The Commodity Investor: Streamers Fund Miners While Generating Value For Investors

Includes: SAND, STTYF
by: Hard Assets Investor

By providing alternative financing, streaming companies acquire a piece of the action from commodity producers.

Following last week’s column on Silver Wheaton (NYSE:SLW), I received feedback from investors regarding the company’s cutting-edge business model and future growth prospects.

Investors who are familiar with SLW point out that much of the value creation has already taken place. While SLW might not be a 10-bagger at these price levels, I believe it’s still a valuable holding to have. For full disclosure, I no longer own SLW, but I’m considering reinitiating a position.

In this week’s column, I’d like to highlight two companies that have a similar business model to Silver Wheaton’s. Both are early enough in their development stage that investors who missed SLW’s ride from $2 to $40 can have the opportunity to get in early with a natural resource royalty exposure. First, let me explain the royalty streaming process and its application in the commodities markets.

The Streaming Process
Production of commodities is a capital- and resource-intensive process. To develop a mine or oil field takes years and hundreds of millions of dollars in capital expenditures to get the final product (be it gold, silver, coal or natural gas) to the end user.

Therefore, commodity companies in general require significant upfront cash for their projects to be viable. Sources of financing are not always available and, if they are, may not be at the most cost-effective rates. Commodity companies often face the challenge of raising capital.

Enter the streaming-financing company. The streaming-financing concept was developed to address financing issues faced by mining companies. Here’s how it works. In exchange for an upfront payment, the streaming company acquires the right to purchase a percentage of the output at a predetermined price for the life of the project (mine, oil field, etc). This allows the streaming company to purchase a stream from the asset — hence the term “streamers.”

In most cases, this is a win-win situation. The operator gets financing to develop the asset and the streamer gets a percentage of the asset. From the streamer’s perspective, it now has access to a quality asset and, more importantly, has a fixed cost associated with it. This is how a company like Silver Wheaton is able to operate on margins in excess of 70 percent. Costs are fixed and, in the case of silver, extremely low compared with the current market price. Therein lies the value generator of streaming companies.

While SLW only focuses on silver assets, we all know the commodity industry is much broader. So why not apply this process to other commodities? Enter Sandstorm.

Sandstorm Resources spun off of Vancouver, B.C.-based Silver Wheaton in 2008 to focus on other commodities that did not include silver. Sandstorm’s mission is to apply the streaming concept to oil, natural gas, coal, copper, gold and other resources.

Noticing that the gold markets behaved in a different way, Sandstorm’s management decided to split into two companies: one company focusing purely on gold streams, Sandstorm Gold (OTC:SNDXF.PK); and a second company focusing on energy and base-metal streams, Sandstorm Metals & Energy (OTC:STTYF.PK). (For full disclosure, I’m currently long SSL but do not own SND.)

Both companies are listed on the Canadian Venture Exchange (CVE), as well as in the U.S. over-the-counter (OTC) market. Since it went into operations, SSL has already developed several gold streams in politically stable and mining friendly jurisdictions. It has a total of seven gold streams in Canada, the U.S., Mexico and Brazil.

The company became profitable in Q4 of 2010 and has been increasing its earnings per share ever since. In fact, SSL’s operating margins are now close to 50 percent (latest YTD figures). SSL has entered into contracts with some of the leading gold operators and has dibs on some of the best-producing mines in the Americas, including the Aurizona mine in Brazil and the Black Fox mine in Canada.

Its average cash cost is $400/ounce, so if gold prices remain at these levels, expect SSL to continue generating strong earnings going forward. Gold prices would have to drop below $400/ounce for SSL to lose money. As with any venture, there are certain risk factors involved; while the following is not a comprehensive list, they are potential risks that could negatively impact EPS growth.

Risk Factors

Investors should understand that this is a play on gold prices. If gold prices weaken, the earnings of SSL will decline as well. In addition, SSL’s revenue depends on the mines being open and operational to deliver its output to market. If a mine shuts down for whatever reason (environmental, labor strike or otherwise), that will have a detrimental impact on earnings.

The last risk to be aware of is that the company’s main asset is its contractual ability to purchase gold at predetermined prices from an operator. If the operator reneges on the contract, which has not happened in the industry so far, the company will have legal recourses, but this may cloud earnings going forward.

SSL’s sister, Sandstorm Metals & Energy (SND), focuses mainly on base metals and energy: coal, natural gas, oil and copper. SND isn’t yet profitable, but has already spent $112 million to acquire some quality streams, including six copper streams and two oil streams.

SND is quickly positioning itself as an alternative financing and joint venture company with many operators in the energy and industrial metals complex.