By Chris Berry
- Despite the beating investors have endured over the past 18 months investing in energy metals, I believe we have reached the bottom and numerous opportunities are in place
- What follows is a rough transcription of my recent remarks at the Cambridge House Vancouver Resource Conference
- I present a balanced case for optimism, the metals I am focused on, the strategy I am employing, and some of the metrics I rely on to gauge value
Is the Worst Behind Us?
If you’re like me, and have invested in the junior markets over the past 18 to 24 months, you’ve likely felt like this:
Events could spiral out of control at any time. The wreckage hasn’t just been centered on one metal either. Here is the one year price performance for a broad basket of rare earth exploration and mining companies that I track measured against major indices:
Rare Earth
Here's lithium:
...and fertilizer:
...and uranium:
As to why this has happened, regular readers of Morning Notes should be well versed in our bias towards deflation in the economy. This is generally bad for commodities and the share prices above only reinforce my belief. The macro data has not been supportive of inflation either. See the velocity of money or the money multiplier:
Velocity of M2 Money Stock (M2V)
M1 Money Multiplier (MULT)
…or the fact that the money supply in various countries (namely the US and China) is shrinking.
Finally, the Baltic Dry Index, one of the more reliable indicators of economic activity on a forward-looking basis has collapsed:
That said, I do think we are at the bottom of this market and while I don’t think we have “turned”, I do think now is the time to be making choices about where to allocate capital amongst metals, sectors, and market caps.
A Ray of Hope
I firmly reject much of the doom-and-gloom fear mongering you see in the media and, despite the headwinds mentioned above, there are positive signs. Beginning with a gradual and sustained improvement in global PMI readings:
Additionally, political risk, as manifested through resource nationalism, is on the rise. Paradoxically, I think this bodes well for metals prices going forward as the reliable or “safe” jurisdictions to explore, develop, and mine are shrinking. Fewer places to mine means a floor under prices:
With respect to interest rates and the “cost” of money, rates are still low by historical standards:
There is a great deal of argument around this last point, to be sure, with the tapering of quantitative easing and the potential for higher interest rates. However, the cost of doing business via debt instruments is not prohibitive.
Finally, and perhaps none too soon, it appears that China is finally serious about changing its growth model from investment and export-led growth to one more focused on internal consumption. These scenes from Beijing cannot continue.
It would appear that “growth for growth’s sake” has outlived its usefulness. It is incumbent upon China’s leaders to provide a backdrop where these types of consumption trends (shown below) can continue, albeit at a more sustainable pace:
Strategy and Metrics
Thought I have spent the better part of the last two or three years focused on rare earths and graphite, I think there are some other, more immediate, opportunities within Energy Metals that I’ll discuss today. Over the next 12 to 24 months, I think tin1, silver, uranium, and phosphate are among the most attractive opportunities. (Ed. Note: I will be providing several companies for your consideration in a future Note).
Regarding strategy, I think just investing in a single metal or in a single market cap is a recipe for failure. The three tactics listed below are in place to diversify risk, but also take advantage of opportunities as they arise.
- “Amongst and Within” – By this, I mean focusing risk management amongst a number of commodities as well as within the entire value chain. My sense is that investing “just” in junior mining companies or “just” in copper is a recipe for failure. Finding those metals or minerals with disparate supply and demand dynamics and uses offer a realistic hedge against volatility.
- Inefficient Markets – By this, I am referring more to those jurisdictions where government interference or resource nationalism can create inefficiencies in supply chains. Two recent examples are the ore export ban in place in Indonesia (this has potential to curtail supplies of tin, nickel and copper) and the DRC, with rumblings of its own ore export ban and an increase in taxes though this hasn’t been implemented. These types of moves can spike metals prices and the demonstrate the potential for a “pop” in junior exploration companies one can take advantage of if properly positioned.
- Off-Take Agreement of Strategic Partner – With the financing environment still challenging, an off-take agreement or strategic partner is a MUST. Many of the energy metals are notorious for a lack of price transparency and a company securing an off-take agreement can help lend credibility to the project and also help clear a path towards securing financing.
As the year progresses, I am sure more criteria will present itself and I’ll continue to hone this tactical approach. In the mean time, I want to provide you with some of the questions I ask when evaluating the unique opportunities in this space.
Six Questions to Ask When Evaluating Energy Metals Opportunities
With the commodity super cycle changing its complexion, we have entered a period where the “wind” isn’t at our backs anymore. This has become a real stock picker’s market and the questions, or points listed below have helped me in due diligence efforts and I present them here and hope they can do the same for you.
Copper
Tin
- What is the futures market saying? With the general lack of price transparency in metals markets, looking at futures curves can tell you what market participants (speculators, hedgers, end users) believe about the current and future prospects for a given metal. For example, the forward curve for copper is saying something very different from that of tin. Are you positioned accordingly?
Is China a net importer? Silver and tin are two examples of metals where China used to export on a net basis (100M oz of silver per year) and is now a net importer. Websites such as http://www.hktdc.com/en-buyer/ can provide export and import statistics and trends.
Is the metal controlled by an oligopoly? If so, this can be problematic for junior mining companies looking to break into the value chain. High barriers to entry and lack of flexibility in pricing are seemingly insurmountable challenges. Lithium is one such example and a main reason why I don’t currently look favorably on the metal.
What are the trends in economic data suggesting? I pay particular attention to ISM and PMI data, capital expenditure trends, and productivity increases at a minimum. Looked at together, these metrics provide a mixed picture, generally in line with the uneven global growth profile. Capital expenditure on the part of companies has taken a back seat to share buybacks and dividend payouts. A shift in sentiment here would be another sign of company executive’s thoughts about the future of their businesses.
What are the market leaders telling us? I listen closely to company earnings calls and read all financial data released by market leaders in the industrial metals space. It does necessitate “reading between the lines”, but a clear understanding of what Rockwood Holdings (ROC:NYSE) says about lithium or GrafTech International (GTI:NYSE) says about graphite or what WR Grace (GRA:NYSE) says about rare earths is a key component in determining the future prospects for juniors involved with a particular commodity. It is true that these companies will tend to “talk down” concerns over security of supply, but listening to their commentary can only help in your analysis. Are you aware of what these companies are saying regarding supply and demand and their supply chains?
Is the company going to produce something the market wants? Are there substitutes? This is perhaps the most simplistic, but most important, question to consider. Molycorp (MCP:NYSE) fell from $75 to $5 per share for a number of reasons, but the fact that they predominantly involved in light rare earth mining and production is a major reason for the share price slide. The game in the rare earth space is with the heavy rare earths – period. For a junior mining company to survive and thrive, it must show it can produce a product an end user is willing to pay for – and do so profitably.
Summary
I have provided a great deal of information today, but I think the time is now to be evaluating opportunities in the energy metals space. During the Cambridge House show, I was privileged to moderate two panels. In one panel, Ross Beatty talked about how bear markets sow the seeds for bull markets. I would argue that those seeds are being sown now and using the strategy and tactics provided above can help position for the inevitable turn in the resource markets.
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