WHO WILL WIN? SENTIMENT (BAD) VS. TECHNICALS (GOOD)

April 23, 2023

The Problem Is – Markets Don’t Always
Anticipate The Downside

Right now the Dow Jones Index doesn’t look that bad–in the last few few months there have been higher lows, and an investor could reasonably think the market could break out, not break down.

But sentiment–and a lot of economic data–is quite negative right now.

How do we reconcile this?

We’re always being told that stocks move ahead of the economy. It is one of the most common tidbits of market wisdom. Stocks move before the news.

Unfortunately, it is not true. At least, not always.

Yes, stocks usually anticipate the news. But the caveat is this: they do so when that news is to the upside.

To the downside?  That one is a bit trickier.

Here is a much lessor known market truism: stocks do not go down until they have to.

Implicitly we know this.  When we talk about volatility rising, we almost always mean because the market is going down.   Volatility, a measure of the sudden movement of stock prices, is subdued in a bull market.

That is because stocks methodically price in the potential that good news is coming.

But bad news?   That is a completely different beast.  Bad news does not get priced in until it has gotten so bad that it can’t be ignored.

A great example of this occurred during the bear market of 2007 and 2008.

Below is the performance of the S&P 500 from July 2007 until October 2008.  July 2007 is, by most accounts, when the subprime crisis took center stage.  House prices began to fall, lenders began to wobble, and the first dominos in the hedge fund business closed shop.

Yet it wasn’t until late September 2008, when Lehman Brothers failed, that the stock market finally fell out of bed.

Source: Stockcharts.com

Zoom in to this chart to the period ending mid-May 2008. At that time the market was only down about 7% from the peak.

Source: Stockcharts.com

Taking the chart on its own, you would be forgiven for thinking that the market had double bottomed and was on its way back to the highs.

Yet by mid-May the burgeoning crisis was well known. It had been over 6 months since the WSJ had published its piece on the United States of Subprime way back in October 2007.

Source: WSJ.com

Bear Stearns had already failed a few months before. The stocks of money-center banks like Citigroup (C – NYSE) and Bank of America (BAC – NYSE) were looking precarious. There was PLENTY of reason to be afraid!

Source: Stockcharts.com

Yet the market as a whole was holding up well. Pockets of the market, commodities for example, were rushing off to new all-time highs.

Source: Stockcharts.com

DON’T RELY ON PRICE ALONE

Of course, what we are experiencing today is not 2008.  In fact, I am always reluctant to use 2008 as a comparison to anything.   The Great Financial Crisis is wheeled out every time a fear-mongering doomer wants to make a point.

But the point I am making is not to compare now to then.   I don’t know what is going to happen.  We may be in the very early stages of the next bull market.  We may not.

It is to point to market behavior.   Particularly, the way the market behaves when it is in a bear market.   While investors expect markets prices will always look ahead, that is not the case when the future is to the downside.

To give another very recent example, consider the banks.

The banks have had an awful month.   The collapse of Silicon Valley Bank (SIVB-NASD), the deposit runs at First Republic (FRC – NYSE) and others, and now the worries about commercial real estate loans.

You know what? None of this is new. All this stuff was plain to see even 6 months ago.

The market? It didn’t care. The bank index chugged along happily. And then the bottom fell out in mid-March.

Source: Stockcharts.com

If you look at the chart of the SDPR S&P Regional Bank ETF (KRE – NYSE) from May 2022 to March 2023 you would have been hard pressed to see what was about to happen–even though all of those factors I mentioned above were already in play.

Again: the market does not care about the downside until it has to care – which in this case meant: when depositors start pulling their cash out.

PRICE DOESN’T ALWAYS TELL THE STORY

I am always wary of simply following the trend. In a bull market, it is a good strategy. Markets are pricing in the probability of future success ahead of time and so you are just riding the wave.

But in a bear market?  That is a bit dicey.

When I look across sectors today, one that seems to be finally getting a little bit of love is biotech.   It has been a rough couple years for the biotech stocks.  They started going down before everything else and since bottoming last May every rally has been sold.

What do I make of this last bit of strength?   Is this finally the move up we’ve been waiting for?

Source: Stockcharts.com

Well… biotechs are starting to get some love but this remains a blah market.   And potentially still a bear market.  I’m not yet ready to call it a bull market.

Until I am, I remain wary of pronouncing any sector as “off to the races” just yet.

You have to remember just how bad 2022 was for most stocks.  The averages don’t truly reflect the carnage that took place.

Just like how the May 2008 rally came off of the depressed “Bear Stearns” lows of February 2008—the rally we are getting now is coming off of a period of real weakness in 2022.

Is this just a dead-cat bounce off of very depressed conditions?   Are we just so happy that the bottom didn’t fall out this year that we are running back to the table without realizing it still could?

In my portfolios I am sitting on small positions.  I am not out of stocks. I don’t want to ever be out because when the turn comes, I probably won’t catch it.  But keeping my position size small lets me have skin in the game while managing my concern.

I am sitting on a large cash position right now.  Larger than I’d like.

I don’t want to be so cautious.  A lot of stocks look cheap.  This is especially the case for the micro-cap names where I play.

But until I get more of an all clear signal from the market I’m just not willing to guess the trend.

Keith Schaefer

HOW GFL ENVIRONMENTAL BECAME A (RENEWABLE) NATURAL GAS PLAY

Keith Schaefer

April 15, 2023

Talk about poor timing!

GFL Environmental (GFL – TSX/GFL-NYSE) saw its IPO debut on March 3^rd, 2020. Smack dab in the middle of COVID and a big plunge in the stock market.

It made for a rough start for the stock. But after falling from an IPO price of C$25 to a low of $16.77 at the peak of the pandemic, it has been nothing but roses for GFL. Even as the market swooned into year-end last year, GFL bucked the trend and has since taken off toward new highs.

Source: Stockcharts.com

How has GFL avoided the ups and downs of the rest of the market?

Some of it can be explained by a flight to safety (GFL is in the waste management business, which you would expect to be reasonably recession resistant).

Some of it can be explained by their successful roll-up strategy. Since going public in 2020 they have acquired over $7 billion of new businesses. In 2022 GFL acquired 40 new business for just under $1.3 billion. The result was 32% revenue growth in 2021 and 22% in 2022
But another factor has passed under the radar of most investors.

By 2025 GFL will be deriving meaningful revenue and EBITDA from natural gas production.

That’s right – natural gas.

In fact, using their own expected pricing, GFL natural gas revenue will be in the same ballpark as some of the biggest gas names in Canada.

Source: Company Filings, GFL Management Estimates

Wait, what?

I kid you not.

To be sure, GFL is not turning itself into a natural gas producer. Natural gas will account for ~5% of revenue and a little less than 10% of EBITDA if all goes well. Yet it is certainly becoming a piece of the pie.

The real story here is in the “how?”

How does a waste management company generate this much incremental EBITDA from natural gas?

The answer lies in the type of gas they produce. GFL produces a special kind of gas, one they get a lot more money for it.

LANDFILLS ARE A GOLD MINE (OR AT LEAST A GAS FIELD)

GFL is waste management company. They operate landfill, recycling and organics facilities across 26 states and 9 provinces.

Source: GFL 2022 Investor Day

Most of what GFL does is contractual waste management with municipalities. While not entirely recession proof, it is about as close as you can get.

The vast majority of the business is boring and dirty. Collecting waste, collecting recycling, managing industrial scale composts. They collect fees from municipalities for contracted waste and recycling disposal.

But those landfills contain a hidden resource.

Deep in the landfills organics are decomposing. That slow decomposition releases methane, which becomes trapped below the waste.

It is that methane that GFL is able to make money on. When extracted, it is considered renewable natural gas (RNG).

WHAT IS RNG?

RNG comes from the decomposition of organic material in landfills. Solids, yard scraps, food.

Source: EPA Landfill Methane Outreach Program

The gas is extracted with wells drilled into the waste. These wells are not that different than the conventional natural gas wells drilled into the ground.

Source: EPA Landfill Methane Outreach Program

The biogas that comes out is not pure natural gas. It is a roughly 50/50 mix of methane and CO2, along with a small amount of other organic compounds.

To be useful, the biogas must be processed. Just how processed depends on the end use. For electricity production a relatively “dirty” mix of methane and Co2 is used. If it is going to be pipeline quality, much more upgrading to pure methane is required.

Source: EPA

At its most pure form, what you are left with is methane – ie. natural gas. The same stuff that comes out of the ground.

IT LOOKS LIKE NATURAL GAS,
TASTES LIKE NATURAL GAS…
BUT IT ISN’T PRICED LIKE NATURAL GAS

While the chemical composition of RNG is no different than the stuff coming out of the ground, the price is a whole new ballgame.

RNG prices can be as high as $75/MMBTU. Even with conservative assumptions you are usually looking at $20/MMBTU+.

Consider GFL’s own pricing assumption on their RNG projects:

US$26/MMBtu over the periods reflected and is equivalent to underlying price assumptions of US$2.00 RINs and US$2.50 natural gas

Clearly the current going rate – $2.50 natural gas – isn’t driving the price of RNG. The vast majority comes from the “renewable” component. In the United States (where most their projects are), that comes from renewable identification numbers (RINs).

ABCs OF RINS

I’ll be honest with you. I hate RINs. Not because there is anything wrong with them. But because every time they come up (and they come up a lot in the refining world), I have to figure out how they work all over again.

RINs are ubiquitous in the (US) refining world. US Refiners are required to attach RINs to gasoline and diesel they sell to verify that they meet renewable fuel content requirements.

If a refiner has not produced enough renewable fuel per gallon of gasoline and diesel, they have to go out and buy RINs from another refiner who has produced enough renewable fuel to have an excess.
Thus, the RIN price is determined by supply and demand.

RNG counts as a renewable fuel. The EPA has determined that RNG producers get 11.7 RINs for each MMBtu of RNG that they produce.

Depending on the RIN price, this can be a windfall. RINs have been as high as $3 at times!

Source: https://www.epa.gov/fuels-registration-reporting-and-compliance-help/rin-trades-and-price-information

At $2 RIN, which is roughly the average over the last 3 years, and RNG producer is getting over $23/MMBtu!
With the going rate for natural gas being under $2/MMBtu, this is obviously a windfall.

GFL – A BURGEONING NATURAL GAS PRODUCER

GFL announced their RNG strategy in 2021 at their Environmental Investor Day.

At that time, they outlined 4 signed projects, 5 more under negotiation and 9 being evaluated.

They estimated $65-$75 million of additional FCF from the 4 signed projects, and $105-$125 million from the first 9.

Source: GFL 2021 RNG Projects from Investor Day

Flash forward to today and we are up to 21 projects, all of which should be producing RNG by 2025.

Together these projects will produce 14.5 million MMBtu of RNG per year.

Now let’s be clear: this is not a massive amount of natural gas. Going back to my earlier comparison, Birchliff (BIR – TSX) produced 10x that amount last year. Peyto (PEY – TSX) produced 20x more.

But on a revenue comparison, GFL stacks up much closer because their RNG gets such a high price.

RNG revenue is expected to make a sizable contribution to corporate EBITDA. GFL is estimating the cumulative run rate to be $175 million of additional annual EBITDA from their RNG.

Source: GFL Q4 2022 Investor Presentation

All the projects are MSW land fills. While the company has not disclosed locations, it appears that most or all are in the United States. They appear to be making headway on at least one project in Canada.

ONE TIME GROWTH

GFL is a very large waste management company. They have a market cap of C$16 billion and an enterprise value of over C$25 billion.

To give some better perspective on the impact of RNG, GFL did $1.7 billion of adjusted EBITDA in 2022.

They guided to US$2 billion to US$2.05 billion of EBITDA for 2023.

That means that the growth from RNG through 2025 is about a ~9% increase to this year’s EBITDA. Not huge, but enough to move the needle.

Could there be more growth ahead?

Honestly, I am not sure.

GFL owns a lot of landfills. Over 90 of them. So far we are talking about RNG from about ¼ of them.

But not every landfill is well-suited for RNG.

While all landfills release methane, to make RNG processing worthwhile, the extracted gas must be tied into a pipeline. That means pipeline proximity is key. Then there is the approval side – both for the pipeline (which is never a slam dunk nowadays) and for a utility to offtake the gas.

GFL has been coy about just how many landfills it can retrofit. When asked straight-up on the Q2 2022 conference call, they stuck to the script that they have 22 active projects.

That suggests to me that GFL is likely not going to become a renewable natural gas behemoth, building ever more production capacity each year.

I expect we will see more to come, but the easiest fruit has been picked.

Getting back to the stock – well, I have watched GFL for some time now and I always feel like I’m waiting for just a little more of a pull back.

Today the stock trades at 13x EV/EBITDA and, based on average estimates, a 5.7% free-cash-flow yield. That makes it neither cheap nor expensive.

But what it does say–is that the Market is looking for every molecule of RNG it can produce.

EDITORS NOTE: I just updated my full report on my favourite RNG play. This stock is–by far–my largest position. And it is bumping up against 52 week highs. I think the catalysts here are near term, and huge for shareholders.

Get the name, symbol and report–RISK FREE–Click Here

Keith Schaefer

Not All Solar Stocks Have Sunny Charts

Keith Schaefer

February 1, 2023

My deep dive into solar has been a good news story. I am finding companies growing revenue and generating cash.

Solar has tremendous growth ahead of it. The Inflation Reduction Act (IRA) will great a boom for years to come.

But not every stock has been a tempting buy.

If the story has an Achilles heel, I can tell you where: Financing.

Solar installations need credit. Preferably cheap credit.

Today credit conditions are going in the wrong direction. Liquidity has tightened a lot. Rates are higher. It is creating pockets of stress in solar financing.

There is no better example of this than the mess that Sunlight Financial (SUNL – NASDAQ) has found for itself.

THE BUSINESS OF SOLAR LENDING

Sunlight Financial came to the public market as a SPAC in January 2021.

Sunlight was born out of the Spartan Acquisition Corp II. At the time of the business combination, they were valued at $1.3 billion.

Today Sunlight has a market capitalization of just under $100 million – or a 90%+ decline.

What happened?

Rates happened. Sunlight got caught on the wrong side of the rise in interest rates. Here’s how:

Sunlight is in the business of lending for residential solar installations and home improvement.

Most of Sunlight’s lending is on the solar side. In Q3 22, 84% of their loans were solar installations. These are loans to homeowners that let them put solar panels on their rooftops.

Sunlight is a big player in residential solar financing: it has an 8% market share in the US.

They get customers via a network of solar installers. When a Sunlight approved installer sells a system to a homeowner, they offer a financing option to purchase the array with no money down, with the loan originated via Sunlight.

A loan gets made, the system installed, and some of the revenue from the electricity produced goes toward paying interest and principal on the loan.

These are decent sized loans, averaging just under $46k in Q3:

Source: Sunlight Financial Q3 Results Presentation

While only 20% of residential solar system sales were financed with solar loans in 2015, by 2020 63% of residential solar loan sales were financed. It is a large market and a growing one.

THE HOME IMPROVEMENT MARKET

In 2019 Sunlight added a new business when it began to originate home improvement loans.

Sunlight makes its home improvement loans in the same way as its solar loans. A contractor agrees to a job with a homeowner, but in this case to pay for a new roof or new windows. Sunlight has a network of ~1,000 contractors that act as their loan originators.

Source: Sunlight Financial Q3 Results Presentation

I’m not thrilled with this business. Home improvement loans are a bit more dicey than solar. They aren’t backed by a revenue stream. These are loans that seem more likely to go south.

On the other hand, this is a small business compared to Sunlight’s solar lending (it is about 1/5th the size and was only 6% of revenue in 2021), the loans are a lot smaller ($17.8k average in Q3) and interest rates on the loans are far higher. Sunlight also seems to be making loans to credit-worthy customers

Source: Sunlight Financial Q3 Results Presentation

At any rate, it isn’t the home improvement lending that causes Sunlight’s book to go south.

A 100 YEAR STORM

Solar lending should have a lot going for it. There are subsidies, electricity rate advantages, and a relatively constant stream of cash.

Considering that ~85% of Sunlight’s loans are solar, you might think that this is a safe bet – cash flows that cover debt and happy lenders.

What could go wrong?

We always hear about 100-year storms. We hear about them so often that it seems impossible that there could be one every 100-years.

The same goes for financial storms. There is a 100-year financial storm about every 10-years. Inevitably when one happens, boats get caught and capsize.

Sunlight found itself caught in the storm. It remains to be seen if they capsize, but it’s going to be rough sailing.

THE LAG THAT CAN KILL

The storm that caught Sunlight was the speed of the rate hikes.

Throughout 2022 Sunlight made more loans than at any time in their history.

Source: Sunlight Financial Q3 Results Presentation

But because rates rose so fast those loans quickly went underwater – before Sunlight could sell them to investors.

Sunlight is a point-of-sale lender. Contractors and installers approach households with their solar product and offer Sunlight financing. Sunlight approaches investors to funds loan. Loans are matched up with lenders.

Source: Sunlight Financial 2021 Investor Presentation

There are two ways a loan can get funded. Either before it is made or after it is made.

Sunlight’s preferred model is to pre-fund the loans. Investors agree to a rate before the loan is even made. This was the process described in Sunlight’s initial investor presentation:

Source: Sunlight Financial SPAC Conversion 2021 Investor Presentation

The key in the above slide is the term “pre-agreed dollar price”. Sunlight clarifies this in the footnote:

Source: Sunlight Financial 2021 Investor Presentation

For a pre-funded loan, there is no lag between originating the loan and funding it. If rates rise sharply and suddenly, that is on the investor, not Sunlight.

But then how did Sunlight get in trouble?

STRETCHING FOR GROWTH

Here’s how.

Historically, most of Sunlight’s loans are pre-funded (they called it direct lending). At the time of the SPAC acquisition around 90% of lending was direct:

Source: Sunlight Financial 2021 Investor Presentation

Direct lending soared after the pandemic. Money was cheap. Banks were bursting with deposits. Investors jumped at the chance to fund solar installs.

But in more normal times Sunlight has more loan volume than it can pre-fund. In that case they take a different tact.

Sunlight uses an intermediary – a bank – to hold onto the loan while Sunlight looks for an end buyer.

They call these “indirect loans”. They are basically loans that are warehoused with the bank until they can be sold to investors.

The process takes 3-4 months.

Source: Sunlight Financial 2021 Investor Presentation

This happens all the time with mortgage loans. There is nothing wrong with the warehousing model.

But for Sunlight, the model went south when rates went north.

The Fed hiked rates by over 4% in less than a year. Last cycle it took 3 years for the Fed to raise rates 2.5%.

Source: CNBC

This broke Sunlight’s funding model. Sunlight was forced to move more loans to indirect funding.

In the first quarter of 2021 Sunlight funded $581 million of loans. $84 million of that was from the indirect channel (15%).

In the first quarter of 2022 Sunlight funded $593 million of loans and $164 million were indirect (28%).

In the third quarter Sunlight funded $834 million of loans and $264 million was from indirect (34%).

At the same time, rising rates and widening spreads made loans only a month or two old underwater – with Sunlight holding the exposure.

On the Q3 call they said:

“we also continue to see interest rate increases of unprecedented speed and magnitude, which… will affect our ability to profitably monetize indirect channel loans originated earlier this year… loans in the indirect channel will be sold at a loss”

A BADLY TIMED BANKRUPTCY (NOT THEIR OWN)

Adding to their woes, in late September Sunlight announced an “installer liquidity event”.

That “event” was the bankruptcy of one of their largest solar installers, Pink Energy.

The bankruptcy hit Sunlight in a few ways.

First, Pink was a large partner and the loss of their business cut into new loan originations.

Second, Sunlight advanced money to Pink to build the customer projects. Sunlight estimated they had about $32.4 million of advances that they would not recover.

Third (maybe most important), this was a hit to Sunlight’s credibility at exactly the wrong time

FIRE SALE

Sunlight is in a tough spot. They are going to have to sell underwater loans and that means sell them at a loss.
They disclosed as much in a December 13th 8-K filing.

The filing announced several changes to the agreement with the bank partner.

The good news is that Sunlight’s bank partner increased their lending capacity. More of Sunlight’s loans can be held on their balance sheet.

The bad news is that amendments changed the fee structure (likely not in Sunlight’s favor) and tightened Sunlight’s collateral requirements on non-current loans.

Sunlight also said in the filing that they will have to “sell a significant portion of their backbook loans in December”.

They will take a loss on these sales. The impact is expected to reduce total platform fees in Q4 to only $0-$5 million – down from $31 million in Q3.

That still leaves $275-$300 million of backbook loans at the bank partner, which Sunlight plans to sell in the first half of 2023.

The long and short of it is that these sales will “significantly reduce the Company’s cash balance and may result in materially less available liquidity through the first half of 2023”.

Not surprisingly, Sunlight is looking at strategic alternatives: selling the company or raising capital.

They said they have “received interest from parties both in investing in the company and in acquiring the company”.

GAME TIME

I have no idea how this plays out. It will come down to whether Sunlight can find a partner with deep pockets, either to buy the company or provide capital to get them out of this jam.

That could happen. Most of the loans are solar loans so these are long-term loans. Long-term rates have come down a lot from the peak.

But Sunlight is distressed. It is difficult to imagine them having much leverage in a negotiation with a potential partner.

That makes me want to sit this one out and just watch.

There may or may not be something worth owning once the dust settles. If there is, subscribers will be the first to know.

COPPER PRODUCERS – THE GOOD AND BAD UPDATE

Keith Schaefer

January 21, 2023

Late last summer we published two blogs outlining the case for copper and copper stocks (here, and here).
What we said was:

Yes, it is hard to buy copper stocks when they are down big (they were at the time) but…
It is always hard to buy commodity stocks at the time you should be buying them.

We argued that if you could “look past the next 6-12 months” and “hold your nose” you would see a “massive tailwind for copper.”

We are now 4 months removed from those posts. And you know what? That “hold your nose” trade worked well.

Our copper stock list has significantly outperformed the market since those articles were published.

Source: Yahoo! Finance

A 36% gain since July is nothing to sneeze at.

WHAT CAUSED THE RALLY?

The rally was not driven by anything company specific. This was a move across the whole group driven by macro.

I’m not talking about “the economy is getting better” kind of macro. We aren’t there yet. But stocks move up well before the economic data gives us a good reason for it.

What we are seeing instead is a “hope” trade. You never can tell if this is the hope trade, the one that will lead us into the next bull market. But sentiment is always the precursor.

The improving sentiment on copper has led to an improvement in the price.

Source: Stockcharts.com

Driving that sentiment has been China and the end of their COVID lockdowns.

With the re-opening of China, a new narrative has emerged. Increased demand from China is hoped to offset weak demand from the developed world as it slows into recession.

There is reason to believe this could happen. China accounts for more than half of copper demand.

What’s more, construction is ¼ of Chinese demand, so recent moves by the Chinese Communist Party to lift the property market adds more bullishness. The construction sector has been the biggest headwind on Chinese demand.

Source: BofA Global Research

Meanwhile inventories of copper across the globe keep falling and falling…

Source: BofA Global Research

LME warehouses are down to only a couple of days of inventory. The Shanghai warehouse is not much better.

While its tricky to estimate exactly what inventories are across the globe, it is safe to say that the number is lower than you’d like to see.

COMPANY PERFORMANCE HAS BEEN MIXED

And how have the companies we tracked performed? Mixed at best.

Q3 results and the preliminary Q4 numbers have seen more misses than beats.

Costs were up across the board on the back of higher energy prices, higher chemical prices, and higher labor costs.

Add on a floundering copper price (under $4 for since Q2), and cash flow has been lackluster. Forward analyst estimates have trended down.

Source: BMO Capital Markets

You simply can’t attribute the relative outperformance of names like Capstone Copper (CS – TSX) and Taseko Mining (TKO – TSX) to their operating results.

Instead, what has driven relative performance has been largely about events not tied to their operations.
Here is a summary of 4 names that did have significant events over last 4 months:

CAPSTONE COPPER – THE PROMISE OF STABILITY

The biggest outperformer of the group has been Capstone Copper. Capstone is up 86% since September.

The reason? Likely an analyst site visit in November that reassured investors, in particular that Capstone’s big development project is on track.

Mantoverde is Capstone’s next big growth driver. The expansion project is expected to add 70 kt per year of copper in 2024.

What Capstone told investors at the site visit was that Mantoverde was on schedule and budget – and that it is 69% complete.

Canaccord said after the visit that they now viewed a capital cost overrun as unlikely. Given the blow up in costs at other projects, this reassurance likely put a bid under the stock.

As a result, we now see 2024 production growth from Mantoverde getting priced in.

Source: Capstone Copper Investor Presentation

Capstone 2024 cash flow per share estimate (once Mantoverde is fully operational) is $0.98/share on $3.40/lb copper. While the share price makes the stock look expensive on today’s numbers, it is less pricey if you look ahead.

TASEKO MINING – A DESTINATION IN SIGHT

Taseko Mining was the second-best performer on the list.

When I wrote about Taseko in September, I noted two points.

First, they needed to show a turnaround at Gibraltar, which I felt was likely.

Second, the BIG question was their development project – the Florence project in Arizona – raising capital for it and getting it through regulatory hurdles.

Taseko delivered on both points, but it was Florence that drove the stock.

In December, Taseko signed a strategic partnership with Mitsui to develop Florence. Mitsui committed $50 million in exchange for a royalty of 2.67% of copper produced, which will be paid for at 25% of spot.

Mitsui can invest another $50 million for a 10% interest in the project.

While the stream adds about 7c/lb to the cash costs of the project, the funding and vote of assurance from a large player added a lot of credibility.

Taseko followed it up with a commitment in January from Bank of America (BAC – NYSE) for $25 million to fund capex costs.

Together that is $75 million of funding ($125 million if Mitsui exercises their option) for a project with a $230 million capital budget.

We are still waiting on the final Underground Injection Control (UIC) permit for Florence from the EPA, which will be the make-or-break moment for the project.

The market is signaling that the deal with Mitsui and funding from BofA are signs that the project will be a go.

COPPER MOUNTAIN MINING – MORE HICCUPS

Copper Mountain Mining (CMMC – TSX) has had a lot of news (both positive and negative) in the past few months.

The news on average seemed to balance out. The stock slightly under-performed the group average.

In my last blog I called Copper Mountain “the poster child for operational risk”.

This turned out to be prescient. Copper Mountain struggled to turnaround their Copper Mountain Mine.

Q3 2022 results were just plain bad. The 13 million pounds of copper produced was less than Q2 and less than already reduced analyst estimates of 15 million.

Cash costs ballooned to $3.70/lb while all-in-sustaining-costs (AISC) were well above the price of copper at $4.50/lb.

Source: Copper Mountain Mining Q3 Results Press Release

The stock price would have been a disaster had it not been for the good news: Copper Mountain announcing the sale of their Eva Project in Australia.

Eva is a late-stage project with high capital costs (estimated at A$850 million in the 2020 feasibility study). Given Copper Mountain’s modest market cap (~$400 million) financing Eva always seemed like an exercise in dilution to me.

Instead, Copper Mountain sold Eva to Harmony Gold Mining (HMY – NYSE) for US$170 million of cash and contingent consideration that could be another US$60 million.

This seems like a great deal. It removes the overhang on financing and – I suspect – sets up Copper Mountain as an acquisition target. Now if they could just get that mine back on track…

FIRST QUANTUM – gamblers only

First Quantum Minerals (FM – TSX) underperformed the group, registering a 28% gain versus the group average 42%. But quite honestly, I am surprised it didn’t do worse.

This has nothing to do with operating performance. First Quantum Q3 was pretty much inline with expectations.

Instead, the big news was an unexpected tax claim by the Panamanian Government.

Panama is home to the Cobre Panama mine, which accounts for $18 of First Quantum’s NAV and over 50% of its EBITDA.

While the details of what exactly is going on is a bit sketchy, the long and short of it is that the Panamanian Government wants First Quantum to pay more taxes – including an “exploitation fee” for copper extracted in prior periods and a much-increased tax rate going forward.

While this news was known for much of H2, the prevailing sentiment seemed to be that it would get sorted out.

That turned out not to be the case, at least not yet.

On December 16^th news was reported that the Cobre Panama mine had actually halted production after a deadline for agreement between First Quantum and the government came and went.

This was subsequently clarified by First Quantum. They said that the mine was still was operating, but only because First Quantum was using legal recourse to avoid a shutdown while they continued to negotiate with the government.

On January 10^th First Quantum had a conference call where they again corrected media reports – this time ones claiming that talks with the government had broken down – but also acknowledging that a resolution had not been reached.

The bottom line is no one knows how this plays out.

We can be sure First Quantum will pay more taxes. How much is unknown, as is whether this will this escalate to the point where Cobre Panama is forced into care and maintenance?

I have no idea, but I am confident that with the stock up 20%+ in the last few months, that outcome is not priced in.

I would wait this one out until we have a firm agreement between First Quantum and the Panamanian government in place.

TOP FUND MANAGER IN 2022 TALKS STRATEGY FOR 2023

Keith Schaefer

December 22, 2022

This guy has my vote for Fund Manager of the Year.

2022 is one of the worst years in history for stocks—yet Rob Mullin continued his winning ways for investors in his Marathon Advisors hedge fund.

Mullin’s fund–it’s called the RAEIF, which stands for Real Asset Equity Income Fund—had a phenomenal year (3rd year in a row) and is one of the top performing strategies in the world over the last 1, 3 and 5 year periods. (due to quirky US securities laws, I cannot provide Mullin’s specific–and impressive—performance data for his hedge fund unless everyone of you readers were accredited investors!)

But trust me, his market savvy and performance make him worth listening to–and below, he shares some of his best ideas for 2023.

His mandate at RAEIF is to find yield through dividend paying stocks in the resource sector.

Mullin uses a broad combination of long and short trades, with option trading of both puts and calls, plus all those dividends to create a portfolio that has given remarkably consistent returns through 2022, increasing the fund’s value roughly 20-25% each quarter.

Considering that commodities and resources is one of the most volatile sectors of the market, that’s impressive.

Mullin says that resource producers have been “demonized” by mainstream investors, and that means they are trading at some of their lowest valuations in history. That makes for very high yields—high single digit often double digits—despite low payout ratios.

In 2021, fund managers just needed to buy oil stocks to have a good year. They went from pricing in bankruptcy to being the single largest cash cows in the S&P 500. But oil producers’ stocks have been flat since March.

In fact, much of the resource sector stalled out at the end of Q1, and Mullin said he had to get nimble, and quickly—weighting his RAEIF LP to the short side in a hurry.

I’ve known Rob for 15 years, visiting him in his San Francisco head office whenever I was in town, and hearing his thought process on the Market at the time.

But he really came back on my radar in early 2020, when he pulled off an incredible trade—buying “put insurance” for the Market just in advance of the COVID meltdown. Every other fund manager (except Bill Ackman; same trade) lost huge, but Mullin’s well-placed insurance markers made his year.

His fund has been open only to American accredited investors, but in November 2022 he set up a fund that TROW—The Rest Of the World—can now invest in, to take advantage of his expertise. You still have to be an accredited investor though.

I’ve convinced him to speak to our paying subscribers once a quarter through 2023. But he agreed to share his strategy and some stock picks for 2023 with us today:

Keith: Rob, you had a great year, congratulations. But let’s look forward now. How are you positioning yourself for 2023:

Mullin: Well, a lot of the stuff that I’m buying is actually a heck of a lot closer to its 52-week lows, than it’s 52-week highs.

Where I’m looking, there’s still a lot of opportunities that aren’t pressing high valuations, not up 50, 150% year to date. So that’s really where I’m focusing.

Keith: Do energy stocks fit into that at all?

Mullin: Yes. So in the energy patch, I think the global integrated oil energy companies are really interesting. You look at things like a Petrobras, (Brazil’s NOC—national oil company) which trades a US ADR (symbol PBR-NYSE).

Or an Ecopetrol, (Colombia’s NOC, national oil company) which trades a US ADR (symbol EC-NYSE). These are global $20 to $60 billion market cap companies, trading at two and a half times earnings, with 20 plus percent dividend yields. And yes, I understand that there are some political things that happened in both Colombia and Brazil, respectively.

Ecopetrol was an $18 stock in March. It’s a $9 stock today, and it’s $18 billion in market cap, earning $2 billion a quarter. You look at Petrobras, a $65 billion market cap, it’s paid off almost $80 billion worth in debt. It may be the greatest pay down of debt in the history of any company in the world. I mean, we’ve never seen anything like it

And again, this is a $65 billion market gap company, that made $9 billion in earnings last quarter. So it produces more oil than Exxon does. Exxon’s got a $450 billion market cap, this is a $65 billion market cap.
So to me, those are really interesting opportunities that offer a lot of asymmetry.

Keith: There’s so many different—and big—macro currents right now in the Market. Will the US Fed pivot or not pivot, COVID in China, the Ukraine-Russia war, COVID supply chain issues etc. When you look at 2023, what would be one of the top two factors that’s guiding your macro thinking.

Mullin: What I’m trying to do is kind of strip out the noise, and really listen to, what are resource inventories telling us? What are inventories telling us about the global economy, on the margin?

And to me, what that is telling me is that demand remains fairly firm. You look at what has happened to oil inventories in the last three or four months. They’ve been fairly steady, they’re not really building, they’re not really coming down. Oil prices have come down a lot, but oil inventories have been pretty flat.

That said, you strip out the impact of the SPR releases, which have added about 350 million barrels to global inventories, global inventories continue to fall really rapidly.

So that backdrop to me, on energy, just seems really robust.

To me, a big part of the reason why oil prices have come down, is because of the massive financial liquidation of oil. You look at the speculative traders positions, the CSTTC reports, and areas where you look at where managed money…you’ve had a selling of financial barrels, but the underlying inventories, which is what I think we should be really listening to, tell you that the underlying demand story is pretty good.

And a related sector is oil tankers, though I call it tanker and infrastructure sectors. I think there may be a case here to pivot back to the bulk shippers, the ones who do iron ore and grains, and things like that. Those stocks have been beaten up pretty good. They’re sort of back again, back a lot closer to their lows than highs. Some companies in there have some pretty substantial dividend yields.

Keith: Any favorite stocks there?

Mullin: So, my favorite in the bulk guys is Star Bulk, SBLK-NYSE. That’s, in all likelihood, call it a $20-ish stock that’s going to pay something close to $4 in dividends, in 2023. So that’s right up my alley. It’s reasonably large, it’s liquid.

Keith: As I read your quarterly letters, you talk about all ELEVEN sub-sectors of resources that you follow. What are two of those 11 you like in 2023.

Mullin: Sure. The Ag space—agriculture—is one. I would say that even before Ukraine, the higher fertilizer prices were causing farmers to cut back on fertilizer applications.

That’s going to start showing up in yields over the next three to six months. I think inventories are going to tighten up considerably, and I think the big risk that we run is going into a 2023 where we’re seeing a lot more in the way of resource nationalism, which I’ve written about a little bit.

That’s where those countries that typically have surpluses, and the ability to export those surpluses, may be less inclined to make those surpluses available to importing countries.

If we continue to tighten up on inventories, like we have been over the last year or two, I think there’s going to be even less of an inclination to share, which when you tighten up the marginal bushel, or marginal barrel, whatever it is. That’s when prices tend to sort of surprise, to the upside.

And then, one other sector for 2023–I actually like the gold space. I think we are seeing, as the Fed marginally moves towards a more flattish outlook, they’re still going to raise, maybe they don’t cut aggressively. But the pace of tightening is going to go down.

It seems like this relentless dollar rally has sort of lost its steam. I’m not saying that highs have been made for USD, but I think we’re kind of in the ballpark. For that reason, I think gold’s performance this year has actually been pretty darn good.

Particularly if you look at it outside of the US dollar, in most other currencies around the world, it’s actually up this year. In some currencies, like the Japanese yen, it’s up a decent chunk.

The fact that gold has held in, despite again heavy financial liquidations, is impressive. Gold ETFs suffered 22 straight weeks of outflows, up until last week. Late November saw the first inflow in 23 weeks.

So you’re starting to see some of this financial demand sort of reverse. I think the physical markets are going to remain relatively tight. Gold stocks have started to rally a little bit, the bigger caps have come up a little bit more.

The smaller caps are still lagging, but they’re sort of coming off their lows. They’re inexpensive stocks, lots of them with kind of reasonable dividend yields, high free cash flow generation.

If you look at them as I do, compared to the valuations over the last 25 or 30 years since I’ve been doing this, I’m not sure I’ve ever seen the gold stocks, in aggregate, at a cheaper price to cash flow, price to free cash flow, price to NAV on strip, than I see them right now.

And so I think it’s sort when everyone has given up on them for being dead, is exactly the time where I want to be sort of kicking around, and looking to position myself in them. So that’s another area.

Keith: that’s great color, thank you. So what’s a stock in that sector you like?

Mullin: Well, I like Sprott—SII-NYSE and SII-TSX. So here you get the benefits of the gold play, but you also have uranium funds, you also have others.

Sprott has traded around this $30 level, when it had $6 billion in AUM (Assets Under Mgmt), when it had $16 billion in AUM. Now it has north of $20 billion in AUM. It’s still right around $30 per share. And so, again, I love places where you’re building convexity and not paying for it

And there’s actually good precedent for that. The same thing happened back in the 2002 to 2007 gold bull market, one of the best performing stocks from 2004 to 2006 US Global Investors (GROW-NYSE), which was the Sprott of its day, in an environment where the GDX went up 50 or 60%, US Global went up tenfold over those two years. So there’s precedent for this, and I think we could see something like that again.

Keith: Rob, any final words of wisdom you have for resource investors in 2023?

So over the top of all of this, investors need to be cognizant, that this is not going to be a straight run. I think that if 2022 taught us anything, none of this is going to come easy.

We as resource investors do not get to have the great technology, healthcare, sort of up and to the right, where you can just lever along and ride it for four or five or seven or 10 years. It just doesn’t happen in our sector.

The nature of resource bull markets, which I’ve said a number of times, is that the fact that commodity prices are rising and inflation expectations are rising, that causes a lot of instability in the broader markets.

The resource cycle doesn’t end until the capital is spent to bring on enough supply, to make it end. If all the politicians and bankers and management teams were able to raise the capital required to produce more oil, more copper, more nickel and more lithium–we would still be five to seven years away from really seeing a meaningful uptick in that supply.

That money to create that extra capacity was not spent in 2016 to 2022 and it’s not being spent now.

So I think it’s really early. The real resource cycle doesn’t end until late this decade, if not even later. We can have volatility and phases within the cycle, but we have years to go here I think. So that’s where I think we are.

Keith: Wow, that’s powerful! Rob thanks for sharing your thoughts and congrats again on an amazing 2022, and look forward to catching up in early 2023.

Mullin: I appreciate your interest Keith. Merry Christmas.

EDITORS NOTE–you can connect with Mullin on LinkedIn at https://www.linkedin.com/in/robert-mullin-58422b84/

Keith

MAKING SOLAR INVESTING A “NO-BRAINER” FOR RETAIL INVESTORS, AND THE BIG BANKS

Keith Schaefer

December 8, 2022

Solar stocks have the potential be No-Brainer investments. In Canada, provincial governments are giving them incredible tax breaks so they start to spit out Free Cash Flow very early in their 20-25 year project life.

And that’s just to mostly—but not all the way—catch up to how many big tax breaks the US is giving them.

There is a HUGE political will for solar to succeed, so you have to make them No-Brainers. Both Canada and the US have just increased tax credits and accelerated depreciation to get more solar projects built.

My job is to go find some good management teams in junior public companies who know how to access this non-dilutive capital and make their shareholders very very happy!!

Of course, increasing solar power capacity is good for the environment/climate change etc. In fact, the only bad part—and it’s not really bad—is that the banks get to win yet again. The (much) smaller solar developers win too, but as I’ll explain, the banks really make out here. (I just like The Little Guy to win a lot, you know?)

Before I get into all this, understand—solar can be profitable without tax rebates. But tax rebates take solar from ‘that’s an okay return’ to ‘this is a no-brainer’!

Which makes sense, I guess. If you want to drive investment into renewables, if you want exponential growth, you want a no-brainer.

In the most un-technical of terms, this is what the government has done.

IT’S ALL ABOUT FAST PAYBACK
FOR THE BANKS AND SOLAR DEVELOPER

I am going to keep this simple. There are two main contributors to tax breaks for solar projects in the United States and Canada:

Investment Tax Credit
Accelerated Depreciation

The intent of both is straight-forward: Recover the costs of the project, and do it FAST.

If you recall from my prior post, the #1 thing to know about solar is how big the capital costs are.

Paying back capital is what limits free cash and free cash is what determines if a project gets built.

The government recognizes this and is here to help. How? By essentially paying for 30-40% of the cost themselves (by not taking taxes).

In the United State the result as much as 40% of the capital cost comes back. In Canada it is a bit less because Canada’s accelerated depreciation is a little more drawn out. But either way it is a big benefit.

#1 REBATE: THE INVESTMENT TAX CREDIT

How does the government do this? For one, with the investment tax credit (ITC).

This credit has been around in one form or another since 2006 in the United States. It was supposed to be tapered off, starting in 2020. No more: the recent Inflation Reduction Act (IRA) entrenched it for the next 10 years, which will give solar (and wind) a long run-way.

The ITC gives a tax rebate equal to 30% of the capital cost of the solar project. For a $300 million project, the ITC allows the owner to deduct $90 million of it.

I was surprised to learn that until this year, Canada did not have an ITC of their own. But now that has changed. This fall Canada met the ITC with their own Clean Technology Investment Tax Credit. Like the ITC, the credit is for 30% of capital put towards renewable energy generation and storage.

Obviously, a $90 million rebate on a $300 million project is a big deal. But it is made much more of a big deal by the way the government lets you use it.

ITC TRANSFER-ABILITY

Let’s start with the basic premise that a tax rebate is worth more the faster you can use it.

If you are a solar company, you may not have a lot of taxes to offset. It may take you 5 years to use $90 million of tax rebate (in other words have $90 million of profits to offset). Maybe more.

Enter the transferability of the ITC. With it, comes the invention of solar tax equity financing.

Solar tax equity is matching a solar project with an equity investor who has a tax liability they can offset right now.

The structure usually looks something like this:

Source: Woodlawn Associates

You have a solar developer, a tax equity partner, and usually some other financing partner that lends the rest of the money (they aren’t very important for us right now).

Together these parties form a “ProjectCo”. The ProjectCo is where the solar project lies.

The whole reason for the structure is to let the tax equity partner benefit from the taxes. While you, the solar developer, still own the project.

How does it work? The ProjectCo is structured to let the tax equity partner take 99% tax ownership for the first year, the year when the tax credit is realized.

Every structure is different, but they usually look something like the table below, which shows the economic interest of the tax equity partner over time.

Source: Woodlawn Associates

For the moment, focus on the ITC row. The tax equity partner gets 99% ITC ownership for tax purposes in the first year. In other words, that entire $90 million rebate is their write-off.

What do you get as solar developer? The tax equity partner funds some of your project.

For our $300 million solar project, the tax equity partner may finance $85 million (give or take) in return for the tax credit of $90 million.

Not bad. But that is just part of it. The tax equity partner will likely finance even more. I will get to that shortly.

But first, who is this tax equity partner?

THE BIG WINNERS? THE BANKS (OF COURSE)

Well, the banks aren’t the only big winners here (the solar developer wins too, as does the environment). But it never hurts the ole page views to make the banks look like the bad guys.

The most common tax equity partners are the banks. In the United States the 3 biggest partners in tax equity are Bank of America (BAC – NYSE), JP Morgan (JPM – NYSE) and Wells Fargo (WFC – NYSE).

It makes sense. Banks virtually always make money. They have lots of taxes to pay. They are happy to share a ~10% return. They have the back-office to handle complicated structures and the capital to make large short-term loans.

The takeaway here is that this is all done to realize the tax credit as fast as possible. Because the faster it is realized, the more money it is worth upfront to the developer.

#2 REBATE: UPFRONT DEPRECIATION

The second tax rebate is accelerated depreciation. Companies in the United States can depreciate 85% of a solar project in the first year of operation (Canada has something similar, but the depreciation is over two years, not one).

In both the US and Canada, this isn’t a new credit; it was introduced in the Tax Cuts and Jobs Act of 2017 in the US and has been around since 2005 in Canada. The recent IRA in the United States extended the credit to apply to renewable storage and hydrogen projects.

Upfront depreciation can be a big benefit to developers. Like the ITC, it takes advantage of banks as partners.

Back to our $300 million capital solar project. The ITC effectively lowered the price tag by $90 million. Now, because of accelerated depreciation, 85% of the other $210 million can be depreciated in the first year of the project ($178.5 million).

In order to take full advantage of this, the solar developer partners likely deal with that same bank that gave them ITC funding.

Below is a re-post the chart I gave above, showing the structure of the partnership.

Source: Woodlawn Associates

We already talked about the ITC, of which the tax equity partner gets 99%. But you’ll notice that the tax equity partner is also getting 99% of the income from the project in the first year.

Why? So that they can benefit from the accelerated depreciation. (In Canada the structure is all the same except it’s over two years, not one.)

Here is the benefit to the tax equity partner. Let’s say they have a tax rate of 25%. With $178.5 million depreciation they can offset $44.5 million of taxes.

In return for the $44.5 million of tax-offsets, the tax equity partner will give the developer more money for the project.

How much? That will depend on factors like the timing of the financing, when they get to realize the benefits, what the discount rate is, and some other aspects of the deal (usually the tax equity partner gets some cash flow stream as well – Cash from PPA in the table above).

Let’s say you get $35 million from your partner in return for the accelerated depreciation. Add that to the $90 million ITC and you have reduced your $300 million project by $125 million – or 41%.
Not bad!

MAKING IT A NO-BRAINER

If a mildly-profitable $300 million project becomes a $175 million project, obviously that project is no longer just mildly profitable. Some might say, it is a no-brainer.

Which is what the government wants.

Together, these two tax incentives allow solar projects to realize a lot of tax benefits right away. Which effectively reduces the cost of the project by that amount.

What does that mean for us investors?

As long as these credits exist, the mantra will be: “build baby, build”. Companies that are involved in these projects, either developers, financers or manufacturers, will all benefit.

The trick, and our job as investors, will be to find the one’s that will benefit the most.

That is my goal over the next few months. Which companies stand to benefit from these big government subsidies which are now virtually written in stone for the next 10 years?

My hope is that I can find a few big winners. Given the market we’ve had over the past year, we all could use them.

EDITORS NOTE

As an addendum, I would say The Little Guy did win once–in the early 2010s the premier of Ontario (14.5 M population), Dalton McGuinty, set out to transform the Ontario electric grid. (A Canadian premier=US governor).

They pushed out a build of wind and solar power projects. To encourage those projects, they signed 20-year power purchase agreements (PPA) with guaranteed power prices.

Flash forward a few years and it was clear that the government had made a BIG mistake. They had way-overpaid for power (2x the going-rate for wind, 3-4x for solar) to get the plants built. And now Ontario was faced with skyrocketing electricity rates. Many farmers had installed huge moving solar arrays in their yards and made big bank!!

Farmers signed PPAs as high as $420/MWh! Holy cow!

Well, a few years later the Ontario government was skewered. Deals like this saddled the province with high power prices and in large part led to the defeat of then Ontario premier Kathleen Wynne’s Liberal government (she took over from McGuinty).

In 2020 the provincial (now a Conservative premier, Doug Ford) government bit the bullet and said the government would pay for the high rates, rather than pushing those rates down on rate payers (which, given that rate payers are generally tax payers, could be taken as – po-tat-o/po-tato – but well, politics…).

Since then, governments have learned their lesson. Not that they should not subsidize renewables. But that they need to more discreet about it. Government is much better today at making renewable subsidies less painful.

Higher monthly power bills do NOT win votes! Far preferable are write-offs of depreciation and capital that can be transferred to 3^rd parties in return for upfront cash.

That’s where the banks started to win—and win big.

HOW PROFITABLE IS SOLAR–REALLY?

Keith Schaefer

December 3, 2022

We all know that solar is a big deal. It is a big industry and it’s going to get bigger.

Solar will see huge growth for the next 30+ years. It is close to inevitable.

Source: Next Era Energy Investor Presentation

The percentage of the electric grid produced by wind and solar will go from 13% to well over 50% in the next 15 years. By 2050 we could be talking 70%+.

There is big growth coming so there has to be opportunities. Finding the next Enphase (ENPH – NASDAQ) could be a life-changing event (it went from $1 – $330 in 4 years!).

But here’s the thing. Whenever I start looking at the public solar companies my eyes glaze over. I have to look at slides like this:

Source: Innergex Renewables Investor Presentation

Big-time revenue growth. Growing EBITDA with massive margins. Growing dividends. But negative earnings and – much of the time – negative free cash flow.

It is a tough business to wrap your head around. Are these companies profitable or not?

WHAT EXACTLY IS PROFITABILITY?

Solar is generally profitable. Especially with some of the huge government subsidies that are available (such as the investment tax credit in the United States – a credit that offsets about 1/3 to ½ of the upfront capital expenditures of a project!!!).

But! But, but, but. That wedge of profitability is not as big as it looks. It comes with a lot of assumptions. And those assumptions make solar ripe for being distorted – to make something unprofitable look profitable.

I have invested in oil and gas producers for 20+ years. I have watched the cycles ebb and flow. I know (almost) every accounting trick in the oil producer book.

While generating solar is a totally different business than drilling for oil, they are surprisingly similar in a couple ways.

What I will say is this: Just about all the accounting that make oil tricky are in solar as well – AND they are even more severe.

4 BIG POINTS ABOUT SOLAR

The nature of a solar project can be dumbed down to 4 elements:

Very high upfront cost
Low operating costs,
A long payout of consistent cash flows
Tax rebates that change the picture completely

A solar project is not that much different than an oil well.   You build it (which costs a lot of money). You operate it (which costs a little money). And every year you operate it, it generates some cash.

But oil wells have three differences. Each difference makes oil well economics more transparent than solar (I can’t believe I am talking about the relative transparency of oil accounting!).

First, an oil well takes less capex; they cost less. That may seem surprising because oil is a very capital-intensive business.

But solar requires A LOT of capital.   A 200 MW solar project may cost $300 million to build. That same project may generate only $20 million to $25 million of revenue a year.

Second, annual operating costs for solar are very small. That same $300 million project may require total annual operating expenses of $7 million.   That means solar can look very profitable for a given year – 80%+ gross margins and 70% operating margins.

Third is payback. The payback of an oil well is weighted to the front end because oil wells have a steep decline in production.

This is helpful for an investor because you see the cash come in quickly. It gives some assurance that its not all smoke and mirrors.

For solar, the payback is not as fast. Solar cash flows are generally flat across the length of the asset.

A solar company signs a power purchase agreement (PPA) with a utility or 3rd party off-take. It could be for a flat rate or market rate. It is for the same amount of electricity every year.

The “gives and takes” on revenue are how much the sun shines, how the solar panels efficiency declines over time, and how power prices change. These all have an impact, but not a big impact.

Finally, taxes.   Oh my stars, taxes and solar. This is, quite honestly, a whole other article.

The short stack is this: Solar benefits A LOT from tax incentives. Tax incentives can eliminate 30% to 40% of capex off the project completely. For projects as capital intensive as solar is, that is a HUGE win.

Tax incentives are the difference between a solar project being a loss and making a double-digit return.

BE CAREFUL!

The only accurate way to evaluate a solar project is to do a discounted cash flow analysis. Figure out the rate of return (the IRR) over the life of the project. That means coming up with a spreadsheet that looks something like this:

Source: My Own Blood, Sweat and Tears

This is not easy. It is painful. But it’s the only way.

And it is even harder for a public solar company.

Why? Because public solar companies don’t just operate one project.

For a single solar project if you do the work and come up with a spreadsheet like the one above you can figure out what that project is worth. You can see what the cash flows have been, what the initial debt was and make sure the debt is being paid back inline with the project life. You can tweak numbers to understand the assumptions. You can’t hide anything.

But because public solar companies are

A. operating multiple projects at various stages of life,
B. aren’t disclosing project level data and
C. are growing, so debt levels are naturally increasing –

…well…you must wade into muddy waters.

My takeaway for solar, as someone who has invested in oil producers, is this: be very careful before investing “for the long run”.

For a trade, considerations about long-run economics don’t matter because the market doesn’t care until it cares. But for the long run, if the assumptions don’t align with reality, eventually that will come out.

There are lots of details that play into that. I tried to give an overview of the main ones in my “4 Big Points”.

I would like to delve into each of these 4 a bit more in an example in another post. You really need an example to see how the numbers work.

But for now, I leave you with this. As I reviewed solar projects in preparation for writing this post, I couldn’t help but be reminded of shale in 2010s.

Companies focused on operating cash flow and EBITDA because those numbers didn’t reflect the full-cycle costs
Half-cycle costs that look marvelous
Large capital expenditures that often exceed operating cash flow

It took 10 years for the truth high capex, high decline wells to come out.

Of course, solar is different in important ways. The biggest being that–the government has solar’s back. They are intent on making sure solar is profitable.

But it is hard to ignore the similarities. Half cycle on solar projects looks great. Companies spew large operating cash flows, and most capex is going toward growth. It looks like a cash generation machine.

Therefore, you see nice dividends for most established solar companies.

But BE CAREFUL. You don’t know the profitability of any given project until you actually build the spreadsheet and work it out from start to finish. And for most public investments, that is simply impossible.

Are the companies drawing on true free cash flow? Or are they just pulling out equity to pay the dividends and levering up (in other words, not paying back the project debt inline with the real depreciation of the project).

Growth is a REALLY good way of making it difficult to figure out what is really going on. That is why some of the biggest scams in the market tend to be growth-by-acquisition companies.

If you are growing fast enough, it can be very hard for the outsider to figure out whether the past investments actually paid off or not.

This is even more the case when the growth is capex-heavy growth and even more-more the case when the payout takes place over a long period of time.

Solar checks ALL those boxes. It doesn’t mean you stay away from it – as I said it is often profitable, especially given the subsidies. But it does mean you need to look at it with a skeptical eye.

THE MOST IMPORTANT LITHIUM TECH EVER IS ABOUT TO GET DISCOVERED BUT BY WHOM?

Keith Schaefer

November 10, 2022

There is a huge catalyst in the lucrative lithium market right now. It’s something that the entire global industry—and the investors behind it—are watching and waiting to happen.

Somebody, somewhere, sometime, is going to perfect DLE—Direct Lithium Extraction from underground brines.

Below, I have one of the world experts on DLE and lithium brine processing, Dr. Andy Robinson President and COO of Standard Lithium (SLI-NYSE/TSX), explain what some of the challenges have been for them to get as far as they are along this road.

Investors thought that Standard would quickly discover a DLE solution (pardon the pun), and the stock ran from 80 cents to $15 in the last two years—but after running their pilot plant for two years they are not yet commercial.

From all their research into this, they have seen the lows—two high profile short reports earlier in 2022 (because of this DLE delay)—and the highs; a US$100 million investment from the Koch brothers. They have raised over $200 million total.

DLE is a process that will dramatically shorten the time (and hopefully the cost) to bring up trillions of litres of brine to surface, run it through a plant to parse/strip out the lithium and send the brine back down to where it came from.

Because lithium prices are so high and so profitable—up 700% to US$80,000 per tonne sometimes in the spot market now—there are dozens of lithium exploration plays listed in Canada and Australia now.

Many of these penny stocks have properties in what’s called The Golden Triangle, high up in the Andes Mountain Range on the Chile/Argentina border.

Producers up there build huge evaporation ponds, which use a lot of water, and let the sun do its magic for free for 20 months, evaporating away the water and leaving a high-grade lithium concentrate to then be processed.

But society no longer wants to wait 20 months for lithium. It wants A LOT MORE lithium right NOW. EV sales are booming around the world. AND… the industry is under huge government pressure in Chile and from environmentalists to do things differently.

A working DLE will almost certainly have huge and immediate impact on the lithium market. I think there’s a good chance the Market will start to price in a large increase in supply.

Will a working DLE become best practice across the industry (this is what happens with drilling and fracking technology in oil and gas, for example) or will it be secretly guarded by anyone who develops it?

Short answer: nobody knows. For now, the Street is discounting DLE in junior valuations—they are not believers yet. To analysts, DLE is being treated like cold fusion—a dream.

For the long answer on the real and imagined challenges for DLE becoming a reality, I interviewed Dr. Robinson. His team has spent the most time and money amongst the juniors so far on DLE, and he was willing to share what they’ve learned to date:

Keith: Andy, you’ve had a pilot DLE plant for two years and raised $200 million. You have a huge body of trial and error to learn from; more than anyone else in lithium. Can you walk us through where you’re at now in commercializing your DLE process, and what you would say are…The Big Learnings?

Robinson: OK that’s a big question.

So, we’ve been running the DLE plant for a couple of years now at the site, getting data, figuring out how to design, but almost more importantly how to operate one of these plants at an operating facility.

We’ve got a team of 30 people in Arkansas right now, running that plant, day and night, 24/7, 365 days a year, and we’ve been doing that since May, 2020. We’re getting the data, figuring out how to build, design, run, and operate one of these DLE plants at an operating chemical facility.

Keith: That pilot plant to extract lithium is on one of the big Lanxess plants, down in Arkansas. Lanxess has three big chemical plants.

Robinson: Right. Now, one thing I’m pretty sure most people don’t appreciate is that–the DLE part is actually that everyone thinks is the magic beans to get lithium out of the brine, that that is the big secret, and that’s the thing to unlock everything.

That’s actually one of the easiest parts to solve.

So those loads of technologies that you can use to get greater than 90% of the lithium out of the brine, that’s actually quite straightforward, okay? There are lithium extraction technologies everywhere.

The key is knitting that into a complete flow sheet. And this is where it gets, you start to just lose the average investor because as soon as you start to talk about process chemistry, people’s eyes glaze over and they don’t want to know how complicated it is, no one wants to know that.

The practical reality is complicated.

You need to bring this giant brine stream into a plant to then have a relatively small stream of very high purity solid product coming out of the other end, which is what we are doing, right?

We’re taking this giant brine flow and we’ve got this very high, almost pharmaceutical purity product coming out of the other end, right? To do that you’ve got 6, 7, 8 separate process steps, basically. And they all have to knit together, they all have to talk to each other. The recycle loops, a flow here, a waste stream here that has to go back here, this has to be able to handle that waste stream, it all has to knit together and each process talk to one another and work on a continuous basis.

It has to happen every single second of every day. The same thing has to happen all of the time. And that’s complicated to figure that stuff out. And we’ve been able to do it because we have access to an actual operating brine processing facility, where we could figure that stuff out in real time. And that’s why we we’re so far ahead of our competitors.

Keith: Ah, so the DLE itself is simple, but getting the right set up for the brine to get DLE’d, that’s the hard part. Is that right?

Robinson: Kind of, sure, nothing is simple about this, but even then, you have to make sure all that happens 365 days of the year, 24 hours a day, to take a natural brine stream and do the necessary work to get it ready for the sorbent to do the lithium removal.

You have to figure out, pick and test the pieces of equipment and have the other right conditions to run a continuous plant.

Keith: What if anything did you have to invent, like, from scratch?

Robinson: Where we can use a commercially available technology, we have taken that action i.e. We have tried to invent as little as possible in our flow sheets. And we’ve tried some of that.

But the best success is where we’ve been able to take a commercially available solution and adapt and adopt that for use in our flow sheet. That helps a lot for where we are right now, which is looking to scale and build the first commercial plant because we can just point to it and say, “Look, we’re going to use that thing and we’re just going to use more of them basically. We don’t have to reinvent anything there.”

Keith: Does that mean barrier to entry is low to create your own DLE technology?

Robinson. No, because it’s only in operating a plant continuously where you learn so much.

Operators come in, they turn something on, they do some chemistry and then you go, “Oh yeah, it’s working great.” Take down some data and you go, “Yeah, everything’s perfect here. It’s all working well.”

Compare that to running a plant day in day out, every hour of the day, having operators adjusting parameters at three o’clock in the morning when the plant’s still running and making a plant work under those conditions, that has been the biggest learning.

Look, there is industry standard equipment that you can use to do this thing. And whilst that’s true, the practical reality—and what we’ve learned is—that getting the right industry standard equipment and learning how to operate it, is really, really important because when you don’t, things foul up, they clog, you have to shut the plant down, you have to use a whole lot of reagents to clean stuff up.

You talk about low barrier to entry, but in the lithium developer world, I think the market has been a little credulous about how easy it is to go from running a pilot plan in a SEA-CAN somewhere separate from the project for a few weeks or a month.

Going from that to actually running and operating a real continuous process is quite complicated, has a lot of practical learnings that you just have to learn. So that’s really been the biggest understanding for us.

Keith: OK, tell us where you’re at in your DLE process. When will you guys be producing home-grown lithium in the USA?

Robinson: The first commercial project is going to be built on one of the Lanxess facilities in Arkansas, near the town of El Dorado. So, it’s the same facility where we’ve got the demo plant running right now. We don’t have to drill a well or build a pipeline; everything is already there on their site.

We’ve done some pre-feasibility work with an engineering construction company. We then went to a competitive tender process to find the best partner to basically do the engineering design, the bankable feasibility study, and with the conversion mechanism defined in the contracts to become the EPC contractor. And, we went through that competitive process in the late spring, early summer.

By the middle of next year we see ourselves moving towards construction; basically second half of 2023.
We think we’re probably the only project in North America that can point to that really quite short period between where we are right now, finishing up all the design studies, the engineering, et cetera, all of that to moving towards construction by the end of 2023.

And the only way we can say that Keith, is we have no permit issues on our critical path, right? We don’t have any federal permits. So we are not on public land, like in the desert in western US. We’re not in California.

Keith: You have all your permits to go into production?

Robinson: We have some minor permits that we’ll need to get from the state, but no federal permits. There’s a minor air emission permit we’ll need to get; it’s about a three month permit process. We’ve got a surface water discharge permit. Again, that’s just a short permitting window. So, we don’t foresee anything that we have to get to allow construction to commence, which is on the critical path.

Keith: How much lithium are you going to produce?

Robinson: Remember, this is the first one, so it’s not a huge project. It’s going to be a little under 6,000 tons per annum of battery quality lithium carbonate for the first commercial project. So it’s not a globally significant project in terms of its scale.

However, it allows us to be fiscally responsible moving into the first project, given that there’s risk. It’s the first one of its kind, and like you say The Street is still not convinced about DLE, but it will be the first one commercially constructed that we can point to, and we’ll get revenue out of it.

Keith: You say this is the first one. How many DLE plants are you going to do? How many can you do?

Robinson: Well, let me put it this way: We’re in the what’s called The Smackover Formation. It is a very large subsurface brine resource, touching central Texas all the way to Florida. This is the best brine resource in North America.

There is nothing like it anywhere else on the planet based on every piece of research that we’ve looked at. The Smackover Formation is globally significant as a lithium resource for the whole EV transition story.

Because the resource is so consistent (and we’re starting at the Lanxess plant at 220 to 240 PPM lithium in the brine, which is good), the brine is the same, the depths of the brine is the same, how we get it out the ground is the same, how we put it back in the ground is the same, and the plant that we need to build to process it is the same.

So, the first commercial Lanxess facility will be proof that our DLE works, and then we can replicate and scale across our asset resource base in the Smackover fairway.

You know we have our South West project, which is a greenfield area of leases in Southwest Arkansas where that’s going to be a 30,000 ton per annum lithium hydroxide project.

I think we’ve got a very compelling story with all that. I think we’ve got great partners to help us do that.

Keith: But you don’t have the entire Smackover staked.

Robinson: No, for sure, but it’s difficult to build up a big land position. You have got to spend a lot of money and it takes a lot of time to do it. And at the same time there’s no point having a big land position unless you’ve got the technology that you know is going to create the value from that land position.

And we’ve been lucky again that we are the only group that’s been able to deal with a real brine coming continuously to the ground, to the surface day in day out and to be able to figure out a process that works with that actual brine, and we can then translate that across the region.

That’s not to say that there won’t be others, I’m sure there will Keith, but I think we feel we’re ahead of the pack. We’ve got a good competitive advantage, we have great partners, we have large partners who want to see this succeed.

Keith: Big partners like Lanxess and Koch Industries.

Robinson: Yes. Koch has put money into a whole bunch of other EV and battery metals related businesses as well. So, they’ve bet very heavily on this particular energy transition story. So yeah, they’re being very, very helpful, very helpful.

So, you need big partners who help push you along because otherwise it’s just hubris, right? You’ve got small developers saying oh yeah, we’re going to do this, that and the other. And it’s not real. They’re just telling fantasy stories about what you’d love to do, but you need big partners who will help you move along, give you the support, give you options, have ancillary businesses that you can lean on, et cetera. That’s actually how you get stuff built.

Keith: Last question Andy—are you—like Standard Lithium—ever going to announce that your DLE technology is commercial or are you going to keep it quiet?

Robinson: Yeah, and I think we’re contemplating doing an investor day, Keith.

Keith: To say what?

Robinson: You’ll find out the same as everyone else Keith.
Keith: Ok. Anything else you want to share?

Robinson: I know that we’ve been very quiet lately Keith. We’ve been very focused on execution to address the short naysayers who I think they’ve knocked the wind out our sails in terms of engaging with the street and the market.

That was a very unpleasant experience. Completely unfounded, just crazy. But those things happen. I think we’ve, as a result we’ve been very conservative about communicating, telling the story, we tended to keep our powder dry a little bit.

I think we are now at the point moving into execution, real execution that we know we can expect to engage a bit more with market and with shareholders on a public communication level.

Keith: OK. Andy, thank you for your time. Very informative and look forward to more communication.

Robinson: Thanks for your interest Keith.

DLE—Direct Lithium Extraction—will be one of the biggest developments in helping the global EV industry catch up to surging demand. It will shorten the time frame and likely lower the cost of lithium production. It’s a big deal—for the sector and its investors.

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The Problem Is – Markets Don’t Always
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