Marshall Auerback of Pinetree Capital Discusses Energy Investment

Pinetree Capital’s Marshall Auerback sees a number of supply/demandimbalances in the energy space, particularly in uranium. "We likeuranium because it’s both a supply and demand story," he says, believing the price could "easily double" over the next few years. But yellowcake won’t be alone in its ascent up the energy hierarchy. As developingnations begin to realize a standard of living more akin to the West,opportunities could arise in other areas across the energy spectrum. Inthis Energy Report exclusive, Marshall decodes the energy enigma, making a strong case for U308, oil and gas E&Ps and even natural gas.

The Energy Report: Shares in Pinetree Capital have had a good run in the last six months,going from about $1 per share in July 2010 to about $3.38 now. What’slargely responsible for that remarkable run?

Marshall Auerback: A number of things. I think Pinetree has been an undervalued stock for a long time based on its net asset value. But we had very adversefinancial conditions in 2008, particularly adverse for small-capcompanies, which comprise most of our portfolio. Even though we startedto see an improvement in the credit markets in 2009, they really didn’tstart to loosen up until last year for the smaller companies. Your riskin holding these small caps is not so much market risk as liquidityrisk. A number of these companies had cash on their balance sheets butthey were clearly capital-constrained because they were dependent onongoing capital injections to develop these assets.

In 2010, the capital markets began to re-engage and that made it easier for some ofthese companies to access funding. In turn, they were able to developtheir assets, which helped improve their share prices. But it took awhile. The markets were basically trendless until about September oflast year, then all of a sudden you have this big move in the commodityspace. Clearly, that’s Pinetree’s sweet spot.

TER: Yourstated objective is to "invest ahead of the crowd by anticipatingemerging trends and macro changes in consumption and translate thatknowledge to successful investments in small- and micro-cap companies."What macro changes are taking place in the energy market, and morespecifically in the uranium market?

MA: People havediscussed peak oil for a long time. It’s been controversial. Some people say you can always find oil at a given price. We don’t disagree withthat but the main thesis behind peak oil is that mother nature has onlygiven us so much oil. The low-hanging fruit has largely been picked.It’s getting increasingly difficult to extract oil from conventionalsources. If you look at each successive economic crisis and the price of oil during each one, we have continued to bottom at increasingly higher prices. Even in the worst conditions we had in 2008 and 2009, the oilprice bottomed at about $36 a barrel and it didn’t stay there for long.It was driven by a collapse in demand.

The other problem inenergy, in all commodities really, was a complete collapse in tradefinancing. So, we had both a financing shock and a demand shock, whichcaused this collapse in commodities. But as trade financing began tonormalize and these emerging economies began to normalize, there was abig increase in demand. Along with that you’ve got very significantshortages in supply. The BP Plc. (NYSE:BP; LSE:BP) oil-spill disaster that occurred in the Gulf of Mexico is a symptom ofthe supply problem. We wouldn’t be drilling for oil three miles belowthe surface of the ocean if it were easier to get oil from moreconventional sources. To me that’s symptomatic of a fact that you haveto look for the oil in increasingly expensive places, which meansincreasingly expensive oil.

TER: How is expensive oil influencing the uranium market?

MA: Clearly, as the oil price has continued to appreciate people havestarted to look at alternative fuels. For a while the sexy ones werewind and solar, but there’s very low power densities in those types ofenergy generation. Wind is intermittent. Obviously, solar is not a great resource to use in cold-climate countries like Canada or Russia.Natural gas is an important transitional fuel, but there’s also uranium.

To me, a seminal moment in the uranium market occurred about five years ago when James Lovelock, a leading environmentalist who used to be the head of Greenpeace, saidthat uranium has to be a major part of our response to global warming.Before that, uranium was seen as part of the problem, not part of thesolution. Clearly, the nuclear waste issue hasn’t gone away but we treat the stuff a lot more effectively than we used to. The waste problemrelative to the millions of tons of coil that get belched out into theatmosphere is fairly minimal.

I think the reason we like uranium is because it’s both a supply and demand story. On the demand side, anumber of nuclear reactors are under construction. Haywood SecuritiesAnalyst Geordie Mark says there’s been a 61% increase in the last couple of years. There’s also been a 54% increase in the number of reactorsplanned and a 45% increase in those proposed. These new plants alonewill eat up 32,900 tons of nuclear fuel annually—that’s almost half thedemand from this year’s 443 commercial reactors. We’ve got a very goodstory there, and then you have the supply side. The current price isaround $68 and that’s still too low to support a lot of new investment.You need much higher prices to invest in large-scale, development-stageprojects.

As it is now, the uranium industry is having a hardtime boosting production. There have been shortfalls from large mines,such as Energy Resources of Australia Ltd.’s (ASX:ERA) Ranger Mine and BHP Billiton Ltd.’s (NYSE:BHP; OTCPK:BHPLF) Olympic Dam Mine in Australia. Of course, Cameco Corp. (TSX:CCO; NYSE:CCJ) had water problems related to reaching production at its proposed Cigar Lake uranium mine. Those are other problems.

TER: Do you think we will see another surge in uranium prices like that in 2005?

MA: Generally, I find that these moves in the commodity cycle take twophases. The first is the "fantasy" phase where you get recognition that a real supply/demand deficiency is developing. A lot of speculative moves are made and the stocks start to go up, but then they crash because ithasn’t yet been validated by actions in the real world. But thisspeculation moved ahead of reality. Typically, what happens is that youget a wash out, and then 18 months to two years later people come backand say, "This thing is for real." We saw that happen in gold. There was a big move in gold in 2003 and 2004, but the gold price didn’t move up a huge amount. So, the market went dead for a couple of years. I thinkuranium would’ve had some interest in 2009, but obviously everything was superseded by the Lehman Brothers meltdown and the financial crash. So, it’s taken a bit longer, but I think the supply/demand outlook I’vesketched here is still very much in existence. Now we’re starting to see an increasing amount of pricing pressure developing on uranium, which I think will help reignite interest in the sector.

TER: What’s your forecast for the price of uranium?

MA: The price could easily double over the next three or four years, and it could even go much higher. A number of these projects in places likeKazakhstan and Namibia don’t even begin to make money until the pricegets closer to $80 or $90 per pound.

A lot of the demand will bedriven by the pace at which these nuclear reactors are built. Theproblem here is that we’ve often got political delays. I don’t thinknuclear construction in the U.S. will come for another four or fiveyears because with natural gas prices being as low as they are there’sno urgency to move into nuclear. However, in other countries wherenatural gas prices are much higher, I think we’ll likely see accelerated development. Certainly, in countries like South Africa, we’re alreadyseeing brownouts. China is definitely going to move ahead very rapidly,as is India—that’s going to be the big source of demand. It’s just amatter of how quickly these countries start to build reactors. It may be a case where, occasionally, perception races a bit ahead of reality;but the underlying reality is that uranium has the soundestsupply/demand features of almost any commodity out there right now.

TER: As of Sept. 30, 2010, Pinetree had 55 separate investments in uraniumplays. That accounted for 18% of your asset mix. With this expectedprice appreciation, do you want to keep your uranium exposure at around20% or are you going to increase that?

MA: I think itreally depends on the opportunities; we’re focused on a number ofventures. Again, you have to weigh the existing investments against theincreased political risks as you move into some of these funkiercountries in central Asia. You’ve always got to measure it against that. I think 20% is a fairly substantial bet, and I suspect that’s evenhigher now due to share price appreciation. But if it’s become a hotsector, we may start to look in an area that’s become less loved.

TER: You mentioned "funkier countries" in central Asia. Do you mean Kazakhstan?

MA: I have a view that it’s always tough investing in any country that ends with "stan." Basically, I’m saying you have to be much more aware ofthat risk. Increasingly, we’re seeing examples of resource nationalism.And that’s not just in the emerging world, it’s in places like Canada.There were very significant resource-nationalism reasons for theCanadian government’s disapproval of BHP’s acquisition of PotashCorp (NYSE:POT; TSX:POT). I happen to think that was the right decision because I believe it’smuch more valuable as a standalone asset. Increasing resourcenationalism means you’ve got to be careful. You don’t want to developsomething, and then find out the local government is taking 50% or moreof it. I think that we have to make political risk assessments as partof our investment judgments going forward.

TER: What are some of your biggest success stories when it comes to picking uranium stocks?

MA: Mega Uranium Ltd. (TSX:MGA) is a classic example. It started to appreciate at $0.10 and got to $9at its peak. That’s probably one of the best examples. A couple of other examples would be Rockgate Capital Corp. (TSX:RGT), which has gone from under $1 to $2.70 recently. It’s a uranium explorer and developer in West Africa.

Rockgate’s main project is the 100%-owned Falea Uranium/Silver deposit located insouthwest Mali. It was initially discovered in the late 1970s by Cogema, now AREVA (PAR:CEI). Rockgate has expanded Falea substantially with 45,000 meters of diamond drilling now completed in more than 175 holes. This work identified anew zone of uranium and high-grade silver; and on May 15, 2009, Rockgate released the first independent NI 43-101 resource calculation for theFalea project reporting a total uncapped resource of 20,252,000 poundsof uranium and 31,600,000 ounces of silver.

Another company is U3O8 Corp. (TSX.V:UWE), which has gone from a $0.35 to a $1.03 stock. It acquired some projects in South America Mega Uranium last year. In Colombia, it acquiredBerlin Project—a 38 Mlb. historic uranium resource at 0.13% U3O8—ahigh-value, multi-element opportunity with the presence of uranium,phosphate, vanadium, molybdenum, yttrium, rhenium and silver grades.

In Argentina, U308 Corp. has sizeable land holdings near the country’s largest known uranium deposits. The surficial uranium target at the company’s Laguna Salada Project there appears amenable to low-cost mining, and it’s working to complete an NI 43-101 uraniumresource estimate on that project.

Additionally, U308 Corp.holds prospective lands in Guyana—in the Roraima Basin, which is similar to Canada’s Athabasca Basin in size, composition and basementcharacteristics. Its Kurupung Batholith Project has an NI 43-101resource of 5.8 Mlb. at an average grade of 0.10% U3O8 (Indicated) and1.3 Mlb. at an average grade of 0.09% U3O8 (Inferred). A pipeline ofuranium-bearing structures will help grow the current resource atKurupung, which is geologically similar to sizeable albitite-hosteddeposits around the world.

Khan Resources Inc. (TSX:KRI) and Summit Resources Ltd. (ASX:SMM) would represent a few of our other big successes.

TER: What are some other promising uranium juniors Pinetree has in its stable?

MA: We like Mawson Resources Ltd. (TSX:MAW; OTCPK:MWSNF; Fkft:MRY), which has metal and energy interests in Finland, Peru and Sweden. Thestock recently went from $0.75 to $1.99. And not long ago, the companyincreased its landholding at the Rompas Gold Uranium Project in Finlandby 40%. Mawson has a strong cash position and a very prospectivedeposit. Highlights from recent channel samples included 0.95m at 1,424g/t Au and 1.3% U308 and 2.05m at 191.3 g/t Au and 0.44% U308.

We also like Energy Fuels, Inc. (TSX:EFR), which is consolidating uranium mining in western Colorado’s Uravan Mineral Belt and eastern Utah, U.S.

TER: Let’s move on to oil. Global oil consumption has rebounded from theearly 2009 lows and now exceeds pre-financial crisis levels. The usagegap between developed markets and their emerging-market counterparts has shrunk from 12 million barrels per day (Mbpd) three years ago to just 4 Mbpd. The International Energy Agency (IEA) forecasts global energydemand will rise to 82.2 Mbpd in 2011 up from 86.9 Mbpd this year—that’s almost 500 billion barrels annually. Where’s that oil going to comefrom?

MA: It’s a good question. Ultimately, I thinkthat’s what keeps the bid on the price. You have these situationswherein you’ve got massive increases in demand and you just don’t havethe available supply, so you’re going to see much higher prices. Milton Friedman once said the best cure for higher prices is higher prices becausethat’s how you solve the problem. I think we’ll see increasing pricepressures. The possibility of a conflict developing or resource wars isrising. I think countries that are in the sweet spot are countries likeCanada, which has very substantial energy reserves.

TER:Since it peaked in the 1970s, conventional oil production in Canada andthe United States has been declining. Recently, the application ofhorizontal drilling and hydraulic fracturing to tight oil basins—or, asone oil pundit put it, "a replay of the shale gas movie with differentactors"—is bringing a growing amount of light oil to market. Perhaps the best example is the North Dakota Bakken where oil production went fromvirtually zero a few years ago to about 250,000 bpd now. Are these newdense rock plays putting an end to the notion of peak oil, or is it toosoon to declare that?

MA: It’s too soon to declare that.First of all, two things are going on there. We need these kinds ofprojects just to sustain the levels of demand going forward, but I don’t think they are a panacea to the problem of peak oil. It’s more accurate to look at them as the response to substantially higher oil prices from conventional sources. And some of the supply gains from thenon-conventional sources are temporary. In the case of these Barnettshale-type developments, for example, you get very significant earlyproduction gains but the asset gets exhausted much more rapidly becausethe technology accelerates depletion rates. Working these tight basinsmay provide a short-term fix but it doesn’t actually solve the problemof peak oil. In fact, I would say it validates the whole thesis. Ifthere was an easier way to find oil, no one would have considered itworthwhile to look at these areas.

TER: What are some of your noteworthy oil holdings?

MA: Brownstone Energy Inc.’s (TSX.V:BWN) stock has gone from a low of $0.27 to a high of $1.16; it’s currentlytrading around $0.75. The company’s main focus remains on its Colombianand offshore Israel projects.

In Colombia, the Canaguay # 1 wellon the Canaguaro Block in the Llanos Basin produced oil at rates inexcess of 3,900 bpd. BWN has 25% working interest and long-termproduction tests are expected to take place in February.

The offshore Israel project is a joint venture with Adira Energy Ltd. (TSX.V:ADL; OTCBB:ADENF). The Noble Energy, Inc. (NYSE:NBL)/Delek Drilling LP (TASX:DEDR.L) Tamar discoveries are within 60 km. of Brownstone’s Gabriella andYitzhak Blocks. Completion of Adira’s 3D high-resolution seismicprograms are expected in January 2011; so far, the results look verypromising.

Donnybrook Energy Inc. (TSX:DEI) is an emerging Canadian oil and natural gas explorer and producer welike. It’s focused on Montney, Bluesky Wilrich and Fahler formations inthe Deep Basin, West Central Alberta. The company now owns workinginterests in 46 gross sections (30 net sections) of Montney petroleumand natural gas rights in its core area of the Alberta Deep Basin.

Primary Petroleum (TSX.V:PIE) has focused a majority of its resources in the acquisition ofprospective oil and gas acreage in Montana. It is engaged in exploration and development activities in Montana and Alberta and owns asignificant land position in the Alberta Basin Bakken Fairway in Western Montana and in the NW area of the Williston Basin in Eastern Montana.The company holds 100% interest in all of its landholdings in Montanaand has been increasing those landholdings.

Centric Energy Corp. (TSX.V:CTE) is another one we like. It is an oil and gas explorer with interests in Kenya and Mali, with a particularly promising land position in Kenya.The Kenyan government recently approved the Block 10BA farmout to Tullow Oil plc (LSE:TLW). The Block is in the northwestern part of Kenya, located in the easternpart of the Tertiary-age East African Rift system and is consideredanalogous to the Albertine rift in Uganda, where an estimated 1 billionbarrels of reserves have been proved to date and contains another 1.5billion barrels of prospective resources. The Lake Albert Blocks areoperated by Tullow Oil, and 35 out of 36 of the exploration wellsdrilled have been successful.

TER: Most people are staying away from gas plays right now. Are you saying that Pinetree is heading in that direction?

MA: There’s a very strong secular case to be made for natural gas in thesense that it’s a "green" fuel and will be instrumental in helpinggovernments achieve their objectives to reduce carbon emissions. Thatsaid, a lot of the so-called gas plays are actually existing byproductsof oil extraction, so there is less price sensitivity to natural gasprices per se. And the new technologies in place have substantiallyincreased extraction techniques, whilst reducing cost. So our focuscan’t be on companies on the basis of higher prices, but rather on good, low-cost producers with ample reserves. Those companies can make moneyat these depressed prices, which are likely to stay low for theforeseeable future.

TER: Do you have some closing remarks on the energy sector on a macro level?

MA: I think what Pinetree Chairman and CEO Sheldon Inwentash says iscorrect. At the end of the day, you’re dealing with a structuralphenomenon where you’ve got 2.5 billion people in India and China andother emerging areas of the world who are rapidly trying to get wealthylike we did using the same sort of growth model. But because thesepeople are at an earlier stage of economic development, the intensity of their commodity usage is much higher. With that in mind, we tend tobelieve that there’s a structural bull market in any number of commodity classes. Pinetree has effectively constructed a business plan on thatthesis. Now, are we likely to see significant corrections in the future? Of course. These things don’t go up in a straight line. You could havevicious 30%–40% falls. We have to learn to live with that volatility. We employ responsible risk-management techniques and do a lot of duediligence and technical work to get the high-quality assets and get them early.

TER: Thank you for talking with us today, Marshall.

As Pinetree Capital’s corporate spokesperson, Marshall Auerback is a member of Pinetree’sboard of directors and has some 28 years of global experience infinancial markets worldwide. He plays a key role in the formulation andarticulation of Pinetree’s investment strategy. Currently, Marshall is a senior fellow at the Roosevelt Institute, a research associate for theLevy Institute and a fellow for the Economists for Peace and Security.He previously served as an advisor to a number of fund-managementorganizations, such as PIMCO, the world’s largest bond fund managementgroup, RAB Capital and David W. Tice & Associates. He graduatedmagna cum laude from Queen’s University in 1981 and received a lawdegree from Corpus Christi College at Oxford University in 1983.

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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Mega Uranium, Mawson Resources, Energy Fuels and Primary Petroleum.
3) Marshall Auerback: I personally and/or my family own shares of thefollowing companies mentioned in this interview: None. I personallyand/or my family am paid by the following companies mentioned in thisinterview: None. See Pinetree Capital’s disclosure policy.

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