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Monthly Market Report

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1Monthly Market Report Empty Monthly Market Report Thu Nov 17, 2016 10:57 pm



With the oil markets starting to look healthier, it is a good time to revisit the oil companies and look for those that can capitalize on the new environment. OPEC looks likely to hold to its production deal for the time being despite the difficulties coming from Iraq, and with other producers coming to the table as well, most notably Russia, the market may have finally turned a corner. If the deal falls apart, it will likely be because of recent comments from Iraq.

Iraq recently demanded that it be exempted from any production limits imposed by OPEC in November, with Iraqi officials arguing that the war against ISIS is a justification for allowing it to produce more. "We should be producing 9 million if it wasn't for the wars,” the head of Iraq state oil marketer SOMO, Falah al-Amiri, told reporters. "Some countries took our market share.”

Still, there are mixed signals for crude going forward. Right now, supply still exceeds demand and inventories are still elevated. Inventory drawdowns in recent weeks have been strong – for instance, the Energy Information Administration just reported a drawdown of nearly 600K barrels for the most recent week.

On the other hand, restored supply from countries like Nigeria and Libya are creating more supply pressures and weak Chinese demand remains a problem. The major catalyst for oil will be next month’s OPEC meeting coming two years after the Thanksgiving “oil massacre” which ignited the oil collapse in 2014.

Adding to concerns about oil prices, the WSJ is reporting that there were 5,069 DUCs in September, up markedly versus the 3,768 count in January 2014. That increase is due to companies pausing their drilling programs and waiting to complete wells until oil prices regain further ground. If all of these wells come online it would add roughly 250,000 barrels per day of additional supply.

Against the backdrop of the troubled oil industry, clean energy Ais still making remarkable progress. So much so that, it appears the clean tech revolution really is upon us. (Clean tech picks will be the subject of a future newsletter in the next month or so.)

According to the IEA, renewable energy outpaced fossil fuels for installed electricity capacity across the globe last year. The fact that clean tech was able to make so much progress despite competition from low oil prices suggests that once oil prices rise, clean tech will truly begin to alter the energy landscape around the globe. 2016 is really starting to look like an inflection point for the transition to cleaner sources of energy.

The world saw installations of 153 gigawatts of renewable energy in 2015, or about 55 percent of the total. 2015 marked the first time that the world installed more renewable energy than fossil fuel-based capacity, and that’s probably going to continue for years to come. The IEA said that an average of 500,000 solar panels were installed every single day last year.

Smart investors should be paying attention to this trend regardless of one’s views about oil and traditional fossil fuels. Being a good investor requires pragmatism after all. In this month’s issue of Energy & Resource Insider, we highlight an oil stock and a backend energy play both of which are poised to build on new opportunities in the energy sector and offer outstanding returns to investors going forward. In addition, we take a look at a Canadian nanocap that is risky, but might just present a good speculative trading opportunity for the near future.

Our first pick for the month is PDC Energy, Inc. PDCE is a mid-cap upstream oil & gas company that has strong cash flow from operations bolstered by an excellent hedging program. PDCE increased production by more than 65% in 2015 and the company appears poised to grow 2016 production by more than 30%. Many oil stocks are a dicey proposition at this point – while oil markets are slowly recovering, the extent of the damage that the oil price collapse has done to the long-term growth prospects of US unconventional producer groups remains unclear. PDCE is not in this boat – instead the company’s fortuitous hedging program has largely helped to insulate the firm from the worst of the collapse.

PDC has three core areas: The Wattenberg Field in Colorado, a new holding of 57,000 acres in the Delaware Basin in Texas, and the Utica Shale in Ohio. The Delaware Basin is the newest area for the company and came about as a result of a transformative deal the company made in August. Utica has a tremendous amount of long-term potential, but Wattenberg is the more important of the two fields.

Total 2015 net production for the Company was 15.4 MMBoe from these two areas, an increase of approximately 65% year-over-year, and consisted of 45.4% crude oil, 18.4% NGLs, and 36.2% natural gas, most of which was derived from the Wattenberg Field. That natural gas production is increasingly looking like it may be a more valuable asset than many investors had assumed thanks to rising natural gas prices and the prospect for a chilly winter this year.

PDC Energy’s stock has stayed mostly steady throughout much of the last year because it is among the strongest companies in the oil sector relative to its size. Consider the following:

-  In October, 2013 PDCE peaked at $73.93/share. With double the production and proven reserves today, we believe the share price can reach a new high, if crude oil prices return to $60.00/bbl.

-  In the 4th quarter of 2015, PDC generated $126.2 million of cash flow from operation ($3.06/share) and we forecast that cash flow from operations will more than cover this year’s capital budget.

-  The Company’s production guidance for 2016 equates to approximately 36% YOY production growth.

-  PDC operates the majority of their drilling program and since most of their leasehold is now held by production, they can adjust their capital program if necessary.

The stock’s performance over the last year should make it more attractive to investors, not less. Put differently, at this point investors are much better off owning a smaller piece of a stronger company than a larger piece of a weaker one.

Investors who are hoping that oil prices will rebound fast enough to salvage the various oil companies on the brink of financial distress are likely to find themselves disappointed; a sustained price rebound cannot come soon enough for many of the weaker players in this industry. Again though, PDC Energy is different and the stock’s performance reflects this.

As the oil price rebound continues, PDCE is poised to capitalize on its financial strength by snapping up distressed competitors. That ability to capitalize on emerging opportunities is already making life easier for PDC Energy as the firm’s shrinking costs show.

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PDC had a strong balance sheet going into the start of the year, but the firm further boosted its balance sheet at the start of the year with a ~$260M equity raise for 5.15M shares, and then a 6.5M share offering in September. While the secondary offering did dilute existing shareholders, it also gives PDCE a fortress balance sheet that most of its peers lack. With that equity raise now behind the firm, it’s unlikely that shareholders will face further dilution any time soon.

The relatively limited dilution that previous equity investors have faced with $2.3B PDCE will be more than made up over time thanks to organic and inorganic growth opportunities. The firm’s production should continue to grow throughout the current crisis, and its financials look robust given the macro environment.

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Importantly, despite the superior performance of the business and despite the stability in its stock price, PDCE is trading at roughly 15X 2016 unhedged EBITDA versus 19x for its peer
group. PDCE is a superior operation compared to most of its peers – yet it trades at a cheaper multiple!

Overall, we rate PDC Energy’s common stock (NASDAQ: PDCE) a Strong Buy up to $65/share with a price target of $88.00 within 12-months. Our valuation of the company’s common stock is based on proved and probable reserves, financial position, historical and expected drilling & completion results and a high level of confidence in the management team’s ability to take advantage of current market conditions.

While PDCE is a strong performer in the energy space, the stock has not seen the kind of decline in price that deep value investors often look for. Our second pick for the month is much more in line with the deep value philosophy and comes from one of the most beaten down verticals in the energy space; offshore drilling.

This is not a sector for the faint of heart, but for those with a long-term outlook, stocks in the offshore space could have 10X returns over the next five to seven years. Most oil stocks, including PDCE, are unlikely to see that kind of upside, no matter how high oil goes.

For those who have not regularly invested in the offshore drilling sector, the story here is an unpleasant one. Over the last few years as relatively high oil prices spurred investmentacross the entire energy sector industry, offshore drilling expanded like everything else.

One area of offshore that saw a particularly large infusion of corporate cash was ultra-deep water (UDW) drilling. UDW companies like Ensco PLC, Seadrill, Transocean, Diamond Offshore, and Noble Corp. all put substantial investments into bringing new offshore drilling rigs to market. (Note: Noble is a separate company from Noble Energy (NBL). The two have a common corporate legacy, but are separate entities today.)

As a result, by the middle of 2014, there was an emerging glut of UDW rigs and day rates on these rigs started to collapse. The oil price collapse last fall exacerbated the supply issues in the industry. By 2015, many offshore drillers were talking about stacking existing rigs.

Stacking involves storing rigs to reduce costs of operation. Stacking can be cold or warm with each process having different costs and benefits but in both cases the step is an extreme one for a company to take. The process of stacking is costly, not easy to reverse, and often leads to subsequent rig scrapping.

Stocks across the UDW space have collapsed in value. Transocean, Ensco, and Seadrill are all down more than 75% in the last couple of years. Many companies in the space have short interest ratios of 10% or more of their float, and most have cut dividends. A few of the smaller players have even gone bankrupt.

Wall Street analysts have cut estimates across the sector, and sentiment across all of the stocks in the space cannot get much worse. No one wants to buy these companies. And that is exactly why sage investors should be looking at the sector very carefully right now.

The downturn in the Deep Water space will not last forever. Already most of the major players in the space are quickly stacking rigs, deferring the delivery of previously ordered rigs, and cutting costs anywhere they can. All of this is setting the stage for an eventual rebound in the sector.

That rebound in the offshore sector could start as early as 2017; the UDW sector still has growth ahead of it. For instance, influential energy research firm Douglas-Westwood projected that capex in deep water exploration will jump 69% between 2015 and 2019.

The best opportunity in the deep water space right now is Noble Corp, trading under the ticker NE. The stock is incredibly cheap compared to its historical metrics and compared to the potential for the future. The company also has a strong and modern fleet. (pictured below)Compared with many peers, Noble has better financial flexibility and its contract coverage is stronger.

Noble Corporation's impressive fleet also means that the company has an impressive backlog. The company earned total revenues of $1.5 billion for the first-half of 2016. The company earned the majority of these revenues from the United States, but also has its revenue well spread out. The company's revenues come from a number of different rig types, but primarily from ultra-deepwater rigs which make up almost 80% of the company's revenues.

Ultra-deepwater rigs tend to have longer contracts that provide income for many years, including during a market downturn. However, it also means that the company's source of income is concentrated primarily in its ultra-deepwater fleet.

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The firm has a current ratio of about 1.67X and has nearly 60% of its average available rig operating days contracted for 2016 with ~50% of average equipment days contracted for 2017.
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Even with the currently atrocious market, Noble is still roughly breaking even. In its most recent quarter NE said that Q2 contract drilling services revenues totaled $877M, helped immensely by a $379M gain from a settlement with Freeport McMoran which canceled a contract during the quarter.

Without that settlement, contract drilling services revenues were $484M, down 18% from $591M in Q1, driven by a reduction in fleet operating days, with fleet utilization declining to 65% vs. 79% in Q1.

The company is well positioned for most of the potential industry disasters on the horizon like Petrobras’ evolving business outlook. Every other major deep water driller will likely find themselves in more trouble than Noble if the market continues to deteriorate.

Overall, Noble is better positioned to survive the downturn than any other deep water firm. As the market starts to turn, Noble should see considerable upside. NE spun-off most of
its low spec rigs in a company called Paragon Offshore last year. PGN eventually went bankrupt. Noble’s decision to a portion of Noble’s debt backed by low quality rigs was a smart move.

Nonetheless, the remaining Noble Corp. assets have significant upside potential in even a modest market recovery. As the market starts to recover, Noble should see cash flow of roughly $4-$5 per share eventually. The company’s higher specification fleet, limited debt, and efficient operations could make it either an excellent acquisition target or an effective acquirer of distressed firms as the sector bottoms. (An ESV/NE combination would be particularly interesting for investors.)

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Putting all of this together, and applying a multiple of 15X cash flows supports a valuation of $75 per share AFTER the market eventually recovers. Right now, Noble is not worth $75 a share. And it will take time for the market to correct itself. But even if the market continues to languish, and competitors start going bankrupt (e.g. HERO earlier this year), Noble would probably be the last major company left standing.

Thus, the stock is essentially de-risked at these levels. A significant stock price recovery may take a couple of years, but for deep value investors with a medium term outlook, Noble is a rare breed in an expensive market; a cheap stock that could see 5-10X returns with significant room for eventual earnings upside. Our final pick for the month is an unorthodox play in the energy space, and is a good choice to balance the broader oil market risks that impact both Noble and PDC Energy. This third pick is perhaps the most exciting in that it encompasses a safe and effective method of playing on a major technology innovation.

Our final pick for this month is an off-the-radar nanocap Canadian company called Patriot One. The firm is not an energy or resource company, but it came across our desk with a story and technology which are compelling enough to be worthy of your consideration.

With that said, like virtually all nanocap companies, Patriot One is a risky venture and any funds invested in the firm should be treated as speculative capital. Patriot One has a very interesting and compelling product, but despite that the odds are high that the firm will run into challenges in the next few years and those challenges will keep the company grounded.

Still, for investors willing to take a risk with an investment, Patriot One is a good choice. IF the company manages to overcome the business obstacles it faces, then the payoff will be enormous. To be clear though, this is not a stock for widows and orphans – it is a stock for speculators who are willing to lose their entire investment on the chance of a 10X or 20X return.

Patriot One is a pre-revenue company, run by CEO Martin Cronin, and it is preparing to launch its first product. The firm trades on the Canadian Venture exchange, and its share price is quite volatile. From a trader’s point of view, it may be a good opportunity though because the launch of Patriot One’s new product should gin up greater interest in and awareness of the company.

Patriot One recently introduced its first product, the NForce CMR1000. The product is a body scanner designed to identify concealed weapons on a person’s body or in baggage using microwave technology combined with pattern recognition. The technology can be "deployed overtly or covertly in a small space profile, giving a very, very high degree of accuracy to detect a weapon concealed on somebody passing through an entranceway". The range is up to 12 feet.

Patriot One's Chief Science Officer, Professor Natalia Nikolova describes the invention as "most effective with metallic weapons, such as handguns, rifles, metallic shrapnel and explosive vests, hand grenades—anything that has metal is certainly detectable… Ceramic handguns is possible to detect", but "explosive powders, no, or gels. This is a radar detector. It is not a chemical detector".

However, the technology does build on artificial intelligence which promises improved detection even years after initial deployment. "The radar is combined with machine learning, some clever algorithms, which understand what that radar signal coming back means", Cronin says. "So it's not a dumb system. It's a very smart system that analyzes the signature coming off the subject". Nikolova says "Because it is based on learning machines, also known as classifiers. You can constantly update your knowledge about what is a threat and what is not a threat. While radar hardware is fixed, the "classifiers are constantly updated" and the "system can learn continuously about the environment, about new threats, and about new non-threats".

Patriot One describes the product as “the world’s most advanced technology for covert screening and detection of concealed weapons.” The company says that the CMR1000 is “far less expensive, easily concealed, and utilizes a single scan for detection, as compared to the numerous scans required by large, expensive and manned static installations… NForce CMR1000 screens individuals in real time as they pass though the CMR1000 detection field in access points, halls and entryways.”

Patriot One lists a number of key features that make its technology a major step up over existing systems.

  • Small enough for covert hall and doorway installations.
  • Images of the target NOT generated; absolutely no privacy concerns.
  • No subject compliance required. System acquires results on moving targets.
  • Secured locations inconspicuous – not institutional.
  • Time consuming scans not required.
  • Doesn’t require line of sight.
  • Compact and lower cost than millimeter-wave units.
  • Low cost allows for multiple networked units.
  • Weapon profiles updated network-wide regularly.
  • Real-time and entirely computer-based. Human operators NOT required.
  • Early detection reduces inspection team size and buys first responders critical intervention time.
  • System “learns” and continuously perfects its detection ability.
  • Frequencies are aligned with international regulations for
  • safe use of microwave bandwidths.

Given security concerns proliferating around the world at this point, there is obviously a huge market for this type of product. Assuming the Patriot One product works as well as advertised, the market will likely embrace the technology quickly. For a parallel, one only needs look at the rise of automated passport scanning machines that did not exist a few years ago, but are now the standard at customs and immigration areas in airports around the world.

That technology was developed by a Portuguese start-up. The same thing MIGHT happen with Patriot One. It’s risky, but possible. Trying to value Patriot One at this point is mostly an exercise in futility.

The target addressable market (TAM) for the company’s NForce CMR1000 units is probably at least 200,000 units in the US alone just based on the number of public schools, hospitals, government buildings, and major airports. Worldwide, the TAM is probably upwards of 2 million units based on reasonable extrapolations off US figures. Market size for Patriot One is not the issue.

Instead, investors need to consider two prospects for Patriot One. First, the company’s stock will probably rise in the short run as the firm gets increased attention around their product rollout. That may make the stock a good short-term trade. Second, over the long-term Patriot One can only be successful if it can scale up production and its sales force economically.

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That’s a lot easier said than done. If the firm does pull of the feat, in a few years this could be a company with $100M+ in annual sales up from nothing today. That in turn would probably lead to a 20X return on the stock and an IPO on a major stock exchange. For the right type of investor then, Patriot One is definitely one of the most interesting investments on the market right now.

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