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Banking on Ethanol and High-Tech Fracking: Keith Schaefer

Source: Peter Byrne of The Energy Report

Ideas get bigger when you share them...

January 9, 2014 (Investorideas.com newswire) Keith Schaefer, editor and publisher of Oil & Gas Investments Bulletin, has built an impressive track record of foreseeing structural changes in the energy industry. Schaefer knows when to take or refuse opportunities in the volatile ethanol industry, as he demonstrates in this interview with The Energy Report. And he knows how to bide his time while waiting for catalytic moments—the singular events that can make all the difference between survival and extinction for a junior oil and gas company struggling to raise above the fray in the fracking fields.

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The Energy Report: Keith, why do you say that there is an ethanol "renaissance?"

Keith Schaefer: Ethanol is one of the most volatile sectors in the energy complex. The industry almost went bankrupt during the crash of '08. It rebounded; 2010 and 2011 were fantastic years for ethanol, with great profits. Then, the drought of 2012 caused corn prices to soar and ethanol profitability collapsed. But here we are a mere year later, enjoying the largest bumper crop of corn in American history. Corn is the main input price for ethanol; its cost determines the rate of profit. With corn locked into low costs for a few quarters, ethanol companies are minting money.

TER: Are ethanol prices always at the mercy of the weather?

KS: Well, yes, but there have been very few droughts in the last 15-20 years, so the swing over the last two years in crop sizes—and therefore pricing and profitability for ethanol—is not normal. I don't see weather as a big statistical factor over the long term. But in the short run, prices will continue to fluctuate in tandem with drought-reduced crops or bumper crops.

TER: Are costs stable in the chain of ethanol supply, from the farm to the storage facility to the distribution networks?

KS: There is not a lot of existing corn storage capacity for the bumper crop excess, but the ethanol industry is building up more storage capacity. The distribution system is tightening, however, because ethanol and corn are shipped in railcars. Due to the large price differential between American oil and international oil, the Brent/WTI spread, the oil companies are renting most of the available tankers to move fossil fuel product. That has negatively impacted the availability of tankers to move ethanol, and there is an actual shortage of ethanol in some areas. I view that as a bullish factor for ethanol going into 2014.

TER: Do you like any particular ethanol companies?

KS: The company that needs to be on everybody's radar screen is Green Plains Renewable Energy Inc. (GPRE:NASDAQ). It is hitting new highs close to $20/share. It was just included in the S&P 600. Green Plains is producing a billion gallons of ethanol per year. To put that in context: The U.S. produces 13 billion gallons per year, so Green Plains has one-thirteenth of the ethanol industry. It is the largest independent ethanol pure play. It has one of the top management teams in the entire business—a very competent, smart set of players. They hedge out a huge amount of their production, as much as possible.

TER: Is hedging a good idea?

KS: Oil can be hedged out two, three or four years. Due to supply variability, ethanol cannot be hedged out more than nine months. And as the new corn crop gets ready for reaping, there is no visibility beyond three months. It is an incredibly volatile sector.

But, right now we have about an eight-month pathway of visibility with unbelievable margins. Including the byproducts—corn, oil and distiller's grain—the margin for ethanol, which is commonly called the crush spread, is higher than forty cents per gallon.

To put that in context, Green Plains produces a billion gallons, so do the math: Forty cents a gallon times a billion gallons is $400 million ($400M) in cash flow. A conservative multiple of five times cash flow generates a valuation of $2 billion ($2B) for a company with only 35 million shares out. The numbers have quickly become very compelling.

Now the reality is that Green Plains is not going to realize that kind of margin because it is such an active hedger. It is willing to mitigate risk by taking a reduced margin. But the large players in the ethanol spot market are just rolling in cash.

TER: Prices in the domestic ethanol market are related to oil supply, politics and also to environmental concerns. Is hydraulic fracturing becoming more sustainable?

KS: Fracking is definitely becoming more sustainable as time goes by. Thanks to pressures from the environmental industry, the oil industry has responded with the creation of food-grade fracking fluid, for example. There is an increasing consensus that fracking does cause micro seismic events, and high-quality baseline studies are being done to assess how best to respond to that issue. Popular opinion polls show that fracking is increasingly accepted by the American public. But, for years, the industry missed the boat on how to sell fracking to the public—particularly on how to calm down fears of poisoned drinking water. Frankly, the industry is still a bit behind on that issue, but it is coming around and slowly adjusting to directly addressing these fears, as opposed to dismissing the concerns outright and just saying, "Well, we create lots of jobs."

TER: What are some of the improvements in fracking technology you're talking about?

KS: There are two different kinds of underground water. Everyone gets excited about the potable groundwater that resides at a very shallow level. The casing for the frack that goes through that groundwater is very regulated. When there has been a problem with groundwater contamination, it's either been tied to naturally occurring methane at shallow levels or to a bad cement job.

But fracking takes place down to two miles below the surface, so that activity has nothing to do with groundwater safety. In fact, there is such a massive amount of water underground that the frackers could be net water producers. Of course, that water is very briny, full of chemicals and dirt, and is not potable. It would take quite a bit of cleaning for this down-deep water to become drinkable.

However, during the last year, the industry has started to change the chemical composition of its fracking fluids, which allows it to use a lot more of the naturally occurring briny water to frack way down deep—reducing the need to use fresh water.

Because the meters being drilled is increasing, the amount of fresh water being used for fracking is still increasing, but the amount of recycled water and deep briny water being used to frack is increasing much more rapidly.

TER: Any other important improvements in hydraulic fracturing technologies?

KS: It's really interesting to see what pioneers like EOG Resources Inc. (EOG:NYSE) and Whiting Petroleum (WLL:NYSE) are doing. Both firms have made simple but very profound changes in their fracking methodology, principally going with short, wide fracks instead of long skinny fracks. The fairly small sets of data available on this approach show the drillers are getting slightly higher initial production (IP) rates compared to the norm. But the real game changer is that the decline rate on the shale wells and the tight oil wells were at 65–80% in year one. With this simple change in fracking from long and skinny to short and fat, those decline rates are now showing at 15–20%. Slower decline rates mean that wells will pay out faster.

TER: Will the U.S.-based shale reserves hold up?

KS: There is a lot of new oil production in the U.S. It seems like every quarter, the experts underestimatehow much oil the U.S. industry is producing. And almost none of these experts are looking at the new wider, shorter methodology being pioneered by Whiting and EOG. Once that method starts to gain widespread acceptance—look out—there could be an unbelievable increase in U.S. oil production in the very near-term.

TER: Have any recent IPOs caught your eye?

KS: Cardinal Energy Group Inc. (CEGX:OTCBB) is a new IPO put out by Scott Ratushny who did Midway Energy, which was bought by Whitecap Resources Inc. (WCP:TSX.V) in early 2012. Scott is one of the top guys on the street in Calgary and his Cardinal sports an A+ management team. It raised public money at $2/share, $4/share and as high as $8/share privately. The Cardinal IPO launched at $10.50/share and the stock is trading at $11.50/share.

TER: What is so attractive about Cardinal?

KS: It controls light oil assets with very low decline rates. But it is breaking ground in the dividend arena. I am not a fan of junior dividend companies—the overall payout ratio between drilling and dividend is usually between 95% and 120% of cash flow. Many juniors spend more than they take in, and then they are forced to rely upon their debt lines and equity to fill in the operating gap. But Cardinal's policy is that the all-in payout ratio, including dividends and drilling, is set at 60% of cash flow. That means that management can use the extra money to pay down debt, or to grow a little more aggressively. And, right now, the market is rewarding that strategy.

TER: Will that joy last?

KS: As time progresses, it will be interesting to see (a) what the Cardinal managers do with the extra free cash flow and (b) if the market will continue to reward them for being conservative. Now the big issue here is that Cardinal does not have a huge growth model ahead, so it will have to employ its cash money to figure out the next best move. In Cardinal's favor, its assets have a low decline rate. It is an example of a different approach from the "grow baby, drill baby" model of the last three years. The market is turning from rewarding growth to rewarding sustainability in the junior sector. Management teams that cannot grow and keep their debt to cash flow ratio steady will be punished.

TER: Is providing energy services for drillers and refiners proving to be a profitable, sustainable sector?

KS: Energy service firms are the no-brainers of the energy market, because nobody really knows where commodity prices are going. It is hard to see oil and gas prices climbing much higher. In fact, I expect to see a 10% drop in commodity prices during the next year. And a 10% drop in commodity prices is a 20–25% drop in profitability for most of the producers, which will blow a big headwind for their stocks. On the services side, the drillers will continue to require chemicals, fluids and equipment.

On paper, the service sector sounds great. But there is not a lot of pricing power in it at the moment. On the ground, utilization rates are perking up, but not to the point where prices are perking up, too.

TER: What service firms should investors look at to survive the next period?

KS: Both Precision Drilling Corp. (PD:TSX) and CanElson Drilling Inc. (CDI:TSX.V) are well-run companies with leverage to an increased cycle. CanElson is a junior with a great team. It is a "forget about it" kind of stock and I have enough confidence in management that I do not watch it day-to-day.

On the fracking side, I am a big believer in the Canyon Services Group Inc. (FRC:TSX) team. They are talking about being close to 100% utilization in Q1/14; that means pricing power should enter the market. I am not long on Canyon stock right this second. I am waiting to see how the winds are blowing. But I love that it has a disciplined team that really understands the business. Management is not willing to take on any job at any price, like some of its American counterparts that throw caution to the wind and lowball prices. I am patiently waiting for a dramatic catalyst to drive that sector in western Canada. It should be liquefied natural gas (LNG).

On the junior side, investors could look to Petrowest Corp. (PRW:TSX). It does a great job with logistics and heavy hauling out in the bush—trailblazing the way for the energy industry to develop the newest areas. Its CEO, Ian Hogg, is doing a champion job and the stock is close to a 50% gain since inception. As it attracts new business, its cash flow increases.

I also cover Enterprise Group Inc. (E:TSX.V). It has had real success in buying what I call "oddball" service companies with proprietary technologies and higher profit margins than the service sector as a whole. Enterprise's managers are good at convincing the oddball firms to sell out to them, and then they grow these acquisitions very quickly under their corporate umbrella. I love that aspect. And the stock is trading great. It is definitely one to watch for 2014. Enterprise could see up to 30% organic growth every year for the next three or four years.

TER: Thanks for the tips, Keith.

Keith Schaefer is editor and publisher of the Oil & Gas Investments Bulletin, which finds, researches and profiles growing oil and gas companies that Schaefer buys himself, so Bulletin subscribers know he has his own money on the line. He identifies oil and gas companies that have high or potentially high growth rates and that are covered by several research analysts. He has a degree in journalism and has worked for several Canadian dailies but has spent over 15 years assisting public resource companies in raising exploration and expansion capital.

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DISCLOSURE:

1) Peter Byrne conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He 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 its services or as sponsorship payment.
3) Keith Schaefer: I or my family own shares of the following companies mentioned in this interview: Enterprise Group Inc., CanElson Drilling Inc., Precision Drilling Corp. and Green Plains Renewable Energy Inc. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
4) Interviews are edited for clarity. Streetwise Reports does not make editorial comments or change experts' statements without their consent.
5) The interview does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports' terms of use and full legal disclaimer.
6) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles and interviews 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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