Geo Energy Resources Investing Thesis Part II

This post was republished on NextInsight:

https://www.nextinsight.net/story-archive-mainmenu-60/938-2016/11059-geo-energy-to-buy-or-not-to-buy-overriding-consideration-is-coal-price

This is a continuation of my earlier post:

Geo Energy Resources Investing Thesis – Part I

Let me delve straight into it.

In Part I, I described the recent history of the company, it’s acquisitions and growth, and the recent positive developments for the company. I also analyzed it’s debt issue and potential cashflow requirements.

In the mid term though, IMHO, the single most important factor that will determine how well the company does, is the coal prices.

That’s probably true of most commodity companies. Acquisitions and offtake agreement are great, but coal price is without doubt, the single biggest factor.

So let’s look into the macro factors for coal.

Coal Price Trend

Coal prices have not been kind to almost anyone in the entire supply chain. This chart gives a gauge of how Indonesian coal prices look like in the past 6 years:

This widely used HBA marker is derived from the average of 4 coal price indices in Indonesia, all of which are of the high GAR value variety, NOT the GAR 4,200 coal that Geo Energy has, but the trends would be rather similar.

Specifically for Geo Energy’s 4,200 GAR coal prices, the price hit a multi year bottom sometime in 1Q2016, and has been recovering strongly since then:

4,200 GAR value coal selling prices  (US$/tonne):

2013: $42.6

2014: $54.3

2015: $31.7

1Q2016: $26.66

2Q2016: $27.96

August 2016: $30.71

September 2016: $36.27

Based on 2Q2016 prices, Geo Energy’s cash profit increased to USD 4.50/tonne.

Since 2Q, the selling price has increased strongly, with costs likely to be roughly maintained. Hence, it is safe to predict that Geo Energy’s cash profit would’ve tracked the increase in coal prices just as strongly, to be significantly >USD 4.50/tonne.

Let’s also bear in mind that there’s lag time between the current coal prices, and the point when the results show up in the financials. This means that a current uptrend in selling prices will show up in improved profitability in the next financial statements, and improved cashflows for the next financial statement and perhaps even the one after that.

Supply & Demand

Global coal production, and consequently coal supply, dropped significantly in 2015:

China, in particular, has seen its coal production cut by 10% y-o-y, with coal imports making up for the shortfall. This coal production cut is actually deliberately done by the Chinese government, amidst concerns of excessive production during the sharp decline in 2015.

Chinese coal demand, on the other hand, has dropped only 5%, hence China has a sudden need to import coal to make up for the shortfall. The import volumes has risen dramatically since the end of Q1. This chart shows it nicely:

As China alone accounts for 50% of the total global coal production, any changes in their coal production and/or coal demand has huge implications on the global markets. Chinese power stations are also the “end-users” of Geo Energy’s coal, although the company is in the midst of negotiating with Indonesian power plants as well. More on this later.

With production falling off in 2016, it is projected that the global demand is likely to exceed supply for the 1st time in recent years. 2016 coal demand is forecast to be 862million tonnes, while supply is forecast to be 846million tonnes.

Aside from the global and China’s demands for coal, Indonesia is also fast becoming one of the major consumers of coal, with it’s consumption increasing by 15% in 2015, resulting in Indonesia being the 8th largest coal user in the world.

Adding to the near to mid term demands for coal is the Indonesian government’s 35GW power plan, released in May 2015. Basically, the Indonesian government has determined that the country needs substantially more investment in power plants to meet the future electricity needs of the country.

Out of the 35GW planned, coal powered power plants will account for 20GW, with a correspondingly increase in coal needs by 85mil tonnes/year.

Being situated in Indonesia, Geo Energy would be well placed to capitalize on this. The company has already indicated that this is one aspect that they are considering.

In fact, they have gone as far as to say that they’re planning to supply coal via Perusahaan Listrik Negara, Indonesia (“PLN”), which is an Indonesian government-owned corporation.

While investors should keep this in mind, currently, I ascribe a value of absolutely zero to this development. This is because Indonesian infrastructure plans have typically proven to be problematic. In fact, there are some reports of delay and stuff regarding this electrification plan. I won’t describe it here, but delays are mainly due to getting the land rights to build the power plants.

To further illustrate my point about ascribing a value of 0 to this potential development, Geo Energy has previously, back in Feb 2015, announced a cooperative agreement with a Chinese SOE to construct, develop and manage power plants in Indonesia.

This is the relevant announcement:

The agreement is non-exclusive, and has a validity of 2 years. All these details are repeated in the AR 2015. Since the agreement was inked in Feb 2015 though, there has been absolutely no further news/developments.

I’d assume this expires in Feb 2017, which is a mere 4 months away, and from what I have found, this agreement has provided no economic benefits to Geo Energy. Except some initial bragging rights.

I can imagine the optimism it provided existing shareholders when it was first announced though. This illustrates why I tend to be more cautious and unless the writing’s on the wall, I’m assuming it’s just noise.

Still, pursuing coal supply agreements with potential end users in Indonesia (coal power plants) makes perfect sense for Geo Energy Resources and I’m glad to see that management has already indicated that they’re pursuing this.

Being situated within the country itself, logistics such as transportation would be much cheaper. The company would also presumably have more local know-how and contacts to secure such deals.

It remains to be seen if they’d be successful. We have to keep in mind that there are many coal producers in Indonesia.

Here is a list of power plants coming up in various parts of Indonesia:

Some of the planned power plants such as No.11 (Kalimantan Barat)  from the 1st slide, No.1 and 2 (Kalimantan Timur) from the 2nd slide and No.7,11, 33, 34 and 37 (Kalimantan Barat, Kalimantan Selatan) in the 3rd slide, are all situated within close proximity to the SDJ and TBR mines, which are situated in South Kalimantan.

These power plants are steam power plants or combined cycle power plants, both of which utilizes coal to generate steam for electricity.

Just to recap: We have considered the coal supply and demand situation in China. We have also considered the potential demand from Indonesia, which Geo Energy resides in.

Finally, let’s consider the coal situation in the US. Although the US does not have a direct impact on Geo Energy, being the 2nd largest coal producer after China, we do have to consider it’s current supply and demand trend, and the implications for the future.

Here are the latest stats/data I derived from the US Energy Information Agency (EIA):

For the week ended 1st Oct 2016, collectively, the US coal producers have produced 16.7mil tons of coal.

This is 6.5% higher than last week’s estimate, and 6.7% lower than the production estimate a year ago (in 2015)

Year to date, US has produced 540.5mil tons of coal, that’s a decrease of 21.9% compared to the same period in 2015.

U.S. coal production in August 2016 was 71mil tons, a 9% increase from the previous month but 14% decrease from August 2015.

In 2016, coal production is expected to decrease by 164 mil tons or 18%, which would be the largest decline in terms of both tons and percentage since at least 1949.

U.S’s domestic coal consumption in the electric power sector, which accounts for more than 90% of total U.S. coal consumption, is forecast to decline by 64 mil tons in 2016

So what does all this mean exactly? I’ll add in a caveat here by saying that it’s notoriously difficult to predict something as global macro as coal prices in the future. (I’ve mentioned this in many earlier articles. Global macro trends are just crazily difficult to predict with certainty.)

What I’ve done is to try to understand the historical coal suppliers (mainly China and US, the 2 largest players), tried to understand the immediate/short term supply and potential demand, and finally, tried to understand and predict longer term how coal will turn out.

Here are my thoughts/conclusions from the data I have listed and analysed above:

1. From the data above, we know that looking at yearly data, coal production has generally fallen off a cliff in 2016. China has cut back 10%, US has cut back 22%. On the other hand, China’s coal usage has fallen 5%, while US’s has fallen 9%. This means that coal’s worldwide usage has actually fallen in 2016, it’s just that production has fallen much faster, giving a resulting net boost to global coal needs from coal producers.
2. Point 1 basically explains the massive rise in coal prices since the lows in 1Q2016. Unfortunately, it also makes me a bit cautious. Sure, there’s a net increase in coal needs, but it’s not because of increased demand. Rather, it’s because of production falling faster than demand. This is good for coal prices, but not great. This is because this can be easily and quickly corrected by increased production, with a resulting fall in coal prices. The rapid rise in coal prices would’ve been better supported if it’s due to increased demand, rather than decreased net supply. In short, increased demand is more permanent, decreased net supply instead, is more easily corrected.
3. In fact, the data seems to support my points 1 & 2. Although production has fallen year on year, in the immediate term though, production has started to rise, probably in response to the sharp rise in coal prices.
4. Longer term wise (>5 years), I’m actually pretty pessimistic about the future of thermal coal. I own Chesapeake Energy, and as part of my research then, I’ve in depth knowledge about the power plants in the US. Coal power plants are pretty much getting obsolete in the US, with natural gas taking over as the primary fuel for power generation. And it makes perfect sense. There’s an abundance of nat. gas in the US, it’s currently very cheap, trading at multi year lows, and most importantly, it releases a fraction of the greenhouse gases and pollutants that coal power stations produce. In the long run, most countries would eventually phase out coal for energy generation.

So how does the above conclusions affect my thoughts on Geo Energy?

Geo Energy’s share price has risen very very rapidly from the time I started writing part I of this investing thesis, tracking the rapid rise in coal prices. I am starting to get cautious. Things always swing to the other extreme and over correct.

In the near term (next few months, till end of 2016), I think coal prices would be more likely to stabilise or even dip, rather than continue on the upward trajectory. 

Morgan Stanley seems to agree with me:

http://www.economiccalendar.com/2016/10/04/morgan-stanley-bets-coal-prices-peaked-but-thermal-coal-could-prove-resilient/

However, since the financials of Geo Energy are lagging behind coal prices, the current large increase in coal prices would be reflected in Geo Energy’s financials in 2016Q3 and probably Q4. Coupled with a projected increase in coal production, I am expecting a good set of results for Q3 and Q4, even if coal prices dip in the near term.

In the mid term, my guess is that power generation via coal in China and Indonesia will continue to hold up, and in the case of Indonesia, will probably increase substantially. Coal powered steam is one of the most cost effective ways to generate electricity quickly and cheaply, the major downside being pollution.

China has started to see that this is a problem, but changing all the coal powered plants will not be easy and definitely not fast. Indonesia though, has no choice but to stick to coal powered plants for now. They need the electricity pronto, who cares about pollution now. Just look at the list of power stations to be built or are being planned to be put up for tender (see above): A significant bulk are either coal powered or combined cycle power plants. (Combined cycle power plants use both steam and gas to generate electricity)

Longer term, utilisation rates of coal power plants globally will keep declining. This graph explains my point nicely:

I’m talking about broad, general trends, the impact of which is best seen over the course of multi years.

The implication though, is that barring dramatic changes to it’s operations, I don’t view Geo Energy Resources as an ultra long term, buy and hold kinda investment.

In the short to mid term though, I think Geo Energy will continue to do well from supplying Chinese and hopefully, Indonesian power plants.

Alright, thus far, I have devoted many pages, (in fact, the bulk of this post) to the supply and demand considerations. This is because as I mentioned earlier, being a commodity company, the one over riding consideration affecting Geo Energy’s fortunes is coal prices.

Competitive Moat

In the commodity business, I generally try not to base my entire investing thesis on macro factors. This is because macro factors affect all related companies, so if rising coal prices is the reason for favoring Geo Energy, how about other related coal companies?

Instead, I’m looking for local factors or competitive advantages that the company has, that’d put it in a better position than similar rivals. Or it could be a situation where the company has been neglected by the markets, such that there’s a wide gap between the intrinsic value that I have determined, and the price that the company can be bought at.

I’ve previously mentioned some of the competitive advantages Geo Energy has. The offtake agreements, and the sub-con of the mining activities are good moves by the management.

Geo Energy’s SDJ and TBR mines are also situated near the coast, and this helps to save  on transportation costs. This map shows the exact location of the mentioned mines. Their BEK mine is situated just north, within East Kalimantan, about an hour+ drive away.

On top of that, in October 2014, the Group’s subsidiary PT Sumber Bara Jaya signed a cooperation agreement with PT Bandar Laut Biru for the management and operation of a port terminal for a period of 15 years.

The port is located in close proximity to the PT Sungai Danau Jaya’s (“SDJ”) coal mine providing the Group with much logistic cost savings and flexibility in arranging shipping schedules.

In addition, I like the fact that both the SDJ and TBR mines have comparatively low strip ratios. That is, a lower amount of useless rock has to be removed to attain the coal.

All these are local competitive advantages that’d ultimately translate, one way or another, to lower operating costs. I am monitoring closely as I expect further synergies from the close proximity of SDJ and TBR mines, such that the operating costs should be kept relatively constant, while revenue increases dramatically.

Insider ownership and recent developments

Surprise, surprise.

I was trying to figure out who are the major players in Geo Energy. It’s not as easy as peering at the top 20 shareholders list, as many of the large players hold their stake in nominee accounts.

I was surprised to find that in April 2015, the company issued 28,000,000 shares at $0.18 to.. Dektos Corp. My previous experience with Dektos is when they took a stake in Hock Lian Seng.

Perhaps I should meet Roland Thng some day, it seems our investments are “fated”.

Anyway, I noted that EVA Capital (fund managed by Dektos) started in the early 2015 with an initial capital of US$5mil. 28mil shares at $0.18 means a capital of about $5mil. (SGD of course). So basically Dektos seems to invest in an “all-in” manner.

I can’t find any news about Dektos divesting, so I assume  they’re still holding on to this 28mil shares.

Aside from Dektos, Geo Energy has also utilised it’s shares as currency in the mine acquisitions. Shares have been issued at $0.15 (for the TBR mine) and $0.18 (for the SDJ mine) for the acquisition of the 2 coal mines.

Other major players to note include the famed Jim Rogers, who, as a non executive director, first bought 2 mil shares at $0.35, and in more recent times, bought another 1.7mil shares at $0.12 or so.

When Mr Rogers first bought his 2 mil shares 3 years ago at $0.35, the share price jumped as many “investors” decided that hey, if it’s good enough for this guy, it’s good enough for me. These investors would’ve suffered and are still suffering now. Goes to show that one should always do your own DD. At the very least, the mistake would’ve been yours and yours only.

In 2015, various members of the management team also bought in at prices largely below $0.14.

Now, my interest in monitoring insider purchases is NOT to follow them. Rather, I’m trying to avoid a scenario whereby these guys unload their shares, and I unwittingly buy from them.

I have had my fair share of situations where I hold large stakes. Exiting can sometimes be a problem. I’d also want to know how much of a margin of safety I have, compared to these guys. In addition, the shares issued are new shares. (Jim Roger’s 2mil shares at $0.35 are due to exercising call options that he was granted). Thus, its good to know if these new shares are dilutive at the current share price. (They weren’t when I started writing part I, but now are!)

My Thoughts

On a related note, Geo Energy Resources has had several analyst reports. I believe I have read and analysed all that are fairly recent. The one I like most, and agree with the most, is the report by NRA capital, dated 8th August 2016.

Not sure if I’m allowed to link to it, but in any case, it can be found easily by googling.

The share price has risen substantially from $0.103 when the report was initiated. I will say that I’m not sure how they derive a target price of $0.225 though. Their only explanation is attaching a 2.2x P/B ratio to the company, but no explanation is given as to why 2.2x.

I currently own 400,000 at the time of writing, having bought in 100,000 chunks at $0.147, $0.148, $0.168 and $0.187. 

Geo Energy Resources is a company that I’ve been monitoring since the divestments of my long held stakes in Hock Lian Seng and Metro Holdings. It has been incredibly frustrating as I was in the midst of doing due diligence when the share price started rising rapidly.

When I started doing serious DD, the share price was hovering around the $0.11 range. This is a situation where I really wished I’d worked faster / started earlier.

As mentioned in earlier posts, I was planning on allocating about $150k to this idea. It looks highly unlikely that that’ll happen now.

Anyway, going forward, I still see several potential catalysts for the company, as well as some potential speed bumps.

Catalysts:

• TBR mine gets a similar offtake agreement
• Coal prices continue rising in the near term
• Agreements to supply Indonesia power plants
• Paring down of debt with improved cashflows
• Synergy between TBR and SDJ, resulting in operating costs remaining flat, while revenues increase

Although IMHO, the fair value is still quite a substantial distance away from the current share price, in my experience, nothing shoots up this rapidly and stays on the same tangent indefinitely.

The risks have risen, yet I have ascertained there’s still value to be bought here, just that the MOS has reduced. I may add to my positions, I may just stay put. It all depends on the share price I can get it at, and perhaps even some short term technical factors.

As always, happy hunting.