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Is there a speculative opportunity in "geothermal"?

We think that "alternative energy" will be one of this decade's most lucrative investment themes, where "alternative" means non-fossil-fuel-generated. Geothermal energy fits into the "alternative" category, and is clean (environmentally friendly) and renewable. It can also be economically viable without government subsidy. The question is: do the stocks of geothermal companies (companies that use geothermal-heated ground water to drive turbines and produce electricity) represent an attractive speculative and/or investment opportunity at this time?

Some of these stocks could turn out to be good long-term investments if they are purchased when their valuations are reasonable, but they don't have sufficient speculative merit for our taste. This is primarily because the geothermal business involves high initial capital costs, just like the metals mining and oil/gas drilling businesses, but doesn't offer the potential for exceptional profits in response to exploration success or large increases in commodity prices. That is, with the geothermal business you don't get the leverage that tends to go hand-in-hand with the traditional mining and drilling businesses.

An advantage is that unlike a mine or an oil/gas well, a geothermal reservoir doesn't deplete (water gets cycled between the underground reservoir and the electricity generation plant). Another advantage is that leverage is a two-edged sword, so while geothermal operations don't offer the potential for windfall profits due to helpful changes in commodity prices, they also don't run the risk of suffering substantial losses due to adverse changes in commodity prices. In other words, an established geothermal operation has relatively low risk as well as relatively modest upside potential. The companies that own such operations could therefore produce steady returns over time, regardless of swings in commodity prices. Hence our comment that the associated stocks could turn out to be good long-term investments IF purchased at reasonable valuations.

Considering that geothermal stocks have generally performed poorly over the past 12 months we expected to find that valuations within the sector were attractive; however, if the three stocks that we quickly reviewed (Magma Energy, Nevada Geothermal and Ram Power) are indicative, that's not the case. Each of the companies we checked was heavily loaded with debt and had a high enterprise value (market capitalisation plus net debt) compared to the size of the underlying business.

Of the three companies mentioned above, the only one that we would seriously consider investing in at this time is Magma Energy (TSX: MXY - see chart below); and that's only because Ross Beatty is the CEO. Mr. Beatty has a terrific track record when it comes to creating shareholder wealth, so it's a good bet that MXY will evolve into a very profitable operation over the years ahead. Our concern is that near the current share price the company has an enterprise value of about $690M, even though it is losing money and has a revenue run-rate of only $80M/year. In other words, this is a loss-making company trading at a very high 8.6-times its present annual revenue. It is also trading at almost 2-times its net asset value. It could be that we just don't understand how to value young and growing geothermal companies, but it seems to us that MXY's valuation is a long way from being "attractive".

The upshot is that the geothermal sector doesn't appeal to us at this time as either a speculation or an investment.

The Stock Market

The US stock market has been climbing steadily, with minimal volatility, for the past 2.5 months. With the exception of the quick 2% decline caused by the Egypt scare in late January, on a daily closing basis the S&P500 Index has not experienced a downward correction exceeding 1.2% since November.

The US market continues to be at risk of at least a 10% pullback, but as at the close of trading on Wednesday the short-term upward trend was obviously still intact. Additionally, there were no significant bearish divergences between the various US stock indices. The only divergences of note are between the US stock market and some of the world's other important stock markets. For example, the sequence of new 52-week highs achieved by the S&P500 Index over the past 2.5 months has not been confirmed by Hong Kong's Hang Seng Index (HSI). As illustrated by the following chart, the HSI has just begun to rebound after dropping back to its low of the past four months.

One of the most remarkable stock-market performances of the past two years has been that of the US Real Estate Investment Trusts (REITs). The US commercial real estate sector appeared to be in dire straits in 2009, but the following chart shows that Real Estate iShares (IYR) has gained 200% since its 2009 bottom and has now recovered all the ground it lost during the 2008 crash.

The Fed can be thanked for the extraordinary recovery in the market value of commercial real estate. However, there is a high cost associated with propping up the prices of bad investments. Of greatest importance, the act of elevating prices to prevent some investors from incurring losses siphons wealth from other parts of the economy (TANSTAAFL - there ain't no such thing as a free lunch). These other parts of the economy would likely have used the wealth more productively, thus allowing the entire economy to achieve greater progress and to create real (sustainable, non-government) jobs.

The high cost of the Fed's price-supporting activities is evidenced by the US economy's 'mysterious' inability to generate employment. The official US unemployment rate has pulled back from 10% to 9%, but the pullback is mostly due to people giving up and leaving the workforce. We think it is both interesting and telling that if the labour participation rate had remained where it was 10 years ago, the official US unemployment rate would now be 13% (the unofficial, or actual, rate would be much higher).

US policy-makers can face up to reality and acknowledge the damage that has been wrought by their attempts to prop-up prices and protect poorly-run, capital-consuming enterprises, or they can refuse to let the facts get in the way of a good story and point the finger of blame at China.

Gold and the Dollar

Gold

Gold's Real Trend

Since April of 2007 we have, from time to time, published a table containing what we consider to be the most important drivers and indicators of gold's REAL trend (its trend in purchasing power terms, as opposed to nominal currency terms). We have been following most of these gold-related factors at TSI for the past decade, but the Trend Table originally published on 2nd April 2007 was our first attempt to determine a single number that represented their combination.

An updated version of our Trend Table is displayed below. Notice that three of the four trend drivers included in the Table relate to interest rates. These trend drivers were discussed under "Gold and Interest Rates" in the latest Weekly Update. Also notice that mine supply changes, jewellery demand changes and central bank gold-market operations aren't included amongst the trend drivers. They aren't included because they aren't important enough.

Table Notes:

  1. A score of 1, 0.5 or 0 has been allocated to each factor for each year. Specifically, a factor scored '1' if it was generally bullish for gold during the course of the year in question, '0.5' if it was neutral (not decisively bullish or bearish), or '0' if it was bearish.

  2. The individual factor scores were summed to yield a total for each year at the bottom of the table. Since there are eight factors included in the table the maximum score (representing maximum bullishness) would be 8 while the minimum score (representing maximum bearishness) would be 0. A total score of less than 3.5 would be considered bearish, a total score of 3.5-4.5 would be considered neutral, and a total score of more than 4.5 would be considered bullish.

When we updated the Table in January of last year we arrived at a score of 7.0, but based on the way the various factors actually behaved last year the score turned out to be 5.0. In other words, we were a bit too bullish on the 12-month prospects for gold's real price (gold's price relative to other assets and commodities) in early 2010. This was a consequence of being too pessimistic about the chances of governments and central banks keeping the 'recovery trade' going for as long as they have. If our 2011 outlook proves to be 'off the mark', it will probably be for the same reason. This is because our overarching assumption is that the global growth/recovery theme will begin to falter within the next few months.

Once the markets sense that real economic growth will likely be weaker in the future than it is in the present, credit spreads will embark on a new widening trend and gold should start to out-perform equities and industrial commodities. However, the shift away from growth-oriented investments could initially be accompanied by a decline in the US$ gold price in a much less dramatic version of what transpired in 2008 (the accommodative monetary backdrop all but guarantees that there will not be a 2008-style market collapse this year).

Current Market Situation

A daily chart of the silver/gold ratio is displayed below.

As noted last week, the silver/gold ratio's move to a new multi-year high increases the probability of both silver and gold making new multi-year highs within the next few weeks.

At no stage since gold's December peak has the price action deviated from what would be expected from a routine short-term correction within a continuing intermediate-term advance. The future is never certain, so there remains a possibility that the correction will morph into the intermediate-term variety. However, the parameters are clear. As we mentioned a couple of weeks ago, every short-term pullback in the US$ gold price over the past two years has ended immediately after a touch of the 150-day moving average. The recent price action has therefore followed the short-term correction pattern "to a T" up until now, which means that a future decline to below the 150-day moving average could be used as a timely warning that something more than a routine short-term correction was in progress.

The 150-day moving average is now at $1318 and will soon be above $1320. This means that if we are right to assume that a move to new highs will soon occur then any decline in the gold price over the next fortnight should end at, or above, $1320.

Gold Stocks

Next resistance of significance for the HUI is in the 550s, while a near-term pullback is likely to find good support at around 520.

If gold and silver move to new highs over the next 1-2 months, the HUI should do the same. In our opinion, there is short-term upside potential to 650-700.

Currency Market Update

The currency market is superficially stable at the moment. It seems that downward pressure on the Dollar Index caused by strength in equities is presently being offset by re-emerging fears of sovereign debt problems in Europe.

Of the major currencies, the Canadian Dollar (C$) continues to be the one with the most bullish-looking chart pattern. The C$'s price action suggests an upcoming test of the 2007 peak, or short-term upside potential of about 7%.

Update on Stock Selections

(Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html)

Andina Minerals (TSXV: ADM). Shares: 108M issued, 129M fully diluted. Recent price: C$1.67

ADM announced the results of the long-awaited Pre-Feasibility Study (PFS) on its large, low-grade Volcan gold project prior to the start of trading on Monday. The stock price ran up last week in anticipation of these results, but the market obviously didn't like what it saw and quickly gave back about three-quarters of last week's gain.

We never really know what the market expects until we see the reaction to news. In ADM's case, we are left to wonder why anyone would have expected a lot more from the PFS than was actually delivered. The PFS confirmed that the Volcan project is marginal at this time, but has the potential to be developed into a profitable mining operation and offers substantial leverage to the gold price. It's beyond us why anyone would have expected much more.

Here are some of the PFS's most important estimates and conclusions:

1. Measured and Indicated (M&I) resources of 8.9M ounces, including 6.6M ounces of Proven and Probable (P&P) reserves.

2. Average annual production of 283K ounces over a mine life of 15 years.

3. Life-of-mine cash cost of $615/oz.

4. Initial capex of $550M.

5. Production to start in 2015 following an 18-24 month construction period.

6. There are several opportunities to improve the project economics, all of which will be considered as part of the Feasibility Study (FS) currently scheduled for completion in mid-2012.

The Net Present Value (NPV) figures calculated as part of the PFS underline the great extent to which the project's viability is levered to changes in the gold price. For example: assuming a discount rate of 7.5% and a share count of 120M, the NPV is $107M ($0.89/share) at a gold price of $1000/oz, $441M ($3.67/share) at a gold price of $1200/oz, and $768M ($6.40/share) at a gold price of $1400/oz. That is, a 40% increase in the gold price -- from $1000/oz to $1400/oz -- increases the project's NPV by 640%.

It's the leverage that keeps us interested in ADM despite its issues. If the gold price does what we expect it to do over the next two years then the Volcan project will become very valuable.

The leverage is a big plus for ADM assuming the gold price stays in a long-term upward trend. It's also a plus that the company has $30M in the bank, which should be enough to fund its activities over the coming 12 months. On the negative side of the ledger, ADM's extreme leverage makes it more vulnerable than many other junior gold stocks to an intermediate-term correction in the gold market (an intermediate-term gold correction will likely occur some time this year). Another negative is that there isn't much chance of ADM becoming a takeover target anytime soon. The managements of large mining companies typically like to buy when the numbers look good, which means that they usually end up 'buying high' and ignoring the most under-valued assets.

ADM is a reasonable candidate for new buying near the current price of C$1.67, but the C$1.40s is the optimum realistic area for new buying.

    Fairborne Energy (TSX: FEL). Shares: 102M issued, 112M fully diluted. Recent price: C$5.24

One of the most remarkable divergences we've ever seen in the financial markets is the one that developed over the past two years between natural gas (the commodity) and the stocks of natural gas producers/drillers. The commodity has languished, but the associated equities have done extremely well.

Mid-tier natgas producer FEL has been a laggard, perhaps because it offers substantial leverage to changes in the natgas price (leverage is a bad thing to have when the price is moving against you). However, despite the fact that the natgas price has just dropped back to near the lows of the past 12 months, FEL has finally broken out to the upside from a 21-month consolidation. As per our previous comments on this stock, C$7.50-$8.00 is the chart-based target created by the breakout.

Traders who are 'long' should consider placing a protective stop at around C$4.70.

    Northgate Minerals (AMEX: NXG, TSX: NGX). Shares: 290M issued, 297M fully diluted. Recent price: US$2.90

On 15th February NXG announced a resource upgrade for the Kemess Underground project, which is part of what was formerly known as the Kemess North project. The resource has gone from 1.4M ounces in the "Inferred" category to 2.6M ounces in the "Indicated" category.

Although the stock market pretty much ignored it, this news is significant. The main reason is that NXG's growth prospects will get a hefty boost if it can be shown that the Kemess Underground project has the economic potential to be developed into a mine that produces, say, 100K ounces of gold per year. The next step in verifying this potential will be the Preliminary Economic Assessment due to be completed in the third quarter of this year.

NXG has moved up to near the mid point of its 18-month range. New buying would be appropriate following a pullback to around $2.75.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html