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Brazil
offers an ideal environment for potash developers, according to Salman
Partners Analyst Jaret Anderson. A robust agricultural sector, favorable government
policy with excellent transportation and infrastructure are leading to the
development of a number of very attractive potash projects in Brazil. In this
exclusive interview with The Energy Report, Jaret details his Brazil
play and others.
Companies Mentioned: Allana Potash Ethiopian Potash Corp OAO
Uralkali PotashCorp The Mosaic Company Verde
Potash Western Potash Corp.
The
Energy Report: We
know the general factors responsible for the growing need for fertilizers,
but are there any growth drivers that aren't quite so obvious?
Jaret Anderson: Absolutely. Everybody knows the earth’s
population needs more food, and there's a greater desire for increased meat
consumption in a number of countries. Hundreds of millions of Chinese and
Indians are making the transition from poverty to having some level of
disposable income, and one of the first things people in that situation tend
to demand is a higher protein content in their diet. One of the things that
tends to get lost in the debate is the fact that in order to produce more
protein we need a lot more arable land, or we need significantly more
production from the arable land currently available.
In order to produce a kilogram (kg.) of beef, it takes about 7 kg. of feed,
whether it's corn or soy or what have you. In order to produce a kilogram of
pork, it takes 4 kg. of feed, and for poultry it takes 2 kg. of feed. So, as
hundreds of millions of people in India and China and around the world
continue to move toward higher protein content in their diets, there is a
need to produce more feed grains on a pretty much finite arable land base in
order to satisfy those demands.
TER: It sounds like making protein is a very inefficient process.
JA: Regardless of whether it is efficient or inefficient, it's what
the world is demanding. I have no desire to give up my meat and I don’t
think anybody else does either. There are ways we can achieve this with
better farming techniques, such as more efficient use of fertilizers,
genetically modified seed and superior irrigation. All of these things can
help us improve crop yields and help us to offer everyone on the planet the food
and protein they desire. So, moving yields up in less developed parts of the
world to the levels that you see in North America and Western Europe, etc. is
something that can be achieved over a longer period of time.
TER: Food producer risks would trickle down to the fertilizer
producers. What are the risks?
JA: At the end of the day, the major risks are the impact of prices,
which incorporate the supply and demand for the various crops, cattle,
poultry, pork, etc. One macro-risk that could have a big impact on the
agricultural system overall—and therefore on fertilizer producers and
those who are trying to bring new fertilizer projects to market over the next
number of years—is the political and economic debate surrounding
ethanol.
A change in the political will to continue to subsidize ethanol in the United
States could potentially have a significant impact on farm economics.
Something like 40% of U.S. corn production is used to produce ethanol. A
$0.45 per gallon subsidy currently goes toward the production of ethanol, and
if that were to go away during this 2012 election season, it could hurt
fertilizer producers.
TER: One Republican presidential candidate went to Iowa recently and
made no bones about the need to reduce subsidies for ethanol.
JA: Yes, Minnesotan Tim Pawlenty made that statement pretty
aggressively. Sarah Palin, whether she's in or out, can have an impact on
this issue. She's saying some of the same sorts of things regarding the need
to end all energy subsidies, including ethanol. So, it's a risk. I don't
think it's something to lose a lot of sleep over, but it is certainly
something that can change the debate and the economics for corn production
and, ultimately, fertilizer products.
TER: In an industry report, you expressed some thoughts about the
significant advantages of producing potash in South America versus Africa.
What thesis are you presenting to your clients regarding these two areas?
JA: Transportation costs represent approximately 40% of the total
delivered North American potash costs. That's another way of saying that
location and infrastructure are critical elements for any prospective
greenfield potash project. It's critical to think about how infrastructure
and transportation costs play into the various projects whether they're
located in Saskatchewan, Canada, Brazil, Ethiopia, Eritrea, the Republic of
Congo or wherever else these projects are being developed.
Brazil, in my view, is a particularly interesting location. It's the
second-largest consumer of potash in the world today, and it has posted some
of the best potash demand growth over the last 10 years. In addition, Brazil
has a number of positive factors going for it. It has a
well-developed infrastructure system, including modern roads, a
well-developed rail network, access to water and power. By comparison, a
number of projects in Africa have very interesting deposits but face
significant challenges with respect to infrastructure, including a lack of
access to rail, water, power and ports.
TER: Potash stocks are taking a well-deserved breather after
phenomenal returns over the past 52 weeks. Is this an opportunity now for
phosphates to catch up?
JA: There has been a big uptick in interest
in phosphate projects over the last six months. I definitely receive more
incoming calls on them than I did a year ago. I believe that phosphate
projects do offer some advantages over potash projects because they are less
expensive to build, and they're generally brought to market faster than the
five-plus years it can take to bring a potash project to market. Overall,
though, the potash industry has offered much better returns over the cycle
than phosphates.
PotashCorp
(TSX:POT; NYSE:POT)—one of the largest fertilizer companies in the
world—has generated an average gross margin over the past five years of
63% in its potash business. Its phosphate business, by comparison, has only
generated an average gross margin of about 22%. I think that is the order of
magnitude you can expect in potash versus phosphate over the cycle. That
makes potash the more attractive business over the long term, but it doesn't
mean there aren't attractive phosphate projects out there that can generate
decent returns for investors.
TER: Companies vary how they report their resources. Investors would
like to understand resource values on an apples-to-apples basis, specifically
when it comes to understanding recoverable potassium chloride versus total
tonnage of ore. This can have significant implications, can it not?
JA: It can. A number of these greenfield potash companies have taken
different approaches with respect to the way they have chosen to report their
resource figures. As you point out, some companies have reported the total
number of tons of potash-bearing rock in the ground while others have been
more conservative and report the amount of potash that they expect to be able
to extract after accounting for the grade of the rock, allowances for losses
during extraction and further losses during processing.
In general, we have found that companies with assets in North America have
been more conservative in the way they have presented their figures than the
companies with assets in Africa. In any event, when comparing two potash
resources, investors have to take into consideration things like the resource
grade, mineralization depth, existing infrastructure and the viability of
moving forward over the long term.
In our opinion, too many of these companies have been painted with the same
brush. Ultimately, not all of these projects are likely to make it to
production. You have to consider carefully which of these projects have the
most desirable characteristics and the lowest risk when making an investment
decision.
TER: Does the Street typically give the recoverable potash resource
reporter a premium?
JA: Not from what I’m seeing when I look at my comps, and that's
where I think there are some opportunities. To me, a company such as Western
Potash Corp. (TSX.V:WPX), which is located in Saskatchewan and has a very
large resource, has been conservative in the way it has presented its
information compared to a lot of its peers in the greenfield potash space.
Yet, it's trading at a discount in terms of absolute EV or market cap to some
of the companies operating in Africa with a fraction of the resource who have
perhaps been less conservative in the way they've presented the figures. So,
I think there are some opportunities there, and I think that a company like
Western Potash does warrant a second look.
TER: Can a prolific producer command a premium price, or is the idea
to get a better margin with lower infrastructure and transportation costs? Or
is it both?
JA: In an ideal world, you want a large potash resource located close
to a large source of end demand with good infrastructure already in place and
a stable geopolitical environment. In our view, the projects in Saskatchewan
and Brazil check most of these boxes. Brazil is particularly interesting in
that it offers well-developed infrastructure, a stable political environment
and very strong growth rates for potash demand going forward. If I had the
ability to create a potash deposit located anywhere in the world, I would
choose to locate it in Brazil. Brazil is likely to overtake China as the
world’s largest consumer of potash sometime in the next decade. In my
view, it offers the best combination of end-user demand, well-developed infrastructure,
and an accommodative and stable government.
Something to keep in mind is the very long-life nature of these projects.
When you're building an operation that is expected to run for several
decades, you need to think strategically about how the world is likely to
unfold. Brazil is currently the world’s number one exporter of beef,
chicken, sugar, coffee and orange juice. Given its very large undeveloped
arable land base, those factors are only likely to go in Brazil's favor. So,
in my view, locating in a country with great
agricultural promise going forward, a stable government, and good
infrastructure makes a lot of sense.
TER: Could you give me a specific example?
JA: Sure, take the example of Verde
Potash (TSX.V:NPK) (formerly Amazon Mining Holding), which has a very
interesting greenfield potash project located in Brazil. Verde plans to
produce a new type of potash in an area called Minas Gerais, a state with a
very high level of agricultural production close to a number of fertilizer
blenders that buy fertilizer today from companies such as PotashCorp, The Mosaic
Company (NYSE:MOS), and OAO
Uralkali (RTS:URKA, MICEX:URKA, LSE:URKA). Verde is likely to face
freight costs of only about $45/ton to truck product from its location a
couple hundred kilometers (km.) to the fertilizer blenders in Minas Gerais
and Mato Grasso states. A supplier today in Saskatchewan such as PotashCorp
or Mosaic is likely to face transportation costs of $35/ton to move its
product from Saskatchewan to the port in Vancouver, another $35/ton via ship
from Vancouver to the port in Brazil, and another $80-$115/ton to move the
product from the port in Brazil to the inland location where the fertilizer
blenders actually need the product. The total cost of end-to-end
transportation is somewhere between $150 and $185/ton. So Verde's $45/ton
transportation cost gives it a very material competitive advantage. It really
can't be frittered away over time unless you believe rail and transportation
costs are going to go down over the years, which is highly unlikely. This is
an enduring competitive advantage.
TER: I am looking at Verde under its old ticker symbol as Amazon
Mining, and its total return for the past 52 weeks is 383%. It's given back
about 14% over the past three months. Is there much left on the upside?
JA: Verde has plenty of upside left. I have a target of $11.50 per
share, and you're talking a return of 64% to my target. I believe there is
certainly another $3–$4 left in the stock over the next 12 months. If
the company's R&D initiatives show positive developments, the stock has
much, much more upside from here.
TER: Is there another company you might discuss?
JA: If you want to play in the Danakhil Basin in Ethiopia, I would
steer someone toward Ethiopian Potash Corp (TSX.V:FED TSX.V:FED.WT), which has
a land package located directly adjacent to Allana
Potash (TSX.V:AAA; OTCQX:ALLRF) and yet has a market cap at roughly
one-third that of Allana's. If you’re bullish on the Ethiopian plays,
they're not all the same. Some are less expensive than others, and I think
that Ethiopian Potash is an attractively valued name.
TER: Isn't the Danakhil project 600 km from a port?
JA: It's roughly 600 km by road to the nearest available port that it
can use, which is Djibouti. Closer ports exist in Eritrea, but political
problems limit access to those ports. Eritrea and Ethiopia have had troubled
relations in the past. So, projects located in Ethiopia may have trouble
gaining access to the ports in Eritrea. That could be resolved over time, but
right now it looks like that's going to be a challenge.
TER: Sticking with that transportation theme for a moment, you're
obviously very positive on Western Potash, but it's 1,730 km to port.
JA: Yes, it's a long ways away from the port in Vancouver. The
difference is that there's well-established rail infrastructure in place,
which has been transporting large quantities of potash from Saskatchewan to
Vancouver for several decades. The risk and the cost in moving potash out of
Saskatchewan is much, much lower than I think you're going to find in other
parts of the world. So, it's a large distance, but the infrastructure is
largely in place to make that feasible.
TER: Thank you for your time. Best wishes.
JA: Thank you.
Jaret Anderson covers the fertilizer, agriculture and
chemical sectors and brings over 10 years of research experience in the basic
materials space to the Salman Partners research team. Jaret spent seven years at
UBS Securities Canada covering paper & forest, fertilizer, chemical, gold
and steel names prior to joining Salman Partners. In 2006 he was ranked #1
for earnings estimates accuracy in the paper and forest sector by Starmine,
and in 2005 he was ranked #2 for quality of written reports (also in the
paper & forest sector) by Brendan Woods International. Jaret holds a
B.Com. (with Honors) from the University of British Columbia and became a CFA
charterholder in 2000. Are there viable options to nuclear power for
clean energy? Is another uranium boom on the horizon? Or should we invest our
resource dollars in thorium? If you've been pondering these questions, join The
Energy Report in this exclusive interview with a pair of the resource
sector's most highly regarded experts, Global Resource Investors Founder Rick
Rule and Exploration Insights Author Brent Cook. The Energy Report
caught up with them during Cambridge House's recent World Resource Investment
Conference in Vancouver.
Companies Mentioned: Extract Resources Ltd. Hathor
Exploration Ltd. Magma Energy Corp. Paladin Energy Ltd. Ram Power
Corp. Rio Tinto Rockgate Capital Corp. Uranerz
Energy Corp. Uranium
Energy Corp
The Energy Report: It may be too soon after Japan's
crisis at Fukushima to judge, but at this point, what's your take on the
worldwide infrastructure for nuclear energy and demand for uranium?
Brent Cook: Uranium's interesting right now and certainly a contrarian
play. Global warming is a fact and the overwhelming majority of the
legitimate research, and I mean legitimate peer-reviewed scientific research,
points to anthropogenic CO2 as the primary cause of global climate
change. So we have a serious environmental issue, and none of the green
energy alternatives will solve it on their own. They can produce only a
relatively small fraction of the energy we're going to need. Nuclear power is
the only non-CO2 emitting energy source out there that can
significantly offset large-scale hydrocarbon-based energy sources.
Nuclear power is a real and viable, albeit imperfect, solution and I don't
think it or the demand for uranium is going to go away. We've had three major
nuclear accidents with a greater than five ranking that I can think
of—Three Mile Island, where there are no documented deaths and it was
pretty well contained; Chernobyl, which was a disaster in a backward
totalitarian country; and Fukushima, which we are still watching but which
appears to be contained. If you pit the damage and deaths from nuclear incidents
against the damage caused by CO2 gases, there's no real
comparison. Nuclear energy just has this irrational phobia associated with
it.
TER: Are the current nuclear facilities' needs for uranium enough to
elevate the uranium price? Or do we need new facilities to increase demand?
Rick Rule: On a global basis, we use about 150 million pounds (Mlb.)
of uranium and we make 90 Mlb. We're living off historical surpluses. When
those surpluses are gone, one of two things will happen—the lights go
out or we produce more power. It's as simple as that.
TER: Even assuming that manmade CO2 is the biggest cause of
global warming, the fear factor of nuclear fallout from a disaster seems
greater than the fear factor of more CO2. There's talk about
taking some plants offline in Europe.
BC: It's true. Germany says they plan to take nearly all of their
nuclear facilities offline by 2022, which I think amounts to somewhere in the
order of 3% of global energy production, so it's not that big a hit to
uranium demand. There's no way we can get the power we need from coal and
fossil fuels without continuing to add to the CO2 problem. The
earth and its inhabitants are feeling the effects of that right now and
it’s bound to get worse. I have to assume a more rational energy policy
will emerge in time that will include nuclear.
RR: Germany has said they're going to bring all of their plants down
in 14 years. As Brent described, that's 3% of current demand. It's 1.5% of
scheduled demand 15 years out. That's irrelevant in the context of the
uranium price and nuclear demand. But more importantly, I suspect that
Germany's announcement is a well-meaning sop to the greens. I don't believe
they'll bring down their nuclear power industry because if they do, they
eliminate 19% of the power in the country, and the lights go out. What will
the German public say about the lights going out?
If you want to see protests in Western countries, wait until people's
refrigerators and air conditioners stop running or the manufacturing base
shuts down because there's no power. Then I think you'll see popular protest
on a truly spectacular scale.
In the immediate reaction to the events in Japan, the discussion about our
nuclear power plants in California centered on two things. One was bringing
down American nuclear power. Because the U.S. gets 20% of its energy from
nuclear power, the chances of taking our nuclear capacity down are zero. The
second argument pertained to California, where our governors have said that
green sources will provide 30% of the State's energy by 2020. That's up from
3% now and California's broke. Another point. There was a lot of discussion
in the popular media about what would happen with the San Onofre nuclear
plant in the context of a Richter 9 (R9) event in Southern California. That's
two orders of magnitude greater than any earthquake we've suffered in
Southern California. I don't know what would happen to San Onofre, but I do
know that a collapse in the natural gas distribution system in Southern
California in an R9 event would probably kill 150,000 people. The impact on
the refining complexes in South Los Angeles, North Orange County, Long Beach
and other places like that probably would kill another 15,000.
TER: Isn't thorium a safer alternative to
uranium in producing nuclear energy?
BC: That's an option, but the technology isn't developed enough for it
to come into the production scenario. It's at least 10 years down the road
and we really need to see economic working examples of this to convince the
power companies of its value.
RR: Thorium appears to particularly excite the subscription-driven
newsletter business. A total of 63 nuclear power plants are under
construction worldwide, with an average price tag of $4B per plant. This
means that the power industry, not the newsletter industry, is betting $250B
on uranium—and, as far as I know, nothing on thorium. In terms of
producing power, you have to decide whether the power industry or the
newsletter industry is better-versed on the economic efficacy of technology.
TER: Nuclear plants require a great deal of permitting. With the
protests, fear-mongering in the media and a lot of politicians on the
anti-nuclear bandwagon, what's the chance that the government will bar
permits for nuclear?
RR: I think it depends on the government. In the immediate aftermath
of the Japanese incident, the Chinese government said that China's nuclear
power industry was going to be under review. The review is about 60%
complete, and it goes something like this: "Those were old, bad Japanese
reactors built on a tectonic subduction zone. Ours are new, good Chinese
reactors built on the Asian plate." That's the series of political
processes that will occur around the world.
A whole range of people—some well-intentioned, others
Luddites—are demonstrating about nuclear. Irrespective of your feelings
about global warming, there's a whole series of environmental risks
associated with non-nuclear energy.
TER: We can all sit here and agree with that logic, and point to all
the people killed in mining coal. But that's not what the populations seem to
be thinking about. Even Japan is talking about decreasing reliance on nuclear
energy in favor of LNG.
RR: If I were a betting man (and I am) and I could find somebody to
take the back side of the bet, I would bet that Japan changes course within a decade. People say, "Well, my investing horizon is
90 days, so what they do a decade from now doesn't matter." But it does
matter because Japan slowing things down doesn't change the demand outlook
for uranium in the near term. And if they don't change, it doesn't change it
in the long term. The only thing that's happened is that people have allowed
their reaction to a boogey man called nuclear power to influence their
response to investing without looking very deeply at the fundamentals.
My own suspicion is that the Japanese have no choice but to stay with
nuclear. The Japanese themselves have said that the advantage of nuclear
power for them was that it was the densest fuel in the world. They can import
uranium and have it on Japanese soil so that they have a geopolitically
secure source of energy in a world where there's less and less security. You
can't store hydropower. You can't store
the sun. You can't store enough natural gas or coal
to make a difference. But uranium is such a dense fuel that Japan could
easily store five years' supply.
You can understand the interest that places like Korea, Japan, Taiwan and
Singapore have had for nuclear energy and the advantage of uranium's density
relative to other sources of energy if you imagine a deeper schism between
Sunnis and Shiites that snaps the Straits of Hormuz shut and cuts off
supplies of export crude from the Persian Gulf and LNG from the fields in
Qatar, Kuwait and Saudi Arabia.
TER: You've both said that we still need to mine more uranium as we
don't produce enough supply to meet the demand of currently operating plants,
let alone any new ones. What are the risks with uranium exploration and
mining?
BC: The same with exploration and mining of anything else on top of a
much more difficult permitting process, particularly if you're looking at a
high-grade deposit. Even in Saskatchewan, if Hathor
Exploration Ltd. (TSX.V:HAT) tries to get a mine permitted, it could be 7
to 10 years before the company could even start digging that first hole.
TER: That's an impossible timeline if demand already exceeds supply.
BC: Oh, other places in the world have much larger deposits, although
they're lower grade, that are ready to go. In Namibia in particular, Paladin
Energy Ltd. (TSX:PDN; ASX:PDN) is already in production. Extract
Resources Ltd. (TSX:EXT; ASX:EXT) has its Husab Uranium Project, the
fifth-largest uranium-only deposit in the world. Rio Tinto
(NYSE:RIO; ASX:RIO) has a huge deposit that's in production and
expanding.
TER: Suppose that the U.S. government decommissions some nuclear
weapons, creating a surplus of enriched uranium that nuclear power plants
could use. Would that additional supply be a black swan that someone
investing in uranium should worry about?
BC: That's a good point. And, yes it's a possibility.
TER: Russia did it for years.
RR: We've done a bit of it too, and I hope it increases. The idea that
we need enough bombs to kill the world's population 1,500 times over seems
like excessive security to me. I'd love to see that stuff blended down as
fast as we can. Although I think the Strangelove argument is a great one,
we're going to need to burn de-fissionable material to keep our reactors open
until such time as we can increase production enough to sustain current
demand and meet future demand.
The risk we run is not having too much but having too little, because having
too little makes nuclear a less secure source of power. For me, the real
question is, can we develop a uranium industry that can produce 200 Mlb. a
year? We need to demonstrate to the people who finance nuclear power plants
that they'll have some uranium to burn in those plants so they get their
loans paid back.
TER: So, what's the opportunity for investment in uranium?
BC: The Paladins and others such as Extract Resources and Rockgate
Capital Corp. (TSX:RGT) have projects drilled out and ready to go. In the
U.S., Uranium
Energy Corp (NYSE.A:UEC) and Uranerz
Energy Corp. (TSX:URZ; NYSE.A:URZ) have good deposits in South Texas and
Wyoming going into production with good margins. So I wouldn’t go out
and fund a junior uranium exploration company right now.
TER: Want to weigh in, Rick?
RR: I would certainly fund a generative uranium exploration business
in the same fashion that I'd fund sand and gravel. I'm commodity-neutral. If
a really good team came to me with a really good idea in the uranium
exploration space, would I finance it? Absolutely, because I believe in the
exploration process and I believe in the ability of earth scientists to
generate money. They've done it for me in the past.
Events in the last few months have reduced the price of existing uranium
deposits to the extent that an exploration proposal put to me would have to
be overwhelmingly attractive because some existing deposits that have been
de-risked are selling for a third of what they're worth. Somebody has to put
a truly extraordinary exploration proposal to me to overcome the discount
that exists in already drilled-off deposits. But I wouldn't be afraid to look
for uranium if the right person put the right proposal to me.
TER: With gold, the underlying equities haven't increased at nearly
the same rate as the commodity itself, in part because investors have an
alternative in gold ETFs. Because that's not the case with uranium, should we
expect uranium equity prices to reflect increases consistent with the
commodity price as it recovers?
BC: Yeah, I think we'll see some good price increases in the
uranium-producing companies. Rick pointed out the uranium equities have been
hammered pretty hard. They're selling at decent valuations if you're willing
to come in and wait it out.
TER: How much volatility will uranium see?
RR: You've seen it. They're uniformly off about 50%. The corollary to
what Brent said is that in the brief uranium boom from 2002 to 2006, the
number of junior explorers in the uranium business increased from 5 to 500.
The problem with that was that we had 20 competent teams, so the probability
of having a good management team was a function of dividing 20 by 500.
I don't think we'll see an across-the-board sector recovery, though, because
investors lost 95% of their money last time. My hope is that investors will
be pickier and show a greater degree of selectivity than in the last boom.
TER: So is this really a speculator's market in uranium?
RR: Maybe an informed speculator's market. Most
"speculators" are truly punters who confuse speculation with
gambling and prefer to feel rather than think. Those people, sadly, just
don't stand a chance in any market.
TER: Early on, Brent, you said that nuclear power is the only clean
energy that's going to help solve the CO2 problem. "Help
solve" implies a continuing need for other clean energy sources. What
else looks interesting to you?
BC: There really are no good alternatives. They all have issues. With
solar, it's night. It's not always windy. The turbines are very expensive to
build and someday will be seen as eyesores that chop birds into little
pieces. Even geothermal, which is a great source of energy, is a tiny piece of
our whole energy budget and carries the added risk of exploration drilling.
TER: But if governments put the same amount of money needed for a
nuclear facility toward building up geothermal capacity, could it take on a
bigger percentage?
BC: No. There are thousands of volcanoes but a very small fraction of
them have the right hydrology to trap the heat in such a way that it could be
used in a geothermal plant. A lot of unique things have to happen for a
geothermal reservoir to actually produce geothermal energy, much the same as
a mineral deposit.
TER: So if this industry will always be a niche, where's the
investment upside?
RR: You don't have to change the world to get stupid rich. Remember
pet rocks? They didn't change the world but they
made $20 million for the guy who created them. I'm not trying to present a
threat to the nuclear industry nor am I trying to deal with global warming
with my own investments in geothermal energy. Will it make a difference to
worldwide energy supply if I develop 1,000 Megawatts (MW)? No. Will it make a
difference to me? Immeasurable.
If I am able to build out a resource at $4M/MW that has a net present value
at a reasonable discount when completed at $7M/MW, that's a good business to
me. It doesn't matter to the world, but it matters to my clients
TER: Could more exploration identify additional geothermal resources?
BC: Yes. A lot more exploration could be done, and there are many
areas to look. There's also deep enhanced geothermal, an idea they're
exploring in Australia. It's not associated with volcanism but rather with
slightly radioactive intrusives at depth, five to eight kilometers down, that
trap the heat. That's a potential source that may prove successful and could
represent a major energy source. But while there are certainly lots of places
to look, we're talking exploration again—and 95% of the projects are
going to be busts.
TER: We've seen a lot of consolidation in the industry, too. Would you
expect consolidators such as Magma
Energy Corp. (TSX:MXY) and Ram Power
Corp. (TSX:RPG) to be doing the exploration? Or will they wait for
explorers to succeed before they buy them?
RR: The lessons I've learned in geothermal are lessons I learned in
other industries—it's about people. It's a spectacular business and
people can wreck it. I suspect that speculators will cease to exist in four
years because power producers will buy up the successful efforts. The very
long lead times to success and the industry's extraordinary capital
requirements make the geothermal business less suited to exploration
speculators than other businesses. And the speculators haven't climbed the
learning curve fast enough. Most resource investors look at ounces per ton,
which doesn't translate particularly well in geothermal companies that report
results in calories or gigajoules or megawatts.
TER: So are you backing away from geothermal?
RR: No. I'm doubling. The more I've come to know the geothermal
business, the more I've learned that the downside can be ameliorated. It's
seven years from slim hole to production, and in the geothermal junior
business we've used up half of those seven years so the time risk is now
halved and the prices are off by 80%. The geothermal junior industry is now a
billion dollars into the capital-spend stage, and capital is coming in at a
fraction of the prices paid earlier, so it's extraordinarily efficient
capital.
TER: Can the companies make money by continuing with the geothermal
they've found already, building it up with the cheaper capital? Or do they
need to find new projects?
RR: This is one of the sexy parts of the story for me. We haven't had
to explore for geothermal for 30 years, not since the oil companies led a
geothermal exploration boom in the '70s, when they were looking for other
sources of energy and they had too much money. So we've had only to explore
the files for the last 10 years.
The public junior companies in the geothermal business now are
opportunity-rich. And, what's wonderful, if they get to the point where
EBITDA is self-sustaining, the opportunity to reinvest the capital they
generate at high, predictable internal rates of return (IRR) will make them
look like the very best junior royal companies, where you can invest at 15%
or 16% unleveraged IRR, 70% leveraged with a 7% cost of capital, and you're
generating 22% to 24% leveraged IRR. You're able to redeploy that
capital—into geothermal resources that you already have on your own
books that you don't have to discover—with the same leverage to
generate the same margins for 6 to 10 years. That's extraordinary internal
compounding unavailable in any other resource industry I know.
TER: Any parting thoughts?
RR: I'd like to reiterate my general energy thesis, which is simply
that the oil markets drive energy prices. The oil markets will be chaotic but
secularly higher—potentially catastrophically higher. Secularly higher
in part due to increasing demand at the bottom of the demographic pyramid,
where increases in disposable income are energy dense. A much more important
reason, though, is that on a worldwide basis, oil is produced not by oil
companies but by governments that can't deliver mail or educate kids. On top
of that, major producing countries—Venezuela, Mexico, Ecuador, Peru,
Indonesia, Iran—are diverting way too much free cash-flow from their
oil industries to politically expedient domestic spending programs. This will
impair their industries' ability to produce for decades.
As a result, I expect worldwide export crude availability to decline by at
least 20% within five years. With import demand increasing by 2% compounded,
if you understand that prices are set in the margin, that imbalance between
supply and demand could lead to catastrophically high oil prices. I hope I'm
wrong, but . . .
Brent Cook, a renowned exploration analyst, geologist and
author of the weekly Exploration Insights—has
devoted 30-plus years to providing economic and geologic evaluations to major
mining companies, resource funds and investors. A 1978 graduate of Utah State
University (BS in geology), he's worked in more than 60 countries on
virtually every mineral deposit type and on projects from the conceptual
stage through to detailed technical and financial modeling related to mine
development and production. Brent was principal mining and exploration
analyst to Global Resource Investments from 1997 until 2002, and since that
time has served as an outside analyst and advisor to several investment funds
and high net worth individuals.
Rick Rule, founder of Global Resource Investments Ltd., is a well-recognized
expert whose company has built a stellar reputation on providing investment
advice and brokerage services to high net worth individuals, institutional
investors and corporate entities worldwide and on taking advantage of global
opportunities in the oil and gas, mining, alternative energy, agriculture,
forest products, and water industries. Rick has been principally involved in
natural resource security investments from the start of his career in the
securities business in 1974. Since establishing Global in 1994, he's also
been particularly active in private placement markets, having originated and
participated in hundreds of debt and equity transactions with public,
pre-public and private companies. Earlier this year, Rick closed a landmark
deal with Eric Sprott, another famous powerhouse in the natural resources
arena. With GRI now a wholly owned subsidiary, Sprott, Inc. manages a
portfolio of small-cap resource investments worth more than CAD$8 billion and
boasts a workforce of more than 130 professionals in Canada and the U.S.
The
Energy Report
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