Chen Lin has gotten so much attention for his investment success, new subscribers to his newsletter, What Is Chen Buying? What Is Chen Selling?, have to line up on a waiting list. Luckily, he sat down with The Energy Report to share some of the investment ideas that helped his portfolio climb 63% in 2012. Learn how Lin played price differentials and dividends to create outstanding gains in a challenging year, and what his moves for 2013 may be.
The Energy Report: Chen, what’s your economic and market outlook for 2013?
Chen Lin: In the past few months, China seems to have turned the corner as its real estate market started to turn up, and so goes its economy. I believe the U.S. will likely do well. I don’t see the EU breaking up in 2013, and Japan is going to be printing a lot of money this year to try to jumpstart its economy. So although I see slow global economic growth, it’s still growing, especially in China and the U.S. I believe the stock market can do quite well as investors have been piling into bonds and cash in the past a few years.
TER: Oil prices have recovered from their lows of last year, but Brent is much stronger than West Texas Intermediate (WTI) and closer to its March peak than WTI. What’s your forecast at this point?
CL: I see relatively stable oil prices. There will be a lot more oil coming from U.S. shale plays. However, the pipeline to the Gulf will be limited and the United States has a ban on exporting oil. We are likely to see a lot of oil coming from Oklahoma to the Gulf Coast. However, the oil has to be refined at the Gulf Coast because it cannot be exported, so the new pipelines will likely push down Louisiana Light Sweet until it sells at a sizable discount to Brent, which could create some interesting opportunities for refiners on the Gulf.
TER: How do you view the domestic versus international production arenas in terms of investment potential? Where do you see the best investment opportunities in 2013?
CL: I’ve been really focusing on international onshore plays in the past few years and will continue to do that. International companies can get the Brent price. Domestic producers are usually shale or offshore plays with high capex. Capital is very hard to get, especially for small companies, so that’s why I’m focused on international onshore players. The geographic area I’m mainly looking at is Southeast Asia and onshore Africa, because those are areas in which China is likely to make more acquisitions.
Last year was very difficult and many juniors were hit very hard—it reminded me of 2008. I see potential on the other side of the trade, where most investors are going to cash and bonds and avoiding risk. Maybe investors are getting ready to take on more risk. That’s got me quite excited for 2013 and I’m continuing to watch the market for opportunities to arise.
TER: What are the global implications of China’s aggressive oil and gas acquisition plans?
CL: I think China’s acquisition strategy is twofold. One is its focus on North America, mostly in Canada, where the primary goal is to understand fracking technology and see if it can be applied in China or elsewhere. The other focus has been on Southeast Asia and Africa, which can be very beneficial to juniors. We’ve seen some M&A activity there and I expect to ride the wave and hopefully take advantage of that.
TER: Has your investment strategy changed at all as a result of developments over the past six months?
CL: Not much, but I have started to look a little at some more risky junior plays because investors have been extremely risk-averse. This is a good time to start looking at them more closely.
TER: You recently closed your newsletter to new subscribers. What was the reasoning behind that?
CL: My newsletter has been getting a lot more popular lately and I really hate to see stocks swing a lot on my recommendations. In an ideal world, stocks should only rise and fall on their own merits and not on my recommendation. So I decided to close it to new subscribers so our existing subscribers could have a better chance to make profitable trades. We are allowing people to go on a waiting list if people drop out.
TER: Do you feel that investors need to be more trading-oriented in order to profit in the energy market these days?
CL: Personally, I’m a pretty long-term oriented investor, but recently the market has been so rough I’ve been forced into taking more of a trader approach. I really enjoy working on long-term winners and energy companies that can be self-funded are extremely attractive. I have quite a few very long-term plays I’ve been in two or three years and still holding. I’m hoping the market will stabilize a little so we can have longer-term trades, but I do short-term as well.
TER: When you talked with us, midyear 2012, your portfolio was up somewhere between 40% and 50% for the first half of the year. How did you do overall for 2012?
CL: My partner, Jay Taylor, tracked it at about 63%. There’s a retirement account without any leverage or option trading, which was intentional. I was fortunate to do very well over three main areas in 2012: energy, mining and biotech. Actually, my biggest winner in 2012 was in biotech. Sarepta Therapeutics (SRPT:NASDAQ), which I discussed in The Life Sciences Report not long ago, has actually returned 15-fold in the call option trade. We also made a few very profitable trades in metals and mining; for example, we bought gold and silver stocks and ETF call options just weeks before QE3, which we sold on the QE3 news market swing. I also did quite well in the energy sector.
TER: What were your best performers last year in the energy sector and are you going to be sticking with them?
CL: I was heavily invested in Mart Resources Inc. (MMT:TSX.V) and Pan Orient Energy Corp. (POE:TSX.V) at the end of 2011. I will continue to be bullish on both stocks and those continue to be my heavy holdings. In terms of Mart Resources, we will likely see dramatic increases in its production when it finally builds out its pipeline. Oil production could easily double, if not triple, after the pipeline is built, so I expect the dividend increase to follow. Right now it’s paying about a 13% dividend. I would expect to see a much higher dividend after the new pipeline goes in.
TER: And when do you expect that will be built?
CL: The company guidance is for the second half of 2013.
TER: And where is Mart trading these days?
CL: It’s trading at $1.76 in Canada, $1.80 in the U.S. It paid $0.20 in total dividends in 2012 and it’s been a big winner. I started buying the stock at $0.15–0.16. I expect the dividend should be relatively stable because the cash flow is just incredible. The risk is that it’s in Nigeria and subject to some political risk. But if you can look beyond that, the stock has a very bright future. China recently made an acquisition in Nigeria paying about $23 per barrel (bbl) oil, so you can see that the upside is very significant. Most recently, Mart announced initial results for the UMU10 well. These new discoveries at deeper zones will not only increase the reserve and production, it may even carry an additional tax holiday that can be very beneficial to Mart shareholders.
TER: What’s going on with Pan Orient?
CL: This year will be the most exciting in the company’s history. It’s a producer in onshore Thailand. It has prepared for the past five years to explore some big targets in Indonesia as well as Thailand and will start drilling this month. There was an excellent article written by Malcolm Shaw, a retired Canadian fund manager. Seldom in my trading career have I seen this kind of risk/reward, and if you ask me which stock I think would have the greatest chance of becoming a tenbagger in 2013, I would say, without a doubt, it would be Pan Orient.
The beauty is it has so much cash on the balance sheet and no debt. It has fully funded all its exploration and doesn’t need to dilute shares. By the end of the year, it should still have a lot of cash left. Management consistently bought shares in the past. Even in the worst-case scenario, the downside is very limited and the upside is very big. Also, I want to say that the Chinese company, Hong Kong and China Gas Co. Ltd. (3: HK), bought the Pan Orient legacy oil field last year for $170 million ($170M), and has been looking for more assets. If Pan Orient makes new discoveries, we have a natural buyer right there to buy them and reward shareholders. That’s why I’m very excited about this one. I purchased the stock a year ago and it has much more room to run. I believe the run for Pan Orient has just started because it takes many years to prepare that groundwork, get approvals, do the seismic and then finally start drilling this year. I’m very excited about the stock.
TER: What other names have been good performers in the last year?
CL: Another stock with a nice return that is still undervalued is Coastal Energy Co. (CEN:TSX.V). It’s offshore Thailand so development is always slower than onshore; fortunately the wells are inexpensive to drill. I wouldn’t put it in the same category of Mart and Pan Orient. I’ve been trading it in and out since the stock was trading at a few dollars. Last year when an Indonesian company proposed to buy Coastal, I sold out all my shares. I told my shareholders to sell on the surge and then when the takeover failed, I bought back, at a much lower price. I’ve been trading in and out of this one.
Another stock I’ve been trading in and out of, so far successfully, is PetroBakken Energy Ltd. (PBN:TSX). It pays about a 10% dividend right now on its Bakken play. It’s quite undervalued if you compare it with its peers. I just bought it back recently after making a 50% return in the last round a year ago. Hopefully, it will rally from here. Many traders like to trade by the chart, which sometimes ignores the fundamentals. I often put “opposite trades” in place to take advantage of market swings.
TER: Do you have any sleeper names that are maybe due to take off?
CL: Porto Energy Corp. (PEC:TSX.V) was probably my major loser in the energy portfolio last year. Porto is an example of my risk-taking. When George Soros closed his position of Porto at $0.07 last summer, I decided to take advantage of it and told my subscribers that I became one of the largest shareholders. My calculations at that time were if its ALC-1 well were successful, the stock would be a tenbagger. If not, it’s still worth a lot of money. But the well was a failure. The stock is still trading at $0.06, so it’s really verified my calculation. You can see the risk/reward was in my favor and, in the future, if this kind of situation arises, I would do it again. But right now, looking at a $0.06 stock, I think it’s still very undervalued.
I had a long discussion with management not long ago. As a large shareholder, I proposed to management to take a look at the current tax-loss carryforward situation. Porto spent over $100M in Portugal and has over $100M in loss carryforward in Portugal. That could be worth a lot of money to its partner, like Galp Energia, which is a $10 billion Portuguese national oil company. Galp can take advantage of that loss and could translate easily to $0.20–0.30 per share. Management told me that they would take that into consideration and they are still in the middle of discussions with Porto to drill two or three wells this year. Those wells will be critical to the company’s future. The silver lining is that if all the wells fail this year, Porto may still have the option to sell to its partner, which may be able to use the loss carryforward on the balance sheet. I like this kind of a situation.
TER: So it may still be a winner for investors.
CL: Possibly. The risk/reward is in my favor, which also tells you how undervalued many resource plays are. The market has been in extreme conditions and Porto is just one example. There are so many undervalued plays out there that I am looking at right now.
TER: Does Porto have enough money to be able to do exploration work on its own?
CL: The two to three wells it plans to drill will be completely on the partner’s money, so it’s kind of a win-win situation for both.
TER: So it doesn’t have to go out and try to raise more money in the foreseeable future.
CL: Exactly. Management owns a lot of the stock and has been very careful about dilution.
TER: Do you have any other situations that look particularly attractive?
CL: A couple of weeks ago I took a position in a refinery play, which is a recent IPO called Alon USA Partners LP (ALDW:NYSE). Its parent is Alon USA Energy Inc. (ALJ:NYSE). Alon USA Partners is a master limited partnership that’s based on a single refinery in the Permian Basin. The Permian Basin right now has huge oil production and there’s a big spread between the local oil—West Texas Sweet—and Brent. Management is guiding about a $5.20 dividend for 2013. Right now the stock’s trading about $22. That means the dividend will be over 20% in 2013.
People wonder what happens if, in the long run we have all the pipelines built in the next 5-10 years. Alon USA Partners LP should still have an advantage because it would be more like a pipeline company. Why? Because it can take oil locally instead of piping all the way to the Gulf Coast and then it can refine that into gasoline and sell locally instead of piping the gasoline from the Gulf Coast. Basically, its margin will be the pipeline cost to pipe oil over and then pipe gasoline and diesel back. It should have a double-digit dividend, even after everything’s settled. Right now we’re looking at a huge dividend, more than the guidance by the company, which is $5.20 for 2013. It hasn’t announced yet, but some analysts are expecting over $2 in dividends for Q4/12—just in one quarter for a $22 stock.
TER: That’s pretty amazing.
CL: It’s a very nice dividend play. Also, Alon U.S.A. Energy owns about 82% of U.S.A. Partners. If you calculate the value of the shares it owns, it’s more than U.S.A. Partners’ whole market cap, which is absurd. Alon U.S.A. Energy also has another refinery in Louisiana that can take advantage of Louisiana Light Sweet, which will go down to the Gulf of Mexico later this year or next year, when the pipeline is built. So to value the rest of the assets to negative is really absurd. I own both companies.
TER: There’s hardly been any refinery capacity built in this country in many years so any company with a refinery is in a pretty good position.
CL: Plus, refineries are closing down on the East Coast and in California because they’re not making money because Brent is so high. The U.S. has the Jones Act, which forbids foreign tankers from shipping oil from one U.S. port to another. After Hurricane Sandy, they had to suspend the Jones Act. All the light sweet going to the Gulf of Mexico cannot go anywhere, which is just absurd under the existing laws.
TER: You’ve given us some really good ideas and follow-up, Chen. Thanks for joining us today.
CL: Thank you.
Chen Lin writes the popular stock newsletter What Is Chen Buying? What Is Chen Selling?, published and distributed by Taylor Hard Money Advisors, Inc. While a doctoral candidate in aeronautical engineering at Princeton, Chen found his investment strategies were so profitable that he put his Ph.D. on the back burner. He employs a value-oriented approach and often demonstrates excellent market timing due to his exceptional technical analysis.
When it comes to supply and demand dynamics, Aheadoftheherd.com Publisher Rick Mills does his own math. China may make a show of its alleged copper surplus and Germany may downplay its need for efficient energy sources, but Mills foresees demand spikes in a number of specialty metals. In this interview with The Critical Metals Report, Mills discusses the positions he’s establishing while looming supply shortages remain under the mainstream radar.
The Critical Metals Report: Let’s talk about specialty metals that present opportunities for investors. What’s on your radar screen?
Rick Mills: There are several metals that we’ve taken for granted because the prices are low, such as nickel and uranium. I shake my head that copper is only $3.50/lb. A lot of what’s going on in copper can be extrapolated to the other metals as well.
Let’s start with capital expenditures, or capex. Mining is definitely one of the more capital-intensive businesses. There are large, upfront costs for construction of the mine. As the low-hanging fruit has been picked, companies have to go off the map to find deposits in remote areas with lower grades and more complex metallurgy. There is little to no infrastructure, so it can cost from $5 billion ($5B) to $9B to build today’s mine.
TCMR: That’s true of any metal you might mine.
RM: True enough, but some metals are more supply-side challenged than others. Operational expenditures are also continually increasing. These are day-to-day costs of operation—wages, tires, fuel and camp costs for employees. The average capital intensity, or the capacity to produce 1 ton (t) copper, for a new mine in 2000 was $4,000–5,000 ($5K). Today, capital intensity is north of $10K/t on average for a new copper project.
Some projects that are $5.5B are going to produce 60,000 tons (60 Kt) copper per year. Do the math; capital intensity numbers are scary. Capex costs are escalated because declining copper ore grades mean a much larger relative scale of required mining and milling operations, and a growing portion of mining projects are in remote areas of developing economies where there is little to no existing infrastructure.
TCMR: Could the declining growth of China, which is probably the world’s largest consumer of copper, be contributing to a slowdown?
RM: China recently published figures saying that it has 1.9 million tons (Mt) copper in its inventory. It brought over a bunch of analysts and showed the copper all stacked up, the stacks leaning over and the ground compressing. The analysts came away suitably impressed that China has too much copper when, in fact, nothing could be further from the truth.
China has 1.9 Mt copper. About half of that would be in the supply line somewhere. It’s going to be used. China usually keeps around 600 Kt as a rainy day fund. The bottom line is China needs 50 Mt copper during the next several years. If you needed that much copper, what would you be doing? What kind of games would you be playing if you knew you had to buy it in the open market? You’d be telling everybody that you had way too much. Let’s face it: China needs copper. It’s going to grow 7.7% this year. It has been growing at an average rate of 9–11%/year for 20 years.
TCMR: How does an investor capitalize on increasing copper demand and shrinking copper supply?
RM: Do you invest in an off-the-map area in a geopolitically risky country? I don’t. There’s enough risk in this sector without purposely increasing it. I also want something that’s high quality yet small enough that capex and opex are not going to be a killer.
I look for a company that turns the negatives, the increased capex/opex, the increasing resource nationalism, the increased environmental regulation, etc., into nonexistents. One on my radar is VMS Ventures Inc. (VMS:TSX.V) There’s little risk of resource nationalism on the Reed Lake deposit in Canada. Its well-funded partner, HudBay Minerals Inc. (HBM:TSX; HBM:NYSE), operates several mines in the area. One of them is going to be closing shortly, so the skilled people will become available. Reed Lake is a high-quality deposit. It’s underground, but it already has infrastructure in the area. It already has the mill and the processing facility. Financing is not going to be a problem. Permitting is not going to be a problem because most of it is already permitted. The area is a well-known mining camp. I don’t see any operational issues. There’s little risk from environmental groups and/or labor.
It’s an economically attractive project, because the risk has been removed. The cash flow for VMS is about $100 million (M) over the present mine life. It’s a very attractive position for investors to start taking as this company is going into production next year. It will pay back its partner HudBay from its first year of production. In 2015, VMS is going to have an enormous amount of money in its coffers.
TCMR: Is it still exploring?
RM: Yes, the company is exploring the area around the mine and will drill from underground, trying to increase even further the size of the deposit, and VMS will shortly be releasing its winter drill plans on its 100%-owned projects.
TCMR: VMS’ stock is trading at $0.19 with a $23M market cap. To what do you attribute the lag?
RM: The best time to buy a junior is when it’s still exploring and hope it makes a discovery, or secondly, just before it puts out its first NI 43-101 or just before it goes into production. We’re in that period of time now when there is not really a heck of a lot to report. It’s that quiet time in front of production and its winter exploration program.
TCMR: What other metals are suffering supply shortages?
RM: Investors should be looking at nickel. It’s present in more than 3,000 different alloys used in more than 300,000 different products.
About 65% of nickel is in alloy with chromium and other metals to produce stainless and heat-resisting steels. Another 20% is used in noncorrosive and super alloys. About 9% is used in plating and 6% is used for other uses, such as in coins, electronics and nickel-hydride batteries in cellular phones. Then there are nickel-cadmium batteries to power cordless tools and appliances.
The U.S. Department of Energy is funding research and development of renewable energy sources. That is expected to expand the use of nickel. It’s quite interesting what they’re discovering as new uses and increasing the old uses of nickel.
Nickel used to be produced from laterite deposits. When the Sudbury sulphide nickel camp was discovered in Canada in the early 1900s, it completely dominated global production.
The problem is that nobody is finding those large sulphide deposits anymore. We’re going back to laterites, which are big, layered deposits of often a billion tons or more located close to the surface. Unfortunately, they necessitate different metallurgical applications and recovery processes for each zone or layer.
The processes have enjoyed a highly mixed performance record and can be extremely expensive. It’s a little different for each deposit. A lot of the companies are having major problems with the metallurgy. Because it’s lower grade, they have to go with that economy of scale.
Because the laterites are caused by weathering of ultramafic rock, they typically occur in equatorial zones. That means that a lot these deposits are located in the sketchier countries that carry heightened geopolitical risk versus the sulphides, which seem to happen in places like Greenland and Canada. The same thing that happened with copper is happening to laterites, with capital intensity shooting through the roof. Here’s what’s happening to a few of the deposits many are counting on for future global nickel supply:
Vale S.A.’s (VALE:NYSE) New Caledonia project, which used to be called Goro, is many years behind schedule. It’s almost become the bad boy poster child for problems with one method of nickel mining technologies, HPAL (high pressure acid leach processing). Sumitomo Corp. (8053:TKY; SSUMF:OTCPK) and Mitsui & Co. Ltd. (8031:TKY) have reduced their participation. Vale has problems in its Onca Puma project. It doesn’t even have a return of production yet. It shuttered its Frood mine.
Xstrata Plc (XTA:LSE) has increased the capex at its Koniambo project due to growing labor costs from competition from the oil and gas sector for an extremely limited labor pool on a very remote island. Its first pour was supposed to be earlier this year, but there has been no news from it. Xstrata has closed its Cosmos mine.
BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) has been trimming costs at its Australian operations.
Anglo American Plc (AAUK:NASDAQ) closed its 17 Kt/year Loma de Níquel mine due to disputes over mining concessions.
TCMR: With mines slowing down or shuttering production, have we seen any increases in the basic commodity price for nickel?
RM: The nickel glut is nonexistent and nickel is going to rally. There is no doubt nickel has been the worst-performing metal lately. However, BNP Paribas is now forecasting a much smaller-than-expected supply in 2013. It has cut its projection three times since April. Credit Suisse and Citigroup have lowered their forecasts. They’re saying nickel is going to average 15% more in the second quarter than now.
TCMR: Where can an investor find companies with deposits that are cheaper to process in areas without jurisdictional and geographic problems? How can an investor participate in the nickel market if there’s this kind of a looming shortage?
RM: One of the reasons market watchers are paring the supply forecasts is because all of these projects are falling behind schedule. The market balance is much tighter than everybody, except apparently me, has been predicting. There are a lot of operations and capacity that have run into various issues. Investors have to figure out which companies don’t have these problems.
One that doesn’t have these issues is North American Nickel Inc. (NAN:TSX.V). It owns a nearly 80-kilometer trend of historical nickel mineralization in Greenland. It has done a small drill program this year to start to define one of its almost 80 targets and had some very encouraging assays come back. It is going to be able to put together a much larger program and get at it next year.
The company is well backed by The Sentient Group and a large institutional player. VMS Ventures owns 26% of its shares and doesn’t want to be diluted; financing is not going to be a problem. This is a company in which an investor can start to take a position and slowly increase it, knowing that there is some time to work on it.
TCMR: Are there any other metals that you want to talk about today?
RM: One that investors are missing the boat on is uranium.
TCMR: What’s your take on uranium stocks right now?
RM: The question is: When do you buy? We talk about this all the time. It’s when nobody else is buying, when the herd doesn’t love it. That fits uranium pretty well right now. The fact is that investors aren’t paying attention to what’s going on on the supply side. The demand side is going to increase. Japanese reactors are off-line. Germany took its reactors off-line almost overnight. Chinese demand slowed as they do some serious safety studies.
Fukushima put a dark cloud of negative sentiment over the entire industry. Demand fell through the floor. People were worried, and rightly so. Everybody was watching the spot price. Utilities weren’t buying; they were sitting on the sidelines, waiting for prices to come down.
China has released its new nuclear energy plans. It has moved toward safety. Any reactors currently under construction will be allowed to continue, but the new reactors will have to use the third-generation technology, the European Pressurized Reactor or the AP1000.
This is a huge boost for the demand side. China has 12.5 gigawatts (GW) in operation with 26 GW under construction. It wants 40 GW in nuclear power by 2015 and to reach 80 GW by 2020. China is back in the market. Yes, the Germans are going to sell, but now we’re finding out that Japan is reopening its nuclear reactors, and I have no doubt it is going to build more.
TCMR: And Germany?
RM: Germany is totally green-washing the world. The monkeyshine coming out of Germany today is off the wall. It is importing more and more nuclear-produced electricity from Holland, the Czech Republic and France than it ever was. It touts itself as a poster child for green energy, yet its industry is suffering and leaving in droves because of blackouts or brownouts and the high cost of electricity. Germany is sucking up nuclear-generated power, just not from reactors on its own soil.
A lot of people don’t know that Germany is currently building 23 new coal-fired power plants because it is worried about the increasing costs of electricity and its industry leaving. If you can’t do business because of brownouts and blackouts, you’re going to move to where you can get a steady supply of electricity.
Germany opened a $3.4B, 2,200-megawatt (MW) coal-fired power plant just in August. Instead of the 15 t of carbon dioxide (CO2) the old ones vomited, these new ones, which are 10% more efficient and burn only the cleanest coal ignite, still pump 13 Mt CO2 into the atmosphere. In just one year, this coal burner is going to generate more CO2 than Germany’s entire nuclear fleet would have over 20 years. Germany’s “green energy” plan doesn’t work; the country can’t afford to be without nuclear energy and it’s very obvious that Japan can’t, either.
TCMR: Let’s talk about uranium companies that you like, Rick.
RM: Nuclear power is not going away. In fact, it will increase exponentially. Mine supply is at $40/lb spot price. You need $70–85/lb incentive price to get new mines going. And then it takes 10 years to get a uranium mine up and running.
Let’s focus on the U.S. The U.S. uses 55 million pounds (Mlb) uranium per year. It produces 4 Mlb. Where is the U.S. going to get its uranium? There are two companies that are going into production right away. I’m not going to mention a certain name because I don’t like being negative, but one of the companies might not make it. Apparently, there are some sage grouse nests on its property. We’re going to save the birds.
TCMR: Which one will go into production?
RM: The one that’s going to make it into production next year is Uranerz Energy Corp. (URZ:TSX; URZ:NYSE.MKT) in Wyoming. It is fully permitted. It is building the pads for the first deep disposal well, which should take several months. Then it will need to build a second. The Nuclear Regulatory Commission has to do an inspection. Remember, this is the first uranium mine that’s been opened in the U.S. since 1996, so the NRC’s going to be very thorough. It will probably take about a month to complete the inspection. I expect Uranerz, barring any inspection delays, to be in production by the end of July 2013. It has two offtake agreements already signed at a much higher price than spot. It has Cameco Corp. (CCO:TSX; CCJ:NYSE) doing its processing. It is going to be producing 600–800 Kt/year yellow cake. It’s in-situ leaching and the company is the world’s leading expert on it.
TCMR: I really enjoyed our conversation.
RM: It’s been a pleasure, thank you.
Richard (Rick) Mills is the founder, owner and president of Northern Venture Group, which owns Aheadoftheherd.com, as well as publisher, editor and host of the website. Focusing on the junior resource sector, Mills has had articles appearing on more than 400 different publications, including The Wall Street Journal, Safe Haven, The Market Oracle, USA Today, National Post, Stockhouse, LewRockwell, Pinnacle Digest, Uranium Miner, Beforeitsnews.com, Seeking Alpha, Montreal Gazette, Casey Research, 24hgold, Vancouver Sun, CBS News, Silver Bear Cafe, Infomine, Huffington Post, Mineweb, 321Gold, Kitco, Gold-Eagle, The Gold/Energy Reports, Calgary Herald, Resource Investor, Mining.com, Forbes, FN Arena, UraniumSeek, Financial Sense, GoldSeek, Dallas News, VantageWire and Resource Clips.
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While the markets have been on edge for the past year or so and have left most investors bewildered as to what to do next, portfolio manager and author John Stephenson thinks that the course is set for higher gold prices. In this exclusive interview with The Gold Report, Stephenson explains why he thinks we will avoid a worldwide economic crash and how the continuing QEs and foreign government bailouts will push more investors into the gold and mining share markets as gold moves above $2,000/ounce. He also talks about some of his favorite gold mining names that should be good vehicles to profit from this move.
The Gold Report: Since you last spoke with The Gold Report in January, we’ve had a seemingly self-feeding cycle of expectations, plans, bailouts, lack of results and back-to-the-drawing-board. Do you see any ultimate resolution to the world’s economic dilemma, or will we somehow just muddle through, or have to go through an actual crash of some sort?
John Stephenson: I think we’ll basically muddle through from here. We’ve had several important developments over the last few weeks. The Federal Reserve’s Quantitative Easing 3 (QE3) $40 billion program targeting mainly mortgage securities has the potential to move the needle. There was a big rally to risk assets when that was announced but that has faded somewhat. The other huge thing is the announcement by European Central Bank (ECB) President Mario Draghi that he would defend the euro at all costs. Later he talked about a bailout plan called the Outright Monetary Transactions (OMT) program that would involve unlimited purchases of sovereign debt for up to three years. The devil is in the details and it may not get implemented in the way the market interpreted it, but nonetheless, that was very positive.
Then the Bank of Japan turned positive with its stimulation of the economy. Lastly, China announced a ¥1 trillion stimulus program directly linked to real infrastructure. So, we think that with the ECB, the Fed, and to a lesser degree the Bank of Japan and the Chinese, we have a very promising case for a slow upward grind in the market. I think the Armageddon or crash scenario has essentially been removed from the marketplace and stocks and commodities are biased higher in this environment. Is it going to be a resumption to robust growth? No, because the West, primarily Europe and to a lesser degree the U.S., still have slow growth ahead as consumers deleverage and as the economies get back on track.
TGR So, basically, the world got ahead of itself in this big race to develop, and all it really did was mortgage its future. Now it’s having to pay back the mortgage.
JS: I think that’s absolutely right. People took out these big bets on real estate, mainly in countries like Spain, Ireland and the U.S. As a result, we had bubbles forming in much of the world, in sunny places where people wanted to retire like Florida, Nevada and California. The same is true in Europe, whether it be Spain, Italy, Greece, etc. So, real estate became the flavor de jour over the last decade or so and we’re still dealing with the overhang and will be for some time.
“Things are looking better in the U.S. and housing prices and consumer confidence is turning up.”
Things are looking better in the U.S. and housing prices and consumer confidence is turning up. I think the Fed has done a great job of getting the economy going. Is it perfect? No, far from it. We still have far too many people unemployed in the U.S. Nonetheless, it’s looking a lot better than it was a couple of years ago. So, that’s the good news and the silver lining. In time we can work our way out of these problems. And, that’s why I’m a little more optimistic than pessimistic right now.
TGR: The other big asset class is obviously stocks. Have the markets turned into little more than a big poker game with mainly short-term maneuvering and no real long-term investment strategy, or is this about all that most investors can do in this market environment?
JS: You’ve keyed on a couple of important things. I would say the markets certainly appear somewhat range-bound; I don’t see much more upside going forward. We’ve had a good run with the S&P 500, up 16% year-to-date. The Toronto Stock Exchange is up roughly 4%. The Canadians have lagged and it’s harder to find good value out there. Markets are trading around 12½ to 13 times next year’s earnings, which is not that expensive, historically. But, the problem is the things that seem to be working, the dividend paying stocks, are getting to be quite a crowded trade.
And, I think the other thing that’s happened is many people have been sitting on the sidelines waiting to get involved. You see that in mutual fund flows, where in spite of the very strong returns on the S&P 500, equity funds have had net outflows for almost all of the last 52 weeks that have been going mainly into fixed-income. Investors are scared and don’t know what’s going on. They see the pain, at least in their neighborhood or their community, with high levels of unemployment and lack of hiring. All the cheerleading out of Washington and even out of Wall Street just can’t overcome that things are still tough. But, the reality is, at least by the numbers, that things are starting to improve. Ultimately, that’s a good thing. And, it will be very good for equities going forward. I think we just need to see unemployment start falling before some enthusiasm returns in the space.
TGR: So, people just need to feel better about taking a little risk, and right now they’re just parking their money and doing nothing?
JS: I think that’s right. People run back to the safety of U.S. government debt when they start worrying about the bigger problems out there, like Europe and to a lesser degree China. They would rather just get a return of capital then a return on capital. But, once rates start going up, bond funds will start losing money and maybe they’ll rethink their strategy and perhaps go into equities where there seems to be some growth. At that point in the cycle, I think you’ll see a reversal, which will be good for equities and potentially good for commodities as well.
TGR: So, next month you’ll be speaking at the big World Money Show in Toronto. What’s going to be the theme in your discussions?
JS: The talk is titled “Booms, Busts and Bailouts.” I think that’s what we’re experiencing globally and we’re going to see these rallies as news is unveiled about another round of quantitative easing—we’ll probably have QE4 and QE5 before all is over. Then we’ll have little busts as some of these issues disappoint. It wasn’t too long ago that Spain didn’t look as if it was going to approach the two European bailout funds for help. Now it looks as if they may. So, you’re going to have these mini-booms and mini-busts for the next year at least and maybe well into 2014. The banking sector in Spain is one of the current issues of concern, so we’ll be talking about that. We’ll also be talking about the slowing in China and the potential problems looming in Japan around the corner. There’s lots to talk about and I’m expecting a great turnout. We look forward to seeing as many of you there as possible.
TGR: It seems that everybody has been banking on China to carry the rest of the world. Has that been more hope and expectation then reality?
JS: China is a developing economy and some countries, like Australia, are much more linked to China because of iron ore demand and prices that have tumbled down to $88/ton from close to $200/ton. So, it’s been a tough year for many of the bigger mining companies, like BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) and Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK). China can only do so much, which Chinese officials have been saying for years. They’ve also been saying for years that they want slower growth and are concerned about a potential housing bubble on that gold coast. The Shanghai, Hong Kong and Beijing markets are now showing domestic inflationary worries, primarily over food, even though China’s inflation is down to about 2% from around 6%. China matters now primarily as a commodities consumer. The rate of change is toward slower growth economically, which is bad for commodity prices generally. The good news is that it’s trying to stimulate and there’s lots of room for that. The problem is that it’s going to have to do all of that in order to light a fire under commodities.
TGR: In connection with that, Australia’s Resources Minister, Martin Ferguson, was quoted a few days ago saying that he thinks the global boom in commodity prices is over. Is he taking the Australian perspective in the iron ore market or do you think he’s right overall?
JS: I don’t think he’s right overall. He’s probably right as far as base metals and maybe iron ore are concerned. If you talk about other metals, like gold, I think he’d be much more bullish about it. Oil has a very bullish case unfolding because the days of low oil prices are dead and gone. So, I think it’s really an Australian view. But, I think it’s fair to say that the best days for commodities may be behind us, although it’s certainly not universal. We’ve seen some very strong moves also in the grains over this period of time. Of course, with the exception of wheat, it’s not really a market that Australia is dominant in. So, I think he’s talking up his book or talking down his book, as the case may be.
TGR: On the other hand, Merrill Lynch just came out with a projection for gold to hit $2,400/ounce (oz) by 2014, based on QE3 and what may follow. That seems to be a pretty optimistic price projection from one of the big names in the investment business, if you compare that to where the Dow would go on a 35% move—18,500. It seems as if they may be being overly optimistic. What do you think?
JS: I tend to agree with you. Could I see $2,000/oz or even $2,100/oz gold? Absolutely. It’s fairly realistic to think that might occur in the next four to six months. The argument for gold is really that it is a currency and a hedge against the debasement of fiat or paper currency. But, in reality, that’s not what’s happening on the ground. The Fed is doing what it can but it’s not increasing the money supply. All it is doing is buying up bonds, creating deposits at the Federal Reserve that member banks can access. The commercial banks are increasing their reserves, but until they start lending, there’s really no multiplier out in the market and therefore the money supply isn’t growing. Can it? Yes, but it depends on the credit health of Americans getting better, which thankfully it is. So, hopefully, we’ll start seeing more lending and more spending in the economy, but right now that’s not the case.
TGR: We’ll have to see how realistic its projections are because Merrill Lynch is talking about all the way into 2014.
JS: That’s a long way. We’ll be a couple of more Money Shows down the road before we see on that one. Investors should look for higher gold prices but I think $2,000/oz is probably a more realistic target, within 6 to 12 months.
TGR: Turning to the companies in the mining business, obviously the majors would get the first crack at investor money. What do you like these days in the majors?
JS: One of the most attractive majors right now is Barrick Gold Corp. (ABX:TSX; ABX:NYSE). It’s dirt-cheap and has really been weak for many years. It now has a new CEO, an internal guy who’s focusing much more on operations to run it like a real business with a portfolio management approach. Mines will have to compete for capital. There’s going to be an emphasis on total return, with shareholder dividend payments and repaying some of the debt.
“I’m a little more optimistic than pessimistic right now.”
It also has this African Barrick Gold Plc (ABG:LSE) piece. It could spin that out with the likely buyer being a Chinese gold company or an arm of the Chinese government. Barrick is now a focused company and the largest gold producer in the world with so much potential upside. Once people see that higher gold prices in the $1,800–1,900/oz range are here to stay, with many years of quantitative easing coming, then I think this will be the go-to name for generalist investors and big mutual fund complexes.
TGR: What else do you like in the majors?
JS: Kinross Gold Corp. (K:TSX; KGC:NYSE) is another great name that’s finally turned the corner. It has a new CEO named Paul Rollinson and there’s a management change coming on. Kinross has a big asset in Mauritania called Tasiast, which Kinross has essentially bet the farm on. The new CEO has decided to take a wait-and-see approach there, after the previous CEO bet his whole reputation on it. It’s a major project but the grade is relatively low and we’re finally seeing a more realistic communication with the Street. The stock has come off because of concerns over management, the project feasibility and the large capital expenditure required. With this more measured approach, Kinross’ valuation is dirt-cheap.
I also highlight Newmont Mining Corp. (NEM:NYSE) as a good larger-cap name.
Among the midtier players, Eldorado Gold Corp. (ELD:TSX; EGO:NYSE) is a name that I would highlight as a good buy. It’s had some hiccups in Romania where the government tried to tear up an environmental permit on its fully permitted Certej project. It does have production coming from several areas: China, Turkey, Greece and Brazil. It has disappointed investors in the last year, but is now well positioned as a lower cost producer.
The other midtier name worth talking about is Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE). This is a company that is growing its production and producing almost 300,000 oz. It’s operations in Brazil, the Chapada mine, and the Mercedes mine in Mexico have done better than forecast. Yamana is one of the names that probably has the best growth in the midtiers. We like it because it’s been consistently meeting or outperforming expectations.
“The argument for gold is really that it is a currency and a hedge against the debasement of fiat or paper currency.”
Claude Resources Inc. (CRJ:TSX; CGR:NYSE.MKT) is a name that was causing some worry for its shareholders for a while but it looks as though it is managed to be fairly cash-flow positive on its Seabee mine in Saskatchewan. It doesn’t really get any credit for its prospective properties—the Madsen project in Red Lake and the Amisk in northern Saskatchewan. Its balance sheet has improved and I think this is one that new money can go into and get a little bit of upside in.
TGR: Claude goes back into the early 1980s, as I recall.
JS: It’s a survivor. It’s been in these near-death situations several times and has been able to ride them out. Management is great and I think this is a name that many small-cap investors could look to.
TGR: Do you think it’s going to take $2,000/oz gold before people start getting really excited about the smaller explorers, or are we in an age of a hundred survivors and a whole bunch of little derelicts floating around?
JS: We could see a little culling of the herd because financing has dried up for them. Capital is a huge problem and many of these guys are reluctant to sell production forward to someone like Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) because they feel that they’d be selling away their future.
I think investors are still skeptical about the strength of the gold market. Although the actions of the Fed, the ECB and the Bank of Japan, acting in concert, are providing a good tailwind for the sector, many gold companies have had high costs and have disappointed investors for some time, so they’ve lost a bit of institutional following.
My suggestion to investors is to concentrate first on some of the bigger players that are also cheap relative to historical multiples. They’ve started to get a bit of a lift finally in the last month or so. Then, once you make a little money on those larger-cap names, you can look to the juniors that have survived and gone through some of these hiccups. Chances are those survivors are going to be around for a while longer.
TGR: So, what’s your takeaway position on how investors should approach the current market?
JS: I think you’ll certainly get lots of upside if Merrill Lynch and people like First Asset are correct, that gold will go higher. There’s plenty of time to start picking away at some of these smaller names. Many of them are going to be news-flow driven. Valuations are certainly cheap. You just want to be careful to pick a few of the winners that will be survivors and are going to be able to hang through the tough times.
TGR: How has your First Asset portfolio performed since we last talked?
JS: We’ve done well with a lot of them. We have Barrick Gold Corp. and Yamana Gold and they have been terrific. IAMGOLD Corp. (IMG:TSX; IAG:NYSE) is another one we like a lot that’s been good for us and is still extremely cheap. One of the smaller names we’ve done well with in the past is Osisko Mining Corp. (OSK:TSX). Detour Gold Corp. (DGC:TSX) is looking good as well, as more of a development play at this point. We’re starting to warm up to the bigger-cap names that I mentioned, such as Barrick. We’ve previously has good success with Goldcorp Inc. (G:TSX; GG:NYSE) although I’m a little worried about some of the grade issues at Red Lake. This is one to keep on your radar screens, but it’s not necessarily anything you need to buy today.
TGR: Well, there are a few good names to consider and things are looking reasonably optimistic from here. Thanks for checking in with us, John, and let’s keep our fingers crossed until next time.
JS: I look forward to it.
John Stephenson is a senior vice president and portfolio manager with First Asset Investment Management Inc., where he is responsible for a wide range of equity mandates with a particular focus on energy and resource investing. He has been recognized by Brendan Wood International (BWI) as one of Canada’s 50 best portfolio managers for the past three years. He is the author of The Little Book of Commodity Investing (John Wiley & Sons, 2010), which has been translated into five languages, and Shell Shocked: How Canadians Can Invest After the Collapse (John Wiley & Sons, 2009), and writes a free bi-weekly investment newsletter, Money Focus, which reaches a global audience of more than 125,000.
Stephenson is regularly quoted by Bloomberg News, Reuters, The Associated Press, The Wall Street Journal and The Globe and Mail and is a frequent guest on Bloomberg TV, CNBC, CNN, Fox Business and Canada’s Business News Network (BNN), Sun TV and the CBC. He is frequently the keynote speaker at investment conferences throughout North America. Stephenson holds a degree in mechanical engineering from the University of Waterloo, an MBA from INSEAD, as well as the Chartered Financial Analyst (CFA) and Financial Risk Manager (FRM) designations. He lives in Toronto.
China and India have always been crazy for gold and the yellow metal remains the choice store of value in those two countries, says Don Coxe, a strategic advisor to the BMO Financial Group. In an exclusive interview with The Gold Report, Coxe explains how demographic shifts are affecting the price of gold and delves into the logic of investing in gold as a long-term strategy. Coxe also draws an important lesson in economics from his reading of Lenin.
The Gold Report: What fundamentally attracts you to gold?
Don Coxe: There are many serious reasons why I like gold, but one very important reason has to do with the shift in the share of world gross domestic product away from the highly industrialized nations toward emerging economies in Asia. For thousands of years, people in China and in India have respected gold. The Western countries, on the other hand, were captivated some decades ago by economists who claimed that gold had become irrelevant as money. But the Chinese and Indian people hoard gold as a store of value and trade it as a treasured commodity.
TGR: Are the pricing mechanisms for gold shifting toward control by the East?
DC: Consider an art auction. If a bidder who 10 years ago only bought one painting suddenly buys 50 paintings, that bidder will greatly influence subsequent bids for the art. In China and India there are suddenly many more wealthy people than they’ve had for millennia. In a culture that values gold, newly rich middle class people will buy the yellow metal not only for personal adornment, but also as a form of savings that is safer than paper money.
“In a culture that values gold, newly rich middle class people will buy the yellow metal not only for personal adornment, but also as a form of savings that is safer than paper money.”
On a trip to India a few years ago, I was fascinated to see poor peasant women wearing armbands of gold as they toiled in the fields. I asked my guide, “Is that actually gold on their arms?” And he said, “Oh, yes, that’s gold.” I said, “Well, aren’t they at risk? I mean, these are really poor peasants, and here they are brandishing all of this gold!” He looked at me in horror and said, “No criminal would be so evil as to steal gold from a poor woman, because that’s her dowry.” There are some pretty powerful taboos in Hinduism, apparently.
Intrigued, I found out that under Indian law, when there’s a Hindu marriage, whatever personal possessions, real estate and investments the woman has become the husband’s except for her gold. That remains hers. So if you’re marrying off your daughter, whom you love, you’re going to make sure that she has some gold in her possession because if the husband turns out to be a wastrel, the dowry might save her from starvation.
As a result, the Indians are the biggest consumers of gold in the world. The Chinese are moving up fast, though. Plus, there are simply more rich people in the world. Hundreds of millions of people now have some form of savings. The best single investment anyone could have made, since the year 2000—apart from buying Apple stock—was in gold. It has gone from $300/oz to $1,650/oz. It’s gone up every year, including this year. So every year in this millennium the price of gold has gone up.
TGR: Let’s talk about the Eurozone problems. How does the euro crisis affect the commodity space in general?
DC: Probably the only commodity that can benefit from the euro meltdown is gold, because the euro is the first currency ever to be backed by no government, no tax system, no army and no navy. It is backed only by a theory and a set of rules, and the people behind it have violated the theory and the rules. I doubt there is any intrinsic value behind the euro. But take the exact opposite extreme from the euro and go to something that’s been a store of value for as long as there has been civilization, gold.
TGR: Do you think we’re in a triple-dip recession in North America?
“The best single investment anyone could have made, since the year 2000—apart from buying Apple stock—was in gold.”
DC: I don’t think so. We have zero interest rates. Every recession we’ve had has always been preceded by a situation of tightening monetary policy because there was just too much spending going on, the yield curve inverted and credit problems developed. In this case, we’ve been getting along with zero interest rates now for more than four years. What we have is lassitude, but I don’t think there is going to be a recession.
That said, it’s going to look like a recession a lot of the time because—particularly as a result of the presidential election campaigns—the Democrats who are against developing power plants, against the oil industry and against the mining industry are going to feel that they have more room to carry out their crusades. That could prove to be a negative for the economy. But in general, we’re going to bump along. We’re going to be better off than the Eurozone is for sure.
TGR: Do you have thoughts about why so much corporate cash is sitting idle and what might change that?
DC: One of the biggest arguments used against gold is that gold does not pay any interest. The monetarists said you might as well keep your money in a bank account. OK, so now that we are getting zero interest on short-term deposits, the single biggest argument against owning gold is gone. As an asset class, gold has gone up every year of this millennium, and it seems to me that investing in gold makes much more sense than holding on to a lot of idle cash.
TGR: Do you think that bullion or gold stocks are the best bet?
DC: Gold stocks are the best investments, but if you want to put your savings into bullion, the easiest way to do it is to buy the SPDR Gold Trust (GLD) listing on the stock exchange, which is backed by the World Gold Council. It’s very convenient, and you can sell the bullion at any time, because it trades during the day. Bullion is a good substitute for having extra cash in hand, but as an investment, I believe you’re better off owning stocks of the well-managed gold companies that do not have political risk. It takes a lot of research to pick out the best ones, but that’s one of the things we do.
TGR: Are there any junior firms involved in these spaces that you would recommend to our investors?
DC: I’m not allowed by the Securities and Exchange Commission rules to be specific about individual stock, but I am bullish on the gold space in general.
TGR: A lot of the larger gold mining companies are moving into politically risky zones like the Democratic Republic of the Congo, Eritrea and Haiti, trying to replace their reserves.
DC: We don’t invest in companies like that, and I don’t recommend that anybody who doesn’t have a very high-risk profile do so.
TGR: In terms of investing in junior mining companies, whether it’s energy or gold, do you think that we’re looking at a period of mergers and acquisitions coming up or are explorers going to be able to make it on their own for a while?
DC: Both will happen. There will undoubtedly be lots of mergers and acquisitions. We look at which of the juniors are most likely to be acquired. So far, we’ve had some pretty good success with doing just that. There will be more of them. But right now, it’s pretty desperate for a lot of the juniors. There is no capital available. They can’t float stock. Their shares are selling at discounts to net asset value on the exchanges. However, if we get to $2,000/oz gold again, which probably won’t be too far off in the future, you’ll be amazed at how much these little gold and mining stocks will suddenly go up. They come back fast.
TGR: China has its own precious and base metal resources and it has growing demand. Do you think in a global sense China is going to start looking more internally to satisfy its metal resource needs, or will it keep looking outward?
DC: After thousands of years living on their land mass, the Chinese understand the limits of their own natural resources. China will reach out to find commodity resources wherever it can in the world. The Nexen acquisition in Canada is a recent example.
TGR: That sounds like a kind of reverse imperialism.
DC: Speaking of which, I highly recommend that investors interested in natural resource commodities read one of the most important books of the 20th century, which is V.I. Lenin’s “Imperialism: the Highest Stage of Capitalism,” written in 1915. It analyzes World War I as being caused by cartels set up in the capitalist nations. It’s a brilliant analysis of the way the world was divided up into empires prior to WWI.
“Bullion is a good substitute for having extra cash in hand, but as an investment, I believe you’re better off owning stocks of the well-managed gold companies that do not have political risk.”
It’s also a textbook for the Politburo, because it sets out the Chinese strategy for economic domination, which is not to be reliant on the big capitalist corporations, but to go into the countries where those companies cannot operate.
For example, BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) and Rio Tinto (RIO:NYSE; RIO:ASX) tried to merge their Australian iron ore operations. That would have meant that two-thirds of all Chinese iron ore imports would have emanated from one organization, which is precisely what Lenin had predicted. The Chinese were horrified by this possibility. They found a way of getting a block on that merger. They are prepared to fight cartelization.
Imperialism is the final stage of capitalism, Lenin said. So the Chinese are saying, we’re going to go out there and do capitalism better than ever during the final stage. We’re going to places around the developing world where American companies can’t go. When the Chinese dig copper out of the Congo, that copper competes with the copper being produced in Arizona by American companies. And it is cheaper.
TGR: You’re one of the speakers at the upcoming Casey seminar, talking about navigating the politicized economy. Could you give us a preview of what you’ll be focusing on in your presentation that relates to gold?
DC: I tell people as rule number one of investing in any commodity, do not invest in companies that produce what China produces or is likely to produce. Rule number two: Invest in companies that produce what China needs to buy. I’ve been saying that for 14 years, and it hasn’t changed. China needs gold.
TGR: Good advice. Thank you very much.
Read Don Coxe’s advice on investing in the energy sector.
If you can’t attend the “Navigating the Politicized Economy Summit,” you can still benefit from the information the 28 experts have to impart in the Audio Collection. Right now you can save $100 when you pre-order the 20+ hours of audio.
Donald Coxe has more than 39 years of institutional investment experience in Canada and the U.S. He is strategy advisor to BMO Financial Group with $500 billion under management. From his office in Chicago, Coxe heads up the Global Commodity Strategy Investment Management Team–a collaboration of Coxe Advisors and Harris Investments to create and market commodity-oriented solutions for investors. He is advisor to the Coxe Commodity Strategy Fund and the Coxe Global Agribusiness Income Fund in Canada, and to the Virtus Global Commodity Stock fund in the U.S. Coxe has consistently been named as a top portfolio strategist by Brendan Wood International; in 2011, he was awarded a lifetime achievement award and he was ranked number one in the 2007, 2008, and 2009 surveys.
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The Economist runs a discussion forum titled The Economist By Invitation. In this, they recently setup a discussion about an opinion piece by Dani Rodrik about the future of manufacturing-led growth in emerging markets. I wrote a response there which is reproduced here.
The role of manufactures
I agree with a small element of Dani Rodrik’s argument, but mostly for different reasons. Rodrik says:
Except for a handful of small countries that benefited from natural-resource bonanzas, all of the successful economies of the last six decades owe their growth to rapid industrialization.
I have seen this kind of thinking among some policy makers in India also: that industrialisation is somehow special and good when compared with services. I would question this proposition, that I term `the widget illusion’. What matters to a country is having sophisticated firms that have a high marginal product of labour. We should not care whether this happens in services or in manufacturing. If anything, the opportunity to do it is perhaps better in services.
India is a good example of a country which embarked on its catchup by connecting into globalisation late: from 1991 onwards. It was probably the last country in the world to shed autarkic policies. This has given a remarkable growth acceleration. Sustained growth of 7 per cent is pretty good by world standards. These achievements have been significantly driven by services production in India within global supply chains (whether within production facilities owned by global MNCs who are operating in India, or contracted-out by global MNCs to Indian firms). If your null hypothesis was that industrialisation is essential to growth, then you would not have predicted what happened in India, where manufacturing was hobbled by an array of policy mistakes.
This illustrates the limitations of manufacturing-focused thinking, which seems a bit out of date in today’s world economy where most output is services. Agriculture and manufacturing have wilted away in the consumption of the global representative agent: to succeed in the world economy today requires prime attention upon services.
Consider India, which demonstrates the limitations of relying on services rather than industry in the early stages of development. The country has developed remarkable strengths in IT services, such as software and call centers. But the bulk of the Indian labor force lacks the skills and education to be absorbed into such sectors. In East Asia, unskilled workers were put to work in urban factories, making several times what they earned in the countryside. In India, they remain on the land or move to petty services where their productivity is not much higher.
As Rodrik points out, there are important gaps between the skills of the great unwashed masses in India versus China, where elementary technical training reached a larger mass of humans. In addition, China did better on core economic policy choices about (a) Removing protectionism; (b) Removing barriers to FDI; (c) Building hard infrastructure; (d) Labour law and (e) Rationalising taxation.
What policy advice would flow from this? India should not have have made these six mistakes in economic policy (low training for the masses, protectionism, barriers to FDI, weak investments into infrastructure, labour law and mistakes in tax policy). At the same time, this does not recommend a bias in favour of manufacturing. It is hard to discern a meaningful choice about emphasising services versus manufacturing in Indian economic policy. Participation in all global production is good. Governments should remove all barriers that inhibit global integration whether in goods or in services – e.g. the six mistakes in Indian policy sketched above.
A paragraph earlier, Rodrik says:
To be sure, some modern service activities are capable of productivity convergence as well. But most high-productivity services require a wide array of skills and institutional capabilities that developing economies accumulate only gradually. A poor country can easily compete with Sweden in a wide range of manufactures; but it takes many decades, if not centuries, to catch up with Sweden’s institutions.
I would point out the contradiction: “A poor country can easily compete with Sweden in .. manufactures” but earlier it was asserted that the gaps in Indian skills inhibited India’s ability to compete with Sweden in manufactures.
Doing things that push skills and institutional capabilities
I would go further to say that it is good to go after fields which require a wide array of skills and institutional capabilities.
I am reminded of Ricardo Hausmann’s `Good Cholesterol’ argument about financial globalisation as opposed to mere FDI. When a poor country operates in an institutional vacuum, foreign investors are uncomfortable, and the only thing that can happen is FDI. To obtain financial flows, the country has to build institutions: laws, regulators, property rights, and so on. This is a good thing! A country that gets to FDI and gets stuck there should ponder what is going wrong. In similar fashion, no country aspires to have low-wage production; every country wants to understand the secret sauce through which a part of the labour force can earn high wages by world standards.
As a country rises out of poverty, it is essential to build up skills and institutional capabilities. If policy makers hinder services and/or favour manufacturing, there is a greater chance of being stuck in low skills and low institutional capabilities. I am not proposing industrial policy in favour of services. I am only proposing the absence of industrial policy; we should avoid a `widget illusion’ and foster more global integration without trying to push towards one industry or another.
In India, with 7 per cent growth, GDP doubles every decade. As a thumb-rule, I feel that a comprehensive transformation of skills and institutions is required across each doubling of GDP, which is roughly each decade for India. A country that is stuck in low-skill manufacturing will find it difficult to achieve the reinvention of this `soft infrastructure’ of the mind. If policy makers tried to push a country towards doing low end grunge work, it would be harder to obtain these repeated transformations of institutions and the furniture of the mind, which would lead to growth decelerations.
As an example, in the article New wave of deft robots is changing global industry, John Markoff says:
Foxconn has not disclosed how many workers will be displaced or when. But its chairman, Terry Gou, has publicly endorsed a growing use of robots. Speaking of his more than one million employees worldwide, he said in January, according to the official Xinhua news agency: “As human beings are also animals, to manage one million animals gives me a headache.”
The project of economic development requires sophisticated interactions between firms and workers. The laws, human rights and management practices that are required when dealing with humans are different from those required when running a firm with `one million animals’. I would hence argue that it is limiting for a country to focus on the political, legal and institutional requirements to produce a la Foxconn. It is better to confront the complexities of high skill, high wage production, and to build the environment for this to happen: in the political and legal system, in management practices of firms, and in the power structure embedded in a conversation between two citizens who are co-workers within a firm. Services production is a valuable learning ground where the complex management practices that involve high skill humans can be learned.
The new world of manufacturing
Rodrik correctly points out that manufacturing has become more sophisticated in recent years. This has some fascinating dimensions:
- The rapid improvements in capabilities and declining costs of robots.
- The rise of open source design coupled with 3-d printers. If a 3-d printer in the US fabricates a part close to its usage in an assembly line, while the labour-intensive design work (”services”) that controls the 3-d printer is done in India, does this entail manufacturing or services work in India?
- The world economy is likely to be in a low interest rate environment for a long time, which will encourage capital intensity worldwide (robots, 3-d printers), thus blunting the value of low wages.
Momentous changes are afoot, which challenge our traditional notions of manufacturing versus services. To some extent, we are even seeing some manufacturing go back to the US.
Things that might `go wrong’
Finally, Rodrik talks about reduced willingness in the West to tolerate unfair tactics like the Chinese exchange rate regime. I would generally consider this to be a good thing, both for developing countries and for the world. In any case, the Asian `Bretton Woods II’ episode seems to be subsiding. As an example of the disenchantment with exchange rate distortions: From 2004 to 2007, India debated exchange rate rigidity, and walked away from it. The links between undistorted exchange rates and growth have not been adequately emphasised in the discourse. A developing country builds up inferior skills and institutional capabilities by exporting under a subsidised exchange rate: it is better to force firms to confront the market price and achieve the productivity required to participate in globalisation when facing an undistorted price vector.
He worries about a rise in protectionism in the West, but we have to admit that the 2008-2012 experience has been pretty good in this regard: by and large the West has not succumbed into protectionism. In 2008, all of us worried about Smoot-Hawley. Today, things seem to be be going well.
In summary, I would argue that we should avoid a `widget illusion’. There is nothing special about manufacturing or industrialisation: as long as people in India get high wage jobs, this is good. Getting there requries deep integration into the world economy, which includes policy battlefronts such as:
- Openness to the Internet
- Use of English
- Inbound and outbound FDI
- The array of cross-border financial services that are the enablers of complex globalised production of both goods and services
- Globalisation-compatible tax policy on both trade and finance
- The absence of either protectionism or mercantalism
- Fostering high quality human skills, and
To the extent that globalised production of goods and services happens in areas which involve high skills and complex institutional development, this is a bonus, since any high growth country needs a rapid pace of reinvention of laws and institutions.
Most of this is the old orthodoxy. Policy makers worldwide are generally focused on these issues, as they should be. From the 1960s onwards, dirigisme has generally subsided, with the twilight of policies like fixed exchange rates, industrial policy, capital controls, protectionism, etc. These key lessons remain intact in the 21st century.
After a week with the family in a cottage in Sweden Alpha Sources is ready to get back into the grind. Returning from holiday as a macro analyst is always daunting given the barrage of news and data that you will have inevitably “missed”. From reading the news and last week’s sell and buy side research this morning Alpha.Sources sees a bit more positive note. Apparently, the significance of recent months’ very aggressive monetary policy easing around the world seem to be having their slow, but predictable effect. A few more sell side notes than Alpha Sources had expected are now looking towards the second half with a bit more optimism.
There is still the strange feeling among many investors however that 2012 will be a repeat of 2011 and that sideways movement into the summer will eventually be released in another sharp draw down in global risk asset prices. As always, the extent to which this remains the consensus among investors even as monetary policy continues to ease in both conventional and unconventional fashion, Alpha Sources is getting more confident that bears may just get caught out.
It is important though to be extremely sensitive to the data at this juncture with key economies such as China and the US at obvious inflection points.
In the US and despite the visible deterioration of the data in the past month, the call for a recession is still at risk. An ISM at 49 is normally not associated with a recession and further deterioration into the mid 40s in July would be needed to give a recession signal. Still, global bond markets continue to predict a very dire future with more and more investment grade yields going into negative territory and anything generally assumed safer than handing over your money to a teenager in a department store, seeing bid. Still, I am skeptical that such signals from an essentially manipulated and stretched market are all they are made out to be and prefer to stay close to the real economic data for now. This week sees a big chunk of data releases as well as the Fed chairman is scheduled to speak, so watch out for direction.
China Rising or Falling?
In the case of China, Prime Minister Wen recently warned that positive momentum is not yet visible in the economy. This suggests more stimulus is on its way beyond the two rate cuts already implemented.
But, is this bullish because monetary stimulus in China will lead the economy up and indeed lead a general continuation of the global EM easing cycle? Or is it bearish because it suggests that conditions in China are worse than expected?
Alpha Sources would lean towards the former, but unless the data starts to turn this remains a hope and perhaps even a fool’s one as it depends on the authorities’ ability to micro manage the economy. As ever, the discourse on China is stretched by unrealistic expectations. On the one hand there are those who believe that China is able to reach pre-crisis growth rates of 10-12%. It isn’t and there is no doubt that many global commodity producers have too much capacity relative to the growth level that China is able to attain. On the other hand, the chorus of those calling for a hard landing and essentially a collapse of the Chinese economy has, at times, been deafening. Alpha Sources finds it difficult to see exactly why this is supposed to happen now. China may be headed for a big crash, but such things rarely occur on the back of and in the midst of extreme euphoria and not excessive pessimism.
Alpha Sources’ base case scenario is that more stimulus from China will be able to drive positive sentiment forward, but also that between those calling for status quo and a crash, China is likely to achieve neither and in stead simply achieve a new trend growth level much lower than before.
Upside surprises in Europe?
Despite the perceived victory of the periphery in the recent EU summit Merkel remains resilient in her demand that if Spain and Italy eventually will need bailout, the price has to be considerable handover of sovereignty to EU and Germany on the fiscal side. This is a reasonable claim even if the message to the outside is that Spain will avoid direct involvement in sovereign affairs due to the technical nature of the bailout money being distributed to its banks.
Still however, the recent sharp reversal in the rhetoric by the Spanish Prime Minister Rajoy and the promise of yet another round of cuts come in nicely on the back of the market finally starting to see signs that perhaps even senior creditors of Spanish banks be forced to take losses. Alpha Sources welcome such realism by part of the periphery, but is still left with the bitter taste in the mouth from watching drastically different measures being applied to the little ones (Greece and Ireland).
In this sense, the ever eloquent Chris Wood is spot on in his recent juxtaposition between the situation in Spain and Ireland.
GREED & fear has been calling for losses to be imposed on subordinated bank bondholders for some time as the best way of imposing a loss, and allowing the capitalist system to start working again. It is, therefore, encouraging that this approach may actually be adopted as already discussed in the case of Spain as one of the Eurozone’s preconditions for recapitalisation, which by the way means a significant diminution in Spanish sovereignty. Still, given that so much of this subordinated debt has been sold to retail investors as savings products, such a policy is going to create a firestorm in Spain politically. It must, therefore, be wondered if the loss ends up being imposed anyway on the sovereign balance sheet of Spain as buyers of these products demand to be made good. The Spanish owners of junior bank debt may also wonder why he or she is being treated so differently from Ireland where the ECB seemingly forced the Irish Government not to impose losses on subordinated bondholders thereby putting the Irish taxpayer on the hook. GREED & fear would not like to be viewed as a cynic. But the difference could be that the Irish subordinated debt was owned by big institutional investors whereas in the case of Spain it appears to be the little guy.
Another case in point that I feel the need to elaborate on is Greece. Only two months ago did the consensus hold that Greece would leave the Eurozone or perhaps even that the country would be forced out. Alpha Sources always thought that this was mad and we know now that it was. The difference between the first PSI and the warmongerings from Merkel and the EU were clear.
In the case of the former, the risk was chiefly that Greece would not accept the terms under the restructuring (laid out by the IMF and the EU) and simply apply a unilateral haircut. In the case of the latter however, Greece was seen being in the corner pleading that the country would not want to leave but simultaneously also getting starved of essential liquidity to keep the country running.
Investors should remember that differential treatment between large and small economies in what has become a near perpetual bailout effort by part of the EU, the IMF and the ECB is a mistake that may eventually become the problem itself.
Finally, it is important to dwell a bit on the recent ECB meeting where not only the main refi rate was reduced but also, and much more significantly, where the deposit rate was cut to 0%. This marks the first major central bank trying to take a stab at the problem of a slump in velocity and essentially a broken monetary policy transmission mechanism. As such, bulging reserves without a corresponding pick up in lending to the real economy remains one of the main problems in the developed world (from the point of view of monetary policy makers that is). Sweden enforced negative interest rates on reserve balances in 2008, and now the ECB is essentially following in the Riksbank’s food steps.
In this way and just as Alpha Sources has spent the last couple of days catching up with the news, so it seems that European policy makers with Spain now apparently open to imposing losses throughout banks’ capital structure and the ECB delivering the boldest monetary policy step since the Fed opened up the QE bag in 2008, Europe may finally be catching up.
China may be investing billions elsewhere to locate new mineral deposits, but Geologist Noel White believes there are huge discoveries yet to be unearthed within its borders. White, an independent geological consultant with Enargite in Brisbane, Australia, says China’s history and politics have slowed development of its mining at home. In this exclusive interview with The Gold Report, White reveals which companies have boots on the ground and the expertise to make the next big strike in China and South America.
The Gold Report: Noel, you’re a geologist with about a 40-year history in mineral exploration. These days, public companies pay you for advice on how to run their exploration programs. What are some common mistakes junior mining companies make when it comes to exploration?
Noel White: Junior companies have difficulty developing a clear and realistic strategy.
TGR: You try to temper their enthusiasm?
NW: Not at all. In fact, I try to encourage their enthusiasm. But I try to get what they do aligned with what their objectives are in a realistic way.
TGR: Do they try to drill too quickly? Do they try to drill too much?
NW: Junior companies commonly feel that there is an expectation to drill quickly, but they also need to do their homework properly. If they jump into drilling before doing the appropriate surface techniques, such as geological mapping, geochemical sampling and geophysical surveys, they can completely waste the very expensive drilling work. It is a serious mistake because bad drilling results have a serious negative impact on how investors perceive a project. A company needs the best possible intersections at the start to raise the value of their projects.
TGR: Have you been an active consultant on projects that have reached production and gone on to be successful?
NW: I’ve worked a long time with Asia Now Resources Corp. (NOW:TSX.V) in China. Asia Now has produced an ore deposit in southern China. That exploration success followed a long period of very careful exploration to find a completely hidden ore body. Without that early work, that success would not have been achieved.
TGR: You often deal with technologies that are new to mineral exploration. Can you talk about how they’re changing the game?
NW: The fundamentals of mining haven’t changed particularly in 40 years—we just use new technologies to achieve the same goals. The major breakthrough in geophysical technology of recent times was the development of airborne gravity. That was one of the Holy Grails.
One of the most basic tools is a magnetic survey. We can get a lot more out of magnetic surveys today than we could in the past. Those surveys provide us with baseline information that’s really important.
Technology is producing major breakthroughs in geochemistry. Geochemistry started off just collecting samples of soil or stream sediments and using simple analytical techniques. More and more sensitive analytical methods have been developed. Partial leach techniques extract part of the geochemical sample to maximize the sensitivity. A major recent development relies on the fact that nature has focused particular elements that are associated with ore deposits into particular minerals. It is now possible to actually look at the chemistry of particular minerals to evaluate the proximity to the target based on its chemistry.
TGR: What do all those technologies mean to the investor?
NW: Smart people follow the lead of smart people and greedy people follow the lead of greedy people. If you follow a greedy person you might get lucky and make a lot of money in the short term. Technically smart people who design exploration programs have a much higher probability of being successful in delivering a discovery.
TGR: A few years ago, the World Bank evaluated the mineral potential of China. How would you characterize China’s mineral potential?
NW: To appreciate China’s potential, you have to understand its history. In the early days of the People’s Republic of China, the country followed the Soviet Union approach and started huge state-funded surveys over massive areas, but the Cultural Revolution disrupted the process. Thousands of state-owned companies with exploration teams suddenly found themselves with no funding. However, the government wouldn’t allow them to reduce staff or stop operations—a major dilemma for management. They started mining any little thing to make money.
TGR: The country is literally dotted with all kinds of artisanal mines.
NW: They were so focused on making money that they were acting as if they were the smallest of junior mining companies where making money was the sole focus, not doing good work.
TGR: But the potential is there.
NW: Oh, the potential is staggering. A mineral occurrence map of East Asia shows multiple world-class deposits around the borders of China. However, there are very few inside China. Why did China miss out? It has nothing to do with geology. I has to do with the history of the country and how exploration developed. China is fantastically endowed, but very poorly explored.
TGR: But even the Chinese government is not compelled by its geology. Chinese state-owned companies are spending billions to develop resources beyond its borders. Isn’t it difficult to argue for further mineral exploration and development in China when the Chinese themselves seem unconvinced?
NW: A huge amount of money is being channeled by the government into exploration teams in China. Some of them are quite competent, but many of them are not. It’s basically pouring good money out after mostly bad.
Then the government asks, “Well, why haven’t we found all these deposits in China?” But the “experts” they are asking don’t know anything about the economic geology of China. They say, “We’ve spent a huge amount of money looking for these deposits and haven’t found them. Therefore, they mustn’t be there.” That conclusion is wrong. Most of the money is being used in completely ineffective ways.
TGR: What is the environment for juniors wanting to capitalize on that potential?
NW: The geological potential of China is fantastic. But let’s not pretend otherwise—it’s a difficult place to work for other reasons. When Asia Now went in 10 years ago, China was encouraging foreign companies to come in. A lot of juniors went into China. Some did quite well. Many of them did really badly. Subsequently, conditions have become less and less favorable. The policies change almost on a yearly basis. It’s more challenging today than it was 10 years ago.
TGR: What’s the best way to get started in China?
NW: The best way to work in China is to joint venture with a good state-owned company. Asia Now chose very good projects and joint ventured with two partners. It’s very much like a joint venture in a Western company. Mining law in China is provincial. Having a Chinese partner that can handle government and community relations for you is a major advantage. Many foreign companies don’t understand the system, the requirements—they don’t have the connections and the relationships that can make things easier. Life is much easier when you have a good local partner.
TGR: Oyu Tolgoi is the mammoth copper-gold porphyry deposit being developed in Mongolia by Rio Tinto (RIO:NYSE; RIO:ASX). You’re an expert in porphyry deposits. Do you believe further exploration of those geological systems could yield a similar deposit in China?
NW: There are a lot of porphyry prospects in China, but there’s been very little effective exploration on them. The situation is changing because more Chinese have familiarity with porphyry deposits. However, in most cases, if they even recognize a porphyry, they will drill a couple of holes and walk away because they didn’t get what they wanted. Porphyry deposits are very big, but that doesn’t mean they’re easy to find. They can’t just drill a couple of holes and say, “Oh well, we’ve done it.” In fact, Asia Now is exploring a porphyry system that had never been recognized in southeastern China, down toward the Vietnam border.
TGR: Is that Habo?
NW: Yes. Asia Now has drilled about 20 holes, but certainly hasn’t finished exploring. The potential remains in that area. But why wasn’t it found before? There were about 10 centimeters of forest soil and dead leaves hiding it. Until the surface was scraped away, it couldn’t be seen. It’s not that geologists hadn’t looked in that area, they just hadn’t seen it. That’s true all around the world. It takes very little to hide something.
China has great potential for more porphyry systems. In fact, there have been a lot of porphyry systems found in Tibet because it’s a well-exposed area and a well-defined belt. There is a need for people to get back into eastern China where there are numerous known porphyry systems that have never been explored properly.
TGR: Do you think that Habo will ever get to the point where it is a major porphyry system that is mined and is economic?
NW: It’s at an important stage now. The work that is being done right now will make or break Habo. So far, no sufficiently wide zones of high-grade mineralization have been found. Many narrow zones have been found, but that doesn’t make a porphyry deposit because large volumes are needed to bulk mine.
It’s still an open question. We still don’t know the answer. We’re drilling targets that have the potential to be an economic ore body. Time will tell.
TGR: Is the work being done on Habo changing the way Chinese geologists think about geology in China?
NW: The Chinese system is very stratified. The people in the field often don’t know what’s happening just down the road, let alone in another province. That knowledge would not be widespread.
TGR: You’ve also acted as a consultant on the Beiya project, which is in northern Yunnan Province. What’s exciting about that project?
NW: We discovered an ore body at Beiya. It’s taken quite a period to achieve that success largely because of the character of the geology. The potential was very clear from the earlier stages. There was a known deposit, which has grown and grown to be the biggest gold mine in Yunnan. Production at the moment is about 200,000 ounces per year from an open pit, but it was a very small underground mine when we started.
The mine was controlled by a state-owned company, now partly privatized, but at the start Asia Now tied up all the surrounding ground because it recognized the potential there. The state-owned company was so focused on drilling and testing that deposit that it wasn’t interested in the surrounding ground. A fantastic ground position was secured by Asia Now through joint ventures that ultimately give it more than 70% equity.
TGR: That doesn’t happen very often in the West, that’s for sure.
NW: It was a fantastic opportunity. It was very insightful to grab it. I’m sure the owners of the Beiya gold mine wish that it had never happened. Now, of course, they’re looking and saying, “Where can we expand to?” They’re basically locked in.
TGR: You wrote an interesting research paper on Minera IRL Ltd. (IRL:TSX; MIRL:LSE; MIRL:BVL) called “Minera IRL: Projects, Personnel and Potential.” Is it common for you to pen pieces like that? I worked at the Northern Miner for 10 years and I’ve never seen something like that.
NW: It was an internal report. The background to that was Minera was having a staff conference at one of its exploration sites. I was asked to speak at that staff conference and give an overview. I sat in on all its project reviews and was on the ground on several of the projects. It is apparent from that document that I was very impressed.
TGR: Indeed, you were. You talk about the mineral potential of Ollachea in Peru and Don Nicolas in Argentina as being significantly greater than what’s being looked at currently. What supports that view?
NW: Ollachea has mineralization exposed in a belt of small workings. The deposit has a fairly shallow dip of about 30 degrees in very dissected country. Very often those sorts of deposits are steeply dipping, which limits the depth at which you can explore them. Here, the host structure extends a long way away from where it’s currently being drilled. Minera knows that there is gold at other points along that structure and that that structure is very persistent.
The amount of blue sky attached to that deposit is startling. There’s plenty more potential. It’s the tip of the iceberg. Nobody knows how much more there is, but definitely one of the things you want with any project, apart from having a good resource, is the potential to grow. There’s extraordinarily good potential to grow there.
TGR: Is there significant potential in the Don Nicolas deposit as well?
NW: I didn’t review Don Nicolas itself. I was supposed to look a lot more closely at that on my last visit, but a little heart attack got in the way.
TGR: Oh, my goodness!
NW: That cut the visit short. However, Don Nicolas is one of many exploration targets within that region. I was startled, to be honest. It’s quite an amazing region. There’s a whole series of other deposits that are known. Minera has tied up a very large land holding in an extraordinarily mineralized region. For a geologist in exploration, it’s the sort of thing that makes your heart beat faster.
TGR: You spoke earlier about how mining rules vary among Chinese provinces. It’s much the same in the different provinces of Argentina. Are the particular provinces where Minera is operating considered mining-friendly jurisdictions?
NW: Yes, very much so. It’s the best in Argentina. To be honest, there’s not a lot more going for this province apart from mining. It’s mostly flat. It’s arid. It’s quite a difficult environment for any other sources of income. The people there recognize that the best opportunity they have to develop is through the mining industry. Consequently, they’re very positive about it. They want to see the mining industry grow.
TGR: There is an economic malaise in this particular sector, but projects are still being found and developed despite lagging share prices. Some of them even look robust. Is that enough to keep investors hopeful about this sector?
NW: Investors are holding onto their money and not investing in anything that’s perceived to have risk. But there still are investors who have a taste for something with big upside potential. Now is the time to be investing in the very good exploration companies—the ones that have very good projects and very good management. Investors get in cheaply and the upside is fantastic. There’s every reason to be optimistic about the mining industry and exploration. Exploration is the future of mining and mining is essential to civilization.
TGR: Do you have any other thoughts you want to share with us?
NW: There will be discoveries that generate interest. In exploration, we benefit greatly from the power of greed because the discovery that excites the market generates a lot more exploration activity. I remember during my BHP Minerals days the young geologists would say, “Isn’t it a pity that we didn’t find that deposit?” I’d say, “Don’t knock it because we benefit from the fact someone else found a deposit that’s got the market excited.” It benefits everyone’s budget.
Dr. Noel White is a geologist with more than 40 years of experience in mineral exploration, operations and project generation worldwide. He was the chief geologist for former BHP Minerals and has visited over 350 ore deposits/mines in 50 countries, including China, where the first foreign joint venture in its mining industry was built up by BHP. White was a consultant to the World Bank Group on its evaluation of Asian mineral potential. He has a strong involvement with professional societies and universities worldwide, such as serving as international exchange lecturer in 1999 and Thayer Lindsley Lecturer in 2008 for the Society of Economic Geologists and served as the vice president of regional affairs for the Society of Economic Geologists. He has authored and co-authored various publications since 1972. White received a Bachelor of Science degree from the University of Newcastle and a Ph.D. from the University of Tasmania.
Just if you didn’t catch it.. there has been a curious news cycle over the observation that there is a lot of real estate investment in Toledo coming from China. See Fortune: Why are the Chinese investing in Toledo, followed up by WSJ: Courting the Chinese Buyer. It’s all really building on some longstanding investigative work by the Toledo Blade: Inquiry Sheds light on Chinese investors.
US. Chinese real estate investment sure is something we have sure tried to encourage. A few years ago I noted the Pittsburgh connection to some Chinese real estate investing in the US. We really are the center of everything these days. Various press on that elsewhere, but nothing really here.
But it is curious. Note there is the obligatory paranoia over all of this. Some may recall similar sentiment when there was a lot of Japanese investment in US real estate 20 years ago. I am not sure any of that turned out badly for the US, though it didn’t work out well for a lot of the investors as I recall my history. Since real estate isn’t going to be moved overseas you have to wonder what the risk is. What I don’t get is that the same folks paranoid over this are likely also paranoid over the state of the US economy and predicting collapse in some near term. So why would these Chinese investors be voting with their wallets and investing here if soon there was going to be this big collapse? In one way or another these investments imply they think the future return is better than anything they can invest in at home. Well.. too big a topic for here, but weekend thoughts to ponder.
China and India have returned to the potash markets, stabilizing current prices as long-term demand continues to grow. In this exclusive interview with The Energy Report, Corey Dias, who covers the industry for MGI Securities, brings us up to date on industry developments and shares why Brazil-based companies offer huge potential for prudent investors.
The Energy Report: Have there been any significant developments in the potash industry since you last spoke with us in January?
Corey Dias: The biggest change has been that China has actually come back to the market and is buying potash. Earlier this year, neither China nor India were buying, hoping to see a price decline. China has since agreed to purchase about 550,000 tons (t) at $470/t from Israeli potash company ICL Fertilizers (ICL:TASE). Canpotex Ltd. (private) signed a similar-sized agreement with China’s Sinofert Holdings Ltd. (297:SEHK) for Q2/12 delivery priced at $470/t. Finally, the Belarusian Potash Company (BPC), the other major potash consortium in the business, signed an agreement with Sinochem International Ltd. (600500:SSE) and CNAMPGC Shanghai Corp. (private) for a price of $470/t. Those buys are underpinning the price as it stands today, slightly below the $500/t spot. It seemed China wanted to hold out for better pricing, but it was inevitable that it would have to come back to the market. India will likely have to do the same soon.
TER: Have your views of the industry’s potential changed as a result?
CD: No, nothing has fundamentally changed. This just reinforces my view that fertilizers remain essential to the global agriculture market in order to facilitate growth, improve yields and provide food for burgeoning middle classes throughout the world.
TER: Do you see anything on the horizon that might have a major effect on the market or the prices, either positively or negatively?
CD: I expect some short-term impacts. Both the U.S. and Europe are obviously still facing economic headwinds, which can impact the fertilizer-buying patterns of those regions. That said, I am still bullish on the industry’s longer-term prospects. At the end of the day, populations will continue to grow, as will the middle class. Diets will continue to change, and therefore increased fertilizer use is inevitable. I expect the market opportunity for fertilizers such as potash to remain attractive going forward. There still seems to be a lot of positive sentiment out there.
TER: Do you expect any major changes in the number of companies entering into the business in the next 5–10 years?
CD: There will probably be a number of new entrants into the marketplace, especially given how topical potash is at the moment. However, as these projects attempt to advance towards production, many will fall by the wayside due to the difficulty of securing financing for these multibillion-dollar projects. I would assume that the first step of financing a major potash project would involve signing a long-term offtake agreement with a third party looking to secure supply in exchange for an upfront equity investment in a project. This offtake agreement, in turn, could be used as a form of collateral for project debt. Furthermore, not all of the output from these potash projects is going to be necessary from a demand point of view. A number of potash producers have new Brownfield projects that could help meet a significant portion of the expected increased demand for potash. That may not leave a lot of room for new entrants.
TER: Do you expect bigger companies to take over smaller projects that can’t finance themselves?
CD: I would think so, assuming that the smaller projects provide some kind of strategic value to the acquirer. That said, many large producers already have an inventory of deposits or projects they can use to expand production without seeking other acquisitions.
TER: Is location the primary factor in determining which projects are “strategic?”
CD: Yes. If one is operating a potash mine in Brazil, one has an internal market that could absorb one’s entire potash output. A company that wants to enter the potash market in a cost-effective manner would certainly aim to buy an asset in Brazil in order to benefit from the significant transportation price advantage expected to be enjoyed by the local potash producers. Moreover, Brazil imports over 90% of its current potash needs and, therefore, the Brazilian government is encouraging local projects to be built in order for the country to reach fertilizer independence by 2020.
TER: How have the major players performed during the first quarter of this year?
CD: Mosaic reported significantly lower sales numbers year over year, as did Potash Corp. This is unsurprising, given that China and India were not participating. Unsurprisingly, both Potash Corp. (POT:TSX; POT:NYSE) and The Mosaic Company (MOS:NYSE) have reduced production twice recently. In Eastern Europe, Uralkali (URKA:RTS; URKA:MCX; URKA:LSE) also reduced its production forecast. These companies are likely reducing production to preserve the current $500/t spot price and will probably continue to do so in order to avoid another price collapse similar to what took place a few years ago. Remember that Potash Corp., Uralkali and Mosaic are each tied to regional consortiums—Canpotex and BPC—and probably represent between 60% and 70% of the supply side of the market, so their actions are quite influential with regard to the rest of the market.
TER: What’s been going on with the smaller companies you cover in the last three months?
CD: The only junior potash company I was covering when we first spoke was Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX). Since then I’ve added five other names. Passport released an NI 43-101 resource estimate for its Holbrook Basin potash deposit, which officially confirmed the existence of potash on its property. While the deposit is relatively low-grade when compared to Saskatchewan deposits, it is also quite shallow, which lends itself to conventional mining methods. This is the first of many milestones that will move the Passport story forward. I expect more and more positive news to come from the company in the next few months, including the release of a Preliminary Economic Assessment (PEA) by the end of 2012 that should provide a boost to the stock price.
Karnalyte Resources Inc. (KRN:TSX) had to provide clarification to the Alberta Securities Commission over a filing it made related to its updated technical report before Christmas. There was supposed to be an equity financing around the time of the report release, which subsequently didn’t take place due to delays related to the technical report. In the absence of clear information with regard to the delay, the market assumed the worst, so the stock price started to slide. Fortunately, the updated technical report was finally released at the end of March and, in fact, some of the numbers were an improvement over the previous technical report.
We still really like Karnalyte. The fact that it is planning to go into production in 2014 – ahead of a number of its peers – puts it in a great position to attract strategic investors interested in an offtake agreement which, in turn, could facilitate debt financing for plant construction.
CD: I also cover Western Potash Corp. (WPX:TSX.V). Western has one of the largest recoverable potash resources in the junior potash developer universe, and three other companies with deposits of similar size in Saskatchewan have been bought by larger entities such as BHP Billiton and K+S Aktiengesellschaft. This could make Western an acquisition target. The Company is currently in discussions with overseas potash buyers with regard to securing an offtake agreement. If Western is successful, the effect on the stock price would be extremely positive.
TER: How about Rio Verde Minerals Development Corp. (RVD:TSX)?
CD: I visited the Company’s assets in Brazil a couple of weeks ago. It’s a very interesting company aiming to produce both phosphate and potash. In the short term, the Company’s first phosphate project is expected to commence production in Q113, thereby providing some cash flow to somewhat mitigate share dilution as it moves its first potash project forward. The important thing about Rio Verde is that it’s operating in a market that has significant potash demand with very little domestic supply. The only potash mine currently operating in Brazil is run by Vale S.A. (VALE:NYSE) and produces less than one million tons a year (Mt/y). Demand for potash in Brazil in 2011 was over 7 Mt/y. So there’s a significant gap that needs to be filled. In addition, shipping from North America to the Brazilian fertilizer markets adds another $150–200/t in costs. A domestic producer could clearly save buyers a lot of money and improve its own the bottom line.
TER: Could Brazil be the next China or India in terms of potash demand?
CD: Brazil is already bigger than India when it comes to potash demand, and not far behind China. Its combination of fertilizer-intensive crops, low fertilizer application rates and little domestic potash supply makes it an ideal market for potash suppliers. Moreover, Brazil probably has the highest amount of available arable land in the world and the water necessary to irrigate it, which means that it has an opportunity to become an even greater agricultural powerhouse.
TER: What about Encanto Potash Corp. (EPO:TSX.V)?
CD: Encanto is another appealing company. It’s an interesting potash play because it involves a First Nations group called the Muskowekwan. Encanto has increased the size of its land package by more than threefold recently, which resulted in an increased potash resource estimate announced in an updated report released in March. The Company has two memorandums of understanding (MOUs) signed with other First Nations groups within Saskatchewan, which means that it could potentially replicate its Muskowekwan junior venture (JV) with these other two groups. That could make the company significantly larger than it is today. Encanto’s PEA states that it is aiming to produce 2.5 Mt/y and has alluded to the potential of doubling that output, based solely on its Muskowekwan JV. Output could be significantly higher should either or both of Encanto’s MOUs be successful.
TER: Looking at the projected price-to-earnings ratios on smaller companies that are planning to be in production in the next two to five years, it seems the markets are not giving them enough credit at this point. Are investors just waiting to see whether things turn out as expected?
CD: As we discussed earlier, not all of these potash projects will reach the production stage. So the market is taking a wait-and-see approach until project financing is secured and construction and production actually starts. Right now the companies basically trade based on the milestones that they’ve reached. A company will start with an NI 43-101 resource estimate and then it will perform an economic analysis on the project in order to determine the project’s viability, whether it’s a PEA or a prefeasibility study (PFS). Even when an economic assessment is completed, the project will still have to be constructed. At that point, the ability to finance the cost of building a production plant becomes a big question.
TER: You just initiated coverage on March 2nd on Verde Potash (NPK:TSX.V). What’s going on with that one?
CD: Verde is another junior potash developer with assets in Brazil. The company plans to produce conventional potash using glauconite, which is a green rock that can be found on the surface of Verde’s property. The company is planning to use a method called the Cambridge process, which was developed as a collaboration between Verde and a professor at the University of Cambridge in the U.K. The company recently released a positive PEA and expects to begin production in 2015, which is still ahead of many other junior developers. Obviously, that should provide Verde with an early-mover advantage in a country that is a major producer of fertilizer-intensive crops and that has very little domestic potash production. Verde seems to have a great opportunity to become one of the major players in the potash space.
TER: Do you expect Verde to have little difficulty financing its project?
CD: I think that would be the case, because the Brazilian government is very interested in becoming fertilizer-independent by 2020. This goal is even more poignant given that, in 2011, Brazil imported 92% of its potash requirements. To this end, the government has lined up lenders or partners who would be willing to help fund the production of these projects.
TER: What kind of market performance do you expect from these stocks as we head into the summer doldrums?
CD: A lot of the junior and small-cap stocks have been negatively affected in the current market environment and the stocks in the junior potash developer sector are no exception. Those are the ones that investors usually abandon first whenever market sentiment turns negative. It might take until the fall for these stocks to start rebounding. However, falling prices present opportunities for accumulation before the summer doldrums really do kick in and volumes completely dry up. I expect to see an uptick, certainly towards the end of the summer and into the early fall.
TER: We appreciate your updates and insights.
CD: You’re very welcome.
Corey Dias has worked in the capital markets industry since 2003 and has spent eight years in institutional equity research and institutional equity sales. In addition, he has worked for a U.S. hedge fund, where he shared responsibility for the running of a $400M portfolio and sought out assets for private equity investment on behalf of the fund. Mr. Dias holds a Master of Business Administration from the Richard Ivey School of Business at the University of Western Ontario.
This may be a targeted and essentially pinpointed move, but looking at the data coming on China in the first quarter of 2012, I think there is plenty more to come as China tries to come to grips with a rapidly slowing economy.
China boosted rural credit by cutting reserve requirements for an additional 379 branches of Agricultural Bank of China Ltd. (601288), the nation’s third-biggest lender by market value.Effective March 25, the ratio falls by 2 percentage points for the branches in the provinces of Heilongjiang, Henan, Hebei and Anhui, the People’s Bank of China said in a statement on its website yesterday. The move expands a trial that previously lowered requirements for 563 branches in eight provinces. The latest move means a total of 23 billion yuan ($3.6 billion) has been freed up, the PBOC said.
Money supply growth has effectively stalled in China and with the recent statement by BHP Billiton that Chinese steel output had flattened what they really meant was that they are now seriously concerned about a severe and lingering slowdown in China. Of course, there are considerable details that must be taken into account here. However, one thing that we must understand is that production capacity (supply) of hard commodities may turn out to have structurally overshot demand even in mighty China.
So far, we must give Chinese authorities the benefit of the doubt and it is almost certain that they will now turn from a focus on inflation to a focus on growth. This is particularly the case as inflation has come down significantly in China and while base effects will be an important part of this story, the sharp retrenchment of liquidity will also have mattered.
In my view, markets are likely to turn to growth in the next months where disappointing data out of China and the US are likely to put a dent in an otherwise strong rally.