Greg Reid: Geothermal - The "Sleeping Giant"
Source: The Energy Report (4/16/09)
With the U.S. stimulus package in place and the politically contentious cap-and-trade program looming, one sector is poised to benefit from both measures. Calling it the "Rodney Dangerfield" of renewable energies, Greg Reid, director of Clean Technology at Wellington West Capital Markets, says geothermal doesn't get a lot of respect right now—but that's about to change. In this exclusive interview with The Energy Report, Greg discusses how the political push, and monetary allocation, for clean energy are aligning the political and social stars over geothermal.
The Energy Report: Greg, in one of your articles, you call geothermal the "sleeping giant" of renewable energy. What makes geothermal so interesting to you?
Greg Reid: I think the political and social stars are starting to align here. One of the key things is political will. You now have the governments that are pushing renewable energy. There was a lot of concern that as the economy went in the tank over the last year or so that the political will to continue to push forward on green energy initiatives would disappear.
But, given what’s happened in the U.S. with the stimulus package and the money that’s been pushed towards green energy, which includes geothermal, and given the recent draft bill put forward in the U.S. related to things like a national renewable portfolio standard and carbon credits, the U.S. government is really taking the initiative here. If you look globally, you have the successor to the Kyoto Protocol; with meetings coming up later this year in Copenhagen. Globally it now seems that being green has gone mainstream. So on the political end, the social side, it seems like things have lined up favorably for geothermal and for green energy.
TER: But geothermal currently is such a small part of the overall energy grid, whereas other renewables are higher. How would this play out over the next couple of years? Continue to be a smaller piece of the pie in a growing marketplace or will it take over from the other alternatives?
GR: I call it the "Rodney Dangerfield" of renewable energies. It doesn’t get a lot of respect right now and I think a lot of it is both education of the political leadership and the education of investors so they realize that this is a very good green resource. If you look at it in terms of the timeline that geothermal property can run for, you’re talking decades. So this is a very valuable resource in the ground; and there is a lot of it. I think the overall green market will grow, but geothermal will grow at least in line with the overall market rate.
TER: One of the downsides of geothermal is the cost of the initial drilling and building of the plants. Is there opportunity for geothermal companies who don’t already have production?
GR: Yes. The biggest challenge for the smaller developers is the lack of access to credit today and having to have a better balance sheet to get these projects going, but we’re hopeful that we’re through the worst of it and things will start to get better. If you look at some of the initiatives in the U.S.—part of the stimulus package, for example—some of these developers will be able to take advantage of getting cash grants up front in lieu of tax credits, which should kick start some of the projects.
TER: When we look at the geothermal market place, most of the interesting plays are companies who are very close to production or already producing. What is the opportunity for smaller or exploratory companies?
GR: The opportunity in this market is tough right now. The reality is, it’s very difficult to raise money to just go out for the drilling phase. It’s even tough for the guys that are later in the development phase that are ready to build. But, like we said, we believe that because of things like the stimulus package in the U.S. and the fact that I believe we’re through the worst of all the negative things in the economy, that things will slowly start to get better. That should make it somewhat easier to raise some money.
TER: If we start putting carbon credits and trading credits in, it appears that that’s going to make certain types of energy like coal and oil more expensive. And the United States is a big coal-eating machine. So will cap and trade make coal more expensive? Will the politicians acquiesce as they look at people who can’t heat their homes in the middle of winter?
GR: Yes, that’s the million-dollar question. It may be one of the most highly contentious issues that we’ll hear about this year on the political side. Obviously, you’ve got the government saying in the U.S. that they want to push cap-and-trade forward and maybe the concessions that they make to get it passed will be like what happened in Europe where a number of the allowances are given away as opposed to being auctioned off. So they’re given away to particular industries. Maybe they’re coal players, maybe they’re a steel manufacturer.
There seems to be political will, both in the U.S. and around the world, to get something like a cap-and-trade program established. The devil will be in the details.
One notable misconception is that a lot of people think that geothermal is a more expensive form of energy, but the reality is it’s more expensive than some other things up front, but when you look at it over the life of the plant, the operating costs are low and there’s no fuel price risk, so it’s actually at least as cost competitive or better than a lot of other energy sources. On that front, one of the major banks in the U.S. recently put out a report looking at the levelized cost of various energy sources and they said even with the existing incentive schemes in the U.S. with production tax credits and no carbon taxes, geothermal was the lowest cost of all energy sources—even better than coal and gas. Add in a carbon penalty and geothermal will look even better.
TER: If that’s true, why don’t we see more geothermal production facilities in transmission?
GR: I think it’s just a matter of time that you’ll start to see more and more. The reality is if you look at the industry today, there’s not a lot of public companies in North America. I think there are six or seven. Australia has a number of players, but they’re all small companies with maybe on average $5 million in cash and sub $50 million market caps. The bulk of geothermal out there today is within divisions of large companies like Chevron or divisions of national energy companies. Because of the incentives, and as people get more educated on geothermal, and especially if we get into an environment where we have carbon being taxed through a cap and trade program, then I think geothermal will start to move up the list in terms of people’s interest level.
TER: To what extent does the success of geothermal require cap and trade to be implemented? Could it be successful if that doesn’t pass?
GR: Yes. I think if it doesn’t pass, it still will be a successful and growing source of energy. Many experts believe that oil prices will rise again as the economy starts to improve. The numbers that I’ve seen, talking to various companies, was even at $40 to $45 a barrel of oil pricing, geothermal still makes sense. So cap and trade would be kind of icing on the cake to push people to geothermal and other sources even more.
TER: Will it continue to require some type of government subsidy?
GR: I think that will be one of the drivers of the industry. Besides the economics, there's timing. From when you first do surface exploration to when you actually have a plant up and running can take anywhere from four to six years. In some cases, people might be more interested in funding a wind project or solar project, which is up and running within a couple of years.
TER: What are some of the ways that individual investors can play the geothermal market?
GR: I think if you look at the Canadian-North American markets, you have your smaller players like a Polaris Geothermal Inc. (TSX:GEO), Sierra Geothermal Power Corp. (TSX.V:SRA), Western GeoPower Corp. (TSX.V:WGP), US Geothermal Inc. (AMEX:HTM) (TSX:GTH), and Nevada Geothermal Power Inc. (TSX:NGP) (OTCBB:NGLPF), and those are the smaller developing stories. Some of them have small amounts of power production today and then have other projects that, in Nevada Geothermal’s case, they’ve got 40 megawatts that will come on at the end of this year. So they’re going from development company to operating company.
Then, if you’re looking for a more liquid name, an industry bellwether, that would be a company like Ormat. The company gets about 75% of its revenues from operating geothermal plants with 20- to 25-year power purchase agreements. The other 25% of their business comes from supplying equipment to the geothermal industry. All of the other development companies, in many cases, would use technology from Ormat Technologies Inc. (NYSE:ORA).
If you look at other countries, you’ve got a number of companies in Australia as well, companies like Geodynamics Ltd. (ASX:GDY), which I think has roughly $100 million in cash and Tata Power, which is an India power company, owns a stake in them. Then you have a number of other companies like Green Rock Energy Ltd. (ASX:GRK), Hot Rock, Panax Geothermal, etc. A lot of them are in the development stage and will still need to raise significant capital to get some of these projects over the goal line. But, on the other hand, they also have energy companies that have been taking ownership positions and have been helping them get things funded.
TER: Are the ones in Australia a similar size to Polaris and Western?
GR: It’s interesting. Most of the names I mentioned are North American plays and then you have Polaris, which has around 340 megawatts or so of potential development in Nicaragua. You also have companies like Magma Energy. Two hundred megawatts is their P90 estimate and they’ve got numerous properties in Chile and Peru and North and South America.
If you look at what’s going on in Chile right now, there’s bidding for geothermal concessions in the north. I think there are seven or eight parties/consortiums that are in the bidding process. There’s not been any development that’s happened in a significant way yet in Chile, but you’ve got all these companies that are coming in to bid and eventually develop there.
And then there's between 25 and 30,000 megawatts of potential in Indonesia and you’ve got government-owned companies that have done most of the development to date. I think you’re going to see a number of international companies come in to help develop there as well.
If you look at some of the resource potential in areas like Australia and Chile and Indonesia, you’re talking a potential of tens of thousands of megawatts. In terms of resource opportunities, there’s a lot of geothermal potential out there. We’re just scratching the surface today.
TER: Well, this sounds like with all the research opportunity out there, something like Ormat would be fabulous potential for growth because they have the most experience in terms of helping to develop the facilities.
GR: Yes, they definitely do and since they’re developing and selling equipment to a lot of developers out there, they obviously get pretty good insight into what areas of the world to be in. From an investor point of view, in a market like we have, people might be more focused on owning some of the bigger names with more liquidity, so Ormat would be the "go to" name.
TER: You have three stocks that you’re currently rating as a buy. Can you talk about them?
GR: Let’s start with Polaris. We’ve got a C$1.10 target price on them. The thesis on Polaris is they operate in Nicaragua. There’s electricity shortages there. There’s been favorable government policies towards private power operators in Nicaragua and specifically for geothermal and we think they have a great resource there, which, when you put it all together, we think the economics of the projects look good. The biggest challenge the company has had is raising capital to get these projects operating.
Currently they operate about a 10 megawatt facility, which has been operational since 2005 and that has gone well. The next phase was another 24 megawatt expansion, which they’re close to getting all the financing lined up, so that could be operational within a couple of years. Overall we think they have roughly 340 megawatts of power potential from Nicaragua where they are today.
One of the interesting things about Polaris is the mixture of water and steam that comes out of the ground there is so hot that after it goes through the plant and gets converted to electricity and then goes back to get reinjected into the ground, I believe it’s still getting reinjected into the ground at 170° C. So that is hot enough to be able to run it through a binary plant again to create more power. We think the 340 megawatts could increase by up to 20% at a very low incremental capital cost.
So just by running the reinjection fluid before it goes back into the ground, they’ll run it through another binary plant and generate an additional 20%. So you could be talking more than 400 megawatts of potential out of Nicaragua. They are also involved in bidding in Chile as well, so for people that have concern about political risk in Nicaragua, they are attempting to diversify and are involved in bidding in Chile. They haven’t named the company, but I believe they’re either in partnership or in discussions with a much larger renewable energy company to help them finance and fund that opportunity there.
TER: As far as the financing for this expansion in Nicaragua, aren’t they pretty close to getting money from various international developmental companies?
GR: Yes. They just announced, actually, within the last couple of weeks, that there’s a Central American development bank that has lined up $77 million U.S. in debt financing, so I think they’ve got all the major syndicate partners lined up or very close and the expectation is that they’ll be able to access that debt within the next couple of months.
As part of that announcement, they also announced that they will be raising equity. Traditionally geothermal is typically 20% to 30% equity and then 70% to 80% debt financed, so expect that you’ll see both debt and equity financing here in the near term on Polaris.
The topic that always comes up with Polaris is the political risk in Nicaragua. The interesting thing is if you go back and look over the last 10 years, Nicaragua has privatized its energy sector and there’s been favorable laws that have come in and favorable incentives in terms of power tariffs and tax holidays for the geothermal industry. All the signals are there that the government is being friendly to international development and specifically in the power sector as well.
The next company I'll discuss is Nevada Geothermal. We’ve got a C55 cent target. We’ve launched in the last month and the stock’s had a nice little move.
We apply some probabilities to the NAV based on what stage the projects are at in development. We might have anywhere from 50 cents to a dollar target on a lot of these stocks, but we believe the true NAV of these stocks are $4, $5-plus. Over time the discount rates will come down and your risking on projects will get better as the projects move forward on development. Net, net on Nevada Geothermal, it's a company that has over 200 megawatts of development all in the western U.S., so the political risk is very low. Their first facility will come on at Blue Mountain, expected to be on-line in the fourth quarter of this year and that’s roughly a 40 megawatt net facility.
Then I think you’ll have a story where a lot of people look at it and say, well, this is one of the first developers, one of the pure play publicly traded companies of the smaller guys that’s taken a project right to operation and they’ve now got a meaningful business on the operating side as opposed to just being the development side. So maybe you get a bit of an upwards rerating on the stock from that point of view.
It is also interesting to note about many of these projects, that when you look at resource risk, several of these projects have had exploration drilling on them back in the late '60s, '70s and '80s. We’re talking millions of dollars of exploration, many wells drilled. So people have a sense of what the temperatures might already be down at 4,000 or 5,000 feet, 6,000 feet as well as if there is actually a reservoir down there. So the resource risk, once you dig into it, might not be as high as person might initially think.
That relates to the third company I want to talk about, U.S. Geothermal. Their site at Raft River used to be the site of a Department of Energy demonstration plant, I think, back in the '70s. Something like $40 million was put into drilling and building the plant by the U.S. Department of Energy. So they’ve taken over that property. They did acquire a small facility as well last year in Nevada (San Emdio). If you look at it today, they’re operating ~ 16 megawatts. Their pipeline is over 200 megawatts of potential as well, so they are on their way to developing and becoming one of these other successful developers as well. Like Nevada Geothermal, U.S. Geothermal, and Polaris, all these companies trade somewhere between .2 to .4 times price to NAV. We think if they’re successful in raising capital and getting projects towards the goal line than you could see rerating on the stocks closer to their net asset value.
TER: What’s the target on this one?
TER: This has been great, Greg. Sounds like there’s some real opportunities here.
Greg Reid, CFA, is director of Technology & Clean Technology Research at Wellington West Capital Markets Inc. The company provides financial advisory and equity research services, including underwriting, institutional sales and trading, investment opinions and equity transactions services. WWCM caters to mining, technology, and energy sectors. Prior to Wellington West, Mr. Reid worked in Equity research with TD Securities, Raymond James and Versant and was Portfolio manager with New Brunswick pension fund manager NBIM.
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