The Energy Report: How do you account for falling commodity
prices?
Steve Palmer: The strong U.S. dollar is driving commodity prices
down. The dollar-based slide is magnified by the summer doldrums and the lack
of liquidity in many of the junior names. There is also a widespread
perception that the Chinese growth rate is slowing, which is negatively
impacting the value of commodity stocks in general.
But the reality is that, even though the growth rate in China has declined
to 7%, it is growing from a much higher base, and this still translates into
strong demand for commodities.
TER: Why does the strong dollar drive down commodity prices?
SP: Commodities are priced in U.S. dollars. As the U.S. dollar
exchange rate goes up, commodities become more expensive for buyers and
demand falls. There is an inverse correlation between the U.S. dollar and
commodities, particularly gold, but also energy.
TER: If the U.S. dollar keeps getting stronger, and producers
cannot afford to buy industrial commodities, then the supply of these
commodities is going to increase, which will also drive prices lower. Between
the strong dollar effect and its consequent supply/demand responses, it
sounds like the perfect storm is brewing. If the Federal Reserve uncaps
interest rates, will that help the energy and gold markets weather the storm
and recover?
SP: Historically, the Fed has always waited until commodity prices
are rising before increasing interest rates. It raises rates to cool a
strengthening economy, so that prices do not inflate. We are longer away from
interest rates rising than most people think, in my view.
However, I do believe that the U.S. dollar is poised to weaken, which
should have a positive impact on commodity prices. Accelerating global growth
in 2016 will also increase demand for commodities and have a positive impact
on prices.
TER: What would be the main catalyst for a weakening dollar?
SP: The U.S. was among the hardest hit countries in the global
financial crisis. The Fed provided a significant amount of stimulus to keep
the battered economy from imploding. The super-stimulated U.S. economy has
been leading the world since 2008. Investors have flocked into large-cap U.S.
stocks and the perceived safe haven of the U.S. dollar. But as Europe and
emerging markets around the world recover and growth strengthens in these
regions, money will start to flow out of the U.S. and into the faster-growing
economies. There will be less demand by investors looking for the safe haven
of the U.S. dollar. This should be positive for commodity prices. Commodities
are cyclical.
TER: The AlphaNorth Resource Fund is stacked at about 17% energy
and 33% precious metals. Why have you weighted your portfolio like that?
SP: There is no magical formula in the weighting. It's just how
things have shaped up given the performance of our investments and the
individual security selection from our bottom-up fundamental analysis work.
However, we do like to keep the portfolio diversified across various
commodities.
TER: As an investor, how would you pick out the potential
survivors?
SP: We identify projects with lower risk and/or higher impact
projects. We like to back strong management teams. We stick with
well-financed companies. When the junior space is depressed, it is a good
time to pick up shares. Commodities are very cyclical, and when the markets
turn back up again, the share price returns will be quite dramatic.
TER: Let's talk about energy. Who do you like there?
SP: We try to minimize the impact of commodity prices in the energy
investment equation by focusing more on international names with the
potential for high-impact discoveries. We have been invested in Sintana
Energy Inc. (SNN:TSX.V) for quite a while. Sintana has partnered with Exxon Mobil
Corp. (XOM:NYSE), which is farming in on one of Sintana's properties in
Colombia's Magdalena Basin. Exxon is funding 100% of the cost to drill two
wells with Sintana. The venture is midway through sinking the first well.
Drillers have entered the main target zone. When a company like Exxon spends
tens of millions of dollars to drill a couple of wells, it is chasing
something significant. For a company like Sintana, which has a market cap of
about CA$13 million (CA$13M), a discovery would be a very material
development. Management believes it has very high odds of success based on
the seismic testing that it has done and the other drilling in the area.
TER: How has Sintana's stock been performing?
SP: Various externalities have negatively impacted the shares. The
price of oil has been a negative, and a major shareholder sold out of its
position. The doldrums and the downswing in the junior markets have stalled
the share price.
TER: How long do you think it will take for the Exxon magic to
elevate Sintana's share price?
SP: Sintana and Exxon are drilling through a very large shale
interval, which they plan to split into different sections. Each section will
be independently fracked and tested. We hope to get initial results in the next
month or two. Sintana retains a 30% interest in the project. Management
believes there could be up to 200 million barrels net to Sintana. On a per
barrel (bbl) basis in the ground, at a low-end price of $5/bbl, that is $1
billion of value to Sintana, versus a CA$13M market cap. Even at $2/bbl, the
return is worth $400M to Sintana. The numbers are pretty silly given where
Sintana shares are currently trading.
TER: I see that Sintana has an interim agreement with Mobius
Resources. What can you tell us about that?
SP: Mobius is a shell with cash. It provides an alternative way to
obtain financing, as opposed to doing a private placement in the market.
Given the state of the junior market, the easier route is for Sintana to
merge with Mobius. It is a cheaper way of financing.
TER: What other energy juniors have your attention?
SP: We have owned a position in Blackbird
Energy Inc. (BBI:TSX.V) for a long time. Blackbird drilled two horizontal
wells earlier this year in the Montney. Blackbird has a sizeable land
position there. It is gearing up to drill two more wells at a lower cost than
the first two wells, having learned a few lessons from that round of drilling
and benefitting from tougher times for the drilling companies these days.
Blackbird is well financed. It has approximately $24M in cash, which is about
50% of the company's market cap.
TER: What is the story going forward for domestic energy juniors in
Canada?
SP: There is no way to gloss over the issue: It is a tough
environment. Many of the juniors have pulled back on capex and are acting
conservatively for the near term. They just do not have the cash flow in this
pricing environment to reinvest in exploration and development. Drilling
activity has fallen significantly.
TER: Let's talk about the precious metals. Have you made any new
investments in the gold space?
SP: We recently purchased Continental
Gold Inc. (CNL:TSX; CGOOF:OTCQX), which has performed well. The stock did
pull back a bit due to short-term gold price weakness, but we view that as
temporary. Continental has a very high-grade, advanced deposit in Colombia.
Its mining operation is more economic than most, given the high gold grades.
Continental trades at a discount to its comps, and there are catalysts on the
near-term horizon, such as the expectation of a mining permit.
It is important to realize that lower-grade deposits do not have much
leeway in terms of commodity pricing. The low-grade mines can be easily
squeezed if gold falls further. But Continental has very high grades and much
more margin. And when the U.S. dollar starts to sink, I expect gold to rise,
at least modestly, which will generate nice premiums for Continental
shareholders.
We also have a position in Standard Tolling Co. (TON:TSX.V), which is ramping up to
be a processor for gold companies in Peru. It does not have any exploration
risk, except the risk that goes along with processing ore for the typical
gold company. Management has recently raised money to start up operations in
the near term. Standard Tolling looks to be earnings-positive soon. And it
trades very cheaply compared to what it could earn.
TER: How is the firm's stock price performing?
SP: Terribly. Everything keeps going down in the current
environment, often regardless of fundamental progress. Fundamentals do not
seem to matter right now. Standard Tolling managers say that earnings next
year could be greater than the current share price, so there is a lot of room
for upside. Low-priced commodity stocks have great potential for rewards.
TER: Is there any merger and acquisition (M&A) activity in the
junior gold space?
SP: We have held positions in two small companies, Temex Resources
Corp. (TME:TSX.V; TQ1:FSE) and Mega Precious
Metals Inc. (MGP:TSX.V). Both are being taken out by larger companies.
Mega Precious Metals was recently purchased by Yamana Gold Inc.
(YRI:TSX; AUY:NYSE; YAU:LSE). And there are competing bids on the table
for Temex: The most recent offer is from Lake Shore Gold
Corp. (LSG:TSX). It is a good sign to see M&A in this space.
TER: Thanks for your time, Steve.
Steve Palmer is a founding partner, President and Chief
Investment Officer of AlphaNorth Asset Management and currently manages the
award-winning AlphaNorth Partners Fund, AlphaNorth Growth Fund and AlphaNorth
Resource Fund. Prior to founding AlphaNorth in 2007, Palmer was employed as
vice president at one of the world's largest financial institutions, where he
managed equity assets of approximately CA$350M. Palmer managed a pooled fund,
which focused on Canadian small-capitalization companies, from its inception
to August 2007, achieving returns of 35.8% annualized over a nine-year
period, which ranked it No. 1 in performance by a major fund ranking service
in its small-cap, pooled-fund category. Palmer earned a bachelor's degree in
economics from the University of Western Ontario and is a Chartered Financial
Analyst.
