oilfield services as they prepare to fill pipelines with natural gas to be liquefied and exported. AltaCorp Capital's director of institutional equity research tells The Energy Report that Canada is pushing hard to approve liquefied natural gas plants, and Canada's proximity to Asian markets gives it an edge. A whole portfolio of companies is poised to support and profit from the business opportunities that will come with that industry.
The Energy Report: Jason, what is your outlook for oilfield services industry in Canada for the second half of 2014?
Jason Sawatzky: We are very bullish on Canadian oilfield services heading into H2/14 and 2015. The only thing that may throw a monkey wrench into the positive view in the short term would be the recent pullback in natural gas prices. We have seen the oilfield services index pull back a bit over the past couple of months. If we see natural gas prices pull back even more, we could see a similar pullback in the oilfield services index and in share prices. Other than that possibility, we remain bullish on the sector.
TER: Do you think there's more to the pullback in natural gas prices than seasonal fluctuation?
JS: We've recently had some large injections into the gas storage levels down in the U.S. That's been the reason for the more recent pullback in gas prices. But we are heading into the winter season, and typically gas prices strengthen as we head into winter, as heating-degree days tend to increase and gas usage increases. Even though we've seen a pullback, we expect gas prices shouldn't pull back much more from where they're at today.
TER: How strong is foreign market demand for Canadian liquefied natural gas (LNG)? Eight or nine Canadian LNG targets are proposed. Can demand support all of them?
JS: We believe one to three projects will eventually go ahead. The Canadian market would have a hard time handling eight to nine projects just from a labor and infrastructure perspective.
TER: Are any of the projects in progress right now?
JS: Not really. A lot of the developers have applied for initial approvals. Many projects are waiting on the British Columbia (B.C.) government's LNG tax package, which is expected in the fall. Companies will decide whether they'll go ahead after that. Petronas (PETRONAS)/Progress Energy Canada Ltd. has started delineation drilling. It's operating between 25 and 30 rigs right now, and that's the predevelopment phase of delineation drilling in preparation for eventual approval—if that happens.
TER: There are a lot of LNG projects in the U.S. that have a head start. Can the Canadian projects compete?
JS: U.S. LNG projects do have a head start, as the U.S. already has infrastructure in place for imports on the LNG side. They're now converting these plants to export. That said, we believe the Canadian projects will definitely be able to compete in building out LNG plants and infrastructure. Just considering Canada's proximity to Asian markets, it can compete. It's all about proximity to the Asian markets.
TER: What about the petrochemical industry? Natural gas is a feedstock for that industry. Would that be an equally good market for western Canadian gas?
JS: We think it will also be a good market. The petrochemical industry already exists in Canada, with plants in Edmonton, Alberta, and Red Deer, Alberta. The industry would definitely be a good market for western Canadian gas, but it would be a much smaller market as compared to LNG, given the global demand for LNG.
TER: Are the First Nations on board with the pipelines that will be necessary to get Canadian LNG to the coast?
JS: The largest pushback from the First Nations is actually around oil pipelines, due to the potential for spills and the environmental impacts around that issue. Their opposition has been mainly to the Northern Gateway Pipeline, an oil pipeline. Natural gas is a much cleaner energy; the B.C. government and First Nations are on board with LNG and the gas pipelines that would be built around that production.
TER: What does Canada want from a tax package on LNG, in terms of policy goals and revenue goals?
JS: Regarding a tax package on LNG, the B.C. government has said it is definitely pro-LNG, given the potential economic benefits for the province if a number of these projects go through—and the economic benefits for Canada as a whole, for that matter. We would expect a tax package in or around the September time frame. We think it's going to be favorable for the industry and for producers.
The B.C. government is looking to change its provincial tax model, which is currently based on the federal model. The new provincial tax model would be based on a cost recovery system (i.e., less tax would be paid overall, but there would be a higher net present value on taxes).
TER: You predict one to three LNG projects, out of eight or nine proposed, are going to go forward. Will the successful ones be those making progress now? Or might one of the late starters have a better chance?
JS: With Petronas/Progress already doing a lot of development drilling, we think that's a pretty positive sign. If the tax package is relatively favorable, we think that Petronas/Progress is prepared to move ahead with its project. Then some of the other larger players, like Royal Dutch Shell Plc ($RDS.A) ($RDS.B) and Chevron Corp. (CVX) , will be willing to move ahead relatively quickly.
TER: Would you talk about companies operating in the LNG space? Which companies are of interest, and what is driving their growth?
JS: Sure. Canadian Energy Services and Technology Corp. ($CEU:CA) is one of our top investment ideas. It's one of the largest drilling fluids providers in western Canada. It currently has roughly 34% market share in Canada, and is growing its drilling fluids business in both Canada and in the U.S. The company is operating in the Permian Basin down in the U.S., which is a large growth area for the company.
What's driving growth in the drilling fluids business for Canadian Energy Services is demand for more complex drilling fluids. That market is growing in both Canada and the U.S., as wells are drilled longer horizontally. The company offers its customers drilling fluids products that actually lower the total cost of a well, and that can raise overall productivity of a well, which ultimately increases the return for exploration and production (E&P) companies. Canadian Energy Services also has good exposure to the LNG build-out in Canada, and good exposure in the U.S. to increasing activity in plays like the Permian.
TER: Canadian Energy Services acquires a lot of its technology in mergers and acquisitions (M&A). Does it do its own research and development too?
JS: It does. When this company first started out, it very quickly became a market leader on the drilling fluids side in Canada. A lot of that was through its own research and development, and through providing proprietary drilling fluids products. But it has done a lot of M&A as well.
Canadian Energy Services has acquired a company called JACAM Chemical Co. Inc. down in the U.S.—a $240 million ($240M) acquisition. That acquisition transformed the company, and gave it another growth area in terms of production chemicals. It was a very positive transaction, and the stock has reacted accordingly.
TER: What was Canadian Energy Services looking for in the JACAM acquisition?
JS: It was looking to diversify its operations. The company's main operation is drilling fluids, which is tied heavily to the drill bit. You can have a lot of volatility in that business when commodity prices fluctuate. Production chemicals are a lot more stable in terms of business, as they are used on wells that are already producing. You have more stability and are less tied to the drill bit on the production chemical side, so it evens out the revenue stream.
TER: How does the company fund its M&A?
JS: It funds the M&A through debt, through equity financings and through cash flow from the business. On the equity financing side, Canadian Energy Services recently did a $75M equity financing and issued some debt as well—about $75m in debt.
TER: How extensively is the management invested in the company?
JS: The management team is heavily invested, and has been since the start of the company. Management and directors currently own 18% of the stock. They have skin in the game, and that's been reflected in how well the company's done over the past number of years.
TER: Is there another company that might benefit from LNG development?
JS: Newalta ($NAL:CA) is one of the three largest oilfield waste providers in Canada. The other two are Secure Energy Services ($SES:CA), which is a public company, and a private company called Tervita Corporation.
If LNG goes through in Canada and one to three projects go ahead, that will create a lot of activity in western Canada, which in turn will generate a lot of oilfield waste for companies like Newalta to handle on the back end. Newalta wouldn't be on the front end of the LNG development—that would be the drillers and the frackers. It would be on the back end, handling the oilfield waste generated from the increased LNG-related activity.
TER: Newalta's industrial division has underperformed recently. Now the company is talking about selling it. Where does that stand right now?
JS: The company engaged an advisor a few months ago to conduct a strategic review of its industrial assets, and it's working through that right now. We believe that we could see either a sale of a portion of the division or sale of the entire division by the end of this year. We think that will be positive for the company, given that the industrial business for Newalta is a lower-margin business compared to its higher-margin oilfield waste business. When Newalta does eventually sell off its industrial assets, it will take those proceeds and reinvest them into the higher-margin oilfield waste business.
TER: Will that materially change the way Newalta operates?
JS: It provides the company with more capital to invest in some of its higher growth areas. For Newalta, that would be its heavy oil business, which is centered on waste processing for steam-assisted gravity drainage (SAGD) and mining operations through onsite locations and fixed facilities. Another growth area for Newalta would be U.S. expansion. It's growing in the U.S., providing onsite and satellite oilfield waste services. Those would be the two main growth areas where it could redeploy capital.
TER: This is a pretty diversified operation. Do you see one of the units as representing the core business, and the others just supporting that?
JS: Once Newalta sells its industrial position, it becomes a pure-play oilfield waste provider in Canada and the U.S. We think that's going to be the focus for the company. Wells are aging in western Canada, produced water is increasing every year, and the amount of waste is increasing as horizontal wells are being drilled longer. We think these are all positive drivers for Newalta's core business of oilfield waste management.
TER: Do you foresee any other sales or acquisitions?
JS: Other than the industrial assets, no. And in terms of acquisitions, not anything in the near term. Over the longer term, if Newalta were to do any acquisitions, it may be in the U.S., buying smaller oilfield waste providers in certain plays. That would be the only potential acquisition.
TER: Speaking of acquisitions, Canyon Services Group Inc. ($FRC:CA) purchased Fraction Energy Services. How did the market respond to that?
JS: The market responded favorably to that acquisition, which was about 8–10% accretive. It allows Canyon to develop a more comprehensive fracking fluid management solution, offering both fracking and water frack fluid management services. Eventually, the goal for Canyon is to offer frack water recycling services. When the frack water is taken from the well, the company would be able to recycle it and frack with the same water. Down the road, that's what Canyon is looking to do.
TER: Any other companies that you're excited about at this moment?
JS: Generally, around LNG development in Canada, I would note some of the companies that we believe are on the front lines, or who will benefit from LNG development. That would include some of the drillers in Canada, such as Precision Drilling Corp. ($PD:CA), the largest driller in Canada. Some of the smaller drillers, like Western Energy Services Corp. ($WRG:CA) or CanElson Drilling Inc. ($CDI:CA), will benefit from the LNG build-out on the front lines.
Some of the fracking companies will benefit as well, such as Canyon Services Group, Trican Well Service Ltd. ($TCW:CA) and Calfrac Well Services Ltd. ($CFW:CA).
Another big area that will benefit from LNG build-out is camp accommodations, so we would highlight companies such as Horizon North Logistics ($HNL:CA) and Black Diamond Group Ltd. ($BDI:CA) as being able to provide pipeline and LNG-related accommodations on the west coast.
TER: You threw a number of companies into that basket. Is there anything particularly outstanding about any one of them?
JS: Certain companies within the Canadian oilfield services space are going to benefit more than others. Frackers and the drillers will benefit the most initially, and then the accommodations segment. Generally, if we do get one to three LNG projects approved and we look at the amount of capital coming into the basin, we think that oilfield services in Canada is the way to play the LNG theme.
TER: Thank you very much for your time today.
Jason Sawatzky is director of institutional equity research at AltaCorp Capital Inc., where he focuses on oilfield services. Prior to joining AltaCorp, Sawatzky was an associate analyst covering oilfield services at Stifel Nicolaus. Prior thereto, he worked at Cormark Securities, covering oilfield services and E&P companies for four years. Sawatzky holds a bachelor of commerce degree in finance from the University of Alberta, and a bachelor of arts degree in sociology/psychology from the University of Calgary.
Source: Tom Armistead of The Energy Report
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1) Tom Armistead conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: Royal Dutch Shell Plc.
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