by | October 8, 2008

A case for buying Vale

The sky is falling! The sky is falling! Buy, buy, buy.

I am looking at the doom and gloom in the marketplace and I think about how in some cases people overreact to bad news. I am going to stay away from the stupid pricing in mortgage bonds and focus on Vale, a.k.a. CVRD. Vale owns the iron ore business. It has the best reserves, the best quality, and a very long life of mine. If they decided to shut down production to Europe, they own enough of the market share to put Europe into a complete economic crash. They also have other assets that are not as nice. The price of nickel is way down as stockpiles grow and demand clearly weakens. Copper is not much better, and let’s not get into the aluminum demand. I am going to focus on the iron ore assets.

You have two forces at play here: The lack of capital is going to suspend lots of projects for the duration, and China has built up inventory because of the slowdown around the Olympics. Independent supply in the iron ore market is just not going to grow. Most of the producers that have production are not leveraged and therefore are going to be much more concerned about profit rather than revenue. China is going to milk its stockpiles as it finally has figured out that it alone was driving up the price of commodities. It has learned that if it takes 1% off of worldwide demand growth, it pays much lower prices for the stuff it wants to import.

So what is going to happen? In a nutshell, we are going to have railroad strikes and mines flooded, and Vale announcing a price rise and then saying it will not ship any product to China until it gets it. Production targets will get lax, maintenance will be done on equipment, and production will go down by 5-10% in the iron ore business. If this were nickel or platinum, global prices would crash, but as this is iron ore, the spot market price will crash, but do not expect the big three to be putting on any inventory reduction sales. The fact is running a mine at 95% of production vs. 102% will reduce operating costs significantly, and it is always much better to cut 7% of your production than 7% of your sale price.

What is going to happen is steel companies are going to get squeezed; the price of steel is going to come down; the price of ore is going to stay high; and we are going to have steel companies doing the dance of the stuck pig. Vale is not stupid. They have no need to ship ore. They can sit on their hands till the customer is begging them to ship. When they do not ship, it costs them $5-10 to idle the tonne of production–to idle a steel mill costs $70. Guess who wins in the waiting game? Vale, and the stuck pig will pay the price.

So what would I do in this market? My gut says buy Vale, as it is trading for the value of its iron ore assets, and the price does not assume any value for anything else. My gut says go short on the steel companies, especially the steel companies that do not have captive iron ore like ThyssenKrupp. There is going to be a consolidation in the junior iron ore marketplace, but the fact is the iron ore production business is going to stay strong because three companies own it and they will treat it well.

Going to be a fun year.

Benjamin

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Filed under By Benjamin, Iron Ore, Steel, Vale

by | September 25, 2008

My solution to the financial crisis

Okay, everyone is coming out with solutions, and I do not like most of them. Let me go over a simple solution. We have to fix two things: Freddie and Fannie, and the existing toxic debt. I have a simple solution to both things in one deal.

We create 10 regional banks that are 100% owned by every U.S. citizen. The banks issue 100% of the shares to the U.S. citizens, one per citizen. They do not trade publicly for five years, and when listed after five years, the banks can only do the listing to take out shareholders who want out, not to raise new capital.

We fund the banks by giving them each the ability to issue $200 billion of U.S.-backed debt that is issued at a term of 25 years at 2.5% interest.

The banks then have the limited mandate of buying only any mortgage-backed securities that they can trade at face value for the federally backed debt. If someone thinks their bonds are worth more than the 25 years at 2.5% in trade, then I would not define the debt as toxic, but I expect that lots of of the bad debt, if not all of it, will get traded.

The banks then rehire lots of the people who have been fired and create a clean regional system to deal with the mortgages. They work to refinance homeowners into 30-year fixed rate mortgages with 80/20 ratios, being willing to write off the equity part needed to get the loans to 80/20. If the homeowners in trouble cannot afford a 80% loan on current valuations at 5-6%, I am sorry to say they should not be in the houses, and the banks will work with them to put the houses up for sale in an orderly manner.

We can be fair and say that these banks can never pay senior management more than 50 times the lowest-paid full-time employee.

First problem is then solved, and what we have is 10 new banks that are regional and cannot operate outside of their region that have very nice balance sheets, $200 billion in assets that will yield 5-10%, and $200 billion in debt that will cost 2.5%. They should have $5 billion a year in earnings each, and they should quickly be able to build balance sheets so that they can compete with Freddie and Fannie on standard mortgage terms.

On any new loan, these banks should be federally limited to doing only 80% loan-to-value mortgages. Or for less than 5% of their business, they could provide low-income loans where they do 95% LTV mortgages for first-time home buyers with credit scores above 700. For new loans, they could issue market-rate debt, and it would be federally backed. They would be mandated to issue the mortgages at 1.5% higher than they borrow money at. They also would be limited to only issuing 15- or 30-year bonds that match the maturity of the underlying mortgages.

The U.S. citizens will become shareholders; the banks will not cost the federal government a nickel as they are buying toxic debt cheap with clean debt; and I can assure you that the default rate would have to hit a very high number not to make money on the interest rate swap. Within 10 years everything will be unwound, and frankly the shareholders will make some serious money at the expense of Wall Street.

We then leave Freddie and Fannie around to compete with these companies, but we make a them follow the same rules: 50 times compensation, 1.5% spread, 100% owned by U.S. citizens, only 80/20 mortages or a very limited number of 95% mortgages to first-time buyers with credit scores above 700, only fixed rate products, and only 15-, 20-, and 30-year term loans.

Problem solved.

Benjamin

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Filed under By Benjamin, Finance/banking

by | August 8, 2008

How to value a project, the inputs

Valuations are traditionally done in boom times and bust times, and they are done very differently in both times. I am going to go over how to value a mineral property in a full market cycle. I am not going to focus on any one project, but I will draw conclusions that can be applied to most any project.

First off, a mineral property should be viewed not as a discounted cash flow asset, but rather as a set of real options. Let me start by going over what shapes those options and how to deal with them. In this update I want to lay out the variables I think about when I do this type of work: project size, capital costs, and commodity pricing.

Project Size

Size does matter. I know you all have been told that it does not matter how large your asset is, but really the people who do your books do care. A property has a binary valuation depending on the size of it. The question of how small a project you can develop will depend on the capital required to get to a minimum amount of production. To take an extreme example, a 100 million tonne iron ore body that needs a 1,000 km railroad will never be developed. A 10 billion tonne asset such as Serra Sol that only needs a 100 km extension to a rail line to be developed will always be developed.

The issue about size is threshold. If you do not have enough size to support the capital invested, you will never have a mine. It is sort of like a roller coaster at Disneyland–you have to be so big to ride. The old rule of thumb was your needed 30 years of production at an economic scale. If you are a low capital scavenger of brownfield like Portman, this does not apply, but for any greenfield project this is a good test to undertake. So if you want 8 million tonnes of ore production out of a mine, you had better have 240 million tonnes of product in the ground. Not ore, product, and of course the first thing that happens in a boom is people do not do proper conversion of resource to product (processed reserves).

Capital Costs

The amount of capital required for development also matters. Now let’s be precise. If you cannot service the debt from the mine, it does not matter how big the ore body is. A simple calculation is in order here: Take the capital cost of the project and divide by five. So if you have a $1 billion project, you end up with $200 million going to debt service. The free cash flow from the project has to be greater than 20% of the capital required to build the mine.

Now how you get the free cash flow number will heavily depend on the commodity price used. In a bull market that price can be very high, but you have to pick a floor on that number. You have to know the price of iron ore or copper at which the mine will not work. You have to know that the unit production cost is well in excess of the “cash cost” of production. I am not saying that you have to do your DCF (discounted cash flow) on the valuation of a project with the floor number, but you have to understand that if you have cash costs of $25 per tonne of product and the 10-year floor is $15, you must have a decent plan on hedging for that, or else you will go out of business during a down dip.

Commodity Pricing

To develop commodity prices, I like to look at a few different things.

How leveraged is the sub-industry? Leverage adds to volatility because with leverage, people have to produce in a full market cycle. You do not shut down if you have a bond payment to make. A highly leveraged industry will work for the debt holders. Even if your own project is unleveraged, you will be working to the tune of steady production and not steady pricing, a tune that will be set by your most leveraged competitor.

How elastic is the demand? Can people live without the commodity? Copper is one such thing where people start to figure out how to live without it. I have written in the past of substitution of copper for aluminum in wiring. I expect at $3 and more per pound, thrifting has to continue. The question is, just how much can demand decrease?

Let’s take the elasticity of demand of oil. If the price of oil goes to $6 per gallon in the U.S., I can assure you that demand will drop. Heck, at $4 demand dropped. When you build your model, you have to figure out if demand will fall apart at a certain price.

My own theory here is that you have to figure out the ratio of the input cost to the end product’s price. So to take an extreme inspired by the fact that I am sitting at an airport, if the price of gravel doubled, people would still expand an airport if there was demand for the airport. The gravel is required for strong foundations, and it is not priced very highly as a percent of the cost of the project.

The more that the product input cost affects the end product and the more nonessential the product is, the more elasticity of demand. So if the price of a one carat diamond went to $15,000, I can assure you that demand for the stones would drop. If the price of a one carat diamond went to $1,000, the demand would spike. In contrast, if the price of gravel went to $2 per tonne, about the same amount of gravel would be used as if it went to $20 per tonne.

How elastic is the supply? This is the next thing that I take into account when I figure out how to value a mining project. I like things like potash where starting new mines is a $2 billion or more concept and not every Tom, Dick, and Harry can start one. These make for excellent assets to own. The problem, of course, is getting the $2 billion, and that creates a barrier for most junior players that is insurmountable. We will cover access to capital later on.

How concentrated is the industry? Now here is something interesting. I do not like industries with one major player and lots of smaller fish. I like strong oligopolies rather than an industry structure with a 50% market share player and lots of 1-4% players. The thing is, the small players do not really care about cleaning up after themselves, and they will make a real mess if it helps them in the short run. I also like real fragmented markets where everyone has to work on their own and no one party can mess with the game.

In markets where there is one almost dominant player, that player rarely can effect enough market control to stabilize prices, and everyone else is in the business of taking from that dominant player. An example of such a market and player would be platinum and Anglo Platinum. Anglo Platinum should own the business, but they do not because they are dancing for every little guy.

Once you have commodity pricing, capital costs, and project size, you can start to build out valuations. I am going to write another update on stages, but let’s sum up a conclusion here. When you start to figure out how to value a project, work out on a worksheet the questions that I have laid out above, then make a decent bet around the project.

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Filed under By Benjamin, Mining

by | August 6, 2008

Nationalization is part of the cycle

The Herald Sun: Whole new ball game

A key note to the Guinea government: Next time you want to nationalize something, wait for the rail line to be built. I mean seriously, if you are going to take Rio Tinto, do it right. Get them to invest at least 1-2 billion in capital and get some extra added value. Taking a project after a resource has been established and a feasibility study is done is rather short-sighted in these trying economic times. It is much better to let them sink some capital into the project first, as once you have nationalized the asset you have to come up with the money to develop it. Or maybe you already have another deal. China and Mittal both come to mind as groups who would be willing to follow in Rio Tinto’s footsteps.

When you discount African or Russian assets, discount with a huge margin. But then again, with Obama coming to power, if you own American resource assets, you could be facing partial “nationalization” in a windfall tax. If I am not mistaken, everyone wants to take from the rich resource companies and give to themselves.

Isn’t greed great?

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Filed under By Benjamin, Rio Tinto

by | August 1, 2008

Put government back in the equation

Does government have a place in business? This is a question that I have been debating for awhile. Orderly markets require regulation, and regulation has to come from government. Too much regulation and you end up messed, too little and you end up fried. This is sort of like cooking a frog.

Now government has to figure out the rules that we all play under. Government has to not be corrupt, has to enforce the laws it puts on the books, and has to be willing to admit it when it makes a mistake. Government has to understand that it will build a set of rules and the market will mess with them till they work for the market.

Some rules, like the Sarbanes-Oxley Act, have to be changed and partially discarded. The American stock exchange will get killed by SOX. The fact is, the American stock exchange has a good market-making system, a good amount of liquidity, and no ability to compete with AIM or TSX venture exchange because no one in his right mind–myself included–would willingly undertake to implement Sarbanes-Oxley, no matter how cheap the market is to access. Bankruptcy laws should make sense. Some debts should be clearable, others not so.

Other rules have to be changed and enforced. It should be a crime to knowingly give people credit when you have statistically less than a 50% chance of getting paid back. Interest rates should be capped at 24%, and that should include hard-money men and payday-loan nasties. The fact is, we need to go to some common-sense laws that take financial predators and feed them to the lions at the local zoo.

On the whole, the presidential candidate that will go through and clean this up, I will vote for. You, however, cannot, in the process of cleaning it up, make America a harder place to do business. The candidate that says we will cut 50,000 pages of regulation, cut the bankruptcy code to 10 pages, and cut the tax code to 500, will win. Let’s open America up to fair business, because until then no one in his right mind will open up new shops in the United States when there are other choices.

I fly out of the country every week. I take a domestic business trip less than one time a year. That does not make sense. We need to rebalance the U.S. government’s regulatory role to encourage, not discourage, fair business in America.

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Filed under By Benjamin, Misc

by | July 30, 2008

The sky is falling!

Chicken Little, the sky is falling. Did you not notice the sky is falling? I mean, everyone knows the sky is falling. Do you not watch TV, read a newspaper, own a house, have a mortgage? Do you not know that the sky is falling is the flavor of the day?

Do not worry. Next we will have the perpetual boom. Everything will be great. Every kid will be above average; the stock market will never go down again, ever; and the price of Starbucks will go up enough that they’ll never have to close a store again.

Then the sky will fall again.

The question I like to ask is, do I mind the sky falling? Does it really affect me? Do I care? Well, yes. This sky-falling business has cost me millions. You should have seen the look on my mother-in-law’s face when I told her I lost at least $500,000 in the market since November. And of course I underestimated—it never helps to tell your mother-in-law that you lost at least $1 million or more. The question, however, that the loss presents is the better one: Is the house I bought, or the stock I bought, something I’ll be happy owning in five years?

Now understand what I mean. If I put the house, or the stock, or the art in a closet and did not look at for five years, when I brought it out again, would it represent value and would I be happy with it? In figuring out my answer, I assume that there will be no earthquake, or fire, or other natural disaster during those five years. And the fact is, if the asset does not meet the five-year test, then into the dustbin it goes.

What is good about the sky falling is this: Into the dustbin goes the junk. Everyone cleans house. The stupid investments are sold. The shaky stores are shut down, and then the mall operators are forced to find new tenants. This type of house cleaning is good. The thing is, to properly clean house, you have to have the eye of a collector and not a demolition man. Get rid of the ugly shoe art from the 1980s, the stupid Starbucks in the bad location. Get motivated, focused, and directed and get some real wealth creation going. When the sky falls is when you make the choices that will make you money when the sun is shining.

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Filed under By Benjamin, Misc

by | July 28, 2008

Drill, drill, drill vs. Research, tax, research

Drill, drill, drill.

Sounds so simple, right? If you drill, you end up with oil. And if you end up with more oil, you will drop the price, right? The reason to drill has to do more with what people think than reality. What I mean by that is the drilling will cause people to think about the supply increasing, and you know what they say about a 1% oversupply to a market, even an illusion of one.

The question is, does drill, drill, drill really work? Can we get more oil? Are we going to end up with lots of extra reserves? Obama does not think so. He thinks oil is a zero-sum game, that there is only so much in the ground. But Obama is not an oil economics guy.

The quantity of reserves are calculated at a cut off of production cost. I do not know what that number is, but I doubt that it is over $35 per barrel. The thing about oil that then sells for more than $100 per barrel is it opens up a free market for capital, and for people to do stupid and risky things. Heck, Freeport is drilling 32,000 feet and going, and in only 70 feet of water. If you can get capital when you define a reserve at $80 per barrel cost, you might be surprised at what is found.

The Wall Street Journal: A famed dry hole gets a second shot (A WSJ online subscription is necessary to read the whole article.)

Stupid, risky things pay off in this business; rarely, but enough times to make the bets happen. And frankly, high oil prices will force the bets. People have to understand that if they hit a well at 35,000 feet, and it pays out, then the whole coastline will be dotted with rigs that will do the same thing, and that will change the supply dynamic.

Now the other option is to force high oil prices via taxes. That does not increase supply, but reduce demand. If this is the approach you take, the question is, what should the government do with the taxes? I would be willing to pay a $1 per gallon tax on fuel if 100% of it went into researching alternative forms of energy production. If you pour money at a problem, you will find solutions to something. Of course, the solutions may not be to the problems that got you researching in the first place. A research initiative into alternative energy production could, like the space program, completely change the world with the side effect inventions that come out of it. You cannot be sure that the solutions will solve the energy crisis, but 10s of billions of dollars per year being forced at research and development with a clear goal in mind would be interesting watch. I would want it to be a five-year program with a clear sunset.

For now, to get the rigs out looking, there is nothing like high prices to just raise the cash and get the drills turning. But Mr. Obama, if you want to sell me on changing energy policy, you’ve got to treat it like the space program and make it a war effort, and you might find some stuff. Just do not be surprised if you find a cure for cancer, or a 20-times-faster computer chip out of the spending, rather than a cheap form of renewable energy. If, however, you treat the new gas tax as a way to pay for social programs, I will be significantly angry.

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Filed under By Benjamin, Energy

by | July 25, 2008

Just trade bad paper for good paper

Without ground rules to play with in the financial markets, people will make stupid bets for short-term profit that cost everyone 100 times over in the long term. The U.S. had–I stress had–the best mortgage system in the world: 30-year fixed paper at a decent rate, with 20% down. This was a bet that created a whole middle class in America and let everyone build some equity. The kicker was it was pre-tax dollars, so the real effective interest rate was even lower. The question is, what is the harm in messing with a system that works? The answer is clear. Now not only do we now have the new alternative mortgages (which look a lot like a standard UK or Aussie mortgage), but we have messed up the standard American mortgage that created the American dream.

Now the question is, how do you, as a government, fix this mess and make it go away? The first solution is to create a clean new bond deal. Any bond or mortgage on an American piece of real estate should be tradable to a new government entity that will swap it for a 2.2%, 20-year bond that will be backed by the government. The deal, however, is it cannot be a secondary swap contract, or an insurance policy, or anything but a primary ownership of a loan. This new government-backed company will then have 20 years to clean up this mess. The first step needs to be to freeze foreclosures, just stop them. The fact is banks do not rent homes, so rents are going up, people are losing houses, and then the houses are sitting empty.

Next, the company would sit down and renegotiate one by one with borrowers. If you have to foreclose, create a group of investors in which no one is allowed to buy more than three homes. Offer these investors a 20%-down mortgage at fair value for the house. Give it a 20-year interest-only term with an interest rate set at 5%. To become an investor in this group, you will have to pass a basic knowledge test on real estate and finance. Trust me, if you spread it out and create a whole new group of people who own three rental properties, the market will stabilize. The mortgages have to be able to be supported by rent, but that should not be hard.

If people want to stay in their homes after renegotiation, the second step has to be create a required course at every community college that people have to take and pass if the government owns their mortgage and they want to stay in their home. Get people to learn basic finance. Heck, make finance a required course to pass high school. Let’s make people financially literate and understand the bets they are making. Then we might end up with less of a mess.

The basic point is if people are willing to take 10 cents on the dollar for real assets, why should the government not offer 100 cents on the dollar at a below-inflation rate of return. Get the underlying paper off the market, and the rest will clean itself up. An interest rate of 2.2% is not a bailout; it is a fire sale. I can promise over the next 20 years this bet will return 10s of billions of dollars in profit.

The underlying real estate is good, trust me. People will still need a place to live.

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Filed under By Benjamin, Misc