Source: JT Long of The Gold Report (10/2/13)
International uncertainty about conflict, growth and market transparency can make the world a scary place to invest your life savings. In this interview with The Gold Report, Windermere Managing Director Brian Ostroff focuses on North American gold and phosphate stories that offer an alternative to risky jurisdictions and can be profitable at even conservative resource prices. By understanding the unique supply and demand factors for each subsector, he isolates the opportunities that often get buried in the big, bad commodity basket.
The Gold Report: When we talked 10 months ago, the U.S. was grappling with cutting more than $1 trillion from its budget, yet you were optimistic about the U.S. economy as a whole. Now we have a government shutdown, possible credit rating cuts if the debt ceiling isn’t raised again and debates about tapering quantitative easing. As a Canadian watching from above, how do you see the U.S. economy?
Brian Ostroff: I think it really comes down to how you define the economy. You could argue that the economy based on paper is doing fairly well. Corporate earnings have been strong and the big-cap equity markets have been doing very well. The real economy, however, seems not to be doing that well. There seems to still be a lot of pain, the number of jobs being created is moderate and people feel very uncertain about their future. There definitely is a dichotomy between the statistics and the real world.
Tapering of quantitative easing had been rumored for months and the consensus was that it would be announced at the last Federal Reserve meeting. I find that interesting because the consensus was shaped by financial people who live in the stock market world. They see the Dow doing well and believe that tapering would be good because it would show the economy was healthy. But the decision not to taper was based on the economy as a whole. For most people, the economy is not the stock market. It is jobs, the housing market and the like. That is why I see the Fed’s decision not to taper as insight into where the real economy is today.
TGR: We’re not seeing Europe in the headlines as much as we did a year ago. Is that because things have recovered or we’ve just gotten tired of it?
BO: Again, based on the markets, you would believe that things are getting better. Even the euro has done a very good job against the U.S. dollar. Government bond yields of Greece, Italy and Spain have come down quite a bit. But is the overall economy better or have we, as you say, gotten tired of the headlines and moved on to focus on the Middle East? Only time will tell.
TGR: What about China and the emerging economies? We’ve heard a lot of debate about whether China is growing and, if so, how much.
BO: I think China is very interesting. When we talked last year, we debated whether China was going to have a hard landing or a soft landing. I said that I thought the outcome could actually be no landing. I still believe that. There is a lot of talk about the pending demise of China and the bubble bursting, but I don’t think the statistics really bear that out. I think it is in China’s best interest for the world to believe that its economy is cooling. Then demand for commodities would cool, keeping prices down and making it easy to accumulate resources. But if you look at the statistics, Chinese imports of crude oil are at all-time highs. Imports of copper concentrates are up 32% year over year. That’s on top of a 22% increase in 2012 over 2011. Not only are those numbers increasing, but they’re increasing at an increasing rate. I don’t think these statistics tell a story of China falling off of the cliff. A rapidly slowing economy doesn’t result in increasing imports of copper and oil, two great economic barometers.
TGR: Are we talking about stealth growth?
BO: Yes. It is always difficult to get accurate statistics from China. But I think the country is using that to its advantage to catch the world flatfooted.
TGR: If China is really growing and Europe and the U.S., at least on paper, are growing, what does this mean for natural resource stocks?
BO: The future continues to look bright for commodities in general. Some have said the supercycle has come to an end. Here at Windermere, we just don’t believe that. But it is important to understand not all commodities are alike. Industrial commodities, currency commodities such as gold, energy commodities and agricultural commodities are all different and they don’t necessarily all move together as they have in the past.
When people talk about commodities being down, they often look at the precious metals, namely gold and silver. They see how much the precious metals have come down and they paint the entire commodity sector as bad. In reality, oil prices are pretty close to their highs. Copper, although off its high, is not down that much. The agricultural commodities are a little bit lower, but certainly not down considerably. What are down quite a bit are the natural resource stocks. They’re down a lot more than their underlying commodities. But in the physical commodity world, I don’t think things are that bad. I do think that there is an underlying demand for this stuff.
TGR: So why are the stocks, the companies that are actually producing these commodities, doing worse than the commodities themselves? If that continues, how will companies still deliver the goods the economy needs to keep going?
BO: People who invest in stocks look into the future. They don’t look at today. So when people truly believe that prices will be lower, even if they’re not lower today, they sell. I think that is what we have seen. Gold has come down from $1,700–1,800/oz. If you believe that gold is going to continue to drop and it’s going to be $1,000/oz a year from now, then you are going to keep selling the stocks and price in a $1,000/oz gold price. If you think that the economy is going to slow and China is going to go off of the cliff, then you price in $2.75/lb copper. Because of this thinking, a lot of the larger resource company stocks have taken a pretty big hit and the junior stock prices have been hit even harder. The juniors really suffer from a lack of liquidity. There have been a lot of redemptions in the space. The small-cap resource sector has been a train wreck. In July, the Toronto Venture Exchange (TSX.V), which serves as a pretty good benchmark of small-cap resource names, traded down to a level that it had not seen since March 2009, which was pretty much when the S&P 500 put in its low. A lot of the gains have been completely erased. Since about April of 2011, when the TSX.V hit its recovery high to its low in July, we’re down in excess of 61%.
It’s been a pretty brutal decline, worse than 2008. Remember, 2006 and 2007 were pretty good years. A lot of smaller companies were able to finance so they went into 2008 with pretty decent cash on their balance sheet. The 2008 drop was severe but it was brief. Within a year, opportunities came back and money started to flow again. The recent decline has been a slow death. The ability to finance has been shut for over two years now. Most of these companies have no access to money. As most of them don’t generate cash flow yet, so they really rely on public markets to raise capital.
TGR: Is that why the larger and producing companies did better than the junior companies? They have cash flow? Is that changing?
BO: Relatively speaking, the large companies have done better than the small companies. It doesn’t mean that the large companies have done well. But we think things are starting to get better. I recently saw a chart that compared the TSX.V to the TSX composite. It showed that the degree of underperformance of the TSX.V had hit a level that was worse than it was in 2008 and that has started to change. It is now showing a similar pattern to what happened coming out of 2008 and so I think that there is some hope.
Over the last month or six weeks, the small-cap resource market seems to be acting a little bit better. There is some volume coming back and there is more interest in the sector. One of the real keys is redemptions. A lot of the funds that were focused in this space had big redemptions and may have been worried about putting cash to work for fear of more redemptions. They just needed that cash on hand. The belief that we have put in a bottom should curtail redemptions and money could start to work its way back into the markets.
TGR: If a bottom has been put in and, at least for now, we’re dealing with gold in the $1,300/oz range, what are some examples of junior mining companies that could do well at that price?
BO: I think that there are a lot of very interesting companies out there today whose stocks have just really been hit well beyond where they should have been. The more immediate opportunities are probably with companies that are currently cash flowing. They already have operations and they’re not dependent on the equity markets being available to them for financing immediately.
One name we like is Scorpio Gold Corp. (SGN:TSX.V). It has the Mineral Ridge project in Nevada, which is already in production. Last quarter it produced 11,000 ounces (11 Koz) at a reasonable cost, just over $700/oz. It had $8 million ($8M) in earnings last quarter before interest, taxes, depreciation and amortization (EBITDA) or roughly $0.04/share. This is great cash flow for a stock trading at $0.21/share. The company is continuing to build out its operations and basically should be a 40 Koz/year producer. Yet, its stock is trading at about 1.25x forward EBITDA.
TGR: It released some drill results Sept. 23 on the Mineral Ridge project in Nevada, but the stock went down. Is that a function of the Venture market or Scorpio’s performance?
BO: I think that that’s just a function of the Venture market right now. We are starting to see a turn, but there are still people searching for liquidity. Good news generates liquidity and the opportunity for people to sell. The sellers are still out there, but piece by piece I think that they’re being cleaned up. It is not representative of Scorpio Gold, but of the tenuous rebound we are seeing in the junior market.
TGR: Were you pleased with the drill results? It showed one hole with 22.3 grams per ton (22.3 g/t) over 10.6 meters. Were the results what you expected?
BO: Yes. I think those numbers are good. One of the knocks against Scorpio Gold is that it hasn’t published a long mine life. It is a balancing act, the gold seems to be there but it is expensive to produce these resource calculations. So far, when it has drilled it has shown that the gold is there. I am comfortable that it still has many years of production ahead of it. As investors come to understand that, the stock should make its way higher.
TGR: Any other companies that you want to mention that could do well?
BO: I would just say, generically, look for companies that are producing cash flow, have kept their costs under control and have decent deposits. If a company has grade, that definitely is a good buffer against low gold prices. A lot of small-cap gold producers out there are very interesting. Even at $1,300/oz gold, they are profitable and their stocks have just been sold down way too much based on a concern that gold will be $1,000/oz or lower a year from now.
TGR: Windermere is known for focusing on less-covered sectors. With the growing global middle class, is agriculture a good investment? What’s the best way to enter that space?
BO: Windermere has done quite well by focusing on lesser-appreciated commodities. Currently, our largest holdings are in phosphate. I think that the fertilizer space, in general, is interesting. Ultimately, population continues to grow and people’s diets continue to get better. There is going to be a continued demand for the grains and farmers need fertilizer to grow those grains. That said, I don’t think that there is a wide spread depth of knowledge in the fertilizer space among investors.
Fertilizer is made up of three components: potash, nitrogen and phosphate. A lot of investors don’t understand how different those three components are and that they each have unique supply and demand mechanics. A good example was in late July, when Uralkali (URKA:LSE), which was in a potash cartel with Belarus, decided that rather than maintaining price, it was going to focus on volume. That threatened potash prices across the board and the potash stocks all experienced a considerable drop. The problem is that all of the fertilizer stocks fell; phosphate and nitrogen included. To me, that shows investors view the fertilizer sector as one without understanding that the components all have separate markets.
Windermere’s interest right now is very much focused on phosphate. Phosphate is the one component of fertilizer where North America is not self-sufficient. Recently, that deficit has grown even larger because Agrium Inc. (AGU:NYSE) closed one of its mines in Ontario due to depletion. This lack of domestic supply is exacerbated because of the source of the imported supply. Most people go to bed at night worried about Saudi Arabia and what could happen to oil prices. But most people don’t realize they should be worried about Morocco. Morocco is four times bigger in phosphate than Saudi Arabia is in oil. Other big players in phosphate are Tunisia, Egypt, Syria, Jordan and Israel. These are not places large integrated fertilizer companies want to rely on for feedstock. Security of supply is a big issue and we think it needs to be addressed.
The term phosphate is used generically. People use it to refer to phosphate rock, phosphoric acid or finished phosphate fertilizer products. Typically, when most people or the media talk about phosphate, they talk about finished phosphate products like monoammonium phosphate (MAP) and diammonium phosphate (DAP). Our interest is in the phosphate rock market, which is the feedstock to make MAP and DAP. That is where there is a shortage of secure supply and thus the opportunity.
Large fertilizer companies want to be vertically integrated. They want their own rock going to their own phosphoric acid plants, mixing their own ammonia to produce and sell their own MAP and DAP. They are going to continue to try and source their own rock supplies rather than depend on third-party suppliers to ensure supply. Aside from the practical reasons for securing their own supply, there are large economic incentives to doing so, namely in the way of increased margins. Agrium recently experienced a sharp miss in earnings. That was the result of compressed margins exasperated by its need to source some third-party rock from Morocco in order to compensate for the mine closure in Ontario. The situation is going to get worse as Agrium, The Mosaic Co. (MOS:NYSE) and Israel Chemicals Ltd. (ICL:TASE) all face further mine closures over the coming years. This does not even address the current list of countries and companies that do not have enough of their own rock. Companies that own their own rock supply can save as much as $100/ton and that can make a big difference to the bottom line when you are talking about millions of tons.
TGR: Right now, the phosphate rock price is at $145/ton. It’s been as high as $420/ton in 2008. What numbers do you use looking forward?
BO: Phosphate is not like gold. Gold that is produced in Argentina or Russia or Canada is all the same—and trades for the same price. Each phosphate deposit has its own unique geology, and results in a different quality of phosphate. The numbers you are quoting are Moroccan FOB. Because they are so large, that is the benchmark. But it is a fairly low-grade concentrate, about 30%. Higher grade concentrates can command higher prices. But even the Moroccan prices will probably increase because of increasing demand. And if there is conflict in North Africa, anything could happen to the price because supplies could be cut off. Ultimately, I don’t believe that the large fertilizer companies want to rely on North Africa for rock supply if there is an alternative.
TGR: What North American companies could help fill this need?
BO: The largest holding in our fund is Arianne Phosphate Inc. (DAN:TSX.V; DRRSF:OTCBB; JE9N:FSE). Since we last talked, the company has been very busy. Additional drilling has tripled the resource in just its Lac à Paul pit. It now has 750 million tons (750 Mt) phosphate rock grading a little over 7%. That makes it the biggest undeveloped phosphate asset in the world. It is a unique deposit. Ninety percent of the world’s phosphate deposits are sedimentary, which often has a higher in situ grade, but cannot be turned into as high of concentrate grade. Sedimentary deposits, such as those in Morocco or in Florida where Mosaic has most of its production, also tend to include contaminants like uranium, thorium and cadmium, which pose environmental issues.
Arianne has an igneous deposit, similar to several Russian deposits. Although a lower grade in situ, it can make a very pure concentrate. Arianne’s metallurgical tests show it produces a 39% concentrate. That gives it roughly 30% more phosphate content than a typical Moroccan style 30% concentrate. The beauty of igneous deposits is they don’t have any of these deleterious materials in them; they don’t have uranium, thorium or cadmium. It also means they can command a premium price. PhosAgro, a Russian producer of 39% concentrate from an igneous deposit, is selling rock in the neighborhood of $230–240/ton. That is the type of pricing Arianne should be able to get.
In addition to tripling its resource and confirming its metallurgy, Arianne has made some additions to its board and management; these are some pretty serious guys. Steven Pinney was former head of fertilizers at Cargill and then senior vice president of phosphates at The Mosaic Co. He joined the board along with Dominique Bouchard who was the president of Rio Tinto Iron Ore and Titanium. Dominique has a great understanding of bulk commodities and how to transport them. He also lives in the region so he enjoys a strong relationship with the community, the First Nations, the port and rail authorities. Brian Kenny, a seasoned mine builder, joined as CEO. He built Falconbridge Ltd.’s New Caledonia mine and spent the last few years in the Middle East with Dubai Aluminium Co. Ltd. He was also president of Bechtel Canada, where he oversaw the design and construction of several projects. The most recent addition to the company’s board was Pierre Fitzgibbon, who has held very senior positions with National Bank and sat on the board of the Caisse de Depot et Placement du Quebec. I think that as the project moves into either a development phase or a merger and acquisition phase, he will be a big help.
TGR: Dundee Capital initiated coverage on Arianne in March with a target price of $1.90/share and several other brokers cover the company as well. The stock is currently at $1.24. What could move the price 50% higher?
BO: There are a number of pending catalysts. First, despite the progress made in the last few months, the market cap remains around $100M, which is only 10% off its billion-dollar net present value. Going forward, the company will put out its bankable feasibility study (BFS) sometime around mid- to late October. That will tell a lot. A prefeasibility study released a year-and-a-half ago estimated a capital expense (capex) of about $800M to build a mine. In my experience, it is not uncommon for a BFS to see a 50% increase. My head is at a capex of $1.2–1.3 billion.
TGR: That’s a big number.
BO: Yes, it is, but I think that has to be put in perspective. If it were gold or copper, that would be a hard number to swallow, especially in today’s world. But, the reality is we are talking about a phosphate mine and there are not a lot of these things all queued up and ready to be built. Further, it’s in a jurisdiction where it’s sorely needed. Lastly, the companies that would have an interest in the project all have market caps in the billions of dollars so, rightly or wrongly, I just don’t see that capex as a major impediment. It’s funny, people look at the capex but don’t give much thought to the other side of the equation, namely, a project that will do roughly $700M in revenue and have gross margins of over $300M a year.
What I do believe is important is the operating expense (opex) and not just how much it costs at the mine. How much does this cost to put onto a ship? Because the infrastructure already exists in Quebec, it should be reasonable. Roads are in place. Power is in place. There is the deep-sea port. Once you start a mine, the capex money has been spent, and while you do depreciate it off your balance sheet, that money is gone. Opex is about what the mine will cost to run for the next 40, 50, 60 years, the life of this mine. That is where the focus will be for the majors considering an acquisition of the company. If the all-in cost to produce the phosphate and put it on a ship ends up being somewhere around $120/ton, that could appeal to a lot of suitors. Remember it’s a 39% concentrate so, $120 and ready to go wherever it’s needed is very attractive.
TGR: So you agree with Dundee’s target price of $1.90?
BO: I actually foresee a higher price because I ultimately see no other logical conclusion to this story than an acquisition. Large, integrated fertilizer companies want to own all the phosphate rock they require. Their missing link is phosphate rock. There are enough large players out there that are short of phosphate rock and not comfortable relying on North Africa and the Middle East for their supply and this, to me, makes an acquisition inevitable.
If these companies see a viable opportunity to go back to being fully vertically integrated and owning their own rock supply, this will be very attractive. If they can save $80–100/ton by owning a mine rather than buying the raw commodity from a third party, at 3 Mt/year (Arianne’s planned production rate), you’re talking about a savings of $300M each year. Within three or four years, the acquirer has made back the cost of building the mine. And for the next 40 years, it will reap the savings while escaping the international supply risk.
TGR: Any other companies in North America that could help fill that need for domestic supplies?
BO: The other project that has moved along is Paris Hills in Idaho, which is owned by Stonegate Agricom Ltd. (ST:TSX, SNRCF:OTCPK). It’s a very different type of situation. The deposit is smaller and the annual production is lower, but it comes with a much lower capex.
TGR: Stonegate is in the permitting phase. Are there any catalysts coming up we should be watching?
BO: It has moved along on its permitting and is hoping to receive the last of its necessary permits by the end of 2014. That is the final catalyst. There are some concerns around permitting process, but this is a resource that North America needs, and I think that it will be successful.
TGR: When could it have a mine?
BO: If everything goes according to plan, it could be in production in 2016.
Between Arianne at 3 Mt and Stonegate at 1 Mt, we could be a long way toward closing the North American deficit. I think there is a strong opportunity for both of these assets to come into production.
TGR: Any final advice for investors looking to protect or even grow their wealth going into 2014?
BO: It is important is to understand the different commodities, the supply-demand dynamics for each and realize that when you’re talking about commodities, you’re not talking about a basket that will all go in the same direction. They each have their own uses. They have their own market dynamics. You have to understand the underlying commodity before you start making choices about specific companies.
TGR: Thank you so much for taking the time to talk to us.
BO: Thank you.
Brian Ostroff is a managing director at Windermere Capital, where he focuses on the junior and mid-tier mining sectors. He brings over 25 years of small-cap mining expertise to the table, having served at RBC Dominion Securities and as a managing partner at Goodrich Capital, an M&A advisory firm. Prior to joining Windermere Capital in 2009, Ostroff spent four years as an independent proprietary trader.
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DISCLOSURE:
1) JT Long conducted this interview for The Gold Report and provides services to The Gold Report as an employee. She or her family own shares of the following companies mentioned in this interview: None.
2) The following company mentioned in the interview is a sponsor of The Gold Report: Adrianne Potash Inc. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Brian Ostroff: I or my family own shares of the following companies mentioned in this interview: Scorpio Gold Corp., Arianne Phosphate Inc. and Stonegate Agricom Ltd. I personally am or my family is paid by the following companies mentioned in this interview: None. Windermere Capital owns stock in Scorpio Gold Corp., Arianne Phosphate Inc. and Stonegate Agricom Ltd. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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