Martin Armstrong:

The metals were one favorite sector where they were constantly bullish – never bearish for 19 years. But hey, the market manipulators always needed cheer-leaders to get people to buy every high so they could sell.

On the Buffett Silver Manipulation, it was PhiBro who had a shill call the Wall Street Journal and tell them I was trying to manipulate silver down because I was short. When the WSJ & I argued and they refused to print the name Buffett they demanded I give them, that forced the CFTC to act calling me to ask where was it taking place. I told them London and they called the Bank of England. When they in turn ordered all silver brokers to show up the next morning, Buffett was forced to come out and admit he bought $1 billion worth of silver but denied he was manipulating the price.

You can ask the guys at GATA. They were well aware of the first 1993 Manipulation by PhiBro (Philips Brothers). They got in bed with Buffett when he stepped in to run Salomon Brothers after they got caught MANIPULATING the US Government bond auctions. They began buying silver and the CFTC stepped in demanding to know who their client was. Now if it had been anyone else, PhiBro’s reply was they refused to tell the name of the client. Forget the law. That does not apply to New York firms. The CFTC responded saying if they could not know who their client was, then PhilBro had to exist the trade. They did and of course made a fortune for the hawkers had all the little guys buy silver just in time for PhilBro to sell it to them.

This is WHY the manipulations began to move to London. Not only did PhiBro try to get me on board, their broker walked across the floor and SHOWED my broker Buffett’s orders at the low!

To create the fundamental, they moved inventory from New York to London. They were manipulating silver as always. Playing games with the inventories. They were moving silver from New York to London where the Buffett orders were being executed. This made the US warehouse inventories drop sharply. Go look at the analysts who talked silver up on that very fundamental. If they said there was a shortage of silver and you better buy it is going to $100, then you may be dealing with a shill or a biased analyst.

Many of the metals analysts with an agenda back then hated my guts. How dare I say there was a manipulation when it was at last silver was going up instead of down. Now I was part of some covert conspiracy hell bent on suppressing the metals because I dared to say “they are back” (manipulators) and the target was $7 by January 1998. To this crowd, a manipulation is always to the downside and never up.

Go check the recommendations of analysts back then. See where they stood. The best one I heard was silver was in demand in London because it was .9999 there instead of .999 in New York.

GATA began to see the same nonsense that I did during the early 1990s. It was just that I saw the manipulations as being UNBIASED. In other words, they did not care what they manipulated as long as there was a guaranteed profit. They manipulated even base metals such as rhodium. They manipulated platinum in league with Russian politicians who strangely recalled all platinum to take an inventory. Hell, Ford Motor Company filed suit over that manipulation.

How do you distinguish a REAL bull market from a bullshit manipulation?

Most manipulations can be seen easily when you look at a market in terms of a Basket of Currencies. Why? Because a REAL bull market must take place ONLY when it rises in terms of ALL currencies. Unless that takes place, investors in some countries will be sellers while others are buyers. Here is a classic example as to why we were bearish on gold for 19 years despite the hate mail and the best attacks of the shills. The manipulators ALWAYS need to get the metals guys worked up into a fever to sell to them to make their profits and big bonuses.

So when analysts only espouse one side, be very careful. For no matter what the market, there is always a time to rally and a time to pause. Nothing is ever straight up or straight down. Anyone who portrays that is either ignorant of the market behavior, or a shill – paid cheer-leader. Putting out bogus research has been the name of the game. Unfortunately, there are just some people who are hardcore.

Markets are the same mix as politics. There are people who simply believe in a given position and no matter what you say or what evidence you present to the contrary, they will never believe it. Thus, I have NEVER been interested in preaching to the choir. I have always preferred the independent thinker – the investor who wants to really learn about market behavior and not read someone who simply supports their never changing view of the world. Nor am I interested in exchange words with those who may not be shills, but are just part of a particular hardcore group. I am cheered only when I agree, and if I disagree, I am despised. But that is expected in the retail world – NEVER in the professional institutional world.

There cannot be a perpetual bull market in anything anymore than you can stand there with your arm straight up in the air. Oh shore, you can do it briefly. But then your arm will feel so heavy you can no longer keep it up. Everything takes a pause for the same reason you sleep at night. Nothing can maintain the same energy output all the time. People come up with all sorts of excuses why they are right yet the market declines. Usually it is some conspiracy of a mythical group so powerful that they just win.

Markets collapse because EVERYONE who ever thought of buying has bought. They are now counting their profits for the next eternity. Something happens and scares the herd. Suddenly, the long try to sell but there is no bid. The market collapses in the blink of an eye. Why, because the majority has already bought and there are no new buyers to keep the momentum going. It is never some mythical short player preventing the upward advance. It is just not time yet.

Philip Tetlock, a professor of organizational behavior at the Haas Business School at the University of California-Berkeley, has been following the so called experts for some 25 years studying primarily the institutional forecasting skill of political experts. He had signed up nearly 300 academics, economists, policymakers and journalists keeping track of more than 82,000 forecasts plotting them against real-world results. He analyzed not just what the experts said but how they reasoned and how quickly they changed their mind in the face of contrary evidence. He also tracked how they reacted when they were wrong, which was of course the majority of the time. Most could not even beat a random forecast generator.

Tetlock’s research did discover that there was one kind of expert turns out consistently more accurate forecasts than others. The most important factor he discovered was not how much education or experience the experts had but how they actually thought. The best forecasters were those who were self-critical, eclectic thinkers who were constantly updating their beliefs when faced with contrary evidence instead of clinging to dogma. He found the best were suspicious of grand schemes and conspiracies and were more practical about their predictive ability. The less successful forecasters clung to the same ideas never wavering pushing the same idea to the breaking point of absurdity. These types of people were more often embraced by the media because they loved to articulate and persuade as to why their idea explained absolutely everything.

Tetlock uncovered widespread forecasting failures. Of course, there is the herd of followers who for some reason want a GURU and unrealistically expect infallibility. This may reinforce the pundits that like to put on a show and claim why they are personally better than everyone else and only their ideas are correct and when wrong, it is the result of some giant conspiracy, not their lack of ability to forecast.

The key to the future lies in the UNBIASED view of whatever it is. You cannot be married to a single position EVER! Tetlock points out that a successful analyst always qualifies their arguments with “however” and “perhaps,” while the dangerous analysts build up momentum with “moreover” and “all the more so” as they try to be more entertaining. The dangerous analyst wants to keep the clients happy and to a large extent preaches to the choir telling them what they want to hear.

The one thing about markets is that the MAJORITY just have to be wrong! Why? They are the fuel that drives the market up and down. Trap the majority either long or short and you create the fuel for the next move in the opposite direction.

So for now, it is far better to let the markets speak. As I stated at just about every conference I have ever given, there is ONLY one analyst that is never wrong – that is the market itself. The key to successful trading & forecasting is to learn how to let the market speak to you and go with the flow. It does so in both TIME as well as PRICE. Turning points are NEVER specific events, but inflection points where highs and lows take place. It would have been nice to have a low first and a more orderly advance afterwards. But markets like to create the worst of all worlds.

So for anyone who thinks he can beat the game as an analyst or trader, must remember one thing. The market is always right. To survive, we have to align ourselves with the market and listen when it speaks. This is not a game for arrogance and prognostications fixed in stone steeped in bias and dogma. History repeats – but also with a slight twist. So how high will gold go? It is a question of CONFIDENCE.

You will ALWAYS be your greatest adversary, for to succeed you must conquer your own biases, fears, and doubts. You cannot do that as Philip Tetlock has keenly demonstrated with fixed ideas. If you are married to a philosophy and will not yield and blame everyone else for conspiring against you and that is the reason something has not yet unfolded, you better see a shrink.

The Energy Report: You last spoke with The Energy Report in June 2011. What has transpired in the fertilizer and potash business since then, both in Canada and in Brazil’s emerging market?

Jaret Anderson: The tail end of 2011 saw a period of weak demand for Canadian potash. Fourth-quarter shipments at Potash Corp. (POT:TSX; POT:NYSE) dropped by about one-third year over year (YOY). General concern over the economy gave dealers an incentive to avoid stocking up their warehouses, resulting in soft shipments, higher unit operating costs and quarterly earnings below expectations. However, Potash Corp. posted a 68% gross margin in its potash segment during the quarter, making it one of the most profitable publicly-traded businesses of this scale.

Meanwhile, Brazil overtook India as the top global importer of potash in 2011, with imports of about 7.5 million tons (Mt) KCl. This figure was up 21% YOY, drawing even more attention to the country’s chronic domestic potash deficit.

TER: What should fertilizer producers expect in the next few years?

JA: We’re going to see bullish prospects for fertilizer producers over the next 12–18 months. Demand for fertilizer products is likely to remain soft in Q112, but as the spring planting season in the northern hemisphere kicks into gear in Q212, we expect markets to tighten.

TER: You put out a report last December showing a fairly large global number of both new and expansion projects in the works. How will these projects affect the supply and demand equation over the next five years?

JA: We actively track 19 different brownfield expansion projects and 26 different greenfield projects around the world, totaling ~67 Mt of planned capacity. If all of those projects were built on the timelines put forward by their respective owners, we would see a massive glut of capacity in the back half of this decade. The reality, though, is that only the best of these projects are going to be built, and those are likely to experience significant delays compared to their projected timelines. Potash demand in 2011 was about 55 Mt. If we assume demand growth of 3%/year for the remainder of the decade, that implies we’ll need an incremental 17 Mt of supply by 2020 in order to maintain operating rates at 2011 levels. That is pretty close to the 20 Mt of brownfield projects currently on the drawing board. Any demand growth beyond this 3% level or further delays of brownfield projects would tighten markets further.

TER: You don’t expect an oversupply or downward price pressure?

JA: In any commodity, things don’t go up forever. At some point, the supply-demand balance is going to shift in favor of the buyers. The next several years however, look very positive for potash producers.

TER: Saskatchewan is the potash capital of North America, and although it’s a major supplier to other parts of the world, the North American market is relatively mature. What North American potash companies are still attractive buys at this time?

JA: In my view, the most attractive greenfield potash project in Saskatchewan is Milestone, which is being developed by a company called Western Potash Corp. (WPX:TSX.V). The company has a very large in situ resource of about 3.5 billion tons (Bt) KCl and has the highest grade of any existing solution-potash mine in Saskatchewan. Milestone looks very similar to the former Legacy project of Potash One Inc., which was purchased by K+S Potash Canada (SDFG:FKFT) in November 2010 for $434 million (M). At a market cap of $200M today, we believe Western Potash represents the lowest-risk greenfield potash company in the world, with a very attractive valuation.

TER: Another Saskatchewan company you’ve discussed in the past is Karnalyte Resources Inc. (KRN:TSX). It is developing a relatively low-cost, solution-mining project. What are your thoughts on the company’s risk-reward ratio?

JA: Karnalyte is focused on a different type of project that will seek to extract carnallite mineralization at its Wynyard property. While its carnallite mineralization is only about half the grade of a project like Milestone, Karnalyte’s engineers have designed a plant that can be built in stages, which offers some advantages in terms of capital expenditures. Karnalyte’s shares suffered a significant decline in December after the company pulled a $115M financing. We upgraded the shares from “Hold” to “Buy” during December and believe that below $10/share, the company represents good value. However, it may be difficult to see performance for Karnalyte until it successfully raises capital to begin construction at its Wynyard project in the spring.

TER: Are its prospects reasonable for the company as long as the market holds up?

JA: Its shares now represent good value. That said, I believe Western has a more attractive valuation and project than Karnalyte. But there is a difference between a good project and a good stock. Because Karnalyte has taken a large hit of late, it has some decent upside, especially below $10/share.

TER: You recently visited Brazil to get a little better picture of the country’s fertilizer business. That’s a very large, growing market. Tell us what you learned.

JA: Each time I visit Brazil, I come away with more anecdotes that convince me of the need to find ways to invest in Brazil’s agricultural future. Brazil has over 400 million hectares of arable land, but uses less than 15% of it today for agricultural purposes. It is the largest global exporter of beef, poultry, sugar, coffee and orange juice, and that production should grow for many decades. The problem is that its Cerrado region is generally nutrient-poor and requires significant quantities of fertilizer. Brazil has only one operating potash mine and imports more than 90% of the potash it consumes. In 2011, Brazil was the world’s largest importer of potash, at about 7.5 Mt. The Brazilian government has set a goal of becoming fertilizer independent by the end of this decade and we believe investors should be looking for ways to gain exposure to Brazilian agriculture and fertilizer markets.

To that end, two companies we’ve focused on are Verde Potash (NPK:TSX.V) and Rio Verde Minerals Development Corp. (RVD:TSX). Verde Potash controls the Cerrado Verde project in Minas Gerais state, which contains a large, at-surface deposit of potash-rich verdete slate. The company has developed and patented a process to convert verdete slate into KCl, the same standardized product that’s produced in Saskatchewan and Russia today. This is known as the Cambridge process. It’s very exciting, as it could allow for large-scale potash production in Brazil from an open-pit operation—something that hasn’t been done anywhere in the world.

Verde Potash recently published a Preliminary Economic Analysis that indicated an operating cost of US$274/t during the early years of production, ramping up to $291/t over the 30 year life of mine as the stripping ratio increases. That would give Verde Potash the lowest delivered cash costs to Brazil of any large-scale competitor globally. The potash producers in Canada and Russia have lower operating costs, but face very large transportation costs to deliver product to farmers in Brazil. Capital costs for Verde Potash’s project are estimated at US$800/t, which is about 25% below a typical greenfield solution mining project in Saskatchewan. Based on these attractive economics, we recently increased our 12-month target to $19.00/share. With the stock trading at about $7.00/share today, this is a very interesting story.

Another name we believe offers good exposure to Brazil is Rio Verde Minerals, which controls a land package near Aracaju in Northern Brazil. It is located adjacent to Taquari-Vassouras, the only operating potash mine in Brazil. Rio Verde is still at an early stage of development, having completed drilling on its first drill hole in November. We visited the site a couple of months ago and inspected the core. We await assay results from that hole. Rio Verde plans to drill three holes at its Sergipe potash property and to publish an NI 43-101 resource during Q212. Given the strong outlook for good potash grades on the property and the company’s ideal location in Brazil, with nearby access to a port, roads, power and natural gas, Rio Verde looks to us to offer excellent risk-reward at current levels. Based on our target of $1.30/share, Rio Verde offers more upside to our target than any other company in our coverage universe.

TER: Can you elaborate on the Cambridge process you mentioned?

JA: In December 2010, Verde announced that it had patented a process to convert its verdete slate into KCl. This process was developed by Dr. Derek Fray at Cambridge University in the United Kingdom. This process was tested and optimized by Hazen Research in Denver, CO, and by FLSmidth in Allentown, PA, and SRK Consulting, which resulted in the publication of a Preliminary Economic Assesment in late January. We visited FLSmidth’s facilities in Pennsylvania last week and observed the process in operation. The process is relatively simple and bears many similarities to the cement production process. It employs a rotary kiln, like cement, but uses different inputs, namely Verde Potash’s verdete slate rock, limestone and salt. The Verde Potash KCL production process takes place at lower temperatures than that of cement, about 900C vs. cement at about 1,450C.

TER: Do you expect the Cambridge process to work on a commercial scale?

JA: It’s moved from a bench scale at a university to a pilot plant. To move to a commercial scale is another jump. Staff at FLSmidth and SRK have indicated to us that they typically see fewer problems with commercial scale facilities than they do with pilot plants. Every indication we have points to the commercial scale kiln as being well within the technical ability and experience of the teams at FLSmidth and SRK.

TER: There’s also been some development on the African continent, and a couple of Canadian juniors are working on projects there that are projected to go online in about five years. How are they progressing?

JA: Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX) and Ethiopian Potash Corp (FED:TSX.V; FED.WT:TSX.V) are both working to develop greenfield potash projects in the Danakil depression in Northern Ethiopia. Allana is the much better capitalized of the two companies. It has published a large NI 43-101 resource based on its successful drill program over the last couple of years. The projects in Ethiopia are interesting in that the high year-round temperatures in the Danakil may allow for solar evaporation, thereby materially lowering energy costs in the solution-mining process. Ethiopia is also located relatively close to China and India, two important potash consumers.

Ethiopian projects face a major challenge, however, in that the logistics of moving thousands of tons of potash per day from the project site to the port at Djibouti some 600 kilometers (km) away over roads of varying quality may be a significant hurdle. We believe the transportation costs will end up being materially higher than current estimates.

Both Allana and Ethiopian Potash have seen their share prices languish over recent months and are both near 52-week lows. We believe both stocks have room to move up as the projects are derisked and as Allana moves toward a feasibility study in August of this year. While Ethiopian Potash has more leverage to positive developments given its smaller enterprise value, it is a much riskier investment given its very low cash levels. Allana, on the other hand, has more than $65M in cash on its balance sheet, providing it with a lot of time and resources to derisk its project and make it more attractive to potential suitors.

TER: Will Allana rely on a rail link to be built in order to get its product to market?

JA: There are plans in Ethiopia to build a rail network in the country, and that rail network is planned to approach Allana’s project site. We’ve met with the minister of transportation in Ethiopia on this topic. That project is probably a number of years away from completion, and for at least the first several years of production, Allana is going to need to find a way to transport its product by road via truck. You can’t assume the rail network is going to be ready in the next few years, in our view.

TER: What effect will trucking the material have on the project economics?

JA: Trucking will be much less economic than a rail network. Allana has published its own cost estimates for transporting the product from its project site to the port at Djibouti. We find its estimate of $12/t to be very low. We see a number closer to $50/t, based on the figures we’ve seen at other operations in existence today, such as those in Saskatchewan.

TER: Do you have any other interesting stories that our readers might find useful?

JA: The potash industry today is generating very high cash flow and strong returns on capital for incumbent producers. Potash Corp. generated a gross margin in its potash business last year of 68%. Apple Computer, by comparison, posted a gross margin of 41% in its fiscal 2011. The levels of free cash flow generated by this business and the strong secular trends in agriculture are going to attract capital and will ultimately lead to new greenfield production. With so many companies chasing so few quality projects though, we would caution investors to think carefully about the merits of each individual project. The size and grade of the deposit, the infrastructure in place, the proximity to major potash-consuming countries and the geopolitical risk are all critical drivers of value.

TER: Do you see any further consolidation in this business at this point? Or is it still too early?

JA: We’ve had a lot of consolidation in this business. The successful business strategy that greenfield potash companies have employed in the past has been to identify a good project; then derisk it by defining the resource through engineering and feasibility studies to make it more attractive to well-capitalized companies. A number of greenfield potash companies have had success with that strategy by ultimately selling to large mining companies like BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), Vale S.A. (VALE:NYSE) and Rio Tinto (RIO:NYSE; RIO:ASX). I think this process makes sense and is going to continue.

TER: What are your top picks at this point?

JA: Our top picks in the sector for 2012 are Verde Potash and Rio Verde Minerals. Both companies offer good leverage to the Brazilian fertilizer market and have the potential to generate meaningful returns to equity investors. By their nature, development-stage resource companies involve much more risk than an operating company. We believe, though, that 2012 is likely to see very strong results for the greenfield companies with the best-quality assets, in the right locations, with attractive valuations. In our view, Verde Potash and Rio Verde check all of those boxes.

TER: Thank you for your time.

JA: Thank you.

Jaret Anderson is a research analyst covering agriculture and fertilizer at Mackie Research Capital. Anderson has 13 years of experience in the investment industry and was rated #1 for earnings estimate accuracy by Starmine in 2006 and #2 for the quality of his reports in 2005. Prior to joining the firm in July 2011 Anderson worked at UBS Securities Canada where he covered Canadian paper and forest companies, as well as chemical and fertilizer industries. Most recently Anderson covered Canadian fertilizer and chemical companies for Salman Partners. He received a Bachelor of Commerce, with honours (Finance) from the University of British Columbia, and was awarded the CFA designation in 2000.

The Energy Report: Total potash demand in 2011 was estimated at 56 million tons (Mt), and the market has traditionally grown at a rate of about 3.5%/year. Do you believe we’ll see a similar increase in 2012?
Corey Dias: I think 3.5% could be at the high end of growth for 2012. I would expect slightly lower growth this year given that India is delaying its potash purchases until the end of Q112. China is also determining its exact needs, and there are rumors that it may reduce its imports this year versus 2011. Everything tends to depend on price. Canpotex (the marketing company for Saskatchewan potash producers) and its Belarusian counterpart are holding out for higher prices than India and the China currently seems willing to pay. With those delays, demand will probably be slightly below the historical 3.5% growth rate.

TER: Potash Corp. (POT:TSX; POT:NYSE) of Canada has shut down two mines in that country, and The Mosaic Company (MOS:NYSE) says potash buying is slow right now as buyers are taking a wait-and-see approach. What do you make of Potash Corp shutting down those two mines?

CD: It is a prudent approach. The company doesn’t want to flood the market with product as it would like to sustain a reasonable potash price that could provide a reasonably profitable return. By shutting down these mines, it’s limiting the output and that should keep the price at a fairly stable level. It’s not a question of shutting down so much capacity that prices are going to spike; it’s simply a way to keep potash prices relatively stable until the moment when a larger buyer comes back into the market, whether it’s India or China.

TER: In 2011, potash had the third-largest price increase among the 32 commodities ranked by the Scotiabank Commodity Index and, over the span of 2011, potash rose about 32%. The leading indicator of potash prices is often the price for corn, which is down significantly after some bumper corn crops in Eastern Europe, Russia, and Australia. What do you believe will be the average price per ton (t) for potash in 2012?

CD: Potash prices seem to be ranging between $450 and $550/t at the moment, depending on the port of delivery. It will probably stabilize around the $500/t level in the short term. I don’t see any reason for a significant spike in the price at this point. Although the corn price has recently seen a dip, it still remains above its historical average. Moreover, given the fact that the U.S. Department of Agriculture said that its stocks-to-use ratio is still well below the historical average, it would take a significant amount of corn production to reach the normal level of 15–20% in terms of that ratio, and reaching that level of production to meet this ratio could be a real challenge, especially when corn demand continues to grow. Therefore, while corn is slightly down, I don’t think there is going to be a downward trend in the corn price, or a complementary downward trend in potash.

TER: You don’t believe that potash will be in the top 10 performing commodities in 2012?

CD: I think it will have a fairly average year. I don’t think it will repeat its price performance in 2012 as it had a relatively low price point from which to start in 2011. It will probably stay somewhere in the middle of the park vis-à-vis other commodities.

TER: In an interview with The Energy Report in May 2011, Dundee Securities’ senior analyst Richard Kelertas predicted that we would see $750/t potash at some point before May 2013. What’s your perspective?

CD: As you said, that was in May 2011. The market looks a little different now than it did then. The fact that India is pushing back on pricing and delaying its purchases and China is reassessing are going to mitigate the potential upside of the potash pricing. Probably $600–650 is a reasonable price going to 2013, but there are a number of different factors that come into play in addition to India and China, whether it is production capacity being added to the market via brownfield or greenfield projects, whether or not there is a recovery in the European market, or whether or not the U.S. recovery continues. The fact that farmers seem to have a lot of money coming out of 2011 could, at worst, bode well for holding a pricing floor on potash at current levels and could potentially even support a higher price. I think that $600–650/t is reasonable.

TER: Tell us about your coverage universe and the types of companies you cover.

CD: I’m now ramping up coverage in the potash space. My first report was about Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX), a name that I’ve followed since early 2011 when I was working in an institutional equity sales capacity at MGI. I really like this story and the fact that it’s in a safe, mining-friendly jurisdiction. An opportunity to build a mine in a potash-rich region—the Holbrook Basin—with only two competitors in the Basin could provide an opportunity for consolidation. It is a story with a great deal of appeal.

Generally, I’m looking at small-cap developers and am not restricted to North America. There are developers in Africa and South America that could be appealing in the same way. It will be up to clients to decide whether or not they have the risk tolerance for assets outside North America.

TER: Is that typically the type of company that MGI covers even in the other sectors?

CD: We tend to cover smaller-cap names. Large-cap names would be a bit more difficult for us to champion in a lot of ways because we wouldn’t necessarily get the mind space from clients for large-cap ideas because clients are well covered by banks and bulge bracket firms that are looking at the Potash Corps of the world, companies like Agrium Inc. (AGU:NYSE; AGU:TSX) and Mosaic.

TER: Passport Potash’s share price took a beating in 2011. It’s currently developing the Holbrook Basin potash project in Nevada. Why do you believe that junior is going to rebound this year?

CD: Part of Passport’s problem this past year was based on the market itself being quite volatile, especially toward the end of the year. In general, small-cap names tend to suffer the most in those circumstances. But management made a few promises to the market that it was unable to keep and probably didn’t realize the extent to which it would be punished by the market by having missed deadlines. However, I believe that the company is starting to right itself. It is in the process of putting together an NI 43-101-compliant resource estimate, which we expect to be released by the end of Q112. Following that, we should see a preliminary economic assessment or scoping study and, further, a prefeasibility study from Passport in order to show the economic viability of its project. In addition, there was an announcement on January 18th that Passport has brought on a new chairman who has significant operational experience gained during his time with Rio Tinto (RIO:NYSE; RIO:ASX). It also has added Ali Rahimtula, who has experience in India, which is key in this type of business because there is the potential for an offtake agreement with an Indian partner. Passport has acknowledged the fact that it needs more relevant experience on the board, and has clearly begun to address this shortfall.

Like most of the names in the junior developer space, there tends to be a rerating—in terms of valuation—of these types of businesses once milestones are met along the road to production. As Passport meets its milestones, the market will likely provide the company with a more positive valuation via a re-rating of its stock. The company’s stock price hit bottom at $0.17 toward the end of last year. Since then, it has been able to at least project to the market that it does have some deadlines, which it intends to meet. Passport has engaged the engineering firm ERCOSPLAN to complete its NI 43-101. ERCOSPLAN has a really good reputation in the marketplace and has done a lot of work for developers in the potash space worldwide. The market now understands that the company is working very hard to meet its current deadline and, once met, Passport will have a potash resource estimate to put to the market. The market at that point will respond favorably, in my opinion.

TER: A competitor operating in the same basin that Passport is operating in, the Holbrook Basin, already has an NI 43-101 resource of 125 Mt potassium chloride (KCl). How large do you expect Passport’s resource to be once it’s published?

CD: The competitor has about 94,000 acres of land, while Passport has about 81,000 acres. If we were to use a ratio of acres to contained tons of KCl for the competitor and apply it to what Passport has, Passport would probably come in somewhere about 100–101Mt of contained KCl. Remember, this is in no way a forecast that I am making as to the size of Passport’s resource. Even if Passport has something like 80% of that number, I think it’s still a decent-sized resource. In my report, I am forecasting that Passport will produce about 1Mt/year over 40 years. That implies about 40Mt of in situ KCl. If we’re talking somewhere between 80–100Mt of contained KCl, there is significant opportunity for Passport to increase the size of production on an annual basis, or it gives a bit more leeway in terms of what the potential resource size could be, on a contained-ton basis.

TER: You have a Speculative Buy on that particular equity. What is your 12-month target?

CD: My 12-month target for Passport is $0.75.

TER: Another junior in that space, Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX), jumped out of the gate in 2011 and slipped above $2 in June 2011 before spending the rest of the year retreating from that benchmark. It now sits well below $1. Will that junior rebound this year? If so, what are the catalysts that are going to make that happen?

CD: I think so. Allana probably jumped up based on speculation more than anything else, but as the actual resource-related numbers come in, then it tends to start trading at some kind of multiple based on its enterprise value (EV), whether it’s EV:resource or EV:ton KCl, et cetera. When the market sees that it’s getting closer and closer to production, that’s when the valuation will start to improve. I think that is something that could happen this year. When one has an asset that doesn’t have any economic information tied to it, it’s very easy to speculate as to what you think the value should be. Obviously, the closer one gets to production, then there are hard and fast numbers that one can start applying some kind of multiple to in order to value a company like Allana Potash. That’s probably why it’s now down below $1. It’s probably more reasonably priced here and as more news comes out that’s favorable to the company, then you should start seeing the stock move back up.

TER: What are your thoughts on the Danakil potash project in Ethiopia?

CD: The Danakil project is interesting because it’s a near-surface project, which means the capex should be low. I think that it will have a fast track to production, which is another positive. And the fact that it’s probably selling to India, and perhaps China, is another positive because there is a quicker trade route to those countries when compared to North American or South American potash producers.

That said, there is no domestic demand for the product in Ethiopia. The companies that I believe have an advantage are those that have domestic demand or significant domestic demand, whether it’s a place like the U.S., which imports most of its potash needs, or South America—Brazil in particular—where 90% of its potash needs are imported. Ethiopia is also landlocked, that is, it has to go through another country in order to reach the port. Moreover, there is a greater possibility of political risk in Africa than in the U.S. or in Brazil. However, if everything remains stable, I think there could be a big opportunity for Allana, especially given its low operational cost base.

TER: What are some other small-cap potash plays that you expect will outperform in 2012?

CD: Verde Potash (NPK:TSX.V) is planning to produce a unique product called Thermopotash. Thermopotash, derived from the combination of glauconite and limestone, is a slow-release potash product with no chloride, which is great for crops like tobacco, coffee and oranges. In addition, the company is exploring the use of a new technology—the Cambridge process—which could potentially convert Verde’s potassium-rich rock to regular KCl. This would be a massive opportunity in Brazil. In terms of available infrastructure, Brazil falls behind North America but is certainly ahead of Africa.

Rio Verde Minerals Development Corp. (RVD:TSX) is another small company operating in Brazil that recently confirmed that it has potash on its property. The stock has moved up a little bit on the back of that news. Once an NI 43-101 resource estimate is released for Rio Verde Potash’s potash asset, we should see another re-rating of the stock.

Karnalyte Resources Inc. (KRN:TSX) is another one. Once again, I tend to favor the junior potash developers that have a bit of a unique element or bring something a little bit different to the table. Karnalyte is focusing on extracting potash from the potash-bearing carnallite layer, which is unusual for Saskatchewan because other producers and developers target the sylvinite layer that is usually closest to the surface. Karnalyte’s deposit is based on an anomaly where there is a significant carnallite layer that is relatively near-surface vis-à-vis the sylvinite layer. The technology that it is planning to use also could provide a magnesium byproduct and sodium chloride byproduct, both of which the Company could potentially market and sell in the future. Karnalyte has a number of things going for it; I think management is very strong. The fact that it has four patents pending for its technology could mean that what it ends up with is going to be very unique. It has a massive land holding and has only conducted advanced exploration on 20% of it. Fnially, it plans to expand its plant by using cash flow generated from its initial buildout.

TER: It has done a nice job of managing its share flow, too, with only about 21M shares outstanding vs. something far greater for a company like Allana.

CD: Yes.

TER: Or do you prefer a larger share count, such as Allana, with its 193M shares verus 20M for Karnalyte?

CD: When you’re in the small-cap space—and especially if your float is small—it becomes a bit riskier for clients to hold when the markets are a bit more volatile. It’s one thing to get into a stock, but when the market is volatile and a client is looking to exit a position, it’s very difficult to do if the trade volumes aren’t there. That’s the risk with Karnalyte. The average trade volume is 34,000 shares a day. So if you have a position that’s 100,000 shares, it’s going to take you roughly three days to get out of that position, and that assumes that you can be 100% of the trading volume over those days. And you could end up driving its price down significantly while you’re trying to exit your position. Having a more liquid position in a stock like Allana that you can get in and out of a lot more easily would likely appeal to portfolio managers.

TER: Could you give our readers an outline of what to look for in the small-cap potash space over the next year or so?

CD: You’ll see a number of companies starting to reach the prefeasibility and feasibility stages. At that point, these companies will start to look for strategic partners, whether it’s to fund the buildout of the products or secure an offtake agreement for the product that’s going to be produced a few years out. At that point, we’ll start to see which projects are going to be viewed as more viable. There probably won’t be enough demand to drive a need for every single junior potash developer that is currently out there to actually move into production. That said, there is also the possibility that some of these companies will be absorbed by larger entities that are looking to enter the potash space given the future, positive fundamentals for potash or those that are currently in the market and are looking to increase potential capacity moving forward. I expect to see a lot of positive news coming out of the junior potash space, especially as a few of these companies meet milestones in order to get a little bit closer to production and production becomes more of a reality.

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.

The Energy Report: 2011 was a pretty exciting year with oil prices all over the map, largely fueled by the European debt crisis. What do you expect are going to be the hot topics affecting energy commodities in 2012?

John Stephenson: The spread between Brent and West Texas Intermediate (WTI) prices, which was a big story in 2011, will continue to play a role. I expect a lot of talk about how WTI has once again resumed its place as the global benchmark. Another big topic, as it always is, will be the continuing geopolitics of oil, be it a possible Arab spring in Saudi Arabia or Iran’s nuclear program and how that impacts the world. In terms of possible black swan events, the Environmental Protection Agency (EPA) or other regulators could limit horizontal drilling and fracking. However, that could be very positive in the short run for natural gas prices.

TER: What caused the big spread between the WTI and the Brent prices?

JS: Everyone used to look at WTI as the main global benchmark for crude oil prices, and Brent historically traded at a slight discount. Then, over time, Brent started trading at a premium to WTI. What people have to understand is that these benchmark contracts specify grade and location. The delivery location of the WTI crude contact is Cushing, Oklahoma. Because it’s landlocked, you can’t get crude in from the Gulf region, which actually traded in line with Brent. There also wasn’t enough pipeline capacity to get the large inventories of crude that had built up in Cushing out to other global markets. So it really was an infrastructure issue that caused the price spread. Now, various companies have gotten together and proposed pipeline alternatives that would alleviate this glut of oil at Cushing. Therefore, you’ve seen the spread go from $25 to about $11.40, where it is today.

TER: Your management company, First Asset Investment Management Inc., manages a variety of different commodity-focused funds. What is your 2012 energy outlook?

JS: Our outlook is very supportive and positive for oil. One of the interesting things about oil is that despite the dire headlines, mainly out of Europe, oil has held in as well as it has. In fact, it’s been hitting eight-month highs recently. Why is that? Partly because demand is so strong. We saw record demand globally in August and near-record demand in October and November and continuing strong demand despite the fact that Europe appears to be dipping into recession and growth is potentially slowing a little in Asia. This is why I’m very positive on this and expect to see oil go higher.

Natural gas, on the other hand, is very weak. It’s sub-$3/million cubic feet (MMcf) right now, and I think it will continue to be weak. Historically the period between December and March is when natural gas trades at a premium to its summer prices. This is actually the first winter I can recall seeing it trading at a discount.

TER: Weak natural gas prices are a result of increased shale gas production through fracking, which has created a significant oversupply in the last year or so. Is this going to continue, do you think?

JS: Yes, the U.S. has 200–250 years of reserves of shale gas at current production rates. I don’t see any reason at all for it to change unless, of course, the EPA or someone else were to rule that fracking was detrimental to the environment and there was a moratorium placed on drilling. That could be a black swan event and could change things. If things continue the way they are, there’s no doubt that prices will stay low. Now, clearly, there is some opportunity to export this, but that means building a liquefaction terminal, probably on the Gulf Coast or some other part of the country where people are willing to have a liquefaction facility. That would turn natural gas into a liquid to be transported to Asia or potentially to Europe, where the prices are much higher than they are in North America.

TER: So even though we may have hit peak oil, we certainly haven’t hit peak gas.

JS: No, I don’t think we’ve hit peak gas. Four years ago, the talk was that we were running out. They were going to build terminals on the Gulf Coast to take liquefied natural gas from Trinidad and other places, gasify it and put it in the U.S. pipeline system and supply the northeast in particular with natural gas. Now we’re finding we have so much of this stuff in various shale deposits that we have the potential to become a huge energy exporter. Hopefully that will be the case, but for now we don’t have the infrastructure in place to make that happen.

TER: In some respects it’s a happy turn of events compared to previous supply concerns.

JS: Not if you’re a producer of natural gas, but if you’re a producer of oil, it’s great. If you’re a consumer of electricity, then it’s great.

TER: As far as your portfolio selections and your outlook for this year, you’re clearly leaning much more toward oil and gas liquids. What other factors do you think are going to be affecting prices this year and into the future?

JS: What impacts prices for commodities is supply and demand. I think you’re going to see that demand continues to grow. The reality of why we’ve hit record world demand is not because consumers in the U.S. are doing so much driving. It’s rather because consumers in Asia are doing so much driving. China is now the number-one car market in the world. Who would have thought? If you look at total energy consumption, including coal and other sources, China has overtaken the U.S as the number-one consumer of energy in the world. That trend will continue and put upward pressure on oil prices over time.

The other theme that I think is important for investors to understand is that most of the majors have had real trouble finding replacement reserves to keep producing at the same level. Most of the industry has run from one country to another, where they’ve been kicked out. When Lee Raymond was running Exxon, he ran over to Russia, then to Nigeria, then Venezuela. The settlement that Venezuela was willing to offer Exxon for its assets was a pittance. This is typical of what we’re starting to see around the world. It’s very hard for most of the majors to find new reserves and to continue to produce at the same levels because most of the world that has energy is not open or friendly to the West. This creates a huge problem for these companies.

Given that backdrop, investors need to find companies with reserves in geopolitically stable locations, or where companies are not in the business of generating the reserves; they’re in the business of helping oil companies produce those reserves. That leads you to the service sector, which I think is a lower-risk area. Investors can stay in North America and invest in companies they know and understand without worrying about geopolitics.

TER: What are some of the names that you like in the service sector?

JS: I think if Saudi Aramco, the largest oil company in the world, is going to do a job and it’s going to produce a new field, it will call in Halliburton Co. (HAL:NYSE) or Schlumberger Ltd. (SLB:NYSE). It’s not going to call in Exxon Mobil Corp. (XOM:NYSE). It doesn’t need Exxon’s expertise or capital. But it does need Halliburton’s or Schlumberger’s expertise. These global majors are going to do well on the service side. In the last 25–30 years, the industry has gone from positive bullish cycles to bearish cycles. The people who had the expertise in down-hole seismic techniques, who understood how to operate drill bits at various angles and how to cement and case wells and all of these other things became outsourced to the service industry. The true oil business expertise is in the service industry; that’s why I see it as a sound investment.

TER: So if I may make a mining metaphor, it’s the guys that supply the shovels to the miners that are going to make the money, not necessarily the miners.

JS: Absolutely. It’s the California Gold Rush all over again, except it’s the global energy rush, and you want to be in the picks and shovels business, not necessarily in the prospecting business laying claims. If you’re a Western company and you’re laying claims, chances are you’re laying claims in some part of the world that doesn’t want you there and that may kick you out down the road. Then what do you have?

TER: What are some other companies in your portfolio holdings that you particularly like at this point?

JS: One area to look at is the smaller energy service companies, like Calfrac Well Services Ltd. (CFW:TSX) and Trican Well Service Ltd. (TCW:TSX). Again, there is an increasing amount of drilling that’s happening, even on the gas side. It’s just happening with these new horizontal drilling and fracking techniques. These are the guys who supply this equipment. That’s very strong.

I also think you want to look at the oil companies that don’t have problems with reserves and short reserve life, including some of the Canadian oil sands producers. I would recommend Suncor Energy Inc. (SU:TSX; SU:NYSE) and Canadian Natural Resources (CNQ:NYSE; CNQ:TSX). These stocks are cheap. They’re trading as if oil were $55 or $60/barrel (bbl) when it’s over $100/bbl. These low valuations offer a great opportunity.

TER: Looking at your portfolio in your First Asset Energy and Resource fund back at the end of last quarter, Sept. 30, you were about 78% in cash. Was that a strategic decision? Have you changed that cash into equities at this point?

JS: No. We were very defensive at that time, and I think the reason was pretty simple: Europe was blowing up and when any major economic zone is blowing up, I don’t think you want to be in commodities or commodity producers. Now we’re seeing that the market has stabilized, and you’re going see growth going forward. Valuations certainly never got ahead of themselves in either individual stocks or in any energy sector, so I expect valuations to move higher at this point.

We’re no longer at that same cash level. Our position at that time reflected an overall nervousness about the world. When you have these dominant issues, you need to take your money off the table, which we did. Ultimately, the trade was to the downside, and we preserved value by doing that. I’m very proud that we were able to raise so much cash and be truly defensive at a time when the market was dropping quite substantially.

TER: Are there any of your other attractive portfolio holdings that you’d like to discuss at this point?

JS: I think in terms of other commodity themes that are working well, certainly Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE) would be a great name—that’s on the copper side; it is the largest pure copper producer out there. On a similar vein with a little bit better growth and a little bit more sensitivity to the market—meaning it will move a little more dramatically than the market itself—would be First Quantum Minerals Ltd. (FM:TSX). That’s another name that I think does very well.

We haven’t talked a lot about the agricultural names. If we’re talking about the broad resource base, it’s been a tough time in the agricultural space, particularly for the fertilizer companies. But I continue to think Potash Corp. (POT:TSX; POT:NYSE) looks attractive, especially at this level. Agrium Inc. (AGU:NYSE; AGU:TSX) looks attractive at this level. It’s a little more defensive than Potash. The Mosaic Company (MOS:NYSE) has struggled. I would probably recommend CF Industries Holdings Inc. (CF:NYSE) over Mosaic. Those are the areas that I would look to.

Also, in terms of other oil and gas producers, Canyon Services Group Inc. (FRC:TSX) does well. Transocean Ltd. (RIG:NYSE; RIGN:SIX), a big supplier of offshore platforms, will do well in this environment. Even Baker Hughes Inc. (BHI:NYSE) is transitioning its fleet to more horizontal drilling from straight vertical drilling. Those are all names that we have held and will continue to hold in the future and expect to do well.

TER: To sum things up as far as the energy outlook for 2012, what would you like to tell us?

JS: I would say that energy remains the most important of all the commodities. It will be the most important in 2012 and likely in 2020. Even though we’re over 100 years into the energy era, we are still very much dependent on oil. While it may seem expensive when we’re filling up at the pump or when we look at the futures prices, it’s still cheaper than orange juice on a volumetric basis. There is no substitute for oil, at least no good substitute. There is no technology right now that is commercially viable enough that could change the industry in the way that horizontal drilling and fracking changed the natural gas world. So I think you’re going to see oil prices move considerably higher.

Demand no longer is being driven by America; it’s being driven by Asia and predominantly by China. That trend will continue. In many parts of the world where demand is growing the fastest, namely the Middle East as well as some parts of South America and Asia, fuel prices are subsidized. In an environment where gasoline prices are subsidized, the consumer isn’t feeling the full impact that we feel here in North America. So for those reasons, I think we’ll see oil prices move higher, stay higher and exit 2012 at least $130/bbl. Natural gas prices, on the other hand, will remain range-bound in the $2.50–3, maybe $4, range. It’s very hard to see a successful investment strategy for investors there, other than with the service companies that are going to be the beneficiaries from all of that drilling.

TER: I think that pretty well sums it up. We appreciate your thoughts and input today.

JS: My pleasure.

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 (www.reportonmoney.com).

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.

The Energy Report: There’s been damage done to potash stocks over the past six months. Why?
Richard Kelertas: Macro issues have hurt all commodities. When the world is worried about its next breath, all these stocks get hit very hard. We’ve had the Euro crisis and then the Greek debt crisis since these stocks peaked in summer. Also, I think there were expectations that North America and Europe would emerge from the last serious recession with half-decent growth going forward, and that recovery would be moderate, measured and continual from 2010 all the way up to 2013–2014. That’s now been interrupted by macro events, and the odds that they will be quickly resolved is almost nil. We are going to have to deal with slower economic growth worldwide, not just in the eurozone and North America, but also in China and all of Asia because it’s all interdependent.

We will also have to expect that the consumer will be drawn back a bit, both in Western societies where food is a necessity and a luxury, and in developing economies where it is a necessity. So, high-end food values, high-end organics and food stocks that are higher priced will be under pressure. That means lower requirements for meats, which means that the farmer may be cutting back on his crop output.

TER: Can you make a case for growth in potash consumption?

RK: For the next six months, I expect flat growth. Prices and volumes have retreated slightly. Inventories dropped in October. That’s good news. I expect prices will be flat to down.

However, if Europe’s debt crisis and low North American growth are resolved in the next 6–12 months, we could then see Asian export nations gear up again. That means that their diets will improve again, and crop prices and speculation in crop price increases going forward will pick up. That will happen sooner than six months in the futures market, but at the same time my expectation is that the next six months are going to be slow.

Within the next year, we should see some growth return. That will be composed of three components: Farmers will use potash at normal levels and growth will be reflected in shipments and prices. Lands that will be brought back into production will expand demand. This is fallow or abandoned agricultural land throughout the world, especially in Africa, that has been bought up by either investment pools or sovereign wealth funds or specialty farm land managers. In the grand scheme of things that doesn’t seem to be a lot in terms of the total farmland area throughout the world; however, potash application rates will be much higher than normal because you are bringing it from infertility to fertility levels. So, we could see a substantial push and it will show up in perhaps a 0.5–0.75% increase in potash demand worldwide.

TER: Are you able to venture a forecast on the price of potash?

RK: My international price forecast, the Vancouver export price, is about $450–465 per ton (/t) right now. For 2012 we expect an average price of $505/t and then moving to $520/t average price in 2013. The peak price in 2013 should be around $650/t, maybe $625/t. But, it won’t be as high as the $700-725/t that I thought may take place when I made that forecast a year ago.

TER: Are fertilizer prices leading or lagging economic indicators?

RK: They are lagging indicators. We need to see economic activity pickup first. The mood of farmers is always pretty gloomy, and getting them to change their view on world markets requires crop prices to move. But, crop prices won’t move really unless you see economic activity pickup.

TER: Is potash still low-hanging fruit? Or is it getting much more difficult to mine?

RK: That’s a good question. We just put on a seminar and heard from ERCOSPLAN, the German exploration consulting firm that has provided a lot of NI 43-101s for potash projects throughout the world. If you’re doing deep shaft, it is very expensive and time consuming, and there are long lead times. I would say that most of the best sites, except in Saskatchewan and Russia, are deep-shaft mines. There may be one or two open-pit opportunities in Ethiopia or in Utah where you’ve got very shallow deposits. Solution mining, though, provides you with the opportunity to get several large sites into production in a relatively short period of time.

But the limiting factor right now is financing, and that’s because you’re dealing with $800 million (M)–1 billion (B) for a 1–1.5 billion tons per year (tpa) equivalent of potash, even for a solution mine. The second limiting factor is cash balances. If we are going to have a long, drawn-out economic downturn here, which is quite possible, then very few of these projects will come to fruition and get into production. They will run out of cash before they can either get taken out or get the financing. So, there are only a couple of strong plays that have plenty of cash and, where cash-burn rates are low, can survive this downturn and lack of liquidity in the marketplace. The third thing is that we could possibly see some deep-shaft mines flood over the next 6, 12, or 24 months like we had in Russia with Sil’vinit (acquired by Uralkali OAO (URKA:RTS; URKA:MICEX; URKA:LSE). We could see something possibly happen in Saskatchewan or in other areas. And I don’t think it’s a question of “if”; I think it’s a question of “when”. Many deep-shaft mines are 2,200 meters down. A lot of money is being spent pumping out water, and you could see some production disruptions. If that’s the case then the market could get tighter very quickly.

TER: Limited access to financing could be a major problem for small companies, couldn’t it?

RK: Yes, absolutely. I think about 100 worldwide projects are being considered in potash, both public and private. I would say 10–15% of them have a hope of getting financing, and of that, I think perhaps three or four might actually get financing.

TER: From everything you’ve just said it sounds like margins are going to have to contract or that prices are going to have to go up. Where does this put the potash producers?

RK: Well, at the current pricing their margins are pretty good. For instance Potash Corp. (POT:TSX; POT:NYSE; Not Rated) is the most visible, and its operating margin, not gross margin, so we’re talking before interest, is about 40%–45%. Terra Nitrogen Co., L.P. (TNH:NYSE; Not Rated) is 65%. CF Industries Holdings Inc. (CF:NYSE; Not Rated) is 60%. Now CF is urea, and it’s a different kettle of fish, but Potash Corp. is about 40%. So, prices can come off quite a bit before they’re going to have any issues. However, I can tell you that any projects that are not in progress will be put on the back burner. You need to have potash pricing power. For instance, BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK; Not Rated) Jansen Project in Saskatchewan needs average long-term potash prices of about $500–550/t really to make a go of it, and from my work the long-term international price is about $410–425/t.

But to answer your question, in a lot of cases their cost inputs have gone up too. So, if they have the combination of prices falling while their cost inputs remain high for let’s say two, three or four quarters, their margins are going to get squeezed quite substantially. But there is no doubt about Q112 and Q212, so If this economic crisis settles down, they’re going to push for higher prices.

TER: The large-cap companies have so many advantages. It seems like there’s so much risk in the small-cap potash equities.

RK: Right: That’s why they’ve been hit very hard. The juniors are the most at risk.

TER: What regions are the most favorable for companies right now?

RK: I would say the best places are Saskatchewan, Utah, Arizona and Ethiopia in Africa.

TER: What specific companies are you telling your clients to invest in?

RK: We’ve been very consistent in the stocks we like since the economic crisis of 2008. On the large-cap side, Agrium Inc. (AGU:NYSE; Buy) has probably had the lowest margins of the big-cap names, but it tends to have the most diversity in its product mix. It has a wholesale nutrient division, a retail division and a specialty fertilizer division, which includes distribution. In a tough economic environment, we opt for diversification. In a very strong commodity market, it makes sense to go to single commodities or pure nutrient plays like Potash Corp., CF Industries, Terra, The Mosaic Company (MOS:NYSE; Not Rated) or Intrepid Potash Inc. (IPI:NYSE; Not Rated). Because we expected the economic recovery to be very difficult, we liked Agrium the best in the large-cap space, and we still feel that way. Until we see commodities fundamentals suggesting a speeding up of economic recovery, we’ll stick with Agrium on the large-cap side.

TER: What about small caps?

RK: On the small cap side our top picks continue to be Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX; Buy) and Karnalyte Resources Inc. (KRN:TSX; Buy). They have the most cash, the lowest burn rate and they are the closest to production and financing. They have all the components in place, including their NI 43-101 resource estimates. But they both have different advantages and disadvantages. Allana has the possibility of being an open-pit mine, or open-pit/solution mine combination, or just a solution mine, which would be low cost because of the solar evaporation in Ethiopia.

Karnalyte is a solution mine, but it’s a gigantic deposit and will probably only need one cavern for 10 years. It does not have to do a lot of drilling. But if it does, the drilling will be horizontal. The key thing with Karnalyte is that it has boron-free magnesium chloride. That is attached to the potassium salt, KCL. The magnesium chloride comes out with the potassium. Thus, its extraction costs are not any different. Refining costs are going to be a little bit more expensive to separate the magnesium chloride, but that’s an extra revenue source.

TER: So, Allana is getting the magnesium chloride practically for free?

RK: That’s correct. Allana has not only the opportunity for MOP (muriate of potash), which is the standard potash, but also SOP (sulfate of potash), which sells at a premium. When the first million tons is fully operational, Allana will be able to produce 20–30% SOP.

TER: Karnalyte is up 31% over the past 12 weeks, and it’s the only one I see with its head above water over that period. Most others are the mirror image of that, down anywhere from 20–40%. Why such high relative strength?

RK: I think there are a few things: One, it has been getting its story out aggressively. Number two, it has been very close to getting the feasibility portion of its magnesium chloride production, and that will be ready by the end of November. I think that’s the most important thing, and it is just now starting to be understood by the market, which has been quite anticipatory of that. Three, there’s been some talk on the street that Karnalyte has worked a 30% contingency into its production costs, which is a lot higher than what it will actually work out to be. That means that its return on the project is much higher, we think, than what the company has been telling the street.

TER: How much per ton is the magnesium chloride right now?

RK: Well, it sells anywhere from $450–700/t depending on the end-product use and the purity levels. It will almost be a one for one. I think that Karnalyte will be able to get 600,000 tpa of magnesium product that they’ll be able to take out of the ground. That’s not factored into its numbers, but my NAV reflects that expectation to a small extent. So, it could be double the size in terms of profitability and revenue than the consensus on the street.

TER: Your target price on Allana is $3.05, which is an implied return of about 200% from current levels. I’m wondering about its preliminary economic assessment (PEA) due out before year-end. What is that going to tell investors?

RK: Well, I think it is going to solidify the resource in terms of measured/inferred. And of course, you’ll get a good idea of whether Allana can go to an open-pit or solution or both. More than everything else it’ll firm up the opex and capex. It will be quite clear that the area will support not just a million tons per year (Mtpa), but 2–2.5 Mtpa.

TER: If it is a solution mine, how much advantage will the solar heat evaporation be?

RK: If it’s open-pit, opex will be $40–50/t. If it is a solution mine it’ll be $65–70. A typical solution mine with natural gas or coal evaporation costs would be close to $90–100/t.

TER: What other companies are you talking to investors about?

RK: Well, at our conference we had nine presenters. Of course Allana and Karnalyte were there. We also had Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX; Restricted). There were others at the conference that we have put on our watch list, and we are bringing them forward to investors as items of interest. We are looking at the resource and numbers on each one. They include Western Potash Corp. (WPX:TSX.V; Neutral), which just came out with a further update on its NI 43-101 and firmed up its resource estimate and capex/opex. We had IC Potash Corp. (ICP:TSX.V; ICPTF:OTCQX; Buy). We had Encanto Potash Corp. (EPO:TSX.V; Buy) and we also had ENP Minerals, which is hoping to get going in Utah. We had Rio Verde Minerals Development Corp. (RVD:TSX; Neutral), Epm Mining Ventures Inc. (EPK:TSX.V; Neutral) and Verde Potash (NPK:TSX.V; Neutral). So, we’re talking about those and getting up to speed as well on the numbers and the resource for each one of those companies. We’ve issued research on them and put them on our watch list, but we don’t have firm numbers or target prices for them yet. We will continue to speak with those companies.

TER: Western Potash CEO John Costigan noted that his company has the largest resource base of current junior potash explorers and developers. What does that mean to you?

RK: Well, there’s the old adage: It’s not necessarily how big it is but how low-cost it gets. To me, quality or concentration of the resource is number one. You have to take a lot of brine out before you get a half-decent concentration of potash. So, it is going to be all about costs. It seems to have fairly low opex costs, but I have to check into that and do more work on it. On the surface, costs seem to be a bit low compared with comparable projects. The initial capex of $2.5B to get it started sounds reasonable for a 2 Mta mine. I think it’s going to be a question of distance to market and ease of getting the mine up and running.

TER: Encanto was one of the presenters at your conference. How much can it expand its resource?

RK: From the information we have, we think the resource could be expanded quite significantly. With all the agreements Encanto has with native groups in Saskatchewan and its proximity to the Esterhazy deposit where Potash Corp., Agrium and Mosiac all operate, I think it has a good chance of expanding its resource anywhere from 25–50%. That is quite possible. But, again, before we make any pronouncements on it, we’re going to be speaking with management and talking with the engineers and geologists.

TER: Were there any other companies you wanted to mention?

RK: Not at this stage. We haven’t done enough work on, for instance, Ethiopian Potash Corp. (FED:TSX.V; FED.WT:TSX.V; Not Rated). We haven’t done enough work on IC Potash or EPM Minerals. So, we’ll reserve judgment on those for the time being.

TER: Richard, it was a great pleasure speaking with you once again.

RK: No problem, my pleasure as well.

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

The Gold Report: China posted its worst growth rate in more than two years during the third quarter. China is one of gold’s biggest buyers and largely drives demand. Should gold bugs be concerned?

David Goguen: I don’t think so. While it was the worst growth rate in two years, China still had a very respectable growth rate of 9.1%. Also adding to demand is China’s growing middle class and its affinity toward gold bullion that has lasted centuries and will likely continue for centuries both as a savings vehicle (through retail investment demand) and as the central bank continues with its purchases to diversify its foreign currency reserves. According to figures released by the World Gold Council, China and India accounted for 54% of global bar and coin investment and 55% of global jewelry demand in 2010. These markets for gold have been growing at a remarkable 30% per annum.

TGR: Global markets seem confident that a plan can be reached to solve the Eurozone’s sovereign debt problems. As more details about a solution emerge, how do you expect gold will react?

DG: There’s a possibility for a pullback in the bullion price if investors perceive that the global macroeconomic risk has been reduced or that systemic risk within capital markets has been reduced because of these measures.

I believe that the bullion price should be well supported by government policies and the entitlement programs that exist in North America and Europe are unsustainable in the long term. Until that has been dealt with, we are still going to accrue large annual fiscal deficits. In that environment people are going to question the soundness of fiat currencies.

I can see gold trading in a range of $1,500–2,000/ounce (oz) through the remainder of 2011.

TGR: Do you think that the gold price has established something of a floor for now?

DG: I believe that we’re probably within 10–15% of a floor. There is still an element of speculative risk capital in the bullion price. Some of that may exit as alternative opportunities present themselves in a more stable, “risk on” type capital market environment.

TGR: In 2010, there were some big takeovers in the sector with Newcrest Mining Ltd. (NCM:ASX) buying Lihir Gold Ltd. for almost $10 billion (B); Kinross Gold Corp. (K:TSX; KGC:NYSE) buying Red Back Mining for $7.2B; and Goldcorp Inc. (G:TSX; GG:NYSE) paying $3.4B to acquire Andean Resources. So far in 2011, the only big deal we’ve seen is Newmont Mining Corp.’s (NEM:NYSE) takeover of Fronteer Gold Inc. for about $2.3B. Why haven’t we seen more big deals in 2011?

DG: It is probably a combination of factors. There has been a lack of big new discoveries made by junior explorers. Also, some of the larger deposits that are under development are considered “wait and see” deposits in terms of their ability to deliver name-plate production results. Having some of these single-mine, large-deposit companies come onstream successfully will derisk these potential acquisition targets and the majors will be more comfortable stepping in and buying them.

TGR: With gold above $1,500/oz, the major producers are selling their gold at somewhat unprecedented margins and have a lot of cash flow. Meanwhile, a number of the juniors have seen their share prices erode throughout 2011. These junior metal explorers have extremely cheap ounces in the ground right now and it seems like the stage is set for a fresh wave of merger and acquisition (M&A) activity.

DG: I agree. Select Golds, our Latin focused, quantitative publication tracking junior gold companies has seen a lot of M&A activity. We see a number of juniors that have made important discoveries advance those projects from resource definition to pre-development. Now they find themselves in a situation where they are forced to choose between building out the mine themselves or putting the company up for sale.

It is at this decision junction that companies need to assess their ability to raise the very substantial capital and recruit the critical personnel, the “build it” personnel that allow them to credibly develop these projects on their own or to put themselves up for sale.

As a result, some takeovers reflect the idea that some junior companies are in the business of making discoveries and are not mine builders. Junior companies at the end of the day have to realize that in many instances the best way to surface and preserve shareholder value is to allow an intermediate or major mining company to develop the deposit through sale of the company. Shareholders often underestimate the execution risk and shareholder dilution required to reach production. At this stage in the mining cycle more juniors are increasingly in this position, hence our expectation of more M&A on the horizon.

TGR: Why is the market not providing full value in these equities with advanced projects?

DG: Mainly because equity valuations across the board are heavily discounted. There exists at the moment a big disconnect between asset values and equity market prices. This can be seen in some of the large premiums we are seeing on announced transactions. They also reflect the market’s aversion to risk.

Acquiring companies are recognizing the long-term value in specific assets. The asset in the sweet spot at the moment is one where capital expenditure (capex) budget is in the order of $150–300 million (M), is fairly defined, and is limited in its probability of unforeseen big capex blowout that would impair the acquiring company’s returns.

Those attributes make a project attractive to an acquiring company. It is easily executable with respect to the capital investment required and also the complexity of project construction. An acquirer with a strong development team can develop projects in an 18-month period as opposed to a two-to-three year build.

The new sweet spot used to be considered too small for intermediates. But it is a really competitive environment for the larger deposits. Some of the better values in the marketplace are for the 2 million ounce (Moz) deposits that have an annual 100,000–150,000 oz production. Those projects are being sought after.

TGR: Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) recently paid about $258M, or a 66% premium, for Grayd Resource Corp. Agnico-Eagle was mostly interested in Grayd’s La India deposit, which has an established resource and simple metallurgy located about 70 kilometers from Agnico-Eagle’s Pinos Altos Gold Mine in Mexico. Is this typical of the deals you expect to see?

DG: Each deal will have its own motivating factors. In the case of Grayd, Agnico-Eagle had capital equipment at Pinos Altos that it foresaw becoming available and the acquisition benefited from that obvious capital savings. It represented a continued commitment by Agnico-Eagle to a geographic region that it was already building competencies in and had a demonstrated track record of being able to execute in. Grayd’s La India project is expected to have a capex of $110M and a fairly simple capital infrastructure required to put it into production. It was a logical transaction for Agnico-Eagle to do.

TGR: What are some juniors in Latin America that have made discoveries that could lead to either mine build-outs or takeovers?

DG: Extorre Gold Mines Ltd. (XG:TSX; XG:NYSE.A; E1R:Fkft) in Argentina has very high-grade ounces at their Cerro Moro project—likely 2 Moz and growing. The resource grade is 24 grams per ton (g/t) gold equivalent—these are near surface ounces that according to a preliminary economic assessment (PEA) could generate internal rates of return in excess of 80%. The anticipated capex is $150M and cash cost are expected to be sub $300/oz.

TGR: Goldcorp bought Andean Resources, which had a gold project in Argentina. Before Goldcorp wound up with Andean, Eldorado Gold Corp. (ELD:TSX; EGO:NYSE) had made a bid. Do you see Eldorado being a potential suitor for Extorre since it was looking at acquisitions in that area?

DG: Eldorado must have become comfortable with the region and its geology through its due diligence. They viewed Cerro Negro as a world-class asset and as a stepping-stone to other potential acquisitions in the area. I still see acquisitions in Santa Cruz, Argentina, as a possibility for Eldorado.

TGR: Extorre hasn’t put out a feasibility study on Cerro Moro, its gold project in Argentina. When do you expect that?

DG: We’re expecting an updated PEA study early in the first quarter of 2012. That will be preceded by an updated NI 43-101 resource in mid-November.

TGR: What is the top end of your estimate for that resource?

DG: Goldcorp has grown Andean’s Cerro Negro from 2 Moz to in excess of 5 Moz since the acquisition. I think that the geology at Extorre’s nearby Cerro Moro deposit has that kind of growth potential.

TGR: What is another junior that you see as being a potential target?

DG: Newstrike Capital Inc. (NES:TSX.V) in the Guerrero Gold Belt of Mexico has acquired a resource from Goldcorp that was north of 1 Moz at the time of acquisition, but has grown that through an extensive drill program. It is probably north of 3 Moz now. It has also benefited from the discovery of high-grade breccia material proximal to the mineralized intrusive body itself. That higher-grade breccia material may very well represent the starter pit material that will provide for some early project payback and thereby impact the project economics positively.

Given some of the existing producers in the area, there’s a ready audience of companies with operating competencies that would see this as a very logical opportunity.

TGR: Newstrike has had some impressive results. It had about 231 meters (m) of 7.5 grams (g) gold. It recently had another intercept that was almost 120m of 3.76g gold. This looks like it could be a high-grade open pit. Is that what you’re seeing?

DG: I think it will be about a 1 g/t Au open-pit scenario that will benefit from some specific higher-grade zones of which the ultimate tonnage has yet to be defined

TGR: What are your thoughts on the management’s ability to continue to derisk that project and perhaps attract a potential suitor?

DG: The exploration team in Mexico has been exploring in that region for over 15 years. They have a good understanding of the geology and a good understanding of local relations. The control of the company largely rests with companies related to Lukas Lundin. Lukas is no stranger to surfacing value in corporate transactions. The company benefits highly from his involvement. Richard Whittall, as president and chief executive, is also guiding the company’s pace of exploration well and is great at communicating its story to the capital markets.

TGR: Which other companies might be ripe for acquisition as they derisk?

DG: Kimber Resources Inc. (KBR:TSX; KBX:NYSE.A) is a good example of a discovery from the early 2000s that is going through a process of derisking. It is currently drilling to expand the resource at their Monterde project for inclusion in a revised NI 43-101 resource calculation. The new data will be incorporated in a prefeasibility expected in Q212.

The prefeasability will effectively assist in derisking the asset and leaving the company open to possible acquisition or a decision to go it alone. There are a number of existing producers in the Sierra Madres for whom this asset would make a good fit. Kimber’s Monterde is profiled to produce 60 thousand ounces gold and 1.9 Moz silver per year for about 12 years. The capital costs there are going to be somewhere in the order of $125M. It’s the typical profile of a small, yet executable, profitable, low-risk acquisition that companies can achieve without getting involved in an extremely competitive process on overly sought-after assets.

Kimber is gaining a better understanding of the geological controls at depth and making some discoveries on its Monterde deposit in the Sierra Madres below the 400m level. It is encountering high-grade, multi-ounce material and opening up the specter of a significant increase in the deposit size. This puts a little fire under any potential acquirers to make a move as Kimber exhibits the continued propensity for new ounces at the Monterde project.

TGR: Could Sulliden Gold Corp. (SUE:TSX; SDDDF:OTCQX) in Peru be a company that acquirers would be interested in?

DG: Sulliden is mostly pure gold with some silver. The model there is for a heap-leach operation producing 150,000 gold equivalent ounces per year with a 10-year mine life and an expected capex of $200M. Sulliden is going down two paths at once. It continues to make large increases in its resource, now in excess of 4 Moz, while refining prefeasibility and feasibility studies. The company expects that ultimately the scale of the operation will need to be expanded in order to accommodate the growing resource. Sulliden is now in feasibility mode and refining the engineering parameters and nailing down costs and project economics.

The simplicity of the operation could leave Sulliden in a position where it could credibly proceed with the development of the asset on its own but more likely it will be acquired before ever breaking ground.

TGR: In another deal, B2Gold Corp. (BTO:TSX; BGLPF:OTCQX) recently bought Auryx Gold Corp. (AYX:TSX) to consolidate gold properties in Namibia. B2Gold already has two operating mines in Nicaragua. Most of the B2Gold management team was with Bema Gold when Bema was bought by Kinross Gold in 2007. It looks like the B2Gold team is setting itself up as a takeover target once again. What are your thoughts?

DG: It is a possibility. However, I would characterize B2Gold as a team that is still looking to build on its assets through both organic growth and acquisition. It has a team that has a proven track record of being able to enter new jurisdictions, understand the local landscape and successfully build and operate mines within that landscape. I would expect B2Gold to evolve into a bonafide intermediate gold producer over the next two to four years.

TGR: Another scenario that has grown in popularity in recent years is large companies, like Barrick Gold Corp. (ABX:TSX; ABX:NYSE) acquiring cooper-gold porphyry deposits. These tend to be large deposits, which really boost reserves, but at the same time, companies are also getting a tremendous byproduct credit with the copper. Are there any projects with established resources that are proximal to other operations that could be targets as well?

DG: There’s a real dearth of large quality gold deposits that fit Barrick’s scale of doing business. The number of politically stable jurisdictions to build operations has shrunk over the years as well. Therefore, Barrick needs to look outside of the strictly gold bracket. I think you will see Barrick add to its portfolio of copper-gold deposits going forward.

TGR: What’s going on in Guyana with copper-gold porphyry deposits? The country has established resources. Are companies like Guyana Goldfields Inc. (GUY:TSX) and Sandspring Resources Ltd. (SSP:TSX.V) on the radar of companies like Barrick?

DG: Guyana Goldfields probably is on the radar as an acquisition candidate. Guyana Goldfields is currently working toward completion of a feasibility study on the 6.9 Moz Aurora project, which is due to be complete in January 2012. The project is expected to profile 300,000 oz of annual production with a life of mine operating cost of $400/oz. The company plans to begin construction on the project in Q112, which is expected to cost $375M.

TGR: If Guyana Goldfields gets up and running, doesn’t that increase Sandspring’s value because it’s not far away?

DG: I think it will have the effect of validating the ability to construct within Guyana successfully and overcome some challenging logistics. Sandspring’s Toro Paru is now moving toward completing a prefeasability study. Through that process the company will continue to refine the amount of capital investment that is going to be required and what kind of returns on a per-ton basis it can expect to generate. It has to refine project economics through more detailed engineering that will provide some comfort that the capex of $637M is indeed the right number. The present valuation on Sandspring, while inviting, does reflect a market awareness of these risks.

TGR: How do you recommend investors play these takeover targets?

DG: Every company is unique. Every deposit is unique. Investors want to focus high-grade deposits that are valued exponentially higher by acquirers because of the margins they tend to generate. While these ounces in the ground appear to trade at premium valuations in the market, they are still some of the best risk-adjusted values in our Select Golds screen.

Investors should also want to be looking at situations where there’s a high propensity to double or triple the existing resource that’s in place. It may be that the target company is focused on engineering instead of exploration and it’s leaving all that value on the table for someone else down the road. The acquiring company recognizes it as being an opportunity and is able to afford to pay a larger premium on the front end knowing that value is going to get backfilled amply with new discovery and additional ounces on that resource itself.

TGR: Thanks for sharing your thoughts with us.

David Goguen focuses on the mining sector at PI Financial Corp. as director, institutional mining sales. Goguen’s focus includes Select Golds—advanced, exploration, emerging producers and junior producers. Goguen earned a bachelor’s in economics from Carleton University and holds the Chartered Financial Analyst designation.