Systemic Uncertainty

Thomas Sowell explains why the recovery is delayed:

That is a big part of the problem. It is not politically possible for either the Federal Reserve or the Obama administration to leave the economy alone and let it recover on its own.

Both are under pressure to “do something.” If one thing doesn’t work, then they have to try something else. And if that doesn’t work, they have to come up with yet another gimmick.

All this constant experimentation by the government makes it more risky for investors to invest or employers to employ, when neither of them knows when the government’s rules of the game are going to change again. Whatever the merits or demerits of particular government policies, the uncertainty that such ever-changing policies generate can paralyze an economy today, just as it did back in the days of FDR.

There are two ways in which government tinkering promotes systemic uncertainty: by discouraging investment or by encouraging malinvestment.
The government discourages investment when it increases taxes and/or the cost of regulatory compliance. The state also discourages investment when it constantly reverses its own policies or is erratic in the enforcement of already existing policies. A continual state of flux discourages long-term investment because no one is able to feel certain about forecasting. One of the main reasons why ObamaCare and its counterpart RyanCare is so damaging is imply due to the fact that businesses aren’t able to feel certain about the future. The vociferousness with which RyanCare was debated helped to fuel systemic uncertainty, to a limited extent, because economic actors weren’t able to tell if any (or all) of the proposal would become law, and were thus unable to also determine what sort of long- and short-term plans would be viable.
But beyond that, the constant flux of change that is government tinkering also has a tendency to encourage malinvestment and market timing. Virtually every subsidy speaks as evidence for the former; Cash for Clunkers speaks as evidence for the latter.
Subsidies encourage malinvestment because they eliminate what economists refer to as moral hazard. Moral hazard is simply a fancy way of saying that people are more careful when investing their own money. When the government, for example, subsidizes corn-based ethanol, farmers have an incentive to grow more corn and venture capitalists have an incentive to invest in companies that will turn corn into ethanol-based fuel. This is generally unsustainable by market means because corn-based ethanol is energy negative, which simply means that producing ethanol burns more energy than it creates. Malinvestment can also be encouraged by indirect subsidies, like tax breaks or regulatory exemptions. This lowers the cost of doing business and increases profits, encouraging companies to pursue certain ventures.
When people think that the government may subsidize them, directly or by tax breaks, they have a tendency to wait until they qualify for the terms of the subsidy. This is true especially of temporary programs, like Cash for Clunkers, as mentioned before, or special tax breaks, like the first-time homeowners tax credit. These programs were ultimately failures because all the accomplished was pulling demand forward by a couple of months. They did not jump start the economy or increase long-term demand. Temporary subsidies, then, contribute to systemic uncertainty because economic actors try to time the market in order to get the most favorable deal. Businesses hold inventories to take advantage of greater demand later on. Consumers delay spending money in order to purchase things later on. Instead of allowing the market to function as it ought and smooth demand over time, government interference causes people to time the market and upset long-term plans.
Incidentally, the reason why temporary government programs generally become permanent is because there are some people who find temporary programs to be personally beneficial. When you have programs that offer lower prices to consumers and larger profit margins to businesses, most of the parties involved want to continue taking advantage of that system. Because of this, politicians vote to make temporary programs permanent because it is politically popular with their constituents, and because the political costs are widely dispersed and indirect.
Of course, the possibility of a temporary program becoming permanent also encourages systemic uncertainty because economic actors are unsure which specific programs will become permanent and if the terms of those programs will be altered in the process of attaining permanence.
In sum, it is simply best to let the market correct itself. Tinkering is futile at best and counterproductive at worst. Therefore, simply letting the market be is the best strategy, even if it is somewhat painful from time to time.

How big is big?

It may be hard to appreciate the story in the news of Chevron leasing 228 thousand acres of land for Marcellus Shale development in the state.  How much is that?  By my calculation it looks like the area in red in the graphic below, compared to the footprint of the entire city of Pittsburgh.

Someone really ought to go and do a study to figure out how much Pennsylvania landowners got for leasing their land and compare it to how much those rights are going for in this mega secondary market.

New?

Apparently, Bernanke is just now learning the purpose of having a national bank:

Federal Reserve Chairman Ben Bernanke said Thursday the central bank was already moving forward with its new mandate to promote broad financial stability in the wake of financial oversight reform legislation that instructed it to do so.

The Fed “has restructured its internal operations to facilitate” a regulatory approach that looks beyond the health of individual financial institutions, to one that looks at the interlinkages between firms and the overall state of the banking system, the official said. [Emphasis added.]

Notice what the FRB has to say on its “About” page:

The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded. [Emphasis added.]

I’m not sure how Bernanke managed to overlook this, what with him being the head of The Fed and all, but the whole purpose of having a central bank was, from day one, to promote financial stability. That has always been The Fed’s mandate. It’s like a default setting for the system, which is why it’s so surprising that Bernanke is just now catching on to this.
Bernanke’s reaction thus speaks to the general problem of bureaucrats. Namely, bureaucrats have a nasty tendency to shirk their duties, which always requires renewing their efforts at doing their job, accompanied with more power and money than before. The reason why bureaucrats fail at their job (micromanaging the economy) is not because they don’t possess enough knowledge and information, it’s because they don’t have enough resources at their disposal.
Thus, no bureaucrat ever admits that he is less than omniscient. He merely pledges to renew his effort, promising that he’ll get the job done right this time. Provided, of course, that he is given more money and power with which to do his job.

Richard Kelertas: Potash Prices Headed to $750?

Richard Kelertas With rising global demand for food comes escalating cash flows that enable farmers to purchase additional fertilizers to further boost yields. Dundee Securities Senior Analyst Richard Kelertas follows junior potash explorers that have been red hot for much of the past six months. In this exclusive interview with The Energy Report, Richard shares some names that he believes could develop into bumper-crop multiples for investors.

Companies Mentioned: Agrium Inc. Aguia Resources Ltd. Allana Potash Intrepid Potash, Inc. Karnalyte Resources Inc. Passport Potash Inc. PotashCorp The Mosaic Company

The Energy Report: Are we at the beginning of a global bull market in food, Richard?

Richard Kelertas: Yes. We believe the upward price pressure started after the economic crisis in 2009, and it could remain a substantial bull market until stocks:use ratios (carryover:total use) in most major food stocks—grains, corn, soy beans—can be brought back up to 10-year averages. Currently, the ratios are well below those averages. There doesn’t seem to be any reprieve in sight, unless we have two to three years of bumper harvests in all grains around the world.

TER: Rising food prices usually mean increased demand for fertilizer, but that hasn’t necessarily been the case this time around. Do you believe the share prices of potash equities have exceeded potential growth rates?

RK: No, not at all. In retrospect, 2009 was a tough year for a lot of fertilizer producers. Farmers had to delay applications, even though they started to see crop shortages followed by slowly rising crop prices. We didn’t really see fertilizer-price recovery until 2010. Around March/April, or mid 2010, we started to see a pickup in fertilizer stock prices. It was slow at first and, in some cases, it has been muted; but at the beginning of 2011, it started to surge dramatically. Now it’s come off again on the expectation that all commodity prices, including that of oil, will come off as the global economy slows down (especially in China). But our view is that this is just temporary, and that these stock prices don’t really reflect anywhere near the fertilizer prices we are looking at in 18–24 months. So, these current stock prices are only reflecting mid-cycle, but nothing near peak, prices.

TER: What is the real driver for fertilizer stocks? China, India?

RK: It’s global, definitely global. China kick-started the demand increase by buying corn on a large scale, but it suffered a significant drought in the southern part of the country. That was followed by several crop failures, droughts, weather—you name it—throughout the world in different locations. However, the main driver, going 5–10 years out, is population growth and the increase of the middle class’ diet requirements. That’s the big driver.

TER: What about phosphates versus potash? Will phosphates catch up in the foreseeable future?

RK: Yes, eventually. Not much phosphate supply is coming out over the next 18 months, so it’s going to catch up. There’s no doubt about it.

TER: What about global potash and phosphates prices? They are not consistent across the world. Do you see them evening out in time?

RK: Well, it all depends. You could look at history and assume that they will, but governments’ export/import restrictions can have a dramatic effect on regional prices. So, it all depends. I suspect that small regional differences will start to coincide at some point. Prices are lower in China, India, Indonesia and the United States. In another six to nine months, we could see increases in all regions.

TER: Is there an arbitrage opportunity for investors there?

RK: Oh, yes, but not really in stock prices. You’d have to play the futures markets and the actual commodity.

TER: Do you have a price forecast for potash? And, will we ever see $1,000/ton again?

RK: No, we won’t see $1,000/ton. I don’t expect the type of hoarding experienced back in 2007 and 2008 will happen again to the same degree. We certainly will get speculation; but, typically, the amount of cash that’s available, the lending requirements and margin calls are more stringent than they were three years ago. You will probably see one-half of the speculative run-up in potash that we saw back in 2007. This time it is coming from actual supply/demand dynamics, not speculative investors gobbling up contracts. So, $1,000/ton?—I’ll never say never, but I think the next peak we’ll see is probably more in the $700–$750/ton range.

TER: Do you have a timeframe for that?

RK: Yes, about 24 months.

TER: How do you start your due-diligence process on something like a potash stock?

RK: Well, there are two different types of companies—the junior exploration plays, which are predevelopment, and the established producers. The established producers are companies like Agrium Inc. (NYSE:AGU), PotashCorp (TSX:POT; NYSE:POT), The Mosaic Company (NYSE:MOS) and Intrepid Potash, Inc. (NYSE:IPI). The due diligence you have to do on those is pretty basic, and a lot of information is available from published sources on the Internet. So, the amount of research is directly related to the amount of information available—and there’s really not much you can’t find. We sit down with management to go through the numbers, and then tour one or two of the operations. We consider the overall picture on different types of fertilizers to determine if this stock is positioned well and rank it next to its peers.

For junior developers, which are either in pre-exploration or exploration phase, it’s more difficult. We spend a lot of time with the management team, going onsite, talking to the geologist and making sure the resource is there. We also ensure that there are no outside risks—no native land claims or land lease difficulties. We want to make sure a company can secure land and exploration leases over a contiguous area, so it will be smooth sailing when drilling starts.

After that, it depends on how well the company is financed, the quality of its management team and the level of its compliance and its experience in the field. Finally, you have to ask: “What are the barriers to entry for these particular players?” It could be country, infrastructure or any of a whole list of risks. The amount of due diligence you do on the smaller companies is a lot more than you would do on the larger ones.

TER: Do you like to see smaller companies being managed, especially in the field, by people who have come from larger companies?

RK: No, not necessarily. It depends on their experience level. They may have worked and been successful at smaller companies in the past. A lot of the guys who work for larger companies haven’t had to go through the exploration phase—they’ve just gone through the production phase. So, the smaller companies don’t really need an expert in production quite yet—they need exploration experts. That’s where the difference lies.

TER: Do you consider these junior exploration companies you’re following value stories or growth stories?

RK: Well, it’s a combination; but sometimes you don’t have the value yet. Some might be growth stories only because they haven’t yet established the resource. Even if a company hasn’t started drilling yet, we look at the historical holes done 15–20 years ago. And if it shows some good concentrations of potassium chloride (KCL) or phosphorus, we’re happy to follow it along and look at the company as a growth story even though the value hasn’t been established.

TER: How long do you typically follow a company before you initiate coverage?

RK: Well, I spend a lot of time with management and going through the numbers. So, we probably spend two to three months with a company before we initiate coverage.

TER: Where are you finding your desired characteristics now?

RK: Right now, the ones that we spend a lot of time on are Allana Potash (TSX.V:AAA) and Karnalyte Resources Inc. (TSX:KRN). These two companies have tremendous potential for resource expansion, as they’ve done drilling on only a fraction of their properties. Allana is in Ethiopia, and Karnalyte is in Saskatchewan.

Another one that we’re looking at is Passport Potash Inc. (TSX.V:PPI, OTCQX:PPRTF) in Arizona near Holbrook. It has a lot of potential based on exploration work conducted there about 25 years ago. Passport’s management team has done a lot of advance work, and drilling is just starting now. But the history indicates, to us, that there will be some fairly large deposits.

We’re looking at another one called Aguia Resources Ltd. (ASX:AGR), which is a Brazilian phosphorus and potash play—a combination play which is fairly unique. We’re doing more work on it, but we think it’s going to an interesting value-and-growth story there also.

TER: The first two you mentioned, Allana and Karnalyte, seem to have a tremendous sense of urgency. Drilling is faster than expected.

RK: Right.

TER: Allana has 105 million tons (Mt.) potassium chloride in the inferred category. Ultimately, how large could this resource be?

RK: The company is looking at the first 11 drill holes and some of the 3-D seismic data, but it has not made anything public yet. The NI 43-101 will be out in mid May. From our experience, we believe that we could be looking at 500 million to 1 billion tons of potash—mineable potash.

TER: Let’s just take the low end of that, 500 Mt. of mineable potash. You’ve got a target price of $2.50 here, which represents 50% upside from where Allana is right now. But, at 1 billion tons of mineable potash, where could that take this stock?

RK: Well, if you put the sensitivity on the mineable potash, it could take AAA’s price well over $10–$12/share quite easily. It depends on the grade; so, there are a lot of ‘ifs.’ That’s why we make a sensitivity table, just to get an idea. If the grade is about 35%, which seems to be the case with the last four or five drill holes, it could be a 25% average grade. That would take us north of $10/share.

TER: Well, grades seem to be high, so far, from what I’ve seen.

RK: Very, very high—and Allana can do open-pit mining.

TER: There are some near-term catalysts; do you believe these catalysts are priced in or discounted to the stock?

RK: No, not at all. But I would say that many unanswered questions remain. There are still some risks and issues having to do with the country, location, infrastructure and things of that nature. There’s also a continuing view that commodity prices, potentially, have topped off here for the short term. We’ll probably see other commodities pull back; but, essentially, the farmer is sitting with lots of money in his pocket and is starting to apply more fertilizer.

TER: Karnalyte was the second company you mentioned, I noted that it was up just 2% over the last three months while Allana was up 79%. Does that give an investor something of a relative-value play here in Karnalyte?

RK: Yes; but, you also have to remember that Karnalyte surged from $8–$13 very quickly after its IPO. So, it put on a lot of its capital appreciation early in the process. Right now, the resource is based on just 7% of its total land holdings. The CEO thinks that the potash deposit is extremely contiguous, very deep and very large. So, if you extrapolate to 100% of Karnalyte’s property and add its newly added exploration rights, you’ll start to see the stock catch up.

TER: Ok, you have a $20 target price on Karnalyte. That’s an implied 60% upside from where KRN is now.

RK: Correct.

TER: And, the next catalyst could move it to there?

RK: Well, I don’t know if it’ll move it to there. It may take a couple more catalysts to get it there. But that’s my 12-month target, and I have no doubt that KRN will blow through that number.

TER: What is your target on Passport Potash?

RK: I don’t have a target yet. The company hasn’t made any resource information public, at least not to the extent that we can infer a net asset value (NAV); but that information will be out shortly. Passport is working on its NI 43-101 now, which will be ready by June. The company’s drilling as we speak and will release its first drill results in the next couple of weeks. Then, after two or three holes, we’ll be able to come out with a valuation.

TER: You mentioned Aguia. Is it formally under your coverage?

RK: Not yet. Like Passport, it’s an item of interest. We will be getting drill results from the company over the next couple of months.

TER: Richard, thank you and best wishes.

RK: Best wishes. Thank you very much.

Richard Kelertas has 25 years experience as a research analyst covering the forest products sector. He has been one of the top-ranked analysts in the sector over the years consistently, and was most recently ranked No. 1 by Brendan Woods. Richard has worked for a number of well-known brokerage firms, including Scotia McLeod, Deutsche Morgan Grenfell, UBS Warburg, and Desjardins Securities. He has a bachelor’s degree in forestry and a master’s degree in forestry and economics from the University of Toronto. Richard is also a Registered Professional Forester.

Economic Events on May 6, 2011

At 8:30 AM EDT, the Employment Situation report for April will be announced, and the consensus for non-farm payrolls is an increase of 165 ,000 jobs compared to a gain of 216,000 in the previous month, the consensus for the unemployment rate is that it will remain at 8.8%, the consensus average hourly earnings rate is expected to increase 0.2%, and the consensus for the average workweek is 34.3 hours.

At 3:00 PM EDT, the Consumer Credit report for March will be released.  The consensus estimate is that there will be an increase of $5.0 billion in the consumer credit available from February to March, after an increase of $7.6 billion last month.