Tag Archives: International

Salamander, a case of de-rating through exploration

Energy, Global Economy, On the cover, Sin categoría,

Being an E&P the main catalyst for the company’s stock is its exploration campaign. However, when it comes to this, Salamander Energy has not had the greatest run.Out of 3 exploration wells dug by Salamander Energy in 2010, none were successful in finding commercial hydrocarbon flows.

Bang Nouan 1 well was spudded in April 2010 in Lao PDR. However, in May the company reported that the zones of permeability encountered in the primary objective were water bearing. All hopes were turned to the gas shows encountered in the secondary objective, which upon a well test, failed to be of commercial level. Thus, the well was plugged and abandoned in early August.

The next blow came from the high-risk Tom Su Lua prospect, Vietnam, where TSL-1X well was drilled. However, in late June the company announced that the well has been plugged and abandoned having failed to encounter any commercial hydrocarbon levels. It had been drilled to a total vertical depth sub-sea of 1,380mt and encountered both, potential seals and high quality reservoir sandstones, which were water-wet in the Tertiary clastic section.

The company then focused on drilling the THX-1X well on the Tom Hum Xanh prospect in Vietnam, 250km south of the TSL-1X well. Similar to its neighbour, THX-1X was announced a dry hole in late July and subsequently was plugged and abandoned as it failed to encounter significant hydrocarbons in the target reservoir sections. It is important to note that the acreage in Vietnam was previously unexplored and therefore was high risk.

The key risk to the share price is the company’s drilling results. Since the start of the year the company has drilled 3 wells, all of which have been subsequently plugged and abandoned as dry holes. Thus, the results of its next planned wells, Angklung and Dambus in Indonesia’s Kutai basin, are the key risks to the stock performance. Serica Energy, operator of Dambus, has assigned a 40% chance of success for the well, while Salamander Energy has estimated the geological risk for the Angklung at 24%. However, both wells are located in a heavily explored acreage, which already contains several producing wells.

Unsuccessful drilling campaign has cost the company in the loss of 40% of its stock value since the beginning of the year. However, although the stock is in a downward trend, it has not reacted greatly to the drilling updates.

The market’s reactions to the updates were positive. Thus, the stock rose on average by 2.00% on the day Salamander Energy plugged and abandoned its wells. Moreover, it seems that the market was reacting to the negative news a day before the announcement was made public. The company is currently trading at 34% above its core NAV (164p/sh) while E&A risked upside is at 116p/sh (632p/sh unrisked).

Overall, the Dambus well looks low-risk, while although the company claims the same about the Angklung, the failure of Unicol as well as the delay in project have put an increased risk on the prospect. Thus, the results of these 2 wells will be crucial to the future position of the company.

The Debacle of Wind Turbine Manufacturers

Energy, Global Economy, On the cover, Sin categoría,

(This article was published in Cotizalia.com on August 19th 2010)

I said it three weeks ago. Sell turbine manufacturers and buy wind developers. Turbine prices are plummeting, margins fall inexorably and the demand bubble, artificially created by the debt and subsidies of the OECD countries, has burst. And the only beneficiaries of this are the wind developers that centre on returns and not empire-building growth. They buy more turbines, cheaper and of better quality.

The turbine manufacturing industry is a great industry with great professionals and great engineers. But as an investment it is a disaster. It committed the sin of greed and the industry has been bloated with excess capacity for some time. Since 2006, the market has not seen anything but cuts to their own estimates for orders and margins. The industry positioned itself for excessive growth, undifferentiated returns and the hope that competition would never appear and are now paying the excess.

And it’s not a cheap sector in any shape or form. My readers who have access to Bloomberg can see that the stock market debacle has been entirely justified by falling estimates. And the sector is trading at 20x 2011 PER and average EV/EBITDA 7.5x. Not cheap at all for a sector that has proven to be more mature and cyclical than its managements and analysts would like to admit.

On Wednesday, Vestas, the largest turbine manufacturer in the world, fell 22% after they announced a downward revision of revenue estimates (for 2010!!) from €7bn to €6bn. The analyst consensus, who claimed that their average estimates were “conservative” (€6.7 bn), again had to slash estimates. This has happened six times in three years. The EBIT margin has been reduced by 50%, no less. Let us not forget that Vestas, like all turbine manufacturers, had given estimates for 2010 only a few months ago. And now they cut their estimates for this year … 50%. Then they say that it’s a temporary issue and that 2011 is fine. Again, something they said in 2007, 2008 and 2009. And some say that the market is speculative and short-term. Come on.

When a global leader is unable to estimate properly a year, THE CURRENT YEAR, how can they demand from us to make long-term valuations and investments? Come on. But what’s more important is that we are also seeing the cash flow fall and what is worse, a deterioration of the ratio of working capital/sales, which is what indicates the strength of the sector. Many firms take 20% WC/sales, which it is too risky,and shows that the industry is so desperate that they could be financing their own clients, in a downward spiral of financial weakness.

Gamesa, only a few weeks ago, further reduced, as it is almost a recurrent episode, its estimate of 2,700-3,000 MW of installations to 2,400-2,500, and their expectations for EBIT margin to 4.5-5.5%, compared with 6 -7% in January’s previous estimate. A very difficult process of adjustment to reality after the aggressive expansion plans and ludicrous expectations to compensate the falling Spanish business with Chinese and US growth.

As I told the CEO of one of these companies, who was asking what to do to mak the shares go up: “for once, please beat your own estimates. Simple.”

The turbine manufacturing sector faces three problems:

– The drop in demand, obviously. As I mentioned three weeks ago, the American green dream has faded. Expectations are for about 4 Gigawatt installed in the U.S. in 2010, less than half that of 2009. The European Union has very high electricity reserve margins. And the growth in renewables in other countries of the world is poor at best, and not enough to justify the “high growth sector” multiples. The bubble has burst.

– Production capacity is excessive. Turbine manufacturers themselves confirm that its plants operate at 50-55% capacity. This makes the need to reduce average prices to their remaining customers (10-12% decline in 2010, after a 12% in 2009) and compete aggressively with low margins. And what is worse, not only there have been no cuts in capacity, but it continues to increase both in European and America as well as Asia.

– Competition in the target market of China, which had been ignored with almost xenophobic arguments. “Not enough quality”, “customers do not trust them”, “European turbine prices can not fall and the Chinese have to accept it.” Well, Goldwind and Sinovel continue grabbing the Chinese market with prices 20% lower than European manufacturers, and what’s more improtant, better margins (12%).

The solution for the sector exists. “Shrink to greatness.” ROCE and margins. Easy. Reduce capacity, focus on margins, be less “engineers”, less empire-builders and more managers… And provide the market with realistic expectations. If we return to the bull market for renewable installations, and believe me, do not expect it, they will generate higher margins, better cash and have sustainable and profitable businesses. If the bull market does not come back, and it isn’t, they will be able to generate solid returns and correct the gradual and painful decline that we have seen since 2007. And do not cling to offshore as a salvation, as it’s more costly, less efficient and riskier… But, what’s most important, as replicable and technologically undifferentiated as onshore.

In an industry where the cost of replacement is reduced in absolute and relative terms every year as the technology is affordable and easy to replicate, basing a business on volume growth is crazy.

Turbine manufacturers should learn from the oil services sector, who suffered the lesson in the 80s when the same “GROWTH FOR GROWTH” and overcapacity issues occurred. Acciona, for instance, has seen this happening for some time. Its turbine manufacturing division is now a mere chain in their renewable business, which allows it to be integrated and manage the total cost in the projects it builds. Indeed, it does not provide the company any higher valuation, but at least they manage the business based on real internal demand, not on unachievable global growth expectations. Gamesa and Vestas have a tough road ahead. But a fascinating one nonetheless. As stocks, still a space to avoid except for very (VERY) short term beta trades. And to me, beta is better found elsewhere.

Iraq, the last hope for Big Oil

Energy, Global Economy, On the cover, Sin categoría,

IRAK (1)

(This article was originally published in Spanish in Cotizalia.com)

We’ve talked on other occasions of the difficulties that big oil companies find to grow. The reserve replacement ratio is still more than disappointing, below 100% since 2004. But in 2010 the industry could change course. In my opinion, the true hope of the sector is Iraq, the third country in the world in proven reserves, 115 billion barrels of oil, behind Saudi Arabia, with 264 and Iran with 138.

The country has generated much controversy in the press for the war but, since Saddam Hussein was overthrown, Iraq has achieved a production increase that was unthinkable under the previous regime, generating tax revenues for the domestic economy of almost $20 billion more that in the period 1980-2005.

Currently the geopolitical environment has improved substantially. Service firms are established, but the risks are not negligible, with nearby local elections, conflicts with the Kurdish minority and the gradual withdrawal of U.S. troops. For example, it remains unclear if the city of Kirkuk, home to a giant oil field, belongs to the Arabs or the Kurds, which prevents investment there.

The local government has advanced rapidly, licensing more than ten fields in the last year. After a false start in which the license auction was declared void (except the Rumaila field, BP -CNPC) because the conditions imposed by the government were too expensive, between the second half of 2009 and 2010 the government has auctioned licenses to operate up to 60 billion barrels in estimated reserves, with a national strategy to increase production from 2.5 million barrels per day today to a very ambitious target of 12 million. From BP, Shell, Statoil and ENI, to Russia’s Lukoil, China’s CNPC or Exxon, most big oil companies have participated in the process.

From my point of view, the goal of exceeding Saudi Arabia’s production is very ambitious. No one has managed to multiply by 5, as intended, the production of a country in 10 years. I think it’s much more logical to assume that production will rise to 3.5 million barrels per day in 2015, in line with the history of typical production recovery in this region (including Iran).

And the problem now is the costs, estimated at $ 19/barrel (F&D), plus an additional fee of nearly $ 2/barrel. The contracts allow the oil companies to cover costs up to a minimum production level. Until there is a contract typical of the industry,within what is called a PSC(production sharingcontract).

But if minimum production targets are not met, oil companies will suffer from profits lower than the average cost of capital, or even losses. The Zubair field, won by ENI and their partners, for example, will likely generate an internal rate of return of less than 20% below $55/barrel, while requiring investments in excess of $20 billion over 20 years.

If you have enjoyed Avatar (great movie, by the way) and the not-so-subtle allegory about the oil companies, you probably think that this whole process is abominable, but the increase in gross domestic product, infrastructure and wealth for the country that these projects, neglected or poorly managed so far, will generate, will be a giant leap for the country’s ailing economy. The investments to be carried out are astronomical, nearly $ 100,000 million between 2009 and 2029, including infrastructure, water, schools, hospitals , almost the construction of entire cities. Consider that some of these fields require about 500 workers. And the fact that contracts are aggressive and costly conditions for oil is a minor problem, because for them it is probably the last opportunity to improve their low reserve replacement for once.

Over 1.2 Billion Chinese can’t be wrong

Energy, On the cover, Sin categoría,
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(Published in Cotizalia in Spanish on Nov 26th 2009). Chart shows monthly car sales in USA vs China.

“Data from China is not credible.” This phrase and similar ones have led many funds, especially traditional ones, to miss part of the rally in stocks and commodities, to give just one example. It seems to me that in 2009 many suffered from a bit of excess of caution and a lot of looking at the growth data in the wrong places (USA, Europe). And it’s already more than a year since the launch of China’s economic stimulus program and the data continue to surprise on the rise.

In 2010, China’s GDP will grow c9%. But more importantly, it is likely to do so with very moderate inflation, around 2.5%, thanks to the fact that OECD countries will continue to be in a difficult economic environment and therefore, prices of products imported by China will probably not increase dramatically, as has happened with oil, coal and gas between 2008 and 2009.

Remember that China imports 3.6 million barrels per day of oil, and growing. Well, that consumption is only 2 barrels a year per capita, c4% of global demand. Meanwhile the U.S. remains about 24 barrels a year per capita, 24% of the total, but falling. This scenario, moderate rise in prices of imported commodities as high domestic growth is financed, is ideal for China to deliver long term economic growth and credit expansion without causing major inflationary moves, and that will likely generate the next local stock market rally. Do you remember Europe in 1950? The same.

Investments in fixed assets in the country will continue growing by c30% in 2010. Over 300 projects implemented on a large scale in 2009 lead me to think that we will see an increase in infrastructure investment over several years. This investment will force Chinese authorities to keep the current loose monetary policy at least for the medium term. Thus, according to several analysts, the figure of bank loans will double in three years. And this expansion of credit obviously generates a massive increase in consumption and spending power of families. The increase in disposable income is what is leading car sales to exceed U.S. figures, and we will see the same for other assets.

The important thing to remember is that the figures for 2009 are the result of a recovery from a downward cycle, and do not include the results of credit expansion and domestic demand, so China will be able to harness the greatest growth in its history without depending so much on exports and with relatively moderate inflation.
And what keeps me comfortably optimistic about Chinese stocks and those companies exposed to the growth of the country is this period of expansion, which coincides with the decline of the OECD, which makes it impossible for Western Central Banks to raise rates in a relevant way, and which will likely make investors increase exposure to risk assets. Alternatively we might lose the other 50% rally worrying about data from mature economies in decline.