Investing opportunities in overlooked Argentina
Mike Niehuser, founder of Beacon Rock Research, recently returned from Argentina where he toured a number of mines in the under-explored Santa Cruz area. In this exclusive interview with The Gold Report, he discusses the cloud of uncertainty hanging over mining after the Argentine government nationalized the oil company YPF and shares why although investors should tread carefully, the political situation creates opportunities for investors willing to do their homework.
The Gold Report: We understand that you were recently on an analyst tour visiting mining projects in Argentina. What did you see?
Mike Niehuser: We toured half a dozen companies in Santa Cruz, a province at the southern end of Argentina. This was my first trip to Santa Cruz and I had been hoping for years to see what had been Exeter Resource Corp.'s (XRC:TSX; XRA:NYSE.A; EXB:FSE) Cerro Moro project following my visit to its Don Sixto project to the north in Mendoza. Santa Cruz is incredible. Mining or not, it's a place everyone needs to put on the bucket list of places to go. In 2010 Exeter spun out its Cerro Moro and Don Sixto projects to Extorre Gold Mines Ltd. (XG:TSX; XG:NYSE.A; E1R:FSE). We first visited Cerro Moro, which is Extorre's most advanced project, located just outside of Puerto Deseado on the Atlantic coast. Puerto Deseado is a modern port with historically significant wildlife areas that Charles Darwin visited. Santa Cruz has modern infrastructure and paved highways. Geologically, the area around Santa Cruz, the massive Deseado Massif Precious Metals Province, is underexplored and is an extraordinarily prospective region for mineral exploration.
TGR: Were you in Argentina when President Cristina Kirchner took over Yacimientos Petrolíferos Fiscales (YPF), the national oil company? Is this a country investors should avoid?
MN: No sooner had we gotten off the plane that we caught wind of the news. Being from the U.S., I had an immediate kneejerk reaction, but it soon became a little more complicated given that the news we received was local and real time, not secondhand from the U.S. It was interesting on a number of levels, from an investment perspective and others.
TGR: What do you mean?
MN: The Argentine people are unique. For South America, they are very European and very proud. The people I spoke with had an intense desire to be understood. There seemed to be disappointment in Repsol for not keeping its commitments to drill and to increase oil production. This led Argentina to become a net energy importer. You can imagine that with increasing oil prices how this may have contributed to the negative trade imbalance and anxiety about another serious round of currency devaluations. Fixing the exchange rate for the dollar has caused a number of problems, primarily getting stuck with pesos. The people we spoke with wanted to be recognized as friends of the U.S. and free markets, but it was interesting that there was privately a sense of embarrassment or denial on how logically to explain how they got to where they are. Clearly, they were falling in behind Kirchner to pull themselves out of their situation.
TGR: Do you think she will be successful?
MN: Hard to say, but it will be fascinating to watch. Since my visit, I have been monitoring the Buenos Aires Herald on the web, which appears to provide the most consistent real time reporting on Argentine politics and economy. The challenge in front of Kirchner is not all that different from what is going on in Europe or any other developed country following the 2008 financial crisis. She is approaching the problem along the lines of a protectionist, centralized economy and selecting winners and losers top-down. The locals seemed to be behind Kirchner; she has made a personal commitment to "pesify" her dollar fixed-term bank deposits and she has encouraged her ministers to do likewise. Oddly, this attempt at moral suasion and leadership reminds me of the campaign to buy war bonds during the Second World War, as buying bonds and buying and holding pesos look to be a financial sacrifice above the call of duty. Rather than taking over YPF to grab windfall profits, it is more a matter of national security. She has pledged to install professionals aligned with the national interests, and the new CEO of YPF has plans to drill 1,000 new wells next year to achieve energy self-sufficiency. This is a significant step up from the past several years, but for centralized economies, saying it is easier than doing it.
TGR: What does this mean for mining companies in Argentina? If Kirchner is not successful, do you think this may lead to nationalizing mining companies?
MN: I think there is a zero chance of nationalizing mining companies along the lines of what we have seen with YPF. Never say never, but YPF was privatized, failed to live up to its obligations to develop resources and was taken over. Those facts notwithstanding, doing business in Argentina may have reduced returns on investment to Repsol, the upside diverted to fund the primary political objectives of entitlements and carry the load of public employees. Careerism for politicians can be confused with national priorities. Mining companies, even producers, might appear to be tempting targets for nationalization, but they do not appear to be the immediate imperative of reversing a negative trade imbalance from having become a net importer of oil. Besides, building mines absorbs foreign capital, which is what the government wants.
Also, I understand that President Kirchner is from Santa Cruz, the area we toured in the south of Argentina that is lacking private sector jobs. The locals say there were about six million sheep grazing in the early 1990s when a volcano in Chile dropped about 30 feet of ash, covering grass and wiping out ranching. I am not sure this is exactly correct, but clearly absent vegetation, with fewer gauchos and farmers, the area was perfect for mining exploration. I suppose nationalization or taking an ownership position is possible, but there are other more plausible reasons why doing business in Argentina may pose special risks.
TGR: Do you mean inflation from a devaluation or trade imbalance?
MN: Certainly, inflation is a challenge for foreigners because of the cumbersome fixed exchange rate for dollars and pesos. These types of price controls result in a black market and shortages of goods and services at the approved exchange rate. Also, as the government looks to increase the export of value-added goods to reduce the trade imbalance, there is, for example, different treatment of exporting dore compared to concentrate. The government also requires that revenues be converted from foreign currencies back into pesos; foreign companies take a cut on the conversion and then again back into foreign currencies and eventually to investors. This cost is much like a tax or a royalty for a mining company. In effect, the government is attempting to make pesos more attractive by encouraging homegrown economic activity and reducing or slowing the conversion out of pesos. For most mining companies, each country is different, and as long as the rules don't change, they can make investment decisions. This is what investors need to be aware of.
TGR: How does Argentina look in this regard?
MN: From some accounts, not so good. The South American columnist for the Wall Street Journal, Mary Anastasia O'Grady, who doesn't suffer fools, said that the seizure of YPF made Argentina "an accident waiting to happen and a good place for investors to avoid." Beyond a free market bias, she argues that the manner in which the nationalization occurred violated Argentine laws. If correct, the disregard for rule of law in my opinion may be the best reason for investors to go slow with investments in Argentina. Nobody likes changing the rules and moving the goal posts. This should not come as a shock for investors and this risk might have already been priced into stock prices; if so, this creates an opportunity for contrarian investors. Personally, with regard to rule of law, Argentina may be just a sideshow, but along with developments in Greece and Spain, it may provide important insights into the long-term direction of the global economy and investments.
TGR: What does Argentina have to do with Greece and Spain?
MN: Conventional thinking is that the population of the planet is growing to over 10 billion, and the planet is warming due to economic expansion of a global middle class, leading to the global depletion of resources. I am not convinced. Except for the U.S. and other rare exceptions, the birth rate in the West is dangerously below replacement level. The Ponzi scheme of government entitlements and the progressive redistribution of wealth work fine when economies are growing, but we have no experience on the near- to long-term effects of a reversal of this trend. I don't believe austerity is the answer for Europe or even China, but the best hope is for liberalizing economies. The eventual expansion of seniors relative to young workers on this scale is new. The novelty of this problem is not unlike that faced by rating agencies in the recent financial crisis not having experienced and recognized a decline in housing prices until it was too late. I think watching nations with falling birth rates should be very instructive as test cases for larger economies that are not immune, like the U.S. and China.
TGR: Are you suggesting that political risk is increasing globally?
MN: I am very empathetic with the Argentineans that I spoke with on the trip. The current administration in the U.S. is not altogether friendly toward mining or free markets. The U.S. Supreme Court is scheduled to rule on healthcare soon, which will greatly impact the back end of the demographic shift. In addition, there are a number of cases where U.S. Supreme Court decisions have pushed back on regulatory overreach. I can't look down on Argentina when the U.S. does not even have a budget and deficits are pushing debt to record levels relative to GDP. Mining is a capital-intensive, long-term business and rule of law is everything. This is the problem for the market and investors as a whole. The economist Milton Friedman opined about the ineffectiveness of temporary tax breaks or stimulus. The micromanaging of the economy through targeted tax breaks or the habit of offering new improved programs for jumpstarting economic growth is not a substitute for confidence in free markets and capitalism. Consider the havoc resulting from interpreting the Fed on ending its Operation Twist or another round of quantitative easing.
TGR: Does this impact your forecast on gold prices?
MN: I'm sticking with my forecast in our last interview. My forecast was for gold to range from $1,400–$1,700 per ounce (oz) with the potential for some catalyst for the upside to reach $1,800–$1,900/oz. I think we can talk ourselves in circles on this one but politics and demographics internationally will drive higher levels of government spending. This will fail, of course, but it will take a long time. Slower growth, including China with its recent interest rate cut, with low rates in the United States, combined with stimulus or propping banks up, will expand the monetary base. Wealth will be redistributed away from savers and producers; this should continue while we have negative real interest rates. Gold remains the "go to" store of value, despite prices held down only by low velocity by a broken banking system and slowing global economies. I expected it, but am still surprised that gold prices have been as stable as they have been, especially compared to stock market indices or mining stocks in general.
TGR: Why is it that mining stocks have not reflected the higher precious metal prices?
MN: We are all growing a little weary of hearing that we are in a "risk-off" environment. Not to oversimplify it, but it is not that complicated. General economic models suggest that current values are a matter of applying rates of return to cash flows over time. To focus on gold prices is not enough, as we saw in 2007 when the industry superheated and costs of labor and material skyrocketed, destroying potential margins and cash flow. Time is also an issue. The sooner one sees cash flows the better; this is more important now more than ever. The big issue now is rates of return, which include not only what investors normally require, but also a premium for risk. This includes a dynamic basket of company, industry and market risks. You can see that even with sustained higher levels of metal prices and stabilizing costs, increasing risks can take down or reprice individual companies and the market. If these risks are already priced into stock prices, there may be opportunities.
TGR: How does this affect your view for mining stocks for the balance of 2012?
MN: I got a funny feeling about a month ago after reading an article in the Wall Street Journal about falling off a financial cliff in 2013 following the expiration of the Bush tax cuts. I told my clients that this suggests there may never have been a better argument for being entirely in cash, especially with moving into the spring with Europe and investors "going away in May." We just got back from a resource conference in Vancouver. The mood was weird, like an aging school reunion. Sort of "hope to see you soon," but maybe not. Companies appear to have dug in financially to protect cash, not knowing if and when they will be able to raise money and at what price. There is a heightened sensitivity among investors exacerbated by excess corporate overhead as opposed to money going into the ground for exploration or advancing projects. It also reminds me of what John Maynard Keynes said, that "markets can stay illogical longer than investors can stay liquid." I think for now we may have hit a point where investors interested in mining stocks may want to look for new ideas.
TGR: So what are you looking at now?
MN: Even with the "risk-off" environment, the market still rewards positive surprises. This includes both exploration discoveries and companies that increase cash flow. Today cash or cash flow is king. In our last interview I mentioned Minefinders Corp. (MFL:TSX, MFN:NYSE.A), which was acquired by Pan American Silver Corp. (PAA:TSX, PAAS:NASDAQ). I also mentioned Alexco Resource Corp. (AXR:TSX; AXU:NYSE.A) and Aurcana Corporation (AUN:TSX.V; AUNFF:OTCQX). Aurcana has done well with the reopening of the Shafter silver mine in Texas. Both companies I suspect should do well in this environment with expansion of resources and production through 2012 and beyond. I regret to say the exploration companies have not fared as well following the general market. Interestingly, the one exception is Argentex Mining Corporation (ATX:TSX.V; AGXMF:OTCBB), both an exploration company and with projects in Argentina.
TGR: What happened with Argentex?
MN: Argentex nearly doubled following the interview, then retraced downward with other stocks giving up more than it had gained until the time of our visit to the project in Argentina. Since that time, the stock has again about doubled. This defies conventional wisdom or fears and demonstrates the potential for stock selection, even in this "risk-off" market and in Argentina.
TGR: Have you changed your opinion about Argentex?
MN: Honestly, I liked it better at lows of around $0.26 per share. No surprise here, but I try to look for long-term unrecognized opportunities. Here was an opportunity to buy an oversold stock, with a general sell off in the market and mining equities, and on top of that located in Argentina following the takeover of YPF. While late on getting out its updated resource estimate, Argentex has been doing a lot right, refocusing on precious metals.
TGR: What made Argentex interesting?
MN: Argentex is still due out for an updated resource estimate at Pinquino. It also got some good visibility by our tour and others joining us at the project. This included some buy-side investors and newsletter writers. They no doubt liked the focus on precious metals over base metals and the fact that Argentex had about $9 million (M) in the bank at that time. The company also has concluded a pretty robust exploration program of about 30,000 meters. It has a large land position and continues to identify veins within a swarm system of over 100 kilometers of veins. At the time of the last interview, Argentex said it had encountered mineralization in as many as 16 of 19 veins encountered, which is only a small percentage of the total number of veins it has since located. This is what makes the Santa Cruz province so attractive for exploration as well as for investment by majors and institutions.
TGR: What other projects did you visit on the trip?
MN: I really liked Extorre's Cerro Moro project; similar to Pinquino and other projects in the Deseado Massif, Extorre continues to locate veins coming to surface but hidden under cover. Cerro Moro is more advanced, with primarily high grades of gold and silver with potential from open pits and later going underground. Extorre is looking at advancing a staged production at 500—600 tonnes per day from an open pit as early as 2014, and then stepping up to 1,000—1,100 tonnes per day within 18 months. What is amazing to me is that initial head grades are expected to be about 30 grams per tonne for the first stage with annual production of 170,000—180,000 gold equivalent ounces. Extorre has about $27M in cash and will need to finance the balance of the $125M capital cost to move into production. The project is already permitted for 750 tonnes per day. Despite the issues with Argentina, the project is very interesting and there may be other routes to finance the project. In any event, I would expect that once Extorre commences production, it will be mining for a very long time.
The Gold Report: Any other companies you would like to note?
Mike Niehuser: I was also impressed with Minera IRL Ltd. (IRL:TSX; MIRL:LSE; MIRL:BVL). Minera IRL said it is the third largest tenement holder in the Deseado Massif with about 2,700 square kilometers. It is not often you get excited about an exploration camp, but it was impressive how the camp was organized to increase the thinking and efficiency of its geologists. Quality assurance/quality control is not sexy, but the setup set high expectations for the quality of work by the team while creating an environment that promoted consistent and accurate treatment of drill core from both brownfield and greenfield exploration that was jaw dropping. Minera IRL recently completed a feasibility study on its 100%-owned Don Nicholas project in Argentina with plans to start production in 2013. The company initially plans to mine gold and silver ore from an open pit with annual production of about 52,000 ounces (52 Koz) gold and 56 Koz silver annually. Like Extorre, the initial resource is large enough to get started and Minera IRL will require additional exploration to extend mine life. Minera IRL also has other projects including an operating gold mine in Peru.
TGR: So are you recommending that investors buy mining companies in Argentina?
MN: I can't recommend that investors act without knowing the mines or knowing all the risks of investing in Argentina. A lot will need to be sorted out in the months and years ahead. Without a doubt, the Deseado Massif is impressive, but on the other hand, the actions and direction of the Argentine government are an issue, especially if it hopes to attract foreign capital and join other developed nations in a global economy. Clearly, much of the risk has been priced into mining company stocks, but if Europe moves into a monetary contraction as we saw in 2008, I suspect shares may get cheaper. In any event, we may have the whole summer to sort this out.
Mike Niehuser is the founder of Beacon Rock Research LLC, which produces research for an institutional audience and focuses in part on precious, base and industrial metals, oil and gas and alternative energy. Previously a vice president and senior equity analyst with the Robins Group, he also worked as an equity analyst with The RedChip Review. He holds a Bachelor of Science in finance from the University of Oregon.
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1) The following companies mentioned in the interview are sponsors of The Gold Report:Exeter Resource Corp., Extorre Gold Mines Ltd., Aurcana Corporation and Argentex Mining Corporation. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
2) Mike Niehuser: I personally and/or my family own shares of the following companies mentioned in this interview: Alexco Resource Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.
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