Bill Bonner's Daily Reckoning recently observed that Greece as a society made promises—to workers who were paid more than they produced, to pensioners and others in the entitlements class who were promised more than they could deliver, to savers who loaned Greece more money than it could pay back. Who should get stiffed? Bill's answer was all of them.
Citing that article, Rick Rule says, "We face the same conundrum in the United States"—and the same dismal prospects. "We have lived beyond our means for many, many years. People who don't produce as much utility as they take out by way of wages and salaries need to adjust their living standards. We have made promises that we cannot keep with regard to Medicare, Medicaid and Social Security. It's as simple as that. Those who loaned money to various entities, individuals, corporations, governments are going to be stiffed either via a default or by inflation."
Stash Some Cash
When people ask Rick about the U.S. dollar relative to other currencies, he falls back on what he calls an old truism: "It's probably the worst currency in the world with the exception of all the others." He sees the USD as a "deeply troubled but deeply liquid market" that "may fare less badly than the rest," with its purchasing power falling 5% or 6% per annum against deeper declines in other currencies. The bad news about that dwindling purchasing power, though, is that people will have to maintain high cash balances to survive ongoing "turbulence and incredible volatility in global debt and equity markets."
Rick figures that we can probably count on major equity markets to rise and/or fall by 25% in any given year going forward, "and the speculative markets will exaggerate those moves." With volatility a given, "you absolutely, positively have to use it."
Naturally, no one knows when these periods of volatility will occur, so we have to be prepared. Investors who are fortunate and are prudent enough to set aside significant cash savings in anticipation of volatility earn next to nothing on cash on deposit. Still, Rick recommends maintaining larger cash balances than you otherwise would despite the fact that your savings are losing purchasing power at the same time as they're collecting scant interest. As he sees it, holding big wads of cash and exposing yourself to 5% declines in real purchasing power beats losing 20%, 30% or 40% in conventional debt and equity markets. "Painful but true," he quips.
"But when very aggressive down moves and market crashes take place, remember to step in and buy. It's not because the cash is valuable relative to the equities in your portfolio," Rick says, "but because the cash will give you the opportunity to take advantage of periodic sales as they occur."
Capital and Courage
As a case in point, Rick looks back to what happened, particularly in small-cap equity markets, in late '07 and '08. He hunted for and found about 20 stocks selling at less than 50% of working capital, "where you got the management teams and the assets for free." With its Exploration Capital Partners 2008 portfolio, Global Resource Investments stepped into those stocks "very aggressively in a down market and profited mightily when the stocks responded upwards." Maybe there was more money to be made "had we been less cautious about the nature of stocks we chose," he adds, "but we speculated only in stocks selling at substantial discounts to free working capital." In any case, "having the courage to step into the markets and having the capital available to do so—when our competitors had neither courage nor capital—stood us in extremely good stead." So Rick's core rule for individual investors, too, would be to have capacity available: capacity in capital and courage alike.
And when you buy, what do you buy? Rick has a number of suggestions, which include:
- Pay attention to buying things that must appreciate over time.
- Buy "when" situations, not "if" situations.
- In addition to having liquidity yourself, buy into companies that have liquidity. If you are buying into an enterprise that will have to raise money in the next 6 or 12 months to continue its business plan, understand that the capital markets may absolutely snap shut.
- Speculate sensibly. It is true that there are 10-fold gains to be made on occasion buying into the gamiest of all possible speculations, but the capital markets experience is such that you should forego the outsize returns that may occur in the riskiest speculations in favor of very nice returns on more sensible speculations. The market is trying to make you more speculative right now, which is a consequence he thinks needs to make you less speculative.
Commodities in Context
Despite the condition of the broad economy, we are in an important secular bull market in resources. This bull market came at the heels of the secular bear market, as they always do. The 18-year bear market from 1982 through 2000 "took out all kinds of investor interest and all kinds of productive capacity," Rick explains, and the constricted investment in natural resources eroded the supply side of the equation. As Rick points out, the large deposits that we as a society depend on—uranium, petroleum, copper and so on—were discovered and developed from the 1950s through the 1970s. But deposits are finite; every barrel you draw from an oil well or pound of ore you dig from a mine takes the resource closer to depletion. Because "you don't stand at the top of a mine pouring in fertilizer and water and expect the mine to grow more copper," those old deposits have grown old and passed their prime. Though the bull market has brought in new investment, from his vantage point we've not yet done a good enough job of replacing or replenishing the deposits that we've been busy exhausting.
Even as supply stagnated or even shrank, demand continued and continues to grow. Every year, more of us occupy the planet. In fits and starts over the last 20 years, populations in Communist countries, emerging markets and developing nations have begun enjoying measures of economic and political freedom that is expanding the middle class and elevating living standards. That phenomenon, in turn, fuels ever-increasing demand for commodities. Rick cites the BRIC countries—Brazil, Russia, India, China—are good, classic examples. Increasing economic activity and increasing economic concentration around the world form a sort of virtuous cycle that is also driving the demand for energy. "My favorite sector is energy," he states. "The supplies will not be able to grow as fast as the demand." Actually, 20 years out he thinks the "supply" we'll be looking at will be processes rather than products: "energy efficiency and conservation, places we're really not looking at now at all."
But for the time being, let's bring it back to commodities. "At the bottom of the demographic and economic pyramid, as the poorest people get more money, they buy more stuff. Most of us here have too much stuff already. We may want more, but we tend to spend a lot on services. There isn't much stuff in an iPod; the value-add is service. You pay $1 for songs for your iPod; none of those songs contains copper or oil. But if you're on the bottom of the economic ladder in Nigeria or Sri Lanka or India or Indonesia and start making more money, instead of walking you might buy a motor scooter that's made of stuff and consumes oil. You may build a cinder block home to replace your Visqueen and patch shanty. You may buy a refrigerator and an air conditioner. What adds utility to poor people as they get more money are things that are made of stuff. There is a boom in stuff in the emerging markets."
Much Ado about a Mini Market
Does that boom in stuff in so many parts of the world bode well for the rare earths sector? Hardly likely, in Rick's view. In fact, he considers one of the biggest-buzz stories of the last couple of years a "sociological curiosity."
He acknowledges that there will be increasing demand for technology-based rare earths, such as those used to make batteries for iPods and electric cars. And he calls it a "stupid decision" that the Chinese have made to constrain rare earths exports. "The truth is, however that the rare earth market currently enjoys about $2 billion a year in gross sales." Rick says. "Of that, 40% or 50% accrue to parastatals in China. Another 30% accrue to very large integrated mining companies that produce rare earths as a byproduct to other metals productions."
That all adds up to "perhaps 20% of the sales going to companies theoretically in the rare earth sector. If you assume that 20% of $2 billion in sales—or $400 million—generates a 20% margin, Rick says, you're talking about infinitesimal free cash flow. "It is truly a classic bubble, brought about by good promotion of a sexy story. That doesn't mean that people who know how to trade investor psychology can't make money trading rare earth stocks. It just means that there isn't any particular economic basis to the trade."
Ugly Cyclical Declines
The rare earths story aside, we find ourselves in a situation where constrained supply of commodities as a function of nearly 20 years of sparse investment meets unconstrained demand. "That means real raw material prices are going to go higher," Rick says. While he looks forward to another decade in this secular bull market in resources, he's counting on it to be a bumpy ride. "If you aren't prepared for the volatility that you're going to experience—financially in terms of your liquidity and psychologically in terms of your ability to deal with 30% or 40% price declines in your portfolio in one quarter—you'll get shaken out of the best market you'll ever experience."
From where he stands, Rick says there's no doubt that "we will see some ugly cyclical declines." Nor is there any question that "absolutely incredible opportunities are ahead of us." He reiterates his guidance: "Use this situation to your benefit by having the courage and the capital available to take advantage of the situation when the people competing with you in the markets have neither."
Volatility ≠ Risk
"Understand that volatility is not the same as risk," Rick says. "It isn't a catastrophe if a company with $100 million in market cap that's in reality worth $150 million experiences a drop to $50 million in market cap. It's an opportunity. Pay attention to the underlying value of the assets, and use that underlying value to put the price of the stock into context. It's absolutely critical if you're going to maintain yourself in these markets that you pay attention to that liquidity."
As he sees it, whether cyclical downturns affect investors unduly is not a function of the market but of the investor. "Cyclical downturns are periodic sales; that's not a bad thing." If you understand the companies you're investing in and confine yourself to viable companies, downturns will be opportunities. "They will certainly test your character," he quips, "but you are going to experience them so get ready for them and in fact welcome them."
If you are the type of investor who considers volatility itself a risk, Rick has three words of advice: "Get out now." But if you appreciate sales, understand that you have to buy companies based on value, not on price. And he thinks this is a pretty good time to be able to find those $100 million market cap companies that should be worth $150 million. "As a consequence of the deterioration in markets that we've already seen, some values are starting to appear," he says. "If you own one of these companies and expect its prospects to improve over time, don't worry that the market marks it down in a period of volatility." If you have the psychological fortitude and financial wherewithal to take advantage of it, and if you like the idea of periodic half-off sales in a secular bull market, the volatility on the horizon will bring "unparalleled opportunities." And, he says, "I think you're going to see opportunities across the board in resources."
Liquidity, Liquidity, Liquidity
In real estate, they say it's location, location, location. In resources, Rick also has three words of advice to remember: liquidity, liquidity and liquidity. "These are capital-intensive cyclical businesses. Without capital they have no businesses. The companies that you invest in relative to their needs have to have liquidity."
He reiterates his earlier point that investors themselves need ample liquidity, because "absolutely without a doubt you will experience volatility in your portfolios of up to 30% or 40% a year." Without liquidity, you won't be able to take advantage of the "unforeseen black swans" that swoop in—"brutal cyclical declines in the context of that secular bull market (that) knock markets off precipices."
Investors always want to know how to get in at the ground floor. Those who speculate in juniors need to pay particular attention to cash-rich shells, Rick advises. In these cases, the company's market cap may be at a substantial discount to the free working capital and treasury. "These are ground-floor opportunities," he states. "Cash at a discount always attracts management, always attracts assets. This is not to say that all of these situations work out, but the risk-reward parameter associated with this type of speculation is unparalleled in any other form of exploration."
It's not as if the bargains are everywhere at the moment. For instance, Rick finds the micro-cap precious metals stocks overpriced at this time "because the market has driven up the bad ones with the good ones." However, the picture will start to change when one of those cyclical downturns hits. "It will flush down the good ones with the bad ones," Rick says. "Be ready to take advantage and you will be able to snap up spectacular bargains."
Cash Includes Bullion, ETFs
Rick will be the first to say that portfolio diversification for the average investor—if there is such a creature—is not exactly up his alley. "My whole portfolio is in my business and in things I understand," he says. Besides, he doesn't believe in a one-size-fits-all approach to investing. But with the caveat that he claims no expertise in what you might call "traditional asset allocation," if pressed he'll go out on a limb to say, "I would suspect that an intelligent passive investor at present needs to overweight cash—35% or 40% in cash and as much as 25% of the cash part in either physical gold or silver bullion or ETFs." Beyond that, "I do suggest investors overweight the raw materials portion of their portfolios to the rest of the portfolio because I think we're probably into a multi-year bull market in raw materials."
If you think the gold price is going to go up, Rick says, buy gold. That's "the best way to participate." As for equities, if you think a company has some competitive advantage, some facet that will cause the company to do well, buy stock in that company, irrespective of what it produces. Most of the time Global buys and recommends a stock, he says that the decision is based on organic growth or "some type of internal event, something that would make the share price respond even in a bad market." The decision is not based on "any sense of what the market may or may not do to that stock in the next 12 months."
Resource Stocks vis-à-vis Stocks Overall
Rick says that he expects the resource stocks to correlate very well with the overall market in the very near term but will diverge in the longer term. He quotes Warren Buffett as "famously saying that markets are 'voting machines' in the very short term and 'weighing machines' in the long term." In other words, emotions move the markets in the short term; in the long term, value becomes the driver.
When stocks fall, all stocks fall but recoveries are uneven. In Rick's view, the recoveries inevitably occur where value is present; where value is absent, so is recovery. But in a dramatic selloff, he adds, the selling decision is not always the investor's to make. "Margin clerks don't care about an investor's asset allocation style. When they are selling stocks to meet margin calls, they sell the things that have bids." He says that the same thing happens in opened-ended mutual funds, when fund managers with $1 billion in assets get calls for redemptions, they sell what they can, not necessarily what the client wants to sell. In fact, "your best stuff, your more liquid stuff, has to be sold at the same time or even before the junk gets sold because there are bids." For these reasons, he expects resource stocks to correlate very well to the overall market in a cyclical decline. "I would also expect the better resource stocks to recover," he reiterates, adding, "That's not something I can say for all stocks."
A Lesson on Steroids
Rick is quick to remind investors that in the vehicles his company really made a reputation with—such as the Exploration Capital Partners 2000 series—most of the big returns came from less than 10% of the positions. "The portfolio performance occurs in a fairly small number of names," he explains. It's the "nature of speculation, sadly, that most positions make only a little bit of money or lose some."
Almost without fail, he recalls clearly, the Exploration Capital Partners portfolio stocks that made 20- or 30-fold gains had handed in 30% or 40% losses before they went higher. In an "extravagant example" to illustrate the point, he talks about a stock Global bought in intervals at $0.10, $0.12 and then $0.015. "An 85% decline before the stock ran up to $10;" Rick says, "a really instructive lesson—a lesson on steroids." But, he adds, "It's important that people understand that value is more important than price and that volatility is an opportunity rather than a risk."
Long or Short? A Matter of Math
As a rule, Rick doesn't short stocks. His reasoning is a simple matter of math. "If I short a stock, the most I can make is 100% while my losses are theoretically incalculable," he says. "In a long portfolio the odds are completely reversed. The most I can lose is 100% (which unfortunately I've done on a couple of occasions) but the amount of money I can make is almost unlimited (and mercifully I've enjoyed a couple of those too). I like the math on the long side way better than the math on the short side."
The Taxman Cometh
Rick also has a take on tax matters that investors might find helpful. The Bush administration's tax cuts will be allowed to expire, he says, but he anticipates that the Obama administration will probably find other ways to "raise revenue." With that in mind, he says, "Investors who have very large embedded gains in some historic positions may want to take those gains this year. If you really like the company, you may want to sell and re-buy after 31 days—the opposite of taking tax losses."
In addition, as a consequence of less favorable capital gains legislation, Rick says, "Equities markets, at least in the U.S., will become somewhat less buoyant than they have been. I think these tax changes will have a profound effect on the venture capital industry and a lot of equity trading."
Furthermore, he sees the U.S. tax structure becoming more "progressive" as time goes on. The "more productive" taxpayers—the rich, as Washington might call them—"will be increasingly victimized." Recalling Willie Sutton's supposed reply when a reporter once asked him why he robbed banks—"because that's where the money is"—Rick notes that already 5% of U.S. taxpayers pay almost 70% of the income and capital gains taxes that the federal government collects. "That's going to continue," he adds, "and that's not the way you engender a recovery." Among the reasons his overall economic outlook is so "muted," he says, is that government's share of GDP will continue to grow partially as a function of taxation.
Energized by Energy
Speaking of taxation takes us into some of Rick's favorite territory (albeit in a roundabout way): energy.
Rightly or wrongly, the "coal is bad" mantra is likely to play itself out either in cap-and-trade legislation or some sort of carbon tax system. Earlier this year, Rick said that one of the easiest themes to play for the next five years would be around large coal-fired utilities taking over well-run alternative energy entities with large development pipelines.
Why? In part, he said, it's "because they want to control the carbon offsets from alternative energy against their coal operations without having to buy those carbon offsets in the market." In that context he mentioned geothermals in particular. "I think ultimately we will see all of the North American geothermal entities taken over either by international power generators or by American coal-fired generators."
If pushed to pick one speculative sector, Rick responds in a heartbeat. "Geothermal," he says. "I personally—not surprisingly—would pick the most out-of-favor sector. The one where the factors are most positively aligned. We don't know when all of the factors will come to play and give us a bull market, but it's a 'when' question rather than an 'if' question. Mercifully for me, nobody else gives a damn about geothermal energy."
Here's Rick's energy hierarchy: "I am particularly attracted to the energy complex, all of it. I look at alternative energy as particularly attractive. I look at geothermal as the most attractive of the alternative energies. I'm increasingly attracted to the uranium sector. I like conventional oil and gas. I like unconventional oil and gas."
Uranium: The Sequel
The story associated with geothermal energy reminds Rick of the story that was associated with uranium in 2000 when nobody cared about the uranium stocks. "The whole story was absolutely, positively true in 2000 when nobody cared," Rick says. "The whole story was equally true in 2006 when everybody cared so much that the price of the stocks got absolutely disconnected from the industry reality. The story is true again. We're coming into a discovery cycle in uranium; value is being added in some of these companies. I expect spectacular speculative opportunities in uranium. This does not mean go out and buy uranium stocks willy-nilly. At the top of the market, 500 companies pretended to be exploring for uranium—probably 10 of them viable. But the market is taking down the prices of the 10 that are good with the 490 frauds. This sets up a really nice opportunity over the next two years.
Ironically, the investing public's outlook with regards to uranium stocks continues to deteriorate as the situation improves for uranium, but as Rick puts it, "This is setting up what I think could be spectacular buying opportunities in the next 12 to 18 months."
Rick, who cut his resource sector teeth in the oil and gas industry, also sees a lot of opportunities in shale plays. He explains why, with a bit of geology and engineering background to set the stage. "The popular shale horizons are referred to in soft rock geology class as 'kitchens,'" he begins. "These are organic-rich sediments where pressure and temperature turns trapped carbon into hydrocarbon. They generate high total organic content and lots of oil and gas, but these horizons are generally not porous and are impermeable, so the oil and gas don't flow easily within the rock and hence aren't so easy to extract."
This isn't news. Geologists and producers have known these things for a long time. "We've drilled through these sections and seen oil and/or gas on logs, and occasionally seen flashes of gas in flares," Rick says. "But the sections don't produce because of very poor reservoir properties."
Technological advances have changed the picture, revolutionizing conventional onshore oil and gas production, particularly in the U.S. "What's making these shale plays economic now is a conjunction of three technologies developed over the last 20 years," Rick says. "One is seismic reprocessing. We have learned how seismic data flows back and learned how to process it so that we can look at shale sections and find those that are naturally fractured—which increases porosity and permeability. We have even learned to differentiate the fracture fairways, the direction of the fractures so that we can exploit them better. In the case of natural gas, with bright spot—amplitude versus offset seismic technology—we have even learned to be reasonably accurate about the material—water or gas?—that fills the cracks in fractures. We have thus been able to orient exploration toward sections in these shales that are more rather than less economic."
Other key developments have taken place in horizontal drilling and measurement well drilling technologies. "When I came up in the oil and gas business," Rick recalls, "we penetrated shale sections vertically. A section may be 1,000 miles wide but maybe 10 or 12 meters thick. If you penetrate it vertically, you may open up 30 or 40 feet to possible exploitation with a wellbore. With directional drilling, entering these shale sections horizontally, you're able to stay in the section for 3,500 feet, opening up and exposing much more of the shale section to the wellbore."
And then there's multi-stage fracturing. Again, Rick recalls his early days in the industry. "You would open up maybe 10 meters of the section and give it an enormous fracture. You pumped in water and sand at very high rates and manufacture a reservoir with the porosity and permeability that nature didn't provide." Nowadays, rather than one massive fracture over 10 or 12 meters, you create as many as 30 smaller fractures over a much larger horizontal extent in the reservoir. "This opens up much more of the horizon to produce and minimizes the risk of damaging the section from an enormous concentrated fracture," Rick observes. "In effect, you take deposits of oil and gas that are constrained in terms of their ability to produce because they have poor reservoirs and manufacturing a reservoir inside the horizon and making it easier to produce."
These processes have "absolutely revolutionized conventional oil and gas production in North America," he says, running through a litany of conventional gas shales that have become famous—the Marcellus, the Fayetteville, the Haynesville, the Barnett in the U.S., and in Canada the Montney and increasingly the Utica. In the oil shales, he references the famous Bakken in North Dakota, the Viking in Saskatchewan and now the Cardium in Alberta.
As a result of these developments, Rick now sees "numerous opportunities in shale," but understanding the nature of those opportunities requires a paradigm shift in the way you look at onshore exploration production activities. Because the chance is very high of drilling a well that at least penetrates a section with oil and gas in it, exploration risk is now low—but other risks remain. "Can you manufacture a reservoir in a rock that will allow you to recover the oil and gas that you know is in the rock?" Rick asks. And if you overcome that engineering risk, "On an ongoing basis, how do you accommodate the upfront capital costs in shale, which are high relative to the energy pricing?"
In particular, with U.S. natural gas, Rick expects gas prices to be a function of shale production. The shale producers are reasonably certain about how much reserves they can discover for every dollar expended, and also within some frame of reference how much physical reserve they will be able to produce per dollar expended. With very liquid futures markets in natural gas, when producers can earn a 20% or 30% real margin—better yet, a 50% margin—on E&P activities you'll see a lot of activity.
Rick Rule, founder and CEO 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. Rick'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. This article is based on his Global Resource Investments webcast, Friday, July 16.
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