The Gold Report: Richard, last month, you made a presentation at the Casey Research/Sprott Inc. “When Money Dies” Summit entitled “The War that Will Kill the Dollar.” You explained that the corrupting influence of power had sent our country’s leaders shopping for war, disregarding Westphalian respect for sovereignty and hastening the collapse of society. What are the signs that we are reaching a critical point? And, is there any way we can change course?

Richard Maybury: You can see the signs very clearly in the Middle East and North Africa. The Federal government is involved in several wars there that have nothing to do with America. One of the best examples is Libya. U.S. officials are taking credit for Moammar Gadhafi’s death just a year after they were bragging about having tamed the threat. Now Libya is a mess. It will very likely be taken over by some sort of Islamic government that isn’t going to be very friendly to America.

TGR: Why do we, as a country, do this? If it’s not going to end well for us, what’s the economic or political reason to get involved?

RM: The U.S. government gets into wars in far corners of the world that have nothing to do with America because the leaders like getting into wars. That is how presidents achieve greatness in the history books. A president has no prayer of going down in history as great unless he has won a war. Look at Mount Rushmore. All four presidents featured there won wars. That seems to be the number one criteria historians use for deciding whether someone is a great president. It constitutes an automatic incentive to go out looking for wars.

TGR: What is the incentive for the American people to go war shopping?

RM: Nothing. It’s absurd. During the First Gulf War, people had a tremendous good feeling about going to war with Iraq. They would come home from work, order a pizza, sit in front of their TV sets and watch the war like it was a football game. War became a form of entertainment.

TGR: Is there anything we could do to incentivize our presidents to act peacefully?

RM: I doubt it very much. People go into politics because they seek political power. Once they get the power, they naturally want to use it on somebody. What is the point of having power if you can’t use it? So, no matter what kinds of controls you put on, future presidents will find a way around it.

The ideal situation would be one where war is used as a last resort. Westphalian sovereignty, a set of agreements dating back in the 1600s, established the precedent that the European powers would only go to war in self-defense. You had to have a clear and present danger before you could go to war. And, even then, it was supposed to be the last resort. That was the basis of international law up until this year. That isn’t to say that the Westphalia treaties weren’t violated a lot of times, but they helped. After Iraq, Serbia and now Libya, it is pretty clear that the policy is we can just go out and hit anybody we want for any reason we want as long as we believe the other guy is up to no good.

TGR: If this is the new reality, then let’s talk about some of the economics around it. War is expensive. You have pointed out that since the Federal Reserve was created in 1913, the dollar has lost 95% of its buying power. You said, “War destroys currencies.” It usually leads to governments printing more dollars to pay for guns and tanks. How much debt and overprinting can the country take before the velocity of economics, which is something that you also talked about in association with how quickly dollars are exchanged, catches up with reality and the dollar loses that last 5% of its value?

RM: Velocity refers to the speed at which money changes hands, and it is a measure of money demand. When people don’t really want the money, they start trading it away faster, trying to get their hands on things they do want, things that have value that they trust. The cost of this war in the Islamic world will continue going up. At some point, it’s going to be a major contributor to people losing what confidence is left in the dollar and people all over the world will start dumping it. This is a psychological thing. It’s about emotions, so it is hard to pinpoint when they will lose all confidence in the dollar.

TGR: What would it look like if that last 5% were gone? Are we talking about hyperinflation? Are we talking about banks collapsing? Are we talking about bartering? What would it look like?

RM: We are talking about all of that. It would be chaos. We saw it in Zimbabwe when the Zimbabwean dollar became worthless because the government printed so many that people wouldn’t accept them anymore. The country experienced enormous runaway inflation where prices were rising 50% a day before the Zimbabwe dollar collapsed.

It would probably start with someone somewhere in the world selling off his dollars and begin trading them for whatever it was he had confidence in. The foreign exchange value of the dollar would fall. Other people would notice; they would get scared and start selling their dollars. The foreign exchange value of the dollar would drop more. This process would continue until you have panic around the world to get out of dollars. Americans would be the last ones to get involved. We are always the last to know what is happening to America. Suddenly Americans would wake up one morning and find that a gallon of milk that cost $4 the day before costs $6 today. The next day they would find that it costs $12. And the next day they would find that it costs $36. That is when Americans would realize that they are in deep trouble; their dollars are about to become worthless.

TGR: Of course the Fed wants to avoid that scenario. You describe yourself as a follower of Austrian economics made famous by the Nobel laureates Friedrich Hayek and Ludwig von Mises. They describe financial systems as complex processes run by billions of constantly changing individuals rather than something that can be manipulated from a central point, which seems to be what is being attempted right now. If that is the case, what will be the outcome if the central government tries to force a more Keynesian control of the flow of money?

RM: They will mess it up even worse than they already have. The world has been living under Keynesian economics since 1971 when Nixon took the dollar off the gold standard. John Maynard Keynes was a semi-socialist. He believed that the way to fix the economy was to print a whole bunch of dollars and dump them out there. This has been standard procedure for the past 40 years. All currencies have been dropping in value during that time. Another round of quantitative easing (QE) could further speed the rate at which the money circulates, something that has the same effect as increasing the supply of dollars, creating a larger demand for goods and services and having an inflationary effect. I think Fed officials are dropping hints about the next QE because they are trying to cause velocity to rise, a secret QE if you will.

TGR: What if the stealth QE campaign doesn’t work? What form might a real QE3 take?

RM: It is hard to tell what they will do. One of the myths that everyone is taught is that the government has some sort of tremendous understanding of economics and the ability to make adjustments to economic activity. The term fine-tuning is used sometimes. Actually, we are talking about a group of human beings who don’t know much more about real economics than anybody else. They think they do, but they don’t. They just bounce around from one attempt to control things to the next, making a mess of the country. The economy is not a machine. It is people, human beings. It is a biological system, not a mechanical system. But, the government treats it like a mechanical system, so they are always making mistakes.

TGR: If war and hyperinflation are the inevitable future, how can investors survive or maybe even thrive during a time like this? What are the opportunities? Natural resources? Commodity equities? Where can we be safe other than putting that $100 bill under the bed?

RM: Well, I wouldn’t put $100 under the mattress, at least not for very long, because it will soon become worthless. But commodities, stocks of raw materials firms, gold and silver and platinum coins have value. Generally, I try to see the world in terms of two kinds of investments: dollars and non-dollars. You definitely want non-dollars, things that do not have their value tied to the value of the dollar. An example of a dollar asset is something like a bond or bank CD. Their values are tied directly to the value of the dollar. If the dollar falls, then their values fall.

Gold is a non-dollar asset. When the dollar falls, usually gold rises. The same is true with silver and oil. All of these things have values that are not tied to the dollar. My advice is to invest in non-dollar assets. Gold would be at the top of the list, silver and platinum and then oil.

TGR: In your Early Warning Report Newsletter, you predicted that gold will top $3,000/ounce (oz), silver will hit $50/oz and oil will exceed $300/barrel. Gasoline will go to $9/gallon. When will we see these rises? And what will be the catalysts that take them there?

RM: The next QE, which I expect to come along no later than March, could set off a flight from dollars. Then we could see those predictions realized within 18 months.

TGR: You said that once we have had this loss of the entire value of the dollar and people are looking for another way to trade, money could be based on some collection of metals with currency acting as a receipt for the tangible gold, silver, platinum and whatever else happens to be in that basket. What would that transition look like? How painful would that be? How would it be orchestrated?

RM: It doesn’t have to be painful. The markets are moving in that direction. People trade exchange-traded funds (ETFs) for practically everything now. I can envision a mutual fund or an ETF that is a collection of various things. It could be gold, silver and platinum. It could have oil in there. It might include Swiss francs. It could even have various patches of real estate. The ETF itself would then become a currency, not because anybody has it planned that way, but because the markets will see that there will be a demand for something that is a non-dollar asset that is easily tradable and seen as a store of value. There would probably be hundreds of these baskets of assets at the start. Some would work better than others would; the less workable ones would shake out. You might wind up with maybe a half dozen ETFs or mutual funds that are baskets of various assets circulating in the world. They would essentially become the currencies.

TGR: Would investing in ETFs now be a good way to prepare?

RM: No. I don’t know of any that are arranged that way. It may be a while until somebody catches the idea and decides to give it a try.

TGR: What about the precious metal equities? Would that be a good way to prepare?

RM: Yes. There are lots of good precious metal stocks. I own quite a few. That is another way to protect yourself. However, be sure to deal with a broker who really knows natural resources. You have to have some skill in picking those stocks. It’s not like going down and buying a gold coin where you just walk into the coin dealer and tell him I want a handful of American Eagles or Canadian Maple Leaves. You really have to know what you are doing when you are buying gold stocks.

TGR: Any final thoughts you want to leave with The Gold Report readers?

RM: The world has changed. When you look at the news and you say to yourself, “My God, America isn’t what it was; the world isn’t what it was,” have the confidence to know you are right. We are probably not going back to what America or the world was anytime in my lifetime. Therefore, you want to start learning everything you possibly can about this new condition and adapt to it.

TGR: Thank you for sharing your thoughts.

RM: Thank you, JT. I appreciate being here.

Richard Maybury, the author of the U.S. & World Early Warning Report, has written 22 books, including the Uncle Eric series, which focuses on economics, law and history. He has been interviewed on more than 250 radio and television shows. He is a Vietnam War veteran who served in the Air Force’s 605th Air Commando Squadron, a special operations unit involved in covert warfare in Central and South America. He has since lived and traveled the world, visiting 47 states and 45 countries. He considers himself a “juris naturalist” who believes in a natural law higher than any government’s law. You can visit his website at or phone 1-800-509-5400.

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The Gold Report: With gold trading around $1,800+/ounce (oz.), famous precious metals investor Eric Sprott announced that he is selling 2 million units, or $30 million (M), of the Sprott Physical Gold Trust. Sprott then said he would take that cash and put it into silver, which he called “the investment of the next decade.” What do you think of his long-term silver strategy?
Chen Lin: Silver and gold are both precious metals, but they move at different times. Right now, the gold:silver ratio is a little bit over 40. Obviously, Sprott is more bullish on silver versus gold. I take a pretty even point of view. I like gold. I like silver. I know that historically the gold:silver ratio is much lower than it is right now. I checked Chinese history and it’s about 10:1. Even China has much less gold than the rest of the world and is richer in silver. We could have a much lower ratio, which means silver would outperform gold going forward, but personally I’m betting evenly on gold and silver.

TGR: Another interesting development is that Venezuelan President Hugo Chavez has announced that he will nationalize all of the remaining non-state-owned gold mining operations in the country. Is this announcement likely to affect the share prices of small-cap companies operating in other countries with leftist leaders, like Bolivia or Peru?

CL: I think it’s possible. What Chavez is doing will probably destroy the country’s gold mining industry because it needs the juniors to lay the groundwork so the majors can dig out the gold. If Chavez nationalizes, it will probably lower the gold production. I think one day he will regret that. It will increase concerns about the political risk in countries that have those close ties to Chavez.

TGR: Recently, we saw the Dow Jones Industrial Average drop a little over 400 points in a day. What’s your outlook for gold? Are we going to see $2,000/oz. gold before the end of 2011?

CL: It’s very possible. I personally do not want to see the parabolic move of gold. I hope gold doesn’t rise as fast as silver did in the second half of last year. But in the back of my mind, I think gold could do that. There is a dramatic difference between this year and 2008, however. In 2008, gold initially went down along with the stock market. This year gold went up as the market went down, which means investors believe gold is the place to put money. I read a report that some banks in China have low gold inventories because individual investors are buying gold like crazy. It’s very possible gold goes to $2,000/oz., but I hope it goes slower. I invest in gold. I have gold exchange-traded funds, gold futures, silver ETFs and silver futures on my recommendation list. But I hope they go up gradually.

TGR: Do you fear a correction?

CL: I hope we have some correction. I expect that the margin will increase another six times before gold has a real correction. That probably will push into early next year. Usually the gold season is strong from September into Chinese New Year. A severe correction could come in February.

TGR: You’ve said that you are seeing a decoupling of gold stocks versus stocks in the broader market. Can you explain that?

CL: Now, when the market takes a huge dive, gold goes up. Quite a few stocks, including Yamana Gold Inc. (TSX:YRI; NYSE:AUY; LSE:YAU) and Franco-Nevada Corp. (TSX:FNV) actually went up into the green. Many others, such as Pretium Resources Inc. (TSX:PVG), are up as well. Majors will start to stabilize and move up despite the stock market going down. As things stabilize, the juniors will likely catch up. As gold moves up, gold stocks are likely to outperform gold for the rest of the year.

TGR: Your investment success is somewhat legendary. You took about $5,000 in 2002 and turned it into about $1.56M by the end of 2010. Even as your portfolio regressed this year, it’s only by 10%. What’s changed in 2011 that is making it more difficult to find small-cap companies poised for big gains?

CL: This year has been difficult. The resource stocks got hit as investors took profits and ran. Fortunately, I have a pretty diverse portfolio. I have stocks, ETFs and futures. It is a very difficult year for small-cap companies, but I see some great opportunities. I’m ready to buy because investors are selling gold stocks indiscriminately. This is the time to buy. There are some great opportunities for investors that have a relatively long-term vision.

TGR: So then, what is Chen buying?

CL: Pretium, which I mentioned earlier, is run by Bob Quartermain, the founder of Silver Standard Resources Inc. (TSX:SSO; NASDAQ:SSRI). Management is really key at gold and silver companies. There are tons of companies that just go nowhere. The management raises money to pay themselves. With great management, like Bob Quartermain, there is a proven track record. He doesn’t just grant options to management. He buys them. He bought shares on the market like every other shareholder. He has a couple of projects that are becoming very promising in British Columbia, which I am visiting next week.

TGR: Is that the Snowfield Project?

CL: Yes. Pretium is in low-grade Snowfield and high-grade Brucejack. I think the Snowfield Project will likely do a deal with Seabridge Gold Inc. (TSX:SEA; NYSE.A:SA). Quartermain is more focused on the high-grade area with about 15 kilograms/ton of gold. Some people don’t believe it. They say it must be silver. It’s gold. That is what he is focused on. He is looking to do a very high-grade underground operation, which was permitted before. He just needs to reapply for a permit and get into production.

TGR: The company has a positive preliminary economic assessment, but it really hasn’t produced a dramatic rise in the stock price.

CL: That was based on previous results. In the new drilling tests, the company intersected a lot more gold. That will help them when people realize the valuation of the deposit. Another catalyst would be the deal with Seabridge and a major investing in the lower-grade area. The feasibility study is not very high, but the company used a conservative gold price. Eventually, people will catch up with it.

TGR: What are some other names on Chen’s radar screen?

CL: Barkerville Gold Mines Ltd. (TSX.V:BGM) has been on my list for a pretty long time. I like the company. I met the management. The stock has already gone up pretty significantly since my recommendation. However, it recently has been in consolidation, which could be an entry point. The company keeps making progress. It keeps producing gold, which means it can generate a lot of cash flow at the current gold price. That will fund its next move versus going into the market begging for money.

TGR: Barkerville is planning to mine about 50 thousand ounces (Koz.) from the QR Mine this year. Is it on target?

CL: I will be following that very closely. As long as the company is producing gold, it should be doing fairly well. As long as it can produce, even if it’s not 100% as planned, the higher gold price will compensate. If the company can make its target, that will be a great bonus.

TGR: Has Barkerville forward-sold any of its gold or is it fully exposed to the gold price?

CL: No, it is fully exposed to the gold price. You don’t want to invest in any company that has hedges in place. Then it would be selling gold at maybe $1,000/oz. when it could be getting $1,800/oz. or more.

TGR: Barkerville has about 937 Koz. outlined in all categories. That is still a pretty small operation. Do you believe that as the company produces gold and takes some of that money to further exploration, it will continue to discover more resources?

CL: The company is getting good drilling results. I’m sure when it updates its new resource, it will be much higher. Once the company starts to get into a good financial situation, it will do more exploration. Gold is prolific in that area—there is a lot to find.

TGR: What else is Chen buying?

CL: There is a very small company called Majescor Resources Inc. (TSX.V:MJX) that just announced fantastic drilling results. The stock is actually up about 89% right now. It’s a very tiny company with about a $20M market cap. It’s drilling next to Newmont Mining Corp.’s (NYSE:NEM) latest project in Haiti. Newmont’s chief executive said it is one of his most important projects. It’s had fantastic drilling results of 77 grams over 10 meters (m). It’s very shallow at about 100m deep. Plus, it has many other intersections with very high-grade gold and copper. For this market cap, it looks very promising.

TGR: It’s trading between $0.25 and $0.30. Is that a good entry point?

CL: I think the current price still looks very good.

TGR: How high could it go and still be a good entry point?

CL: There are heavy insider purchases at $0.20. I think anything between $0.20 and $0.30 is a great buy.

TGR: Majescor is effectively almost like an exploration arm for Newmont at this point. Does Newmont have a position in it?

CL: No, but Majescor has a mining license while Newmont is still applying for a mining license. That makes them a very good target for Newmont.

Haiti is on the same island as the Dominican Republic, which hosts one of the largest gold mines in the world. Since the earthquake, the U.N. is trying to help the country create jobs. One of the key areas it is looking at is mining. Haiti could be opening up and this could be a hot new mining area in the world.

TGR: What’s another name, Chen?

CL: I just visited Prophecy Platinum Corp. (TSX.V:NKL; OTCPink:PNIKD; Fkft:P94P). It’s in the Yukon, very close to the Alaska border and only about 10 miles from the Alaskan highway. It just announced a NI 43-101 for about 12 million ounces (Moz.) of platinum, gold and palladium. The key for the company is to have very high grades. Right now, it has consolidated a little bit as the company is probably going to raise money. Sprott just announced it bought about 10% in the open market. I would assume Sprott would probably participate in one of many raisings. Then we can potentially consolidate the stock and it could go higher.

TGR: It also has a producing coal mine in Mongolia, correct?

CL: That’s actually its parent company, Prophecy Resource Corp. (TSX.V:PCY). Prophecy Resource owns 45% of Prophecy Platinum, which is a spin-off. Prophecy Resource is also a very interesting story because Prophecy Platinum’s price almost covers the entire market cap. You’ve got a producing coal mine almost for free.

TGR: It just discovered a substantial coal seam in Mongolia about 20 kilometers away from its existing coal mine, which actually hasn’t had any effect on the stock to date. It certainly could be a promising find in the future.

CL: Exactly. There are bargains almost everywhere. Investors are just selling by emotions. There are a lot of opportunities and Prophecy is a perfect example. It owns 45% of Prophecy Platinum. You can calculate the market cap. It doesn’t make sense, but the market still treats it like this. I bet the market probably won’t treat it this way for too much longer.

Another is Romios Gold Resources Inc. (TSX.V:RG; NASDAQ:RMIOF; Fkft:D4R), which I am going to visit next week as well. It is drilling the Trek Property in northwestern British Columbia, right next to NovaGold Resources Inc. (TSX:NG; NYSE.A:NG) Galore Creek Project. It’s actually drilling on top of the company’s proposed mill site, so drilling results are pending. This stock could have a very explosive movement because its market cap is very small at about $70M.

NovaGold and Teck Resources Ltd. (NYSE:TCK; TSX:TCK.A, TSX:TCK.B) need to build a $1B tunnel to get ore from the other side of the mountain. But if the pair can find ore on the Romios side of the mountain, right on top of the mill, they could save $1B and take the company over. If there are good drill results, Romios will be an easy takeover target for NovaGold and Teck.

TGR: Romios recently found some massive sulfide mineralization at the Trek Property, which is known to host large gold and copper deposits. Can you tell us about those results?

CL: It has a lot more results coming. The assay is pending, but it looks very promising. If it has a grade similar to Tech and NovaGold’s Galore Creek, this is a very easy takeover target.

I want to mention another stock that is under the radar, Helio Resource Corp. (TSX.V:HRC), which is drilling in Africa and already has 1 Moz. of gold. Its market cap is very tiny, but it has some very important, pending results coming in the next few weeks. It is drilling to a mere 200m for open-pit gold. If it can upgrade its resource to a few Moz., that could make the company very cheap versus its market cap. It could see some major movement in the second half of the year.

TGR: That is the SMP Gold Project in Tanzania that has multiple zones of gold mineralization at shallow depths. Could that be a target for a company like African Barrick Gold plc (LSE:ABG)?

CL: It’s possible. Helio is an exploration company run by geologists. Its goal is to find a deposit and then sell it to the majors. If we use $100/oz. in its existing gold inventory that is already worth $100M and it is looking at a much higher stock price. It could expand dramatically with its recent drilling results. The company is well funded with $8M in the bank. It doesn’t have to raise money for a long time.

TGR: Helio is trading at just below $0.30 right now. At what point would you not get into Helio?

CL: I think it is dependent on its drill results and those are unknown. When the stock moves, it can move very fast. With its existing resource, around $0.30 is pretty good. But I don’t know what the drill results look like, so that will decide what the new valuation will be.

TGR: On the other side of the ledger, what are you divesting yourself of right now?

CL: I have been gradually selling some gold and silver ETFs. They have appreciated a lot, so I use them as buying power on the dip on the miners. Instead of following Sprott by selling gold and buying silver, I’m reducing a little bit to use that as capital to buy undervalued small-cap gold and silver miners.

TGR: You have had success in pulp, paper and oil and gas. What other sectors do you believe are poised for growth?

CL: I like the pulp sector, including the company Mercer International Inc. (NASDAQ:MERC). There are a lot of very undervalued energy stocks, as long as oil finds a floor somewhere in the $60–$70/barrel range. China does not have enough strategic oil reserves. If oil really dips, China would probably use the opportunity to build up more oil reserves. India has no strategic oil reserve. The pressure is on both countries to stock up if oil dips. In 2008, the worldwide oil demand only dipped like 1–2%. As long as investors stay with low-cost producers with good balance sheets, they will ride out the storm.

TGR: Any parting thoughts for us?

CL: I think this market correction will create a lot of opportunity for us. The market is putting a lot of pressure on the European leaders to get their acts together. There is a lot of pressure on Federal Reserve Chairman Ben Bernanke to do another round of quantitative easing. I hope the outcome will have some stabilizing effect on the market. In the meantime, when investors are selling everything, that’s a very good buying opportunity.

TGR: Excellent. Thanks, Chen.

Chen Lin writes the popular stock newsletter What Is Chen Buying? What Is Chen Selling?, published and distributed by Taylor Hard Money Advisors, Inc., publisher of J. Taylor’s Gold, Energy & Tech Stocks newsletter and Roger Wiegand’s Trader Tracks. Using his wife’s Roth IRA account, Lin invested $5,411 in December 2002, and by December 31, 2010, it was worth $1,188,993—with no cash added. You can see his portfolio chart here.

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. Chen worked in the Internet and computer area where he founded a few start-up companies. After the tech bubble burst of 2000, Chen was able to move his technology portfolio into the resource sector with considerable success. Chen employs a value-oriented approach and often demonstrates excellent market timing due to his exceptional technical analysis. To subscribe to Lin’s What Is Chen Buying? What Is Chen Selling? newsletter, click here or call Claudio Bassi at (718) 457-1426.

The Gold Report: You had an interesting career that included being a floor trader on the CBOE when you were at Lakota Trading. You mastered skills there that could never have been developed in any other way aside from being on the floor of the Exchange. How does that inform what you do today, considering that so many of your current equity holdings are micro-cap, small cap or China-related and may not have derivatives attached to them?
Stephen Taylor: I started on the floor back in the days of floor trading, when it was open outcry and traders stood next to each other yelling and screaming. This was before the screen-based computerized trading of today, and it allowed you to see the emotional elements of markets up close and personal.

TGR: That’s actually what I was getting at.

ST: When you were going down to the trading floor, you could hear the roar of the crowd before you got there. Depending on that tone and the volume you could tell if the market was up, if it was down, how fast it was moving. In the trading pit itself you saw those periods when fear or greed would take over. There’s nothing like seeing it up close and personal and watching individuals or firms panic and make trades that maybe with the passage of time would not appear to be completely rational. So, in that sense it was an invaluable experience.

TGR: Your Taylor International Fund is heavily weighted in natural resources and emerging markets. Given that this space has seen a pullback and is generally soft at this point, how is your fund pacing so far in 2011?

ST: Well, we’ve taken our lumps. We’re not too far behind some of the resource-related averages, such as the TSX Venture. We’re down a little bit over 10% this year. But, you know, volatility is something that comes with this space. It’s something we’re comfortable with as long as we believe in the companies and the management teams that we’re investing in. We maintain a long-term perspective. We seek out and encourage our investors to maintain a long-term perspective. So, we’re not really rattled or shaken by these sorts of pullbacks. It just goes with the territory.

TGR: Do you think of the volatility as your friend?

ST: In many cases, absolutely. Not everybody likes volatility. Not all funds are able to deal with it. But it does present some opportunities. I think we’ve seen some overdone selloffs in the resource space. We’ve seen some extreme selloffs in the China space. And that’s presenting some good opportunities, in our opinion.

TGR: Your China positions represented about half of your portfolio when you last spoke to The Gold Report six months ago. Some of these were private equity. The due diligence would be daunting to most people. How do you research and verify these assets, liabilities and valuations in what I might refer to as esoteric investments?

ST: As you know, diligence is an ever-present issue, not just in this China space, but in the resource space as well. We are big believers in looking at management teams that have delivered in the past. We look at the partnerships that management teams and companies have, and the banking teams that they choose to deal with. We look at the strategic investors that they bring along, as well as the firms doing their auditing and legal counsel. We do site visits, and repeatedly meet with management teams. We try always to look at what companies do, and not what they say.

TGR: Is there any China counterpart to Sarbanes Oxley Section 404, requiring executives to be responsible for their financials?

ST: Well, I would point out that SarbOx has certainly not been a panacea in and of itself here in the U.S. A number of the high-profile blowups here in the U.S. were Sarbanes-Oxley-compliant, or at least testified that they were. Ultimately, whatever regulatory structure you have is only as good as people backing it up. With respect to China, clearly it’s a developing market. Their financial markets are not as mature as those in North America or Europe, and it’s an ongoing process. I think you’ll continue to see some progress being made in that area over the next year or two, especially with respect to allowing for broader SEC investigation and actions in China and harmonization of accounting standards.

TGR: When you founded the Taylor Fund in November 2008, you had $10 million under management, I believe. How much do you currently have under management?

ST: We’re a little under $50 million at this point.

TGR: So, you have almost five times the assets you started with two and one-half years ago. Has that growth occurred mostly without new investment?

ST: It’s been a combination of organic growth, some new investment and some follow-on investment from existing investors.

TGR: Have you reopened the fund to new investors?

ST: We haven’t formally reopened the fund. I suspect that we may do that sometime in the fourth quarter. That’ll be our three-year anniversary and an appropriate time to take a look at it.

TGR: That’s when the lockup will end for your initial investors?

ST: That’s correct, at least for a portion of them.

TGR: In a fund of this type, you really have to be as comfortable with the investor as the investor has to be with the portfolio manager.

ST: Oh, absolutely. In an ideal world, all funds would be that way. As a manager, it’s vital to know the risk tolerance and financial profile of your investors. I couldn’t operate nearly as well if I were concerned that some of my investors were taking inappropriate risks for themselves. It really has to be a good match.

TGR: You have to walk a narrow path, where you hold enough different positions that you’re not dangerously under-diversified, but where at the same time you can potentially achieve outstanding capital appreciation. Currently, how many different securities does your fund own? How are you weighted by country and sector?

ST: We have approximately 45 positions right now. In terms of weighting, we’re probably 20% in the energy space, 20% to 25% in the mining space, and we have probably about one-third in China-related investments. We currently have a 2% or 3% weighting in the financial space, but I suspect that will change to about 10% in the next few months. And we have roughly 5% or 6% in cash.

TGR: In part, you buy very small companies, some of which are in the micro-cap range. In many cases, they probably require some tinkering or restructuring. Do you think of yourself as an active investor or an activist investor? How do you see yourself?

ST: We like to look at ourselves as being positive, additive, collaborative shareholders. We like to think of ourselves as always having a good relationship with management teams. Depending on that relationship, CEOs will reach out and may ask for our input from time to time. We like to work on a collaborative basis in a win/win situation. Having said that, there are times when we have had to become active.

One case that I mentioned in the December interview was the Chapter 11 case of Meruelo Maddux Properties, Inc. (OTCPK:MMPIQ). It unfortunately required a lot of time and effort on our part, and it’s something that we’re happy we did. As part of the confirmed reorganization plan, which we believe will be effective this week, I will be taking a board slot there. So, I’m going to restrict my comments on that for now.

TGR: You invest in event-driven situations, and I assume distressed situations as well. Can you describe events and other situations where you might enter a position?

ST: By event-driven, we mean company-specific events that we believe will drive increased shareholder value. That could be a new project. It could be drill results. It could be a financial restructuring. In the case of Meruelo Maddux, it was bankruptcy reorganization. Another company that we were involved in early, of which I continue to be a big fan, is Red Eagle Mining Corp. (TSX.V:RD). I love Red Eagle Mining. We participated in this company as a private venture and knew it would ultimately move toward an IPO, and that it would bring in some very attractive additional properties in Colombia.

TGR: What’s your favorite region?

ST: Central and South America, because of its mining companies. We are big fans of Lumina Copper Corp. (TSX:LCC), which has its Taca Taca project in Argentina. The drill results just seem to get better and better. Its recent spinoff of the royalty company was very shrewd in our opinion.

Anfield Nickel Corporation (TSX.V:ANF) in Guatemala has the same management team as Lumina and is very good. Also, Silvermex Resources Ltd. (TSX:SLX) in Mexico is ramping up production now and is very good. We continue to like silver here. We think these are terrific names.

In New Zealand, we like energy companies, including Tag Oil Ltd. (TSX.V:TAO) and New Zealand Energy Corp., which should be having an IPO in the near term. We’ve been an investor in three rounds of private funding in the company, and think it’s really worth a look at the IPO.

We like Miranda Gold Corp. (TSX.V:MAD) in the U.S. We like Largo Resources Ltd. (TSX.V:LGO) in Brazil and in Canada. Largo has made some great progress since we last spoke. It’s completed the financing on its Maracas vanadium project, and the drill program is now underway in the Northern Dancer tungsten-molybdenum project up in the Yukon. This company continues to make great progress.

TGR: What’s the near-term catalyst with Largo?

ST: I think you could see some drill results out of the Northern Dancer project. The company began the drill program for a pre-feasibility study up there. They will begin construction on the Maracas project. I think vanadium is a metal that we’re going to hear a lot more about in the years ahead, and Largo arguably has the best undeveloped vanadium deposit in the world down in Brazil—one of the best markets. So, I think you’ll keep seeing good things about them.

TGR: Silvermex acquired the La Guitarra silver mine and put it back into production. Is that the principle growth driver here?

ST: Yes. You saw the first quarter production coming out, and it’s ramping nicely. The company has a shrewd, experienced team. It’s a bunch of ex-Hecla Mining (NYSE:HL) guys.

TGR: Going back to Miranda Gold for a moment. It’s a micro cap; about a $22 million market cap. Is there an exit strategy for the company?

ST: I’ve known Miranda Gold President and CEO Ken Cunningham for a lot of years. It just seems like people are finding more and more gold closer to his neck of the woods in Nevada, where Miranda has a great land package. And I like to say that Ken has a good nose for gold—I think over the next few months the company’s going to find some. It’s a dynamic company, and it has some great JV partners. It’s shown the ability to get into new jurisdictions such as Colombia and Alaska. I have a lot of respect for Ken and his team. I think they know how to find gold.

TGR: Miranda shares have been strong over the past month—up about 15%. I presume this is about the initial drill results from the Red Hill Project.

ST: That could be a lot of it. That stock is down 30% or so since the first of the year. I just think it’s a bargain. It’s been way oversold. I think there’s good potential news coming out of Nevada; don’t forget the joint venture with Red Eagle on a number of Red Eagle’s Colombian projects.

TGR: You also like energy.

ST: Yes, I like Saratoga Resources Inc. (OTCQB:SROE). It’s a Louisiana-based oil and gas company active along the Gulf Coast. It was in Chapter 11 a couple of years ago and management just refinanced some long-term debt. It’s completed two equity rounds this year and we participated in both. It’s our understanding that The Blackstone Group LP (NYSE:BX) is a big participant in the most recent round. Management owns a substantial stake in the company and is highly incentivized.

As the company has emerged from Chapter 11, it’s been able to spend on the necessary capex to bring back online a lot of the existing production that suffered during the Chapter 11 process. We see the company’s production and revenue growing very sharply over the next few quarters. Now that refinancing is out of the way, I think that stock has a lot further to go.

TGR: Do you see this a distressed situation or as a turnaround story?

ST: It’s a little of both. It had been a distressed situation, and like a lot of companies that have found themselves in the last few years with good operations and good managements but weak balance sheets, it got caught in a bind. Often it’s just a case of needing to find the right type of investor to step up and lead that first equity round or to bring in a few partners and demonstrate some confidence in these companies and their management teams, and be willing to be the first person in the water. We felt we played a little bit of that role with Saratoga. We’re playing that role with Pan Pacific Bank. It’s the type of role we don’t shy away from, and we think we could really earn some outsized returns for investors willing to take that risk.

TGR: You mentioned Anfield Nickel a bit ago. The stock is flat over the past six months, but it’s up about 49% over the past year. Do you feel there’s a lot more to go there?

ST: I think there could be. The recent preliminary economic assessment on its Guatemalan nickel zone was very decent. But it also is only based on a portion of that deposit. We think the company may be positioning for either a full or partial sale. The presence of Lumina guys [Lumina CEO] David Strang and [Chairman and Founder of Pan American Silver Corp. (TSX:PAA)] Ross Beaty as significant shareholders in Anfield is a very positive sign.

TGR: What about a China play?

ST: In China, I think LianDi Clean Technology Inc. (OTC:LNDT) continues to show terrific results. I mentioned it in December. The stock has been overly beaten down here, and I think it’s a real bargain at these levels.

On the China space in general, a lot of the good U.S.-listed Chinese companies will not tolerate these extremely depressed valuations for long. I believe you’ll see them move to delist from the U.S. and relist in places like Singapore or Hong Kong in order to receive fair and higher valuations. I think that’s a move that a lot of investors may not fully appreciate. Certainly the shorts may not be fully thinking about that yet.

LianDi is trading for two times next year’s earnings here, but in a place like Singapore or Hong Kong, it could probably be valued at 8 or 10 times earnings very easily. If you’re a short, you might have a problem there.

TGR: This has all been very exciting, Steve. Thank you.

ST: Thank you very much.

Stephen Taylor is chairman and CEO of Taylor Asset Management, a Chicago-based investment management firm focusing on small-cap domestic equities and emerging markets. He also serves as a portfolio manager for the Taylor International Fund, Ltd., a small-cap equity fund. In addition to emerging markets, Stephen’s area of expertise includes private equity, restructuring and turnaround situations and both small- and mid-cap companies. He has considerable experience in the natural resources and finance industries in Canada and China.

The Energy Report: Your Encompass Fund has had some pretty spectacular returns over the past three years. How have you been able to do this and what are your selection criteria?
Marshall Berol: Malcolm Gissen and I started Encompass Fund five years ago. We’ve been very ably assisted by Craig Valdes and Kevin Puil. Our concept was to invest globally in any market cap size company, utilizing both a top-down and bottom-up approach. That results in us looking at sectors we find to be attractive going forward, and then selecting companies within that segment that could experience long-term capital appreciation, which is the objective of the Encompass Fund. We also look at individual companies regardless of industry, where we like the company’s fundamentals.

We have liked resource companies for the past decade. When we started Encompass Fund in 2006, we had already been invested on behalf of individual private client accounts in various sectors of the resources industries, including energy, primarily oil and gas. We have continued to be invested in those industries because they have had some excellent growth and we expect that to continue in the future. So, that’s what led to the Encompass Fund performing very well in the last several years.

The end of 2008 is very painful to recall, as I’m sure it is for all of your readers. But, in late 2008 and the beginning of 2009, we eliminated some companies in the portfolio that we didn’t feel were as strong as some of the others and added to the companies that we thought were particularly strong, but suffering from the general stock market problems. That led to a 137% gain for Encompass Fund in 2009 and a further 60% gain in 2010. For the trailing one-year and three-year periods, Encompass Fund ranks as the top International Mutual Fund, according to Morningstar.

TER: In reviewing your portfolio, nine of the 10 largest holdings are resource companies. Is that the approach you’ll likely be following in the future?

MB: At this point, the outlook is bright for resource companies, including precious and base metals as well as oil, natural gas, coal and uranium. At some point in the future, one or more of these sectors will be less attractive for investment opportunities and we’ll adjust accordingly.

TER: What is your current thinking on where the various energy areas are headed now, in light of the changes since our last interview here in May 2010?

Craig Valdes: We like natural gas as a commodity and as an energy supply. But, because of advanced technologies such as “fracking” and horizontal drilling, you’ve seen an abundance of supply. And so, we might not be as positive on the direction of the price, meaning that it’s probably going to stay in the $4 to $5 Mcf. (thousand cubic feet) range in the near-term. But, as an energy component, we strongly believe that over the longer-term our energy policies will lean more toward natural gas.

Oil has backed off from its recent highs, but the oil price is really a function of how well the global economy is doing. As long as we have an environment with even slow to expanded growth in emerging economies, there’s going to be a continued demand for energy. So, we like oil for the near and long term.

TER: Do you expect any sort of a stabilized price range for oil, or are we going to see big moves up and down?

CV: I think that has a lot to do with energy policy. It also has to do with global growth and the emerging growth economies. We believe that prices on the low end may trade somewhere in the $70-$80/barrel (bbl.) range and at the high end it could be as much as $100-$120/bbl. I think oil stays in a reasonable trading range over the near-term and the next couple of years. The only thing that could easily change that are the Saudis and the Middle East geopolitics, which could affect pricing and supply. We believe that pricing is not going to change that much over the next couple of years.

MB: Certainly, geopolitical issues will have a large bearing in the short-term. We take a nine- to 12-month view in any of these industries. Short-term you get a lot more volatility. For example, when it was announced they were going to release 60 Mbbl. of oil from strategic reserves around the world, including 30 Mbbl. from the U.S. strategic reserve, the WTI oil price went down about 10% from around $100-$90/bbl. Now it’s back up to near $100/bbl. So, in the short-term it had some affect. In the long term it doesn’t. Overall demand continues and overall supplies are basically tight. Some particular situations could lead to a larger decline or, more likely, a larger spike.

TER: Can you tell us about some oil and gas situations you particularly like at this time?

MB: One company that is a major holding in Encompass Fund and has been for some time, is a smaller low-priced stock, GeoPetro Resources Company (NYSE.A:GPR). GeoPetro has five different projects, any one of which could be a real company maker. We have participated in private placements with the company, as well as buying the stock in the open market. The company has an operating natural gas plant and some natural gas wells in Texas. It has a very interesting project in the San Joaquin Basin area in south-central California. It sold a couple of large land positions it held in Alaska to Linc Energy Ltd. (ASX: LNC; OTCQX: LNCGY) of Australia and retained an attractive royalty interest. It is also one-third partner in a project in Canada with PetroBakken Energy Ltd. (TSX:PBN). That is less likely to be acted upon in the near future, but it’s got some very good promise.

GeoPetro has a minority interest in a project in Indonesia with the majority interest held by Chinese companies. The Chinese are actively doing seismic work and plan on drilling later this year. Any one of those projects with drilling success could be extremely beneficial for the company’s stock. GeoPetro has contracted to sell some excess equipment this September that will bring in more than $9M. That would be used to increase production from the Madisonville, Texas, wells and improve the natural gas processing. Those improvements should take the company to at least a positive cash-flow situation, which would be very attractive also. It’s a low-priced stock and there aren’t hundreds of millions of shares outstanding, as you sometimes see.

TER: What else do you like?

CV: We’re very bullish on the San Joaquin Basin in south-central California. NiMin Energy Corp. (TSX:NNN) is in the San Joaquin Basin. There are some big players down there like Occidental Petroleum Corp. (NYSE:OXY) with its huge find in 2009. NiMin is just a stone’s-throw away from some of that production. It’s heavy oil and NiMin has an enhanced oil recovery process called CMD, (Combustion Miscible Drive) on which they have applied for a patent. The company creates steam using a kind of soapy oxygen and injects this into the well reservoir. That heats up the heavy oil and it comes to the surface at a faster rate. The first well they demonstrated this on was producing about 30 bpd (barrels per day) of oil. Now it’s up to about 250 bpd. NiMin has identified a number of heavy oil opportunities in old existing wells in the U.S., which they can pursue. The company has a nice land package in the San Joaquin Basin (Santa Margarita Reservoir) and it is going to drill two additional wells in the second half of this year. Secondly, it may joint venture this enhanced oil recovery process with some larger oil companies. We think that’s a great opportunity, which only enhances the company’s other primary exploration and production focus in Wyoming.

Another company we like that has a large land package in the San Joaquin area is called Zodiac Exploration Inc. (TSX.V:ZEX). It is actually targeting light oil in the Kings County region, and drilling very deep wells. It just started drilling a horizontal well and we look for some updates on that in the next few weeks. When the company finished its first vertical test well to 14,000 feet a few months ago, it found between 500 and 1,000 feet of actual pay in about four different zones. We think Zodiac has a great opportunity long term in the Southern California oil sector.

MB: One of the things we look at in junior companies is the management, because it’s extremely important that management has been in the industry for a number of years and has achieved past successes. That’s the case with Zodiac, NiMin and GeoPetro. These smaller companies will often seek out a larger joint venture industry partner or partners with technical expertise, knowledge and the ability to handle financials. Then the junior will have an ongoing interest in any of the production that comes out of that well and any succeeding wells.

TER: A lot of oil and gas exploration is going on in South America these days. We don’t hear that much about it, but there have been some big finds down there. Can you bring us up to date on what’s going on?

CV: Obviously the interest has been spurred by the big find by Petrobras in Brazil (NYSE:PBR) in the last year or two. There’s oil and gas all over South America but we’ve focused on companies in Colombia because of the way it is regulated, much like the way the U.S. and Canadian governments operate. So, many of your Canadian and U.S. operators have gone to Colombia. We presently own three oil and gas companies in Colombia. One is actually a mid-tier company, Gran Tierra Energy Inc. (NYSE:GTE; TSX:GTE). It’s a larger company with current production of approximately 18,000 barrels of oil equivalent per day. One of the smaller exploration companies in our portfolio is PetroDorado Energy Ltd. (TSX.V:PDQ). PetroDorado, has working interests in a number of different blocks in Columbia and Peru. It has a 30% working interest in one block called CPO-5 that it would like to increase, but its partners are reluctant to sell any additional interest based on the recent seismic work completed. The company is going to be drilling that later this year. We’re looking for excellent results from this exploration region.

Another company that we like in the area is a service company called Estrella International Energy Services (TSX.V:EEN) working in Colombia, Peru and Argentina. Management was working for Schlumberger Ltd. (NYSE:SLB) and left a few years ago and formed Estrella. It’s a full-service oil and gas service company consolidating a fragmented industry in South America. Obviously the exploration companies and producing companies are looking for teams that have expertise and these guys have a great reputation. We think there’s a great opportunity just on the service side for Estrella. The company has demonstrated over the last couple of years that it is able to bid and win good contracts with top-tier companies, including some of the large ones such as Pacific Rubiales Energy Corp. (TSX:PRE; BVC:PREC), Petrobras (NYSE:PBR) and Canacol Energy Ltd. (TSX:CNE). That’s another company that we like on a long-term basis.

MB: Colombia has come a long way in the past decade. There is a lot of growth there and a lot of industry. A number of mining projects and energy-consuming industries are located there. With increased stability in the region, there has been far more activity. We think it has led to some significant oil and gas discoveries and a bright future for some companies.

TER: Moving on to uranium; it’s seen some turbulence since Fukushima. What are your thoughts on that market?

MB: There has been a lot of turbulence. But, long term we’re very bullish on uranium and the companies that are exploring for and producing uranium. Approximately 440 nuclear energy plants operate today around the world. Maybe half a dozen will be taken out of operation in Japan and another half dozen in Germany in the near future. The overwhelming majority of the 440 plants are continuing to operate.

As many as 50 new nuclear energy plants are still being built around the world. South Korea, France, Slovakia and even the United States, have said they intend to continue on the road to increased nuclear energy. There will be increased safety precautions. New designs have been developed for reactors over the last several decades and put in place subsequent to the reactors that were built at Fukushima. Nuclear energy provides 15% to 20% of the world’s growing electricity needs.

While 180 million pounds (Mlb.) of uranium is currently being used around the world to fuel nuclear energy plants, only about 110 Mlb. to 120 Mlb. is currently being produced. The balances come from inventories above ground and from the deactivation of the Soviet Nuclear Arms Agreement. This agreement ends in 2013 and Russia has stated it does not intend to renew it. So, somewhere between 25 Mlb. and 30 Mlb./year will need to be replaced. We think it’s going to cause an increase in the price of uranium in the years to come. The companies that are either producing it or exploring for it and will be producing it are very attractive and we remain very bullish.

Solar and wind are fine, but it’s a minuscule output now and probably for many years to come. Geothermal and hydro are also fine, but they’re extremely limited in production and location. Other difficulties emerge with increasing electricity generation from oil or gas or coal. So, nuclear energy plants have a definite long-term positive outlook.

It’s strange, but in the investment business, people don’t want to buy things that are on sale. The uranium companies are currently on sale. We were in uranium companies prior to Fukushima. We have increased some of those holdings and added new ones. People should pay attention to the uranium industry and what’s actually going on in the nuclear energy industry, rather than merely drawing conclusions from headlines.

TER: Can you tell us about some of the ones you like that are in your portfolio?

MB: One of the top holdings for some time has been Uranium Energy Corp (NYSE.A:UEC). The company’s primary projects are in South Texas. It started production in November 2010 using in-situ recovery (ISR). It’s a far less costly and far more environmentally friendly method than either open pit mining or underground mining. Uranium Energy Corp also has other projects they are bringing into production in South Texas. The company recently made an acquisition of a very large land package in Paraguay. It also owns additional exploration properties in Arizona, Colorado, Utah and Wyoming. It just recently signed its first long-term contract to sell some production.

Another current producer we find attractive is an Australian company, Paladin Energy Ltd. (TSX:PDN; ASX:PDN) with projects in Australia, Malawi and Namibia. It also acquired a project in Labrador and Newfoundland that looks very attractive.

A company that is near production is Ur-Energy Inc. (NYSE.A:URG; TSX:URE), which has some advanced projects in Wyoming and should be in production within the next year.

Tournigan Energy Ltd. (TSX.V:TVC, FSE:TGP), which is in Slovakia, is an interesting situation. More than 50% of Slovakia’s energy is generated from the four nuclear energy reactors currently operating in that country. The country is currently building two additional reactors. Tournigan is in advanced stages of exploration and prefeasibility on its Kuriskova project in Slovakia, which will be able to provide uranium for all the European Union countries.

A company we think is attractive and is earlier stage, is Crosshair Exploration & Mining Corp. (TSX:CXX). It has uranium projects in Wyoming, Labrador and Newfoundland along with some other commodities. Currently, the major uranium producer in the world is Cameco Corp. (TSX:CCO; NYSE:CCJ). BHP Billiton Ltd. (NYSE:BHP; OTCPK:BHPLF) and Rio Tinto (NYSE:RIO; ASX:RIO) are major multi-metal and multi-commodity miners that are also involved in uranium production.

TER: Do you have any thoughts on coal?

MB: We think coal is also attractive. While it has some environmental and safety problems depending on where the coal is being mined, 50% of the electricity in the United States comes from coal. It’s a higher percentage in China. That’s not going to change dramatically for quite some time. We are invested in several coal companies, one of which is operating in Mongolia, 20 miles from the Chinese border. Every bit of coal that is being produced by SouthGobi Energy Resources Ltd. (TSX:SGQ) in Mongolia is being purchased and used in China. SouthGobi has been in production for several years and is increasing production every year. We think it’s a very attractive company and very attractively priced because the price is down, for whatever reasons.

A large quality coal company is Peabody Energy Corp. (NYSE:BTU). We have holdings in Forbes Coal (TSX:FMC), which is in production in South Africa, and in L&L Energy Inc. (NASDAQ:LLEN). L&L is a U.S. company that has acquired several coal mines and coal washing projects in China and is producing and selling coal in China. We think coal is a very attractive industry now and going forward.

TER: Do you follow the potash industry? What are your thoughts there?

MB: We do and we like it because the growth of the population and economies in the emerging markets means that more people have more money and can afford, and want, better food. There’s a tremendous ongoing need for potash and the other types of fertilizers.

Over the years we’ve been in and out of PotashCorp (TSX:POT; NYSE:POT). While we are not traders, sometimes the price of a company gets bid up and we believe it’s time to either sell some or all of a position depending on valuation. That has been the case with PotashCorp.

The Mosaic Company (NYSE:MOS) is another very attractive large fertilizer company. A smaller one that we have invested in is Verde Potash (TSX.V:NPK), which is developing a large potash project in Brazil. There is enough demand from Brazilian agricultural industries that the company will probably sell the majority of its production in Brazil.

Passport Potash Inc. (TSX.V:PPI, OTCQX:PPRTF) is an early stage company with a very large land package in Arizona that likely will be brought into production. Another smaller company is Western Potash Corp. (TSX.V:WPX), which is using the ISR process in Canada’s Athabasca region.

TER: Can you to summarize your overall view of where the energy industry is going?

MB: As should be apparent, we are positive on the energy industry and the various components of it. Oil, coal and uranium are very attractive and there are a number of companies in those industries that we believe will do well. The Encompass Fund is focused on the long term and not day-to-day trading. When you look at the long-term factors involved in supply and demand for the various segments of the energy industry, they are very positive. Natural gas is in a somewhat different situation, but as evidenced by BHP’s proposed $12.1B acquisition of Petrohawk, natural gas is also valuable.

TER: We greatly appreciate your time today.

MB: We appreciate it. We’ve enjoyed it. And, if your readers are interested in more information about the Encompass Fund, we would refer them to the website, www.encompassfund.com. The ticker is ENCPX.

CV: Thank you.

Marshall Berol has been involved since 1982 as an investment manager in San Francisco, CA. He and Malcolm Gissen co-founded and co-manage the Encompass Fund, a no-load mutual fund. Also since 2000, he has been the chief investment officer of Malcolm H. Gissen & Associates, Inc. Mr. Berol did his undergraduate work at the University of California (Berkeley) and received a JD degree from the University of San Francisco School of Law.

Craig Valdes has been an investment manager in the San Francisco Bay Area since 1982. Since 2006, he has been the director of research and trading at Malcolm H. Gissen & Associates Inc. He previously was a partner and portfolio manager at Genesis Capital Management and Hutchinson Richardson Investment Management in San Francisco, CA.

The Energy Report: You spoke to The Energy Report approximately three months ago. We’ve been experiencing some weakness in natural resources since then. How has your portfolio performed since that time?
Chen Lin: It’s doing relatively OK. It’s down slightly, but not much. In the past few months, I’ve been telling my subscribers to be careful, to raise some cash and to be prepared and to buy on a dip. In the past couple of weeks, I have started to deploy some capital into buying those cheap, undervalued stocks. So far I’ve been doing OK, down slightly, I would say a few percent.

TER: Have these buys on dips been additions to existing positions? Or are these new stocks?

CL: Some of these stocks were already in my portfolio and some are new positions. I also want to say that I have sold some at a profit, including some of the stocks mentioned in my last interview with The Energy Report.

TER: You’ve told me that you focus on resources because the entire sector is under-researched, and you can find undiscovered jewels. How do you find an orphan stock? Do you discover these companies at conferences, seminars? What is the process?

CL: I find some companies at conferences. Some are already known and they come here to have private meetings, at which time I’m able to talk to the management. Also, I receive recommendations from people I know and trust who have already done some screening. So I can take a look see if a company’s really good.

TER: Typically, people won’t be talking to you about companies that they might buy next week or the week after. They’re talking to you about companies they already own. You have to make a judgment at that point on whether or not you’re throwing good money after bad, or whether it’s truly a great growth or value opportunity. Don’t you?

CL: Yes, absolutely. I should also add that some companies actually have business relationships with some of my friends who may already own the stock. So, they have some personal incentive to promote the company. But that’s fine. I only look at the valuation. When they bring companies to my attention, I do the research, and elect not to buy most of them. Many stocks have been thrown to me, but I only pick a few that I believe are the best.

TER: There is so much risk involved in a company that is not under the microscope. So much can fly under the radar. How much diligence do you do? How long does it take before you enter a position in a company that you’ve never known before?

CL: Usually it takes some time. Sometimes it takes days. Sometimes it takes weeks. Sometimes it takes months and then years. If I find a company of interest, I’m going to look at the back history. When did it do a private placement? When does a share become a free trade (expiration of lockup period)? Is it a flow-through share, or is it a regular share? Who are the shareholders? I want to see when it might be most likely that people will be selling the stock.

So even if I like a particular stock now, I might put it on my calendar to look at it six months from now. Perhaps at that time those private placements will be finished selling shares, and it could be a better time to enter the stock. So to answer your question, it really depends.

TER: So you want to see how much selling there is after a lockup expires.

CL: Exactly. As I told my subscribers, one stock I was recently buying is a flow through, and it will expire. You buy a little bit, and then when it drops, you buy more. When the stock dropped 30% in a couple of weeks, we bought more. Now it’s up 30%. If you followed those steps, you could have 30% gains in a week or two.

TER: You probably find it to be a good sign if insider ownership is increased from quarter to quarter.

CL: Absolutely. We’re in a period in which some energy stocks were hit really hard. And when an insider buys from the open market, that’s a very good sign.

TER: Out of the entire resource sector, in which industries are you currently overweight, and in which are you underweight?

CL: I’m currently overweighting energy because usually summer is a very good season for energy stocks. There are going to be heat waves and rolling blackouts, and oil demand is very high.

TER: Do you currently prefer oil to gas?

CL: Oh yes, I’m heavily in favor of oil. I would not want to look at a company producing gas in North America unless it’s an extremely compelling situation. Gas is very, very cheap here in the United States. If you calculate the gas-to-oil equivalent, the gas price is $25–$30/bbl right now, while WTI oil is $100/bbl. So, basically, if you use gas to run your car, it’s about $1 per gallon gasoline equivalent.

The United States is the world’s largest oil consumer, and it should be a no-brainer to switch to natural gas. In fact, most of the natural gas here is produced in North America, while oil is produced around the world, and by a lot of countries that are enemies of the United States. Even in China, where the price of imported natural gas is very high, people are still switching from gasoline to natural gas.

It’s very easy to switch. You just need to convert your engine, and it’s a very simple conversion. But it takes government will to do that because you need to build natural gas fueling stations nationwide. Once those are built, people will enjoy $1 per gallon natural gas that is sourced in North America. I do not understand why the government is not going for that. Government is run by a lot of supposedly intelligent people. One day they will wake up and say we should use natural gas, and so I’m very bullish on natural gas for the long run.

TER: During the month of May, Brent crude tested $110/bbl on the downside three times. It looks like a perfect triple bottom, and now oil has bounced. Was that what we needed for oil to continue its bull market?

CL: Goldman said before that it was bearish on oil, and that pushed oil down. Now Goldman is bullish on oil, and it goes up. I think maybe we’re in a trading range for the near future. But my energy companies are making extremely good cash flows at the current price. I’d like the price to go lower.

Although I invest in energy companies, I wish oil would go down to $80–$90/bbl. My oil companies are low-cost producers, and they can still make a lot of money at $80–$90/bbl. They don’t really need $110/bbl to make extra profits. So I actually hope energy prices will come down further, but I’m not counting on that. As for the technical side, $110/bbl seems to be the support level.

TER: What companies are you favoring right now?

CL: My current biggest position is Mart Resources Inc. (TSX.V:MMT). It’s a light sweet oil producer in Nigeria. The company has been ramping up production very nicely; current production is probably three times last year’s rate, and going higher. Well drilling continues, and production just keeps growing. The stock is trading at 1X pretax cash flow right now, and if production continues to progress, it will be trading below 1X cash flow. We know that most of the energy companies are trading at least 3–5X cash flow. Because it’s a Nigerian company, you have to give it a little discount, but it’s still extremely undervalued.

TER: You say it’s undervalued, but its share price performance has been stronger than most of its peers over the last year.

CL: Yes. I think that’s partly because it has such a strong cash flow supporting its stock. This company is generating $15–$20 million per month in pretax cash flow right now, and the market cap is only $200M; that’s a really compelling valuation, and I believe the stock will go much higher. [Editor's note: After the interview, Mart Resources published a new presentation stating that they were generating $13.5 million in monthly after-tax cash flow and around $20 million pretax.]

TER: I’m noting that Mart’s share of the Umusadege oil field play during Q410 produced 104,000 bbl of oil, compared to 317,000 bbl of oil in Q409. What happened there?

CL: There was a problem with a pipeline. What I heard was that the pipeline owner fired the security staff, and then there was some trouble and a significant pipeline disruption in Q410. But right now, everything has quieted down, and there has been almost no disruption since the beginning of the year.

TER: I also noted that the company announced that the total gross proved reserves in that field increased 56% year over year, to 9.6 MMbbl of oil on December 31, 2010, compared to 6.1 MMbbl at the previous year-end. Is that where you’re hanging your theory?

CL: Yes, but I think that’s just part of the picture. As the company continues to drill and develop, I believe that the net present value will continue to increase. So far, every well drilled has been a success. So the number will be much higher by the end of this year.

TER: You’re still very high on Mart Resources even though it’s up 153% over the past year, right?

CL: Yes, that’s correct.

TER: OK.

CL: Another company is Porto Energy Corp. (TSX.V:PEC). It’s a new addition to my newsletter. It owns almost 100% of a big land package in Portugal, but the area has not had any modern exploration yet, and so it’s a virgin play. There are top-notch people on board from Devon Energy Corp. (NYSE:DVN), including Joe Ash, who ran the Devon International division, and that was a $10 billion business. He left to run the Porto Energy startup, and it already has a natural gas discovery.

I want to add that the natural gas price in Europe is much higher than in the United States. Porto has a natural gas discovery with a much higher value than the current stock price; also, there are going to be some very exciting oil wells drilled. You can look at Porto’s recent presentation to see how big it’s aiming. This is an elephant, and so the upside is very big.

TER: Chen, I noted that Porto raised $70 million with its IPO back on March 28th. Did you buy in at the IPO, or after the IPO?

CL: Oh, I didn’t participate in the IPO. I already participated in the placement earlier, about two years ago. But I bought from the open market recently, when the price dropped below the IPO.

TER: You said it was a virgin play. Will that $70 million take it to production?

CL: It will take the gas into production. My understanding is that Porto will start producing the gas already discovered in the first half of next year. The good thing about these small companies is that if they drill a well, and it’s successful, they can start pumping oil and then truck it out. There are two refineries in Portugal, and both are importing oil. So I think they’ll probably be more than happy to replace that with domestic oil, and as soon as the oil flow starts, cash flow will start.

TER: Will the gas production fund operations for oil?

CL: The $70 million will fund the drilling campaign this year and next; next year, the plan is to start selling gas. Joe Ash told me that if oil is found, it’s very unlikely that Porto will be an independent company a year from now.

TER: You have been watching insider ownership.

CL: Yes. There are three insider purchase companies I’ve been watching. One is Groundstar Resources Ltd. (TSX.V:GSA); I mentioned it last time I spoke with you. There has been insider buying, and recently the stock started to rebound. There’s one play in Kurdistan, one in South America and one in Egypt. The good thing is that Groundstar is not paying for the drilling, except in Kurdistan. All the others are currently in production.

There are two other companies. One is Harvest Natural Resources Inc. (NYSE:HNR). It’s pretty significant that one company vice-president spent a half million dollars to buy on the open market. This company has properties in Indonesia, in Africa (offshore) and in Venezuela. There’s an African well being drilled right now, in Gabon. I didn’t mention the company last time because it had a little too much debt on its balance sheet. But since then, it has sold its U.S. property for $4–$5/share cash, and the company today has a very clean balance sheet.

After paying down debt and all the other improvements, HNR probably has $3 or $4/share in cash, and this is a $12 stock. The Venezuela property is fully funded and paying dividends, and there is no need for funding. So it’s a very good value proposition, and the company is for sale. Management wants to maximize shareholder value. Then you can see the VP put a lot of money into this.

TER: OK, you said there was another insider play?

CL: Yes, another one with a pretty large insider purchase is actually a coal company called Prophecy Resource Corp. (TSX.V:PCY). The CEO has been buying the stock with significant amounts of money recently. Also, other members of management have been buying over the longer term. This company is starting two coal mines in Mongolia. One is already started, and one is in the process of getting the final permit. As we’ve seen, the price of coal has been rising dramatically. This summer, China is going to be experiencing the worst rolling blackouts in history. So I think there will be a lot of demand from China for its major power source: coal. The future looks very bright for coal. The insider purchases make Prophecy Resource look really good.

TER: Your three insider plays, Groundstar, Harvest Natural Resource and Prophecy, are very interesting stories. What else did you want to mention?

CL: Last time, I mentioned a few stocks I’m still holding: Vaalco Energy Inc. (NYSE:EGY), Pan Orient Energy Corp. (TSX.V:POE) and Vast Exploration Inc. (TSX.V:VST). VAALCO and Pan Orient both have some very significant drilling results coming in the next 6 to 12 months.

TER: You’ve sold your Leader Energy Services Ltd. (TSX.V:LEA), correct?

CL: That’s correct, yes. Leader Energy went up a lot, and I had a pretty good profit so I decided to take the profit on that. I was pretty lucky because I sold it when it was quite high—much higher than the current price.

TER: Leader is up 300% over the past 52 weeks.

CL: I just wanted to say QE2 (Quantitative Easing 2) is finishing at the end of June. The market could be volatile this summer, so it’s always nice to have some dry powder. That’s pretty much my message right now.

TER: Thank you, Chen.

CL: Thank you—likewise.

Chen Lin writes the popular stock newsletter What Is Chen Buying? What Is Chen Selling?, published and distributed by Taylor Hard Money Advisors, Inc., publisher of J. Taylor’s Gold, Energy & Technology Stocks newsletter and Roger Wiegand’s Trader Tracks. Using his wife’s Roth IRA account, Lin invested $5,411 in December 2002, and by December 31, 2010 it was worth $1,188,993—with no cash added. You can see his portfolio chart here.

Finding companies with growth potential is just the start for Windermere Capital, according to Managing Director Brian Ostroff. An active philosophy and deep technical expertise allow the firm to invest “anywhere along the spectrum” from exploration to production, all the way to operation. In this exclusive interview with The Gold Report, Brian delves into the gold-silver value proposition and names a couple of promising players in the Abitibi.

The Gold Report: Brian, let’s start with you telling us about Windermere Capital.

Brian Ostroff: Windermere is an investment manager. We currently oversee two hedge funds with a natural resource focus. The Breakaway Strategic Resource Fund and the Navigator Fund are both offshore hedge funds based in the Cayman Islands. They serve high net-worth individuals, family offices and institutional investors.

TGR: Do they have an open-ended structure or are investors committed to a cut-off investment?

BO: Both are open-ended. Navigator is a monthly. Breakaway is a quarterly.

TGR: So they’re corporations. Do they trade on an exchange?

BO: Yes, both funds trade on the Irish Stock Exchange, and they are quoted there. Subscriptions are done directly with the fund.

TGR: What is Windermere Capital’s investment philosophy?

BO: In terms of the basic investment theory behind both of our funds, we feel that we are quite different than most of the other funds in our space. For starters, we have strong technical expertise. Most of the people here have technical backgrounds as opposed to a financial or capital markets background.

We have two partners in our fund. One is a group called Ocean Partners, which is made up of the former ores and concentrate trading team at Pechiney. When Alcan bought Pechiney, these guys did a management buyout. They do business in roughly 35 countries and have a physical presence in 15. They are geologists, mining engineers and metallurgists, and their global footprint allows us to send someone to an opportunity quickly. Our other partner is Peter Hawley and his group. These guys have all been in the business for +30 years building and operating mines. Once again, this is an area where we think we have an advantage. We can look at various assets, not only as financial guys, but also with a deep understanding of the geology and the likelihood of it going into production.

The other area where we think differently from other funds is that a lot of funds do their due diligence and write their checks, make their investment. We find that our work really begins after we’ve written the check. We’re not activist investors, but we’re definitely active. We tend to take fair-sized stakes in companies, and then we try to help it going forward by making additions to its board, perhaps helping it operationally, assessing its assets and either helping the company divest or find other assets.

TGR: Active versus activist implies that you do everything but management—seed, assistance, banking, financing.

BO: We certainly assist in all those roles. We do not take board seats. What we do is find people in the industry with whom we have a relationship, people we think can help advance the company. With regards to our investment theory, we are extremely value oriented. Primarily, we invest in the micro- through mid-cap stages; but our alpha really comes from the micro-cap stuff. We tend to look at a company, assemble a peer group and try to understand why the company we’re looking at is considerably cheaper than its peer group. Once we understand that, we gather around the table with our partners to have an honest discussion as to what the issue may be and what we can do to fix it. Once we get to the point that we think we can help close that gap with the target’s peer group, we have a discussion with management to see that we’re all on the same page.

Once again, we are active—not activist. We have a meeting of the minds and when everyone is comfortable with the business plan, we tend to make our investment. Of course, that’s only in situations where we have large stakes. We use the mid-cap companies to move our positions around and get exposure to various metal groups. In the micro-cap space, we tend to take a position anywhere between 10% and 19.9%.

TGR: Micro cap is what, US$10–$75 million?

BO: Yes, actually, US$10–US$100M. If we’ve done a good job with that micro cap, hopefully, it really starts to grow from there.

TGR: The idea is to get it over US$100 million in market cap, so mutual funds can buy it?

BO: Yes.

TGR: Would you tell us about the differences between your two funds?

BO: The Breakaway Strategic Resource Fund is mining only. Due to the technical expertise to which I had alluded, it can make investments anywhere along the spectrum. The fund was first conceived in the dark days, just coming out of the global crisis. We felt there were a lot of good assets that were orphaned or had been lost and financial players had taken them over. We were looking to buy distressed assets, even outright buying the properties or mines. We do structured debt through our partners and offtake deals all the way through outright investment in the company’s equity. I like to describe Breakaway as a complete “rocks to stocks” Investment vehicle.

TGR: And what about Navigator?

BO: Navigator is all natural resources. Aside from mining, it also does energy and agriculture, paper and forest, etc. Its investments are primarily in publicly traded equities; however, we do have some room for near-public investments (i.e., those that we think can go public within about six months).

TGR: Does Breakaway Strategic also buy equity in private companies?

BO: Yes, Breakaway looks anywhere along the spectrum, and it’ll outright buy a mine if the opportunity presents itself.

TGR: So, does Breakaway Strategic own precious metals?

BO: Yes. Both funds have a fair-sized stake in some precious metals companies.

TGR: Where do you stand on precious metals? Are you bullish on gold, silver, platinum, palladium, whatever?

BO: Yes. I believe that we continue to be in a secular uptrend that will lead us significantly higher, but there will always be bumps along the way.

TGR: Why are you bullish on precious metals?

BO: I’ve always believed that gold is a currency. Ultimately, investors have a choice—put their money in dollars, yen, euros or pounds, as they choose or in gold. The one difference is that gold, unlike paper currencies, has to be found and mined. Last year, gold production was up about 3%. That compares with all the central banks around the world that are just printing money.

Now, I don’t put myself in the camp of being an absolute doomsayer, in terms of the fiat currencies or the U.S. dollar. What it really comes down to is—if the Americans print 20% more dollars, the Europeans print 20% more euros and the British print 20% more pounds, you can’t all of a sudden come up with 20% more gold. The relative valuation continues to favor gold.

TGR: What about silver?

BO: We love silver. It has definitely come into the forefront and has been a much better performer. Like many people who like silver, the physical market characteristics are very positive. Ultimately, we view silver as gold on steroids. When you’re in these uptrends and everyone’s looking at precious metals, silver tends to perform much better. We think that, as the whole precious metals bull market proliferates and more average investors start to look at it, silver at US$35–$40/oz. might be more appealing than gold at US$1,400–$1,500/oz.

As bullish as we are on precious metals, we’re even more bullish on precious metal stocks. We believe they are very cheap. If one was to go back 20 or 30 years on the XAU (the Philadelphia Gold and Silver Index) and do a relative valuation to the price of gold, one would see that it is still trading under the band at which it typically trades; so, we think there’s value there. Additionally, if one was to take a look at the TSX Venture Index as a benchmark (obviously, not all the stocks on the TSX Venture are just mining but it has a high percentage of them), that index is still considerably lower than where it was in May 2007.

TGR: Let’s stay with the XAU. You say it is trading at a discount to its traditional band. Could you tell me, to what is it trading at a discount?

BO: To physical gold. In other words, if you were to look at the valuations of gold stocks to physical gold, you would see that, historically, gold stocks are still trading well under their norm given where gold prices are. Of course, that can correct in one of two ways: Either the gold stocks relative to gold can appreciate or gold relative to the gold stocks can depreciate. Because we are still in a secular uptrend in precious metals, our feeling is that the stocks, ultimately, will catch up to the metal, as opposed to the metal catching up to the stocks.

TGR: So, you believe that the risk is greater to the upside than it is to the downside?

BO: Correct.

TGR: You mentioned that there was more value in silver due to the psychological perception of silver’s price per ounce versus that of gold. Does that imply greater volatility?

BO: It does; and in terms of value, I’m quick to say that value is a relative thing. So, is there value in silver? I’m not sure. Our feeling is that silver offers a better opportunity relative to gold—but make no mistake about it, silver is a lot more volatile. If we get a downturn in precious metals, silver will fall harder than gold.

TGR: Sticking to that value theme, could you say more about silver stocks offering value relative to the actual metal?

BO: There are very few producing silver names, and this is particularly valid for people who are looking for leverage in silver and don’t want to go into the bigger names, like Pan American Silver Corp. (TSX:PAA; NASDAQ:PAAS) or Silver Wheaton Corp. (TSX:SLW; NYSE:SLW). If their interest is in something a little more speculative, there aren’t many names that are already in production in the 2–5 million-ounce (Moz.) range. As more and more money comes into the sector with fewer names to invest in, those stocks should continue to get a disproportionate lift.

TGR: In effect, fewer opportunities mean greater demand?

BO: Exactly.

TGR: To recap, you see gold and silver as a store of value. If you can’t print more gold, you have to find it. And if you do, it just adds value to the entire gold supply. If I’m not putting words in your mouth, isn’t this a currency devaluation play?

BO: Yes, that is the basis of our theme for investing in precious metals.

TGR: So, where do you find value?

BO: We think there are opportunities in niche stories—a company out there that the market hasn’t paid much attention to or, perhaps, a commodity that hasn’t received much attention. Those opportunities still exist and will always exist; they just get that much more difficult to find as a market matures.

TGR: Can you give me some specific places that an investor might look?

BO: Adventure Gold Inc. (TXS.V:AGE) is one of our large portfolio holdings. It’s a company led by a wonderful management team; Marco Gagnon is the CEO. His whole team comes from larger firms. In its three-year existence, the company has assembled a large portfolio of properties in the Abitibi. Its general philosophy is that the best place to find gold is right beside other gold mines that either are operating or will be in production soon. Adventure has accumulated close to 20 properties, which is quite a handful for a small company. But, it’s done a very good job of prioritizing.

It has what we would consider four flagship properties. The first one is the Meunier 144 property, which is in West Timmins. When Lake Shore Gold Corp. (TSX:LSG) bought over in West Timmins, it encircled Adventure’s property. As a result, Adventure made a deal that allowed Lake Shore Gold and RT Minerals Corp. (CNSX:RTM) to earn a stake in Adventure’s property by spending US$3 million in drilling. Adventure’s property is right beside Lake Shore’s Timmins and Thunder Creek zones, which are going into production. The theory is that the down-dip extension of those two deposits enters into Adventure Gold’s property, and it is currently being drilled to test that theory.

Adventure also joint ventured (JV’d) its Dubuisson property, which is right beside Agnico-Eagle Mines Ltd. (TSX:AEM; NYSE:AEM) Goldex Mine. A couple months ago Agnico, picked up 51% of Dubuisson through payments and drilling commitments. Agnico will continue to drill the property out, starting within the next month or so. What interests us about Adventure is that it’s almost a hybrid model. The company will option off some of its properties and keep others to work on itself.

Adventure recently put out drill results from its third flagship property, Pascalis-Colombière. This is the area surrounding and including the old L.C. Béliveau Mine, owned by Cambior. Cambior had mined it up until the early 1990s and, over a four-year period, it produced close to 170,000 ounces (Koz.) of gold. With gold prices coming down back then, Cambior closed the mine. Subsequently, IAMGOLD Corporation (TSX:IMG; NYSE:IAG) bought Cambior and viewed Pascalis as a non-core asset. Adventure picked up the property and has come out with very encouraging drill results. It’s important to note that production at that historic mine had been done only down to the 300-meter level, which, in Val-d’Or, is not very deep. But the company believes there’s still a lot of gold to be found beneath the existing and to the west of the mine.

The fourth flagship property that Adventure is working is the Granada Extension, which is next to Gold Bullion Development Corp. (TSX.V:GBB) Granada Property. Adventure picked this property up toward the end of 2010 and has received some encouraging sampling results. The belief is that the Granada Extension is similar to Osisko Mining Corp. (TSX:OSK) Malartic property. You’re looking at a large tonnage, low-grade type deposit. Gold Bullion has drilled aggressively and put out a non-compliant NI 43-101 block model, showing 2.5 Moz. in a relatively small area.

Adventure’s other properties also are in historic areas: Detour East, which is east of Detour Gold Corp. (TSX:DGC) property and Casa-Berardi, near the operating Aurizon Mines Ltd. (TSX:ARZ; NYSE.A:AZK) space.

These properties, coupled with the fact that the company has close to US$4M in cash and cash equivalents sets Adventure up very well. It has a lot of opportunities. With four properties now being worked, we think Adventure will generate a lot of news flow. We’re quite optimistic that, with a US$35M market cap, the market has not really given this company the attention it is due.

TGR: Could Lake Shore and Agnico, the two JVs Adventure is working with, act as something of a poison pill in hindering a takeout of Adventure?

BO: Our feeling would be that, if there were any interest in the company, it would probably be property by property. It is unlikely that one company would come in and take all those assets. Case in point, if drilling proves out the down-dip extension from Lake Shore’s property, Lake Shore might be interested in the Meunier property. If Agnico’s drilling proves out that there is more gold beside its Goldex mine, we would see Agnico having an interest in that property. Adventure’s assets are spread out within the Abitibi region, so we would see logical buyers on a property-by-property basis as opposed to an outright acquisition of the company itself. Particularly on its four flagship properties, we feel that any one of those could be a company-maker.

TGR: That is a great story, Brian. Do you have another one?

BO: Our funds are fair-sized holders of a company called Cartier Resources Inc. (TSX.V:ECR), which is a gold resource exploration company in the Abitibi. It is earlier stage than Adventure, in that its properties are more grassroots. There is some historic drilling, but we think the opportunity is more a combination of being in the right location and having an excellent management team that can move these properties along. Cartier owns a significant land position along the Cadillac Fault, an area that has seen significant interest by companies like Osisko and Aurizon. It also has assembled other very interesting properties within that area and has embarked on an aggressive drill campaign that we think should start to prove out some potential.

TGR: Brian, thank you for your time.

Brian Ostroff joined Windermere Capital, Inc. in 2009 and is a managing director. His area of focus is the junior and mid-tier mining sector. His previous experience includes a stint as a proprietary trader at a major Canadian bank and four years trading on his own. He also worked at the M&A advisory firm Goodrich Capital, where he was the Canadian managing partner overseeing mandates across a spectrum of industries with a focus on display technologies and mining. He worked at RBC Dominion Securities, where his focus was on smaller-cap special situations and alternative investments. Brian is a graduate of the University of Toronto. He can be reached at bostroff@windermerecapital.com, 514-908-4202.

There’s more to fertilizer than potash, according to Windermere Capital Managing Director Brian Ostroff. He touts the value to be found in phosphate and offers his take on how the unrest in Africa, environmental concerns, global food prices and basic geology drive the phosphate market in this exclusive interview with The Energy Report.

The Energy Report: Brian, please start by sharing Windermere Capital’s investment philosophy.

Brian Ostroff: Windermere is an investment manager. We currently oversee two hedge funds with a natural resource focus. The Breakaway Strategic Resource Fund and the Navigator Fund are both offshore hedge funds based in the Cayman Islands. They are open-ended funds designed for high net-worth individuals and institutional investors. They are quoted on the Irish Stock Exchange, but subscriptions are done directly with the fund. Most of the people here have technical backgrounds as opposed to a financial or capital markets background. We have two partners in our fund—Ocean Partners, which is made up of the former ores and concentrate trading team at Pechiney and Peter Hawley and his group. These guys have all been in the business for +30 years, building and operating mines.

The other area where we think differently from other funds is that we are active investors. We tend to take fair-sized stakes in the companies in which we get involved. Then, we try to help the company going forward by making additions on its board, perhaps helping it operationally, assessing its assets and either helping the company divest or find other assets.

Finally, we are extremely value oriented. We tend to look at a company and assemble a peer group. We try to understand why a given company is trading considerably cheaper than similar operations, and then we identify the issues and how we could close the gap. After that, we have a discussion with management to see that we’re all on the same page. Once again, we are active—not activist. We have a meeting of the minds and when everyone is comfortable with the business plan, we tend to make our investment.

TER: Would you tell us about the differences in your two funds?

BO: The Breakaway Strategic Resource is mining only. Due to the technical expertise to which I alluded, the fund can make investments anywhere along the spectrum. Originally, we looked to buy distressed assets, even outright buying the properties or the mines. We do structured debt through our partners and offtake deals all the way through outright investment in the company’s equity. I like to describe Breakaway as a complete “rocks to stocks” investor.

TER: And what about Navigator?

BO: Navigator is all natural resources. Aside from mining, it also does energy and agriculture, paper and forest, etc. Its investments are primarily in publicly traded equities; however, we do have some room for near-public investments (i.e., those that we think can go public within about six months).

TER: Aside from precious metals, does the Breakaway Fund invest in other mining operations?

BO: We tend to have a place in our portfolios for niche commodities, or what I call the funky metals. That would be strategic metals, not necessarily rare earth elements (REEs) but things like graphite or vanadium.

We’ve become fairly involved in phosphate, which is a necessary component of fertilizer. Currently, potash is on the minds of most agricultural investors as the area has done very well. I think we may be going into a time when people will start to look at phosphate. There are a couple of important things to understand in the world of phosphate. First, there are two types of phosphate deposits. Most—probably 90%—are sedimentary; the rest are igneous.

Most of the world’s production comes from the sedimentary deposits. But they tend to have a lot of nasty contaminants in them. And due to the mineralogy of the sedimentary deposits, the concentrate that comes out is not as high as the concentrate that you can get out of igneous deposits. That can be a confusing factor for people who are not that familiar with the industry and the types of deposits. People will look at a 25% sedimentary phosphate deposit, and then look at an 8% igneous phosphate deposit and come to the erroneous conclusion that the 25% deposit is better than the 8%.

TER: But you would make a better margin on the igneous because you don’t have to purify out all the cadmium and uranium and such, right?

BO: Right. A sedimentary deposit might start at a 25% grade, but when you beneficiate it, you’re not going to get much higher than the low- to mid-30% range. Whereas, because of the mineralogy, you can beneficiate an 8% igneous deposit as high as 40% grade. What you really have to look at isn’t your starting grade, but rather what the concentrate will be and, ultimately, the price you will be able to get for the product.

The other interesting thing about the world of phosphate is that, right now, China is the largest producer, but it doesn’t export. The biggest player in the world of phosphate export is Morocco. Morocco comprises roughly 35% of the entire phosphate export market, which really makes the country the swing factor. Other players in the space include Jordan, Tunisia and Egypt. Given the turmoil in North Africa, that could present a big problem to the world.

Right now, North America runs a deficit in phosphate. We have to import it now and will continue doing so for the foreseeable future. Canada, while rich in potash, only has one operating phosphate mine—and that mine will probably deplete within the next two to three years. The other big phosphate areas in North America are Idaho and Florida. Both of these are sedimentary-type deposits, which brings environmental issues into play. In Florida, environmental problems have brought shutdown threats. One Florida mine operated by The Mosaic Company (NYSE:MOS) was shut down. It currently has a stay of execution, pending appeal. But, if that were to close, it would only exacerbate the deficit that North America runs.

In terms of pricing, phosphate is very different from things like gold and copper, which have a global price. Gold is gold and it’s at or above US$1,450/oz. everywhere in the world.

TER: You can’t arbitrage gold.

BO: Correct. Gold coming out of Chile, Australia, South America or Canada will get the same price in the open market; whereas, phosphate is a negotiated market. Contracts and things like location, transportation and quality of the concentrate are going to be the driving forces. That means pricing on all phosphate is not the same. The closest thing that we have to a benchmark is Moroccan FOB (freight on board), and that’s roughly US$150–$160 per ton.

At the end of the day, it all comes down to what’s the investment opportunity in phosphate? Our current view is that the world is quite aware of potash; potash stories have done extremely well and are actually quite numerous. Now, people are waking up to phosphate—and there are nowhere near as many opportunities in phosphate as there are in potash.

As investors start to understand the importance and the dynamics of phosphate, there will be increased investor demand. With considerably fewer situations to look at relative to potash, even a small shift out of potash into phosphate will have a pretty significant effect. I anticipate the sector, as a whole, will perform quite well.

TER: It also serves as a nifty hedge against falling dominos in North Africa.

BO: Absolutely. Supply security has become an increasingly important investment theme. Certainly, in the case of phosphate, it would be very important.

TER: Where does an investor take advantage of this opportunity?

BO: There are several names in the phosphate sector. Our fund is a large investor in a company called Ressources d’Arianne (TSX.V:DAN; OTCBB:DRRSF; Fkft:JE9N), more commonly referred to as Arianne Resources Inc. The company is based in Québec, so that addresses the security of supply. And it has easy access to the deprived North American markets.

As North American phosphoric acid producers for fertilizer start to look for more phosphate deposits in North America, Arianne will be very well situated. It’s close to infrastructure; an overload road that currently carries timber runs right through its property. It is within easy trucking distance of both a deep-sea port and the railway.

Arianne has an igneous deposit that yields a very pure concentrate, near 40% grade. The company already has a scoping study and it’s drilling to expand that resource. Arianne should have its prefeasibility report out sometime this summer and the original scoping study shows very healthy economics on this project. Actually, we find it is more advanced than most of the phosphate stories out there. It currently trades with just a US$60M market cap. This goes back to the question of where Windermere finds value. Relative to its peer group, Arianne is definitely at the bottom end with what we consider a superior asset.

TER: How long have you owned it?

BO: We’ve owned it for a little less than four months.

TER: Arianne’s stock is up almost five times over the past six months. Any stock would be due for a pullback after that. Yet, you still see this as a value play?

BO: Absolutely. For us, value is a relative matter. So, although the stock has performed very well and is up about fivefold over the last few months, it also has pulled back about 40% from its highs. Arianne has a US$60M market cap. The closest peer would be somewhere around a US$130M market cap, ranging all the way up to about a US$300M market cap.

TER: Arianne Resources produces many different metals in addition to its phosphate division, but you’re saying that phosphate is the mover, the catalyst for this company.

BO: Yes, Arianne owns exploration assets in other commodities but its main focus is the phosphate deposit. That is where the company is focusing 100% of its energy.

TER: In the first half of February, we saw some really unusual activity in Arianne’s shares; in fact, it was so pronounced that the company put out a press release saying it had no knowledge of any material change. Was this a manifestation of home gamers, day traders, do you think?

BO: No, I think what happened was that, when the agricultural cycle started to heat up again as a whole, people started to take a look at Arianne in light of our investment. They came to the same determination that we had, which was, relatively speaking, this company looks really, really cheap. As the stock started to appreciate, it gained momentum. More people saw the name and took the time to understand the situation. That continued to drive it.

TER: There was a lot of press at the end of 2010 and continuing into 2011 about the rising cost of food all over the world. I know that had an effect on fertilizer stocks—both phosphate and potash—but there was also anticipation of Lac à Paul deposit results. Do you think that could have been part of it, as well?

BO: Certainly, Arianne put out some results. Those numbers will be reincorporated into its resources numbers associated with the prefeasibility study. Previous drilling in that zone had been done only to 200 meters. The drilling that came out in February was down to the 400-meter level and showed the continuity of the deposit.

TER: Does Arianne own any of its own supply or processing chain?

BO: No, the company is in exploration mode. I think the prefeasibility study will start to determine what needs to be done to put this thing into production.

TER: And therein lies the value.

BO: Yes.

TER: Do you have another name for us in the phosphate sector?

BO: Yes. Going a little further down the chain, we are currently in the process of making an investment in a company called Glen Eagle Resources Inc. (TSX.V:GER), which is very, very early stage. Drilling on its property isn’t set to commence until sometime this summer. The company picked up a property, Lac Lisette, which is 40 kilometers away from Arianne’s property, attached by the same main road. Preliminary results from some grab samples seem to indicate a similar type of deposit; but, of course, until the drilling is done, it is a bit of a question mark.

TER: Obviously, you saw something in it that you liked. In fact, your investment philosophy is to be early.

BO: Glen Eagle’s proximity to Arianne, the fact that it is an igneous deposit in the same general macro-phosphate and proximity to infrastructure are advantages. And given the North American deficit in phosphate, we think there would be room for a couple of quality assets in that area.

TER: Those are a couple of good phosphate stories, Brian. Thanks for your time.

Brian Ostroff joined Windermere Capital, Inc. in 2009 and is a managing director. His area of focus is the junior and mid-tier mining sector. His previous experience includes a stint as a proprietary trader at a major Canadian bank and four years trading on his own. He also worked at the M&A advisory firm Goodrich Capital, where he was the Canadian managing partner overseeing mandates across a spectrum of industries with a focus on display technologies and mining. He worked at RBC Dominion Securities, where his focus was on smaller-cap special situations and alternative investments. Brian is a graduate of the University of Toronto. He can be reached at bostroff@windermerecapital.com, 514-908-4202.

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Cartoon by Nicholson from “The Australian” newspaper: http://www.nicholsoncartoons.com.au/

Anyone interested in a summary of Wright’s book will not find it too difficult to find one elsewhere. What I want to do here is to attempt to identify what makes Wright so pessimistic about the future of civilization.

An obvious starting point is his view of human nature. Wright doesn’t believe in the innate goodness of humanity. He suggests that ‘prehistory, like history tells us that we are at best the heirs of many ruthless victories and at worst the heirs of genocide. We may well be descended from humans who repeatedly exterminated rival humans – culminating in the suspicious death of our Neanderthal cousins some 30,000 years ago’ (p. 31). Furthermore, an inability to foresee – or to watch out for – long range consequences of our actions may be inherent in our kind (p. 108). We are doomed by hope. Hope drives us to invent new fixes for old messes, which in turn create ever more dangerous messes (p. 123). Homo sapiens is still ‘an Ice Age hunter only half-evolved towards intelligence; clever but seldom wise’ (p. 132).

Wright acknowledges that humans have been influenced by culture. In fact, he suggests that culture is a key to our success: we are ‘experimental creatures of our own making’. Yet culture also poses risks to us: ‘As cultures grow more elaborate, and technologies more powerful, they themselves may become ponderous specializations – vulnerable and, in extreme cases, deadly’ (p. 30). He describes this as a ‘progress trap’. The wreckage of past civilizations litters the earth because their populations grow until they hit the bounds of food supply, while the concentration of wealth and power at the top of large scale societies gives the elite a vested interest in the status quo.

According to Wright’s view, all large-scale societies are locked into some kind of path dependency – leading them to outrun natural limits and collapse. How then does he explain the success of modern civilization despite all the failures that have occurred in the past? His explanation seems to be that nature has been forgiving. When societies failed there was natural regeneration and human migration to lightly settled areas. Civilization has been exceptionally long-lived in Egypt and China as a result of ‘generous ecologies’ – extra topsoil brought in from elsewhere by water and wind.

I think Wright’s pessimism stems from his views on both human nature and culture. His model doesn’t seem to recognize that humans have biological instincts that encourage cooperation and that this enables rules of conduct to evolve to meet changing circumstances. His model fails to take account of cultural evolution. Our ancestors may have helped destroy mega-fauna through their hunting practices, but hunting and gathering rules evolved in the more successful societies to avoid wanton destruction of valuable resources. Further rules followed including those relating to ownership of animals, grazing rights, land ownership etc. – all serving to encourage more efficient use of scarce resources.

Whether societies collapse or survive and prosper depends largely on the rules they live by. People in advanced western societies live by rules that have evolved to encourage mutually beneficial exchange, specialization and innovation, to ensure valuable resources are not wasted and to avoid environmental degradation.

Is modern civilization locked in to a path that will lead to chaos and collapse if we don’t immediately mend our ways? I don’t think so. Once the hyperbole about running out of resources is cleared away, the only real concern that remains in my view relates to environmental pollution that cannot be controlled by any one government acting alone. Even here there are grounds for optimism. Despite their many failings, the governments of major countries show enormous goodwill toward the future of humanity. We can be reasonably confident that concerted international action will be taken if a major environmental catastrophe ever actually threatens the future of humanity.