Elliott Gue Selectively Plays Uranium and Gas
Interview

The Energy Report: You have coauthored two books, the most recent of which, The Rise of the State: Profitable Investing in Geopolitics in the 21st Century, chronicles how the global economy got where it is today, where you believe it's going and how people can profit along the way. Other than money, what compelled you to write The Rise of the State?

Elliot Gue: Well, as you mentioned, I cowrote another book a few years ago—The Silk Road to Riches: How You Can Profit by Investing in Asia's Newfound Prosperity—which discussed some of the same issues, albeit from a slightly different perspective. I wanted to update some of those themes, as a lot of the things we talked about in it came to pass. When we wrote that in 2005, I think a lot of the trends in the emerging markets weren't quite as apparent to everyone. China has seen amazing growth since then, particularly in energy, my area of expertise.

Over the last 10 years, Chinese oil demand has grown to more than 4 million barrels per day (bpd); that's where most of the international growth in oil demand has come from. Another aspect of it is that the Chinese government, through sovereign wealth funds, is investing directly in resource-producing assets all over the world. For example, they're in Africa and South America. I felt that we needed to update some of the trends we had discussed in that first book.

TER: The press release for The Rise of the State says the book contains "70 specific investing recommendations for far-sighted global investors." Could you provide our readers with an investment thesis or two from your book that apply to alternative energy and uranium, in particular?

EG: Uranium is a major part of the book, and we're seeing a renaissance of the global nuclear power market. If you had asked most U.S. analysts 10 years ago, they would have said the U.S. would be unlikely to build any new reactors. In Europe, countries like Germany had planned to phase out nuclear power entirely. In the United Kingdom, the public was very anti-nuclear; for example, Italy had a ban on it.

If you look at the developed world countries today, there's really been a sea change in sentiment. Most countries recognize that it would be impossible to generate enough power to meet growing demand and still cut carbon dioxide (C02) emissions without a large nuclear component.

But the real story on nuclear energy, again, is coming from emerging markets; nuclear is going to be a much larger portion of their energy pie. China has a very aggressive plan to build 30–40 new nuclear power plants over the next 20 years. If you look at India, which did not sign some of the international nuclear agreements, it has cut deals with the U.S. and other countries to import more nuclear technology and is preparing to do a major buildout of nuclear power.

Another interesting country is Russia. Most people think of Russia as an energy producer, not a consumer; but the economy there has been booming. The Russians are planning to build a large number of nuclear reactors so they can use nuclear power domestically and increase their exports of natural gas to Europe. Nuclear is really a major trend.

We've recently seen an uptick in uranium prices, as it is the key fuel for nuclear power plants. Uranium prices had been depressed for most of the 1980s and 1990s, so why would companies go out and spend billions developing new mines for a commodity trading under $10 per pound? Over the last several years, of course, we have seen a major run-up in uranium prices.

TER: They peaked in 2007 at $136 per pound, right?

EG: Yes, it was a very dramatic run-up that was followed by a collapse. Prices dipped to the $40 range but not back to 1990s levels. I believe the uptick we've seen lately stems from the growing realization that, although there's probably plenty of uranium right now, we may be looking at a supply crunch two to three years from now.

The Russian program for reprocessing nuclear weapons is scheduled to end in 2013. With some of those secondary sources drying up, some companies and countries are concerned there won't be enough uranium around to load all these new plants they're building. That's really starting to push up prices and some of the uranium mining stocks.

TER: The price is trending up now. How high do you think it could go? What's it going to do in 2011 and 2012 in your models?

EG: The thing with uranium is that prices don't really make much difference to the cost of nuclear power. Natural uranium accounts for only 5%–10% of the price of nuclear energy, whereas natural gas accounts for 80% of the cost to produce power from a natural gas plant.

With nuclear power plants, most of your costs are upfront capital costs for construction and the cost of the regulatory burdens. Uranium prices could go back up over $100/lb., and it really wouldn't have much of an impact on the economics of nuclear power. That's a big difference from natural gas or oil. When oil prices spiked at $125 per barrel, you saw real demand destruction. And when natural gas prices spiked up into the teens, you saw demand destruction. With uranium, I would expect to see less of that.

I think you're going to see a lot of these countries, especially China, going out and securing uranium under long-term supply contracts. If that happens, you'll see all these new sources of supply scheduled to come online get locked up. I think that could be a catalyst for a pretty aggressive run-up in uranium prices. I wouldn't be surprised to see prices exceed $100/lb. And some of the smaller mines in the U.S. and Canada might need those price levels to make them economic.

TER: Last week, the CEO of Exelon Corporation (NYSE:EXC)—one of the biggest uranium power producers in the U.S.—said that with gas prices where they are, it's not remotely profitable to build a merchant nuclear plant. Does that mean uranium is mostly a long-term play?

EG: I think there's a little bit of a difference between the U.S. and other countries on that score. U.S. gas prices are very depressed right now, and it really isn't about a lack of demand. In fact, we just had a very hot summer in the United States—about 40% hotter than the 10-year average; and we had a very cold winter—about 20%–30% colder than average. Those seasons drove very strong demand for natural gas in electric power plants. What's amazing is the growth in U.S. natural gas production from these shale fields, these unconventional natural gas fields around the U.S.

TER: Those supplies are keeping the price low.

EG: That's exactly it. It's truly astonishing to think that the United States is the world's largest producer of natural gas, producing about 15% more than Russia. We produce almost as much gas in the U.S. as the entire Middle East and Africa combined. Just 10 years ago, we were hearing that U.S. gas production was declining. I think gas prices in the U.S. will remain relatively low for a long period of time; and, when I say "relatively low," I imagine that ultimately a price around $6 per BTU will be required to encourage ongoing production and drilling.

A lot of foreign countries don't have that advantage. If you look at Europe, some unconventional plays are being looked at but that industry is probably at least a decade away from becoming significant. If you look at Asia, China has some shale fields; but, again, those are only in the very early stages of development. And those countries are probably going to face higher prices. That makes the economics of nuclear power in a country like China, India or even Europe look a lot more attractive than it would in the United States.

TER: What are some uranium plays you're following?

EG: The largest, of course, is Cameco Corp. (NYSE:CCJ; TSX:CCO). It owns some of the richest uranium mines in the world, in terms of the quality of the ore. As a result, Cameco is a very low-cost producer. It can produce uranium profitably even at prices in the upper $20s or low $30s, and we're a long way from that now. And, because of its size, Cameco has been able to make major investments around the world. One example is Kazakhstan, a major nuclear producer, and Cameco's been able to make investments in other countries with promising uranium projects. It is sort of the 800-pound gorilla, if you will, of the uranium mining industry.

TER: Yes, it's the Exxon Mobil Corp. (NYSE:XOM) of uranium. But what are some off-the-radar, small-cap plays?

EG: If you move down the scale a little bit, you want to look at some of the companies that are already producing uranium. They are smaller producers, but they often grow faster. An example would be Paladin Energy Ltd. (TSX:PDN; ASX:PDN) in Canada. The company has two major mines in Africa, which traditionally has been a pretty significant uranium producer—Namibia, in particular. Paladin is really emerging as an important producer there.

Another company to look at is Uranium One Inc. (TSX:UUU). The company actually sold a majority stake in itself to a Russian company to help them develop uranium mines in Kazakhstan. That scares some people, but Russia is a major investor in Kazakhstan. You really want to have the support of a Russian company when negotiating deals in that country. Uranium One is a fast-growing producer; it's smaller than Cameco but, potentially, could become a major producer with the mines it has underway in Kazakhstan.

TER: In a recent edition of Energy Strategist, you said numerous alternative energy companies carry little debt and are posting earnings growth, but then you added: "The trick is separating those alternative energy companies with low debt, positive earnings and/or deep-pocketed partners from the fly-by-night junk." How do you separate the wheat from the chaff there?

EG: When you're talking about alternative energy, I think one of the problems is that the sector tends to attract a lot of hype. Let's look at solar energy. A lot of people think it's a great way to use a freely available resource to produce power and it doesn't produce C02 or any other pollutants. The problem is, it is extremely expensive.

TER: And it takes up a lot of space.

EG: Absolutely; just the sheer size of some of these solar power plants makes them almost impractical. The only reason use of that technology is growing is because of government subsidies, particularly feed-in tariff subsidies in Europe. For example, if you build a solar power plant in Germany, you're guaranteed a very high rate for the energy you generate for 20 years. That makes it very economically attractive to build the plants, even though Germany gets about 5% of its energy from solar. It's been a major builder of solar facilities in recent years because of these subsidies.

You really have to be careful in investing in solar companies. Some of the better ones, like First Solar Inc. (NYSE:FSLR), will likely survive and make money in the long run; but you have to remember the government side of that equation. A lot of what solar companies do depends on the largesse of governments. Most European countries are cutting back on spending to bring their deficits under control and, as a result, they're cutting back on these subsidies. I think that's really going to create a lot of problems for solar companies.

Looking more at the uranium side, one of the problems is that a lot of these small-cap junior companies advertise that they have all this acreage for the exploration or development of uranium mines. But there's no way to know how much it will cost them to mine that uranium. In some cases, uranium prices may need to exceed $100 before those mines become economically viable. One of the things I look for on the uranium side is companies that actually produce some uranium.

TER: When our readers visit a company website to view financials, what should they look for on the balance sheet?

EG: Energy can be a cyclical business, so you want to look for companies with relatively low debt. If you look at a lot of the big energy companies, the Exxons of the world, they have tons of cash on the balance sheet; that allows them a lot of flexibility. When credit markets are in turmoil, such companies can take advantage of that and make acquisitions.

Most alternative energy companies have relatively low debt. First Solar, for example, is one that has a very clean balance sheet. But you also have to weigh that against the particular segment of the energy business they're in. For example, one group that I like a lot is energy midstream companies—companies that own pipelines and natural gas storage facilities.

TER: Master limited partnerships (MLPs)?

EG: Yes. Their balance sheets typically have a humongous amount of debt, but it's really not a problem because their revenues are pretty stable from their basic business, so they can carry high levels of debt. You have to look at how much debt is on the balance sheet, and then what part of the energy business they're in. Are they in a segment of energy that is very cyclical, or are they more of a fee-based, MLP-type company?

TER: Is there a certain threshold, as in a price-to-earnings (P/E) multiple, that you prefer when it comes to alternative energy companies?

EG: I don't really have a specific target. I typically look at how a company is valued compared to other similar companies. If you're analyzing a natural gas producer, you want to look at how its P/E compares to, say, Chesapeake Energy Corp. (NYSE:CHK) or one of the other big producers. There are often wide variations in the valuation, so you want to determine why. Is it because the company has much better growth prospects? You want to know exactly where its acreage is. In the energy business, it's pretty complicated to do a proper valuation of companies because it really depends on the quality of the resource base.

I like to look at the underlying business. What is it? How is the company going to grow? How is it going to make money? Does it have any forthcoming news events that will likely catalyze a big run-up in the stock? For example, the catalyst with nuclear power is the uptick in uranium prices that gets more investors interested in the sector. The other thing is a looming expiration of things like the Russian reprocessing program. Those types of catalysts can really get a stock or sector moving, and that's what I tend to look for more than any particular valuation metric.

TER: Can you share a few more of your favorite alt energy investment ideas that most people probably haven't heard?

EG: Sure. In The Rise of the State and in Energy Strategist, I look mainly at uranium companies, nuclear power companies and natural gas. I think natural gas will eventually be the most important play of all on alternative energy. I say that because wind and solar plants generate intermittent power; therefore, you typically need a natural gas-fired facility to put power on the grid when power drops off from solar or wind plants.

I think natural gas is going to be a major factor in the development of alternative energy, and those are the companies we've been focusing on in the newsletter. One example is Range Resources Corporation (NYSE:RRC)—a major gas producer in the Marcellus Shale. The interesting thing about the Marcellus is that it's very high in natural gas liquids (NGL) content, which includes ethane, methane and butane. A barrel of NGL is priced much more like a barrel of oil. So, in addition to producing natural gas, Range produces something of much higher value—NGL.

With gas prices around $5, Range is probably earning north of $7 for every 1,000 cubic feet of gas it produces based on the value of the NGL. And because we're producing so much gas from shales and a lot of the major shale reserves are rich in NGL, it's become a major boon to the petrochemical industry. They use ethane to produce ethylene, which is a basic building block of plastic. Range Resources is a player I would look at and, with natural gas prices depressed, now's not a bad time to start prospecting for value in that sector.

TER: You mentioned some MLPs earlier. What names do you like in that space?

EG: Well, they're really facilitating the development of shale. In order to produce all these new plays, we need more basic infrastructure. That is one of the untold stories of the shale plays. One of the largest players there and one that I have recommended for many years is Enterprise Products Partners, L.P. (NYSE:EPD). It's working on a lot of major projects, including a new pipeline in the Eagle Ford Shale in southern Texas. The Eagle Ford is another major gas play with a high NGL component. Enterprise also offers a really nice dividend yield of around 7%, and it's been growing distributions at a very steady rate for years. Not only do you get a nice yield with EPD, you also get a lot of upside in terms of future distributions.

A little bit further down the size curve is Targa Resources Partners, L.P. (NYSE:NGLS), another MLP. As its ticker implies, it really focuses on the NGL side of the business—NGL storage, pipelines and gathering and processing. These are all major businesses that are booming because of all the NGL production coming from shales.

As far as pure alternative energy plays like solar and wind, we're pretty much advising people to stay out of those right now. I think that there's potential for a glut of solar cells, particularly in Europe. That's going to bring down prices. There are some promising projects underway in the U.S. but, as the money from Europe starts drying up, how quickly are we going to see a ramp-up in U.S. utility activity to offset that weakness? There will be some struggles there. Currently, I am focusing more on uranium and natural gas.

TER: You've given our readers lots to ponder. Any final thoughts you would like to leave us with today?

EG: Be very careful about hype. Sectors like solar and wind are often subject to a lot of promotion and a lot of hype. For example, when Barack Obama was first elected president, I read all kinds of newsletters that recommended buying alternative energy because the new president was going to be a major promoter of it. As it turns out, he has promoted alternative energy; but those stocks have generally underperformed the rest of the energy space since he took office. You have to be very vigilant and very selective. Don't assume alternative energy is a sure road to riches just because it's carbon free and people are talking about it.

Elliott Gue's semimonthly newsletter, The Energy Strategist, unearths profitable opportunities—from traditional fuels like coal and crude oil to the latest alternative energy sources—in this booming sector and outlines the interrelated economic and geopolitical forces that drive these markets. Gue also brings an international perspective to Investing Daily, analyzing the complexities of global energy markets and related industries for Personal Finance, as well as more specialized publications.

In addition to his work on energy markets, Elliott is co-editor of MLP Profits, an online newsletter that takes the guesswork out of identifying high-growth, high-yield partnerships through studied advice and sound market intelligence.

Before joining KCI, Elliott lived and worked in Europe for five years, earning a bachelor’s degree in economics and management and a master’s degree in finance at the University of London—the first American student to complete a full degree at this prestigious business school. He also coauthored a book on investment opportunities in Asia, The Silk Road to Riches: How You Can Profit by Investing in Asia's Newfound Prosperity.

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DISCLOSURE:
1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Elliott Gue: From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.