Rick Rule on Commodities: Be Prudent, Study Hard, and Take Advantage of Volatility
Source: The Energy Report (11/5/08)
Legendary investor 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. In this edited transcript from a presentation for clients, Rule shares his thoughts on the current situation.
. . . I expect the outlook for commodities to be good relative to other sectors, and I think in certain instances. . we’re going to see this year. . .some extraordinary opportunities.
My belief is that we are still in a secular bull market in commodities. I think that we’re in a cyclical decline that's very strong, very sharp, very ugly. I think we’re in a cyclical decline in a secular bear market.
Now, let me explain this thesis. In agricultural minerals, base metals, and energy, worldwide, we are living off of resources that were discovered and developed in the '50s, the '60s, and the '70s and maybe the early '80s. The natural resources business has already been in a 20-year recession, and that 20-year recession limited exploration and it limited production. To the extent that there has been exploration in the last 15 years that was successful, the current credit crisis probably forestalls the development of many large new deposits, meaning that the very credit crisis that we’re experiencing will limit new supplies of base metals, agricultural minerals, and energy as a consequence of the fact that we have 6.5 billion people in the world, and all of those 6.5 billion people want a better standard of living. There will always be some base level demand for natural resources.
What is important to know about the current economic climate is that, perversely, many developing economies have the ability to borrow enough money to get themselves in the kind of trouble first world developed economies are in today. As a consequence of that, to the extent that we see political liberalization and a little more individual freedom in very poor countries like China, India, Indonesia Mexico, Pakistan and Egypt, we see pretty decent increases in wealth—wealth at the bottom, if you will.
And what is interesting about increases about wealth at the bottom is that when people at the bottom spend money on things, they spend money on things that have inordinate amounts of inputs of natural resources. Let’s go deeper into this.
In western economies where people are rich and they have houses, and they have cars, and they have things like that, the stuff they buy is largely services, largely intellectual services. Somebody might buy a new cell phone; they might buy an IPOD; they might buy music to load their IPOD with music; none of that requires very much natural resource input. But if you are a poor person who is becoming less poor in Southern India; you live on the equator, the first thing you might buy is a refrigerator. They're useful on the equator. If you have a little more money, you might buy an air conditioner. After that you might buy a motor scooter to replace your bicycle. In this case, you’re not buying a service; you’re buying something that has steel; it has copper; it has aluminum; it consumes energy. The input of natural resources is very, very, very important in the products that people buy as their wealth increases in developing markets, and that’s a big, big, big thing.
It used to be that our standard of living was so much better in the West that we were the only ones who could afford these natural resources, but that’s no longer the case. We’re facing competition from around the world, and that’s why the natural resource prices have been headed higher.
This will not cease. If you look suddenly at where the aggregations of capital, the aggregations of savings have happened on a global basis, it has not happened in the United States. It has not happened in Germany; it has not happened in Iceland; it has not happened in Great Britain. It has happened in India; it has happened in Dubai; it has happened in China, and places like that.
And in those societies, two things are happening. The consumer class, if you will, is going farther and farther down the traditional economic scale, leading to incremental demands on a per capita basis, spread over billions of per capitas, at the same time that the countries’ saving rates as a whole are allowing them to update their infrastructure. In both China and India they have under construction the equivalent of the U.S. Highway commission; they’re electrifying the countries on a very broad scale, and these types of increases in demands for commodities, both on the individual and the societal level are increasing demands for things like cement, coal, oil and gas.. And I suspect that over the next five or six years the natural resource base and commodity-based businesses will do surprisingly well. There will be challenges, capital markets challenges for those companies. Appetite for risk, which was rampant a year and a half ago, three years, five years ago; that’s gone. That’s gone.
So, the surpluses enjoyed by explorers in the context of the worldwide appetite for risk is gone. Credit will be very, very difficult to obtain I would say, for the next 18 months. The fact is if you want to build a big copper mine now in Chile, let’s say you need to borrow $1.5 billion. If you go to Citicorp and talk to them about $1.5 billion, you are going to find out that if Citicorp can raise $1.5 billion dollars, they’re going to keep it, not use it to finance some copper mine in Chile. So that’s going to be a problem.
That’s a problem that I believe works itself out in two to three years, maybe five years, because there are large aggregations of capital available in the world right now to finance natural resources. Those large aggregations exist in the Persian Gulf. I know because I go there fairly frequently. They exist in China; they exist in India. What is missing right now in those countries is the knowledge of how to structure the financing of these things. In other words, the software for deploying capital in natural resource markets. It doesn’t exist in the places that have the capital to deploy it. They have for the last 15 to 20 years relied on their friends who were bankers in London or New York, and right now, they’re licking some pretty serious wounds as a consequence of their trusting the Western world intermediaries. But they’re developing their own capabilities fairly quickly, and I think that you will see in the context of viable natural resource projects, an unlocking of credit markets over a three-to-five year timeframe, particularly as societies that are short some types of commodities—the Middle East is an example in terms of metal, or China and India in terms of metal and energy—high debt finance associated with these projects to off-take. In other words, they use the debt finance to get an assured supply of commodities that they need for their economies to grow.
So, let’s look at this sector-by-sector.
It is my belief that in the very, very, very near term, the only thing you’re going to see in precious metals prices is extraordinarily volatility. What the world is doing now, perversely, is putting money in U.S. Treasuries, not because they like the dollar, but because the dollar is liquid and the U.S. markets are very, very transparent. It is my belief increasingly, however, that some of that money will spill into gold. I think the market for gold will be extremely volatile in the near term. I believe it has the potential to be extremely extremely biased to the upside in a three-to-five year timeframe. I am very, very, very bullish on the gold market looking longer term.
I think the base metals commodity prices will go lower in the near term. The widespread consensus is reduced demand as a consequence of the Western world’s recession or depression will take the base metals lower, and I think those are accurate assumptions. I think, however, that third world demand for base metals as a consequence of people upgrading their living standards or changing their infrastructure will be such that base metals will respond much quicker than people think.
Now, in the consequence of base metals stocks, the difficulty is going to be project finance—the ability to put projects that you’ve discovered and matured into production in the context of broken global credit markets. It's going to be problematic. People who look to finance projects are going to look at a period of two, two and a half years, maybe three years where project finance is unavailable. So, when you are assessing the valuation of a base metals company, trying to make a present value calculation, you can’t assume that they’re going to be able to commence construction any time before 2010, 2011. There’s been an extremely vicious sell-off in the base metals stocks, and there will be some extraordinary bargains to be had.
The oil and gas business—the oil price will go lower, the natural gas price will go lower. That will happen for a couple of reasons. The institutional investors who have taken speculative or hedge positions in those energy markets are out of money. They will be sellers; they will not be buyers. Reduced economic activity means reduced demand for energy. That one’s a no-brainer.
Looking a little bit further ahead, however, these are extraordinarily attractive businesses. They’re extraordinarily attractive businesses, again, perversely because of governments. Most oil in the world, strangely, is not controlled by oil companies. People think, if you read the popular media, that the world oil prices and the world oil supply is controlled by people like Shell and Exxon, British Petroleum, but that’s not the case. Most oil in the world is controlled by national oil companies and the governments that run the national oil companies do as good a job running the national oil companies as they do their societies.
And let’s look at the national oil companies, let’s look at the countries that they run: Iran, Mexico, Venezuela, Indonesia, Russia—not much cause for optimism. In fact, what occurs on a global basis with these national companies is that these national oil companies divert most of their free cash flows to the governments for social expenditures. In fact, every country that I’ve mentioned uses the free cash flow from the oil and gas business to subsidize domestic gasoline and energy consumption meaning that they are encouraging domestic consumption.
What is happening is that so much of the cash flow in these national oil companies is going to domestic and social expenditure that not enough of it is being reinvested in the oil and gas business. So, the production in these countries is really in terminal decline. It is my belief that in a three to five year timeframe and maybe sooner, several countries, which are prominent oil exporters, will no longer have oil for sale in world markets. I believe this will happen in Venezuela; I believe this will happen in Mexico. I believe this will happen in Indonesia. It may occur, surprisingly in Iran. The interesting thing about that is that those four countries control about 25% of the world’s supply of export crude. If you take 25% out of the world’s export crude supplies, you do an awfully strange thing to the oil price. And I think this is going to happen; I don’t think it may happen. I think it is going to happen. That will be very interesting.
Now, the natural gas market is going to be fairly interesting. In the U.S. you’re going to see lower natural gas prices for old-fashioned reasons. Those reasons are that markets work. A period of high natural gas prices in the United States led to incredible increases in technology for exploring for natural gas, particularly in terms of unconventional sources like shale. And for the first time in 25 years, in the domestic U.S. market, reserves and production are increasing rather than decreasing, and that’s happening in the face of an economic slowdown. Increasing supply, reducing demand means lower prices.
This is, looking forward, if the market is left to its own devices, a self-correcting problem. About 50% of U.S. production comes from wells that have been drilled within 40 months or less. At a lower natural gas price new drilling slows down dramatically; so flush production from new drilling slows down dramatically; so supply slows down dramatically. The swing supplier for the United States has always been Canada. And increasingly, Canadian natural gas production will be constrained because of the actions of the Alberta government stealing more from oil and gas producers.
Secondarily, because Canadians are relying more and more on natural gas for power generation in their own economy, and third, and most importantly, because natural gas is the energy is that fuels the sand, crude, and tar sands program. So, there is going to be a reduced supply of Canadian natural gas to U.S. markets.
The third determinant for U.S. natural gas markets is liquefied natural gas or LNG. The truth is the U.S. has the world’s best natural gas distribution and storage facility, but the U.S. also has some of the cheapest natural gas in the world. LNG, liquefied natural gas supplies compete with crude oil on a worldwide basis in the global energy matrix. So, the shipment of natural gas, say, from Egypt to world markets, that producer has a choice between landing that gas in New Orleans for $8/1000 or landing that gas in Tokyo for $13/1000. Guess which market wins? So, in the near term, energy prices are lower; in the intermediate or long term, energy prices are higher.
For alternative energy, the macro in one sense looks good; on a worldwide basis, there’s a consensus for alternative basis. On a worldwide basis, there’s a horror with regards to carbon. But there are now some clouds on the alternative energy horizon. The first of which is the contraction in credit availability; building these things is credit intensive. Traditionally, these plants are built with 30% equity, 70% debt. What happens if in three years if that debt is not available? These facilities which should have been built, which would have been built six months ago may not get built.
The second problem that alternative energy may have, at least in the context of the Global’s business, we got involved in alternative energy projects because they were fairly priced relatively to oil and gas, which was too expensive, and certainly to mining which was horrifically expensive. The problem is that alternative or different outlets for capital exist today. At Global we were de-emphasizing mining as much as two years ago. All of a sudden there were lots and lots of places to put money, not merely in alternative energy.
So, let’s talk about the junior markets. Let’s talk about capitulation because capitulation is what we’re seeing. These markets will be incredibly volatile. They will be sold for no reason other than fear and the need for liquidity. You are going to see these stocks, as I said at the beginning of this talk, go up and down by 30% for absolutely no reason. The market took these things up for no reasons; the market is going to take these things down for no reason.
This is going to lead to incredible pain and incredible gains in the period going forward. In fact, this is the most rapid contraction in junior resource equities in 30 years of experience in these markets. We are heading into a period that the market will look back on as a dark period. The last dark period, as many of you will remember, was the 1998-2002 period, which happened to be the very best speculative period of my life. “If you keep your head, as those all about you are losing theirs," the opportunities that confront you are simply spectacular, simply spectacular.
In truth, the silver lining on this very, very dark cloud that we see is that the period of low pricing that we’re headed into is a period where the junior resource market is in better fundamental shape than it was the last time. What is changing is the price more than the conditions.
Why do I say that? In 1998, which was the beginning of the last truly dark period, natural resource businesses on a worldwide basis were in liquidation. The copper price was at 70 cents a pound; so the industry sold copper for 70 cents; the problem was they made copper for 85 cents. So they were losing 15 cents a pound and trying to make it up on volume. In the zinc business, they were zinc for 40 cents a pound, but they were making it at 75 cents a pound, losing 25 cents a pound and trying to make it up on volume. And the same on energy.
The difference between then and now—right now at least commodity prices are such across the board the commodity producers are actually making money. The industries are not in liquidation. They are just priced as though they were in liquidation. That is a very, very important difference.
The second difference with regards to the juniors is that in 1998 we were coming off a two-year bull market; that is '95 and '96. So, some of the companies came into the decline with decent treasuries; some of the companies came into the decline having spent a fair amount of money. Coming into this bear market, we are coming off of the second greatest bull market in the history of junior resource equities. Millions and millions—no, make that billions and billions of dollars worth of money came on to these balance sheets. So, in the first instance, many of the companies that have gone down in price by 70% or 80% have several years of working capital in the treasury. They are extremely well financed.
The other thing is that many of the juniors that are in the bargain basement today have seen a billion or two billion dollars worth of work done on their balance sheets. And you have the opportunity today to buy two or three billion dollars worth of work, some of it done very well, at deep, deep, deep discounts to book—deep, deep, deep discounts to book.
The question is, I guess, in the context of fear and volatility, are you going to be one of the group that is going to be victimized by this market or are you going to be part of the group that is going to take advantage of the reallocations of capital that are going to occur in this market?
I know from my particular point of view that I have been trained my entire life for this particular set of circumstances that I find myself confronting. In fact, the 1998-2002 bear market in junior resource equities that caused so many of my competitors to go out of business coincided with the best investing period of my life. Many of you are partners in the exploration capital partnership series that were founded in that time and that delivered results that exceeded even my most optimistic projections. It is my own personal belief that the set of circumstances that we find ourselves in, if you are solvent and if you are intelligent and if you are courageous, are in fact better than they have been at any time in my investing career.
That doesn’t mean it is going to be easy; that doesn’t mean it’s going to be riskless. That just means in the context of the ancient Chinese curse about living in interesting times that in periods of crisis, there is opportunity. We’re in a period of an extraordinary crisis, which means that we’re in a period of extraordinary opportunity.
When I look back at successful participants in cyclical, volatile capital intensive activities like natural resource speculation, what I see that is interesting is that the very best participants, among whom I include myself somewhat immodestly, seem no matter what their efforts are, to lose 40% to 50% of the quoted value of their portfolios in these sharp, savage downturns, extraordinarily unpleasant. The interesting thing is by reorganizing their portfolios and deploying their remaining cash when other people are afraid to, they put in place the set of circumstances that allows for a 20-fold gain coming out of the market.
Now, let’s put that in numbers. What that means is the best participants, if they start with $100,000 in an historical sense, we will see the $100,000 cut to $50,000, and then the $50,000 grow into some number like a million dollars. That is, I think, these set of circumstances looking forward that we have the opportunity to achieve. If we’re prudent, if we use our heads, if we study hard, if we take advantage of volatility rather than having have volatility take advantage of us, here at Global we are going to do our very best to establish a focus list of speculative equities, and we are going to recommend that you look very hard at your own portfolio and sell merely good stocks to re-deploy the capital in great stocks. I have every confidence that the next 6 to 12 months are going to be utterly terrifying and utterly fascinating. And I have every confidence, based on my experience, that the set of circumstances that the opportunities that we’ll have available to us in the next two-to-three years will cause us to look back on this period sometime in the future and say, “While it was the worst of times for us, it was the best of times.”