by Shubho Roy.
What has happened?
SEBI was investigating Saradha for more than 3 years before the deposit schemes of the company collapsed (See here). Saradha seems to have used two methods to delay the investigation:
- When SEBI asserted its authority to stop Saradha group from collecting money, Saradha challenged the jurisdiction of SEBI in district courts. It quickly got orders to prevent SEBI interfering in its businesses. These orders were eventually overturned by the High Court.
- When SEBI requested information from Saradha about their schemes and investors, Saradha responded by providing large volumes of documentation without specifically answering SEBI’s questions. This slowed down the entire investigation.
Why is this a problem?
In those three years Saradha took on new depositors and collected money from existing ones. All this money is now lost. Two years of investigation were required to stop what seems to be a run of the mill ponzi scheme. The tactics employed by Saradha are not new. They are similar to those employed by Sahara in delaying investigations in the OFCD schemes and in many other white collar crime investigations. The disturbing fact is that they seem to succeed time and again. While SEBI has wide powers of entities registered with it, if someone does not register with SEBI, the system of enforcement of laws changes completely. The current system requires SEBI to approach the local courts for prosecuting violations of the SEBI Act which constitute an offence. Moreover, SEBI cannot directly appoint lawyers for prosecuting the offences and must rely on the state government prosecution machinery to get criminal prosecution started.
The source of these difficulties
The present system suffers from a number of weaknesses, two of the most important are:
- The normal court systems do not have the time or expertise to enforce violations of investment and securities laws. This leads to confusing orders which sometimes exceed the jurisdiction of the courts. Even in the case of Saradha, the High Court set aside the orders preventing SEBI from exercising its powers over Saradha, noting that the courts were out of jurisdiction when they prohibited SEBI. However, High Court orders take time, and in this time period the operator of the ponzi scheme can continue to collect money or misappropriate the money already deposited. Expertise in deciding jurisdiction and applicability of SEBI laws is also not available in most normal district courts. It will be extremely expensive and wasteful to train all district judges in securities laws for the once-in-a-decade case in financial laws.
- The use of state public prosecutors for violations of financial laws is problematic for two reasons. First, the normal public prosecutors office is flooded with normal criminal cases like theft, murder, etc. A complex financial law case will never be the priority of the normal public prosecutors office. Second, the average public prosecutor who is extremely busy with the daily load of run of the mill criminal cases is not trained investment and securities laws. Just like district judges, it is not cost effective to train all public prosecutors in securities laws.
How would this work under the IFC?
The Indian Financial Code, drafted by the Financial Sector Legislative Commission, addresses these issues in the following ways:
- The whole system of investigation is formalised under an investigator appointed by the regulator. The terms of reference for the investigator, the system of investigation and the time for investigation has to be written down at the onset. Since all incomplete investigations will require extensions, there will be system of raising alarms for an unusually long investigation. See draft clause 394 of the IFC.
- The code allows the investigator to apply for a warrant for the search and seizure of documents. The investigator does not have to go to the area where the scheme is operating. He can apply for a warrant with the magistrate where the head office of the regulator is situated. This allows the government to create a special magistrate’s office. This magistrate can be trained in issues of finance and fraud and be a proper judicial check for warrants. See draft clause 396 of the IFC.
- The code also allows the financial agency to make an order preventing transfer of any money or assets pending an investigation if there is a reasonable fear that the assets of clients are at risk. Any violation of such orders is also punishable by imprisonment up to five years. See draft clause 398 of the IFC.
- The code empowers the central government to set up special courts to try cases involving the violation of investment laws. This allows for far quicker and more efficient disposal of cases. These courts will be district courts and follow all due process of law required under the Evidence Act and the Criminal Procedure Code. However, unlike general criminal courts, judges in these courts can be experts in securities and investment laws. See draft clause 417 of the IFC.
- Finally the code envisages that the financial sector regulator appoints its own lawyers to prosecute cases of criminal offences. These lawyers will have the same powers as a prosecuting lawyer under the criminal procedure law. Since most financial regulators have legal officers on staff today, this allows specialised expertise to head the prosecution of these crimes rather than a generalist public prosecutor.
The strategy used in the IFC is similar to that used in securities laws in the U.S., where dedicated federal court benches are used to prosecute securities frauds. Even in India, special courts and prosecutors have been created for the CBI and for prosecution of offences under the Prevention of Corruption Act. The longer a ponzi scheme lingers the more victims it accumulates. The Indian Financial Code provides a system to effectively shut down schemes like these and a specialised criminal law system to prosecute violators.
The loss of critical savings by many have raised demands for retribution. A hurried response to such demands can bring in laws which dilutes the principle of `innocent until proved guilty’ or reduce the procedural and evidentiary standards. The Code scrupulously avoids this by placing the power of issuing warrants and convicting offences on the same standards as envisaged in the laws of evidence and criminal procedure. However, it addresses the problems of a slow judicial system and dedicated expertise in resolving financial crimes.
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Mining companies have lost the trust of investors, says David Baker, managing partner at Baker Steel. Baker sees the gold market as at a watershed point and the miners must change to stay afloat. In this interview with The Gold Report, Baker sets out his prescription for nursing the industry back to health. Will the restrictions his company and other investors are putting on gold companies increase reporting clarity, investor trust and money earned?
The Gold Report: The major gold producers have ceded market share to gold exchange-traded funds and royalty companies and are vastly underperforming those investment vehicles. If you were running a major gold producer, how would you go about restoring the appeal of your company’s shares?
David Baker: Mining companies need to restore trust and give more clarity. They are confusing investors because on the one hand they tell us they have so many ounces of gold in reserves and are producing so many ounces of gold, and then they confuse us by benchmarking all this to dollars—a depreciating asset. We believe the mining companies should be consistent and report in gold; this would then give investors a clearer picture on how much gold it is costing to mine the resource and how many ounces of gold are added to the shareholder vault.
“Holding gold instead of dollars will also preserve the purchasing power of the company.”
There are a number of challenges out there; first is the issue of the dollar cost inflation. When measured in dollars, the capital and operating costs of a mine have gone up, but when measured in gold, costs are fairly stable. Back in 2008 when gold was $800/ounce ($800/oz), a 100,000/oz per annum gold mine would typically cost $80 million ($80M) or 100,000 oz, today that same mine will cost around $170M, again around 100,000 oz. In dollars, costs are up by over 100% but in gold ounces they are steady.
We are using the wrong measure of costs; we are using a depreciating asset—dollars—to measure costs instead of a real asset, gold. So by mixing dollars and gold we are confusing investors. Now if costs in ounces had risen, we would have a serious problem! To compound the issue, analysts are forecasting higher dollar costs and lower future gold prices. Put these together and this spells a potential margin squeeze. Under this scenario, a new gold project has little value, and the shares get de-rated.
Second, the gold exchange-traded fund (EFT) has outperformed the gold equities; how do we reverse this trend and convince investors to sell some of their EFTs to buy a gold share? As it stands today, if you sell your gold ETF to buy a gold share, what you get is a company who digs gold out of the ground, brings it to surface and then converts it back to dollars, which when you think about it, is not what the EFT holder wants. We believe gold miners need to give investors gold, not dollars, and they could start doing this by reporting in gold, holding gold on their balance sheet instead of dollars and paying a gold royalty or gold dividend.
TGR: Even if companies do put their gold production on the books, they’re still going to need to liquidate some of that gold in order to meet day-to-day expenses.
DB: That is exactly right, but the balance should be held in gold. When we analyze a typical gold mine, it takes about 10% of the deposit to build the mine, 40–45% of the deposit to mine it, about 15% to pay government taxes and maybe 5% for sustaining capital. The balance, 20–25%, is the return and instead of selling this for dollars, the mining company should hold these gold ounces on its balance sheet.
“Gold is a currency that can’t be printed.”
Why is this a good idea? First, it makes no sense to sell an appreciating asset for a depreciating one; second, holding gold instead of dollars will also preserve the purchasing power of the company. A mining company with gold in its vault and lucky enough to discover a new gold project will no longer face a problem of capital cost inflation. As explained, capital costs are fairly stable in ounces and account for around 10% of reserves. Holding gold on the balance sheet will also act as a new source of demand, keeping more gold off the market. Gold producers should then start to emulate the ETF.
Companies should review their mission statements; they should change it ”to build and grow shareholder value expressed in ounces of gold.” This will give management more focus and investors greater clarity.
TGR: When you bring up this idea to boards of gold companies, what’s their response?
DB: I would say that overall we are getting a very positive response; they like the logic and it is certainly stimulating debate.
There is clearly an appetite for gold projects: Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) recently raised $1.9 billion to buy a gold stream off Vale S.A. (VALE:NYSE); it risked that amount for a gold stream at a fixed cost. So we can conclude there is a market for this model. Unfortunately, when gold companies sell a royalty to the royalty companies, they have been giving real margin to the royalty companies, and shareholders have ended up with less. Just look at the difference in share price performance of the royalty companies and the gold miners—it says it all. The gold companies don’t give away much and they hope shareholders hardly miss the 1.75–2% of the gold they sell, but the royalty companies have made a great business out of this.
“We’re looking for well-managed companies and companies that are diversified and well capitalized.”
There is an understanding that something has to change, that the business model isn’t exactly working for gold equity investors—we are giving our margin to others. We argue that royalties should also be paid to current shareholders of the mines. It doesn’t have to be much, say 2–2.5% of the gold mined, but this will link the gold in the ground to what the shareholders get; there is then a tangible way to define what an increase in reserves means to the value of the company. After all, I tell the mining companies, “When you’re going down to your pit and you do 20 shovels to put to the mill, all you have to do is one-half to one shovel to shareholders. It’s not too much to ask.”
TGR: How far off is that?
DB: We’re starting small. Korab Resources Ltd. (KOR:ASX), an Australia-listed company, has just announced a gold reporting, gold strategy and gold dividend policy. We have others in mind. We have confirmations that the strategy will be discussed at board level for a number of companies with the view that they will adopt these policies, so we are getting traction. They are listening, but it is hard being the first mover. Our aim is to allocate funds to those companies who adopt our strategies.
In a nutshell we need to restore the trust between the mining companies and investors and we believe our strategies are one way to do just that. The miners have to be held to account.
TGR: There’s precedence for this. After gold reached its all-time high in early 1981, a number of companies started forward-selling their gold so they could better control their costs. Shareholders ultimately were the benefactors of that. They’ve done it once before, so it can be done again.
DB: In the 1980s and 1990s, the gold price was falling and the dollar was rising. It made every sense that once you dug your gold out of the ground, you converted it straight into dollars. It was such a convincing trade that people were selling gold they had yet to mine to convert into dollars, and that was the advent of forward selling. It took about 10 years to get it entrenched that the gold price was falling, and the dollar was rising. We then took 10 years, from 1990 to 2000, for everyone to get on the trade and forward sell. At the bottom of the market, there were well over 3,300 tons gold forward sold.
TGR: Practically all production.
DB: It was over one year’s annual production. Now the situation has reversed; the gold price is rising and the dollar is depreciating, and this should continue as long as the central banks carry on printing more and more money. Over the last 10 years, gold has been rising at around 15% per annum, so we are now just getting the hang of this trend. We have to become gold centric; the miners need to be forward buying gold (holding gold on the balance sheet) instead of forward selling gold. The dollar period was the 1980s to the 2000s; now we’re in a gold period.
TGR: Some countries are doing that. China has dramatically increased its gold imports from Hong Kong, putting it ahead of India as the world’s largest gold consumer.
DB: Many central banks are printing money. They’re trying to get their currencies cheaper than others so they can capture market share and generate growth, the so-called currency wars, but they all know that if everyone is printing money, they cannot all devalue against each other. They have to devalue against something, and gold is a currency that can’t be printed. So these central banks are starting to see the writing on the wall, and they’re buying physical gold, converting dollars and buying gold. That’s a positive. That’s going to carry on. But nothing goes up in a straight line. At the moment, we’re going through this consolidation, which has felt as if it’s lasted forever. It’s probably been about two years. Hopefully, we’re coming to an end of it.
TGR: In early February, a story in Canada’s Globe and Mail suggested that IAMGOLD Corp. (IMG:TSX; IAG:NYSE) could soon be the subject of a takeover bid. Do you believe there’s any substance to that idea?
DB: I’m not convinced. IAMGOLD has purchased a project in Canada that is very low grade with low returns. Maybe that’s the opportunity, but not in our book. Baker Steel separates the wheat from the chaff by looking at the quality of the projects. We analyze returns and how the company is going to finance the development—will it use debt or equity? In a high inflation environment, debt would be the logical choice, but we’re very reluctant to go down the bank route as this normally entails forward selling part of future production. Recently an Australian company raised $50M of debt and had to forward sell over $300M worth of gold to do that. That didn’t seem logical to us.
In the last 10–12 years, we’ve seen cost inflation of 12–15% and the gold price running up at a similar rate. If you forward sell $300M of gold, and gold continues to rise at the same pace it has over the past 10 years, then in a couple of years, the cost of this debt is going to be greater than 100%, simply in the lost opportunity cost of not being able to sell gold at market. A disproportionate share of our projected returns will either end up in money heaven through the lost opportunity of forward selling or to the bank through fees—again shareholders are short changed. Investors have cottoned on to this and are deserting the developers in droves.
TGR: Baker Steel funds have underperformed in lockstep with gold equities. What approaches are you employing to offset the recent dismal performance in gold equities?
DB: The market is very cheap. A lot of resource companies are trading on single-digit multiples, whereas the market as a whole is trading at 15–20 times multiples. Gold equities used to trade at a premium to the general market but are now trading at a significant discount. That’s the opportunity. We’re looking for well-managed companies and companies that are diversified and well capitalized.
Our focus is the mid-cap, 400,000–600,000 oz (400–600 Koz) gold producers that have two or three operations, with potentially a growth asset as well. We’ve built up a nice portfolio of these. Unfortunately they still haven’t caught traction in the market; you can buy these companies for around 6–8 times price-earnings ratio. They’re very cheap.
TGR: Do you visit the companies?
DB: Yes, last year I went to Chile, Sudan and the Democratic Republic of the Congo (DRC) and others in our investment team travelled to Papua New Guinea, Africa, Indonesia and other sites. We do a lot of due diligence.
TGR: You have investments in what would be classified as safer jurisdictions, like Canada, Mexico and Australia, but you also have investments in places with greater risk, like South Africa, Eritrea and Zimbabwe. Would it be fair to say that when Baker Steel is evaluating a potential asset, it doesn’t put as much emphasis on jurisdiction risk as it does on potential return?
DB: We risk adjust all of our investments; we are interested in risk-adjusted returns. For example, we would place a higher discount rate on a mine in Zimbabwe. Zimbabwe producers have been completely de-rated by the market, to the point it probably couldn’t really get much worse. In an effort to survive, many of the Zimbabwean companies have had to modify the way they do business in an effort to make their model work. They’re starting to produce gold at relatively good costs. There are still some political issues, but you can buy these assets for 10 cents on the dollar. We’re putting in just enough money that if we get it right, investors will be glad. And if it doesn’t go right, it’s not going to be so big a deal for us.
South Africa has been a challenge, but Harmony Gold Mining Co. (HMY:NYSE; HAR:JSE), which has been totally de-rated, came out with a result this week that shows that the company is actually performing quite well. We see great value in a number of South African companies.
AngloGold Ashanti Ltd. (AU:NYSE; ANG:JSE; AGG:ASX; AGD:LSE) produces about 42% of its gold in South Africa yet has been sold down as if all its ounces were in that country. And even those South Africa ounces are generating very good cash flow. Those are the opportunities that we’re looking at. AngloGold is trading at a projected seven times earnings; its yield could be higher but it is currently in a capital intensive phase.
Endeavour Mining Corp. (EDV:TSX; EVR:ASX) is one of our bigger holdings; the company is a diversified producer that recently acquired Avion Gold Corp. It’s a low-cost producer that has a reasonable balance sheet and looks interesting.
TGR: Most of Avion’s producing assets are in Mali.
DB: There is obviously a risk, but we believe this is somewhat discounted by the market. Take Resolute Mining Ltd. (RSG:ASX), for example; the company operates the Syama gold mine in Mali and gold mines in Australia and has a market capitalization of $840M. It has $100M worth of gold/cash and investments on its balance sheet and is generating probably $60–70M/quarter—now that is cheap. There’s been no production lost at Syama but the market has sold it down as if the mine faces major disruption. Now, admittedly, the costs have had to increase because Resolute has had to add to security, but the stock does look very cheap.
Also, we manage a diversified portfolio. It’s not as if we’re putting everything into these names. We have around 4% in both Endeavour and Resolute. We can live with the individual company-specific risk, particularly for the price. And while we are waiting for the market to recognize the opportunity, Resolute is paying us a good dividend yield as well, and it is holding some of its profits in gold, which, as we have discussed, matches our strategic objectives.
We have a position in Ivanplats Ltd. (IVP:TSX) across some of our funds. Founder Robert Friedland used to be in Ivanhoe Mines Ltd. Ivanplats has three world-class assets; it just increased its resources at its Platreef project, an ore-body that is around 14 meters in width, compared to 40–150 centimeters for the typical Merensky reef mine, both with similar grades. Ivanplats is going to be a game changer in this industry.
TGR: Are you bullish on platinum?
DB: You have to be positive on platinum, given the problems in South Africa and the challenges that the platinum producers have there. Anglo American Platinum Ltd. (AMS:JSE) has recently cut production. I don’t think there can be a lot of downside in the platinum price. If there’s not a lot of downside, presumably there’s some good upside.
TGR: Do you have any holdings in the DRC?
DB: We have a very small holding in Banro Corporation (BAA:TSX; BAA:NYSE).
TGR: Is its Namoya project on track to begin production later this year?
DB: That is correct but we understand that the company will need $35–45M to complete this. With Banro’s Twangiza project, we’re getting there, but we’re not there yet.
TGR: It produced about 20 Koz gold in Q4/12.
DB: Twangiza needs to be doing much more that, at least 35–40 Koz/quarter and we need to see some consistency of production. Having said this, we did note that the increase in the resources and the oxide is a positive for that company.
TGR: Let’s move to the South Pacific and New Zealand.
DB: Evolution Mining Ltd. (EVN:ASX), OceanaGold Corp. (OGC:TSX; OGC:ASX), Kingsgate Consolidated Ltd. (KCN:ASX), Silver Lake Resources Ltd. (SLR:ASX), Archipelago Resources Plc (AR:LSE) and St. Barbara Ltd. (SBM:ASX) are our key holdings in this region. They all have decent balance sheets and are generating cash. You can buy Evolution under single-digit multiples. It seems incredible.
TGR: What sort of growth should investors expect from Archipelago in 2013?
DB: Archipelago is producing around 120–140 Koz with potential going up to 165 Koz and even maybe 200 Koz per annum, all self funded. It is getting some good results from recent drilling and this will allow the company to upgrade its plant and increase production and profits. Archipelago is generating good cash at the moment, although I would like to see that reported and held in ounces. The challenge for Archipelago is whether the major shareholder allows it to grow through acquisition.
TGR: What’s on your list in North America?
DB: Lake Shore Gold Corp. (LSG:TSX) and AuRico Gold Inc. (AUQ:TSX; AUQ:NYSE), which owns the Young-Davidson mine. Lake Shore reduced its 2013 capital expenditure budget by about $18M, but we need to start seeing some returns. When we see Lake Shore this month at the BMO Conference in Miami, this is what we’re going to be discussing. It sold a royalty to Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), so maybe the company should consider a royalty to shareholders in return for all our patience. AuRico sold off some assets to focus on Young-Davidson, so now it has a better balance sheet. It is looking at potentially paying a high yield. We’d like to see that as a gold royalty as opposed to a cash yield, but that’s a discussion we have to have with the company.
TGR: What about your silver holdings in North America? You have a position in First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:FSE).
DB: We used to, we made a good return on that and moved on. Our main silver holding is Polar Silver (privately held), this company owns a share of a very high-grade silver project in Russia, which we’re valuing at about $0.25/oz silver. We think we can bring that to market for at least $1/oz, if not more.
TGR: Thank you for your insights.
David Baker is a managing partner at Baker Steel and heads the company’s Sydney, Australia, office. Prior to founding Baker Steel in 2001, Baker was part of the award-winning Merrill Lynch Investment Management natural resources team, successfully managing the Mercury Gold Metal Open Fund, the largest precious metals fund in Japan, from its launch in 1995 until his departure in 2001. Prior to joining MLIM in 1992, Baker was a gold and mining analyst for James Capel Stockbrokers in London from 1988 and held a similar role at Capel Court Powell in Sydney from 1986 to 1988. Baker started his career in 1981 as a metallurgist at CRA Broken Hill, Australia. He holds a degree in mineral processing and a master’s in mineral production management from Imperial College, London.
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Low market valuations for junior mining companies have Michael Ballanger, director of wealth management at Richardson GMP, feeling like a kid in a candy store, and equities satisfy his sweet tooth more than the metal right now. Ballanger has had enough years in the business to recognize the advent of gold fever. In this Gold Report interview, Ballanger discusses his personal views and discusses how he looks for “well-incubated” companies that meet budget and timelines and raise funds without diluting shareholder value. He also shares why he sees junior miners as higher reward and lower risk than gold itself.
: Bitterroot Resources Ltd. : Comstock Metals Ltd. : Kaminak Gold Corp. : Kinross Gold Corp. : Tinka Resources Ltd.
The Gold Report: Michael, can you tell us why you believe we are at the psychological and valuation bottom of the trough in the junior mining sector?
Michael Ballanger: Using the TSX Venture Exchange (TSX.V) as a proxy for the junior mining sector, the TSX.V between 2003 and 2007 traded in a range of approximately 1.5 to 3.3 times the price of gold. In the 2008 crash, it went down to 0.8 times the price of gold. Going back 15, 20, 30, 40 years, the TSX.V had traded on a 1:1 correlation with either the oil price or the gold price. Since the 2008 crash, there has been an immense aversion to risk in the junior mining space. At the end of 2012, trading was around 0.71 times the gold price. We have never seen valuations like this in the junior mining sector.
“I am far more bullish on the senior producers and on the junior and intermediate developer/producers and explorers than I am on the physical gold price.”
At the bottom of any bear market, sellers become exhausted so only survivors are left. If you accept that premise, it becomes important to see who has survived or who has the management capabilities, the financing and high-caliber projects to advance. Those are companies that will benefit from what I think will be a normalization of the Venture Exchange’s ratio to the actual gold price. I think a realistic level would be 1.5–2.0 times the gold price.
Unlike most experts, I am far more bullish on the senior producers and on the junior and intermediate developer/producers and explorers than I am on the physical gold price. I think there is a lower-risk, higher-reward potential in the shares than in the metal right now.
TGR: Given the market performance in the junior precious metals sector and in the junior mining sector as a whole over the last couple of years, do you feel like the characters in the film “Groundhog Day,” reliving the same events over and over?
MB: What is peculiar about this cycle is that we have not experienced the “mania phase” that typically happens at the end of a bull market. At the bottom in 2009, again in 2011 and all through 2012, despite near-record gold prices and very high energy prices, it felt as if we were in the post-Bre-X Minerals Ltd. period.
You need to remember that the symbol for crisis in the Chinese language is made up of two symbols: the first one is danger and the second is opportunity. I see tremendous opportunity, but not without challenges.
In my work, I have to be very good at identifying management teams and projects that will survive and will excel in most environments. With market valuations so low, I feel like a little child in a candy store with $10 in my pocket. There is so much to choose from.
Due diligence takes longer, yes, but when I find something, I can hand my clients an awfully big rate of return if they are prepared to take the risks associated with the sector.
TGR: We hear a lot about management teams at junior mining companies. You have said that you prefer management teams that incubate companies to preserve shareholder value. Can you expand on that concept?
MB: The perfect way to incubate a junior mining company requires, first, a private company with a very small group of shareholders who are looking three to five years down the line. The caliber of the shareholder base is paramount. The ideal shareholder is one who has been successful in his or her own business and knows how long it takes to start up, develop and eventually reap the rewards of owning a start-up. Having shareholders with a three-to-five-year timeframe eliminates frequent turnover in the shares, which makes it a lot easier for the management to raise capital for development at progressively higher prices.
“A well-incubated company keeps its financing strategic.”
The second most important thing relates to raising money. If a company needs $3 million (M) for a project, it should not try to raise $10M. If a company raises only what it needs, it avoids diluting shareholders’ equity. Do you remember the old expression “Friend or foe, take the dough”? In the last few years, junior mining companies have taken the dough, which is always associated with larger percentage fees charged by the investment industry, and companies have been trashed by the market. They have diluted shareholder equity.
A well-incubated company keeps its financing strategic, on a needs basis and at progressively higher levels. This minimizes dilution and enhances shareholder value. These companies can go to their shareholders first for financing. If they wrote a check at $0.10/share, they will write another check at $0.35 and another at $0.75 because they understand the business model.
TGR: How does an average retail investor find out who the shareholders are in a junior mining company?
MB: I wish I had a good answer to that. You might start by searching the company’s press releases on its website or through SEDAR. You can cross-reference what the company financed at and measure that against how much it is spending on a month-to-month basis. If the company has executed its business plan and hit its benchmarks of estimated ounces, was that done on time and on budget?
That information will infer the caliber of the shareholder base and the kind of guidance the company is getting from its fiscal adviser. It will tell you how committed management is to preserving and enhancing shareholder value.
TGR: Can you give us a couple of examples of companies that have succeeded with that incubation strategy?
MB: Tinka Resources Ltd. (TK:TSX.V; TLD:FSE; TKRFF:OTCPK) is the best example. Its Colquipucro property in Peru is a great asset. I have been recommending Tinka to Gold Report readers since 2009.
In 2010, we raised a little over $1M and asked management to get the permits in place to develop the silver resource. Just before the meltdown in mid-2011, after the shares had hit a high of $0.75, there was a correction. We were set to do a $0.50/share financing to raise $5M. We scaled that back to $0.35/share to raise $2.25M. This minimized the dilution during a difficult period in the market.
In December 2012, Tinka moved its Zone 1 silver resource from 20.3 million ounces (Moz) to 32.7 Moz, under budget and in a very acceptable timeframe. The share price responded; the market went to $0.75–$0.80/share. The $2.25M raised was within the budget. If the company moves forward over the next 6–12 months to a level representative of fair value relative to its proven resource, it can do a much bigger financing at fair value. This gives the early shareholders a significant lift and, most important, a reason to hold the shares.
Another company that did not get hit in the downturn due to the caliber of its shareholder base is Kaminak Gold Corp. (KAM:TSX.V) in the Yukon, led by Rob Carpenter. It started off in 2009 at around $0.15/share. In 2011, when everybody thought the Yukon would become the next Northwest Territories diamond rush, it moved above $4.50/share. When the European meltdown hit, Kaminak executed beautifully. It minimized dilution and did not issue overly aggressive amounts of paper. The company still has less than 100M shares outstanding and 1.9 Moz or more.
Kaminak’s shareholder base is primarily institutional. The people who run these portfolios are very capable and very sharp, but their hands are tied. If the retail public decides to redeem the fund, the portfolio manager has no choice but to liquidate to meet the redemptions. When they sold Kaminak, it was not because they wanted to, but because they were forced to. In the case of Tinka, no one was forced to sell through redemptions.
Both companies have executed beautifully. Both represent great shareholder value at current levels and have lots of blue-sky potential. Tinka closed at an all-time, 52-week high in 2012, while Kaminak closed at about 35% of its all-time high.
TGR: Tinka’s share price has been trending higher since August. What is its next step? When can we expect a maiden resource estimate?
MB: Tinka has an Inferred, NI-43-101-compliant resource of 32.7 Moz. It has a permit and recently announced a villager agreement.
Tinka’s management team in Lima has a done a superb job. The team has 30-odd years of experience in the mining industry in Peru. They negotiated both the government permits to drill the Zone 1 silver project and the Ayawilca base metal massive sulphide discovery. They also navigated relations with the local communities and what is called the “social contract” in Peru.
It took six months longer than expected to negotiate the villager agreement with the Pillao village, which is associated with the silver resource. It took longer than expected in Yanacocha, where Ayawilca is, as well. But if your shareholder base understands how politics and business co-mingle in Peru, they have the patience to let management do it right. Tinka’s community relations staff used education and fairness to turn the villagers into advocates who are now running around wearing Tinka T-shirts and baseball caps.
TGR: What can you tell us about Tinka’s two projects?
MB: Tinka’s safety valve is its silver resource, Zone 1, which is being expanded rapidly. I expect the infill drilling has the potential to substantially move up that resource’s 32.7 Moz; a resource of about 35–40 Moz is necessary to get on the radar screen and I am confident it will achieve that level in 2013.
The second thing that sets this resource apart is that it is all on the surface; it is in an oxide zone, amenable to leaching, and you get 97% recovery rates after 72 hours using bottle-roll technology. The feasibility of putting something like this into production with a very low capital expenditure is extremely high. This offers a level of security for Tinka’s shareholders—you can get that valuation metric with very little risk.
Ayawilca is a new, massive zinc sulphide discovery made in late 2011. It is my passion. I am a base metal person and massive sulphides are the Holy Grail for me. When Tinka started hitting intercepts of massive sulphides containing economic-grade zinc, the hair on the back of my neck started turning up; this thing has structure. The geophysics say that Ayawilca has elephant capabilities. It is 70km down the road from Cerro de Pasco, one of the biggest zinc mines in Peru, owned by Volcan Compañia Minera SAA (LIN:PE:VOLCAAC1). The number-one marker mineral at Cerro de Pasco is rhodochrosite, and Tinka’s discovery holes contain a lot of rhodochrosite. I am really excited about Tinka and its current share price objective has not factored in Ayawilca.
TGR: Kaminak put out a resource estimate in December of roughly 3.2 Moz Inferred at its Coffee project in the Yukon. What did you think of those numbers?
MB: Rob Carpenter has delivered more than people ever expected. I am bullish on the Yukon. I expect it will be the next major Canadian gold mining camp, not unlike Timmins or Kirkland Lake. And I think Kaminak has above-average potential for people willing to take the risk and have the patience to understand that these businesses take time to develop.
TGR: A lot of investors in this sector are employing strategies that worked in previous cycles in the junior mining sector, but seem ill-suited to today’s market. Why is that?
MB: It dovetails with what we discussed about how you do your due diligence.
In 2000, coming off the Bre-X Minerals Ltd. disaster, junior mining companies could not raise money for any project regardless of its potential. It was easy to make money in the early part of that cycle because valuations were so depressed.
From February 2011 to the end of 2012, we were in what I call a “valuation compression cycle.” Normally, you expect increased gold or silver prices to attract new investors when a company announces a discovery, and that demand will take a share price higher. In a compression period that does not happen. In a compression cycle, you have to make sure that your entry point is at a level that has already wrung out all the early or mid-range investors who bought it at the wrong price.
If you or your adviser has been investing only since 1991, 1998 or 2001, you may think that a company that has been in the range of $0.50 to $2/share, and that if you buy it at $1/share, the worst it can do is go back to $0.50/share. That is not the case; it can go back to zero.
There is an expression in this business, “there’s no fever like gold fever.” No one younger than 35 or 40 has any idea what a “mania phase” is like. And I maintain that we are heading into a mania phase for the junior mining sector.
I am not sitting here with a starter pistol, ready to tell you exactly when the mania will start, but there has never been a time when the gold price has advanced as it has over the last 12 years where the entire mining sector—junior, intermediate and senior—did not move to bubble valuations.
We may see gold at $10,000/ounce (oz) or $5,000/oz, but the lower-risk entry point now is into the abject, stark psychological depression that is the mining shares. That is the lower-risk transaction right now.
TGR: What are some other names you are high on now?
MB: In the Yukon I like Comstock Metals Ltd. (CSL:TSX.V). I have spoken to CEO Rasool Mohammad a number of times; I like his passion and commitment. Kinross Gold Corp.’s (K:TSX; KGC:NYSE) Golden Saddle project is across the Yukon River from Comstock, and Kinross needs to find more resource ounces to rationalize its infrastructure. If Comstock puts any ounces together in its 2013 campaign, it could be absorbed like a minnow in front of a shark because Kinross needs those ounces.
Bitterroot Resources Ltd. (BTT:TSX.V) has a nickel-copper, platinum group metals prospect in northern Michigan tied to Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCP). Bitterroot trades at $0.11-0.12/share. I am just in the due diligence process right now, but it certainly has my attention.
TGR: You follow the Chicago Board Options Exchange Market Volatility Index (VIX) and you track volatility. Should retail investors get used to more volatility as 2013 unfolds?
MB: They certainly should. Howard Marks wrote an article commenting on the high level of complacency in the market. People are buying into the equity markets because they see the Federal Reserve or the Treasury defending equity levels through interest rate policy or open market operations. That is why the VIX has come down so far.
I like seeing the VIX trade at a reasonable level—20 or 22—because it says to me that there is some fear in the market. A VIX under 15 tells me there is too much complacency. I would use VIX to hedge portfolio positions looking six to nine months out, particularly now that it is trading at a multiyear historical low, under 14.
TGR: What wisdom can you share with our readers from your 35 years in the business?
MB: A phrase I learned at the Wharton School has always served me well: “Never underestimate the replacement power of equities within an inflationary spiral.”
All the central banks on the planet are doing their best to re-inflate their way out of their debt problems. When they all are doing their best to debase their currency, it is no different than a company trading on an exchange excessively diluting its shareholder capital. In the equity market, that is a negative for price. In the fiat currency world, currency dilution is punitive to the purchasing power, to the value of that currency. This makes currency the great short sale for 2013.
I recommend that people short sell or sell cash. The inverse of that is to buy assets. The integrity of the purchasing power of cash and cash equivalents is the greatest danger right now. People sitting on a pile of cash for retirement could wake up to a situation like Weimar Germany in 1921–22, instead of paying $1.20 for a loaf of bread, it suddenly costs $5 or $6. Inflation is like toothpaste, once it is out of the tube, it is impossible to get it back in.
Investors should be buying things, investing, taking their savings and making sure that they are selling or shorting cash. That includes owning companies that produce gold, silver, resources, farmland, anything that kicks out a rate of return on commodities and goods that people require.
In nominal terms, that means you could see a much higher equity market 12–18 months down the line without feeling it in the economy, because it is the currency that will have gone down, not the inherent value in the businesses or the shares.
TGR: Michael, thank you for your time and your insights.
Originally trained during the inflationary 1970s, Michael Ballanger, director of wealth management at Richardson GMP, is a graduate of Saint Louis University where he earned a Bachelor of Science in finance and a Bachelor of Art in marketing before completing post-graduate work at the Wharton School of the University of Pennsylvania. With more than 30 years of experience as a junior mining and exploration specialist, as well as a solid background in corporate finance, Ballanger’s adherence to the concept of “Hard Assets” allows him to focus the practice on selecting opportunities in the global resource sector with emphasis on the precious metals exploration and development sector. Ballanger takes great pleasure in visiting mineral properties around the globe in the never-ending hunt for early-stage opportunities.
Gold stocks, especially juniors, have been undervalued for longer than most investors thought possible. The result is what David Skarica, founder of Addicted to Profits, calls a “maximum pessimism trade.” In this interview with The Gold Report, Skarica summarizes his analytical tools and provides clear examples of companies that meet his criteria as “screaming buys.” Gold junior investors might feel as if they live in the movie “Groundhog Day,” but the undervaluation cycle will eventually be broken. Is spring just around the corner for the junior gold miners?
The Gold Report: In your recent newsletter, you wrote about “screaming buys” in gold stocks. Over the past couple of years, many investors have thought that gold stocks have been too cheap to pass up—and have been burned. Is this a new position for you or has your view changed?
David Skarica: Unfortunately for gold investors, historic valuations of gold stocks linked to the price of gold have remained undervalued for too long. If you look at valuation metrics of large-cap gold stocks compared to the price of gold, many of these stocks are historically at very cheap valuations and that has persisted for some time. The AMEX Gold BUGS (Basket of Unhedged Gold Stocks) Index (HUI), is trading at roughly $420–430. It broke $400 to the upside for the first time back in 2006 when gold was in the $600–700 range. That tells us where we are. In the past year, gold stocks have been undervalued by anywhere from 20–50% based on historical valuation methods. Despite the bargain prices, a rally has failed to materialize.
“When you’re trading the juniors, you need to be very disciplined.”
I have refined my message to focus more heavily on junior mining stocks because they have underperformed compared to the large caps. Juniors will fall harder and faster in a weak market even though there is value in the stocks. I, like everyone else, can learn my lessons from the market. The one thing I’ve really learned the last couple of years is when you’re trading the juniors, you need to be very disciplined. The reason that I’m going so heavily toward juniors now is based on recent history. If you look at the rebound after the last big down market of 2008–2009, there were many juniors that had quality assets that were five-, ten- or twentybaggers. There will be companies that come through this market that will have similar performances.
TGR: Do you have a particular phase that you like—exploration, development or near-term producers? Or are there other factors?
DS: There are a lot of dynamics. If I find an exploration company that’s in the early stages yet has good management and lots of cash in the bank, I will definitely consider it.
I like the stories that have a well-defined resource or can build upon a resource. Near-term production stories often have huge upside potential. They still have execution and financial risk, but near-term producers are the ones that really can take off when the market finally turns. Near-term cash flow coming down the pipeline and the capital investment behind them make them attractive to the market. Such stories can get punished in a market downturn because there’s no news flow. They’re quietly building the mill, building the mine and, finally, when the production starts, it’s. . .wow.
An example that follows this pattern is Avion Gold Corp., a gold producer in Mali. During the financial crisis, it went to $0.05/share. We put it in the newsletter at $0.06/share and the stock went as high as $2/share. Avion was taken out by Endeavour Mining Corp. (EDV:TSX; EVR:ASX) for $0.88/share. The catalyst was production and cash flow.
TGR: Was Avion a near-term producer when you recommended it?
DS: It was on the cusp of starting production when I first discussed it. Buying near-term producers isn’t quite that easy; you still need to look at the fundamentals of the project. A different type of example is Baja Mining Corp. (BAJ:TSX; BAJFF:OTCQX), which is over budget, over budget and over budget. The company response was to dilute, dilute and dilute. As an investor, that is probably not something that you want to get involved with. My strategy is to look for projects that are relatively within budget. A lot of mine building goes somewhat over budget because capital expenditures and basic inputs have increased in price. That is even true in the emerging world, where cheaper labor is not as cheap as it was 20 years ago. Look for projects with costs under control and no delays.
“Near-term production stories often have huge upside potential.”
I also look for companies that are takeover targets. An example is one that I own now, Castillian Resources Corp. (CT:TSX.V). Castillian has the same head geologist as Desert Sun Mining & Gems (DEZ:NYSE.MKT) and Central Sun Mining Inc. (CSM:TSX; SMC:NYSE.A), both of which were taken over by majors. To be clear, we’re talking about a $0.03/share stock with a minimal market cap. Companies of that size could have liquidity and cash concerns, but Castillian has built up a small resource of 0.5 million ounces (Moz). It is a situation where it could grow to well over 1 Moz and build a nice little project. If that works out, it has real upside. (Editor’s note: Castillian currently has 590 Koz Indicated and 548 Koz Inferred.)
Sometimes it is hard to understand the reason why a stock is priced the way it is. Some stocks go to $0.02/share and become $0.02 stocks that won’t rebound in the next cycle higher. But not all stocks are that way—some stocks are simply oversold. As John Templeton used to say, it’s “maximum pessimism.” In some of those cases of maximum pessimism, the stocks are going to turn around and be ten-, twenty- or thirtybaggers. We are talking mining stocks for this interview, but the same market psychology applies to many sectors right now, from solar to coal to stocks in many countries in Europe.
TGR: Because you were describing Castillian, what conditions are needed to improve the share price?
DS: Castillian has used flow-through to finance. Some of that money can be used to drill. There are three factors that are needed to help out its share price:
- Improved market conditions. A lot of financial issues can be solved just if the juniors begin to rally. Looking back to 2008–2009, there was a real V bottom in many juniors because the selling dissipated and most investors left. That set the stage for a turnaround. Overall market conditions are critical for individual companies to succeed.
- Resource increase. If there is new drilling success, it will be reflected in the share price.
- Secure financing. In the current market, it doesn’t make sense to finance at $0.03/share or $0.05/share, because it’s too dilutive. Castillian is under the Forbes & Manhattan umbrella and may be able to tap into corporate resources that other juniors cannot.
The three conditions are related, especially with improved market conditions that could create a snowball effect. With improved market conditions, then the stock goes to $0.10/share. Financing becomes easier and the company can drill. And that creates a positive feedback loop. A lot of times, you just have to wait for the market to turn around to get things moving.
TGR: When evaluating juniors, there are a lot of things that you could look at, but what are the three most important things that you must look at?
DS: I have five, and I call them the Five P’s. And I am paraphrasing from Doug Casey. I first saw him write about these back in the 1990s when I got involved in this industry. The five are:
- People. That is obvious because people do everything. You need solid management, people with a history of getting quality assets, making things work and hiring the right specialists.
- Property. You need good geological properties. You don’t want moose pasture in the middle of nowhere; you need something that can become viable and economic.
- Politics. You want to be in a stable mining country. It could be somewhere in Canada, Nevada or Mexico, which is not a stable country in other ways but is a very solid mining jurisdiction. A lot of countries in South America, especially Chile, have become solid mining jurisdictions where maybe some places in the middle of Africa haven’t.
- Phinancing. You need the ability to raise money. It could even be directors with deep pockets to do a personal loan during a tough time.
- Promotion. Although it sometimes gets a bad name, you need the ability to tell the story. Consider a tree that falls in the forest. If nobody tells the story, then you’re done.
TGR: Your analysis includes considering the Five P’s and looking for “maximum pessimism.” Do you have other companies that fit that model?
DS: Western Pacific Resources Corp. (WRP:TSX.V) is one. It is an exploration company with a mine from Pegasus Gold Inc. in Idaho. The company has solid management. The property has excellent infrastructure and Idaho is a politically safe location. In terms of financing, Western Pacific has $2 million (M) in the bank. When it hit its low, $0.10–$0.11/share, it had a $3M market cap with $2M in the bank. You’re getting everything else in the company thrown in for free. Even after it rebounded to $0.20/share, the market cap was still only $6M. I would call that stock an exploration company even though its flagship property is a past producer. Like many other stocks I watch, it will rise with the overall market. A typical recent pricing pattern for junior stocks would be to go from $0.80/share to $0.20/share in this weak overall market. But when this market turns around, many of those stocks will rise back into the $0.50–0.60/share range. That would be an example of the maximum pessimism trade.
“I believe the breakout will be huge when it happens.”
A similar pattern might fit to another stock I like, which is also under the Forbes & Manhattan group. That one is an iron ore project called Black Iron Inc. (BKI:TSX.V), which is located in the Ukraine. This project will be a massive producer starting in Q4/15. However, at the moment, it is in the “quiet stage” prior to production as the mine and mill are being built. The stock has fallen with the rest of the market. At this point, Black Iron is a $45M market cap, with a potential 16-to-20-year mine life. The infrastructure and the properties are fantastic.
TGR: You like gold, but iron ore is a very different commodity. Does it concern you to pursue a commodity like iron ore that is linked to a healthy economy and financial system? In some ways, isn’t the iron trade the opposite of the gold trade?
DS: One of my best-performing deals was a company called Consolidated Thompson Iron Mines Ltd. (CLM:TSX), which I bought between $1 and $2/share. I sold around $10/share. It eventually got taken over for roughly $15/share. That was an iron ore deal. People tend to forget that something like Diamond Fields wasn’t diamonds; it was nickel.
You have to get back to your belief system in this situation. I like to consider the macro trends, the kind of the things that Jim Rogers talks about and I’ve talked about in my book, “The Great Super Cycle,” where we are in an inflationary stage. The last year or two we haven’t seen a huge move up in commodities, which are digesting huge gains from the last 10 years and especially from the 2008 lows through 2011. It’s perfectly normal to see one-, two- or three-year consolidations on these macro moves higher. I believe we’re in a re-inflation cycle. Things we need, like energy, are going to go up in price. And things we want but don’t need, like flat-screen TVs and cell phones, are going to go down in price. Japan is now joining the money-printing fray, and that should put more pressure for higher commodity prices. It’s the old monetarist arguments by Milton Friedman—too much money chasing too few goods is inflationary. You’re going to continue to see all commodities increase because of that.
I’m a little more bullish on parts of the global economy in the short to intermediate term. Longer term, I feel as if the U.S. is going to have a debt crisis, similar to what happened in the European countries. Most of the economic indicators in Europe, at least in the short term, are positive. Probably in H1/13 we should see a short- to intermediate-term bottom in the Italian, Spanish, Portuguese and Greek economies. Markets may be already discounting that bottom. Interestingly, no one talks about the potential for those markets to recover. From a technical point of view, those markets are looking attractive as they build a base.
TGR: That’s your maximum pessimism trade applied to a set of countries?
DS: The PIGS (Portugal, Italy, Greece and Spain) were the maximum pessimism trade for last year, and they have stabilized. Recent indicators out of China show that China is beginning to stabilize from its slowdown. Similar things appear to be happening in India. My thesis is that the rebound in Europe and China will drag U.S. markets higher.
That same macro analysis can be applied to make a bullish case for precious metals stocks. Recently, the chart of the HUI is not similar to the Standard & Poor’s 500. The HUI is more similar to Italy, Spain or the emerging Asian markets. The gold stocks are behaving as risk-on trades, as have these markets. If the emerging markets are showing signs of stabilizing and climbing, so will the gold and precious metals stocks.
Another index to watch because of positive macros is the S&P/TSX Venture Composite Index (CDNX), which is building a great base. It has a range from $1,120 on the downside to $1,350 on the upside. It’s right in the middle of that range now. The chart appears to be an example of a classic bottoming base. The big money printing that we saw in the U.S. after the 2008–2009 financial crisis is detrimental in the long term. But in the short term, it does boost the economy and I think we are seeing that in Europe. That will stabilize the rest of the world in the short term. Long term, it will have inflationary consequences.
I am a bit of a contrarian on Europe—I’m not as bearish as many. The simple reason is that the European countries are doing some excellent things to modernize the regional economies. In many parts of Europe the economies are 20 years behind Germany. Germany modernized after the fall of the Berlin Wall and went into a production-based, efficiency-based economy. It may not apply to all areas, but the Germans are opposing free market restrictions and want the Spanish and the Italians to do the same. Italy has a large industrial base, so it could probably pull it off. Spain is a little more of an unknown. With austerity, the Europeans are addressing some of the problems of bloated government. There is short-term pain for long-term gain, and that has been something that Americans have not been willing to address. We keep hearing this thing about the fiscal cliff. The fiscal cliff wasn’t a one-day event on Jan. 1, 2013; it’s a permanent condition. At some point, we have to solve these trillion dollar deficits.
Coming back to gold and precious metals, there is flight away from risk assets into bonds and the U.S. dollar. If there is real growth in Europe, the next crisis could be a run on the dollar. All these crises have seen gold stocks fall with the market, but what we could see in the next crisis is the gold stocks rise while the S&P flounders. Again, that’s two to three years off. The next couple of years are the transition period. The U.S. has really led in the last couple of years during this European crisis and Europe will now probably outperform; the dollar will weaken, and that’s another positive factor for gold.
TGR: Are there any other particular stocks that you watch that fit the maximum pessimism trade?
DS: I think that what has happened in Newmont Mining Corp. (NEM:NYSE) and Barrick Gold Corp. (ABX:TSX; ABX:NYSE) is interesting. It’s similar to what happened in Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) in late 2011 when it essentially threw the baby out with the bath water. Agnico had bad earnings; it downgraded the resource on one of its mines and wrote off a bunch of assets. It downgraded future production, future profits, etc. Agnico has performed well since then. It bottomed at roughly $30/share and rallied to the mid- to high $50s, and it’s about $50/share right now. If you look at Barrick and Newmont’s Q4/12 earnings, they did the same thing—wrote off assets, wrote off resources, wrote off future profits. Both of those companies had minor warnings last year, but what they decided to do is throw everything out. Now the expectations are very low. Both Newmont and Barrick trade at ridiculously low valuations. Barrick has a forward price/earnings ratio of 6 or 7, which for the whole mining sector is unheard of. Newmont has a dividend linked to the price of gold. There are many reasons to like each of these companies. Now that expectations are so artificially low, which the companies themselves created, there is a solid base for stock performance in the future.
Another producer I like is Eldorado Gold Corp. (ELD:TSX; EGO:NYSE). Eldorado is in a similar position to where Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE) was a few years ago when Yamana was expanding rapidly and issued stock to fund that expansion and mine building. Eventually, the production and profit show up in the bottom line. As a result of that well-timed expansion, Yamana has held up much better than the rest of the mining sector. That is where Eldorado is right now. From a valuation perspective, those are my three top picks of the senior gold producers.
TGR: In The Gold Report interview in February 2011, when gold was at $1,355/ounce (oz), you said, “I think that after the next rally we’re going to see a significant pullback in gold probably in the 2012–2013 period, but that will just be a buying opportunity.” So two years ago, it looks as if you pretty much nailed it. Do you have an update to that forecast or the next forecast to layer on top of that?
DS: From a technical perspective, in mid-2011, we had a big spike in gold prices over $1,900/oz. We are now in the second longest consolidation of the gold bull market. The only one that was longer was the 2004–2005 consolidation, and that was longer by only a couple of months. Technically, a spike high followed by a sideways trading range that builds the base between $1,530/oz and $1,650/oz is a positive development. As the saying goes, “The longer the base, the more the space.” It could also be called a “coiled spring.” The longer we trade sideways, the bigger the break out should be. I don’t anticipate new lows. It appears that we are nearing the end of the base and, though I don’t want to sound like an out and out goldbug, I believe the breakout will be huge when it happens.
One driver of the breakout, which no one is really talking about, is what’s going on in Japan. Japan has now decided to devalue and print for the first time in 20 years. It is going to print more money than the U.S. and Europe combined, even though it is a much smaller economy. That third nation of money printing—counting the Eurozone and the European Central Bank as one nation—is going to be phenomenal for the price of gold. Now you just have to be patient. I don’t know if this breakout is going to start in March, June, September or December, but I really think that 2013 will be the year that we will break out. If you’re looking at a price target, I’ll just use the easy price target of $2,000/oz by the end of the year.
TGR: Fair enough. I hope your forecast for the next year works out. We look forward to checking in with you again.
In 1998, David Skarica started Addicted to Profits, a newsletter focused on technical analysis and the psychology of markets. From 2001 to 2003, Stockfocus.com ranked Addicted to Profits third out of over 300 newsletters for performance. He is also the editor of Gold Stock Adviser and The International Contrarian, which focus on gold and global investing. Skarica has also been a contributing editor to Canadian MoneySaver and Investor’s Digest of Canada.
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Chen Lin has gotten so much attention for his investment success, new subscribers to his newsletter, What Is Chen Buying? What Is Chen Selling?, have to line up on a waiting list. Luckily, he sat down with The Energy Report to share some of the investment ideas that helped his portfolio climb 63% in 2012. Learn how Lin played price differentials and dividends to create outstanding gains in a challenging year, and what his moves for 2013 may be.
The Energy Report: Chen, what’s your economic and market outlook for 2013?
Chen Lin: In the past few months, China seems to have turned the corner as its real estate market started to turn up, and so goes its economy. I believe the U.S. will likely do well. I don’t see the EU breaking up in 2013, and Japan is going to be printing a lot of money this year to try to jumpstart its economy. So although I see slow global economic growth, it’s still growing, especially in China and the U.S. I believe the stock market can do quite well as investors have been piling into bonds and cash in the past a few years.
TER: Oil prices have recovered from their lows of last year, but Brent is much stronger than West Texas Intermediate (WTI) and closer to its March peak than WTI. What’s your forecast at this point?
CL: I see relatively stable oil prices. There will be a lot more oil coming from U.S. shale plays. However, the pipeline to the Gulf will be limited and the United States has a ban on exporting oil. We are likely to see a lot of oil coming from Oklahoma to the Gulf Coast. However, the oil has to be refined at the Gulf Coast because it cannot be exported, so the new pipelines will likely push down Louisiana Light Sweet until it sells at a sizable discount to Brent, which could create some interesting opportunities for refiners on the Gulf.
TER: How do you view the domestic versus international production arenas in terms of investment potential? Where do you see the best investment opportunities in 2013?
CL: I’ve been really focusing on international onshore plays in the past few years and will continue to do that. International companies can get the Brent price. Domestic producers are usually shale or offshore plays with high capex. Capital is very hard to get, especially for small companies, so that’s why I’m focused on international onshore players. The geographic area I’m mainly looking at is Southeast Asia and onshore Africa, because those are areas in which China is likely to make more acquisitions.
Last year was very difficult and many juniors were hit very hard—it reminded me of 2008. I see potential on the other side of the trade, where most investors are going to cash and bonds and avoiding risk. Maybe investors are getting ready to take on more risk. That’s got me quite excited for 2013 and I’m continuing to watch the market for opportunities to arise.
TER: What are the global implications of China’s aggressive oil and gas acquisition plans?
CL: I think China’s acquisition strategy is twofold. One is its focus on North America, mostly in Canada, where the primary goal is to understand fracking technology and see if it can be applied in China or elsewhere. The other focus has been on Southeast Asia and Africa, which can be very beneficial to juniors. We’ve seen some M&A activity there and I expect to ride the wave and hopefully take advantage of that.
TER: Has your investment strategy changed at all as a result of developments over the past six months?
CL: Not much, but I have started to look a little at some more risky junior plays because investors have been extremely risk-averse. This is a good time to start looking at them more closely.
TER: You recently closed your newsletter to new subscribers. What was the reasoning behind that?
CL: My newsletter has been getting a lot more popular lately and I really hate to see stocks swing a lot on my recommendations. In an ideal world, stocks should only rise and fall on their own merits and not on my recommendation. So I decided to close it to new subscribers so our existing subscribers could have a better chance to make profitable trades. We are allowing people to go on a waiting list if people drop out.
TER: Do you feel that investors need to be more trading-oriented in order to profit in the energy market these days?
CL: Personally, I’m a pretty long-term oriented investor, but recently the market has been so rough I’ve been forced into taking more of a trader approach. I really enjoy working on long-term winners and energy companies that can be self-funded are extremely attractive. I have quite a few very long-term plays I’ve been in two or three years and still holding. I’m hoping the market will stabilize a little so we can have longer-term trades, but I do short-term as well.
TER: When you talked with us, midyear 2012, your portfolio was up somewhere between 40% and 50% for the first half of the year. How did you do overall for 2012?
CL: My partner, Jay Taylor, tracked it at about 63%. There’s a retirement account without any leverage or option trading, which was intentional. I was fortunate to do very well over three main areas in 2012: energy, mining and biotech. Actually, my biggest winner in 2012 was in biotech. Sarepta Therapeutics (SRPT:NASDAQ), which I discussed in The Life Sciences Report not long ago, has actually returned 15-fold in the call option trade. We also made a few very profitable trades in metals and mining; for example, we bought gold and silver stocks and ETF call options just weeks before QE3, which we sold on the QE3 news market swing. I also did quite well in the energy sector.
TER: What were your best performers last year in the energy sector and are you going to be sticking with them?
CL: I was heavily invested in Mart Resources Inc. (MMT:TSX.V) and Pan Orient Energy Corp. (POE:TSX.V) at the end of 2011. I will continue to be bullish on both stocks and those continue to be my heavy holdings. In terms of Mart Resources, we will likely see dramatic increases in its production when it finally builds out its pipeline. Oil production could easily double, if not triple, after the pipeline is built, so I expect the dividend increase to follow. Right now it’s paying about a 13% dividend. I would expect to see a much higher dividend after the new pipeline goes in.
TER: And when do you expect that will be built?
CL: The company guidance is for the second half of 2013.
TER: And where is Mart trading these days?
CL: It’s trading at $1.76 in Canada, $1.80 in the U.S. It paid $0.20 in total dividends in 2012 and it’s been a big winner. I started buying the stock at $0.15–0.16. I expect the dividend should be relatively stable because the cash flow is just incredible. The risk is that it’s in Nigeria and subject to some political risk. But if you can look beyond that, the stock has a very bright future. China recently made an acquisition in Nigeria paying about $23 per barrel (bbl) oil, so you can see that the upside is very significant. Most recently, Mart announced initial results for the UMU10 well. These new discoveries at deeper zones will not only increase the reserve and production, it may even carry an additional tax holiday that can be very beneficial to Mart shareholders.
TER: What’s going on with Pan Orient?
CL: This year will be the most exciting in the company’s history. It’s a producer in onshore Thailand. It has prepared for the past five years to explore some big targets in Indonesia as well as Thailand and will start drilling this month. There was an excellent article written by Malcolm Shaw, a retired Canadian fund manager. Seldom in my trading career have I seen this kind of risk/reward, and if you ask me which stock I think would have the greatest chance of becoming a tenbagger in 2013, I would say, without a doubt, it would be Pan Orient.
The beauty is it has so much cash on the balance sheet and no debt. It has fully funded all its exploration and doesn’t need to dilute shares. By the end of the year, it should still have a lot of cash left. Management consistently bought shares in the past. Even in the worst-case scenario, the downside is very limited and the upside is very big. Also, I want to say that the Chinese company, Hong Kong and China Gas Co. Ltd. (3: HK), bought the Pan Orient legacy oil field last year for $170 million ($170M), and has been looking for more assets. If Pan Orient makes new discoveries, we have a natural buyer right there to buy them and reward shareholders. That’s why I’m very excited about this one. I purchased the stock a year ago and it has much more room to run. I believe the run for Pan Orient has just started because it takes many years to prepare that groundwork, get approvals, do the seismic and then finally start drilling this year. I’m very excited about the stock.
TER: What other names have been good performers in the last year?
CL: Another stock with a nice return that is still undervalued is Coastal Energy Co. (CEN:TSX.V). It’s offshore Thailand so development is always slower than onshore; fortunately the wells are inexpensive to drill. I wouldn’t put it in the same category of Mart and Pan Orient. I’ve been trading it in and out since the stock was trading at a few dollars. Last year when an Indonesian company proposed to buy Coastal, I sold out all my shares. I told my shareholders to sell on the surge and then when the takeover failed, I bought back, at a much lower price. I’ve been trading in and out of this one.
Another stock I’ve been trading in and out of, so far successfully, is PetroBakken Energy Ltd. (PBN:TSX). It pays about a 10% dividend right now on its Bakken play. It’s quite undervalued if you compare it with its peers. I just bought it back recently after making a 50% return in the last round a year ago. Hopefully, it will rally from here. Many traders like to trade by the chart, which sometimes ignores the fundamentals. I often put “opposite trades” in place to take advantage of market swings.
TER: Do you have any sleeper names that are maybe due to take off?
CL: Porto Energy Corp. (PEC:TSX.V) was probably my major loser in the energy portfolio last year. Porto is an example of my risk-taking. When George Soros closed his position of Porto at $0.07 last summer, I decided to take advantage of it and told my subscribers that I became one of the largest shareholders. My calculations at that time were if its ALC-1 well were successful, the stock would be a tenbagger. If not, it’s still worth a lot of money. But the well was a failure. The stock is still trading at $0.06, so it’s really verified my calculation. You can see the risk/reward was in my favor and, in the future, if this kind of situation arises, I would do it again. But right now, looking at a $0.06 stock, I think it’s still very undervalued.
I had a long discussion with management not long ago. As a large shareholder, I proposed to management to take a look at the current tax-loss carryforward situation. Porto spent over $100M in Portugal and has over $100M in loss carryforward in Portugal. That could be worth a lot of money to its partner, like Galp Energia, which is a $10 billion Portuguese national oil company. Galp can take advantage of that loss and could translate easily to $0.20–0.30 per share. Management told me that they would take that into consideration and they are still in the middle of discussions with Porto to drill two or three wells this year. Those wells will be critical to the company’s future. The silver lining is that if all the wells fail this year, Porto may still have the option to sell to its partner, which may be able to use the loss carryforward on the balance sheet. I like this kind of a situation.
TER: So it may still be a winner for investors.
CL: Possibly. The risk/reward is in my favor, which also tells you how undervalued many resource plays are. The market has been in extreme conditions and Porto is just one example. There are so many undervalued plays out there that I am looking at right now.
TER: Does Porto have enough money to be able to do exploration work on its own?
CL: The two to three wells it plans to drill will be completely on the partner’s money, so it’s kind of a win-win situation for both.
TER: So it doesn’t have to go out and try to raise more money in the foreseeable future.
CL: Exactly. Management owns a lot of the stock and has been very careful about dilution.
TER: Do you have any other situations that look particularly attractive?
CL: A couple of weeks ago I took a position in a refinery play, which is a recent IPO called Alon USA Partners LP (ALDW:NYSE). Its parent is Alon USA Energy Inc. (ALJ:NYSE). Alon USA Partners is a master limited partnership that’s based on a single refinery in the Permian Basin. The Permian Basin right now has huge oil production and there’s a big spread between the local oil—West Texas Sweet—and Brent. Management is guiding about a $5.20 dividend for 2013. Right now the stock’s trading about $22. That means the dividend will be over 20% in 2013.
People wonder what happens if, in the long run we have all the pipelines built in the next 5-10 years. Alon USA Partners LP should still have an advantage because it would be more like a pipeline company. Why? Because it can take oil locally instead of piping all the way to the Gulf Coast and then it can refine that into gasoline and sell locally instead of piping the gasoline from the Gulf Coast. Basically, its margin will be the pipeline cost to pipe oil over and then pipe gasoline and diesel back. It should have a double-digit dividend, even after everything’s settled. Right now we’re looking at a huge dividend, more than the guidance by the company, which is $5.20 for 2013. It hasn’t announced yet, but some analysts are expecting over $2 in dividends for Q4/12—just in one quarter for a $22 stock.
TER: That’s pretty amazing.
CL: It’s a very nice dividend play. Also, Alon U.S.A. Energy owns about 82% of U.S.A. Partners. If you calculate the value of the shares it owns, it’s more than U.S.A. Partners’ whole market cap, which is absurd. Alon U.S.A. Energy also has another refinery in Louisiana that can take advantage of Louisiana Light Sweet, which will go down to the Gulf of Mexico later this year or next year, when the pipeline is built. So to value the rest of the assets to negative is really absurd. I own both companies.
TER: There’s hardly been any refinery capacity built in this country in many years so any company with a refinery is in a pretty good position.
CL: Plus, refineries are closing down on the East Coast and in California because they’re not making money because Brent is so high. The U.S. has the Jones Act, which forbids foreign tankers from shipping oil from one U.S. port to another. After Hurricane Sandy, they had to suspend the Jones Act. All the light sweet going to the Gulf of Mexico cannot go anywhere, which is just absurd under the existing laws.
TER: You’ve given us some really good ideas and follow-up, Chen. Thanks for joining us today.
CL: Thank you.
Chen Lin writes the popular stock newsletter What Is Chen Buying? What Is Chen Selling?, published and distributed by Taylor Hard Money Advisors, Inc. While a doctoral candidate in aeronautical engineering at Princeton, Chen found his investment strategies were so profitable that he put his Ph.D. on the back burner. He employs a value-oriented approach and often demonstrates excellent market timing due to his exceptional technical analysis.
Global population growth and escalating food demand underpins long-term upside for potash, phosphate and nitrogen producers, but fertilizer oligopolies may have jumped the gun last year with aggressive rates that priced farmers out of the market. As farmers expand acreage rather than boost yields in now-tired fields, grain prices have backed off recent highs. That’s why Robert Winslow, agriculture research analyst and director at National Bank Financial, is picking his stocks with care. In this interview with The Energy Report, he shares where he sees strengths and weaknesses in the industry and names some interesting contrarian plays.
The Energy Report: Your last interview took place in April of 2011. What have been the major developments on the agricultural front impacting the fertilizer markets since then?
Robert Winslow: Increased weather volatility, like last summer’s drought in the U.S., which led to modern-era highs in corn, wheat and soybean prices, have had a significant impact on the market. Although grain prices have softened of late, I believe you’re likely to see somewhat higher-than-usual grain prices through at least the first half of 2013, given the persistent dryness in the U.S. corn belt and wheat-growing regions. Grain prices drive farmer sentiment and buying, and therefore the price and the demand for fertilizer.
We’ve seen some disconnects when it comes to potash, such as in India: Because the rupee was devalued about 20% through 2012, Indian farmers can’t afford to pay the prices that the potash companies would charge, and this resulted in subdued demand. Chinese demand has been somewhat subdued as well. Globally, we’ve had this really interesting dichotomy with high grain prices buoying larger demand in places like North America and even Brazil, but softening demand in yet other parts of the world with country-specific issues. In total, we haven’t seen the demand strength in potash that you might have otherwise expected with this high grain-price environment.
Some would say it’s partly because grain prices are not sustainable at these high levels. We are actually of that view. Like any commodity, when the price gets too high, two very simple things play out: demand destruction and supply response. You’ve seen demand destruction over the last 3–6 months. For example, high-cost ethanol plants have been shuttering production. High-cost producers of cattle, pigs and chickens have been culling their herds because they can’t afford the feed costs unless meat prices rise in conjunction, which they have not.
Then there’s supply response. Farmers are expanding acreage by moving into marginal land. You may not get robust yield on that land, but you can still increase production, which we’re seeing play out now. Brazil is expected to increase soybean acreage by 8–10% this year. With these dynamics playing out, the grain prices are beginning to come down. We expect that by the second half of 2013 you should start to see lower fertilizer demand reflected in pricing, even in the U.S. and Brazil. That is why we maintain a fairly cautious view on the fertilizer sector at this stage.
TER: How might continuing climate change and severe weather affect grain prices and fertilizer demand?
RW: Nobody really knows the answer. I don’t pretend to, but I will say that the stocks-to-use ratio for grains right now, globally, is about 68–69 days of supply. It’s relatively tight compared to the last 30 years or so, and it doesn’t take much to tip over and get a real spike—or falloff—in grain prices. When you do get these supply shocks through floods or droughts, the relatively tight supply situation can move prices quite dramatically, which we saw just this past year.
Many investors don’t believe such price spikes are sustainable and they aren’t going to pay for them. We’re probably at least two years away from where we have a bit more of a buffer in the stocks-use ratio to get us away from this tightness that is causing more volatility in the grain price. In the meantime, we can expect continued volatility in both grains and fertilizer equities.
TER: How have the various segments of the fertilizer industry performed in the last year and a half?
RW: Potash has been the commodity with the most interest. We’ve been a bit of an outlier in the investment community, with a rather bearish view on both the commodity itself and on some of the senior potash producer equities. We are of the view that the potash oligopolies (and we all know who they are) have been rather aggressive with their pricing. In a perfect world, you might be able to raise your prices every year, but we don’t live in a perfect world. Places like India just couldn’t afford the higher prices, so they bought less. The oligopolies and agronomists are right in saying that parts of the world, like India and China, need more potash in the soil, but ultimately, demand is price dependent.
In 2012, global potash demand looked to be in the neighborhood of 50 million tonnes (50 Mmt), which is below the levels we saw back in 2004. Thus, the commodity usage has been basically flat to down over the last 7–8 years—not a compelling investment theme. But the potash price more than tripled over that period. This aggressive pricing has since come back to bite the oligopolies. I expect a demand recovery in 2013 because India has been under-applying fertilizer, and it will need to make up for that at some point. I doubt India would purchase its full allocation, which would be 6–7 Mmt, unless it can buy potash near or below $400/Mmt. And if it does buy the 6-7 Mmt, then there’s a good chance India might buy less again in 2014, with Indian farmers trying to mine the soil. Of course, if the rupee comes back with vigor, India would have more buying power.
On the supply side, there’s tremendous brownfield supply expected over the next three to four years. Most of it is coming from the oligopolies themselves. It looks like the global supply will be growing about 4% per year, on average, over the next four years. So if your demand is flat and supply is up 4% per year, it doesn’t bode well for potash prices. That doesn’t include the greenfield supply that could come on from BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), K+S Potash Canada (SDFG:FSE) or any of the juniors that are working to build mines. So the supply/demand dynamics are not, in our view, compelling for potash over the next two years, particularly if we get less volatile global weather patterns and grain prices trend down.
TER: How do the prospects look in the other fertilizer segments?
RW: Phosphate is looking rather interesting here. Not unlike potash, there’s a bit of an oligopoly situation, with Morocco controlling half or so of the global phosphate rock market. It appears that Moroccans really want to move more into the higher-margin business. Instead of just selling rock to the world, they figure they can make monoammonium phosphate and diammonium phosphate, which are finished fertilizer products. This will make it rather challenging for the non-integrated phosphate producers and/or companies that still rely on imported rock. U.S. phosphate producers like The Mosaic Co. (MOS:NYSE) and Agrium Inc. (AGU:NYSE; AGU:TSX), for example, rely or expect to rely to some extent on Moroccan rock.
On the other hand, that should provide some interesting opportunities for the greenfield phosphate companies, certainly in North America, that are developing phosphate deposits. There are a couple of companies in particular that you might want to keep an eye on. One is d’Arianne Resources Inc. (DAN:TSX.V; DRRSF:OTCBB; JE9N:FSE) and the other is Stonegate Agricom Ltd. (ST:TSX, SNRCF:OTCPK). Both are working on projects here in North America. The next few years could be interesting for them.
TER: Then how about the nitrogen products?
RW: Unlike potash and phosphate, nitrogen isn’t reliant on ore bodies. It’s produced all over the world, so you don’t get the sort of concentration you get in potash and phosphate. If you’re investing in that sector, you have to be a little careful, because we believe that nitrogen producers in North America, in particular, are near peak margins due to the low price of natural gas, which is a big input component. In our view, you shouldn’t generally buy equities that are about to post peak earnings and peak margins, especially when the market already expects those peak results.
Two companies in particular, Agrium Inc. (AGU:NYSE; AGU:TSX) and CF Industries Holdings Inc. (CF:NYSE), have share prices near their all-time highs, and the market’s already valuing some pretty robust results for them. We would be very cautious, and, in fact, we have an Underperform rating on Agrium. That stock’s trading a little over $102 today, and we have an $87.50 target on it.
TER: How are current commodity and financial market conditions affecting plans for junior mining companies in the project development stage?
RW: It’s a challenging time. Finance risk is the key challenge for a lot of these junior companies, whether it’s potash or phosphate. That means that if you have an ore body or an asset, it needs to have some competitive advantages, for example by being a low-cost operation either at the mine level or through low distribution costs. We look at projects like Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX) in Ethiopia, for example, which looks to be well positioned as a low-cost operation at the mine gate and could be one of the lowest-cost delivered potash suppliers into India, which has no domestic potash. Companies are better off when they have these types of strategic advantages, but at the end of the day, the finance risk is still an overwhelming one today.
There is one development stage fertilizer company that we’re most intrigued by, and that’s MBAC Fertilizer Corp. (MBC:TSX; MBCFFOTCQX), because its finance risk is now largely behind it—it is about to move into production in the next few months or so. It has a phase one phosphate project in Brazil called Itafos, right in the Cerrado, which is the breadbasket of Brazil. It also has another phosphate asset to the north of the Cerrado. This company has a logistic advantage because half of the phosphate fertilizer manufactured in Brazil uses imported rock from Africa. We are extremely interested in this stock and it has our Top Pick rating in the sector. We have a $5.25 target on the stock with an Outperform rating. Frankly, the company is a potential acquisition target because there are parties that appear to be aiming to consolidate the phosphate fertilizer sector in Brazil. We believe MBAC Fertilizer is one to own for 2013.
TER: It’s nice to see some blue sky on the horizon.
RW: I’m not a complete bear on the sector. There are some bright spots in my coverage list.
TER: Do you expect any other interesting M&A activity in this industry due to current market conditions?
RW: I don’t see much particularly different about 2013 versus 2012 as far as the macro call goes. There’s been expectation for some time that the Indians and/or Chinese would come in and buy up more of the junior fertilizer companies to help secure supply, particularly in the potash sector. That just hasn’t happened yet. One thing that’s different about 2013 is that there should be a number of bankable feasibility studies completed this year, which will help derisk a number of the early-stage projects. It looks like Allana Potash is expecting its bankable feasibility any day now and d’Arianne Resources is expecting a bankable feasibility mid-year. Elemental Minerals Ltd. (ELM:TSX; ELM:ASX; EMINF:OTCPK) has a bankable study expected in the second half of 2013 on its potash project in the Republic of the Congo. Even IC Potash Corp. (ICP:TSX; ICPTF:OTCQX), which is a company looking to develop a sulfate of potash fertilizer project in the U.S., expects a bankable study in mid- to late 2013 as well.
There are number of bankable feasibility studies coming, which will help derisk these projects and could spur some investment by the likes of the Indians, the Chinese and even the Brazilians as they look to secure fertilizer, but time will tell. Because finance risk is quite significant for these companies, they ultimately need strategic partnerships and/or offtake agreements to help mitigate that risk. So as these studies come out in the next 6–12 months, that could change the equation for many of them. We’ll have to wait and see how that plays out.
TER: You talked about MBAC, which you like. What’s the situation with PotashCorp. (POT:TSX; POT:NYSE)?
RW: We’re bearish on that one. I believe we have the only Sell rating for that stock on Bay Street and Wall Street. So if you like contrarian views, that’s us. The potash commodity supply/demand situation is not particularly compelling. In terms of valuation, we look at that company as having mid-cycle earnings around $3.05 a share in our 2014 estimate. A typical multiple on mid-cycle earnings tells us this stock is overvalued at $41–42. The Street and most analysts seem to love it. They believe it’s worth $50+. Considering the cyclical downside potential for grain, we’re not of that view. We had a sell on it for most of 2012 and it’s been the right call. We’ll have to see how 2013 plays out.
TER: What do you see ahead for fertilizer producers and how can investors position themselves in this industry, if they like the future prospects?
RW: It’s as simple as this: The correlation between grain prices and agricultural equities, particularly the fertilizers, is quite high. Grain prices have retreated of late but still appear to have more downside risk than upside and we would argue over the next year or so, barring unforeseen supply shocks, the trend for grain prices is for further downside. If you’re of that view, then the bias for the agricultural equities would be down as well. So we’re pretty cautious here. We’d be inclined to sell into strength, if these agricultural equities rally, and focus more on the supply/demand fundamentals for grains. With that view, we have only a select few buys and we’re more cautious with a number of sells in our universe.
TER: And there’s a little bit of news on the horizon for mid-year with some of the smaller companies if they can get their act together.
RW: That’s correct, on the bankable feasibility studies coming out.
TER: We greatly appreciate your time and input today, Robert.
RW: Thank you very much.
Robert Winslow is an agriculture research analyst and director at National Bank Financial (NBF). Prior to joining NBF, Robert was an analyst, managing director, and the head of research at Wellington West Capital Markets Inc. (WWCM). Prior to WWCM, Winslow was a special situations analyst at Orion Securities. Winslow began his career at Solar Turbines Inc. (a Caterpillar company) in Dallas, TX, where he was a senior product engineer. He has a Bachelor of Science in mechanical engineering from Queen’s University, a Master of Science in mechanical engineering from Texas A&M University, and a Master of Business Administration from Cornell University. He also holds the Chartered Financial Analyst (CFA) designation.
The Peruvian mining sector has lots of promising developers and producers, but don’t ignore the smaller companies—2013 may surprise to the upside in Peru. In this interview with The Gold Report, Ricardo Carrión, managing director for capital markets and corporate finance for Kallpa Securities in Lima, Peru, says it is fine to ride the wave with the rest of the market as lower-risk projects advance toward production in Peru. However, smart investors should balance a mining portfolio with smaller and earlier-stage companies that are selling at compelling valuations. Get there before the majors go on a New Year’s shopping spree.
The Gold Report: How’s the mining investment climate looking in Peru for 2013, especially compared to 2012? What are the main trends and what are people looking forward to in 2013?
Ricardo Carrión: Our outlook for 2013 is generally pretty good. That was our assessment at the beginning of last year for 2012 and it has turned out to be a good year. Mining in Peru is set up to have another positive year. There are a lot of projects in the pipeline and the macro situation is strongly positive for the sector. However, in 2013 as projects advance, we are more actively watching project specific factors that control the advancement of individual projects including the environmental impact assessment (EIA) approvals. In addition, we are keeping an eye on the resolution of social situations on the more advanced projects.
“Mining in Peru is set up to have another positive year.”
One key project everyone is watching is the Conga project in the north of Peru, a joint venture between Newmont Mining Corp. (NEM:NYSE) and Compania de Minas Buenaventura (BVN:NYSE; BVN:BVL). That project has been delayed a couple of years and has caught a lot of media attention. Many other projects are quietly making progress in addressing social, environmental and community issues. We are watching these factors on a project by project basis for 2013. Overall, the project pipeline is very strong and in most locations communities are working with companies to explore and develop new mines.
TGR: Is the EIA process new or has it been recently revised?
RC: The EIA process has been stable for some time. The Conga example is a case where investors are concerned about the implementation of the EIA process—specifically, the revision of a previously approved EIA. In that case, the EIA was originally approved by the government, but was then revised after local social activists demanded changes. One result was uncertainty for investors.
TGR: Are EIA approvals at the regional or the national level?
RC: It starts at a regional level and ends at the national government level. In the case of Conga, social movements within the communities near the project resulted in the national government revising the EIA. There are other examples of how the EIA process works. We have three projects that have already submitted EIAs—one by Bear Creek Mining Corp. (BCM:TSX.V; BCM:BVL) for the Corani project , one by Minera IRL Ltd. (IRL:TSX; MIRL:LSE; MIRL:BVL) for the Ollachea project and also Sulliden Gold Corp. (SUE:TSX; SDDDF:OTCQX; SUE:BVL). That process will take up to eight months and will be followed by investors closely.
TGR: In the meantime, while companies await EIA approval, there is no shortage of things they can do including drilling, resource definition, securing financing and so on, correct?
RC: Exactly. In many cases, the EIA process does not slow down the overall project because there is a lot to do to build a mine.
TGR: For those two projects in particular, Bear Creek’s Corani and Minera IRL’s Ollachea, is there strong opposition? Both of those projects are in the south of the country, far away from Conga.
RC: Both projects are in the southern province of Puno. In the past, there have been some social issues with mine development in Puno. In fact, Bear Creek had the Santana project that faced such a problem two years ago. To make a long story short, the government decided to revoke the license to operate the Santa project because of unresolved social and community issues. The Corani project is completely different. For starters, it is located north of Puno. It’s very close to Ollachea, which has good community relations.
“In Peru, the project pipeline is very strong and in most locations communities are working with companies to explore and develop new mines.”
In the case of Minera IRL, building organic community support is a core competency, so we are confident that Corani can follow its example in that area. Minera IRL has set a good example benchmarking local mining projects and we believe that the companies and the communities will win from that investment. At Ollachea, the local community owns 5% of the project and has a clear financial, as well as social, interest in that project succeeding. We believe Corani will follow in those footsteps.
TGR: Bear Creek is listed in Canada and Peru. Are there new dual listings coming out?
RC: Yes, there are several. Last year was a good year for the Peruvian market. For example, three months ago we listed a company named Andean Gold Inc. (AAU:TSX.V; AAU:BVL), which has a small silver project in the north of Peru. Then we had the listing of Duran Ventures Inc. (DRV:TSX.V; DRV:BVL), which is a copper project located in the center of Peru. And now, we are also in the process of getting the listing done for Lupaka Gold Corp. (LPK:TSX), which is also located in the south of Peru. Also, just recently we received the final approval for another dual listed company, Southern Legacy Minerals Inc. (LCY:TSX.V; LCY:BVL). It has a very interesting copper-gold project located in the north of Peru.
TGR: What size market cap do these new listings have?
RC: The new listings in Peru have a variety of market cap sizes. We have small companies the size of Andean Gold with a $5 million (M) market cap all the way to large companies like Rio Alto Mining Ltd. (RIO:TSX.V; RIO:BVL), which has a market cap over $900M. There is an extensive range of sizes of companies here in Peru.
TGR: We talked about developers and producers. What about earlier in the mining life cycle—are there many companies active in exploration in Peru?
RC: For public companies, there is always interest in all the stages of mining from exploration to production. Notably, the current investment market has undergone a structural change toward later-stage projects that have less risk. Because of current market conditions in the smaller stocks, many advanced projects are very, very cheap. Investors should be migrating to these projects, but in many cases it hasn’t happened yet. By an advanced project, I mean those projects that already have a feasibility or prefeasibility study or are under construction or in development. A good example is Panoro Minerals Ltd. (PML:TSX.V: PZN:FSE; PML:BVL), which has a copper-gold project under development in the south of Peru. It expects to have a prefeasibility study by the end of this year. For a junior company, Panoro is one of the more liquid companies in Peru. Another company that is very interesting is Sulliden Gold. Sulliden just announced that it is fully financed to develop and construct a gold project named Shahuindo.
TGR: We discussed Sulliden six months ago and it was interesting at that time. How much financing did it need to build out?
RC: Sulliden needed approximately $150M and is fully funded. Here again, the company requires approval of the EIA before it can start construction. We expect it will be approved within the next eight months, then mine construction begins.
TGR: The last time we talked, you were looking for some short-term catalysts to potentially start the stock moving upward. Specifically, you were anticipating a revised reserve and the financing. It looks as if Sulliden delivered on both and the stock responded—and then gave up the gains. Is that the general mining equity market conditions or something else?
RC: In the case of Sulliden, there are two things to consider. First are the general market conditions—Sulliden is in the same boat as all the other junior mining companies. The junior mining indexes have been trending down for the past six months and Sulliden was caught in that downdraft. Another consideration with Sulliden was that it defined the Shahuindo feasibility study project as a smaller project than in the prefeasibility study. That conservative approach may have caught investors by surprise. As analysts, we understood the strategy of the company: start small and then ramp up. That is how Rio Alto did it. Soon, Rio Alto will be nearing 36,000 tons per day. In the case of Sulliden, it is also a good strategy. We see it as an undervalued company. The main event that everybody is waiting for is the EIA approval. After that, it will inevitably become a mine.
TGR: For North American investors, we are just finishing up the U.S. presidential election cycle and lots of national budget debate. What is the government situation in Peru? Is the president and legislature stable? Is the government providing a good environment for the companies to build mines and invest in Peru?
RC: The current situation can be summed up “so far so good.” The government of Peru has proven itself to be stable. Not everything is perfect; if you look for problems, you can find them. In the mining industry, you can find community issues that we discussed. But apart from that, much of the rest of the government and political situation has been very stable. The economy is growing at a very decent level considering the global market conditions. Probably we will finish this year with a GDP growth of around 6.3%. That is a reflection of the strategy of the government, which is generally a market friendly government.
TGR: Are there other companies or projects you’d like to mention that are interesting and investors should keep an eye on?
RC: One interesting project from a social and community point of view is Candente Copper Corp. (DNT:TSX; DNT:BVL). Candente is peculiar because it is close to completing final feasibility. However, the company is dealing with social issues that have gotten a lot of attention from local media and some investors. If the company can address the situation, it will have a 9+ billion pound copper project with only a $40M market cap company. That is quite a disconnect and is a project worth watching because of the potential upside.
Last week Candente announced that the government granted the water permits needed for drilling and also announced the commencement of the drilling program. This will allow the company to complete the final feasibility study. Although the social environment hasn’t been solved 100%, we see this as a good sign. Over the last week the share price gained almost 65%.
“All portfolios need diversification, not only focusing on well-developed stories that protect from downside, but also remembering to own some smaller assets that will potentially dramatically outperform if the market surprises in a positive way.”
TGR: Is Rio Alto’s current production sufficient to fund expansion, or does it need additional financing?
RC: It will depend on the results of the studies. The capital expenditure requirements will determine the strategy needed to finance the project. But the current production will greatly assist in raising whatever funds it needs. The cash flow from the oxide gold project will be more than enough to finance the secondary sulfide. On the other hand, from a financial point of view, it’s good to diversify and to find an additional source of financing as well.
TGR: We have been talking a lot about gold. What do Peruvians think of gold or silver as assets? Is there a domestic market for bullion, gold-related financial products or mining equities in Peru?
RC: Domestically, there is not yet a large market for gold investment, but it is growing from a small base. Investors are starting to get interested in securities related to gold, for example gold exchange-traded funds (ETFs). In Peru, we haven’t reached the point where there’s a high demand for physical gold. But things are changing. The domestic gold market is growing. Regarding the mining equities, Peru’s stock market is underdeveloped. The stock market volume traded compared to GDP is around 5%, which is much lower than other Latin American countries such as Chile and Columbia. A mirror of that situation is that Peruvians are starting to be more financially sophisticated. As a country, we are starting to buy ETFs. There is a lot of potential upside for Peruvian financial assets.
TGR: Are there any other special situations that investors in the Peru mining sector should be watching for?
RC: Yes. There is a trend in the North American and European markets away from risk. Investors should be ready for a time when the confidence comes back into the market. Confidence in the market is needed for mergers, and in the past, mergers have rewarded careful risk takers. The last time this happened was 2010 when there were some very interesting stories that alert investors could profit from. In 2010, we had two very good acquisitions with First Quantum Minerals Ltd. (FM:TSX; RQM:LSE) acquiring Antares Minerals Inc. (ANM:TSX.V) and HudBay Minerals Inc. (HBM:TSX; HBM:NYSE) acquiring the Constancia project from Norsemont Mining Inc. (NOM:TSX, NOMFF:OTCBB, N8SA0:FSE).
Those two acquisitions were catalysts for the junior mining sector in general. We did not see anything similar in 2012. Investors with foresight should be positioning themselves for the next acquisitions that take place in 2013 and beyond.
I have been reviewing a lot of analysts’ comments on Peruvian projects that could be targets for acquisitions. There are a couple that are very interesting. One is Panoro Minerals, a copper-gold company that has released a good resource and is continuing to grow that resource over the next six months. Many majors are interested in that project. Another potential target is Trevali Mining Corp. (TV:TSX; TREVF:OTCQX; TV:BVL), which is starting production at its Peruvian asset named Santander. Trevali also produces from a Canadian asset and has become a success story in the zinc environment, which is a tough market to be profitable in. There is a lot of news about zinc mines closing, yet Trevali is starting up. Both Panoro and Trevali look like candidates for a buyout transaction next year.
TGR: Do you have any final comments about what smart investors should look for in 2013?
RC: It is understandable that investors are focusing on risk aversion and more developed stories in the mining sector. Everybody needs to remember that if 2013 becomes an excellent year, as we feel that it might, smart investors should be positioned to capture some of that upside with a portion of their portfolio in early-stage projects as well as in the lower-risk development stories.
All portfolios need diversification, not only focusing on well-developed stories that protect from downside, but also remembering to own some smaller assets that will potentially dramatically outperform if the market surprises in a positive way. That’s the message I tell investors, go with the trend and ride the wave. But if the market is saying “go to the safer assets,” it doesn’t mean you have to allocate 100% to the safer assets. Positioning some of your investable assets in higher-risk, less-developed projects should provide higher overall return.
TGR: Thank you. It has been great to talk to you again.
Ricardo Carrión is the managing director for capital markets and corporate finance for Kallpa Securities in Lima, Peru. He served as a senior analyst of Banco de Credito in the areas of corporate banking, corporate finance and capital markets and was an adviser to Lima’s Stock Exchange. Carrion holds a bachelor’s degree in business administration from Universidad de Lima with a specialization in finance and capital markets.
It is difficult for retail investors to sift the wheat from the chaff in the junior miner sector. In this interview with The Gold Report, Rick Winters reveals how RMB Resources, a resource merchant bank, figures out what projects to invest in and those to pass over and talks about some of the companies that made the cut.
The Gold Report: Rick, RMB Resources invests in resource companies throughout the world. Why is RMB flocking to resource companies when most investors seem to be running in the opposite direction?
Rick Winters: RMB Resources is the resource merchant banking division of the FirstRand Group, one of South Africa’s major financial institutions. We’ve been in the business of providing finance to the junior resource sector for 18 years. We look at junior resource opportunities everywhere in the world outside South Africa.
As resource investors, we’re always in the game, even when the market doesn’t seem to care. Our product mix may change with market conditions, but we stay in the market and are always active.
TGR: With the risk-off sentiment that’s prevalent in the market right now, are you making changes to your overall strategy?
RW: As a merchant banking operation, we look at junior resource finance and focus on relatively higher-risk, higher-return opportunities. In times like this, when junior resource equities and mining equities aren’t in favor, we look more toward quasi-equity and quasi-debt investments as a way of providing finance to companies. We do this when we have confidence in their projects, using their projects as security for a debt structure. This saves companies from dilution in a time of very low share prices.
TGR: Can you talk more about quasi-debt and quasi-equity investments?
RW: We invest all along the spectrum, from pre-initial public offering seed capital through to corporate debt and project finance. When we talk about quasi-equity and quasi-debt, it’s a reflection of the stage that a project or a company is at. Quasi-equity tends to be higher risk.
“We focus first on people and identifying good management that we’ve done business with in the past and that currently has good opportunities.”
One example of such a transaction is Bullfrog Gold Corp. (BFGC:OTCBB). We have funded Bullfrog Gold as a quasi-equity opportunity because it has a very attractive project that’s had a significant amount of work done on it in the past—a feasibility study, initial permitting and the like. But now, it needs funding to confirm what was done in the past and to expand the project. The transaction uses the project as security for the facility. We have a significant warrant package associated with that facility that represents the return we need for the risk profile.
An example of a quasi-debt transaction would be Solitario Exploration & Royalty Corp. (SLR:TSX). It has a project in Nevada, a gold heap-leap project, Mt. Hamilton. That project completed a final feasibility study in 2012, so the project is well defined. Solitario continues to optimize that feasibility study. Once again, the project is used as security for a debt facility but because the project is well defined it has a lower risk profile and our required warrant exposure is consequentially lower than a quasi-equity opportunity. That facility is to provide working capital to complete the permitting process so that the company can go forward with obtaining project financing and put the project into production.
TGR: What is the total amount of your investments in resource companies, both in 2011 and in 2012?
RW: We have a lot of movement in and out of our portfolio but, generally speaking, we have a portfolio of about $100 million (M)in equity and around $200M in debt.
TGR: Do you expect those levels to increase in 2013?
RW: Not necessarily. But we’ll probably see our debt portfolio grow in 2013 because of the nature of the market.
TGR: With all the companies knocking on your door, how do you decide which ones you’re going to invest in and which ones you’re not?
RW: We really stay with the fundamentals. In a buoyant equity time, the spectrum of the projects that we look at is much broader and we do look at exploration and very early-stage projects and seed capital. But we’re doing much less of that these days.
We’re focused now on projects where we can assess the project and the opportunity technically. We assess the tradeoff between what we believe will be the fundamental value and the opportunity for the project to actually become a cash-flow generator. In other words, we’re looking at the feasibility stage and above.
TGR: What are some investment themes that you expect will govern most of your investment decisions in 2013?
RW: The last year and a half has been an unprecedented period for the industry. We expect 2013 to be the same. We seek to patiently invest. We continue to have a minimum three-to-five year investment horizon.
“Retail investors need to look behind the retail promotion and see where serious money is getting invested.”
We focus first on people and identifying good management that we’ve done business with in the past and that currently has good opportunities. We focus on projects and make sure there’s sufficient asset value to justify the risk-return profile. We also focus on our companies’ abilities to promote and raise capital because the mining business is very capital intensive.
TGR: Are your investments geared toward rising commodity prices or are you looking for specific situations that merit your expertise and your cash?
RW: We’re happy to participate in the equity upside that comes along with rising metal prices, but we have more of a banking mindset than an equity investor mindset. We’re always looking for the recognition of fundamental value at rational metal prices, which are often lower than the current price. In other words, we focus on project fundamentals.
TGR: Where do you see metals prices, particularly precious metals prices, in 2013?
RW: Prices will be relatively stable. There will be volatility within the metal prices, precious metals in particular. We’re in an environment where fiat currencies and the major economies in the world are in trouble. The debt situation has to be dealt with, and is not going to go away for at least a few years. That’s why I don’t see a precious metal environment that’s much different than what we’ve seen over the last couple of years.
TGR: RMB Resources is an investor in Sutter Gold Mining Inc. (SGM:TSX.V; OTCQX:SGMNF) and you are a director of that firm. Is it common for RMB to have a position on the board of a company that you’re investing in?
RW: No, it’s not typical for us. One of our most treasured mantras is not to become involved at the board or management level. We believe that if we can’t have confidence in the boards and managements of the companies we invest in, we probably shouldn’t invest in the first place.
“When this market turns, it will come back with a vengeance.”
We became involved in Sutter when the former largest shareholder decided it didn’t want to be in the gold business anymore. We purchased half the company from that shareholder and then sought to move the company and the project in California forward. When we started, we had 49% of a junior public company and had to build a management team and a new board from the ground up.
TGR: Sutter just poured gold, its first doré, at the Lincoln project in northeastern California. Will this news move the share price?
RW: Sutter’s price graph shows that it’s one of the better-performing junior stocks and has been over the last year. With the mine being built and coming into production, the value of the company has more than doubled over the last 12 months.
TGR: But the share price has been roughly the same since March.
RW: Now that the company poured the first gold in the Mother Lode in 54 years, the market is waiting to see the mine start to generate cash flow. The first six months of 2013 will be the ramp-up phase and the mine should be in full production by midyear. Then we’ll see what value the market assesses for the Lincoln-Comet project.
That initial project is based on a five-year resource of about 180,000 ounces (180 Koz). What the market will come to appreciate is the immediate upside for Sutter. There is a second project, the Keystone project, which lies immediately north of the current mining resource. That’s about a 400 Koz resource. The mill has been designed and built so its capacity can be doubled at a cost of about $700,000–750,000.
TGR: Has Sutter provided any production guidance for the first year?
RW: Not yet. It will going forward, but that will be a function of how the ramp-up goes. Once the Lincoln-Comet project is in full production, about 23 Koz/year is anticipated. There will be less than that in 2013 given the ramp-up for half the year.
TGR: Has any of that gold been forward sold?
RW: It has—RMB Resources provided a prepaid gold facility. To fund the project and get the mill built, we sold forward half the production of the current mine plan at a price of $942/oz. Sutter got—this was at a time when gold was around $1,540/oz—$20M in finance to sell 54 Koz forward for which it will receive $942/oz. In effect, it got a price of about $1,320/oz, selling forward in July 2011.
TGR: Do you know its cost per ounce?
RW: It should be around $700–725/ounce.
TGR: What are some other junior mining companies that RMB helped finance?
RW: Another recent one was Bullfrog Gold. It’s a relatively new company and has a current market cap of about $11M. It has an advanced exploration project in Arizona called the Newsboy project.
In the 1990s, an Australian company did quite a bit of work and actually defined a resource of about 5 million tons (Mt) at about 1.5 grams/ton (g/t) gold. It completed a feasibility study and started all its permitting work in Arizona, so the state regulators are aware of the project. It then fell by the wayside in the mid-1990s. A Canadian company had it for a period of time, did a bit of work and then dropped the project in the late 1990s. In the early 2000s, a private group restaked it, and Bullfrog optioned the property from that private group.
Bullfrog is now working hard on it and is doing a lot of drilling to confirm the historic resources. It’s gone a long way in doing that. It started to expand the deposit beyond the limits that were known in the 1990s. We think there is likely a deposit there that will be around 7 Mt at 1.5 g/t. Our facility, which is $4.2M, is to fund work at the project for the next 18 months. The work is intended to do the additional drilling and resource evaluation to complete the initial resource re-estimations and to begin, if not complete, feasibility and get the final permitting under way. It’s a new opportunity that the market hasn’t known about because it was in private hands, but we think it will become a mine.
TGR: Do you think that the management at Bullfrog has what it takes to go beyond what previous operators could do?
RW: Yes. The management is led by a gentleman named Dave Beling, who is a very experienced mining engineer. He’s been involved with several different junior companies and has done lots of consulting work. We see eye to eye with Mr. Beling on what work needs to be done to bring a project to a development decision. Right now, it’s a very lean and mean management team, but that’s by design. At this point, the focus needs to be on the geology of the project area in the drilling and the resource estimation. But Mr. Beling also has all the experience to bring a development team together when the time comes.
TGR: Sounds like a lot of what your job is in this business is not to see what a project is but what it could become. What could the Newsboy gold-silver project in Arizona become?
RW: If it develops as we think it should, it will be a project that should be producing around 35–40 Koz/year and probably generating annual earnings before interest, taxes, depreciation and amortization of about $25M. On paper at $1,700/oz gold, it preliminarily has a net present value (NPV) at a 5% discount of around $90M in comparison to a market cap of around $11M.
It’s a good example of how we try to assess fundamental value. It’s also what allows us to have patience in our investing because with most of the companies that we’re involved in we’re looking at the opportunity for a four or five time increase in value.
TGR: What are some other companies you’re invested in?
RW: Along the same theme is Solitario, which I mentioned earlier. It has a current market cap of about $50M, but its Mt. Hamilton project at $1,700/oz gold has an NPV of $260M. That’s another deep value discount situation.
We recently became involved with Mercator Minerals Ltd. (ML:TSX) out of Vancouver. It has an interest in an operating copper-molybdenum mine in Arizona, the Mineral Park mine, as well as advanced development-stage assets in Mexico. We were a part of an overall balance sheet restructuring of the company. It had to restructure the debt associated with Mineral Park. Mercator just completed a major expansion at that mine to 50,000 tons per day. It’s a large-tonnage, low-grade mine that produces around 40 million pounds (Mlb)/year copper and about 10 Mlb/year molybdenum.
Mercator is currently trading at about $0.58/share, down from over $4/share two years ago. It’s a situation where the market has lost confidence in that company’s ability to service its debt, so it needed to restructure its debt more in line with the long-life nature of the Mineral Park asset.
We refinanced a $30M facility that it had with a group of Canadian investors for its El Pilar project in Mexico, which is a large, low-grade, heap-leach opportunity in northern Sonora, just across the U.S. border. That project, which is where our security lies, has a final feasibility study completed. It’s fully permitted to go into production. It only needs to obtain project finance to move the project forward.
The El Pilar asset really is one of significant value. That project has an after-tax, all-equity NPV8 of $460M at an average copper price of $2.82 per pound over the life of the project in comparison to a current spot price of $3.67 per pound. It’s in a very good location with very good infrastructure, so it has a relatively low $280M capital expenditure requirement to put it into production. But with that sort of NPV after tax and with the current market cap of the company at about $180M, the value of El Pilar is over 2.5 times the current market cap without giving any credit to cash flow from its mine in Arizona or its other projects. That’s another example of the type of things we look at.
TGR: Is El Pilar close to any larger producing companies in Mexico?
RW: Yes, it’s about 45 kilometers northwest of the Cananea mine, the largest copper mine in Mexico. It’s also about 50 miles southeast of some of the large Arizona copper mines, such as Sierrita/Twin Buttes. It’s a unique deposit, but it’s in a very good address for copper mining.
TGR: Another investment you made?
RW: Another one that we put some real equity into is a unique story, Highland Copper Company Inc. (HI:TSX.V). It’s a Vancouver junior that has an interest in copper in the Upper Peninsula of Michigan. Most people don’t remember that the Upper Peninsula was one of the greatest copper belts in the U.S. for some time. It produced over 5 Mt of copper.
Highland Copper did a joint venture with a Houston group, BRP LLC, which holds interest to about 13 million acres of mineral claims in the U.S. It purchased the mineral claims in the Upper Peninsula in a bankruptcy in the late 1990s and really didn’t know what to do with them. To Highland’s credit, it did a joint venture with BRP to earn a 65% interest in the Upper Peninsula mineral holdings by spending $11.5M and producing a feasibility study.
The problem came with the markets over the last 18 months and the company’s inability to finance itself and move forward on the earn-in conditions of the joint venture. We became aware of it when a notable mining entrepreneur, David Fennell, learned of this opportunity and discussed it with us.
It was a restructuring exercise to take this Canadian company, which last May had a market cap of about CA$2M. At that time, Fennell brought in new investors including RMB Resources, new money ($16.5M), new management and renegotiated the earn-in option appropriately to allow it to go forward. We now own about 10% of the company.
The company has, since July, drilled 160 holes and over 24,000 meters. It is focusing on the chalcocite part of the belt. Unlike the native copper, chalcocite as a mineral is much more friendly from a metallurgical standpoint and produces a very high-quality, clean copper concentrate. No one had really focused on the chalcocite part of the belt in the old days.
We would expect that sometime in Q1/13, Highland Copper will come out with its initial resource estimate, and it will probably be on the order of 6–7 Mt initially of 2.2–2.5% copper, most of it open pitable, which is quite significant these days where the average grade of a copper deposit is more like 0.5%.
There was a joint venture by Inco and Homestake Mining Co. in the later 1970s and early 1980s, and they defined three deposits, conducted preliminary evaluations and produced resource and reserve estimates. Highland got an inventory of around 2 billion pounds of historic chalcocite and native copper resource, which needs to be prioritized and confirmed.
Bottom line, Highland has a high-grade deposit near the surface in an area that has a copper mining tradition. It is fully funded to meet its obligations under the joint venture earn-in. It has also been producing fantastic results, but people haven’t really noticed. That said, it currently has a market cap of about $24M, up from $2M, with about $14M in cash and a lot of work going on to get an initial mine going and really explore and evaluate the 13,000 acres of holdings that it has in the Keweenaw project in the Upper Peninsula of Michigan.
TGR: What about permitting in a place like Michigan, which hasn’t seen a lot of mining over the last 30 years or so?
RW: Michigan seems to have quite favorable attitudes toward mining and mining regulations. Most of the project is on private land, so the federal part of the permitting equation is less of an issue. The Keweenaw part of the Upper Peninsula is economically depressed. There is still a history and heritage of mining there, so in general people are very supportive. But time will tell. The permitting anywhere in the world these days is every bit as important as any other part of the job. That work is currently being initiated by Highland Copper.
TGR: Are there any other companies you want to comment on?
RW: Trevali Mining Corp. (TV:TSX; TREVF:OTCQX) is one of the better stories in the marketplace and we are working on it right now. We’ve been mandated to arrange $60M of finance for its mines and its development opportunities in New Brunswick as well as in Peru.
It’s a complicated task because Trevali has a lot going on simultaneously, including three mines and two mills. For investors who like zinc, it’s definitely one to pay attention to. It also has quite an ability to raise capital. But it is at that cusp where quite a bit of money is needed, and we’re one of the groups working on that. We have confidence it will go forward.
TGR: Its biggest project is the Santander base metals project in Peru. That has bounced around from company to company for years. Why does that project make economic sense now?
RW: It makes economic sense for two fundamental reasons. One is that there is already a tremendous amount of capital invested there. There is already a mill at Santander. There is housing at Santander and a complete mining camp. The other factor is that it has good zinc and silver grades in a well-established mining resource.
But it’s a big project. The challenge is getting all the final mine plans in order and properly developing the underground deposit. Santander should start producing metal in 2013. What makes these types of projects successful is that some management groups bring a focus and a commitment to it. That’s what’s happened at Santander. Glencore International Plc (GLEN:LSE; 0805:SEHK) has a major interest there along with Trevali. But it’s Trevali, and the confidence that Glencore has in Trevali to put the mine into production, that will bring it to fruition.
TGR: The junior mining space used to be predominantly the domain of retail investors. Is there still room for retail investors in the sector? Would they be well served to follow the investments made by large companies, such as those made by RMB?
RW: There is always room for retail investors. One of my attractions of getting into the junior sector when I became an analyst many years ago at Robertson Stephens & Co. was the realization of the mining industry in general, but the junior sector in particular, that it’s really a very small sector. There are lots and lots of companies; in Canada, there are around 1,500 listed junior companies.
But if you take the total value of those companies, or even the entire mining sector, it’s not very significant. Apple is probably bigger than the entire global mining sector. So when investor interest flows into the sector, it doesn’t take much for all the boats to rise, and do so rapidly. But when the interest leaves the sector, the inverse is true. The tide goes out, and all the boats fall quickly.
For people who think about fundamental investing, and not trading, there is a lot of opportunity in the junior sector because of this complete disconnect between the current valuations for companies and value of the metal in the ground and even cash flow given the current and expected prices for the commodities that these companies are producing.
I think for a lot of retail investors, it’s very difficult to know who’s who in the zoo. Just because a company is a very good promoter doesn’t mean that it has very good assets. People with a view like ours, which is a bit longer-term, fundamental resource-oriented view, would be well served by looking at what some of the other successful major resource investors do in trying to cull the number of opportunities and focus on those things that provide the best risk-reward. Institutional investors, as a group, typically do not seek market returns. We are looking at higher-risk, higher-reward opportunities. Retail investors need to look behind the retail promotion and see where serious money is getting invested.
When this market turns, it will come back with a vengeance. Everybody will be very happy. The people who will be most happy will be the people who were already invested.
TGR: That sounds like sage advice.
Rick Winters has been president of RMB Resources, the resource merchant banking division of the FirstRand Group, since August 2005. During the previous five years, he served as vice-president of RMB Resources. Prior to his time at RMB, Winters also had stints at Golden Star Resources Ltd., Robertson Stephens & Co., Phelps Dodge and the Colorado School of Mines, where he holds a master’s degree in mineral economics.
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.
There is a war raging behind the scenes among the world’s currencies. Chris Mancini, an analyst with the $400-million Gabelli Gold Fund, believes that gold will emerge the victor. In this interview with The Gold Report, Mancini makes his case for why gold is a currency and not just a relic, and why his fund doesn’t own bullion. He also shares names of companies operating around the world that offer great upside potential.
The Gold Report: You recently wrote, “Gold mining companies are no different from any other company in that company managements must determine the most effective way to return capital to shareholders.”
In an environment where there haven’t been corresponding increases in equity prices to the price of gold, how does a management group effectively grow per-share value for shareholders?
Chris Mancini: If you’re too big and don’t think that you can grow on a per-share basis, the answer is to return some of the cash to shareholders through a dividend. If a company doesn’t have high-quality, high-return-on-capital, low-risk projects to deploy that cash flow into, then a portion should be returned to shareholders as a dividend.
TGR: We haven’t seen a whole lot of that.
CM: Take Barrick Gold Corp. (ABX:TSX; ABX:NYSE) as an example. It had a goal of eventually mining 9 million ounces (Moz) gold and should produce around 7.5 Moz in 2013, which is a difficult thing to do. Barrick has been focused on growing for growth’s sake. It undertook two very capital-intensive projects, Pueblo Viejo in the Dominican Republic, which is complete and should be producing commercially sometime next year, and Pascua-Lama, which is an enormous, capital-intensive project in the Chilean/Argentinean Andes, which the company is doing a poor job of building. That being said, it will be very cash-flow generative once it’s built.
“We are in a positive macroeconomic environment for gold.”
The question becomes at that point, once Pascua-Lama is built, what does it do with its cash flow? We’re getting a sense that it wants to be a leaner, meaner company and that it’s not going to focus on growing its very big production base. That’s a good sign that it might start distributing more of its cash in a dividend.
TGR: A lot of senior producers, and even midtiers, are focusing on grade. Irrespective of all things, the higher the grade, the better the economic return.
CM: That’s the key. A higher-grade deposit means processing fewer tons to get out the same number of ounces without the capital intensity of a big, bulk-tonnage, low-grade operation. The cost per ounce is also lower given that not as many tons need to be processed to recover the same amount of metal.
TGR: You don’t hear many pundits predicting a falling gold price in 2013, yet we continue to see volatility in the space. What’s your forecast for the gold price in 2013?
CM: We’re very constructive on the gold price in all currencies. All over the world, money is being printed, and gold is the one currency that can’t be reprinted or replicated. The money that’s being printed will ultimately lose its purchasing power, and gold should retain its purchasing power. Gold should continue to go up relative to currencies that will be losing their value. More debt leads to more money printing, and more money printing leads to continued devaluation of currency. It’s a positive macroeconomic environment for gold.
TGR: Some investors don’t view gold as a currency. They view it as a metal, a relic.
CM: Historically, gold has been the ultimate currency and, at some point in the future, will again be the ultimate currency. It’s not legal tender, but that still doesn’t mean it’s not something that will hold its value over time relative to paper.
TGR: Utah and a couple of other states have actually passed legislation that gold is considered a currency.
CM: In some states, you can bring in gold or silver and get goods for that gold or silver. The problem with that is federal tax. If you buy gold and it appreciates in value and there’s a gain on that gold, when you sell or transfer that gold, then there is a federal tax on that transaction. Until that goes away, it will be hard to use gold as a real currency in the U.S.
TGR: Even in a world that hasn’t descended to a serious level of crisis, gold can still be appreciating as a currency.
CM: It is a currency war. Currencies are devalued against one another. Recently, the Japanese elected the Liberal Democratic Party leader Shinzo Abe. One of his talking points during the election was that the Japanese economy is uncompetitive because the yen is too strong. Abe’s theme is more monetary and fiscal stimulus, and a weaker yen. He and the Japanese people think that the country needs a much weaker currency in order to be competitive in the world economy. That’s also why the Swiss agreed to their money printing exercise—in order to stop their currency from appreciating more and more.
TGR: It does feel like a race down the hill when you talk about it like that.
CM: If the Japanese, Swiss, and other Europeans print more and more money to make their currencies less valuable, ultimately the U.S. is going to be uncompetitive from a manufacturing perspective. It gives the U.S. impetus to also print more money.
TGR: We’re talking about trillions of dollars of deficit. It’s almost beyond comprehension. Because you value gold as currency, why don’t you hold any bullion in the fund?
CM: Gold miners are undervalued relative to bullion, and investors can get bullion cheaper themselves. They shouldn’t be paying us to own bullion. Bullion is a savings instrument. Gold equities are investments.
TGR: The fund’s No. 1 holding, at about 12%, is Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE), which is heavily involved in Africa. I’ve traveled to Africa and was very impressed with the mineral wealth there. Yet some investors are not comfortable with that location. Why are you?
CM: When a company comes into a community, builds a mine and employs people, it liberates those people from poverty. They’re building skill sets that they have for the rest of their lives.
“While precious metals is an extremely volatile sector, it can be volatile on the upside, as well as the downside.”
A well-respected institutional mining company like Randgold comes into a region, employs people, educates people, liberates people—those people want that company to be there. It greatly reduces jurisdictional risk when you have that much local support.
TGR: Yet, there are places in Africa without that support. There are roving bands of thugs that are creating problems in the Democratic Republic of the Congo and Mali. Do you see these as temporary blips in an otherwise bullish and opportunistic area, or do you see this as a long-term thorn in the side of companies working in those areas?
CM: They’re not necessarily blips, but they’re not meaningful to the operations of Randgold. A place like Mali or the Congo is vast. As long as there are no specific problems near Randgold’s mines, it’s a non-event.
TGR: There are hundreds of kilometers of distance between the places where the problems are occurring and Randgold’s operations, and no connecting infrastructure.
CM: It’s extremely remote relative to political circumstances that may be transpiring around the country.
TGR: Your second largest holding is Fresnillo Plc (FRES:LSE), the No. 1 silver producer in the world. In a report you wrote that one of the things you like about Fresnillo is that it acts like an owner. “Unlike many other large precious metals companies, Fresnillo is an owner-operator company that’s 80% controlled by a family-owned Mexican conglomerate.”
CM: You have to ask yourself, as an investor, what’s the management’s incentive? For a large institutional-type precious metal mining company, their incentives may not be directly with the shareholders, whereas the owner of a company focuses on maximizing returns and cash flow.
TGR: Do you routinely look for companies with a lot of management ownership?
CM: That’s something that’s important to us. We look for skin in the game in the form of shares, not options, because we do want to see companies paying bigger dividends. If managers own shares, then they’ll benefit when dividends are paid out, too.
TGR: Is there another example of a company with vested management that you are particularly excited about going into 2013?
CM: Guido Staltari, the chief executive officer of Australia-based Saracen Mineral Holdings Ltd. (SAR:ASX), is the founder of the company, has an ownership stake in the company and is very invested in the company. Saracen should produce around 115 thousand ounces (115 Koz) gold at a cash cost of around $950/ounce (oz) this year. It’s in the process of expanding its operations. With an incremental spend of around $40 million (M), it should be able to increase its production by around 75 Koz/year and it should also be able to bring its cash costs down to around AU$850/oz.
TGR: That’s a name I’ve never heard of before.
CM: Saracen is producing now. It’s relatively low-risk growth and relatively high return on capital. The company has built a mill that needs some modifications. It has leases on its mining equipment, so it can upgrade the size and benefit from economies of scale that will come with using the new equipment without having to make a large capital outlay.
It also has some very prospective land that is relatively high grade where it is exploring. We hope that it will be able to increase its reserves. One of its deposits, Red October, is a higher grade than what it is currently mining. If it can grow the Red October deposit through exploration, then its average grade should increase, its costs should decline and its production should increase even more.
TGR: Are there any North America-listed names that are piquing your interest?
CM: One that has been hurt this year but has the potential within the next 18 months or so to do well is Kirkland Lake Gold Inc. (KGI:TSX). Kirkland Lake operates a mine in its namesake Kirkland Lake, Ontario, which is along the Abitibi gold belt. It’s an old mine in transition. As it increases its production, it should benefit from economies of scale. Kirkland is also exploring a new, high-grade portion of the deposit called the South Mine Complex. It won’t be without its fits and starts, and it’s not without risk because it’s a very difficult expansion that it’s undertaking. If Kirkland does succeed, its production should grow from around 100 Koz this year to around 250 Koz at full capacity. Its cash costs should decline from around $900/oz to closer to $600–700/oz.
TGR: Assuming operating costs stay the same.
CM: Kirkland Lake’s operational costs are going to go up, but not to the same extent that its production should go up. Right now, it is mining from 800–1,000 tons per day (0.8–1 Ktpd). The goal is to produce up to 22 Ktpd. It has around 900 workers underground now and wants to grow to 1,200 workers. It can more than double its production by just increasing its workforce by about 30%.
TGR: It’s trading near $6/share now, after trading as high as $18/share. This stock has been smacked.
CM: Kirkland Lake’s management has miscommunicated its production goals to the market. It has consistently changed its production guidance. First, it was going to be 2012, then 2013, and then 2014. The market doesn’t trust anything that it is saying. Yet, that’s why, over the next 18 months, it could do well, because the mine will be at a point where we will be able to see whether the company has been able to execute on its plan. The market wants to see consistent growth quarter over quarter and consistent decline in costs quarter over quarter. But given the nature of its operations, it’s going to be lumpy for a while until it gets to a steady state. The operations are at this point essentially paying for exploration and/or serving as a training ground for new underground miners at the operation.
TGR: Have you been there?
CM: Yes, I recently spent a day underground with Chief Operating Officer Mark Tessier getting a sense for the operations and the expansion project. It’s striking how many people go underground every day. It’s only going to ramp from there. A lot of the miners come to the operation without any mining experience. It takes a while for them to get up to speed and to productive capacity. Once they do, the company has the potential to be a midtier producing company in one of the best jurisdictions in the world, producing at reasonable unit cash costs.
TGR: With explorational blue sky.
CM: If the exploration does work out from the South Mine Complex, then its costs should be below average, at about $550–600/oz.
TGR: It did a $69M private placement in November.
CM: Yes, and it did another one in the summer for about $57M. Right now, it has around $120M of debt. That makes it more risky. The balance sheet is more levered. I still like it, but it’s not for the faint of heart.
TGR: What’s another company in a great jurisdiction you can tell us about?
CM: Another North America-listed gold name is Aurizon Mines Ltd. (ARZ:TSX; AZK:NYSE.MKT).
TGR: That’s another one that’s had great success, but a few bumps in the road.
CM: Aurizon doesn’t necessarily have the growth prospects that Kirkland Lake does. However, it does have downside protection. It has a rock-solid balance sheet with $200M in cash.
“Our hope is that in the coming year, precious metals move fast and furiously on the upside and the environment is more constructive for gold and for gold miners.”
It has had some operational issues recently, but the market is not latching on to the essence of the story. It is mining an old area and it is going to start mining in a new area, Zone 123 at its flagship Casa Berardi mine. Once it starts mining the new area, it should get steady production and generate a good amount of cash flow. In 2014, the company should be producing 135–150 Koz/year gold at cash costs of $700–800/oz, generating a good margin, in a great jurisdiction in Northern Quebec.
TGR: Aurizon is not flashy or sexy, but it sure gets it done. It’s been impressive to watch that company.
CM: It has. The fact that it hasn’t done an acquisition yet with its $200M cash hoard speaks volumes.
TGR: One of the things that is compelling about a lot of midtier producers is that they are nimble. They can pare back a little bit. They’re small enough to decide to stick to where they’re having explorational success with their own assets. We’re seeing that with several of these midtier companies. As an investor, it makes them more attractive in some ways than the seniors.
CM: Yes, I agree. They don’t have the overhead of the seniors. The seniors almost have to buy something in Nevada, for example, because they currently have all of the overhead in Nevada and they have to sustain it. That’s not the case with these small, single-asset companies.
TGR: Let’s go to silver. Could you talk about a couple of silver names that you find compelling?
CM: The one that makes sense to talk about, given that we spoke about Fresnillo, is MAG Silver Corp. (MAG:TSX; MVG:NYSE). MAG Silver has 44% of the Juanicipio project, a property that is near Fresnillo’s namesake mine. Fresnillo has the rest of the project.
Fresnillo is the highest-grade silver mine in the world. Juanicipio has a similar geological structure to the Fresnillo deposits. These are epithermal vein systems. At Juanicipio, the company has delineated a deposit that is around 230 Moz silver at very high grades. It’s a silver equivalent grade of 700 grams per ton; this is an extremely high-grade deposit in one of the best jurisdictions in the world, Zacatecas state. Fresnillo is the best miner and developer of high-grade underground silver deposits in the world.
TGR: What needs to happen with Fresnillo and MAG Silver to unlock the value of MAG Silver for shareholders?
CM: Obviously, for Fresnillo to buy out MAG Silver’s 44% stake of the Juanicipio project. That’s the best-case scenario for both companies and for shareholders of both companies. They just have to sit down in a room, hash it out and come up with something that’s reasonable.
If they can’t agree to a price, MAG Silver could spin out the Juanicipio asset to shareholders, who would then get one piece of paper that’s 44% Juanicipio and another piece of paper that is all of MAG’s other exploration assets, some of which are very prospective. For that 44% in Juanicipio, ultimately the shareholders would get a cash call. They would have the option to either participate in the cash call to fund a portion of the capital expenditures for the project or get diluted down. Once Juanicipio gets built by Fresnillo, shareholders would still have the 44% stake in the cash flow from this operation that would be returned in the form of a dividend.
TGR: That’s an interesting idea.
CM: Yes. I think that it would be valued very highly in that it would be like a royalty company. It would be 44% of the profit from one of the best silver mines in the world, operated by one of the best silver miners in the world.
TGR: It might be easier from both companies’ perspectives if everything is separated that way.
CM: That’s true, too. The first step is separating the assets out. But value can be surfaced for a MAG shareholder even if Fresnillo doesn’t buy it.
TGR: Is this something that’s already on the table?
CM: I’ve spoken about it with management. Director Peter Megaw is a relatively large holder of MAG Silver. He is motivated to do what’s in shareholders’ interests. If it does spin this out, it makes what’s remaining a smaller company. It has to start over again, which is fine because Megaw is one of the best exploration geologists in the world at finding epithermal vein and carbonate replacement deposits.
TGR: It’s not really starting over because what it has outlined in its exploration assets is actually pretty compelling.
CM: That’s true. It’s not starting from nothing. It has delineated some exciting prospects at its Cinco de Mayo project in Chihuahua.
TGR: Do you have some final thoughts for us on the mining space?
CM: It’s been a difficult year. Yet, while this is an extremely volatile sector, it can be volatile on the upside, as well as the downside. Our hope is that in the coming year, it moves fast and furiously on the upside and the environment is more constructive for gold and for gold miners.
TGR: Excellent. Thanks for taking the time to speak with us today.
Chris Mancini is a research analyst at Gabelli specializing in precious metals mining companies. He has over 13 years of investment management experience, including research analyst positions at hedge funds Satellite Asset Management and R6 Capital Management. Mancini earned a bachelor’s degree in economics with honors from Boston College and is a holder of the CFA designation.
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