TICKERS: ENB, PDN
Rick Rule: Courage of Conviction
Source: Karen Roche of The Energy Report (10/26/10)
Rick Rule has mastered his fear. A renowned resources investment manager, Rick likes underdog sectors that have fallen out of favor with the wider investment world and has the fortitude to hold those stocks through volatility. In this exclusive interview with The Energy Report, Rick explains why he likes the pummeled natural gas sector and why he hopes he loses money on his sizable bullion holding.
Rick Rule: People draw psychological comfort from increasing share prices; but, if trying to increase wealth, they also have to augment their assets. Assets are cheap during bear markets and expensive during bull markets. The virtues of bear markets are fairly obvious—assets are cheap and customers (the consumers of assets and providers of capital, if you will) are afraid. Companies are more willing to offer inducements for you to buy financings, such as long warrants. Another bear-market advantage is that asset markets become more and more constrained, which go to stronger players with established management teams.
TER: Do you think we're in a bear market? Investors have had some pretty nice returns this year.
RR: No. I think we're in a raging bull market in the resource sector. It's arguable that some sectors of the general securities market are in a bear market; but even that market has been very generous relative to what I think the economy would sustain.
TER: If we're in a raging bull market in resources, should investors be buying resources?
RR: There's always a bear market somewhere. The resources sector is a broad one, running the gamut from conventional to alternative energy, agriculture to agricultural minerals and forestry. Under the broad heading of "resources," some sectors are extremely strong, read expensive and are weaker, read cheap. We go to the out-of-favor sectors rather than the in-favor sectors; and we're finding adequate opportunities in certain aspects of the natural resource business.
TER: Can you briefly summarize the in- and out-of-favor resource sectors?
RR: The most in-favor portion of the precious metals sector seems to be large, very low-grade gold deposits that didn't stand a chance when gold was $500—or even $1,000—an ounce. But perhaps they stand a chance now that gold is over $1,300/oz. Those deposits have become extraordinarily popular of late, so we're avoiding them like a plague. That isn't to say that gold won't go to $1,600 or $1,700 an ounce and money won't be made on these; but I think the market capitalization of those opportunities exceeds a risk-adjusted price that I'd be willing to pay.
On the other hand, sectors like alternative energy—hydro and geothermal—continue to be cheap and are selling below risk-adjusted net asset values (NAVs). We're attracted to that. Although early, we're beginning to walk back into the extremely unpopular natural gas sector.
The entire conventional energy sector in Canada in the sub-$300 million market-cap range is very cheap. We're looking at companies in the range of about 2,000 barrels per day (bpd). If we buy some that aren't too highly leveraged in the next two or three years, they will be taken over by their bigger brethren, which is a trend we've played before to good effect.
We're also very interested in the uranium sector. We had extraordinary luck with that sector 15 years ago, before anybody cared about it. When that sector returned to favor, we were very aggressive sellers. The uranium sector went from 5 junior companies to 500 companies, which was problematic because there were roughly 20 competent management teams at the time.
TER: Didn't the commodity price grow dramatically, as well?
RR: That was part of it, but there are some less-rational explanations. I think most of the mania that occurred in the stocks really stemmed from the fact that the first stock to run, Paladin Energy Ltd. (TSX:PDN; ASX:PDN), went from $0.05–$10. Yes, the commodity price ran but it ran from an unsustainably low price to one that was unsustainably high. During the unsustainably high price period, people wanted to believe they had uncovered a perpetual money machine.
The thesis regarding uranium pricing and world energy security is extremely attractive. At the same time, the capital raised by the industry so cheaply from 2003–2007 has been deployed. Paradoxically, the same speculators who put up all the money are now disgusted and selling before they get to recognize the benefit. We're very attracted to that.
TER: To what extent does the uranium market comeback depend on continued electrical demand?
RR: I think that's critical. One thing that protects nuclear power demand is that it's likely the cheapest power to generate in the world.
TER: A lot of uranium companies disappeared when the price went down. Now that the industry has been flushed out, is it safe to say most remaining players will make discoveries?
RR: Most companies won't have a discovery, so the discovery cycle won't pertain to the industry as a whole. I think around 90–100 listed companies worldwide are at least still pretending to be active in the uranium space. I wouldn't expect more than 10 of them to make a discovery. That means 10% or less of the active participants will generate economic value, but some of the value they generate will be spectacular. This is a game that should be played only by people who have the knowledge to play it.
TER: Compared to other energy sources like geothermal and natural gas, where does uranium fit into your out-of-favor sectors?
RR: Currently, I think uranium, natural gas and geothermal are the most out of favor. There's an awful lot of room in the next 18 months to position in uranium stocks that will do extremely well over a three- to five-year timeframe. You have to buy the stock with the view that you're going to get some validation in two years and big validation in three–five years. A lot of speculators don't have sufficient courage of conviction to be in a stock for that long.
TER: You are perpetually early to the market. You're saying three–five years, but are you really looking at a longer timeframe?
RR: No, I don't think so. My clients are frequently bored, and then elated. Most speculators experience trauma holding stock over a long weekend. My way to manage risk is ensuring that I buy assets cheaply. I get into investments before the crowd is interested in them—sometimes a long time before. That technique has worked very well for me. I'd rather be as early as I was in uranium and have to wait two–three years for a 2,000% run-up than be late and endure an 80% decline.
TER: Is the geothermal market large enough to take off or too small to garner much attention?
RR: I don't think it will ever garner widespread investor interest, but it is extremely lucrative. Geothermal is the first resource I've ever been involved with that has widespread social and political acceptance. Political acceptance surrounding the world of "green" energy has led to both political and social acceptance of paying a premium for it.
In Imperial County, California, we modeled the power purchase agreement (PPA) rates that are being offered for "green" energy on geothermal projects. We model 20% unleveraged internal rates of return (ROR)—very high due to high power purchase agreements. At the same time, the industry's cost of capital is being subsidized by the federal government with equity grants of up to 30% of a project's allowable expenditures and a Department of Energy loan of up to 80% of project revenues. The numbers in geothermal are very compelling: 18%–20% internal ROR on a project basis and 5% capital costs. Given the relatively low risks associated with geothermal developments, the guaranteed ROR between the unleveraged project returns on the cost of capital are probably the most attractive risk-adjusted returns I've ever seen in the resource industry.
TER: With such high returns, why isn't there more geothermal development?
RR: The industry is so new that people are just starting to learn about it. I'm on the phone every week with major U.S. utilities or major international power groups. Big power producers are circling the industry. Three weeks ago, a benchmark agreement was reached wherein Enbridge Inc. (NYSE:ENB), a large Canadian power producer and pipeline owner, joint-ventured into a project controlled by a geothermal junior. The pros in the industry are seeing that these assets are worth two–three times as much on a standalone basis as they are in these public vehicles.
TER: There aren't many geothermal producers in the U.S. Is the sector a relatively short-term opportunity if major power producers are circling the industry to make acquisitions?
RR: I think it may be, at least in the U.S. There are five public small-cap geothermal companies, which I expect will attempt to merge with one another or be acquired by major power producers. Perhaps that will open up a second round of more-speculative geothermal activity in which companies actually explore for geothermal rather than resurrecting projects already explored by major oil companies in the 1970s. It will also open up capital markets for geothermal activities outside of the U.S. in Guatemala, Nicaragua, Costa Rica, Panama, Chile, Peru, the Philippines and Indonesia. I think the second round for geothermal, after the U.S. companies get gobbled up, will be the internationalization of the industry as capital markets become familiar with geothermal.
TER: Round one for geothermal is U.S.-based, but round two will be international?
RR: That's correct. A unique set of circumstances exist in the U.S. with a lot of geothermal prospectivity in the western states: U.S. acceptance of geothermal energy, the desirability of "green" energy manifesting high PPAs and federal incentives leading to low capital costs. Those factors aren't present anywhere else in the world. Other parts of the world are less developed for geothermal energy. They probably represent better exploration terrain than the U.S., particularly places like Indonesia, the Philippines and Chile.
TER: I doubt there's a sector more out of favor than natural gas. Could this sector take off?
RR: I think we're about two years early, which is just about right for me. Technological advances have allowed companies to produce gas out of shales that hadn't been accessible before and unleashed a tremendous supply of natural gas, driving down the price. The big component will be increasing demand. Paradoxically, that can be a function of increasing reliance on alternative energy. Many of the alternative energies that we're using are intermittent producers. Solar, for example, has to deal with a very simple problem called night. The sun doesn't shine at night, but people want power at night. We have to make up the power we don't get from solar with some other energy source. The easiest and cheapest interruptible, intermittent power supply we have is natural gas, which, fortunately, is in abundance.
TER: I'm surprised that's where the demand will come from given T. Boone Pickens is trying to convince the transportation industry, specifically trucking, to convert to natural gas.
RR: Your point is very prescient. Pickens is trying to convince the U.S. government to finance the conversion. I don't think it needs to do that. Gas is enough cheaper than diesel that the market will work the transfers. Using natural gas as a motor fuel is a chicken-and-egg conundrum. It costs money to convert gas stations to sell nat gas. However, until it's available at gas stations, you won't be able to put it in a vehicle.
The savings to the nation's long-haul trucking fleet from converting from diesel to natural gas could be as much as half. I think that you'll start to see real conversion in the U.S. within five years. That'll be the magic moment for natural gas.
TER: Gasoline prices aren't high enough to convince individual drivers to start incurring the conversion costs now?
RR: I suspect the cost of running an automobile on natural gas would generate a 50% fuel savings because it is astonishingly less expensive than gasoline. I suspect natural gas will be a less heavily taxed motor fuel than gasoline. The discount to gasoline and the tax savings could easily generate a market in which natural gas was available at 40% of the price of gasoline. I think that 60% savings on a fuel bill would be sufficient inducement to convince many to change.
TER: So many positives, and yet the media focuses on nat gas' collateral issues—fracking and gas in groundwater. Is that a red herring or just something the industry needs to overcome to achieve widespread use of natural gas?
RR: I think it's both. A lot of the objection to water formation damage from fracking comes from people who don't understand anything about the fracking process. Having said that, fracking uses enormous amounts of water. The oil and gas (O&G) industry has been woefully deficient in recycling treatment water. What they do is take a bunch of this good, clean, cheap water and make it into dirty water and dispose of it. Then they get a bunch of good, cheap, clean water and they wreck it again. The industry will have to do a better job of recycling process water it uses in fracturing.
Ironically, that's less of an issue now than the concern that fracking O&G reservoirs will pollute freshwater aquifers. O&G reservoirs and the freshwater aquifers are typically separated by thousands of feet of rock, so the risk of underground fracture channeling from the O&G reservoir into a freshwater aquifer is extremely slim.
TER: We've discussed how investors must be patient to allow these industries to reward them with returns. What do you suggest investors do in the interim?
RR: In periods when volatility is high, prices across many markets are high and interest rates are very low; so investors have to hold a greater amount of cash than most consider reasonable. Investors tell me they think holding cash is extremely painful due to the low interest rate and the inflation rate. Investors rightly point out that holding cash exposes them to a -3% to -5%/year real ROR. My response to that is that it's likely a crash could happen in the next two–three years. If it doesn't happen, market swings of broad indexes of up to 20%–40% could occur.
Holding large amounts of cash is good for two reasons: 1.) Losing 3% a year is better than losing 40% in a precipitous decline; and 2.) In response either to a crash or volatility, having cash available to pick up bargains when the market becomes attractively priced is something people need to consider. Think of cash the way a hunter thinks of ammunition during hunting season. It does you no good to find a deer if you don't have any cartridges. Cash is your cartridge.
Although gold and silver prices are very high, I believe bullion is an important part of a cash component. This is the most honest advice you can get from a broker because I don't sell gold or silver bullion. Bullion comprises about 25% of my cash holdings and it's going up. I would be delighted if I ended up losing money on my bullion, which is something you own because you're afraid. I'm afraid the U.S. dollar and the other fiat currencies are on the way to some zero-like price. I hope I'm wrong, but the circumstances that would cause gold to go to $2,000—or even $4,000—an ounce, are extremely unpleasant. So, ironically, I suggest people hold relatively large amounts of bullion while praying they don't make money on it.
TER: Is it possible that investors getting into these sectors now could still lose 20%, 30%, even 50% of the value on those investments before it comes back to them?
RR: Absolutely. My experience in uranium stocks was just that. From 1998–2000, I was a big buyer of the uranium stocks. Between 1998 (when I got in) and the bottom in 2001, I suspect I sustained 20%–30% losses. Mercifully, I had the courage of my convictions and bought lots more. I was rewarded with 2,000% and 3,000% gains. If you're not in position once the market starts to move, you can get left behind very easily.
TER: What would you tell investors holding lots of bullion or cash as they reposition their portfolios for what could be a mild upswing, a bigger recession or the complete collapse of fiat currencies?
RR: Be very careful about long-term bonds. Investors are getting pushed further out of the maturity cycle in bonds to try and grab more yield. I think that's suicidal. When interest rates turn around and go up, investors holding long bonds will absolutely get massacred. Sophisticated investors should be participating in private placements rather than secondary market transactions simply to get the warrant, which is the right, but not the obligation, to buy more equity at a fixed price over a fixed period of time.
The next five years will be both wonderfully rewarding and terribly treacherous. I think companies' stocks will go up or down 20%–30% over relatively short periods of time for almost no reason. Investors have to be both financially and temperamentally ready to deal with that volatility; if they're ready to deal with such volatility, it becomes a bonus and benefit for them. Goods go on sale more frequently than occasionally.
In my talk at the Casey Conference in early October, I reminded the attendees that the greatest bull market I've ever experienced was the gold bull market from 1971–1981 when gold ran from $35/oz. to $800/oz. Right in the middle of that spectacular bull market, we had a cyclical decline of 50%. The gold price halved from $200/oz. to $100/oz. Some investors got the cycle right and were long gold; but, because they didn't have the courage of their convictions, they still went broke—a true tragedy. Volatility has been a wonderful tool for me over the last 20 years.
TER: So, investors with speculative money to invest should look at private placements. How do you advise investors find brokers in good private-placement deal flow?
RR: I, of course, would recommend my own firm first, but there are four or five brokers in the U.S. with reasonably consistent access to Canadian, Australian and British private placements. Reasonably sophisticated clients can find the best, unbiased source of access to those brokers by placing a call to the investor relations department of the companies they own and get recommendations from them and see if there's any crossover.
TER: Excellent tip. Thanks so much for your time today, Rick.
Rick Rule is the founder of Global Resource Investments, Ltd., which he recently agreed to sell to Sprott Inc. Rick 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. His research and brokerage capabilities are frequently recommended by distinguished financial newsletter writers such as Bob Bishop, Jim Blanchard, Doug Casey, Adrian Day, Richard Maybury, Paul Van Eeden, Mark Skousen, Jack Pugsley and others.
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1.) Karen Roche of The Energy Report conducted this interview. She personally and/or her family own shares of the following companies mentioned in this interview: None.
2.) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3.) Rick Rule: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.