Explorers and producers need to go where the oil is. But how do you balance resource upside potential with jurisdictional risk? Amin Haque of Stonecap Securities argues that jurisdiction risk isn’t a deal-breaker if management knows how to mitigate it. In this interview with The Energy Report, Haque shares some companies that meet those criteria, favoring redevelopment plays that avoid exploration risk. Find out which teams are using new technologies to turn proven reserves into economic international projects.
The Energy Report: Amin, you started your career in the consumer credit industry, where you were involved in risk management at a major bank. How does that translate to the securities industry?
Amin Haque: The company I worked for was MasterCard International Inc., and as director of risk management, my focus was on macroeconomic risk management in international jurisdictions. That gave me a very good foundation for evaluating sovereign, political and currency risks. In my four-year career with MasterCard, I focused on countries in Africa, the Middle East, South America, the Caribbean and the Asia Pacific. These are the same regions where many of the exploration and production (E&P) companies I’m interested in operate. My previous experience is proving quite useful as an oil and gas analyst.
TER: When you look at a company, do you consider the jurisdictional risk first?
AH: Jurisdictional risk differentiates a company focused in North America from one that operates internationally. For the latter, geology, exploration history and reserves matter as much as they do for a North American company, but equally important considerations are geopolitical or currency risks. These issues affect operations as well as profit repatriation.
TER: Do you focus on the downside?
“If management addresses the risks and has a program to meet and mitigate them, I feel more confident. But if they paint too rosy a picture and gloss over the risks, I try to steer away from that company.”
AH: No, I try to look at the company as a whole. In the oil and gas business, one has to be an optimist. As an analyst, I try to be a rational optimist. I use risk as a tool to screen management. I make a list of all the jurisdictional risks as I understand them. If management addresses the risks I have identified and they have a program to meet and mitigate those risks, then I feel more confident about the quality of the management.
But if the management paints too rosy a picture and glosses over the risks, which seems unrealistic for even a layman like me, then I try to steer away from that company and its team. But I don’t always start with the downside.
TER: You seem to be concentrating on a theme of oilfield redevelopment.
AH: Yes. Of the six companies, four are focused on redevelopment.
TER: Do redevelopment projects inherently carry less risk, because reserves in the ground are already established?
AH: That would be a fair statement. I play to my strength. I do not have a background in geology or petroleum engineering. I’m trained as an electrical engineer. I can relate to the basics of oil and gas science, but I am not an expert.
But if you start with a proven reserve that has not been extracted for various reasons, then you have a head start on the companies with exploration risks, where the outcome could be binary. You either find oil or you drill a dry hole for up to $50 million ($50M) per well.
“If you start with a proven reserve that has not been extracted, you have a head start on companies with exploration risks that will either find oil or drill a dry hole for up to $50M per well.”
If you have a proven reserve, then the outcome is not binary. There are risks. There are challenges in extracting the resources, both operational and geopolitical. But if you have competent management in place, then you have the confidence that they’ll find ways to meet those challenges, mitigate those risks, extract that oil and find a way to sell it.
TER: Is this redevelopment theme dependent on technology that we didn’t have a decade ago?
AH: That’s an absolutely fair statement. With most of these old fields, development success is predicated on applying new technologies and new ideas. We take new technology for granted in North America, but not so in these international jurisdictions.
Let me start with examples. Two of my Nigeria-focused companies, Oando Energy Resources Inc. (OER:TSX) and Mart Resources Inc. (MMT:TSX.V), are working mostly on oilfields that were discovered some time ago but have not been fully exploited. Mart has been in West Africa for quite some time, but its latest success was due to its use of three-dimensional (3-D) seismic data that was acquired some 15 years ago. It then used new technology to reinterpret it and the company found success. Oando is on the same path, and so are many other Nigeria-focused independent E&Ps.
A company in another part of the world, Azerbaijan, is Greenfields Petroleum Corp. (GNF:TSX.V). Azerbaijan has been producing oil and gas for at least 100 years. The field Greenfields focuses on has been producing at a very marginal level for the last 30 years because operators were still using Soviet-era drilling rigs and completion technologies. Greenfields acquired new two- and 3-D seismic data and new ways to model the reservoir. It is also using new drilling technologies. That’s how it hopes to find success.
TER: Define “marginal field” for me.
AH: Different countries have slightly different definitions. Generally, it is a field that has been discovered years ago and may have been producing for some time. But the initial leaseholder, which in most cases is an international oil company of substantial size, does not find it economic for continued development.
“Marginal fields are economic for smaller E&Ps because they operate with a shoestring budget and often introduce new technology.”
Therefore, these fields get marginalized and do not receive any new capital expenditure. That’s what’s happening right now for many fields in Nigeria, for example. Fields are declared marginal under new laws and regulations, and the original discoverer farms it out to, in most cases, a smaller outfit. That smaller company puts in new resources to start producing from it. Marginal fields are economic for smaller E&Ps because they operate with a shoestring budget and often introduce new technology. The government gets royalties and taxes, and the original operator gets some farm-out royalties. So it’s a win-win for everyone.
TER: It sounds like once the low-hanging fruit is gone, it’s necessarily going to cost more to drill these wells. Is that fair?
AH: It could go both ways. There are many marginal field opportunities like that. If a marginal field is large enough, then from the first well drilled to the, say, fifth or 10th well, the development cost actually declines over time. But when people start hearing about these new, unexplored opportunities, new companies come in and bid up the price for assets.
Even if not a marginal field story, let us think about Colombia, for example. About five years ago, Canadian energy companies went into Colombia and found success. More and more companies began flocking in, bidding up the price for new fields. That adds to the cost. That makes it more expensive for even established companies to expand and obtain access to new assets. So that’s a challenge.
TER: You follow junior E&P companies, where investors can hopefully get a large return on their money. Can you give us some of your favorites?
AH: Yes. Let me start with Mart Resources. Only recently, the institutional investors have been paying some attention to Mart. In June, the company declared a very generous dividend payment to its shareholders of $0.05 per quarter.
TER: Even after the dividend was paid on July 19, the stock still behaved quite well. At times, after a one-time dividend, shares fall. But investors have favorably viewed this stock.
AH: You’re correct. I’d like to note that when management declared this dividend, it made a strong statement about its commitment to return of capital to the shareholders. Although it was a one-time special dividend, management spoke of continuing special dividends in times of good cash flow.
TER: Can the regular $0.05/quarter dividend be sustained?
AH: I believe so, despite some of the risks the company faces. Since the end of October, Mart has not been able to produce and pump oil because of pipeline disruption as well as flooding in the Niger Delta area. Losing 15–20 days of production from its only producing field made for a challenging quarter. But Mart has a large stash of cash it can use to pay the dividend as well as continue its development program. In the future, it expects to increase oil sales with the help of a second pipeline, at which point a $0.05 quarterly dividend should not be a big challenge.
TER: Does Mart have prospects for increasing its reserves and production?
AH: Let me address the production issue first. The field is averaging about 12,500 barrels per day (bbl/d). Depending on Mart’s entitlement production, the production allocation to Mart goes between 50% and 82% but averages about 65%. It has drilled 10 wells so far, but the problem is that the field cannot produce to its maximum capacity.
The field has pipeline constraints. Five different producers in the area share the same pipeline, so there is a rationing of pipeline capacity. Unless that restraint is removed, Mart cannot produce to its maximum capacity, which I believe to be on the order of 15,000 barrels per day (15 Mbbl/d).
The company’s management is working on two things to remove the constraints. First, it is negotiating with the pipeline company that it uses right now to expand the capacity. In addition, Mart and its partners, along with other E&P companies in the area, are building a second pipeline that will connect to a Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) facility. A second pipeline should do two things—provide the company with redundancy and excess capacity, as well as giving it access to a second export terminal. That should allow Mart to significantly increase its production, which I expect to be achieved gradually between the beginning of 2013 through the end of the year.
TER: What is it about Mart’s management team that impresses you?
AH: First, they have done a good job of building relationships in Nigeria. Mart’s two partners for the Umusadege field proved to be sound partners. In Nigeria, many joint ventures by international junior and intermediate E&Ps have failed because of partnership issues. Secondly, the Umusadege field is one of the few marginal fields that have succeeded. Mart’s management has shown that the marginal field is a viable concept and it works.
“Nigeria is making progress in building a corporate culture, and it has created a middle class that’s generating its own energy demand.”
I’d also like to make one other point about Nigeria. The country is making some tangible progress in building a corporate culture, in building a civil society. It has created a middle class that’s generating its own energy demand, which is good for natural gas production in Nigeria. With increasing demand for electricity, entrepreneurs are looking at natural gas as a source for electricity generation. If smaller E&Ps get a chance to sell their natural gas, that’s a separate and new revenue stream for them. So the timing is also good for Mart, Oando and other independent junior E&Ps.
TER: Mart’s market cap is now just over $600M. At that market cap, this is a company that now can be owned by mutual funds. Do you expect to see this transition from it being a retail story to an institutional story?
AH: Yes. Institutions expect to buy a sizable chunk of shares and the market cap is getting to that level. Also, Mart did not have any institutional coverage before. Institutional investors expect some institutional broker support while they take an interest in a company.
TER: Could you talk about another story that you like?
AH: Sure. A similar story to Mart, also in Nigeria, is Oando Energy Resources. One risk about Mart is that its production is from a single asset. For Oando, the picture is different. It has interests in nine different blocks. It produces from two. So it’s not that dependent on a single field or a couple of fields. It has production and cash flow. At the same time, it has some very lucrative exploration blocks. Its management has worked for Schlumberger Ltd. (SLB:NYSE) and other international companies. But at the same time, it’s a Nigeria-based company, so the management team has more appreciation of the issues on the ground.
TER: You have a really nice target price with over 100% implied upside from current levels. But I see that 95% of outstanding shares are held by one entity, its parent, Oando Plc (OANDO:NSE; OAO:JSE).
AH: You are correct. But other than Mart, there are not many opportunities to get exposure in Nigeria. Oando will need additional capital to develop these assets. My belief is that it will come to the capital markets, and that will create an opportunity for investors who have interest in Nigeria.
TER: As an investor, you’re not concerned that 95% of these shares are owned by one entity?
AH: I think that should change over the short term. Oando Energy Resources came into being as a spinoff of the upstream assets of the parent company, Oando Plc. The current shareholding structure is a result of how this company became public, through a reverse takeover and through a spinoff of assets. But my strong belief is that that’s not the ideal situation for any of the parties involved and that situation is going to change.
TER: Is there another story you’d like to talk about?
AH: I mentioned Greenfields Petroleum earlier. It has assets in Azerbaijan, the Bahar project, where it has a one-third interest. An Azerbaijani company holds the remaining two-thirds. Azerbaijan is a country that has the longest history of producing oil and gas. But in the middle of the last century, when Azerbaijan was part of the Soviet Union, all the capital was shifted from Azerbaijan to Western Siberia, so it did not receive any new capital, new ideas, technology, focus or interest.
But the resources are there. It was very astute on the part of the Greenfields management to find this particular asset. Greenfields’ management team is trying to prove what can be done in an old field using new technology. When you are operating in a country that has not seen the introduction of new energy technologies for over a half a century, you face challenges—getting trained people, moving equipment, procuring supplies, etc.
The project has been delayed by a year or so, but it looks as if everything is lined up and drilling should start within a couple of weeks. Greenfields should be able to get some good results out of its current drilling program.
I would also like to mention that several key people in the management team of Greenfields have worked in Central Asia—in Azerbaijan and some of the neighboring countries—for over a decade. So management has connections there. They know the country and the people. I would say those relationships and that knowledge are extremely important for any junior E&P getting into a lesser-known international jurisdiction such as Azerbaijan.
TER: Another you might mention if you wish?
AH: The last one I’d like to mention is Touchstone Exploration Inc. (TAB:TSX.V; TCHSF; OTCPK). It is located in Trinidad and Tobago, which is a country with a very long history of petroleum production. Again, it’s a redevelopment story, where production went down in some fields because there was no infusion of new technology or capital.
The state oil and gas company, Petroleum Company of Trinidad and Tobago Ltd. (Petrotrin), owns this concession. Touchstone went into an arrangement called a lease operatorship agreement whereby Petrotrin would still hold the concession but Touchstone would get a percentage of the production when it brings in new capital and increases production. But one major challenge in Trinidad and Tobago is its vast bureaucracy.
What I like about Touchstone is its dogged persistence. In the last year, it has faced many challenges. But it still has been able to increase production from 500 bbl/d to about 2 Mbbl/d currently. Consider that there are thousands of old wells that can be recompleted and brought into production. Even if they contribute 15–20 bbl/d, you are talking about a very large level of incremental production at a low cost. That’s what Touchstone is targeting.
TER: Did you want to mention one more?
AH: Another company on my list is New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX). For Canadian companies, New Zealand is a comparatively new jurisdiction. There are a couple of Canadian companies active there. New Zealand Energy had some impressive initial successes. It has a large land position right now. The thesis is that it can replicate the initial success in the remaining land base.
TER: The stock has suffered over the past six months. It’s down about a little bit more than one-third. What were the issues that contributed to that?
AH: The first three wells were quite successful, but the decline rates were high. So current production has come down. I guess the market is waiting for new wells to start augmenting production.
TER: It’s been a pleasure. I thank you for taking the time.
AH: Thank you. It’s been a great pleasure talking to you.
Amin Haque joined Stonecap Securities’ oil and gas research team in Calgary in October 2011. He provides research coverage of international explorers, producers and oilfield service companies. Haque brings 14 years of financial market experience, seven of which have been devoted to equity research analysis. He worked as an analyst both on the buy and sell side, focusing on energy and other resource sectors. Prior to joining Stonecap, he provided independent valuation services to oilfield services, logistics and related companies.
The Gold Report met up with Rick Rule, founder and chairman of Sprott Global Resource Investments Ltd, at the Hard Assets Conference in San Francisco. In this interview with The Gold Report, he shares his belief in the power of gold as both “catastrophe insurance” and an investment vehicle. As to equities, he sees a new discovery cycle lifting the prospects of majors and juniors alike, as long as they act like “rational” businesses.
The Gold Report: Rick, you believe the natural resources sector is experiencing a cyclical decline in a secular bull market similar to the 1970s. Is that true for other sectors as well?
Rick Rule: I learned the hard way not to assume that my success in the natural resource business was transferable to other sectors, so I am going to stick with resources.
However, there are parallels with the gold market. In the 1970s, we had a spectacular resource market, in particular for gold. Its price soared from $35/ounce (oz) to $850/oz. By 1975, in the middle of that secular bull market, gold had fallen to $100/oz. Those who sold at the bottom missed an 800% move in six years.
“I own gold the way that I own life, auto or homeowner insurance. I regard it as catastrophe insurance.”
It is important to understand that in cyclical markets like resources, declines in secular markets are to be expected. From my point of view, you need to understand cyclical declines for what they are—sales.
TGR: Is it fair to think that the prices of natural resources will bounce back as they did in 1970s, when the recession was much shorter and not as global?
RR: That depends on the resource. For gold, the answer is yes because the parallels between the 1970s and today are striking.
The U.S. dollar has stayed fairly strong, not because of the strength of the economy but as a function of the dollar’s liquidity. As the U.S. dollar appreciates relative to frontier and emerging market currencies, we are causing very real inflation in places like India, Vietnam and South Africa.
In the U.S. however, we are seeing inflation in two places: in the liabilities that we are leaving for our heirs and in a tremendous bond bubble. The prices of U.S. Treasury securities, the inverse function of the yields, suggest that we are in the biggest economic bubble in history.
When the U.S. went through the economic turmoil of the 1970s, we went into it with a much stronger national balance sheet than we have today. Then, we had the ability to capitalize our reconstruction while we serviced our debts. I am not sure we have that ability anymore. Our federal on-balance sheet and off-balance sheet liabilities, relative to our ability to service those obligations, are much lower. The alternative is to inflate our obligations away, which would be good for bullion.
Finally, in a demographic sense, our needs will continue to outpace our means. In the 1970s, you and I were coming into our productive years. Today, you and I are at the opposite end of our productive years, no matter how much we want to forestall it. The demographic implications of that are profound. If a country cannot produce its way out of its deficit, it has to default.
TGR: Or quantitative ease.
RR: That is a form of default. There are two ways to default. You can renounce your obligations or you can lie. Quantitative easing (QE) is the lying part. You depreciate the currency that your obligation is in.
TGR: But with the entire world in that situation, are we in a cyclical decline or is the bull market over, specifically for gold?
RR: The West is in for a period of muted demand for commodities. As the advanced economies become less free and poorer, and frontier markets become more free and richer, it will lead to volatile demand characteristics for many industrial commodities.
“Increasingly, investors are telling management teams to be rational.”
Overall, I am afraid that the circumstances ahead of us will be very good for all precious metals. Traditionally, gold has been a great way to avoid the impact of chaos. When other exchange mechanisms—yen, renminbi, euros, dollars—are engaged in competitive devaluation while managing a staged default, people will look for a medium of exchange that is also a store of value: gold. It is not a promise to pay; it is payment.
TGR: Does more QE portend that gold or equities will be a better return?
RR: They are very different asset classes.
Rationally, I might not be well advised to own any gold at all because I have so much of my net worth tied up in my business, which reacts to the gold market. Nonetheless, I own a lot of gold, silver and platinum bullion. I own it the way that I own life, auto or homeowner insurance. I regard it as catastrophe insurance.
I would suggest that your readers establish a core or insurance position in bullion and hope to God that later on they can regard that investment as a waste of time and money.
TGR: Over the last several years, if you bought gold for its investment return, you would have done better in bullion than in equities. Why do we keep telling people not to look at physical gold for investment return when it has outperformed equities?
RR: I would not discourage that either. It is implied at the Hard Assets Conference that rising gold prices will affect the share prices of the exhibitors, most of whom have no gold; they are looking for gold. If the price of something you do not have goes up, it should not have any impact on your share price.
As for the companies that do have gold, their performance over the last 10 or 12 years has been pathetic relative to the increase in the price of the commodity that they produce. That said, I believe we are through the worst of that. We should see the senior and intermediate gold companies begin to perform surprisingly well at the corporate level.
RR: The companies have learned lessons. Investors asked mining companies to exhibit, as an investment characteristic, leverage to the commodity price. In other words, we asked them to be marginal. Marginal producers enjoy the most outsized gains in an escalating commodity price environment. The industry gave us exactly what we asked. They became extraordinarily marginal and inefficient.
Four years ago, an irrational metric appeared that sticks in investors’ minds: ounces of gold in the ground per dollar of enterprise value. You divide the enterprise value into the number of ounces, without taking into account the capital cost of bringing the ounces into production, the cost of extracting the gold or the time value of money. Ounces were valued irrespective of whether or when they would be recovered.
“The first point of attraction for juniors is that the major mining companies, in order to stay steady—much less grow—will have to acquire deposits. “
Increasingly, investors are telling management teams to be rational. They are telling managements, “In addition to giving us some leverage to the gold price, it would be nice if you made money. We do not want to see you buy 20 million ounces at 5,000 meters (m) in the Andes, only to have to spend $7 billion to bring the deposit on and generate an 8% internal rate of return (IRR) with a 7-year payback. We would rather see you do something that generated a 30% IRR with reasonable amounts of capital where you pay back the capital in three years.
Investors are asking the gold mining business to become a business. That is not too much to ask.
TGR: But in your opening remarks at the Geo Tips seminar, you noted how many of the publicly held mining companies have no gold. That seems contradictory.
RR: There is no contradiction. We want the producing companies to be rational. With regard to the juniors, 80% of them have no net present value (NPV).
The attractiveness of the juniors is twofold. The junior share prices have all been taken down, the good companies along with the bad. There are probably 20 developmental-stage juniors selling at substantial discounts to the NPV of their existing deposits, even though those deposits will grow through exploration. The major mining companies know it will be easier to buy that resource than to discover it. So the first point of attraction for juniors is that the major mining companies, in order to stay steady—much less grow—will have to acquire deposits.
The second thing, and it is somewhat hidden, is that we are coming into a discovery cycle. In the next 12 to 24 months, we are going to see reasonable, maybe spectacular, discoveries with increasing frequency. This is a market that rewards tangible results, for example, GoldQuest Mining Corp. (GQC:TSX.V) going from $0.06/share to $2/share; Reservoir Minerals Inc. (RMC:TSX.V), $0.30/share to $3/share; Africa Oil Corp. (AOI:TSX.V), $0.80/share to $10/share. There is nothing like discoveries to add hope and liquidity in the junior market.
TGR: How does an investor know when to jump into a junior exploration market?
RR: That is a big topic. In brief, the dynamic changes from market to market. You need to figure out which parts of the market are unloved and, hence, available. You have to pay attention to where the values are and set your strategies not by what you wish would happen but by the facts represented by pricing in the market.
The most common mistake I see speculators make is regarding the market as a source of information. It is not. It is a mechanism for buying and selling fractional ownership of businesses. Getting your information from the market is the same as getting your information from the expectations of 10,000 people who probably know less about the topic than you do.
TGR: But can an investor use catalyst events like a preliminary economic assessment (PEA) or a drill result to minimize the risk?
RR: The beauty of a bear market is that people’s expectations are so low that many companies sell off on news, even news that is not truly spectacular. For the first time in my career, I see developmental-stage juniors with PEAs selling at substantial discounts to the admittedly speculative values established in the PEA.
We look for three things in a company: One, the sum of the enterprise value of the issuer and the front-end capital costs are lower than the NPV at today’s gold prices. Two, IRRs above 25% but preferably about 30%. Three, capital payback within three years. I have not seen these three things come together very often in my career, but they are occurring right now.
With a good deposit, a couple of things will happen between the PEA and the bankable feasibility study. In the two years it takes to get from PEA to bankable feasibility study, the deposit is likely to be bigger and higher grade. More important, the bankable feasibility study gives legal cover to the outside directors of an acquirer. It takes courage to take over a company based on a PEA; with a bankable feasibility study in hand, you are covered.
Canplats Resources Corp. (CPQ:TSX.V) is a recent example. For a long time, it traded at a substantial discount to the indicated value of the deposit established by the PEA. In the two years between its PEA and bankable feasibility study, the stock chart looked like the electrocardiogram of a corpse. Within eight or nine weeks of the bankable feasibility study, Canplats had three takeover offers. The professional risk to the acquirer’s board of directors was effectively eliminated. That was the catalyst.
TGR: You mentioned earlier that the majors have to acquire. How much does proximity to a major increase the likelihood of a junior being acquired?
RR: Being next door to an existing operation lowers the total cost associated with the acquisition. Because the infrastructure costs have already been paid, the major can afford to pay more for you.
TGR: But there also is no bidding.
RR: That is the bad news. It is tough to have an auction with one bidder.
There are two positives in this market. First, compared to 2010 at least, it is cheap. And cheap is good. Second, some of those cheap companies are also good companies. Granted, investors may not get huge premiums in a takeover, but a probable 40% or a 50% premium today is better than a mere possibility 12 to 24 months out.
The wild card that few people are focusing on is this discovery cycle. Having a low-cost entry point in 2012 is preferable to a high-cost entry point in 2010, in particular because we are two years further into the exploration cycle and the payoff is closer. People are going to make tenbaggers or fifteenbaggers.
TGR: Rick, I know you like the prospect-generator model. Would you advise investors just coming into this market to start by investing in prospect generators?
RR: Because prospect generation is such a rational approach, most people cannot do it. Most people come into the exploration sector for emotional reasons. They want to believe the newsletter propaganda, “I made 603% in seven trading days.”
If you want to take emotion out of the exploration business and focus on cash and cash returns over time, you can pursue a portfolio strategy that will give you three standard deviations of superior performance over a decade. You have to manage your hope and be willing to watch your portfolio decline 30% or 35% in a bad year.
TGR: It really comes down to a risk-appetite decision.
RR: You just put your finger on the most important part of the equation. If you are engaging in a high-risk, high-return activity, returns take care of themselves. You have to manage risk.
The expectation of exploration has to be failure. When most of your investment decisions are unsuccessful, your winners have to amortize your losers. Every step that you take in building a speculative portfolio has to be a step taken with the view to minimizing portfolio risk in an extremely risky activity.
Most speculators are reward chasers not risk managers, which is why most people who come into the sector fail.
TGR: You have long been involved in debt financing. Is that on the increase?
RR: Yes, for a couple of reasons. First, we have had 10 years of extraordinary equity investment in resources. That builds up collateral for a lender. Today’s collateral values in the mining business are orders of magnitude better than they were 10 or 15 years ago.
Second, equity costs companies money now. In 2009 and 2010, underwriters and speculators were throwing equity at companies. Now, equity issuers believe, rightly or wrongly, that they are selling at 30 or 40% of net asset value, which makes issuing equity very expensive. Companies realize that coming to us as bridge or mezzanine lenders is substantially cheaper than equity financing.
Oddly enough, the market often sees that these companies need capital and prices the equity down in anticipation of an offering. If the company borrows $30–35 million from us, the pressure comes off and its market increases by 25% or 30%. The company can then raise what it needs to pay us back in the equity markets.
Now is the best set of circumstances to be a bridge or mezzanine lender that I have seen in 30 years in the natural resource markets.
TGR: Do bridge and mezzanine financing carry less risk with slightly less yield?
RR: Yes. In effect, it is junk debt, but not the kind that Wall Street offers up. As lenders, we will not make a tenfold return, but we have a probability rather than a possibility of 15% compounded annual returns with much less risk.
TGR: How does one get involved in debt financing?
RR: You can own shares in us or participate with us in private lending syndicates. You can also buy shares in Dundee Bank Corp. or Macquarie, the Australian bank. There are also public markets for high-yield or junk debt, primarily in Canada. There are some very nice bond issuances in the mining and the oil and gas sectors with returns in the 7.75–8% range.
TGR: At the conference, you are talking about The 9 Nosy Questions to Ask Mining Experts. What is the one fatal question investors do not ask?
RR: Can I have two?
First, you must ask a management team to describe its track record of success. For example, a promoter might tell you he operated a gold mine in Precambrian rocks in French-speaking Québec but his new project is exploring for gold in tertiary volcanics in Spanish-speaking Peru. It is important to understand management’s track record of success in an endeavor that is relevant to the current situation. Investors are not discerning enough with regard to the specific expertise needed in every task.
The second thing that’s critical is to ask management how funding will be obtained. Reward chasers will sit at a booth and the promoter will say we have 800,000 oz (800 Koz), we’re going to drill 50,000m, there’s going to be this new flow, we’re going to do this and we’re going to do that. What the investor has to say is, hmm, interesting, so how much money is this going to take over 18 months? How much general and administrative (G&A) expense do you have? What’s the relationship between G&A expense and exploration expense? If you don’t have the money, why am I listening to you? Many times I’ll be on the exhibit floor and somebody will have a $10M exploration budget and a $3M G&A budget, so there’s $13M to answer my unanswered question. And they have $2M in the bank. I say to them that I don’t really have to listen to you anymore because you’re $11M away from giving me the answer that’s going to get me an increased share price.
TGR: But isn’t that what you do in your private financings?
RR: Sure. If I can answer the question as to where the capital is coming from, then I’ve removed the risk. But if I can’t, I won’t.
TGR: So absent the ability to go into private financings, you need to have the money to answer the questions.
RR: Yes, absolutely. I’m not suggesting this is a recommendation. If you talk to a prospect generator, Altius Minerals Corp. (ALS:TSX.V) might be an example, its exploration budget this year may be $20M, and joint venture partners are going to spend $17M of that. So its net exploration expenditure is $3M. Its G&A budget is $2M. So it needs to find $5M and it has $180M in cash and securities. The question is answered. You have a yes. You see another company, however, that is operating on its own nickel, whose budget is five or six times the cash it has, and if it can’t give you a very, very, very good answer as to where it is going to get the money, you get to walk away.
About 20 years ago probably, I gave a speech at one of the predecessors of this conference, the Boston Gold Show. After I got offstage and changed into casual clothes, I was wandering around the exhibit hall. A particularly aggressive salesman tackled me, brought me in the booth and went on and on about all the stuff he was going to do. I said that’s very interesting. It’s going to cost a lot of money. How much money do you have? He said, well, that doesn’t really matter; I said tell me more. I didn’t have my nametag on. He said that there’s a really, really hot California stockbroker named Rick Rule. I said that I have heard of that guy, he spoke here. He said that he’s going to finance us. I said, is that so? He said the opportunity really is that Rick doesn’t like to finance things below $2/share, and our stock is at $0.60/share. When we get it up to $2/share, he’ll finance us and, in effect, you can leverage off his money. I asked why would he do that? He said that’s just the way he is. So at that point, I got out my driver’s license and I said I know this Rick Rule guy really well.
TGR: Rick, any final words of wisdom for our readers?
RR: It’s important to understand that part of this business involves painting dreams on a piece of paper and marking up the paper based on the dream. With 4,000 companies out there, the game is not finding something to invest in. The game is throwing away stuff quickly so that you are not wasting time on the dross.
TGR: Rick, thank you for painting a rational approach to gold investing for us today.
Rick Rule, founder and chairman of Sprott Global Resource Investments Ltd., began his career in the securities business in 1974. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. His company has built a national reputation on taking advantage of global opportunities in the oil and gas, mining, alternative energy, agriculture, forestry and water industries.
John Hathaway, senior managing director of Tocqueville Asset Management, does not particularly trust banks to keep stores of physical gold safe and segregated. Indeed, he considers his black lab Jake a better watchdog than the SEC. That is why he favors the SmartMetals program from Hard Assets Alliance, a new service launched in July. Hard Assets Alliance has partnered with Gold Bullion International (GBI) to offer precious metal purchasing and storage solutions to retail investors. With more investors realizing that safety of capital is the real reason to own gold, safe storage is more important than ever. Read more in this exclusive Gold Report interview.
The Gold Report: John, you predicted $2,000/ounce (oz) gold prices. After rising to $1,900/oz last fall, the price has hovered at $1,500–1,600/oz much of 2012. What will cause it to take the next leg up?
John Hathaway: There are several factors that I think will drive gold higher. On the monetary side, central bankers and treasury secretaries are bobbing and weaving, making it up as they go. They lack a comprehensive solution to the sovereign debt crisis in Europe, to the forces that are pulling the Eurozone apart or to the stagnation in the world’s key economies. Ultimately, all of this will further debase the value of paper currency.
More quantitative easing may also be on the table, and I have read a good deal about taking nominal rates to less than zero. That would mean people who have money in savings accounts would be charged a fee for keeping the money, as opposed to earning interest. It would not surprise me to see that evolve as a way to get all of these free reserves in the banking system into the economy.
TGR: How soon might that happen—in the coming months, by the end of 2012, in 2013?
JH: It is hard to say, but we are at a pivotal point. The economic reports are very lackluster. The headlines out of Europe continue to be, at best, dismaying. The upcoming U.S. presidential election complicates things. The Federal Reserve probably does not want to do anything that would be construed as tilting the election one way or the other.
“I would say $2,000/oz gold is very close.”
Gold has been correcting for almost a year now. Last August, it reached $1,900/oz. It has had every opportunity to sink below the low it made at the end of 2011. Basically, the price has been in sideways movement for the last seven months.
I see gold coiling, moving into stronger and stronger hands. There are not many sellers left. People who wanted to sell it have and have gone on to other things. I am more and more encouraged that the downside to gold is limited; it is all about the upside. I would say $2,000/oz gold is very close.
TGR: Could it go higher than $2,000/oz?
JH: Oh, sure, much higher.
TGR: When we spoke at the Casey Conference, you bemoaned the fact that even gold-producing companies were trading at a discount compared to the commodity price itself. What will change that trend?
JH: A higher gold price. You need a change in the perception of what gold is doing. You only buy a gold stock if you are bullish on gold prices. Since there has not been that kind of encouragement from the bullion market, I am not surprised that the stocks are dogging it. You need a lot of patience and tolerance to go through a period like this.
Everything else you hear about—the arguments about political risk, cost pressures and the competition from the exchange-traded funds—goes away pretty quickly once the perception of the gold market turns and gold starts advancing, as I am certain it will.
TGR: You also said that physical precious metals have a place in a diversified portfolio. What percentage do you usually recommend?
JH: In today’s world, I think 5% to 10%. By physical, I do not mean an exchange-traded fund (ETF) or commodity contracts, which are really paper gold, but actual physical gold that you can touch—gold that is outside of the banking system, that you know where it is stored and what your bar numbers are.
TGR: Are more institutional and individual investors including physical metal in their portfolios?
JH: More and more people are thinking strategically about gold. Owning physical gold should not be viewed as a way to make money. Rather, it is way of saving capital that creates optionality for future spending power and investment resources.
The impetus to get into gold is not because someone like me says the next step is $2,000/oz. The real reason is safety of capital.
TGR: Do you also see precious metals as a hedge?
JH: Absolutely. It is optionality. If you look at what is going on in banking regulations, everything banks are now required to ask for regarding personal finances that are nobody’s business, and you couple that with the trend toward negative nominal interest rates, why would you keep all of your money in the banking system?
TGR: Does it matter what form the physical gold is in—coins, bars, bags?
JH: You pay a premium to have coins. Whenever I try to buy coins, I feel moderately ripped off because you pay a premium over the bullion content. However, there is a convenience factor to coins.
“Owning physical gold is way of saving capital that creates optionality for future spending power and investment resources.”
When buying physical metals, you have to consider your needs. If you intend to take personal possession of your holdings, sovereign coins may be a good option for you. Or 1 oz bullion bars. That’s the convenience factor; sovereign coins are more easily verifiable in the retail market.
If your intent is to have a third party store your metals, and you are comfortable with the storage options being offered, it may make more sense to purchase large bars, as your cost per ounce will be lower. It costs less per ounce to cast a 400 oz bar than it does a 1 oz coin.
Either way, you can do better than hoarding coins in your safe deposit box at the bank or in your house.
TGR: If you do not take physical delivery of the coins or bullion, how do investors know that it exists, that it is not being shared or pooled? And does that matter?
JH: If you have your gold in a bank, you cannot be sure it is not being pooled. Banks say it is safe and segregated, but after the LIBOR scandal and JPMorgan’s issues in terms of marking, who can be sure? There is no integrity left in the banking system.
There are other ways to hold gold that would give investors greater peace of mind.
TGR: What are they?
JH: We have invested in a company called Gold Bullion International (GBI), that to date had solely focused on servicing financial institutions and wealth management firms. GBI provides them with trading and logistics platforms to buy, sell and store precious metals in the U.S. and abroad. Noticing that the direct retail market was underserved when it came to institutional-quality platforms for sourcing and storage, GBI decided to partner with the Hard Assets Alliance to introduce the SmartMetals program. Now retail investors can store their metals in secure commercial vaults, outside of the banking system. This is important.
TGR: How does Hard Assets Alliance differ from SPDR Gold Shares (GLD) ETF, gold coins or bars?
JH: With SPDR Gold Shares, you cannot get your hands on the physical gold; it is segregated gold and it performs the very useful function of allowing investors to hold a security that tracks physical gold in their portfolios. But the gold itself is held at a bank, HSBC. If worse came to worst, all you would have would be a portfolio holding that is still part of the banking system.
“Physical gold is one of the most liquid assets you can think of.”
If you want to take the next step, having physical gold in your possession or outside of the banking system, that is just a further degree of protection of your assets should we go through a difficult period of severe market disruption. This is a better way to ensure your preserved capital, buying power and investment power.
I am also concerned that government intervention into our personal lives and financial assets will become more and more intrusive. Having physical gold may be not perfect, but it is the best way to counteract that. This is why I keep coming back to the idea that people need to think about more than capital appreciation when they buy physical gold. Gold is actually the antidote to what we think of as money, which is just basically scrip that’s issued by governments.
TGR: The other problem often with bullion is its liquidity. How would something like Hard Assets Alliance make it easier for individual investors to buy and sell their gold, silver, platinum or palladium?
JH: Physical gold is one of the most liquid assets you can think of. Hard Assets Alliance facilitates not only the purchase but also the sale. Whether you do it through its website or through its trading desk, liquidity is simply not an issue, in my opinion.
TGR: That does sound easier than going to the guy downtown who offers to buy your jewelry for cash.
JH: If you need cash, you do not want to be carrying a bag of coins to a dealer, especially in a time of stress when he will take advantage of you in terms of valuation. This is a much better system.
TGR: Do you have any other advice for investors looking to diversify their portfolios in a volatile market?
JH: I think you have to be conscious of the risks in the financial system, the risks of paper currency and the assumptions that we make about what it represents in terms of current and, more importantly, future buying power.
I am perfectly fine with owning blue-chip stocks and high-grade corporate bonds, but the world is so different today. I am talking about an additional degree of protection. I wish buying stocks and investing in bonds were enough to protect peoples‘ savings, but I just do not think that’s the case today.
TGR: John, thank you for your time and your insights.
Learn more about the Hard Assets Alliance.
John Hathaway, senior managing director of Tocqueville Asset Management, manages all gold equity products and strategies at Tocqueville Asset Management. He holds a bachelor’s degree from Harvard University, a Master of Business Administration from the University of Virginia and is a chartered financial analyst. He began his career in 1970 as an equity analyst with Spencer Trask & Co. In 1976, he joined investment advisory firm David J. Greene & Co., where he became a partner. In 1986, Hathaway founded Hudson Capital Advisors and in 1988, he became chief investment officer of Oak Hall Advisors.
The pullback in oil prices has created some attractive buying opportunities in both developing and established oil and gas companies, even if oil prices settle in the $80-90/bbl range. In this exclusive interview with The Energy Report, Joel Musante, senior analyst with C. K. Cooper & Co., gives us his insights into current energy markets and talks about several of his favorite names that may reward investors with an appetite for risk.
The Energy Report: We’ve had some pretty interesting ups and downs since your last interview with us in September of 2010. What’s your assessment of the current situation in the oil market?
Joel Musante: Most of the focus is now on whether the European Union is going to hold together. This could cause the European economy to weaken and the dollar to strengthen against the euro, sending oil prices lower. At this point, we really don’t see any resolution in sight. So there’s still risk that oil prices could continue lower.
TER: What portion of the decrease is attributable to a stronger U.S. dollar?
“In a broad market pullback . . . there is an opportunity to buy quality names at discounted prices, providing you can stick it out and weather the storm.”
JM: It’s hard to separate all that out. Oil went up to $109/bbl when there was fear the U.S. or Israel might attack Iran’s nuclear facilities. Now, this Eurozone crisis seems to be dominant in the market. Oil prices are very volatile, and they tend to trade on investor sentiment over political and economic risk rather than just supply and demand fundamentals of the commodity itself.
TER: Could we be headed down to $60/bbl oil as an ultimate downside?
JM: That price level is pretty low and not very sustainable. It could reach that, but I don’t think it would stay there for any length of time. Saudi Arabia and some of the bigger Organization of the Petroleum Exporting Countries (OPEC) members need $80+/bbl oil to pay for their fiscal budgets. Outside of OPEC, $90/bbl oil is necessary for many commercial development projects or to maintain drilling at the current pace.
TER: In the short term, there is obviously going to be some effect on earnings of companies that are currently in production. How do you assess the impact of that?
JM: I still think it’s going to be short lived, but if prices stay low for an extended period, it could have some negative impacts for companies. Drilling for oil is a very capital-intensive business. These companies depend on cash flow. When prices fall, they have to cut back on their development programs. The alternative is to take on more debt or issue equity at not-so-attractive terms, which most companies will try to avoid. Most companies will cut back on spending and accept lower growth. This will ultimately lead to lower valuations.
TER: The other side of the picture is the natural gas markets, which have been pretty sick for quite a while. Are you expecting anything to turn around there?
JM: We are starting to see the initial signs of a turnaround in natural gas, but it is still difficult to put a timeframe on it. The natural gas drill rig count has fallen significantly and dry gas production is starting to decline. But there is still a large storage surplus, and production is still outpacing demand by a pretty large margin, so we have a long way to go before supply and demand comes back in line. The interesting thing about this natural gas supply-demand cycle is that the oversupply was driven by aggressive development in shale gas areas. These wells come on at very high rates, which would account for the steep supply increase. But they also decline very quickly, which could mean we are in for a rapid correction. So far, the production data is not showing a fast correction, but it is still early in the cycle.
TER: Is the worst behind us as far as declining prices?
“If the gas buildup during the summer months is similar to what it has been in the past, then we may see full storage by the end of the summer. With nowhere to store the gas, we could see the gas price fall very steeply.”
JM: Not necessarily, gas storage is at record-high levels. If the gas buildup during the summer months is similar to what it has been in the past, then we may see full storage by the end of the summer. With nowhere to store the gas, we could see the gas price fall very steeply. This would be temporary, as gas is depleted from storage during the winter months.
TER: Let’s talk about some of the companies you cover. In your last interview, you discussed Evolution Petroleum Corp.’s (EPM:NYSE) artificial lift technology. What’s developed with that? Has it been able to implement that more to its advantage?
JM: Yes. Tests on Evolution’s artificial lift technology are ongoing. Early results look pretty promising. In one instance, the company increased production from a nonproducing well to 11 barrels oil equivalent per day (boe/d), consisting of about 60% oil and 40% gas. It’s only been on-line for a short period, but the company is estimating that it could increase the reserves of the well by 50 thousand barrels oil equivalent (Mboe), though more testing is needed to better estimate the reserve increase.
TER: That’s significant if the cost to do that isn’t very great.
JM: It’s actually fairly cheap—a couple hundred thousand dollars to implement the equipment in the well and it looks like you could get quite a bit of oil and gas out of it. So far, there are not a lot of results, but when you get these kinds of numbers, it looks very promising.
TER: Fifty thousand barrels at $80/bbl is $4 million (M). If it only costs a couple hundred thousand to do it and ongoing expenses aren’t that great—that’s found money.
JM: Yes. The company is not saying it can definitely get 50 Mbbl; it said it can get up to 50 Mbbl. Even with 40% of the production being natural gas, that’s still an attractive proposition. The company’s main asset is the Delhi Field in Louisiana, which another company operates. A carbon dioxide (CO2) flood is being applied to this old oil field and production has responded better than the company had originally anticipated.
TER: Can that production stay up at a reasonable level or is it going to fall off quickly?
JM: The CO2 that’s pumped into the formation gets into the oil, lowers its viscosity and surface tension, releasing it from the pore spaces of the rock. The pressure from the CO2 helps mobilize the oil, and move it to an extraction well. Success of these kinds of operations depends on a number of factors, but in this case it is working exceptionally well, certainly better than expected. The field development is going to take place in phases. The company is in the third phase of five and is producing between 5–6 Mbbl/d. The whole field should get up to 12–14 Mbbl/d over time. Evolution’s interest in the field will increase significantly after the operator recovers its initial development cost, per the agreement between the two companies. I have an $11 target, which is pretty conservative. The stock is trading at $7.90. All the company is doing now is converting proven undeveloped reserves to proven developed, so the market should recognize it.
TER: Last September you resumed coverage on FX Energy Inc. (FXEN:NASDAQ) That company is operating in Poland, which most people don’t even consider as an area for oil and gas production. What’s the story there?
“Poland is trying to develop its own resources, rather than depending on Russia, which has used its gas supplies as a political weapon against neighboring European countries.”
JM: FX is unique because it operates almost exclusively in Poland. It targets high-risk, high-potential-return exploration prospects in contrast with most oil and gas companies in the U.S. that focus more on lower-risk resource plays. For investors who can tolerate the risk of an exploration-oriented company, FX may be attractive. Some of the drilling prospects the company is testing have the potential to double or triple its reserves, if successful. Some discoveries it has made are quite large and some not so large, but when it does hit a prospect, it’s usually very economically attractive.
TER: Is Poland interested in developing gas reserves, rather than importing from Russia?
JM: Yes. There isn’t a lot of gas production in Poland, so it does import a lot from Russia, which pegs the price of its gas to oil prices. But Poland is trying to develop its own resources, rather than depending on Russia, which has used its gas supplies as a political weapon against neighboring European countries.
TER: What caused you to resume coverage on FX?
JM: I thought it was an interesting story. It wasn’t well covered at the time. In the past, FX was only drilling about one exploration well a year, and when it made a discovery it took a while to bring the well on-line and establish commercial production. Through the accumulation of its past discoveries, it has brought on a lot of production recently. Now, it’s using its cash flow and reserves as a funding source and drilling quite a few exploration wells. Some prospects are small and others are quite large, so there is a lot more going on now than in the past.
TER: What is your target on FX and where is it now?
JM: I have a $9 price target on it. It’s at $4.80. In an exploration-oriented company, valuation is tricky because you have to assume that it’s going to make a discovery, and there’s no guarantee that will happen. The only way that you can get ahead of this is if you buy it before it makes a discovery. If you don’t, as soon as it makes one and announces it, the stock is going to appreciate, and you’re going to miss out.
TER: So you are betting on a hit rather than just a somewhat predictable earnings stream.
JM: Exactly. In research reports, I try to make clear that my target price and rating really depend on a discovery, which is hard to predict, to say the least.
TER: Another one on your coverage list is PDC Energy (PETD:NASDAQ), which has been around for many years. That’s a higher-priced stock, but it’s become more of a bargain recently. What’s the story on that one?
JM: The stock has fallen recently, mainly due to lower commodity prices. Some of the decline may have been due to lower expectations in the Utica Shale, which is a relatively new oil and gas play where the company has established an acreage position. Some recent well results have raised concerns that the Utica shale may be gassier than previously thought. We saw a pullback in the share price of several other companies that held Utica acreage around the same time the well data was made public.
I still like the story and its position in the Wattenberg field, which is one of the oilier regions to drill in North America. The Wattenberg has evolved over time. More recently, companies have tried horizontal drilling and hydraulic fracking in some of the formations there, and the field has responded pretty well to that new technology.
TER: So this company has somewhat more of a history, with hopefully more predictable cash flow and earnings. Is that right?
JM: That’s correct. It’s a much more established company with production and reserves comprised of a lot of natural gas. But most of its drilling is oriented toward oil and liquid-rich gas.
TER: What’s your target on that one?
JM: I recently upped my price target. It’s $45 now. It pulled back quite a bit recently with all of the economic turmoil in Europe. It got pretty close a short time ago, when macroeconomic fears were less of an issue.
TER: Where is it trading these days?
TER: There’s some pretty decent upside there if the market turns and oil prices strengthen. Are there any other companies you think are interesting that you’d like to mention?
JM: I just initiated coverage on Bonanza Creek Energy Inc. (BCEI:NYSE). Like PDC Energy, the company operates in the Wattenberg field. It has a strong management team and a lot of very attractive, oily prospects.
TER: So where is that one trading now and where do you think it’s going?
JM: I have a $27 price target, and it’s trading at $16. It IPOed in December, so it’s a relatively new entrant to the public market.
TER: Do you have some closing thoughts on the energy markets and how people can best play things under current circumstances?
JM: I would suggest that investors focus on the quality names. In a broad market pullback like what we are seeing in the market today, there is an opportunity to buy quality names at discounted prices, providing you can stick it out and weather the storm.
TER: Thanks a lot for joining us today.
Joel Musante, CFA, is a senior analyst in the Research Group for C. K. Cooper & Co., a full-service investment bank. In 1998, he began his career with W.R. Huff Asset Management; in 2000, he joined the E&P team at Wasserstein Perella Inc. He has also worked with Ferris, Baker Watts Inc., Zacks Investment Research and John S. Herold Inc. He has a Master of Business Administration from the University of Rochester and a Bachelor of Science in geology and geophysics from the University of Connecticut.
The continued expansion of the welfare state is a grave concern to me, now more than ever. I fear the expansion of the welfare state because I believe it infantilizes society. By this I mean that citizens of the United States become more dependent on the federal government’s largesse, and in so doing become less inclined to behave responsibly, secure in the knowledge that if all else fails, the government will be there to save.
Now freed from the main concerns of life, such as finding food and shelter, and now freed from having to constantly be working to afford these things, people will be increasingly able to enwrap themselves in their own little petty dramas. In a panem et circenses world, this will mostly take the form of eating junk food and watching mindless entertainment, which is what a large number of US citizens already do anyway. The more serious minded might make an effort to watch and read the news, but the news is still entertainment, although more deceitfully packaged. Ultimately, the infantile society is one where innovative risk is discouraged, moral risk is subsidized, and the pursuit of leisure and entertainment becomes the point of life.
This is not healthy, and is indeed a form of arrested development, for people will not be expected to worry too much, nor will people be expected to work hard, at least in the sense of doing labor. The emphasis will be on being compliant citizens and, above all else, being safe. This emphasis on safety is the most infantilizing action of all. Consider, for example, how risk-averse boys are treated by their more adventurous peers: they are often called babies. And the more risk-averse men are often called boys by their peers. The idea is that there is some shame to be found in prizing safety above all else, and that aversion to risk is a hallmark of youth, wherein one lacks the resources to deal with the risks that adults often face.
What’s interesting about this infantilization of society, though, is how it is self-perpetuating. The childish mindset belied by the focus on safety—which is very much in full effect in the United States, as evidenced by the DHS, among a variety of other safety-oriented federal agencies—is often accompanied by another childish mindset: tattling.
And here is how it all works: citizens are treated like children, and they eventually come to act like children: dependent ignorant, unthinking, and hedonistic. They are unduly focused on safety, being generally unable to provide it for themselves, and they are told that they can only be safe if they obey The Rules. Nothing enrages the infantile mind more than disobedience to the rules; it is as if the fundamental justice of the universe has been called into question if anyone ever disobeys The Rules. They are in place to keep us safe, after all, and therefore everyone must comply with them.
Therefore, when the infantile-minded of society observe someone disobeying the rules, like running a red light or holding gold when it’s forbidden to do so, the infantile-minded will have no qualms about tattling to the paternalistic government because they perceive themselves to be acting in the best interest of society. In reality, the tattlers are nothing more petty tyrants who wish to exercise power over others, in the guise of acting in everyone’s best interests.
Nonetheless, that is how the paternalistic society works and self-perpetuates. Citizens are treated as children, then act as children, and eventually take on the vices of children. And then society collapses on itself.
Is being poor self-reinforcing because it forces one to spend more on stuff a little bit at a time over time, as opposed to saving up and/or forking over a large sum at once, and eventually spending less?
I don’t consider myself “poor,” but I do have a personal situation that illustrates the question:
I have dental problems. That’s no secret — I’ve talked about it, and other people have talked about it, both to my face and behind my back (no, Sully, it’s not “meth mouth” — I’m not a druggie).
I’ve had these problems for years, and have taken steps toward getting them corrected. A couple of years ago, for example, I had all of my top teeth pulled and got a denture. That ended up costing around a thousand bucks.
The denture only got used for awhile. My remaining bottom teeth are so fragile that if I wear the denture, it breaks them … and I haven’t been able to afford to address the bottom teeth yet.
Essentially, I need another thousand bucks worth of dental work (at a minimum — if I go to one of the $299 denture places, they’ll extract my remaining teeth for $30 a pop, so $600 for two dentures since the old one has long since ceased to fit due to gum shrinkage, and $340 for the extractions).
Since I don’t have a thousand spare bucks to get all that done, I spend money on benzocaine gel, over-the-counter pain relievers and decongestants (I’ve noticed that usually the most painful times are when I’m congested — I guess the sinuses press on the tooth nerves), occasionally on antibiotics, etc.
I can attest with certainty that I’ve also missed out on opportunities to make more money due to this problem. Not only am I embarrassed to be seen this way (which means that I no longer do public speaking engagements, which have been an occasional income source in the past), but I spend probably a week out of each month in severe, sometimes literally blinding, pain that reduces my personal productivity.
And, like I said, I don’t consider myself “poor.” Granted, I personally make little enough that even if I consented to fill out tax returns I’d have little or no liability; and granted, until very recently about half (sometimes more!) of what I made went to a child support obligation; but my significant other makes fairly good money, nobody’s starving at my house, and we do live beyond the bare necessities.
I suspect that laying out a thousand bucks at a whack is a pretty big deal for most people, and out of the question for the truly “poor.”
I also suspect that this is self-reinforcing because various things nickel-and-dime the truly poor to death and stop them from getting out of the hole.
A newer car would set them back three grand, but they can’t manage that … so they trickle out $50 or $100 a month repairing the old clunker because they absolutely have to have it to get to work.
Or they mow two or three yards a week and know they could make good money running a full-time lawn service, but they can’t fork over for the additional equipment and other startup costs, so they just keep on working at Taco Bell.
Or any health problem — mine above is just an example — costs them X days in lost income from being off work each year, but they can’t get the cash together to get it correctly addressed, so they spend a little bit at a time on pain reduction and such and just try to muddle through.
I assume that this is a well-described economic phenomenon, but I thought I’d bring it up for comment. It’s pretty much a matter of needing to post something to the blog, and the only thing on my mind being this damn toothache. So anyway, discuss.
Let’s start with the already famous exchange in which Justice Antonin Scalia compared the purchase of health insurance to the purchase of broccoli, with the implication that if the government can compel you to do the former, it can also compel you to do the latter. That comparison horrified health care experts all across America because health insurance is nothing like broccoli.
Why? When people choose not to buy broccoli, they don’t make broccoli unavailable to those who want it. But when people don’t buy health insurance until they get sick — which is what happens in the absence of a mandate — the resulting worsening of the risk pool makes insurance more expensive, and often unaffordable, for those who remain. As a result, unregulated health insurance basically doesn’t work, and never has.
There are at least two ways to address this reality — which is, by the way, very much an issue involving interstate commerce, and hence a valid federal concern. One is to tax everyone — healthy and sick alike — and use the money raised to provide health coverage. That’s what Medicare and Medicaid do. The other is to require that everyone buy insurance, while aiding those for whom this is a financial hardship.
Now, there is no doubt that non-participation in a market has an impact on that market, regardless of whether we’re talking vegetables or health care. Krugman’s conclusion is essentially correct given it’s implicit assumptions and general framework of analysis. However, there are two essential problems with his arguments.
The first problem is that what is generally referred to by most as “health insurance” would be more accurately described as a combination of medical insurance and prepaid health care. Insurance, by definition, does not cover unavoidable risks. For example, homeowner’s insurance does not cover self-caused damage, like arson committed by the homeowner, because such behavior has no risk, in the sense that everyone who intentionally burns their house own does so intentionally, and therefore the odds of someone intentionally burning their house down are either one hundred percent or zero percent (i.e. they either will do it or won’t do it, and in either case the outcome is due to intentional behavior and not random chance).
In a like manner, there are certain medical procedures that are perfectly predictable, like having a cold or needing a physical. These things are routine, and thus predictable. As such, the risk profile for everyone regarding these things is essentially one hundred percent, which is why insurance coverage for these sort of things is so expensive: “insurance” providers know they’re going to pay for these things, so they simply charge them in advance.
Real medical insurance would only insure for things that are both individually unpredictable and personally undesirable (like a broken leg, e.g.). Thus, Krugman is not talking about real insurance, but rather prepaid health care. He is wrong to say that everyone should be forced to buy health insurance, but he is correct to say that everyone should be forced to buy prepaid health care, for the reasons he listed above.
The second problem is that Krugman conflates economic laws with constitutional laws. While it is true, as noted before, that even non-interaction with a market still impacts a market, this simple (and true) observation is irrelevant to the issue at hand.
The question the Supreme Court needs to answer is not whether an individual’s decision to refrain from buying health insurance will at some point impact interstate commerce (it undoubtedly will, seeing as how all aspects of the economy are interrelated). Rather, the question the Supreme Court needs to answer is: what does the constitution mean when it says “interstate commerce”?
The latter question is indeed the more relevant one, particularly in light of the nature of constitutional law. What is the purview of the federal government in light of its authority to regulate interstate commerce? Laws are, in a sense, quite arbitrary in their scope and application, so the answer to the question doesn’t have to make sense to an economist. It need only have an objective and unchanging definition. As such, it behooves Krugman, as well as all nine justices, to spend some time trying to figure out what the authors and ratifiers of the constitution meant when the constitution was written and adopted. It may be interstate commerce refers to direct trade among the states. It may be that interstate commerce refers to any and all economic activity. It may even be the case that interstate commerce refers to economic non-activity or inactivity.
However, it is the original legal definition of the term that matters when considering the application of the law in this case; the rambling opinion of a doddering Keynesian does not. Therefore, Krugman’s argument is wholly irrelevant to the question at hand because the Supreme Court is not trying to write an economics paper but rather interpret the constitution. The two are not the same, and Krugman’s conflation simply reveals that he is quite clearly outside his realm of expertise, and so he should simply move on to other subjects where his ignorance is not as readily apparent.
Volatile markets. Natural disasters. Geopolitical turmoil. Last year was definitely one for the record books, according to Carlos Andres, managing editor and publisher of the Frontier Research Report. With the world in turmoil, is there any upside for mining investors? Andres believes there is for investors courageous enough to look past the perceived risk and snap up battered, but fundamentally sound, junior mining stocks. In this exclusive interview with The Gold Report, Andres talks about why historical data points to a breakout year for gold and perhaps gold shares.
The Gold Report: In a recent edition of the Frontier Research Report, you wrote, “As perplexing and disconcerting as it may be, the performance of major global stock markets currently has a much stronger influence on share prices in the mining sector than the actual performance of the underlying commodity.” How is that different from previous cyclical dips in the resource commodity space?
Carlos Andres: It’s not different at all. The commodity space tends to be viewed with a bit of fear and skepticism by most retail investors and analysts generally. By extension, mining companies are viewed skeptically also, especially those in emerging and frontier markets. As a result, resource companies in emerging and frontier markets tend to be the last to receive investment capital during a bull market in stocks and the first that investors exit when markets get rattled.
TGR: Do you see a time in the near future when mining equities are influenced more directly by commodity prices instead of overall market conditions?
CA: It happens in the mature phase of a commodity bull, but the dynamic just described isn’t going to disappear. However, I wouldn’t be in this space if I didn’t expect there to be appreciation in the shares. Although rising commodity prices drive the process, investors and analysts cannot ignore rising profits at mining companies as commodity prices rise. Analysts begin to look foolish by ignoring sectors that are outperforming. Generally, these rising profits begin to attract the investment herd to the mining space. Some of this money will also find its way into the junior resource exploration companies we cover. Because this market is relatively small compared to the overall market, it doesn’t take much investment capital to drive share prices significantly higher, often many multiples higher than where the share prices bottomed.
TGR: In your latest edition of the Frontier Research Report you wrote, “Gold outperformed all major stock markets (in 2011) with a gain of +10%, confirming its role as the ultimate safe haven.” Yet many pundits believe gold plays second fiddle, if not third or fourth, to the U.S. dollar in terms of “safe haven” investments and that gold’s fall in the latter half of 2011 severely tarnished gold’s reputation as a safe haven. Whom should retail investors believe?
CA: Since January 2000, the dollar is down 22%. During that same period, gold is up 497%. During this same period we have had a tech bubble, 9-11, wars in Iraq and Afghanistan, a global financial crisis in 2008 and the global train wreck that characterized 2011. This is a hint at the answer to your question. In 2011, the dollar was flat, while gold was up 10%. You be the judge.
TGR: Last year marked the 11th straight year of gains for gold. It has only returned less than 10% in four different years: 2001, 2004, 2008 and 2011. That pattern suggests that gold slumps slightly every three years. It begs the question: What’s the pattern in the years immediately after a slump?
CA: Gold has performed very well after the years with single digit gains. For example, gold returned 1% in 2001, but then returned 26% in 2002 and 20% in 2003. In 2004, gold had a 5% gain, but in the following years it was 17%, 23% and 32%. In 2005, it returned 5% again. However, in 2009, it reached 25%, and in 2010, it hit 30%.
Based on historical returns, gold could perform quite well in 2012. It could also break the pattern and underperform, and that wouldn’t shock me or cause me to change my outlook on gold. If gold didn’t perform well in 2012, I would still keep my eye on the supply and demand fundamentals, which are as positive, if not more so, than they were at the beginning of the gold bull more than a decade ago.
TGR: The gold price is already off to a good start for the year.
CA: That’s right. It’s up 14%. As you say, we’re off to a good start.
TGR: What role could China play in gold’s performance this year?
CA: China’s role could be huge. China is the largest gold producer on the planet. It is also the second largest consumer behind India. However, China’s demand is rising at a torrid pace and thus will likely pass India in the near future. No other countries even come close to the level of demand from these two. The Chinese government has become extremely aggressive in building up the country’s gold reserves as well as promoting gold ownership for its citizens. It has adopted a long-term policy of accumulating gold reserves with a goal of catching the U.S. Believe it or not, China would ultimately like to see the yuan established firmly as a global reserve currency like the dollar. The government is also encouraging the public, which has a historic affinity for gold anyway, to accumulate a significant portion of its already large savings in gold. Therefore, China will continue to be a huge driver underpinning a rising gold price.
TGR: If there were transparency in China’s purchasing patterns, would we see a rise in the gold price?
CA: It’s widely believed that the Chinese are buying far more than it admits to. It’s only recently that China has admitted to having over 1,000 tonnes, which was a surprise because it was believed to be much smaller than that. This revelation provided strong support for the gold price. We know that over the short term, China wants to catch up with the reserves of Germany, France and Italy at around 3,500 tonnes and ultimately the U.S., which has around 8,000 tonnes. If China’s true activities were revealed, I suspect it would drive the gold price to much higher levels.
TGR: You haven’t ditched gold because of events in 2011. What opportunities are you looking at this year?
CA: No, I haven’t steered away from gold. The fundamentals look fine to me, so I’m happy to buy junior gold explorers in emerging and frontier markets at these distressed levels.
TGR: What does your research process involve when you’re investigating a mining company?
CA: I generally visit exploration projects, interview management and perform extensive due diligence on all public and private information I can get my hands on. I’m very interested in looking for opportunities in emerging and frontier markets because they tend to be shunned for their perceived risk as opposed to actual risk.
Our approach is to take a close look at these companies, their projects, the jurisdictions they operate in, their management teams, financing, and investor relations as factors to get a feel for their prospects, regardless of the fact that they may be in emerging and frontier markets where perceived risk is fairly high. We pick the best of the best. Honestly, the more risk associated with these companies, the more we like it. It means we’ll be able to buy the shares at depressed prices that don’t reflect their inherent value.
TGR: What are some of those names?
CA: Sulliden Gold Corp. (SUE:TSX; SDDDF:OTCQX; SUE:BVL) in Peru is a favorite. It has an excellent management team. Its Shahuindo gold project represents a large, low-grade, bulk-tonnage affair with a deposit that is literally open in all directions, including at depth. The company continues to find mineralization in all directions that’s consistent with what it has already found. It had 1 million ounces (Moz) defined when we first recommended the company in 2010. Since then the resource has grown to about 3.4 Moz and it likely has a long way to go before Sulliden finds its limits. We wouldn’t be surprised if it has 5 Moz by the end of the year, and in our opinion the sky’s the limit beyond that.
In terms of jurisdiction, Peru is one of the biggest gold producers on the planet with a mature mining industry; however, it has had a few hiccups on the local level lately. Some mining operations have experienced protests, sometimes violent, from the local communities, including Newmont Mining Corp.’s (NEM:NYSE) giant Conga project, which was under construction. There were serious local protests and, as a result, it shelved that project temporarily. The project appears to be back on track and Newmont expects to begin production from the new mine in 2015. Although we are watching all aspects of the situation in Peru closely, events have not been sufficient to cause us to turn negative on the country as a mining jurisdiction.
TGR: Sulliden recently purchased a 1.5% net smelter return royalty on Shahuindo for $11 million (M). Was that a good price, or did it create a lag on Sulliden’s stock?
CA: I don’t believe it caused a lag on the stock. Sulliden’s stock price has retreated in lock step with the overall markets in general and along with the gold mining sector in particular. The current mine plan calls for 105,000 oz of annual production with a 10-year mine life. We think the mine life will ultimately be much larger than that. However, using these figures and a $1,500/oz gold price, Sulliden paid $11M now to obtain $24M in revenue over the 10-year mine life. That’s not a bad deal and given that the deposit and the mine life are likely to grow, this is probably a shrewd move by management.
TGR: Sulliden recently had a drill intercept of about 54 meters (m) at 0.85 grams per ton (g/t) gold and 71.4 g/t silver in the central corridor of Shahuindo. What’s interesting about that is the high-grade silver aspect of that intercept. Do you believe that this is becoming more of a silver play than a gold play and may garner some interest from some of the big silver players?
CA: It certainly has the potential. At current market prices, the gold deposit is roughly 2.6 times bigger than the silver deposit. If Sulliden continues to encounter silver grades and intercepts like this going forward, it may indeed reduce that ratio further, making it more attractive to silver players over time.
TGR: What other companies interest you right now?
CA: Because we are talking about Peru, let’s talk about Minera IRL Ltd. (IRL:TSX). It has a strong management team led by Courtney Chamberlain, a man whose capabilities we highly respect. Although considered a junior explorer, the company has a producing gold mine, Corihuarmi, in Peru, which is helping to finance exploration at its flagship project named Ollachea, a much bigger project in Peru. Existing production is always nice as it diminishes the company’s need to raise capital and dilute shareholders.
Ollachea, so far, has 1.4 Moz of Indicated resources, of which 1.1 Moz are classified as “Probable,” and an additional 1.2 Moz of Inferred, with strong grades between 2.8 g/t and 4.0 g/t. That’s 3.6 Moz in all. To make things more exciting, the deposit consists of two separate zones and both are open in all directions. The company is on to something very large. This will be an underground affair, and as such, Minera is currently digging a lengthy tunnel into the mountain that will be both the basis for production as well as for further exploration deeper into the existing deposit. The project is advancing rapidly as Minera has already completed a prefeasibility study and the definitive study is expected by the 3rd quarter of this year. It currently expects to bring the deposit into production in 2014 at a rate of 117,000 oz (117 Koz) per year. To top it off, the company maintains outstanding relationships with the local community.
The company also hopes to rapidly advance production on its Don Nicolas project in southern Argentina. Don Nicolas is in a highly prospective gold district known as the Deseado Massif, where many of the majors are located. It’s turning into a gold-silver district of significant proportions. The project already has an established resource of over 500 Koz with respectable grades between 1.5 g/t and 2 g/t. Minera is planning to bring this deposit into production in 2013.
Don Nicholas is right next door to another promising company that we cover, Mariana Resources Ltd. (MRY:TSX; MARL:LSE). Minera and Mariana actually own separate halves of the same deposit. The property line between them bisects the deposit. As each company makes progress, it actually helps both to assess the geology.
TGR: Don Nicholas’s recent feasibility study indicates that at $1,250/oz gold, it would create an internal rate of return (IRR) of about 35%. If the price of gold increases by $300/oz, the IRR could top 50%. However, Pan American Silver Corp. (PAA:TSX; PAAS:NASDAQ) has had some issues with permitting its Navidad project in Chubut province in Argentina. Is Minera likely to encounter problems, too?
CA: No, we don’t think so. Don Nicholas is in the Santa Cruz province, which is known to be extraordinarily mining-friendly. The agriculture and ranching economy of Santa Cruz was destroyed 20 years ago by a blanket of ash dropped by a volcano in Chile. The area has welcomed mining to restart a dead economy, but other provinces in Argentina have proven to be unfriendly to mining.
TGR: Are there any other unusual jurisdictions that you’re looking at?
CA: Lion One Metals Ltd. (LIO:TSX.V; LOMLF:OTCQX; LY1:FSE) is advancing the Tuvatu gold deposit in Fiji. A previous owner had defined an underground deposit and prepared a feasibility study. The project was shelved due to low gold prices in the late ’90s. This was all prior to the advent of NI 43-101 standards so Lion One has to carry out definition drilling again to define the deposit based on current standards. The bottom line is that we know there’s gold there; the question is how much. All indications are that there is a great deal. In addition, survey work and drill results have caused the company to reinterpret the geology of Tuvatu in a way that suggests the potential for a large open-pit bulk mining operation.
TGR: Lion One has split Tuvatu into a number of development areas. It would like to expand the high-grade underground epithermal system in addition to proving up the larger bulk tonnage target. Is this accurate in your view? And what do you think the upside potential is?
CA: We should know a lot more by the end of the year. There is an underground situation with an existing tunnel, so it doesn’t have to dig a new one. It allows the company access into the heart of the mineralization that’s already been discovered. Lion One can explore from there. But this tunnel is about 200m underground, and there is mineralization between the surface and the top of the tunnel. If the mineralization is sizeable enough, a bulk-tonnage low-cost open-pit mine may indeed be what makes sense there. That, combined with the fact that it’s identified a few other target zones close by that have consistent geology, means the size and scope of the deposit may be very large. Some important milestones are going to be reached in 2012. We should see a maiden resource estimate and some light should be shed on whether the mineralization conforms to an open-pit bulk-mining solution.
TGR: Fiji is a beautiful place. A large, open-pit gold mine doesn’t seem to fit with the country’s tourism-based economy.
CA: That’s a good point and worth talking about. We can’t guarantee that there won’t be issues, but the government of Fiji has historically been friendly to mining. The Vatukoula gold mine has operated for decades just 50 kilometers up the road. In addition, China recently opened a bauxite mine there. We are not overly concerned about it. But an open-pit mine in this particular area of Fiji is new territory, so there will be environmental issues that will have to be addressed successfully.
TGR: Do you have some parting thoughts on this space?
CA: The markets, natural disasters, financial crises, economic upheaval, geopolitical events like the Arab Spring—all of these things made 2011 one for the record books. It created a great deal of fear in the minds of investors, even though the junior gold mining sector had positive fundamentals. The markets were overwhelmed, even in the places where there was some light. Investors need to stay dialed into the fundamentals because, over the long term, fundamentals will assert themselves regardless of short-term shocks to the marketplace. I encourage investors to be bold enough to take advantage of price weakness when it comes. This is one way in which you mitigate risk in the sector. Buy strong companies where the underlying fundamentals are also extremely strong. Even when those companies get hammered during hard times, investors should use those as buying opportunities to add new companies to your portfolio or reduce the basis in your existing holdings.
TGR: Thank you for your time, Carlos.
CA: It was my pleasure, Brian.
Carlos Andres is the managing editor and chief analyst of the Frontier Research Report, a natural resource-oriented monthly investment newsletter focused on high-risk, high-reward junior exploration companies in emerging and frontier markets. Andres applies a potent mix of world-class expertise and lengthy experience in identifying countries and companies where “perceived” risk is much higher than “actual” risk, providing opportunities to profit significantly on the difference. Andres has been a natural resource analyst and investor for over 15 years.
The resource markets have weathered some death defying ups and downs lately. But Michael Ballanger, senior investment advisor with Toronto-based Union Securities, is looking for a renewed period of growth in the TSX Venture Composite Index. Is it too soon to see such a heady rebound? In this exclusive interview with The Gold Report, Ballanger makes his case for history repeating itself.
The Gold Report: The TSX Venture Composite Index reached a bottom of around 1,300 in October after it more than tripled from 2009 to early 2011. You believe the index is poised for another two-year gain. It’s an interesting theory. Why should we believe that history will more or less repeat itself so quickly?
Michael Ballanger: It’s all about mathematics. However, underneath that forecast lurks a much deeper premise. I’m a member of a very small minority that believes we’re now in the continuation of a massive bull market in resources. The TSX Venture Exchange has had one sharp correction since 2008. It’s now resuming its uptrend.
I’m also looking for a resurgence of the “manic phase” of markets. During the last manic phase in 1978–1981, the Vancouver Stock Exchange quadrupled in an 18-month period as gold went into its final ascendancy.
TGR: What were some characteristics of the market in the ’70s that are comparable to what’s happening now?
MB: Psychologically there are a lot of similarities to 1978 because investors have been behaving like scared rabbits. Fund managers were throwing things under the bus in October that I couldn’t believe. It was mass liquidation for no reason. It was a generational buying opportunity.
TGR: There seems to be a lot more global instability now. Are you expecting “black swan” events in the next few years that could create further instability?
MB: I’m not looking for Armageddon at all. I think we are going to have a really good two-year run. There will be bumps along the way as the world financial system irons out its issues. Nothing cures debt levels better than inflation and growth, however.
TGR: This does seem to be a very friendly environment for commodity prices and resource companies. But aren’t we just one negative macroeconomic data point away from being right back where we were?
MB: The problem with the media is that it continues to use European and North American data as its guidepost. Developing nations are creating demand for resources like I’ve never seen before. The population is growing and resources are being used at an increasing rate despite Europe, Japan and the U.S. struggling.
A lot of these populations approach gold and silver differently than the West does. They’re not looking to trade it. It is part of their legacy that they pass down to generations. That’s where the demand for the precious metals will come from. It’s a shift in demand.
TGR: Most of the junior mining companies listed on the TSX Venture Exchange are gold companies. If you believe the TSX Venture Index is going up, you have to believe the gold price will head higher, too. What’s your trading range for gold in 2012?
MB: Industrial metals, like zinc, copper and nickel, are going to outperform the precious metals in 2012. Just as the base metals got hammered violently in ‘08, the same occurred in the latter half of ‘11. The resultant rebound should show a greater percentage move based on the global recovery.
Silver could outperform gold in 2012 due largely to the supply-and-demand situation. However, gold and silver could both take out their 2011 highs this year. Gold at $1,525/ounce (oz) and silver at $25/oz will be seen as the correction lows in this multi-decade bull market. Those are two levels I wouldn’t want to see violated.
TGR: What’s the upside for gold and silver prices?
MB: Gold and silver could both take out their 2011 highs, but I don’t like picking numbers. It just gets meaningless. It is an absolute breeding ground for gold and silver bugs. Not that I’m one of them, but it is a very favorable environment for the metals. If you’re on the right side of the trend, you make money in the junior mining stocks.
TGR: You created a 2012 list of your top value plays. Could you tell our readers about some of those names?
MB: We emphasized Yukon stocks last spring and our two picks, Kaminak Gold Corp. (KAM:TSX.V) and ATAC Resources Ltd. (ATC:TSX.V), hit record highs in July. The bright spot for this summer was the relatively superb performance of Tinka Resources Ltd. (TK:TSX.V; TLD:FSE; TKRFF:OTCPK), which closed 2011 above the July 2011 financing crisis of $0.35.
Another favorite that we’ve been involved with for four years and participated in multiple financings for is Explor Resources Inc. (EXS:TSX.V). It reported an NI 43-101-compliant 800,000 oz resource recently. It has been one of our top five companies since 2007.
Kaminak is still our darling of the Yukon. There’s a lot of wannabes running around, but Kaminak is superbly run by Rob Carpenter.
Our junior penny stock in the Yukon is Stakeholder Gold Corp. (SRC:TSX.V). It is sandwiched between Kaminak and Kinross Gold Corp. (K:TSX.V; KGC:NYSE) in the Ballarat Creek area, which is located on Thistle Mountain.
TGR: Tinka’s Colquipucro silver-lead-zinc project in Peru looks promising. What do you know about what’s happening there?
MB: I must confess, Tinka has been a nice surprise. It was orphaned after the 2008 meltdown despite having drilled off an NI 43-101-compliant silver resource of 20.3 million ounces (Moz). It has two drills working about 1 kilometer apart at its deposit and at a new discovery, Ayawilca.
It’s all open-pittable. Just move the top of the rock off, throw it on a crusher and you’re away to the races. It’s an engineer’s dream. The first game plan is to get that resource up to north of 30 Moz. Now the blue sky becomes what is happening at depth underneath this oxide cap.
Just to the south is Cerro de Pasco, which is owned by Peruvian mining company Volcan Compania Minera SAA. It’s the fourth biggest mine in Peru, one of the largest in South America and it is a massive epithermal. What’s interesting about Cerro de Pasco is that the mineral rhodochrosite is prevalent there. Rhodochrosite isn’t prevalent except in an epithermal. Tinka recently indicated that it has rhodochrosite at Ayawilca. There isn’t enough drilling into it yet to confirm it’s an epithermal, but Ayawilca’s blue sky just lights up like a Christmas tree when you look at it.
TGR: How does its valuation compare with other companies at similar stages?
MB: It’s too early to value Ayawilca, but you can value Tinka’s silver. Tinka’s got 20.3 Moz Inferred, but I have confidence it’s going to move to 30 Moz.
With a rising silver price and the investment public warming to juniors again, it could reach a market cap of around $60–75 million (M) up from $38M today. That’s based on the known. The unknown is where you accelerate your return. Ayawilca is the blue sky. If Mother Nature and Lady Luck bless us then we’re going to be looking at the Ayawilca zone adding a lot more upside in the future.
TGR: Kaminak just recently optioned some potash properties in Michigan. Do you have any idea why?
MB: Shareholder value. Rob Carpenter knows that the ultimate rate of return for Kaminak is going to be the Coffee gold project in the Yukon. Kaminak has other assets that aren’t being paid much attention. The best way to get shareholder value out of those is to let somebody else go to work on them while maintaining focus on a flagship property like Coffee. Let other people bear the risk and costs of exploring those properties.
TGR: Kaminak and ATAC shares have started to climb higher this year. ATAC reported a nice intersection in early December of 44 meters at about 4.5 grams/ton gold at its Osiris zone. Is ATAC going to return to its 2011 high?
MB: When a stock like ATAC, which moved to $10/share in July, is thrown irreverently under a bus, I have to ask why. I still can’t figure that out. It wasn’t the retail public. It had to be quasi-professional investors. ATAC has an excellent chance to get back to the midrange between where it bottomed around $2/share and its high of $10/share last year.
I think Kaminak is a takeover waiting to happen. The way that the Coffee property is being developed, there could be 6–8 Moz there. It has only drilled off 15% of the land package.
TGR: Stakeholder Gold is a micro-cap company with a market cap of just a few million dollars. Are they going to be drilling anything soon?
MB: Stakeholder had originally planned to drill the Ballarat property in July, but through some unfortunate developments it wasn’t able to. I’ve looked at all the soil and trenching analysis. Various creeks flow down the sides of the mountain into the Yukon River. Where theses creeks flow is where the Klondike Gold Rush was. The source of that mineralization was in the upper elevation where Stakeholder’s Ballarat property is. Stakeholder has excellent soils. It has good trenching results. It has two anomalies there. That property’s got to get drilled. It’s got every bit as much of what I call “geochem evidence” as Kaminak did before it drilled the Coffee property.
Yes, Stakeholder is a micro cap. But some Yukon juniors had $35M market caps when they didn’t have any discoveries two years ago. I view Stakeholder as a bottom-feeding expedition now that it has dropped down to $5M. Stakeholder has got an excellent land package. It’s compelling. That’s why we like it.
TGR: Some market pundits feel that the junior exploration and mining sector has been hurt over the past decade as it moves from being a retail investor sector to an institutional investor sector.
A share price would jump on news and the retail investor would cash out and watch the stock come back down and buy back in. The retail investor would make money two or three times while supporting the stock price. Now the institutional investors get in, make their money and get out and stay out. What are your thoughts on that?
MB: If a management group executes its plan, the company gets rewarded whether it has an institutional, retail or a combination shareholder base. Take Kaminak as an example. Despite the recent correction, Kaminak has been a very successful company.
People have asked me, “Why aren’t the juniors attracting the same kind of dominance they had in the ’90s and the late ’70s?” There are other reasons than the institutional involvement, such as the advent of exchange traded funds (ETFs). I’m going to get into hot water, but I absolutely detest ETFs. They’re a financial product developed by and for the express benefit of the financial industry as opposed to the investor. I don’t believe in them, I don’t agree with them and I don’t use them.
The problem with ETFs is they create this risk on/risk off attitude that the junior mining sector is a basket and it doesn’t matter what Tinka’s got or Explor’s got or Kaminak’s got. That’s what happened in the latter part of 2011. Investors said, “Oh, we better get out! We’ll sell everything.” They didn’t care that Kaminak’s last three drill holes were spectacular. It didn’t matter. They sell their ETF associated with junior mining companies and all the companies that are covered by that ETF get blown off.
TGR: Do you have any parting thoughts for us on this sector?
MB: In 2009, I predicted higher gold and silver prices and a booming mania-driven junior mining sector. We got the move in the precious metals. We have yet to experience anything close to the mania that we saw in 1978–1980. The TSX Venture Exchange traded to a new low on Oct. 4 relative to the gold price. It was absurd by any measure. Companies are taking the risks to find new deposits. That’s precisely where the big upside is moving forward into 2012.
TGR: Thanks, Michael.
Michael Ballanger currently serves as an investment advisor at Union Securities, Ltd. He joined the investment industry in 1977 with McLeod Young Weir Ltd. His substantial background in financing junior resource companies is further informed by his 30 years of experience as a junior mining and exploration specialist. Ballanger earned a Bachelor of Science in finance and a Bachelor of Arts in marketing from Saint Louis University.
Economics and politics. Accretion and repletion. Mergers and acquisitions. Joe Mazumdar, senior mining analyst with Haywood Securities, sees all of these as catalysts for a rebound in the junior gold space in 2012. In this exclusive Gold Report interview, he reveals the names of companies he expects to take off.
The Gold Report: What is the consensus among Haywood analysts on what 2012 will bring for mine commodities, particularly precious metals?
Joe Mazumdar: Last year, risk aversion was a common market theme. In 2012, some of the same global economic concerns, such as the ongoing Eurozone crisis and the future of the euro, will continue to draw attention. But we also believe there is potential for positive economic indicators, primarily from the U.S., where there have been upticks in manufacturing and GDP growth. Also, unemployment in the U.S. is down to 8.5%, generating some consumer confidence. Recently, GDP growth for Q411 came in at 2.8%, which was slower than consensus forecasts—3%—but still the strongest in over a year.
Political factors will play a role in 2012. There could be a change in leadership among four of the five permanent members of the U.N. Security Council. The presidential election will be a key focus of the U.S. and global market. There are also presidential elections in Russia, France and Mexico. There also may be a changing of the guard in China in the latter part of 2012. The potential for changes in leadership in these key nations will generate a bid to market volatility in 2012.
Beyond gold and silver, our preferred commodity sectors include copper, iron ore and coal. Gold continues to be adversely affected by its own volatility, which continues to tarnish its reputation as a safe-haven asset. We note that during 2011, U.S. Treasury securities, the most liquid safe-haven asset, was a preferred recipient of capital investment, providing a ~10% return, its highest annual return since 2008 when it was 14%.
TGR: Will the strengthening American economy have an adverse effect on the gold price?
JM: Yes, the gold price quoted in U.S. dollars will be hindered by any U.S. dollar strength based on economic growth and increasing consumer confidence. In the current environment, gold, quoted in U.S. dollars, is still holding up well at price levels over $1,700/ounce (oz).
We note that the Federal Reserve said recently that it remains concerned about the “vigor” of U.S. economic growth and pledged to maintain low interest rates until at least 2014. The latter is a positive for gold prices.
In the medium to long term, increasing confidence levels in U.S. economic growth we believe will drive higher capital investments domestically and potentially raise inflation expectations, which would be a positive for gold.
TGR: What about silver and copper?
JM: We see copper on the brink of a rebound in 2012. The London Metals Exchange inventories are at low levels and Chinese imports of refined copper accelerated in the latter part of 2011. Copper is covered by Stefan Ioannou/Kerry Smith of Haywood Securities and they highlight a structural tightness in the copper market as supply growth remains constrained while a portion of future production growth resides in higher geopolitical risk jurisdictions. They note that the GFMS has estimated a deficit of 372 Kt copper in 2011 and forecast yet another deficit for 2012, 101 Kt.
Chris Thompson covers the silver sector for Haywood Securities and has commented that despite the growth in investment demand over the past five years, silver is still very much an industrial metal. Volatility, he believes, will be underpinned by potential contradictory moves by those who see silver as an industrial metal and others who seek it as an investment asset.
TGR: Did the junior mining sector hit bottom in 2011?
JM: Within the current cycle, I think it has hit bottom. For me, the question remains: What are the catalysts that will move individual stocks up within the sector?
For a number of the majors, growth has been increasingly difficult to achieve given the higher amounts of reserves they must replete on an annual basis. Companies such as Newmont Mining Corp. (NEM:NYSE) have been offering higher and more levered dividend payout structures to attract investors.
In 2012, we see the potential for more merger and acquisition (M&A) activity, specifically in the junior to intermediate sector, given the plethora of small-cap stories in the gold sector. Producers have performed better with respect to their paper in 2011, compared to development stocks, and boast healthier balance sheets. M&A activity will be driven not only by a desire for growth but also motivated by financing risk to capture any synergistic opportunities such as sharing infrastructure and the potential to merge critical skill sets. There is a paucity of people who can bring projects into production and operate them. Merging structures and management is very important right now in the junior and intermediate sector. Without it, a lot of these companies with development assets may continue to struggle.
TGR: Do you expect the Kinross Gold Corp. (K:TSX; KGC:NYSE, Not Rated) write-down to have an adverse effect on M&A?
JM: Large projects that are required to move the needle in the growth strategy of a large gold producer have a scale and scope that naturally expose them to significant execution risk. So, in a nutshell, escalating capital costs for projects of this magnitude are nothing new.
The M&A opportunities I refer to are at a scale that would be accretive to a junior to intermediate company from a growth perspective and offer opportunities to capture synergistic value. From a valuation perspective, many companies with development stage assets are trading well below their underlying asset valuations. M&A activity allows also for some consolidation in the junior sector given the plethora of small-cap gold plays.
TGR: Did you make any adjustments to your investment thesis following the dip in precious metals equities late in 2011?
JM: In our top picks, which we put out on Jan. 9, we focused on producers generating cash flow and developers with permitted or on a clear path-to-permitted projects in low geopolitical risk jurisdictions.
One pick was Midas Gold Corp. (MAX:TSX, Not Rated), whose flagship asset, the Golden Meadows project, hosts a global resource of 5.8 million ounce (Moz) in the Yellow Pine Stibnite area on a large land package (11,600 hectares) in west-central Idaho, a re-emerging gold district. The company is working toward an updated gold resource estimate before the end of Q112, leading to a preliminary economic assessment (PEA) by Q312.
TGR: Can you give us another name on your list?
JM: Yes, Midway Gold Corp. (MDW:TSX.V; MDW:NYSE.A, Sector Outperform, CA$3.25 Target Price). It has the Spring Valley gold project, an intrusive-hosted gold deposit with a global resource, we estimate at over 5 Moz, in a district close to Lovelock, Nevada, where Barrick Gold Corp. (ABX:TSX; ABX:NYSE, Sector Outperform, CA$61 Target Price), is earning in up to 70% by 2013 by cumulatively spending US$38M.
From a metallurgic perspective, the gold is free, not occluded in pyrite and potentially amenable to be economically extracted via a heap-leach process. Barrick, the joint-venture operator, is currently drilling the edges of the deposit to find out how big it could be. This means the near-term news flow will be linked to drilling results and less about a resource update in 2012.
Midway has a portfolio of projects that it is capable of bringing on-line. Its Pan project, a low strip open-pit, heap-leach gold project in Nevada, has submitted a completed bankable feasibility study and a plan of operations. Its Gold Rock project, only 8 kilometers from Pan, is in an earlier stage where we anticipate a resource by Q112 with additional drilling in Q2–Q312, leading to another resource update by Q412 and a PEA by 2013. Additionally, Midway is working a low-sulphidation, high-grade gold project in the Tonopah District.
Midway has a portfolio of projects and is assembling a team to build and operate them. Its COO, Ken Brunk, formerly with Newmont and Romarco, is very familiar with the permitting process and developing/operating projects in Nevada. I believe the company can manage this project pipeline of financeable projects in the low geopolitical risk jurisdiction of Nevada.
TGR: Your target price for Midway is $3.25, up $0.25 from your last report. With that many projects in the development stage, it seems that Midway would be a prime takeover target, especially given its joint venture with Barrick.
JM: Barrick is looking at a number of projects in Nevada, some of which are billion-dollar-plus projects that would add significant ounces to its production profile including Spring Valley, Goldstrike and an expansion at Turquoise Ridge. I believe that Spring Valley may be a target for Barrick going forward as it has potential to contain a +5 Moz global resource and lies in Nevada where Barrick has a significant infrastructure and asset base.
However, the other components of the company’s portfolio, which include smaller open-pit, heap-leach projects, such as Pan and Gold Rock, that could potentially produce between 70–90 thousand ounces (Koz)/year, would not move the needle for most majors. These smaller projects do generate cash flow and are more readily financeable by a company the size of Midway. They could also be attractive to an intermediate operating group looking at accretive transactions with junior developers.
TGR: You cover Orvana Minerals Corp. (ORV:TSX, Sector Outperform, CA$2.25 Target Price), which is in production at its Don Mario mine in Bolivia and its El Valle-Boinás/Carlés (EVBC) mine in Spain. From June to October 2011, gold grades there increased incrementally from 1.4 to 2.17 grams per tonne (g/t). Nevertheless, Orvana’s throughput at EVBC is below your forecast. Results at Don Mario in Bolivia also were below estimates. Is this a make-or-break year for Orvana?
JM: It is a critical year for the company. Bill Williams, formerly Orvana’s vice president of corporate development, is now the CEO. He is an ex-Phelps Dodge vice president and has been instrumental in generating the revised technical reports on both operations, EVBC and Don Mario Upper Mineralized Zone (UMZ), while advancing the Copperwood project. We believe his appointment reflects the company’s focus on getting the operations back on track.
Orvana is currently in the process of re-benchmarking both EVBC and Don Mario UMZ. For Don Mario—an open-pit mine with an upper mineralized zone containing a lot of copper, as well as gold and silver—Orvana has delivered a new life-of-mine forecast that addresses the difficulty of getting copper out using a leach precipitation flotation circuit on a much bigger scale than has been used before. The Don Mario operation also has been troubled by high costs of reagents for the circuit, which has raised the processing costs.
We had originally forecast an annual production profile of 10–15 Koz per year of gold and 10–15 million pounds (Mlb) of copper. We are now looking at a production profile of 9–10 Mlb copper and 8–9 Koz of gold, whereas Orvana is still signaling 13 Mlb of copper and 12 Koz of gold. In Q411, the Don Mario UMZ operation produced 2.5 Mlb of copper and 2.3 Koz of gold, which is a positive. Now, it has to consistently achieve its new benchmarks over the next few quarters so the market can gain confidence in its operational abilities.
At Orvana’s flagship, the EVBC gold-copper project in northwest Spain, the operational issues have been related to head grades. Underground bottlenecks have hindered the company’s ability to blend higher grade feed to the processing plant. We anticipate that a shaft will be in place by April/May 2012, which should alleviate some of the bottlenecks. We had originally forecast that the feed grade, at steady state levels, would be in the area of 5 g/t. However, revised guidance indicated that it would be lower, 3–3.5 g/t gold, which also conspired to lower our target. We anticipate a revised technical report for EVBC prior to March 2012 with updated life-of-mine forecasts.
Orvana’s Copperwood project in upper Michigan is a 50 Mlb/year copper project, now in bankable feasibility study, and Orvana is seeking to permit this year. Even with up to 800 Mlb of copper reserves, we believe that the Copperwood asset is not being valued at its current price levels as Orvana has been heavily discounted in the market due to poor operational performance.
TGR: Given the lower recoveries and production estimates at Don Mario UMZ released in late January, you lowered your target price by $0.15 to $2.25. Yet you still give it a sector outperform rating. Why?
JM: Due to the heavy market discounting related to disappointing results from both operations over the past few quarters, Orvana still provides about a 100% return to our target from where it is trading right now. I continue to believe that management can redeem themselves by achieving the revised benchmarks consistently over the next few quarters. As Orvana meets its goals, I believe the market will appreciate the cash flow being generated, worry less about its working capital position and give the company credit for its advancement of the Copperwood project.
TGR: Prodigy Gold Inc. (PDG:TSX.V, Sector Outperform, CA$1.20 Target Price) recently published an updated PEA on its flagship Magino gold project in northern Ontario. Your model for Prodigy, using the updated PEA, projects a 20,000-ton/day operation, producing 222 Koz of gold per year over 13 years at total cash cost of roughly $775/oz. That would generate annual earnings before interest, taxes, depreciation and amortization margin of more than 50%. Yet, your target price of $1.20 is only about 40% above where Prodigy is trading. Why so conservative?
JM: Given that gold indices provided a negative return in 2011 ranging from 13% to 20%, I think that a positive 40% return to target is probably not conservative in the current market environment. With respect to the valuation, I have adjusted for the technical and execution risk of the study level (PEA) and the fact that I have modeled a larger mineable resource base than that used in the December 2011 PEA. As a company derisks the project from PEA to a feasibility study, I revise the multiples applied to the asset valuation.
Prodigy is planning a significant drill program of 60,000m in 2012 to infill/upgrade and expand the resource base while condemning areas for locating site facilities. We also anticipate an updated resource by Q312 leading to a feasibility study by Q412.
TGR: Do you expect a takeover offer for Prodigy?
JM: I try not to work off the takeover model because it is highly uncertain but focus on the underlying valuation. While I do believe that the Magino asset would be a good takeover candidate for an intermediate, I think that there are opportunities for consolidation and capturing some synergies with Richmont Mines Inc. (RIC:TSX; RIC:NYSE.A), which has an underground operation that abuts Prodigy’s land package. Consolidation would probably be a good idea, given that Prodigy could have underground targets within the same host rocks as Richmont, which has a fully permitted and functional process plant.
TGR: In your last interview with The Gold Report, you talked about Revolution Resources Corp. (RV:TSX; RVRCF:OTCQX, Not Rated). You said it was looking for analogs of Romarco Minerals Inc.’s (R:TSX, Not Rated) Haile Deposit in the Carolina Slate Belt. What’s happening with Revolution now?
JM: Revolution still occupies a significant land package of 7,500 acres along a 25-kilometer corridor within the Carolina Slate Belt at its Champion Hills Gold project in North Carolina. It drilled 19,150m in 2011 and is working on a resource estimate in 2012. Currently, gold equity plays exploring in the Carolina Slate Belt are strongly tied to news flow from Romarco’s multimillion-ounce Haile gold development project in South Carolina and its ability to permit it. In an effort to diversify its portfolio, Revolution acquired a significant land package (~400,000 hectares) in two prospective regions in Mexico from Lake Shore Gold (LSG:TSX, Sector Outperform, CA$3.50 Target Price) in 2011. These assets host high-level low-sulphidation epithermal, gold and silver mineralization and we anticipate news flow from drilling results by Q1–Q212. The company wanted to present the market with multiple catalysts from a diversified asset base and this project has allowed it to achieve that goal.
TGR: In late December 2011, Eldorado Gold Corp. (ELD:TSX; EGO:NYSE, Sector Outperform, CA$19.00 Target Price), made a takeover bid for European Goldfields Ltd. (EGU:TSX; EGU:AIM), which has gold exploration and development properties in Greece, Turkey and Romania. Last year, you discussed Carpathian Gold Inc. (CPN:TSX, Sector Outperform, CA$0.90 Target Price) and its Rovina Valley copper-gold-porphyry project, which contains about 10.7 Moz gold equivalent in Romania’s Golden Quadrilateral. Does the proposed European Goldfields takeover make Carpathian Gold more attractive to larger suitors?
JM: Barrick’s private placement in August 2011 into Carpathian to fund additional drilling at Rovina Valley already speaks to the attractiveness of these gold rich porphyry systems to larger suitors. Mining activity in Romania is heavily linked to news flow on the permitting activities at Rosia Montana operated by Gabriel Resources Ltd. (GBU:TSX, Not Rated).
Eldorado Gold’s proposed takeover bid for European Goldfields does put in a bid for assets in Europe, however, the majority of European Goldfields’ assets are located in Greece (Olympias/Skouries) and less so in Romania (Certej). For me, the takeover trigger was related to the receipt of permits to develop its Greek projects in July 2011. Permitting of those projects took an extended period of time. A positive permitting environment in Europe bodes well for Carpathian at Rovina Valley and it will benefit from any positive news flow from Gabriel. The risks include royalty increases and potential free carried interest that the government wants to negotiate.
TGR: Royalties are going from 4% to 8%. That certainly is not positive, but to get those revenues the government has to permit the mines.
JM: Herein lies the rub. On Jan. 3, we lowered our target by $0.10 on Carpathian to $0.90 to accommodate an increase in the gold and copper royalties to 8% at Rovina Valley. However, on the positive side, by defining the mining royalty rates and the tax structure and negotiating a free carried interest, the Romanian government has shown its desire to have these companies invest in these projects and generate the revenue streams within a restructured rent-sharing framework. We note that the local government is also looking to privatize some state-owned mining assets to raise revenue.
TGR: What do analysts, investors and companies need to look out for in terms of geopolitical risk?
JM: I would highlight countries—emerging or developed—that are in economic dire straits with prospective geology whose mining sector is underdeveloped and has untested mining laws and poor infrastructure. Geopolitical risk carries a few facets including outright expropriation to creeping nationalism, which is linked inextricably to a company’s ability to develop/permit the project. These countries will continue to seek foreign direct investment to explore/develop these assets. Outright expropriation is difficult in countries where there is no mining history and a paucity of critical skill sets locally, unless of course it is looking to sell the asset to another bidder. Alternatively, the country may alter its mining laws to increase its share of resource rents derived from the exploitation of these assets. We have observed higher rent sharing globally via increased royalty payments, higher taxes and/or the introduction of windfall tax structures in countries such as Peru, Argentina and Romania, to name a few.
Assets in higher geopolitical risk jurisdictions must provide the investor a high return and quick payback commensurate with the elevated risk profile. Note that assets within higher geopolitical risk jurisdictions may be more difficult to finance and there may be a limit on potential takeover suitors, depending on their risk appetite. To properly risk adjust and quantify these uncertainties remains a challenge.
TGR: Is that because it is not going away?
JM: Let’s not forget that mining is a great way to get an injection of direct investment into an economy and generate employment. For example, high rates of unemployment in developed countries such as the U.S. and European countries are driving mining activity in places where permits have historically been difficult to attain.
TGR: Joe, thank you for your time and your insights.
Joe Mazumdar is a senior mining analyst with Haywood Securities in Vancouver. Previously, he served as director of strategic planning at Newmont Mining and was the senior market analyst for Phelps Dodge. He has held a variety of geologist positions with other mining companies including RTZ, MIM, North and IAMGold working in South America, Australia and Canada, rounding out ~20 years industry experience. He holds a Bachelor of Science in geology from the University of Alberta, Canada, a Master of Science in exploration and mining from James Cook University, Australia, and a Master of Science in mineral economics from the Colorado School of Mines, U.S.
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