How can retail investors protect themselves during inflationary times?
Disclaimer: I’m not an investment professional nor have any financial training. I write this substack for my own learning and pleasure. Stop here if you value your time.
Today, everyone is a macro-economic forecaster. The headline topic of the day is inflation. Questions of the day include, will it be transitory, what will the central banks do, and how can I protect my wealth? The beautiful thing about macro-economics is that everyone can have an opinion and having a plausible well-articulated thesis can make you look very intelligent. Unfortunately, the reality is that only a handful of people can make an accurate forecast. So, what is a pragmatic thing that a partially informed retail investor supposed to do?
We begin by learning some of the common narratives:
1. The money-printing by global central banks have resulted in trillions of negative yielding debt. This has benefited capital relative to labour. The rich have gotten richer, and the working class are the ones that have suffered. Companies with poor economics have survived longer than they would have otherwise. The debt to GDP ratio for many countries is unsustainable.
2. We might be facing some turning points. The FED has signalled that they are going to slow down their money printing experiment for now but there are significant US social entitlements that will dictate additional money printing in the future. There are political pressures in all countries to re-distribute wealth. The current “US dollar is as good as gold for oil” system, makes many countries lose the ability to control their destiny and makes the entire system fragile. China, Russia, Europe and others are quietly trying to break free from the US Petro-dollar hegemony by diversifying their central bank reserves and forming alternative national strategic alliances.
3. Commodities have been under-invested over the past several years due to ESG (Environmental, Social, Governance) activism and the lack of profitability in this sector. Some predict that future supply of commodities is constrained and will be more costly to extract because of geological difficulty and ESG demands. Producers are more fiscally disciplined to return excess cash back to shareholders instead of reinvesting toward new supply.
4. All industries are facing labour shortages, from technology giants to industrial manufacturers, and mom and pop businesses. The labour supply shortage has resulted in increased wages.
5. Retail investors and fixed income savers, without proper financial knowledge and facing negative real interest rates on their savings account (eg <1% interest rate minus 5-8% inflation = negative 4-7% real returns), have turned to stocks and crypto-currencies as a savings vehicle because of FOMO (Fear of Missing Out), gamification of the industry, and lack of safe alternatives.
These topics are complex but for those looking to dig in deeper, I would recommend the following people who offer free or inexpensive materials on their websites, podcasts, Twitter or YouTube. Lyn Alden, Luke Gromen, Grant Williams, Murray Stahl and the podcast “We Study Billionaires – The Investor’s Podcast Network”, are some of my sources.
So what? How does this all impact me?
As a public sector employee with a steady job, I am blessed with income stability but challenged with sparse retirement benefits and a salary with limited inflation adjustments. This situation is further exacerbated by my declining productivity with age. My discretionary expenses have been within my control, but food and education costs continue to rise and are difficult to cut. It is unlikely my taxes will decline, especially after the massive government debt levels resulting from the COVID-19 pandemic.
With a limited ability to increase income and reduce household expenses and taxes, and being too old to pivot entirely into another career, I have made it a priority to save as much as I can for the future. The problem is with bank deposit savings rates so low and inflation so high, my future purchasing power is declining by 5-7% annually.
So where do I store my savings? What are my options and how appealing are they?
1) Long-term fixed income instruments (3+ year bonds) are the worst choice. They yield very little and will suffer capital losses if interest rates rise. Short-term fixed income instruments carry a lower risk of capital losses but will still erode purchasing power with time.
2) Cash in a bank account, with its non-existing yield, will have declining purchasing power as we continue to need to pay for growing daily living expenses. The only benefit with cash, is it allows flexibility when opportunities arise.
3) Purchasing a rental property is a good choice, but would involve a significant amount of personal time in learning how to manage tenants and becoming handy. Furthermore, housing prices are so high in my local areas, limiting my return. REITs, with great irreplaceable class A properties, and farmland could be a viable option.
4) Equity investments in a broad global market index will likely be safe if its components are not too overvalued. However, significant shifts in global economic returns may create volatility and suboptimal returns for decades.
5) Holding a basket of commodities and their respective producers has traditionally resulted in poor long-term returns. Businesses in this space have no control over their prices, nor their competition’s irrational behaviours. Their substantial fixed costs and capital investments, coupled with long lead (development) times, put them at risk especially if they get their timing wrong. However, with a correct macro-economic picture, and if entered during the right time within the industry cycle, it can provide positive returns.
6) Gold and other precious assets (silver, diamonds, artwork) can be appealing due to their scarce supply and historical monetary premium (store of value) characteristic. In high inflation and stagflation environments, these are good choices. However, they do not have immediate cash flows and their markets are opaque with high transaction costs when buy and selling these items. You could buy the securitized form (closed end funds, ETFs, options), but these have varying liquidity and require a degree of trust in the management who runs these precious asset derivatives. Bitcoin would be considered a digital form of unencumbered commodity asset that might act like a store of value if there is enough global acceptance.
Warren Buffet has written extensively on inflation. This blog has compiled 100 pages of his writings here. In this first article published by Fortune in 1977 http://csinvesting.org/wp-content/uploads/2015/01/Buffett-inflation-file.pdf, he discusses how businesses can fight inflation.
In general, there are 5 ways a business can combat inflation: (1) an increase in turnover, i.e in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margins on sales. The challenge with businesses with tangible assets is that they have reinvest money to buy more equipment or inventory at ever inflating prices. The challenge with intangible-based businesses, is the access to cheap knowledge workers and the ability for competitors to copy ideas putting pressure on operating margins.
According to Murray Stahl, businesses that can navigate inflationary times would be characterized by the following:
1) Businesses with significant pricing power where it’s products or services are embedded deeply into their customer’s lives, where substitution and switching are difficult. This allows these companies to increase their prices without fear of losing their customers to competition.
2) Royalty businesses tied to commodities. These firms put money upfront in exchange for a % of the top-line future revenues of a mine or a well. If the production volume expands or the commodity price increases, these companies get to participate without needing to inject new capital for this growth.
3) Asset management companies tied to real assets. Asset management firms typically have high returns on capital due to their intangible nature. The challenge is finding places to re-invest this capital given its asset-light nature. Hiring more people does not usually equate to better returns in incremental investment. However, asset management firms that focus on real assets, such as real estate or critical infrastructure, can reinvest their returns in large amounts leveraged by other people’s money.
4) Stock exchanges. These businesses have significant regulatory barriers and due to their demand scale of economies, most local markets consolidate around a few major exchanges. Stock exchanges, as a data intermediary, have some IT infrastructure requirements but, operating expenses are, more or less, fixed compared to revenue fluctuations. This dynamic allows stock exchanges to survive better than others in an inflationary environment.
5) Difficult-to-replicate core real estate with fixed long-duration debt. These leveraged tangible assets with a locked-in client base (location, location, location) are more resilient to inflation due to their abilities to increase rents adjusted for inflation. However, it does depend on the local rental control policies and whether its inflation indicators accurately reflect its true magnitude. Perhaps, the most important factor for resilience is the fact that its fixed debt will be repaid back with less valuable future money.
I started writing this post January 10, 2022 but took a hiatus because my attention got distracted exploring various commodity-based businesses. During this timeout, Russia invaded Ukraine. This war has been a tailwind for commodities and precious metals and their producers. I got a little luck on timing before the run-up. The following is a summary of few royalty businesses that I like, have purchased, or on my wish list.
Altius Minerals
What does the business do and where does it operate?
Altius Minerals is a royalty company headquartered out of Newfoundland, Canada. It has 2 main operating segments, project generation (PG) and base metal royalty streams. In general, it is a non-debt/equity financing source for mining companies seeking funding to explore or for early production ramp-ups. In return for its capital, mining companies will pay a royalty to Altius when it starts production, and this contractual promise will continue even if the project is sold to another producer in the future. This contract stream will continue until the mine life is exhausted. The royalties are based on the price of the commodity as well as the volume of production. It ranges from 2-8% of the mining companies’ top-line sales.
Altius is primarily involved in a diversified mix of base metals (iron, potash, copper, zinc, nickel, lithium, uranium, cobalt, coal) and to a much smaller degree, precious metals (gold and silver). The mining royalty space has been around for many decades, but most of the royalty companies are focused on precious metals. Base metal mines have much longer mine lives than precious metal mines (Potash mines last for 1,000 years). Altius’ royalty streams come from an aggregate mine life of 38 years, in contrast to the best gold mines, which only have 15 years of life. According to their presentations, they believe that geological and social inflation will cause high production costs and longer commodity super-cycles.
The elegance of the Altius royalty business model is that they will get to capture the upside without having to participating in the ever-rising production costs or operating risks. Finally, another bonus is that Altius can grow its revenue without adding on any new employees (currently have 15 employees), having to invest in any fixed (buildings) or working capital (inventory).
When was it founded and what were some interesting points in its history?
Altius Minerals was founded in 1997 by Brian Dalton who at that time was a geology student with a group of entrepreneurial friends. They were selling their university research projects to mining exploration companies. Their project generation success led them to formally incorporate and start their business. During the commodity boom in the early 2000s to 2010, they were extremely cash generative and their stock price reflected the excitement of the day. As the super-cycle turned into a bust, the largest question of the day was what would they do with all its cash? At that time, there was significant debate in the financial community about Altius’ fate. Should it buy back their undervalued stock and issued special dividends or morph into a mining producer moving forward? Dalton did neither as he had no interest in becoming a mine operator. Instead, he patiently waited until miner desperation was at its peak (which occurred around 2015) and started offering royalty financing to now underwater miners. From 2015 to 2019, he reinvested the prior decade’s cash into the next phase of their business.
Who are the major stakeholders and what are their incentives to create long-term shareholder value?
Brian Dalton owns 3.1% of the outstanding shares. The directors and executive officers collectively own 6.3% of the shares. Fairfax Financial owns $100 million worth of preferred equity that have the option to convert at a price $15/share with the right to extend the expiry date if the share price remains below $24/share. If this is converted, Fairfax will own ~ 14% of the company’s diluted outstanding shares. Roger Lace, a Fairfax Financial insider, sits on the board of directors. Edgepoint Investment Management, a portfolio manager, also owns ~14% of current undiluted share count. Management is expected to own 3x their salary in shares. Their compensation comprises of 1/3 salary, 1/3 short-term incentives and 1/3 long-term incentives. Their performance targets include EBITDA/share growth over an 8% hurdle from the prior year, as well as the amount of share price appreciation using a 12-month volume-weight moving average. Dalton is paid $400K in salary and $800K in stocks and options. He states that his entire net worth is in this business.
Why has the business been successful (key drivers) and what changes will create headwinds or tailwinds to these factors (risk)?
The key driver of Altius’ success has been Brian Dalton and his team. They’ve demonstrated a counter-cyclical and patient approach to opportunistically deploy cash to buy royalty streams after project generation revenue from the prior cycle dried up from the commodity bust. They aim to use a barbell approach to smooth out their returns (high risk, high return project generation and low risk, low return royalty streams). In addition, they take advantage of depressed market prices by buying back their undervalued stock. Also admirable is their go-forward strategy of not buying more royalties during the current inflection (2021) of commodity pricing. They have been disciplined to focus on a minimal cost of capital of 7.5-10% on all their investments. Of interest, is that when they create a royalty stream, they account for this 7.5-10% return even before the commodity is dug up. There is a catch-up period when production starts, so that their investment rate of return (IRR) is acceptable. If priced correctly at the low point in commodity cycle and their estimated production volumes are conservative, then the potential upside on the present value of the royalty stream is a function of unit price x unit volume. Finally, they have been good geologists, capable of identifying reserves and brownfield opportunities in an accurate manner to price out their royalty agreements.
For this stock to do well in the future, it must coincide with a new commodity super-cycle moving forward. These cycles are typically ~ 15-20 years. If the bear market bottom was 2016 and with 2022 headlines now speckled with inflation talk, the next 5-6 years would be productive for commodity-based equities. Population growth, energy transition, geological and social inflation, broad base metal supply shortages from lack of capital expenditures in new mines, and investor demands in adequate returns on capital are currently contributing to this rally. My go-to-sources to learning about commodities are linked below.
How can I estimate its intrinsic value and how can I make this grow my net worth over time?
Although the business model is simple to understand, its diversified nature across varying base metals as well as financing activities (project generation vs royalty segments) coupled with IFRS mark-to-mark and equity/joint venture accounting, dissecting out the value of each stream is a herculean task. There are a couple of ways to parse this out.
Fairfax Financial is willing to put in capital at $15 per share. Assuming they have done a more in-depth diligence, purchasing around $15 per share should at minimum give a long-term market rate of return. If they are also willing to extend their expiry date if the share price is under $24. Then $15-24 should be what a professional would be willing to pay for this business.
Altius’ management also gives some clues how to think about their value. They consider their ownership of Labrador Iron Ore Royalty of Canada (LIROC) and Altius Renewable Royalty (ARR) to be a liquid balance sheet item that can be readily converted to cash. They also provide updates on their estimates of their project generation items on their website. Finally, if you dig into its annual filings, you can separate out the royalty streams from LIROC and ARR to get an estimate of their current royalty revenues. From this you can back out the cash, junior mining portfolio, LIROC, ARR, and add back Fairfax’s preferred equity to estimate the post-tax unlevered earnings yield. My average purchase price was $16.59, giving me an unlevered earnings yield of ~ 8.5%. Reasonably priced with potential upside on unit volume increases since unit prices have already risen in 2021 before I opened my position.
Finally, a quick and dirty way is to use their enterprise value per gross profit ratio through the prior cycle, average of the last 3 years of revenues (which doesn’t include the dividends from LIROC and ARR) and a gross profit margin of 80%. This would peg their value at $60/share. With a target 15% IRR over 10 years, this would suggest a $15/share entry price.
Although far from precise, I think directionality it is correct in this macro-economic environment.
https://altiusminerals.com/storage/webcasts/altius---investor-day-vpub2-1620911300.pdf
http://gorozen.com/
https://www.lynalden.com/
Franco Nevada
What does the business do and where does it operate?
Franco Nevada is a primarily a precious metal royalty company. 91% of their royalty revenues are derived from gold, silver, and other metals. The remaining 10% is involved in oil and natural gas. As of 2021, their asset proportions were: 72% were precious metals of which 54% is gold and is 13% silver; 13% in platinum group metals (PGM – platinum, palladium, rhodium, ruthenium, osmium, and iridium, and 28% diversified. Like Altius, it acts as a non-equity financier for miners in return for a percentage of the top line sales of the metal. Unlike Altius, gold mines don’t have the same long lives as base commodities. The average high-quality gold mine lasts ~ 10-15 years. Franco Nevada’s mine life is ~ 18 years. It requires more deal flow to continue replacing mines in their portfolio when they become deplete.
Franco Nevada’s headquarter is based out of Toronto, Ontario, Canada. They have 405 assets covering 63,000km2 of land. 38% are producing or in advance stages of development. 62% are in exploratory stages. Their assets are in the Americas, Australia, and west coast of Africa. 57% of their revenues come from the following operators: First Quantum, Glencore, Lundin, Teck, Coeur, Vale and Barrick. These links describe their assets in detail: https://www.franco-nevada.com/our-assets/portfolio-overview/default.aspx and https://s21.q4cdn.com/700333554/files/doc_presentations/2022/02/Franco-Nevada-BMO-Presentation-2022-03-01.pdf .
Finally, like Altius Minerals, the company is operated by 35 employees.
When was it founded and what were some interesting points in its history?
The idea of Franco Nevada started with Seymour Schulich and Pierre Lassonde in 1983. Their original company was acquired by Newmont Mining in 2002. There, Schulich and Lassonde, met David Harquail, and together continued under the Newmont umbrella until it was spun-out in 2007 with its other royalties. The team at Newmont followed the spin-out and this created Franco Nevada. David Harquail became its CEO and Pierre Lassonde its chairman until they both, in 2020, retired. David Harquail became its chairman and Paul Brink its new CEO. Brink has been with the company since its IPO in 2007.
They’ve always operated with no long-term debt to allow them to take advantage when market dislocations occur. They’ve used a combination of their own cash flows and equity issuance to fund purchase of new royalties. Over time they have diversified from gold to other metals and energy royalties as well.
Who are the major stakeholders and what are their incentives to create long-term shareholder value?
Franco Nevada is primarily owned by institutional investors. The top 8 institutions own 30% of its outstanding shares. The top 3 institutions are Fidelity, Van Eck Associates, and MFS (Massachusetts Financial Services) Investment Management. David Harquail owns 0.5% of outstanding shares worth ~ $151 million. Interestingly, Harquail reduced his compensation from $4.1 million to $1.3 million in 2020 during the Covid pandemic. The Board of Directors is required to own at least $135,000 CAD worth of shares at market price. The median ownership among the 10 directors is 35x more than the minimum requirement (~ $4.7 million). Paul Brink has a minimum requirement to own 3x his salary of $715,000 or $2,145,000. Brink owns 17x more than his minimum at $37 million in equity and restricted share unit. Paul Brink owns 0.1% of outstanding shares worth ~$34 million. This degree of ownership suggests skin-in-the-game to make this company work for the long-term with significant oversight from large institutional money managers. And the fact that this management team has been with the company since inception, gives some reassurance that their future actions will reflect their past behaviour.
Another place to get a clue of incentives is their management information circular. Here they lay out how management gets rewarded for their performance. It would be too much to describe every detail, but the following things stand out:
1) Their performance is measured against their performance index. This index is a weighted to S&P Composite and global gold index, 3 major peer companies (Wheaton Precious Metals, Royal Gold and PrairieSky Royalty) as well as a basket of commodity prices (Gold, Silver, Platinum, Pallidium, and West Texas Intermediate).
2) Resource replacement per share to ensure that the resource base is growing sufficient on a per share basis to replace the ounces realized by the company over time.
3) General and Administration cost per gold equivalent ounce to minimize any management drag on shareholders as the company grows.
4) Each of these easily measurable metrics are evaluated over a 1- and a 3- year rolling time frame to promote longer-term focus.
These metrics, in combination with significant insider ownership, encourage accretive growth, cost control and per-share value creation over time.
Why has the business been successful (key drivers) and what changes will create headwinds or tailwinds to these factors (risk)?
This royalty business model has been success for following reasons. The royalty model captures the upside over time if operating partners are chosen correctly for their abilities to execute. This model works particularly well in cyclical industries where boom and bust provides them opportunities to offer partners non-equity financing deals. Finally, management reputation and business scale, very likely influences the velocity of their deal flow pipeline. With the management team working together for decades, it provides some comfort that these elements will remain intact.
The ultimate success of this business relies on the pricing of its precious metals operating segment. Over the past decade, gold prices have increased over time as it tracks the M2 money supply and real interest rates. M1 money includes cash and checking deposits. M2 money encompasses M1 and near money (savings deposits, money market securities, and other time deposits (<$100K)). Because the US Petro-dollar is the most influential source of money across the global, tracking the US M2 money supply acts as a proxy for global M2 money. Below are 2 Lyn Alden charts that I replicated from the FRED website (interestingly, this can no longer be done because the FRED website no longer has gold pricing available as of 2022). If you believe that we are in a similar situation like the 1940s, high inflation, high debt levels +/- tepid growth, then it would not be inconceivable to expect negative real interest rates and continued M2 money supply expansion. In this scenario, gold prices will have a tailwind.
How can I estimate its intrinsic value and how can I make this grow my net worth over time?
Franco Nevada regularly provides the number of gold-equivalent ounces (GEOs) realized based on their expected prices of various commodities. I brushed off my regression analysis skills and created a couple of models to help predict gold prices depending on M2/capita and real rates. Using these prices, I can estimate the fair value of FNV using their historical per share enterprise value:gross profit multiples. This gives me a range of values that should reflect its intrinsic value. My best guess is that the fair value lies somewhere between $135 to $200 CAD/share with Gold prices ranging from $1600 - $2500/oz in the next 5 years.
Warren Buffett considers gold as a pet rock. Ray Dalio considers it a key component to his all-weather portfolio. Personally, I don’t have the skill to pick winners like Buffett, and diversification across industries is vital to give me the portfolio resilience across time and environments. Physical gold is the most resilient but transaction costs to convert into spendable cash is high as is storage costs. Redeemable gold-related securities (MNT.to, KILO, and PHYS) have their own challenges with respect to conversion and at risk of ownership dilution by these entities. Gold royalty companies, like FNV, has performed the best compared to these other options and pays out a steady spendable dividend. However, it is ultimately an abstraction from physical gold ownership and subject to governmental financial regulations. Even if the government makes personal gold ownership illegal, it would be conceivable that there would still be demand from national treasury reserves and the gold mining ecosystem is unlikely to collapse. This would only occur if this ecosystem were completely disconnected with the financial markets simultaneously.
PrairieSky Royalty
What does the business do and where does it operate?
PrairieSky is a Canadian oil royalty company. It owns 9.9 million of fee simple mineral title lands and 8.3 million acres of gross overriding royalty (GORR) interests in Alberta, Saskatchewan, British Columbia and Manitoba. It generates revenues based on oil and natural gas production by third parties using their private lands. The third parties assume all drilling costs and liabilities for this production. These are only sub-surface rights applicable to natural resources under the ground. It does not include the land surface, gravel, or water rights. Fee simple mineral titles have indefinite lives whereas GORR will expire when the underlying lease does. The reason why drillers prefer working with PrairieSky vs Crown land operated by the provinces is the friction to get a deal done. This may take a week with PrairieSky but months with degrees of uncertainty when dealing with the provincial government.
At the end of 2021, it had ~ 66,000 MBOE (thousand of barrels of oil equivalents) in its proven and probable reserves (2P) of which 50,000 MBOE are proven and 16,000 MBOE are probable. For context, in 2016, Canada is estimated to have ~ 171 million MBOE of oil reserves. Cumulatively, since 1963, they have produced 4.5 million MBOE. In 2021, 60% of its total revenues ($291 million) came from its fee mineral title lands. Over the last 6 years, it produced ~ 7,900 MBOE annually.
Although, oil and natural gas production is its primary revenue driver, it has a few other revenue sources such as proprietary seismic data licensing, lease acquisition bonuses, and per-hectare rent. It also has several future potential revenue opportunities. These include production expansion from enhanced oil recovery (EOR) techniques (eg underground CO2 injection), royalties from hydrogen, methanol, and carbon credits as well as CCUS (carbon capture, utilization, and storage) revenue partnerships.
It operates with 55 full-time employees and 1 part-time employee.
When was it founded and what were some interesting points in its history?
Its history begins in 1676, when England granted 948 million acres to the Hudson’s Bay company. In 1868, 95% is sold to the Dominion of Canada. To encourage the pan-Canada railway construction, 25 million acres is granted to the Canadian Pacific Railway (CPR). After the discovery of natural gas, CPR sells 5 million acres to various land syndicates and returns 7 million acres to the government as a loan payment in 1886. From 1887 onward, Canada no longer grants mine and mineral rights with land sales. In 1958, the remaining 13 million acres and their mineral rights are spun-out into Canadian Pacific Oil and Gas Limited. Eventually, these rights are rolled into Encana when it was formed in 2002. In 2014, after purchasing Range Royalty, PrairieSky is spun-out of Encana in an initial public offering (IPO). The management team from the IPO remains the same today.
Who are the major stakeholders and what are their incentives to create long-term shareholder value?
The top 6 institutions own ~60% of the outstanding shares. Edgepoint Investment Group, RBC Global Asset Management, M&G Investment Management, Canadian Natural Resources, Fidelity Management and Research Company, and 1832 Asset Management, L.P.. The board of directors is expected to own 3x their annual retainer, which amounts to $4.34 million. In aggregate, the BOD owns 6.9x the minimum requirement. Andrew Philips, the CEO, owns ~0.3% of outstanding shares worth ~ $10 million. His minimum share ownership requirement is 5x his annual salary of $550,000. He owns ~ 19x his salary in shares. Like Franco Nevada, management has skin-in-the-game and significant institutional ownership should allow activism if needed to keep capital allocation in check.
Their share rewards are structured to be evaluated over a 3-year time frame. Management can receive 0 to 2x their targeted bonus. Fifty percent is based on their total relative share price performance compared to a peer group of 14 companies (e.g. Franco Nevada, Wheaton Precious Metals and Tourmaline Oil Corp are the 3 largest by market capitalization). Fifty percent is based on meeting a detailed set of business objectives over a 3-year time frame. Some of these objectives include metrics such as operating margins, cash administrative expenses per BOE, growth in acreage per share, funds from operations per share, debt to EBITDA ratios and available credit facilities. This targeted bonus is paid 75% in cash and 25% in shares that would not be paid out until they retire or there is a change in control (e.g. the company is bought out).
Why has the business been successful (key drivers) and what changes will create headwinds or tailwinds to these factors (risk)?
The key current financial drivers are the annual production of BOE from their properties and the market price of BOE. However, neither of these drivers are within management’s control. What management can control is how they decide what to spend their capital on. In other words, increase the number of acres per share at accretive prices, buyback shares and pay dividends, and keep fixed administrative cash as low as possible as measured on a per share and per BOE basis. Since their IPO in 2014, they have increased their per share acreage by 80% but their revenue per share dropped by 50%. This increase in acreage suggests an opportunistic mindset by acquiring oil and gas properties during low commodity pricing. Since 2017, which Altius Minerals surmised was the bottom of the commodity cycle, they have been buying back their undervalued shares.
For this business to thrive, global oil prices must remain elevated for the next 5 – 10 years. There is a fair amount of evidence to suggest that there will not be enough supply to meet even a declining demand over time. The curtailing of exploration of new oil fields, reduction of tier 1 assets due to high grading of supplies by undisciplined drillers (e.g. US shale), ESG mandates to reduce oil production, financial shareholders suffering the past losses, are now demanding fiscal discipline and a focus on return of and return on capital, geopolitical conflicts (Russian – Ukraine war) have revealed the fragility of the current supply chain, and inability for OPEC+ to meet rising quotas (e.g. African supplies). Jeff Currie of Goldman Sachs, Goehring & Rozencwajg, and Pierre Andurand are good resources to learn from. Here is a video from a European investment conference on this subject:
The adage that the cure for high prices is high prices. This leads to more supply coming on- line and demand destruction. Although this is true, the lead time for new oil projects can take 7-10 years and demand destruction heuristically occurs at ~ 5% of global GDP. The GDP per capita is $10,918 USD. The global population is ~ 7.9 billion. Approximately 30-35 billion global barrels are produced annually which is about the same amount that is normally consumed. This puts demand destruction at ~ $123-143 WTI/bbl (West Texas Intermediate) provided there are no prolonged supply-demand imbalances. As of March 21, 2022 – WTI is $112. https://www.worldometers.info/oil/
What this suggests to me is that there is a good likelihood that the oil prices we experience today will remain with us longer than we expect.
How can I estimate its intrinsic value and how can I make this grow my net worth over time?
With a conservative pricing of WTI at ~ 3% of GDP, this would translate to ~ $80 WTI USD/barrel. Historically, Western Canadian Select (WCS) is at a $10-20 discount to WTI over the past decade. This would give PrairieSky a realized price per BOE of $60 USD. If they produce 20,000 BOE per day or 7.3 million BOE per year, this translates to $1.83 of revenue per share. With an operating netback[i] received at 90%, this would equate to $1.65 USD or $2.06 CAD per share of free cash flow. At a current price of $17.50 CAD, this gives a 12% earnings yield.
Another way to approximate their value is based on past transactions. In 2018 and 2019, they had purchased 1.2 million GORR acres for $69.8 milllion CAD when WTI pricing was ~$60.5 USD. This would peg it to be worth $58 per GORR acre. Using long-term WTI price of $80 USD, this land should be worth $77 per GORR acre. Similarly, using the 2021 Heritage transaction, where PrairieSky purchased 1.7 million Fee acres and 0.2 million acres of GORR acres for $728 million CAD from the Ontario Teacher’s Pension Plan, fee acres could be worth ~ $420 CAD per acre. Currently, they have 9.7 million Fee acres and 8.3 million GORR acres with 236 million outstanding shares. The intrinsic value point estimate would translate roughly to $19.97 per share.
Conclusion
It has taken me a bit of time to write this post. The numbers will be a little out-of-date. I own shares of Altius Minerals and PrairieSky. Unfortunately, I missed out on Franco Nevada. The inflation and negative real interest rates is a bit out of the bag and the run up has increased the risk : reward ratio in this particular name. But as Peter Cundill has famously said, “There’s always something to do”. I continued to explore new ideas, seek good business models led by good people that I can understand. I can’t assure that that readers of this post will learn anything new, but I appreciate your time reading my random thoughts.
[i] Average realized price per BOE x Annual BOE production = revenues //// Average operating netback per BOE x Annual BOE production = pre-tax operating margin