DNNGY - Are Geothermal Stocks A Good Investment As Japan And U.S. Agree To Geothermal Cooperation?

2023-04-28 10:00:00 ET

Summary

• Geothermal energy is a low-carbon source that can provide reliable baseload.
• Between the political opposition to nuclear power and the intermittency of wind and solar, geothermal may emerge as more important.
• There aren't that many investment choices in this space, but I offer one idea of how to play the geothermal trend indirectly.

Geothermal energy, nicely explained by the U.S. Energy Information Administration here , has become an important part of the energy transition discourse. For energy and generalist investors alike, though, the more interesting question may be if and how one should invest in this domain.

This article tries to offer a high-level perspective on the geothermal topic and discusses one specific investment idea that I find attractive in this space.

Is Geothermal Energy Worth Investing In?

When thinking strategically about geothermal, we first have to recognize that the energy landscape over the next decade will be shaped by the tradeoffs between supply security and de-carbonization. Whether the aggressive de-carbonization agenda is appropriate from a policy perspective may be a question in itself, but, as investors, we have to accept the political realities. In the Global North (North America, Europe and a few others), de-carbonization has set a firm foothold among our political elites, and there are few indications the green energy trend may reverse.

Going "all in" on renewables, though, has run into supply reliability issues and, insofar Europe is concerned, has taught politicians an expensive lesson. When Russia cut natural gas supplies to the continent, Europe was only able to save the day after spending a fortune on LNG imports, re-starting coal plants and shutting down industrial production. The warm winter was also a tailwind, but that was pure luck which may not repeat.

Intermittency, Baseload and Storage

Energy is consumed 24/7 and has to be generated continuously to match demand. Further, given the lack of storage, the generation capacity must be able to accommodate the peak demand in the day. Here is a typical illustration of this concept:

Historically, the baseload has been supplied by nuclear and coal, which take more time to ramp up, though modern coal plants are more flexible. Natural gas or hydropower have been good peak load solutions as they can be brought online faster.

At the same time, most green energy investment has been into solar and wind, which are intermittent power sources, as a chart from the International Renewable Energy Agency shows:

Wind and solar only work when the weather cooperates. Worse, solar peaks in the middle of the day when demand is lower and may force grid operators into curtailment , but doesn't help in the evening with peak demand.

This Is Where Geothermal Comes In

There are two widely discussed solutions to the green energy dilemma:

1. Develop and install massive battery storage that can "collect" the power from solar and wind when produced and dispatch it to the grid later when it's actually needed. I am skeptical this can happen soon, especially with the escalation of critical minerals "nationalism." Just this week, for example, Chile's national ambitions for lithium caused market panic ( SQM ). The critical minerals needed for the energy transition is a big topic in itself, so if I can refer you to this report from the IEA if you want to appreciate the challenges.
2. Rely on nuclear power for the baseload. Nuclear ( URA ) is a low-carbon source and is very reliable; to me, if you want achieve de-carbonization while retaining the reliability of supply, nuclear is a no-brainer. However, many countries in the Global North, like Germany , reject nuclear for political reasons. Germany's decision to go ahead with shutting down its last reactors amidst the ongoing energy crisis in Europe signals that the sentiment won't change soon.

We can throw other possibilities into the mix, like the new "hydrogen" buzzword, but the only other alternative that serious observers of the energy industry speak about is geothermal. Like wind and solar, geothermal is a low-carbon energy source, but unlike them, it is also reliable as baseload. Moreover, geothermal doesn't carry nuclear energy's political stigma and would be more acceptable to local communities; after all, even pro-nuclear folks don't always want a nuclear plant right in their backyard.

So, at a macro level, geothermal energy is worth investing into because it may be the only solution for our current "green and politically acceptable" versus "reliable" energy dilemma. That said, there are practical and technological challenges that are yet to be solved.

Who Are The Top Producers Of Geothermal Energy?

One challenge with translating the promise of geothermal into an investable idea is the lack of many pure plays in this space. A stock that is frequently talked about is Ormat ( ORA ), the second largest geothermal owner and operator:

As Ormat's own analysis shows, many of its competitors are utilities like Enel ( OTCPK:ENLAY ) or CFE, or national oil companies like Petramina. Even Ormat itself engages in other activities like developing storage.

How Do Geothermal Stocks Compare To Other Energy Stocks?

To expand on the producers, there are some important differences from traditional energy stocks. Not unlike wind giant Ørsted ( OTCPK:DNNGY ), Ormat has a risk-return profile similar to that of a utility.

The business model of Ormat, Ørsted and others revolves around signing long-term power purchase agreements (or PPAs) with offtakers that could be a government or private entity. These PPAs can go for 25-30 years in Ormat's example, which de-risks the geothermal producer from a demand and pricing perspective. The remaining risks are mostly on the project execution and operation side, which is not that different from a utility ( XLU ).

On one hand lower risk is good, but on the flipside the returns are also going to be to utility-like. There's nothing wrong with this and utilities can be great investments, but it is important for potential geothermal investors to understand that you aren't getting the asymmetric upside you see with other energy investments.

An oil producer or uranium miner put their own capital at risk to explore and develop a resource, and also take the market risk that the demand for their resource may not be there when the project is complete. However, if things go well, you may also be lucky to get multibagger returns. The utility model won't give you this upside, but the downside is limited too.

What Are Other Ways To Ride The Geothermal Trend?

The geothermal owner-operator typically won't have the know-how or engineering capacity to develop a project. This work is contracted out, just as in the utility model. So a better investment focus may be to target companies that supply know-how and services to the geothermal developers. Ormat itself also provides engineering services but that is only 10% of its business:

From Ormat's own analysis though, most companies that supply geothermal equipment like Toshiba ( OTCPK:TOSBF ), Mitsubishi ( OTCPK:MSBHF ) or General Electric ( GE ) aren't pure plays either.

Why Vallourec Could Be A Good Option

Besides the surface equipment, the geothermal plant requires pipes and connections to build the geothermal well and these components must be able to perform under very high temperatures. Vallourec S.A. ( OTCPK:VLOWY ) is a leader in premium tubular solutions for energy, power generation and industrial applications. Much of the company's focus has been on supplying tubulars for oil and gas wells, but Vallourec also invests significantly in R&D on new, high-performance technologies.

Vallourec's research teams have in particular been working on the high temperature challenges for the subsurface geothermal equipment. As per the company's explanation:

Oil and gas wells usually require connections to be qualified at 180° C. In geothermal wells, given that the pipes and connections are exposed to much higher temperatures, they are even more subject to the effect of material dilatation and need to be qualified accordingly.

As an illustration of this, an API-5CT Range 3 pipe, which is around 12.5 meters long, heated up to 350° C gains around 60 mm of length. This means that for a 2,000 m deep well, if the string is free to move, it gains around 9 meters of length. Given that the casing is cemented, the ends cannot move meaning that the strain is shared along the string. To accommodate these conditions, the TWCCEP standards - the dedicated standards for high temperature wells - require connections to be tested and qualified at 350°C. Not only does this expand the possibilities for geothermal operators, but it also represents an opportunity to harness more energy through the same process.

Just this week, Vallourec announced that it had successfully qualified its proprietary connections for up to 350° C, which could be a game changer:

When you double the temperature, say from 200° C to 400° C, you multiply the energy generated up to 10 times . There is huge potential for the industry to design and validate solutions to build systems at those levels.

By getting to the 350°C barrier, Vallourec positions itself well for the expected rise in higher temperature wells:

Not Just An R&D Center

The second reason I like Vallourec is because it isn't just a technology incubator. VLOWY is a manufacturing company with global operations and relations with customers in the energy industry, so it has the capability to scale up its innovations.

In the meanwhile, Vallourec is also riding on a strong resurgence in the development of traditional fossil fuel energy. I have explained my macro view for the energy sector in detail here , but one dominant theme is the shift of bargaining power to equipment and services providers. Vallourec's latest investor presentation highlights the strong pricing gains for the so-called oil country tubular goods (or OCTG) pipe:

Vallourec seems to believe geothermal will grow significantly, as evidenced by its investment in Greenfire Energy last year. However, while waiting for the geothermal future, investors can benefit from VLOWY's current bread-and-butter tubular products that generate cash today.

Valuation And Risks

Vallourec is relatively inexpensive; here are Seeking Alpha's estimated multiples:

Source: Seeking Alpha

The debt is high, which is a risk. However, Vallourec's rating was recently upgraded by S&P from B+ to BB-, suggesting the worst is over; S&P believes VLOWY will be free cash flow positive for the full 2023.

What Is The US Japan Geothermal Agreement And Should You Care?

Geothermal made headlines a couple of weeks ago when the U.S. and Japan governments signed a "memorandum of commitment" to cooperate on geothermal R&D efforts. Despite the media noise, this memorandum doesn't change the investment thesis as much. Geologically, Japan can benefit from geothermal projects and many of the plant equipment suppliers are indeed Japanese companies.

On the U.S. side, the positive aspect is perhaps that Sec. Granholm may now be talking about geothermal and wind on equal footing. The Inflation Reduction Act also added tax incentives for geothermal. The hope is that the U.S. administration won't discriminate among different types of renewables, which should naturally over time boost the share of geothermal as the superior power source. However, a lot of big money has been poured into wind and solar already, so the push for them will likely continue.

What Is The Outlook For The Geothermal Industry?

Ultimately, the industry's future will be determined by how successfully it can resolve its main technological challenges. One downside of geothermal is that it can't be deployed everywhere as the geology is a limiting factor. However, the possible locations may be expanded as the IEA explains in its Geothermal Roadmap document:

So far, utilization of geothermal energy has been concentrated in areas of naturally occurring water or steam, and sufficient rock permeability. However, the vast majority of geothermal energy within drilling reach - which can be up to 5 km, given current technology and economics - is in relatively dry and low-permeability rock. Heat stored in low-porosity and/or low-permeability rocks is commonly referred to as hot rock resources. These resources are characterized by limited pore space and/or minor fractures and therefore contain insufficient water and permeability for natural exploitation.

The technological know-how is a related aspect; if you have more advanced technology, the range of possible locations increases:

Technologies that allow energy to be tapped from hot rock resources are still in the demonstration stage and require innovation and experience to become commercially viable. The best-known such technology is enhanced geothermal systems. Other approaches to engineering hot rock resources, which are still at the conceptual phase, try methods other than fracturing the hot rock.

Vallourec's R&D efforts aim precisely to increase the economically feasible development opportunities through more advanced technology.

Bottom Line

Save for nuclear energy, geothermal may be the only other option to de-carbonize power generation without the intermittency problems that come with wind and solar. While I would bet on nuclear if I had to, many countries around the world are inherently opposed to nuclear power. This makes it hard to imagine a future world where geothermal isn't at least part of the solution.

However, investors shouldn't naively expect that any company which touches on the geothermal value chain is going to generate abnormal returns. The operators, in particular, are most likely going to be rewarded with utility-like returns because the offtakers assume much of the risk. Equipment and services providers look to be a better bet, but not many are pure play.

Vallourec is a tubular goods company that is making important technological contributions to the geothermal space. While not a pure play either, Vallourec is a reasonable way to ride the trend in my view. While investors wait for geothermal technology to become more mainstream, with Vallourec they will also benefit from the current cyclical upturn in oil and gas capacity expansion.

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