Founder Brian Tang and the Fundamental Research crew are back this week, offering a value-based perspective on natural resource investment. In this exclusive interview with The Energy Report, FRC provides its macro view on mining, oil and gas and recommends an up-and-comer in the uranium space.
The Energy Report: Brian, could you give us a summary of your firm and its business model? You have strong opinions about how individual investors should approach paid-for research.
Brian Tang: Sure. I founded the firm in 2003. At that time, a lot of the investment banks were being scrutinized for producing research that was tied to corporate finance and I was also in corporate finance—but more on the debt side. On the debt side, all research is paid for. Firms like Moody’s and Standard and Poor’s will charge firms money, and then issue a credit rating on them. So given that the corporate finance model was being scrutinized, I thought why not apply the debt model simply to the equity side, where we would charge a fee to issue a rating on the equity of companies?
Of course, there is the potential for a conflict in that type of situation. What we’ve done is instigate policies to mitigate those conflicts; for example, we only charge our fees flat and in advance and we don’t accept stock, so the companies have to pay in full before we get started. We sign agreements with the companies that basically relieve us from any liability for negative reports. They agree that they will not sue us for negative comments. Once we’re engaged, we have to finish the contract. They cannot prevent us from publishing further research. And, if you look at the distribution of our ratings—where 25% of our ratings are hold, sell or suspend—I think you can get an idea that our analysts are truly independent. We’ve issued sell ratings right off the bat, and that company has paid, we’ve done our due diligence, and we didn’t like the company; so we initiated coverage at a sell. So that is the business model. Also, if you look at our performance on Investars, you will see we have done quite well in the past.
In terms of our focus, we focus on small and micro cap companies that aren’t widely followed by brokerage firms. We think by focusing on companies that no other analysts are following, we can add value by discovering these undervalued companies.
Currently, a lot of our coverage is in the natural resource sector—mining, oil and gas—and the other two sectors that we cover are industrials and healthcare. From time to time, we publish special reports, industry reports, on topics of interest that we think investors would like to read about.
TER: In the research you do and provide to subscribers, do you give specific sell-hold recommendations and pricing?
BT: Yes. We have three ratings: buy, hold or sell recommendation. We don’t call it a target price; we call it a fair value, and we also issue a risk rating from very low risk to highly speculative. We’re registered as a securities advisor with the BC Securities Commission.
TER: What’s your outlook on oil, considering today’s oil price and the more macro picture with oil and gas?
BT: I have always been bullish on oil. I started following oil when it was $12 a barrel; and, when it went to $24, we thought, wow, 100%, and then it shot up to over $100.
In general, I’ve always been bullish on oil, basically it’s because oil is a finite resource. It’s being burned every day, supply is getting lower; and, to me, it just means that the price has nowhere to go but up. Of course, it will experience volatility day to day but I think, in the long term, the trend for oil will always be up. When you look at oil compared to other commodities, oil is unique because it’s consumed. You actually burn it, and then it’s no longer around; whereas, for gold, whatever’s been extracted in the past 100, 200, 300 years is still around. So, in that way, I think oil is different.
The second main sort of big picture theme would be the increasing finding and development costs, where people are having to drill deeper and deeper to extract a barrel, so it’s costing more and more. These are long-term issues supporting oil. In the short term, the factors that will affect oil are GDP growth and OPEC production, and that will cause short-term volatility. But, again, in the long term, I don’t see it going anywhere but up.
We did a study and looked at the correlation between changes in global GDP and the changes in oil consumption. We found that the correlation was 58%, which is quite a significantly high correlation. When we looked at OPEC, we wanted to see how important OPEC is and how much of an impact they actually have on oil prices. Our research showed that OPEC is still important. It currently accounts for about 40% of the world’s oil supply.
We found a much stronger negative correlation between OPEC production and WTI (West Texas Intermediate Oil) prices. For example, from 1973 to 2008, the correlation between OPEC production and WTI was -.13 vs. non-OPEC production to WTI with a correlation of -.04. Because .04 is nearly zero, the statistics are saying, basically, for non-OPEC producers, the correlation is almost none. And when you look at a chart of the oil prices vs. production of OPEC and non-OPEC, you can clearly see that when OPEC cuts production, the price tends to respond by going up. Whereas, the non-OPEC production tends to just trend up. Since 1973, there’s volatility in it; but, in general, it just goes up.
In the short term, OPEC’s spare capacity is tight, but they’ve announced recent cuts. Spare capacity averaged 2.8 million barrels per day from 1998-2008. Spare capacity is basically what they could produce on top of what they’re already producing, so it’s kind of like if a factory was producing at only 80%, they have a spare capacity of 20% to increase production. But we think this spare capacity will increase, which means they’re going to cut back supply. Spare capacity of OPEC is forecast to increase to 3.95 million barrels per day in 2009, and 4.56 million barrels per day in 2010 vs. the historical average of 2.8 million barrels per day.
Finally, for our short-term outlook—because of the GDP growth that’s expected to decline in 2009—we also think oil prices will stay around current levels for 2009. However, as OPEC responds with the production cuts and, as the economy recovers, we believe that the long-term price of oil will be about $80 per barrel, and we expect this to start around 2010. That’s our long-term forecast: $80.
When you look at the current and long-term outlook for oil prices, they’re still going to be much higher than what oil has averaged historically. So you might not see a return from ’07 levels, but definitely the prices are still higher than they’ve been historically. And at these prices, a lot of projects are still economic.
TER: With these new ETFs, people can really kind of play oil as a commodity. As you look at micro cap stocks or just plain oil as a commodity, what advice would you give investors?
BT: Siddharth Rajeev, our head of research, can talk about the investment demand for ETFs because he looks at that when he’s making his supply-demand forecast. But one interesting use of these ETFs, or investing in oil directly or oil stocks, which are correlated to oil prices, is to hedge.
For example, a lot of people complain when gas prices are high, but I think one of the benefits of having financial markets is that you can actually offset your risk from high gas prices. And, although the price of gas and the price of oil stocks, or even oil, don’t move 1:1, if you can adjust your position, you can actually offset your risks. For example, if you go long in something like, say, Exxon Mobil Corporation (XOM), and let’s say Exxon had a high positive correlation with gas prices, when gas prices go up, you’re going to lose money at the pump but then your stock portfolio is going to go up; so, in theory, they should offset each other. And that’s the definition of a hedge—to remove all risk. If the correlation was 1:1, you would remove all risk. So in terms of a risk reduction strategy to minimize your exposure to energy prices, that’s one way to think about how to use hedging other than just to profit. Sid will now talk about investment ETFs.
Siddharth Rajeev: If you look at silver ETFs, silver ETFs were introduced in April 2006 and then if you see the statistics, the total amount of ounces held by the ETF increased by about 1,000% since then. Currently, the ETF holds about 230 million ounces of silver, which is like a 43% year over year increase. So there is a big demand for such products, and we believe that it gives you direct exposure to commodity prices.
TER: If we’re looking at oil, and we’re thinking long-term oil’s got to be going up, why wouldn’t we go directly to the commodity rather than going through Exxon?
BT: That’s actually been a long-term dilemma. Also, for example, there was one classic case people debated: If a mutual fund company is outperforming the market and it’s publicly traded, should you invest in the mutual fund or just buy shares in the mutual fund company? So there are a lot of factors involved that would go into this decision. You could make a case a lot of ways.
For example, if you invest in an oil company, the oil company has professional management. So, if oil prices decline, the stock might not decline as much because they can do things like cut costs and diversify into other industries; whereas, in oil, you’re just 100% exposed to oil. So it would depend on somebody’s risk tolerance, and it would also depend how that asset interacted with other assets in your portfolio. I can’t really give you a straightforward answer on that. There are a bunch of different factors.
SR: If I could add to that, if you’re holding oil and gas equities, oil or gas prices are just one of the inputs for valuing it. There are a lot of other inputs that are going to the valuation of those equities. So, basically, it reduces your exposure to oil and gas prices if you hold equities relative to holding an ETF.
TER: Can you share a few of your favorite picks with us?
SR: Sure. We like Great Plains Exploration Inc. (TSX:GPX). They have properties in Alberta and Northeast B.C. About 60% gas and 40% oil. The best part is that they produce light crude oil, which has high net backs. All our valuation models show that the company shares are currently undervalued. For example, the EV (enterprise value) to BOE ratio for GPX is $6.5, while the average ratio of its peers it $8.5. If you look at the EV to BOE per day, they’re currently trading at $18,000 for BOE per day, while the industry average is about $22,000 for BOE per day. Another thing is that their enterprise value is currently at a 60% discount to their net asset value (NAV) estimate. From our list of comparables—we have a list of 16 comparables—only three other companies are trading at a much higher discount to NAV.
TER: So the comparables are what you call industry average, or are they micro cap averages?
SR: When we look at comparables, we look at production, reserves, where they’re producing, their market capitalization, etc. Based on all these factors, we select a group of companies. That’s how we find averages because we believe that this approach captures a better average applicable to our subject company. Instead of taking broad industry averages, I think this approach is a better definer of averages.
When we look at a company, we do more than two or three valuation models, and Great Plains was undervalued in all those metrics. Other undervalued companies, using the same metrics are Highpine Oil & Gas Ltd. (TSX:HPX) and West Energy Ltd. (TSX:WTL), which are much bigger than Great Plains in terms of market cap; and those two companies are also Great Plains partners.
One of the main positives is that Great Plains focuses on Pembina Nisku plays in Alberta which has wells capable of producing up to 2,500 barrels per day (per well). In Alberta, an average well produces 18 barrels per day.
TER: And this is light crude?
SR: Yes, it’s light crude; so it’s high net back and high productivity. The ROI for these wells is much higher than the average wells you see in Alberta.
TER: Are they currently producing oil, or are they still exploring for it?
SR: Currently producing at about 2,200 barrels per day. In 2008, they and their partners made two discoveries—the high productivity wells that I was talking about.
TER: Are they cash flow positive?
SR: They are not free cash flow positive now, but our model shows they will be in 2010.
TER: It sounds like such an incredible discovery right here in our own backyard in Canada. How long do you expect that these wells to produce?
SR: We believe the well life is about five to eight years for these wells.
TER: That’s just with the ones they’ve found already?
SR: Yes. Note that their current reserve estimate does not include the reserves on the new discovery.
TER: So the geology looks good for additional discoveries of the same quality and quantity of oil in these additional wells?
SR: Yes. Also, their partners, I mentioned earlier, WTL and HPX, have extensive experience in the Pembina-Crossfire area, and they are producing similar wells in that area.
TER: From an investor point of view, your top pick is Great Plains. Is there also an investment opportunity for High Pine and West Energy?
SR: We have not really looked at those companies from an investment point of view because we don’t cover them. We have only looked at them compared to Great Plains.
BT: Also, we haven’t done enough research on them to know. So just on initial back-of-the-envelope metrics, yes, they are undervalued; but when an investor does some due diligence, they might uncover reasons not to invest (such as the well life is only one or two years, they could be not replacing their production efficiently, etc.). There could be a host of other problems with the companies; so, at this time, we wouldn’t be able to say whether or not they would be good buys.
TER: Earlier in the discussion we were talking about oil prices and the reason that oil prices will continue to go up. As we look at the whole genre of energy, where do you see other types of energy going, specifically nuclear, uranium, hydro and geothermal? Do you see any of those being players in the next year or two and, if so, which ones?
BT: We definitely see more emphasis on uranium as more and more countries are announcing that uranium will become a larger part of their energy makeup. In terms of hydro, it’s really limited because you need sort of a perfect condition to build a hydro plant, a certain kind of water system. Going back to uranium, though, there’s going to be a few factors that we think will drive increasing uranium use.
Number one is, of course, concerns about global warming; and number two, as the price of oil goes up, people are going to look for alternatives and we think uranium could be one of them.
Currently, 35 new reactors are under construction worldwide. Over 100 power reactors are planned, and over 250 are proposed. Right now, the consumption of uranium far exceeds production. The deficit is made up by stockpiles. We believe that, in the short term, the uranium market is expected to be in balance; but in the longer term, definitely, we see increasing demand.
SR: Demand cannot be supplied by stockpiles forever, right? So new production has to come to the market to meet demand.
TER: Do you have any names you like of uranium producers or near producers?
SR: We don’t have a top pick for uranium, but one of the companies that we recommend – we currently have a BUY rating on them is called Terra Ventures Inc. (TSX.V:TAS).
They have a 10% carried interest in Hathor Exploration Ltd. (TSX.V:HAT) property, and Hathor made one of the biggest uranium discoveries in recent times in Canada. And then the best part is that Terra Ventures does not have to pay a single penny until the property reaches bankable feasibility. So that’s one of the properties. They also own 100% interest in a uranium property in Quebec, which made pretty good progress in 2008. They are planning to do further drilling in 2009. Another thing that stands out for this company is that they are in a very good cash position; because of the discovery, they were able to consistently raise capital during these bad conditions. So I think they have $10 million in cash, and that’s more than enough for them to survive for at least the next two years.
TER: You said they’re in a good cash position because of the discovery. Are you talking about the Hathor discovery or the property in Quebec?
Vincent Weber (Geologist, Fundamental Research): The Hathor discovery. It's the Midwest-Northeast discovery. They’ve actually discovered mostly uranium in the Athabasca Basin. Most of the large deposits are at the sub-Athabasca Unconformity, and this discovery was actually made in the basement rocks below that. So Hathor kind of feels that their main targets haven’t even been discovered yet; and they just recently announced their 22,000 meter drill plan for 2009.
SR: And that expense will be from Hathor. Terra Ventures does not have to contribute any capital for that.
TER: So absent the 10% interest in Hathor, is Terra Ventures still an interesting company to look at investing in?
VW: The project they’re working on in Quebec is also quite interesting. They now hold a huge amount of land—150,000 hectares. They completed just over 10,000 line kilometers of geophysical survey in late December and, based on that, they picked up a whole new set of land claims for the prospective areas. Plus, they have positive drilling results on the land that they already own there.
TER: Very good. We appreciate your time. This has been great.
Brian Tang, BBA, CFA, founded Fundamental Research Corp in 2003, and has successfully led the firm to be recognized as one of the fastest-growing companies in the province of B.C. Prior to Fundamental Research Corp., Brian was an analyst in the corporate banking group of one of the world's largest international banks where he performed fundamental analysis on Financial Post 500 companies (the Canadian equivalent of the Fortune 500). Prior to this, he worked at a financial advisory firm where he analyzed and published research on Canadian equity mutual funds.
Fundamental Research provides institutional quality equity research coverage on small and micro cap companies through its extensive distribution network. Its major institutional delivery channels include institutional sites such as Reuters, retail sites such as Stockhouse, and subscribers. Fundamental Research’s performance has been highly ranked in the past by Investars.
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