An update from Ukraine...

In all the coverage about the latest in Crimea, something I didn't read much about was efforts from the European Union (EU) late last week to move forward with an agreement to tighten relations with Ukraine. As you might remember, protests started in November when former Ukrainian President Viktor Yanukovych decided to abandon talks with the EU, opting instead for closer links to Russia... which culminated in Yanukovych fleeing the country and, subsequently, Russia claiming Crimea.

 

It's surprising that the EU is pushing ahead with certain political elements of its association agreement with Ukraine (which is an early and preliminary precursor to joining the EU)... If anything, this could provoke Russia to shake things up even more than it already has. Above all, Russia and Putin don't want Ukraine to fall into the orbit of the West. And an association agreement would be one step closer to that.

 

As a result, the risk of an invasion of eastern Ukraine is higher... My former colleagues explained, "Putin is likely, assuming the EU makes good on today's pledge to tighten links with Ukraine, to take additional retaliatory steps. They won't be pretty, but we can't at this point responsibly speculate on what he might do."

 

Russia has likely stepped away from the precipice, but there's a chance things could get worse. Russian shares are cheap for a reason. And they could get cheaper.

If the fracking boom continues to grow, I think you're going to see an easy triple-digit return on C&J Energy Services (CJES), possibly a 200% or 300% rise from the current share price, within two years...

 

The shale boom sweeping across the United States is necessarily also a hydraulic fracturing boom. Fracturing is the lifeblood of the boom. Without fracturing, the boom dies. That's true because there's really no other cost-effective way to break up the dense shale rock where the oil and gas are trapped.

Right now, C&J owns six hydraulic fracturing fleets, which are essentially sets of high-pressure pumps for injecting sand and water into a shale well at high pressure...

 

C&J's earnings come mostly from multiyear contracts. Right now, two of its six fracking fleets are contracted through the second half of 2012, and the other four are contracted into 2013, with one contracted to mid-2014. All the contracts are "take or pay." That means C&J gets paid a minimum amount of revenue, even if the customer doesn't use the equipment. Customers pay an hourly rate for service exceeding the contracted minimum. All the contracts state that C&J can employ the equipment in the spot market on days when the contracting company can't use it. The fleets are never idle... They're always working.

Question: One of your smaller competitors who entered the business in 2011 made the comment to me that he'll have to rebuild completely his first fleet by early 2015. His comment was that we [have] rising demand, increasing service intensity, higher utilization... And on the other side of the equation is a bunch of people who haven't properly maintained their equipment, service quality from some companies going down, thus setting up a great opportunity for those companies that have performed well to not only capture market share, but just giving him some confidence that the pricing can move higher. What would your response to his comment be?

 

Comstock: What folks haven't realized is you have emissions laws where you have Tier 4 engines that you have to go through, you have new transmissions coming out. You have the manufacturers of that type of equipment, the Caterpillars of the world, the Detroits of the world, the Cummins of the world, that, obviously, there has been no equipment ordered in the past – to speak of, in the past 16 months. So they ramped down, and we have seen from our own internal usage that, well, you could buy an engine essentially within one week because there was inventory sitting around. Now they're four months out.

 

I talked to a manufacturer, a local manufacturer ... yesterday. And he told me that he needs six months' notice to build a frack fleet, to get engines and transmissions. And so if there's a run, I mean – and that's one [or] two frack fleets. If there is a run on equipment, that equipment's not going to be able to be built in a time frame that is going to outpace the fall of the existing equipment.

 

And so they'll ramp it up, just like they always have, but you will have a period of time that there's going to be a shortage again. We've seen it over and over in our industry. And it's going to happen again as long as we keep a steady drilling rig count. And I would argue if there's any uptick in rig count, there's going to be an imbalance fairly quickly.

The reservoirs being discovered right now in the deepwater Gulf of Mexico will position the United States as the world's largest producer of energy. The energy boom we're enjoying today – brought on by the discovery of onshore shale oil – will be expanded by a scale unimaginable to most investors by the offshore assets being pioneered right now.

 

Meanwhile, the best news for investors is that the oil industry's success with onshore shale has temporarily overshadowed all of these offshore discoveries. There's a widespread (and false) belief that the expense of offshore production means that these oil resources won't be produced as long as the shale boom remains. That's wrong... But as long as that view remains dominant, we have an excellent opportunity to buy up the best offshore-production assets for a fraction of their cost to build.