So if you care about what the (r)evolution in shale gas development means to the economy and have some illusion it is a simple question this is required reading… NYT: Would Exporting the Natural Gas Surplus Help The Economy, or Hurt?
On how bad forecasting energy markets can be. Coalguru: Natural gas prices in US to remain low in 2013
How bad is it for coal these days: Coal Loses Crown As King Of Power Generation
From the coal beds of Indonesia to oil and gas fields throughout Europe, Sam Wahab of the London-based investment firm Seymour Pierce is a master at spotting investment opportunities in the topsy-turvy world of fluctuating energy prices. In this interview with The Energy Report, he deftly defines the structural problems affecting gas and coal markets, while identifying some plays that demonstrate the savvy to come out on top.
The Energy Report: Sam, with natural gas production stalling in North America, where can investors find good deals in the junior exploration space?
Sam Wahab: Gas exploration in the U.S., especially of the unconventional type, has resulted in diminishing Henry Hub spot prices. Nevertheless, gas exploration on a global scale remains strong. The key reason is that gas prices in Europe and Asia are underpinned by robust consumer demand and the need for energy security.
A clear example is in Central and Eastern Europe, where Gazprom (OGZD:LSE; GAZ:FSE; GAZP:MCX; GAZP:RTS; OGZPY:OTC) has a strong monopoly on gas supply despite a plethora of untapped resources. Many of the governments in these countries (Poland, Romania, Ukraine, etc.) are now incentivizing junior domestic players through undemanding fiscal terms to prove up these resources to secure energy self-sufficiency. In return, these junior companies enjoy gas prices far in excess of the Henry Hub, which is about $3 per thousand cubic feet (Mcf).
The Romanian gas market is slated to deregulate its gas prices next year. That should bring it inside the European average of $8–13/Mcf. We have a Buy recommendation on Hawkley Oil & Gas Ltd. (HOG:ASX), an Australia-listed company that owns and operates Ukrainian assets. It was getting $11.80/Mcf, which is a fourfold multiple to the Henry Hub. Our target price for Hawkley is $0.72/share. Other beneficiaries of this type of price movement in Europe include Zeta Petroleum Plc (ZTA:ASX), Aurelian Oil & Gas Plc (AUL:LSE) and San Leon Energy Plc (SLE:LSE; SLGYY:OTCBB), which is merging into Aurelian.
Another interesting proposition for investors, in my view, is the growing interest in the supply of regassified liquid natural gas (LNG) to gas-starved West African markets. To clarify, LNG is natural gas that has been converted to liquid form for ease of storage or transport. Regasification is the process of returning the LNG to natural gas prior to distribution.
London-listed Gasol Plc (GAS:LSE) is looking to service this growing demand by securing sales agreements with LNG suppliers and national governments for fixed periods. LNG cargoes will be delivered to a floating LNG regasification facility, which will then either pipe gas to nearby industry or power generation facilities.
TER: Are the explorers that you cover focused on finding and developing gas-producing properties that they can hold onto as income producers, or are they typically more interested in selling their properties to a major corporation once the resources are proved out?
SW: That’s a very good question and the answer will strongly depend on the individual management team, their strategy and the diversification of the company’s asset portfolio. It is extremely difficult for a junior gas explorer to prove up and commercialize an asset alone, given the significant financial and technical resource base necessary to do so. We often see juniors acquire an asset, shoot seismic and potentially drill one or two exploration wells, at which point they have sufficiently derisked the acreage to attract a partner to assist in bringing the asset through field development.
We’ve seen this strategy work recently with Tethys Petroleum Ltd. (TPL:TSX; TPL:LSE). Seymour Pierce has a Buy recommendation on Tethys and a target price of $0.72/share. Its most significant asset is the Bokhtar area in Tajikistan, with an estimated 27.5 billion barrels oil equivalent (Bboe). The company recently announced a farm out of this asset, bringing in Total S.A. and CNODC as equity partners.
We also have a Buy recommendation on CBM Asia Development Corp. (TCF:TSX.V), with a target of $0.54/share. CBM is acquiring high-quality cold bed methane (CBM) acreage in Indonesia. It plans to derisk the properties to about 80% certainty by drilling low-cost wells to reach early-stage production and generate cash flow. At that stage, the company will seek to sell the property to a major oil company to capture the valuation upside from the derisking process and unleash shareholder value.
TER: Indonesia is a microcosm of East Asian energy development. It is balancing its domestic needs against export demands and it enters into production-sharing contracts between the government and the CBM explorers that bear the burden of derisking the gas fields. Where is the margin in this type of public-private venture?
SW: The country’s natural gas market is characterized by a declining supply of conventional gas and a rapidly growing domestic market with a large export segment. A clear margin exists where the domestic gas price is between $5–11/Mcf, whereas the export prices go as high as $15/Mcf.
It turns out that 50% of Indonesia’s gas is exported to North Asian markets in the form of LNG—down from 62% during the past decade. So a declining conventional gas production combined with driving domestic gas consumption is crimping Indonesia’s ability to meet its own LNG export obligations and its ability to capitalize on the high gas prices in North Asia. Meanwhile, domestic consumption has risen over 100% during the last 10 years. That’s largely a function of Indonesia’s strong economic growth, which is headed toward a gross domestic product of $1 trillion this year.
Looming shortage of supply is causing the Indonesian government to support public-private CBM development projects with incentivized production-sharing contracts (PSCs). The terms allow contractors to take 40–45% on an after-tax basis—higher than the industry average. The capital requirements for CBM exploration, which is classed as unconventional, are low—between $2.5–3 million ($2.5–3M) to acquire a production-sharing agreement and up to $4–6M to complete the exploration phase. The risk and costs are low with the potential for high returns. The situation has set off a bit of a land grab in Indonesia.
TER: What other companies are focused on CBM exploration?
SW: In addition to CBM Asia, other companies active in CBM exploration in Indonesia include BP Plc (BP:NYSE; BP:LSE), Dart Energy Ltd. (DTE:ASX), Exxon Mobil Corp. (XOM:NYSE), Santos (STO:ASX) and Total. Whilst in our view CBM Asia and Dart Energy have the most compelling investment case at the moment, we would expect more entrants into this particular market given the low cost of drilling and access to existing infrastructure.
The Australian CBM industry is mature. Between 2003 and 2011, Australia’s CBM industry consolidated through 33 mergers of small, independent operators with a value of over 30 billion Aussie dollars. I believe a similar consolidation could occur in Indonesia as acquirers of Australian CBM assets such as Total and Santos, which are active in Indonesia, look to pick up small companies like CBM Asia.
TER: Let’s talk about CBM drilling for a moment. How does it differ from conventional gas drilling?
SW: Coal bed methane is a byproduct of the coal formation process. It’s chemically identical to other sources of natural gas, but it’s cleaner than hydrogen sulphide. In the reservoirs, the methane is absorbed into the coal surface—held tightly in place by a layer of water. Drilling a production well releases the water pressure in the coal stream, allowing the gas to float to the surface following the water. The wells are shallow, less than 1,000 meters down to the gas-rich stream. Remarkably, such a well can be drilled and completed in less than 48 hours.
TER: When a major is looking at CBM juniors, what metrics do they require?
SW: The effects of the U.S. shale boom on the Henry Hub have led many majors to deploy their technical resource base in extracting unconventional resources in high spot-price environments. They are constantly on the lookout for sufficiently derisked assets, made through a combination of seismic and drilling activity. They want to take a significant equity portion, and they want the asset to be located in geopolitically stable regions with a strong demand or sufficient infrastructure in place so that they can easily export the hydrocarbons. If most of these boxes are checked, there is a good chance that a major will show interest in a junior oil and gas company.
Recently, BP divested many of its non-operating gas interests in the North Sea, while increasing its presence in West Africa. It has just farmed in to Chariot Oil & Gas Ltd. (CHAR:LSX) block. Exxon exited many of its Polish shale concessions in favor of the reported interests in onshore United Kingdom shale by Egdon Resources Plc (EDR:AIM). The U.K. government has lifted a suspension on fracking in the U.K. Now Exxon is interested in some of the onshore U.K. assets. Egdon Resources could be a key benefactor.
TER: Nonetheless, share prices for many gas explorers are not very robust. Why?
SW: Historically, gas prices have been linked to oil prices. Starting with the U.S. shale boom, we have seen a divergence—oil prices have remained strong, while gas prices have generally fallen. However, contract prices for drilling infrastructure such as rig equipment and personnel continue to be linked to oil prices. The upshot is that gas exploration has become increasingly less viable.
There have also been a number of micro-economic events that affected individual companies and regions. The difficulty in employing extraction methods in Central Europe using similar techniques as those in North America arises from the significant differences in the geological makeup. This has led to disappointing exploration performance.
TER: Are there limits to the supply of natural gas that can be profitably brought to market?
SW: The movement of the gas market is largely randomized on a macro level. Shifts in supply and demand are being dictated by economic growth in emerging economies and continued productivity from existing and untapped resources. It’s fairly unpredictable.
But in the near term, gas prices will be dictated by the aggressive use of gas in China and India from their growing economies, which will push prices on a global scale. As will the discovery and utilization of gas resources in Latin America—an up-and-coming region with a huge, untapped potential for natural gas. There is a move away from nuclear power in Japan and some European countries in response to the nuclear incident in Fukushima. And Europe is continuing to process policies requiring greenhouse gas emissions reductions. That could hinder direct gas exploration there.
In Russia, however, people are slowly chipping away at Gazprom’s monopoly. In response, it is looking to regasify the Far Eastern region, which could also push prices. Generally, the ongoing search for shale and other unconventional gas will dictate the global gas price regime. In the U.S., though, the low Henry Hub price could result in a lot less drilling for gas and more of a focus toward oil production, which could drive gas prices back up.
TER: Thanks very much, Sam.
SW: Many thanks, Peter.
Sam Wahab began his career at PricewaterhouseCoopers (PwC), where he qualified as a prize-winning chartered accountant. On PwC’s energy team, he specialized in assurance and transaction advisory. His clients including Royal Dutch Shell and JKX Oil & Gas. Following a spell in the oil and gas research team at Arbuthnot Securities, Wahab joined Seymour Pierce in 2011. He heads up oil and gas equity research at the firm. His coverage includes companies with global operations on multiple stock exchanges.
When oil was in the limelight, Sprott’s Bambrough and Dimitriadis went for wallflower companies in beaten-down sectors. Since 2007, the pair has seen striking highs and lows in natural gas, coal and potash and invested accordingly, infusing companies with much-needed capital and creating startling profits during sector upswings. Read on to benefit from the wisdom these two successful fund managers share in this Energy Report interview and find out where the duo is looking next for major growth.
The Energy Report: Much has happened on the economic, political and financial fronts since your last interview in February 2011. Obama has been reelected, oil is now at $87 a barrel (bbl) and quantitative easing is the new normal. Have any of these developments changed your investment perspective?
Kevin Bambrough: They haven’t changed our perspective because we’ve been prepared for these events for some time. We view this as a 15- to 20-year trend where runaway deficits and printing money is the chosen solution central bankers will provide to the markets. It will ultimately result in the U.S. dollar losing its reserve currency status and paper money, as we know it, becoming essentially worthless over time. Real businesses and real assets are what you should own.
We focus solely on resources at Sprott Resource Corp. (SCP:TSX) and Sprott Inc. (SII:TSX) focuses primarily on resource-related investments. Our long-term strategy is to sell businesses with strong margins in fairly buoyant sectors that could become unsustainable and depressed in value over time. We then recycle those investments into areas of the resource sector that are quite depressed and have an upside in valuation and margins. At the same time, we focus on building solid businesses in jurisdictions where we can develop our assets and create value.
Paul Dimitriadis: We started out in September 2007 with roughly $70 million ($70M) of capital with the idea of building a publicly traded private equity firm. Over five years, we’ve compounded capital, net of fees, at roughly 28% annually, growing the net assets to over $450M during a period when the resource sector has been extremely volatile and most resource stocks and the major indexes are down. We’re quite proud of that record. We’ve also been very active in buying back our shares to increase the net asset value per share, and have bought back a little over $70M worth over the last five years, which we’re committed to continue doing.
TER: In the broad economic/financial picture, how far down the road can governments keep kicking this can?
KB: I think the printing is going to continue out of necessity because governments need to provide funding for their operations. When governments issue bonds, central banks are the ultimate backstop for buying them. This process will continue on until investors around the world stop holding onto bonds or currency as a store of value and decide to own something more concrete than a promise from a bank or a government institution.
PD: To follow up on that, over the past 5–10 years, there’s been a lifestyle adjustment taking place globally that’s being reflected in the price of real assets. The emerging markets are getting wealthier and competing for real assets with the developed economies. We’re going to continue seeing the pressure on the EU and North American economies as the middle class gets squeezed further, while the emerging economies continue to progress and consume more, putting additional pressure on the resource pricing.
TER: Maybe we can talk about the individual resource segments you’re interested in at Sprott, starting with the oil market.
KB: In 2007, when everybody was loving oil at $140/bbl and gas at $10 per thousand cubic feet (Mcf), most resource funds were very heavy in oil and gas. We went to investing in coal, phosphate and potash. Nobody was really even looking at phosphate and potash at that time and the coal market was facing bankruptcy. Sprott Resource stepped in and gave capital to a company called PBS Coals Ltd. during a very weak time in the market when we saw a rebound coming. When that rebound came with very high coal prices in 2008, we took the company public and ultimately sold it. It’s now fully owned by Severstal Russian Steel (SVST:LSE).
Similarly, we monetized some of our potash and phosphate investments during a lofty period in that sector during 2009 and reloaded most of our capital into oil and gas.
TER: What’s your view of the oil market now, considering all the development going on all over the world with new offshore reserves that are fairly substantial?
PD: There’s been a lot of development in unconventional drilling and development of offshore reserves that were previously difficult to produce economically. Much of this new production is relatively short life and expensive, and is putting us on a treadmill just to maintain current global production rates. Bakken marginal production is over $80/bbl. Offshore is very expensive, so we’re putting a floor under oil prices at around $80/bbl West Texas Intermediate. It’s going to be difficult to sustain production with these unconventional barrels that have steep decline rates.
KB: To continue on Paul’s point, when the marginal price goes below that $80/bbl, we’ll be buyers because that price is unsustainable and oftentimes companies will be trading at very low values to a low oil price. When the price gets high and multiples tend to expand on optimism, we’ll be looking to monetize again. We’ve been continually adding to our oil and gas position. We’ve managed to merge Orion Oil & Gas Corp. with a company called WestFire Energy Ltd., and another company we invested in called Galleon Energy Inc., which became Guide Exploration Inc. They all came together and now it’s called Long Run Exploration Ltd. (LRE:TSX). It’s a very large oil and gas producer with significant upside.
PD: Long Run is currently producing around 23,000 barrels of oil equivalent per day, at a roughly 50/50 ratio of oil to gas. It has an incredible land package of around 600,000 net acres in northern Alberta and over a billion dollars in tax pools. We’re excited about this because it’s incredibly undervalued relative to its peers—probably 30–50% lower than companies of its size. Also, with its huge land package, we think that the company will be able to grow successfully over the next few years, principally in the Viking and the Montney. We’re buying the cheap of the cheap and it’s a core holding for us.
TER: Are you going to continue to grow Long Run or is it going to be taken out at some point by somebody larger?
PD: With sovereign funds and state oil companies, you never know where a bid might come from. But our focus is on building the company and developing its land position.
KB: An asset needs to be fully valued before we even consider parting with it because we’re very patient, long-term oriented investors and we can afford to take our time to advance it.
TER: What are your thoughts on natural gas?
KB: The conventional wisdom in 2007 was that the gas price was going to stay above $10/Mcf. That winter everyone was concerned that we’d run out of natural gas. Fast-forward to 2011, when natural gas plummeted to $2/Mcf, and people were saying it was going to zero because the storage was going to fill and we wouldn’t be able to deal with it. Finally, we had a big rinse-out in the sector. We continued to invest capital to build a bigger, stronger company that would be positioned for the rebound. Now we have a more positive market, and we think it’s going to continue to improve. In 2007, the question was whether we could build enough terminals to import enough gas quickly enough. Now everyone’s talking about exporting it—it’s a complete mirror opposite.
TER: What are your expectations for the coal market?
KB: The coal sector is looking a lot like it did in 2007, when we were buying PBS Coals. It’s a very depressed sector and we haven’t begun to see a strong rebound yet. Almost every coal stock has been crushed back to lows they hadn’t seen in years, and we’re looking to put capital to work. We’re trying to find the right opportunity, although it may still be a little early. We’re focusing on emerging markets, where we would like to make long-term investments, buy assets or partner with foreign entities that want to access fuel sources for their own country. The main key is to be in a country where we don’t have to worry about expropriation or excessive taxation. That’s becoming more difficult, considering all of the government budget problems all over the world.
TER: Uranium appears to be coming out of the doldrums. What’s your take on the sector?
KB: Despite Fukushima, many large utilities are seeking to build new nuclear facilities, especially in emerging markets and the Middle East. It’s becoming increasingly evident that there’s going to be a shortfall of uranium production in the coming years as some of the old mines are depleted. The depressed price doesn’t make most new mines attractive investments, so the sector has been starved for capital for a few years now. We expect that higher prices will inevitably attract capital to the sector. The new facilities under construction are going to have to pay up to secure supply and they’re going to have to fund mining projects, which is something we’re actually looking at. We’re working with some parties now that want to fund development projects in order to get offtake agreements in place.
TER: What uranium price would make uranium mining projects more economic?
KB: Investment would be much more attractive with uranium nearer the $75 per pound level. It may take a couple of years to get there.
TER: How are you playing that market?
PD: Our principal investment in the uranium sector right now is Virginia Energy Resources Inc. (VUI:TSX.V), which owns the Coles Hill deposit in Virginia. It’s the largest untapped deposit in the U.S. and it would be an economic boon to the area, if developed. The big issue is the moratorium on uranium mining in Virginia, which explains why the stock is so cheap relative to the project size and economic value. The legislature is going to consider a new mining law in the near future and we’re hopeful it will pass. If it does, that would obviously revalue this investment, probably making it worth multiples of what it is right now.
TER: When do you expect to see a legislative decision on this?
PD: The matter should be examined in the 2013 legislative session.
TER: Are there any private equity deals you’re involved in that will soon be going public?
PD: We don’t have any that we’re going to be taking public soon. We just monetized an oil and gas investment called Waseca Energy for a large win. We’re sitting at roughly $115M in gold bullion and $25M in cash.
KB: Right now we’re very focused on getting Sprott Resource’s stock trading much closer to its net asset value. It traded at two times net asset value when we first started the business, and as low as $0.50 on the dollar during bad times in early 2009. We’ve been buying back stock aggressively. We just announced a four million-share block purchase. We’re going to keep doing whatever it takes to tell our story and attract investors that are interested in sticking with us for the long run.
TER: What do you see ahead in 2013, and how can investors profit or protect their assets?
KB: I see more of the same—more deficits, more printing, more bailing and more volatility. We think that precious metals are going to do very well in this environment and that investment demand is going to eventually overwhelm the paper market. In the 1970s, gold went from around $35 per ounce (oz) up to $850/oz in 1980. That was a 25-fold increase within 10 years. This gold bull market started at around $250/oz in 2002 and I’m convinced that this run will carry a larger magnitude at a higher multiple because there isn’t as much physical gold held by central banks.
The seventies boom was ended in part by central banks dumping gold onto the market and leasing out their gold to bullion banks to flood the market in order to regain stability in the currencies, versus gold. That took interest rates to double digits all around the world. Now, no government can afford to raise interest rates because they’re already at huge deficits and raising them would make deficits even larger. Gold’s been up every year for the last 10 years but, at some point the doors are going to blow open.
TER: When do you expect mining stocks to perform more in step with the metals themselves?
KB: I think there’s going to be a continued separation between quality stocks and the more speculative ones. In the early boom in the gold stocks, almost any stock went up 10- to 20-fold over a period of 10 years. Some of the bigger ones that had hedges didn’t. The unhedged gold juniors and the exploration companies were awarded capital with very little discrimination by the investment community. Now we’re starting to see more emphasis on the companies that could actually produce gold profitably and be free cash flow generators that become dividend-payers. They make money the old-fashioned way—they mine it.
TER: Let’s end on that positive note. Thanks for speaking with us today.
KB: Thanks for having us.
PD: Thanks for the opportunity.
Kevin Bambrough founded Sprott Resource Corp. in September 2007. He is a seasoned financial executive with more than a decade of investment industry experience and is a recognized leader in the commodity investing space. Since 2009, he also has served as president of Sprott Inc., one of Canada’s leading asset managers, which has more than $8 billion in assets under management. Between 2003 and 2009, he held a number of positions with Sprott Asset Management, including market strategist, a role in which he devoted a significant portion of his time to examining global economic activity, geopolitics and commodity markets in order to identify new trends and investment opportunities for Sprott Asset Management’s team of portfolio managers.
Paul Dimitriadis is Chief Operating Officer for Sprott Consulting and Sprott Resource Corp. He has been with Sprott since 2007. Dimitriadis evaluates and structures transactions, coordinates and conducts due diligence and is involved in the oversight of subsidiaries and managed companies. He serves on the board of directors of two of Sprott Resource Corp.’s subsidiaries, Stonegate Agricom Ltd. and Long Run Exploration Ltd. Prior to joining the Sprott group of companies, he practiced law at Blake, Cassels & Graydon LLP. Dimitriadis holds a Bachelor of Laws degree from the University of British Columbia and a Bachelor of Arts degree from Concordia University.
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Is this not one of the biggest threats to Pittsburgh’s economy in years?
Why a local economic story? A lot of this stuff is not leaving here by plane:
If you dig into that export data lots of things pop out. The value of international exports in “Mining (except oil and gas)” went up over 60% between 2010 and 2011. That is data for the MSA, which means it does not even capture the prodigious coal being mined in nearby counties like Greene. Might be worth noting that more recent national data shows more coal exports for 2012 thus far at least when measured in tons, if not value.
Fracking in the U.S. is here to stay, affirms Keith Schaefer, editor of the Oil & Gas Investments Bulletin. North American business is dependent on cheap energy, and even energy utilities are switching from coal to natural gas. Although environmental concerns remain, the industry has incentive to do the right thing, says Schaefer. In this exclusive interview with The Energy Report, Schaefer profiles service companies that are using cutting-edge technology to make fracking safer, greener and cheaper.
The Energy Report: Keith, considering that natural gas prices are still near all-time lows, can you still argue that fracking has improved North American energy markets?
Keith Schaefer: In just a few short years, fracking grew the supply of natural gas way ahead of demand. The price of natural gas fell from $8–9/thousand cubic feet (Mcf) to $2/Mcf! Natural gas is the low-hanging fruit for the energy sector and for consumers. Cheapened feedstock provides a huge boom for American business.
TER: Have fracked oil prices kept pace with falling natural gas prices?
KS: It has not declined by the same degree, but it has lowered the cost of North American oil. West Texas Intermediate (WTI) used to be the major benchmark for oil around the world. Now, WTI is only a benchmark for a small area of the United States and Canada. In addition, the flood of supply coming out of new shale oil wells in North Dakota and Texas is overwhelming the refinery complex in the Gulf Coast, which is about 50% of North America’s refinery capacity.
TER: Is there a glut of gasoline? Prices for consumers are certainly high.
KS: That’s a great question. The short answer is no. But the long-term answer is yes. People are saying, OK, how come gas prices at the pump are so high when we’ve got all this oil? What’s going on? Here is how the game works: the refineries are moving their production flows to produce the least amount of driving gasoline possible, and the most amount of other refined products, like home heating oil fuel, diesel, kerosene and jet fuel. These are products they can export, in which case they get to use the Brent prices, which are 15% higher than WTI prices. These refineries generally operate on skinny-to-average margins, so 15 points is huge for them. That is why the price of retail gasoline for driving is 50% higher than it was in 2008.
Let me give you an example. I’m in Vancouver. We sell gas by the liter, not the gallon. Back in 2008, we had an uncanny relationship where if oil was $100 a barrel (bbl), gasoline was $1 a liter (L) at the pump. If it was $110/bbl, it was $1.10/L. If it was $1.35/L in Vancouver, oil was $135/bbl. Now, gasoline is $1.35/L, but oil is only $96/bbl. Why? Because the refineries are producing the least amount of gasoline, and the most amount of other refined products.
TER: Does fracking lower oil production costs?
KS: As a rule of thumb, the cost of production for most shale plays in North America is $40–45/bbl, which is not that much different from costs using conventional methods. It is above-ground logistics that cause lower prices for fracked oil. We don’t have enough pipelines to efficiently transport the fracked oil to the refineries. Consequently, supply backs up at the hubs, creating big discounts. For example, in late June, Canadian oil and Bakken oil were at huge discounts, almost $20/bbl to WTI. Because of pipeline disruptions and refinery downtime, Canadian producers were receiving under $70/bbl for their oil. But only 2½ months later, the logistics are running smoothly and Bakken oil is now selling at only a $3/bbl discount to WTI.
TER: Why do we see regional price differentials at the pump?
KS: Logistics. Here is an example. Recently, BP Plc’s (BP:NYSE; BP:LSE) Cherry Point refinery, which is just south of the Canadian border, went down. The next day, gas prices jumped $0.30 per gallon from Seattle to San Diego.
It’s not like we have no new refining capacity. Even though no new refineries have been built since ‘76 in the U.S., refineries have been expanding. Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and Saudi Aramco have spent $10 billion during the last few years, doubling the size of their Motiva refinery in Texas from 300,000/bbl per day (bblpd) to 600,000/bblpd. It immediately ran at full capacity. But, then, an industrial accident took the new expansion offline for nearly a year, which boosted the retail price.
TER: Why is fracking politically controversial?
KS: Scientific studies have shown that fracking is not an environmental issue. It does not contaminate the ground water. There is usually more than a mile of granite between where the fracking takes place and the water table. On the other hand, the government of British Columbia has released a study finding that fracking causes earthquakes. And there is seismic activity associated with fracking and saltwater disposal wells, but that takes place in the formation where the fracking is occurring. The quakes are no different than any of the millions of micro seismic events that happen around the world every day. Of course, there is an impact. Blasting for mining creates seismic events. Building a dam creates seismic events. Filling a large manmade lake creates seismic events, because water is heavy. Fracking is no different.
It is the fierceness of emotion that is the big issue here. People get nervous about the safety of their water supplies and say, “Hey, prove to me that fracking is really safe!” Industry has responded by saying, “Look, here’s the science. We’ve been doing this for 50 years. No need to worry, it’s all good.” But that’s not what people need to hear. People need to hear, “Hey, we hear that you’re really concerned about this, that it’s a big issue for you. Let us come together at a community hall and talk about it.” That would be more effective than just taking out ads that say, (a) we bring so many jobs to the area, why are you bugging us? and (b) we’ve done this for decades, why are you bugging us? That kind of attitude is not going to win any arguments.
TER: Are drought conditions in the Southwest and Midwest affecting the availability of water for fracking?
KS: Due to drought, the price of water for oil and gas companies has more than doubled in the Midwest and Texas. Some of the oil and gas companies are not drilling as much as they said they would this year because they need to figure out where to get the water and how much they want to pay for it. Even though the amount of water used by the industry isn’t huge compared to irrigation, there are areas where the oil industry is bidding for water rights against farmers. The industry needs to be very careful about public relations. Otherwise it becomes a case of the big guy against the little guy.
TER: Are there any technological fixes to that issue?
KS: Yes. Firms involved in the fracking supply chain are figuring out how to source, treat, recycle and dispose of water efficiently. One company that comes to mind is Ridgeline Energy Services Inc. (RLE:TSX.V). It has a proprietary water recycling technology. EOG Resources Inc. (NYSE: EOG) is a Ridgeline client, as is Pure Energy Services Ltd. (TSX:PSV). These companies are starting to recycle their fracking water, which is great.
Other companies doing water management include GreenHunter Energy (GRH:NYSE:MKT). That’s Mark Evans’ deal from Magnum Hunter (MHR: NYSE.A). This company is determined to use saltwater disposal wells as its entrée into the water management sector. Another company is Poseidon Concepts Corp. (PSN:TSX). It has a water storage product and is branching out into more vertically integrated work in the water sector. There are lots of companies experimenting with this, and for good reason—there are very big margins, 50–85% gross margin. That’s fantastic. It beats the pants off any other service in the oil patch. Investors should be taking a strong look at fluid and water service companies.
TER: Aside from the Bakken shale, what are the most exciting international sources of shale oil and gas?
KS: The only other notable proven deposit of size is the Vaca Muerta shale in Argentina. There are a few Canadian juniors down there, but the Argentine government has started to nationalize part of YPF SA (NYSE: YPF). Plus, some permits were pulled from juniors by provincial regulators. That put a huge chill in the market for these stocks. They are well funded and cashed up, but the market’s just not going to care about them until there’s real production growth.
European shales have been fairly slow to take off. Poland’s been on the hot list for a while, but nothing’s happened. During the next two to three quarters, we could see a few wells get plunked down in New Zealand. That looks like a fairly thick formation. If it gets going, it could be a big win for investors next year.
TER: What about the oil and gas shale near Paris, France?
KS: Fracking is still banned in France. ZaZa Energy Corp. (ZAZA:NASDAQ) dropped its French play and is now focused on the Eagle Ford shale and the Eaglebine in Texas.
TER: Could fracking be banned in the U.S., either in certain areas or in its entirety?
KS: Fracking will never be banned in the U.S. But if it did happen, businesses would go bankrupt left, right and center. Many companies are hooked on cheap gas. There would be widespread bankruptcies and unemployment. Power companies are using cheap gas instead of coal. The U.S. reduced its greenhouse gas emissions more than any other country in the world over the last two to three years because of shale gas.
TER: What technological changes will keep fracking profitable, while reducing its environmental footprint?
KS: A company called GasFrac Energy Services Inc. (GFS:TSX) has been trying to get the industry to start using liquid petroleum gas (LPG) for fracking, instead of injecting water into the ground. LPG is propane, which is a naturally occurring substance in the formation, so it doesn’t damage the formation, as water can. Unfortunately, the company is not having very much success. But the industry is doing a lot of research into food-grade fracking fluid. The idea is to make fracking fluid as green and environmentally friendly as possible. That’s a couple of years away, but it’s only a matter of time.
TER: Any other names on the cutting edge of fracking technology?
KS: Raging River Exploration Inc. (RRX:TSX) has a big play in the Viking formation in Saskatchewan that is very profitable. Its water flood technique is returning incredibly cheap oil. It got the first half million barrels of oil out at about $30–35/bbl, and the last half million barrels at $5–10/bbl. It is at the forefront of recovery technology. Normally, a firm is lucky if fracking returns 10–15% oil. But with the water floods, the recovery factor can go way up. That is great news for Raging River stockholders.
Renegade Petroleum Ltd. (RPL:TSX.V) is also working in the Viking formation, and it has two other upcoming plays worth watching. One is the Slave Point play in Red Earth, which is north of Edmonton. Pinecrest Energy Inc. (PRY:TSX.V) has been involved. Renegade will drill the first well later this year. If it can prove up one or two wells, it has a big enough land package to allow a lot of new locations to open up. Renegade also has a really interesting conventional play in southern Saskatchewan called Souris Valley. It’s turning out to be a lot more profitable than the company had originally thought it would be.
TER: What is your bottom-line message on the future of fracking?
KS: Mainstream public attention on water management isn’t a bad thing. It makes the industry do things that should get done. Fracking water should be food grade. The market rewards stocks for doing the right thing. There’s nothing that the market hates more than uncertainty. If the industry starts to lose what I call its “social license” in the United States, that loss will have a very big impact on valuations. Companies are incentivized to do the right thing, to do it well—and to do it fast. That’s why we will soon see a resolution to the fracking issue.
TER: Thank you for chatting with us today.
KS: A pleasure as always.
Keith Schaefer of the Oil & Gas Investments Bulletin writes on oil and natural gas markets. His newsletter outlines which TSX-listed energy companies have the ability to grow and bring shareholders prosperity. Keith has a degree in journalism and has worked for several dailies in Canada but has spent the last 15 years assisting public resource companies in raising exploration and expansion capital.
Oil prices are starting to creep back up while gas, coal and uranium are poised for moves this fall, according to Mark Lackey, long-time energy analyst now representing resource companies with CHF Investor Relations. In this exclusive interview with The Energy Report, Lackey shares his current insights on energy markets and talks about a number of companies he thinks are sleepers, ready to move quickly when the energy commodities take off.
: Bri-Chem Corp. – Cameco Corp. – Cline Mining Corp. – Colonial Coal International Corp. – Corsa Coal Corp. – Fission Energy Corp.
– Forum Uranium Corp. – Greenfields Petroleum Corp. – Primeline Energy Holdings Inc. – Rio Tinto Plc – Strathmore Minerals Corp.
The Energy Report: Since your last interview, you’ve made a jump from the research side of the business to the investor relations (IR) side. How has the view changed?
Mark Lackey: When I worked in the brokerage industry, I relied on IR people to bring me clients and stories, updates on companies I was following or promising companies of which I was never aware. There are over 3,000 companies listed on the TSX and TSX Venture exchanges and you can’t know all the stories, so analysts often need introductions. Here at CHF, I’m involved in taking clients, largely in the resource sector, to meet with research and corporate finance people and brokers as well as retail and institutional investors. We also help with companies’ press releases, presentations and even market-making.
But regardless of whether I’m doing research or IR, it’s still a function of whether you believe in commodity cycles and how certain sectors, companies, locations and managements will benefit and profit.
TER: Talking to other brokerage firms and people in the investment business, what’s the general mood at this point?
ML: In the small- and mid-cap market, the mood has been mixed. Some people are negative about the commodities sector in the short run, and some even think the whole commodity cycle is over. Others are more neutral. Then you have a smaller group of people who tend to support my view and are much more positive in the very short run.
TER: How does this affect your view of the oil and gas markets?
ML: I’m actually quite positive. After getting down below $80/barrel (bbl), West Texas Intermediate (WTI) is now back up over $96/bbl. The Brent price is at $115/bbl. Recent inventory numbers, particularly in the U.S., are down, so there’s no overhang in the near term. Demand has hung in reasonably well, considering all the European problems, and there’s still decent demand coming from the emerging markets. WTI will likely trade between $100/bbl and $105/bbl next year, with Brent between $115/bbl and $120/bbl.
Natural gas has been somewhat weaker, but it bounced off the $2/thousand cubic feet (Mcf) price a few months ago up to the $2.85–3/Mcf range in North America. With more industrial demand coming back, particularly in the auto sector, and stronger demand from electric utilities, gas should move back up closer to $3.25–3.30/Mcf in the next year. By way of comparison, prices in Europe can be anywhere from $4–8/Mcf, and in China they’re as high as $15/Mcf.
TER: What interesting oil and gas situations have you recently come across that deserve some investor attention?
ML: The first company I’d like to talk about is Greenfields Petroleum Corp. (GNF:TSX.V), which has production in Azerbaijan, a country that used to produce about 70% of the old Soviet Union’s oil and gas. Azerbaijan probably has the best history and the best understanding of oil and natural gas relative to most of the other countries in that area. Another advantage there is getting the Brent price for oil.
Azerbaijan still has some pretty good land positions available that would be more difficult to get in North America these days. Greenfields has gone back into some of the previously developed areas and is doing more delineation work, rather than wildcat exploration. It also has some greenfields projects. It’s going to get some pretty good returns given the prices over there for both natural gas and oil. I think you’ll see growing production from this company over the next few years in an area where there’s potential to see some real improvement in cash flow. The stock has had pretty nice moves off its lows. With higher expected oil prices in the next year, we would anticipate that the share price should move higher.
TER: Is Azerbaijan stable?
ML: Yes. Azerbaijan has had an oil and gas industry for over 50 years and recognizes that this is its biggest source of income. It understands the oil and gas industry and this is a relatively good place to do business compared to all the potential places that you could look for oil in the world.
TER: Who else is on your radar?
ML: We like Primeline Energy Holdings Inc. (PEH:TSX.V) and its prospects in the South China Sea. Its partner is the China National Offshore Oil Co. (CNOOC), which is a huge company. Primeline just put out an updated resource report and should be producing by the middle of next year. With the extremely high natural gas prices in China, the company should have good cash flows and earnings within the next year or two, as well as some pretty good capital appreciation potential.
The stock started to gain momentum after the company filed its Overall Development Plan for the Lishui gas project in June and it’s now pushing its 52-week high of $0.60. We think it offers investors a really attractive opportunity over the next few years.
TER: Oil services have been getting some positive press lately. Are you following any companies in that sector?
ML: The oil services side is often overlooked by investors. But drilling activity and rising prices create rising demand for oil services. We represent Bri-Chem Corp. (BRY:TSX), which is a North American wholesale distributor of oil and gas drilling fluids and piping products to the energy business. Bri-Chem is well integrated in the oil and gas service industry and expanded from Canada to the U.S. last year. It has earnings and cash flow and it is one that investors should be looking at.
Up until a couple of years ago, U.S. production had been on the decline for 40 years. But in the last few years, production has increased with improved technology accessing unconventional hydrocarbons, particularly in the shale formations. This has been a boon for many of the oil service companies like Bri-Chem, which is likely to grow its cash flow and earnings even more over the next few years. It’s trading around $2.65 and provides a pretty good opportunity for capital appreciation at these levels.
TER: Let’s talk about the uranium market. Prices have been fairly flat and they’ve shown a little weakness in the past month. What do you think is happening there?
ML: Uranium was $70/pound (lb) back in March 2011 and then drifted down after the Fukushima incident. Japan took steps to close all 56 of its reactors and the Germans have taken out about seven or eight. There are about 445 operating worldwide.
The price has been sitting around the $50–$51/lb range for a number of months and recently has gone down to $49/lb on the short-term market. The lower demand in the short run is the reason for the $20 hit. The Japanese have probably gone through three-quarters of their reactors, testing them to make sure they can withstand certain high-strength earthquakes. They are also putting up larger retaining walls and doing other things to prevent future problems from flooding. Our guess is that at least half of those reactors will be back in operation in the next six months and maybe as many as 75–80% of them within the next year, period. Nuclear power accounts for 15% of Japan’s needs. Japan’s economy really can’t function without some nuclear power in order to meet demand; its manufacturing sector requires an ongoing, inexpensive, stable power supply.
There are 60 other reactors around the world under construction and about another 240 planned over the next 5–10 years. Another factor is that next year, the phaseout of the Russian exports to the U.S. of highly enriched uranium from its nuclear warheads will end. Thus, demand is coming back and some supply is constrained, which should cause prices to move up in the next couple of years.
TER: What stocks do you like in the uranium industry at this point?
ML: We have followed Strathmore Minerals Corp. (STM:TSX; STHJF:OTCQX) for a while. It has large positions in both New Mexico and Wyoming, which has produced 90% of past U.S. uranium production. In 1980, the U.S. was the biggest producer of uranium in the world. Today it only produces about 4 million pounds (Mlb) a year, making up about 8% of its needs. Strathmore is sitting on large reserves and has the potential to be a significant producer down the road. It expects to be producing in 2016 out of Wyoming and in 2017 out of New Mexico. The stock price has probably been hurt by the weaker uranium price and the fact that it is three years from production. We expect uranium prices to rise to $65/lb by the end of next year and to $75/lb by the end of 2014. This could be a perfect storm for Strathmore, and the market will start to recognize this stock. I think you’ll see quite a bit of capital appreciation over the next two to four years.
TER: What else are you looking at in the uranium sector?
ML: We like Fission Energy Corp. (FIS:TSX.V; FSSIF:OTCQX). It recently took over another uranium company, Pitchstone, which had some very good properties, also in the Athabasca Basin of Saskatchewan. What makes Fission very attractive is its proximity to Hathor, which was taken over by Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK) last year in a battle with Cameco Corp. (CCO:TSX; CCJ:NYSE), the world’s largest uranium company. It’s obvious that Rio Tinto wants to get bigger in North America and Cameco would also be interested in making acquisitions.
One of the potential takeover candidates would have to be Fission. It does need to do more drilling and prove up its resource over time. But, it’s well positioned, has the money and is certainly in the right address near some of the biggest and highest-grade uranium mines in the world. It has good management and the company is well funded. We think this is a stock that people should also be looking to invest in. As this company moves forward and proves up more reserves, it will become a much more likely takeover candidate, perhaps in the next couple of years.
The other company that I like in this sector is Forum Uranium Corp. (FDC:TSX.V), which is really more of a microcap company, of which I only follow maybe three or four. My interest in Forum is based on its very good project location in the Athabasca Basin and its very experienced management team. Its partner is Rio Tinto, which just took over Hathor and wants to expand in the area. Other than maybe Cameco, you couldn’t ask for a better partner. It’s done some drilling and needs to do more to move this stock to a point where somebody would consider taking it over. For a micro-cap uranium play, Forum is a good one to look at considering its project and its partner.
TER: The other part of the energy market is thermal and metallurgical coal used in steel production. What have those two markets been doing?
ML: We tend to follow more of the met coal market. The weakness in the natural gas price, particularly in the U.S., has hurt thermal coal producers, especially in Appalachia, where there are somewhat higher costs. We think the thermal coal market will see some recovery over the next couple of years because it’s not just the U.S. that uses thermal coal. Far more thermal coal is used in China than in the U.S.
The high-cost producers have been affected the most as thermal prices have been hit as much as 20–30% in the last three to four months. That’s made a difference to the bottom lines and investment analysts’ view of that sector.
The same thing has happened in the met coal market. Because Chinese steel prices, particularly in China, have gone down 20% in the last three months, iron ore has gone down 20%, putting downward pressure on the met coal price because the biggest steel market in the world is China.
On the Australian market, the price has gone from $225/ton (t) down to $175/t. We think that this is probably the bottom of the market for steel, iron ore and met coal because construction activity usually picks up dramatically in China in October, November and December. We expect that all three areas will see recovery moving into the fall and through next year.
Weakness in the met coal market has affected the prices of all the companies we’re going to talk about. I’d rather be buying when the met coal price is $175/t than when it was $225/t three months ago or when it was $300/t at one point last year. Now you can buy these companies at much lower prices and probably get much better value for your money.
TER: Let’s talk about some of the companies you like.
ML: The first one I like is Corsa Coal Corp. (CSO:TSX), based in Ontario with production largely in Pennsylvania and some in Maryland. It’s largely metallurgical, and a little bit thermal. Corsa has very high-quality coal that can be blended because of its low sulfur and ash levels. It’s well-located in Pennsylvania near the major U.S. steel industry, which is still the third-largest producer in the world.
If you’re one of the somewhat bigger neighboring producers in Pennsylvania whose quality of met coal is not as good, I think Corsa could be a good acquisition target. It expects to have some significant increases in production in the next two to three years. With the met price getting back up to the $225/t range over the next year or two, it should have some pretty good cash flow and potential earnings over that time.
The stock’s trading right now at $0.17/share. I don’t follow that many microcaps but Corsa is certainly one of the few I do and like.
TER: How about some other ones?
ML: Another one we follow is Cline Mining Corp. (CMK:TSX), a Toronto-based company with a significant met coal operation in Colorado that was about to start production within the last month. The decline in the price of met coal caused the company to postpone start-up and lay off people for 60 days. As a new producer, it could have been difficult to sell any of its coal. I think management did the wise thing by waiting to see if the market will come back in the fall and not build up too much inventory in a weak market.
Of course, this disappointed the market and it hit the stock price fairly hard. Cline has very good-quality coal with significant reserves and could be a pretty significant producer within the next two to three years, selling some in the U.S. and shipping some through Texas all the way over to China. With the expansion of the Panama Canal in 2014, bigger ships can go to China and a company like Cline would probably sell most of its coal abroad in the future.
TER: What other companies do you like?
ML: Colonial Coal International Corp. (CAD:TSX.V) is a western Canadian met coal company in the Peace River area in Alberta. It’s in a good met coal-producing area with infrastructure, rail, experienced labor and decent power prices. Colonial is working on developing two very high-quality met coal properties, suitable for coking, with large reserves. There have been a number of takeovers in this area in the last year. And, looking at valuations, this company could certainly be trading at a much higher level if somebody was targeting them. If I had to pick someone in the met coal business in western Canada right now, Colonial would be my most likely acquisition target. Comparing it to the value of some of the other companies out there, its stock price should be considerably higher than where it’s trading right now, at around $0.76/share.
TER: To wrap things up, give us your general thoughts on where you think things are headed and how the average man on the street should be looking at these energy investments.
ML: If you believe we’re in a long-term commodities cycle, as we do here at CHF, then this is probably one of the best points to enter these markets.
We think oil is going higher, while some of the natural gas prices in the world are already extremely high. Coal and uranium markets appear near the bottom and we expect to see higher prices over the next two to three years.
In short, we think this is actually one of the better buying opportunities we’ve seen in the last decade for small and mid-cap companies in these sectors, and select micro-caps with sound fundamentals.
TER: Thanks for talking with us today. There are certainly lots of good opportunities out there.
Mark Lackey, executive vice president of CHF Investor Relations (Cavalcanti Hume Funfer Inc.), has 30 years of experience in the energy, mining, banking and investment research sectors. At CHF, Lackey involves himself with business development, client positioning, staff team coaching and education, market analysis and special projects to benefit client companies. He has worked as chief investment strategist at Pope & Company Ltd. and at the Bank of Canada, where he was responsible for U.S. economic forecasting. He was a senior manager of commodities at the Bank of Montreal. He also spent 10 years in the oil industry with Gulf Canada, Chevron Canada and Petro Canada.
Mongolia, which is not on most investment menus, could soon become famous for much more than Ghengis Khan. Sandwiched between China and Russia, with a land area one-sixth that of the U.S., it has a population of less than three million, yet holds the potential for developing into a major minerals producer. With national elections on June 28, in this exclusive interview with The Gold Report, Eric Zurrin, CEO of Resource Investment Capital Ltd., who lives and works mainly in Mongolia, gives us an insider’s view of what’s going on in this true land of opportunity for investors who recognize its huge potential. He also talks about several of his favorite companies that could profit from the vast mineral riches hidden under the Mongolian steppes.
The Gold Report: Thanks for joining us today, Eric. Mongolia has a population of fewer than 3 million people and most investors don’t really have it on their radar. Why do you think they should and how did you happen to become involved in that country’s investment markets?
Eric Zurrin: Mongolia will be one of the key global mining stories for the next 20 years. It’s a simple story driven by emerging market demand for resources, primarily from China, which accounts for 90% of Mongolia’s exports. The importance for investors is the speed of the country’s growth and how to get exposure to it. In the first quarter of 2012, gross domestic product (GDP) grew by 17% real, 30% nominal (year-on-year Q1 growth). For 2011, real growth was 8%, but we’re expecting to see real growth of 15% in 2012. So as an investment destination, particularly in today’s climate of lower global growth, Mongolia is extremely attractive.
I found myself in Mongolia due to my mining background in investment banking going back for the last 10 years in North America and Europe. I came out of the UBS mining team in London and have been backed by a private equity group called Origo Partners Plc (OPP:LSE), which is a listed investment company with about $125 million (M) of net asset value invested in Mongolia. The group is in Mongolia, led by Luke Leslie, who was a colleague at UBS.
“Mongolia will be one of the key global mining stories for the next 20 years.”
TGR: So what does Resource Investment Capital Ltd. do in Mongolia?
EZ: Resource Investment Capital (ResCap) is a corporate finance advisory boutique linking international capital with domestic investment opportunities. We are also one of the top three securities traders on the Mongolian Stock Exchange (MSE) and recently started investing proprietary capital alongside investors in private deals that we bring to the local stock market. Luke Leslie at Origo Partners made his first investment in Mongolia buying out Oleg Deripaska’s Mongolian coal interests for $15M. The value of this holding has increased 5.8x at the last capital raise. I joined Luke in Mongolia in 2010 after forming Rescap together and seeding it with initial capital. I now spend most of my time in Mongolia and I am long the local property market in Ulaanbaatar, which itself has been a lucrative investment on its own. There’s no better way to get your hands dirty and to fully understand the opportunities than to be on the ground and see the flow of inbound investors and outbound opportunities, both inside and outside of the mining space.
TGR: It seems that Mongolia first got on the horizon when my old friend, Bob Friedland, became involved there through Ivanhoe Mines Ltd. (IVN:TSX; IVN:NYSE) over 10 years ago. He was probably one of the early pioneers in getting Western companies to exploit Mongolia’s natural resources. Then, Ivanhoe came up with that huge Oyu Tolgoi project. What’s happening there?
EZ: Friedland has been involved in Mongolia for about 15 years, and he is undoubtedly one of the early visionaries for frontier resource investors. Ivanhoe Mines owns 66% of Oyu Tolgoi, the world’s second largest, undeveloped copper-gold asset, which goes into production at the start of Q4/12. Oyu Tolgoi is one of the world’s great copper assets. It is the backbone of the Mongolian economy and will be for the next 50–60 years. The capital expenditure bill at Oyu Tolgoi is $7 billion (B), of which 80% has already been spent. It has 100% financing guarantees by the current majority owner of Ivanhoe, which is Rio Tinto (RIO:NYSE; RIO:ASX), the bellwether mining investor and mining company that is underwriting its share of Ivanhoe’s current $1.8 billion rights issue. This gives us comfort that the operation will be there over many decades.
In its first 10 years, Oyu Tolgoi will produce 650,000 ounces gold and 600,000 tons copper annually, and, importantly for Mongolia, will result in billions of dollars of royalties and taxes for Mongolia. Oyu Tolgoi will come to dominate Rio Tinto’s copper portfolio. Rio has over a 50% interest in Ivanhoe, controls the board and the management, and has essentially taken over Ivanhoe. We think it’s probably not too far away from a full takeout of the minority positions as Oyu Tolgoi comes into production and once a new government is formed after the national election on June 28.
TGR: I noticed that Bob Friedland isn’t anywhere to be found on the Ivanhoe website. I thought he would at least be on the board of directors.
EZ: It’s a very recent change. His official title now is Founder of Ivanhoe and Oyu Tolgoi, but he’s no longer in management or on the board. We think there’s still one more really interesting chapter in the Rio Tinto/Ivanhoe/Oyu Tolgoi’s book that’s being written as we proceed—that being the takeover of Ivanhoe.
TGR: Of course, Bob has never been one to turn down a good deal. He can take credit for being the founder, take the money and do something else with it.
EZ: You’re absolutely right.
TGR: It seems as if there was a little finagling last year between Mongolia and this project over how much Mongolia was going to end up getting out of it.
EZ: That is correct. Last October, headlines coming out of Mongolia talked about the Oyu Tolgoi interest increasing to the Mongolian government. A new foreign investment law has been passed, after considerable watering down by local and foreign businesses. A former prime minister and president has been arrested and is on trial. These are important domestic political issues in the context of a national election that takes place June 28. This will be one of the most important events in Mongolian history. It will set the government up for the next four years and, likely, for the next two to three terms of government, as the incumbents ride the tide of what will be incredible growth in one of the fastest-growing countries in the world. This is a fiercely competed election.
TGR: What’s at stake? Are there competing factions that have some drastically different ideas? Or is it just about who gets to pull the strings?
EZ: There are two leading parties, the Democratic Party and the Mongolian People’s Party. Both are pro-business; both share very similar ideologies and a similar mandate. Three of the last four governments became coalitions, despite one of the parties typically having a majority. At the last election, the coalition controlled 90% of the Parliament and set out a framework with consensus decision makers. Although it takes a lot longer to get things done in Mongolia because of this process, it does set out widely adopted and endorsed policies that guide the country forward.
TGR: What’s the level of corruption or lack of corruption in Mongolia? How straightforward is its system?
EZ: In any frontier market, you’re always going to see some issues around corruption. Mongolia’s democracy is only 20 years old and is going through growing pains. It’s setting out rules and being increasingly strict to the letter of the law around keeping all businesses and politicians in line with Western standards. As more foreign investors and money come into the country, those are subject to rules in the U.S., the UK and Australia, which have their own corruption standards and bribery acts. These are now being brought into Mongolia as adopted standards.
TGR: It sounds as if Mongolia actually had an opportunity to build a system from the ground up without decades or centuries of corruption in place.
EZ: It’s obviously a sensitive topic and one that we’ve seen across Africa, Russia, China and Kazakhstan. Because of the size and scale of some of these mining projects, the incentives just become far too distant from the reality of the people setting up policy and rules. What you have are these massive projects being governed by individuals who are sometimes being paid $800/month, and signing off on $1B checks. There’s a massive disconnect there, which is coming into line in Mongolia. The rules being put into place are all great steps forward for the country.
TGR: How strong is China’s influence on what’s going on in Mongolia as far as the development and maybe even the government?
EZ: Mongolia’s lifeblood is essentially China—90% of the exports last year were China-bound, but China is also Mongolia’s Achilles’ heel. Mongolia finds itself land-locked between two of the biggest political giants in the world, Russia and China. To the south, the Chinese share nearly a 5,000 kilometer (km) border with Mongolia and have the strongest hand of anyone because the Chinese are the only consumers at the moment, and likely to be for a while, of Mongolia’s exports. Mongolia is 1,500km from the nearest seaport, which is in China.
To the north is Russia. Ulaanbaatar, Mongolia’s capital, literally means red hero. The Great Wall of China was built centuries ago to keep Mongolia’s national hero, Genghis Khan, out of China. So there’s a long history between the three countries. Unfortunately, China is essentially calling the shots on some of Mongolia’s commodities pricing. Mongolia is a price-taker to the Chinese who pay about $0.50 on the dollar for coking and thermal coal versus what it would pay to the Australians or Canadians for the same seaborne coal delivered to the ports on the Eastern Chinese Coast.
TGR: So China really calls the shots, because it’s the only reasonable buyer in sight at this point.
EZ: It is. Mongolia will finally begin building 5,000km of rail that will provide an alternative route for Mongolian commodities up through the far eastern Russian ports in Vladivostok and Vostochny. When that day comes, the valuation argument on many of the Mongolian commodity companies will be incredible because it will essentially reset the selling price of what they’re producing to a much higher level.
TGR: Let’s talk about some individual investment opportunities that our readers might be interested in taking a look at.
EZ: I’ll kick off with Ivanhoe. I can’t stress it enough. The current share price around $10/share implies about a $7.5B market cap. Put that in the context of the cash flow that is essentially underwritten, fully financed and near term from Oyu Tolgoi, with copper-gold coming out of the ground at next to zero or negative cash costs for the next 50–60 years. This is a near-term production story just months away. Now, put the $5B in revenue this project will see in only a couple of years, as it ramps up, into context with the other assets in the Ivanhoe portfolio.
These include SouthGobi Resources Inc. (SGQ:TSX; SGQRF:OTCBB) and Ivanhoe Australia Ltd. (IVA:TSX; IVA:ASX). Combine those two and some other peripheral assets and the Ivanhoe stable is probably $1–1.5B in value. Adding the sum of the parts, excluding the peripheral assets, it’s essentially valuing Oyu Tolgoi at $5–6B, less than the $7B capital that’s been put into the ground. It’s hard to see how Ivanhoe can get any cheaper. Rio Tinto obviously understands how good this company is and has been out in the market buying shares as high as $25 not too long ago. I don’t think Rio will delay the inevitable by doing a creeping takeover over many years. This will be a play that it just has to get its hands on quickly and at the right time and price. Rio Tinto is really an iron ore company with a mix of other commodities, when you look its commodity portfolio. Some 75% of its cash flow is from its iron ore assets. Oyu Tolgoi is a tier one global mining asset and goes a long way to solving a commodity diversification problem for Rio. So that’s Ivanhoe for you.
TGR: What else do you like?
EZ: In the copper-gold space, there’s one that we know quite well, Kincora Copper Ltd. (KCC:TSX.V), which listed last summer. We are a small shareholder in Kincora. The company holds a former Ivanhoe group of licenses in the South Gobi, about 140km northeast of Oyu Tolgoi and on the same copper-gold belt. Kincora is a vast exploration copper-gold company. It’s well known in Mongolia. It has a known and very large porphyry system, spanning about 7km across. There have now been about 100 holes drilled over the last decade in Kincora’s license area known as Bronze Fox and it was one of the top three priority targets, along with Oyu Tolgoi and one other in Mongolia, which Ivanhoe was exploring five or six years ago, before Ivanhoe was forced to succumb to political pressure to relinquish a significant part of its Mongolian land holding in order to advance Oyu Tolgoi with government support.
Robert Friedland in a famous quote once said that Oyu Tolgoi and Bronze Fox both kept him awake at night. He was not sure which one, if not both, would end up being the next jewel. He’s discovered Oyu Tolgoi, and we think Bronze Fox is on the cusp and is a fantastic target as well. Just a bit about the company—it has a massive continued mineralization zone, across 7km, completely open at depth. Kincora is now drilling for the high grade having identified an incredible copper-gold porphyry footprint spanning several kilometers. The company is drilling throughout the summer, as many others are in Mongolia. Four rigs are on site with a world-class team of geologists both formerly of Rio Tinto and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK).
The risks on junior miners are always that the high grade is never found and the company suffers a painful, slow existence. To mitigate that while continuing to drill for the next Oyu Tolgoi, Kincora is reviewing plans for a small operation to mine out the copper oxide ore and also reviewing a small operation of the gold and copper sulphide ore. That can be done at low capital cost of under $15M. The company is currently working at a scoping study level with indicative results showing a $10M/year cash flow operation for the next 10 years, which would provide funding for continued exploration without dilution to shareholders. It’s by no means definite and by all means risky, but it is unique in the junior mining space.
A third company I’ll touch on briefly, which we know well, is Undur Tolgoi Minerals Inc. (UTM:CNSX), backed by Firebird Funds, which is a New York private equity fund. Firebird has been in Mongolia for about five years and has sizable investments across much of the coal space and has been involved with Undur Tolgoi for the past year and a half. Undur Tolgoi is an early-stage copper exploration prospect in the South Gobi. It has yet to drill, but it is doing sampling and some seismic work. It’s less advanced than Kincora but also could be a very exciting prospect in the near or medium term.
TGR: When might there be some news on Undur Tolgoi?
EZ: The news flow in Mongolia dries up in the winter other than selective M&A because the temperature goes to -50′C. It’s not a very pleasant place to be managing drill rigs and pipes in the Gobi desert. The drill rigs come out in early April and drill through October/November. The lab results come out in late summer/early fall and into early winter. That’s when the news flows out of some of these companies. We would expect to see news from both Kincora, Undur Tolgoi and potentially even Ivanhoe over late summer, if not sooner, providing an extra bit of volatility to get share prices moving and returns for investors.
TGR: Are you seeing much investor interest in Mongolian resources from around the world? Or is it still not that high profile?
EZ: No, it is. We’ve been on the ground floor for the past two years and we see investors who actually want to be there and come and kick the tires on their own. We’ve seen a cross-section of private family offices, high net worth individuals, commodity traders, big and small companies and sovereign wealth funds coming through the office on a regular basis, looking for opportunities firsthand. Some of these individuals and family offices you never knew even existed. You can’t Google these investors. These are very sophisticated people who understand the risks of frontier markets and are very open to taking that risk on and looking for exceptional returns. Last summer, we had six of the world’s top 250 billionaires literally come through our office. That shows that Mongolia is on the radar of some of the big investors, and they’re coming to take a look for themselves. Some are leaving frustrated because they know something is going to happen but they just can’t quite figure out how to get involved. The smart money investors are finding a way in the end.
“Mongolia is on the radar of some of the big investors, and they’re coming to take a look for themselves.”
TGR: How does the average Mongolian feel about all of this influx of capital and interest?
EZ: Most Mongolians understand the value of foreign investment. There was $5B of foreign direct investment last year versus a GDP of only $8B. Mongolians are seeing their lives change. They are seeing roads and apartments being either built, fixed or completely overhauled. They are seeing the value of wages increase and the ability to travel abroad. Improvements in medical standards and social programs will take longer. But these are all improvements that are well applauded domestically. There is always a small minority of disinterested locals who think foreign investors have no business in their country. Sometimes that becomes the more vocal view, but it’s not the case in Mongolia.
TGR: Pretty much everybody has something to gain other than the people who want to continue living in their yurts and herd animals.
EZ: For example, TavanTolgoi, a 7 billion ton (Bt) coal deposit, which is the world’s largest or second-largest coking coal complex globally, is carved into 1 Bt pieces. One of those pieces is called Tsankhi, which will be listed; 20% is being given outright to Mongolian citizens as a birthright in the form of electronic shares in this company. They haven’t turned into cash yet, but there is the clear opportunity for domestic citizens to be able to participate in the Mongolian growth story along with foreigner investors.
TGR: Can you leave us with some parting thoughts on the investment opportunities in Mongolia and what our readers ought to consider if they decide they want to get involved in the region?
EZ: Mongolia is an investment destination that is too good to be overlooked. It should be a piece of any emerging market investment portfolio, providing exposure to a growth story that has 30% nominal growth and 16–17% real growth, at a time when much of the world is in a very fragile state.
There are a number of ways to get that exposure with varying degrees of risk. You can go as far as being a direct investor in the asset. I personally own real estate in Mongolia. You can do it through listed companies. You can do it through private funds. You can do it by holding cash in a high, 12% deposit rate bank account in some of the most secure banks in Mongolia, which are well-applauded by foreign investors and something we do through the MSE Liquidity Fund that I co-manage with Luke Leslie and have seen eight consecutive months of positive investment returns since inception at an annualized rate of 20% to investors.
We think listed companies are interesting. They’re the safest and most liquid. They are obviously further down the chain in that other investors have participated ahead of the listing. Direct investing comes with its own inherent risk of due diligence, property diligence and illiquidity. The various alternatives are really dependent on individual investor appetites.
TGR: It seems the easiest way for most North American investors would be to invest in U.S. or Canadian companies that have projects going on there. I suppose they can also try to buy things that are listed on the Mongolian Stock Exchange, which we really didn’t get into.
EZ: We’re also putting together private domestic bespoke deals that we’re immediately taking public on the MSE and are just completing our first listing with eye-watering returns for our clients and MSE Liquidity Fund that participated in the private round in February. This is another way for investors to participate. Ultimately, it comes down to the individual risk profile, the need for liquidity and taking a long-term view of Mongolia. Cut away the headlines, the rhetoric and the news ahead of the election, and simply look at the growth and the fantastic tier 1 mines in Mongolia that have already caught the attention of some of the best global mining companies. Look at what this is going to do to a population of 2.8M people with a GDP of only $8B. It’s incredible for a small democracy where the rule of law stands, where there are no religious sectarian views and there’s a very young, ambitious population, with a free-flowing currency and market economy. The recipe doesn’t get much better than that for frontier investing, in my view.
TGR: It is a very interesting situation. Thanks a lot for joining us today.
EZ: I appreciate you having me.
Eric Zurrin is director general of Resource Investment Capital, responsible for its operations in Mongolia and coordinating capital sourcing through partner distribution networks in the international markets. Zurrin joined ResCap in 2010 with nearly 10 years of investment banking experience with UBS Investment Bank’s Global Industrial Group in London and BMO Capital Markets in Toronto and London. Zurrin holds a Bachelor of Commerce degree from the University of Manitoba in Canada.
So I saw a price for gasoline advertised at $3.35/gal the other day. I remember some goal of $2.50 a gallon being talked about in one of the presidential debates earlier in the year. I suspect when that was being bantered about gasoline in the region was right at $4/gallon. So in a sense we are just almost halfway to that nominal goal. via gasbuddy.com (link on the right) you can see the chart for how the trends have looked in the Pittsburgh region over the last two months.
As for the near term future? Oil continues to drop around the world. CSM: Oil prices hit eight-month low in Asia.
Natural gas itself is plunging again. (real time prices). I would not trust anyone’s predictions in NatGas markets, but there was serious talk of ever more drops not long ago. If any of those predictions come to pass CHK will be in a lot more trouble than it is even today. So will a lot of other producers I imagine. Does not seem to be slowing down the development of new supply locally however.
and even the PG caught my coal musings last week. Probably the ‘distuptive technology’ line. but again: exports? coal? Pittsburgh? See theStreet this AM: Peabody Shows China Is Coal’s Best Recovery Bet
On airlines (connected only in that they use fuel as well I guess).. while there is an interesting controversy over a plan to get a new hub operation going in Pittsburgh, out in Philadelphia they are moving ahead with a multi-billion dollar airport expansion.
I don’t quite have it in me to wade into the ever and yet again ascendant assessment issues in Allegheny County…. leaving me a bit factoid deficient for the day.
So apologies a bit for the echo chamber-ness of this, but Jim R. has some interesting catches for the day. One is a whole story: From Rust Belt to Exporting Giant.
Nice pic… amazing how the fountain is always functioning so well. I swear these photos will be 2-3 skyscrapers behind the times before the media starts using current versions. We might need some Photoshop assistance in the end.
But the article there does have one very interesting factoid. If you check out the latest stats on international trade for the Pittsburgh region (link there on the right has the data fyi) a factoid pops out. Between 2009 and 2010 international exports from the Pittsburgh region jumped from $8.3 to $12.2 billion. As a percentage it is one of the biggest metro area jumps. Part of that follows from a pretty depressed 2009, but still looks like a new peak value for international exports for Pittsburgh in 2010.
Before anyone gets jumping to conclusions… what is the biggest export from Pittsburgh… and what saw the biggest jump in export value between 09 and 10? Coal. Hard black stuff. Pittsburgh’s disruptive technology of 1783. Remember when I said that one of the overlooked issues impacting the region are the coal-jams on the high seas.
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