Wall Street Double Talk and Double Opportunity of Falling Oil Price

By Tony Sagami

The stock market has developed a new type of love-hate relationship with the price of oil. In the past, falling oil prices were treated as an economic positive because they freed up more money for Americans to spend on other things, such as dining out or clothing. However, the steep plunge in oil prices has triggered a reverse psychology reaction on Wall Street: falling oil prices are bad because they signal a slowing global economy.

An even bigger head scratcher is the convoluted reaction that rising oil prices are good for the economy. Go figure.

Wall Street’s collective reaction, silly or not, is important because oil prices are what is currently driving the ups and downs of the stock market. And if you can divine the future direction of oil prices… you’ll find yourself on the right side of the stock market roller coaster.

What do I see when I connect the dots? That oil prices will fall even further.

Connecting the Dots #1: Helmerich & Payne. Helmerich & Payne is the largest lessor of oil rig drilling platforms in the US and recently announced that it would lay off up to 2,000 workers and chop its rig construction pace from four to two new oil rigs a month.

Moreover, Helmerich & Payne said that its active rig count has slid from 297 at the end of Q3 2014 to less than 200 today. “The rig count reduction thus far has been more swift than many expected,” said CEO John Lindsay.

And the price that H&P is receiving on that smaller amount of working rigs is falling. The daily revenue per rig is expected to average $27,000 to $27,500 this quarter, well below the $29,457 it received last quarter.

Connecting the Dots #2: Oil Pros Take Flight. For the week ending January 27, noncommercial traders increased their bets for oil prices to fall even more by adding 22,771 short contracts.

NOTE: Investors who use futures as hedges are called “commercial traders” while those who trade for speculation are called “noncommercial traders.”

The professional traders in the commodities pits make mistakes like the rest of us… but they’re right enough to make a living at it, so it’s dangerous to bet against them.

Connecting the Dots #3: Baker Hughes. In the last week of January, U.S. oil producers shut down 94 drilling rigs, which is the largest one week shutdown in 28 years!

That leaves 1,233 active rigs in North America—a three-year low.

Connecting the Dots #4: Supply Glut. The US Department of Energy reported that crude-oil stockpiles reached 406.7 million barrels in January, the highest level since the government started keeping records in 1982.

Higher supplies wouldn’t be an issue if demand were keeping pace, but thanks to improved drilling technology (fracking), the US is now awash in oil.

Connecting the Dots #5: USW Strike. Adding to the oil-patch pain, the strike of 3,800 members of the United Steelworkers union from nine refineries and chemical plants that process roughly 10% of US gasoline, diesel, heating oil, and jet fuel.

There are many ways to profit from falling oil prices, such as airlines and trucking stocks, but the most profitable is by betting against the companies that supply oil drilling equipment.

The Philadelphia Oil Services Index (OSX) is a price-weighted index composed of 15 companies that provide oil drilling and production services, oil field equipment, and support services.

If you’re confident that oil prices are headed lower, you can buy put options on the OSX index. And if you’re right… you’ll make a bundle. For example, my Rational Bear subscribers made over 200% in a few short weeks.

I’m not suggesting that you rush out and make big bets on oil prices tomorrow morning. As always, timing is everything, so wait for my next signal; but I am very confident that the profits of oil services companies are headed for the toilet.


Tony Sagami

30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here.

To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

The article Connecting the Dots: Wall Street Double Talk and Double Opportunity of Falling Oil Price was originally published at mauldineconomics.com.

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The New Normal for Crude Oil?

By Marin Katusa, Chief Energy Investment Strategist

You may have come across the word “contango” in an oil related news report or article recently and wondered, “What’s contango?”

It isn’t the Chinese version of the tango.

Contango is a condition in a commodity market where the futures price for the commodity is higher than the current spot price. Essentially, the future price of oil is higher than what oil is worth today.

The above forward curve on oil is what contango looks like. There’s more value placed on a barrel of oil tomorrow and in the future than over a barrel today because of the increased value of storage.

I personally believe our resource portfolios are in portfolio contango—but that’s an entirely separate discussion that I’ll get to later. In today’s missive, I want to focus entirely on oil contango.

Crude oil under $50 per barrel may seem to put most of the producers out of business, but many oil and gas exploring and producing (E&P) companies are sheltered from falling prices in the form of hedges.

Often, companies will lock in a price for their future production in form of a futures commodity contract. This provides the company with price stability, as it’s sure to realize the price it locked in at some future date when it must deliver its oil.

But the market will always figure out a way to make money—and here’s one opportunity: the current oil contango leads to plenty of demand for storage of that extra oil production.

With US shale being one of the main culprits of excess crude oil production, storage of crude in US markets have risen above seasonally adjusted highs in the last year. This abundance of stored crude has pushed the current spot price of crude oil toward five year lows, as current demand is just not there to take on more crude production.

When in contango, a guaranteed result is an increase in demand for cheap storage of the commodity, in order to clip the profit between the higher commodity price in the future versus what’s being paid for the commodity at present. This is precisely what’ playing out in oil today.

Contago, Five Years Later

Looking back at the similarities of the 2009 dramatic free fall in oil prices to $35 per barrel, after a five year hiatus, crude has returned to a similar price point, and the futures market has returned to contango (green shows oil in contango).

Floating Storage Is Back in Vogue

Oil traders are now taking advantage of the contango curve through floating storage in the form of waterborne oil tankers.

This is what a big oil tanker looks like:

I’m personally reminded of contango whenever I look out my living room window:

Here’s a photo taken out my living room window—and this is non-busy part of the harbor. At times when I do my runs along the seawall, there have been up to 30 large oil tankers just sitting in the harbor. (On a side note, Olivier and I went for a run in July along the Vancouver seawall, and we counted 26 oil tankers.) All that pricey Vancouver waterfront will have an incredible view of even more oil tankers in the years to come when the pipelines are eventually built. I can only imagine what the major import harbors of China and the US look like… never mind the number of oil tankers sitting in the export nations’ harbors and the Strait of Hormuz. Multiply the above by at least 50 red circles.

As the spread between future delivery of oil and the spot price widened, traders looking to profit from the spread would purchase crude at spot prices and store it on oil tanker ships out at sea. The difference between the spread and the cost to store the crude per barrel is referred to as the arbitrage profit taken by traders. Scale is a very important factor in crude storage at sea: therefore, traders used very large crude carriers (VLCC) and Suezmax ships that hold between 1-2 million barrels of crude oil.

In the late summer of 2014, rates charged for crude tankers began to climb to yearly highs because of the lower price that spurred hoarding of crude oil. This encouraged VLCCs to lock in one year time charter rates close to and above their breakeven costs to operate the ship.

Time charter rates share similarities to the oil futures market, as ships are able to lock in a daily rate for the use of their ships over a fairly long period of time. VLCC spot rates have reached around $51,000 per day; however, these rates tend to be booked for a shorter period of around three months. These higher spot rates tend to reflect the higher cost paid to crew a VLCC currently against locking in crew and operating costs over a longer-term charter that could last a year. Crude oil is often stored on floating VLCCs for periods of six months to a year depending, on the contango spread.

Floating Storage: Economics

Many VLCCs are locking in yearlong time charter rates at or above $30,000-$33,000 per day, as that tends to be the breakeven rate to operate the vessel. If we assume that a VLCCs charge their breakeven charter rate and we include insurance, fuel, and financing costs that would be paid by the charterer, storage on most VLCCs in the 1-2 million barrel ranges are barely economic at best.

However, they’ll soon become profitable across the board once the oil futures and spot price spread widens above $6-$7 per barrel.

The red star depicts the current spread between the six-month futures contract from the futures price in February 2015. Currently companies are losing just under $0.20 per barrel storing crude for delivery in six months. However, once that $6-$7 hurdle spread is achieved, most VLCCs carrying 2 million barrels of crude will be economic to take advantage of the arbitrage in the contango futures curve.

The VLCC and ULCC Market

VLCC= Very Large Crude Carrier
ULCC=Ultra-Large Crude Carrier

VLCCs store 1.25-2 million barrels of oil for each cargo. Globally, there are 634 VLCCs with around 1.2 billion barrels of storage capacity, or over one-third of the US’s total oil production. The VLCC market is fairly fractioned, and the largest fleet of VLCCs by a publicly traded company belongs to Frontline Ltd. with 25 VLCCs. The largest private company VLCC fleet belongs to Tankers International with 37 VLCCs. In early December, Frontline and Tankers International created a joint venture to control around 10% of the VLCC market. Other smaller VLCC fleets belong to DHT with 16 VLCCS, and Navios Maritime with 8 VLCCs.

The lowest time charter breakeven costs of $24,000 per day are associated with the largest VLCC fleet from Frontline Ltd. and Tankers International. This is followed by the smaller fleets that have time charter breakeven costs of around $29,000 per day. Of course, on average the breakeven costs associated with most VLCCs is around $30,000 per day, and current time charter rates are around $33,000.

Investing in companies with VLCC fleets as the contango trade develops can generate great potential for further profits for investors. The focus of these investments would be between the publicly traded companies DHT Holdings, Frontline Ltd., and Navios Maritime.

But one must consider that investing in these companies can be very volatile because of the forward curve’s ability to quickly change. It isn’t for the faint of heart.

However, if current oil prices stay low, there will be an increase in tanker storage and thus a sustained increase in the spot price of VLCCs. However, eventually low prices cure low prices, and the market goes from contango to backwardation. It always does and always will.

Shipping companies have been burdened by unprofitable spot and charter pricing since the financial crisis, and these rates have only recently started to increase.

Warning!

As I sit here on a Saturday morning writing this missive, I want to remind all investors now betting on this play that they’re actually speculating, not investing.

There’s a lot of risk for one to think playing the tankers is a sure bet. I have a pretty large network of professional traders and resource investors, and I do not want to see the retail crowd get caught on the wrong side of the contango situation.

In the past, spot rates for the VLCCs usually decline into February and have dropped to as low as under $20,000 per day. It is entirely possible that if the day rates of VLCCs go back to 2012-2013 levels, operators will lose money.

Conclusion: this speculation on tankers is entirely dependent on the spot price and the forward curve.
The risk of this short term trade is that these companies are heavily levered, and some are just hanging on by a thread. Although this seasonal boost to spot rates has been a positive for VLCCs and other crude carriers, the levered nature of these companies could spell financial disaster or bankruptcy if spot rates return to 2012-2013 levels.

What should be stressed are the similarities to the short-lived gas rally in the winter of 2013-‘14, and the effect these prices have had on North American natural gas companies. A specific event similar to the polar vortex has occurred in the oil market, which has spurred a seasonal increase in the spot price tankers charge to move and store oil.

However, much like the North American natural gas market, the VLCC market is oversupplied; a temporary increase in spot prices that have led to increased transport and storage of oil will not be enough to lift these carriers from choppy waters ahead. Future VLCC supplies are expected to rise, with 20 net VLCCs being built and delivered in 2015 and 33 in 2016. This is much more than the 17 net VLCCs added in 2013 and 9 in 2014.

Another looming and very possible threat to these companies is the same debt threat that affected energy debt markets as global oil prices plummeted. If VLCC and other crude carriers experience a fall in spot prices, these companies’ junk debt could be downgraded to some of the lowest debt grades that border a default rating. This will increase financing costs and in turn increase the operating breakeven costs to operate these crude carrying vessels. The supply factor, high debt, and potentially short-lived seasonally high spot market could all affect the long-term appreciation of these VLCC stock prices. Investing in these companies is very risky over the long run, but a possible trade exists if storage and transport of oil continues to increase for these crude carriers.

Portfolio Contango—An Opportunity Not Seen in Decades

If you talk to resource industry titans—the ones who’ve made hundreds of millions of dollars and been in the sector for 40 years—they’re now saying that they’ve never seen the resource share prices this bad. Brokerage firms focused on the resource sector have not just laid off most of their staffs, but many have shut their doors.

The young talent is the first group to be laid off, and there’s a serious crisis developing in the sector, as many of the smart young guns have left the sector to claim their fortunes in other sectors.
There’s blood in the streets in the resource sector.

Now if you believe that, as I do, to be successful in the resource sector one must be a contrarian to be rich, now is the time to act.

I have invested more money in the junior resource sector in the last six months than I have in the last five years. I believe we’re in contango for resource stocks, meaning that the future price of the best juniors will be worth much more than they are currently.

I have my rules in speculating, and you’ll learn from my experience—and more important, my network of the smartest and most successful resource mentors whom I have shadowed for many years.

So how can we profit from the blood in these markets? Easy.

Take on my “Katusa Challenge.” You’ll get access to every Casey Energy Report newsletter I’ve written in the last decade, and my current recommendations with specific price and timing guidance. There’s no risk to you: if you don’t like the Casey Energy Report or don’t make any money over your first three months, just cancel within that time for a full, prompt refund, no questions asked. Even if you miss the three month cutoff, cancel anytime for a prorated refund on the unused part of your subscription.

As a subscriber, you’ll receive instant access to our current issue, which details how to protect yourself from falling oil prices, plus our current top recommendations in the oil patch. Do your portfolio a favor and have me on your side to increase your chances of success. I can’t make the trade for you, but I can help you help yourself.

I’m making big bets—are you ready to step up and join me?

The article The New Normal for Oil? was originally published at caseyresearch.com

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How Does Fracking Really Work? Video from Marathon Oil

Do you understand how fracking really works? If you are investing in the oil sector it's important to know how the technology that is driving the boom we are experiencing works. Marathon Oil [ticker $MRO] has put together this great animation on the basics of hydraulic fracturing, or "fracking."

This video is intended for novices, it explains how horizontal drilling works and explains the roles of water and sand.

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Safe, cost effective refinements in hydraulic fracturing (also known as fracking), horizontal drilling and other innovations now allow for the production of oil and natural gas from tight shale formations that previously were inaccessible. This video introduces the proven techniques used to extract resources from shale formations in a safe, environmentally responsible manner. Includes Spanish subtitles.

America is Going to Have to Learn to Play Nicely......Where Have All the Statesmen Gone?

By Marin Katusa, Chief Energy Investment Strategist

One of the most striking things about the Colder War—as I explore in my new book of the same name—has been the contrast between the peevish tone of the West’s leaders compared to the more grown-up and statesmanlike approach that Putin is taking in international affairs.

Western leaders and their unquestioning media propagandists appear to believe that diplomatic relations are some kind of reward for good behavior. But it’s actually more important to establish a constructive dialogue with your enemies or rivals than your friends, because that’s where you need to find common ground. Indeed, it’s been the basis for diplomacy since time immemorial.

Reassuringly, despite having been the target of the Ukraine crisis rather than the instigator, Putin still sees the West as a potential partner, not an enemy. Nor does, he says, Russia have any interest in building an empire of its own. In theory, if Putin is sincere, there should be plenty of room for cooperation, especially in the fight against terrorism.

As Putin said in his speech at the Valdai International Discussion Club in Sochi in October—whose theme was “The World Order: New Rules or a Game without Rules”—he hasn’t given up on working with the West on shared risks and common goals, provided it’s based on mutual respect and an agreement not to interfere in one another’s domestic affairs.

Putin has, of course, already shown that he can rise above the fray. By negotiating the destruction of Assad’s chemical weapons arsenal under international supervision, he did Obama a big favor and got him off the hook in Syria. But his collaboration with Obama went further than that. Putin had helped persuade Iran to consider making concessions on its nuclear program and was working behind the scenes on North Korean issues.

But as we’re discovering, this was precisely the sort of statesmanship that the neoconservative holdouts in Washington could simply not abide, because it would wreck the plan they’d been hatching for decades to bring about US military strikes against Assad and to move beyond sanctions and more aggressively confront Iran.

Determined to drive a wedge between Obama and Putin and punish Putin for interfering with their goal of regime change in the Middle East, these masters of chaos—like National Endowment for Democracy President Carl Gershman, the US Assistant Secretary of State for European and Eurasian Affairs Victoria Nuland, and Senator John McCain—sprang into action.

These crazies first started fantasizing openly about regime change in Russia, and demonizing the “ideology of Russian imperialism that Putin represents,” before helping to topple Ukraine’s constitutionally elected government.

This is hardly the sort of behavior, to put it mildly, that would lead the Russians to trust American motives—especially after two rounds of NATO expansion in Central and Eastern Europe.

And the Russians also really don’t know what to make of the fact that one second Obama is including them on the list of the top global threats, and the next they’re being asked—yet again—to help secure a truly historical rapprochement with Iran. “It’s unseemly for a major and great power to take such a flippant approach toward its partners. When we need you, please help us, and when I want to punish you, obey me,” Russia’s foreign minister Sergei Lavrov said last week.

The West has squandered the opportunity, after its victory in the Cold War, to establish a new stable system of international relations, with checks and balances, said Putin in Sochi. Instead, the US trashed the system to serve its own selfish ends and made the world a more dangerous place.

A particularly disturbing accusation Putin made is that the U.S. has been using “outright blackmail” against a number of world leaders. “It is not for nothing,” he added, “that ‘big brother’ is spending billions of dollars keeping the whole world, including its own allies, under surveillance.” If true, it would put the US beyond the pale of the civilized global diplomatic community.

Last year Putin reminded Americans, in a New York Times op-ed, that the UN was founded on the basis that decisions affecting war and peace should happen only by consensus, and that it’s this profound wisdom that has underpinned the stability of international relations for decades. The UN risked suffering the same fate as the League of Nations, he said, if America continued to bypass it and take military action without Security Council authorization.

What really amazes Putin—and most right-minded people—is that even after 9/11, when the US finally woke up to the common threat of Islamic terrorism and suffered the most epic blowback of all time, it continued to use various jihadist organizations as an instrument, even after getting its fingers burnt every time.
What did toppling Gaddafi achieve? Nothing, except to turn Libya into a total mess and fill it with al-Qaeda training camps. And what is Obama’s present strategy of funding “moderate” rebels in Syria going to achieve, if not more of the same mayhem, as one US-backed group after another joins forces with the Islamic State?

It’s hard to disagree with Putin that America’s neoconservatives have sown geopolitical chaos, by almost routinely meddling in others’ domestic affairs. He lists the many follies the US has committed, from the mountains of Afghanistan, where al-Qaeda had its roots in CIA-funded operations against the Russians, to Iraq and Saddam’s phantom weapons of mass destruction, to modern-day Syria, where the Islamic State appears to have benefited at least indirectly from some serious funding—and weapons smuggled out of Libya by the CIA.

Instead of searching for global solutions, the Russians think the US has started believing its own propaganda: that its policies and views represent the entire international community, even as the world becomes a multipolar one. It would appear that Putin is in good company. No less a statesman than former US Secretary of State Henry Kissinger agrees with him.

Sanctions against Russia are a huge mistake, says Kissinger: “We have to remember that Russia is an important part of the international system, and therefore useful in solving all sorts of other crises, for example in the agreement on nuclear proliferation with Iran or over Syria.”

Like Putin, Kissinger argues that a new world order is urgently needed. In an interview in Der Spiegel, he adds that the West has to recognize that it should have made the negotiations about Ukraine’s economic relations with the EU a subject of a dialogue with Russia. After all, he says, Ukraine is a special case, because it was once part of Russia and its east has a large Russian population.

So how has the current generation of American leaders responded to Putin’s accusation—shared by his allies Argentina, Brazil, China, India, and South Africa—that the U.S. is riding roughshod over the interests of other nations?

By mocking him with the sort of childishness that was on display at the G20 summit, where Canadian Prime Minister Stephen Harper grabbed headlines when he told Putin: “Well, I guess I’ll shake your hand, but I only have one thing to say to you: you need to get out of Ukraine.” While Putin is obviously no saint, his presence at the G20 summit shows that far from being isolated, he continues to be treated as respectable company, despite his actions over Ukraine.

At least Germany and the EU now appear to understand that diplomacy, not military action, is going to resolve differences between Russia and the West—even though Russia expelled one of Germany’s diplomats in Moscow last week. Following up on the four-hour meeting Merkel had with Putin in Melbourne and the call for intensified diplomacy by the EU’s new foreign policy chief, Federica Mogherini, German Foreign Minister Frank-Walter Steinmeier is now engaged in intensive shuttle diplomacy with Moscow.

The world will be better off if we all stop using the language of force and return to the path of civilized diplomatic and political settlement, as Putin says. That’s what real statesmen would do, rather than trying to provoke Russia into a new Colder War. America is going to have to learn to play nicely. Otherwise, as Putin says, “today’s turmoil will simply serve as a prelude to the collapse of the world order.”

As you can see, there’s no greater force in geopolitics today than Vladimir Putin. But if you understand his role and how it influences the energy sector as Marin Katusa does, you’ll know how to get out in front of the latest moves and profit along the way. Of course, the situation is fluid, which is why Marin launched a brand new advisory dedicated to helping investors avoid energy companies that are being left behind and move into ones that will benefit from the tremendous shifts in capital being created by Putin. (In fact, Marin has the very best plays for taking advantage of cheap oil.)

It’s called The Colder War Letter. And it’s the perfect complement to Marin’s New York Times best seller, The Colder War, and the best way to navigate today’s fast-changing energy sector. When you sign up now, you’ll also receive a FREE copy of Marin’s book. Click here for all the details.

The article Where Have All the Statesmen Gone? was originally published at casey research

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New LNG Plant in North Dakota will Supply Oil and Gas Producers

A new natural gas liquefaction plant is slated to come online this summer in North Dakota to reduce the flaring of gas in the Bakken Formation and provide fuel for Bakken oil and gas operations. The developer, Prairie Companies LLC subsidiary North Dakota LNG, announced earlier this month that the plant would provide an initial 10,000 gallons per day (gal/d) of liquefied natural gas (LNG), and could expand to 66,000 gal/d. Assuming a 10% processing loss, the plant would take in a maximum of 6 million cubic feet per day (MMcf/d) once expanded. In 2012, North Dakota vented and flared 218 MMcf/d of natural gas because of record high oil production and insufficient pipeline takeaway capacity for natural gas produced as a byproduct.

Hess Corporation will supply the natural gas for liquefaction at Prairie's Tioga natural gas processing location. After the LNG is produced, it will be sent via truck to storage sites at drilling locations, where – once regasified – it can be used to power rigs and hydraulic fracturing operations as well as LNG vehicles. LNG itself cannot burn; in its liquefied state, its temperature is minus-260 degrees Fahrenheit. However, as a liquid, it takes up only 1/600th of its volume as a gas, so LNG is an excellent form to store or transport natural gas. Currently, most drilling operations run on diesel, and converting to natural gas provides potentially significant cost savings given the current differential between diesel and natural gas prices. In 2012, EIA estimated that nationally oil and gas companies consumed more than 5 million gal/d of diesel in their operations, representing a significant expense.

While conversion to natural gas might not be possible in many cases, in the past few years, several companies have developed and are marketing technologies that would allow drilling rigs and fracturing pumps to run in both dual fueled and or single fueled modes.

Although the liquefaction plant will be the first LNG project in the Bakken, some producers have begun using natural gas to power their operations, citing cost savings, access to natural gas, and environmental benefits. Statoil uses compressed natural gas (CNG) to fuel some of its drilling equipment. The natural gas is produced in the Bakken and compressed using General Electric's CNG in a Box system.

Additionally, outside of the Bakken, other companies have successfully used natural gas to power drilling operations. In 2012, Seneca Resources and Ensign Drilling installed GE LNG fired engines on drilling rigs in the Marcellus Shale. Apache, Halliburton, and Schlumberger have successfully used CNG and LNG to power hydraulic fracturing operations in the Granite Wash formation in Oklahoma.

Some of these companies have estimated fuel savings on the order of 60% to 70% compared to diesel, as well as payback on the conversion investment in about a year. The basic economics that have driven the recent interest in converting or manufacturing more heavy duty trucks to run on LNG are driving some of the interest in converting to natural gas for fueling stationary oil and gas operations.

Posted courtesy of the EIA


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Telephone Stocks Hang Up and Autos Run Us Over as Markets Head Lower. Here's our Summary - Gold, Crude Oil, Natural Gas, SP 500 and Coffee

The DOW closed sharply lower on Monday as it extends the decline off January's high. Today's sell off was triggered by a sharp decline in telephone stocks, disappointment over auto sales by Ford and General Motors and reports that Jos. A. Bank Clothiers will not enter into takeover talks.

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The SP500 closed sharply lower [March contract] on Monday and below the 2012-2013 uptrend line crossing near 1744.00 confirming that am intermediate trend change is taking place. The low range close sets the stage for a steady to lower opening when Tuesday's night session begins trading. Stochastics and the RSI are oversold but remain neutral to bearish signaling that additional weakness is possible near term. If March extends this year's decline, the 25% retracement level of the 25% retracement level of 2012's rally crossing at 1692.03 is the next downside target. Closes above the 20 day moving average crossing at 1811.38 are needed to confirm that a short term low has been posted. First resistance is the 10 day moving average crossing at 1791.33. Second resistance is the 20 day moving average crossing at 1811.38. First support is today's low crossing at 1735.50. Second support is the 25% retracement level of 2012's rally crossing at 1692.03.


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Crude oil closed lower due to profit taking on Monday as it consolidated some of the rally off January's low. Today's low range close sets the stage for a steady to lower opening when Tuesday's night session begins. Stochastics and the RSI are overbought but are turning neutral to bearish hinting that a short term top might be in or is near. Closes below the 20 day moving average crossing at 95.00 would confirm that a short term top has been posted. If March extends the aforementioned rally, the 87% retracement level of the December-January decline crossing at 99.58 is the next upside target. First resistance is the 75% retracement level of the December-January decline crossing at 98.47. Second resistance is the 87% retracement level of the December-January decline crossing at 99.58. First support is today's low crossing at 96.26. Second support is the 20 day moving average crossing at 95.06.

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Natural gas [March contract] closed lower on Monday. The high range close sets the stage for a steady to higher opening on Tuesday. Stochastics and the RSI are bearish hinting that a pause in the rally is possible or that a short term top has been posted. Closes below the 20 day moving average crossing at 4.528 would confirm that a short term top has been posted. If March renews this winter's rally, monthly resistance crossing at 6.108 is the next upside target. First resistance is last Wednesday's high crossing at 5.486. Second resistance is monthly resistance crossing at 6.108. First support is the 10 day moving average crossing at 4.843. Second support is the 20 day moving average crossing at 4.528.

Here's detailed analysis on the March Natural Gas contract

Gold closed higher [April contract] on Monday. The mid range close sets the stage for a steady opening when Tuesday's night session begins trading. Stochastics and the RSI are neutral to bearish signaling that sideways to lower prices are possible near term. If April extends last week's decline, the reaction low crossing at 1215.30 is the next downside target. If April renews the rally off December's low, the 50% retracement level of the August-December decline crossing at 1306.20 is the next upside target. First resistance is last Monday's high crossing at 1280.10. Second resistance is the 50% retracement level of the August-December decline crossing at 1306.20. First support is the reaction low crossing at 1230.80. Second support is the reaction low crossing at 1215.30.

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Coffee closed sharply higher on Monday [March contract] as it extends this rally off November's low. The high range close set the stage for a steady to higher opening on Tuesday. Stochastics and the RSI are bullish signaling that sideways to higher prices are possible near term. If March extends the rally off November's low, last July's high crossing at 13.80 is the next upside target. Closes below the 10 day moving average crossing at 11.87 would confirm that a short term top has been posted.

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Get Positioned Now for the Next Great Natural Gas Switch

The Energy Report: Ron, welcome. You are making a presentation at the Money Show conference in Orlando in late January. What is the gist of your presentation?

Ron Muhlenkamp: The gist of my presentation is that natural gas has become an energy game changer in the U.S. We are cutting the cost of energy in half. This has already happened for homeowners like me who heat their homes with natural gas. We think the next up to benefit is probably the transportation sector.

TER: What is behind this game change?

"Natural gas has become an energy game changer in the U.S."

RM: The combination of horizontal drilling and fracking has made an awful lot of gas available cheaply. There's a whole lot of gas that's now available at $5/thousand cubic feet ($5/Mcf) or less. I live in Western Pennsylvania, and 30 years ago, Ray Mansfield was in the oil and gas drilling business, having retired from the Steelers. He said, Ron, we know where all the gas is in Pennsylvania; it's just a matter of price. If the price runs up, we will drill more. If the price runs down, we will drill less. Any way you slice it, we are just sitting on an awful lot of it.

Two years ago, we had a warm winter, and the price of gas actually got down to $2/Mcf. You saw an awful lot of electric utilities switch from coal to gas. Literally in a year, what had been 50% of electricity produced by coal went to 35%. The difference was made up with natural gas.

In transportation, the infrastructure to make the switch to natural gas has not been in place. We didn't have the filling stations or the trucks. Now, the trucks are just becoming available. You can buy pickup trucks from Ford Motor Co. (F:NYSE) and General Motors Co. (GM:NYSE) that run on natural gas. Furthermore, Clean Energy Fuels Corp. (CLNE:NASDAQ) has established natural gas filling stations coast to coast, every 250 miles on five different interstate highways.

Westport Innovations Inc. (WPRT:NASDAQ) has been producing 9 liter (9L) natural gas engines. Waste Management (WM:NYSE) uses 9L engines on garbage trucks and expects 8590% of its new trucks to be natural gas fueled. Westport has just come out with 12L engines, which are used for over-the-road trucks. I don't expect those engines to get adopted as fast as the utility industry made the switch to natural gas, but there has been a fairly rapid adoption in the waste management industry. I think we're on the cusp of a major trend.

TER: That fuel switching in the power industry has been going on since 2008. Is it still progressing at the same rate or is it picking up?

"The big switch is over in utilities. But we've barely begun the transition with transportation fuel."

RM: It's pretty much leveled off. In fact, there's probably a little bit less gas used than when gas was below $3/Mcf. The latest numbers I've seen show that we're running about 37% coal and about 3334% gas. Going forward, I think coal use will continue to decline, and natural gas use will continue to rise. The big switch is over in utilities, and it will be gradual from here. But we've barely begun the transition with transportation fuel.

TER: So the game has changed for the power industry, and the transportation industry is next. What other changes do you foresee in the future?

RM: We will continue to use more natural gas and less crude. Right now, for equal amounts of power, crude oil is priced at about three times the natural gas price in the U.S. That is too wide a spread to ignore, economically.

The Natural Gas - Crude Oil Spread

source: Bloomberg

Incidentally, in Europe, natural gas is still at $12/Mcf. It's on a par with crude. Most European chemical plants use a crude oil base to make chemicals. U.S. plants use a natural gas base. Natural gas becomes ethane, then ethylene, then polyethylene and then plastic. So producers of plastics or the feedstocks for plastic in the U.S. now have an advantage they didn't have before.

"The natural gas price advantage will be with us in North America for quite a long time. It's huge."

In Japan, the natural gas price jumped from $12 to $16/Mcf just after the tsunami wiped out the Fukushima nuclear power plant. To ship gas from the U.S. to Japan, the cost of compression, liquefying and decompression is about $6/Mcf. Executives at U.S.-based companies like Dow Chemical Co.

(DOW:NYSE) are saying they don't want the U.S. to export gas because that would drive the price up. But domestic gas consumers already have that $6/Mcf advantage. Meanwhile, in Williston, N.D., the natural gas price is effectively zero. Producers still flare it because they don't have the pipelines to take it out of the area. So this price advantage will be with us in North America for quite a long time. It's huge. That's why we call it a game changer.

TER: So how can investors take advantage of these changes?

RM: Well, any number of ways. We hold some fracking services companies, like Halliburton Co. (HAL:NYSE). We own a couple of drillers, including Rex Energy Corp. (REXX:NASDAQ). And we invest in the people who build natural gas export facilities, such as Fluor Corp. (FLR:NYSE), KBR Inc. (KBR:NYSE) and Chicago Bridge Iron Co. N.V. (CBI:NYSE).

I already mentioned companies building natural gas-fired engines, including Westport, which makes a kit to modify a common diesel engine. And because natural gas will require new, larger fuel tanks, investing in companies that build natural gas tanks is another way to play it. One of the disadvantages of natural gas versus gasoline or diesel is compressed natural gas takes about three to four times the volume to get the same range. Liquefied natural gas (LNG) takes about two times the volume.

Of course, compressed natural gas is stored in pressure tanks, so it takes a pressure tank of larger size. Fuel tank conversions have been almost as expensive as the engine conversions. 3M Co. (MMM:NYSE) has gotten in that business, as has General Electric Co. (GE:NYSE). There's another outfit called Chart Industries Inc. (GTLS:NGS; GTLS:BSX), which has already run a good bit.

"We want a foot in each of these camps because we're not quite sure who the ultimate winners will turn out to be, but we know what the product lines will have to be."

We want a foot in each of these camps because we're not quite sure who the ultimate winners will turn out to be, but we know what the product lines will have to be. Don't forget about the companies that own the LNG export facilitiesCheniere Energy Inc.'s (LNG:NYSE.MKT) facility should be up and running in probably 2015, but, again, that stock has run up a good bit, too.

Pipelines will benefit from the switch. One of the biggest pipelines in the country is Kinder Morgan Energy Partners L.P.'s (KMP:NYSE) Rockies Express Pipeline, which stretches from Northern Colorado to Eastern Ohio and ships gas east. Kinder Morgan recently filed to reverse the flow on part of the line. Right now, in Western Pennsylvania, we have a glut of gas. A few months ago, they reversed the flow of the pipeline from the Gulf Coast that used to come up to Western Pennsylvania. There's a whole lot going on.

TER: After some serious oil train derailments in recent months, pressure is building now to increase pipeline capacity, but there is also pressure on producers to reduce flaring, which is happening on a huge scale in the Bakken Shale. How will the economics and the operations of Bakken producers be affected if they can't flare and pipeline capacity is not increased?

RM: The Bakken is primarily an oilfield; the gas is a byproduct. We hear a lot about the Keystone XL Pipeline, which is meant to carry oil from the Bakken south. I can't speak specifically, but if you're going to lay an oil pipeline from the Bakken, you should lay a gas pipeline alongside it. You can ship oil by rail, but it's not economic to ship gas by rail. One way or another, the oil will be shipped.

TER: Bill Powers, the independent analyst and author of "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth," says gas prices are going to rise steadily to as much as $6/million British thermal units ($6/MMBtu) because U.S. gas production has peaked and now is now flat or declining. Do you agree with that?

RM: Our production of gas has not peaked and is not declining. We are using fewer rigs drilling for gas, but each well, particularly if you drill horizontally instead of just vertically, is producing so much more gas. Production is not declining and isn't likely to for at least a decade. At current rates, we can drill in Pennsylvania for another 50 years. Yes, you drill the best wells first but also, over time, you get a little bit better at timing this stuff. I'd be very surprised if the price in the next decade gets over $5/Mcf for any extended period of time because there's an awful lot of gas that's very profitable at that price. I'm willing to make that bet with Bill Powers. But even $6/Mcf gas would equate to $55/bbl crude, which is still a huge spread and wouldn't negate my general argument.

TER: What's your forecast for gas prices in 2014?

RM: My forecast is $4/Mcf, give or take $1. We just had a big cold snap on the East Coast. What used to happen is any time you had a cold winter, the price of gas jumped. For instance, in 2005, when crude was selling about $50/barrel ($50/bbl), gas began the year at about $7/Mcf, which was on par with crude, but in the wintertime, it doubled and ran up to $14/Mcf. The recent cold snap took gas all the way up to ~$4.20/Mcf. Gas is going to be in that range for a long time.

TER: Your advice to investors in natural gas is to get exposure to exploration and production companies, service companies and even LNG plant constructors. What about the LNG plant owners, the pipelines and the railroads?

RM: The pipelines will do well. They've already been bid up. The railroads will benefit from oil and gas, but they're getting hurt because coal tonnage is way down, CSX Corp. (CSX:NYSE) just reported. So for the railroads, it's going to be a wash. They'll haul less coal and more oil. The railroads won't haul gas. How much oil they haul is an open question. We're about to tighten restrictions on how tank cars are built.

TER: What did well in the Muhlenkamp Fund last year?

RM: The fund was up 34.4%. We did very well in biotech stocks. We did very well in financial stocks. We also did well in some energy stocks. Airlines did well for us. Incidentally, airlines benefit big time from cheaper energy, as you know. So it's fairly diverse.

TER: How are you adjusting your portfolio this year?

RM: Not too much has changed. We're no longer finding many good companies that are cheap. So we're monitoring and adjusting a little bit around the edges. We do think banks have further to go. We think the economy will grow somewhere between 2.53% this year. We've owned no bonds for the past couple of years, but with the Treasuries now, the interest rates on the longer end are high enough so that savers can get a little bit of return.

TER: I was surprised to see a really sharp drop in November for Fuel Systems Solutions Inc. (FSYS:NYSE). Why did that happen?

RM: Fuel Systems makes conversion kits for cars to burn compressed natural gas. In places like Pakistan, 40% of the cars run on natural gas; this is not new technology. A number of its customers decided to make these kits in-house. Fuel Systems is a small position of ours, but, yes, it got hit in Q4/13 when it announced that a number of its customers decided to produce their own kits. One of the nice things about this is there's no new technology involved. We've been using natural gas as a power source for generations. What has changed is the amount that's available reliably at a cheap price.

TER: There was another sharp drop in Clean Energy Fuels in October. What happened there?
RM: Clean Energy, so far, doesn't make a profit because it has been shelling out all the money to build all these filling stations. It's just taking a little longer than people expected. The stock is compelling at these levels. A number of these companies ran. Westport doubled, and we took some profits. It's now back down, and we should do a Buy rerating. There is volatility in this stuff, but the economics are undeniable. We still managed a 34.4% gain this year, which isn't bad.

"Royal Dutch Shell Plc is building natural gas fueling stations in concert with another truck stop operator."

Clean Energy has signed a joint venture with Pilot Flying J to build natural gas fueling stations at Flying J truck stops coast to coast. Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) is doing a similar thing in concert with another truck stop operator. For instance, the Port of Long Beach, Calif., passed a rule several years ago that the trucks on the port need to burn natural gas. The Port of Hamburg, Germany, has contracted to put a natural gas-fired power unit on a barge so that when cruise ships come into the harbor, instead of running their own power off their diesel engines and generators, they'll use this barge to supply power to the cruise ship because natural gas exhaust is cleaner than diesel exhaust.

TER: A couple of other companies had surprising drops Rex Energy and Westport Innovations. Rex rose all year until October or November, when it suddenly dropped. Westport also dropped suddenly. You had a wild ride in your portfolio, didn't you?

RM: We bought Rex at $13/share, and it went to $22 or $23, and it's now $19. I can live with that. The dips give you a chance to load up again. That volatility is why we have a diversified portfolio. That's why you don't just bet on three stocks.

As an investor, most of the time what you're looking for is to find a difference between perception and reality. Today, we have two realities: One is the price of crude oil, and the other is the price of natural gas. So it's literally an arbitrage if you can buy energy either at the equivalent of $100/bbl or at a third of that.

Four dollar gas is equivalent in energy content to about $35/bbl crude. So I can buy my energy either at $100/bbl or $35/bbl. Economics says that spread is too wide. It won't necessarily close, but it sure as heck will narrow a good bit. For instance, I own no conventional oil companies. I think the price of oil will be coming down.

TER: So what companies in your portfolio look most promising?

RM: If you really want to get me excited, we can talk about natural gas, which we've been talking about. We could talk about biotechnology, which is exciting but I don't understand it as well. We can talk about U.S. manufacturing, but that's basically based on cheaper energy. I just bought more Rex. At these prices, I'm buying Westport. I just bought Chicago Bridge. I just bought KBR.

TER: What is your main motivation in buying these companies? Is it just the stock price or is there something about the management of the company or the technology?

"I want to buy Pontiacs and Buicks when they go on sale. I don't want a Yugo at any price. I would like to buy Cadillacs, but they don't go on sale very often."

RM: We're in the investment business. What we rely on is good companies, and we look to buy them when they're selling cheaply. Our first measure of how well a company is run is we start with return on shareholder equity. So we like companies that are at least above average in return on shareholder equity. I cannot yet say that about Clean Energy, but we do think Clean Energy is at the forefront of something that's needed for this transition. We're always looking for good companies. Then the question is whether you can buy them at a decent price.

My phrase is: I want to buy Pontiacs and Buicks when they go on sale. I don't want a Yugo at any price. I would like to buy Cadillacs, but they don't go on sale very often. But if I can get Buicks when they're on sale, I'll make good money for my clientele. We think that the companies we have are at least Buicks. If we can get them at Chevy prices, that's when we buy them. I will not pay an unlimited amount for any company.

I've never seen a company that was so good it didn't matter what you paid for the stock. To us, value is a good company at a cheap price. Some people bottom fish. They look to see when they can steal companies, and there are times when you can make money that way. But at that point it's not often a very good business, and there aren't too many well run companies at bargain basement prices. So it's very unusual for us to buy a weak company or a weak industry.

TER: Ron, this has been a good conversation. I appreciate your time, and good luck with your Money Show presentation.

RM: Thanks; it'll be fun.

Ron Muhlenkamp is the founder and portfolio manager of Muhlenkamp Co. Inc., 


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Energy Outlook: What’s Hot in 2014

By Marin Katusa, Chief Energy Investment Strategist

Investors who want to know how the energy sector will be doing in the coming year are, in my opinion, asking the wrong question. There really is no such thing as "the energy sector," because the performance of the different resources—from oil and gas, to uranium, to coal, to renewables—can vary dramatically.


Case in point: while unconventional oil exploration and production have seen a huge upswing in recent years, thanks to the vast success of the Bakken and other oil rich shale formations, at the same time natural gas has taken a nosedive, due to a supply glut that still hasn't found its balancing point.

To find out which investments will deliver the greatest profits for well positioned investors in 2014, my team and I have identified three trends that are hot… and may become even hotter in the course of this year.

HOT: Service Companies in North America

The oil and gas production in the United States is mature. Rather than looking for new basins, companies are looking to "rediscover" the past by applying new technology to increase economic production from known oil and gas fields.

This new technology comes in a variety of shapes and sizes: better software, bigger rigs, more efficient drilling processes. And it's being applied everywhere, onshore and offshore, conventional and unconventional alike.

Just as an example, today we're seeing operators drill more than 50 horizontal wells from a single well pad, a far cry from just a decade ago.

Exploration and production companies know that the focus moving forward is not just the amount of oil they can pump out of the ground, but the profit they can extract from every barrel (what we call the "netback"). This is even more true in the mature unconventional basins such as the Bakken, Eagle Ford, and the Marcellus shale plays, where the margins are tight and require an oil price of more than US$70 per barrel in order to be economic.

This means E&P companies have to use the best ways to increase production from every well—while at the same time reducing their drilling costs. Failure to do so would be to guarantee a firm's demise.

The dilemma for E&P companies is having to prioritize what their shareholders want in the short term—growing production and dividends—over whatever may be best for the company in the long term. At the same time, they have to fight the natural decline of oil coming out of their wells.

All the while, service companies continue to extract fees for their tools and services. Drillers, pumpers, frackers, and other oilfield-service guys make money regardless of whether E&P companies find oil or produce it at economic rates.

We've said it before: Many E&P companies are running on a treadmill, and the incline is going higher and higher, which means higher costs to produce the same amount of oil.

Of course, not all service companies will rake in the dough. The ones that will do the best are the ones that can consistently stay at the forefront of technology and keep signing contracts with the supermajors like Exxon, Chevron, and Shell.

HOT: European Energy Renaissance

Russia's grip on European energy continues to tighten, and there's a push to produce oil and gas within their own borders all around Europe.

2014 looks to be an exciting year for companies like one of our Casey Energy Report stocks, a TSX-V-listed oil and gas explorer and producer with a 2 million acre concession in Germany. We call the deposit it's sitting on the "Next Bakken" because we believe that its potential to deliver exceptional output could rival that of the famed North American formation.

This development is still in its early stages, but investors who position themselves now could see outsized gains for years to come. It's not really a question of "if" the oil is there—previous oil production in the very same location yielded more than 90 million barrels—but of "how much" oil can be extracted with the modern methods not available the last time companies worked on this field.

The company has completed its first well and will continue to drill additional wells (both vertical and horizontal) next year. While the initial well cost more than anticipated, it's a good start that indicates economic oil can be produced in Germany. We're also confident this company's experienced management team is applying the lessons of its first foray to reduce drill costs on future wells.

As our Energy Report pick proves up any of its projects in 2014 and early 2015, we can expect another of our holdings, which has just entered the German oil and gas scene, to either farm into the company or even buy it out.

We predict that by the end of 2015, our "Next Bakken" play, and others like it, will have attracted a lot of attention, not just from individual speculators, but from institutional investors as well—and investors who have gotten in early will be very happy indeed.

Another of our portfolio holdings is just beginning to drill on its Romania projects after a series of delays due to politics and bureaucracy. We have reason to be optimistic because its JV partner, a Gazprom subsidiary, has drilled successful wells on the same basin on the other side of the border in Serbia. If our pick has anything close to that level of success, the markets will surely take notice and its shares will go much higher.
As the "Putinization" of the global energy markets continues and Russia's dominance grows, European countries become increasingly more desperate to escape from under Putin's heavy thumb and to start developing their own energy resources.

The European Energy Renaissance is real, and we continue to monitor companies that are funded and have the permits and ability to drill game-changer wells in Europe in 2014.

HOT: Uranium

During a recent trip to London, I spoke with Lady Barbara Judge, chairman emeritus of the UK Atomic Agency and an advisor to TEPCO on the Fukushima nuclear disaster in Japan. I asked her point blank whether Japan was willing to bring any nuclear reactors back online in 2014.

Her answer was an unequivocal "Yes." The Japanese have no choice, really, because the alternative—importing liquefied natural gas (LNG)—is far too expensive.

Japan is the world's largest importer of LNG and has had to double its imports since the Fukushima incident. For that privilege, the country pays some of the highest rates on the planet, almost four times more than what we pay for natural gas in North America.

South Korea also shut down its nuclear plants post-Fukushima to do inspections and maintenance upgrades, and it, too, has had to import a lot of LNG. Both countries are looking to restart their nuclear reactors so they can stop paying a fortune to foreign energy suppliers. When these countries restart their reactors, they'll also restart the uranium market, so we expect uranium prices to begin to shake loose of the doldrums this year.

Another driver will be throwing the switch at ConverDyn, the U.S. uranium facility that is slated to start converting natural U₃O₈ to reactor-ready fuel in late 2014 or early 2015.

We currently hold two solid uranium companies in the portfolio—one is a U.S. based small cap producer (one of the very few in America), the other is the lowest risk way to play the uranium market that I know of. Both, we believe, will take off in 2014 on the renewed interest in uranium and the associated stocks.

If you want to know more about our thoroughly vetted energy stocks and their potential for amazing gains in 2014 and beyond, give the Casey Energy Report a try. You'll find all my "What's Hot" predictions and the full names of the stocks I've mentioned above in our January forecast issue… plus the energy sectors you should avoid like the plague this year… as well as a feature article on elephant oil deposits in the Gulf of Mexico and a new stock pick ready to profit from them.

Giving the Casey Energy Report a try is risk-free because it comes with a 3 month, full money back guarantee. If the Energy Report is not all you expected it to be, just cancel within those 3 months and get a prompt, full refund. Or cancel any time AFTER the 3 months are up for a prorated refund. Getting started is easy.......Just Click Here.


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Baker Hughes Announces Fourth Quarter 2013 Well Count

Baker Hughes Inc. (NYSE: BHI) announced today that the U.S. onshore well count for the fourth quarter 2013 is 9,056 wells; down 19 wells from the revised 9,075 wells counted in the third quarter 2013. Compared to the fourth quarter 2012, the well count was up 398 wells or 5%. Due to improved drilling efficiencies, the average US onshore drilling rig now produces 9% more wells compared to the same quarter last year.

Compared to the third quarter 2013, the well count increased most notably in the Eagle Ford (up 75 wells or 7%), Mississippian (up 23 wells or 6%) and Marcellus (up 21 wells or 4%) basins. These increases were offset by reductions in the Fayetteville (down 29 wells or 18%) and Granite Wash (down 22 wells or 13%) basins.

The average US onshore rig count for the fourth quarter 2013 was down 12 rigs from the previous quarter at 1,697 rigs. On average, the US onshore rig fleet produced 5.34 new wells during the fourth quarter, representing a 1% improvement in drilling efficiencies compared to the third quarter.

For more detailed Well Count information by basin, including historical well counts and a map, visit www.bakerhughes.com/wellcount.

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Merrill Lynch Offers Energy Themes to Watch in 2014

Energy stocks have underperformed this year, but Merrill Lynch analysts are reasonably positive on the sector for 2014, pointing to some key themes:

With the price of gas likely to remain in a narrow range next year, the firm says investors should buy high quality, large resource based stocks such as COG and RRC.

The net asset value race is over, and the coming year is about execution, Merrill Lynch says, seeing PXD and WLL as winners here.

Following 2013's wave of activism, the firm sees gains in HES and OXY.

Favorable outlooks for E&P budgets could lift oilfield services stocks focused on North America, such as HAL and SLB.

The Merrill Lynch team sees crude production rising to the highest level since 1989, and pinpoints TSO and VLO as the refiners to benefit the most in 2014 because they're "crude advantaged" and have stock specific catalysts for next year.

Finally, the firm suggests Investors with significant gains in CVX may want to take those and buy XOM for 2014.

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The Energy Report: Where to Drill for Portfolio Outperformance

The Energy Report: Chad, you recently released an early look at 2014 titled, Drilling Down for Outperformance. You noted that you saw an average 3540% upside on your Buy rated names. What are your criteria for picking companies?

Chad Mabry: To start, we use a discounted cash flow based net asset value (NAV) approach to valuing exploration and production (EP) stocks. While cash flow is an important metric, NAV does a better job of comparing companies with different asset profiles, specifically within the small and midcap EP space. NAV does a better job of accounting for a company's upside potential than cash flow metrics. We use a bottom-up approach to drill down into a company's asset base, its average type curve, estimated ultimate recoveries (EURs), well costs and so on. In this way we find out about the economics of those plays and what the sensitivities are to our commodity price deck. We then try to sort out companies that aren't being valued appropriately and identify strong risk reward opportunities.

TER: There has been a lot of commodity price volatility this last year. How do you determine what prices to use when you're estimating NAV?

CM: That's a good question. Given the volatility inherent in oil and gas commodity price movements, forecasting prices is somewhat of a losing proposition. We try to set a long term price deck based on the industry cost structure, which is based on the marginal cost of new production. Over the long term, laws of supply and demand will win out and commodity prices should normalize toward equilibrium levels, which are currently about $90 per barrel ($90/bbl) for oil and $4.50 per thousand cubic feet ($4.50/Mcf) for natural gas.

TER: The Energy Information Administration (EIA) is forecasting U.S. oil production to increase by about 1 million barrels/day in 2014 with year-over-year growth in the 1015% range. What impact could that have on the price of oil going forward?

CM: There is an oil production renaissance in the U.S. We expect that to continue, driven by the independent EPs. We're forecasting production growth in 2014 of about 5055% in our coverage universe. That is going to be driven by oil growth as companies continue to allocate the vast majority of their capex budgets next year to oil and liquids-weighted projects.

TER: Are there certain sectors of the oil market that you like better than others?

CM: We feel the outperformers into 2014 are the companies that have established core positions in some of the more economically attractive oil and liquids resource plays in North America. It won't come to anyone's surprise that some of the best-in-class resource plays include the Eagle Ford, the Bakken and the Niobrara, to name a few. But we also feel like there are some pretty intriguing, earlier-stage plays that offer exposure to oil and liquids that we're going to be keeping an eye on into next year, specifically the Utica, the Tuscaloosa Marine Shale and the Woodbine.

TER: What do you like about developed areas, like the Eagle Ford?

CM: Eagle Ford has become the standard bearer for the oil and liquids resource plays in the U.S. The geography is best in class and it is a repeatable play with very compelling economics. As we move into development mode in the play, we continue to see the potential for additional catalysts, which should continue to lead to outperformance for our names that have exposure there.

As well costs continue to reduce and recoveries and completion designs improve, we expect rates of return to drift higher. As various operators focus on additional zones, there is additional upside potential to companies' drilling inventories in the form of additional pay zones.

The best exposure to the Eagle Ford and one of our top picks is Carrizo Oil Gas Inc. (CRZO:NASDAQ), which has established a very nice sweet spot in La Salle County.

We also like Sanchez Energy Corp. (SN:NYSE), which has become somewhat of an Eagle Ford pure play with a very robust inventory across the play.

TER: Carrizo is in the Utica, the Marcellus and the Niobrara. In November, it announced record oil production, and the stock price is up pretty dramatically, although it's off its all-time highs. Is there still upside?

CM: We believe so. We see roughly 50% upside to our NAV from current levels. One of the reasons that it is a top pick of ours is that it has core positions in very attractive plays. You mentioned its position in the Utica, the Niobrara and the Marcellus. It has some best in class exposure to these plays.

We expect the company to have some downspacing results in the Eagle Ford as it continues to test 500 foot (500 ft) spacing versus 750 ft, where it is today. We don't have that in our numbers right now. We estimate that could add about $10/share to our NAV from current levels.

"Given the volatility inherent in oil and gas commodity price movements, forecasting prices is somewhat of a losing proposition."

In the Utica, the company's acreage is in a very delineated, core spot of the play. While it is still early on in its activity in the play, we expect it to have initial well results in the near term. We think that could be another catalyst for the name.

Then, like other operators in the Niobrara, Carrizo is also testing downspacing, which, if successful, could yield incremental upside to what we're giving it credit for right nownot only core positions in core plays, but also the catalysts that we expect to drive the stock up toward our NAV over the next 12 months.

TER: You have a Buy rating on Sanchez. It also has a secondary in the Tuscaloosa Marine Shale. What impact could the Tuscaloosa have on its share price?

CM: We have just $1/share of Tuscaloosa Marine Shale value in our NAV right now. It's very minimal at this point. At current levels, investors are getting a free option on Sanchez' Tuscaloosa Marine Shale potential, which could be very meaningful.

One of the reasons that we like these more emerging areas is that you're not really paying as much for some of these positions. Contango Oil Gas Co. (MCF:NYSE.MKT), which is more of a legacy name, also has exposure. I'd even classify it as a Tuscaloosa Marine Shale sleeper because it doesn't register on a lot of people's radars as having a significant position in that play following its merger with Crimson Exploration Inc. (CXPO:NASDAQ).

If you're a believer in the long-term commerciality of the play, which we are, then a name that you need to own is Goodrich Petroleum Corp. (GDP:NYSE), which has by far the most leverage to that play with around 300,000 net acres. As that company accelerates to a five rig-operated program in the Tuscaloosa Marine Shale next year and gets away from the well watch nature that's made for a volatile 2013, its position in that play delivers outperformance for the stock. If you're a believer in the play, then Goodrich is a must own name. As the play advances further along the development curve, Goodrich becomes a takeout candidate for any larger company looking to gain exposure in a material way.

TER: What else is intriguing in the Niobrara?

CM: A lot of these names with exposure to the Niobrara have been some of 2013's outperformers.

But when we look at who has exposure to the play and who maybe isn't getting as much credit as the next guy, an attractive name to us is PDC Energy Inc. (PDCE:NASDAQ). It's the third-largest producer and leaseholder in the Wattenberg. In addition, it has a pretty significant position in one of the emerging areas of the Utica. At these levels, it's a pretty compelling investment.

TER: The price is down from earlier in the year. Is this a buying opportunity?

CM: The stock did correct a bit after a Q3/13 earnings miss and its initial results in the southern part of its Utica position, which didn't meet Street expectations. This did present a nice buying opportunity. It does have a number of upcoming catalysts, not only in the Utica, but also from additional downspacing and testing of other formations in the Wattenberg/Niobrara. At current levels, investors are getting a free option on its position in the Utica.

TER: Are there any neighbors you like?

"As we look into 2014, we're more focused than ever on company-specific fundamentals and relative performance indicators that should help pick the outperformers into next year."

CM: Yes, as a matter of fact. Bonanza Creek Energy Inc. (BCEI:NYSE) has a very quality position in the Niobrara; it's essentially a Niobrara pure play. But at current levels, it is receiving closer to full valuation for that position, and we see better risk-reward in other names, specifically Carrizo and PDC.

TER: Bonanza Creek is both in Colorado and the Cotton Valley sands in Arkansas. What are the next steps?

CM: Its focus will be on its Wattenberg/Niobrara position. It has a four-rig program in the play, which should drive 2014 production growth of 4550%. But at the same time, the Wattenberg valuation is more than $50,000/acre, which just seems closer to full value at these levels.

TER: Did you also initiate coverage on Gulfport Energy Corp. (GPOR:NASDAQ)?

CM: Yes. We have a Hold rating on Gulfport for similar reasons. Whereas Bonanza Creek has a quality position in the Wattenberg/Niobrara, Gulfport has a fantastic position in the core of the Utica. The valuation is a bit stretched at these levels, however.

TER: You have a Buy on Midstates Petroleum Co. Inc. (MPO:NYSE). Is that based on its exposure to the Anadarko Basin?

CM: The Buy on Midstates is based on the fact that its portfolio is misunderstood and undervalued. It also has a leading position and is one of the biggest operators in the Mississippi Lime play in Northern Oklahoma. Then it has the third leg of the stool, if you willthe Wilcox play in Louisiana, which is an earlier-stage play that it is not receiving any credit for. As we move into 2014 and the company executes and delivers what we feel like will be above-average production growth, that value gap is likely to narrow.

TER: Do you still like the Gulf of Mexico?

CM: It's all about relative valuation. The Gulf of Mexico players had a nice tailwind earlier this year with Light Louisiana Sweet oil prices enjoying a healthy premium to West Texas Intermediateclose to $20-plus/bbl earlier this year. That premium has since eroded. It's not something that will likely come back in a meaningful way in the near term. As a result, you lose that benefit looking into 2014. But, like I said, it's all about relative valuation.

We do think there are some nice opportunities in the Gulf, specifically Stone Energy Corporation (SGY:NYSE). It has several impactful catalysts in the form of deepwater exploration wells that should have results starting in early 2014, which could drive outperformance for the stock. Investors aren't paying for any of that upside at these levels, so that's really why we have the Buy rating on Stone at this time.

TER: Its stock is up to $40 from $32 last month. Is that mainly because of the new spudding in early 2014?

CM: Fortunately for Stone Energy, there are a number of wells, operated and non-operated, that should provide a steady flow of catalysts throughout 2014 and 2015 in the deepwater Gulf of Mexico. We expect several catalysts over the course of the next couple of years.

TER: Are there other relative outperformers in the Gulf of Mexico?

CM: Right now, our two names that operate exclusively on the Gulf of Mexico shelf are Energy XXI (Bermuda) Ltd. (EXXI:NASDAQ) and Energy Partners, Ltd. (EPL:NYSE). We have a Buy rating on Energy XXI and a Hold rating on Energy Partners. Shares of Energy XXI, on a relative basis, are more attractive because they are trading below their proved-only valuation and the company is pursuing a number of exploration objectives, which could cause the stock to outperform. Energy Partners has had some issues in some of its core fields recently, which could provide a headwind for shares in the near term.

TER: Energy XXI also has been doing quite a bit of consolidating of other smaller players. It is pursuing some deeper salt plays. When could those start to pay off?

CM: It's the third largest oil producer on the shelf. It is taking advantage of its footprint in the area and its expertise of the geology in the basin to pursue some deeper exploration targets, not necessarily the ultra deep. We should get some results into 2014 from the company.

You mentioned it being a consolidator. Both Energy Partners and Energy XXI have become consolidators on the shelf. Looking into 2014, we wouldn't be surprised to see Energy XXI target some larger objectives internationally, specifically in Malaysia, which offers a nice analog field to what we've seen in the Gulf of Mexico, but with larger scale.

TER: Energy XXI also just initiated a share buyback program and raised the dividend. Is that part of a trend?

CM: It's a representation of its confidence in the stock and in its performance, its belief that shares are undervalued and its willingness to buy back shares at levels it feels are too low.

TER: Smart capital allocation has been a differentiator for some of these companies in 2013. How are successful companies better using their resources?

CM: Since we've seen commodity prices somewhat range-bound with a lot of the land grab more or less over, investors will be even more willing to reward companies that demonstrate effective and efficient operations in 2014.

TER: Companies have been trying to create some new catalysts and value, and derisk their new projects. Is that paying off?

CM: Yes. We've seen that across the board in terms of drilling efficiencies. As companies have migrated away from acreage capture to development mode in their core resource plays, we've seen rig productivity increase fairly dramatically. That's been an area where companies have been able to deliver meaningful cost savings while, at the same time, enhancing their drilling and completion techniques, essentially making bigger wells and increasing their IRRs in these plays. Downspacing has also been a catalyst in a lot of these plays and, looking into 2014 in some of the more developed plays, whether it's the Bakken, the Eagle Ford or the Niobrara, additional downspacing results will be a major catalyst for a number of companies.

TER: Can you leave us with some advice for investors in the space as they prepare for 2014?

CM: Stock selection will be more important than ever looking into 2014. While this is a group that historically has a high correlation to oil and gas prices, it's becoming more of a stock picker's market. As we look into 2014, we're more focused than ever on company specific fundamentals and relative performance indicators that should help pick the outperformers into next year.

TER: Thanks for joining us today.

CM: Thanks for having me.

Chad Mabry is an analyst in MLV's Energy and Natural Resources Research Department. Bringing over 10 years of experience in the oil and gas industry, he primarily focuses on small- and mid-cap companies in the Exploration Production sector. Prior to joining MLV, Mr. Mabry was a senior analyst with KLR Group and Rodman Renshaw, and an associate analyst with Pritchard Capital Partners. Mr. Mabry holds an M.A. in Accounting and a B.A. in Philosophy from the University of Texas at Austin.

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