Let’s discuss structural changes going on across commodities markets that also play into the equities. There is currently a myriad of macro challenges: a hawkish Fed, war in Europe, supply chain challenges, and banking sector bailouts as well. Are we in a perfect storm for investing?
Justin Machin: Denham Capital is a mining-focused private equity firm and we focus our efforts in late-stage development and construction. Our approach is global. We invest in places as benign as Canada and as exciting as the Democratic Republic of the Congo (DRC) and Indonesia. A typical cheque size is about US$100M. We pride ourselves on digging deep into different metals and minerals.
Now, we’re looking at challenges in the banking sector. With everything that has happened with Credit Suisse and Silicon Valley Bank, what’s next? There’s been strong policy moves to ensure that we’re not going to see mass contagion, but that’s certainly a concern.
I think another key theme is inflation. Policymakers have a difficult decision. Do they keep rising rates and potentially cause more harm to the economy, or do they start slowing rate increases to keep things propped up and ensure markets are performing well?
Roger Mortimer: I manage a global energy transition fund at KraneShares. We invest in equities that benefit from the grey to green transition. Our thesis is that the greatest opportunity is in the dirtiest companies. 90 companies account for two-thirds of global emissions. You can’t solve that problem without these companies. And they are better placed to step into these new businesses because they have solid global infrastructure, technology, and customer bases. Our thesis is predicated on a change in investor perception. That’s going to occur as these large companies are revealed to have all kinds of skills that people didn’t expect them to have.
About the macro, I’ve been a global equity investor for 25 years. I’m also a public equity investor and I’m market-to-market every day. For a market-to-market investor, the current environment is extraordinarily difficult because you have a lot of short-term volatility. There are a lot of negative factors. Broadly speaking, as it relates to metals, you’re trading off a coming super-cycle. That’s an investment that’s going to increase demand against extremely disruptive short-term factors. And at the end of the day, the prices of commodities like copper are still influenced by coincident consumption.
The key take away is that interest rates have primarily fallen for the past 40 years, which isn’t the case anymore. As investors, we’ve been operating with a tailwind that we didn’t realize we had. Inflation’s not going away. Interest rates are not going down and are going to remain high for a long time. Reducing liquidity and available capital for investment is making everything more difficult.
Unless you believe that the Fed is going to drop interest rates, then I think you should operate on the assumption that inflation is going to be persistent.
And what do you think the Fed’s going to do?
Roger Mortimer: I think the Fed has interpreted its primary mandate as inflation reduction and financial stability. This is going to become an issue. First Republic, for example, is a stable well-run bank that has been caught up in the Silicon Valley Bank failure. It shows that the market can force things to happen, and that can be very unpredictable.
The Fed’s going to have to find a way to paper these issues over, but I don’t think they’re going to fold and give the market what it wants.
Keith Spence: I’m the head of private equity firm, Global Mining Capital. For the last 20 years or so, most of our activities have been in Asia, in particular China. Most of our funding and deals are Asia-based in terms of funding background. Overall, we focus on late stage near-development projects all over the world.
The mining space is global. If you look at the Toronto Stock Exchange, which is number one for the mining industry, some 60% of all listings, especially on the venture exchange, are companies with projects outside of North America, mainly in emerging markets with some in developed markets.
Geopolitics is going to affect exploration in some countries. Just recently, the Canadian government banned three lithium-related companies. These companies only had projects outside of Canada. They had nothing to do with Canada, except that it was listed on a Canadian exchange. So, geopolitics, I would say, is the biggest macro issue that we must face.
Dan Denbow: I was the portfolio manager for the US Precious Metal Fund for 23 years, running a global dividend and a domestic dividend fund. I’m currently a director for a private Finnish exploration company, an interim CEO and director with an Ontario exploration company, and I have a small oil and gas company in Texas.
I don’t believe there is a banking crisis. I think the tide went out and some didn’t have their board shorts on. They’re just poorly run companies with bad strategies that got caught in the tide. Nevertheless, I don’t think there’s going to be a major contagion.
The hardest challenge is geopolitics. You’re playing chess against seven or eight different opponents, all with different rules and interests.
Further, you have ESG pressure. Your board is supposed to greenlight a US$6B investment that’s going to take seven years before you see any income, and you have no idea what’s going to happen going forward. The country’s politics, ESG criteria, and investor support are all unstable because you’re trying to solve a problem by providing more copper or critical metals, but you’re still viewed as the evildoer.
Conversely, you have inflation and labour inflation that’s going to grow, because we are becoming more isolated. COVID showcased supply chain issues and now everybody wants domestic supply chains. This requires a huge amount of capital.
I think the Fed is going to be fighting inflation for a long time, but it’s also going to be fighting politics.
The one good thing I will say, for the first time in 20 years, investors are winning. Being a money manager today is fraught with challenges but also great opportunities because they’re beating the index, making better choices, and choosing better stocks. Copper companies and those in critical metals – they’re growth companies and we must convince everybody that we’re focused on growth.
Keith Spence: With respect to copper, grades are going down. I would say it’s the most critical of all the minerals right now. There’s not going to be any charging stations without copper. If you look at where copper comes from, there’s lots of problems in Peru, Chile, Argentina. Chile is the world’s largest supplier of copper. And in Africa where Zambia is a major producer, they have significant problems with respect to production. I think this copper issue is going to be a big one going forward, even more than what we’re seeing with lithium right now.
How are inventories of copper? Is there a supply tightness for this year?
Keith Spence: Yes, this year and in the short term there will be.
China has pivoted away from its COVID lockdown policy. How does that impact copper and other base metals?
Keith Spence: China was the big driver for copper prices. So goes China, so goes copper. You must remember, copper (like iron or steel) was a principal industrial driver.
And the new thing that has happened is that copper is now new energy. The Chinese have had a suggested growth of about 3 – 5%. In this environment, 5% growth is a lot. So, there will be huge demand for copper from the Chinese driving that supply chain issue.
Roger Mortimer: There are two ideas being talked about here. One is the price of the commodity, and the other is the access to the commodity. They are different. The price of the commodity is a function of short-term factors and coincident demand. The strength of the industrial economy, Europe, the US, etc. but access is a whole different story.
This re-shoring de-globalization trend is fundamental to the energy transition and China exists in a universe by itself. They’re building a whole supply chain and we will be beholden to it.
That means the asset value of resources in developed markets are going to trade at a premium to those in other places. And the price of copper doesn’t really matter if you don’t have access to the resource.
Justin Machin: I think with copper specifically, the cupboard is bare. For several reasons, primarily ESG driven. Permitting timelines have blown out. In many cases, it takes four or five years just to permit a project after you fully de-risked it. And the de-risking process itself can take upwards of 10 years. So, there’s no ability to turn on the taps and mobilize new copper supply.
To bring on new copper in the near term, we need higher incentive prices to unlock some large low-grade copper porphyries that have been de-risked. Otherwise, I think it’s going to be a painful period as we try and de-risk new supply.
Dan Denbow: From the market perspective, people have seen what’s happened to the energy companies. They stopped investing and those stocks have done well. Mining stocks have not done well for several reasons. But I think those who did return capital, the bigger cap guys, saw a benefit.
The price of commodities always gets you to act in a certain way. So, it’s going to take higher prices to fix this. The same thing for rare earths. I’m not a big believer in rare earths, I apologize, but they’re not rare. They’re uneconomic earths. They’re rare because they’re tiny and they’re very hard to produce and get out to process. Once they become economic, when the prices rise enough, you will be able to start processing them and realize there’s tons of them.
Lithium’s going to find the same thing, it’s critical, it’s important now, but you also must remember there’s tons of it. But, it takes a lot of money to get a pristine product out. It’s going to mean a lot higher prices.
Ontario is getting very aggressive in trying to speed up mining and solve some of these permitting issues because they’re seeing the problem coming.
Shouldn’t some of that incentive pricing already have happened and new capital be coming in? Things like the Inflation Reduction Act probably don’t touch upstream like the mining equities yet, but it certainly hits the components that need those metals such as wind turbines. Have we seen any positive capital coming into the sector?
Dan Denbow: The simple truth is, yes, there’s been price benefits. For example, gold price is high, but the stocks are down. The benefit has not come through. It’s partly due to inflation being higher. There has been some impact to earnings, but no, because they’re all chasing growth projects.
Keith Spence: Gold equities are underperforming in a time they should be performing. It’s because the money is going after critical minerals and lithium, etc. If you look at all the factors that drive gold inflation (the US dollar, uncertainty, the bank financial crisis) those are things that normally would drive gold to the roof, but equities, no.
Roger Mortimer: We’ve seen this before. I’ve been a global equity investor and lived in San Francisco for more than 25 years. In 1999, there was a tech boom where pets.com was worth hundreds of millions of dollars and everybody thought the world was going to be reinvented around a series of new ideas enabled by the internet. And then that got debunked. Between 2002 and 2008, there was the financial crisis. You could have put all your capital into mining companies and that would’ve been the best thing you could have done.
Today looks exactly like 2002, where everybody’s been on one side of the boat. There are five companies that have been running the S&P for the last decade and people think that they can do no wrong. They’re highly valued, but why are gold companies not trading up?
The real reason that the stocks haven’t started working yet, is that these companies have been so marginalized and their weight in the indices is so small, that investors don’t have anybody on staff who knows anything about this stuff.
So, are we at a point of low valuations relative to the value of these businesses?
Roger Mortimer: Yeah, these companies are cheap. Our strategy is to focus on companies that are changing their business models and are going to be perceived differently in the future. I’ll give you an example.
We own a company called Fortescue Metals Group, an Australian iron ore producer. It’s the fourth largest iron ore company in the world behind Vale, BHP, and Rio. Fortescue sells primarily to the Chinese, the Koreans, and to Japanese steel mills. They take a commodity price that is negotiated, but there’s a market indication and that company trades at a 20% free cash yield. That’s incredibly cheap stock because everybody thinks that something’s about to roll over. It’s a cyclical stock.
They put US$1B dollars last year into a new hydrogen unit that they’re creating called Fortescue Future Industries. They are attempting to build out what they believe will be a merchant business for global green hydrogen. It employs 1,500 people and there is zero value in the stock for that. You get that for free.
People see something that they didn’t see before. A lot of the mining industry looks like that, where you have a very limited investor audience and people have not yet fully calibrated that you can’t build the electrified economy without copper and nickel.
Justin, where do you sit on the valuations of the moment as a private equity view?
Justin Machin: We’re fortunate where mining companies are unfortunate, because we invest at the bottom of the Lassonde curve when companies are typically in the orphan phase. The issue is that with a lack of generalist interest in the space, there’s no real public equity available for these companies to go out and raise capital to build their mines. Sure, there might be some debt available from the government or grant money, but that’s only part of the puzzle.
We’re privileged to get to invest at a point in time and space where it’s kind of valuation agnostic because everything is very cheap. It’s about finding the best projects at that stage and then putting capital to work.
Roger Mortimer: The mining insight and talent as it exists today, is largely in the private equity community. The opportunity is accruing to your asset class and the public market investors are going to have to wait.
Is this something about how private equity remunerate their teams?
Justin Machin: I think in mining private equity (PE), we are the only players in town in some respects, but we’re still a very nascent industry. You can count the number of mining PE sponsors on two hands, which is a far cry from where oil and gas was previously.
I believe it’s that lack of interest that we see in the public markets, that also still extends to the limited partnership (LP) community, those are the people who invest in our funds. A big part of our job when we’re out talking to pension plans and endowments is trying to educate them on things like the energy transition and the mining sector and why this is important and why we should be a part of their portfolios.
Justin Machin: When I first joined Denham, we were raising our first dedicated mining fund. It was an interesting time because when we were out talking to prospective LPs, it was a two-step process. One, you had to educate them on the mining sector, because they weren’t very familiar with it. Two, you had to convince them whether they wanted to invest. And so that was a long-life cycle kind of gestation process.
Now when we go see LPs, everybody is aware of the energy transition. They understand that these critical metals and minerals are absolutely required for what we’re trying to achieve. And so now they often have dedicated people looking at the space. Now, it’s just a question of who they want to invest their capital with.
Dan Denbow: The hard part with that is just the time. PE investors are used to startups but there are some things you just can’t do the same way in the mining space, because the timelines are hard.
I want to probe around the oil and gas companies being considered growth companies. Roger, you’re sort of seeing an alternative view to energy transition with these companies and how they might be part of the solution in the long run. They’ve got the skills, innovation, and capital. What do you see as their key role in this narrative?
Roger Mortimer: The energy transition capital cycle is the largest the world has ever seen. Think of this as the industrial revolution 2.0. We’re trying to overhaul about 20% of the global economy and transition from fossil fuels to electrification. That reduces demand for all kinds of things CO2-emitting and increases demand for everything that enables electrification.
The group of the people who I interact with every day understand that this is the biggest show in the world, and governments are throwing money at it.
Governments are competing to give capital to the companies in these areas. At a time like this when the economy is slowing, interest rates are rising, people are getting laid off, here’s an area where the governments are competing to give you capital and incentives to be in the business. You have very high certainty of growth.
Then you have a group of companies that have been viewed historically either as cyclical, or low growth that are about to become very high structural growth. I’ll give you an example; Baker Hughes, an American oil service company, historically trades at a low multiple because it’s cyclical. Oil service spending goes up and down and it is going to evolve into something that has high structural growth.
For the metals companies, these assets will largely be consolidated by people who have large structural plans and need security of supply.
Keith Spence: The metals and the oil and gas industry are similar. They drill. They take stuff out of the ground. I wouldn’t be surprised if you see a lot of oil and gas companies looking to diversify into the mining space.
How does the US and Canada better integrate supply chains without the mainstream processing facilities domestically?
Keith Spence: Metal processing is dominated by China, and most of the upstream aspects of mining have been handled by the major countries, Canada, Australia, etc. The downstream and the midstream have been left for others.
The problem with processing is that it’s dirty, and China didn’t mind the environmental issues. Something we must accept in North America. Of course, it’ll be done with ESG principles, but there’s no processing without some environmental issues.
What do you think is the new level of incentive pricing that’s going to kick capital back to the sector?
Dan Denbow: We already saw it a bit when copper spiked before. Now that China’s coming back on, you should get that back. You’ll start getting copper back up there again, but it’ll be seven years before we can bring that capacity to market. So, you’re going to zoom past that stimulus price to a pain price and then you’ll settle back at what is a reasonable investment level.
Gold is at US$2000, that’s sustainable. Oil is going to be close to triple digits again. We’re under investing. We don’t have enough refining capacity. That’s the biggest problem here that people don’t realize. Refining has collapsed in the oil and gas space and so we’re going to be short there again.
It’s sounding like fossil fuel is the best opportunity right now, even better than gold and silver?
Roger Mortimer: I don’t know that it’s possible to judge one against the other. Fossil fuels are a coincident indicator of economic health. And so, the oil price was higher. It was over US$100, now it’s back in the mid-70s.
I wouldn’t say fossil fuels are the sure bet. I’d say copper is the commodity that is most required and the lead time to deliver scale is quite long and mainstream investors are going to invest in that commodity.
