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:

1. Very high upfront cost
2. Low operating costs,
3. A long payout of consistent cash flows
4. 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!

 

• 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

Halliburton (HAL – NYSE) released their third quarter results on Tuesday night and boy were they ever bullish on oil field services (OFS).

Right out of the gate CEO Jeff Miller put it bluntly – “our outlook is strong”.  He followed it up by saying why: “oil and gas supply [will] remain tight for the foreseeable future”.

These comments echoed what we heard from Baker Hughes (BKR – NYSE) when they reported last week.

While Baker Hughes admitted that the macro-outlook was “increasingly uncertain” they said they were looking forward to a “multiyear upswing” in upstream oil and gas spending.

The irony is that what is driving the outlook is the lackluster response of operators.  There is no drilling boom.  Quite the opposite.

It is financial discipline that is setting the stage for a much longer – and potentially more profitable – upcycle.

Baker Hughes expects prices to remain strong even if there is a recession because we just aren’t seeing the usual “drill-baby-drill” response we have seen in the past.  Halliburton pointed to “multiple years of underinvestment” supporting their long-term thesis.

While North America is strong, it is international operations that are accelerating.   South America, West Africa and the Middle East are leading the way.
 
That’s probably why Schlumberger (SLB-NYSE) is up 50% in a month, and hitting 4 year highs.  This OFS major is very well distributed around the globe.

In the US, The S&P Oil & Gas Equipment & Services Select Industry Index (XES-NYSE) has also had a run recently, within 8% of its year high (which is also its 3 yr high).

In Canada, analysts are talking about a 30% increase in OFS fees to producers this year, with another 10% next year.

So it looks like an increase in revenue and EBITDA for the rest of this year and next year is in the bag—much of it at the expense of oil and gas producers, their customers.

Like the producers, OFS companies have gone crazy trying to grow, with new capex for yellow iron remaining low.  The most I see in costs is actually a “greening” of OFS equipment—moving away from diesel to natgas fueled rigs and machinery.

PRODUCER CASH FLOW COULD FLATLINE OR DROP
EVEN IF OIL GOES HIGHER

 
If you have been reading my blog for even a couple years (I started blogging in 2009) you will remember one of my sayings—there is no such thing as an American oil stock.  They are almost all natgas producers with a 40% + wighting in oil.  The Permian starts off oily, but gets gassy quickly.  Only the Bakken up in North Dakota—where the geology is shallower—do you see true oil stocks.

That means producers’ cash flows are heavily weighted towards natgas—which is looking weak right now, and will likely get weaker.

Natural gas pricing has dropped from levels that quite honestly, I never thought we’d see.  Some say a correction was due.  I say the industry is catching up.  It always catches up.

So there’s a good chance that even if oil prices rise a bit–highly likely–overall cash flows for NA producers might not benefit from higher cash flows if natgas falls even more.

And that’s VERY possible.  The big headline this week was that spot EU natural gas prices went negative.  Less of a headline was that Permian natural gas prices (the big Texas oil play that produces many billions of cubic feet of associated natural gas) also went negative.

Of course, that has everything to do with pipeline constraints.  But it does demonstrate that producers of natural gas are doing what they do best – producing more of it.

In the Marcellus (northeast USA)  and Haynesville (Oklahoma/Louisiana) rigs are up 50%.  In the Permian, it’s up 30%.  We are seeing higher output as a result – up 4.5 bcf/d year-over-year.

Source: Bank of America Global Research

Production of natural gas is sneaking up.  I’ve been telling subscribers for weeks that prices will be coming down as the US is increasing natgas production steadily in 2022—often by 500 million – 700 million cubic feet of natgas per day per month. Inventories of natural gas are sneaking back up towards the 5-year average. 

Prices are going the other way.

Source: Bank of America Global Research

Natural gas prices are still above $5 which means there is still incentive to drill.  But it won’t take much (a warm winter anyone?) to send them down further. 

At some point that could mean a much lower natgas rig count in the US—now at 157.  My research suggests it only taks 110 rigs to keep US production flat, so that’s 47 rigs that could drop over time.  But while the front month natgas price is down a lot, the pricing two years out on the futures curve has not moved near as much.

That’s not a huge predictor of price, but I think that’s what producers will be looking at before seriously putting down rigs. (That will take pricing even lower of course!)

WHAT IF OIL JUST GETS BORING?

 
While natural gas has a few headwinds, oil looks better.  Trying to figure out what oil prices should be (meaning absent intervention) is impossible.  What with

1. the OPEC+ cuts,
2. SPR releases in the USA
3. Chinese lockdowns,
4. and the huge shortages of refined products (especially diesel) in the western world

that are pushing up prices further up the chain – it makes my head hurt.

The simplest answer – the one no one ever says – is maybe oil prices just don’t do much of anything at all?

We’re always looking for a big run up or a huge collapse.  It would confound everyone if oil just sat this one out, in a relatively tight range, and bored all the traders to sleep.

If it does that, the OFS providers will take it as a win.  Those with international exposure (to Brent and Middle East pricing), will do well.

The operators with the biggest exposure are the big guys.  Baker Hughes, Halliburton, Schlumberger (SLB – NYSE).

Going big is usually out of my wheelhouse.  But international small cap OFS is a tough find these days.

The problem with the big boys is that they aren’t exactly cheap.

Source: Sentieo Data

There may be upside to these estimates, but paying some 20x earnings and 10x EBITDA for OFS doesn’t strike me as a bargain.
 

GO TO SEA

 
One comment that caught me off guard came from Baker Hughes.   They made special note of the growth in offshore activity – saying it is “noticeably strengthening”.

Baker Hughes forecasts “several years of growth” in their international and offshore business.  Quite the statements given that offshore has been left for dead by many.

Those comments led me to do a shallow dive into Transocean (RIG – NASDAQ).
I fully admit I had written off companies like Transocean just like everyone else.

Yet Transocean did $245 million of EBITDA last quarter   On their last call, which was Q2 back in August, Transocean said they saw a “rapid tightening of the offshore market for high capability drilling assets unfolding across multiple regions”.

Yet the stock is barely back to where it was at the end of August and still well off of levels from March to May.

Source: Stockwatch.com

Of course, everyone watching Transocean is worried about the debt.  For good reason.  One year default swaps on Transocean imply about a 1 in 5 chance they default.

Transocean has a lot of debt–$7.2 billion of it.  While they have $2.5 billion of liquidity today, they expect that liquidity to decline to $1.1 billion by December 2023.

Lots to worry about.  But its hard to ignore what they are saying about the business.  A “very constructive outlook”, expecting “further tightening”, and “increasingly healthy day rates” – again this was back in August.  Now Baker Hughes is telling us that the outlook has only gotten better.
 

WHAT COULD HAVE BEEN

 
What I would really like is a straightforward bet on international OFS activity.  Fortunately, I know just the name!  Unfortunately, there is a catch.

I owned National Energy Services Reunited (NESR – NASDAQ) as a portfolio company from mid-2020 until the summer of 2021.

This is not a household name, but also not a micro-cap.  You may never had heard of NESR.  But it is one of the largest OFS companies in the Middle East and Asia Pacific region.

NESR is the only publicly traded oilfield service pure play in the region.

You could argue a focus on the Middle East, what with OPEC+ cuts to production, does not play in their favor. 

But NESR might make up for it on volume.  In September they announced that they had secured their first multiyear directional drilling contract with Saudi Aramco.  This after they were awarded a $300 million fracturing contract from Aramco in April.

NESR seems in many ways like the ideal play.  

The problem, for the moment, is that they have no financials.

In February NESR announced they would have to restate their 2021 financials due to issues with accounts payable and accrued liability accounting.

They’ve quantified the restatement (at most $90 million) and at the time of the restatement announcement they guided to decent YE results.  But still, its tough to make a call here until the restatement is out of the way.

I’ve always liked the NESR business, and as I said I owned them in the portfolio last year, but I never jump into a stock where I can’t see the numbers.

I am on the lookout for news that the accounting issues are behind them.
 
In North America, there are 6-10 drillers and frackers in both Canada and the US.  Like the producers, they were priced for bankruptcy and then had GREAT stock runs in 2021. 

Energy is slowly getting more respect from generalist funds due to low valuation and return of capital (Share buybacks and dividends). Now energy charts suggest they could run again–but multi-baggers are gone, just like with the producers now. 

I’m happy with 50% in a year.  But unless the multiples get up off the mat–most are trading 2-3.5x cash flow–they will need their multiple to almost double as well.  With lower natgas potentially keeping producer cash flows in check, I think we’re at that part of the energy cycle where if it happens anywhere, it can happen in OFS stocks.

I have a hard time saying this sometimes—but The Big Money in energy is still in renewables.  I mean, oil especially but also gas stocks are (across the board) cash cows right now—like never before in modern energy history—and they’re so CHEAP—like, 2-4x cash flow.  That’s half to one-third the multiple of the last cycle ending in 2014.
 
We should all be buying them hand over fist, right?  But we’re not, or those cash flow multiples would be higher.
 
I have to say–whether it’s lithium or hydrogen vs oil & gas, or energy storage vs transmission lines and pipelines, the Market is screaming at me to focus more on renewables.  Renewables are—yes a bit more risky—but much more highly valued.
 

The poster child for this was this week when energy major BP (British Petroleum; BP-NYSE) paid US$4.1 billion, or 25x EBITDA, for RNG–Renewable Natural Gas–producer Archaea Energy (LFG-NYSE), which also equates to a more than double since it got listed less then two years ago.  They mostly produce gas from landfills.  Archaea got a big premium (think that Continental minority shareholders got almost no premium).

RNG is very costly to produce—the numbers I see suggest a ballpark price of US$15/mcf, but can be as low as US$10/mcf.  Selling prices are (or were, up until natgas recently coming back to $6/mcf in a hurry) roughly $23-$30/mcf—so big profit margins for the producer. 

(But that also makes it tougher to sell to utilities, who obviously want the cheapest natgas they can find—except if it helps their ESG score with the institutional investment community)

LFG operates 50 RNG and landfill sites across the US, producing about 6000 boe/d of volume, with a development pipeline that the company thinks can increase RNG production by 500% by 2030. They’re talking EBITDA growth towards $500 million by 2025 and $1 billion by 2027 from the asset base.  That’s BIG growth, and of course it’s ESG-friendly. 

Nobody is paying 25x EBITDA in oil and gas. To wit:
 
Bank of Montreal rightly pointed out in one of their morning energy notes recently that (everything in brackets I’ve added):
 
“from a North American upstream E&P perspective, notwithstanding the macro & commodity price volatility over the last 4 months, we have seen

1. the definitive take-private of Continental (Resources, CLR-NYSE, for a single digit premium),
2. Diamondback’s (FANG-NYSE) US$1.6 bn acquisition last week of (privately held) FireBird Energy, (3x EBITDA, and the Hart Energy story said that wasn’t cheap as some deals recently)
3. Warren Buffett increase his Occidental (OXY-NYSE) stake to nearly US$13 bn or ~21% of the company (not including his US$10 bn preferred shares & US$5 bn of warrants),
4. EQT’s US$5.2 bn acquisition of Tug Hill, (2.7x EBITDA and 27% FCF—Free CashFlow—yield—that’s CRAZY CHEAP)
5. multiple billion dollar bolt-on acquisitions from Devon, (they bought Validas in August—35K boe/d at 70% oil for 2.0x EBITDA)
6. while in western Canada we saw private-co Hammerhead’s ~$1.4 bn SPAC transaction last week
7. Tamarack’s (TVE-TSX)recent acquisition of Deltastream for ~$1.4 bn, (with $500 M EBITDA this is 2.8x EBITDA)
8. private-co Strathcona’s ~$2.3 bn cash acquisition of Serifina,
9. Whitecap’s (WCP-TSX) ~$1.7 bn cash acquisition of XTO Canada (3.3x cash flow with 20% FCF yield)
10. Cenovus’ (CVE-NYSE/TSX) ~$1.0 bn cash acquisition for 50% of the Sunrise oil sands project; (BMO said just under 2x cash flow)”

Add to that—renewable stocks have been destroyed in the last year.  Oil stocks are holding in really well after rising 5-10x in 2021; but most of them are now flat since March.  Oil prices are doing OK—but natgas prices are coming to earth as I write, down to $6.50/mcf in the US from $10 earlier this year.  And as I have pointed out a couple times on Twitter recently, Canadian natgas prices have been ZERO several times this year already, and small hubs are even NEGATIVE some days.
 
So if you have a bit of risk tolerance, I see The Big Wins in energy in the renewable space right now.  They get way higher multiples—every additional Gigajoule or barrel of oil equivalent of energy they add gets rewarded A LOT MORE by the Street.
 
And after looking around for months, I think I have found one.  I’m almost done my research—I’ve talked to management several times.  They have  millions in the bank. They have powerful friends in high places.  I’m going to be telling you about them very soon.  Stay tuned.

The Consumer Price Index (CPI) came out this morning (Thursday October 13,2022) and it was HOT, HOT, HOT.  In response, markets did exactly what you would have expected: they full-on collapsed – well, for about 90 minutes anyway.

The CPI print came in at 8.2%.  Consensus had expected 8.1%.   The higher number just meant more of the same – more Central Bank tightening for longer and more chance of recession.

The S&P tumbled all the way down to 3,500.  It even tapped out below 3,500 briefly in pre-market.  It looked like we were in for another rout.

Nope.

Instead, we got a half hour of EXTREME weakness and then strength and more strength.  The S&P is now UP 100 points on the day.

What the heck just happened?

Don’t ever forget that the stock market is just a bunch of buyers and sellers.  It is not forecasting the shape of the economy on any given day.  When the buyers outweigh the sellers, the market can go up, regardless of the news.

I believe this rally was foretold in the positioning.

Goldman Sachs published data heading into the CPI number that showed just how much fear there was in the market.

Source: Goldman Sachs

The chart is telling us two things: Gross leverage among hedge funds has been going up and net leverage has been going down.

What does this mean?  It means funds are getting more leveraged but also less long of stocks.

You can see that gross positioning is going up.  That is telling you leverage is going up.  

It is back to where it has peaked out a few times this year.  It is close to the February 2021 highs.

But net exposure is going down.  This is NOT AT ALL like February 2021.  At that time net positioning was high.  Meaning funds were very long.   Now it’s the opposite.

Funds are leveraged up and short, or at least a lot more short then they have been in a very long time.

In other words, funds are bearish (not without good reason).  But they haven’t been expressing that bearishness by selling out of their long positions.  They’ve been adding to their shorts.

Doing this makes it much more likely that if the market goes the wrong way they will need to respond.  

If a hedge fund is just bearish and is therefore decreasing their gross exposure (ie reducing their longs) they wouldn’t panic when the market goes against them.  But if they are levered up with both long and shorts, they have to start selling to make sure things don’t get out of hand.

That is what is happening today.  It’s a short squeeze.

How long will it continue?  The million dollar question and if anyone says they know, don’t believe them.  

What I will say is that this scenario has come up twice before this year.  Once in April, once in June.  Those two other peaks you see on the gross exposure line.

Both led to rallies that lasted 5-10 days. The June rally petered out but got a second wind in mid-July when markets began to take the pivot to heart.

This time around?  Well, the headwinds are bigger now.  

It is getting harder to ignore the bad economic data. It is getting harder to defy all the hawkish FedTalk.  It is hard to imagine a pivot.

But you can try to find positives and a rally will make everyone look hard for some reason to pin it on.

It may be in the minority, but some are seeing positives in today’s inflation numbers.

Source: Twitter

This is not without merit.  The reality is that inflation IS coming down. You can see it in nearly all the commodities, in inventory data, in the shipping indexes, and in leading indicators of rents. 

Source: Twitter

At 930am EST it was very easy to spin today’s data into a big doomsday narrative that takes the market down 3%.   That is exactly what we had everyone talking about – until 10am.

But it not all that hard spin it the other way, at least for a few days.

I wrote a month ago that “when inflation starts to fall the market is going to start looking at what the world post-inflation looks like.”

Source: Bloomberg

Inflation is not quite falling yet.  But its not rising all that much.  And there are bunch of forward-looking measures that usually precede dis-inflation and they ARE falling.

Does all this make me bullish?  Well, no, not exactly.  Because the reason inflation is topping out is because the economy is not doing very well at all.  Which is not good for stocks.

In the long run that is.  But for a few days?  Sure. 

With the kind of offside positioning that we have right now, inflation topping out is good enough for a short run-up.

For weeks (months?) I have been telling my subscribers that the best thing they can do in this stock market is…nothing.

My own trading has borne that out this year.  I am sitting on 80% cash and 20% losers.  And in the junior markets, I think that makes me look good . All the junior indexes are down 20-30% this year.

Markets are up big this morning after a horrible September, and we could see a big 2-3 week rally  after seeing a little bit of real fear in the markets, with the UK bond scare last week.  But there are still 4 Big Problems out there that are having a global impact:

1. rising interest rates
2. rising US dollar (better today though!)
3. The Fed getting more hawkish than every publicly
4. data showing a clear slowdown in global economy

But how much worse can The Dow get with oil down to the high $70s/barrel already and Mega-Tech trading at single digit PE ratios?

I certainly don’t know, but there is one trade idea–one that could happen soon—like, by the end of October. Let me set the stage:

For me, the Market has had two likely scenarios lately: 

1. Hold the June Lows–in the Dow, the big US index, and we bounced around in a choppy market for a few months until the US Fed paused on interest rates; then get a (potentially very strong) rebound
2. Break the June Lows—which we have now done.  So now I think we drop 5-10%–taking the S&P to 3300 or so (despite today’s bullish action). 

So far, this has been quite a steep but a somewhat orderly downturn in US equity markets—then came the UK bond scare, caused by hedging out low interest rates with leverage.  This came out of nowhere; no one gave two toots about UK pension funds until a few days ago.

The upshot is that after this week’s scare, now there’s some real fear among senior levels of int’l banks, regulators and finance politicians—because the Market doesn’t know what it doesn’t know—the Unknown Unknown as the late US politician Donald Rumsfeld said many years ago.

All I want to point out here, this first Monday in October, is that investors are starting to see some breaking points in global finance—first the UK bond market, then Credit Suisse.  Both are arguably small and isolated.

But these cracks could create an opportunity for investors. Keep reading.
 

THIS IS NOT YOUR 2010’s FEDERAL RESERVE

 
Rising interest rates and leverage are a bad combination.  And figuring out exactly where they might combine into a toxic mess is really hard to do.

There are a lot of bears out there.  They are predicting a lot of bad things.  Exactly ZERO of them were saying the big risk was in UK pension funds.

The single biggest risk that we have right now is another “credit event”.  And I haven’t the slightest idea where that risk may come from.

A credit event can come from all sorts of backwaters of the financial markets.  The Lehman blow-up was a credit event.   The Greece crisis was a credit event.   Even Covid came within a hair of a credit event.

The problem today is that every credit event that we have had since 2000 led to the Federal Reserve and other Central Banks coming to the rescue in some form.

This time, I’m not so sure that will happen.  No one is sure that will happen.  At least not right away—which is why the market can’t find a footing. 

You see, the psyche of the Federal Reserve today is different than it’s been in 20+ years.

Inflation is a problem.  The #1 mandate of the Central Bank is to control inflation.  It takes precedence over everything else.

The only historical example of successful inflation control is the Paul Volcker Fed.  He “tamed” inflation.

He did it by not backing down.

I was listening to an interview former Fed President Thomas Hoenig a couple of weeks ago.  He made the point clear.  If they want to slay the inflation dragon the Fed can’t back down.  They must let unemployment rise.  They must let loans go bad.

This is a fine, fine line.  It is what makes a credit event so dangerous right now.  In the wake of a credit event, the Fed will be slower to come to the rescue.  It will let stock markets fall further.

At worst, it won’t act until things REALLY go south.  As we know from 2008, you can reach a point where it is truly too late.

I hope this doesn’t happen.  Nothing says it has to happen.  But with rising interest rates and leverage, we’ve got the pot, the soil, the water and the seed for my trade idea.

Investors ARE starting to see signs that The US Fed is getting worried. 

Last week, journalist Charlie Gasparino tweeted out that the Fed is “worried about financial stability”.

Source: Twitter

Often, more important than the news itself is the fact you are hearing that particular story at all.  You don’t hear about a leak like this by accident.  The Fed wants you to know that they know they should be getting worried.
 

SO WHAT SHOULD INVESTORS DO NOW

 
The Big Trend for investors is to—continue to do nothing.  Publicly, The Fed is saying they’re not done yet—only a systemic malfunction in markets would get them to pivot dovish.  So investors don’t want to get in the way of that.

But they are absolutely putting out subtle messages now that say they understand market stability is an issue. 

I don’t think that will mean a pause …BUT…I think it’s possible (plausible??) this could mean we have now seen the end of 0.75% increases in US interest rates every two months.

I think The Fed has to stem the rise in the US dollar more than interest rates. 

Market mayhem WILL keep erupting in the developing world—where many global credit events have started—if the greenback continues to rocket up.  It moved up 15-20% against most currencies in a two week stretch.

THE FED WON’T SAVE THE MARKET
BUT THAT COULD BE GOOD FOR GOLD

I’m not convinced a lower dollar would save US markets.  But I do think GOLD could start A Big Move.

Everybody hates gold.  Gold has been doing what it does so well—break the hearts of believers.  It is mostly an inverse-US dollar play to me, and the window of where it is truly useful in economic disaster is, IMHO, very small.

But

1. it’s there,
2. and nobody owns it,
3. and it’s just enough of an insurance market to just enough people
4. and valuations are low,
5. and it’s a VERY small market that would need very little capital coming into it on a global scale to make it A Big Trade

And I think this theory gets tested very soon—quite possibly by the end of this month.  Realistically, we would need to see another sign or two that the higher dollar and interest rates were causing more problems before this happens—but then again, gold is up today with the Market.

Or maybe the Market starts to price in slightly lower peak rates for Q1 23, or consensus builds that the 0.75% rate increases are done.  History says (look what gold did 2009 – 2011, post GFC) gold could be the big winner in Q4 this year.

There’s so much fear out there in the Market now—but fear, like euphoria, only lasts for awhile.  The Market gives and takes—it’s just hard to figure out how much time each swing will be.
 
I’ve made a lot of money over the last 15 years following Nathan Weiss of Unit Economics, out of Rhode Island.  It’s an independent research firm for a limited number of institutions (and me). Weiss’s ability to use hard data to back up his market thinking is somewhat unique. 
 
Last week he laid out what he sees as a probable scenario for North American markets for the next 15 months.
 
Key to his thinking is understanding how and why The Fed reacts to the economy—and reacts is the key word.  Weiss is a big believer that investors have a bit of a mistaken view of how The Fed and the Market work.
 
He says the Fed prepares itself to be reactive—it is not proactive.  Interest rates were low for a long time so they could raise them when inflation got too hot—like now.  And the Fed will keep rates high as long as they can to have lots of ammunition to lower them when the economy cools off—which he doesn’t expect to happen in a big way until the second half of next year, 2023.
 
So while many investors may cheer The Fed lowering rates late next year and think that will be good for the Market, Weiss believes the opposite—it will be a sign that a potentially long recession is looming.  He put together this historical chart that outlines quite clearly that recessions happen (the grey bars in the chart) as the Fed LOWERS rates:
 

 
 
Of course, The Big Question everyone is asking is—well, when will The Fed stop raising and start lowering rates?
 
Weiss has looked at the history of the ups-and-downs of The Fed on interest rates, and says while there is no specific date in mind (though he has one!!), there is a good range to go by. 
 
He says market history suggests The Fed ‘pauses’ are generally short-lived–since 1990, an average of 10 months from the final hike to the first cut with a range of 4 to 17 months. And again, investors should be careful what they ask for because this pause could ultimately be negative for equities.
 
So when does he think interest rate increases end and The Pause starts?
 
“My best guess is the January 31^st  – February 1^st Fed meeting will mark the last rate increase, making March 21-22 the first ‘unchanged’ meeting,” he told me this week. 
 
And here is his back up:
 
Last Thursday (15th), August Retail sales came in at +.3% sequentially (from July) – a seemingly strong number until the report went on to detail July retail sales were revised down from +.0% sequentially (from June) to -.4%. 
 
Taken together, retail sales declined slightly in July+August.  See the far lefthand column—it is showing the beginnings of a come down in inflation.

 

 
Those are hard numbers.  He points that rents are The Big Culprit in inflation, and everything else—energy and food in particular—is coming down.
 
Now, moving into extrapolating this data forward—and Weiss admits that is tough to do more than a couple months ahead at any time, much less a volatile one like this—he says if CPI comes in at +0.1% sequentially every month going forward, the monthly YoY CPI readings would be as follows:
 

 
 
Now, if you bump that up to .3% sequential monthly increases after November, the trajectory of YOY CPI inflation would be as follows:
 
 

 
So he is thinking in the low 5% range for CPI readings, The Fed pauses its interest rate increases.
 
How do stocks respond to this, assuming this is what happens?
 
“My simple mental roadmap suggests equities decline into year-end – largely due to earnings disappointments and continued ‘high’ CPI readings amidst Fed rate increases.
 
“But then a substantial rally comes in the first half of 2023, particularly for bonds. In the second half though, it will become apparent Fed policy is too restrictive, especially for housing, capital investment and exports, all due to the strong US dollar.  And I think labor markets will remain too tight for sustained economic growth above potential.”
 
Now, a strong labor market does not imply that the economy is OK—another big misconception, says Weiss..  First off, the highest unemployment usually happens at the END of a recession (much like the best business conditions happen immediately BEFORE a recession).

“The loss of consumer CONFIDENCE launches recessions, the loss of EMPLOYMENT comes later,” he  says. “And most people struggle to believe recessions START with very low unemployment and unemployment typically peaks 12 to 36 months after the END of the recessions.”

 
Ever humble given his small town Midwestern roots, Weiss admits this is just one possible scenario. But with me, he has had a track record that’s worth following. 
 
EDITOR’S NOTE: I’m getting ready for a big rally in my portfolio. This coming week I’ll tell you about one of my favourites, with soaring revenue (they’re on a $60 million annualized run rate now), positive adjusted EBITDA and a crazy cheap valuation.

A few weeks back I laid out the case for copper.

Yes, we are probably going into recession.  Yes, that means at least a bit more weakness for copper and copper stocks (most copper stocks fell 50% in three months this summer).
 
But on the other side, as electrification and EV adoption take center stage, copper will be in demand.  As Bloomberg pointed out in a recent article, we may be starting to see that already. In the article John Paulsen, Chief Investment Strategist of Leuthold Group, made note that the copper/gold ratio is reaching a point that suggests growing confidence in the metal and usually precedes a move up.

If that’s right, now is the time to make a list of copper stocks.

That’s what I have been doing.  I’ve worked my way through the producing universe of copper companies listed in Canada or the United States.

A couple general points before I dig into a few names.  First, these stocks are not expensive.  They aren’t expensive at $3.50 copper and are certainly not expensive at $5+ copper. 

Second, it is hard to find the perfect play.  At least on the junior end of the spectrum. Every junior has some hair.

Of course, that can also mean opportunity for the diligent stockpicker to find that diamond in the rough.

But if you are looking for a simple play on the price of copper, it is a tougher find.

The risks fall into one 3 buckets:

1. Operational
2. Development Financing
3. Jurisdiction

In this post I’ll go through a few names, highlighting the good and the bad.  Start making that list so I’m ready to buy when the time comes.
 

COPPER MOUNTAIN MINING – SINGLE MINE HICCUPS

 
The poster child for operational risk is Copper Mountain Mining (CMMC – TSXv).

Copper Mountain’s flagship asset, the Copper Mountain Mine in British Columbia, has been a mess this year.

The mine produced 27 million pounds of copper in H1 22.  That is barely half what it did the year before.

The problems have been twofold.  Lower grades and equipment failures.

The lower grades were expected.  It was mine sequencing and lumpy production is what you get with a single mine operation.

The equipment failures were not.  The mine’s secondary crushing unit was damaged in Q4.  Production still has not recovered from that.

Q2 results brought a painful guide down–from 80-90 million lbs in February guidance (this was after they knew about the crusher failure) to only 65-75 million lbs as of July!

Copper Mountain has a late-stage development project – Eva – but before we can even talk about financing it (it’s not cheap – A$850 million in 2020, likely higher now), they need to get their mine turned around.

These are the risk of a single mine operation, and they aren’t limited to just Copper Mountain.
 

TASEKO – NAVIGATING DEVELOPMENT

 
At Taseko Mines (TKO – TSX), the Gibraltar mine has suffered from production problems of its own.

Mine sequencing is again the culprit. Lower grade zones led to a 0.17% Copper head-grade in H1, down from 0.28% a year earlier (this is a low-grade porphyry deposit).

The result – a 35% reduction in copper produced in Q2 – to 22 million lbs.

Higher grade sequencing should lead to more pounds of copper in H2.  I believe it.  Gibraltar has been a reliable producer for years.

Source: Taseko Mines Investor Presentation

The question with Taseko is their development project – the Florence in Arizona.

Taseko is expecting permits at Florence in H2.  It just might happen.  They received a positive draft permit a few weeks ago, which bodes well.

If Florence is permitted the question will shift to building it.

The budget for Florence was originally US$230 million and is likely higher today. That’s a lot for a company with a $400 million market cap.  Taseko has cash – $175 million of it – but also a lot of debt – over $500 million.

The debt and Capex needs mean Taseko will be walking a tightrope, particularly if copper prices stay weak for a while.
 

CAPSTONE – BETTING ON CHILEAN STABILITY

 
While small, single mine producers may struggle to self-fund their growth, bigger producers like Capstone Copper (CS – TSX) should have an easier time of it.

Capstone has four producing assets: Pinto Valley in Arizona, Cozamin in Mexico and Mantos Blancos and Mantoverde, both in Chile.

Together these assets, along with their Santo Domingo project in Chile, set up an impressive growth profile over the next few years.

Source: Capstone Copper August Presentation

Capstone’s risk is location, which surprisingly is Chile.  Chile has historically been a safe place to mine, but that changed with the election of the current government, which has talked taxes and re-permiting.

The Chilean government is proposing a royalty tax for producers that produce >110 million pounds of copper.  It is a price-based formula that could be as high as 32% on operating margin if copper exceeds $5.

With the expansion of their Mantoverde mine, Capstone would be over that threshold.

Once their Santo Domingo project is in production (still probably 5 years off), about ¾ of Capstone’s production will come from Chile.

However its not all doom and gloom.  Last week the Chilean people had a referendum vote where they rejected a new constitution. 

The constitution would have been unfavorable for mining companies.  The focus was the environment, which would have made permitting a new mine much more difficult.

The defeat puts the government back on their heels. But Chile comes with other risks.  For one–water. 

Water is in short supply through much of Chile.  Yet copper mining needs a lot of it.

The Mantos Blancos mine depends on water that comes from government concessions.  While the current water supply agreement is good until 2025, if it isn’t extended Capstone will be scrambling for another solution.  Mantos Blancos is about 30% of Capstone’s copper production.
 

AMERIGO – STAY HYDRATED

 
Amerigo Resources (ARG -TSX) is in the same boat, one that may ground ashore.

Amerigo isn’t a true copper “miner”.  They produce copper from the tailings of Chile’s enormous state-owned copper producer, Codelco.

Amerigo has more immediate water worries than Capstone.  Taken from their own presentation, Amerigo estimates they have water for 18 months.

Source: Amerigo Resources Investor Presentation

Amerigo has been a steady producer and gives a nice dividend.  But the water is a worry in the long-run.

Source: Amerigo Investor Presentation

While Amerigo says there is nothing to worry about, I worry because 18 months is not a long time.  I wonder about the long-term plan if the drought persists.
 

HUDBAY MINING – A WORLD OF COPPER

 
Hudbay Mining (HBM – TSX) has operating mines in Manitoba and Peru.   They have two large development projects in the United States.

Hudbay plans to grow production both this year and next.  Because of by-product credits, cash costs will decline to close to $0.

Source: Hudbay Investor Presentation


That translates into free cash flow.  Hudbay has one of the best free cash profiles over the next few years.

Source: Hudbay Mining Investor Presentation

The first risk is political, in this case, Peru.  But while Peru is far from perfect, it is so bad it may be good?!? 

Peru’s left-leaning government has had to pull back from their tough talk (nationalization, big taxes) that got them elected.  Right now the government is having enough trouble just keeping power.   

There are corruption issues–the prime minister resigned and there was an impeachment vote.  It is too much disarray to drive sweeping reforms.

Hudbay’s second risk is permitting.  They have had their own issues permitting in Arizona.

Hudbay’s Copper World project is the going to drive future growth.  It is an open pit project, low cash costs ($1.15 per pound), and will produce 190 million pounds of copper per year (compare this to the 255 million pounds Hudbay will produce this year).

Bu part of the Copper World project lies on Federal lands.  While permits were issued, they have since been reversed by a District Court ruling.  That decision was upheld in an Appeals court this year.

Hudbay pivoted by focusing on private lands.  They can operate a 15-year mine life before they need to tap the Federal land.   The entire project has a 44-year mine life.

The focus on the private lands only should mean an easier permitting process.  But as Hudbay said on their Q4 2021 conference call, they “have the interest of the environmental crowd”. 
 

FREEPORT – THE BIG KAHUNA

 
Given the landscape, maybe the best way to play copper is just to KISS – keep it simple stupid.

That means Freeport McMoran (FCX – NYSE).

Freeport is the biggest copper play by some margin.  They will produce 4.2 billion pounds this year, 4.45 billion next year.  That is a little under 10% of global supply.

They are also a low-cost producer.  While cost ballooned at many junior operations, Freeport put in a $1.41 cash cost number in Q2.

Being the biggest and low-cost copper producer, Freeport should trade at a premium valuation – and they do.  But not as much as you might expect.

Source: BMO Capital Markets 2023 Estimates

Smaller names can be as much as half the valuation.  But they all have risks that Freeport does not.
 

YOU GET WHAT YOU PAY FOR

 
With Freeport’s diversity of low-cost production, they are better prepared to survive a prolonged bear market.  In fact, they will still generate cash.

The capex and cash flow estimates below come from the #2 Canadian brokerage firm, BMO.  Their tables assume $3.50 copper for ’23 and ’24.

Source: Company Data, BMO Capital Markets

Freeport is the safest.  Hudbay and Capstone give you multiple mines, some future growth, and free cash flow. 

Taseko and Copper Mountain need to turn it around, but they could turn out to be triples when copper turns. 

There is something there for everyone.  It just depends on how much risk you want to take.