Feature interview
Laurentian Research, a Ph.D. in geoscience, worked as a natural resources industry insider and invested successfully for years, before launching a Seeking Alpha Marketplace service to share his unique investment insights with a rapidly growing community of value investors. Join his premium service The Natural Resources Hub, the one-stop solution for investors who want to profit from the unfolding commodity super-cycle. Members get the best investment ideas pitched in the form of trade alerts backed by frequent in-depth research reports, weekly market commentary newsletter, a lively friendly chat room, his prompt responses to your questions (in private if preferred), and a suite of Google Sheet-enabled tools loved by busy investors. We discussed common traits of multi-baggers, how to determine whether a resource base (and management) is low or high quality, and why the natural resources sector is a great hunting ground for high-yield income and dividend growth ideas.
SA: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?
Laurentian Research: To put it simply, I apply value investing to the natural resource sector.
Idea generation and evaluation: I source investment ideas from The Natural Resources Hub community, my industry network, oil and mining industry journals and conferences, and social media. I next screen these ideas with regard to their asset quality, management ability and shareholder-friendliness, and relative valuation, often enlisting the help of Seeking Alpha screening tools. I then conduct in-depth research on a select few targets with a particular interest in uncovering hidden risks as well as ascertaining a more than adequate margin of safety, in order to find out whether there exists an exceptionally asymmetrical risk-reward profile that fits my idiosyncratic investment goal, risk appetite and time horizon.
Portfolio management: I try to keep an eagle eye on the operations of underlying businesses to guide the trimming or adding to individual positions. That way of risk management typically leads to a diversified portfolio with a meaningful concentration in a number of key positions. I never set out to diversify for its own sake, although I am agnostic to commodity types, jurisdictions and market cap within the natural resource sector.
One can really thrive on commodity cycles, given the maximum information inefficiency existent in the natural resource universe. As my experience shows, the success of my value investing approach seems not to depend on commodity price prophecies with granularity. I also learned that the downside risk associated with commodity cycles can be mitigated by sticking to high-quality businesses as well as by executing timely exits by monitoring the general industry conditions.
Focus area and employed strategies: Besides the oil patch and mining industry, I view what I call the digital resources space as another circle of competence of mine. The delineation of the digital resources space allows me to construct two additional strategies for accounts intended for the near-retirement and the retired individuals, i.e., secular growth at a reasonable price (or GARP) and dividend growth (or DGI) investing. Overall, my portfolio ends up being barbell-like, with high-risk cyclical ideas at one end and secular growth at the other, which helps me limit risk on the portfolio level without sacrificing capital appreciation potential.
Interested readers are referred to a previous interview for a detailed discussion of my investment decision-making approach.
Given the latest development in the natural resource investment circle, I do wish to emphasize the following points.
Firstly, geology is a very local science and is finely specialized so hiring a consulting geologist without intimate knowledge of the concerned reservoir may not be able to substitute an industry network built over decades of working as an industry insider. Take Pantheon Resources (OTCPK:PTHRF) to appreciate why local knowledge is important and how irrelevant local knowledge can mislead. A debate broke out recently in various online communities after a City analyst had released a bearish research report on the stock. In an effort to refute the investment thesis, he used buried hill reservoirs in North Sea as the analog to the geologically different shelf margin deltaic, slope fan, and basin floor fan reservoirs found by Pantheon in Alaska North Slope. It turned out later that even geologists with experience in nearby conventional oilfields, e.g., Prudhoe Bay, found it hard to envision the semi-unconventional resource needs to be developed via horizontal drilling and hydraulic fracturing as in typical shale oil provinces in the Lower 48.
Secondly, a systematic methodology for analyzing stocks is extremely important for generalist investors who are new to the natural resource sector. An inexperienced analyst tends to do monofactorial decision-making, i.e., relying on one single factor to make a call on a rather complex investment idea while ignoring numerous other relevant variables.
Thirdly, a sound investment approach is important today more than ever, if only to guard against the gunslinging pundits who emerge on social media in number as the oil bull market roars on, and prod starry-eyed investors to plow hard-earned money into stocks that feature the so-called torque. A stock with torque supposedly delivers the maximum upside on rising oil price. Torque addict’s typical rhetoric goes like “the stock will be worth Y when oil reaches X“, under the often-unspecified assumption that the model requires the oil price to increase continually. A search for high torque almost always leads investors to high-cost assets, heavy debt and inadequate hedging against commodity price volatility. Unfortunately, human nature dictates that unsophisticated buyers have a tendency to ignore those risks and fall for promises of maximum upside, until the commodity price inevitably turns against them.
SA: You’ve said there is a generational investment opportunity due to the commodity super-cycle – can you discuss this, from the factors driving the super-cycle, to which commodities will benefit the most and which companies are the best way to play it?
Laurentian Research: A commodity super-cycle is an extended period, usually more than a decade, of increasing commodity demand. The previous commodity super-cycle was driven by the urbanization of China in the backdrop of radical globalization. It ended around 2014 when Chinese economic expansion began to lose steam.
The current commodity super-cycle has two engines both in the form of major societal changes:
One engine is the populist movement in the developed and developing countries alike, with the so-called Fourth Turning in the backdrop. Through street protests and strikes and by voting supposedly of-the-people leaders into public offices, the populists succeed in extracting better compensation from their employers, and bigger income redistribution checks (for pandemic relief, inflation relief, fuel tax holiday and so on) from governments. One would have been living under a rock over the last few years without noticing such a trend in countries rich (e.g., the U.S.) or poor (e.g., Ecuador). With more money in their pockets, the 99% consume more tangible stuff, which results in surging demand for commodities, as opposed to the 1% who tend to use their incremental income to buy more financial assets.
The other engine is the decarbonization movement, mostly in the developed world. Sustainability has become both a popular demand and an official mandate across the North Atlantic. The West devoted the last decade or so to creating an internal green consensus (albeit not always successfully) on the one hand, and proselytizing the rest of the world to bring about a worldwide momentum toward net zero carbon on the other hand. Under the initiatives of energy transition, the world’s ICE vehicle fleet will be replaced by EVs, and infrastructure rebuilding must to be done in an unprecedented scale to facilitate the generation, transmission and distribution of zero-carbon electricity to billions of EVs where the road takes them, which needs a humongous amount of metals, ranging from steel, aluminum and copper, via lithium, cobalt, nickel, manganese and graphite, to REEs and uranium. As an unintended consequence, the extraction of metals from the Earth’s crust actually requires a lot of fossil fuels, at least in the foreseeable future.
I don’t think these profound societal changes – the driving forces behind the commodity super-cycle – will peter out anytime soon. As long as these engines continue to hum, the commodity super-cycle will go on. Precisely for that reason, I believe the commodity super-cycle may well last until 2032, if not for longer.
The commodity super-cycle cannot choose a worse time to start because the supply side is totally unprepared:
Firstly, the entire commodity patch has suffered from years of under-investment, since the GFC for some commodities and since 2014 for others. There simply is not enough spare production capacity in place, to meet a rising demand. Mind you, commodity extractive projects are long-cycle in nature so the issue of tight supply cannot be resolved overnight as demanded by politicians.
Secondly, many (oil and gas) producers are reluctant to hike capital spending on production growth, which is understandable given the oil industry has been told by Wall Street that it should focus on rewarding shareholders, by the public that it is dirty and unwanted, and by the government that it is in terminal decline and in the process of being ‘phased out’. Even if an operator wants to drill and complete an extra well beyond its capital budget, according to the most recent Dallas Fed energy industry survey, it takes more than 6 months to get it done, thanks to supply chain constraints and shortage of skilled labor. Talking about skilled labor, few young kids want to be petroleum or mining engineers these days, thanks to a decade of green education.
Thirdly, coming out of the Covid-19 pandemic, the West is scrambling to purge unfriendly vendors from its not-so-resilient supply chains, not an easy task considering China and Russia control a big part of the upstream and even more significant part of the refining of so many commodities. The Russian invasion of Ukraine only serves to highlight how deep a commodity supply chain trouble the West is in. How do you replace a top-three oil producer while even OPEC is running out of spare capacity? It may take many years for the West to rebuild a safe commodity supply chain that is not under the yoke of a menacing enemy.
The above-described double whammy in balancing the commodity supply and demand means discerning investors are presented with a generational investment opportunity.
Before moving on, a few confusions need to be clarified. Commodity super-cycles are demand-driven, not supply-driven. The driving forces behind the ongoing commodity super-cycle are independent of China; it follows that a Chinese economic slowdown probably won’t bring an end to it. The Ukraine war postdates the beginning of the commodity super-cycle; so the end of the war is unlikely to make the commodity super-cycle go away. A commodity super-cycle has its own internal logic that operates largely independently of the general market. During the 14-year oil bull market in the 2000s and early 2010s, there were two major recessions, namely, the internet bubble burst and the GFC, both of which resulted in a flash crash in the oil prices but none of which was able to prevent the oil bull market from continuing.
SA: In your last interview we discussed the mispricings in non-U.S. companies – as you also cover micro and small caps, is there a similar opportunity or mispricing there?
Laurentian Research: Yes, that’s right. Quite a few mining and some oil and gas holdings in my portfolio are micro and small-caps although my digital resource holdings are all large-cap.
Thank you for the great question because it gives me an opportunity to highlight the inherent advantage retail investors have over Wall Street in reaping multi-baggers by investing in high-quality micro and small-cap stocks but they, unfortunately, give up that edge for no good reason.
Micro and small-cap companies usually are not clients so Wall Street banks have self-interested aims to steer investors away from micro and small-cap stocks.
Independent financial media often parrots what Wall Street banks want us to know. For instance, we are routinely warned about the risks associated with micro and small-cap stocks, OTC stocks, and penny stocks; however, I bet you have never come across a warning at the end of any article that goes like this: “This article discusses one or more large-cap stocks. Large cap stocks may go bankrupt, as was the case with, e.g., Lehman Brothers, General Motors, Enron or LyondellBasell. Bankruptcies may cause painful loss of capital so please be aware of the inherent risks in large-cap stocks.”
But seriously, when it comes to micro and small-cap stocks, information is extremely inefficient thanks to the reality that they are systematically under-covered, woefully under-followed, and often irrationally despised.
In the micro and small-cap space, I mainly focus on Canadian and Australian miners that trade on TSX-V, ASX or OTC, which are typically lumped into the penny stock category. Talking about penny stocks, most people don’t appreciate the fact that TSX-V and ASX actually serve as a venture capital platform for pre-revenue early-stage explorers, which have no access to the bond market, so which have to resort to equity issuance to fund its exploration program. After a few rounds of private placements and several phases of exploration, these stocks may end up trading as a penny stock. However, one may find a select few of them that are well-funded, are run by the-salt-of-the-earth management, and own evidently high-quality projects that will likely become a profitable mine in the foreseeable future.
Here are three examples that caught our eyes: with a market cap ranging from $17 million to $31 million and no debt, the first one is actively drilling to double its mineral resource currently measured at ~79 Moz AgEq; the second one is working to expand the 8.4 Blb CuEq of mineral resource in a top-ranked jurisdiction; the third one owns not only a producing copper-gold mine that generates a 36% FCF yield but also a permitted copper-gold project that is ready for mine construction.
It is safe to say, to someone who knows what he is looking for, the micro and small-cap space is veritably the most fertile land to pick low-risk, multi-bagger targets.
SA: You’ve invested in a number of multi-baggers in this sector –are there any common traits of these types of stocks? How do you identify them in the idea gen process? How do you tell if you should continue to hold even after a 100% gain?
Laurentian Research: My multi-baggers seem to share three common traits: high-quality assets, serially-successful management who align their interest with that of retail shareholders, and an enormous margin of safety – the three criteria that I use to screen targets in the idea generation process. I found those ideas that failed to deliver a multi-bagger return all came short in at least one of these traits.
Peter Lynch once said,
“My best stocks have been in the third year, the fourth year, the fifth I owned them. It’s not the third week, the fourth week.“
Having learned from the investment maestro, I came to realize multi-baggers are had by holding, not by buying. That requires me not to exit from a position just because it has reached a certain milestone in percentage gain. In practice, I make relatively early entries and then closely monitor the operations over the span of a few years, to understand the upside and downside of local subsurface geology, to study the management, and to assess whether the project is being advanced toward the predetermined goal in a satisfactory manner. If I find I have made a mistake in the investment thesis, I will exit from the stock on profit or loss. However, if the management runs a tight ship and treats shareholders fairly, if the project is being continually de-risked (or the operating costs are being reduced), and if the stock is not overvalued, I will continue to hold the stock. I may even add to the position by picking up more shares on dips.
I must point out that position sizing is extremely important. Landing a multi-bagger merely proves I happened to be right with that particular investment thesis. My goal in this game is to make adequate profit by allocating capital. That’s why being proven right yet failing to reap a sizable profit sounds like an empty win to me. Only when a whole bunch of money has been made by piling on the stock I believe in, do I view the multi-bagger as a meaningful success.
SA: How do you determine whether a resource base (e.g. oil/gas, metals) is low or high quality? Can you give an example?
Laurentian Research: For a pre-revenue exploration project, I’d try to ascertain if the acreage is richly-endowed with the target commodity, and whether reserves can be found, delineated and developed at relatively low costs. It is a policy of mine to stay away from complicated projects, tricky metallurgy, and tough jurisdictions from a fiscal regime, permitting, and community relations point of view. Accessible infrastructure is critical for capital efficiency.
As a good example, the Cabaçal project of Meridian Mining (OTCQB:MRRDF) is an extremely richly-endowed camp-scale VMS belt in mining-friendly Brazil. The copper-gold mineralization occurs in shallow levels, which not only lowers exploration drilling costs but also makes the deposit amenable for low capital intensity open-pit mining. As a brownfield project, Cabaçal is metallurgically simple.
For producing assets, I evaluate the quality of the asset in terms of two main measurements, namely, the profitability per unit of production and longevity of reserves.
As I explained in a recent article on the Montney natural gas play in Canada, the profitability per unit of production is determined as follows:
E*/[Production] = {[Realized price] – [OpEx] – [F&D]} X {1 + g}, where OpEx is the full-cycle operating expenses, F&D is the cost to find and develop one barrel equivalent of oil and gas reserves, and g is the production growth rate.
In this equation, various operational parameters come together to determine the profitability of a business. The above equation makes it possible to compare different oil and gas businesses using concrete operational parameters.
The longevity of reserves measures for how much longer the operator can continue to produce until the reserves are depleted. Because oil and gas projects on average take ~7 years to advance from exploration to production, I require at least 12 years of proven reserve life. On the other hand, holding too large an amount of reserves on the book hurts capital efficiency, because finding and development (F&D) capital has time value. An exception is oil sands or natural gas reservoirs, which are so continuous that reserves can be delineated at extremely low costs.
SA: To follow up, how do you determine management quality, as this is just as important and equally difficult (if not more so) to evaluate?
Laurentian Research: Management quality includes two aspects: the ability to execute and shareholder-friendliness. I evaluate management quality both qualitatively and quantitatively. A proven track record of serial entrepreneurial successes is a good indication. Scuttlebutt by talking to knowledgeable sources in my industry network, especially competitors of the company, may reveal precious insights as to key personnel in the team. Findings gleaned elsewhere should be adroitly verified by talking to the CEO herself/himself.
Management ability refers to the ability to raise low-cost capital, which can be assessed through the WACC and whether the operations are well-funded; the ability to efficiently allocate capital, which can be measured by computing the ROIC; the ability to build and motivate the team; and the ability to shepherd the project toward successful completion within schedule and under budget.
Shareholder friendliness involves the extent the executives align their self-interest with that of retail investors, by looking at the average cost basis of their stock holdings; if they put their money where their mouths are, by checking their public market stock purchase record; and whether they have substantial skin in the game.
SA: Can you discuss how the natural resources sector can appeal to investors seeking income and dividend growth, not just capital appreciation? Can you give any examples?
Laurentian Research: Natural resources sector is a great hunting ground for me to locate high-yield income and dividend growth ideas for the income strategy in my portfolio. Income ideas from the natural resources sector are a perfect complement to the core income-generating positions sourced from the spaces of digital resources and under-regulated infrastructure operations (e.g., railroads and airports).
I am aware high-yield may mean trouble is brewing in the underlying business. To mitigate that risk, I insist on two criteria being met for an idea to be selected:
First, the company behind the stock commands an economic moat, having built a secularly growing business in the notoriously cyclical industry and/or having succeeded in eliminating the operating costs by adopting the advantageous royalty business model.
Second, I am offered a large margin of safety on the way in, such that the high beta the natural resources sector is known for is turned to my advantage. As Rick Rule put it, “Investors need to develop the point of view that volatility becomes a tool rather than a risk.”
Here are two examples:
Natural gas is called a widow maker. However, Diversified Energy (OTCQX:DECPF) came up with a differentiated business strategy that delivers durable shareholder returns and secular growth through the cycle by acquiring old but low-decline gas wells at bargain prices, owning midstream assets to reduce expenses, hedging to protect cash flow and stabilize margins, and amortizing the debt structure through ABS issuances. Serial acquisitions jointly with Oaktree Capital are expected to enable Diversified to continue to raise dividends in the foreseeable future. The stock currently yields 12.41%.
Labrador Iron Ore Royalty Corp, aka, LIORC (OTCPK:LIFZF) holds a 15.10% equity interest in Iron Ore Company of Canada or IOC that operates long-life iron ore mines in Labrador, Canada, and receives a 7% gross overriding royalty and a 10 cent/ton commission on all iron ore products produced, sold and shipped. LIORC currently yields 16.34%, which is expected to decrease as IOC declares lower dividends while executing an ambitious capital expenditure plan in 2022. That uncertainty, in combination with volatility in seaborne iron ore prices, may help create a great entry opportunity in the near future.
SA: What’s one of your highest conviction ideas right now?
Laurentian Research: Minera Alamos (MAI.TSX-V)(OTCQX:MAIFF) is one of my highest conviction ideas right now. Minera is a serial mine builder in Mexico, currently having three low capital intensity, high margin projects lined up in the pipeline, which is supposed to underpin organic growth and compounding for years to come. The talented team managed to carve a blue-ocean niche in constructing open-pit, heap-leach gold mines in a country they know the ropes to handle community relations, permit projects, and manage operating risks.
Despite all the challenges that came with the pandemic, Minera successfully built the Santana gold mine, and is now on the eve of declaring commercial production and positive free cash flow. That, in my opinion, represents an inflection point for the company. Minera recently received the surface rights agreements for its Cerro De Oro gold project, making it possible to finish remaining activities necessary for the permit application submission.
However, the skittish market is not in the mood to give the company credit for all the operational progresses. The management clearly disagrees with Mr. Market, since the president of the company continues to buy the stock in volume in the open market and he participated in a recent private placement. I believe the recent share price weakness represents another great opportunity for value investors to buy this hidden gem.
Pipestone Energy (PIPE.TSX)(OTCPK:BKBEF) is a natural gas-condensate producer in the Montney play. In Canada, condensate captures a premium over crude oil because the oil sands producers need a lot of it. With some 29% condensate in its production mix, Pipestone realizes C$61.85/boe on total production, leading the pack of the Montney pure plays.
Pipestone was able to find and develop proved developed (or PDP) reserves at a finding and development cost of C$10.37/boe. Its all-in cash costs came to C$22.05/boe in the 1Q2022, which is projected to decline as a result of growth-driven economies of scale. Between advantageous price realization and low F&D and operating costs, Pipestone emerges as one of the highest-margin producers in the Montney play. For every boe of production, Pipestone generates C$38.26 (or US$29.68) of profit.
Pipestone has an ambitious growth plan for the next three years, expected to achieve a 30% production growth in 2022. With 15.9 years of proven reserve life, the growth plan is well supported by the reserves.
Pipestone is projected to pull in C$155-C$185 million of free cash flow in 2022, giving a forward FCF yield of 24%. The C$204 million net debt may be paid off in one year. The irrational selloff of late has created a great opportunity to make an entry into this under-followed stock.
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Thanks to Laurentian Research for the interview.
Laurentian Research is long Pantheon Resources, Meridian Mining, Diversified Energy, Labrador Iron Ore Royalty Corp, Minera Alamos, Pipestone Energy
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