From Canadian Business magazine, September 28, 2009

Mining: Trouble in Socialist paradise

Will Cuba's downturn leave Sherritt in the lurch?

By Rachel Pulfer

Ian Delaney, chairman of global commodities company Sherritt International Corp. (TSX: S), is known in business circles as Fidel Castro’s favourite capitalist. That’s because 19 years ago he forged a groundbreaking relationship with the dictator that has fuelled Sherritt’s growth ever since. But all is not well in socialist paradise. The commodities downturn has put Cuba in an economic straitjacket — and that is severely testing the Sherritt-Cuba relationship.

Sitting in his office, atop a nondescript building in midtown Toronto, Delaney is sanguine about the Cuban government’s decision earlier this year to rip up a long-term oilfield production-sharing contract with his company. The loss represented 26% of Sherritt’s net oil production on the island. “Sure, I’m owed,” Delaney says, referring to the fact that the company is still waiting on receivable payments. “But that’s OK. We have an amazing book of assets in Cuba. We’ve still got 25-year nickel assets, 12-year oil assets and 15-year power assets.”

“You want royalty grabs?” he continues. “Try Alberta.”

Cuba’s economic problems can be traced to last year’s hurricane season, which knocked out much of its agricultural sector. The country now imports 80% of its food, which helps explain why, in 2008, imports soared to US$14.2 billion, while exports fell to just US$3.7 billion. Meanwhile, the price of Cuba’s lifeblood commodities, nickel and oil, plunged this past winter. Cut off from international credit, the country must still meet its commitments to supply jobs, health care and food to its 11.5 million inhabitants. So President Raúl Castro implemented new austerity measures in mid-summer, including the rationing of gasoline and electricity. He also slashed Cuba’s growth projections from 6% to 1.7%. Sherritt is caught in the downdraft.

Delaney first met Fidel Castro 19 years ago. At the time, the Cuban leader’s back was against the wall. The former Soviet Union was collapsing, and with it went the U.S.S.R.’s appetite for Cuban sugar. That wiped US$5 billion in foreign exchange off the books. Cuba plunged into an economic downturn so severe locals were rearing livestock in their bathrooms.

Delaney had long sought access to Cuba’s nickel, estimated to represent a third of the world’s total reserves. From Castro, he negotiated rights to exploit the metal, plus cobalt, oil and gas; this eventually gave Sherritt a near-monopoly position in Cuba. In return, Sherritt would effectively bankroll and power Cuba’s Communist regime through the post-Soviet era.

The deal meant Sherritt could no longer do business in the United States under the terms of the Cuban trade embargo. But it paid off in other ways. At the end of 1995, Sherritt booked assets of $677 million; they now top $10.1 billion. Approximately a third of the company’s value now derives from Cuba, courtesy the 2003 to 2007 commodities boom.

Unfortunately, the good times are now over, and Sherritt’s future in Cuba suddenly looks less certain. In late July, Sherritt reported half-year earnings that showed how painful that ripped up contract turned out to be. Net working-interest oil production for the second quarter was down 29% over last year. Oil and gas revenue plunged to $96.8 million in the first half of 2009 from $192 million in the first half of 2008. Total net earnings for the quarter dropped to $24.4 million from $80.3 million — a decline of almost 70%.

Earlier, Sherritt announced Cuba would pay US$60 million in compensation on the lost oilfield. That’s on top of the $44.7 million in unpaid oil, gas and power receivables currently overdue. Cuba paid a second tranche that totalled US$161.1 million in February 2009. Sherritt promptly then invested theproceeds in Cuban government bonds. Those won’t mature for another five years.

Yet if Delaney is worried about Havana’s ability to pay him out, he doesn’t show it. He says he’s committed to the country — and a company announcement in late June estimated Cuba would pay up in full by the end of the first quarter of 2010.

Delaney’s confidence is well-founded. Sherritt supplies Cuba with much of its oil, gas and electricity. What’s more, says metals analyst Raymond Goldie of Salman Partners Inc. in Toronto, Cuba hasn’t missed a payment this year.

But according to Heather Berkman of the Eurasia Group, a New York–based think-tank specializing in political risk, the Cubans see Russia, Brazil and Venezuela as better political bets than Canada. Given that, Sherritt’s Cuban interests may now be further threatened by an apparent chill between Canada and Cuba, which manifested earlier this year in visa spats between Canadian and Cuban officials. Sure enough, on July 29, Cuba’s state media announced new contracts with a Russian company to exploit the holy grail of its resources: rights to drill for oil and gas offshore. In an earlier era, those contracts might have gone to Sherritt.

Even so, Sherritt has extensive holdings outside Cuba. And it habitually trades at a discount to its peers, due to perceptions of political risk that analysts deride as overblown. Robin Kozar of RBC Capital Markets now puts that discount at 50%, compared with other companies in RBC’s Canadian Mining Index, and rates the company a Buy.

Throughout 2009, investor confidence in Sherritt has surged in lockstep with the price of nickel. Its stock is up sharply from its January low of $2.56; it’s now trading at around $6.60 a share. Kozar has a one-year target of $7.50 — nudging toward the $9 Sherritt traded at before the global market meltdown.

Mark Entwistle, Canadian ambassador to Cuba from 1993 to 1997, believes Sherritt’s good fortune on the island will survive the downturn intact. “Cuba is a long-haul market,” Entwistle says. “To be successful, companies must believe they are investing in a long-term relationship with an entire nation. I put Sherritt in that boat.”

And the royalty problem? “Everyone wants to get paid,” Entwistle acknowledges. “Trading companies that are too exposed in Cuba won’t survive. But Sherritt is in a category by itself. They will ride it through. Nickel prices will go back up, and they will suddenly look brilliant again — just for being in Cuba.”

Many believe Sherritt will soar anew once the United States lifts the Cuban trade embargo, thus giving it access to the U.S. market. This April, the Obama administration eased restrictions on Cuban-Americans travelling home; investors bumped Sherritt’s stock up 25%. However, for domestic political reasons, it’s unlikely the embargo will be lifted any time soon.

Delaney says he isn’t planning his business around what the Americans do or what the Street thinks. “With commodities, you’re planning for decades, not half-years,” he adds. “It’s like driving down a long highway. You see lights coming the other way, but you don’t get distracted. You just keep on driving.”

Sherritt shareholders are betting he’s right.