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Commodities / Energy Resources Nov 12, 2009 - 02:21 PM GMT

By: The_Energy_Report


Best Financial Markets Analysis ArticleAlthough Q1 Publishing's Founder and Chief Investment Strategist Andrew Mickey expects to see the U.S. stock market slip as much as 25% over the next 6 to 12 months, he comes to The Energy Report to share tidbits about several companies in his scopes that present low downside risk with ample upside potential. Generally beyond media noise and the glare of market spotlights, these companies are carving niches for themselves in various segments of the energy industry. For example, Andrew's list includes a junior lithium company uniquely positioned, an up-and-coming miner that "if you like lithium, you'll have to like," and one of the only ways regular investors get into the fastest growing venture capital sector.

The Energy Report: In one of your recent articles, you suggest that even if good economic news continues coming out next year, the market is likely to drop 20% to 25%. Would you go through the logic that leads you to that conclusion?

Andrew Mickey: If we look back to the way the stock market has moved over the past 20 to 30 years, it has always been valued relative to earnings. The most common valuation for the market has 15 to 20 times the 10-year average annual earnings. That smooths out the up-and-down years and brings you to a fair valuation—with the S&P 500 between 800 and 1000. Granted the stock market goes much higher and much lower than that—and can stay at an extreme for longer than most investors expect—but it always returns to its fair value.

Now that so many stocks have had a great run, the S&P is up to around 1100 and it's overvalued. The market basically has a lot of positive expectations built in. Earnings estimates are starting to rise, though all CEOs are still trying to keep expectations low. Economic expectations are rising. Expectations for everything are rising and we've learned consistently throughout the years—great expectations usually lead to great disappointments.

So as long as GDP growth is low, the market will fall right back to fair value. That's why, even with the big picture news getting better, the very real risk is that it's still insufficient to hold the S&P up at 1050, 1100, or wherever it does eventually top out at.

We may not have an outright crash because everyone is still on watch, but probably a slow, steady fall over maybe six months to a year.

TER: Are all sectors currently overpriced, or will some continue to appreciate?

AM: There will be some that will appreciate. But it won't be a case of great or greater returns like we've had. There is some great historical research done on the way stocks move. One important factor is the factors of market, sector and stock. If you break it down, basically 50% of a stock's movement is usually tied the overall market.

There's nothing you can do about the overall market, but there still is opportunity in that another 30% of that stock's move depends on the sector. And the remaining 20% can be attributed to the individual company. In other words, you can expect the initial impact across all sectors. There will, however, be the divergence between the quality and value and all the garbage that's done so well recently.

TER: How much focus should individual investors put on international investments versus North American-based investments in this environment?

AM: A lot of it depends on your time horizon. If you have five years or more, you can build a reasonable case for focusing 30% to 50% of your money in international stocks.

That's a very high concentration for any portfolio in any particular sector. If you're looking out that far, you definitely want to be in the emerging markets. In the short term, the falling dollar has been very helpful to some of the really large, high-quality U.S. companies.

TER: Another of your recent articles suggests you're pretty bullish on lithium due to the growing demand for lithium ion batteries. But why lithium rather than the battery market in general?

AM: Hybrid electric vehicles (HEVs) and electric vehicles (EVs) are going to be a big opportunity. And history provides a good precedent for how to invest in them successfully. For instance, let's compare it to the growth of computers. Everyone was getting them in the '80s and now they've become standard parts of most folks' lives. By the mid '80s, about a decade into the growth of computers, everyone knew that it was inevitable that everyone would have one in their homes and in every office around the world. But if you tried to pick a computer maker, you'd have to be right about which company to invest in and at which time. You'd have to buy Apple early, then Gateway and Dell, then Apple again. That's a lot, probably too much, to get right.

That's kind of what we're seeing with the HEVs and EVs. The producers battle it out for market share. Toyota and Honda have led the way, but there are a lot of companies catching up to them. It's anybody's guess who the winner will be. But there is one thing we do know; the market will be very competitive. And in a competitive market, maintaining market share kills profit margins and you'll see stock valuations usually follow the profit margins up or down.

Right now dozens of companies are trying to produce HEVs, EVs and the batteries to go along with them. They all have their own specific deals, so at this stage, I am not going to even try to pick the winner. The odds are so stacked against you.

But the bottom line is this growing industry will demand lithium. We know that. So we might as well just go there. It makes it all easier and cuts down the risk of trying to figure out the right company at the right time.

TER: So it doesn't really matter who wins the battery race. You just know they're going to have to use lithium.

AM: Exactly. But I know there are even competing technologies with lithium ion batteries too, such as super capacitors. They may even be better, safer and more efficient. But lithium will be the winner because the U.S. specifically is going to invest $27 billion of government money into batteries and alternative fuel for vehicles over the next few years. Maybe $10 billion or $15 billion has already been doled out. If you look where that actually goes, more than 90% of it is going to lithium ion battery research, building lithium battery factories and outright buying the batteries for the U.S. automakers.

So another technology may be better, but it has to compete against a reasonably good one that has been heavily subsidized.

Another positive for lithium is the lithium production industry is dominated by a small group of companies. It reminds me of a similar opportunity we jumped on back in 2006 when I first started researching potash. The potash is dominated by two global oligopolies. They semi-openly work together to fix prices at the highest possible level. It's kind of an obscure industry, so they get away with it. You aren't going see Congress calling "Big Potash" to testify the way oil executives are called when oil prices are up.

That's why the lithium industry can be dominated by a few large companies and continue to be for years. No one is likely to stop them.

That's basically what the lithium makers do, too. In an unofficial way they're an oligopoly. They fairly easily expand or cut capacity to match market demands. And their costs are all similar. So they don't go out battling it out for market share. They know they can all make some money as long as no one gets too aggressive.

It's not illegal or anything like that. Just look at how often the cell phone companies and rail liens lose money. They don't because they all get along. It's just how it is. The way I see it is they've been working together for maybe 20 or 30 years, this is the golden era they've all been waiting for, and the odds of one breaking from the group are very low.

TER: So where are the investment opportunities under those circumstances and with the market so tightly controlled by the leaders?

AM: There is room for small juniors as long as they can compete on price.

TER: What juniors are you following in this space?

AM: The one I like best is Lithium One, Inc. (TSX-V:LI). The company is being led by a quality management team of real developers.

For instance one of the directors is Paul Matysek, who built Energy Metals Corporation up long before uranium really got hot. He ended up selling the company to Uranium One, Inc. (TSX:UUU) during the boom for over a billion dollars. That was a massive success.

I first met him in 2006; we just crossed paths on potash at the time. To his credit, he was there a few years before me and now, he's involved in Lithium One. That's a good sign.

Also, the key difference between Lithium One and most other lithium juniors is the types of properties it owns. Many own the hard-rock lithium that has to be mined the old-fashioned way, which costs a lot more.

Lithium One has the hard-rock (in Canada), but it also has the lithium brines in South America, or salars.

That's the difference maker for me. Basically, to mine the brines you just pump this solution out of the ground and then just let it dry on drying pads. Once it's dry, you scoop up all the lithium. They're about half as cheap to operate as the hard-rock lithium mining.

So those with salars will be able to compete right alongside the big boys. So here you have a company that can produce, be competitive and actually increase shareholder value over time.

That's the kind of stuff to look for if a boom really comes. Suppose lithium demand increases about 8% per year. That's about seven times faster than oil and twice the rate of copper over the past decade. There are a lot of other factors, but it's shaping up to be a solid opportunity. But if there are supply disruptions or anything like that, it's going to turn into something great.

Finally, lithium stocks are still relatively cheap to a lot of other metals. There's still a lot of contention over future production capacity, total demand, ability to recycle it and a lot of other factors—but we're looking at the big picture. The story is great, simple and tangible for most investors, and that's a big part of it too.

TER: Is Lithium One the only producer with salars?

AM: Outside of China, which produces 37% of the world's lithium, the only other companies that have it are major ones, such as SQM (NYSE:SQM), Rockwood Holdings Inc (NYSE:ROC) and FMC Lithium Corporation (NYSE:FMC).

They produce more than 60% of the world's lithium and they're all big in South America. That's where their salars are and that's where Lithium One's salar property is as well.

TER: Is the magnesium story similar to the lithium story?

AM: Magnesium is another metal that could do really well when it comes to batteries. There are three main lithium ion types of batteries and the lithium-manganese battery has shown the biggest potential so far. So if you like lithium, there could be a big opportunity in manganese as well.

In the past, about 80% of manganese has been used in steel production, but there's this new demand for it now in batteries and there are no manganese-only miners out there.

However, our best-performing recommendation, Ventana Gold Corp. (TSX:VEN), was actually spun out of a company called Wildcat Silver Corporation (TSX-V: WS). Wildcat owns 80% of what is basically a silver/manganese deposit in Arizona. And if Wildcat has the same backers, well, it is going to be another solid winner.

Its net present value is probably about four times higher than its market cap right now. There is plenty of exploration upside left, too. And there's silver exposure, too.

TER: You're also bullish on some LNG plays. Natural gas supplies in storage and in production are at all-time highs in the U.S. and so the price is really low. What opportunities are you seeing in LNG?

AM: We know LNG is going to be a growing fuel source for the next 20 years. Everyone is building facilities. All the major oil service companies, like Schlumberger Limited (NYSE:SLB), and the smaller ones, like Chicago Bridge & Iron Company (NYSE:CBI) , have been doing a lot in LNG. They're facing backlogs of five or six years for LNG construction jobs in some cases. Australia just announced they're expanding their $20 billion facility. And Indonesia is expanding theirs, too.

We know it's coming. And as long as you can sell it into an end market for more than $2 per Mcf (million cubic feet), everything on top of that's pretty much profit.

That's why, even though we see U.S. reaching very high production, LNG is still headed toward the U.S. from all over the world right now. There's not enough natural gas demand in Asia yet, and in the LNG market, you essentially just dump it all in the U.S. if you have no other market for it.

All along the West Coast, LNG regasification facilities are set up to receive LNG. They've been running at 5% to10% of capacity for the last few years or, in some cases, aren't doing anything. They've been real loss leaders. So as long as U.S. gas prices are above $2.50 Mcf or, the LNG can and will come here all day long.

TER: With record production, record levels of storage and the world dumping LNG on the U.S.; where is the opportunity?

AM: Well, that's why I'm staying away from the natural gas producers in the U.S. Most of them have returned back to the same levels they were at in 2005, which was when the natural gas market was tight and getting tighter.

It's not 2005 in the natural gas market and there's just not going to be a huge rebound in natural gas demand. Still though, waves of LNG tankers are coming toward the U.S. as we speak. So I don't necessarily like the U.S. producers because they were paying them a $1 per Mcf just to buy reserves and then production costs on top of that. Frankly, a lot has to come together economically for natural gas demand to roar back. It's possible, but investing is about odds, and odds are against it.

TER: And it's a different story overseas.

AM: Absolutely. In Asia, companies are buying natural gas for less than 10 cents per Mcf—even cheaper in some cases. So you can buy the same amount of natural gas in Asia for 90% less than you can in the U.S.

There are more risks, but you're getting a huge head start. That puts them way ahead of the U.S. companies. Even after the costs to ship an Mcf of LNG, they're still well ahead of U.S. producers expanding into unconventional reserves when it comes to costs.

CBM Asia Development Corp. (TSX.V:TCF) (OTCBB:CBMDF)—which is in Indonesia—has anywhere from 1 to 8 trillion of cubic feet of reserves. They develop coal bed methane, which is a bit different than natural gas the way it's produced.

TER: So you see good upside potential there?

AM: I look at it like this, CBM Asia owns a gas field in Indonesia—and they pretty much own rights across the whole island of Sumatra—and if it hits, you're looking at a company that could easily be worth a few hundred million dollars as it builds provable reserves and determines the economics of them. And I think the market cap is still at less than $20 million. So, that's the type of idea we're looking for.

TER: Will CBM Asia need to rely on U.S. consumption to be able to sell all of this natural gas they're producing? Or can Asia, being an emerging economy, absorb it?

AM: Over the long run Asia will be the large natural gas consumer, and eventually most of Asia, at least in the north, will end up looking like Japan—which imports more than 90% of its natural gas because it has no real local resources. South Korea is already in the same situation as Japan, with a desperate need for LNG. Their demand will increase. Right now, they're the ones supporting the LNG market, especially the developments in Indonesia, Australia and the Middle East.

The U.S. is the safety valve, because U.S. gas prices will always be above $2 Mcf barring an outright depression, of course. They dropped below $2 temporarily, but that's the new normal, just like oil is always going to be above $30. And if you're paying 5 cents per Mcf for reserves, you can still make a lot of money in LNG.

TER: What's unique about CBM Asia that's interesting to you?

AM: Mostly the value and risk/reward at these levels. Their land package is absolutely huge; and if this coal has high permeability, which we should be learning more about in a few weeks, the upside is tremendous and downside risk is relatively low.

Also, the key with CBM Asia is that it's in an area where there already is a LNG liquefaction facility built. These facilities generally take $5 billion minimum and 5–10 years to build. So, that's where CBM Asia is kind of in the perfect spot geographically. CBM Asia can just plug right into that, and start flowing cash fairly quickly.

And beyond that, Indonesia is an up-and-coming country, young population, and I'm not really concerned about the political risk.

TER: How about Europe?

AM: That's another wild card. They're currently building LNG regasification plants in Europe to deleverage Gazprom's position as the dominant natural gas supplier to Europe.

European LNG demand is going to be very big over the next 5–10 years, too.

TER: What other trends are you're following in the energy sector?

AM: Companies going green. It's not necessarily environmental consciousness or because they buy into the global warming nonsense. The simple reason is you can charge customers more in the green space. A recent survey found that customers are willing to pay as much as 5% to 10% more for a product, just because it's green. That creates a situation where if you can green your products for an additional 2% cost, you can increase your margins, as well as use green to take market share. So, there's a huge opportunity there in green marketing.

TER: Any particular players in that space that you like?

AM: Greenscape Capital Group (TSX-V:GRN) has already had success across all kinds of different sectors. It owns a women's line of organic luxury golf clothing and some other products that are all green-focused.

They have a unique selling proposition; essentially Greenscape Capital was founded on acquiring growing companies in the green space. Basically, it's impossible for many regular investors to get into the companies at very early stages.

TER: Interesting.

AM: Greenscape has already started making acquisitions too. Greenscape recently announced a deal to acquire a company that "greens" parking garages. Again, it's not because parking garages are big polluters, it's because they can save them money. For essentially an upfront cost of $26,000, they can go into a parking garage, replace light bulbs and a few other things, and save the garage $16,000 per year. It's going to add $10,000 to your bottom line next year and $16,000 a year after that all for $26,000 upfront.

If I'm a parking garage manager or owner, the only thing I would say is, "Green or not, when can you be here?"

A company like Greenscape, which is so flexible and its focus is on green and amassing companies, it has tons of opportunities to cross sectors like that—from apparel to parking garages and into anything you can think of.

That's something that is really in demand right now and will continue to be. And Greenscape is filled with professionals who have already shown they can do it well, get necessary financing and move their business along quickly.

Best of all, with a market cap around $10 million, the market clearly doesn't get this company yet. It's not some hippie-pipe dream company that's going to make the world a better place at any cost to itself and its shareholders. It's focused purely on economics. And it's really the only way to get into the biggest growth area for venture capital investors. The market will figure it out eventually.

DISCLOSURE: Andrew Mickey
I personally and/or my family own the following companies mentioned in this interview: CBM Asia, Greenscape and Wildcat Silver

I personally and/or my family am paid by the following companies mentioned in this interview: NONE

Andrew Mickey is Q1 Publishing's Chief Investment Strategist. Q1 Publishing provides investors with "well-researched, level-headed, no-nonsense" business analysis and advice that claims to filter out 99.9% of the noise in the financial world to help investors "secure enduring wealth and independence in today's turbulent financial markets." Its products include subscription-only communications such as Andrew Mickey's Prudent Investing and the President's List as well as a free eletter called Prosperity Dispatch.

Andrew's investment philosophy is based on being prudent (limiting risk without surrendering upside potential), paying close attention to risk-reward relationships and evaluating a variety of asset classes. He searches relentlessly for explosive assets and businesses off the beaten track, traveling often to unearth hidden gems. Over the past few years he has visited Indonesia, the Ukraine, Papua New Guinea, Russia, Mexico, Australia, China, Thailand, Albania, Croatia, Norway and many other places. His research has been featured on CNBC, BNN, BusinessWeek and other media outlets.

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