Written by The Energy Report
Rick Rule probably could draw an audience if he were talking about the weather, but combine his presence with knowledge, understanding, experience and a track record of success, particularly in the resource arena, and the crowd falls silent. Founder and chairman of Global Resource Investments, Rick recently made himself available for a brain-drain, the foundation of the piece that follows. . .
Lest you think the rallying stock market serves as a leading indicator that good times will soon roll again, along comes Rick Rule to rain on your parade. "The greatest bull market in history, beginning in 1982," he says, has trained people "to believe things will do well and get better"-training he considers lethal-and conditioned them to "buy the dips."
Furthermore, he adds, "The amount of liquidity being injected into the system is truly spectacular. A lot of the stock market rally has been liquidity-driven." Interestingly, he notes, that liquidity is short term; while banks are still avoiding long loans that they can't resell to the federal government, Rick sees plenty of short-term money, lots of margin, ample lending to hedge funds, capital markets firms and individual investors.
He considers the markets "seriously overvalued" with the economy in no condition to support the capitalization rates, but expects the rally to continue on the basis of those two reasons plus the gradual thawing of bank credit for merger and acquisition activity.
Bottom line, though, Rick calls it "a bear market trap, a real sucker rally. . .driven by liquidity rather than valuation. And when the inevitable shock to liquidity hits-from additional foreclosures, a collapse in commercial real estate, implosion of municipal markets or wherever-this bull market will be over in a tremendous hurry. He sees a variety of potential catalysts that could take this market down. There's no way of knowing when it will happen and how bad it will be, but he compares the likelihood of it happening to walking through a minefield. The odds are you'll step on a mine and it will explode. "This is a minefield that it would be helpful if you were extremely drunk to stagger through. I do not like the probability of us getting through this without a couple more ugly, ugly, ugly shocks. The idea that we're going to get through this unscathed just doesn't make any sense."
What could go wrong? Leveraged buyout loans in a weak economy. Additional reset loans in the residential market. Commercial real estate lending and commercial real estate capitalization rates. Municipal bond markets.
Rum to Treat Tequila Hangover
As Rick sees it, "The entire set of circumstances that led us into the crash 18 months ago is before us again. . .None of the underlying causes of the problem have been dealt with at all. We had a balance sheet problem; as a society we'd lived beyond our means and our liabilities exceeded our assets both in short and long term. As a society, we've decided to spend more and borrow more. We had too much collective debt, so we took debt from $2 trillion to $9 trillion. We've exacerbated the problem. It reminds me of a mathematical truism-you cannot add a column of negative numbers and get to a positive. That's not the way it works. This is the equivalent of trying to cure a tequila hangover by switching to rum."
Speaking of mathematical truisms, Rick referred to the "cashless earnings" recently reported by a major financial institution. Though he's much smarter than the average bear, Rick confesses that he has "a very difficult time understanding the concept 'cashless earnings,' but the idea that people are excited about it from a bank whose assets are largely ephemeral and whose deposit liabilities people believe are real-that seems very, very problematic."
The idea of ephemeral assets leads to the topic of the U.S. dollar. Isn't its recent strength an encouraging sign? Rick repeats a wisecrack he hears (and makes): "The dollar is in fact the worse currency in the world except all the others." He also alludes to Doug Casey's description of the dollar: "IOU Nothing" (and the euro "Who Owes You Nothing"). As Rick sees it, "currency crises in the last couple of years have always been kicked off by the dollar because people understand its counterfeit nature. For example, if one measure of value is scarcity, they've made the dollar substantially less scarce in the last 18 months by printing so many of them. But so has everyone else. The race to the bottom in the context of the debasement of currencies is a hotly competitive arena. . .the descent will be gradual but punctuated by air pockets. I can't tell you when we'll hit dollar or euro or yuan or peso air pockets, but I guarantee it won't be pleasant on the way down."
When it comes to the debate about whether the current environment is inflationary or deflationary, he thinks the coin falls in favor of inflation. "From a traditional economic viewpoint, you'd have to say the circumstances are deflationary. We are in the midst of a balance sheet recession. We have lived beyond our means and can't service our debts. The normal way to get out of that would be to stop consuming, start earning, paying down debt, defaults and foreclosures-that's clearly deflationary."
The Yield-to-Politician Factor
But ours is a political economy, he argues, and therefore "If you look at inflation-versus-deflation in yield-to-politician (which is what matters), you find a politician has no yield whatever from deflation. A politician who presides over foreclosures and unemployment will get kicked out of office."
Looking ahead to the effects of this economic climate on the resource sector, it's not too surprising to hear Rick say he anticipates a mixed bag. He does expect resource stocks to face some trouble, because "when liquidity is drawn out of the market, either intentionally or as a consequence of hitting an iceberg, there's no mercy. When speculators have to sell, they sell what they can, not necessarily what they want to."
For those reasons, Rick sees "extraordinary volatility. . .with a downward bias in equities markets in general" over the next 12 months. He's been increasing his energy exposure, though; even in a weak economy, "I'm attracted to all forms of energy."
Energy: Powerful Attraction
He describes his outlook on oil prices over the next five years as "very, very bullish." The primary reason is that major oil producers are busy "reducing supply while stimulating demand." Contrary to popular belief, Rick explains, the familiar names we see on the gas pumps aren't culprits here; the major producers are the national oil companies of the world. For an extended period of time, he says, many of the those companies have diverted too much cash flow to "politically expedient domestic expenditure, including starving the oil and gas businesses for reinvestment capital while at the same time subsidizing gasoline, kerosene and heating oil prices." Even if they change direction now, he adds, it's "already too late to forestall declines that are built into their production."
The upshot? "Important exporting countries, especially Mexico, Venezuela, Peru, Ecuador, Indonesia and Iran, could very likely cease to export any oil at all within five years. A market where export demand is growing at 1.5% a year and export supply falls by 25% is in very dangerous imbalance. So without the influx of substantial new production from only three jurisdictions-Saudi Arabia, Kuwait and Iraq-much higher world prices are inevitable."
Rick isn't worried that the oversupply of natural gas will be a serious dampener of the crude oil price in that timeframe. While the infrastructure investment necessary to substitute liquid natural gas for gasoline as a motor fuel is coming, he doesn't see it on the near horizon. In the meantime, "demand for motor fuel will pull up residual fuel oil prices, which will steady the natural gas price." That's as good as it gets for as an energy investor, in Rick's opinion: "Steadily rising prices with moderating costs of production."
Energy investors may also be interested in Rick's take on the future of Canadian income trusts. Although he expects tax law changes taking effect next year to lead to restructuring, he also expects some of the corporations that emerge to remain active in plays that have presented unusually good opportunities to recycle free cash flow. Although investors who purchased trust units for yield might not like it, Rick says, "In the context of energy prices I see five years from now, I forecast actually a relatively bullish future for these companies. In particular, companies with large land exposure in areas where new technology has led to the revitalization of historic plays will grow their asset base by recycling the cash that they would otherwise distribute to unit holders," he says. He specifies four such plays:
Speaking of economics, Rick foresees North American natural gas trading in the range of $4 to $8 or $8.50 per million BTU, with occasional spikes lower or higher "over an extended period of time." At the lower end, few of the North American shale plays can produce economically, so drilling and production will fall off dramatically when gas prices are low, spot shortages will result and prices will rise in response. The higher price will re-stimulate drilling and production because it would be economic once more, until the price drops to the lower end of the band again and the cycle repeats.
"If you assume the middle of that band ($6 per million BTU) and fully loaded that the industry will be able to deliver gas in the shales for $4.50," Rick says, "the recycle ratios-the ability to redeploy earned capital to grow reserves and production" should make the North American natural gas industry be very lucrative for 10 to 15 years for the most efficient producers.
Furthermore, he states that the "very stable nature of the supply. . .will lead to increasing utilization of gas in North America across a variety of activities, including peak power generation but also ultimately as a motor fuel. In fact, he expects that with "incredible increases" in transmission infrastructures-largely out of Russia and North Africa into Europe and for LNG-natural gas will come to substitute for oil, at least in generation and petrochemicals. "And I think you'll see within five years fairly widespread adoption of natural gas as a motor fuel."
Rick acknowledges that North America has a systemic oversupply of natural gas, but he calls this "a really wonderful thing-good for investors, good for consumers, good for producers, good for everybody."
In summary, he says, "I feel better about the oil and gas sector than I do any other resource sector, with the sole exception of alternative energy."
Size, Scale and Mass Matter
While Rick sees constraints on the supply side (particularly in crude oil) over the next five years, he also sees energy demand (particularly from emerging markets) continue to climb. Societies are now competing for energy supplies that didn't have the financial wherewithal to do so 20 years ago. The increasing demand for energy crosses the spectrum from traditional fossil fuels to renewable resources. Of course, as he points out, alternative energy has an advantage over conventional energy in being politically correct. "You can permit this stuff; there is social and political acceptance of all forms of alternative energy. Because credit delivery is increasingly controlled by governments that have bailed out banks), financing is available for alternative energy projects.
Rick divides the alternative energies into basically two camps-those that work in an economic sense and those that work only in a political sense. He puts certain hydroelectric projects and many geothermal propositions in Camp A. Solar and wind occupy Camp B.
He considers geothermal the best of the bunch for major utilities because it generates baseline power consistently. It provides 24/7 power. Other alternatives present challenges: "Hydro, which I also like, has problems during a drought, during the summer. It requires water flow. Wind requires that the wind blows, and places where wind is a very efficient energy source are lousy places to live-the plains of North Dakota. Solar has this overarching problem-night."
The economics factor in the equation is compelling, too. In the U.S., Rick says that geothermal practically locks in secure near-term internal rates of return. "Utilities are being forced to offer feed-in tariffs for alternative energy that makes solar and wind economic. And the economic threshold of geothermal is much lower, so the impact of those feed-in tariffs on geothermal companies is a huge explicit subsidy. The other subsidy is even more explicit: gifts and subsidized loans from the Department of Energy." Rick posits that a geothermal operator can earn a 22% internal rate of return with a cost of capital less than 5%-far better than returns generated by solar or wind projects. "Cost of capital as a consequence of subsidies in the 5% range while unleveraged project and IRR can exceed 20% seems like an opportunity too good to forego," he says.
Penalties, too, add weight to the geothermal case. While it appears that Washington has put cap-and-trade legislation on the back burner for the time being, Rick says that penalties on coal are coming to the U.S. "Despite the political strength of senators and representatives from the coal states, who are doing whatever they can to forestall it, it is absolutely inevitable. And when it comes, major power producers who generate a lot of power from coal will need to diversify their energy sources to non-carbon-generating production. The best baseline non-carbon generating production out there, at least in the alternative sphere, is geothermal."
The economics are convincing enough that Rick says geothermal companies of "the correct size, scope and scale should focus most of their near-term activity in the U.S. while at the same time providing a pipeline in other areas of tertiary volcanic activity that will give them growth three to five years out. "In terms of security of cash flow and ease of financing, the low-hanging fruit is in the U.S.," he says. "The chances for quantum improvements, however, come in parts of the world where the geothermal resource has been less thoroughly explored and exploited. There are gigawatts of energy to be discovered and exploited in places like the Philippines, Indonesia and in particular Chile."
In his opinion, the geothermal arena does not appear to favor small players. Consolidation makes sense, at least in the U.S., and Rick says that's largely because the combination of the direct subsidies and incentives the utilities offer via power purchase agreements to meet government mandates put a premium on organizations with experience in financing, developing and operating plants. They have to attract management teams that have done it in the past and can do it now. Obviously, according to Rick, this doesn't lend itself well to market capitalization of $50 million or $100 million. "Size, scale and mass matter." For that reason, from economic point of view, small geothermal operators that can't raise money in $100 million and $200 million chunks are nonviable. As he sees it, "The only thing that could change the equation for the small entrants would be a real near-term boom in alternative energy stocks, that sort of rising tide that floats all ships."
Absent that rising tide, the thinks the consolidation up the food chain would be rational: "the micro-juniors absorbed into the mere juniors and the juniors themselves absorbed either by utilities or global power producers" until the whole sector is ultimately "upstreamed into the power generation sector, which is a very large, global, multi-billion dollar sector."
A potential geothermal spoiler arose in December. The day after the Swiss government permanently shut down a geothermal project in Basel blamed for causing earthquakes, a supposedly similar California project that was part of the administration's geothermal development program came to a halt. Although the two were not linked explicitly, the timing led to speculation that the California project ended for the same reason.
"People get cause-and-effect back-asswards," Rick states. "Geothermal activity that works engages in areas of tertiary volcanics and very young volcanic rocks. Young volcanic rocks are there because the areas are tectonically active. They have earthquakes. Apparently you can create micro seismic activity by changing the flow of water through subterranean rocks," he adds, "but the idea that a 12,000-foot hole 6 or 8 inches in diameter will be the catalyst that unlocks the San Andreas Fault is one of the silliest scientific rumors I've been exposed to in my life."
Unfortunately, he goes on, "Given the fact that our society seems to make all kinds of decisions based on how they feel as a substitute for having to think, I guess I can see this being a political issue. People tend to lend a lot more credence to the easy thing rather than spending 10 to 15 hours acquainting themselves with the basic tenets of geology or even thinking about how much 12,000 feet of strata weighs on top of a zone that might be impacted by the withdrawal of water. Ninety-nine percent of the people don't reflect. They react."
Still, the geothermal space holds great appeal for Rick and he thinks it remains politically correct. "It's useful to see that a major U.S. utility got an $8 billion subsidy from this administration to build nuclear plants in Georgia. If nuclear is going to be politically acceptable, I cherish the thought of well geothermal producers will be regarded."
Run-of-River Works, too
In addition to geothermal, run-of-river hydroelectric projects constitute the other alternative energy that works for Rick. Conventional hydro means building great big dams that not only cost a lot but do a lot of environmental damage. "In run-of-river hydro," he explains, "you are allowed, to store no more than 24 hours' flow, which means you don't do a lot of damage to the riparian environment."
Because run-of-river projects require cascading water to work, the best places are (not surprisingly) mountainous, such as North America's West Coast, with the Sierras and the Rockies, works well, as do the Andes in South America, the Himalayas in Asia, the Central African Rift. "You're taking water out of the water course in a cascade and returning it to the river at the bottom of the cascade. This doesn't impact fish life, either, because they don't live in places where the water pressure is so great," Rick says.
"There are many, many gigawatts of undeveloped run-of-river hydro projects around the world. The financing to put them in production is available, the technology is off-the-shelf, the engineering talent to build and operate these things is freely available." He expects junior companies to be able to build themselves over a period of eight to ten years, and when they reach critical mass because of the incredible stability of the cash flows they exhibit and the incredible ease of obtaining project financing, these companies will be sold at good multiples to power users."
Sounds a bit like a no-brainer, but Rick finds that it doesn't appeal to speculators. "The idea that somebody would put money in the face of a rational rate of return over an extended period of time in a bull market rather than gamble wildly to try and discover which penny stock the tooth fairy's going to alight on, sadly pulls capital from run-of-river toward tooth fairies. For me, that's wonderful. That I can buy stabilized internal rates of return more cheaply is a very good thing."
If? Or When?
According to Rick's analyses and observations over the years, "In bull markets at least, most speculators prefer 'if' questions. 'If' questions regard a fundamental speculation as to whether there will be a return of capital rather than a return on capital. So to the extent I can involve myself in undervalued speculations that have 'when' rather than 'if' answers, I prefer those. I consider a run-of-river project in terms of a 'when' question. When will project financing occur? When will the project go into production? Having gone in production, when will somebody else pay more for the cash flow that the company's current shareholders are paying?
Rare Earths: Too Much Ado?
Rick considers rare earth metals the latest of a fairly interesting, basically North American phenomenon, sector rotation. In a bull market, where sectors get ahead of themselves, promoters make money dreaming up new stories, and stories in a sector where people haven't been burned before are the easiest to sell. "Nobody had ever lost money in niobium or gallium or germanium because nobody could pronounce them or spell them" until these stories came out, he notes. "I think this is an enormous bubble that's going to crash. I have been delivering a lecture at some conferences about the real emerging minerals in this market-storium, fraudium, scamium, or for those who saw Avatar, my new favorite, unobtainium."
'"Yes, this stuff can be used in cell phones (in miniscule amounts). Yes, lithium has some future in batteries." But the fact is, Rick says, the worldwide market for rare earth elements is about $2 billion. As he works out the math, it doesn't work. "If you assume a 30% margin (which I don't know is reasonable number)," he figures, "you are talking about $600 million in EBITDA. At a 10 times EBITDA number, you're talking about a $6 billion prospective market cap of that industry."
He cites another mystifying bit of math. "The largest lithium producer in the world is now down to 140 years' supply of lithium. The only reason they don't have a bigger supply is there's no particular sense spending money now to develop resources that you'll need in 150 years."
In contrast to the rare earth elements' tale, Rick believes that the uranium story that fed the mania three years ago remains credible. In fact, he says, "Everything that was true in the uranium story three years ago was 10 years ago and it's all true today, but it's been priced differently." That's because uranium-which first captured his attention in the early 2000s when it was pretty unpopular, trading below $10 per pound and bottoming out at $7.10 on December 25, 2000-"is a strategic fuel that has a great place in the world's energy mix. The world is consuming more uranium than it produces. . .the above-ground supply will eventually go away and there will be shortages."
He lost interest during the manic period of 2007, when the uranium price peaked at nearly $138 per pound, but is looking at uranium stocks again, with yellowcake prices pretty much confined to the $40 to $50 band since the end of 2008. Because we consume more than we produce, we will have shortages, and the competition among users who need it will drive up prices, he reasons. "Many countries are staking their energy future on uranium. I don't believe all of the plants that are planned and talked about now will be built, but enough will be built that there will be severe supply shortages. The uranium price has to go up to reflect that," he says, "and more importantly, it can go up. The price of uranium is a fairly small component of the cost of the electrical production from a nuclear power plant; the price could double and still not have too measurable an impact on the power price that comes out of the reactor."
As he surveys the uranium landscape, Rick sees a world that "hadn't looked for uranium for 20 or 25 years as a consequence of the fact that they were losing so much money on the uranium that they had found. When uranium prices rose and the uranium companies were able to attract cheap capital and deploy it to exploration, there was an amazing amount of low-hanging fruit because for all practical purposes it was a new activity. There have been some very attractive recent discoveries that haven't been rewarded with the escalation of market capitalizations that you would have seen with a discovery of equivalent value in the gold business," he adds.
A new twist to the uranium story makes it even more compelling than before, in Rick's view. "In the past, the development of a uranium mine was really the sole province of a major or a super-major," he observes, "but increasingly-due to the strategic nature of uranium deposits-juniors that discover major uranium deposits will have financing options open to them that were not open in the past." He explains that lenders increasingly are requiring plant operators to lock in supplies of uranium over the entire amortization period of the loan. For example, if an operator were to build a new reactor in for $6 billion and borrowed $4 billion over 30 years to finance it, the bank would require them to lock in a million pounds of uranium a year for 30 years. Given that there are well over 100 reactors planned for the next 10 years, probably 50 of which will be built, I believe there will be incredible demand to lock in supplies. Those off-take agreements can be used by fairly small companies to finance the construction of uranium mines."
Make Volatility Your Ally
The "extraordinary volatility" Rick foresees in the equity markets might scare some investors away, but he argues, "Volatility's good if you use it as opposed to being used by it. It allows you to pick up assets on the cheap. I don't try to mitigate volatility. I think volatility is a tool. I try to enhance it. I have learned to react with absolute delight when a stock I think is worth a dollar falls to 50 cents. I buy the hell out of it at 50 cents. I seek to profit from volatility rather than to guard against it."
Rick Rule, founder of Global Resource Investments, began his career in the securities business in 1974, and has been principally involved in natural resource security investments ever since. He is a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture. Rule's company has built a national reputation for its specialist expertise in taking advantage of global opportunities in the oil and gas, mining, alternative energy, agriculture, forestry, and water industries.