Taking Stock of 2007
There are 10 economic sectors that make up the S&P 500; last year, the best performing of all was energy, up 34.4 percent for the year. That’s more than 10 percentage points better than the second best performing index–the S&P 500 Materials Index–and dwarfs the 5.5 percent total return from the S&P 500 itself. To make a long story short, 2007 was a great year to be invested in energy stocks.
And the three The Energy Strategist portfolios largely outperformed their benchmarks for 2007. The conservative, income-oriented Proven Reserves Portfolio managed a gain of 13.1 percent, despite unprecedented volatility in most income-oriented stocks since the credit crunch first struck last summer. The growth-oriented Wildcatters and aggressive growth Gushers portfolios managed total returns of 48.7 percent and 55 percent, respectively.
I started tracking the three main portfolios separately at the end of the second quarter in 2006; the chart below shows the relative performance of the three TES portfolios and some common industry benchmarks.
Source: The Energy Strategist, Bloomberg
One of the longest-standing themes in TES is deepwater drilling. One of my favorite players provided a great outlook for 2008, and I see several indicators as well that this year will be another interesting year for drillers. See Deepwater Boom.
My four basic ideas for playing deepwater drilling have fared well last year. Although some outran my original expectations, I still see all as solid plays and will look to jumping into previous positions, as well as some new ones, throughout the upcoming year. See Playing Deepwater.
Three of my Portfolio recommendations have done very well as foreign demand for US coal has risen in the past year. These plays continue to supply niche markets and expand into foreign mines as well, increasing the opportunity for gain in 2008. See Coal.
The nuclear field bet was the first one I issued to play the risky market of uranium. With gains up to 240 percent, these uranium producers still appear to be moving at a solid clip. I provide a couple forecasts below. See Uranium and Nuclear Power.
Equally important are my biofuels and alternatives field bets. The US Energy Act of 2007 has certainly placed importance on the use of biofuels in years to come, and I see advantages from government subsidies in the alternative field bet as well. See Biofuels and Alternatives.
Of course, that wasn’t the first issue in which I covered this topic. Growth in deepwater exploration, drilling activity and spending has been one of the longest-standing themes in TES. In fact, the boom in deepwater production goes hand in hand with another core long-standing theme in this newsletter–the end of “easy” oil.
Simply put, the large onshore fields that have met the world’s oil demand for decades are now mature and already seeing declining production. To offset declines from these easy-to-produce oil (and gas) fields, producers will increasingly target smaller, more-complex fields, as well as fields that are harder and more expensive to reach.
In other words, the world isn’t running out of oil, but we’re already seeing the end of “easy” oil. Targeting these more-complex fields will require the application of sophisticated new technologies and techniques.
In addition, the era of cheap oil is over. To make the production of “hard” oil economically viable, prices will need to remain elevated.
Deepwater is a prime example of what I mean by “hard” oil. No producer would bother spending billions of dollars on a deepwater oil project if it could simply and easily ramp up production from existing oilfields. But deepwater is one of the final regions of the globe where there are large, untapped reserves of oil and gas to be exploited.
Most of the biggest oil and gas finds over the past few years have been in the deepwater. Chevron Corp’s (NYSE: CVX) successful test of its deepwater Jack field in the Gulf of Mexico in late 2006 and Petrobras’ more recent find of the deepwater Tupi field are just two prominent examples.
To make a long story short, according to Offshore Magazine and a recent survey published by energy analysts Douglas-Westwood, total global deepwater oil production will grow from 4.5 million barrels per day in 2007 to more than 8 million barrels per day in 2011. Over the same time period, deepwater gas production will nearly double from 1.6 million barrels of oil equivalent per day (boe/d) to some 3 million boe/d in 2011.
And for the US, check out the chart below.
Source: Energy Information Administration (EIA)
This chart shows US deepwater oil production as a percent of total oil production over the past decade, with projections out to 2030. As you can see, deepwater production accounted for just less than 24 percent of total US production in 2007 and is projected to grow to more than 35 percent of the total by 2030.
With all the growth potential of deepwater, it should come as no surprise that producers have been spending more on deepwater developments and exploration in recent years. Moreover, surveys of exploration and production (E&P) companies consistently show that deepwater is one area where most companies intend to continue to boost their spending.
In fact, if anything, the world’s producers would like to spend more on deepwater developments but are constrained by the lack of availability of drilling rigs, qualified labor and equipment necessary to undertake such developments.
Longtime TES subscribers are aware that one of the companies I follow most closely is oil services giant Schlumberger. Schlumberger, the largest oil services firm in the world, is working in every conceivable oil- or gas-producing country in the world.
It also has at least some exposure to most of the world’s highest-profile oil and gas projects, both on- and offshore. In short, Schlumberger has an unparalleled bird’s eye view of the industry.
In its third quarter conference call, an analyst asked Schlumberger CEO Andrew Gould what the biggest challenge the industry faces is. Gould replied:
Source: Schlumberger, Third Quarter Conference Call, Oct. 19, 2007
Clearly, Schlumberger believes that the biggest challenge to deepwater’s growth is logistics, not willingness to spend. This may be bad news for some producers relying on big new deepwater developments to grow production.
But longer term, it’s great news for companies leveraged to deepwater services and equipment sales. Such firms will have the ability to sell into a supply-constrained market; tight supply and copious demand spells rising prices.
And Gould’s comments also support the view that deepwater spending will actually accelerate generally over the next few years. Consider that one of the biggest constraints on deepwater’s growth in recent years has been the availability of deepwater rigs globally.
There are two main rig types used in deepwater–drillships and semisubmersibles. Drillships look like regular ships and move to a drilling location under their own power. Typically, they’re dynamically positioned; computer-controlled thrusters hold the ships in place during the drilling process.
Modern drillships are capable of drilling in very deep waters. The advantages of drillships include flexibility and maneuverability. Because they move under their own power, they’re appropriate for exploiting even remote reserves.
The main disadvantage: In rough seas, drillships will rock just like any other ship, and thrusters may have a hard time maintaining position. Therefore, they’re typically used in calmer waters.
Semisubmersibles (semis) are essentially a platform with two large pontoons. Semis are towed to a location, and those pontoons are filled with water, sinking the lower part of the rig. Pontoons can be sunk as far as 100 feet beneath the ocean’s surface.
Semis are typically moored and dynamically positioned; the submerged pontoons offer a further level of stability in even the roughest seas. Semis are typically capable of drilling in deeper waters, and their main advantage is stability in rough seas. The main disadvantage: They must be towed to location, so they can be tough to move into remote locations.
Offshore deepwater rigs can be further divided into “generations.” The first deepwater rigs were built back in the 1970s; since that time, they’ve become progressively more advanced. Newer generations of rigs are capable of drilling into deeper waters, offer greater stability and have more-advanced onboard equipment.
Although supplies of both semisubmersible rigs and drillships will remain tight well into the coming decade, there are a number of rigs currently under construction and scheduled for delivery over the next few years. The chart below summarizes major newbuild deepwater rigs scheduled for delivery.
Source: Offshore Magazine 2007 Worldwide MODU Construction/Upgrade Survey
This chart accounts only for brand-new rigs and those undergoing major rebuilds. I also only included rigs capable of drilling in waters more than 2,500 feet deep.
It’s clear that starting in mid-2008, a rash of newbuild drillship and semisubmersible rigs are scheduled for delivery. As Schlumberger noted, it will take some time for these rigs to reach peak efficiency; crews need to become comfortable with rigs and equipment issues, and glitches aren’t uncommon. But there is a wave of new rigs coming.
But I don’t see an oversupply of rigs developing. Most of these newbuild rigs have already been booked under long-term contracts signed by major global producers, so the demand is definitely there to absorb this supply. However, a somewhat more-balanced supply picture will allow producers to finally accelerate deepwater development projects.
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FMC Technologies rallied a total of 90 percent before I finally recommended selling the stock in the Nov. 12 flash alert, Shorting Halliburton.
FMC Technologies is a leader in the subsea equipment business. When producers finish drilling a well, they install a series of pipes and valves on top of the well to control the rate of production.
Because of the shape of this equipment, it’s known as a Christmas tree or simply a tree. In onshore developments, trees are relatively simple devices. Offshore they must be designed to withstand the extreme temperatures and pressures encountered at great depths. Offshore in deepwater developments, trees are typically installed directly on the seafloor and can be controlled remotely from the surface.
And trees aren’t the only sort of subsea equipment that’s necessary when drilling in the deep. While drilling, producers use a device installed on top of the well, known as a blowout preventer (BOP).
BOPs are used to close off a well quickly when changes in reservoir pressure raise the risk that hydrocarbons will flow out of the well in an uncontrollable fashion–a situation known as a blowout. Although producers use BOPs on an offshore, the offshore variety is far more complex and must be capable of dealing with more extreme conditions.
FMC Technologies is a leader in the subsea tree business, controlling around 40 percent of the total subsea tree market. And FMC is even more dominant in the most advanced subsea tree business; these are trees designed for ultra-deepwater environments and offer far higher profit margins for manufacturers.
My positive outlook for FMC is undimmed; I recommended selling the stock only because it had seen a huge run-up, expectations for future growth were sky-high and valuations were stretched on a near-term basis.
In the past 12 months, FMC has won a series of major contracts to build subsea equipment for major deepwater developments. Many of these contracts cover the most profitable advanced subsea trees.
Investors bid the stock up as it became clear that FMC is coming to dominate this business. That makes the stock vulnerable to the slightest whiff of negative news. And because FMC has been among the best performers in the energy equipment industry this past year, it’s also vulnerable to profit-taking at the first sign of a pullback for energy stocks at large.
On a valuation basis, FMC began 2007 trading at less than 20 times trailing earnings; the stock reached a peak valuation of 45 times back in late October. And the stock is now trading at 39 times trailing earnings.
That valuation isn’t quite as stretched as it sounds because FMC has a huge backlog of unfilled orders for 2008 and earnings visibility is extremely high; based on next year’s estimates, the stock is only trading at about 25 times earnings. Earnings growth is likely to remain in the 25 percent range for at least the next three to five years.
The stock is already off its highs and is lower than where I recommended selling. I’d been looking for this as the healthy correction of overly bullish sentiment.
For now, I recommend standing aside FMC Technologies. However, FMC and its major competitor in the subsea tree business, Cooper Cameron (NYSE: CAM), are topping my watch list as possible new recommendations in 2008.
I continue to recommend buying deepwater contract driller Seadrill in the Gushers Portfolio. Seadrill owns one of the world’s largest fleets of drilling rigs—a total of 37 rigs, roughly 14 of which are still under construction.
Nine of these rigs are semisubmersibles, mainly fifth- and sixth-generation rigs capable of drilling in a wide variety of harsh environments and in water up to 10,000 feet deep. Four rigs are drillships; all four of the company’s drillships are rated for ultra-deepwater work.
In addition to that deepwater fleet, Seadrill also owns nine so-called jackup rigs, designed for drilling in shallower waters up to about 400 feet deep. And the driller also owns 15 tender rigs designed to perform tasks such as moving people and equipment on and off rigs and maintenance work.
Clearly, Seadrill’s deepwater fleet is its most valuable asset. Producers are anxious to secure such rigs so that they’re able to undertake planned deepwater developments over the next few years.
But rigs capable of drilling in deepwater are in extraordinarily short supply. Most of the world’s deepwater fleet has already been contracted out through at least the end of 2010. Some contractors have already signed deals that will tie up rigs well into the coming decade.
Although supply of deepwater rigs is set to rise over the next few years, so is demand. Moreover, a deepwater rig takes roughly 1,000 days to build; such large-scale production projects inevitably experience delays.
That’s particularly true when you consider that the world’s shipyards are already working at capacity and experiencing labor and parts shortages. Constrained supply and rising demand spells rising day-rates for Seadrill’s rigs.
Even better, Seadrill is in a position to sign contracts at truly stellar day-rates because the company is among the only in the world with available rig capacity in the next few years. Specifically, Seadrill’s West Eminence semisubmersible rig is scheduled for delivery in the fourth quarter of 2008 but currently has no contract. This is a sixth-generation, harsh environment rig–exactly the sort of unit that’s in highest demand right now.
The West Taurus semi scheduled for delivery in late 2008 is a fifth-generation rig but also has no contract signed yet. And a bit further down the line in mid-2010, the West Orion semi and West Gemini ultra-deepwater drillship will be available; neither rig has a contract.
As producers scramble to claim the few available rigs on the market today, day-rates are likely to rise even further from current levels. Although Seadrill isn’t a cheap stock as the company signs new contracts for its newbuild rigs, I see further upside catalysts for the stock.
My biggest mistake in playing deepwater was not adding Transocean to the portfolios alongside FMC and Seadrill. Although I recommended the stock and explained its business at great length in the Jan. 3 issue, I stated that I preferred Seadrill.
My reasons were twofold. First, Transocean had fewer rigs uncommitted to contracts; therefore, it had less upside leverage to rising day-rates.
Second, Transocean’s management team had already paid down most of the drillers debts but seemed unwilling to return cash to shareholders in the form of a special dividend. With the company’s free cash flows all but guaranteed by existing signed contracts, I saw no reason for Transocean not to be returning more cash to investors.
The first point remains valid: Seadrill will see faster growth in coming years as the company signs contracts at high rates.
However, I was wrong on the second point. In midyear, Transocean announced a deal to acquire Global SantaFe. As part of that acquisition, Transocean paid a nice $33.03 cash dividend to its investors.
This deal helped Transocean to become the fifth best-performing stock in the Philadelphia Oil Services Index last year, up about 70 percent. This return was enough to beat Seadrill, up just under 50 percent over the same time period.
At any rate, I’m not ready to add Transocean at this time. However, I’m eyeing another offshore driller, Diamond Offshore (NYSE: DO), as a possible addition in the new year. Diamond has an excellent offshore fleet and has been the most proactive of any of the drillers in terms of returning cash to shareholders.
Diamond has been paying all its excess cash to shareholders as a series of special dividends. In 2007, those dividends totaled more than $5.50 per share; dividends are likely to rise in 2008 and 2009 as some of Diamond’s rigs go off existing contracts and start working on new projects at much higher day-rates. Diamond is currently being tracked in the How They Rate Table as a hold.
The other deepwater plays I have on my watch list are the engineering and construction firms I outlined in the Dec. 5 issue, Engineering and Construction. Acergy (Norway: ACY; NSDQ: ACGY), Saipem (Italy: SPM; OTC: SAPFF), SBM Offshore (Netherlands: SMBO; OTC: SBFFF) and Subsea 7 (Norway: SUB; OTC: SBEAF) are the four that top my list; see the above-referenced issues for detailed explanations of the sector and these four stocks.
One final stock worth mentioning as a play on deepwater is Smith International (NYSE: SII). This company’s drilling fluids business is highly leveraged to offshore developments and complex drilling projects outside of North America.
Finally, note that although I recommended taking a big profit in Schlumberger earlier last year, I’m looking for an opportunity to re-enter the stock. And Weatherford (NYSE: WFT) remains my favorite oil services name right now.
The company is the fastest-growing oil services name in my coverage universe. And trading at less than 16 times 2008 earnings estimates compared to 19.5 for Schlumberger, the stock continues to represent great value.
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My rationale for recommending coal stocks was simple: Expectations surrounding the group were too negative given the fundamentals, and investors were too bearish.
At the beginning of 2007, coal inventories in the US were bloated mainly because of a warm winter in 2005-06. This warm winter meant lower demand for electricity and lower coal burn; inventories of coal at the nation’s utilities soared. However, electricity demand has normalized in 2007, implying greater demand for coal.
At the same time, coal supplies have been contracting. A series of new environmental and safety regulations have made it far more difficult to mine coal in Appalachia, a key center of US coal production. Chief among these new regulations was a decision by the Mine Safety and Health Administration (MSHA), part of the US Dept of Labor, to drastically change the regulations governing how mines are sealed.
Basically, in underground mines, abandoned sections of mines are sealed off from the rest of the mine. This is to prevent any dangerous gases from moving from these sections to areas that are being mined. These seals are far more expensive than older seals used in underground mines; the new regulations meant that some higher cost mines in the East have closed.
MSHA is also requiring more frequent safety inspections and appears to have become stricter in terms of enforcement actions. Often, safety inspections require that mines are temporarily closed.
Also, a decision by a judge earlier in the year effectively shut down the practice of mountaintop mining, at least for some producers. The judge’s ruling changed the way mining companies can dispose of dirt and debris from such mines. This also negatively affected production in the eastern US.
The combination of rising demand and tightening supplies has started to bring coal inventories back down from their highs earlier in the year. Coal prices are firming up, and coal stocks are rallying on the news.
In addition, there’s a new catalyst for the coal mining firms: rapidly growing foreign demand. Check out the chart below.
Source: The Energy Strategist, EIA
This chart shows US coal imports and exports over the past seven quarters. The trend here is clear: Exports of coal have been rising steadily since the beginning of 2007. Meanwhile, imports into the US market have been falling steadily for over a year. The result is net US exports are on the rise.
There are a few reasons for this. One is simply that the fall in the value of the US dollar makes US coal cheap in foreign currency terms. Therefore, utilities in places such as Europe find that cheap, abundant US coal represents a great value.
But the more important reason is simply surging foreign demand. The primary swing market for US coal right now is Europe.
Despite all the talk to the contrary, coal is still a very important part of the European electric grid. Coal accounts for about 50 percent of Germany’s electricity production, 34 percent in the UK, 17 percent in Italy and a whopping 93 percent in Poland.
Europe is also a big steel producer. Producing steel requires the use of a high-quality coal known as coking or metallurgical coal.
Europe doesn’t have enough coal production locally to satisfy demand. Coal has traditionally been imported from places such as South Africa or even Australia. This coal, often called seaborne coal, is carried on dry-bulk carrier ships.
But there’s a problem with that. China is now a net importer of coal for the first time in the nation’s history, and demand is exploding because of rapid economic growth and development. Meanwhile, India is also becoming an increasingly big exporter.
Australia and Indonesia, the world’s two largest coal exporters, are having a tough time ramping up production enough to keep pace with the new wave of demand. The result: Most available shipments of seaborne coal are finding their way to Asia at sky-high prices.
China’s decision last month to eliminate import tariffs on coal and add new export tariffs will just serve to accelerate this trend even further. Clearly, the Chinese government wants to keep Chinese coal in China and encourage imports.
That leaves Europe short of coal. So, for the first time in more than a decade, European utilities are actually contracting with US producers to buy coal under long-term contracts. European buyers are willing to pay prices for thermal (power plant) and met coal that are far above what’s available on the local US market.
Wildcatter Portfolio recommendation Consol Energy (NYSE: CNX) recently announced that it’s signed deals with European buyers for three-year terms. Management is now in talks for even longer-term deals with European companies.
This is a huge shift. Traditionally, Europeans have only done short-term spot deals covering one-off shipments of coal from the US. The fact that they now want to make longer-term deals at higher prices suggests they’re desperate to secure coal supplies. The result is further upward pressure on demand for US coal.
This is all bullish for my three coal mining recommendations: Consol Energy, Peabody Coal (NYSE: BTU) and MacArthur Coal (Australia: MCC). These stocks are up 67 percent, 51 percent and 50 percent, respectively.
Peabody is the largest dedicated coal mining firm in the US. The stock is attractive thanks to its vast exposure to the US Powder River Basin, a prolific, low-cost, coal-producing basin.
This region isn’t as exposed to new MSHA regulations and hasn’t been as heavily depleted as mines in Appalachia. And via a spin-off in late October, Peabody has eliminated its exposure to less-attractive mines in the east.
Peabody also bought a major Australian producer and exporter, Excel Coal, in 2005. This gives the company direct exposure to surging Asian coal demand. Peabody is the world’s premier coal play, and valuations have risen along with the stock in anticipation of continued firming of global coal markets.
I don’t think the run is over, however. The rise in coal prices is only starting to get noticed in the popular press, and I expect to hear news of new coal export deals as we head into the new year.
Peabody Coal remains a buy despite the big run-up in the stock. For those looking to protect big gains, I’m raising my recommended stop.
MacArthur Coal owns a series of coal mines in the Bowen Basin of Queensland, Australia. Macarthur does produce some thermal coal, but its primary product is pulverized coal injection (PCI) coal. Basically, PCI coal is crushed and injected directly into steel blast furnaces; it can be used as a partial replacement for met coal.
Interesting, MacArthur Coal produces nearly half the entire Australian export supply of PCI coal. Buy MacArthur Coal up to its new target of AUD10.25.
Consol is the largest coal exporter in the US, so it stands to benefit handsomely from rising demand as well. In addition, Consol has large reserves of high-sulphur coal, a product that’s seeing demand rise as more utilities install scrubbers.
I still see additional upside for Consol Energy, but given its meteoric rise, I’m cutting the stock to a hold in the Wildcatters Portfolio. New subscribers should consider jumping into Peabody Coal and MacArthur Coal instead.
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In the longer term, my recommended plays in uranium have been big winners. But over the past year, it’s been a story of boom-and-bust with mixed results. It’s high time I updated the recommendations.
In the July 26, 2006, issue, I inaugurated my uranium field bet, a mini-portfolio of higher-risk stocks designed to play the boom in uranium demand and pricing. Uranium mining is a risky business. Production delays, unforeseen project cost, and simple labor and raw materials inflation can all have important effects on the economics of a particular mining project. And production costs vary wildly depending on the grade of ore mined and how large overall reserves are.
Riskier still is exploration. Uranium explorers buy acreage and drill holes, taking core samples to evaluate reserve size and ore grades.
Sometimes even the most-promising reserves just don’t pan out and can never reach economic production. It’s impossible to know this for sure until you’ve spent considerable sums on exploration; only once uranium is produced can we really know for sure the full costs and viability of a project.
To account for this higher level of risk, I’m recommending that risk-tolerant investors take a more diversified approach to playing the junior uranium producers and exploration companies. Specifically, you must recognize that no matter how careful your selection criteria, some promising uranium exploration stories will never work out.
Fortunately, there are high rewards to be found in this sector as well. Famed mutual fund manger Peter Lynch used to look for what he called ten-baggers–companies with the potential to earn investors 1,000 percent or more on their investment. Obviously, you don’t need many ten-baggers to make a solid return and make up for the inevitable losing plays.
If my bullish thesis on uranium prices and nuclear power is even half correct, I suspect there will be many ten-baggers among the uranium juniors during the next few years. In fact, in just the past year, The Energy Strategist has produced returns of as much as 245 percent on recommended uranium junior mining stocks.
For the best chance at big returns, I recommend casting a wide net. Instead of just buying one or two high-risk names, I recommend placing a smaller amount in five to 10 such companies. I call this the uranium field bet. Here’s the current list:
Source: The Energy Strategist
At first glance, this table looks fairly positive for the uranium field bet, even on a year-to-date basis. After all, a 17.4 percent gain isn’t bad compared to the S&P 500’s 5.5 return in 2007. And since its inauguration, the uranium field bet has certainly trounced the S&P and most energy-related indexes with an 80 percent-plus gain.
But the reality is that most uranium mining stocks rallied strongly into about April or May and then sold off precipitously through early fall. The charts of field bet recommendations Uranium One and Paladin Resources below illustrate the basic pattern from the field bet’s inception through the end of 2007.
Source: StockCharts.com
Source: StockCharts.com
Note the inverted “U” shape of both charts. In addition, these charts serve to illustrate just how volatile uranium mining stocks can be. This is precisely why I recommend as a field bet and not as stand-alone plays.
The longer-term fundamental case for uranium is intact in my view. I highlighted the bullish case at great length in the July 18 issue, so I won’t rehash all those arguments here. Suffice it to say that nuclear power is the only truly large-scale, baseload power source that produces no direct emissions of pollutants such as sulphur dioxide, nitrous oxides, mercury or so-called greenhouse gases.
I’m not here to save the planet; rather, the goal of TES is to generate profits in the energy markets. As such, it’s not really my place to comment on the global warming debate; opinions differ as to the extent of the problem.
What I can tell you is that governments the world over are passing legislation to control greenhouse gas emissions. Investors can’t afford to ignore this trend.
Nuclear power is also cheap. Eighty percent of the cost of electricity generated from natural gas is the cost of the natural gas itself; rising natural gas prices mean soaring electricity prices. For nuclear, a doubling in the price of uranium produces only a roughly 9 percent jump in the cost of nuclear-generated power.
These facts are starting to become more widely recognized. China is in the process of a rapid nuclear build-out that will mean 40 new reactors by 2025. Russia plans a similar build-out as that nation seeks to diversify its generation capacity away from heavy reliance on natural gas. And India also has big plans for a nuclear build-out to meet burgeoning demand.
In the developed world, opposition to nuclear power is melting away. Highly respected environmentalists are going pro-nuclear, recognizing that it’s the only reliable way to reduce carbon emissions.
And the US and other governments are starting to offer incentives for utilities to build the first new fleet of reactors in decades. For example, the US Energy Act of 2007, signed in the waning days of last year, offered loan guarantees for new nuclear plants that could total as much as $25 billion. This makes it more likely that plants already pending construction permits will actually be built in the coming decades. This surge in new reactor building spells more demand for uranium.
Meanwhile, uranium mines aren’t keeping pace with demand. Global mines only produced 60 to 70 percent of the uranium used in plants last year. Secondary sources of uranium such as government stockpiles are now winding down.
I fully believe that these long-term fundamentals are intact. This is what’s been driving uranium prices and uranium mining stocks sharply higher over the past few years.
My mistake with the nuclear field bet in 2007 was to pay too little attention to shorter-term concerns. During the big uranium run-up in the first half of 2007, I recommended taking partial profits off the table in some of our biggest winners. For example, in the March 5 flash alert, The Selloff, I advised taking a third of your position off the table in four of the most extended field bet picks. I reiterated that recommendation on a few occasions.
And in the June 6 issue, Looking Back, Looking Forward, I advised selling out of Energy Metals to take a more than 240 percent gain. The stock was acquired in August by fellow field bet pick Uranium One (TSX: UUU, OTC: SXRZF), and I didn’t feel it was prudent to be double-weighted in this stock.
This is a key aspect of the field bet strategy. Specifically, the three field bets recommended in TES–uranium, biofuels and alternatives–are all long-term, multi-year themes to which I believe you should retain exposure.
However, even the strongest bull markets see pullbacks and corrections in the context of multi-year uptrends. Therefore, I will typically recommend taking some profits off the table after big run-ups and then adding exposure during pullbacks. Over time, I believe this strategy offers a shot at the best possible returns with the least possible risk.
However, I wasn’t aggressive enough in taking gains off the table during the big run-up because I didn’t expect the subsequent selloff to be quite as dramatic as it was during the summer months. My mistake was to be overly complacent about a trend that I believe still has legs. Those subscribers who did follow my advice with the partial sales were rewarded with gains well above what the table above suggests.
As for the current situation, the primary problems hampering the uranium mining stocks lately have been related to the spot market for uranium. Check out the chart of spot uranium prices below.
Source: Bloomberg
The spot market is the price a buyer would pay for immediate delivery of uranium. It’s quoted in terms of dollars per pound of U-308, which is natural uranium oxide.
Spot prices give us a good indication of supply and demand in the uranium markets. But it’s important to remember that the spot market is truly tiny, accounting for 10 to 20 percent of traded uranium at best.
Most uranium is bought and sold under long-term contracts between utility customers and mining firms. These longer-term contracts are signed at fixed prices or a hybrid contract that allows for floating prices with pre-set floors and ceilings.
The spot market really isn’t as important as some make it out to be; however, it does affect sentiment surrounding uranium. Moreover, note that, although uranium prices are still up more than 25 percent over the past year, the June-September drop was precipitous.
This is particularly true when you consider that, until June of last year, uranium spot prices hadn’t seen a week-over-week decline for several years. This spooked traders and accounts for most of the selloff in uranium mining stocks after midyear.
There are a few lingering concerns in the spot market. One is simply a lack of volume traded. Volume in the uranium spot market is always thin, but it was particularly nonexistent during the height of the summer selling. This was because some buyers simply left the market, refusing to pay more than $130 per pound for U-308.
In addition, there have been some cash-motivated sellers in the market in recent months. The list would include a significant auction of US government stocks by the Dept of Energy, which was completed in September.
In addition, speculative buyers such as hedge funds have been buyers of uranium in recent years. There’s been a lingering concern that these so-called discretionary buyers would have to sell down their holdings to raise cash in the midst of the global credit crunch.
As ridiculous as it sounds, the weakening credit market did have an effect on uranium spot prices. And it does appear that these discretionary buyers stepped away from the spot market over the summer.
Although uranium prices have recovered nicely off their lows around $75 per pound in September, there remain some concerns that have been capping recent rallies. One is a dispute between the US and Russia.
In early December, the US and Russia reached a preliminary accord that would allow Russia to continue exporting uranium to the US after the current Megatons to Megawatts program expires in 2013. The program was set up to sell reprocessed Russian nuclear warhead material to US utilities as a fuel for plants.
The new agreement would provide quotas on uranium imports into the US. These would be direct exports to US utilities rather than reprocessed nuclear material sent through America’s only nuclear enrichment company, USEC. There’s been some concern that this may eventually result in larger Russian supplies entering the US than under the current agreement.
However, I think these fears are overblown. The reality is that rising demand for uranium will mean that US utilities are competing with China, Japan, France and other major uranium consumers for available supply. No matter what the final form of the US-Russia deal is, there will be plenty of demand to absorb Russian supply.
My view remains that we’re just seeing shorter-term hiccups in a longer-term uptrend for uranium prices. Mine production isn’t keeping pace with demand; prices will need to remain elevated to encourage new production.
These uranium spot issues are the primary reason for the recent pullback in uranium mining stocks. However, there are some stock-specific issues worth mentioning as well.
Paladin Resources (TSX: PDN; Australia: PDN, OTC: PALAF) is a small uranium mining firm with actual production. The firm’s most advanced mine is the Langer Heinrich uranium project located in the African nation of Namibia, which is on the southern tip of Africa along the west coast.
Langer Heinrich produced roughly 650,000 pounds of uranium oxide in the fourth quarter of 2007. This was under Paladin’s original quarter expectations for 900,000 pounds. The company experienced a series of minor bottlenecks and bugs when ramping up the project throughout 2007.
But such bugs are to be expected in the mining business. Even the world’s largest uranium mining firms such as Cameco (NYSE: CCJ), BHP Billiton and Rio Tinto have experienced delays and problems with their mines from time to time.
Langer Heinrich is an in-situ leach mine (ISL); this form of mining involves pumping water and special chemicals into the ground. This water actually dissolves uranium and is pumped back to the surface as a so-called pregnant liquid. Pregnant liquid is then dried, and the uranium separated.
As you can imagine, this procedure involves a number of steps. It can take a few months after a mine is started up to work out minor kinks and bottlenecks.
At any rate, Paladin expects to have the Langer Heinrich facility operating at its full-rated capacity of 2.6 million pounds per annum for 2008. In addition, Paladin has scheduled a series of add-on projects to increase maximum production from this mine to 3.7 million pounds per annum sometime after 2009.
Paladin’s second major project is its 85 percent owned Kayelekara ISL mine in Malawi, a landlocked country in southern Africa. The project is scheduled to start production late in 2008.
Paladin’s management believes the company could produce around 9 million pounds of uranium from Langer Heinrich and Kayelekara combined in calendar year 2009. This would place Paladin among the world’s largest uranium mining firms. Paladin Resources rates a buy.
Uranium One (TSX: UUU, OTC: URPTF) has a number of producing or near-producing uranium mines in the US, Asia, Australia, Africa and Canada.
The company’s Dominion mine in South Africa began actual production in 2007 and is eventually expected to become one of the world’s largest mines. Uranium One is looking to produce 3.8 million pounds of uranium per year from the mine by the time it hits full maximum production by around 2011.
The Dominion mine isn’t a brand new mine but a reserve that was heavily explored and produced during the ’50s through the ’80s. This is beneficial because the mine is a known producer and the geology is well understood. The mine was closed when uranium prices collapsed in the ’80s and sentiment surrounding nuclear power soured.
In the US, the company has a number of near-producing uranium assets throughout the southeast. In particular, Uranium One has plans to begin production at its Texas properties in 2008, with Wyoming and Utah projects expected to come online by the end of this decade.
The stock was hit hard in October 2007 after management announced updated production guidance that disappointed many investors. Specifically, management cut estimates for 2007 production from 2.5 million pounds to just 2.1 million pounds per day mainly because of delays in ramping up its massive Dominion project.
Even more disappointing is the fact that Uranium One slashed its 2008 production guidance from 7.4 million pounds of uranium to just 4.6 million pounds. This cut was the result of a shortage of sulphuric acid at some of its mines in Kazakhstan; this acid is used to dissolve uranium in ISL projects.
But I’m not overly concerned about any of these shortfalls. As noted earlier, mining projects are prone to delay; this is just the nature of the mining business. And the reasons management cited for forecasting a production shortfall have nothing to do with the quality of Uranium One’s mines and reserves.
Longer term, these problems won’t effect the company’s ability to become one of the world’s largest uranium producers. In fact, Uranium One believes it will see production ramp up to 8 million pounds per day in 2008 and 11 million in 2010. Buy Uranium One.
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Source: The Energy Strategist
* Returns from original 05/02/07 recommendation date. + Returns from original 01/24/07 recommendation date.
Source: The Energy Strategist
I just covered the biofuels field bet at great length in the Sept. 19 issue, Down on the Farm; I won’t repeat all my arguments here. Suffice it to say that the agriculture industry is benefiting from two key trends: rising meat consumption in the developing world and the booming biofuels industry.
As to the first point, meat consumption per capita tends to rise the wealthier a country becomes. China, for example, is seeing booming meat consumption, which means more grains are needed to feed livestock.
On the second point, the recently signed US Energy Act massively ramps up the biofuels mandate. The new law requires that the nation use 36 billion gallons of biofuels by 2022, up from the c
And the three The Energy Strategist portfolios largely outperformed their benchmarks for 2007. The conservative, income-oriented Proven Reserves Portfolio managed a gain of 13.1 percent, despite unprecedented volatility in most income-oriented stocks since the credit crunch first struck last summer. The growth-oriented Wildcatters and aggressive growth Gushers portfolios managed total returns of 48.7 percent and 55 percent, respectively.
I started tracking the three main portfolios separately at the end of the second quarter in 2006; the chart below shows the relative performance of the three TES portfolios and some common industry benchmarks.
Source: The Energy Strategist, Bloomberg
In This Issue
With the books now closed on 2007, it’s an opportune time to reflect and review some of our key calls and investing themes. In this issue, I’ll review some of the year’s most memorable recommendations and calls, both those that turned out profitably and those that didn’t work out quite as well as expected. I’ll also take a closer look at the current positioning in the portfolios and some of the key themes and stocks on my watch list as we head into the new year.One of the longest-standing themes in TES is deepwater drilling. One of my favorite players provided a great outlook for 2008, and I see several indicators as well that this year will be another interesting year for drillers. See Deepwater Boom.
My four basic ideas for playing deepwater drilling have fared well last year. Although some outran my original expectations, I still see all as solid plays and will look to jumping into previous positions, as well as some new ones, throughout the upcoming year. See Playing Deepwater.
Three of my Portfolio recommendations have done very well as foreign demand for US coal has risen in the past year. These plays continue to supply niche markets and expand into foreign mines as well, increasing the opportunity for gain in 2008. See Coal.
The nuclear field bet was the first one I issued to play the risky market of uranium. With gains up to 240 percent, these uranium producers still appear to be moving at a solid clip. I provide a couple forecasts below. See Uranium and Nuclear Power.
Equally important are my biofuels and alternatives field bets. The US Energy Act of 2007 has certainly placed importance on the use of biofuels in years to come, and I see advantages from government subsidies in the alternative field bet as well. See Biofuels and Alternatives.
Deepwater Boom
It’s only fitting that the first theme covered in this issue was the topic of the first issue of 2007—the Jan. 3 issue, The Deep End.Of course, that wasn’t the first issue in which I covered this topic. Growth in deepwater exploration, drilling activity and spending has been one of the longest-standing themes in TES. In fact, the boom in deepwater production goes hand in hand with another core long-standing theme in this newsletter–the end of “easy” oil.
Simply put, the large onshore fields that have met the world’s oil demand for decades are now mature and already seeing declining production. To offset declines from these easy-to-produce oil (and gas) fields, producers will increasingly target smaller, more-complex fields, as well as fields that are harder and more expensive to reach.
In other words, the world isn’t running out of oil, but we’re already seeing the end of “easy” oil. Targeting these more-complex fields will require the application of sophisticated new technologies and techniques.
In addition, the era of cheap oil is over. To make the production of “hard” oil economically viable, prices will need to remain elevated.
Deepwater is a prime example of what I mean by “hard” oil. No producer would bother spending billions of dollars on a deepwater oil project if it could simply and easily ramp up production from existing oilfields. But deepwater is one of the final regions of the globe where there are large, untapped reserves of oil and gas to be exploited.
Most of the biggest oil and gas finds over the past few years have been in the deepwater. Chevron Corp’s (NYSE: CVX) successful test of its deepwater Jack field in the Gulf of Mexico in late 2006 and Petrobras’ more recent find of the deepwater Tupi field are just two prominent examples.
To make a long story short, according to Offshore Magazine and a recent survey published by energy analysts Douglas-Westwood, total global deepwater oil production will grow from 4.5 million barrels per day in 2007 to more than 8 million barrels per day in 2011. Over the same time period, deepwater gas production will nearly double from 1.6 million barrels of oil equivalent per day (boe/d) to some 3 million boe/d in 2011.
And for the US, check out the chart below.
Source: Energy Information Administration (EIA)
This chart shows US deepwater oil production as a percent of total oil production over the past decade, with projections out to 2030. As you can see, deepwater production accounted for just less than 24 percent of total US production in 2007 and is projected to grow to more than 35 percent of the total by 2030.
With all the growth potential of deepwater, it should come as no surprise that producers have been spending more on deepwater developments and exploration in recent years. Moreover, surveys of exploration and production (E&P) companies consistently show that deepwater is one area where most companies intend to continue to boost their spending.
In fact, if anything, the world’s producers would like to spend more on deepwater developments but are constrained by the lack of availability of drilling rigs, qualified labor and equipment necessary to undertake such developments.
Longtime TES subscribers are aware that one of the companies I follow most closely is oil services giant Schlumberger. Schlumberger, the largest oil services firm in the world, is working in every conceivable oil- or gas-producing country in the world.
It also has at least some exposure to most of the world’s highest-profile oil and gas projects, both on- and offshore. In short, Schlumberger has an unparalleled bird’s eye view of the industry.
In its third quarter conference call, an analyst asked Schlumberger CEO Andrew Gould what the biggest challenge the industry faces is. Gould replied:
I think the constraints on logistics, and it’s really an end of 2008 problem, but the idea that the industry is going to ramp up 146 offshore rigs in a period of 18 months without a considerable loss in drilling efficiency is quite difficult for me to imagine…offshore growth is going to be limited by the number of new rigs coming on to the market in the first three quarters [of 2008].
Source: Schlumberger, Third Quarter Conference Call, Oct. 19, 2007
Clearly, Schlumberger believes that the biggest challenge to deepwater’s growth is logistics, not willingness to spend. This may be bad news for some producers relying on big new deepwater developments to grow production.
But longer term, it’s great news for companies leveraged to deepwater services and equipment sales. Such firms will have the ability to sell into a supply-constrained market; tight supply and copious demand spells rising prices.
And Gould’s comments also support the view that deepwater spending will actually accelerate generally over the next few years. Consider that one of the biggest constraints on deepwater’s growth in recent years has been the availability of deepwater rigs globally.
There are two main rig types used in deepwater–drillships and semisubmersibles. Drillships look like regular ships and move to a drilling location under their own power. Typically, they’re dynamically positioned; computer-controlled thrusters hold the ships in place during the drilling process.
Modern drillships are capable of drilling in very deep waters. The advantages of drillships include flexibility and maneuverability. Because they move under their own power, they’re appropriate for exploiting even remote reserves.
The main disadvantage: In rough seas, drillships will rock just like any other ship, and thrusters may have a hard time maintaining position. Therefore, they’re typically used in calmer waters.
Semisubmersibles (semis) are essentially a platform with two large pontoons. Semis are towed to a location, and those pontoons are filled with water, sinking the lower part of the rig. Pontoons can be sunk as far as 100 feet beneath the ocean’s surface.
Semis are typically moored and dynamically positioned; the submerged pontoons offer a further level of stability in even the roughest seas. Semis are typically capable of drilling in deeper waters, and their main advantage is stability in rough seas. The main disadvantage: They must be towed to location, so they can be tough to move into remote locations.
Offshore deepwater rigs can be further divided into “generations.” The first deepwater rigs were built back in the 1970s; since that time, they’ve become progressively more advanced. Newer generations of rigs are capable of drilling into deeper waters, offer greater stability and have more-advanced onboard equipment.
Although supplies of both semisubmersible rigs and drillships will remain tight well into the coming decade, there are a number of rigs currently under construction and scheduled for delivery over the next few years. The chart below summarizes major newbuild deepwater rigs scheduled for delivery.
Source: Offshore Magazine 2007 Worldwide MODU Construction/Upgrade Survey
This chart accounts only for brand-new rigs and those undergoing major rebuilds. I also only included rigs capable of drilling in waters more than 2,500 feet deep.
It’s clear that starting in mid-2008, a rash of newbuild drillship and semisubmersible rigs are scheduled for delivery. As Schlumberger noted, it will take some time for these rigs to reach peak efficiency; crews need to become comfortable with rigs and equipment issues, and glitches aren’t uncommon. But there is a wave of new rigs coming.
But I don’t see an oversupply of rigs developing. Most of these newbuild rigs have already been booked under long-term contracts signed by major global producers, so the demand is definitely there to absorb this supply. However, a somewhat more-balanced supply picture will allow producers to finally accelerate deepwater development projects.
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Playing Deepwater
This bullish thesis on deepwater, outlined in the Jan. 3 issue, was a big winner for TES in 2007. In that issue, I recommended four basic groups to play the trend:- Deepwater-focused contract drillers. These are companies that own semisubmersible and drillship rigs. Contract drillers don’t own oil or natural gas reserves but simply lease rigs to producers for a pre-set daily fee known as a day-rate.
- Oil and gas services. These companies perform services related to exploration and development of deepwater reserves.
- Equipment. Producing deepwater fields requires the use of specialized equipment such as subsea pipelines and a network of valves and pipes known as a subsea tree.
- Producers with deepwater plays. Companies with access to promising deepwater reserves will benefit from the potential for rapid production growth in coming years.
FMC Technologies rallied a total of 90 percent before I finally recommended selling the stock in the Nov. 12 flash alert, Shorting Halliburton.
FMC Technologies is a leader in the subsea equipment business. When producers finish drilling a well, they install a series of pipes and valves on top of the well to control the rate of production.
Because of the shape of this equipment, it’s known as a Christmas tree or simply a tree. In onshore developments, trees are relatively simple devices. Offshore they must be designed to withstand the extreme temperatures and pressures encountered at great depths. Offshore in deepwater developments, trees are typically installed directly on the seafloor and can be controlled remotely from the surface.
And trees aren’t the only sort of subsea equipment that’s necessary when drilling in the deep. While drilling, producers use a device installed on top of the well, known as a blowout preventer (BOP).
BOPs are used to close off a well quickly when changes in reservoir pressure raise the risk that hydrocarbons will flow out of the well in an uncontrollable fashion–a situation known as a blowout. Although producers use BOPs on an offshore, the offshore variety is far more complex and must be capable of dealing with more extreme conditions.
FMC Technologies is a leader in the subsea tree business, controlling around 40 percent of the total subsea tree market. And FMC is even more dominant in the most advanced subsea tree business; these are trees designed for ultra-deepwater environments and offer far higher profit margins for manufacturers.
My positive outlook for FMC is undimmed; I recommended selling the stock only because it had seen a huge run-up, expectations for future growth were sky-high and valuations were stretched on a near-term basis.
In the past 12 months, FMC has won a series of major contracts to build subsea equipment for major deepwater developments. Many of these contracts cover the most profitable advanced subsea trees.
Investors bid the stock up as it became clear that FMC is coming to dominate this business. That makes the stock vulnerable to the slightest whiff of negative news. And because FMC has been among the best performers in the energy equipment industry this past year, it’s also vulnerable to profit-taking at the first sign of a pullback for energy stocks at large.
On a valuation basis, FMC began 2007 trading at less than 20 times trailing earnings; the stock reached a peak valuation of 45 times back in late October. And the stock is now trading at 39 times trailing earnings.
That valuation isn’t quite as stretched as it sounds because FMC has a huge backlog of unfilled orders for 2008 and earnings visibility is extremely high; based on next year’s estimates, the stock is only trading at about 25 times earnings. Earnings growth is likely to remain in the 25 percent range for at least the next three to five years.
The stock is already off its highs and is lower than where I recommended selling. I’d been looking for this as the healthy correction of overly bullish sentiment.
For now, I recommend standing aside FMC Technologies. However, FMC and its major competitor in the subsea tree business, Cooper Cameron (NYSE: CAM), are topping my watch list as possible new recommendations in 2008.
I continue to recommend buying deepwater contract driller Seadrill in the Gushers Portfolio. Seadrill owns one of the world’s largest fleets of drilling rigs—a total of 37 rigs, roughly 14 of which are still under construction.
Nine of these rigs are semisubmersibles, mainly fifth- and sixth-generation rigs capable of drilling in a wide variety of harsh environments and in water up to 10,000 feet deep. Four rigs are drillships; all four of the company’s drillships are rated for ultra-deepwater work.
In addition to that deepwater fleet, Seadrill also owns nine so-called jackup rigs, designed for drilling in shallower waters up to about 400 feet deep. And the driller also owns 15 tender rigs designed to perform tasks such as moving people and equipment on and off rigs and maintenance work.
Clearly, Seadrill’s deepwater fleet is its most valuable asset. Producers are anxious to secure such rigs so that they’re able to undertake planned deepwater developments over the next few years.
But rigs capable of drilling in deepwater are in extraordinarily short supply. Most of the world’s deepwater fleet has already been contracted out through at least the end of 2010. Some contractors have already signed deals that will tie up rigs well into the coming decade.
Although supply of deepwater rigs is set to rise over the next few years, so is demand. Moreover, a deepwater rig takes roughly 1,000 days to build; such large-scale production projects inevitably experience delays.
That’s particularly true when you consider that the world’s shipyards are already working at capacity and experiencing labor and parts shortages. Constrained supply and rising demand spells rising day-rates for Seadrill’s rigs.
Even better, Seadrill is in a position to sign contracts at truly stellar day-rates because the company is among the only in the world with available rig capacity in the next few years. Specifically, Seadrill’s West Eminence semisubmersible rig is scheduled for delivery in the fourth quarter of 2008 but currently has no contract. This is a sixth-generation, harsh environment rig–exactly the sort of unit that’s in highest demand right now.
The West Taurus semi scheduled for delivery in late 2008 is a fifth-generation rig but also has no contract signed yet. And a bit further down the line in mid-2010, the West Orion semi and West Gemini ultra-deepwater drillship will be available; neither rig has a contract.
As producers scramble to claim the few available rigs on the market today, day-rates are likely to rise even further from current levels. Although Seadrill isn’t a cheap stock as the company signs new contracts for its newbuild rigs, I see further upside catalysts for the stock.
My biggest mistake in playing deepwater was not adding Transocean to the portfolios alongside FMC and Seadrill. Although I recommended the stock and explained its business at great length in the Jan. 3 issue, I stated that I preferred Seadrill.
My reasons were twofold. First, Transocean had fewer rigs uncommitted to contracts; therefore, it had less upside leverage to rising day-rates.
Second, Transocean’s management team had already paid down most of the drillers debts but seemed unwilling to return cash to shareholders in the form of a special dividend. With the company’s free cash flows all but guaranteed by existing signed contracts, I saw no reason for Transocean not to be returning more cash to investors.
The first point remains valid: Seadrill will see faster growth in coming years as the company signs contracts at high rates.
However, I was wrong on the second point. In midyear, Transocean announced a deal to acquire Global SantaFe. As part of that acquisition, Transocean paid a nice $33.03 cash dividend to its investors.
This deal helped Transocean to become the fifth best-performing stock in the Philadelphia Oil Services Index last year, up about 70 percent. This return was enough to beat Seadrill, up just under 50 percent over the same time period.
At any rate, I’m not ready to add Transocean at this time. However, I’m eyeing another offshore driller, Diamond Offshore (NYSE: DO), as a possible addition in the new year. Diamond has an excellent offshore fleet and has been the most proactive of any of the drillers in terms of returning cash to shareholders.
Diamond has been paying all its excess cash to shareholders as a series of special dividends. In 2007, those dividends totaled more than $5.50 per share; dividends are likely to rise in 2008 and 2009 as some of Diamond’s rigs go off existing contracts and start working on new projects at much higher day-rates. Diamond is currently being tracked in the How They Rate Table as a hold.
The other deepwater plays I have on my watch list are the engineering and construction firms I outlined in the Dec. 5 issue, Engineering and Construction. Acergy (Norway: ACY; NSDQ: ACGY), Saipem (Italy: SPM; OTC: SAPFF), SBM Offshore (Netherlands: SMBO; OTC: SBFFF) and Subsea 7 (Norway: SUB; OTC: SBEAF) are the four that top my list; see the above-referenced issues for detailed explanations of the sector and these four stocks.
One final stock worth mentioning as a play on deepwater is Smith International (NYSE: SII). This company’s drilling fluids business is highly leveraged to offshore developments and complex drilling projects outside of North America.
Finally, note that although I recommended taking a big profit in Schlumberger earlier last year, I’m looking for an opportunity to re-enter the stock. And Weatherford (NYSE: WFT) remains my favorite oil services name right now.
The company is the fastest-growing oil services name in my coverage universe. And trading at less than 16 times 2008 earnings estimates compared to 19.5 for Schlumberger, the stock continues to represent great value.
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Coal
Coal recommendations were among the top performers in the TES portfolios last year. I discussed coal on multiple occasions in the newsletter, but the May 2 issue (King Coal), the Sept. 5 issue (Australia, Asia and Coal) and the Nov. 7 issue (Coal and Services) are the most relevant to the topic. I won’t re-hash all my arguments for owning the group, but here’s a brief review.My rationale for recommending coal stocks was simple: Expectations surrounding the group were too negative given the fundamentals, and investors were too bearish.
At the beginning of 2007, coal inventories in the US were bloated mainly because of a warm winter in 2005-06. This warm winter meant lower demand for electricity and lower coal burn; inventories of coal at the nation’s utilities soared. However, electricity demand has normalized in 2007, implying greater demand for coal.
At the same time, coal supplies have been contracting. A series of new environmental and safety regulations have made it far more difficult to mine coal in Appalachia, a key center of US coal production. Chief among these new regulations was a decision by the Mine Safety and Health Administration (MSHA), part of the US Dept of Labor, to drastically change the regulations governing how mines are sealed.
Basically, in underground mines, abandoned sections of mines are sealed off from the rest of the mine. This is to prevent any dangerous gases from moving from these sections to areas that are being mined. These seals are far more expensive than older seals used in underground mines; the new regulations meant that some higher cost mines in the East have closed.
MSHA is also requiring more frequent safety inspections and appears to have become stricter in terms of enforcement actions. Often, safety inspections require that mines are temporarily closed.
Also, a decision by a judge earlier in the year effectively shut down the practice of mountaintop mining, at least for some producers. The judge’s ruling changed the way mining companies can dispose of dirt and debris from such mines. This also negatively affected production in the eastern US.
The combination of rising demand and tightening supplies has started to bring coal inventories back down from their highs earlier in the year. Coal prices are firming up, and coal stocks are rallying on the news.
In addition, there’s a new catalyst for the coal mining firms: rapidly growing foreign demand. Check out the chart below.
Source: The Energy Strategist, EIA
This chart shows US coal imports and exports over the past seven quarters. The trend here is clear: Exports of coal have been rising steadily since the beginning of 2007. Meanwhile, imports into the US market have been falling steadily for over a year. The result is net US exports are on the rise.
There are a few reasons for this. One is simply that the fall in the value of the US dollar makes US coal cheap in foreign currency terms. Therefore, utilities in places such as Europe find that cheap, abundant US coal represents a great value.
But the more important reason is simply surging foreign demand. The primary swing market for US coal right now is Europe.
Despite all the talk to the contrary, coal is still a very important part of the European electric grid. Coal accounts for about 50 percent of Germany’s electricity production, 34 percent in the UK, 17 percent in Italy and a whopping 93 percent in Poland.
Europe is also a big steel producer. Producing steel requires the use of a high-quality coal known as coking or metallurgical coal.
Europe doesn’t have enough coal production locally to satisfy demand. Coal has traditionally been imported from places such as South Africa or even Australia. This coal, often called seaborne coal, is carried on dry-bulk carrier ships.
But there’s a problem with that. China is now a net importer of coal for the first time in the nation’s history, and demand is exploding because of rapid economic growth and development. Meanwhile, India is also becoming an increasingly big exporter.
Australia and Indonesia, the world’s two largest coal exporters, are having a tough time ramping up production enough to keep pace with the new wave of demand. The result: Most available shipments of seaborne coal are finding their way to Asia at sky-high prices.
China’s decision last month to eliminate import tariffs on coal and add new export tariffs will just serve to accelerate this trend even further. Clearly, the Chinese government wants to keep Chinese coal in China and encourage imports.
That leaves Europe short of coal. So, for the first time in more than a decade, European utilities are actually contracting with US producers to buy coal under long-term contracts. European buyers are willing to pay prices for thermal (power plant) and met coal that are far above what’s available on the local US market.
Wildcatter Portfolio recommendation Consol Energy (NYSE: CNX) recently announced that it’s signed deals with European buyers for three-year terms. Management is now in talks for even longer-term deals with European companies.
This is a huge shift. Traditionally, Europeans have only done short-term spot deals covering one-off shipments of coal from the US. The fact that they now want to make longer-term deals at higher prices suggests they’re desperate to secure coal supplies. The result is further upward pressure on demand for US coal.
This is all bullish for my three coal mining recommendations: Consol Energy, Peabody Coal (NYSE: BTU) and MacArthur Coal (Australia: MCC). These stocks are up 67 percent, 51 percent and 50 percent, respectively.
Peabody is the largest dedicated coal mining firm in the US. The stock is attractive thanks to its vast exposure to the US Powder River Basin, a prolific, low-cost, coal-producing basin.
This region isn’t as exposed to new MSHA regulations and hasn’t been as heavily depleted as mines in Appalachia. And via a spin-off in late October, Peabody has eliminated its exposure to less-attractive mines in the east.
Peabody also bought a major Australian producer and exporter, Excel Coal, in 2005. This gives the company direct exposure to surging Asian coal demand. Peabody is the world’s premier coal play, and valuations have risen along with the stock in anticipation of continued firming of global coal markets.
I don’t think the run is over, however. The rise in coal prices is only starting to get noticed in the popular press, and I expect to hear news of new coal export deals as we head into the new year.
Peabody Coal remains a buy despite the big run-up in the stock. For those looking to protect big gains, I’m raising my recommended stop.
MacArthur Coal owns a series of coal mines in the Bowen Basin of Queensland, Australia. Macarthur does produce some thermal coal, but its primary product is pulverized coal injection (PCI) coal. Basically, PCI coal is crushed and injected directly into steel blast furnaces; it can be used as a partial replacement for met coal.
Interesting, MacArthur Coal produces nearly half the entire Australian export supply of PCI coal. Buy MacArthur Coal up to its new target of AUD10.25.
Consol is the largest coal exporter in the US, so it stands to benefit handsomely from rising demand as well. In addition, Consol has large reserves of high-sulphur coal, a product that’s seeing demand rise as more utilities install scrubbers.
I still see additional upside for Consol Energy, but given its meteoric rise, I’m cutting the stock to a hold in the Wildcatters Portfolio. New subscribers should consider jumping into Peabody Coal and MacArthur Coal instead.
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Uranium and Nuclear Power
The global Renaissance in nuclear power has been a theme in TES from the very inception of the newsletter. The two most recent issues of TES relevant to this theme are the July 26, 2006, issue–The Nuclear Option–and my one-year update of that issue on July 18, Yellow Fever.In the longer term, my recommended plays in uranium have been big winners. But over the past year, it’s been a story of boom-and-bust with mixed results. It’s high time I updated the recommendations.
In the July 26, 2006, issue, I inaugurated my uranium field bet, a mini-portfolio of higher-risk stocks designed to play the boom in uranium demand and pricing. Uranium mining is a risky business. Production delays, unforeseen project cost, and simple labor and raw materials inflation can all have important effects on the economics of a particular mining project. And production costs vary wildly depending on the grade of ore mined and how large overall reserves are.
Riskier still is exploration. Uranium explorers buy acreage and drill holes, taking core samples to evaluate reserve size and ore grades.
Sometimes even the most-promising reserves just don’t pan out and can never reach economic production. It’s impossible to know this for sure until you’ve spent considerable sums on exploration; only once uranium is produced can we really know for sure the full costs and viability of a project.
To account for this higher level of risk, I’m recommending that risk-tolerant investors take a more diversified approach to playing the junior uranium producers and exploration companies. Specifically, you must recognize that no matter how careful your selection criteria, some promising uranium exploration stories will never work out.
Fortunately, there are high rewards to be found in this sector as well. Famed mutual fund manger Peter Lynch used to look for what he called ten-baggers–companies with the potential to earn investors 1,000 percent or more on their investment. Obviously, you don’t need many ten-baggers to make a solid return and make up for the inevitable losing plays.
If my bullish thesis on uranium prices and nuclear power is even half correct, I suspect there will be many ten-baggers among the uranium juniors during the next few years. In fact, in just the past year, The Energy Strategist has produced returns of as much as 245 percent on recommended uranium junior mining stocks.
For the best chance at big returns, I recommend casting a wide net. Instead of just buying one or two high-risk names, I recommend placing a smaller amount in five to 10 such companies. I call this the uranium field bet. Here’s the current list:
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Uranium Field Bet
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Company Name (Exchange: Symbol)
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Entry Price (USD)
|
Total Return From 07/26/06 (%)
|
Total Return for 2007 (%)
|
Advice
|
| Energy Metals (TSX: EMC, NYSE: EMU) | 5.09 | 245.3 | 92.1 | SOLD, 240% Gain |
| Paladin Resources (Australia: PDN, TSX: PDN, OTC: PALAF) | 3.28 | 77.1 | -15.3 | Buy |
| Pitchstone Exp. (TSX V: PXP, OTC: PEXPF) | 1.42 | 52.0 | -8.8 | Buy |
| UEX Corp (TSX: UEX) | 3.23 | 108.6 | 39.6 | Buy |
| UNOR (TSX V: UNI, OTC: ONOFF) | 0.47 | -52.7 | -56.4 | Buy |
| Uranium One (TSX: UUU, OTC: SXRZF) | 8.22 | 11.6 | -33.2 | Buy |
| Uranium Participation Corp (TSX: U, OTC: URPTF) | 7.38 | 46.3 | 2.2 | Buy |
| Uranium Resources (NSDQ: URRE) | 4.95 | 156.8 | 119.1 | Buy |
Source: The Energy Strategist
At first glance, this table looks fairly positive for the uranium field bet, even on a year-to-date basis. After all, a 17.4 percent gain isn’t bad compared to the S&P 500’s 5.5 return in 2007. And since its inauguration, the uranium field bet has certainly trounced the S&P and most energy-related indexes with an 80 percent-plus gain.
But the reality is that most uranium mining stocks rallied strongly into about April or May and then sold off precipitously through early fall. The charts of field bet recommendations Uranium One and Paladin Resources below illustrate the basic pattern from the field bet’s inception through the end of 2007.
Source: StockCharts.com
Source: StockCharts.com
Note the inverted “U” shape of both charts. In addition, these charts serve to illustrate just how volatile uranium mining stocks can be. This is precisely why I recommend as a field bet and not as stand-alone plays.
The longer-term fundamental case for uranium is intact in my view. I highlighted the bullish case at great length in the July 18 issue, so I won’t rehash all those arguments here. Suffice it to say that nuclear power is the only truly large-scale, baseload power source that produces no direct emissions of pollutants such as sulphur dioxide, nitrous oxides, mercury or so-called greenhouse gases.
I’m not here to save the planet; rather, the goal of TES is to generate profits in the energy markets. As such, it’s not really my place to comment on the global warming debate; opinions differ as to the extent of the problem.
What I can tell you is that governments the world over are passing legislation to control greenhouse gas emissions. Investors can’t afford to ignore this trend.
Nuclear power is also cheap. Eighty percent of the cost of electricity generated from natural gas is the cost of the natural gas itself; rising natural gas prices mean soaring electricity prices. For nuclear, a doubling in the price of uranium produces only a roughly 9 percent jump in the cost of nuclear-generated power.
These facts are starting to become more widely recognized. China is in the process of a rapid nuclear build-out that will mean 40 new reactors by 2025. Russia plans a similar build-out as that nation seeks to diversify its generation capacity away from heavy reliance on natural gas. And India also has big plans for a nuclear build-out to meet burgeoning demand.
In the developed world, opposition to nuclear power is melting away. Highly respected environmentalists are going pro-nuclear, recognizing that it’s the only reliable way to reduce carbon emissions.
And the US and other governments are starting to offer incentives for utilities to build the first new fleet of reactors in decades. For example, the US Energy Act of 2007, signed in the waning days of last year, offered loan guarantees for new nuclear plants that could total as much as $25 billion. This makes it more likely that plants already pending construction permits will actually be built in the coming decades. This surge in new reactor building spells more demand for uranium.
Meanwhile, uranium mines aren’t keeping pace with demand. Global mines only produced 60 to 70 percent of the uranium used in plants last year. Secondary sources of uranium such as government stockpiles are now winding down.
I fully believe that these long-term fundamentals are intact. This is what’s been driving uranium prices and uranium mining stocks sharply higher over the past few years.
My mistake with the nuclear field bet in 2007 was to pay too little attention to shorter-term concerns. During the big uranium run-up in the first half of 2007, I recommended taking partial profits off the table in some of our biggest winners. For example, in the March 5 flash alert, The Selloff, I advised taking a third of your position off the table in four of the most extended field bet picks. I reiterated that recommendation on a few occasions.
And in the June 6 issue, Looking Back, Looking Forward, I advised selling out of Energy Metals to take a more than 240 percent gain. The stock was acquired in August by fellow field bet pick Uranium One (TSX: UUU, OTC: SXRZF), and I didn’t feel it was prudent to be double-weighted in this stock.
This is a key aspect of the field bet strategy. Specifically, the three field bets recommended in TES–uranium, biofuels and alternatives–are all long-term, multi-year themes to which I believe you should retain exposure.
However, even the strongest bull markets see pullbacks and corrections in the context of multi-year uptrends. Therefore, I will typically recommend taking some profits off the table after big run-ups and then adding exposure during pullbacks. Over time, I believe this strategy offers a shot at the best possible returns with the least possible risk.
However, I wasn’t aggressive enough in taking gains off the table during the big run-up because I didn’t expect the subsequent selloff to be quite as dramatic as it was during the summer months. My mistake was to be overly complacent about a trend that I believe still has legs. Those subscribers who did follow my advice with the partial sales were rewarded with gains well above what the table above suggests.
As for the current situation, the primary problems hampering the uranium mining stocks lately have been related to the spot market for uranium. Check out the chart of spot uranium prices below.
Source: Bloomberg
The spot market is the price a buyer would pay for immediate delivery of uranium. It’s quoted in terms of dollars per pound of U-308, which is natural uranium oxide.
Spot prices give us a good indication of supply and demand in the uranium markets. But it’s important to remember that the spot market is truly tiny, accounting for 10 to 20 percent of traded uranium at best.
Most uranium is bought and sold under long-term contracts between utility customers and mining firms. These longer-term contracts are signed at fixed prices or a hybrid contract that allows for floating prices with pre-set floors and ceilings.
The spot market really isn’t as important as some make it out to be; however, it does affect sentiment surrounding uranium. Moreover, note that, although uranium prices are still up more than 25 percent over the past year, the June-September drop was precipitous.
This is particularly true when you consider that, until June of last year, uranium spot prices hadn’t seen a week-over-week decline for several years. This spooked traders and accounts for most of the selloff in uranium mining stocks after midyear.
There are a few lingering concerns in the spot market. One is simply a lack of volume traded. Volume in the uranium spot market is always thin, but it was particularly nonexistent during the height of the summer selling. This was because some buyers simply left the market, refusing to pay more than $130 per pound for U-308.
In addition, there have been some cash-motivated sellers in the market in recent months. The list would include a significant auction of US government stocks by the Dept of Energy, which was completed in September.
In addition, speculative buyers such as hedge funds have been buyers of uranium in recent years. There’s been a lingering concern that these so-called discretionary buyers would have to sell down their holdings to raise cash in the midst of the global credit crunch.
As ridiculous as it sounds, the weakening credit market did have an effect on uranium spot prices. And it does appear that these discretionary buyers stepped away from the spot market over the summer.
Although uranium prices have recovered nicely off their lows around $75 per pound in September, there remain some concerns that have been capping recent rallies. One is a dispute between the US and Russia.
In early December, the US and Russia reached a preliminary accord that would allow Russia to continue exporting uranium to the US after the current Megatons to Megawatts program expires in 2013. The program was set up to sell reprocessed Russian nuclear warhead material to US utilities as a fuel for plants.
The new agreement would provide quotas on uranium imports into the US. These would be direct exports to US utilities rather than reprocessed nuclear material sent through America’s only nuclear enrichment company, USEC. There’s been some concern that this may eventually result in larger Russian supplies entering the US than under the current agreement.
However, I think these fears are overblown. The reality is that rising demand for uranium will mean that US utilities are competing with China, Japan, France and other major uranium consumers for available supply. No matter what the final form of the US-Russia deal is, there will be plenty of demand to absorb Russian supply.
My view remains that we’re just seeing shorter-term hiccups in a longer-term uptrend for uranium prices. Mine production isn’t keeping pace with demand; prices will need to remain elevated to encourage new production.
These uranium spot issues are the primary reason for the recent pullback in uranium mining stocks. However, there are some stock-specific issues worth mentioning as well.
Paladin Resources (TSX: PDN; Australia: PDN, OTC: PALAF) is a small uranium mining firm with actual production. The firm’s most advanced mine is the Langer Heinrich uranium project located in the African nation of Namibia, which is on the southern tip of Africa along the west coast.
Langer Heinrich produced roughly 650,000 pounds of uranium oxide in the fourth quarter of 2007. This was under Paladin’s original quarter expectations for 900,000 pounds. The company experienced a series of minor bottlenecks and bugs when ramping up the project throughout 2007.
But such bugs are to be expected in the mining business. Even the world’s largest uranium mining firms such as Cameco (NYSE: CCJ), BHP Billiton and Rio Tinto have experienced delays and problems with their mines from time to time.
Langer Heinrich is an in-situ leach mine (ISL); this form of mining involves pumping water and special chemicals into the ground. This water actually dissolves uranium and is pumped back to the surface as a so-called pregnant liquid. Pregnant liquid is then dried, and the uranium separated.
As you can imagine, this procedure involves a number of steps. It can take a few months after a mine is started up to work out minor kinks and bottlenecks.
At any rate, Paladin expects to have the Langer Heinrich facility operating at its full-rated capacity of 2.6 million pounds per annum for 2008. In addition, Paladin has scheduled a series of add-on projects to increase maximum production from this mine to 3.7 million pounds per annum sometime after 2009.
Paladin’s second major project is its 85 percent owned Kayelekara ISL mine in Malawi, a landlocked country in southern Africa. The project is scheduled to start production late in 2008.
Paladin’s management believes the company could produce around 9 million pounds of uranium from Langer Heinrich and Kayelekara combined in calendar year 2009. This would place Paladin among the world’s largest uranium mining firms. Paladin Resources rates a buy.
Uranium One (TSX: UUU, OTC: URPTF) has a number of producing or near-producing uranium mines in the US, Asia, Australia, Africa and Canada.
The company’s Dominion mine in South Africa began actual production in 2007 and is eventually expected to become one of the world’s largest mines. Uranium One is looking to produce 3.8 million pounds of uranium per year from the mine by the time it hits full maximum production by around 2011.
The Dominion mine isn’t a brand new mine but a reserve that was heavily explored and produced during the ’50s through the ’80s. This is beneficial because the mine is a known producer and the geology is well understood. The mine was closed when uranium prices collapsed in the ’80s and sentiment surrounding nuclear power soured.
In the US, the company has a number of near-producing uranium assets throughout the southeast. In particular, Uranium One has plans to begin production at its Texas properties in 2008, with Wyoming and Utah projects expected to come online by the end of this decade.
The stock was hit hard in October 2007 after management announced updated production guidance that disappointed many investors. Specifically, management cut estimates for 2007 production from 2.5 million pounds to just 2.1 million pounds per day mainly because of delays in ramping up its massive Dominion project.
Even more disappointing is the fact that Uranium One slashed its 2008 production guidance from 7.4 million pounds of uranium to just 4.6 million pounds. This cut was the result of a shortage of sulphuric acid at some of its mines in Kazakhstan; this acid is used to dissolve uranium in ISL projects.
But I’m not overly concerned about any of these shortfalls. As noted earlier, mining projects are prone to delay; this is just the nature of the mining business. And the reasons management cited for forecasting a production shortfall have nothing to do with the quality of Uranium One’s mines and reserves.
Longer term, these problems won’t effect the company’s ability to become one of the world’s largest uranium producers. In fact, Uranium One believes it will see production ramp up to 8 million pounds per day in 2008 and 11 million in 2010. Buy Uranium One.
Back to In This Issue
Biofuels and Alternatives
My two other recommended field bets in biofuels and alternatives have been huge winners for TES subscribers last year, up 109.9 percent and 107.5 percent, respectively, for 2007. Unlike the uranium field bet, there’s been no sign of a pullback late last year; most stocks are actually accelerating into year-end. Here are the two field bet tables.|
Alternatives Field Bet
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|||
|
Company Name (Exchange: Symbol)
|
Entry Price (USD)
|
Total Return Since 01/24/07 (%)
|
Advice
|
| EDF Energies Nouvelles (France: EEN, OTC: EDFEF) | 49.86 | 39.9 | Buy |
| Hexcel Corp (NYSE: HXL) | 20.01 | 20.9 | Buy |
| MEMC Electronic Materials (NYSE: WFR) | 45.70 | 95.5 | Buy |
| SolarWorld (Germany: SWV, OTC: SRWRF) | 37.51 | 63.2 | Buy |
| SunPower Corp (NSDQ: SPWR) | 41.34 | 215.6 | Hold, SELL one-third position |
| US Geothermal (OTC: UGTH) | 1.40 | 180.7 | Hold, SELL one-third position |
| Vestas Wind Systems (Denmark: VWS, OTC:VWSYF) | 45.24 | 136.5 | Hold, SELL one-third position |
|
Biofuels Field Bet
|
||||
|
Company Name (Exchange: Symbol)
|
Entry Price (USD)
|
Total Return Since 09/20/06 (%)
|
Total Return for 2007 (%)
|
Advice
|
| Anglo-Eastern Plantations (London: AEP) | GBP2.99 | 59.3 | 47.3 | Buy under GBP4.50 |
| Earth Biofuels (OTC: EBOFE) | 2.17 | -98.1 | -96.1 | Hold |
| Monsanto (NYSE: MON) | 46.91 | 141.6 | 115.5 | Buy under 115, Stop@74.95 |
| Mosaic (NYSE: MOS) | 21.89 | 462.2 | 338.5 | Hold, Stop@47.50 |
| Metabolix (NSDQ: MBLX) | 23.94 | -1.3 | -1.3 | Buy under 29 |
| MP Evans (London: MPE) | GBP2.82 | 51.1 | 34.4 | Buy under GBP4 |
| Novozymes (Copenhagen: NZYMB, Frankfurt: NZMB, OTC: NVZMY)* | 103.50 | 11.6 | 11.6 | Buy under USD130 |
| Potash Corp (NYSE: POT) | 33.30 | 331.7 | 201.6 | Hold, Stop@95 |
| PowerShares Deutsche Bank Agriculture (AMEX: DBA)+ | 26.05 | 27.9 | 27.9 | Buy under 34 |
| Sipef (Belgium: SIP) | EUR187.00 | 147.9 | 80.7 | Buy under EUR400 |
| Syngenta (NYSE: SYT) | 29.40 | 41.3 | 38.4 | Buy under 53 |
Source: The Energy Strategist
I just covered the biofuels field bet at great length in the Sept. 19 issue, Down on the Farm; I won’t repeat all my arguments here. Suffice it to say that the agriculture industry is benefiting from two key trends: rising meat consumption in the developing world and the booming biofuels industry.
As to the first point, meat consumption per capita tends to rise the wealthier a country becomes. China, for example, is seeing booming meat consumption, which means more grains are needed to feed livestock.
On the second point, the recently signed US Energy Act massively ramps up the biofuels mandate. The new law requires that the nation use 36 billion gallons of biofuels by 2022, up from the c