Folks, a lot of the small banks in the US are–for now anyway—technically insolvent. 

That sounds scary.  And it could be.  But only maybe.  Because on the other hand the banks aren’t actually insolvent. Not in real life.  Most of them, any ways.  But The Street isn’t exactly sure which ones are and which ones are not.

That’s why the US banking index—symbol KRE-NYSE—has such a horrible chart.

 
Most banks are still going about their business – making loans, taking deposits.  In fact, most banks are still making a lot of money, just as their first quarter earnings showed.

As long as the banks collect on their loans, as long as there is no devastating recession, and maybe most important: as long as the banks can continue to hold their assets through to maturity and not be forced to sell, they will be just fine.

In other words, everything may work out.

Unless it doesn’t. 
 

BANKING MAKE BELIEVE

 

How can everything either be just fine or totally off the rails?  Talk about black and white!

Welcome to the world of banking.  It’s a true confidence game.

The difference between good and awful comes down to mark-to-market.

You might remember mark-to-market from its top billing in the Great Financial Crisis.  Back then it was the mark-to-market of mortgage loans that threatened the system.  Today it is…well, actually it is still largely the mark-to-market of mortgage loans.  But this time there are also other loans and securities as well.

Mark-to-market means just what it says: pricing the asset at what the market would pay for it TODAY (or whatever day it is).

We do this every day with our own portfolios.  We open our bank app and are greeted with the value of portfolio is at that minute.   That is mark-to-market.

But banks do not typically mark their assets to market—almost never with their loans and often not with their bonds.

Why?   Because banks have no intention of selling them.  Who cares what it is worth right now. 

It is literally the job of a bank to hold a loan until it comes due (with a few exceptions of course).

Most loans and securities on a banks balance sheet are priced at what they were made at, NOT at what the market would pay for them on any given day.
 

THE BIG, BAD FED

 
There’s really only one scenario where the mark-to-market value matters to a bank–if there is a sudden, massive change in interest rates that occurs over a very short period of time.

Which almost never happens—except last year, when it did!

When the US Federal Reserve raised interest rates it was not the most they have ever done, but it was probably the fastest since the 1970s.   And it was the first time they had raised them this fast from 0%, which had an outsized impact on the price of assets.

Source: St. Louis Fed Economic Data
 

KICKING THE CAN

 

The one thing that is on the side of the banks is time.

Every month that passes their loans and bonds get a little closer to coming due.  When a loan comes due, it will (God willing!) get paid back at par.  The bank that owns it is a little closer to being made whole.

The Fed knows this.  They are trying their best to kick the can down the road.

The Fed has now created a lending window that lets the banks park their underwater securities at par, while they wait for them to come due.

The Fed said that they would take any and all government and quasi-government bonds, stuff like Fannie Mae, Ginnie Mae securities, at par value, so even better.

What that means for the bank is–that they can take their $150 TLT-NYSE equivalent bond, give it to the Fed, and get $200 worth of credit.

It is effectively a way of artificially pumping reserves into banks.  Instead of holding an underwater bond they can hold cash – if they need it.  When you see/hear people talking about the $160 billion at The Fed Window and how it’s money printing–this is what they are talking about.

Is it money printing?  That might be a stretch.   But it certainly is giving the banks a lifeline when they really need one. 

Without this, I can almost guarantee the DOW/S&P charts would look a lot more like KRE than they do now.  Investors are completely reliant on The Fed right now for this.

One could argue that these big board index charts are pricing in almost NO systemic risk.  And to be fair, big banks are not in (near as much) trouble.
 
 

THE SCHWAB SCENARIO…

 

There are plenty of banks that are at the center of this storm but the stock that has held my curiosity the most has been Charles Schwab (SCHW – NASDAQ).

Schwab just seems like such a stalwart.  You’d expect Schwab to run into trouble about as much as you’d expect JP Morgan (JPM – NYSE) to run into trouble. 
Yet trouble it found.

Everybody says Schwab is unfairly sold down because they’re enjoying great account growth, they’re taking share, their earnings are up.

Yet the stock price keeps going down!

Source: Stockcharts.com

Schwab may not be as safe as everyone says.

If you tweak your numbers enough, make some assumptions about the haircut they would have to take on their assets if they absolutely had to sell them TOMORROW, you can imagine a distressed scenario where the company’s earnings would be..A LOT less.

We think of Schwab as a broker but Schwab is also a bank.  And banks need to maintain capital.  Schwab, like all banks has capital but some of that capital is underwater if it is marked-to-market.

Now if something went south and Schwab was in the place of having to sell assets they probably wouldn’t be able to – at least without raising more capital to offset the loss – by selling shares.

If Schwab did that, the dilution would lower EPS. 

Schwab is really the poster-boy for the entire banking system right now.  It is not about whether they are going to make it – Schwab is going to make it – it is more about what the earnings look like on the other side. 

Schwab made $6.6 billion last year, or $3.52 EPS.  With some not-so-heroic assumptions you could spitball $5 billion of forward earnings on a higher share count to get <$2.50 EPS.   Suddenly that $50 share price is 20x earnings and the stock isn’t looking “cheap” anymore.

What can be said for Schwab can be said for much of the system.

 

Two Possible Outcomes

 
In the first, we scoot on through with a version of Extend-and-Ignore.  Eventually the mark-to-market losses get amortized and marked toward maturity.

In the second, events happen that cause “a deleveraging event”. That means banks become forced sellers of assets.  If this happened and the Fed didn’t step in (I think they would), they would all be taking massive losses.

That’s why investors are now SO DEPENDENT ON THE FED.

This whole thing is like watching a kid chase a ball into the street as a car barrels ahead further down the block.  You don’t know how it ends.  

You think the driver of the car is probably going to see the kid, it is probably going to stop in time, or someone else could even jump out in the street and save the day.  In other words, there are a lot of things that could go right.

But there is one outlier scenario where things could go very, very wrong. 

The thing about banks is that the whole system can quickly become reflexive, self-reinforcing.   That can create a downward spiral. And that is the big risk.

There has been a big spike in downside volatility in the last few days. You know, something that anticipates the possibility of big down days.

A lot of this is going to depend on the Fed.  Not to overdo it.  More importantly – to take their foot off if it begins to look like that spiral is about to start.

I REALLY hope that they manage us through this.   If they do, this could be the start of the next bull market


Keith Schaefer

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

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

THE LAG THAT CAN KILL

STRETCHING FOR GROWTH

A BADLY TIMED BANKRUPTCY (NOT THEIR OWN)

FIRE SALE

GAME TIME

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

1. Yes, it is hard to buy copper stocks when they are down big (they were at the time) but…
2. 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

 

CAPSTONE COPPER – THE PROMISE OF STABILITY

TASEKO MINING – A DESTINATION IN SIGHT

COPPER MOUNTAIN MINING – MORE HICCUPS

FIRST QUANTUM – gamblers only

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

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:

1. Investment Tax Credit
2. 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.