As the political and financial pressures on fossil fuels mount, investors
are starting to explore the renewable energy space with an eye toward reaping
its potential. Rupert Merer analyzes that growing energy sector for National
Bank Financial and tells The Mining Report why betting on the future of
renewables is a prudent strategy for profit growth.
The Mining Report: Where is the renewable energy space
headed in terms of profitability?
Rupert Merer: Most renewable power companies have long-term
production contracts that provide a relatively low-risk return on invested
capital. This is a capital-intensive industry with a lot of invested debt and
equity capital. There is excellent visibility on cash flow and revenues—as
long as 40 years out in the case of small hydro contracts. The duration of
small wind and solar contracts is 15–20 years.
With steady cash flow, the renewables sector can provide dividends of more
than 5% for income seekers, typically with good visibility on future dividend
growth. As solar and wind power have seen rapidly declining costs over the
last few years, they have also seen very high growth. We think that this
growth will continue and there should be an increasing number of investment
opportunities.
TMR: What are "sustainability investors"?
RM: There are a few funds in Canada, the U.S., and the United
Kingdom that invest only in renewable power assets. Some of these fund
managers believe that there is an inherent risk with fossil fuel investments.
Of course, if governments start to tax carbon at a higher rate or introduce
cap and trade, then that could be a limiting factor for using fossil fuels to
generate electricity.
Investors in the energy sustainability space typically look for a ratio of
more than 50% clean energy in the stocks in their portfolios. Clean energy
includes renewables and power plants that use natural gas, provided that the
plants are high-efficiency co-generation plants or combined cycle plants.
TMR: How does a renewable energy project secure a long-term
contract?
RM: That depends on the jurisdiction. The Canadian power market is
regulated at the provincial level. Ontario is the most populated province in
the country and it has been the most aggressive at developing renewable power
over the last decade. In the past, the government has offered fixed price
contracts, or "Feed in Tariffs," for renewable power at a price
that would provide an attractive economic incentive for developers. However,
generally, in Ontario or in other provinces, firms will bid on, say, delivering
200 megawatts (200 MW) of wind power, under a competitive request for
proposal. The contract will typically go to the lowest price bid from a
viable entity.
In the U.S., contracts are often arranged between developers and utilities
or businesses in the private sector. Projects have typically also included
financial partners that have purchased tax credits from the developer.
TMR: Given that wind and solar intermittently generate pulses of
energy into the grid, has the grid developed the capability to access renewable
energy when it is live, while compensating for it when the generator goes
temporarily fallow?
RM: The easiest way to compensate for intermittency is to increase
transmission capability.
If the local area has more wind or solar power than it can use, it can
send it to a neighboring region. Another way to manage intermittency is to
decrease the use of power on the grid when there is a deficit of renewable
energy. For example, operators can shut off air conditioning loads when there
is a deficit of power. As the amount of renewable power grows, we will need
to find better ways to store power.
Today, the best way to manage volatility in electricity supply is the
regulation of hydropower production. With our hydro capability, Canada is a
giant battery for the U.S! British Columbia controls about 13 gigawatts (13
GW) of hydro. It actively trades power back and forth with California. In
Quebec, more than 30 GW of hydro leverages a storage capability that can
trade power with the Eastern Seaboard. Manitoba trades 10 or 13 GW with the
Midwest. This works for Canada today, but it may not be enough in the future.
TMR: Electrical storage is an issue for the renewable energy
sector. What are the advancements in battery and other storage technologies?
RM: The majority of dedicated electrical storage in North America
is in pumped hydro. The use of compressed air storage and reliance on
batteries is increasing. But the lithium-ion battery technology has only
advanced incrementally during the last few decades. The cost of manufacturing
batteries has dropped with higher demand for battery use in electronics and
electric vehicles. Today, batteries are still relatively expensive, but there
is a push to increase the amount of storage on the grid, which could increase
the demand for batteries.
Last year, there were 35 gigawatt hours (35 GWh) of lithium ion batteries
produced globally. Now, Tesla Motors Inc. (TSLA:NASDAQ) is slated to produce
35 GWh by 2020 at its Gigafactory. We have seen similar goals for 2020
announced by BYD Company Ltd. (BYDDF:OTCBB), which is the electric car
company backed by Warren Buffett. LG Chem Ltd. (051910:KRX) and Foxconn
Technology Group are also adding battery capacity. We think that the total
production of lithium-ion batteries could increase by a factor of four or
five by 2020. Ultimately, we could see dedicated battery storage of electricity
on the grid or the use of the batteries in electric cars to manage grid
power.
Hydrogen technology and flywheels also continue to develop and should also
play a very important role in grid management in the future.
TMR: What is the role of graphite in battery production?
RM: There is 10 times more graphite than lithium in a lithium-ion
battery; it's an important part of the makeup of the electrodes. Typically,
batteries employ a mixture of synthetic and natural graphite, but the
synthetic material is relatively expensive at up to $6,000/ton. On the other
hand, natural graphite is mined and processed for between $400 and $500/ton.
Graphite prices have been relatively soft for the last couple of years,
but the high growth in battery markets should drive an increase in the demand
for graphite.
TMR: What will be the effect of the demand factor on the price of
graphite?
RM: One can argue that the price will rise because the demand is
going to grow, but there are a fair number of deposits that are out there
that are feasible at the current price. If the average price was to move up
from roughly $1,100–1,200/ton today to $1,500–1,600/ton, a number of deposits
could come on line. As with the history of most commodities, the graphite
price will remain relatively stable in the long run. It can be volatile in
the short term, but I do not assess that it will take a big increase in the
price of graphite to increase the supply.
TMR: Do the existing graphite mines have the capacity to absorb the
projected demand or is meeting that demand going to require exploration?
RM: Most graphite—roughly 500,000 metric tons per year—comes out of
China. But in the short term, we believe that there will be a contraction of
supply coming from China. The Chinese government is clamping down on
polluting mines, and there are news reports suggesting that the quality of
the Chinese graphite is degrading as the miners strip the good deposits.
Battery-grade material needs to be high purity. We see opportunities for
graphite mines outside of China, provided that they can access very good
quality graphite.
Graphite is not like other commodity businesses. A customer cannot just go
onto a commodity board and pick up the desired product. Graphite customers
have very specific technical needs for their products, and they look for
producers who can meet those requirements.
We track Mason
Graphite Inc. (LLG:TSX.V; MGPHF:OTCQX), which has the lowest capital and
operating costs of any graphite mine that we have seen. Mason Graphite has an
experienced management team and has financial backers that could provide some
of the equity and debt capital for building out Mason's production facility.
TMR: Is a firm like Mason Graphite going to be competing with
Chinese firms or other firms around the world?
RM: When we model Mason Graphite, we assume that it will sell
graphite into the global commodity markets. However, the company will focus
on meeting the needs of specific customers. It will build a facility to
process graphite within a range of purity attributes and flake size
distribution attributes. It will meet very specific customer goals in the
very high-purity markets for batteries or electronics.
The number one strength of Mason Graphite is its executive team. Its CEO,
Benoit Gascon, has spent the majority of his career building graphite
operations, specifically the Timcal deposit in Quebec that was bought by
Imerys (NK:PA). Benoit went on to run Imerys' graphite operations. He's a
world-class expert.
In our view, Mason Graphite's Lac Guéret deposit is the best in the world.
It is located in a low-cost area in Quebec, a safe, mining friendly, low-risk
jurisdiction. If Mason's deposit has any negatives, it is that, as the Street
points out, Mason's average flake size is smaller than a lot of the other
deposits that are looking to be developed. We took a hard look at the flake
size distribution and at the various prices for graphite depending on flake
size, and Mason's deposit is very economical. The Lac Guéret deposit seems to
have a short payback period—not only in the current market but, also if
graphite prices go down. And, naturally, the economics for every deposit look
better as the prices go up.
TMR: Is Mason highly leveraged to debt or does it have enough cash
on hand to go forward?
RM: The company does not have enough cash to finish building the
mine and processing facility at this point, but it has enough cash to
complete its permitting and its feasibility studies to get to the point of
construction. Mason will then find the debt financing and revenue stream to
build the mine and the processing facility.
TMR: At what point in the development process does it become
attractive to invest in Mason?
RM: We have a Buy rating on the stock now and we typically look out
12 months on our investment recommendations. The company will be more
attractive when the bankable feasibility study is completed in the next four
months. The feasibility study should confirm the low operating cost and low
capital cost of the deposit and underpin the economic feasibility of the
project. It already has financing from a couple of institutions in
Quebec—Sodémex, which is a division of the Caisse de dépôt, a big pension
fund, and Resource Quebec, which is part of Investissement Québec, a
government-backed fund. We believe that with those two organizations behind
it and an attractive bankable feasibility study, Mason Graphite will find the
capital partners it needs to push forward.
TMR: Mason Graphite is currently trading around $0.55/share. What
is your target price?
RM: Our target is $1.20/share. To get there, we use a 14% discount
rate on a discounted cash flow analysis. Once the bankable feasibility study
is completed and Mason finds funding, the facility will be derisked, with the
discount rate dropping to 9% or less. And of course the target price would
move up from that point.
TMR: Returning to wind, do you have any picks in that space?
RM: We cover wind farms in Canada, the U.S. and Europe. Wind
companies have very good visibility on future revenue to amortize debt and
also to pay a healthy dividend to shareholders. Our top pick of the companies
that are highly exposed to wind is Boralex
Inc. (BLX:TSX). We believe that Boralex is trading at a 10% discount rate
today, versus most of its largest peers at about 8% or less. The company has
very good visibility on a compound annual growth rate of greater than 20% for
its cash flows available for distribution, between 2014 and the end of 2017.
TMR: Boralex is leveraged across a broad spectrum of
renewables—wind, water, solar and thermal, correct?
RM: That's correct, although 75% of its production comes from wind.
TMR: Is the technology for wind farms improving? What are the main
goals for wind technology going forward?
RM: Yes, the performance on wind turbines is constantly improving.
Wind turbines are larger and cheaper than a decade ago. Whereas the first
generation of turbines were 50–100 kilowatts, they are now more than 2 MW.
And there are big improvements in turbine blade aerodynamics, which allow for
30% increased production from a single wind turbine. Ongoing technological
improvements in turbine design mean that wind farms are efficient in
relatively low wind speed environments, and that opens up the number of
places where wind power can function competitively. The cost of wind power
has dropped across the board. Wind farms are being built that deliver product
priced at $0.06/kilowatt hour or less, which is very competitive with power
generation from any other source.
TMR: Are industrial users saying, "We're going to build a big
turbine and when the wind is not blowing, we'll tap into the grid?"
RM: That is a growing trend, but a wind turbine-powered factory
could end up paying more for the grid portion of its electricity. When users
start to cut out the utilities, they will incur higher standby charges. I
expect that industrial users will want to be completely self-generating in
order to cut costs. That brings us back to batteries, of course.
TMR: Is there anybody else in wind that you like?
RM: We have a Buy rating and a $33/share target price for Pattern
Energy Group Inc. (NASDAQ: PEGI), which is trading around $30/share. The
company pays a healthy dividend of 4.7%. It has recently announced acquisitions.
The company has increased its guidance on cash flow available for
distribution based upon a 12–15%/year growth factor. Since Pattern Energy
went public late in 2013, it has been increasing its dividend by 2% per
quarter. That could grow to 3% per quarter. Investors will reward Pattern
with a higher share price, and that 4.7% dividend will likely increase. There
are some larger yield companies in the U.S., but we think that the valuation
on Pattern and its growth profile make it quite attractive.
TMR: Will companies like Pattern and Boralex be acquisition
targets, or should investors expect them to grow on their own?
RM: In theory, they are acquisition targets of the larger
yield-companies, because they do trade at attractive valuations. Boralex is
certainly a very attractive takeover target. Pattern Energy is a little bit
larger and harder to acquire, but it, too, could be a takeover target. We
would not own these stocks for that reason, though, but we would look at them
for their attractive dividends, and the growth potential on the dividends.
TMR: Thanks for your time, Rupert.