Matt Badiali: A Great Resource Bull Market
Interview

The Energy Report: The big news on the energy front has been the oil spill in the Gulf of Mexico. Is this offshore drilling's Three-Mile Island?

Matt Badiali: I think maybe it is. The International Energy Agency (IEA), concerned about a possible ban on new permitting, warned U.S. lawmakers not to overreact. But I think it could go that far or further.

If you saw the testimony transcripts, basically three players were involved: BP (NYSE:BP; LSE:BP), the operators, were the ones telling people what to do. They were drilling the well. It was Transocean Ltd.'s (NYSE:RIG; SIX:RIGN) Deepwater Horizon that exploded and sunk. Then Halliburton Co. (NYSE:HAL), a service company, had people on the rig doing what was called a cement job. In each case, somebody screwed something up. What happened? It will be years before we know exactly what went wrong—if we ever know.

But we do know that the disaster is terrible. It's definitely going to have an impact on fishing, which means that people are going to be very, very upset. We may lose Louisiana's oyster beds. This will motivate the crowd that doesn't like offshore drilling to begin with.

We produce 29% or 30% of our oil offshore, and so if there's big push back against offshore drilling—even a widespread temporary suspension—that would deliver a tremendous blow to oil and gas production. Lawmakers could say that they want to put a moratorium on oil and gas drilling and production offshore just until they're satisfied that what happened on Transocean's rig and BP's well won't happen again anywhere else. Even halting new wells only would jeopardize supplies to the U.S. I think one of those scenarios is likely.

TER: In light of that, are there some companies with significant offshore projects that people should perhaps get out of their portfolios?

MB: Many of these companies could be fine, and I'm still a big fan of a lot of the offshore drillers. I would let the market tell you what to sell, because we could be wrong. For instance, I recently recommended McMoRan Exploration Co. (NYSE:MMR). They're not deep water; they're shallow water, but they have a really exciting new gas discovery; a great big natural gas field. This is a sub-salt discovery, so it's much deeper than the previous shallow shelf drilling. This area was drilled to pieces down to about 16,000 feet. But nobody went any deeper than that. Even though they're not deepwater drillers, McMoRan's share price plummeted after the disaster, and I was really concerned. I had a 25% trailing stop on it, though, and we recently hit it.

TGR: How about the impact on oil prices?

MB: I do think you're going to see ripples in the oil price. A curtailment in drilling could imply lower future supply, which would push up prices. A draft of the energy bill I read included some language about states making up their own minds about offshore drilling. That means they could do something drastic like stopping offshore drilling within 75 miles of their coastline if they don't want it.

TER: How far off the coast was the Deepwater Horizon working?

MB: About 50 miles—so 75 miles is significant. It's well out into federal waters anyway. And I would expect the oil price to spike if something like came to pass. I actually told readers months ago that we need to be looking at newer technologies and marginal oil plays just to hedge against a big jump in price in oil.

I really honestly thought that political tensions in Iran could send the oil price up over $100 this summer—and I still think it could happen. Back in March, we bought Suncor Energy Inc. (NYSE:SU; TSX.V:SU), the big integrated energy company that works the Athabasca oil sands. It's safe, it's uncomplicated and it makes a whole lot of money when the oil price is above $80 a barrel.

At that same time, back in March, I also recommended companies that do something called EOR—enhanced oil recovery. They inject different things into old oil fields to produce more oil from them. For example, Rex Energy Corp. (NASDAQ:REXX), which is better known for a pretty big position in the Marcellus Shale up in the Northeastern U.S, also has a big old oilfield in Illinois that they're flooding with different substances, such as polymers, to extract more oil.

So Rex could come back in and recover another 20% to 30% of the oil from an oilfield that was basically abandoned. Fairly often, you only got a third of the deposit out of these old oilfields anyway. If it was a billion-barrel field, you pulled maybe 300 million barrels, and left 700 million in the ground.

TER: Why were they leaving oil in the ground?

MB: A lot of fields were abandoned in the '80s when oil was at $12 or $15 a barrel. It's not economic to produce if it costs $25 or $35 to get the oil out. The advent of oil above $60 is a very, very recent phenomenon—2007 or 2008. Plus it takes a while to engineer these fields for EOR.

TER: What are some other plays in this EOR space?

MB: Kinder Morgan Energy Partners L.P. (NYSE:KMP) has been doing it for a long time. So has Occidental Petroleum Corp. (NYSE:OXY). I really like Denbury Resources Inc. (NYSE:DNR). They have a pretty good handle on the economics, and just finished absorbing a company called Encore Energy Partners, which also was in the EOR business. With that acquisition, Denbury is probably the biggest of these companies now, but I really like that they're building a carbon dioxide collection pipeline. They're piping along the Gulf Coast, going to all the different industries there—the refiners, the chemical plants—taking CO2 from these producers, compressing it, putting it in the pipeline and sending it to these giant old oilfields and then injecting it to recover the oil.

TER: What does the carbon dioxide do?

MB: Two things. It pushes against the oil already in the ground, but it also mixes with it and decreases its viscosity. It's like warming up honey; it flows better. In this case, a little carbon dioxide in the oil makes it flow better, which enables you to pull another 20% to 30% of the oil out of the ground. At the same time, they can return credits from the government to the CO2 producers in exchange for carbon dioxide; so it's a win-win all the way around. They get paid for sequestering carbon dioxide in the ground in these oilfields. They can produce oil from these existing oilfields, keeping costs fairly low because they don't have to build a lot of new pipelines and so forth. They just have to pay to drill the wells. You don't have exploration risks or costs. The fields have been pin-cushioned in the past, and 50%, 60%, 70% of the original oil's still in the ground. There are no dry holes. All they have is technical risk. I think that's a pretty good investment.

TER: You call these big oil companies "hedge funds." Why is that? And which ones do you like?

MB: Have you ever looked at a major oil company's annual report? Ever tried just going through their assets and try to do an evaluation? You start looking at their assets and come across all their partnerships, all their little deals; the entities they own which own another entity which holds half of a giant shipping line or whatever. "Holy smokes!" you say. "I didn't know they were into this and that."

People pretty much think "oil company" when they look at a ConocoPhillips (NYSE:COP), a Chevron Corporation (NYSE:CVX) or Exxon Mobil (NYSE:XOM). But how do you get a handle on what they're worth?

You may call them "oil companies," but that's not even close to what they actually do. They own pipelines; they own gas stations; they own ships; they own land; they own petrochemical plants; they own all sorts of things. In fact, it's kind of fun going through their assets. I am always surprised, because there's always something I missed the first time around. The diversity of their assets is enormous.

I talked about ConocoPhillips as the very first "hedge fund" because of all the various assets they owned. Shares of ConocoPhillips fell to ridiculous prices in the economic collapse at the end of 2008 and beginning of 2009. When you looked at the assets in terms of their liquidation value, it was a joke. You could have broken ConocoPhillips up and made twice the money. They were incredibly undervalued. That's where the idea of giant energy hedge funds originated.

ConocoPhillips made a lot of its revenue—and still makes a lot of its revenue—from refining. Their refining margins were absolutely terrible in 2009, and continue to be pretty bad. Somebody at ConocoPhillips finally looked around and said, "This is crazy; we bring in all this money, and it all goes out in costs on the refining end." So they began a program to divest $15 billion worth of assets—anything that wasn't core to their business model. They let go of a couple of big refining projects.

TER: So how are you feeling about your premiere "hedge fund" nowadays?

MB: I really like ConocoPhillips right now. They're getting out of non-core assets because they've identified the most profitable areas, and that's where they're focusing. They've been beaten down, but they still have an enormous amount of good assets. They're selling off the fat, getting rid of the bad stuff. They're really on a shape-up program. When they're leaner and trimmer, I think their profits will surprise everyone.

And when you look at who owns these, it's a "who's who" of the really smart investors. Warren Buffet and George Soros, for instance, are big shareholders.

But I also recommended Exxon Mobil, the hedge fund of all hedge funds. They are everywhere and in everything. I got some insight into Exxon Mobil when I was in graduate school at the University of North Carolina, where they recruited and got all of the best talent. I went to a short course at Duke University, and all the guys there were really smart geologists, really aggressive. You could see from the questions that they asked and the things they did that they were outstanding. I still get e-mails from a lot of my peers in graduate school. They're out in the field training, camping in the wilds of Wyoming or Utah and looking at rocks—because that's what Exxon Mobil guys do. They are constantly training. It's not just about drilling the wells and producing more and more gas. It's about doing it better; figuring things out, improving every single time. And that's just from the people side of things. They have an enormous amount of assets all over the world, world-class stuff.

Stupendously well run, fiscally responsible, no debt and they're trading at incredibly low prices. They're flirting with the March 2009 lows, when the financial world was in chaos. I think they're priced right. Ultimately, I think they're a hedge against rising oil prices. You can bank on it; their margins will continue to go up.

I don't consider Exxon Mobil to be a speculation. I put it in a different timeframe. It's the kind of company in which to buy shares and let price appreciation compound. Put it into a retirement account and when your kids graduate from college, you give them a gift—Exxon Mobil shares.

TER: Part of your legacy.

MB: Absolutely. And one more thing—I don't care if you're a 90-year old retiree or a 35-year old with lots of earning power ahead, you must have gold (the metal) and big oil in your portfolio. We are in the midst of one of the greatest resource bull markets of all time. You've got to have exposure. You absolutely must.

TER: Switching gears a bit, you mentioned natural gas income trusts in an April report. Tell us some of the reasons why you like them.

MB: I've told people about these trusts because commodities are so cyclical. They go up and they go down. It's very hard to pick the tops and bottoms, but you know when you're getting close. Look at the sentiment of commodity traders. They are usually really good in the middle of the cycles and really bad at the extremes. A couple of weeks ago the number of traders who were long oil and short natural gas was the largest ever. When you have the greatest concentration ever, long oil and short gas, it makes perfect sense to be a contrarian and buy gas.

TER: Speaking of short gas positions, what's your outlook for natural gas?

MB: I have some caveats about natural gas; I am afraid of the volume that's going into storage. We're producing a lot. When you check the amount of natural gas in storage against the Energy Information Agency's website—which gives you a five-year range, high, low and average in the middle—you'll see we're already over the highest volume of gas in storage for this time of year in the last five years.

I am a concerned about the valuations of a lot of the producers, too. For a commodity that's near bottom, the market's giving the producers a lot of value. They're valued as if the price of natural gas is going up. I don't believe that to be the case. Thus, I'm concerned about the likes of Chesapeake Energy Corp. (NYSE:CHK), Southwestern Energy Co. (NYSE:SWN) and other traditional producers that are gas-heavy.

TER: What's your thinking about the gas royalty trusts?

MB: Their dividends are nice and high—10% plus. They aren't hedged, so they don't sell their gas forward. They sell it spot. When I bought it, natural gas was selling below $4 per 1,000 cubic feet—not the bottom of the range, but pretty close. I thought my commodity risk to the downside was negligible. It may get cheaper than $4, but I don't think it would stay there for very long. However, a couple of hurricanes in the Gulf of Mexico could push the price of natural gas up. But when you buy royalty trusts, you don't really care about that. You get paid 10% to sit and wait.

I figure if we're close to the bottom of the cycle in natural gas, and if I can make 10% for the next two years while we wait for someone to come up with a way to bring the prices back up, that's a better trade than most. The downside risk in these trusts is fairly low; they make their money because somebody else is doing the work.

TER: Are any specific natural gas royalty trusts that you feel are better than others at minimizing the downside and paying the nice dividends?

MB: I've recommended San Juan Basin Royalty Trust (NYSE:SJT) and I like it. A couple of others—Dorchester Minerals, L.P. (NASDAQ:DMLP) and Hugoton Royalty Trust (NYSE:HGT) come to mind. One downside, though. There's virtually no information available about these businesses. They literally are a lawyer and a bank. Their websites are as unhelpful as they come.

TER: Before moving on from royalty trusts topic, you've dubbed Royal Gold Inc. (NASDAQ:RGLD; TSX:RGL) the Colorado Gold Bank. As I understand it, one of the reasons you're such a big fan is that there's a lot more to it than gold. What's the story there?

MB: When Royal Gold came to own some royalties on the Cortez Pipeline Mining Complex in Nevada, it did very well for them and became the platform for today's efficient royalty business model. Earlier this year, they bought International Royalty Corporation, which had a lot more base metal royalties—including their premier royalty on the Voisey's Bay Nickel Mine in Sudbury, Ontario—than Royal Gold did. I am thrilled by this acquisition. It diversifies Royal Gold's portfolio; they now have royalties not only on coal, oil, a couple of aggregate mines. They've also picked up some sand mines, which are an ideal source of proppant. Do you know what proppant is?

TER: Some of our readers may not.

MB: The big technological revolution in all of the oil and gas shale plays of the moment is drilling horizontally into these fine-grained rocks and exploding them with high-pressure fluids. They use this proppant (sand or ceramic spheres) to keep the cracks in the rocks open. That's how they produce oil and gas from the Eagle Ford Shale, the really wild new play in South Texas, the Bakken in the Dakotas, the Haynesville and the Barnett in Texas.

TER: For the most part then, you like the trusts, but you tell people to stay clear of natural gas ETFs, right?

MB: I do, absolutely, because natural gas ETFs use futures. Basically, the ETF buys a contract for natural gas one month out. Suppose they pay $4.25 for a one-month future contract. However, the spot price of natural gas is actually $4. Since they don't want to actually take delivery on that gas, they roll your futures once they get close to the expiry date. So they sell that future contract (which is now worth the spot price, $4). Then they buy another one-month contract. . .for $4.25. If you lose $0.25 on every contract every month, it doesn't take long to lose a lot of money.

Anybody can see the result from the performance of the ETFs. Compare the one-year chart of a natural gas ETF to the one-year chart of the natural gas actual price. Natural gas remained about even over the last 12 months, and the ETFs lost about 45% of their value—losing ground with every rollover trade. To me, that is a horrible investment.

TGR: You've apparently been pretty disappointed of late with the geothermal sector, too. Is it a timing problem there, or what?

MB: I really believe that people get behind the alternative energy plays when they feel as if the existing energy supply is going to be hammered, by the government or whatever. And if-and-when the price of oil goes back up, they'll come back into vogue. I think the groundswell behind geothermal emerged when Obama was elected. Everybody was excited, and thought he would usher in a brand new energy revolution, where all the power was going to come from green energy and he would tax anything that created carbon dioxide.

We bought right into the middle of that, and the timing was terrible. He had so much trouble with the healthcare bill that people thought he used up his political capital. That pushed the carbon tax far off in the future and a lot of the alternative energy plays suffered. Having said that, the technology is still there and the tax credits are still there; the technology works; the tax credits work.

Schlumberger Ltd. (NYSE:SLB) is a giant oil services company; the ones who really facilitated shale development. They're the folks who said, "Sure, we can figure out how to frack that shale. Sure, we can figure out how to drill horizontally." They just bought a geothermal drilling company, GeothermEx. Drilling in hot rocks is tough; that's a very specialized technology. Schlumberger just bought them. Say what you want about the big oil service companies, I think they're pretty smart, and so when you see a company like Schlumberger acquiring geothermal drilling companies, they see some benefit in it. And Schlumberger is the cream of the crop.

TER: Are there any companies in the geothermal space in particular that you'd recommend?

MB: I would recommend Calpine Corp. (NYSE:CPN), which produces the most electricity from geothermal power plants in the U.S. They also produce a lot of electricity from natural gas; so they're in a very good position to profit from rising electric prices.

There are two other good geothermal plays I like; but if you buy these, I would recommend using and honoring a trailing stop because we really don't know what's going to happen either with these companies or the geothermal markets. One is Magma Energy Corp. (TSX:MXY); that's Ross Beaty's vehicle. I like Ross Beaty a lot and have a lot of respect for him, and I think this will work. Down the road, I think investors will make a lot of money.

Another one I like is Ram Power Corporation (TSX:RPG), where Rick Rule is a significant investor. Ram Power has some really interesting geothermal projects, and a fantastic team of really, really smart people who have built geothermal projects all over the world. They consolidated some of the other juniors into themselves. I consider Ram Power the right kind of company in terms of people who run it and the places it operates. They did such a good job marketing it that it got very expensive very quickly, so it's stayed outside of my buy price range.

TER: Do you follow master limited partnerships (MLPs)? If so, what do you think is going to happen in that arena now that they've lost some of their tax advantages and are restructuring?

MB: I haven't looked at them lately because as you suggest, they've come to some bumps in the road. That said, investors who like to read annual reports and look at assets in terms of revenues they generate, probably could find some fantastic opportunities. Even though they seem to be un-killable, my problem with a lot of MLPs is the amount of debt they took on in 2007 and 2008. They always seem to carry way more debt than they're supposed to, and then they always somehow manage to pull it out in the end and restructure. I am leery of companies with really high debt-to-equity ratios; so that would be something investors might want to be wary of.

Still, I suppose there are some really good opportunities. Atlas Pipeline Partners, L.P., (NYSE:APL) was one building pipelines in the Marcellus Shale, and they got absolutely destroyed in 2008 and 2009. They were sitting on an enormous amount of debt, and I really expected them to implode. They didn't. They've come roaring back this year. So I've been wrong about some MLPs, just so you know.

TER: What are some of the energy stories you expect to see unfolding over the next few years, Matt?

MB: I haven't talked about this to my readers yet, so I will give you a glimpse into something I've thinking about. I don't have the statistics at my fingertips, but, for example, something like 70% of the world's oil is held by national oil companies. In my experience, national oil companies are very poorly run. Nepotism is rampant. They don't have the smartest or the brightest, and most of all, they don't have the competition.

Take Pemex, for example. It's Mexico's state-owned oil company, the world's 10th-largest oil company in terms of revenue. Just north of the border, we have probably 14 companies in South Texas drilling in the new Eagle Ford Shale. They're probably running 50 drill rigs, pulling enormous amounts of oil and gas from a swath about 100-plus miles long that goes right up to the Mexican border. A political boundary doesn't change the geology; these rocks keep going. This is an old shelf from the Gulf of Mexico that goes right around into Mexico, but there isn't a single drill rig turning on the Mexican side. Not a single one.

TER: Amazing.

MB: If that were a Mexican trend going across the border into the U.S., I'll bet you dollars to doughnuts somebody would be out there drilling it on the U.S. side. We have people who are motivated; they want their companies to succeed. They compete. We compete. National oil companies are nothing like that. They're single entities—run by the government—and poorly run, especially in places such as Mexico and Venezuela.

My point here is that when they need to get real work done, these national oil companies don't hire Exxon Mobil; they hire Schlumberger; they hire Halliburton; they hire Weatherford International Ltd. (NYSE:WFT). These entities are welcome in sovereign nations because they aren't chasing oil reserves. When an Exxon Mobil comes in and says, "We'll do the deal, but we want to claim half of those reserves as our own," the sovereign state says, "No, no, no. That's our national wealth; you can't have that."

But that's not how Schlumberger does things. They come in and do the work. They charge through the nose, but they get the work done. I think that is going to be a really interesting trend to follow over the next decade—the growth of these giant service companies with the ability to go into places such as Mexico and Venezuela and turn their oil and gas industries around just by virtue of the fact that they have very smart engineers and modern technology.

TER: Any parting thoughts you'd like to wrap up with?

MB: Yes. On the natural gas side, the price outlook is not good; so I would steer clear of the big natural gas producers, companies that are carrying a lot of debt absolutely need gas above $4.25 per 1,000 cubic feet to make their margins. But because we're at or near the bottom of the natural gas price cycle, for investors who aren't thinking about making a profit in the next six months and don't mind making 10% for a couple of years, those natural gas royalties are excellent vehicles.

Now, oil. Oil prices are well outside of the logic of supply-and-demand reasoning. Right now, they reflect a lot of emotion. I am concerned that the same emotion will carry through the summer, if we get a couple more bits of bad news. I've been really worried about tensions in Iran keeping oil prices up in the high $80s and low $90s. Now we have to worry about the fallout from the disaster in the Gulf of Mexico. It's a very emotional issue. If a couple of big hurricanes clobber the Gulf Coast this year—and they're saying it's going to be a very active hurricane season—the price of oil could really spike. If it does, some of the on-shore biggies, out of the danger zone from hurricanes—such as Suncor, Exxon Mobil, Denbury Resources—might snag an easy 35% to 40% this summer, if you buy them now.

That takes care of liquid gold. I know we're talking energy here, but investors absolutely, positively have to own gold stocks now. For the conservative folks, buy Newmont Mining Corp. (NYSE:NEM), buy Barrick Gold Corporation (NYSE:ABX; TSX:ABX), buy Goldcorp Inc. (NYSE:GG; TSX:G). This is an unbelievable bull market, one that you just absolutely have to get your money into. That's it.

Matt Badiali is the editor of the S&A Resource Report, a monthly investment advisory that focuses on natural resources—from small exploration outfits, to equipment companies, to the biggest commodity companies in the world. In Matt's own words, "as a geologist, I focus on all natural resources including silver, uranium, copper, natural gas, oil, water, and gold, just to name a few." His research has been published in several scientific journals; he's taught at three prestigious universities and been a guest speaker at numerous industry conferences. He's a longtime member of the American Geophysical Union, the Geological Society of America and the American Association of Petroleum Geologists. Matt's also a regular contributor to Growth Stock Wire, a free pre-market briefing on the day's most profitable trading opportunities. Matt has real-world experience as a hydrologist, geologist and a consultant to the oil industry and he holds a master's in geology from Florida Atlantic University.

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DISCLOSURE:
1) Karen Roche of The Energy Report conducted this interview. She personally and/or her family own the following shares of companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report of The Gold Report: Ram Power, Transocean and Goldcorp.
3) Matt Badiali: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family are paid by the following companies: None.