Friday, January 2, 2015
Tekoa Da Silva
Rick Rule: We Need To Cut G&A Fat From The Industry So There Are Fewer, But More Solvent Players
During a time where the pain of downward pricing has spilled from minerals into the energy sector,
Rick Rule, Chairman of
Sprott U.S. Holdings was kind enough to share a few comments.
On the recent collapse in oil Rick noted that,
“[M]arkets work.
The cure for high prices (despite Washington’s consternation last year
over high gasoline prices), is precisely that—high prices. The best they
can possibly do is nothing. The cure for low prices, simultaneously, is
low prices. The truth is that low energy prices will constrain supply
over time and stimulate demand.”
When asked about the historical precedence of today’s levels of G&A in resource industry, Rick explained that,
“I’ve never seen [corporate] compensation as a percentage of assets or total expenditures come close to this… [it’s] deplorable.
The severance payments associated with change in control have been the
main reason why you haven’t seen amalgamation in the industry—which the
industry needs to survive.”
“Don’t give these guys any more money,” Rick added.
“Make them go to company heaven.”
As a final comment to current and prospective speculators in resource markets, Rick noted that,
“Markets
work—but they’re very messy and unpleasant if you get caught on the
wrong side of them. That’s the truism that all of our readers need to
remember.”
Here are his full interview comments with Sprott Global Resource Investment’s
Tekoa Da Silva:
Tekoa Da Silva: Rick, in some of our previous interviews
we’ve talked about the fear that’s been in the sector recently, led by
Ebola and Burkina Faso. Now the dominating headline seems to be energy.
Oil has just collapsed. Is this the next excuse for a person looking to
avoid the resource sector at all costs?
Rick Rule: I suspect it is. It might not deter speculators
because oil and gas are not as speculative as mining, despite the fact
that people have been punished fairly severely in the last 60 days. I
don’t think a decline in oil prices would scare too many mining
speculators out of the market. Those who are inclined to panic have
probably already exited.
It’s worth noting, Tekoa, that a decline in oil prices is temporary to begin with.
When I say temporary, that could mean two or three years. But as
we’ve discussed before, markets work. The other thing we should note is
that the decline in oil prices is good for the mining industry in a
couple of very important ways.
One of the most important marginal costs in production is energy, and
a lower energy price has certainly helped energy-intensive businesses
like mining.
The second thing is that lower energy prices in effect act as a tax
cut. They increase the average worker’s disposable income as a
consequence of cutting his or her expenses. It has been estimated in the
United States that today’s reduced crude oil prices will save the
average motorist $100 a month, which may – I’m not saying it will –
stimulate the economy at least in the near term and increase demands for
goods. That in turn would increase demand for commodities, and
ironically, oil and gas.
TD: Rick, we had some really nice charts here circulated by
Jeff Howard recently, showing the collapse in oil from 1985 to 1987 and
then again from 2007 to 2009. Both of those collapses showed about a
70% sell-off in the price of oil. If past is prologue, should we expect a
similar sell-off in percentage terms?
RR: We could. But it’s really a function of the demand
response. I think people mischaracterize the nature of sell-offs. It’s
important to talk about what you expect with regards to the duration and
extent of the sell-off. A lot of people point to increased American
supply but I think that mischaracterizes the nature of the sell-off. I
think it’s demand-related.
If the nascent recovery that appears to be occurring in the United
States continues, then this sell-off in energy could be remarkably
short-lived. Notice that I said ‘if.’ I’m not an economist.
The irony of course is that in the last three or four years, the only
private sector in the United States where wages and salaries for the
average American worker have been rapidly rising is the oil and gas
sector. The wage pressure in the oil and gas sector is probably going to
come off as a consequence of lower prices.
The truth is I have absolutely no idea what will be the extent or
duration of the sell-off. I only know that markets work. The cure for
high prices (despite Washington’s consternation last year over high
gasoline prices), is precisely that—high prices. The best they can
possibly do is nothing. The cure for low prices, simultaneously, is low
prices. The truth is that low energy prices will constrain supply over
time and stimulate demand.
Markets work, but they’re very messy and unpleasant if you get caught
on the wrong side of them. That’s the truism that all of our readers
need to remember.
TD: We’ve had some internal conversation recently regarding
ramifications to the energy credit markets as a result of the sell-off.
In terms of market size, something over a trillion dollars worth of
energy-related debt might now come into question with these lower
prices. Can you explain how the process works?
RR: The structure, particularly in the exploration-production
part of the business, which we’re mostly concerned with, involves a
lending structure called a production credit facility, known as an
“evergreen” facility. The way it works is that a company has its
production reserves evaluated by a third party, and that third party
presents the management team with an evaluation of the net present value
of the cash flows from those existing oil and gas reserves.
A lending institution then establishes a borrowing base at about 50%
of the net present value of the company’s proved developed producing
reserves. These facilities are usually evergreen, meaning that they’re
interest only and they roll over from year to year as long as the
collateral doesn’t exceed some collateral test.
Now the problem with the situation we’ve just experienced in the
market, particularly because it occurred at year-end, is that the net
present value of production at $100 per barrel is much higher than the
net present value of that same production at $60 per barrel.
So borrowing bases will be reduced as a result of write-downs over
the next 2-3 years. In some of the credit arrangements, what was an
interest-only evergreen facility will become a four or five-year term
facility with no room for additional credit. In fact, the requirement to
pay down the existing credit may mean some companies will have no
expansion capital.
If a company has been drilling shale wells with very high initial
production rates but then rapidly declining production, your production
and hence your cash flow falls off very, very quickly.
So this is a situation which, if you’re as old as I am, you have
observed two or three times before. The problem that some of the smaller
overleveraged producers will have is that they’re going to have to sell
some properties in competition with other small producers who are
similarly overleveraged in a market that is cash-constrained because
there isn’t much credit available for acquisitions either.
Now for Sprott, this will be a wonderful set of circumstances. We
have 25 years experience in the mezzanine lending business, and in this
sort of situation if you’re Sprott, you go to the senior bank and you
say,
“Term out this loan. We will add the capital to the company to
do the development drilling to support your facility. Agree in a
creditor agreement with us that you won’t foreclose for five years. In
other words we aren’t contributing money to pay down your debt.”
So the bank will then term out a facility at prime plus 1.5%, we’ll
put in a mezzanine structure behind their 1.5% credit at prime plus 8.5%
or prime plus 9.5%. The shareholders of the company get a chance to
live. The senior bank doesn’t have to provision for their loan and we
make an extremely attractive rate of return on low risk development
drilling. So your view of the upcoming credit contraction in oil and gas
really depends on who you are.
It’s worth noting that Sprott makes a substantial number of energy
credits available from its own balance sheet. So Sprott shareholders are
automatically indirect participants in this business right now.
I need to say one more thing. In terms of the solvency of the banking
system in general in the United States, this decline in energy prices
is a very good thing. As painful as it may be for the exploration and
production business in the United States, it’s pretty good for the
refining and marketing business. Their crude costs fall and it’s
wonderful for energy-intensive businesses like chemical producers,
trucking companies, airlines, etc.
So while on one hand the sell-off weakens the credits behind $1.6
trillion in credit facilities in the United States, it probably
strengthens another $6 trillion of corporate loans in the United States.
So on balance, declining energy prices are good.
TD: In that type of lending activity Rick, what’s the biggest risk in your mind?
RR: The biggest risk is the manager (me or the rest of the
Sprott team), making a mistake in evaluating the credit. We try to
ameliorate that risk by knowing our borrowers fairly well and by not
putting all our eggs in one basket.
But the truth is that this is hybrid debt equity. You’re taking a
subordinated position to the senior lender and if you make a mistake,
you get hurt. Our track record with regards to not making mistakes over
time in the credit business is pretty good. But certainly somebody needs
to know that the biggest risk is manager mistakes.
TD: Rick, I had a conversation with one of our in-house
geologists, Andy Jackson, the other day, and we talked about reserves
and resources on some companies still being valued at higher gold and
silver prices. Where are we in terms of getting the sector written down
to today’s prices?
RR: We’re lagging substantially. In the minerals business,
there have been a lot of 43-101s (which are thumbnail economic
evaluations of projects) that have been written at much higher commodity
prices. The one in question was written I think at $1350 gold and
something like $30 silver, numbers that are substantially higher than
the numbers that prevail today.
One of the things that’s important for us as analysts (and it’s
important for individual investors to do the same), when they look at
the headline number on a 43-101 or a preliminary economic assessment or a
feasibility study, is to pay close attention to the assumptions. The
idea that you can look at the executive summary, the final number and be
happy with the process is certainly a mistake. You have some companies
that are reporting gold project assumptions at $1000 gold. You have
other companies reporting gold projects at $1350 gold.
So this is not comparing apples to apples. This is comparing apples
to oranges and the problems don’t stop there. You have some companies
talking about mining costs at $4 a ton. Other companies are talking
about mining costs at $1.50 a ton, with each mining very similar
projects. You will have other companies talking about 95% recovery
rates—this is fiction. It’s important for investors who look at these
third party or internal evaluations, to not just look at the final
number. Pay real attention to the assumptions.
TD: Rick, would you say that industry-wide write-downs and a resetting of assumptions are essential for the sector to find a bottom?
RR: I think it’s part of the process. I think what’s more
important is for individual and institutional investors to have a much
more jaundiced view of the industry generally.
The fictional nature of some of the economic data is one
manifestation of a financial services industry and an investor base that
has been way too tolerant of management misfeasance and malfeasance.
The levels of general and administrative expense in the mining
industry (in particular the junior exploration industry) relative to
capital employed, return on capital employed, and exploration
expenditures is deplorable. There’s too much G&A.
The salaries have been too high, particularly in periods of time like
the last three years when the industry can’t afford them at all.
The severance payments associated with change in control have been
the main reason why you haven’t seen amalgamation in the industry, which
the industry needs to survive.
So a focus by the investor on the upside and the downside is what
will allow the industry to thrive. As an example, in the TSXV, there are
probably 400 or 500 surplus companies in Canada. As my friend Otto Rock
says, please don’t feed the animals. Don’t give these guys any more
money. Make them go to company heaven. Thank and excuse.
Think about it—500 companies at maybe $700,000 a year in general and
administrative expenses including listing fees and auditing fees. That’s
an enormous amount of money and every dime of it’s wasted. We need to
cut this out of the industry so that there are fewer, better, more
solvent players.
TD: Rick, recently as a group we studied the subject of G&A expenditures.
I remember asking you in that meeting and I’d like to ask you here
again—at previous market bottoms, have you ever seen this outsized
level of compensation offered to executives and directors, where in many
instances their corporate share prices are down 70% to 90% over the
last two to three years?
RR: I’ve never seen compensation as a percentage of assets or
total expenditures that come close to this. This industry was
obnoxiously overcapitalized in the period of 2004 to 2011 and most of
that capital went to capital heaven—a substantial amount of it as a
function of G&A.
We’ve done some work internally here (and perhaps we’ll recruit a
very smart intern to finish it off), that talks about compensation as a
percentage of book assets and as a percentage of expenditures on the
TSXV. The preliminary work we did showed that TSXV companies in the sub
$50-million market cap range, represented by a statistical sample of 75
companies, spent more than half of total expenditures on G&A.
We need to true up that study over five years and expand the scope to
determine the accuracy. The other scary thing we’ve seen is the
severance liabilities these companies have, in the event of amalgamation
or change of control.
A company was pointed out to us by a customer that had an $8 million
market cap and a $7.8 million change of control obligation. It’s pretty
obvious that no merger would take place, because if that happened, there
would be what--$200,000 or $300,000 left for the shareholders? The
managers would get the rest of it. This is scandalous. The industry and
we gatekeepers in the financial services industry need to address it. We
need to address the issue right now at market bottom because greed will
prevent us from being able to do it at the top. At a market top, nobody
will care.
TD: Rick, I’ve thought about the word “entrepreneur” in the
past and what it means. In the relationships you’ve had over the years
with the great entrepreneurs of the sector—the Ross Beatys, Lucas
Lundins, Bob Quartermains—how would you define the entrepreneur? Is he
usually the guy who “eats last,” metaphorically speaking?
RR: Well, certainly the entrepreneur is driven, and the great
entrepreneurs eat fine anyway. But in my experience, the great
entrepreneurs have been much more focused on building value than making
money. As a consequence of that, they’ve made a lot of money.
There are people who engage in an activity with the point of view
that it will yield them a nicer house or a Lamborghini. Those aren’t
entrepreneurs, they’re hustlers, and there’s nothing wrong with a
hustler. But a hustler isn’t necessarily somebody who’s going to make
you any money.
A Ross Beatty or a Lucas Lundin looks at a task and focuses on the
task itself. It’s the project that is the motivation. That isn’t to say
those people don’t want to make money. But they make money by generating
lots and lots of utility.
So I would say the qualitative differentiation between an
entrepreneur and some other primary economic actor would be that the
entrepreneur sees a way to create value in society and just can’t help
him or herself. They have to attack that problem, and they see the
solution to the problem as being far more important than the timing or
even the extent of the compensation that they get in return for solving
the problem.
The consequence is that more often than not, they manage to solve the
problem and by not worrying about making money, they make lots of it.
TD: Rick, in winding down, is there anything you think we may have missed here?
RR: Well the thing I want to come back to again for our
clients and our readers—is that markets work. The oil business
demonstrated that very well. We had four years of extraordinary oil
prices and extraordinary margin. The consequence was that the incentive
to innovate and produce more was very strong and there was capital
available to do it.
At the same time, the utility of oil at $105-$115 was lower and the
consequence was that people began doing things like buying
fuel-efficient cars or develop fabrication or manufacturing technologies
that conserved energy.
A situation where we have increasing supply and declining demand
means that you’re going to have lower prices eventually. And guess what?
We had them. Now, people are looking for an excuse to justify low
prices and they’re acting as though low prices are going to be here to
stay. Equally silly. Low prices eliminate conservation. There’s no
particular incentive to save when you aren’t saving much as a
consequence of that effort and when there are lower financial incentives
to produce.
20:18
Unknown
He
judges that we are now somewhere between the "selfishness" and
"dependency" stages of Tyler's cycle, hopes that things will turn
around, but keeps his diversification intact just in case it does not.
The politicians, he observes, have not acted well this past year.
Washington, he says, seems to be confused and lacking direction and more
interested, as Tyler suggests, in getting re-elected than making
responsible decisions about the future of the country.
