSX.V). General Wesley Clark
is also on the board. The caliber of people involved is quite impressive.
The company is the largest landholder in Europe in terms of shale gas
formations. Its share price has fallen, which is an opportunity for
risk-tolerant and opportunistic investors. It is trading at $1.70 and has a
total market cap of $250 million. In Europe, it is largely in Spain and
Poland—two countries that need the bounty afforded by rich gas
deposits. It also has very large land holdings in Texas and in Oklahoma in
the Tishomingo field. Considering the size of its land position and the
scarcity of gas in Europe, the company is in the right places.
It is in production: just under 40 Mboe, 24% of it oil and 40% is natural gas liquids. There is a real
premium for that. I recommended it at $2.20. Then it lost $1.70 on the
negativity associated with its lack of success on its first wells in Poland.
This was an overreaction by the market. I think the company will rebound.
TER: What are some liquids-rich plays that you have some exposure to
in terms of condensates?
JW: Again, BNK is a good one. New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX) has just
started to really get up steam in the market. Here too, management is
important. John Proust and his team have been working diligently.
This is the first onshore drilling production in New Zealand, which has
always been a large importer of oil and gas. The company is producing 550 bpd
light crude from its Copper Moki-1 well in the Taranaki
Basin. It will drill as many as 10 exploration wells in 2012. The company has
152,000 acres, a potential 66 MMbbl resource and
730 MMbbl oil in plays.
TER: For the first time since 1978, the U.S. Nuclear Regulatory
Commission has licensed construction of two new nuclear reactors, and you
mentioned the Chinese nuclear construction plans earlier. Are you partial to
any particular uranium plays?
JW: Athabasca Uranium Inc. (UAX:TSX.V; ATURF:OTCQX) is shaping up
well. It just finished its first round of drilling and we are waiting for the
assays.
NexGen Energy Partners LLC is another. It is a
private company at this point, but will be going public. The dough is still
rising. This is going to be the uranium play of the year if Athabasca Uranium
is not.
TER: Do you have any parting thoughts on the energy space?
JW: I think lithium is going to be of growing interest and would like
to mention a couple of companies close to production. Lithium One Inc. (LI:TSX.V) is headed by
Paul Matysek, who created Uranium One Inc.
(UUU:TSX), a multibillion-dollar company. Its board of directors includes Sal
de Vida and, as a major offtake partner, the Korean
consortium. It has a salar deposit project in
northwest Argentina that is in prefeasibility. Its other project is a
pegmatite deposit in Ontario's James Bay.
I also like International Lithium (ILC:TSX.V), which just
started trading last year. It has the same sort of profile. Its pegmatite
deposits in Ireland and Canada are very advanced and very rich. It also has a
160 square kilometer salar brine deposit in
Argentina that looks very rich.
TER: Is International Lithium's Argentine project close to any others,
making it a takeover target?
JW: Yes, there are a bunch of lithium companies operating in the
northern Argentina zone, south of Bolivia, but I am not as familiar with
them. I'll stick with Lithium One and International Lithium, the two that I
think really have a shot.
TER: James, thank you for your time and your thoughts.
Read James West's gold and precious metals market insights here.
Midas Letter is the investment strategy journal of the Midas Letter
Opportunity Fund, a Luxembourg-based Special Investment Fund that specializes
in Canadian-listed emerging companies in the resource sector with a focus on
precious metals explorers and miners. James West is
the portfolio and investment advisor to the fund. Every month, West's Midas
Letter Premium Edition deconstructs the economic and political events of
the past and upcoming week, and identifies risks and opportunities to
investors seeking to profit while the majority of investors are losing money.
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DISCLOSURE:
1) Brian Sylvester 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 or The Gold Report: Royal Dutch Shell plc, Lithium One Inc., New Zealand Energy Corp., B2Gold
Corp., Aroway Energy, Inc., Athabasca Uranium Inc.,
Prophecy Coal Corp. and Prophecy Platinum Corp. Streetwise Reports does not accept stock in exchange for services.
3) James West: I personally and/or my family own shares of the following
companies mentioned in this interview: Aroway Energy
Inc., Athabasca Uranium Inc., Birchcliff Energy
Ltd., BNK Petroleum Inc., Crescent Point Energy Corp., Encana
Corporation, International Lithium, Lithium One Inc., New Zealand Energy
Corp., Painted Pony Petroleum Ltd., Progress Energy, Prophecy Coal Corp.,
Prophecy Platinum Corp., Royal Dutch Shell Plc and
Talisman Energy Inc. I personally and/or my family am
paid by the following companies mentioned in this interview: None. I was not paid by Streetwise for this interview.
The Energy
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