Kevin Quon: How Solazyme’s Encapso Serves As An Oilfield Enhancer

Renewable specialty products and oils producer, Solazyme (SZYM), continues to search for a new bottom in light of a missed expectation with its Moema facility. The large 100,000 MT algal oils plant in Brazil is the product of a joint venture with Bunge (BG) and stands as the flagship manufacturing site for Solazyme’s technology.

Yet, fueled by a new cogeneration power plant, the attached renewable oils facility and its ongoing production temporarily remain restrained at the high end of the cost curve. This is likely to stand as the case until the cogeneration power plant is improved upon to operate more consistently or until the facility as a whole is linked to the national power grid. While the path to both targets continue to improve daily and Solazyme’s oil still continues to flow out from Moema, a strategic shift in prioritizing high-margin value has placed increased attention onto Solazyme’s brand of Encapso.

As mentioned in my prior article found here, Encapso is an oilfield product brand that is quickly gaining acceptance by exploration & production (E&P) operators. The brand’s first product of a drilling fluid additive serves as a biodegradable targeted friction inhibitor capable of providing cost savings for operators. These savings come in the form of reduced drilling days, reduced equipment maintenance, and improved fluid recovery options.

What has made Encapso a highlighted brand now is that Solazyme’s 20,000 MT facility in Clinton, Iowa has become a focal point for marketing the company’s high-margin product lines. Initially, this focus will begin with the production of Encapso. Based on Solazyme’s most recent partnership with Versalis, the two companies are currently targeting sales volumes in excess of 3,000 MT annually from this partnership alone.

 

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Just The Start In Specialty Oilfield Chemcials

Solazyme’s partnership with Versalis, the chemical subsidiary of Eni S.p.A. (E), remains an impressive feat considering that its $68 billion parent company is one of the largest E&P operators around the globe. It is also quite suggestive considering that Encapso’s drilling lubricant has only been tested in 30 wells to date across 10 unique operators. More so to this point, the new product was only introduced commercially to the market in March of this year.

Despite its short testing period, Solazyme was able to secure the interest of the large global E&P operator. Comparable well tests have consistently shown the product’s ability to improve rates of penetration, to reduce drag, and to reduce torque. Much of this was due to the unique ability of Solazyme to offer a targeted solution when it comes to drilling lubricants. This was possible because of the encapsulated nature of the drilling lubricant.

But what investors should also consider is that Solazyme’s ambitions for Encapso are unlikely to stop with its unique targeted drilling lubricant. Consider the following excerpt found in the US patent application US20140256600 A1:

“[0175] Due to the protection afforded by encapsulation, the encapsulated oils provided herein can be proactively added to drilling fluid systems (e.g. water-based systems), where it circulates through the system until conditions are met to break the encapsulation and release the oil lubricant.

[0176] The fluids provided herein include aqueous and non-aqueous drilling fluids and other well-related fluids including those used for production of oil or natural gas, for completion operations, sand control operations, workover operations, and for pumping-services such as cementing, hydraulic fracturing, and acidification.”

What is key to note here is that Solazyme is filing intellectual property for its encapsulated product line, but is also expanding the scope of that operation to include aspects of completion operations, sand control operations, workover operations, and etc. In each of these areas, it remains possible for the company to explore additional opportunities to address the specific needs of operators.

An Advantage in Providing Options To Operators

In regards to meeting these customized needs of operators, Encapso also begins to distinguish itself from a technological point of view. Claim 18 of the above mentioned patent application asserts that the drilling fluid may be used in a drilling mud that is a water-based mud, a synthetic-based mud, or an oil-based mud. For investors, the market opportunity only grows with such flexibility. Taken from the latest earnings conference call found here, CEO Jonathan Wolfson had this to say in regards to the latest development of utilizing Encapso in an oil-based mud:

“In fact, we recently demonstrated rate of penetration improvements in an oil-based mud system for the first time. While this has been accomplished on only a single well to date, we believe that our ability to function in an oil-based system could potentially double our market opportunity both in North America and internationally.” Jonathan Wolfson, CEO of Solazyme.

Beyond mere mud types, however, the company offers additional flexibility to operators in terms of how the drilling lubricant can function. Shown in the chart below taken from the same patent application, we see two control samples found in a water-based mud and a mud mixed with a liquid lubricant (Mud+3% MilLube). Their static coefficients of lubricity are due to the fact that they are not using an encapsulated product and therefore have all of the lubricant already mixed in.

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Yet, because Encapso is an encapsulated product, Solazyme can offer flexibility to operators as to how that lubricity is controlled. This is important when it comes to determining when to turn on the lubricant and at what rate it is released. Rather than constantly having the lubricant interfere with an operation when it is not needed, an operator can now control this variable in order to produce a more efficient drilling operation.

Immediate Impact Of Falling Oil Prices

One of the largest market concerns now surrounding Solazyme is the rapid fall in global oil prices and its potential impact that it can have on the markets Solazyme finds itself in. While justified by the headlines when we consider significant declines in oil drilling activity here in the United States, it’s important to put into perspective the position Solazyme now finds itself in.

To begin, let us recall that Encapso has not yet been adopted by the industry as a whole. In 2013, there were approximately 37,000 U.S. onshore well completions according to the article found here. Yet, the company’s product has only been tested in a mere 30 wells. Even with these stark initial declines, it remains clear that the current market size for Solazyme will only continue to grow even as the overall market opportunity initially shrinks here in the United States.

Beyond this, investors should recall that Encapso can be used in both horizontal and vertical wells, and that it is now being used internationally. This significantly expands the market size as well. A look at the same article indicated that there were 79,000 wells drilled in 2013 overall. If we were to consider that approximately 10 MT of Encapso is used per well, we would still see that a small fraction of the market opportunity still far exceeds the reasonable capacity of what we would expect Clinton to produce over the next year.

Yet, one underlying benefit that actually exists because of this rapid fall in oil prices is an increase to the general adoption rate by companies to seek technological improvements. The benefit of Solazyme’s Encapso is that it exists as a drop-in replacement solution for an increase in performance and a decrease in costs. One recent article found here even highlights Encapso as an “enhancer”, a type of technological innovation which is more quickly adopted by industry.

As market prices place increased pressures on operators to reduce costs and improve the performance of their wells, they will inevitably be pushed down the route of incorporating new technologies. As a new innovator in a largely ignored sector (drilling mud) when it comes to cutting costs, Solazyme is more likely to have a positive boost when it comes to the negative economic environment found in the industry. CEO Wolfson once again suggests this concept with his comments found on the last conference call:

“Also, I think one of the things that some of our people in the field have told us is that as there’s more pressure on oil prices, it drives a greater discussion about how they can actually have savings during the drilling process, which I can’t promise you will end up working in our favor. But certainly, that’s some of the potential feedback that we’re getting.” – Jonathan Wolfson, CEO of Solazyme.

A Look At The Company Now

As of the last price of $2.56 as of December 5, Solazyme now trades with a market capitalization of $203 million. Over the last year, Solazyme has fallen more than 80% from its 52-week high of $15.00 per share. Ironically, this came after the company raised $212.8 million in April 2014, an amount that surpasses the company’s current market capitalization. This former equity offering was conducted at $11.00 per share with the convertible debt fraction hosting an even higher conversion price at $13.20 per share.

As Solazyme now searches for a bottom on the stock market, the company’s operations continue to improve. As stated in my last article found here, Solazyme’s operational expenses appear to have slowed. At the same time, the new shift in strategy aligns the company with a marketing plan that takes advantage of their most valuable products’ growing momentum.

Undoubtedly, the market has been spooked by the ongoing delay that occurred over at Moema. Market perception itself has become a short-term risk that will require a significant rebuilding effort on the part of management when it comes to restoring investor confidence.

Nevertheless, there is a significant argument to be made that the stock price drop itself has largely become an overreaction. Current oil price volatility has little near-term impact when it comes to how Solazyme now derives its revenue. For Q3 2014, research and development revenue accounted for 33% of the quarter’s revenue. Revenue from Solazyme Consumer Products (which includes Algenist) accounted for 39% of total revenue. Only the remaining revenue, which includes products such as Encapso and the company’s first generation oils, are indirectly affected by the price of vegetable and crude oil prices.

Final Thought

Encapso remains a growing market opportunity in the oilfields at a time in which the industry is searching for increased performance, efficiencies, and cost savings. The new product line currently offers all of these through an innovative drilling fluid additive that can be used in combination with, or as a replacement to, existing lubricants now on the market. More so, it provides increased functionality to E&P operators through its unique encapsulated nature.

As much of the downside has largely been played out, Solazyme now appears to be a stock that investors should treat as a speculative buy. Short-term investors should continue to remain cautious over the volatility which should be expected from any company that has fallen as fast as the company has. Yet, for long-term investors, the potential at this company has not actually been as radically changed as the market might suggest.

After nearly a dozen years, Solazyme now has three manufacturing facilities which have been constructed and are in the process of ramping. Solazyme’s products range across markets that vary in terms of higher margins and higher volumes. The company also has the flexibility to change its product mix according to market conditions. Solazyme has also established key relationships with multiple blue-chip partners who have already committed capital. Last of all, the company has more than $250 million of cash on hand and short-term investments. When one keeps this bigger picture in mind, it remains difficult to believe the company remains fairly valued in the present.

 

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