HIGH-GRADE NI-CU-PT-PD-ZN-CR-AU-V-TI DISCOVERIES IN THE "RING OF FIRE"
NI 43-101 Update (September 2012): 11.1 Mt @ 1.68% Ni, 0.87% Cu, 0.89 gpt Pt and 3.09 gpt Pd and 0.18 gpt Au (Proven & Probable Reserves) / 8.9 Mt @ 1.10% Ni, 1.14% Cu, 1.16 gpt Pt and 3.49 gpt Pd and 0.30 gpt Au (Inferred Resource)
Message: Insight from a very smart man!
BMO Capital Markets Client Conference Call for February 7, 2008
Don Coxe
Montreal
“While You Were Weeping”
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Thank you all for tuning into the call, which comes to you from Montreal. And we had to move the call to Thursday because I’m traveling tomorrow for meetings that I’m having on the weekend. The chart that we faxed out was Minneapolis Grain Exchange Wheat and the tag line was “While You Were Weeping”. What we did was we picked as our start date the beginning of the recognition of the global banking crisis.
And the point of the chart was to illustrate that there’s always some good news somewhere, even if all the news seems to be bad.
And the fact that Minneapolis Grain Exchange Wheat closed yesterday roughly at the Columbus level of 14.92 illustrates something else about this whole ag business, which is that we don’t have in some of these commodities the singularity of being one price somewhere. There’s a huge spread between the price that you see for wheat on your screens and that’s used in the CRB, which is the Chicago Board of Trade wheat, which is trading just over ten dollars. And the Minneapolis price…the reason for this gigantic spread between them is two-fold. One is that this is hard red wheat. And it’s spring wheat with a high protein content as opposed to the soft wheat, which is used in the Chicago Board of Trade contract, which is lower protein.
But in addition, when you get a spread this gigantic it illustrates that some arbitrageurs have been caught offside. Because for years spreads have tended to be narrow and at a time when most people weren’t interested in trading the grains at all, the arbitrageurs would trade off the three markets: Kansas City, Chicago and Minneapolis on the basis of historic spreads in them.
And so they’d be going along, one would short the other and the fact that the Minneapolis contract has been going up-limit day after day would indicate that there are some short positions out there. And certainly it’s not because of anybody who’s ever listened to our call. What it does illustrate though, again, is the scarcity factors that are out there in the agriculturals. That you can get these kinds of prices. And it also illustrates that agriculture is a different kind of commodity investment thesis than the others.
I’ll get to that later but of course what we have to move immediately to discussing the resumption of the bear market.
Last week we had this wondrous week and I got some phone calls from clients who pointed out to me that the bank stocks were soaring and had three up days in a row. And the question that was being asked was is the bank bear market over yet? And the answer I gave them was “This is the equivalent of setting out on a drive across the US, starting in San Diego, heading for Boston with a four-year old child. And before you’ve reached Denver, the child has already asked three times, are we there yet?” And there’s a long way to go.
What makes this different from other bank bear markets even, because if you look at the bank stock index compared to sell offs in recent periods of major bank corrections, as I was asked at a meeting this morning, it looks as if this one has already done as much as any of the others and therefore we should be close to the bottom.
Let me distinguish this one from the others.
In past banking crises, what we knew was that the banks had a bunch of bad loans on their books. And having lived through each one of these I can tell you that it wasn’t long before the analysts had figured out which bad loans on their books were going to have to be marked down. And therefore the extent of the downside risk to the banks was analyzed fairly early in the game and before all the write downs were completed. And therefore it would not be a long, sustained bear market for the banks.
This one is different because – as I’ve told you so many times now – bank bear markets are driven off the balance sheet not the income statement. And we have no precedent for a bear market in the banks where the problem of the balance sheet is almost entirely a Basel Accord problem. Which means, it’s not the balance sheet so much, it’s the way the balance sheet is analyzed for Basel Accord rules, which means you only look at the left-hand side of the balance sheet.
The crucial relationship is the relationship between the Tier One equity, which can’t be below six and a half percent. And that is the stuff that you don’t take any discount with for risk. It’s the T-Bills and the other unimpeachable quality liquid assets. And then every other asset on the balance sheet is subject to risk adjustments used by the Basel Committee. And that’s on the basis of the agreed on level of the risk based on experience, for that asset class.
One of the reasons we’re in this mess is because home mortgages have been always ranked as one of the least risky asset classes – particularly for US banks because of the presence of Fannie and Freddie. And it begins to look…well, it certainly is the case that what has happened then is that banks who took the top tranches of the CDOs, the Triple A tranches, which were the ones that gave the whole CDO the Triple A rating – and those were the ones that they bought for their own account and they would sell off in many cases the other ones. Which in some cases have been selling for as little as three cents on the dollar. Those were supposed to be the protections which made the higher tranches bullet-proof.
Well, we don’t know what these hundreds of billions of dollars of CDOs, credit swaps and so forth, that they have, related to mortgages…we have no idea what they’re worth. And although this has been unfolding now for about the last nine months, that doesn’t mean that we’re about to give birth to a new bull market. Because we just keep finding new problems in the way the banks were getting around the Basel Accord. Last summer we found out about them using SIVs, where they had, they were borrowing very short, in the SIVs off the balance sheet and investing in CDOs and subprimes off the balance sheet.
They thought the only risk they were taking was duration risk. And it turned out they were also taking massive credit risk, which they didn’t understand. Gradually some of these are being put back on the balance sheet because of pressure from regulators and others. And so the supply of SIVs out there is shrinking.
What we’re finding out now is the symbiotic relationship that developed in the last few years at least some of the banks and the monolines and…we understood this in the last few months because of Bill Ackman’s work, who’s short the monolines. And he’s referred to now sarcastically, but with respect as the unofficial regulator of the monolines. Because now that he’s published on his web site his model showing that they’re all broke, he’s challenged people to show him what’s wrong with it.
Discussions are proceeding to try to come up with a bail out formula for the monolines, but as Warren Buffett commented in Toronto yesterday, he’s only interested in being involved with the traditional business of the monolines, which is municipal bonds. He’s not interested in trying to bail the banks out of their problems, which is, with their exposure to the CDOs.
And what we found out most recently – and there’s a good article on it in today’s FT – is that some of the banks came up with a brilliant structure for rewarding their traders. What they would do is put a CDO in their balance sheet and get a monoline to write a credit default on that. And then what they would do is buy a credit default swap on a monoline which insured that other monoline on the theory that, because you could buy those credit default swaps very, very cheaply, and that would give you a negative spread on that which was pocketed by the bank and by the traders. And this was…could be a pretty gigantic business because you were getting spread of more than a half a percent of supposedly risk-free money.
Well, that means of course they all go down together. But meanwhile, the traders and the CEOs have already pocketed their bonuses for the deal. In other words, the more we go along, the more we find out that the practices that were engaged in during this period of easy credit got sleazier and sleazier and they were all based on the notion there was no real risk in anything related to mortgages.
Basel is not rewriting its rules on these things, but until we’ve got a situation that we know what the Tier One equity of these banks is worth, after the write downs, we will not know when it is safe to buy the banks. And that will mean that we’ve also come near the end of the stock bear market. I just cannot - based on having gone through all these past crises - tell you when that will be. But it doesn’t have to be a deep bear market, it just may be a long period of slow decline. But just don’t be impatient to rush in with new money.
One of the reassuring things, in a way, about this is the fact that NASDAQ is underperforming other markets. And as you know, when they’re in a Triple Waterfall, that’s a good sign that the market is rapidly adjusting. Because one of the reasons we turned so bearish last year was NASDAQ outperformed. And an inviolable rule of Triple Waterfalls is that any rally where the asset class that’s in a long-term crash is outperforming, that’s a rally that you sell into.
And the reason for that, of course, you always find out why it is that that rally was misplaced. And in this case it’s good old Cisco each time which has been clipping NASDAQ. And Cisco at one time, briefly, was the most valuable company in the world. Of course, it was selling at an infinite multiple of earnings because they didn’t account for stock options and things, but Cisco now, which sells at a P/E ratio allegedly as low as 12, again there’s questions about the earnings, but most importantly, even their top line is growing very slowly. And as Cisco, which is a brilliantly run company, if you don’t think about the CFO side of it, if they’re saying that their growth is going to be slower, what that does is suppurate right through the rest of the NASDAQ story.
So I suspect that again, another sign of when we’ve, we’re close to bottom for the overall bear market will be when the banks and the technology stocks will be showing signs of slowing down their rate of descent or bottoming out. But again, there’s no sign of that on the horizon at the moment.
The fact that you could make such a fortune in wheat, is illustrative of our basic thesis, which is that notwithstanding the view out there which is still widely held, that commodities are the riskiest asset class in a bear market which leads in to a recession, it’s because there’s so few people out there who do any of these calculations who’ve actually ever traded commodities or understand the dynamics that make this commodity bull market that we’re in so different from the others.
And I’d like to spend a few minutes explaining the dynamics that differentiate one class of commodities from another. This week, BP, which no longer calls itself British Petroleum because for years on their web site when you go to it, it starts with solar power and their slogan “More Than Oil”, which was being done by the politically correct John Brown, and John Brown was doing all these things and spending billions of dollars in ways of getting himself beloved by the greenies. But he wasn’t doing things like fixing up his refineries or doing maintenance on the Alaska pipeline. That was just too boring. Which lead to the Texas City refinery blast in Galveston, which killed fifteen people. And BP is being prosecuted criminally.
Why is that an important development? Well that helps to explain why the crack spread is so low. Because the possibility of prosecution, criminally, for not refurbishing refineries is scary for everybody. And what we see at an 84% refinery run in the US, is that oil companies in the US are really spending the money on fixing up their aged refineries . Because of course there hasn't been a new one built since the '78. And that means that more gasoline has been imported from refineries abroad as opposed to crude oil so refinery runs in the US are less. So the crack spread is down at levels which have made it tough on the pure play refiners.
That's an example of the differences between this kind of asset class and the other. But the biggest difference is that in the metals and oils, what we have is a few major producers that are crucial for the pricing structure worldwide.
And in the case of oil the term Big Oil is no longer really all that relevant because Big Oil has been in shrinking mode. They're buying back stock, in the case of Conoco. They simply said that they only replaced 15% of their production last year because they took the write down on their Venezuelan exposure. But, they're buying back stock because they're generating enormous cash flow out of oil fields that they've had for decades. They're not able to replace that because of political risk factors. So they're in a big shrink.
So Big Oil, big shrink. Therefore they are not long term commodity inflation hedges. And yet they're the biggest market cap in the S&P in the oil group. So there are lots of clients out there who say, "I'm overweight the S&P in commodities," but what they have is - great companies with good dividends and all those nice things - but they are not subject to the dynamics of the commodities themselves in terms of what you want which is as close to the origin of the commodity or in the case of the refiners, a pure play on how the crack spread works.
And more and more, of course, the real production control is coming from sovereigns of one kind or another whether they are in OPEC or outside OPEC. And so they're outside the way of the market being able to evaluate them or invest in them. And in some cases of course they aren't putting their revenues back into the ground, which creates further supply problems further out. That's the case particularly in Venezuela. And it's also the case in Russia. And it's the case in some OPEC countries such as Iran.
So one of the reasons for the long term bullishness on owning unhedged reserves of oil in the ground - for the E&P companies - is that although predicting near term oil prices is a perilous undertaking, what you can simply say is that oil in a few years is going to be selling at a higher price than it is today.
In the metals, the story is different again, as we're seeing in the dramatic battle going on with BHP's bid to buy Rio Tinto and the intervention that we received from Chinalco and Alcoa partnership. And what was going on here is a combination of the fact that the big mining companies, more and more, have succumbed to the Chip Goodyear view which is that opening a new mine these days, is not done in a short space of time.
As Chip Goodyear told the Society of Economic Geologists Convention, anybody in this room who still thinks you can open a new mine in the Third World in five years is a menace to your stockholders and to this industry. Figure eight to eleven years to build the schools and the hospitals and the community relationships so that you'll get to keep what you get and it will be welcome as coming into the country. And also the fact that even those that behave well are subject to changes in their operating rules, because countries find ways of changing their tax schedules. Or in the case of Mongolia even before the mine comes in, imposing big new taxes. Therefore it's much simpler when they've got gigantic cash flows to buy each other than it is to take on new risks.
As of four years ago the 25 biggest mining companies of the world were spending the same amount on exploration that they had spent in 1996. They're relying on being able to buy up small mining companies who will find the stuff and then they can assess the political risk and everything and buy those ore bodies. Or in the case of BHP they've said, "Rio Tinto is really cheap because they've got these wonderful mines and we know we can assess the political risk of each of their exposures.
So these companies trade at low multiples, because investors look at what's happened to metals' prices and they devalue the stocks accordingly. If you look at the chart for copper, it's a perfect flag pattern. It's a textbook for technical analysts. And we're coming to the stage where we're going to get the moment of truth, where copper either trades through the bottom of the flag signaling a drop to $2.00 or it breaks out on the upside signaling a move well past $4.00.
If you're a pessimist about the global economy, you break through on the bottom and copper goes to $2.00. The consolation for investors is, these stocks are already trading as if copper were at $2.00.
There is still so little faith. The essential thesis in investing in the base metals is that we are not going to be able to bring on enough new production to finance the next wave of growth in particularly China and India, because of the metal intensity in those economies.
So we're going to have shortages in the next decade far beyond what we’ve experienced in this but that takes a patient Buffet investor. Not that Buffet is an investor in commodities. And…I don't know how many on the call have that kind of staying power.
The agriculturals are very different because, what we don't have is that they produce the commodities. What they do – there’s millions of producers of grains in the world. What these companies do is help those producers increase their profits and yields which the world desperately needs. Because the carryovers of grains are at record lows in relation to consumption. And in some cases we're really down to a situation where the true expression is living hand to mouth.
When the World Food Council spoke at Davos, which was the page 16 story, they said that they had run out of emergency food supplies to use for earthquakes and disasters. They've updated that story showing just how serious their problem is about having extra supplies of food, because there isn't stuff easily available. And governments who used to give them stuff because they were eager to get rid of it. Now the grains are being sold immediately on world markets at the kinds of prices that you see on the charts.
So the investment thesis with the big ag stocks, is that they are absolutely necessary to avert a global food crisis. And therefore their profit margins will continue to rise because the profit margins of those they sell to continue to rise. And the farmers are having the best growth in income. That is cash crop farmers in the US. They were the best growth in income of any sector of the US economy last year. Now they didn't include in that case an analysis of investment bankers. That wasn't one of their subsets.
So, when you've separated out these different kinds of investment thesis, you can decide what kind of weighting you want to have in commodities. And, as a group, they've continued to outperform the stock markets of the world. And that's because overall they're exposed to less real risk, notwithstanding that the experts are telling you that because in past cycles they sold off heavily, that they're subject to cyclical risk.
Of course, what they love to do is cite the experience of the '80s and '90s where in each downturn these stocks got hammered. Naturally! These assets were in a triple waterfall crash. So when things went down, they went down big time.
Well, whenever there's this disjunction between what true experts on the commodities industries understand, and what the broad class of investors and of strategists understand, that's the stuff of great investment concepts.
So, I believe that we're going to have a period of months in here, where we're going to have a chance to accumulate portfolios of the great commodity producing companies. We're going to be able to buy them at prices that will seem as ridiculously low in a couple of years as what you could have bought in the year 2001, 2002 or 2003, as against what those stocks sold at in 2006 through 2007. But getting from here to there is going to involve lots of excitement, lots of pain, lots of disappointment and lots of throwing in of the towel of those who bought these stocks just as momentum plays.
So, we go back to the beginning - start with "b". "A" is for agriculture. That's a great thing to have. "B" is for banks and that's a bad news story, which we're going to be living with for some time. "C" is for copper, which will tell you if there's a global slowdown. With that ABC in your mind you can decide how you want to do your weightings and what it is you're going to wait to buy cheaper.
That's it. Any questions?
Question (Bill Maschovitz): Just on your comment I guess in terms of takeovers. I've been surprised. We hold a number of domestic, politically safe E&P companies here in America. And some of these well they're even listed in New York but maybe - I guess they'd be considered small cap - a billion dollar market cap - but they're selling amazingly three times cash flow, two times cash flow or less. And at big discounts to conservative estimates of proven reserves. And I'm surprised that there hasn't been more - in the low interest rate environment today - why there hasn't been and the risk as you talk about that there hasn't been more takeouts.
DC: That's a very interesting question and I think part of it has to do with the fact that in the US, that Big Oil is at bay before Congress. And with an election year the - what you've got - remember that Nancy Pelosi and others pilloried Lee Raymond and others, pointing out how much money they made and they developed a correlation between that and how much gasoline cost to people. As if the money these CEOs made was a big part of the cost of gasoline. And this is an industry facing the likelihood of a Democrat landslide this year. And remember that during the early Democratic primaries, in many ways the most powerful speaker next only to Barack Obama, was John Edwards. And he specifically referred to Big oOil as the kinds of company that was strangling the children of the nation with their greed.
Well, the spectacle of that day in which the CEOs of the five Big Oil companies were just denounced as if they were the worst kind of villains before a Congressional committee. That is a tough experience for these people who are largely anonymous in that sense. And I suspect that if they are seen to be buying up what immediately will be is demands of antitrust prosecution and things.
So I think this is a different kind of political risk that we're talking about. Political risk up until now was having your production assets seized by a left-wing government. This kind of political risk is the risk of being pilloried. And therefore the best thing to do is to keep your head down and increase your dividend and buy back your stock.
And the other thing that they're facing of course is that they're watching that their stocks have been supported by commodity investors who seeing greater risk out there have said, "Well I want to keep exposure in the group so what I’m going to do is I'll sell my risky E&P companies and I'll move my money into Exxon and Chevron and I'll get good dividends and these stocks are safe because of stock buybacks. And I'll still be exposed to oil."
So you've got a pattern where this is not one that encourages the assumption of new kinds of political risk. We don't have…the people who have succeeded the Lee Raymonds of this world are more sort of corporate bureaucrat types or finance types and not the kind of larger than life human beings of the kind that J. R. Ewings or T. Boone Pickens or these kinds of people.
For that reason I think that - without knowing this for sure - I'll bet that they've had enough discussions in their board meetings saying, "Let's not do anything which is going to arouse the politicians' wrath."
So, if it's anything more than that it's also I think this pattern that people have succumbed to the arguments of Wall Street that the commodity stocks are very risky in a cyclical environment. So they've just been moving out of small into big. And big is not prepared to do anything that seems to be cruel to small.
Thank you. Any other questions?
There are no questions registered at this time, Mr. Coxe.
DC: Thank you all for tuning in to the call. We'll talk to you next week.
Don Coxe
Montreal
“While You Were Weeping”
Thank you all for tuning into the call, which comes to you from Montreal. And we had to move the call to Thursday because I’m traveling tomorrow for meetings that I’m having on the weekend. The chart that we faxed out was Minneapolis Grain Exchange Wheat and the tag line was “While You Were Weeping”. What we did was we picked as our start date the beginning of the recognition of the global banking crisis.
And the point of the chart was to illustrate that there’s always some good news somewhere, even if all the news seems to be bad.
And the fact that Minneapolis Grain Exchange Wheat closed yesterday roughly at the Columbus level of 14.92 illustrates something else about this whole ag business, which is that we don’t have in some of these commodities the singularity of being one price somewhere. There’s a huge spread between the price that you see for wheat on your screens and that’s used in the CRB, which is the Chicago Board of Trade wheat, which is trading just over ten dollars. And the Minneapolis price…the reason for this gigantic spread between them is two-fold. One is that this is hard red wheat. And it’s spring wheat with a high protein content as opposed to the soft wheat, which is used in the Chicago Board of Trade contract, which is lower protein.
But in addition, when you get a spread this gigantic it illustrates that some arbitrageurs have been caught offside. Because for years spreads have tended to be narrow and at a time when most people weren’t interested in trading the grains at all, the arbitrageurs would trade off the three markets: Kansas City, Chicago and Minneapolis on the basis of historic spreads in them.
And so they’d be going along, one would short the other and the fact that the Minneapolis contract has been going up-limit day after day would indicate that there are some short positions out there. And certainly it’s not because of anybody who’s ever listened to our call. What it does illustrate though, again, is the scarcity factors that are out there in the agriculturals. That you can get these kinds of prices. And it also illustrates that agriculture is a different kind of commodity investment thesis than the others.
I’ll get to that later but of course what we have to move immediately to discussing the resumption of the bear market.
Last week we had this wondrous week and I got some phone calls from clients who pointed out to me that the bank stocks were soaring and had three up days in a row. And the question that was being asked was is the bank bear market over yet? And the answer I gave them was “This is the equivalent of setting out on a drive across the US, starting in San Diego, heading for Boston with a four-year old child. And before you’ve reached Denver, the child has already asked three times, are we there yet?” And there’s a long way to go.
What makes this different from other bank bear markets even, because if you look at the bank stock index compared to sell offs in recent periods of major bank corrections, as I was asked at a meeting this morning, it looks as if this one has already done as much as any of the others and therefore we should be close to the bottom.
Let me distinguish this one from the others.
In past banking crises, what we knew was that the banks had a bunch of bad loans on their books. And having lived through each one of these I can tell you that it wasn’t long before the analysts had figured out which bad loans on their books were going to have to be marked down. And therefore the extent of the downside risk to the banks was analyzed fairly early in the game and before all the write downs were completed. And therefore it would not be a long, sustained bear market for the banks.
This one is different because – as I’ve told you so many times now – bank bear markets are driven off the balance sheet not the income statement. And we have no precedent for a bear market in the banks where the problem of the balance sheet is almost entirely a Basel Accord problem. Which means, it’s not the balance sheet so much, it’s the way the balance sheet is analyzed for Basel Accord rules, which means you only look at the left-hand side of the balance sheet.
The crucial relationship is the relationship between the Tier One equity, which can’t be below six and a half percent. And that is the stuff that you don’t take any discount with for risk. It’s the T-Bills and the other unimpeachable quality liquid assets. And then every other asset on the balance sheet is subject to risk adjustments used by the Basel Committee. And that’s on the basis of the agreed on level of the risk based on experience, for that asset class.
One of the reasons we’re in this mess is because home mortgages have been always ranked as one of the least risky asset classes – particularly for US banks because of the presence of Fannie and Freddie. And it begins to look…well, it certainly is the case that what has happened then is that banks who took the top tranches of the CDOs, the Triple A tranches, which were the ones that gave the whole CDO the Triple A rating – and those were the ones that they bought for their own account and they would sell off in many cases the other ones. Which in some cases have been selling for as little as three cents on the dollar. Those were supposed to be the protections which made the higher tranches bullet-proof.
Well, we don’t know what these hundreds of billions of dollars of CDOs, credit swaps and so forth, that they have, related to mortgages…we have no idea what they’re worth. And although this has been unfolding now for about the last nine months, that doesn’t mean that we’re about to give birth to a new bull market. Because we just keep finding new problems in the way the banks were getting around the Basel Accord. Last summer we found out about them using SIVs, where they had, they were borrowing very short, in the SIVs off the balance sheet and investing in CDOs and subprimes off the balance sheet.
They thought the only risk they were taking was duration risk. And it turned out they were also taking massive credit risk, which they didn’t understand. Gradually some of these are being put back on the balance sheet because of pressure from regulators and others. And so the supply of SIVs out there is shrinking.
What we’re finding out now is the symbiotic relationship that developed in the last few years at least some of the banks and the monolines and…we understood this in the last few months because of Bill Ackman’s work, who’s short the monolines. And he’s referred to now sarcastically, but with respect as the unofficial regulator of the monolines. Because now that he’s published on his web site his model showing that they’re all broke, he’s challenged people to show him what’s wrong with it.
Discussions are proceeding to try to come up with a bail out formula for the monolines, but as Warren Buffett commented in Toronto yesterday, he’s only interested in being involved with the traditional business of the monolines, which is municipal bonds. He’s not interested in trying to bail the banks out of their problems, which is, with their exposure to the CDOs.
And what we found out most recently – and there’s a good article on it in today’s FT – is that some of the banks came up with a brilliant structure for rewarding their traders. What they would do is put a CDO in their balance sheet and get a monoline to write a credit default on that. And then what they would do is buy a credit default swap on a monoline which insured that other monoline on the theory that, because you could buy those credit default swaps very, very cheaply, and that would give you a negative spread on that which was pocketed by the bank and by the traders. And this was…could be a pretty gigantic business because you were getting spread of more than a half a percent of supposedly risk-free money.
Well, that means of course they all go down together. But meanwhile, the traders and the CEOs have already pocketed their bonuses for the deal. In other words, the more we go along, the more we find out that the practices that were engaged in during this period of easy credit got sleazier and sleazier and they were all based on the notion there was no real risk in anything related to mortgages.
Basel is not rewriting its rules on these things, but until we’ve got a situation that we know what the Tier One equity of these banks is worth, after the write downs, we will not know when it is safe to buy the banks. And that will mean that we’ve also come near the end of the stock bear market. I just cannot - based on having gone through all these past crises - tell you when that will be. But it doesn’t have to be a deep bear market, it just may be a long period of slow decline. But just don’t be impatient to rush in with new money.
One of the reassuring things, in a way, about this is the fact that NASDAQ is underperforming other markets. And as you know, when they’re in a Triple Waterfall, that’s a good sign that the market is rapidly adjusting. Because one of the reasons we turned so bearish last year was NASDAQ outperformed. And an inviolable rule of Triple Waterfalls is that any rally where the asset class that’s in a long-term crash is outperforming, that’s a rally that you sell into.
And the reason for that, of course, you always find out why it is that that rally was misplaced. And in this case it’s good old Cisco each time which has been clipping NASDAQ. And Cisco at one time, briefly, was the most valuable company in the world. Of course, it was selling at an infinite multiple of earnings because they didn’t account for stock options and things, but Cisco now, which sells at a P/E ratio allegedly as low as 12, again there’s questions about the earnings, but most importantly, even their top line is growing very slowly. And as Cisco, which is a brilliantly run company, if you don’t think about the CFO side of it, if they’re saying that their growth is going to be slower, what that does is suppurate right through the rest of the NASDAQ story.
So I suspect that again, another sign of when we’ve, we’re close to bottom for the overall bear market will be when the banks and the technology stocks will be showing signs of slowing down their rate of descent or bottoming out. But again, there’s no sign of that on the horizon at the moment.
The fact that you could make such a fortune in wheat, is illustrative of our basic thesis, which is that notwithstanding the view out there which is still widely held, that commodities are the riskiest asset class in a bear market which leads in to a recession, it’s because there’s so few people out there who do any of these calculations who’ve actually ever traded commodities or understand the dynamics that make this commodity bull market that we’re in so different from the others.
And I’d like to spend a few minutes explaining the dynamics that differentiate one class of commodities from another. This week, BP, which no longer calls itself British Petroleum because for years on their web site when you go to it, it starts with solar power and their slogan “More Than Oil”, which was being done by the politically correct John Brown, and John Brown was doing all these things and spending billions of dollars in ways of getting himself beloved by the greenies. But he wasn’t doing things like fixing up his refineries or doing maintenance on the Alaska pipeline. That was just too boring. Which lead to the Texas City refinery blast in Galveston, which killed fifteen people. And BP is being prosecuted criminally.
Why is that an important development? Well that helps to explain why the crack spread is so low. Because the possibility of prosecution, criminally, for not refurbishing refineries is scary for everybody. And what we see at an 84% refinery run in the US, is that oil companies in the US are really spending the money on fixing up their aged refineries . Because of course there hasn't been a new one built since the '78. And that means that more gasoline has been imported from refineries abroad as opposed to crude oil so refinery runs in the US are less. So the crack spread is down at levels which have made it tough on the pure play refiners.
That's an example of the differences between this kind of asset class and the other. But the biggest difference is that in the metals and oils, what we have is a few major producers that are crucial for the pricing structure worldwide.
And in the case of oil the term Big Oil is no longer really all that relevant because Big Oil has been in shrinking mode. They're buying back stock, in the case of Conoco. They simply said that they only replaced 15% of their production last year because they took the write down on their Venezuelan exposure. But, they're buying back stock because they're generating enormous cash flow out of oil fields that they've had for decades. They're not able to replace that because of political risk factors. So they're in a big shrink.
So Big Oil, big shrink. Therefore they are not long term commodity inflation hedges. And yet they're the biggest market cap in the S&P in the oil group. So there are lots of clients out there who say, "I'm overweight the S&P in commodities," but what they have is - great companies with good dividends and all those nice things - but they are not subject to the dynamics of the commodities themselves in terms of what you want which is as close to the origin of the commodity or in the case of the refiners, a pure play on how the crack spread works.
And more and more, of course, the real production control is coming from sovereigns of one kind or another whether they are in OPEC or outside OPEC. And so they're outside the way of the market being able to evaluate them or invest in them. And in some cases of course they aren't putting their revenues back into the ground, which creates further supply problems further out. That's the case particularly in Venezuela. And it's also the case in Russia. And it's the case in some OPEC countries such as Iran.
So one of the reasons for the long term bullishness on owning unhedged reserves of oil in the ground - for the E&P companies - is that although predicting near term oil prices is a perilous undertaking, what you can simply say is that oil in a few years is going to be selling at a higher price than it is today.
In the metals, the story is different again, as we're seeing in the dramatic battle going on with BHP's bid to buy Rio Tinto and the intervention that we received from Chinalco and Alcoa partnership. And what was going on here is a combination of the fact that the big mining companies, more and more, have succumbed to the Chip Goodyear view which is that opening a new mine these days, is not done in a short space of time.
As Chip Goodyear told the Society of Economic Geologists Convention, anybody in this room who still thinks you can open a new mine in the Third World in five years is a menace to your stockholders and to this industry. Figure eight to eleven years to build the schools and the hospitals and the community relationships so that you'll get to keep what you get and it will be welcome as coming into the country. And also the fact that even those that behave well are subject to changes in their operating rules, because countries find ways of changing their tax schedules. Or in the case of Mongolia even before the mine comes in, imposing big new taxes. Therefore it's much simpler when they've got gigantic cash flows to buy each other than it is to take on new risks.
As of four years ago the 25 biggest mining companies of the world were spending the same amount on exploration that they had spent in 1996. They're relying on being able to buy up small mining companies who will find the stuff and then they can assess the political risk and everything and buy those ore bodies. Or in the case of BHP they've said, "Rio Tinto is really cheap because they've got these wonderful mines and we know we can assess the political risk of each of their exposures.
So these companies trade at low multiples, because investors look at what's happened to metals' prices and they devalue the stocks accordingly. If you look at the chart for copper, it's a perfect flag pattern. It's a textbook for technical analysts. And we're coming to the stage where we're going to get the moment of truth, where copper either trades through the bottom of the flag signaling a drop to $2.00 or it breaks out on the upside signaling a move well past $4.00.
If you're a pessimist about the global economy, you break through on the bottom and copper goes to $2.00. The consolation for investors is, these stocks are already trading as if copper were at $2.00.
There is still so little faith. The essential thesis in investing in the base metals is that we are not going to be able to bring on enough new production to finance the next wave of growth in particularly China and India, because of the metal intensity in those economies.
So we're going to have shortages in the next decade far beyond what we’ve experienced in this but that takes a patient Buffet investor. Not that Buffet is an investor in commodities. And…I don't know how many on the call have that kind of staying power.
The agriculturals are very different because, what we don't have is that they produce the commodities. What they do – there’s millions of producers of grains in the world. What these companies do is help those producers increase their profits and yields which the world desperately needs. Because the carryovers of grains are at record lows in relation to consumption. And in some cases we're really down to a situation where the true expression is living hand to mouth.
When the World Food Council spoke at Davos, which was the page 16 story, they said that they had run out of emergency food supplies to use for earthquakes and disasters. They've updated that story showing just how serious their problem is about having extra supplies of food, because there isn't stuff easily available. And governments who used to give them stuff because they were eager to get rid of it. Now the grains are being sold immediately on world markets at the kinds of prices that you see on the charts.
So the investment thesis with the big ag stocks, is that they are absolutely necessary to avert a global food crisis. And therefore their profit margins will continue to rise because the profit margins of those they sell to continue to rise. And the farmers are having the best growth in income. That is cash crop farmers in the US. They were the best growth in income of any sector of the US economy last year. Now they didn't include in that case an analysis of investment bankers. That wasn't one of their subsets.
So, when you've separated out these different kinds of investment thesis, you can decide what kind of weighting you want to have in commodities. And, as a group, they've continued to outperform the stock markets of the world. And that's because overall they're exposed to less real risk, notwithstanding that the experts are telling you that because in past cycles they sold off heavily, that they're subject to cyclical risk.
Of course, what they love to do is cite the experience of the '80s and '90s where in each downturn these stocks got hammered. Naturally! These assets were in a triple waterfall crash. So when things went down, they went down big time.
Well, whenever there's this disjunction between what true experts on the commodities industries understand, and what the broad class of investors and of strategists understand, that's the stuff of great investment concepts.
So, I believe that we're going to have a period of months in here, where we're going to have a chance to accumulate portfolios of the great commodity producing companies. We're going to be able to buy them at prices that will seem as ridiculously low in a couple of years as what you could have bought in the year 2001, 2002 or 2003, as against what those stocks sold at in 2006 through 2007. But getting from here to there is going to involve lots of excitement, lots of pain, lots of disappointment and lots of throwing in of the towel of those who bought these stocks just as momentum plays.
So, we go back to the beginning - start with "b". "A" is for agriculture. That's a great thing to have. "B" is for banks and that's a bad news story, which we're going to be living with for some time. "C" is for copper, which will tell you if there's a global slowdown. With that ABC in your mind you can decide how you want to do your weightings and what it is you're going to wait to buy cheaper.
That's it. Any questions?
Question (Bill Maschovitz): Just on your comment I guess in terms of takeovers. I've been surprised. We hold a number of domestic, politically safe E&P companies here in America. And some of these well they're even listed in New York but maybe - I guess they'd be considered small cap - a billion dollar market cap - but they're selling amazingly three times cash flow, two times cash flow or less. And at big discounts to conservative estimates of proven reserves. And I'm surprised that there hasn't been more - in the low interest rate environment today - why there hasn't been and the risk as you talk about that there hasn't been more takeouts.
DC: That's a very interesting question and I think part of it has to do with the fact that in the US, that Big Oil is at bay before Congress. And with an election year the - what you've got - remember that Nancy Pelosi and others pilloried Lee Raymond and others, pointing out how much money they made and they developed a correlation between that and how much gasoline cost to people. As if the money these CEOs made was a big part of the cost of gasoline. And this is an industry facing the likelihood of a Democrat landslide this year. And remember that during the early Democratic primaries, in many ways the most powerful speaker next only to Barack Obama, was John Edwards. And he specifically referred to Big oOil as the kinds of company that was strangling the children of the nation with their greed.
Well, the spectacle of that day in which the CEOs of the five Big Oil companies were just denounced as if they were the worst kind of villains before a Congressional committee. That is a tough experience for these people who are largely anonymous in that sense. And I suspect that if they are seen to be buying up what immediately will be is demands of antitrust prosecution and things.
So I think this is a different kind of political risk that we're talking about. Political risk up until now was having your production assets seized by a left-wing government. This kind of political risk is the risk of being pilloried. And therefore the best thing to do is to keep your head down and increase your dividend and buy back your stock.
And the other thing that they're facing of course is that they're watching that their stocks have been supported by commodity investors who seeing greater risk out there have said, "Well I want to keep exposure in the group so what I’m going to do is I'll sell my risky E&P companies and I'll move my money into Exxon and Chevron and I'll get good dividends and these stocks are safe because of stock buybacks. And I'll still be exposed to oil."
So you've got a pattern where this is not one that encourages the assumption of new kinds of political risk. We don't have…the people who have succeeded the Lee Raymonds of this world are more sort of corporate bureaucrat types or finance types and not the kind of larger than life human beings of the kind that J. R. Ewings or T. Boone Pickens or these kinds of people.
For that reason I think that - without knowing this for sure - I'll bet that they've had enough discussions in their board meetings saying, "Let's not do anything which is going to arouse the politicians' wrath."
So, if it's anything more than that it's also I think this pattern that people have succumbed to the arguments of Wall Street that the commodity stocks are very risky in a cyclical environment. So they've just been moving out of small into big. And big is not prepared to do anything that seems to be cruel to small.
Thank you. Any other questions?
There are no questions registered at this time, Mr. Coxe.
DC: Thank you all for tuning in to the call. We'll talk to you next week.
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