Marin Katusa on Investing in Energy in 2012
(Interviewed by Louis James, Editor, International Speculator)
L: Here we are at the outset of 2012, with energy markets up, down, sideways – anything but clear. But Marin, in our last meeting you had some pretty clear ideas on how to play the field, so I’m glad you’re taking the time to give us an update.
Marin: Sure. And it’s important because a lot of people are expecting, hoping, or just wishing that 2012 will be the year that natural gas makes its comeback. This is a major factor in energy investing today. First, though, investors need to understand that natural gas works in very localized markets. The price in Europe is going to be very different from that in North America, and even within North America, prices vary a lot from region to region.
That said, my projections are that for the first half of 2012, prices will remain low, for many reasons. A big factor is the success of the shale gas deposits, but also the milder winter we’re experiencing. From Alberta to Maine, the winter has started out unusually clement, and that’s having a big impact on prices. So, I think the first half of 2012 will be pretty disappointing for those who think natural gas will pop – it won’t.
L: But why do prices even spike in the winter? I mean, it’s not like winter comes as a surprise – we have one every year. If natural gas costs more in the winter, why don’t distributors stockpile it in the summer or take hedges, and even out their costs? This industry has existed for a hundred years – shouldn’t they have figured these things out by now?
Marin: Well, the big producers do hedge, but you have a floor and ceiling on your hedge, so there’s only so much protection that can offer. And no, you can’t stockpile – natural gas is not as dense in energy as gasoline or fuel oil. You can’t build reservoirs and pipelines all over the place, and people wouldn’t want stockpiles of something explosive in their back yards, even if you could.
But there’s more to this than the weather. Remember back in 2005 when hurricane Katrina caused speculators to send natural gas prices rocketing upwards? Right now, we’re seeing the opposite effect – not just because of the mild winter and disappointing winter heating season, but because of the unbelievable success and huge amounts of supply of shale gas hitting the market. Demand is down, supply is up, and market players are reacting aggressively and bearishly.
L: So, what happens next?
Marin: Remember that the cure for low prices is low prices. We’ve already seen rig counts decrease. Because of the production glut and low costs, producers just can’t make money on it, so they’re cutting back. That will slow the growth of supply, which will show up in the price sooner or later.
L: Interesting. So, I remember reading about shale gas when it was just a crazy idea people were “gee whiz” wondering about in pop science magazines. Serious people seemed quite skeptical – doubtful of the real-world economics of extracting natural gas from hard rock. But the field seems to have exceeded its proponents’ wildest expectations – this has turned into a huge supply of low-cost energy for North America. A real game-changer.
Marin: Right; and this is just the beginning. We’ve been writing about shale gas in our newsletters for over five years, and we were leading the charge in the field. North America is ten years ahead of any other region in the world for shale exploration – it’s just started in Europe, just started in South America. The Canadian and US companies really have the leading edge on the technology in this field.
But there are hurdles… factors that could lead to increased costs. Number one would be environmental concerns leading to higher regulatory burdens. People are concerned about hydrofracking deep in the earth affecting ground water – it’s all hysteria, but the fear is widespread and that means there’s political advantage to be found in pandering to that fear. So we’re likely to see higher costs due to regulation of fracking techniques and fluids.
There’s also a new fear that we’re writing about in our newsletters – that fracking is causing earthquakes. It’s true that it can cause microtremors, but a heavy truck rumbling by on the street will shake your house more. But still, it is what it is, and there will be more regulation and higher costs driven by this fear.
That’s par for the course when you’re deploying a new technology commercially, so it will all work out. The main point for now is that shale gas is just getting started, and yes, it’s a game-changer in the field.
L: And it’s just starting globally.
Marin: Yes – as in Europe, for example. Natural gas prices are generally twice what they are in North America. That’s because of the reliance on Russian natural gas, which we wrote about as far back as 2007. It’s really a fascinating story.
L: Hm. Do you think it’ll really happen in Europe? They are so much greener. The Germans say they’re going to shut down all their nuclear power plants because they have so many tsunamis in Germany and rely on solar power, because they have so much sunshine… Policy there looks literally insane to me.
Marin: There’s huge potential in the European shale sector – and we at Casey Research were the first to write about that potential, back in 2007. But you make a great point. Take the UK, for example. They get about a third of their gas from Russia. That gives Russia huge political leverage, which is of some concern to the UK. And yet, there are serious protests going on, focused on a shale gas company called Cuadrilla. Cuadrilla became the first company to successfully drill a shale gas deposit in Europe.
L: Just to help you toot your horn – that was a multiple winner for subscribers who got in early, wasn’t it?
Marin: Yes, Casey subscribers made over 600% gains on Cuadrilla, and that was during 2008-2009, which was a very tough market in the commodity sector. Fast forward to today: These protesters aren’t just waving signs; they’ve actually attacked the drill rigs, storming them like villagers with pitchforks and torches. The drillers had to shut down and evacuate, because people were climbing over the rigs. But at the same time, people in government recognize the strategic importance of this domestic discovery, which they’re calling a national treasure. The amount of gas is huge, estimated to be over 100TCF – yes, trillion cubic feet. No one realized it could be so big or economic – enough to power all of the UK for many decades. This can change the game for them, allow then to get away from the high-priced and politically burdened Russian natural gas. They now have the resources to do that right under their feet. And this isn’t in central London or some place like that, but in an area with no major metropolis and easy access.
L: It’ll be interesting to see how that plays out. Staying warm in the winter or environmental hysteria – which will come out ahead?
Marin: Yes, just a few wells have been spudded; it’s just starting. But I have to believe that sooner or later, being able to stay warm during the winter will trump other concerns.
Back to Germany – you bring up great points. Personally, I believe that’s all political lip service. I don’t think we’ll see any of those plants actually shut down. The simple fact of the matter is that it’s just too high cost to import the electricity. And the irony of it all is that they would be importing the electricity from France, which not only generates a lot of its power from nukes, but those nuclear plants are near the border with Germany and just as close to many German citizens as the ones Merkel says she’ll shut down.
Marin: It’s funny, but at the same time, it’s not. Just think about it. They are not going to shut down those plants – it simply makes no sense. And shale gas exploration will proceed in Europe. There are opportunities in this reality – but I have to say that it’s also very expensive exploration over there, and these deep wells cost a lot of money anywhere.
L: Okay; so for energy investors among our readers, what’s the bottom line? Shale gas will have its day in the sun, but the immediate future is perhaps not the best time for investing?
Marin: I’d say that there are opportunities, even now, but they are very specific to company and location. In fact, we’ve recently become very bullish on the price of natural gas in North America, as it’s reached a point that is below the cost of production for most companies. We think natural gas at US$2.50/mcf is very cheap. Also, the price ratio of oil to natural gas is currently above 37:1 – that has only happened once before in the last 15 years, and within a few weeks, the price of natural gas corrected significantly. So, we’re very bullish on gas in certain areas of the world, but we think that those who expect to make money on higher natural gas prices over the next two quarters could be disappointed. Over the longer term, however, there will be a lot of money made on such speculations – this will be the decade of natural gas.
L: Hm. Would you go so far as to call this a bottom, for those long-term investors with the intestinal fortitude to buy now and wait for higher prices?
Marin: Well, prices are about as low as they can go. The lowest-cost producers in the sector are barely breaking even – and losing money when you incorporate debt costs. But look at the history of other energy commodities. Take uranium, for example: It took years of prices below production cost to shake out the oversupply. Natural gas could go lower, and it will take time to go higher – but it’d be tough to see it going much lower. So I’m not going to try to time the bottom, but yes, I think we’re down at about that level. The key question is how long it will take for the low prices to cure the low prices.
L: So you’re not speculating on that now, but are waiting for clear signs that the bottom has been reached, then you’ll buy?
Marin: That’s exactly what the February Casey Energy Report is all about.
L: Oops. Well, a sneak preview for CDD readers, then. That’s a good overview – what about oil? You called it “the wild card of 2012.”
Marin: Oil is the blood in the veins of the global economy. I see two wild cards here. If things turn hot in the Middle East – Iran, for example – something closes the Strait of Hormuz, you could easily see crude oil pop over $150 per barrel… Brent Crude especially.
Another wild card in play at the moment is Nigeria. Just today, the main workers’ union announced its intention to strike, which would shut down major oilfields – the heart of Nigeria’s resource-dominant economy. This would be equivalent to what happened in Libya. Anything like this could send oil prices much higher in short order.
L: I’ve been wondering about that; is the damage to production that has resulted from the Arab Spring – so far – really already factored in to oil prices? Large swaths of the oil-producing regions of the world are in, or near, chaos.
Marin: A lot of the production that was put on hold in Libya is already back online. These markets are very sophisticated – they respond to supply issues very quickly. And they would do so again if more such wild cards come up in the game.
On the other hand, if oil prices go too high, the global economy just doesn’t work. The cure for high prices is also high prices, and that alone could force prices back down.
When I evaluate a company, the price I use is $55 to $65 per barrel. If the company can’t break even down at that price level, then I’m not interested.
L: That’s pretty conservative.
Marin: Yes, but so many of these companies have borrowed huge amounts of money to spend on exploration, expecting $100 to $125 oil. They are taking a big risk. If oil goes higher, fine – but if it backs off to $65, how will they survive? The assumptions underlying many massive debt positions in the sector break down at lower prices, and these companies won’t survive. Investors in this sector must be very cautious about the amount of debt that companies took on during past years of high prices – you have to ask who is going to renew that debt and at what rate. This is the subject of this month’s Casey Energy Report.
L: Is this a trend you see leading to more consolidation in the sector? If the little guys take on too much debt and end up bankrupt, the major companies can pick up the ones that succeed in making discoveries, right out of bankruptcy.
Marin: Maybe, but I’m not talking about little juniors. Multibillion-dollar oil companies have taken on too much debt. Some of these have total debt to equity leverage up over 50, 60, and even 70 times. When the banks got in trouble in 2008, they were leveraged, on average, at about 40:1. That overleverage ratio is what got the banks in a lot of trouble. There are big oil companies out there, in which big pension funds and other major institutions have large share positions, that are leveraged up to 90 times debt to equity.
L: Holy cow!
Marin: It’s serious. And there are big national oil companies that have debt burdens that are simply unbearable. And this isn’t being talked about. When I do talk about it, I’m seen as the bad guy on the street.
L: No sympathy for the devil. But that’s the contrarian’s lot – and that’s why we make money when others don’t.
Marin: Right. So, the bottom line here is to be very cautious, and make decisions that are company specific. You can’t count on a rising tide to lift all ships in this market sector, at least not yet.
L: Very interesting. Does this apply to the big household names? Exxon? BP?
Marin: Not so much, but they have other problems, especially in their relationships with the countries in which they operate. Look at what’s going on in Ecuador, Peru, Brazil, and even the Middle East. You can’t change an oil concession contract. Those deals with governments are legally binding, everywhere in the world. They can’t change the terms. But the governments are finding ways around that. Consider that when BP had that big oil spill in the Gulf of Mexico, its fine worked out to just over $8,000 per barrel spilled. In Brazil recently, Chevron got fined over $3 million per barrel for a small spill. Chevron has a similar disputed penalty in Ecuador.
That’s beyond punitive. It’s governments finding an alternative way to extract more money from the big oil companies, since they can’t change the contracts. And it works, because there are always going to be some small mishaps, and sometimes not so small ones. They are par for the course.
L: And is it selective? Would Brazil fine Petrobras the same as Chevron?
Marin: No, they sure don’t – it’s not equal treatment. American companies are paying much heftier fines – I call it wealth redistribution. And, by the way, I don’t think this sort of thing will be limited to the oil sector – we’ll see it across all natural resources. It’s a form of hidden, shadow nationalization.
L: I sure see it in mining. Governments everywhere are looking to extract a larger piece of the action while commodity prices remain high. No surprise there. But as for oil, I read you loud and clear: no commodity price speculation, no sector-wide bets – just highly focused speculations on specific companies.
Marin: I see oil in 2012 being binary. A major geopolitical event will cause Brent Crude to pop. Absent that, the slowing economy could take oil down a good 40%, to $60 a barrel or so. And that’s why I won’t invest in a company unless it can make money at that level, its debt levels are not too high, it has a lot of value to add for shareholders in the near future, and so on.
L: Okay. What about nuclear energy?
Marin: This is the dark horse of 2012. I think we’ll see a substantial increase by the end of the year. The HEU agreement ends in 2013. This time, Putin won’t just be dancing with the Americans, but also with the Chinese and the Indians. The Chinese have 26 reactors under construction and will be adding another 51. Meanwhile, the US has become so addicted to the down-blended nuclear fuel produced by Russia as part of the HEU agreement that it only produces about eight percent of what it consumes. So, when the US goes back to the negotiation table, this time competing with Asian consumers, the Russians are obviously going to be able to extract a higher price. And they will succeed, because the fuel is such a small part of nuclear power production – even if you double t he price of uranium today, it would make less than 5% difference to the cost of producing electricity.
And right now, existing production from mines basically doesn’t work. The international spot price is in the low $50s per pound, and conventional mining costs in the US average about $60 to $65 per pound.
With that reality, so little domestic supply, and Asian competition, I predict that the price Americans will have to pay as a result of the next HEU agreement will be much closer to the international spot price which is around $52 at present – no more sweetheart deals.
That creates opportunities in unconventional uranium production, such as in-situ leaching. That technology has lower production costs, averaging around $30 per pound – I know one company that’s doing it for $20. There’s more of this coming online, and I think investors will make a lot of money on the right companies, but it won’t be enough to make up for the loss of HEU supply from Russia, so I still see higher prices ahead.
And that’s not going to be a slow, steady rise all year. You’re going to wake up one morning and see a jump in price, after the Russians announce they’ve signed a long-term contract with the Chinese at some price – say, $75. Overnight, the game will change in uranium. We’ve discussed this in the Casey Energy Report as well, and we think that we’re positioned in the best companies to benefit from that.
L: So, bottom line here is that you’re bullish, but there’s time to build positions over the coming months – no big rush?
L: All right then. Alternative energy?
Marin: Alternative energy has been a big disappointment across the board. The whole green sector has been a fountain of disappointment. A lot of the incentives have been cut back – as in the geothermal sector, for example. The guaranteed construction loans are ending in 2013, and the US government has given no indication that they will extend the program. And I don’t blame them; there have been a lot of delays. Many of the management teams trying to build these projects have never done it before – the last major wave of geothermal power construction was 30 years ago. Many of the projects have had delays, cost overruns, and didn’t produce the amount of green energy expected. Eventually these issues will be worked through and the projects, once built, will produce green energy. We’ll revisit the green sector at that time. It’s such a beaten-down sector that there will be some great, undervalued deals – but patience is required.
L: What about the funds supposedly already allocated for alternative energy? Isn’t there supposed to be billions of euros already sitting in European banks, waiting to be spent on green-energy projects?
Marin: Yes, such funds exist. In the US, billions and billions of private dollars have already been spent, with disastrous returns. Investors have pulled out of many of these funds, which have slaughtered share prices in the companies that they invested in. In Europe, there are billions approved for these things, but we both know how bureaucratic it is over there and how long it takes to get anything through the process. To get through the permitting and actually ready to use construction financing is going to take much longer.
L: Sure, but okay, say someone does advance a project through all the red tape in Europe and gets it ready to build. Do you think the money won’t be there when it gets to that stage?
Marin: That’s been the case in other places. Economic crisis, changing priorities – “Sorry, that program’s been canceled.” It could work and in some places, I’m sure it will – but you’d have to be very, very careful and understand the huge risk you’re taking in counting on those promised funds.
L: Like the Promised Land. Okay, so then, green energy is another minefield. Where do you look, then? Where are you investing in 2012?
Marin: The frontiers. If you go places where others dare not tread – the sort of thing the Lundin family is famous for doing – and you are strong enough to operate in such places, you can still make world-class discoveries. You put one of those in a tiny company, and the potential returns can be enormous.
We’re doing a piece in the Casey Energy Report on Chinese takeovers in the energy sector. We’re compiling data on every single one we can find, and the pattern is clear: The Chinese are looking for large, world-class deposits, and they are willing to buy them in Africa, Latin America, and other places that make North Americans nervous. In many cases, the discoveries were actually made decades ago by the big oil companies – the “seven sisters” – but were deemed uneconomic or too risky. Now, with better technology and Chinese fearlessness, some of these old discoveries are being advanced towards production again.
Now, the market is very volatile, and many investors are scared. But one thing you can bet on is that, regardless of the market conditions, if a tiny company makes a world-class discovery, it will get taken out – and at a premium for early investors. That’s why I’m so excited about frontier exploration.
There’s one company we recommended in CER just a couple of months ago; it’s a bigger company and it’s up over 35%. I love this company because it has solid fundamentals on conventional production – good share structure, good management, a lot of cash, they’re making money – but the big upside is on a frontier exploration play. It’s a massive shale gas project – a real game changer. A major oil company is committed to spending $100 million over the next 12 months to explore this project. If they have any success at all, the share price of the little company will go through the roof. And the beauty of it is that you have little risk in the play, because the smaller company is profitable and the bigger company is spending the high-risk exploration dollars. An investor is paying a cheap price for its growing conventional production and the upside unconventional exploration assets are free: That’s smart investing.
This is the kind of stock I want to be invested in this year.
L: We’re doing something similar in the metals; we like emerging production. We have the protection of profitable operations with the upside of major discoveries still on tap. So I read you: Fear-driven investors aren’t paying attention to the real values that exist in the energy sector. That’s no surprise after these last few very rough years. We can’t time the market, but for contrarian investors who can be patient, there are low-cost and even sometimes relatively low-risk plays on energy – which is, after all, absolutely vital to the world economy. Will 2012 be the turning point? We don’t know, but it certainly has the potential to offer some amazing opportunities to profit in the various kinds of energy by focusing on the lower-cost producers that you’ve lined up.
Anything else, brother?
Marin: No; I think we’re probably close to wearing out our welcome in readers’ inboxes. I do want to invite all readers to come to the World Resource Investment Conference coming up in a couple of days in Vancouver. It’ll be a great show, and we’ll have a Casey Research pavilion there with top-notch speakers to help us educate resource investors.
L: Great. And thanks for taking the time – some very interesting insights in this conversation I hope readers will heed.
Marin: You’re very welcome. See you soon, bro.
[A little-known crisis is brewing in the Middle East - and OPEC is desperate to hide it. While it portends big trouble for Saudi Arabia and other Persian Gulf oil producers, it's creating an outstanding profit opportunity for energy investors.]