Marshall Auerback: Decoding Energy Investment
Interview

The Energy Report: Shares in Pinetree Capital have had a good run in the last six months, going from about $1 per share in July 2010 to about $3.38 now. What's largely responsible for that remarkable run?

Marshall Auerback: A number of things. I think Pinetree has been an undervalued stock for a long time based on its net asset value. But we had very adverse financial conditions in 2008, particularly adverse for small-cap companies, which comprise most of our portfolio. Even though we started to see an improvement in the credit markets in 2009, they really didn't start to loosen up until last year for the smaller companies. Your risk in holding these small caps is not so much market risk as liquidity risk. A number of these companies had cash on their balance sheets but they were clearly capital-constrained because they were dependent on ongoing capital injections to develop these assets.

In 2010, the capital markets began to re-engage and that made it easier for some of these companies to access funding. In turn, they were able to develop their assets, which helped improve their share prices. But it took a while. The markets were basically trendless until about September of last year, then all of a sudden you have this big move in the commodity space. Clearly, that's Pinetree's sweet spot.

TER: Your stated objective is to "invest ahead of the crowd by anticipating emerging trends and macro changes in consumption and translate that knowledge to successful investments in small- and micro-cap companies." What macro changes are taking place in the energy market, and more specifically in the uranium market?

MA: People have discussed peak oil for a long time. It's been controversial. Some people say you can always find oil at a given price. We don't disagree with that but the main thesis behind peak oil is that mother nature has only given us so much oil. The low-hanging fruit has largely been picked. It's getting increasingly difficult to extract oil from conventional sources. If you look at each successive economic crisis and the price of oil during each one, we have continued to bottom at increasingly higher prices. Even in the worst conditions we had in 2008 and 2009, the oil price bottomed at about $36 a barrel and it didn't stay there for long. It was driven by a collapse in demand.

The other problem in energy, in all commodities really, was a complete collapse in trade financing. So, we had both a financing shock and a demand shock, which caused this collapse in commodities. But as trade financing began to normalize and these emerging economies began to normalize, there was a big increase in demand. Along with that you've got very significant shortages in supply. The BP Plc. (NYSE:BP; LSE:BP) oil-spill disaster that occurred in the Gulf of Mexico is a symptom of the supply problem. We wouldn't be drilling for oil three miles below the surface of the ocean if it were easier to get oil from more conventional sources. To me that's symptomatic of a fact that you have to look for the oil in increasingly expensive places, which means increasingly expensive oil.

TER: How is expensive oil influencing the uranium market?

MA: Clearly, as the oil price has continued to appreciate people have started to look at alternative fuels. For a while the sexy ones were wind and solar, but there's very low power densities in those types of energy generation. Wind is intermittent. Obviously, solar is not a great resource to use in cold-climate countries like Canada or Russia. Natural gas is an important transitional fuel, but there's also uranium.

To me, a seminal moment in the uranium market occurred about five years ago when James Lovelock, a leading environmentalist who used to be the head of Greenpeace, said that uranium has to be a major part of our response to global warming. Before that, uranium was seen as part of the problem, not part of the solution. Clearly, the nuclear waste issue hasn't gone away but we treat the stuff a lot more effectively than we used to. The waste problem relative to the millions of tons of coil that get belched out into the atmosphere is fairly minimal.

I think the reason we like uranium is because it's both a supply and demand story. On the demand side, a number of nuclear reactors are under construction. Haywood Securities Analyst Geordie Mark says there's been a 61% increase in the last couple of years. There's also been a 54% increase in the number of reactors planned and a 45% increase in those proposed. These new plants alone will eat up 32,900 tons of nuclear fuel annually—that's almost half the demand from this year's 443 commercial reactors. We've got a very good story there, and then you have the supply side. The current price is around $68 and that's still too low to support a lot of new investment. You need much higher prices to invest in large-scale, development-stage projects.

As it is now, the uranium industry is having a hard time boosting production. There have been shortfalls from large mines, such as Energy Resources of Australia Ltd.'s (ASX:ERA) Ranger Mine and BHP Billiton Ltd.'s (NYSE:BHP; OTCPK:BHPLF) Olympic Dam Mine in Australia. Of course, Cameco Corp. (TSX:CCO; NYSE:CCJ) had water problems related to reaching production at its proposed Cigar Lake uranium mine. Those are other problems.

TER: Do you think we will see another surge in uranium prices like that in 2005?

MA: Generally, I find that these moves in the commodity cycle take two phases. The first is the "fantasy" phase where you get recognition that a real supply/demand deficiency is developing. A lot of speculative moves are made and the stocks start to go up, but then they crash because it hasn't yet been validated by actions in the real world. But this speculation moved ahead of reality. Typically, what happens is that you get a wash out, and then 18 months to two years later people come back and say, "This thing is for real." We saw that happen in gold. There was a big move in gold in 2003 and 2004, but the gold price didn't move up a huge amount. So, the market went dead for a couple of years. I think uranium would've had some interest in 2009, but obviously everything was superseded by the Lehman Brothers meltdown and the financial crash. So, it's taken a bit longer, but I think the supply/demand outlook I've sketched here is still very much in existence. Now we're starting to see an increasing amount of pricing pressure developing on uranium, which I think will help reignite interest in the sector.

TER: What's your forecast for the price of uranium?

MA: The price could easily double over the next three or four years, and it could even go much higher. A number of these projects in places like Kazakhstan and Namibia don't even begin to make money until the price gets closer to $80 or $90 per pound.

A lot of the demand will be driven by the pace at which these nuclear reactors are built. The problem here is that we've often got political delays. I don't think nuclear construction in the U.S. will come for another four or five years because with natural gas prices being as low as they are there's no urgency to move into nuclear. However, in other countries where natural gas prices are much higher, I think we'll likely see accelerated development. Certainly, in countries like South Africa, we're already seeing brownouts. China is definitely going to move ahead very rapidly, as is India—that's going to be the big source of demand. It's just a matter of how quickly these countries start to build reactors. It may be a case where, occasionally, perception races a bit ahead of reality; but the underlying reality is that uranium has the soundest supply/demand features of almost any commodity out there right now.

TER: As of Sept. 30, 2010, Pinetree had 55 separate investments in uranium plays. That accounted for 18% of your asset mix. With this expected price appreciation, do you want to keep your uranium exposure at around 20% or are you going to increase that?

MA: I think it really depends on the opportunities; we're focused on a number of ventures. Again, you have to weigh the existing investments against the increased political risks as you move into some of these funkier countries in central Asia. You've always got to measure it against that. I think 20% is a fairly substantial bet, and I suspect that's even higher now due to share price appreciation. But if it's become a hot sector, we may start to look in an area that's become less loved.

TER: You mentioned "funkier countries" in central Asia. Do you mean Kazakhstan?

MA: I have a view that it's always tough investing in any country that ends with "stan." Basically, I'm saying you have to be much more aware of that risk. Increasingly, we're seeing examples of resource nationalism. And that's not just in the emerging world, it's in places like Canada. There were very significant resource-nationalism reasons for the Canadian government's disapproval of BHP's acquisition of PotashCorp (NYSE:POT; TSX:POT). I happen to think that was the right decision because I believe it's much more valuable as a standalone asset. Increasing resource nationalism means you've got to be careful. You don't want to develop something, and then find out the local government is taking 50% or more of it. I think that we have to make political risk assessments as part of our investment judgments going forward.

TER: What are some of your biggest success stories when it comes to picking uranium stocks?

MA: Mega Uranium Ltd. (TSX:MGA) is a classic example. It started to appreciate at $0.10 and got to $9 at its peak. That's probably one of the best examples. A couple of other examples would be Rockgate Capital Corp. (TSX:RGT), which has gone from under $1 to $2.70 recently. It's a uranium explorer and developer in West Africa.

Rockgate's main project is the 100%-owned Falea Uranium/Silver deposit located in southwest Mali. It was initially discovered in the late 1970s by Cogema, now AREVA (PAR:CEI). Rockgate has expanded Falea substantially with 45,000 meters of diamond drilling now completed in more than 175 holes. This work identified a new zone of uranium and high-grade silver; and on May 15, 2009, Rockgate released the first independent NI 43-101 resource calculation for the Falea project reporting a total uncapped resource of 20,252,000 pounds of uranium and 31,600,000 ounces of silver.

Another company is U3O8 Corp. (TSX.V:UWE), which has gone from a $0.35 to a $1.03 stock. It acquired some projects in South America Mega Uranium last year. In Colombia, it acquired Berlin Project—a 38 Mlb. historic uranium resource at 0.13% U3O8—a high-value, multi-element opportunity with the presence of uranium, phosphate, vanadium, molybdenum, yttrium, rhenium and silver grades.

In Argentina, U308 Corp. has sizeable land holdings near the country's largest known uranium deposits. The surficial uranium target at the company's Laguna Salada Project there appears amenable to low-cost mining, and it's working to complete an NI 43-101 uranium resource estimate on that project.

Additionally, U308 Corp. holds prospective lands in Guyana—in the Roraima Basin, which is similar to Canada's Athabasca Basin in size, composition and basement characteristics. Its Kurupung Batholith Project has an NI 43-101 resource of 5.8 Mlb. at an average grade of 0.10% U3O8 (Indicated) and 1.3 Mlb. at an average grade of 0.09% U3O8 (Inferred). A pipeline of uranium-bearing structures will help grow the current resource at Kurupung, which is geologically similar to sizeable albitite-hosted deposits around the world.

Khan Resources Inc. (TSX:KRI) and Summit Resources Ltd. (ASX:SMM) would represent a few of our other big successes.

TER: What are some other promising uranium juniors Pinetree has in its stable?

MA: We like Mawson Resources Ltd. (TSX:MAW; OTCPK:MWSNF; Fkft:MRY), which has metal and energy interests in Finland, Peru and Sweden. The stock recently went from $0.75 to $1.99. And not long ago, the company increased its landholding at the Rompas Gold Uranium Project in Finland by 40%. Mawson has a strong cash position and a very prospective deposit. Highlights from recent channel samples included 0.95m at 1,424 g/t Au and 1.3% U308 and 2.05m at 191.3 g/t Au and 0.44% U308.

We also like Energy Fuels, Inc. (TSX:EFR), which is consolidating uranium mining in western Colorado's Uravan Mineral Belt and eastern Utah, U.S.

TER: Let's move on to oil. Global oil consumption has rebounded from the early 2009 lows and now exceeds pre-financial crisis levels. The usage gap between developed markets and their emerging-market counterparts has shrunk from 12 million barrels per day (Mbpd) three years ago to just 4 Mbpd. The International Energy Agency (IEA) forecasts global energy demand will rise to 82.2 Mbpd in 2011 up from 86.9 Mbpd this year—that's almost 500 billion barrels annually. Where's that oil going to come from?

MA: It's a good question. Ultimately, I think that's what keeps the bid on the price. You have these situations wherein you've got massive increases in demand and you just don't have the available supply, so you're going to see much higher prices. Milton Friedman once said the best cure for higher prices is higher prices because that's how you solve the problem. I think we'll see increasing price pressures. The possibility of a conflict developing or resource wars is rising. I think countries that are in the sweet spot are countries like Canada, which has very substantial energy reserves.

TER: Since it peaked in the 1970s, conventional oil production in Canada and the United States has been declining. Recently, the application of horizontal drilling and hydraulic fracturing to tight oil basins—or, as one oil pundit put it, "a replay of the shale gas movie with different actors"—is bringing a growing amount of light oil to market. Perhaps the best example is the North Dakota Bakken where oil production went from virtually zero a few years ago to about 250,000 bpd now. Are these new dense rock plays putting an end to the notion of peak oil, or is it too soon to declare that?

MA: It's too soon to declare that. First of all, two things are going on there. We need these kinds of projects just to sustain the levels of demand going forward, but I don't think they are a panacea to the problem of peak oil. It's more accurate to look at them as the response to substantially higher oil prices from conventional sources. And some of the supply gains from the non-conventional sources are temporary. In the case of these Barnett shale-type developments, for example, you get very significant early production gains but the asset gets exhausted much more rapidly because the technology accelerates depletion rates. Working these tight basins may provide a short-term fix but it doesn't actually solve the problem of peak oil. In fact, I would say it validates the whole thesis. If there was an easier way to find oil, no one would have considered it worthwhile to look at these areas.

TER: What are some of your noteworthy oil holdings?

MA: Brownstone Energy Inc.'s (TSX.V:BWN) stock has gone from a low of $0.27 to a high of $1.16; it's currently trading around $0.75. The company's main focus remains on its Colombian and offshore Israel projects.

In Colombia, the Canaguay # 1 well on the Canaguaro Block in the Llanos Basin produced oil at rates in excess of 3,900 bpd. BWN has 25% working interest and long-term production tests are expected to take place in February.

The offshore Israel project is a joint venture with Adira Energy Ltd. (TSX.V:ADL; OTCBB:ADENF). The Noble Energy, Inc. (NYSE:NBL)/Delek Drilling LP (TASX:DEDR.L) Tamar discoveries are within 60 km. of Brownstone's Gabriella and Yitzhak Blocks. Completion of Adira's 3D high-resolution seismic programs are expected in January 2011; so far, the results look very promising.

Donnybrook Energy Inc. (TSX:DEI) is an emerging Canadian oil and natural gas explorer and producer we like. It's focused on Montney, Bluesky Wilrich and Fahler formations in the Deep Basin, West Central Alberta. The company now owns working interests in 46 gross sections (30 net sections) of Montney petroleum and natural gas rights in its core area of the Alberta Deep Basin.

Primary Petroleum (TSX.V:PIE) has focused a majority of its resources in the acquisition of prospective oil and gas acreage in Montana. It is engaged in exploration and development activities in Montana and Alberta and owns a significant land position in the Alberta Basin Bakken Fairway in Western Montana and in the NW area of the Williston Basin in Eastern Montana. The company holds 100% interest in all of its landholdings in Montana and has been increasing those landholdings.

Centric Energy Corp. (TSX.V:CTE) is another one we like. It is an oil and gas explorer with interests in Kenya and Mali, with a particularly promising land position in Kenya. The Kenyan government recently approved the Block 10BA farmout to Tullow Oil plc (LSE:TLW). The Block is in the northwestern part of Kenya, located in the eastern part of the Tertiary-age East African Rift system and is considered analogous to the Albertine rift in Uganda, where an estimated 1 billion barrels of reserves have been proved to date and contains another 1.5 billion barrels of prospective resources. The Lake Albert Blocks are operated by Tullow Oil, and 35 out of 36 of the exploration wells drilled have been successful.

TER: Most people are staying away from gas plays right now. Are you saying that Pinetree is heading in that direction?

MA: There's a very strong secular case to be made for natural gas in the sense that it's a "green" fuel and will be instrumental in helping governments achieve their objectives to reduce carbon emissions. That said, a lot of the so-called gas plays are actually existing byproducts of oil extraction, so there is less price sensitivity to natural gas prices per se. And the new technologies in place have substantially increased extraction techniques, whilst reducing cost. So our focus can't be on companies on the basis of higher prices, but rather on good, low-cost producers with ample reserves. Those companies can make money at these depressed prices, which are likely to stay low for the foreseeable future.

TER: Do you have some closing remarks on the energy sector on a macro level?

MA: I think what Pinetree Chairman and CEO Sheldon Inwentash says is correct. At the end of the day, you're dealing with a structural phenomenon where you've got 2.5 billion people in India and China and other emerging areas of the world who are rapidly trying to get wealthy like we did using the same sort of growth model. But because these people are at an earlier stage of economic development, the intensity of their commodity usage is much higher. With that in mind, we tend to believe that there's a structural bull market in any number of commodity classes. Pinetree has effectively constructed a business plan on that thesis. Now, are we likely to see significant corrections in the future? Of course. These things don't go up in a straight line. You could have vicious 30%–40% falls. We have to learn to live with that volatility. We employ responsible risk-management techniques and do a lot of due diligence and technical work to get the high-quality assets and get them early.

TER: Thank you for talking with us today, Marshall.

As Pinetree Capital's corporate spokesperson, Marshall Auerback is a member of Pinetree's board of directors and has some 28 years of global experience in financial markets worldwide. He plays a key role in the formulation and articulation of Pinetree's investment strategy. Currently, Marshall is a senior fellow at the Roosevelt Institute, a research associate for the Levy Institute and a fellow for the Economists for Peace and Security. He previously served as an advisor to a number of fund-management organizations, such as PIMCO, the world's largest bond fund management group, RAB Capital and David W. Tice & Associates. He graduated magna cum laude from Queen's University in 1981 and received a law degree from Corpus Christi College at Oxford University in 1983.

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DISCLOSURE:
1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Mega Uranium, Mawson Resources, Energy Fuels and Primary Petroleum.
3) Marshall Auerback: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. See Pinetree Capital's disclosure policy.