Rick Rule: We’re Entering a Great Era for Resource Investing
Below is the transcript for the podcast with Rick Rule: We're Entering a Great Era for Resource Investing.
Chris Martenson: Hi! Welcome to another www.PeakProsperity.com podcast. I am your host, of course, Chris Martenson. And today, we have the good fortune of speaking with Rick Rule, one of the best-known natural-resources investors alive today. He spent the past thirty-five years investing in mining, energy, water, forest products, infrastructure, and agriculture, and founded the successful Global Resource Investment group of companies, which was acquired last year by the Sprott group. And as you know, I have interviewed Eric Sprott here before as well.
Rick and I just met recently at the Casey Research Conference in Phoenix earlier this year. And it felt a little bit like reuniting with a brother who had been separated at birth, because we see the world through such a similar lens. I am very excited to dive deeply today into the resources space — because you know how important that is to me — with such an experienced mind, Rick, hey, it is a real pleasure to have you join us today.
Rick Rule: Well, my pleasure. As you point out, I enjoyed your speech very much at Casey Summit. It felt like you gave the first half of my speech. But unfortunately, you give it better than I could have. So, it is a pleasure to be here.
Chris Martenson: Oh, very nice of you to say that. It is a speech I have been practicing for a while. Rick, I guess it was at the Hard Assets Investment Conference in San Francisco, I hear you detailed out your thoughts on the good news, and the bad news facing investors today. Can you dive right in? Can you give us some quick highlights of that?
Rick Rule: Y eah, I think I can. I talked about the fact that we were going to face an awful lot of volatility. And I should start by saying that volatility can be good news for you if you are prepared for it. It gives you frequent sales. Why the volatility? In the first instance, there are seven or eight trillion dollars sitting on the sidelines just in the United States looking to be invested. That has some upward bias.
The second part of the good news is that we are in a secular bull market in "stuff," in resources, for reasons that you have done a great job pointing out. But, let’s back up on a few of them. The bottom of the demographic pyramid as it gets richer — and it is getting a bit richer — uses a lot more stuff than the top of the pyramid. So per capita consumption of stuff is growing, spread over lots and lots and lots of capitas.
The third thing that I tried to point out in San Francisco, and I am sure that some of your veteran investors are familiar with, is that resource stocks have not kept pace with commodity prices. So resource stocks, for the first time in several years, are attractively priced. That is the good news. The bad news is also pretty straightforward. It appears to me like we are headed towards a liquidity or credit crisis, as a consequence of the fact that the political will does not exist, to cause the citizenry of western nations to live within their means, and because the banking system as we know it is bankrupt.
An example would be Germany; the lender of last resort for the European economic community had a failed bond auction. If the lender of last resort cannot lend, you have a fairly interesting set of circumstances. Of course, they did find another lender of last resort, and that is us. And the market has not seemed to figure out that we are in some danger of going broke ourselves. So I think there is plenty of good news and plenty of bad news for everybody.
Chris Martenson: With this liquidity crisis, you have maybe two competing theses going on here. One is that yes, we have this large tailwind demographically speaking with resources. That is on one side propelling us upward, but wouldn’t a liquidity crisis be arguing that we will be facing some sort of an economic crunch, maybe another recession, or maybe something harder that would drive resource price down?
Rick Rule: I think that might happen. I am completely conversant with the fact that resource stocks could get cheaper before they get expensive. You are a good mathematician, and you know that you have a mean line and a median line, because things do not revert to mean or median, they revert through the line. And the fact that stuff is gotten cheap probably means it gets cheaper. But the nature of investing in natural resources is investing on a net present value basis, not on a relative value basis, and the stuff is cheap. We do not see it cheap very often. Now back to your question. Yeah, you have two countervailing pieces of data. Seven or eight trillion dollars of cash is looking to be invested. At the same time that some of the institutional forces of debt funding, i.e., the banks, are shutting down inter-bank lending, and short-term credit is becoming very hard to get, which is often a portent that long-term credit will become unavailable.
Chris Martenson: Yeah, you know there is a very interesting dynamic here. If I am somebody with a relatively large pool of money plus a longish-term time horizon, I have a pension fund, I have an endowment, I have a sovereign wealth fund. I would be looking at the resource plays very, very carefully here in a large part because of the MF Global disaster and what we see going on in the banks. The idea that the Fed hid $7.7 trillion dollars of emergency loans to these institutions, I am just looking for someplace where I can park my funds, hopefully on a net present value basis that is favorable. But I am looking to park my funds somewhere where I can trust that no matter what happens out there, that I have got a steady stream of cash, I am invested in a real asset that has tangible wealth that I can identify. I am surprised given the $7.7 trillion dollars floating around out there that more of them have not tried to squeeze through what I consider to be a pretty tiny doorway.
Rick Rule: I think that it is a matter of time. And I guess I have a little more good news that I should have talked about on the onset, which is that the senior resource companies, including the mining companies that have been real underperformers for the last decade, are starting to make an awful lot of money. And one of the themes I think that you are going to see in the resource space is mergers and acquisitions. I think the best trade that can be made, in particular the developing and junior resource space, is to buy shares in companies that won’t be bought by funded managers, that won’t be bought in fact by endowments, but will be bought by industry players. So in terms of who can come into this space, by all means the pension funds that you are talking about, by all means the individual investors who have all the money in NOW accounts, but particularly I think by other industry players.
Chris Martenson: Right. I mean, we have certainly seen that happen in the oil industry, and that is sort of a maturation story that is happening there. As you know, we over here on my side of the camp, we tend to see the current economic crisis. It is rooted in this larger story of depletion of the key inputs modern economies just need to function, most notably oil. So you know about Peak Oil. I am wondering, how does Peak Oil or peak anything fit into your strategy for investing?
Rick Rule: Well, Peak Oil in the geological context is something that will absolutely happen. But I think you need to look at Peak Oil in an economic context. We have passed Peak Oil in the sixty-dollar or sixty-five-dollar-a-barrel real range. Never mind the nominal range where the value of the denominator goes down. I do not think we have passed or even reached Peak a-hundred-and-fifty-dollar Oil.
I think one of the lessons that people need to understand is that in time frames, which are relevant to you and I, markets work. High oil prices will constrain demand and increase supply. One of the things, however, that people need to understand, is that ninety-five-dollar oil now is not the same as ninety-five dollars ten years ago, because the dollar isn’t the same as it was. Looking forward, the challenge that we face in conventional energy markets isn’t Peak Oil. The challenge that we face is the fact that most of the oil in the world is produced by national oil companies. By the same sort of government entities that cannot deliver the mail and cannot educate the kids.
And in several large oil exporting companies now — I am speaking specifically about Venezuela, Mexico, Ecuador, Peru, Indonesia, and probably Iran — the national governments that diverted so much of the sustaining capital from their oil industry to subsidize politically expedient domestic spending programs that they are in declines that cannot be arrested for five, seven, or ten years. It is my belief that within five years, at least twenty percent of the crude oil, which is currently available for export on an annual basis, comes off the market.
And unless Libya and Iraq can make up that shortfall, you are going to have a market that sees world import demand growing by 2.5 percent compounded walk into a supply side where supplies are twenty percent less, which would have a dramatic, dramatic increase impact on prices in the three-to-five year timeframe. Looking further out, certainly Peak Oil from the point of view of geological capacities is an issue, but we are going to face a different problem before we have to face that problem.
Chris Martenson: Sure. So we are passed Peak cheaper-grades-of Oil. We have that. And your twenty percent, I think there is about thirty-five million barrels a day, goes on the world export market. So you are calculating a seven, eight million barrel per day shortfall running headlong into probably a two or three million barrel per day increase over that same period of time. So we have the pieces brewing there. I have seen the same thing in my own calculations. And all that we really need is for one of these nationalized oil companies to say, “Hold on, we are saving this stuff for our own country,” maybe Norway. I do not know, somebody. I do not think Iraq and Libya can come online fast enough. They would both have to double their production from current levels, and neither of them can do that.
Rick Rule: Chris, one of the ironic follow-ons to that is that one of the things that these national governments do, ironically, that cannibalizes capital from their oil business, is they subsidize domestic energy consumption. So as an example, in both Venezuela and Mexico, on the one hand the national oil companies are constraining supplies with consequence of their diverting free working capital. And, ironically, on the other hand, one of the things that they are using the money for is stimulating domestic demand by subsidizing energy consumption. It is a fairly ugly circumstance, in terms of world oil supply on a going-forward basis.
Chris Martenson: Yeah, that is a two exponential functions sort of pinching together, one from above and one from below, taking oil off the market. You know, somebody who is twenty-two years old today has been alive when half of all the oil ever burned in history has been burned. And so you have been in business and looking across resource plays for thirty-five years. I am wondering, what are the trends that you have seen, in terms of the quality of the resource plays that you can identify over your career? I do not care what resource we are talking about; whatever ones you are familiar with. Are we still finding ample supplies of high-quality ores, or are we really squinting at these things and chasing stuff in the lower and lower grams per ton, or however we are measuring these things these days?
Rick Rule: Well again, markets work. I think the easy to find deposits, particularly in the minerals business, ones that stick out of the ground, in pieces of ground that are safe to walk on, those are gone. If we are going to find deposits at outcrop that stick out of the ground, we are going to find them in places like Somalia, Afghanistan, and Bolivia. Hard places. There are high quality of deposits to be found, but they are going to require more and more expensive exploration techniques, ground penetrating radar, and things like that. And it is the same with oil and gas. We are here in the United States reversing long-term trends, in terms of both oil and gas production, but we are not doing it in a conventional sense. We are doing it in an unconventional sense. We are looking at the conjunction of three technologies; amplitude versus offset three dimensional seismic, directional drilling, and multi-stage fracturing. We are doing really truly a tremendous job of unlocking American energy. But we are doing it at a very, very, very high capital cost. If you compare the development cost for Bakken Oil, relative to the development cost of some of the Permian Basin pools that were discovered in the fifties, there is no relationship between production costs. What we are doing is wonderful, but as you pointed out in an earlier question, this is not low cost oil. All oil is good, but these are hard, hard deposits to develop from a financial point of view.
Chris Martenson: I have heard that the average Bakken well is paying out at about a hundred and fifty barrels per day, which isn’t bad when you say it is a hundred dollars a barrel. Not that you can sell Bakken oil for that right now, but for the sake of argument to make the numbers easy. That is not insignificant, but you compare that to a Galar oil well that might pay out at thirty thousand barrels per day, or some ridiculous number like that, it is a flow rate issue as well. It is not just that they are more capital intensive, but peak oil is really about the peak flow rate that we are going to hit as well. And these plays require an extraordinary number of wells to just maintain what we would consider to be a reasonable flow rate.
Rick Rule: And Chris, you are starting to see this in the gas business. One of the things about these multi-stage horizontal wells is that the initial flow rates that the industry tends to get from them are spectacular, but they suffer exponential declines. And we have seen this on the gas side, not on the oil side yet. And what happens is as long as the forward strip in natural gas, that is the price that producers can sell gas forward on for two or three years, is sufficient to pay out the well in twelve or eighteen months of flush production. The industry will drill the well. Once they have their capital back after they have suffered the exponential declines, the continuing operating costs are fairly low. So we saw an incredible explosion of gas drilling, even dry gas drilling, three or four years ago when the forward strip was in the six or seven dollar range, because the initial flush production could come on, and the producers could sell into the forward strip and pay the well off in twelve to eighteen months. And then have an annuity from a paid off well over time. Now that the natural gas price has fallen fairly substantially and the forward strip is flat, what you are seeing is a tremendous reduction in the rig count for natural gas wells, with the exception of wells in the liquids rich window in the Marcellus and in Eagle Ford where there is enough heavy liquids in the gas stream that the dry gas is in effect for free. But in terms of the dry gas, the thing like the Barnett that was very, very, very active five years ago, the rig count there has really fallen off.
Chris Martenson: What is the rough break even on a DCF basis there for gas?
Rick Rule: You know the industry is going to tell you that they can break even; a lot of them can break even at three dollars and fifty cents a thousand. I do not think that is right. I think a fully loaded break even in the dry gas business with no liquids is more like five dollars a thousand, because you have witnessed in the last twelve months a dramatic shift of rigs available to drill in dry gas locales to wet gas locales. I do not know what the corresponding number is going to be in the oil business. It is going to take a little while longer before we have a type curve, a depletion type curve in the liquids part of the Eagle Ford, up in Bakken, and in Niobrara. We do not know enough about how the type curves, the decline curves are going to work in those fields so that we understand what an economic well is as various price points. But we will understand that in the next eighteen months.
Chris Martenson: Right. And so the general story here is that there is a decent amount of oil, obviously there is some issues around fracking, some concerns there for some locales, but the bottom line is that we are going to be drilling thousands of wells, where we used to drill hundreds of wells. I mean, there is just a whole order of magnitude increase in the activity. And I just want people to think of the capital involved in that, the amount of steel, the amount of high technology, the amount of labor, all of that actually just means that it is there. It is useful. It is an exploitable energy source, but it is not really directly comparable to what we were pulling out of as you mentioned, the Permian Basin in the fifties.
Rick Rule: Quite right. Now the interesting thing for investors, is that for investors who care to study, in some senses this new technique makes them better investments, because it is easier to develop a risk adjusted net present value calculation for a company that has six hundred proved undeveloped locations where you understand their type curve than it is to estimate success in the exploration business, which is what we used to do. Ironically, although the cost structure of the business is getting worse as a consequence of the development costs, the finding costs are coming out of the equation. So for investors who understand the nature of these resource plays, there is fairly certain money to be made in a volatile market when the market price of a company falls substantially below the discounted net present value of the future cash flows of proved undeveloped locations. These companies go on extraordinary sale. And they go on sale with a high degree of probability of success. It is a very interesting set of circumstances, where although in some sense the industry fundamentals have deteriorated, the industries attractiveness to intelligent, hard working speculators, have increased. It is very ironic, and it is very pleasant.
Chris Martenson: Interesting. So you have a number of these on your radar screen I assume?
Rick Rule: We do.
Chris Martenson: Excellent.
Rick Rule: Securities laws prevent me from sharing them.
Chris Martenson: I understand that.
Rick Rule: It is a consequence of being Securities licensed. I can talk about anything, as long as it is not really useful.
Chris Martenson: Alright, so let’s generalize this. Which natural resource sectors that interest you the most right now?
Rick Rule: I am interested across the barrel, but I think I am particularly interested in sub five hundred million market cap resource plays in the western Canadian sedimentary basin, Canadian listed companies with repeatable resource plays in oil. I am also very, very, very attracted to the uranium space. As a consequence of the events in Japan, the uranium space got cut in half, but uranium consumption has not budged. So I like the risk to reward checks to position in uranium. What really has me excited right now however is that for the second time in the last ten years, the smaller gold stocks are attractively priced relative to the gold price. You know Chris, I found myself in the embarrassing position in 2010 to be a fairly well known gold stockbroker that did not have any gold stock recommendations. As a consequence of the fact that the gold stocks were assuming very, very, very high gold prices, but were not putting on very good corporate performances. We have seen the situation now where the bullion price has continued to go up, but the share prices of the stocks have gotten absolutely creamed. So what is probably most attractive to me of all are the shares of the pre-feasibility stage junior companies, and some of the smaller producers that have large organic development pipelines. We think that they are absolutely cheap, and that is something that does not happen very often.
Chris Martenson: Right, and so they got hammered for a variety of reasons, including share dilution and mysterious lack of free cash flows from what should have been a really incredible environment. Do you think those have reversed somewhat now?
Rick Rule: It is interesting. I think it has. As you may know, I was a very vociferous critic of the sector for the last ten years, particularly the senior producers. I expected like many people did when the product price went from two hundred and fifty dollars an ounce to fifteen hundred dollars an ounce, that free cash flow should absolutely soar. But they forgot to do it. And what has interested me is that really just in the last two years, the incredible amount of capital that the industry has forced into mine development has begun to pay off. And by all measures now, the senior gold mining companies, which were absolute cash generating laggards, have turned into truly spectacular cash cows. And this is useful from a couple of fronts. The major mining companies have begun to be confident enough in their cash generating capabilities that they are returning some of it to the owners in the face of dividends and share buy backs. But the other thing is that it allows them, gives them the ability, and in fact the need, to buy new deposits from discoverers and developers and often finance these acquisitions and finance the development of the undeveloped deposits with cash that they have on hand, rather than cash that they have to raise either from shareholders or financial institutions. It is a truly virtuous circle. And it is a virtuous circle that has happened at a time when the share prices are reasonable. That is a particularly pleasant conjunction of circumstance.
Chris Martenson: Well, that puts them at odds with a lot of corporate share buy backs, which tend to happen at rather inopportune moments like all time highs and things like that. So that is always a nice thing. This is beginning to sound suspiciously like true fundamental analysis, where you really dive in and you look at a company. Can you walk us through what your process is when you are investigating a company and you say, “This is somebody we want to put money with, or buy shares of.” What is your process?
Rick Rule: Sure. You know for many years I have been a bridge and mezzanine lender. I tend to look at these things from a lenders point of view. So for me, the market capitalization of a company is really only of interest after I have tried to establish what I think the value of the company is. And what works in my world is net present value. Let’s say as an example that a company has a gold deposit and a bankable feasibility study that says that they have a million recoverable ounces. They are going to produce these ounces to keep the math simple, at a hundred thousand ounces a year for ten years. It is going to cost four hundred million dollars to build this mine, and they will produce the gold at five hundred dollars cash cost per ounce. So if we assume again to keep the math simple, gold is selling for fifteen hundred dollars an ounce, you have a sense that in the first year you are going to have a cash margin of a thousand dollars an ounce on a hundred thousand ounces. And to keep the math simple, let’s just suggest that you do not escalate the gold price and you do not escalate the costs. In fact, you do escalate both. And a bankable feasibility study will do that in some fashion for you. But it is really a simple measure of taking out that thousand dollar an ounce margin on a hundred thousand ounces, and discounting the ten years of cash flow back at whatever interest rate you believe is appropriate. Some people use the thirty-year treasury rate, and some people use ten percent for ease. Whichever discount rate you think is appropriate, and you get a net present value number. You subtract the capital costs and the sustaining capital costs. And the number that you have left over after you have recouped your capital and paid interest charges if any on your capital is the net present value number. There are other methodologies that other people use. As an example, a much simpler calculation which many people use is in-situ value. That is, how many recoverable ounces the company has, divided by market cap. I think that is an illusory number. It is easy to calculate, but it does not take into account the capital costs to develop the ounce, the operating costs per ounce produced, or the time value of money. It values ounces produced fifteen years from now, at the same value that an ounce, which would be produced tomorrow is valued at. So although it is a simple number, it is an illusory number. For me, that present value is what matters. And when you have the net present value number, you have to discount that too by the general administrative expense that the company will have to pay on a going forward basis. But if you find a company with a net present value that is net of capital expenditures of say a billion dollars that is on sale in the market for three hundred and fifty million dollars, you have a reasonable chance of seeing an industry buyer come in and pay seven hundred million dollars for that billion dollars in net present value so that they can earn an acceptable return on the surplus, over and above. We are in market conditions right now where those types of valuations, in fact abound in the sub one billion, and more spectacularly in the sub five hundred million marketplace.
Chris Martenson: Interesting. And this is across the various resource plays that we talked about before? Are you seeing this as pretty general in the resource area, or is this concentrated anywhere at this point?
Rick Rule: No, I am seeing it pretty much across the board. I am attracted to the values in the gold business, because I think the gold price is going higher. The under valuations were ubiquitous in the oil and gas business. And I think the valuations are more certain in the oil and gas business. But certainly, we are seeing these sets of circumstances occur across the market.
Chris Martenson: And are you constraining your analysis to, and let me see how to put this politely, geopolitically stable areas to take that risk off the table?
Rick Rule: Well you know Chris; I have a different definition of geopolitically stable than most people do. I live in the People’s Republic of California, and I would regard my home state as an extremely risky place to do natural resource development. When most people talk about geopolitically risky places, they talk about frontier markets. I have done a lot of investing in frontier markets. And I have to say that I have been treated just as poorly in California as I was in Congo. The difference is that a place like Congo needs mining. So in some sense, political risk is a function of how much you are paid to take it. I would certainly prefer an extraordinary good deposit in a bad place to a bad deposit in a good place. Better yet of course, would be a good deposit in a good place, but that does not happen often, unless you are in an extremely, extremely bad equity market and do not have the courage for it.
Chris Martenson: Interesting. So here we are, and one of my views right now is that actually there is relatively little investing being done these days. By most people it is just speculating. So anybody who has invested in an index fund, a general S&P index fund, or an ETF that is broadly across a huge sector, I think is largely speculating, and here is why. Nobody knows what the Federal Reserve or the ECB is going to do next week, how much money they are going to dump in. Is it going to be one trillion or ten trillion? We do not know. And so on that sense, there is a little bit of speculating going on, but you are talking about a world of investing that makes a lot of sense. So let’s imagine that you are an average investor, and you are just trying to make it through the next decade without your wealth evaporating somehow. How appropriate do you think are the resource investment opportunities at Global Resource Sprott for the average investor?
Rick Rule: I think they are extremely appropriate. One of the things that we can do is tailor a portfolio to people according to the risk appetite that A) They profess, and B) We think is appropriate for them. There are real values in the resource sector. And the other thing I think is that the average investor is still relatively under weighted in resources, as a consequence of the fact that this market really did not get started until 2005. The period of say 1982 to 2005 were markets that were generally not favorable for resource investors, although they were very nice to me. And as a consequence, people have not yet been trained to look in the resource space. So from the point of view of risk allocation, most people are under weighted in resources, which I think is ironic, given the fact that I think the broad outlook for the resource and raw materials sector is probably better than the outlook for the broad market.
Chris Martenson: Yeah, I agree with that. And on much of this I think, I get the question all the time; people are just flat out confused how they even would invest in the resource space. So I think there is just a little bit of learning curve to go through here for all concerned. This has been a fascinating conversation, because I totally agree with you. The main summary of course jibes with my own, which is that I think we crossed the seven billion threshold mark for humans on the planet. And as you mentioned, most of those are desperately trying to get up the living standard curve. That of course requires resources. So no matter how many ways I tilt this cube and look at it and squint at it, I cannot find a way to suggest anything other than there is going to be increasing competition for what I see to be as a steadily dwindling pool, in both quantity and quality of high grade resources. So there it is. And for those who are looking to learn more about your work and the solutions that Global Resource Investment and Sprott can offer, where can they go?
Rick Rule: This is on the web at www.sprottglobal.com or call us here at 800-477-7853.
Chris Martenson: Alright. Well, I hope people do, because you guys are the best. You have been doing this a long time, and it is just good, solid, fundamental analysis, which is something I just believe in. I am keeping my fingers crossed that it comes back in style at some point, because it is how things should be. I truly believe in the resource story. And so for people who can get involved in that, I still to this day think that there is still a first mover advantage in this space. I believe that seven trillion has not quite figured this story out yet. It will, and some portion of that will migrate over through what I consider to be a relatively tiny doorway. We will find out whether that is right or not I believe in the next few years.
Rick Rule: I could not agree more.
Chris Martenson: Alright. Well, thank you so much for your time. And I hope we get to do this again.
Rick Rule: I look forward to it.
Chris Martenson: Alright. Thanks Rick.
Rick Rule: Thank you.