Fiat Currencies Are Worthless, Hold Commodities
Commodities / Commodities Trading Feb 09, 2011 - 05:22 AM GMT
Kevin Bambrough founded Sprott Resource Corp. in 2007 to take advantage of a future in which he believes trust in paper currencies will diminish. The idea is to invest in natural resources, including precious metals, energy and agriculture, which represent tangible value from which investors will benefit as necessities become more precious. Unlike closed- or open-end mutual funds, the business is a corporation that can buy private equity to ultimately sell, spin out or even take an active investor approach through majority ownership in publicly traded companies. The company also looks for distressed deals. In this exclusive interview with The Energy Report, Kevin and Sprott COO Paul Dimitriadis share their investment philosophy and ideas on how to protect wealth.
The Energy Report: Kevin or Paul, Sprott Resource Corp. (TSX:SCP) bought $74 million of physical gold in 2008 and 2009, which is held in vaults at Scotiabank. How much is that holding worth today?
Paul Dimitriadis: It's worth roughly $105 million, I believe.
TER: It sounds like you're still bullish on gold. Do you think of it as a hedge, a store of value, insurance against catastrophe or all of the above? What is your investment theory here?
Kevin Bambrough: I believe that it's all of the above; but, more so, it's that I place no value in paper money. Fiat currency is worth exactly zero. Right now, we're in a unique time in history in which the populace, as a whole, perceives currency to have value; so, therefore, it does. But I believe that faith is going to continue to dwindle. Ultimately, investments like gold are a much better store of value.
TER: Do you believe that Sprott's stock price will typically underperform its internal rate of return (IRR) until there is some catalyst that causes dramatic inflation or something similar?
KB: In terms of market volatility, I think the market will overvalue our assets at times. Other times, it will have a very negative view and undervalue our assets. The greatest example is to look at the history of Sprott Resource Corp. When we first started the company, we had basically $1.50 per share in cash—that was it. But sometimes the market traded us above $3/share, so we were trading at 2x cash—having done absolutely nothing.
Then, after making significant gains and during the pessimism of late 2008 and early 2009, the stock traded down to about half cash. We had $3.55 in cash and gold per share and we traded down to the $1.80 range, which made no sense. Our goal is not really to trade in line with our asset value at any given point, but rather to be given some value for management's ability to source transactions, create companies and take them public, which we have already done repeatedly. SCP should get a premium value for our ability to involve the right people, including investors and directors, and marry business plans with high-quality assets so our companies outperform their peer group.
KB: Paul, did you want to add to that?
PD: In the oil and gas (O&G) sector, people have no trouble trading companies above their net asset value (NAV) due to their strong management teams. Investors are willing to pay a premium for that. Our hope is that, over time, they'll also be willing to pay a premium for our stock.
KB: With that in mind, we want to make sure we maintain at least a reasonable valuation relative to our assets. Management has committed and demonstrated that we will buy back our stock when it trades at what we believe is an unreasonable discount to the market. So, that really helps to mitigate the risk. We're very aware of the fact that closed-end type vehicles typically trade at a discount because what they do could be replicated fairly easily. You can look at the contents of a mutual fund or a closed-end fund and say, "Well, I could go buy those stocks." But the difference here is that we create businesses in unique sectors with unique opportunities well ahead of when they're properly valued.
TER: Give me an example of that.
KB: We've gotten some significant gains that have come from what initially appear to be very minor investments or very little capital being committed. For example, Stonegate Agricom Ltd. (TSX:ST). In that case, we started with an option agreement totaling $53,000 that turned into a mark-to-market gain of nearly $100 million over a couple of years. And we have made much larger investments, buying things like PBS Coals Limited (LSE:SVST) or Orion Oil & Gas Corporation (TSX:OIP) that were very cheap relative to the public market comparables.
TER: You wanted to get into the fertilizer business with Stonegate because it's a play on agriculture (Ag), a sector on which you're bullish. But doesn't a mining operation add risk to what you already believe is a relatively safe way of playing agriculture?
KB: Let me first say I agree that resource exploration has got to be one of the riskiest sectors in which to be involved. Typically, the odds are insurmountable but Stonegate is not a grassroots exploration. Both of Stonegate's properties had proven historical merit; and our agreement was structured in very low-risk terms, which would minimize any material damage to our assets or the NAV of our company. We approached the transaction, got involved and advanced the asset to the point of going public.
We started with a small investment of $53,000, which was an option agreement that we rolled into a private company, and we ended up with 80% of that company. We were in a very, very comfortable position as far as the money that we had to put in. Stonegate went public with a $50 million offering and, post-IPO, we retained about 54% of the company. We put $12 million into that IPO, which basically gave us a claim on 54% of $50M through our shareholdings. So, there was very little risk.
TER: You've said you're bullish on uranium. Could you tell me your investment thesis there?
KB: The investment thesis on uranium really stems first from the fact that I'm a believer in peak oil. The major oil discoveries were made in the 1960s and 1970s, and the world's major oil fields on most continents have already peaked in terms of production. Now, the discoveries are getting smaller and those that get headlines from time to time are really irrelevant compared to the scale of global consumption. We still get something like 50% of our energy from oil. That statistic—and the fact that the U.S. is a massive importer of oil and runs a substantial trade deficit—has led me to the view that energy prices in the U.S. will go up dramatically. Also, in looking at the cost of coal production, we don't properly account for the environmental costs. I don't think we've begun to come close to accounting for greenhouse gases or general pollution.
So, I think nuclear fuel and nuclear power will grow out of necessity. There's really no other choice than to see significantly higher uranium prices to spur production to meet what I believe is going to be burgeoning demand. In the U.S. in particular, where 90% of uranium is imported, I believe that it'll become an issue of national security that the government will get behind; it'll advocate increasing production in order to protect our energy security.
TER: How are you playing uranium?
KB: We own approximately 20% of the Coles Hill uranium project in Virginia mostly through a private company, of which Virginia Energy Resources Inc. (TSX.V:VAE) owns roughly 30%.
TER: The stock is up more than 300% over the past six months. Back in mid-October, the company announced an NI 43-101 preliminary assessment that stated the net present value (NPV) of the Coles Hill uranium project was more than $400M. Do you see more upside to this stock?
KB: Well, if you look back on that study, you'll see that with higher-priced uranium, the NPV rises dramatically. That's what we've seen recently, as the price of uranium has moved up. And I think you need to see uranium in the $75/lb. area on a sustained basis to encourage supply. Then I think the NPV will be in the $600 million area. But I don't think that study really optimizes uranium's value because, if you were to increase production rates, you would potentially get a higher NPV; and I think that ultimately is what should happen. The reason it's still trading at such a discount to that NPV is purely due to the lack of a uranium mining law in the state of Virginia. We're hopeful that, eventually, it will be resolved in a positive way so the project can go forward.
TER: Sticking with your peak-oil view, you mentioned Orion Oil & Gas a moment ago. Tell me about that.
PD: We completed the transaction in September of 2009. It was a private company that had been distressed. The banks were closing in on some of its lines. The company was looking for recapitalization. We co-invested with Gary Guidry, who, as CEO of Tanganyika Oil Company Ltd., sold his company to Chinese refiner Sinopec Shanghai Petrochemical Company Ltd. (NYSE:SHI) for CAD$2.2 billion. We purchased 80% interest in Orion for $107 million with a mixture of cash and stock; the total purchase price of the deal was $130 million. We just announced that Orion had released updated reserve numbers demonstrating an NPV of $440M on a 10% pre-tax basis—an increase of $106M over the prior year and a 34% increase in reserves from the prior year. Those results stem principally from the large capital program that was put in place this year. The assets are 50% oil and natural gas liquids (NGLs) and 50% natural gas.
TER: You invested $107M. How much have you made on this?
KB: Mark-to-market, it's more than double today.
TER: Orion is 50% gas weighted. Kevin, you've said cheap gas is a myth.
KB: Gas is cheap today, obviously; I think it's very cheap. But I think it's too cheap compared to the level at which it should be trading. I believe the average gas company is engaging in production despite the fact that it can't make money at current prices; and, ultimately, we may find that reserves are overstated and companies can't produce at these prices.
TER: Then why produce gas?
PD: They're doing it for a variety of reasons. First, they have commitments on leases that they must maintain, so they are forced into drilling those properties even though it may not be economic. Secondly, we've seen some alternative forms of financing emerge in the form of joint ventures (JVs) and other creative-financing techniques that are enabling these companies to continue their drilling programs. But I think, slowly, you'll start to see the switch to more liquids-rich deposits by some of these producers. In order to sustain the production needed to meet demand, we're going to need higher prices than those currently in the market.
TER: What are you doing in private equity?
KB: We have two entities that are the hardest to value but potentially the most exciting assets. Right now, very little value is being given to them in the Resource Corp. share price but, eventually, their value could be very large. These are the One Earth companies—One Earth Oil & Gas Inc. and One Earth Farms Corp., both of which are private. One Earth Farms is something we started working on in 2007. It's taken a few years to get there, but we're very pleased that it'll be the largest farm in Canada and one of the largest farms in North America in 2011. It's also positioned to be one of the largest farms in the world in the coming years.
One Earth Farms has synergistic cattle and grain operations. Its real goal is to change the typical farming model, wherein the average farmer buys retail and sells wholesale. By that, I mean he buys his equipment, fertilizer, etc., from a local dealer or store, and then sells his crop as a commodity at harvest time based on wholesale prices. With the size and scale we've already attained, we've established that we can buy wholesale. And now we're working on the model that can allow us to capture some of the retail margin by partnering with food processors or retail outlets. It's almost impossible to find good investments in the Ag sector, and there are very few corporate farms in which to invest around the world. We're building one that, hopefully, will provide inflation protection, as well as food security for potential investors and partners.
By the way, One Earth Farms is, in our minds, the only way you can invest in Canadian farming in a large way. That's because it is in partnership with the First Nations groups of Canada, which are federally regulated and permitted to allow public companies and foreigners to lease land. Typically, non-First Nations lands in Manitoba and Saskatchewan are restricted under provincial law from public company ownership or leasing or foreign participation.
TER: How will you exit this company in the end?
KB: I think that One Earth Farms is a company that ultimately will be highly valued and coveted by three different types of investors. First, large pension funds might find it very desirable for the inflation protection it could provide pension fund holders. Also, I think that the sovereign wealth funds and the Ag ministries of the world that are trying to get food security for their nations would find this to be very strategic. Lastly, we feel it would be valued by ordinary institutional and retail investors if it were publicly listed.
KB: Paul, would you touch on One Earth Oil & Gas?
PD: The One Earth Oil & Gas concept is related to that of One Earth Farms in that it's in partnership with First Nations of Canada. On One Earth Farms' management team, we have former Grand Chief of Saskatchewan Blaine Favel. He was instrumental in creating One Earth Farms. Through his relationships and knowledge of the First Nations sector, we've been able to sign agreements with a number of First Nations with the hope of developing some of the O&G prospects on their lands that have thus far remained undeveloped for a variety of reasons. We've managed to tie up a significant amount of acreage to date, both in Canada and in Montana. This year, we're in the process of drilling some of those prospects and further defining some of their resources, and then we'll bring on production through various plays.
KB: Just to clarify, when Paul says a "significant land package," we're talking about more than 300,000 acres and growing. We're optimistic that we're going to increase our optioned acreage. This is a very, very significant land package, which, in my mind, gives us an eventual opportunity to have real upside to oil and gas prices as we prove up the plays.
PD: Again, we've invested only about $10 million to date in this business. It's another example of us starting a business for a very small amount of capital that could potentially be worth significant sums of money. The risk/reward, in my opinion, is exceptional.
TER: Kevin, you don't have much faith in paper currencies. Do you foresee a time when people will be holding gold, silver or other metals in bank vaults and writing checks based on their value, or using a debit card based on the value of the resources they are holding?
KB: I think that we're going to come up with different monetary instruments that are reflective of precious metal or other holdings. Sooner or later, I envision we'll have a currency that may be reflective of a basket of commodities that we may trade in units tied to something tangible. Ultimately I think we could have an energy-based currency.
TER: I enjoyed meeting you both. Thank you.
KB: Thank you.
Kevin Bambrough founded Sprott Resource Corp. in September 2007. He is a seasoned financial executive with more than a decade of investment industry experience and is a recognized leader in the commodity investing space. Since 2009, he also has served as president of Sprott Inc., one of Canada's leading asset managers, which has more than $8 billion in assets under management. Between 2003 and 2009, he held a number of positions with Sprott Asset Management, including market strategist, a role in which he devoted a significant portion of his time to examining global economic activity, geopolitics and commodity markets in order to identify new trends and investment opportunities for Sprott Asset Management's team of portfolio managers.
Paul Dimitriadis is chief operating officer, general counsel and corporate secretary for Sprott Resource Corp., a position he has held since 2008. He evaluates and structures transactions; coordinates and conducts due diligence; and is involved in the oversight of the operating subsidiaries. He serves on the board of directors of Orion Oil & Gas Corporation, Waseca Energy Inc. and Stonegate Agricom Ltd. Prior to joining Sprott, he practiced law at Blake, Cassels & Graydon LLP. Mr. Dimitriadis holds an LLB from the University of British Columbia and a BA from Concordia University. He is a member of the Law Society of Upper Canada.
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