Early in my career I interviewed for a job with a company that had brought in a new chief investment officer to revamp its research department–a job I (luckily, as it turns out) didn’t get. In the interview, the CIO said he thought that any competent analyst could figure out most industrial or service companies, but that there were three areas that demanded special expertise, They were: financials, technology and natural resources.
Personally, I’d take technology off the list, leaving financials and natural resource companies as the real specialist endeavors. I’ve coped with financials by either avoiding them entirely, buying plain vanilla commercial banks in emerging markets, or by mirroring the index (so they neither help nor hurt performance). As it turns out, I spent about eight years concentrating on natural resource companies at the start of my career (true, during the last century). Rightly or wrongly, I feel comfortable with them.
Two thing make natural resource production companies unusual:
–their revenues depend on the price of the mineral commodities they mine, which can be very volatile, and
–their stock market value most often depends on the amount and value of their proved reserves, something that only appears tangentially in the firms’ financial statements. Companies routinely disclose at least some information about their reserves, but it’s in supplemental disclosure that you have to find elsewhere in the annual.
Proved reserves are deposits of minerals that can be recovered:
–at a profit,
–with today’s technology, and
–at currently prevailing prices.
Almost always, natural resource companies have more stuff in the ground than they report as proved reserves. Two possible reasons: the minerals genuinely aren’t recoverable at a profit, given today’s technology and pricing; or (commonly with small companies) the firm hasn’t wanted to spend the money to get hard geological evidence of the extent of their holdings.
why this is important
1. When prices go up, two good things typically happen to natural resource companies: the value of each unit of reserves rises and the volume of reserves rises as well. The opposite happens when prices fall.
Most people don’t realize the volume part. That will be particularly important this year when gold mining companies report their reserves.
2. When technology changes–as is currently the case with the development of horizontal drilling and hydraulic fracturing in shale–acreage that previously seemed worthless may suddenly become a big source of profits.
In the case of natural gas in the US, this is a two-edged sword. The amount of new gas production that fracking has spawned is so great that it has lowered the domestic gas selling price. This means that some high-cost operations that were previously economically viable are no longer so–thereby moving those reserves out of the proved category for the companies affected. For particularly maladroit drillers, where the value of the reserves found is barely higher than their finding costs (i.e., where the stock market appeal is purely the bet that prices will rise steadily), fracking can be a death knell.