Submitted by Tekoa Da Silva, Sprott’s Thoughts:
I had the chance to sit down once again with Rick Rule, Chairman of Sprott US Holdings.
It was an interesting conversation, as Rick noted natural resource markets are transitioning into a phase in which “optionality” is becoming a highly attractive speculative strategy.
“Optionality [or hoarding] is a speculative technique that works particularly well when entered into during bear markets, transitioning into bull markets.”
Optionality involves hoarding enormous commodity deposits, “when commodity prices are low,”Rick continued, “And sell[ing] the deposit[s] intact when prices are high and the industry is screaming for it.”
“Lumina Copper was a classic hoarding strategy,” Rick added. “[F]rom a low of $.50 cents per share…it was sold off in pieces for a total realization of about $160 per share over the course of six to eight years, [from about 2005-2014].”
“A well-constructed public company that has fairly low general and administrative and holding costs is almost like a perpetual [call] option—a 10-year or 12-year option,” Rick added, “[and] the leverage inherent in these options [can be] unbelievable.”
Here is the full conversation with Sprott Global Resource Investment Ltd.’s Tekoa Da Silva:
Tekoa Da Silva: Rick, I’d like to ask you about a concept we’ve talked a little bit about in the past called ‘optionality.’ In the resource business, I understand that term has a pretty specific definition.
For the person reading—can you talk a little bit about the meaning of that term in the context of the resource business?
Rick Rule: Optionality is a speculative technique that works particularly well when entered into during bear markets, transitioning into bull markets. What optionality refers to is buying into a company or a deposit that isn’t economic at current commodities prices, but could be very economic at much higher commodity prices.
An example would be a copper deposit that makes no money at $1.50 lb. copper, but might be extremely economic at $3.00 lb. The consequence of that is that you might be able to buy the deposit at $1.50 lb. copper based on its net present value (which is almost nothing) and sell it if the copper price goes to a much, much higher price.
In the last bear market we went through, the 1998 to 2002 bear market, the predecessor to Sprott Global which was Global Resource Investments used this technique to very good effect.
As an example, Paladin Uranium, which we’ve talked about before, was a play on higher uranium prices. It benefited by going—I’m not kidding—from a low of $.01 per share to a high of $10.00. But it wasn’t the only uranium play that soared on higher uranium prices.
The whole early stage uranium group, the ‘hoarders’—groups that were playing on optionality, all went higher and it wasn’t just in uranium.
Pan American Silver went from a financing price of $.50 cents to a high of $40 something. Silver Standard went from $.72 cents to a high of $40 something. But the real winner was Lumina Copper.
Run by Ross Beaty, Lumina Copper was a classic hoarding strategy which went from a low of $.50 cents per share. As I remember, it was sold off in pieces for a total realization of about $160 per share over the course of six to eight years, [from about 2005-2014].
So the optionality idea goes like this: One of the fallacies in the exploration & development business is that if you think a commodity is going to go up in price, you should buy a deposit and spend hundreds of millions of dollars putting it in production because you think the commodity price is going to go up.
Often, 5 or 6 years later, when the commodity price actually does go up—all you have left is a hole in the ground where your gold used to be. The gold price is up and your gold is all gone.
Why not leave the gold in the ground and when the price goes up, sell it to somebody else who wants to use the then present gold price to establish the deposit’s value?
TD: Ok. So the term “optionality”—that means a company or a deposit that functions like a ‘call option’ on the price of a given commodity?
RR: Yes, but truly a leveraged call option. One of the things about commodities options is that they have ‘fuses’. A two-year option gives you a play with a two-year ‘fuse’. A six-month option gives you a play for six months.
A well-constructed public company that has fairly low general and administrative and holding costs is almost like a perpetual option—a 10-year or a 12-year option. The leverage inherent in these options is unbelievable.
When Bob Quartermain was constructing Silver Standard, he didn’t pay more than $.05 oz. for silver in the ground. Six or seven years out, people were paying $1.00 oz. or $1.20 oz. for silver in the ground.
Along the way, Bob didn’t have to do anything to advance his ounces. All he had to do was own them and not mine them.
So one thing I’ve learned over 40 years in this business is that not mining is much easier than mining.
TD: Rick, you mentioned general and administrative costs and some other important variables, which leads me to ask—what can go wrong with an optionality play?
Also, what needs to go right? What are the basic elements needed to make a great optionality investment?
RR: Timing is one. I think you need to do it when the anticipation in the general market is that commodity prices aren’t going to go up. When despair is present.
I have to say that over the last 2 months, despair has been particularly thick. That isn’t to suggest that despair hasn’t been present for the last three years. But despair after the Anglo American layoff announcement in December has been very thick.
So the first criterion has been met. The second criterion is that as a consequence of financial distress in the mining business, companies are looking to sell assets that they consider to be redundant. Those are assets that aren’t generating cash. Certainly assets that aren’t economic at this price must be considered to be redundant and the industry does in fact need to raise cash.
The third thing is the management team has to be – and this is going to sound very strange, but it will make sense to the reader as we go on.
The management teams have to be desperate enough that they’re willing to do the right thing.
Convincing a management team that has been brought up to put stuff into production, to move projects forward—to convince them to do nothing is very difficult.
And to convince them to be paid appropriately for doing nothing is even tougher.
TD: I guess that begs the next question—if a management team veers in strategy, can that destroy the optionality feature?
RR: Absolutely. There’s an incredible bias in the exploration development business. In fact there’s an incredible bias in commerce generally to ‘do something.’ The right thing to do in optionality is to do nothing.
Think about a company that has a very, very large deposit. I’m not going to name names, but I’m thinking of one.
This company five years ago would have had a $2 billion market cap with one of the biggest copper-gold porphyry deposits in the world. A $2 billion market cap, while only owning half the deposit.
Now it owns the entire deposit and has about an $80 million market cap. So that’s down from $2 billion for half of the deposit—to $80 million for the whole deposit. You get twice as much for about 4% of the price.
The problem is that this company is spending $2 million a month on general and administrative and holding costs, and is trying to advance the property.
So what happens to the shareholders?
Well, the shareholders who own this deposit with an $80 million market cap are getting diluted by more than 25% a year. The money spent on G&A doesn’t actually advance the property, nor does it advance the value of the property to the extent that the equity issuances dilute existing shareholders.
So it’s very, very important with an optionality play that the first thing you do is nothing.
Now it’s true that subsequent to the bottoming period in commodities, demand begins to return, and commodities begin to return to favor. Share prices go up, and the issuer’s cost of capital goes down.
When that happens it may be appropriate to raise money and do some exploration, because the best place to look for gold or copper is around a gold or copper mine.
But during the point in time in which despair is pervasive, share prices are low, and the cost of capital is high—the right thing to do is nothing. Or if you choose to do something, raise money and buy another deeply ‘out of the money’ (optionality) deposit.
One more thing: If you’re going to play the optionality game, play it big. Don’t buy little deposits. Buy great, big deposits.
In the current market, gigantic copper-gold porphyry deposits that would have traded during 2011 for $2-$3 billion are going to change hands for $10 million or $15 million. This is absolutely going to happen.
It’s going to happen because these deposits won’t make any money until copper is at $3.00. But nobody knows when or if copper is going back to $3.
Management teams know that to put these properties into production would cost $2-$3 billion. The $2 billion or $3 billion necessary to put them into production won’t be attracted in this market.
But the truth is, every day we mine more copper and the longer this lower copper price environment remains, the more productive capacity we destroy in copper.
Low prices will destroy productive capacity in copper. Mark my words. Supply destruction is occurring and will continue to occur until we have copper shortages. When that happens, the $3 billion deposit that somebody buys now for $15 million will command a $3 billion price tag again. That will happen.
TD: Rick, what timeframe do we need to have in mind for a commodity price recovery in order to succeed with an optionality investment?
And does the fluctuation of general and administrative costs—does that resemble an ‘option decay’ chart that one may imagine when visualizing option contracts?
RR: Answering your questions backwards, absolutely. As opposed to a time decay, what you have is a ‘spend decay.’ But the analogy is very useful.
In theory, the decay in terms of the optionality here is very, very flat. It’s really up to management and how much they spend. So it isn’t a time decay, but rather a spend decay.
Now in terms of price recovery & optionality timeframe—when we were raising money initially for the names I told you about earlier in the interview; Silver Standard Resources, Pan American Silver, Lumina Copper—in all of those plays we told investors to think in the context of five years.
So I think five years is a realistic timeframe. My own suspicion is that these stocks will begin to move in less time than that. But in order to really take advantage of the strategy, I think you need to think in 5-6 year terms.
Certainly since I began thinking in 5-6 year terms (that occurred 20 or 25 years ago), my own results began to differentiate themselves positively when compared to my competitors who thought in much shorter timeframes.
TD: Rick this interview is taking place in the first quarter of 2016. Why should a person consider an optionality strategy now?
Could there be 3-4 more years of downward trending commodity prices? What are your thoughts?
RR: There actually could be 3-4 more down years. But what I did when thinking about what to do in 2016, was put myself through two exercises:
- What worked the best for me in the last cycle?
- What is most hated now?
At the top of the last cycle, optionality is what paid. At the bottom of the last cycle, optionality was the most hated.
If you want to play the cycle, why not think about the sector that worked the best at the top, was the most hated during the previous bottom, and that is most hated now?
The other thing this addresses is one of the critical concerns those of us in this market have. Actually there are two concerns.
One is the explosion of general and administrative expenses. The truth is that part and parcel of optionality is consolidation—the idea that one management team (rather than five) can manage five projects.
If what investors have asked management teams to do is nothing (or minimally maintain the projects), why couldn’t a management team manage five projects as easily as they could manage one?
So moving larger amounts of assets under administration relative to general and administrative expense is something that the industry needs and it’s the key to optionality.
Sprott will be looking for companies that are willing to amalgamate. Management teams that understand that putting five assets together under one team is the key to survival.
Sprott will be writing checks towards this matter. Checks sufficient to keep companies alive for 2-3 years (or 5 in the right set of circumstances) and we aren’t the only institutional investors who are committed to doing this.
TD: Rick, for the person reading—what is the most intelligent way they can learn about and participate in this process?
RR: Well, I’m prejudiced with regards to this. But I suspect that the only institutional investor in the world right now trying to cause this to occur is Sprott.
But if you want to look backwards and see how this mechanism played out during previous cycles, go on the web and look up the share price history of: International Uranium, Paladin Resources, Pan American Silver, Silver Standard Resources, Vista Gold, Lumina Copper.
Read the press releases on a historical basis as well, provided you have the time.
Look at the strategies that worked in the last market and look at how well they worked. If you follow the lessons that we’ve talked about before in this interview series on securities analysis, and you apply these lessons retroactively to the names that I just named—you will understand extremely well the thesis with regards to optionality.
TD: In winding down, do you think there’s anything we may have missed?
RR: I don’t think so. I think most people invest in commodity-based stocks because they think the commodity price is going to rise. If you believe that the commodity price is going to rise, rather than looking for a commodity, why wouldn’t you buy a commodity?
Further, if you believe the commodity price is going to rise, why on earth would you produce the commodity when the price is low? When the price rises, you don’t have any more of the commodity left.
There is one more item I should mention.
One of the things that happens consistently during periods of low metals prices, is that the industry ‘high grades’. That means they mine the best parts of their deposit, to lower their current cash costs to survive.
What that means however is that when the commodity price begins to go up, the best part of the deposit has already been mined. So they have to mine the lower grade parts of the deposit and their costs rise.
Think about this—in 2000, the gold price was about $260 an ounce. By 2011, the gold price had run to $1900 oz. and per share cash flows in the industry had declined.
The gold price went up six fold and per share cash flow declined.
What happens in any commodity market, is when the price goes up, there will be a need for new deposits. Probably the best way for a company to address this, is to not ‘high grade,’—not mine when prices are low but rather hoard.
Hoard when commodity prices are low, and sell the deposit intact when prices are high and the industry is screaming for it.
Remember the saying: Buy low, sell high. Rinse, repeat. That’s what hoarding is all about. That’s what optionality is all about.
TD: Rick Rule, Chairman of Sprott US Holdings. Thank you for sharing your comments with us.
RR: Thanks for the opportunity Tekoa.