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  • Lithium Demand Will Rise Significantly: Mansur Khan
    Lithium Demand Will Rise Significantly: Mansur Khan

    Source: George S. Mack of The Energy Report (5/16/12)

    http://www.theenergyreport.com/pub/na/13395

    Lithium is lightest of all metallic elements, with low density and high electrochemical potential. These are essential characteristics that make the element especially suitable for use in various power-storage applications, including electric vehicles (EVs). In this exclusive interview with The Energy Report, Equity Research Analyst Mansur Khan of Dundee Capital Markets talks about his favorite junior lithium stocks that he expects to be major beneficiaries of dramatic growth in lithium-ion battery demand over the coming decade.

    The Energy Report: EVs don't burn gas, but power must come from some source of fuel, such as nuclear, coal, hydro, gas, solar, geo or wind. So, what is the value of an electric vehicle (NYSE:EV)? How does it help?

    Mansur Khan: From a societal and governmental point of view, there are a number of benefits. EVs can really help reduce carbon emissions. Their energy efficiency is very high, sometimes over three times that of conventional combustion engines. I think it can be argued that, even assuming an EV uses a power-generating mix that includes carbon-emitting sources such as coal- or gas-fired power plants, its life-cycle net carbon-emission production is significantly less-anywhere from half to one-third of that from comparable combustion vehicles. Reducing our dependence on oil is another concern, although it's more geopolitical. I think there is a top-down push to essentially steer the automotive industry into adopting electric vehicles.

    Finally, from the end-consumer point of view, the operating cost of an EV is expected to be significantly less than an internal combustion vehicle. On average, they are about one-third the cost on a per-mile basis.

    TER: In January, General Motors Inc. (GM:NYSE) announced that it would be producing 60,000 (60K) Chevrolet Volts per year, beginning this year. Does this signal a new wave of EV or hybrid development? How positive is this for lithium consumption?

    MK: GM's commitment to the EV model is reflective of what you're seeing across the board with major auto manufacturers rolling out some form of an EV model in their lineup.

    Aside from GM and Toyota Motor Corp. (TM:NYSE), Hyundai Motor Co. Ltd. (HYMLF:OTCPK), Nissan Motor Co. Ltd. (NSANY:OTCPK;7201:TYO), Volkswagen AG (VLKPY:OTCPK)-all the majors have announced their own models. And when you look on the battery side, you're seeing considerable research and development (R&D) investment going into battery manufacturing and technology development. Majors like Chinese battery and car manufacturer BYD Co. Ltd. (BYDDF:OTCBB), of which Warren Buffett owns approximately 10%, and BASF Corp. (EUR53.17:XETRA) are making inroads into the technology's development.

    To answer your question, this is of course positive for lithium demand and consumption. Industry consultancy SignumBOX put out an estimate that electric and hybrid electric vehicles made up about 5% of total lithium carbonate equivalent (LCE) consumption in 2011, and that's expected to grow to about 25% by 2020. So there's quite a bit of room for growth there. The industry still has a long way to go, but in general, it's absolutely positive.

    TER: Mansur, what is the lithium-ion battery industry's biggest challenge right now?

    MK: The industry's main challenge is really to scale up in size, from the small consumer electronics to the larger batteries required for EVs, and to be able to do this without compromising on cost, safety and longevity. Technological development may not be happening as quickly as people had expected a few years ago, but it is certainly happening, and I think you will see these growing pains addressed over the coming years as other derivative applications are opened up.

    As manufacturing capacity continues to expand, the cost of these lithium-ion batteries will come down, and that is already happening. A few weeks ago a Bloomberg report said the cost of lithium-ion batteries fell 14% year over year, and has fallen about 30% since 2009.

    TER: Your February 2012 report cited a third-party consultancy firm, Roskill, which found that lithium consumption has outperformed both industrial production and GDP trends since 2002. But I don't see that reflected in equities. An index of small-cap lithium stocks shows a 40% decline over the last 10 years. A mix of larger- and small-cap companies is down 30% during the same period. Can you talk about the disconnect here?

    MK: Without knowing the specifics of this particular index, I think I can make some general comments. Our view on this is that there are two aspects at play here, and both stem from the global recessionary environment that we are in.

    Against this backdrop and coupled with slower technology development, we have seen a slower-than-expected uptake of lithium-ion batteries and EVs. The consensus view still holds that you're likely to see a mass adoption of EVs by about 2015 and thereafter. We argue that the equities are taking a bit of a wait-and-see approach to this, and so that would probably be one aspect of why they have not done so well. EVs currently make up only a small part of the overall lithium market, as just mentioned, but they are expected to really drive the majority of the growth over the coming decade.

    The second aspect is more directly linked to equity markets in general. As you know, stock markets dislike uncertainty and volatility, and unfortunately we have plenty of both right now. In this kind of risk-averse environment, small-cap stocks can face the additional challenge of financing their exploration and development projects without causing a lot of dilution. So there's a bit of an added risk that is reflected in small-cap performance. We think these factors explain why the equity markets have not really kept pace with the underlying growth and demand for lithium that we are seeing.

    TER: You've written that the lithium market is currently in a tight supply-demand balance, and that this has prompted capacity expansions by three of the four major lithium producers. You also wrote that prices have stabilized in the $5,500-6,500 per ton (/t) LCE. I realize there are different lithium compounds, but do you foresee a futures market for lithium?

    MK: I think it's too early for that. You would need a market sizeable enough to maintain a spot supply inventory. Right now, what we are seeing is that most of the supply and demand is on a contract-by-contract basis, and these are typically one-year contracts. There isn't much of a spot market to speak of, and until you have a secondary market open up, you are unlikely to see a futures derivatives market develop.

    TER: Looking at the lithium equities market today, do you see it as a deep-value market? Or do you see it as a growth market? Are we at the foot of a growth curve?

    MK: Going to the question of growth, I think that's definitely there in our view. The majors have been reflecting that, not just in what they've reported, but also in their outlooks. If you peruse through some of the recent commentary by the majors, they are all reporting strong growth in volume and prices, and in general they expect real growth in lithium demand to continue-anywhere from 6-11% by 2020. So that's a fairly healthy growth in demand. If you look at Talison Lithium Ltd. (TLH:TSX; Not Rated), for example, it is saying that the lithium market will almost double by 2020, and that's even excluding the EV component that you hear so much about. So that's definitely positive, and there's growth absolutely happening there.

    TER: What lithium equities are you recommending to investors?

    MK: When you're looking at the juniors, we believe that only companies with quality assets that are in advanced stages or have strategic backing will have a reasonable chance of making it to production.

    I would highlight Nemaska Lithium Inc. (NMX:TSX.V; NMKEF:OTCQX). We have it rated Buy, Speculative Risk with a $1 target price. Unlike the brine developers in Argentina and Chile, this is a hard-rock developer based in Québec. Its Whabouchi property project has a Measured and Indicated resource estimate of 25 million (NYSE:M) tonnes (metric ton or mt) grading at 1.54% lithium oxide. It also has an Inferred resource of 4.4Mmt grading at 1.51% lithium oxide.

    The company is envisioning a two-phase strategy. Phase one will see production of 200K tonnes per year (tpa) of lithium concentrate. This is concentrate, not carbonate, at about a 6% Li2O grade. The operating cost is about $138/t of concentrate. And the preliminary economic assessment (PEA) from last year had an initial capex of $86M for the project.

    Phase two essentially envisions a chemical conversion plant that would produce higher-value downstream chemicals, and in particular they're looking at lithium hydroxide. The PEA on this option was just commissioned. It has also done some pilot-level testing that shows some innovative departures from the conventional process used to produce lithium hydroxide, and the company is going to be filing for a patent on this pretty soon. This could be an interesting development.

    Both the definitive feasibility study (NYSE:DFS) of the concentrate production and the PEA are expected to be out in Q3/12. The company has a strategic partner behind it, Chengdu Tianqi Industry Group Co., the largest lithium battery material supplier in China, which owns 20% of Nemaska. Tianqi recently entered into an agreement with Targray Technology for international distribution of lithium compounds in North America and Europe. We see Nemaska fitting in quite well with this strategy.

    Another thing we like about Nemaska is that it's located in a mining-friendly jurisdiction of Québec, which is trying to build a world-class EV industry by supporting R&D and bringing mining companies and strategic partners together. And of course you could argue that the open-pit conventional mining process has less mining and processing risk. Also, there are a couple of upcoming milestones, the DFS and the PEA. So we like that name.

    TER: Another company?

    MK: Going over to the brine-developer world, I would highlight Rodinia Lithium Inc. (RM:TSX.V; RDNAF:OTCQX). We have it rated Buy, Speculative Risk, with a target price of $0.80. This is a lithium brine developer with its flagship 100%-owned Diablillos project in the province of Salta in Argentina, which hosts resources of about 5 Mmt of LCE and is adjacent to one of the largest lithium producers in the world, FMC Lithium Corp.'s (FMC:NYSE; Not Rated) Hombre Muerto project, which has been producing for decades.

    Diablillos is also adjacent to Lithium One Inc.'s (LI:TSX.V) Sal de Vida project. As you know, Lithium One is currently in the process of being acquired by Galaxy Resources Ltd. (GXY:ASX; Not Rated), which has a wholly owned lithium carbonate plant in China. So that's definitely an interesting development in the area. Diablillos has high lithium and potassium grades and low impurities that could enable economic extraction, and the PEA put out last year suggests robust economics. With cash costs coming in at a bit over $1,500/t of LCE, along with a strong potash byproduct credit potential, the company is envisioning production of 15K tpa of LCE. Aside from the flagship project, Rodinia also has a brine project in Nevada adjacent to Chemetall Foote's [subsidiary of Rockwood Holdings Inc. (ROC:NYSE)] existing project there.

    But despite all this, the company trades at a large discount to its brine-base developer peers. We estimate an enterprise value of about $3/t, compared to the average of about $10/t. We would say that part of this has to do with Rodinia's relatively early-stage project and tight cash position. That's a risk, given the nature of current markets. Management is being prudent with cash, but it is steadily moving the project forward. Also, it does have the Chinese company Ningbo Shanshan Co. at its side.

    TER: You said your target on Rodinia was $0.80. You have just taken that down from $0.90, is that right?

    MK: That's correct. We put out a commodity update at the end of every quarter where we go back to the drawing board and look at foreign exchange (NYSE:FX) rates and commodity assumptions. So part of the discount was about the FX, and the other part is that we are applying a slightly higher discount to the brine developers in Argentina due to the investment climate resulting from expropriation of Argentina's largest energy company, YPF from Spain's Reposol.

    TER: You mentioned Rodinia's neighbor producers. You must be implying potential M&A.

    MK: Yes, and overall, what we like about this story is that the company has a salar that it is not sharing with anyone else, and it will potentially have two large lithium producers right in its backyard, FMC and potentially Galaxy, both of which have talked about expansion. The company has a strong management team, and both CEO Will Randall and head of exploration Ray Spanjers have extensive experience in managing projects. And Ray actually was previously with FMC's lithium division.

    TER: Another company?

    MK: The second brine company that I would highlight is Lithium Americas Corp. (LAC:TSX; LHMAF:OTCQX). We are rating it a Buy, High Risk with a target price of $2.60. Now this is a more advanced brine developer, located in the province of Jujuy. Its Cauchari project hosts a high-grade resource of 8Mmt LCE. It's had extensive pump tests, pond- and pilot-level tests, as well as hydrological work done, and the company is currently on the verge of putting out a DFS on the project. It's also interesting to note that the DFS will trigger a decision by its strategic partners, Mitsubishi Corp (8058:TYO) and Magna International Inc. (MG:TSX, Not Rated), who have the option to secure 37.5% of lithium production in exchange for financing up to 37.5% of capital costs. So that's definitely a good arrangement to have in this kind of market.

    Lithium America's PEA from last year had estimated low cash costs of about $1,434 per ton, based on 20K tpa of phase one production. And of course one common theme with these brine projects is that, given their low impurities, there's strong byproduct credit potential. There's good infrastructure in place. And as I said they're currently working through the final project approval from the province of Jujuy, which should be another catalyst for the stock. By the way, the province of Jujuy had essentially designated lithium as a strategic metal last year, and both Lithium Americas and Orocobre Ltd. (ORL:TSX; ORE:ASX) are currently working out approvals here.

    Orocobre will be the last one I'll mention today. We have it rated Buy, High Risk with a target price of $2.80. This is the most advanced brine development project in our universe of coverage. Immediately north of Lithium Americas' Cauchari project is Orocobre's flagship Olaroz project, which also hosts a high-grade lithium resource of 6.4 Mmt of LCE. The company already has a DFS out on the project, and the cash costs are estimated at $1,512/t of LCE, and once again, given the low impurities, there is potential for byproduct credit.

    A production rate of about 16K tpa is expected by the second half of 2013, and at the end of last year Orocobre finalized terms with its strategic partner, Toyota Tsusho Group (TYHOF:OTCPK). This will essentially enable Toyota to take an equity stake of up to 25% based on the project's net present value (NYSE:NPV) estimated from the DFS. This also includes debt financing by a Japanese consortium for 60% of the project capex, which is a bit over $200M. So the final sign-off on these financing agreements would occur once the Jujuy provincial approval comes through.

    TER: I've enjoyed meeting you very much, Mansur.

    MK: Thank you very much, George, I really enjoyed the interview as well.

    Mining Analyst Mansur Khan joined Dundee Capital Markets in 2007 as an associate covering the industrial, aerospace and special situation sectors. In late 2010, he switched into Dundee's mining group, where he covers a range of exploration and production companies in the uranium and lithium sectors. Since 2012, he has been providing lead coverage on the lithium sector. Prior to Dundee, Mansur worked for a number of years at a private design engineering company on various information systems and operations projects. He holds an MBA from the Rotman School of Management, University of Toronto and a Bachelor of Commerce in systems development from Ryerson University.

    Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.

    DISCLOSURE:

    1) George S. Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.

    2) The following companies mentioned in the interview are sponsors of The Energy Report: Lithium Americas Corp., Lithium One Inc., Nemaska Lithium Inc., Rodinia Lithium Inc. and Talison Lithium Ltd.

    3) Mansur Khan: I personally and/or my family own shares of the following companies I mentioned in this interview: None. I personally and/or my family am paid by the following companies I mentioned in this interview: None.

    4) Dundee Securities Ltd. and its affiliates, in the aggregate, beneficially own 1% or more of a class of equity securities issued by companies under coverage: None.

    5) Dundee Securities Ltd. has provided investment banking services to companies under coverage in the past 12 months: Nemaska Exploration Inc.

    6) All disclosures and disclaimers are available on the Internet at www.dundeecapitalmarkets.com. Please refer to formal published research reports for all disclosures and disclaimers pertaining to companies under coverage and Dundee Securities Ltd. The policy of Dundee Securities Ltd. with respect to research reports is available on the Internet at www.dundeecapitalmarkets.com.

    Streetwise - The Energy Report is Copyright © 2012 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part.

    The Energy Report does not render general or specific investment advice and does not endorse or recommend the business, products, services or securities of any industry or company mentioned in this report.

    From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

    Streetwise Reports LLC does not guarantee the accuracy or thoroughness of the information reported.

    Streetwise Reports LLC receives a fee from companies that are listed on the home page in the In This Issue section. Their sponsor pages may be considered advertising for the purposes of 18 U.S.C. 1734.

    Participating companies provide the logos used in The Energy Report. These logos are trademarks and are the property of the individual companies.

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    May 21 6:22 PM | Link | Comment!
  • What Lies Ahead For Junior E&Ps: Bruce Edgelow

    What Lies Ahead for Junior E&Ps: Bruce Edgelow

    Source: The Energy Report Editors (5/15/12)

    http://www.theenergyreport.com/pub/na/13369

    The landscape of the junior oil and gas industry has changed significantly over the last five years. What will the playing field look like five years from now? These are the questions that ATB Financial's Bruce Edgelow will discuss at his upcoming SEPAC Oil & Gas Investor Showcase keynote address, but in this exclusive interview with The Energy Report, Edgelow gives us a sneak preview. Read on as Edgelow examines which industry trends are likely to continue, and what it will take for juniors to attract investment capital in an increasingly competitive market. The only constant investors can expect, Edgelow argues, is change.

    The Energy Report: Bruce, what major changes do you see under way for junior explorers and producers (E&Ps)?

    Bruce Edgelow: Juniors have begun to transition from drilling moderately priced individual vertical wells to drilling much more capital-intensive resource plays. For example, in 2000 the cost to drill and complete one well in Pembina was ~$330,000. By 2010, the cost had ballooned to ~$2.75 million (NYSE:M) due to horizontal drilling and more complex completion techniques. This trend is expected to continue as resource plays become increasingly dominant and as larger budgets, bigger capital bases and higher production become more commonplace. As such, access to capital will be more vital for juniors than it has been in the past.

    We expect consolidation to occur as a result of the critical mass needed to meet these increased capital requirements. Liquidity-challenged small producers may be attractive targets for larger, well capitalized companies looking to expand their asset bases. In this landscape, juniors will need to be nimble early movers. Those that can jump on a niche emerging resource play and pioneer economic extraction techniques will have an advantage.

    TER: Which resource plays will remain hot spots for junior E&Ps?

    BE: Development plays such as the Cardium, Viking and Bakken shales should continue to dominate the oil and gas landscape. These repeatable development-style plays require ample land inventory to provide sufficient drilling opportunities. Given increasing operating prices, juniors will need enough capital to fund full-cycle economics. Moreover, drilling and completion costs are likely to further increase as even more advanced technology will be required to unlock the full resource potential.

    On the other hand, demand for conventional plays with smaller pools bearing exploration risk is reducing. The appetite to fund natural gas activity is virtually non existent unless the producer is in a niche play that can still be economic at current depressed prices. Investors and capital providers will need to develop an increasingly keen eye toward overall corporate economics in order to determine if a company has the scale, talent and asset profile to exploit the opportunities available.

    TER: You've addressed the higher costs associated with horizontal drilling. How are revolutionized extraction techniques benefiting juniors?

    BE: The industry is reporting fewer dry holes. Technological innovation has made previously uneconomic plays much more viable. Five years from now, one can expect significant advances in fracturing technology to have further increased economies of scale. It is expected that there will be a significant uptick in the number of plays that are not even on the radar screen at this time. Going forward, the industry will likely find that larger pools are repeatable and that the technology being deployed is increasingly efficient.

    TER: Can you tell us more about full-cycle economics and why they matter?

    BE: The full cycle growth story will be the preeminent method whereby juniors thrive in a changing marketplace. This includes organic growth, acquisitions, farm-ins and joint ventures. As in the past, juniors will continue to drill using cash flow, available debt and equity to grow with the end goal being a corporate sale to a larger company with excess capital looking to diversify. Full-cycle economics refers to this entire trajectory from small- to mid- or large-cap companies. Investors will have to assess a junior's ability to progress to the next few stages.

    TER: What kinds of business strategies will boost a junior's odds of making the leap to the next market-cap level?

    BE: A land accumulation strategy could be a viable and successful method for a junior company over the coming years. For instance, with the Duvernay in its infancy and largely unproven at this time, a junior might choose to assemble a strong land base and sit on it without expending the large capital requirements to drill. It may be able to wait for better-capitalized players to prove up the regional play with the exit strategy to sell their land at higher values.

    TER: You've placed a lot of emphasis on organic growth and scalability. Are the days numbered for small companies out there?

    BE: Junior oil and gas companies will still be very active in this space in five years. However, there will likely be fewer of them as a result of consolidation and incrementally higher entry costs. We expect that the overall environment for juniors will be made more difficult as significant equity support will be imperative for juniors. We expect a $10M starter kit will not meet the capital needs of a junior going forward. To have a greater probability of success, a junior may require $100M or more to sustain an adequate capital program for one to two years. To receive this backing from investors, juniors will need to deliver top-quartile reserves, production and cash flow growth on a per share basis. If they don't perform at these levels, investors will be much more likely to deploy their capital to more stable mid-cap companies that yield a higher risk-adjusted return, including dividend income.

    The number of juniors in the defined universe has increased nominally in recent years in comparison to significant growth in revenue and capital spending [see table below]. As I alluded to earlier, we expect this number to reduce due to consolidation and further increased capital requirements.

    TER: So what will it take for an undercapitalized junior E&P to attract investment?

    BE: For a junior oil and gas company to thrive in an increasingly competitive market, numerous attributes will be critical. A quality, experienced management team will be more important than ever before. It is crucial that management maintains a strong balance sheet and keeps capital spending within board-approved budgets. Furthermore, maintaining an optimal capital structure with reasonable and serviceable debt levels will be of the utmost importance. We expect to see a greater number of juniors succumb to high debt, while others will risk the company on the success of a few high-risk wells. Executives will need to manage risk appropriately in terms of effective deployment of capital as well as hedging commodity price fluctuations. They will also need to plan for potential higher-interest costs on debt and manage those costs through a stand-alone interest-rate hedging program.

    TER: Currently, natural gas prices are lagging far behind oil prices. Do you think this trend will continue?

    BE: The commodity pricing environment will likely dictate that plays be oil focused with strong netbacks. Notwithstanding, juniors will likely require multiple core areas of strong assets that each add economic value and the ability to increase reserves, production and cash flow on a per share basis. Finally, a company must not fall in love with their assets, but be willing to adapt quickly to changing market conditions. But who knows? With all the conversion to oil activity and some recent positive signs for natural gas demand, it may not be too soon before there is a swing back into the currently abandoned natural gas space. Time will tell.

    TER: Thank you for sharing your thoughts on what's to come in this space.

    BE: Thank you for having me.

    Bruce Edgelow is responsible for helping to build ATB Financial's energy business and capabilities. His team consists of industry specialists in all aspects of the energy industry, including drilling and service, pipelines, utilities, midstream, exploration and production. Before joining ATB, Edgelow was a senior Royal banker and has more than 39 years of experience with a focus on the oil and gas industry. He is a Fellow of the Institute of Canadian Bankers, has attained the ICD.D designation, and is a very active participant in community and church activities. He also serves as a director for the Calgary Counselling Centre and sits on SAIT's Board Advisory Council. Edgelow has also been a speaker at numerous oil and gas industry seminars on finance.

    Upcoming SEPAC Presenters:

    For more information on the SEPAC Oil & Gas Investor Showcase, click here.

    Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.

    DISCLOSURE:

    From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

    Streetwise - The Energy Report is Copyright © 2012 by Streetwise Reports LLC. All rights are reserved. Streetwise Reports LLC hereby grants an unrestricted license to use or disseminate this copyrighted material (i) only in whole (and always including this disclaimer), but (ii) never in part.

    The Energy Report does not render general or specific investment advice and does not endorse or recommend the business, products, services or securities of any industry or company mentioned in this report.

    From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.

    Streetwise Reports LLC does not guarantee the accuracy or thoroughness of the information reported.

    Streetwise Reports LLC receives a fee from companies that are listed on the home page in the In This Issue section. Their sponsor pages may be considered advertising for the purposes of 18 U.S.C. 1734.

    Participating companies provide the logos used in The Energy Report. These logos are trademarks and are the property of the individual companies.

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    May 17 3:38 PM | Link | Comment!
  • Canadian Coal Moles: Jerome Hass And Jimmy Chu
    Canadian Coal Moles: Jerome Hass and Jimmy Chu

    Source: Brian Sylvester of The Energy Report (5/10/12)

    http://www.theenergyreport.com/pub/na/13331

    For low-risk returns, Lightwater Partners' Fund Managers Jerome Hass and Jimmy Chu look seaward. Bulk commodities like metallurgical coal, they explain, offer greater stability because a small number of major buyers determine pricing, while shipping logistics provide a yardstick to determine a project's economics. In this exclusive interview with The Energy Report, Hass and Chu talk about how international supply is shifting and which junior stocks may experience a jump in a steady-as-she-goes market.

    The Energy Report: To get started, what differentiates Lightwater Partners from other hedge funds?

    Jerome Hass: Canadian hedge funds tend to be high-risk/high-return strategies primarily focused in the resource space. We focus on risk-adjusted returns, as opposed to trying to hit homeruns with individual stocks. As a consequence, we concentrate on the mid-cap space. That's our investment sweet spot, rather than the small- or micro-cap names. And we have the in-house research capability to explore names that are not well covered by the street.

    TER: What energy resources best fit your investment strategy?

    JH: Generally, we favor the bulk commodity producers. That's not limited to metallurgical coal or thermal coal; we also look at iron ore, potash and any other bulk commodities. We like bulk products because of the industry structure. For example, with base metals, everyone is a price taker; no single buyer has much price influence. With bulk commodities, major players and global oligopolies have price influence.

    TER: How does metallurgical or "met" coal fit into this desirable bulk category?

    JH: Met coal is an integral requirement for all steel mills that use blast furnaces. It is baked to form coke, which fuels the blast furnaces. Arc steel mills use recycled steel as fuel, but there's really no substitute for met coal in the global space. Most met coal is open-pit mined; moving it is all about logistics as the cost of shipping is a major factor.

    "Junior players in the metallurgical coal mining space are a relatively new development. They give more torque to the industry." -Jerome Hass

    TER: Is the met coal space dominated by established energy companies, or is there room for junior mining firms in that?

    JH: Met coal mining has been dominated by major producers and integrated steel producers, including BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), Rio Tinto (RIO:NYSE; RIO:ASX), Xstrata Plc (XTA:LSE) and Kumba Iron Ore Ltd. (KUMBA:JSE) in Africa. We focus on coal that is not vertically integrated, which is internationally exported or traded.

    Junior players in this space are a relatively new development. They give more torque to the industry. Juniors have much lower valuations and much higher growth profiles. There are some junior met coal pure plays; in fact, there are very few listed large-cap met coal plays globally. The one exception to that is Walter Energy Inc. (WLT:NYSE), which is listed in the U.S. and in Canada.

    TER: How is international supply and demand for met coal playing out?

    JH: The story is China. Over the last 15 years, growth in met coal has been a function of China's demand, which relates to China's growing importance, or dominance, even, in the global steelmaking industry. Seaborne met coal and iron ore were most in demand. Largely because of geographical proximity, Australia has been China's major coal supplier. This has resulted in a displacement of supply for Europe that Canadian producers can replace. India is also increasingly aggressive in the steel space. Its demand for met coal and iron ore continues to increase.

    TER: Is there a danger of an oversupply of met coal? If so, how would that affect market prices?

    Jimmy Chu: I don't think there's a danger of oversupply. Supplies have, at times, been constrained by weather and labor issues out of Australia, and we've noticed that some customers are asking companies for an advance on shipments. As for demand, China is producing steel at an annual run rate much higher than what the market anticipated a month ago. In the intermediate term, we don't see an oversupply in met coal, and the demand side looks good. In the longer term, it comes down to the big players, China and India. But we feel very bullish on long-term demand for met coal.

    JH: One reason we like the bulk commodities relates to industry discipline. Large players with pricing influence can effectively manage the supply of met coal to a degree that's not possible in base metals or in gold. The majors have proven to be rational competitors and players in the marketplace.

    Let's look at Potash Corp. (POT:TSX; POT:NYSE), which has long exhibited price leadership in the industry. It has announced production cuts in order to manage price. With a 100-year reserve life, it is the Saudi Arabia of potash. If it wanted to restrict supply, it could push that price up, as it did in 2008, but it has generally been a very rational market player.

    Other players that have followed suit with Potash Corp. are The Mosaic Company (MOS:NYSE) and Agrium Inc. (AGU:NYSE; AGU:TSX). One of the reasons that potash is attractive is that there is effective supply management. We think the same industry conditions exist in iron ore and met coal.

    TER: What about met coal operations in Canada? Do you have interests there?

    JC: Our preferred play is a small cap called Cardero Resources Corp. (CDU:TSX; CDY:NYSE.A; CR5:FSE). We like Cardero because it will send its coal into the seaborne market-Asia, in particular. It holds the Carbon Creek Project in the Peace River region in British Columbia, which is one of the last remaining regional coal deposits not controlled by a major company and it has an experienced management team. The president and co-founder, Michael Hunter, was a co-founder of First Coal, which was sold to Xstrata Plc for $147 million ($147M) despite permitting issues, which shouldn't affect the Carbon Creek Project. That implies a value on Cardero's shares of about CA$2.15. We do not see Cardero encountering the same permitting issues as First Coal did.

    JH: Peace River coal is attractive because it's very high quality. Steel mills typically blend coal. Currently, Teck Resources Ltd. (TCK:NYSE; TCK.A:TSX) is the market leader for coal in western Canada. Its met coal attracts a premium price. Consequently, the Chinese and Japanese and other Asian buyers are excited about the prospect of having another supplier in the market. I believe someone will either sign an offtake agreement or a joint venture deal with Cardero in the near future because, as Jimmy mentioned, there are very few independents left in western Canada.

    TER: How does the geology of Carbon Creek impact development and operation costs?

    JC: The coal seams are wide and canoe shaped. The dips are very shallow, ranging from 0-15 degrees to a maximum of about 30 degrees. This beneficial configuration reduces mining costs.

    JH: It's a relatively flat and slightly sloping ore body, but there is a caveat. Walter Energy Inc. and Grande Cache Coal Corp. (now owned by Winsway Coking Coal Holdings Ltd. (01733:SEHK) and Marubeni Group) have both had quite a few problems mining coal in the area. Management tends to be dismissive of the complexity of any project. An investor has to bear in mind that there are always going to be a few developmental wrinkles.

    TER: Is the Carbon Creek product "clean" coal?

    JH: All of the met coal produced in the Peace River basin can be characterized as clean coal because it has low sulfur content. The concept of clean coal is more related to thermal coal than to met coal. Thermal coal is burned in electric power plants. High sulfur content produces a lot of acid rain. It is a bonus for met coal to have lower sulfur content, but it's really not that critical in terms of the characteristics of Peace River coal.

    TER: What are the pluses and minuses of transportation and other infrastructure considerations at Carbon Creek?

    JC: Carbon Creek is in a well-established coal-producing region. Other developers or operators in the region include Anglo American Plc (AAUK:NASDAQ), Xstrata and Walter Energy. There is good road infrastructure, constructed by the local forestry operators. The CN rail line passes 50 kilometers south of the property, providing access to the ports of Vancouver and Ridley terminals. It's all about getting coal from Peace River-which is about 1,200 kilometers from the coast-to port for shipping to Asia. The economics of met coal are determined by logistics.

    TER: What is Walter Energy doing at the Peace River coal field?

    JH: In the summer of 2011, Walter bought one of the larger TSX-listed pure coal companies, Western Coal, a producer in the Peace River basin. Western is a major producer of PCI or pulverized coal injection. Steel manufacturers started using PCI in blast furnaces due to the declining supply and high prices of coke, which is produced from met coal. Steelmakers inject pulverized coal into a blast furnace to conserve their met coal resources.

    TER: Walter Energy also has projects in Alabama. How does that affect the value of its stock?

    JH: Most of Walter's mines are in Alabama. What we like about Walter is that it's a large liquid pure play on met coal. We don't think Walter is going to be independent for very long. It's very attractive to the global resource majors. A takeout bid potential from Anglo American has long been rumored. But Walter has gone through some production problems with its recently acquired Western Coal operations, as well as at some of its Alabama mines. There have been a few production hiccups in the last two quarters, but management indicates that it has righted those problems.

    TER: Are those operational issues behind the fall in Walter's stock price during the last year?

    JH: That's been one of the major reasons. The other is that they did spend a fair amount of money to buy Western Coal. It's partially just a reflection of declining valuations of coal names in general.

    TER: Let's back track to Cardero for a second because they have an operation in Ghana. How does that factor into the value of Cardero?

    JH: We are not assigning any value to the Guyana project at this point. Cardero has announced a deal to spin off their Guyanese assets. Cardero is operationally focused on the Peace River met coal. Investors would much rather see a pure play there.

    Cardero also has an investment in Trevali Mining Corp. (TV:TSX; TREVF:OTCQX), which is a zinc producer. There's a fair amount of the value captured by the implicit value of the listed shares of Trevali. Eventually, Cardero will sell this stake as well.

    TER: What is your strategy regarding hedging met coal?

    JH: It's very tricky to hedge, because the spot market is minute relative to the contracted market. Plus, intelligence on the spot market is very murky. So, when it comes to hedging, there is not really a futures market. You don't have an index you can use. But if we wanted to hedge our position on Walter, we would short it against another coal-listed name, such as Teck Resources in Canada. We use Teck because it's primarily a met coal play, although it does have some copper and zinc exposure. However, the share class structure of Teck would prohibit a hostile takeover bid for the company. For that reason, it's attractive as a hedge for our position in Walter. When you short junior names in the marketplace, there's always a risk that they will be bought out. That's one of the limiting factors in mitigating our risk position.

    TER: What other commodities do you invest in?

    JH: We invest in anything we think we can make money on-uranium, for example. That sector was beaten up very badly in the wake of the Fukushima nuclear disaster in 2011-a very rough year for uranium names. But, the reality is that uranium and nuclear power plants are here to stay. We believe that demand for uranium will slowly return to its previous levels.

    TER: What other energy prospects interest Lightwater?

    JC: We've invested in Denison Mines Corp. (DML:TSX; DNN:NYSE.A). It's been of interest to investors in the last few weeks because it sold all its U.S. assets, thereby cleaning it up for a potential take-out bid. It holds an attractive mining property called Wheeler River, which hosts the Phoenix deposit in the Athabasca region of Canada, the world's most prolific uranium belt. We believe that as the global players consolidate the Athabasca area, Denison is a very attractive near-term takeover target.

    TER: Thank you for the interview.

    JH: You are welcome

    JC: Thank you.

    Based in Toronto, Canada, Lightwater Partners is an asset management firm specializing in alternative investments. Partner Jerome Hass has 16 years experience in the financial industry. He joined Lightwater from Epic Capital Management. Previously, he was a portfolio manager and head of international equities at Montrusco Bolton Investments, where he managed $450M directly, co-managed large global funds, and oversaw $1 billion in private wealth. Partner Jimmy Chu has 10 years of experience in hedge and investment funds. His duties at Lightwater are focused on developing detailed financial models for existing and potential equity investments, used as tools for making investment decisions.

    Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.

    DISCLOSURE:

    1) Peter Byrne of The Energy Report conducted this interview. He personally and/or his 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. Streetwise Reports does not accept stock in exchange for services.

    3) Jerome Hass: I personally and/or my family own shares of the following companies mentioned in this interview: Walter, BHP, Cardero and Mosaic. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.

    4) Jimmy Chu: 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. I was not paid by Streetwise Reports for participating in this story.

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