Going Underground for Hot Buys
Source: The Energy Report††(11/20/08)
John McIlveen, a veteran securities analyst specializing in renewable power, turns The Energy Report on to a hot but hardly new source of energy in this exclusive interview. Geothermal power runs 24/7, is clean, cost-competitive and ready now. McIlveen, who recently joined Jacob & Company, an independent investment bank providing financial services to the renewable power sector, shares the names of some small geothermal companies with big multiples in their future.
The Energy Report: Letís start with your outlook for geothermal. Where is it going?
John McIlveen: For starters, geothermal is the only renewable power that is base load, so it can run 24/7. Wind is only available 30% of the time and solar, 12%. Geothermal is 98% available. If youíre trying to retire coal, gas and nuclear plants, youíd have to triple, quadruple build to replace them with wind. Youíd probably need a gas backup in case the windís not blowing. Geothermal is actually more available than coal and gas, which are typically around 80%. So thatís the first point.
Second, like any renewable, geothermal doesnít have a fuel cost. So if you manage the amount of flow you take from the earth with the amount you pump back into the earth, you can essentially create a closed loop sustainable resource. The fact that it requires no fuel means thereís no risk exposure to the price of oil, the price of gas, etc. And, itís ready now.
TER: The higher the price of oil, the more attractive the alternatives become. But youíre saying thatís not the case here.
JM: Utilities treat the price of power as a ďlevelizedĒ cost. This compares all costsócapital and operatingódivided by the number of megawatt hours generated over the life of the plant. For example, theyíd use 30 years for geothermal; 25 years for a coal plant, and compare costs on that basis. Geothermal is as competitive as coal; itís clean and available 24/7.
TER: Itís cost competitive so it doesnít matter what the price of oil is.
JM: Thatís right. It obviously doesnít move with oil, but when oil is up at these levels and higher, then it sure looks good. However, itís cost competitive with coal now.
TER: Because coal is the cheapest source compared to oil or natural gas?
TER: It just has that nasty environmental problem.
JM: Geothermal has a much smaller footprint than other alternative energies. Because geothermal sites are often remote, NIMBY is not an issue. Geothermal exists where tectonic plates intersect in zones of high seismic activity.
TER: So typically you donít get the NGOs protesting?
JM: You can usually tuck geothermal sites behind a mountain. Last week I toured Nevada and we drove for four hours down a dirt road. We never saw a single car during the entire trip and only two ranch houses but there were three geothermal plants.
TER: Describe the typical geothermal plant.
JM: Itís closer to the ground than a gas or a nuclear facility. Anything thatís burning somethingógas, coal, and nuclear all boil waterórequires a large boiler and a tall smoke stack. Geothermal doesnít burn anything. The plants are only about three-stories high, so theyíre unobtrusive. Their gathering systemsóthe pipes that connect the main plant to the different wellsóare generally located about half a kilometer apart, so they donít limit the use of the land. You could still farm it, feed cattle on it or even build solar power plants on it.
TER: I live near the geysers in California. There is concern that pumping water from those areas could cause earthquakes. Are earthquakes more likely in a geothermal area?
JM: By definition, you find geothermal activity in earthquake-prone areas.
TER: I see.
JM: Theyíve been trucking in treated wastewater to replenish the reservoirs in Californiaís geyser zones, which they hadnít done for years. All of the geothermal plants operating throughout Nevada and Utah re-inject water. Thereís 9,000 megawatts worldwide of this, but I havenít heard that this is a problem. But geothermal plants are located in earthquake-prone areas. There was a situation in Switzerland where they were experimenting with one of these Enhanced Geothermal Systems (EGS). What that means is, although thereís lots of hot rock down a couple of kilometers, thereís no natural water reservoir. So, in order to create electricity, youíre going to have to bring in water from an outside source, put it down the well, let it heat, and then bring it back up. That process triggered a series of small tremors strong enough to break a few windows. In this instance, they added water where there wasnít any in the first place. Australia is at the forefront of the geothermal arena. Theyíre doing some pretty large-scale pilot projects there and I havenít heard of this being a problem.
TER: Are costs still coming down?
JM: Geothermal has been around for 100 years but new developments continue to make it more efficient and bring costs down. For example, advances in oil and gas drilling techniques are fully transferable to geothermal. There are a number of new technologies being tested that operate at much lower temperatures. That means shallower wells could be drilled maybe a half a kilometer instead of three kilometers. There is also the possibility of tapping areas that lack the hot temperatures you really need, but are still warm enough to generate power.
TER: Obviously thereís a renewed interest in geothermal. Iíve got the book: The Geysers Album: Five Eras of Geothermal History. This shows geothermal being used in California as far back as the 1870s. Itís been around a long time. Whatís prompting this renaissance?
JM: In order for any product to have that hockey stick curve to it, itís got to be better and cheaper. Itís clearly better if it has zero fuel costs, no commodity risk, and is a closed loop, non-depleting resource. But now itís also cheaper and cost competitive with coal. With all of those advantages, the productís got to take off.
TER: What about some companies that youíre currently recommending or looking at in that space?
JM: Weíve got five junior geothermals on the Toronto or the Toronto Venture Exchange. Then there are two on the NYSEóOrmat Technologies Inc. (NYSE: OMA)
and Raser Technologies, Inc. (NYSE:RZ). Raser has an electric motor business as well.
TER: So itís not a pure play.
JM: Thatís right. Since Ormat is the granddaddy, letís look at that first. Obviously, itís been cut way down and is 50% off its annual high. The junior geos are all about 20% to 35% of their annual highs. They fell to a quarter and the big daddy fell by a half. In a normal market, Ormat was trading roughly 20 to 25 times trailing enterprise value to EBITDA.
To put that into perspective, the big $20 billion utilities usually trade around 9 times enterprise value to EBIDA. This is because the big utilities have a 1% growth rate and they pay a 4% dividend. On the other hand, Ormat is going to double its megawatts over the next, say, three years of construction, so the difference is really high growth vs. no-growth. Thatís why you get the nice big multiple and thatís where all of these little geos are going because every one of them has a pipeline full of projects.
For example, Ormat is generating on 400 megawatts right now. Only two of these are generating, Polaris Geothermal (TSX:GEO) and U.S. Geothermal (AMEX:HTM), at 10 and 17 megawatts, respectively. However, they have the capacity for 500 megawatts and 250 megawatts. The others have pipelines ranging from 200 to 400 megawatts. This gives them a locked-in growth profile for a good ten years after they get going. So this bad market has not hurt the fundamentals.
Whatís attractive about these geothermals is their 20-year Power Purchase Agreements (PPA). This is an agreement with the local utility or the grid operator so you know your price and quantity, and you keep it for 20 years. There are no surprises. That means you have a predictable cash flow for 20 years at IRRs in the mid-teens if youíre not counting any subsidies or incentives such as the PTCs. The long-term average of the market is in the 10 to 12% range. So, if you pick the right project, it could be a perfect hedge with a superior return and none of the volatility.
TER: Are Polaris and Geothermal are actually in the business of producing electricity right now?
JM: Yes. Polaris generates 10 megawatts. U.S. Geothermal has about 17 megawatts.
TER: But they are expanding that.
JM: Oh, yes.
TER: By how much?
JM: Right now I would say the Polaris siteóthe one in Nicaraguaóhas probably about a 500-megawatt potential. Theyíve already drilled production wells equivalent to about 70 megawatts. Now itís a matter of installation of the pipes and turbines, and attaching them to the wells. In about a year and a half, theyíll be producing 82 megawatts.
TER: What comes next? Would they enter into an agreement with an electric utility, a government, a grid operator?
JM: Thatís right. Union Fenosa is the grid operator in Nicaragua and thatís their customer.
TER: Where would you expect to see this stock trade? Do you have a buy recommendation out on Polaris?
JM: I actually havenít published any formal recommendations since coming to Jacob & Company. But theyíre all fabulous buys by virtue of the fact that theyíre about a quarter of their annual highs. Theyíve all at or below their tangible book value. Some of them, like Sierra, trades at about its cash.
TER: Whatís the risk with these companies? That they wouldnít be able to get an agreement with the utility?
JM: I donít see that as a risk because everybody needs power. Take Nicaragua. Theyíre only 50% electrified. All of their electricity comes from foreign oil, diesel and gas, so thatís a huge balance of payments problem for them. In the U.S. most states have renewable portfolio standards (RPS) that vary by state. The average target is to achieve 20% renewable by 2020. There will be continual pressure to add renewables to a utility's portfolio. So I donít see that as a big risk. The real risk has been prices for cement and steel. The price per megawatt has gone from about $3 million to $4 million over the last three years.
TER: This is the cost to produce?
JM: Cement and steel appear to have peaked and are starting to come down, so maybe weíll get some breaks on that in the future. Thatís the construction risk. The resource risk is the other one. You need good geologists and engineers to figure out the resource itself because you can get a dry well just like in oil and gas. However, getting a dry well isnít necessarily a useless thing because, you also need injection wells.
TER: Injection wells send your water down to hit this heat and create the steam.
JM: Right. Youíve got water super heated above the boiling point, which is 100į C. A lot of this water is roughly 200į C, so itís twice the boiling point, but it still exists in a water state because it has no room to expand into steam. Steam requires a lot more space. Once it hits the surface, it turns into steam and thatís what rotates the turbine. So once youíve done that, you re-condense the steam into water and pour it back down another hole. So getting a dry hole isnít necessarily a bad thing as long as itís close enough to the reservoir to be used as a reinjection well.
TER: Got it. So weíre saying $3 to $4 million per megawatt?
JM: Yeah, itís running about $4 million now. Actually, three years ago it was about $3 million.
TER: Itís a commodity price that can come down. But letís use $4 million. So going to Polaris saying that theyíre going to have 82 megawatts, theoretically thatís going to cost them $328 million?
JM: Yes, roughly. Thatíd be a little bit on the high end for them because things are cheaper in Nicaragua, especially the labor costs. But that would be an accurate figure for some of the U.S. developments.
TER: Iím trying to understand the financial model. So Iíve got to spend $300 million to build this thing.
TER: Youíre saying that one could expect a 10% to 12% profit on what Iím going to sell this for?
JM: I think youíre looking at about a mid-to-high teens IRR.
TER: Internal rate of return.
JM: If you can get the proper amount of debt leverage youíd get closer to 210%.
TER: Could these become REITs?
JM: These are classic models for a REIT. In fact, if you look at the Canadian Power Trusts, most of them have heavy renewable components.
TER: So have any of these geothermal stocks converted to that status?
TER: Do you think they will?
JM: In Canada, no new company can become a REIT. In fact, all the existing trusts have to convert to corporates in 2011. However, they could become high dividend paying stocks. So rather than being a utility that pays out 4%, you could probably get an 8% or 9% yield out of these things and theyíd be very attractive that way.
TER: You think thatís whatís going to happen? For instance, take Polaris, where do they grow, how do they grow?
JM: If youíve reached the end of your development pipeline, then thatís probably what you do.
TER: So theyíll be taking that money and developing more geothermal megawatts.
TER: How do investors look at that then? Thatís a growth company?
JM: Oh, yes, absolutely. In fact, the way to really look at these things is as high growth consumer staples that will trade anywhere from 10 to 20 times enterprise value to EBIDA. Take pharmacies for example. If youíre willing to pay 12 times for a pharmacy with an 8% growth rate, which is typical, then why wouldnít you pay closer to 20 times for one that has a 25% growth rate? After food and shelter, you need power. Thatís the problem with these things when they were brand new, power utility analysts ended up covering them. They are not power utilities; they are a high growth consumer staple.
TER: And theyíre green.
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