All models are wrong, some models are useful. A model reduces complications that are true in return for tractability and insight. In finance, all too often, one complication which has been wished away is transactions costs. A great deal of what we see in the world around us is caused by the costs of transacting. Some of the most important finance is about analyzing the causes and consequences of the costs of transacting.
The bid offer spread as a measure of transactions costs
The first flush of the literature draws on markets with market makers, and treats the bid-offer spread as the measure of the cost of transacting. On the NYSE, the specialist posts a bid price and an offer price. If you do two transactions in quick succession — buy 100 shares and then sell them back — you will be poorer by the bid-offer spread. The spread is like a tax on a speculator doing a round-trip for a small transaction.
There is no doubt that in that environment, the spread measures something important about transacting. Large databases about the spread are available. A whole literature arose which is rooted in the spread as the measure of the cost of transacting.
Limit order book markets are a whole new world in observability of liquidity
The world changed. Across countries and across asset classes, exchanges have been morphing into anonymous open limit order books. The market maker is not as important. On the open limit order book market, the full set of limit orders are observable, using which we can simulate a market order of any size, and calculate the exact cost that is paid. Suddenly, instead of just seeing a bid-offer spread, we see a whole new world which displays the full `liquidity supply schedule’ (LSS) that has the impact cost (in per cent) associated with a single market order of all possible sizes.
|An example of the `Liquidity Supply Schedule’: The impact cost associated with all possible transaction sizes
When the bid/offer stands at 98/102, and the midpoint quote is 100, if a single market order to buy 1000 shares gets executed at an average price of 105, the buy impact cost for 1000 shares is 5%. This calculation, repeated for all possible transaction sizes, paints the full Liquidity Supply Schedule (the LSS).
Once the LSS is visible, and we start thinking about the world in new ways, and the spread feels like a highly unsatisfactory measure of the cost of transacting. At the NYSE, the market lot is 100 shares for all firms. A share price of $5 means the spread refers to the cost of a transaction size of $500. If the share price is $200 instead, the spread pertains to a transaction of $20,000. Hence, the spread is itself not comparable across securities. In contrast, the LSS can be a standardised calculation that is comparable across all firms, with standardised units on the x axis either in rupees or basis points or market capitalisation.
For us in India who grew up with limit order book markets (NSE from 11/1994 onwards; BSE from 5/1995 onwards), the mainstream Western literature seems a little quaint, given their emphasis of the spread as the measure of transactions costs. We are seeing much more of the liquidity elephant through the LSS, while so many researchers are only seeing it’s tail through the spread. In India, the construction of Nifty required the capture of multiple snapshots of the entire limit order book per day, and has generated information about the LSS going back to the mid 1990s.
Since exchanges worldwide have shifted over to an open electronic limit order book, the new focus of measuring liquidity in finance lies in understanding the LSS. What explains cross-sectional and time-series variation of the LSS? What are the consequences of various features of the LSS? These questions have only begun to be addressed in the literature. Rosu has a fascinating recent paper in the Review of Financial Studies, 2009, titled A Dynamic Model of the Limit Order Book that presents one of the first models which predicts the shape of the LSS in an open ELOB market.
Does the impact cost in buying differ from that faced when selling?
One interesting dimension which the LSS makes possible is to think afresh about buying versus selling. The bid-offer spread tells us the round-trip transactions cost. It does not differentiate between buying and selling. When you see that the bid and offer are 100/102, there is no sense in which the transactions cost in buying differs from the transactions cost in selling.
But with the full LSS, we see the impact cost of buying at all transaction sizes separately from the impact cost of selling at all transaction sizes. A first question to ask is: Is there symmetry in liquidity? In the example of the LSS graphed above, it’s quite obvious that the impact cost when buying is superior (i.e. lower) than that faced when selling. But this is just one anecdote.
In a recent paper Measuring and explaining the asymmetry of liquidity, Rajat Tayal and Susan Thomas explore this question. With equity spot trading on the NSE, they find strong evidence in favour of asymmetry: impact cost is higher for large sell market order compared to large buy market orders.
Why might asymmetry arise?
What features about traders in the market generate differences between buying and selling? There is one candidate: how traders perceive sell market orders, particularly large sell orders that come despite constraints on borrowing shares, and restrictions on short-selling.
The speculator who makes a forecast that a share price will go down seldom owns the shares; selling requires borrowed shares. Particularly, in India, where formal mechanisms for borrowing shares are as yet quite small, a speculator who wants to sell physical shares has to mobilise borrowed shares on his own.
This may shape the thinking of the people placing limit orders. When I place limit buy orders (which will get hit by a speculative seller), the adverse selection runs against me. If the speculator was not confident about his forecast, he would not bother to borrow shares and sell short. Only when the speculator is really sure would he take the trouble of borrowing shares and doing a sell order. Hence, the person placing limit orders to buy would demand a bigger price of liquidity (i.e. the impact cost), since he runs a greater chance of losing money when giving liquidity to sellers.
The paper highlights a fascinating identification opportunity : at NSE, alongside the trading of the equity spot market, we also have trading in single stock futures. Everything about the two markets is identical: the same securities, the same trading system, the same participants, the same hours of day, etc. There are only two differences: stock futures trading is leveraged, and stock futures trading has cash settlement — which removes the short-sales constraints. Cash settlement induces full symmetry between buying and selling.
If short sales were the reasons asymmetry in liquidity on the equity spot market, then the stock futures market should have no asymmetry between buy and sell orders. The paper uses the same measurement procedures and statistical tests to compare the asymmetry of liquidity on the spot market as well as for the stock futures market. They find that there is no asymmetry of liquidity on the stock futures market.
If their story is correct, it has many implications. In other market settings observed worldwide, cash settled derivatives should have symmetric liquidity. Physical settled derivatives should have asymmetry – which might get more accentuated as you come closer to expiry. Many natural experiments have taken place worldwide, where futures contracts have shifted from physical to cash settlement: these are all nice natural experiments where changes in asymmetry should become visible. On spot markets, asymmetry should vary with the ease of borrowing. Future research projects could explore these questions.
Financial economics benefits from the best datasets in all economics, and we are able to get sharp and clean papers which pretty decisively answer questions. In India, it has started becoming possible to do innovative work by drawing on data from the open ELOB equity exchanges, CMIE, etc.
Smaller Canadian-based companies are exploring and producing in countries all over the globe, in areas that may present even greater returns in the coming years. Frederick Kozak, oil and gas research analyst at Canaccord Genuity, draws on nearly 30 years of experience in the field to focus on investment opportunities in locations ranging from New Zealand to Colombia and Egypt. In this exclusive interview with The Energy Report, he discusses hospitable jurisdictions (it’s not what you think) and which companies are flourishing in them.
The Energy Report: It seems the oil market has defied the expectations of all of those who were predicting $5/gallon ($5/gal) gasoline this summer. What happened to the $130/barrel ($130/bbl) oil that people were talking about?
Frederick Kozak: When oil gets into triple digits, $100+, $110, $120/bbl, it really starts impacting the North American economy, particularly the U.S. As gas approaches $5/gal, people start cutting back, which impacts worldwide demand. Combined with issues in Europe, China and other world political and economic events, the markets get nervous. The price of oil has turned around to reflect, perhaps, a less rosy economy for the next 12–18 months. The number of contracts that are traded on a daily basis on the NYMEX certainly outnumber real physical daily oil production by a larger multiple. Any way the wind blows influences the paper trade and it’s not blowing in their favor right now.
TER: What are your oil price expectations for the foreseeable future?
FK: Our long-term view is for $100/bbl Brent with West Texas Intermediate (WTI) at around $92.50/bbl through at least next year. That translates to $100/bbl Brent with a permanent differential reflective of the increasing demand from undeveloped parts of the world. Over the last 10 years, the Chinese have doubled their per capita consumption of crude. There’s still a huge amount of consumption growth potential there. So, is $40/bbl oil ever feasible again? Certainly on a spike down, but the latest numbers out of the oil sands show that $65/bbl is the break-even number. That might be the floor. However it trades, it’s probably going to be higher than that.
TER: How do the prospects look for oil exploration and production companies (E&Ps)?
FK: North America has seen a wonderful resurgence in oil production due to newer technologies. The shales and tight oil sands that were previously uneconomic at $30, $40 or $50/bbl are exceptionally economic now. Canadian oil production has also increased. Roughly 75% of the world’s crude oil reserves are in the hands of national oil companies, some of which are not friendly to the Western world. That really limits where people can go. My analysis indicated that one of the best places in the last five years for oil exploration has been in South America, in Colombia.
TER: You cover a pretty broad range of companies. Most of these are Canadian companies looking in a lot of places outside of Canada. What are your criteria for companies you want to cover?
FK: I mentioned Colombia, but there are other countries I’m covering, including New Zealand as well as Egypt. I like countries with favorable business climates that are friendly to Western business practices, good fiscal terms and the ability to take money in and out of the country without onerous currency controls.
TER: Besides Colombia, several countries in South America are getting a lot of attention from oil explorers. What is the big appeal?
FK: Let’s start at the bottom end of the spectrum with Venezuela, which has huge natural resources of heavy oil in the Orinoco belt and a government that is extremely unfavorable to Western interests. As a result, Petróleos de Venezuela S.A. (PDVSA), the national oil company, was once producing in excess of 3 MMb/d. About 10 years ago, Hugo Chavez started firing the competent oil and gas people and started replacing them with ones you might call political appointees. As a result, the country’s oil production has gone down. The government also nationalized a number of projects and took away the commercial viability of foreign oil and gas companies to do business there. As long as he and people of his ideology are running that country, as rich as it is in resources, it’s not a place you can do business.
Argentina now appears to be turning in that direction with the nationalization of Repsol-YPF S.A. (REPYY:OTCPK). I cover three small oil and gas companies in Argentina, and I downgraded my outlook for them. As rich as the country is in natural resources, the current government is still influenced by the policies of Peron and is doing some very odd things. Although it’s not a stay-away-from country, it’s much less attractive and that is reflected in the share prices of other public companies involved there.
At the other extreme is Colombia, where I first got involved in 2007. My catalyst at that point was the second election of President Uribe. In many South American countries, you get one president who makes a bunch of changes and then he’s gone after one term. Being around for a second term basically allowed Uribe to institutionalize the first four years of changes. That’s when I thought it was the time to be investing in Colombia.
For many years, people thought about Colombia in terms of Miami Vice and the Colombian drug cartels and missed the fact that the country had been at civil war for nearly 50 years. It has great oil and gas potential with a number of very significant oil discoveries, including Cano Limon, Cusiana-Cupiagua and others. Most of the country was unexplorable because of the problems with the various guerilla groups.
Once Uribe started getting that under control, it became attractive from a security perspective. Also, he recognized that the Ecopetrol contracts of the 1990s had become so onerous that nobody was investing there, so he had the Colombian fiscal regime completely revamped for new exploration blocks. As a result, Colombia has gone from 525 Mb/d in mid-2007 to nearly 1 MMb/d today. That’s nothing short of remarkable given that the government is also looking at potentially 1.5 MMb/d total production in the next five years.
That’s one of the reasons the oil and gas community has focused on it. Many of the oil and gas companies involved in Colombia are Canadian-listed or with Canadian senior management teams. We’re entrepreneurs and we’re all over the world, exploring for oil and gas. Surprisingly, you can count the number of public American oil and gas companies operating in Colombia on one hand. There have been and are a lot more private enterprises still operating in Colombia that are U.S. based, but surprisingly few public ones.
TER: How about Brazil?
FK: Brazil has huge offshore potential. I’m less of a fan of Brazil, and I put it somewhere in the middle of the list because I’m wondering which direction it’s going to head. Brazil dwarfs the rest of the South American economies and is less inclined to have foreign capital come in. There are foreign oil and gas companies operating there, but it has not opened up like Colombia. Because it has so much work to do in the offshore sector, there is some discussion as to whether or not Petrobras (PBR:NYSE; PETR3:BOVESPA) will open onshore production to foreign capital exploitation. I have been watching with great interest what HRT Participacoes em Petroleo SA (HRTPY:OTCBB) has been doing up in the Solimoes Basin. It’s a Brazilian company that went public in Brazil with a number of North American private shareholders.
TER: So what’s higher on your list?
FK: I would rank Peru after Colombia, ahead of Brazil.
TER: Even though there are potential political problems there?
FK: I think that perception has yet to be established. The president has well-documented past socialist leanings but he has kept a number of the key pro-business advisers and government ministers, even civil service people in those positions under a previously more business-oriented government. We are seeing examples out of Peru where things are working just fine.
Gran Tierra Energy Inc. (GTE:NYSE; GTE:TSX) has a working interest in Block 95 in the Marañon basin, which was assigned to it without any timing issues or onerous changes to its oil and gas contract terms. Similarly, Pacific Rubiales Energy Corp. (PRE:TSX; PREC:BVC) is going into Peru now, on a joint venture deal with BPZ Energy Inc. (BPZ:NYSE). While that deal has just been announced and hasn’t proceeded through the regulatory process, indications are there shouldn’t be any issues related to that.
Peru has a very robust mining industry and there have been a bunch of changes to that. It does have a very robust natural gas industry, but on the crude oil side, it is very under explored. Peru appears to be a very good business environment for oil and gas companies. Some people have compared it to Colombia 10 years ago.
Pacific Rubiales remains my top pick and has been for a couple of years. When I first met the management team in Bogota in 2007, they presented the plan for the Rubiales oil field. I’ve seen many business plans come and go and not work out. That is why I’m usually skeptical. My technical background and experience in oil and gas engineering indicated that Pacific Rubiales’ plan could work. Of all of the companies I’ve ever looked at in my career as an analyst, going back more than a decade, this is the only company with a management team that has delivered exactly what it said it would five years ago, virtually on time and on budget from an oil field that is probably going to exceed production expectations as the year progresses.
It has a very strategic thinking team that ran Petróleos de Venezuela S.A. back in the good old days. It also has an enviable inventory of exploration lands in Colombia, and it has been very good or very lucky in finding heavy oil, which it continues to do best.
The joint venture in Peru with BPZ Energy is another very logical example of taking advantage of great technical expertise it gained in Lake Maracaibo in Venezuela, that’s similar to the shallow, offshore water off northern Peru where BPZ’s assets are. I very much like what Pacific Rubiales is doing and can see how 100 Mboe/d today, in five years could be developed into 170 Mboe/d.
TER: What else do you like in that area?
FK: In Colombia, I like Petrominerales Ltd.’s (PMG:TSX) exploration inventory. The company struggled for the last half of 2011 with its exploration program in the Colombian foothills, but over the last couple of months, it seems to be having success. We just need the news on the testing of its more recent wells in the Corcel trend to see if it’s back on track. I like its exploration inventory in the Colombian foothills, where it just finished drilling on a potential high-impact well called Bromelia. It will be testing that over the next two to three months to see if it’s made an interesting discovery there.
TER: You also cover New Zealand, which is an area most people don’t associate with oil and gas production.
FK: I have followed New Zealand’s oil and gas industry for more than 10 years. It has to import the majority of its crude oil because only one-third of its domestic consumption comes from within in the country.
I cover a company called New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX), whose president was the president of the very first company I wrote a research report on as an analyst when I first started. Fortunately, for me, he was successful. Otherwise, I might not be here today. So, when I look at oil and gas companies, regardless of where they are, I always look at the people first. As president, he’s successfully run a number of public and then private oil and gas companies in the last 10 to 15 years. I know that the company management, with him at the helm plus its technical people on the ground in New Zealand, is quite viable.
The company has an enviable position in the Taranaki Basin in New Zealand, the only currently producing basin in the country. I like its land base. I rank it up there with the best of the companies that are operating in New Zealand right now. It has been lucky on its first two wells. It’s producing around 1,000 boe/d, but those wells are limited until it ties in its gas production. It has great conventional exploration potential, and like its next-door neighbor, Tag Oil Ltd. (TAO:TSX.V), which I do not cover, it has a very large land base on the east coast of New Zealand’s North Island, which is potentially oil-shale prone. That could become a very interesting catalyst for both of the companies in the future. Right now, I’m more interested in what New Zealand Energy is doing on its conventional stuff.
TER: What do you see for upside on its stock?
FK: My target price is $4.50, but it’s a highly risked target price based on its exploration inventory. The company has over 20 exploration locations that it could be drilling in the next 18–24 months. Where could the stock go? I have an official target and another number in my mind that might be a double of that. It’s going to depend on its exploration success in the basin in a very underexplored mostly 100% working interest land base. I’ve looked in detail at all the prospects and I have to say it is extremely impressive. Time will tell.
TER: Another couple of areas that haven’t had much publicity or visibility are Egypt and Yemen. You cover a company that’s pretty active in those two countries. What’s going on there?
FK: TransGlobe Energy Corp. (TGL:TSX; TGA:NASDAQ) is one of my favorite names right now. I’ve followed the company for 12 years, so I am extremely familiar with it and its management. I just came back from Egypt where the company ran an analyst trip field trip to update everybody on its properties and operations. Yemen is where TransGlobe got started. TransGlobe situated itself right beside Nexen Inc.’s (NXY:TSX; NXY:NYSE) producing Masilla field in eastern Yemen. It was directly offsetting that with a small amount of production net to it, and then on the western side of the country, right beside existing infrastructure and existing oil and gas. That production net to them, if it was all onstream, which it’s not right now because of pipeline disruptions due to the tribal issues that are ongoing in Yemen, would be about 2,500 bbl/d. The company’s total production today is 17 Mbbl/d roughly. So it’s become much less material to it. At some point in time, it’s going to divest itself of Yemen, but not at this point and, certainly, not when production is shut in. When it’s producing, it spins off really good cash flow. So that’s valuable for it to finance other activities.
TransGlobe got into Egypt about four years ago when it acquired a 2,800 bbl/d field that had been undercapitalized for a number of years, doubling that field’s production to about 6,000 bbl/d over time. It has also made a very significant discovery in a formation that nobody had paid any attention to, which appears to be pervasive throughout the land. Its current production is all on the Gulf of Suez within 10–20 kilometers (km) of the ocean and a very short distance to get the oil to port for export. This has been the focus of its operations, growing that production to about 17 Mbbl/d today.
Egypt just had a bid round, which closed at the end of March. The successful bidders should be announced sometime this summer. The company has bid on all the lands around its current production, which if successful, will really set it up for a lot of future exploration and production potential. Its management team has been very conservative in running the business and it presented its roadmap to 40 Mbbl/d to the analyst and investor community in the trip to Egypt. The company’s current assets are probably good enough to get it to 30 Mbbl/d. With success in the upcoming bid rounds, it’s not a far cry to get to 40 Mbbl/d.
The bid round was mostly focused in the Gulf of Suez region, but the company also acquired a number of blocks in the western desert of Egypt, which is where the big companies are operating—Apache Corp. (APA:NYSE) et al. TransGlobe has two discoveries that are going to be brought onstream—one in the middle of this year and one at the end of the year. And it’s about to spud a very material exploration well in a block that it’s just acquiring that is a 200 MMbbl prospect size. If that’s successful, it changes the game for it all over again. I like TransGlobe because of the management, the prospect inventory and the production potential. I can’t say enough good things about the company and its potential. The stock had been an absolute champ this year since mid-December, until it put out a really good first quarter and the market decided that it didn’t like the company anymore and sold the stock off. I think it’s a very attractive company at this valuation.
TER: Are there any other attractive opportunities that you’d like to talk about?
FK: One company that is an interesting one from an exploration perspective is also operating in South America, but it’s offshore. That’s CGX Energy Inc. (OYL:TSX.V), which I cover and have a $1.85 target price on. It just drilled a dry hole offshore Guyana that cost it $71M. It drilled that 100%. It also partners with Tullow Oil Plc (TLW:LSE) and Repsol in an adjacent block on a well that’s costing $160M, of which it has 25%. It could be one well away from either being a hero or not. CGX has been around for a long time, but it’s drilling in a basin where very few wells have been drilled. Tullow and Repsol are known explorationists, particularly Tullow, which has had great success around the world, offshore in this very same play type. Tullow just drilled a successful well off French Guiana. Now, it’s moved into offshore Guyana in a similar basin with the same play type. Everybody has their fingers crossed, and if this well doesn’t work for CGX, the share price is probably going to be reflective of very expensive wallpaper.
TER: That’s a pretty expensive bet, isn’t it? Even 25% of a $160M well is a lot of money.
FK: Yes, it is.
TER: But on the other hand, the upside is that if it hits, the payback can be pretty quick.
FK: Exactly right.
TER: Based upon what you’re expecting for the oil markets in the coming months and years, what investment strategies would you suggest for playing this market?
FK: It’s been a challenging market, no question. Investors should be looking at oil companies as opposed to natural gas companies, in friendly jurisdictions. I have what I call the five Ps, and I alluded to three of them: first and foremost, people; secondly, exploration prospects; thirdly, production; a very important one is profitability; and lastly, the politics, and how well they’re politically connected.
You can trade Argentinean stocks, but I’m not a fan of actually owning them for a long term. Colombia, I would own long term. It has proven itself to be a very good environment for investment.
Similarly, Egypt is going through real political change. A lot of the things you see on the evening news and the headlines are just that, headline risk. Through the entire Arab Spring last year, TransGlobe did not lose a single day of production. It is being paid on time by the Egyptian government. Egypt relies on three things for its income. Two of those are tourism and oil and gas. So I wouldn’t hesitate, despite the headline risk and the fear, to invest in quality companies in Egypt, particularly TransGlobe.
TER: Thanks for joining us today and for some very interesting ideas.
Frederick Kozak joined Canaccord in early 2007 and has nearly 30 years of oil and gas industry experience in his role as an oil and gas research analyst at Canaccord Genuity. Kozak previously worked as a research analyst at a Canadian boutique investment firm, where he was ranked the #3 Stock Picker for Oil and Gas in Canada for 2005 in the annual StarMine Analyst Awards. Since being at Canaccord, he has added to that award with the #3 Earnings Estimator award for 2009 and the #2 Stock Picker for 2010 for Oil and Gas in Canada, as recognized by StarMine, as well as being recognized by Zack’s Investment Research as being #1 Stock Picker, North America E&P companies. Kozak started his career as a petroleum engineer and has also worked in the oil and gas industry in financial analysis and corporate planning. Kozak holds a Bachelor of Applied Science in geological engineering from the University of British Columbia and a Master of Business Administration from the Ivey School of Business at the University of Western Ontario. He is a registered professional engineer in the province of Alberta.
So the monthly news cycle over the latest dump of labor force data for the Pittsburgh region is pretty muted per the PG, Trib, PBT. Not much to say since the numbers are nominally unchanged and any changes you parse out of it are likely well within sample error or other variations that should not be overinterpreted. Yet again, the state is saying the region’s seasonally adjusted unemployment rate was 6.8% in April. Just fyi the Federal Bureau of Labor Statistics’ calculation is coming in at 6.7% for April.
But here is the bigger deal again. The national news is all about how the labor force participation rate is falling as it has been since the ‘Great Recession’.
Yet here is the region’s labor force in April of each year since 1990.
The monthly Chain Store Sales report will be released today. This report on sales in chain stores gives a look at the health of stores that make up about 10% of all retail sales.
The Challenger Job-Cut Report will be released at 7:30 AM Eastern time, providing an estimate of the number of layoffs in May.
At 8:15 AM Eastern time, the monthly ADP Employment Report will be released. Investors will be watching this number to get advance notice on the state of the job market in advance of the government’s report on Friday.
At 8:30 AM Eastern time, the U.S. government will release its weekly Jobless Claims report. The consensus is that there were 370,000 new jobless claims last week, which would would be the same as the previous week.
Also at 8:30 AM Eastern time, the preliminary GDP report for the first quarter of 2012 will be announced. The consensus is an increase of 1.9% in real GDP and an increase of 1.5% in the GDP price index. The real GDP estimate is 0.3% lower than the advance value for the first quarter of 2012, and the GDP price index is the same.
Also at 8:30 AM Eastern time, the monthly Corporate Profits report from the Bureau of Economic Analysis will be released.
At 9:45 AM Eastern time, the weekly Bloomberg Consumer Comfort Index will be released, providing an update on Americans’ views of the U.S. economy, their personal finances and the buying climate.
Also at 9:45 AM Eastern time, the Chicago PMI Index for May will be announced. The consensus index value is 56.1, which is 0.1 points lower than last month, and is still above the break-even level at 50.
At 10:30 AM Eastern time, the weekly Energy Information Administration Natural Gas Report will be released, giving an update on natural gas inventories in the United States.
At 11:00 AM Eastern time, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.
At 3:00 PM Eastern time, the Farm Prices report for May will be released, giving investors and economists an indication of the direction of food prices in the coming months.
At 4:30 PM Eastern time, the Federal Reserve will release its Money Supply report, showing the amount of liquidity available in the U.S. economy.
Also at 4:30 PM Eastern time, the Federal Reserve will release its Balance Sheet report, showing the amount of liquidity the Fed has injected into the economy by adding or removing reserves.
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So Japan, which is spending heavily for post-tsunami reconstruction, is growing quite fast, while Italy, which is imposing austerity measures, is shrinking almost equally fast.
There seems to be some kind of lesson here about macroeconomics, but I can’t quite put my finger on it …
Krugman is, of course, referring to that well-known macroeconomic principle known as the “you-will-become-ridiculously-wealthy-if-you-dump-your-capital-in-the-ocean” principle. It’s a close cousin to the “become-ridiculously-wealthy-by-burning-your-capital-to-the-ground” principle, which actually the basis of modern financial planning, wherein investors are encouraged to buy houses and land, then render them uninhabitable by completely scorching them, which then leads to wealth untold.
Oh wait; it doesn’t. In fact, increased GDP growth is not a good thing unto itself, especially if the growth comes on the heels of replacing destroyed capital (though it should go without saying that, ceteris parabis, it’s better to experience GDP growth in the aftermath of capital destruction than to experience non-growth or shrinkage). Quite simply, it is always a net negative to have capital destroyed, and that the destruction of capital is indicative of a net loss of wealth. Thus, replacing what was lost, while good for GDP growth, is a contra-indicator that simply implies that a great loss has taken place.
Krugman once again shows himself to be a complete idiot, and wholly undeserving of the Nobel prize in economics. The broken window fallacy was debunked over 160 years ago, and yet Krugman has apparently never read it (which means he’s ignorant) or it means that his allegedly superior intellect is simply too undeveloped to draw the same conclusion on its own (which means that Krugman is stupid). Either way, Krugman is not to be trusted for advice or analysis.
Remember when the steel industry rated local news?
The 24 hour news cycle can be brutal. Just beyond greater Pittsburgh, but near the center mass of Cleveburgh is Trumbull County, Ohio… home to Warren, Ohio and part of the Mahoning Valley were these two stories recently:
24 hours ago the headline was: Valley employment picture improving
Then a half day later:Over 1,000 RG Steel Workers to be Laid Off. All of those 1,000 jobs are located in Trumbull County, a county with a total population just over 41K in 2010.
No schadenfreude here… those headlines were de rigeur here we all know. Still, the recent news for Pennsylvania is that mass layoffs.
and while some say steel in the greater region is still improving, there are some bigger issues on the horizon. Steel is ever more an internationally traded commodity. Just yesterday the US slapped tariffs on steel imports from India. Whatever the details are in that trade spat, the bigger issue that will only exacerbate the problems of domestic steel producers is the continued appreciation of the US dollar. Stronger dollar = harder for US producers to sell products elsewhere. It is a particular issue in the steel industry.
Aaron Kennon, co-founder and CEO of Clear Harbor Asset Management, shares some of his company’s trade secrets in this exclusive interview with The Gold Report. Educating yourself is critical before investing, and Kennon suggests questions to ask, what specialized knowledge your adviser should know and why small-cap and junior resource equities are offering surprisingly thrilling returns.
The Gold Report: Clear Harbor Asset Management actively invests in resource equities, and it’s doing so during one of the most bearish periods ever for resource equities, particularly for small-cap resource equities. Some institutions are leaving the space altogether while others are reducing their exposure. What are your plans?
Aaron Kennon: While the resource benchmarks have all suffered significantly over the last several years, Clear Harbor’s natural resources strategy has returned more than 58% since inception 27 months ago. This compares to an approximately 4% return by our benchmark, which is the Standard & Poor’s Global Natural Resources Index. We’re thrilled with this performance and believe that our team is well positioned to take advantage of investment opportunities in a more proactive fashion while the vast majority of investors remain either defensive or rattled. So our plan is to stick to our disciplined, value-oriented approach to the sector and continue to perform well for our clients.
We have also constructed a strategy where the majority of our securities are listed and operated outside the U.S., with approximately 50% of the positions representing small-cap companies. This contrasts with most of our competitors, who are forced into the mid-cap and large-cap segment of the market due to the size and scalability of their investment strategies. Clear Harbor has no intention of backing away from this sector, which has long been a specialty for us. There are too many attractive investments and too many compelling macro tailwinds. From the rise of the global middle class to the future population expectations to the undeniable fact that the world is embarking upon the most expansive monetary experiment of all time, resources are an essential component for any investor’s portfolio.
TGR: You said most of the equities that you invest in are based outside the U.S. Do you have anything in China?
AK: Our position in Eldorado Gold Corp. (ELD:TSX; EGO:NYSE) represents our only natural resources investment in China at the moment.
TGR: Are you employing new or different strategies to counteract or even take advantage of the risk-off sentiment in the resource space right now?
AK: Yes. Some companies in the sector possess more cyclical risk than others. The larger, more diversified resources companies capture the general cyclical trends in the market but do not have as much business-level risk imbedded in them, whereas many of the smaller-cap companies significantly outperform or underperform due to geological or operational success. We attempt to balance both of these risks in the portfolio and adjust our strategy based on shifts in company-level valuations and macro risks. Our strategy provides us with the flexibility to shift from resources equities into the actual commodity, which some other strategies do not have. In an environment where we believe that equities could experience significant stress, we have the ability to lighten up on our gold mining exposure and perhaps allocate that capital into bullion, or shift from the mining sector altogether to agriculture or oil and gas. Of course, we can also maintain cash when we deem appropriate.
TGR: Could you break down the asset allocation inside Clear Harbor’s Natural Resources Strategy?
AK: One third of the portfolio is in the metals and materials sector, just under two thirds is in the energy sector and the remaining piece represents agriculture.
TGR: Has that changed over the last year?
AK: The allocation has remained relatively steady.
TGR: Many analysts will tell investors that they need to do their due diligence before investing in junior resource plays, but that’s very easy to say and much harder to do.
AK: Due diligence is critical when analyzing the investment merits of a junior resource company. We always try to meet with management teams and determine their knowledge base and try to glean an understanding of their past successes and failures. We also seek to determine a company-level valuation based on existing and future resource potential. A drilling program at the junior exploration level can either kill a project or expand its resource potential and legitimize management’s vision for the company. This speaks to the geologic risk and, therefore, the investment risk that is inherent in a junior company.
TGR: Are there some rules of thumb that you apply to your due diligence?
AK: There are several. A few that immediately come to mind are: quality and flexibility of management, appreciation of the capital markets and valuation of the stated and prospective resource assets. The ownership structure is also of interest to our due diligence. Does management own equity? If so, how much?
TGR: Do you have a geology background? Do you like to look at the core?
AK: I’ve looked at lots of core. I do not have a geology background in an academic sense, but I spend a good deal of time on the ground with geologists. For example, when I was in Argentina recently, we had an opportunity to travel with a geologist from one mining company to the other, and he was extraordinarily helpful in connecting geology to an investment thesis.
TGR: These days, geologists can put numbers into computer models to build preliminary economic assessments and NI 43-101 technical reports. But these models often don’t take into account things like structural controls in terms of geology and other nuances of a deposit. As a result, are these mines not performing to the levels put out in prefeasibility and even feasibility studies?
AK: It varies. I make sure that there is a good deal of geology knowledge at the company level but also a respect for and an understanding that, at some point, an exploration program needs to go from being a science project to potentially a business model that can return value to shareholders. Part of my job as a portfolio manager is to find companies that have people at the top who can merge those critical components.
TGR: While you were in Argentina, the country’s government nationalized Repsol YPF SA (REP:BMAD), a division of a Spanish oil company. What was your reaction to the news?
AK: While this was a significant event for the country and the capital markets, my initial reaction was not one of shock but of disappointment. The government’s decision follows a pattern of contempt for foreign creditors. With that said, some of the largest companies in the world continue to wade into the country and accept the political risks. Apache Corp. (APA:NYSE) is increasing its capital expenditures in the country by 20% to $300 million (M). In my opinion, the Argentine government will find it challenging to seek out international partners to operate and expand the YPF resource in production. That will lead them to conclude that what occurred in this particular instance should not apply to other resources companies in the country in the future.
TGR: How does this compare to Venezuelan President Hugo Chávez seizing the assets of a number of oil contractors there as well as the Crystallex International Corp. (KRY:TSX) gold mine?
AK: Time will tell. YPF was once a publicly owned company, owned by the Argentine government before it was privatized and sold to Repsol in the 1990s, so the YPF nationalization was justified through several lenses: populism, colonial angst and national pride. The Argentine government recently aired a commercial that presented the history and identity of Argentina as firmly entwined with the history of YPF: former Argentine President Juan Perón, the Argentine flag, a crowd of children waving flags and a YPF gas station choreographed together in this television commercial. I’m not sure the government could pull off a similar ad displaying McEwen Mining Inc. (MUX:NYSE; MUX:TSX; MAQ:TSX) or Minera IRL Ltd. (IRL:TSX), for example.
TGR: While in Argentina, you spent time with Rob McEwen, the former CEO of Goldcorp Inc. (G:TSX; GG:NYSE). McEwen had remarkable success building Goldcorp into a top-tier gold producer, now the second largest gold company in the world. After he left Goldcorp, he started U.S. Gold Corp. (UXG:TSX; UXG:NYSE) and that performed remarkably well for shareholders as well. Then he took a large position in Minera Andes Inc. (MAI:TSX; MNEAF:OTCBB), and the two companies came together to form McEwen Mining. How did he react to the news of YPF being nationalized?
AK: He didn’t panic. He is a seasoned mining executive who has had to assess political, geological and execution risk on many occasions in the past. I’m sure he was disappointed, but he continues to believe there is good reason to maintain a significant presence in the highly prospective Santa Cruz province of Argentina.
TGR: Apache is there, and it is going to up its investment by 20%. On the gold side, Goldcorp is there. McEwen is there. AngloGold Ashanti Ltd. (AU:NYSE; ANG:JSE; AGG:ASX; AGD:LSE) is there as is Pan American Silver Corp. (PAA:TSX; PAAS:NASDAQ). For silver, Coeur d’Alene Mines Corp. (CDM:TSX; CDE:NYSE) is there. Does the presence of these companies provide you with a measure of security in some of your Argentine investments?
AK: Certainly. These global players see the rewards in this region while also recognizing the risks. A junior investor should welcome their activity in the region. Juniors may seek partnerships with the larger players that have significant cash reserves and a desire to grow production in the coming years. Approximately 10 companies are actively exploring, developing or producing in this province. It remains a largely untapped opportunity, and that always attracts me as an investor.
TGR: This is a growing theme in this space that countries, especially in South America, continue to nationalize resource-based assets. It seems like it’s only going to get worse before it gets better. What makes it get better?
AK: We don’t see the core natural-resources countries in the region moving in this direction. Chile, Peru and Colombia are the other South American countries that remain on our radar screen. These three governments and their respective jurisdictions all function in their own unique way, but we do not see a thesis that what has occurred with YPF, for example, applies to the entire mining sector.
TGR: But Peru withdrew a mining permit from Bear Creek Mining Corp. (BCM:TSX.V). And there’s across-the-board resource nationalization via higher royalties and ownership stakes.
AK: Santa Cruz is a tundra, a desert-like environment with very few people and very little surface water. Peru has mountainous areas, ravines and the potential for mining activity to interfere in a negative way with the natural environment and local populations. We need to be careful not to confuse a removal of a permit for environmental purposes and local concerns with a true interference of government due to a desire to nationalize and retain capital within the country.
TGR: Apart from the Santa Cruz province being rather isolated and lightly populated, what else makes it a point of destination for mining companies seeking precious metals?
AK: Santa Cruz is vast but has significant infrastructure—roads, electricity—and also a meaningful level of collective mining knowledge on the ground there, both local and international. Most important, the geology appears exceptional by global standards. It was untouched by the mining industry until the mid-to-late 1990s. In other South American countries there are hundreds of years of artisanal mining. While San Juan has more history with mining and energy, Santa Cruz is in just the first years of what should be several decades of significant exploration and production success.
Larger producing mining companies with clean balance sheets and cash to put to work want to seek out mining companies in this capital markets environment that are on the verge of developing their mines, have already started to develop or are just in the process of producing. The geology is critical, but considering the stage of mine development may be an interesting strategy right now. A mid-stage or predevelopment-stage company is a multibillion-dollar company’s acquisitions sweet spot right now. In this challenging capital markets environment for the junior space, there may exist very interesting opportunities for the majors.
TGR: Are you buying companies, with that thesis in mind?
AK: Yes. The geology is exceptional, similar to Nevada in the mid-1800s: outcroppings, very little activity. This is a geologist’s and a gold miner’s paradise. And we’re not day traders in our strategy; we like to make investments, establish relationships with management and see a return on our capital over time.
TGR: You’re saying buy-and-hold can still work in this space.
TGR: What is the typical hold time?
AK: It’s significantly above the average holding period for a typical natural-resources strategy, particularly in the junior space. Greater than two years. Our strategy is only 27 months long, and many of the positions that were in the strategy on day one are still there today.
But we also look at every position objectively. We’re not beholden to the notion that every position needs to be a long-term holding. If the facts change, if management changes and we do not like the direction of the investment, we will change course as well.
TGR: What are some of your positions in precious-metals equities in Argentina?
AK: The positions that we own at the firm level that have exposure to Argentina are Minera IRL and Argentex Mining Corporation (ATX:TSX.V; AGXMF:OTCBB), but we have several names on the radar screen that we’re still doing work on: Extorre Gold Mines Ltd. (XG:TSX; XG:NYSE.A; E1R:FSE), Mariana Resources Ltd. (MRY:TSX; MARL:LSE) and McEwen Mining.
TGR: Why did you decide to take a position in Minera IRL, a small, precious metals–focused company?
AK: Minera IRL is an interesting company not only because it is a small cap that is under the radar screen of many investors, but it also represents the characteristics that an acquirer ought to look for in its business model: It has some existing production. It has a huge land resource. It has geographical diversification. It is active in Peru as well as in Argentina—it has production in Peru and is about to build an open-pit mine, Don Nicolas, in the Santa Cruz province. I am impressed with operational management, its geology knowledge base of the area and its willingness to be creative and nimble. The team is highly motivated and organized. It seems to communicate extraordinarily well and work well together across cultures, experiences and skill sets.
TGR: Argentex is developing its Pinguino silver-gold project in the Patagonia region of Santa Cruz province. What do you make of that deposit?
AK: The risk-reward profile of Argentex is different than that of Minera IRL, but I still think it’s a compelling profile. It has a resource estimate coming out this quarter, which should prove up the highly prospective nature of its resource, which is a silver resource. This is an asset that is trading at $0.10–0.12/ounce. The company has a bit of cash. It is drawing down about $200,000/month. It has probably $9.5M cash on its balance sheet. I am particularly impressed with the chief geologist over there, Diego Guido. He is also a professor at University of Buenos Aires and has access to other interesting perspectives within the geology space.
TGR: That stock is down about 20% this year. Does that make you nervous, when you see a company sliding 20–25% in less than half a year?
AK: We bought it about 30% lower than current prices. So it’s down on a year-to-date basis, but it’s a recent acquisition for us. So we’re actually quite pleased with where it is at this juncture. I think it speaks to who we are here at Clear Harbor Asset Management, which is a group of patient investors, and it also speaks to a little bit of luck.
TGR: Is that one of the things that you’re doing right now, seeing a lot of value out there and cherry picking some of the low-hanging fruit?
AK: Yes. There is some exceptional low-hanging fruit in the mining space at the moment. If you look at any sort of multiple across the space, cash-flowing gold mining companies are trading at historically extraordinarily cheap multiples. There are lots of reasons for that. One is the general nature of capital markets at the moment. Another one is disbelief that we’re going to see gold prices remain at current levels and perhaps go higher. Third is the historic transition of capital from the equity gold mining space to exchange-traded funds. There’s a significant opportunity to take advantage of these prices and carefully allocate capital across companies that you’ve done your work on and companies that represent different risks: country risk, perhaps geology risk to some extent and the risk of some being development stage, others being exploration stage and others being operational stage. Having a diversified portfolio is also important at this juncture.
TGR: Eldorado Gold, with an asset in Brazil, tried very hard to buy Andean Resources Ltd. (AND:TSX; AND:ASX), but Goldcorp ultimately won that auction. Do you believe that Eldorado will attempt at some point to reenter Argentina?
AK: Perhaps. It now is integrating the European Goldfields Ltd. (EGU:TSX; EGU:AIM) acquisition. This is a very talented management team. This is a group of people that has outperformed expectations over the last several years. To the extent that it integrates and moves the Turkey plans in the right direction, it wouldn’t surprise me if we see it dabbling in Argentina.
TGR: Are Argentex and Minera the only two in which you have positions in Argentina?
AK: Yes, but we are doing some additional work and believe that if someone is looking to allocate capital to the country based on the thesis that the YPF scare is overdone, you want to look not only at Minera IRL and Argentex but also look at Extorre, Mariana Resources, Mirasol Resources Ltd. (MRZ:TSX.V) and McEwen Mining.
TGR: Do you have some parting thoughts on the space at large?
AK: The capital markets are going to continue to challenge the juniors. This is an extraordinary time to be in the driver’s seat with capital and to allocate selectively to compelling investments, not just in Argentina but around the world.
TGR: Thanks for your time.
Aaron Kennon serves as chief executive officer of Clear Harbor Asset Management and is a member of the firm’s Investment Committee. Prior to co-founding Clear Harbor, he was a portfolio manager at Ingalls & Snyder LLC where he managed multi-asset class securities portfolios for institutions and high net worth individuals. Prior to joining Ingalls, Kennon worked at the Royal Bank of Canada and Citigroup Inc. Kennon is a graduate of Yale University.
The Mortgage Bankers’ Association purchase index will be released at 7:00 AM Eastern time, providing an update on the quantity of new mortgages and refinancings closed in the last week.
The Challenger Job-Cut Report will be released at 7:30 AM Eastern time, providing an estimate of the number of layoffs in May.
At 7:45 AM Eastern time, 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 Eastern time, the weekly Redbook report will be released, giving us more information about consumer spending.
At 10:00 AM Eastern time, the pending home sales index for April will be announced. The consensus is that the index increased 0.5% last month.
The number of PhD recipients on food stamps and other forms of welfare more than tripled between 2007 and 2010 to 33,655, according to an Urban Institute analysis cited by the Chronicle of Higher Education. The number of master’s degree holders on food stamps and other forms of welfare nearly tripled during that same time period to 293,029, according to the same analysis. [Hat tip.]
There have been some that have proposed that the current surge in college costs is not proof of a bubble, but rather the natural byproduct of college’s sorting function. (I think I first heard this proposal at Foseti’s.) If that were the case, it doesn’t make sense that holders of advanced degrees are having difficulties getting good jobs, since the natural purpose of sorting is to take the best and brightest and put them in the best positions.
The theory of sorting makes its case on the grounds that colleges are largely meritocratic—a dubious claim at best, though true relative to colleges of, say, fifty years ago—and that they can be trusted to determine the best, brightest, and most dedicated. Naturally, employers cannot perform direct testing for this, mostly because those sort of tests are racist, and so they need other proxies. The meritocratic elite just so happen to provide those proxies.
Unfortunately, the sorting theory of higher education is untrue because the reality does not follow the model: namely, those who have earned high educational honors and degrees aren’t more employable or working the better jobs. Thus, if college is supposed to sort people, it has obviously failed, as evidenced by the fact that holders of advanced degrees are 300% more likely to receive food stamps now than three years ago, while US citizens in general are only 43% more likely (see linked article above.)
Funnily enough, there is a model that would generally predict this occurrence, and it is the bubble model, which posits that wages for holders of college degrees will decline as the supply of holders of college degrees increase, which is a direct result of government intervention into the market, particularly through the expansion of cheap credit and direct subsidy. Low and behold, this has come to pass, mostly because the bubble model has better predictive power than the sorting model, and is thus more correct.
Since we’re on the subject of college degree holders, I’d like to point out as an aside that the idea that degrees aren’t real property because they aren’t transferrable is partially false. It is true that one student can’t sell his credentials to another student, but it should also be noted that students aren’t the only ones who use the credentials they earn. Employers also use student credentials by hiring employees who have certain credentials. While they don’t “transfer” credentials per se, it is observably true that when someone switches jobs, the people employing their credentials also changes as well. Given that there are signaling elements to college credentials (as evidenced by every guidance counselor that ever repeats the trope that college grads do better on the job market because they’re college grads), it should be plausible that there is a type of transference that exists with college credentials, except that is at the employer level, not the possessor level. Incidentally, this conceptual model reinforces the idea of a college bubble since it suggests that there can be diminishing marginal returns to adding one more college educated participant to the labor market, thus driving down wages.
Gold and silver began a correction nine months ago, but shares of the mines that produce these valuable metals have suffered in a much more exaggerated fashion. Mine2Capital Co-Founder and Partner Alka Singh has prospected for ideas that she believes will maximize shareholder value when the markets turn upward in the relatively near future. In this exclusive interview with The Gold Report, Singh delivers her best junior ideas, and she also sweetens the story with a handful of more liquid names that she recommends in a fear-driven and uncertain environment.
The Gold Report: In early 2009, gold began its ascent that lasted for two and a half years until it began to correct at the beginning of September 2011. What were the issues that caused the rise, and what caused the correction?
Alka Singh: Gold prices have actually been on a rise since early 2002, but you are right that the last leg up started about two and a half years ago. The issues that led to the rise were that countries were printing money to finance themselves.
Gold is considered a safe haven, but the issue that gave rise to the correction is mainly the Eurozone concern—in Greece, Spain, Portugal, Italy and Ireland. Equity markets appear to be stabilizing as a consequence of quantitative easing in Europe, the U.S. and China and the apparent easing of concerns in Greece. This liquidity has forced interest rates down, pushing investors into riskier instruments, including equities, which in turn has lowered perceptions of default risk. The markets appear more confident, hence gold’s attractiveness as insurance is fading.
Also, as the euro was depreciating, a lot of money moved from euros to U.S. dollars, and we did see improving economic numbers from the U.S., which strengthened the U.S. dollar. Because gold is priced in U.S. dollars, gold started declining as the dollar appreciated. There’s another factor: India and Vietnam increased their excise and import taxes on gold, which also curbed demand for physical gold. India is one of the largest consumers of gold, so that had a big impact on the gold price as well.
TGR: Physical gold prices and gold mining equities appear to be disconnected. I’m looking at the Market Vectors Gold Miners ETF Trust (GDX:NYSEArca), which contains producers. It’s down 23.5% over the last 12 months. I’m also looking at the Market Vectors Junior Gold Miners ETF (GDXJ:NYSEArca), which is down 46% over the past 12 months. But spot gold is up 6.7% during that same period. Why the disconnect?
AS: A lot of times there is a disconnect between commodities and equities. Even though gold is up 6.7% over the last 12 months, Junior Gold Miners ETF is down 46%. This disconnect is due to two factors: 1) gold equities are driven by the general market and 2) gold miners have not only commodity price risk but also operational risk and geopolitical risk depending on where their assets are located.
Why juniors underperform seniors when gold prices are going down has something to do with the nature of the junior miner sector itself. When gold prices are going down, the gold producers—the seniors—are already mining and selling the gold and making profits. So investors prefer to hold the gold producers rather than the junior explorers. Let me also say that when the prices of the commodity are going down, investors would rather have their money in more liquid names, which are generally the large caps.
TGR: Let’s go to silver for a moment. Spot silver is down about 18% over the past 12 months while the Global X Silver Miners ETF (SIL:NYSEArca) is down 26% during the same period. The performance differential is not nearly as wide between silver equities and physical silver as it is between gold equities and physical gold. What does that tell you?
AS: Pure silver companies are scarcer than gold companies, which is why I think that the disconnect between silver and silver equities and gold and gold equities is different. You and I can name lots of gold companies. However, pure silver companies are much fewer in number.
I also think that silver has more upside potential than gold. If you look at the historical price ratio of silver to gold it’s about 16:1, but that ratio is very, very wide right now, about 56:1. And, even at $1,575/ounce (oz) gold price, I think silver should be at $98/oz. So, I think that there is a disconnect between silver and gold prices as well, and I don’t expect gold to come down to make that historical ratio closer to 16:1.
TGR: What is your current theme in regard to precious metals miners?
AS: Well, presently I think investors should definitely take a look at the more liquid large-cap gold and silver names but keep their eyes open. And, at any sign that the market for the juniors is turning up, they should have their top three or four junior gold and silver names that they would like to own. I think the situation is very similar to what happened in 2008 when the juniors were trading at cash value, if not below it. By the time Q1/09 came, the junior miners were up and in some cases over 60–70%. So, I think there will be a very fast turnaround as well for the junior space.
TGR: Alka, you said investors should first go with the more liquid names. Is that right?
AS: For right now, given the market volatility, I would go for more liquid, larger-cap names for the short term, yes.
TGR: What would those larger, more-liquid names be?
AS: Well, for the larger, more liquid gold names I would probably go and invest in Goldcorp Inc. (G:TSX; GG:NYSE), Barrick Gold Corp. (ABX:TSX; ABX:NYSE), Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) and Eldorado Gold Corp. (ELD:TSX; EGO:NYSE). Eldorado is one of my favorite names in the mid- to large-cap gold space. Those are the types of companies I would own right now before jumping into the junior space.
TGR: Now let’s go ahead and talk about some of the juniors that you are recommending for investors.
AS: One of my gold names is Atacama Pacific Gold Corp. (ATM:TSX.V). I have liked the company for the last two years, in fact, since it came out with its IPO. Atacama’s Cerro Maricunga has exposure to a large gold asset, which is rapidly increasing in size in the Maricunga Gold Belt in Chile. It is a single-asset vehicle with simple metallurgy, a near-term catalyst and a seasoned management team plus high leverage to gold price. The phase 3 drilling program is almost complete. There is also a new zone discovered to the east of the main trend. It’s still early days there, but it looks like it has some potential. The company still has $30 million (M) in cash, and the Cerro Maricunga gold project currently has a resource estimate of 1.6 million ounces (Moz) gold in Indicated and an additional 2 Moz in the Inferred category. We expect this to go over 5 Moz. And, this is all oxide gold mineralization, which has lower capital expenditure (capex) requirements and lower operating costs and risk.
TGR: You mentioned catalysts.
AS: The near-term catalysts at Cerro Maricunga would be more drill and metallurgical test results; a preliminary economic assessment, which will be completed and released any time now; and an NI 43-101 compliant resource estimate that is expected in late-July/early-August.
TGR: Alka, I note from a company presentation that insiders own 42% of the company. How does that compare with other companies in the $175–200M market-cap range?
AS: That’s a great question, and the reason I like this company so much is that the insiders have a lot of conviction in the deposit and in the company. Yes, they own over 40% of the shares. Gold Fields Ltd. (GFI:NYSE) and Kinross Gold Corp. (KGC:NYSE) together own about 16% of Atacama. So, there are not a lot of shares floating that can be traded. So, it’s a thinly traded stock, but I like the fact that management has its own skin in the game. Not a lot of juniors in this market-cap range have 40% or even close to that much insider ownership. This is a plus for Atacama for sure.
TGR: Go ahead with another pick.
AS: Another junior gold company is Volta Resources Inc. (VTR:TSX), working in western Africa. Early in May the company released a prefeasibility study on its Kiaka gold project in Burkina Faso, and a feasibility study is due in Q2/13. The company has almost 4 Moz gold in reserves. Volta will be drilling 105 kilometers and continuing to grow Kiaka. It is also finding higher grades in the Kiaka South area, which should improve the economics of the project a lot. It also has other exploration projects in Titao and Nassara. The near-term catalysts for Volta would be when it comes out with more drill results from Kiaka South and also drill results for other exploration areas close to Kiaka. The company has a very good management team and a very good asset.
TGR: What about political risk in this region? Is this a safe jurisdiction?
AS: Burkina Faso is a safe jurisdiction. There were some issues regarding labor late last year and earlier this year, but it’s a very safe, democratic country. The mining laws are similar to Ghana, which is one of the largest gold producers in Africa. And, Burkina Faso right now is about the fourth largest gold producer in Africa.
TGR: OK, what about another company?
AS: It’s Timmins Gold Corp. (TMM:TSX.V; TGD:NYSE.A), which is already in production. The reason I like the company is because there are some short-term catalysts, which should drive the stock higher. It is planning an expansion of the mill from 14,000 tons per day (tpd) to 18,000 tpd this year, which would take gold production up to about 130,000 oz; by the end of 2012 Timmins will again expand the mill to 32,000 tpd, which will take the production to 150,000 oz per year. One of the main reasons I like Timmins is because it is cash-flow positive, and it has production growth. Another good thing is that operational improvements have increased recoveries up to expected levels. Timmins was getting low recoveries, and investors were afraid that they would not reach the feasibility level. But recoveries have gone up to the 58–68% level, which was the expected recovery rate.
TGR: Does the company have visibility on its exploration prospects?
AS: It does, and it has another project that is close to Goldcorp’s Peñasquito project. Management has done some geological mapping and some grab samples. There is some good exploration upside there.
TGR: Alka, Timmins shares have had higher relative strength next to some of its peers, and I wonder if the valuation is as compelling as some of these others?
AS: The reason current valuation is better than most of the other juniors is because it’s in production and has positive cash flow, and that’s one of the reasons why investors like it. They can also see the ramp up to gold production growth over the next few years.
TGR: What about silver? We broached that earlier.
AS: Yes, and I would like to talk about Levon Resources Ltd. (LVN:TSX.V; L09:FSE; LVNVF:OTC) because we do have a silver theme as well. I just initiated on Levon, and I really like the company’s Cordero asset, which is geologically similar to the Peñasquito mine that Goldcorp is putting into production in Mexico. It has over 500 Moz silver in resources, and we expect a new resource estimate any time now. I expect that to increase the resource estimate by at least 10–15%. I have modeled the company, and I think that right now it is trading at very low levels. It has over $56M in the bank. So, it’s a junior name, but it has one of the best undeveloped silver deposits in the world. I believe the discount that the market is attributing to these shares right now is unreasonable; it is one of the better junior silver names out there.
TGR: The valuation does indeed sound unreasonable considering that the company has an $80M market cap with $56M in cash.
TGR: With that amount of cash, it should not have to dilute out investors.
AS: I don’t think so. It has enough cash to last another four years, and CEO Ron Tremblay is very conscious about diluting shareholders as well. I don’t expect to see much dilution.
TGR: Do you feel that the zinc and lead prospects can reduce silver cash costs significantly?
AS: Yes, Levon has a lot of zinc and lead production, which will lower cash costs significantly. I expect the cash costs would be around $3.75/oz silver. If not for the zinc and the lead, it would probably be over $7–8/oz.
TGR: Could you give me another name?
AS: I would like to talk about another junior name, Probe Mines Ltd. (PRB:TSX.V). The reason I like this company is because of its flagship Borden Lake project with a 3.4 Moz gold discovery in Ontario, Canada, a mining-friendly jurisdiction. At the end of April, IAMGOLD Corp. (IMG:TSX; IAG:NYSE) acquired Trelawney Mining and Exploration Inc. (TRR:TSX.V), which is also in Canada. I think that IAMGOLD was driven by the fact that Canada has much lower political risk than some other countries where it has mines. Probe has slightly lower grades but still a big resource number of about 3.4 Moz at 1.02 grams per ton. It also has some higher-grade zones, and it proved to have enough volume with the potential of lowering the capex, and that will make the project less sensitive to the gold price.
TGR: With a $73M market cap, Probe has the highest relative strength of all the juniors that I’ve looked at over the past month. It’s up 11% over the past four weeks. All I see is red ink/negative returns everyplace else. What was the issue here?
AS: Basically, Probe is a story that everybody likes. It’s in Ontario, and the recent acquisition of Trelawney has helped the stock as well. People do look at it, and they can see the upside potential. But again, I would say that people should be aware of the risks that juniors have sometimes.
TGR: Because silver and silver equities have more upside in your opinion, could you talk about one more silver name?
AS: Apogee Silver Ltd. (APE:TSX.V) is a silver name with a small market cap of $25M. But, that valuation doesn’t speak about the good quality projects it has in Bolivia and Argentina. In this volatile environment, people are afraid, and they are in cash-preservation mode. Investors are just afraid of political risk with Bolivia, given that some countries have tried to nationalize assets. The market is very tough on juniors right now, but I think all this fear is a bit overdone. Apogee has a nice little silver deposit that could actually be built and even fast-tracked into a mine. This company is doing all the right things, but the market is not helping. I like both the assets the company has.
TGR: Back last September you told us that you had a $1.25 target price on Apogee. That would be something like a 1,300–1,400% return from current levels. Do you still feel as bullish about the company?
AS: Well, I still feel that the company has a lot of potential. Obviously things have changed. Silver prices have since then come off of where they were at $45–50/oz. There is a lot of value in the stock at $0.09. I would buy as much as I could and just sit on it until the market turned and easily make 200–300%.
TGR: You told us before that you expected Apogee’s production to grow from 2.6 Moz in 2014 to over 4 Moz in 2017. Does that still sound right?
AS: That is still right. The only issue is I think companies are just afraid of spending all that money on capex; however, the capex for the Apogee project is not that high, and I’m still expecting the production to grow that way.
TGR: Alka, thank you. It’s been a pleasure talking with you.
AS: Thank you, George. I have enjoyed it, too.
Alka Singh started her career as a mining research associate with Wellington West Capital Markets in Toronto. Since then she has worked for Orion Securities and Merrill Lynch in Canada. She then moved to New York City to build the mining franchise for Rodman and Renshaw, where she covered 24 precious metals, base metals and uranium names. Singh has since started her own independent research firm, Mine2Capital, to provide unbiased research for clients. She holds a Bachelor of Science in geology and a Master of Business Administration in finance and is a CFA charter holder.