Jittery regimes fix prices

The puzzle

All of us are now curiously thinking about the abrupt phase transition that seems to sometimes occur in the endgame of an authoritarian regime. The traditional script was: The people rise up to rebel and the strongman murders them.

When the USSR collapsed, we thought it was special: it was a defunct regime that had just lost the will to live. But for the rest, the basic rulebook stood: the people get mowed down. And sure enough, that happened in Tiananmen Square.

But now, there are an increasing number of success stories with `velvet revolutions’, and one has to think more carefully about what goes in an authoritarian regime.

Conflicts beneath the surface

What appears like a monolithic regime from the outside can actually often reflect a diverse array of interests tugging in different directions. In this beautiful article by Laurence Wright on Saudi Arabia, he says:

I had begun to look at Saudi society as a collection of opposing forces: the liberals against the religious conservatives, the royal family versus democratic reformers, the unemployed against the expats, the old against the young, men against women.

On that same thread, Why do protests bring down regimes? A follow up by Graeme Robertson says:

While the news media focus on “the dictator”, almost all authoritarian regimes are really coalitions involving a range of players with different resources, including incumbent politicians but also other elites like businessmen, bureaucrats, leaders of mass organizations like labor unions and political parties, and, of course, specialists in coercion like the military or the security forces. These elites are pivotal in deciding the fate of the regime and as long as they continue to ally themselves with the incumbent leadership, the regime is likely to remain stable. By contrast, when these elites split and some defect and decide to throw in their lot with the opposition, then the incumbents are in danger.
So where do protests come in? The problem is that in authoritarian regimes there are few sources of reliable information that can help these pivotal elites decide whom to back. Restrictions on media freedom and civil and political rights limit the amount and quality of information that is available on both the incumbents and the opposition. Moreover, the powerful incentives to pay lip service to incumbent rulers make it hard to know what to make of what information there is.

I have also read others write similarly about China (but sadly, I do not have the reference): That in the absence of freedom of speech, the regime actually has no idea about where the problems lie, and is hence hypersensitive about criticism, and about solving the problems that it thinks do matter.

The behaviour of a jittery regime

Democracy matters in two ways. First, the regime has legitimacy. It is not worrying about a sudden upheaval that will destroy the regime. And, freedom of speech carries a steady flow of information to the regime. The UPA leadership does live in a bubble, but even they know that 8% inflation is a serious problem.

When a regime lacks legitimacy, and does not know what is going on, it is constantly fearful. It does not know what is going wrong and it can go off into extremes in trying to stave off some problems that it believes are first order. One area where this shows up is inflexible prices. To an external observer, it may be obvious that allowing price flexibility is better, but the regime is terrified about what will happen, so the price stays fixed.

Three examples

In a blog post titled Garam Masala: Bread And The Life Of Egypt, Vikram Doctor writes:

I first realised how different Egypt was when I saw the bread in the street in Cairo. It was piled on low charpoy-like tables, thick rounds of freshlybaked bread, slightly scorched from the oven, a bit like tandoori rotis, but heavier…. Someone would replenish them from the bakery close by, and collect the money that people left, but nothing seemed to stop them just taking it away… the other reason why no one took the bread free was that it was so ridiculously cheap that they might as well just leave the few coins needed (in fact, buying bread seemed to be pretty much all that the piastre coins were used for). I calculated that, at that time (over 12 years back), the cost of a round of bread converted to something like three paise : something I could not imagine anything costing in any large Indian city. But this was the point: the price was unreal because a massive bread subsidy was one of the basic ways the Mubarak regime stayed in place.

From The regime tightens its belt and its first, in the Economist:

From top ayatollahs to the IMF, everyone agrees that spending $100 billion each year to pin down petrol, gas and electricity prices, besides the cost of staples such as flour and cooking oil, is a bad way to dispose of Iran’s hydrocarbon revenues, accounting for more than 10% of GDP and encouraging waste on an epic scale. The symptoms of the malaise are legion: tea kettles simmer all day; the streets clog with recreational drivers out for a spin; lights glare because no one can be bothered to turn them off. `We can do it because we have oil,’ Iranians used to tell incredulous visitors.

The outstanding price inflexibility of China is that of the exchange rate. Consider the Chinese and the Indian exchange rates of recent years:

There is a dramatic difference in the exchange rate flexibility. The Chinese authorities are extremely loath to allow the exchange rate to fluctuate, even though it induces massive distortions in the economy. Why? I would venture to guess that once a large export reprocessing sector has built up, the regime is just scared to rock the boat, to displease many workers.

The exchange rate is the most important price in any economy. A country that can handle a floating exchange rate is a flexible economy, one in which firms are born and die, workers move across locations and industries, and prices fluctuate. Deep and liquid markets are shock absorbers. Firms have ample equity capital, i.e. low leverage, so that they are able to absorb shocks. There is a whole configuration of institutional arrangements which are conducive to price flexibility. By and large, India fares well on these counts, particularly in the vast informal sector where there is extreme flexibility. And most of all, when things do hurt, individuals are able to express their discontent through democratic politics.

If India did not have these long-standing strengths, Governors Reddy and Subbarao would not have been able to move to a flexible exchange rate. And this exchange rate flexibility, in turn, enables an array of other economic reforms in favour of a market-based system.

Also see: The message for China from Tahrir Square by Minxin Pei in the Financial Times and The Secret Politburo Meeting Behind China’s New Democracy Crackdown by Perry Link, on the New York Review of Books Blog.

Stability that is illusory

The regime change of recent years should make us think afresh about the notion of `political stability’. Democracy is always messy: demonstrations, machinations of party politics out in the open, colourful and often intemperate figures on television, elections, change in the ruling arrangement. But at a deeper level, this can be a more stable arrangement; there is no revolution at the end of the tunnel.

Similar reasoning applies in economics. Economists have always known that when prices appear to be stable, they often mask real trouble underneath. It is far better to have a small fluctuation every day, i.e. a steady flow of vol. The alternative — of clamping down on price movements on most ordinary days — merely yields big price movements on some days, which are far more difficult to handle.

Economic agents are not fooled by this stability on the surface. As Mark Roe says on Project Syndicate:

Even if all of the rules for finance are right, few will part with their money if they fear that an unfavorable regime change might occur during the lifetime of their investment.
More importantly, the grim stability of the type displayed by Hosni Mubarak’s Egypt is oftentimes insufficient for genuine financial development. Authoritarian regimes, especially those with severe income and wealth inequality, inherently create a risk of arbitrariness, unpredictability, and instability. They are themselves arbitrary. And everyone knows that beneath the stability of the moment lurk explosive forces that can change the regime and devalue huge investments. Because financiers and savers have limited confidence in the future, such regimes can’t readily build and maintain strong foundations for financial development.


This is a `capitalism and freedom’ style argument: that democracy and markets interact in the double helix of modern civilisation.

Price flexibility works best when there is price flexibility in a lot of markets. If all prices were fixed, and you only freed up one, then it could easily make things worse. It is hard, crossing the hump, and reaching over to the other side where all prices are flexible. And, price flexibility goes well with democracy. Flexible prices are constantly disruptive. Every day, there are a few pockets of the economy that are really getting hurt in the creative destruction. It requires a confident regime to take these fluctuations in its stride. A jittery and illegitimate regime may be more likely to clamp down on price fluctuations since it fears these could destabilise it.

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John McIlveen: Alt Energy Is Still at Value Levels

Alternative energy is a catchall axiom referring to any source of power generation and use that can replace fossil fuels, including nuclear, solar, wind and geothermal. Humankind will by necessity adopt renewable energy sources but, like all disruptive ideas, acceptance is preceded by doubt and hesitation, resolution of which comes only after systemic shocks like shortages and rising prices. Jacob Securities Research Director John McIlveen staked out this new economic sector to become one of the first North American analysts to specialize in renewable energy stocks. He believes these industries—particularly geothermal, solar and wind—could present unusual publicly traded opportunities for investors seeking truly unique diversification and significant capital appreciation. John spoke with The Energy Report in this exclusive interview to explain his focus and offer several ideas to round out growth-oriented portfolios.

The Energy Report: On June 15, 2010, you wrote that you believed the chances for U.S. passage of climate legislation were improving. Of course, that would be bullish for renewable energy around the globe. But now the political climate in the U.S. has seen an ideological shift with the leadership change in U.S. House of Representatives. Do you think climate change legislation will occur in the U.S.?

John McIlveen: Well, last summer it looked like the Gulf oil spill had played into the Democrats’ hands and improved their position in both the House and Senate. However, voters preferred spending cuts and tax-cut extensions instead because the economy and jobs were on their minds. In a better economy, I believe the environment would have been the voters’ priority. So, cap and trade and/or a clean-energy standard are likely off the table until the economy improves. There is room for a deal here, however, because with the current makeup of Congress, the Senate can block any restrictions the House would like to put on the EPA—and the House can block any clean-energy standard that comes out of the Senate. So, there’s a possible trade in there somewhere.

TER: What about renewable energy as a job creator? Clearly, a nascent industry isn’t employing a lot of people, but what’s the prospect for renewable energy companies producing large numbers of jobs?

JM: Oh, I think they will and I think they already have. It’s certainly the fastest-growing sector in the German economy now, and it’s probably now one of the largest sectors in terms of jobs. Going through the whole value chain from manufacturing to service, installation and operation, I think there are millions of jobs to be had.

TER: You’re saying it’s not just jobs for engineers, but also for workers.

JM: No, not just for engineers. It runs the full gamut—it’s construction, maintenance, managers, business offices, etc.

TER: Assuming we lost some of the older energy-industry jobs, could renewables augment jobs in the future?

JM: Yes, I think we’ll see a net increase. Construction is certainly job intensive. Renewable energy plant operations are not as job intensive; however, all the service industries that these facilities require are indeed job intensive.

TER: I looked at some alt energy exchange traded funds (ETFs) and indexes you recommended back in mid-June. I put them in an unweighted portfolio and they seemed to show some weakness right after President Obama’s State of the Union speech in January. Do you think that resulted from the fact that he didn’t commit to an alternative energy plan, or was it just part of the general weakness in renewable energy companies?

JM: No, I don’t think the speech had any particular direct impact. Obama’s speech was positive for renewable energy stocks—targeting 80% clean energy by 2035, even though we know that has no teeth to it with this Congress. The weakness is a continuation of a trend that started in January 2010, when we saw a rotation into yield stocks and an exit from project stocks. In the second half of 2010 (Q210), project stocks did not enjoy the same rise as the general market. Project stocks are defined as those that need to raise equity to get their projects done and are not yet mature enough to have a positive cash flow. So, the market is continuing to punish stocks that need money.

TER: The ETFs and indexes you recommended were up 16% over the past 52 weeks versus a 23% return for the S&P 500. On a relative strength basis, do you think they are a better value today and are you still recommending them?

JM: Yes. There are two groups here. The project stocks have held these indexes and ETFs back, and they continue to do so. For example, our yield stocks are up 18% in the last six months while the project stocks are up only 1%. There are also a wide range of returns in the project stocks—from up 100% to down 79%, whereas the yield stocks are in a much tighter band—between 7% and 30% up. So, these project companies are now all “show me” stocks. We see them move on achievement of milestones, and this is why we changed our valuation methodology in Q210 to what we call an “as-is” basis—meaning we only value equity-financed projects. We give no value to pipeline projects that may require the raising of equity. You have to see the cost of that equity before you can put a proper valuation on any project.

TER: You moved to a model of not discounting the non equity-financed projects.

JM: If you include the projects that aren’t equity financed, you have to include an assumption in your model as to the price that they can raise equity. And as we’ve seen in this market, everyone would have been wrong in terms of the prices they had in their model.

TER: What kinds of stocks are you recommending investors sell today?

JM: I cover the project companies; within that sector, I have three stocks that are at a Hold rating. They are Ormat Technologies Inc. (NYSE:ORA), Run of River Power Inc. (TSX.V:ROR) and Magma Energy Corp. (TSX:MXY). I think all three of those are fully valued for the coming year.

TER: So, a Hold rating means you should sell?

JM: We define Hold-rated stocks to give less than a 10% return. So, although there may be small returns left to be made, your money might work harder somewhere else.

TER: What about non-renewables like natural and shale gas and oil sands? I know gas is still weak; do you expect these to strengthen further?

JM: Well, results largely have been negative for gas and positive for oil. Obama’s speech included gas as a partial clean energy source because it has half the emissions of coal. It is also necessary to reduce emissions in the mix, as backup gas plants must be built for wind and solar for when the wind doesn’t blow and the sun doesn’t shine. The only risk I see is that if natural gas plants are built instead of other types of renewables, you won’t want to see a gas plant actually replace wind or solar. After all, gas plants still have half the emissions of a coal plant but a natural gas plant could be built in roughly 18 months for just about $1 million per megawatt (MW). I believe both the politics and fundamentals of needing gas to back up some renewables will help going forward.

TER: Geothermal is, of course, an alternative energy source. Is it renewable?

JM: Oh, absolutely—there’s no fuel cost for renewables. Essentially, what you’re doing is taking hot water out of the ground and using it to spin a turbine to make electricity, and then you put the water back into the ground. So, as long as you don’t take the water out of the ground faster than you can put it back in the ground, it’s a completely sustainable, non-depleting resource, hence it is renewable.

TER: I know you like some geothermals. Could you talk about those names, please?

JM: Yes, in the project category, Ram Power Corp. (TSX:RPG) has been badly beaten up, but the company will be bringing 36 MW online at San Jacinto-Tizate, Nicaragua in July. That should contribute $20 million a year in free cash flow. Drilling on the next 36 MW at the same site should be announced and is expected to be positive, as well. Also, Ram should be debt financed to begin construction on another 25 MW at the Geysers project in Northern California in Q2 and we should hear good drilling results at its Orita (Imperial Valley) in Southern California. So, there are a number of milestones for Ram throughout the year.

TER: You just reduced your target on Ram to $3.60 from $5, but there’s still potential upside or an implied return of 150% from here. Could the company be considered a deep-value story right now?

JM: Yes, I would say so. We trimmed our target because the company ran $50 million over budget versus our forecast; so, essentially, the market took more than that off its market cap. Then the CEO resigned and we again reduced our target price to $2.30. And the market punished Ram again to the point that it’s trading at just the value of its soon-to-be-online project in Nicaragua. These things always get overdone, and that’s the situation with Ram.

TER: Other alternative companies?

JM: There is also Nevada Geothermal Power Inc. (TSX.V:NGP) and a few others— U.S. Geothermal Inc. (TSX:GTH; NYSE:HTM), Etrion Corporation (TSX:ETX) and Western Wind Energy Corp. (TSX.V:WND). They’ve all been logging milestones and the stocks have begun to recover.

Nevada Geothermal should increase production at Blue Mountain from 38–45 MW this summer, and it should complete a feasibility study on adding 17 MW to the site. We also expect to see another joint venture (JV), probably with Ormat Technologies (like the first one it did). The company would start drilling that one at its Pumpernickel site. We also expect some good results to come out of its Ormat JV at the Crump Geyser site.

TER: A depreciation tax shield might become a windfall for the company. Is that assured, or is it just a possibility?

JM: We’ve seen this in the sector, but we just haven’t seen it in the geothermal industry yet. So, yes, there’s a vehicle to allow for the tax monetization of a company’s depreciation and depletion allowances— particularly under the new program that extended the investment tax credit (ITC) grants for another year, which means a company can write off 100% of the project in the first year. Normally, it would create nine years of income tax losses to shield income; but with this structure, they can claim the whole thing upfront.

TER: That would be roughly $20M for Nevada Geothermal, right?

JM: Yes, that’s the number we’d be expecting.

TER: For a company with a $75M market cap, that’s pretty significant.

JM: Yes, absolutely.

TER: What about U.S. Geothermal?

JM: U.S. Geothermal should complete its drill program and start constructing 23 MW at Neal Hot Springs, which is a joint venture with Enbridge Inc. (NYSE:ENB). The company could also announce a second JV with Enbridge on its San Emidio expansion of 9 MW. And it should also bring another 5 MW online in Q411, again at the San Emidio site. So, there are a few milestones to look for there.

TER: Is U.S. Geothermal now at free cash flow break-even?

JM: This year, it should be roughly -$2M free cash flow and in 2012 it should be break-even. Then in 2013, the company should move into a very healthy, positive free cash flow.

TER: And Western Wind?

JM: Western Wind is building 130 MW mostly in California, and it’s doing it without raising any equity. Instead, the company is using the ITC grant as collateral to get equity bridge loans. The 130 MW should be online in December; and we expect further equity bridge-loan deals to expand, thereby avoiding adding any new equity into the market.

TER: Western Wind seems to have a lot of catalysts on the horizon. You rate it Speculative Buy with a target price of $2.35. That’s still pretty good upside from where it’s trading today at $1.41. But WND is up 44% over the past six months—a pretty good run for a company in this group.

JM: Yes, that’s right—and that’s based solely on the 130 MW it has under construction and the fact that the company was able to do it without issuing equity. There’s still another window here next year for Western Wind to do more of these equity bridge deals using the ITC grant as collateral. Now, in our model we don’t include any of those possibilities. We include them only when they are equity financed. So, if you add another 50–100 MW project to the portfolio and don’t have to issue new equity to get that done, then it’s going to be accretive to our model.

TER: How about one more?

JM: Finally, Etrion is a photovoltaic (PV) solar generator based in Italy that’s listed in Toronto. In the last nine months, the company’s brought on 47 MW—and it’s adding another 10 MW in Q211. We also expect Etrion to break ground on an additional 40 MW in Q211.

TER: Thank you. It was a pleasure meeting you.

JM: Thank you. Have a good day.

Jacob Securities Research Director John McIlveen has been with the firm 4 years and has a total of 25 years’ experience in special-situations research and merchant banking. In 2004, he became Canada’s first sell-side analyst to focus solely on renewable energy research and consistently has been ranked a top performer by Bloomberg on accuracy of estimates and returns. He is currently treasurer of the Canadian Geothermal Energy Association and a published academic with 15 papers, including his and coauthor Alan Rugman’s 1985 best Canadian book-nominated Megafirms: Strategies for Canada’s Multinationals.

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Economic Events on February 23, 2011

The Mortgage Bankers’ Association purchase index was released at 7:00 AM EST, and there was a week to week increase of 5.1% in the Purchase Index and a week to week increase of 17.8% in the Refinance Index.

At 7:45 AM EST, the weekly ICSC-Goldman Store Sales report will be released, giving an update on the health of the consumer through this analysis of retail sales.

At 8:55 AM EST, the weekly Redbook report will be released, giving us more information about consumer spending.

At 10:00 AM EST, the Existing Home Sales report for January will be released.  The consensus is that existing homes were sold at an annual rate of 5.25 million last month, which would be an decrease of 30,000 from last month.

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Other Alpha Sources

I am not sure I buy the story that if China allowed its currency to appreciate all the world’s problems would be brushed away in one clean stroke. But I concur that the appreciation of China’s currency and indeed that of many of the big emerging markets primarily against the USD would certainly help. This is especially the case now that China (and the rest of the EM edifice) are sitting on a mounting inflation problem.

Dave Altig from the Atlanta Fed delivers a nice argument;

(…) if printing money does not buy you control over real stuff, it is very definitely a factor in controlling the nominal exchange rate—a measure of the value in trade of currency for currency. And there, I believe, is the crux of the problem. To keep the nominal exchange rate from rising, the People’s Bank of China in effect prints yuan and buys dollars. Though this has limited impact on any real fundamentals, it is the source material for inflation. In fact, if a monetarist heart beats within you, the picture of the recent Chinese inflation experience will surely warm it.

I have long believed that one part of the problem here is the unique focus on China where the real focus should be on much broader based global currency alignment in which a basket of emerging market currencies appreciate against the G3 as a whole. This would then serve to rebalance global aggregate demand most efficiently.

As an economist there are many things to feel negative about at the moment and I would honestly admit that also I must sometimes struggle not to descend into the bottomless pit of eternal doom and gloom. In that vein, I was refreshed by the Economist’s recent look at 3D printing which basically covers a whole new and growing area of manufacturing (of everything imaginable) in 3D much the same way as printing a piece of paper.

THE industrial revolution of the late 18th century made possible the mass production of goods, thereby creating economies of scale which changed the economy—and society—in ways that nobody could have imagined at the time. Now a new manufacturing technology has emerged which does the opposite. Three-dimensional printing makes it as cheap to create single items as it is to produce thousands and thus undermines economies of scale. It may have as profound an impact on the world as the coming of the factory did.

It works like this. First you call up a blueprint on your computer screen and tinker with its shape and colour where necessary. Then you press print. A machine nearby whirrs into life and builds up the object gradually, either by depositing material from a nozzle, or by selectively solidifying a thin layer of plastic or metal dust using tiny drops of glue or a tightly focused beam. Products are thus built up by progressively adding material, one layer at a time: hence the technology’s other name, additive manufacturing. Eventually the object in question—a spare part for your car, a lampshade, a violin—pops out. The beauty of the technology is that it does not need to happen in a factory. Small items can be made by a machine like a desktop printer, in the corner of an office, a shop or even a house; big items—bicycle frames, panels for cars, aircraft parts—need a larger machine, and a bit more space.

Needless to say that this holds the potential to completely revamp manufacturing processes and re-define the nature of scale economies. However, apart from the potential to re-navigate the face of the already established manufacturing industry two things stand out to me.

Firstly, the notion of 3D printing brings the world of science fiction closer by leaps and bounds. Forget about printing a cup at home if you break one in the kitchen. Think 3D printing in conjunction with the emerging technology of manufacturing organs and other organic material. Then think about the promise that much less raw material need to be used and you are only a small step away from Picard pushing a button in Star Trek and invoking a meal or of course the irresistible scene in the Fifth Element in which an obviously hungry Leeloo creates a nice juicy chicken on a split second using, presumably, a small capsule containing the condensed raw material to create such a meal. Clearly, such things would easily be possible in a 3D printing setting and indeed, once transferred into a setting of “organic material”, the possibilities are mind blowing.

Secondly, I am in awe about the potential this holds for home and small scale manufacturing in connection with an open source environment. Obviously as the Economist points out, the flip side to this is that companies will need to come up with new ways to protect source codes (or blue prints) to their products since this would be the main source of their intellectual property. Yet, the heretic in me marvels on the potential of this coupled with some nifty reverse engineering. Imagine a complex product such as a Porsche 911. What if you could reverse engineer it, supply the material, and then feed the blue print into your generic manufacturing scale printer and presto, you would be the maker of luxury German (or Danish) sports cars. Clearly, how companies serve to protect themselves from exactly this kind of abuse is crucial to the success of 3D printing. But then again, one could easily imagine companies selling blueprints online to simpler products which consumers could then produce at home.

In short, if you want a positive view of the future look no further.

Finally and perhaps because it spoke kindly to be prejudices in relation to the ongoing climate change debate, I really liked Leon Neyfakh’s review of a new book by Colby College historian of science James Rodger called “Fixing the Sky: The Checkered History of Weather and Climate Control,”;

One can’t help but feel a little embarrassed on behalf of the species, to have been involved in all this fuss over something as trivial as the weather. Is the human race not mighty? How are we still allowing ourselves, in the year 2011, to be reduced to such indignities by a bunch of soggy clouds?

It is not for lack of trying. It’s just that over the last 200 years, the clouds have proven an improbably resilient adversary, and the weather in general has resisted numerous well-funded — and often quite imaginative — attempts at manipulation by meteorologists, physicists, and assorted hobbyists. Some have tried to make it rain, while others have tried to make it stop. Balloons full of explosives have been sent into the sky, and large quantities of electrically charged sand have been dropped from airplanes. One enduring scheme is to disrupt and weaken hurricanes by spreading oil on the surface of the ocean. Another is to drive away rain by shooting clouds with silver iodide or dry ice, a practice that was famously implemented at the 2008 Olympics in Beijing and is frequently employed by farmers throughout the United States.

And of course, the last paragraph strikes a special chord with me;

The good news for practitioners of weather control is that amid all this complexity, they can convince themselves and others that they deserve credit for weather patterns they have probably had no role whatsoever in conjuring. The bad news for anyone who’d like to prevent the next 2-foot snow dump — or the next 2 degrees of global warming — is that there’s just no way to know. As Fleming’s account of the last 200 years suggests, it may be possible to achieve a certain amount by intervention. But it’s a long way from anything you could call control. Those who insist on continuing to shake their fists at the sky should make sure they have some warm gloves.

Makes sense to me.

Daily ranking:

Say it ain’t so….

Folks are not supposed to beat me to this, but the Economist has again ranked Pittsburgh higher than any other US region for livability.  You can read more on our sustained ascendancy from the Huffington Post.

The UK’s Daily Mail has the best headline though.  They literally say:  It’s official: Pittsburgh is best place to live in U.S. (it even beats Honolulu)

Reads like they may be suffering from a bit of cognitive dissonance I guess.  Someone should send this over to Newsweek where just last month they ranked us among the most dying cities in America.  My brain hurts.  I guess it would be a good time to go back and rehash some of our history with these livability metrics for what they are worth.

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Economic Events on February 22, 2011

At 9:00 AM EST, the monthly S&P/Case-Shiller home price index report will be released.  Given that most economists don’t expect the overall U.S. economy to improve until housing prices end their decline, the market will be watching this number closely.

At 10:00 AM EST, the monthly report on Consumer Confidence for February will be released.  The consensus index level is 65.0, which would be a 4.4 point increase from January.

Also at 10:00 AM EST, the State Street Investor Confidence Index will be released, which looks at changes in the amount of equities held in the portfolios of institutional investors.

Takeover Talk with Michael Fowler

Michael Fowler is a senior mining analyst with Loewen, Ondaatje, McCutcheon in Toronto and he was more than willing to speculate on potential takeovers in this exclusive interview with The Gold Report. “All of these gold producers are going to be active in the mergers and acquisitions (M&A) market. They are going to acquire because there’s a huge amount of cash on their balance sheets,” he says. Michael also talks about some undervalued names in his coverage universe, including one junior he thinks could climb 210% before year-end.

The Gold Report: Michael, please tell us a little bit about Loewen, Ondaatje, McCutcheon (LOM).

Michael Fowler: LOM Ltd. is the oldest independent research boutique on Bay Street. It’s been around for 40 years or so. What we are today is an institutional broker that focuses on small- to mid-cap mining issues. We also do high tech and biotech.

TGR: There is certainly a lot of room for growth in those sectors. Today, we’re focusing on potential takeovers and mergers among Canadian junior gold companies. Last week, Goldcorp Inc. (TSX:G; NYSE:GG) sold its 10% stake in Osisko Mining Corp. (TSX:OSK) for $530 million. What did you make of that deal?

MF: I think it was telegraphed by Goldcorp to some degree, but what interests me is the timing of that transaction. I suspect that Goldcorp probably didn’t want to wait until Osisko’s Canadian Malartic mine in Quebec went into production. Mines that go into production have huge amounts of risk. Also, I would speculate that Goldcorp is certainly in the market for other assets. It’s an interesting transaction.

TGR: Well, it’s not like Goldcorp is cash-poor. Have you heard anything on Bay Street about potential targets?

MF: Goldcorp is reviewing targets all the time. I wouldn’t be surprised to see the company pop its head up and look at Ventana Gold Corp. (TSX:VEN), for example, even at this late stage. There are other targets that it also might go after, which might suit its portfolio. I haven’t heard of anything specific.

TGR: One common tack of majors like Goldcorp or mid-tier producers like Agnico-Eagle Mines Ltd. (TSX:AEM; NYSE:AEM) is to take a stake in a junior, get a look at the drill core and the deposit models and get a seat on the board. Do you know if Goldcorp has any seats on junior boards?

MF: I’m not aware of any particular boards on which the company sits. I wouldn’t be surprised if it had stakes under the 5% threshold, which it doesn’t have to report. The company took an equity interest in Gold Eagle Mines, which it took over a couple of years ago. I wouldn’t be surprised if it had equity stakes all around the industry actually.

TGR: Despite about a 30% upswing in the gold price over last year, Goldcorp shares traded between $37 and $49. Over the same period, it’s a similar story with Barrick Gold Corporation (TSX:ABX; NYSE:ABX) with its shares roughly trading from $37–$56. Those aren’t bad gains but if Goldcorp were to take over something substantial, would that dramatically move the needle with those majors? Or are we going to need a merger of a couple of those large gold companies for that to happen?

MF: First of all, let’s talk about mergers of big gold companies. In my opinion, that really doesn’t create any value. You can look at Barrick Gold as an example. Since 1993, Barrick really hasn’t created much in terms of shareholder value, despite several large takeovers. Although mergers may occur, I think the big gold companies realize that getting too big is not all that advantageous.

Secondly, a gold company would be more likely to take over a deposit, because there’s great value enhancement from taking an undeveloped, or developed, project through to production. Companies gain accretion from that; they just can’t pay too much for those assets. Some big gold companies have been paying a high price for some of those assets and may not benefit much from the acquisitions. Goldcorp’s Andean Resources acquisition is a good example. Gold producers are going to be active in the mergers and acquisitions market. They’re going to acquire because there’s a huge amount of cash on their balance sheets.

TGR: You mentioned Goldcorp buying Gold Eagle, but there have been some other transactions in Canada’s junior gold space. In 2011, Osisko took out Brett Resources, and Kinross Gold Corp. (TSX:K; NYSE:KGC) bought Underworld Resources. In 2007, Agnico acquired Cumberland Resources and its Meadowbank gold project, which is now a gold mine in Nunavut. The latter deals involved mid-tier producers buying some promising gold projects in mining-friendly jurisdictions. Do you see more of these deals happening in 2011? Is that part of your investment thesis in terms of your coverage sector?

MF: Not really. I do see some potential takeovers by those sorts of companies, though. Detour Gold Corporation (TSX:DGC) might be an example. Its shares are very highly priced; therefore, it may take over lower-priced or lower-valued shares of another company in an all-share takeover.

I see the Osisko-Brett takeover as being a weak transaction. You don’t tend to get a non-producer taking over another non-producer unless it has some risks associated with its own deposit being brought into production. The biggest upside for Osisko, in my view, would’ve been just to get its mine into production and not bother taking over other producers. I see that type of transaction as being rather sporadic. If there are takeovers, we’re more likely to see a big gold producer or a mid-sized gold producer taking over a company that has a gold project close to the feasibility-study stage.

TGR: That’s twice you’ve alluded to potential problems with Osisko’s Canadian Malartic Mine. Do you believe there could be issues there?

MF: It’s not that I believe there are fundamental problems for Osisko at Malartic. It’s just that the company is mining a very low-grade deposit. If it’s wrong on the grade that goes through the mill by 10%, then there’s a lot of risk associated with it. There aren’t that many open-pit gold deposits in Canada. I just find Goldcorp’s timing in disposing of its shares interesting.

TGR: I would suspect that people like Osisko CEO Sean Roosen were none too happy with Goldcorp selling at this point, but let’s move on to your coverage area and some small- and micro-cap names. You have a Speculative Buy rating on Fire River Gold Corp. (TSX.V:FAU; OTCQX:FVGCF) with a 12-month target price of $1.40. Considering the company is currently trading at around $0.53, that would be a gain of more than 210%. FAU is scheduled to relaunch production at the Nixon Fork Gold Mine in Alaska later this year. It bought the property after Saint Andrews Goldfields (TSX:SAS) was forced to close the mine in 2007 due to production problems. What makes you think Fire River has solved those problems?

MF: First of all, let’s talk a little bit about St. Andrew. These comments are not really about today’s St. Andrew because it’s a different company now than in the past. But previously, St. Andrew had a pretty poor mining record. It also had problems with another project in the Timmins area of Ontario. I think that in those days St. Andrew’s management was heavily weighted toward miners and less so toward geological engineers. The real problem at Nixon Fork was the lack of understanding of the deposit’s geology. By the way, St. Andrew wasn’t the only operator of the Nixon Fork Mine. Consolidated Nevada Goldfields Corporation (now Real del Monte Mining Corporation, a private company) operated the mine in the 1990s and actually made profits.

Moving forward to today, what can Fire River do differently from St. Andrew? One point is that it has a little bit of time. Financial obligations forced the company to produce, but Fire River actually has time to do some drilling. It’s currently doing 28,000 meters of drilling in order to really understand the Nixon Fork ore body—that is the key to that operation. It’s a very low-tonnage mine, so the company needs to have good control over the geology. That’s the focus that Fire River is taking and I’m betting that it’s going to get that right. The mere fact that there are very high-grade resources is going to give Fire River some leeway if it has any problems associated with the grade.

TGR: In your discounted cash flow (DCF) model for Fire River, you used a 5% discount rate and a $1,400/oz. gold price. I would say, generally, that the discount rate is a little bit low and the gold price is probably a little high. Why did you choose those numbers?

MF: The discount rate has always been a topic of conversation in the industry. What discount rate does one use? Traditionally, analysts use 5% discount rates for gold companies; and, actually, some use 0% as a discount rate. The reason is that the DCF method is very inflexible. It doesn’t really tell you the potential for increases in reserves or resources or the potential for rises in the gold price. Therefore, if you do a DCF of 5% on a lot of producers, you’ll find that they actually trade at premiums to that discount rate. In fact, I use 5% on just about every company out there.

TGR: What about the $1,400/oz. gold price?

MF: I don’t think that’s a bad gold price to use. I think we’re going to soon see gold closer to $1,400/oz., and then a year later, it will be over $1,400/oz. I’m bullish on gold. I don’t see any reason to change that view. I guess the biggest risk on gold is interest rate hikes. I just don’t think that’s going to happen. I think that $1,400/oz. is a very good price to use; but, even if gold went to $900/oz., I still believe Fire River would make a small but reasonable profit.

TGR: Fire River released its Preliminary Economic Assessment (PEA) of the Nixon Fork Project on February 17. We can also expect to see drill results from that 28,000m drill program you mentioned. What are you expecting from that scoping study?

MF: I’m expecting a robust scoping study. It may not show the same level of net asset value (NAV) that we calculated because the NAV that we calculated assumes some additions to the resource. So I think the scoping study will be a little bit less than the NAV we’ve used. The other thing is that the scoping study will use $1,200/oz. gold, not $1,400/oz. gold. Nevertheless, I think we’re going to see a fairly robust situation. I do have to warn people that we may not see the same level of value that we calculated because we used a higher gold price. We also assumed that Fire River would find extra resources through the drilling that’s taking place.

TGR: You’re projecting $36 million in cash flow in 2012 once Nixon Fork reaches production. Do you believe Fire River could become a takeover target at that point, or is that scenario is more likely before Fire River reaches production?

MF: No, I don’t think it’s going to happen before the company reaches production. I want to point out that there’s a lot of skepticism out there about this story. We’re banking on it working out. That is probably one of the most fundamental reasons to buy the stock right now. It could be a takeover target if it’s successful in production. But I have a feeling that it might be the acquirer down the road rather than the acquired. Fire River will be a relatively small producer; if it works out as we expect, the company may be in the market for a merger with another small producer.

TGR: That’s certainly not the only company you cover. You have Speculative Buy ratings on Richfield Ventures Corp. (TSX.V:RVC), Clifton Star Resources Inc. (TSX.V:CFO) and Fortune Minerals Limited (TSX:FT). Why do you like those stories?

MF: Let’s start with Richfield, which has drilled about 100 holes in Blackwater Gold Project—a low-grade, bulk-tonnage target. It’s had consistently good results and I it looks to me as though we’re heading toward 4 million ounces (Moz.) or more in the ground for that deposit. We haven’t had a resource estimate from the company, but the company is planning a PEA in the fall. I suspect that we’re going to get some very good numbers from that study. Richfield is trading at a fairly low valuation, and with further drilling I expect to see that increase.

TGR: Richfield has had some impressive drill results at Blackwater. One was 72 meters of 1.6 grams per ton (g/t) gold; another returned 183m of just a little over 1 g/t gold. Those results would indicate a bulk-tonnage target, but what is the ownership situation with Silver Quest Resources Ltd. (TSX.V:SQI)? Richfield optioned that property from Silver Quest, but it’s not quite that clear-cut, is it?

MF: Well, it’s pretty clear-cut. The northern half of the project is actually part of a 75/25 joint venture (JV) with Silver Quest. But the bottom half of the project is 100% owned by Richfield Ventures and most of the drilling has been on the ground that Richfield owns. Now, I suspect that the two parties are talking to try to get the best value for their shareholders from that deposit. In the future, I think you may well see some news regarding a revised deal with Silver Quest for the northern half of the deposit.

TGR: Please tell us about Clifton Star.

MF: Clifton Star Resources is working on the Destor Porcupine fault zone on the Quebec side of the border with Ontario. The Destor Porcupine fault has produced more than 100 Moz. gold, so we’re onto a great location. The infrastructure is there and it’s in Quebec, the best location in the world for finding a mine.

Osisko is actually earning a 50% interest in this project. Clifton Star is trying to find a large, bulk-tonnage deposit. At the moment, it has close to 3 Moz. gold in terms of NI 43-101 reports. But, quite frankly, I think we could be well over 5 Moz. as a result of the drilling done with Osisko. Again, this is an undervalued situation. I see some upside potential in Clifton Star.

TGR: Maybe one more for our readers?

MF: I’d just like to mention Fortune Minerals, which is a different type of story. Fortune has two deposits. One is a gold-cobalt-bismuth deposit in the Northwest Territories, which has about 1 Moz. gold. The other is a coal project in BC. The coal project is interesting because coal is very hot right now. The price of metallurgical coal is about $250/ton. Fortune’s coal contracts are being written as we speak, so that coal deposit is very valuable. Fortune’s NICO Deposit in the Northwest Territories is totally undervalued in terms of our DCF model. I would say there’s about $5 of value in those two projects, and that’s not even using today’s prices of coal, cobalt or gold. We are really excited about that company.

TGR: Most of the companies you like have projects in Canada, as you said, it’s one of the most mining-friendly places in the world.

MF: I like Canada. Richfield is in a good spot; it’s close to infrastructure. Clifton Star is close to infrastructure. Infrastructure at Fortune Minerals, however, is not as good; though it is in Canada. I’m very bullish on Canada.

TGR: What can our readers expect in terms of the number, or size, of deals that could happen this year? Of course, it’s pure speculation but what do you think will happen?

MF: I think there are going to be a lot of deals in the $1–$10 billion range and maybe even down to the $500 million range. I expect a lot of activity. The big gold producers are looking for good deposits with some upside potential, but one of the best ways of generating shareholder value is through exploration, not acquisition—resource expansion by the drill bit. So, look for bigger exploration budgets from these gold producers. It makes a lot of sense economically; it just takes time to generate a mineable deposit.

TGR: Thank you for talking with us today, Michael.

Michael Fowler, senior mining analyst with Loewen, Ondaatje, McCutcheon Ltd., has worked in the investment industry since 1987 as a base and precious metals mining analyst for numerous high-profile firms. His coverage list includes the major North American gold mining companies. Previously, Michael worked as a geophysicist involved in mineral exploration for 10 years. He was involved in the discovery of the high-grade Cigar Lake uranium mine in Northern Saskatchewan in the early 1980s. Michael holds an MBA from Cranfield University, UK, an M.Sc in mineral exploration from Leicester University, UK, as well as a B.Sc in geology with geophysics from Liverpool University, UK. He is a member of the Institution of Materials in the UK and a member of the Canadian Institute of Mining and Metallurgy.

Interesting readings

My collection of links on the transition at SEBI from C. B. Bhave to U. K. Sinha.

How India’s banks killed the future of commerce on the Cleartrip blog.

The defining problem of the Indian State is the tension between spending on program that benefit the few (e.g. the typical UPA
welfare program) versus programs that benefit all (i.e. public goods). This problem even extends to skimping on resources for the
judiciary. See Dhananjay Mahapatra in the Times of India.

Greasing our shock absorbers by Ila Patnaik in the Indian Express, 3 February 2011. And watch her talk about the economy.

There is quite a bit of debate in India about big government versus small government. On this subject, Blanca Moreno-Dodson and Nihal Bayraktar have a note How Public Spending Can Help You Grow: An Empirical Analysis for Developing Countries. They compare a set of fast-growing developing countries to a mix of developing countries with different growth patterns. Considering the full government budget constraint, the empirical analysis shows that public spending, especially its `core’ components, contributes to economic growth only in countries that are capable of using funds for productive purposes. In addition, those countries must have an adequate economic policy environment with macroeconomic stability, openness, and private
sector investments that are conducive to growth.
Unfortunately, their definition of `productive and core sectors’ reflects World
Bank ideology, and does not focus on public goods.

IT strategy for the Goods and Services Tax.

A great article on Saudi Arabia by Laurence Wright.

Tunisia and Egypt continue to be incredibly important and riveting. I really enjoy the thought, however fatuous, about every
strongman across the world sleeping a little less easy. See Why Egypt should worry China by Barry Eichengreen on Project
Syndicate. On the East Asia Forum, Peter Beck tells the story about how the dictatorship collapsed in Korea. Robert
L. Tignor
on Project Syndicate locates the present discussion in Egyptian history.

Read this interview with Andreas Wesemann.

The wonderful world of Android: link, link.

Is Your Job an Endangered Species? by Andy Kessler in the Wall Street Journal.

Abrupt change in authoritarian regimes: Gary Becker, Richard Posner.

The energy story of the year!

Maybe it will be coal?  Yeah, coal.

You would be surprised what my regular reading list includes, but PilotOnline has a story today:  Coal ships create a traffic jam on Hampton Roads waters.Where is all the coal being loaded in Hampton Roads coming from? I once had to inspect a coal ship loading down there… in a white uniform no less.  Not the greatest idea in the world.

and you thought this was going to be about shale.  How’s Marcel doing?

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The State of Unemployment

The State of Unemployment

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