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

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

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.

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?

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.