James West: The Revolution in Energy Investments
Interview

The Energy Report: I understand the Midas Letter has recently begun to focus on energy stocks in addition to mining stocks.

James West: Yes, that's correct. We began covering energy stocks earlier this year and now seek to provide a balance between mining and energy. With the increasing shift away from conventional oil and gas (O&G) sources, future energy will be derived as much from mining various substances as it will from oil and gas.

TER: And what does Midas Letter see for the future of energy investors?

JW: Well, first of all, energy investment can no longer be accurately categorized as one asset class. Besides the traditional O&G investments, we've now got energy metals, shale oil and gas, heavy oil companies, new energy technologies and alternative fuels as distinct categories that appeal to completely different classes and categories of investors. So when you say, "What do we see for the future of energy investors?," my first response is "Which ones?"

Second, I think energy investment is undergoing a revolution, in that with the momentum towards more ecologically acceptable forms of energy generation, there is an equal rush to exploit what's left of the dirtier fuels—coal especially—before the regulatory willpower of world governments renders them obsolete.

Third, the global economy is still very much a lame duck. So investment and development of alternative fuels (algae, bio-diesel, hydrogen, etc.) remains quite distant right now. They are super-clean, yet it's very expensive to develop the infrastructure for full commercialization that these require.

The upside to that situation is new technologies have the opportunity to develop at the university level and displace technologies that are also new, but have been rendered obsolete by the rapidly evolving science surrounding various technologies. For example, the great hope surrounding hydrogen fuel cells has been displaced by rapidly advancing battery technology.

So these three major factors have caused a shift in the traditional energy investment paradigm, and investors need to change their thinking accordingly when it comes to each of the various energy sub-sectors.

TER: Why don't we start with oil and gas, and expand from there?

JW: Okay. Well this week, we're seeing the price of crude hovering around $100 a barrel, and there is no reason to expect that price to go down in the immediate term. The reason for that is simple: Oil is pretty much globally perceived as the most strategic commodity on the globe in terms of security. And so we're now locked into a pitched battle for control of the world's last known remaining conventional oil fields, because they are the easiest and least expensive to produce.

So the price is no longer affected merely by near-term supply and demand, but also largely by a new dynamic that puts a premium on larger, conventional oil fields close to and exploitable by existing production and distribution infrastructure.

For investors, it's hard to find emerging (junior) companies in this space with large potential upside, because in general, the prime addresses where huge discoveries have been made are quickly tied up by major exploration companies. The only option for junior investors is in new jurisdictions like Colombia, offshore West Africa and less stable regions of the Middle East. Unlike mining, where a junior can usually quite easily stake good ground at a low cost right next to a major mining company, O&G majors price concessions out of the realm of possibility for juniors, which are typically limited to capital projects with an entry fee of less than $10 million initially.

After the major Brazilian discoveries of the last couple of years, juniors that held ground even in onshore Brazil found that the concession rates rose astronomically, and they could no longer hang on to them. So opportunities for junior investors in Brazilian oil don't exist anymore.

TER: So is there anywhere junior investors can get a foothold in companies with mega-discovery potential?

JW: Oh yes, absolutely. . .there are always exceptions. One premium opportunity that made an absolute fortune for Midas Letter subscribers was Xcite Energy Ltd. (TSX.V:XEL). Xcite management is all ex-ConocoPhillips (NYSE:COP), with hands-on experience developing fields in the North Sea, which is where Xcite's fields are. CEO Richard Smith was formerly with Halliburton Group. So this team of well-seasoned oil and gas production executives was able to acquire prime real estate in the North Sea and with their depth of experience, were able to establish and beat milestones very quickly. That stock took off from just under a dollar in the summer of 2010, and now is trading in the $5–$6 range. The company owns 100% of the Bentley Block, where flow testing in December recently confirmed 2,000 barrels of oil per day (bopd).

TER: So would you say that Xcite is still a buy?

JW: Well, yes and no. It still has the potential for share price appreciation, but there are better opportunities out there at this point. Xcite will probably grow in share price more incrementally in the near future. It was a win for our subscribers, but we're looking at earlier-stage opportunities with better upside potential at this point.

TER: Like?

JW: Well, I'm really liking what I see in Brownstone Energy Inc. (TSX.V:BWN). I spent a full hour on the phone with President Jonathan Schroeder back in December, and these guys have multiple high-impact plays going on in a geologically diverse portfolio that is truly impressive.

They've got a 25% working interest in the Canaguaro Block in Colombia, and the operator of the project recently flow-tested rates in excess of 3,900 bopd. They also have a 20% paying interest to earn a 14% working interest in Block 36 of the Llanos Basin. And they are shooting 3D seismic across that and Block 21, which is a 50% paid interest to earn 35% working interest, and Block 27, where they are earning a 34.25% working interest.

3D seismic routinely delivers a success rate of 80%–90% in wells drilled to date, so that gives the company a lot of upside just on its Colombian assets.

They also have 300,000 acres in the prolific Piceance/Uinta Basins in Colorado and Utah, 253,000 acres in Rio Negro province in Argentina, some prospective interests in Brazil, a 50% interest in 300,000 hectares in the Quebec lowlands and 15% participating interests in several offshore Israel O&G concessions.

So the company is really nicely diversified across conventional O&G as well as shale oil and gas plays.

TER: Colombia really seems to be quite the destination for oil and gas plays at this point?

JW: You bet. The country is coming out of almost 60 years of a murderous war involving rebel guerilla groups and of course a narcotics traffic trade that kept Colombia's resources largely out of the realm of possible exploration. Now, with almost 10 years of relative security, the country is rushing to replace the narcotics trafficking economy with a resource-based economy in the interests of domestic security.

So Canadian resource entrepreneurs like Frank Giustra and Sheldon Intwentash (Brownstone Energy CEO) have been able to acquire high-potential assets on very attractive terms. Giustra's PetroAmerica Oil Corp. (TSX:PTA) is another case in point. We got into the stock very cheaply, and probably sold it too early, even though it was a 100% win for some of our subscribers.

I'd say there's a lot of upside potential in Petroamerica again that wasn't there when we sold it. Since then they’ve signed a definitive agreement with Talisman Energy Inc. (TSX:TLM), a Canadian major producer, to acquire participating interests in four exploration blocks in the Llanos Basin, which is the same basin where Brownstone's assets just started pumping 3,900 bopd. Petroamerica will earn 25%–50% working interest in these blocks for US$18 million, which sounds like a lot, but is actually a very good deal for Petroamerica.

Unlike Brownstone, Petroamerica's strategy is to focus exclusively on the Llanos Basin in Colombia, which is a good strategy too, considering the success that has been seen there lately.

TER: You mentioned you like the fact that Brownstone was diversified into shale oil and gas plays. Shale oil is not something we've heard much about in the last 10 years.

JW: That's true, and that's because since the conception of shale oils in the first part of the last decade, we knew they were there, but we didn't really know how we could get at them. Now hydraulic fracking has made these deposits accessible, and that has had the effect of creating a new exploration rush into shale O&G plays that are still more or less under the radar of the average energy investor.

Fracking is basically delivering high-pressure fluids to underground rocks that contain kerogen, which is contained in fine-grained organic rich sedimentary rock, from which shale O&G are extracted, so that the rock is fractured, allowing the contained hydrocarbons to flow towards a gathering point in the deposit deep underground.

With recent advances in this technology, combined with the enhanced precision now available in horizontal drilling, these previously inaccessible hydrocarbons have become very much accessible. In fact, in the EIA's latest update, "U.S. Crude Oil, Natural Gas, and Natural Gas Liquids Reserves," a summary of its Annual Energy Outlook 2011, the agency reports U.S. natural gas reserves, driven almost entirely by shale gas additions, increased by 11% in 2009 to 284 trillion cubic feet (Tcf.) That's the highest level since 1971. The EIA now projects technically recoverable unproven shale reserves standing at around 827 Tcf., 474 Tcf. above its 2009 projection— twice as much as previously estimated.

So that means shale O&G production may actually have the effect of displacing conventional O&G production where shale gas and oil production is cheaper.

TER: So you have some promising companies in this sector?

JW: Oh yes, definitely. One that we talked about in the September Midas Letter when it was trading at $0.30 was Realm Energy International Corp. (TSX:RLM), which has large landholdings in Poland. Realm has seen its share price soar from that $0.30 to current levels of around $1.43, which was a 400% win for our subscribers—and the company is still in its early days.

They're sitting on a 2,500 sq. km. land position there, which is huge, and obviously Realm itself isn't going to have the access to capital necessary to develop anything that shapes up there, but with the success recently of other companies operating in the area, Realm's land position becomes more and more valuable without their lifting a finger to do any exploration on their own. It's the ultimate example of being in the right place at the right time.

TER: So there has been drilling success in these Polish shale gas deposits already?

JW: Sure there has. Lane Energy drilled Lebien LE1 in September, the first of two wells that Lane is drilling in there, and reached in record time, including coring operations of the target shales. Drilling on the second well, Legowo LE1, began on August 27 and operations are proceeding on schedule. And just last week, LNG Energy Ltd. (TSX.V:LNG) announced it had spudded its first shale gas exploration well. By some geologist estimates, there may be as much as 100 billion barrels of light oil in the Paris basin where Realm has ground.

TER: Where do you see Realm's share price going in the next few years?

JW: Well, you know I'll get myself into trouble if I start pulling numbers out of thin air. . .I'm not the Federal Reserve after all. But let's just say that if Conoco Phillips and Talisman Energy, both of whom have major exploration budgets on European shale oil plays in 2011, see anything approaching large-scale success, the sky is the limit for Realm, just because everybody is going to be fighting over the company's assets. They're almost better off not doing any of their own exploration and just waiting for their more powerful neighbors to prove the concept for them.

TER: So Europe is the center of shale oil and gas exploration activity and potential?

JW: Oh no, I wouldn't say that. . .not by a long shot. Europe is seeing aggressive exploration because there are serious issues in terms of energy security for Eastern Europe, thanks to Russia's control over the majority of heating energy and the transportation pipelines that currently have the area over a barrel when it comes to pricing and delivery. If those area could be brought onstream relatively quickly, that will have the benefit of significantly kneecapping Russia's highly abusive stranglehold on the region. So there is a real drive to get those assets producing sooner rather than later.

But exploration is considerably more advanced, and the fields more accessible in areas like the Quebec lowlands, and the Bakken Formation in northwestern United States/southwestern Canada.

One of the companies we really like there that has been a winner for Midas Letter subscribers is Primary Petroleum (TSX.V:PIE). I think Primary Petroleum is shaping up to be a takeout target long before tenbagger status is ever achieved. They're becoming too important a player in the Montana extension of the Bakken Formation, which is seeing an awful lot of well development attention from some 50,000 bopd players in Alberta and south of the border. In total, there are four companies that have drilled a total of 20 wells on either side of the border, though no flow rates have yet been published. Strong flow tests from any of these will likely make Primary's share price respond favorably.

TER: Okay, so what about the "energy metals" group you mentioned above?

JW: Well, the number-one energy metal, in terms of consumption and value going forward, is uranium. If the Chinese raging bull can stay on its feet for another decade, Chinese consumption of uranium will drive prices significantly higher.

TER: What companies do you like in this space?

JW: Well, at the top of my list is Uranium One Inc. (TSX:UUU), which just announced last week record production and sales for the fourth quarter of 2010. They produced over 2.1 million pounds (Mlbs.) of uranium, a 75% increase over the same quarter in 2009, which is really impressive.

As a producer, and industry consolidator, the company has demonstrated an aggressive growth strategy that I think will make it a takeout target sometime in the next year, if not sooner.

TER: What about junior companies?

JW: There are a handful of Canadian juniors that I think have a great future— especially if the anticipated demand from China materializes. Athabasca Uranium Inc. (TSX.V:UAX) would appear to have a great portfolio of projects on the southeastern margin of the Athabasca Basin in Saskatchewan, which is really the premier address in the world for an exploration junior. They have 100% interest in 24,000 hectares there and a 50% interest in a 7,500 hectare piece adjoining Denison Mines Corp.'s (TSX:DML; NYSE.A:DNN) and JNR Resources Inc.'s (TSX.V:JNN) South Cigar Project.

Another Canadian junior that I've liked for a long time, and which was formerly a client of a related company, is Strateco Resources Inc. (TSX:RSC). The company has raised a pile of dough (over $13 million last year alone) to put its 100%-owned, 60 Mlb. Matoush project into production. Strateco is essentially the most advanced uranium deposit in Canada that is not yet a mine. A lot of people are completely obsessed with Hathor Exploration Ltd. (TSX.V:HAT), which is a great company as well, but I think there's a lot more near-term potential in terms of share price appreciation in Strateco.

TER: Now what about some of the other energy metals. What about lithium, for example, or rare earths?

JW: Rare earths prices have been going through the roof, and the bottom-line effect is that resource company executives are scrambling to transform their companies into rare earths deals. There's a lot of "me too" going on, where the "wannabes" are doing everything under the sun they can to look just like the "gonnabes," who are the real players in the rare earths space.

It's largely rare earths prices—particularly for lanthanum and cerium, which are used in fluid catalytic cracking units (FCCUs)— that have driven up the price of gasoline. Prices for these two rare earths have tripled just between the second and third quarters of 2010. It's only going to get worse. So there's a real boom on the horizon for rare earths explorers that can credibly identify potentially economic deposits.

One of my favorites is Hudson Resources Inc. (TSX.V:HUD), which started off as a diamond exploration company, but in the process of exploring for diamonds, stumbled across a significant rare earths deposit in Greenland. In the last 18 months, Hudson has defined a pretty substantial resource at its 100%-controlled Sarfartoq Rare Earth Element deposit there, having identified 40 million kilograms of neodymium oxide, for example, and the deposit is still open along strike and down dip.

As far as lithium is concerned, I like Lithium One Inc. (TSX.V:LI), because they have a strong management team and two really great projects. Their flagship, the Sal de Vida Lithium project in Argentina, is in one of the richest commercial lithium-producing regions of the world, where 16% of the global supply currently comes from. They've got a world-class exploration team, and with many of the same players who got Uranium One off the ground, you can pretty much count on the same outcome for Lithium One.

TER: Thanks very much for your time James. Illuminating as ever.

Publisher of Midas Letter, James West has devoted over 20 years to helping small companies in the resource sector—helping them raise money, further their projects, build their identities and get their stories in front of investors on the lookout for quality investments with excellent returns.

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DISCLOSURE:
1) Alan Trujillo 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: Primary, Strateco and Lithium One.
3) James West: I personally and/or my family own shares of the following companies mentioned in this interview: PetroAmerica, Brownstone, Hudson and Primary. I personally and/or my family am paid by the following companies mentioned in this interview: None.