My Interview with Rick Rule

Editor's note: Yesterday, we gave you a rundown on our favorite way to own gold. Today, we're taking a look at the wider commodities market in an interview with Rick Rule, our friend and founder of Global Resource Investment. Rick is the best and most-informed resource investor we know. He has made a fortune for himself and his clients.

In October, Porter asked Rick for his views on the resource markets. Rick told us his long-term outlook and how he's investing his clients' money...

My Interview with Rick Rule

By Porter Stansberry

From the October 24, 2008, S&A Digest

Porter Comment: This is a transcript from a phone call I had [October 17] with Rick Rule, the founder of Global Resource Investment Ltd. Rick agreed to the interview with about one hour notice. He didn't have any of my questions in advance.

Porter Stansberry: I think the most the crucial question, at least for me, is the big picture. How long do you think resource asset prices will fall in this bear market?

Rick Rule: There's going to be a very interesting tug of war. On the lower side will be, I think, rapidly declining developed-nations demand. Meaning recession in the United States and Western Europe. And on the other side is going to be, I think, steadier emerging-market demand than many people think. Simply because the developing countries' balance sheets are better than we are accustomed to.

I think the very sharp moves down in commodity prices are over. I think that those sharp moves down were not a reflection of fabrication in consumer markets. But rather, [they were] a function of financial players that were involved in the new carry trade involving low U.S. dollar interest rates where people were going long commodity, short the U.S. dollar; a trade that worked for a year and unwound very, very, very aggressively. So I think the sharp down move that we've been through is in some part over. I think it's likely to be replaced in the base metals by a grinding move lower. It probably will not be particularly deep but maybe four to six months longer in duration.

Porter Stansberry: Does this bear market remind you of any other particular bear market? I understand all these things have a lot in common. But I just wonder if this is particularly reminiscent of anything that you can specifically remember.

Rick Rule: No, it is not. First of all, the synchronicity of this decline proves to me we truly do have a global economy. The fact that the Russian capital market, the Chinese capital markets, the emerging markets, the developed markets all came off in tandem. I was going to say it was impressive. It was terrifying.

Porter Stansberry: To a large degree, the U.S. housing market became the financial foundation for so much of the world's speculation.

Rick Rule: I think that's partly true. I think the other thing is the U.S. financial model – that is banks that didn't have any equity. As I understand it, the Icelandic banks that failed had balance sheets 10 times the size of the domestic economy of Iceland. That's impressive... I think you're at least half right in the sense that the asset class that bothered the banks and particularly the part that bothered the wholesale banks in the overnight market was securitized U.S. housing assets. You know, we are inclined to think that banks are places that have money. It sort of bemused us to find out that wasn't true.

Porter Stansberry: Have you heard any stories from Vancouver about particular resource investors who were, as Buffett says, "naked when the tide went out"? Have any of them gone bust, a la Sumner Redstone (Viacom), Kerkorian, or the guy from XL Capital?

Rick Rule: Of the younger players, there are a couple who likely got stopped out. The equity-oriented merchant banks, and I won't for various reasons give their names, were extremely aggressive in the Canadian capital markets. They employ a lot of margin debt in their business models, and they have thus far had problems. I think they're going to continue to have problems. But none of us had as much cash as we should have, understanding how capital-intensive and how cyclical these markets are.

Porter Stansberry: That's a very surprising admission from you.

Rick Rule: Well, you may as well be honest. I have a lot of cash, both personally and in my partnerships. In retrospect, should I have had more? Absolutely. Hindsight is always 20/20. There are two or three old financial players who have decent amounts of cash, myself among that crew, but none of us have as much as we should.

But there was one lucky guy – the one guy who didn't get caught naked when the tide went out. That was Kevin Bambrough, who works for Eric Sprott (Sprott Resource Corp). He had a coal transaction close that put $350 million on his balance sheet, and the market fell away before he had the opportunity to spend it. So he's selling at a substantial discount to cash in the treasury, and he's a smart guy.

Porter Stansberry: We've talked about how much longer you think this bear market can continue. What about in terms of magnitude? How much farther do asset prices have to fall to catch up with stock prices or vice versa?

Rick Rule: That's a difficult question because that assumes the TSX Venture market is made up of companies primarily engaged in natural resources. It is primarily made up of companies that didn't have any hope at all in a good market, never mind the bad market. So in that context, you are going to watch, I think, as early as six months from now, that market bifurcate where 5% of the companies, which are really good companies, begin to move up in a stealth bull market, while the rest of the exchange continues its march toward its intrinsic value, which is zero.

And I think you're going to see the TSX Venture exchange itself be in a grinding bear market that is probably going to be four years or more in duration. In that regard, it will resemble in some fashion the 1998 to 2002 market, which of course was devastating in Canada. From the point of view of prudent, discerning players, you know how I play the game. The 1998-2002 market was absolutely spectacular for me. And I think people who understand this market will do very, very, very well...

With the exception of zinc, the pricing structure in every industry that constitutes a major sector in resources is solidly cash-flow positive from an industry basis. So that's a very different set of circumstances than we saw in 1998.

The second set of circumstances that's different is, when we came into the '98 to 2002 downturn, it had been preceded by two good years but not good enough years that the industry had the ability either to come into the downturn with a lot of cash or to have allocated a lot of capital productively beforehand. In this particular case, we are coming into a set of circumstances where the industry had three or four extraordinarily good years and billions and billions and billions of dollars were raised and a little bit of it was intelligently deployed. Meaning that we are coming into a downturn where a few companies have had the ability to spend an awful lot of money wisely.

What's important about that is, we're in a market that rose indiscriminately with the lousy companies rising as well as – and, frankly, better than – the good companies because they were good at telling stories. And the counter-trade to that is that the good companies are falling in price with the bad companies. So the opportunity, of course, will be to search among the dross, which is most of the listings, for the companies that have employed large amounts of cash intelligently and are selling at stupid discounts.

The other differences between this downturn and the last downturn are more financial. An outcome of this crash will be profound in ways that didn't exist then.

The American public is going to want scapegoats for this and lots of guys in New York are going to go to jail. And that is going to scare participants both in capital markets and among the issuers in a way that they didn't get scared in 1998. It's going to be very, very, very unconducive to commercial trust and normal business transactions.

The second thing I see going forward is there's going to be an incredible profusion of regulation, none of it useful. All of it increasing the costs of public company business. It's worth noting, as even Buffett has noted, that the Sarbanes-Oxley "protections" that were put in place as a consequence of Enron cost public companies $100 billion a year. Meaning that Congress institutionalized a loss to the economy on an annual basis that's equivalent to the amount lost by shareholders of Enron on a one-off basis. I think the penalties of excessive regulation on the market – not just the resource market, but all markets – will increase.

The third factor I think will be different is there will be a much more aggressive Chinese wall between the investment banks and commercial banks. Which means that both debt and equity, at least for the next two years, will be much less freely available than would have existed in a situation where there was more cooperation between both sides of these big banks. And I'm talking about on both sides of the border. I don't think there's going to be any particular difference between the set of circumstances the Bank of Montreal faces and the situations that are going to be faced by JPMorgan Chase, as an example.

Another difference is, the recovery from the last down cycle was lead by hedge funds. And I think, both in terms of number and size, the hedge-fund industry for a long, long, long period of time is going to be very different. So a recovery, when it occurs, or support in a bear market, is not going to come from the financial services industry or from aggregations of financial capital. It's going to come rather from the mining and oil and gas industries.

The last two points are probably self-evident, but I would suspect the appetite for risk on a global basis is greatly, greatly, greatly diminished, which will of course impact the speculative premiums paid by financial investors in speculative markets. And the last way in which this is different from the last cycle is that credit markets on a global basis are truly broken. I guess I don't need to tell anybody that. But the idea that for the next two years at least, a smaller company is going to be able to get a project financed, to move a project forward, and to be able to grow internally within its own vehicle... is highly unlikely. To the extent that financing is available to build big projects, the bank will take a charge against the project. But the issuing entity is also going to have to take and guarantee that project with its own balance sheet, and it's going to have to have a balance sheet that's capable of making that guarantee. All of this, by the way is very, very, very healthy.

Porter Stansberry: All these things in the long run mean higher commodity prices.

Rick Rule: Of course, the barriers to entry got much higher. When I say all of these things are healthy, that is with the exception of the stupidly increased levels of regulation, which is a permanent and useless cost.

Porter Stansberry: When stocks started falling, I wrote down a list of 20 names of legendary operating companies I wanted to buy if they got cheap enough. And I thought in my mind, they're never going to get cheap enough. Then, I woke up last week, and they were all about 30% below where I would have bought.

So I wonder – I know you are reluctant to name individual stocks – but how much could you tell us about the kind of assets you would like to pick up during this down cycle? I want to know, what are the trophy assets that Rick Rule would love to own?

Rick Rule: There are two different types. For my investment portfolio, I want to buy large, low-cost companies with good enough balance sheets that they have the ability to take advantage of the distress. In other words, companies that have good enough balance sheets that they will be able to add balance sheet guarantees to project finance...

Porter Stansberry: How cheap is cheap enough on these guys in terms of book?

Rick Rule: Book is not the right place to look. You have to work a little harder than that. What you really have to do is look at how much room there is on the balance sheet, which is really represented by cash or near cash. And what the maturities in terms of principal are in terms of their debt. And then, you have to do something a little trickier. You have to look in last year's 10-K. And you have to look at the all-in production costs by commodity and try and make yourself a very simple, going forward, cash-flow model using commodity prices from the current strip [the futures market prices for the commodity] and build yourself some sort of picture. And I would suggest you want to buy these things at less than a 30% or 40% discount to present value. And you want to buy companies with lots and lots and lots of financial flexibility.

For the little guys, I'm starting to nibble right now, although I would expect the nibbling will get much, much, much better in November and December. The first thing, I'm doing is buying cash boxes. These are companies that have 30% or 40% or 45% discounts in terms of their market capitalization from cash in the Treasury. It is possible to lose money-buying cash at a discount, but it's one of the most difficult feats I've ever observed. You need to buy cash that's run by management teams that understand the right thing for them to do at present is nothing. Basically shut down the business and look for superb opportunities on a going forward basis.

The second thing I'm looking for is companies that are likely to be taken over. The easy take-over targets are Canadian oil and gas, conventional oil and gas producers, in the sub-$200 million market-cap range. Here you want companies – and you can get this off their annual reports – that are selling at 50% discounts to the net-present value of their producing properties at the forward strip price. There are scores of them. I mean truly, scores of them.

Porter Stansberry: What's the risk that the assets in the ground, which were thought to be worth $700 million a year ago and are now worth maybe $150 million, will get much, much cheaper? I personally think this is the kind of bear market that's eventually going to let you buy huge projects for $50 million or $25 million in a year or two.

Rick Rule: With any luck.

Porter Stansberry: I know you don't know the future, and you're famous for saying you don't have crystal balls. But I wonder what your instinct is. Seems like the bust in any given market is normally correlated to the boom. And this was a huge and speculative boom in both finance and commodities.

Rick Rule: That's a very good point, Porter. But what you need to understand is that mostly the boom had nothing to do with reality. In a bear market, you have to liquidate mal-investment. In this market, you already have liquidated a lot of the mal-investment. It wasn't like in a period where we raised $12 billion or $15 billion for exploration, and we spent $12 billion or $15 billion intelligently and developed a $25 billion net-present value pipeline of projects. Mostly what happened is we raised $15 billion, and we wasted $11 billion. So we have to work off a pipeline of only $4 billion – not $25 billion.

Porter Stansberry: So you're saying you don't expect commodity prices to go a lot lower and stay low for a long time because there will be demand from the emerging markets and there haven't been enough good new projects developed.

Rick Rule: Exactly. And what's happening in the western world is, there are so many barriers to entry for building new projects, the new project supply will be artificially constrained.

Porter Stansberry: Given your outlook – for a relatively short bear market – how much of that cash will you hold in reserve for the risk that you have the opportunity in five years of writing those save-the-company checks for almost nothing?

Rick Rule: In terms of cash that I have now, the probability I will conserve it for five years to write checks is nil... I mean this is a period right now where it's very important everybody be very honest with themselves about the mistakes they've made thus far. You bought a stock for five bucks that's selling at 50 cents. Doesn't matter that you paid $5 for it. The stock doesn't care; the market doesn't care; the guy who sold it to you doesn't care. So the first thing that you do is you optimize your existing portfolio. I expect that you are going to see the better companies in this market, which is a very, very, very tiny minority, begin their up-cycle in June, July, and August of next year. But I think that what people don't recognize is that the number of companies that are truly viable among the juniors is so small, it isn't going to feel like there's even a stealth bull market underway. It's going to feel like there are a couple of anomalies. They won't be anomalies, in fact. The market is going to segregate qualitatively but it's not going to feel like that...

But there are still places in the world that have a substantial amount of capital that didn't go away. In particular, the Middle East still has an awful lot of spare liquidity. And China has an awful lot of spare liquidity. China, in particular, I think, will continue to emerge in the next 18 months to two years as consumers of high-quality resource assets. And I think one of the realignments you're going to see is emerging-markets banks become more important providers of credit for resource projects. When those emerging-markets banks develop the underwriting and analytical capabilities to do it, which they don't have yet, you're going to see a move away from the British, German, American, and Canadian banks toward emerging-markets banks. And you're going to see a lot more credit provided to projects in conjunction with off-take agreements or some mechanism for securing the flow of raw materials to markets who perceive themselves to be short of raw materials. I think that's going to be an important theme going forward.

Porter Stansberry: Which metal has the most favorable supply/demand characteristics right now?

Rick Rule: Boy, that's hard. I would say uranium. You know the uranium market – the uranium equities market – has fallen extremely hard. And I was a real uranium bear.

Porter Stansberry: So was I.

Rick Rule: I would say we are a year away from being able to consolidate the uranium space. You know forget about the 500 juniors that tried. Take a look at the eight or nine that succeeded.

I'm a real, real, real energy bull. I think the oil price in particular goes not merely higher, but substantially high in the five-year term. What people are missing in particular in the oil market is that most of the world's export crude isn't controlled by oil companies. It's controlled by national oil companies. And it's extremely important for people to understand this. These national oil companies, at least to a substantial degree, are not reinvesting enough money in the oil company to maintain their current production, never mind to grow their current production. That's very, very, very important. National oil companies in places like Iran, Venezuela, Mexico, and Indonesia are diverting cash flow from their domestic oil and gas industry to social expenditure. In fact, some of the diversion is used to lower energy prices. So they're encouraging domestic demand at the same time that they're reducing future supply.

What's important about the four countries I have named is in the three- to five-year timeframe, those countries will not be exporters. And currently, they supply about 25% of the world's export energy. If you take 25% of the world's export energy off export markets, with export demand growing at a reduced rate of 1.5% compounded per annum for five years, it's absolutely stupid what can happen to the oil price. I won't even venture a guess, but I don't believe that if all four of those countries started spending money now to increase production that they could undo the harm that they've done by the spending constraints that they've imposed on their domestic industry in the last three years.

Porter Stansberry: That all makes sense to me. I don't know what side of the fence you come down on in terms of "Peak Oil" but I think a lot of the evidence for Peak Oil has been actually created by the mal-investment of the state oil companies.

Rick Rule: I think that's absolutely true. I think Peak Oil – at least from my point of view at age 55 – is an economic rather than a geological function. You'll notice gasoline prices are falling and storage numbers are rising. And the politicians are sort of flummoxed as to how that happened. Well, it happened because markets worked. People could afford less of it at $4, than they could at $1. And you know, from an economic point of view, this makes sense. From an economic point of view, Peak Oil is a function of price in the near term, not geology.

Porter Stansberry: In regards to oil prices, over five years, I can see your point. But, in the short term, I think the carnage is going to get a lot worse. What happens to the oil-sands companies, for example, if they have to shut down production because the cost of oil falls below their cost of production, which is around $70 on average?

Rick Rule: They'll get murdered.

Porter Stansberry: Even more so than they already have been?

Rick Rule: Yep.

Porter Stansberry: I agree completely. One last question – What are you doing with your partners' capital these days? [Rick runs a series of private partnerships for high net worth investors.]

Rick Rule: We are very, very liquid here. We have a lot of cash as a percentage of total assets, and I would say my principal constraints, in terms of taking new capital, is I usually take capital on with the point of view that it will last me for a cycle and a half. A cycle and half is 10 years. At age 55, my constraints are more how much of my life do I want to devote to this than the availability of capital.

Porter Stansberry: That's a good question. How much more of your life do you want to devote to this?

Rick Rule: I think it's very fair to say I've been doing the same thing for 35 years and there's a lot of life's experiences, almost all of them, that I haven't experienced. I don't know what I'll feel like at 55. I can tell you if we had continued with three or four more good years, I would have quit. But this opportunity we have in front of us right now, this is something that I've trained my whole life for. This is just as good as it gets. I have the reputation. I have the capital. I have the experience.

Porter Stansberry: Thank you so much for spending, geez, an hour with us...

Rick Rule: Always a pleasure.