Fracking in the U.S. is here to stay, affirms Keith Schaefer, editor of the Oil & Gas Investments Bulletin. North American business is dependent on cheap energy, and even energy utilities are switching from coal to natural gas. Although environmental concerns remain, the industry has incentive to do the right thing, says Schaefer. In this exclusive interview with The Energy Report, Schaefer profiles service companies that are using cutting-edge technology to make fracking safer, greener and cheaper.

Everyone agrees that high energy prices are here to stay, so most companies should perform well in the long run. But what about near-term opportunities? Taylor MacDonald, associate portfolio manager at Pathfinder Asset Management, is looking to service companies for industry outperformance. In this exclusive interview withThe Energy Report, he describes why proprietary niche service companies virtually own the markets they are establishing

COMPANIES MENTIONED : AFRICA OIL CORP. : CORTEX BUSINESS SOLUTIONS INC. : HUSKY ENERGY INC. : NEW ZEALAND ENERGY CORP. : NXT ENERGY SOLUTIONS : PRD ENERGY INC. : RIDGELINE ENERGY SERVICES INC. : SYNODON INC. : TAG OIL LTD.

The Energy Report: It’s been almost a year and a half since your last interview. We’ve had lots of ups and downs in the market. What is your current outlook for oil and gas? Are prices going to be stable or do you expect significant movement one way or the other?

Taylor MacDonald: Eric Sprott put it best when he said something along the lines of “Tell me how many greenbacks the Federal Reserve is going to print and I’ll tell you where oil prices are going” Greater easing is bad for the U.S. dollar and good for things priced in dollars. In a supply-constrained environment, the potential for shocks exists, but demand will continue to grow as long as oil prices don’t run too quickly or so far as to cause too much of a drag on global economic activity.

If there’s an incident in the Middle East that shuts down oil infrastructure in Saudi Arabia or the Strait of Hormuz, we could easily see oil at $150/barrel (bbl) or even $200/bbl. Hopefully that would be temporary. But irrespective of that possibility, we are quite bullish on the energy space. Until someone develops something to supplant it, we are still going to need a lot of oil and gas to fuel global economic activity.

TER: Would additional easing make much difference?

TM: I don’t think there’s any end in sight to easing, which will only continue to devalue the dollar—and that is good for commodities priced in dollars. Realistically, we are looking at steadily higher oil prices going forward.

TER: It seems that most of the easy oil has been found, at least onshore. A lot of activity is taking place offshore in places people didn’t consider potential oil-producing areas. Is this the future of oil and gas production?

TM: That is certainly going to be where we’ll continue to see a lot of action. We look at both new exploration on old fields and new exploration on new fields. Pathfinder has done very well in the past with holdings in Tag Oil Ltd. (TAO:TSX.V) and New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX), two companies that are developing what was previously seen as an “exotic basin.” We’ve also done very well with our holding of Africa Oil Corp. (AOI:TSX.V). We think that companies going into underdeveloped or unproven basins are ripe for the picking. The other place we’ve seen a lot of potential is in companies going into past-producing fields. One company in this arena, which we have a large position in and from which I recently got an update from management is PRD Energy Inc. (PRD:TSX.V). It’s acquiring acres and acres of land in Germany, Lower Saxony, and going back into fields that produced until World War II—and some more recently. PRD is going to rework them by applying modern extraction techniques to fields that have produced a mere fraction of their potential. This could be one of the better plays we see over the next year.

TER: Would you classify these as unconventional oil plays or extensions of existing technology?

TM: These are about as conventional as things get. I think the money that’s going to be made at the moment will be on normal oil and gas production. There is a lot of potential in unconventional reservoirs and new extraction techniques, and in applying conventional techniques to unconventional reservoirs. But right now, the simpler it is, the better.

TER: Have there been any major developments in some of the companies that you talked about last year?

TM: There’s a saying in the mining business that the best way to make money in a mining boom is to be in the business of picks and shovels. We are looking beyond that to “Picks and Shovels 2.0.”

In the oil and gas space, a handful of companies are applying new technologies to old industry problems. The first one is Ridgeline Energy Services Inc. (RLE:TSX.V), which we discussed at length in April 2011. It’s a cutting-edge energy services and water treatment company applying a proprietary technology to treat water from the industrial and commercial wastewater markets. We feel that Ridgeline is likely to be the victor in the race to provide the best solution for the treatment of dirty water from fracking—and really for most kinds of industrial process flow-back water.

Ridgeline made the transition from a relatively short research and development (R&D) period (three years) to full commercial deployment, and boasts a formidable list of major clients, including ConocoPhillips (COP:NYSE), Devon Energy Corp. (DVN:NYSE), Enbridge Energy Partners L.P. (EEP:NYSE), EOG Resources Inc. (EOG:NYSE) and Progress Energy Resources Corp. (PRQ:TSX ), to name a few. When we discussed Ridgeline last year, the shares were trading in the $0.50 range. After a meteoric rise to a high of $1.41 last March, the price has come back down to earth and is now settling in the high $0.50s. We recently added a sizeable position to our Pathfinder Partner’s Fund and it is now our single largest share holding. We believe investors would be wise to pick up a position in the company here.

After a number of significant developments, Ridgeline is far better positioned than it was last year. First, it acquired 100% of the global rights for its technology for just less than 35 million shares. This was expected, but still a milestone for the company. Second, the company added a strong new CFO and a new COO as well as a Fortune 500 director. Third, the company set up a fully operational commercial facility with EOG Resources in New Mexico, which we visited earlier this year.

Ridgeline also finalized an agreement to purchase an industrial wastewater pretreatment facility in Los Angeles, where it’s currently treating industrial wastewater streams. Although this application doesn’t get the same attention as the company’s work in the oil and gas space, it has more profitable margins that are multiples of what is seen in oil and gas. And the near- and mid-term revenue growth from the facility should underpin Ridgeline stock at a higher price.

Lastly, the company started manufacturing its water storage units, which are bladder-and-manifold systems. The growth of competitor company Poseidon Concepts Corp. (PSN:TSX) has shown that the market for water storage in the oil and gas industry is massive. Ridgeline’s storage system may not have the same growth, but we do expect it to be a significant contributor to sales and profits as it is rolled out.

This treats a huge and growing problem of water usage and disposal when fracking. It is cost competitive with down-hole disposal—if not cheaper—and also allows reuse of the water in the next frack. Not only does it save on the disposal cost but also on water acquisition cost. This is my favorite company and our largest holding.

TER: What are the growth prospects in terms of revenues?

TM: I expect the company will bring in $27 million (M) in the next year, and then $55–70M the following year. This will be a very high-margin business, especially as Ridgeline branches out into industrial wastewater treatment and into its water storage system. The water storage uses bags, as opposed to Poseidon’s system, which uses giant “kiddie” pools full of water. Poseidon’s system works much better in Alberta, where surface land area is a constraint. The bag system lays flat on the ground and is also fully contained. If land isn’t an issue, as in Texas, and where evaporation is a huge issue, such as with the current drought, the bag system presents a very interesting solution to water storage needs.

TER: And the company is going to make money regardless of what oil prices do because these are services that companies need to use one way or another.

TM: Definitely. Ridgeline also has two other businesses. One of them is treating hydrocarbon contaminated soils at its GreenFill sites; there are many throughout Alberta. The other is an underlying environmental consulting business, which was how the company started. These other business streams help to support the company and add to both the top and bottom lines.

TER: With regard to profit margins, how sensitive to oil prices are most companies at this point, relative to future exploration activities and the profits that they are making right now?

TM: Cost inflation is something that every single business space is currently experiencing, not just oil and gas. Companies must do whatever they can to become more efficient and save on exploration, development and production costs, etc. One company we are very keen on is Calgary-based NXT Energy Solutions (SFD:TSX.V; NSFDF:OTCBB), which has a disruptive, patented and patent-pending airborne survey technology for oil and gas exploration called Stress Field Detection (SFD).

SFD is a little difficult to explain, but it’s essentially a jet with a passive sensor array on board that flies a grid over large swaths of land looking for drops in the gravity stress field. Surveys can be completed in one-tenth of the time and cost of 2-D and 3-D seismic surveys. This doesn’t replace seismic, but rather pinpoints where to shoot the seismic. It allows companies to survey hard-to-reach areas with virtually zero environmental impact. The technology is fully proven and can be used onshore, offshore, and in mountainous terrain. It’s been used and verified by Pacific Rubiales Energy Corp. (PRE:TSX; PREC:BVC), Pengrowth Corp (PGH:NYSE), Pemex (PEMEX:MSX), BP Colombia (NYSE:BP) and Ecopetrol (Colombia’s national oil company).

To envision the process, imagine a river with a rock in the middle. As the river, an analogue for the stress field, reaches the rock, it will wrap around it. This means that the river, or again, the stress field, will have to change direction, which shows up in the gravity field, where the SFD can detect it. It’s based on quantum physics. Flying a grid pattern, the SFD equipment measures and detects orientation changes in that stress. A trapped reservoir, for example, will affect the SFD, and allows delineation of prospective areas. The fluid could be oil, gas and/or water. The resulting data shows exactly where to shoot your 2-D and 3-D seismic.

This technology slashes permitting time, lessens environmental impact, and can literally save a company up to 90% on seismic acquisition costs. The technology only requires a flight plan, not exploration permits, which allows NXT to mobilize quickly instead of waiting up to three years just for the seismic permit. SFD also improves the success rate dramatically on wildcat exploration wells in frontier areas. NXT Energy has a growing revenue base and client list, with a rapidly increasing acceptance of the technology. It’s also profitable on an earnings-per-share (EPS) basis over the last two quarters, and is a well-held and well-structured company. We think the company’s future is very bright.

TER: Is this somewhat similar to airborne geophysical surveys for mineral deposits?

TM: Yes. But I would say this is much more precise in that it can tell you exactly where to find million-barrel fields. There’s also the ability to locate water aquifers. Who knows where it could lead? This is one of the most interesting technologies I’ve seen in the business in my years in the industry.

TER: That’s definitely a revolutionary technology. What else do you like in the services?

TM: This may not sound like the sexiest business on the planet, but in some ways it is. Cortex Business Solutions Inc. (CBX:TSX.V) provides an electronic procurement and invoicing system for the oil and gas business. It set up an electronic network to process invoices and convinced Husky Energy Inc. (HSE:TSX) to essentially come on as a beta test. Let’s say Husky operates a hub with 10,000 (10K) different suppliers, ranging from modular assembly to pipe fabrication to wiring to meals and housing for employees, etc. A big rush of invoices come in at the end of the month and all are prone to human error. Using the Cortex system, every time a supplier initiates a document they’ll pay a transaction fee of between $0.25–2.50 depending on the number of invoices sent in a month while the hubs pay a capped monthly fee in the thousands to tens of thousands of dollars. As you can imagine, the system started to take hold.

Husky streamlined invoice receipt and processing functions, saving millions of dollars per year. It even mandated that its suppliers all join the Cortex system. Cortex has now signed more than 40 major buying organizations in Canada and the U.S. onto the system, including such major names as Apache Corp. (APA:NYSE), Hilcorp (private), Energen (EGN:NYSE), Bonavista Energy Corp. (BNP.UN:TSX) and Murphy Oil Corp. (MUR:NYSE). I’d also point out that Cortex has also boarded over 8,000 suppliers to the system and that many of those suppliers are turning into hubs themselves, demonstrating accelerated acceptance. Every added hub creates a new network effect, because most suppliers don’t work for just one company. As you add another hub, your average revenue per supplier, or ARPS, goes up. What I refer to as “manifest destiny” will likely enable Cortex to take over the oil and gas space.

The company’s revenues will grow and multiply. I believe it’s at the beginning of that hockey stick curve we all love to talk about. Cortex is about to turn the corner on profitability and cash flow, and the modeling I’ve done shows the numbers getting pretty heady a year or two out.

TER: Do you think Cortex will lock up the whole business, since there doesn’t appear to be anybody else that’s made significant inroads?

TM: It has signed up two utilities clients, and is also looking into the construction sector. Every major type of industry can probably make their systems better with Cortex. I think we are just starting to see Cortex’s system take hold and it’s one of the ways that oil and gas companies can fight rising costs in other areas of their businesses.

TER: What are your expectations for the company at this point?

TM: It did about $4.6M over the last year or so, and is trading at $0.18. From January 2013 and moving one year forward, I expect roughly $0.04 of free cash flow per share. Applying a 10 times multiple to that, which is justifiable given the growth curve, we can easily see a double from here. It went from signing one hub a month to four, then six, and now just announced that it signed a total of seven major buying organizations to the system in August. The worse things get for the oil and gas companies, the more they are going to need a service like this, because they are going to want to control costs and have a better handle on information. This is one of the best companies I’ve seen—and because it’s so simple it is very difficult for it to go wrong. We are the company’s second largest shareholder, after Fidelity.

TER: What else do you like?

TM: Another company we find very interesting is Synodon Inc. (SYD:TSX.V), which has developed and field-tested a remote gas-sensing technology called realSens, which it purchased from the Canadian Space Agency and has invested $47M in, to date. This promises to be a game-changer in the gas detection space. There are a range of applications, but the most near-term opportunity is in the gas transmission space, where the sensor is mounted on a helicopter that flies gas pipelines to detect any leaks in both industrial and commercial transmission. Two percent of all gas put into a pipeline doesn’t make it to the other end. More than $300M is spent and more than 2M pipeline leaks are detected globally every year. Synodon’s competitor dominates 80% of that $300M. That alternative method involves manually walking the lines with a “sniffer” device that detects gas. It’s inefficient and extremely costly. There’s also a large legislative environmental concern, which could really give Synodon a push.

This is a best-in-class technology and Synodon has some strategic partners already lined up, like TransCanada Corp. (TRP:TSX) and Enbridge Inc. (ENB:NYSE). The contracts are starting to roll in and the company has been finding massive leaks that previously went undetected.

The reason we got involved with this story is because Paul van Eeden, a preeminent resource newsletter writer, has come on as a director and owns over 20% of the company. That was the vote of confidence we needed to look deeper. This is, without a doubt, a best-in-show company in terms of cost, speed and efficiency, and we think it will become one of the go-to technologies oil and gas producers and distributors use to ensure efficiency and not leave any money on the table.

Agricultural commodities prices resumed upward trends in June 2012, largely due to drought conditions in key global farming areas on top of existing low inventories. Extreme global conditions continue, with the period June-August of 2012 the hottest such period historically on record.

 Taking a broad agricultural commodities ETC (ETF), we can see that softs are now back up into the price range experienced in 2011, and not far from 2008′s peaks.

 Agricultural commodity price rises typically feed through to retail food prices 4-6 months later, which means we could expect food prices to really escalate as of the final quarter 2012. Here is the UN food price index up to the end of August 2012:

Now take a look at how the 2008 and 2011 episodes of rising food prices brought about social unrest and political upheaval in poorer countries across the world:

The chart shows when outbreaks of violence erupted in different countries. As food prices escalate towards those levels again as we reach into 2013, the likelihood is of renewed protest and conflict.

We can cross-reference this with solar cycle studies. 2013 is the year of the forecasted solar maximum. Alexander Chizhevsky’s analysis of 2500 years of human history and solar cycles revealed that the period into and around solar maximums (4 years) was historically one of protest, revolution and war. Last year’s North African and Middle Eastern revolts fit with this, as does the prospect of food-price based protest and conflict into 2013.

The Arab Spring revolutions and protests in 2011 brought about oil supply disruption, both real and perceived, which in turn rallied oil prices. Rising oil prices feed back into food prices through processing and distribution. Precious metals in turn benefit as inflation hedges.  A price feedback loop develops between these different commodities, and a feedback loop also occurs between commodity price rises and social conflict.

These two charts confirm the close inter-relations of food prices with oil and gold:

 

As we stand in September 2012, energy and metals are lagging soft commodities as supportive evidence for an inflationary spike in 2013. Global economic weakness is the reason, whilst grains have accelerated largely on extreme weather conditions. In response to the economic slowdown, central banks have cut interest rates and renewed stimulus (such as China’s infrastucture programme and US Quantitative Easing (QE) 3). This in turn should be reflationary, which should lift commodities as a class. In reponse to the US Fed’s announcement of renewed QE, five year inflation breakeven expectations surged, as shown in the chart below. Official inflation, CPI, has historically followed this indicator with a lag, suggesting inflation should accelerate as we enter 2013.

 

 

 

There is a feedback loop here too, as rising inflation inspires more money into hard assets as inflation hedges, which lifts commodity prices, which in turn brings about higher inflation.

With renewed QE, the US Fed continues its policy of massive money supply expansion, although this is not as potent as it might be, due to a weak money multiplier. However, the money multiplier shows evidence of having bottomed out and dollar circulation in the economy is beginning to gather pace, which can be inflationary.

 

 

Renewed QE also devalues the currency. As the US dollar is the world’s reserve currency, to which many nations peg their currencies, a US dollar devaluation acts as a global devaluation. As commodities are priced in US dollars, this global currency devaluation typically brings about a commodities revaluation (hard assets rising in value versus paper).

The first chart below shows that the US dollar is labouring at secular lows in real terms, whilst the second chart shows that it is gradually making a rounded base around these levels. Its recent technical behaviour post QE announcement, namely the loss of a key support, in addition to its languishing near secular lows, suggests that it can provide the backdrop for an inflationary finale into 2013, before a new secular dollar bull gradually emerges.

 

 

 

Inflationary monetary policy has become the norm, not just in the US but throughout indebted nations globally. Official US CPI inflation calculations have been gradually changed since the 1980s, but John Williams’ Shadowstats data provides a more consistent picture of inflation over time and reveals that the Federal Reserve has been successful in restoring price inflation since 2008′s deflationary panic. I have used official US stats until 1980, then Shadowstats, to maintain a continuous picture of real US inflation:

 

 

This chart also show the compelling historic relationship with solar cycles.

2013 is forecast to be the solar maximum, and if history repeats, we should see an inflationary peak close to the solar peak. As the chart shows, peaks in inflation correspond to solar maximums and troughs in inflation to solar minimums, historically. The biggest peaks in inflation corresponded to secular commodities peaks, as we might expect due to commodity prices fuelling inflation. These secular commodities peaks all occurred close to the solar maximums, with one luni-solar cycle between each, which is around 33 years. These ultimate peaks in inflation / commodity prices were preceded by a shadow peak 5 years prior.

The last secular commodities peak was 1980. One luni-solar cycle later is 2013. The solar maximum for solar cycle 24 is forecast for 2013, 5 years later than 2008, when we experienced a (shadow) inflation/commodities peak. Drawing together secular, solar and inflation history, I can therefore forecast a secular commodities peak and an inflation peak in 2013. Regular readers know this is a forecast that I have held for some time, and as we close in on the end of 2012, we see increasingly supportive evidence for its fulfillment, as documented above: forthcoming food price inflation from current soft commodity price rises; social conflict from food price inflation; central bank policies of reflation and paper/hard asset revaluations.

This table shows how close the inflation peaks were in relation to the official solar peaks: between 2 months before and 4 months after.

 

Currently NASA forecast the solar maximum for around September 2013, whilst SIDC project around March 2013. I expect the difference to be resolved one way or the other as we end 2012, as the sunspot data gradually gives more clues.

From a fundamental perspective, an inflationary peak in 2013 could be justified by a three-way feedback looping between commodities and other commodities, between commodities and conflict, and between commodities and inflation, supported by inflationary monetary policies. From a solar studies perspective, maximum solar activity brings about maximum human biological and behavioural excitability, which manifests as buying, speculation and risk-taking in the markets and economy, and the feedback loops are therefore between solar peaking, secular asset peaking (in this case commodities) and inflationary peaking (speculation into commodities and buying/risk-taking mania). From this alternative perspective, it is the solar maximum of 2013 which is the key driver. Either way, evidence is building towards a fulfillment of an inflationary peak in 2013, and I am positioned accordingly, with my biggest weighting long commodities.

Next: Forecast 2013 Part 2: Secular Commodities Peak

John Hampson, UK / Self-taught global macro trader since 2004
www.solarcycles.net (formerly Amalgamator.co.uk) / Predicting The Financial Markets With The Sun

 

 

 

 

For every 10 percent increase in global food prices there is a 100 percent increase in anti-government protests, according to a recent report from the International Monetary Fund. Looking at recent price increases in global ag commodities — up about 20 percent so far this year — it’s no wonder there are Arab Fall flare ups (this time directed at America) breaking out across the globe. According to the IMF, a 20 percent increase in foodstuffs should triple the levels of unrest, and that seems to be precisely what’s happening.

 The chaos caused by food inflation and hunger back in 2011 was heartwarmingly marketed by propagandists as democratization. Remember the French Revolution and “let them eat cake.” The causa proxima was food inflation, not stupid remarks or films. I hypothesize: Food Price Index + FAO Hunger Index = Riots, Civil Wars and Revolutions.

The United Nations’ Food and Agriculture Organization also offers a Global Hunger Index that measures levels of food stress around the world. According to the 2011 index, a hunger level above 30 is considered extremely alarming, 20 to 29 is alarming and 10 to 19 is serious.

 Among the countries to watch is Nigeria with a level of 16. About 10 percent of U.S. oil imports come from Nigeria, and it’s the sweet oil variety that can’t be substituted if disrupted. In 2011, Yemen, which is in open disorder and a completely failed state, had a hunger index of 25. Angola, another oil producer, had a hunger index of 27 and considered be in the “extremely alarming” category. Cameroon, a small African oil producer, had a score of 18. That country was severely impacted by food riots during the 2008 commodity bubble. Both Bangladesh and India were ranked 24. Both countries were impacted this year by a poor monsoon period, which normally brings much-needed rain for crops. Trouble spot Pakistan is 21.

Obviously, not all countries are in high-hunger-index situations, but most of the world is spending a larger percentage of income on food. This includes 48 million Americans qualifying for food stamps. A 35 percent pop in prices for people already paying 30 percent of their income on food has the effect of triggering civil unrest.

Egypt is the world’s largest wheat importer, bringing in 60 percent of what it consumes from varied global sources. Egypt also imports 40 percent of its food and is highly vulnerable to rationing and steep prices. On average, Egyptians use 42 percent of their income on food. Watch wheat prices carefully. It is showing new signs of another lift off since the Fed’s open-opended QE announcement.

A new quantitative easing program is oppressive in a strong food-inflation environment. It also aggravates the effect of the drought and encourages speculators to pile into commodities that are already facing rationing. The Bank of Japan released a report that examines the financialization of commodities. With some big players effectively substituting foodstuffs and other commodities for near-zero-percent returns at the bank, the heightened interest in these commodities goes far beyond normal economic demand. It is key to understanding the impact of both QE and Zero Interest Rate Policy (ZIRP). The end result of the monetary experiment is a massive misallocation of capital, resulting in global hunger and social-political instability. Indeed, this is Ben Bernanke’s ultimate gesture to global food consumers.

Commodities surged broadly after this week’s Fed announcement of QE3. Only corn ended the period in the red due to the latest supply and demand data from the USDA.  Stocks, as measured by the S&P 500, rose 2 percent to the highest levels since 2007. The stock index is now up almost 17 percent year-to-date.

The Federal Reserve unveiled what some characterized as a “monetary bazooka” in this week’s policy decision. The central bank said it would buy $40 billion worth of mortgage-backed securities per month, indefinitely. The purchases will begin today. Total purchases could conceivably end up at over $1 trillion.

On the other hand, it could be much less. But in either event, the U.S. Central Bank has made it clear it will provide an extremely accommodative monetary backdrop as long as economic growth remains sluggish. Commodity bulls couldn’t have asked for more.