The Energy Report: Shares in Pinetree Capital have had a good run in the last six months, going from about $1 per share in July 2010 to about $3.38 now. What's largely responsible for that remarkable run?
Marshall Auerback: A number of things. I think Pinetree has been an undervalued stock for a long time based on its net asset value. But we had very adverse financial conditions in 2008, particularly adverse for small-cap companies, which comprise most of our portfolio. Even though we started to see an improvement in the credit markets in 2009, they really didn't start to loosen up until last year for the smaller companies.
Your risk in holding these small caps is not so much market risk as liquidity risk. A number of these companies had cash on their balance sheets but they were clearly capital-constrained because they were dependent on ongoing capital injections to develop these assets.
In 2010, the capital markets began to re-engage and that made it easier for some of these companies to access funding. In turn, they were able to develop their assets, which helped improve their share prices. But it took a while. The markets were basically trendless until about September of last year, then all of a sudden you have this big move in the commodity space. Clearly, that's Pinetree's sweet spot.
TER: Your stated objective is to "invest ahead of the crowd by anticipating emerging trends and macro changes in consumption and translate that knowledge to successful investments in small- and micro-cap companies." What macro changes are taking place in the energy market, and more specifically in the uranium market?
MA: People have discussed peak oil for a long time. It's been controversial. Some people say you can always find oil at a given price. We don't disagree with that but the main thesis behind peak oil is that Mother Nature has only given us so much oil. The low-hanging fruit has largely been picked. It's getting increasingly difficult to extract oil from conventional sources.
If you look at each successive economic crisis and the price of oil during each one, we have continued to bottom at increasingly higher prices. Even in the worst conditions we had in 2008 and 2009, the oil price bottomed at about $36 a barrel and it didn't stay there for long. It was driven by a collapse in demand.
The other problem in energy, in all commodities really, was a complete collapse in trade financing. So, we had both a financing shock and a demand shock, which caused this collapse in commodities. But as trade financing began to normalize and these emerging economies began to normalize, there was a big increase in demand. Along with that you've got very significant shortages in supply.
The BP Plc. (NYSE:BP; LSE:BP) oil-spill disaster that occurred in the Gulf of Mexico is a symptom of the supply problem. We wouldn't be drilling for oil three miles below the surface of the ocean if it were easier to get oil from more conventional sources. To me that's symptomatic of a fact that you have to look for the oil in increasingly expensive places, which means increasingly expensive oil.
TER: How is expensive oil influencing the uranium market?
MA: Clearly, as the oil price has continued to appreciate people have started to look at alternative fuels. For a while the sexy ones were wind and solar, but there's very low power densities in those types of energy generation. Wind is intermittent. Obviously, solar is not a great resource to use in cold-climate countries like Canada or Russia. Natural gas is an important transitional fuel, but there's also uranium.
To me, a seminal moment in the uranium market occurred about five years ago when James Lovelock, a leading environmentalist who used to be the head of Greenpeace, said that uranium has to be a major part of our response to global warming.
Before that, uranium was seen as part of the problem, not part of the solution. Clearly, the nuclear waste issue hasn't gone away but we treat the stuff a lot more effectively than we used to. The waste problem relative to the millions of tons of coil that get belched out into the atmosphere is fairly minimal.
I think the reason we like uranium is because it's both a supply and demand story. On the demand side, a number of nuclear reactors are under construction. Haywood Securities Analyst Geordie Mark says there's been a 61% increase in the last couple of years. There's also been a 54% increase in the number of reactors planned and a 45% increase in those proposed.
These new plants alone will eat up 32,900 tons of nuclear fuel annually—that's almost half the demand from this year's 443 commercial reactors. We've got a very good story there, and then you have the supply side. The current price is around $68 and that's still too low to support a lot of new investment. You need much higher prices to invest in large-scale, development-stage projects.
As it is now, the uranium industry is having a hard time boosting production. There have been shortfalls from large mines, such as Energy Resources of Australia Ltd.'s (ASX:ERA) Ranger Mine and BHP Billiton Ltd.'s (NYSE:BHP; OTCPK:BHPLF) Olympic Dam Mine in Australia. Of course, Cameco Corp. (TSX:CCO; NYSE:CCJ) had water problems related to reaching production at its proposed Cigar Lake uranium mine. Those are other problems.
TER: Do you think we will see another surge in uranium prices like that in 2005?
MA: Generally, I find that these moves in the commodity cycle take two phases. The first is the "fantasy" phase where you get recognition that a real supply/demand deficiency is developing. A lot of speculative moves are made and the stocks start to go up, but then they crash because it hasn't yet been validated by actions in the real world.
But this speculation moved ahead of reality. Typically, what happens is that you get a wash out, and then 18 months to two years later people come back and say, "This thing is for real?" We saw that happen in gold. There was a big move in gold in 2003 and 2004, but the gold price didn't move up a huge amount.
So, the market went dead for a couple of years. I think uranium would've had some interest in 2009, but obviously everything was superseded by the Lehman Brothers meltdown and the financial crash. So, it's taken a bit longer, but I think the supply/demand outlook I've sketched here is still very much in existence. Now we're starting to see an increasing amount of pricing pressure developing on uranium, which I think will help reignite interest in the sector.
TER: What's your forecast for the price of uranium?
MA: The price could easily double over the next three or four years, and it could even go much higher. A number of these projects in places like Kazakhstan and Namibia don't even begin to make money until the price gets closer to $80 or $90 per pound.
A lot of the demand will be driven by the pace at which these nuclear reactors are built. The problem here is that we've often got political delays. I don't think nuclear construction in the U.S. will come for another four or five years because with natural gas prices being as low as they are there's no urgency to move into nuclear. However, in other countries where natural gas prices are much higher, I think we'll likely see accelerated development.
Certainly, in countries like South Africa, we're already seeing brownouts. China is definitely going to move ahead very rapidly, as is India—that's going to be the big source of demand. It's just a matter of how quickly these countries start to build reactors. It may be a case where, occasionally, perception races a bit ahead of reality; but the underlying reality is that uranium has the soundest supply/demand features of almost any commodity out there right now.
TER: As of Sept. 30, 2010, Pinetree had 55 separate investments in uranium plays. That accounted for 18% of your asset mix. With this expected price appreciation, do you want to keep your uranium exposure at around 20% or are you going to increase that?
MA: I think it really depends on the opportunities; we're focused on a number of ventures. Again, you have to weigh the existing investments against the increased political risks as you move into some of these funkier countries in central Asia. You've always got to measure it against that. I think 20% is a fairly substantial bet, and I suspect that's even higher now due to share price appreciation. But if it's become a hot sector, we may start to look in an area that's become less loved.
TER: You mentioned "funkier countries" in central Asia. Do you mean Kazakhstan?
MA: I have a view that it's always tough investing in any country that ends with "stan." Basically, I'm saying you have to be much more aware of that risk. Increasingly, we're seeing examples of resource nationalism. And that's not just in the emerging world, it's in places like Canada. There were very significant resource-nationalism reasons for the Canadian government's disapproval of BHP's acquisition of PotashCorp (NYSE:POT; TSX:POT).
I happen to think that was the right decision because I believe it's much more valuable as a standalone asset. Increasing resource nationalism means you've got to be careful. You don't want to develop something, and then find out the local government is taking 50% or more of it. I think that we have to make political risk assessments as part of our investment judgments going forward.
