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Ian Ball: Above-Average Capital Allocation Yields Above-Average Results In Mining

Strategies for capital allocation. Where are the bottlenecks in mine efficiency? Beware of excessive share dilution in mining stocks. Companies seeking capital meet potential financiers via the internet. Ian Ball brings us Abitibi Royalty Search, an online platform where mining companies in need of financing can easily submit geological data on their projects for consideration. In the mining sector, above-average capital allocation yields above-average results. The bottleneck in efficiency is in equipment provider innovation. Ian sheds light on our current position in the commodity market cycle, he expects the bottom within 12 months and his investment strategies reflect this. He advises to beware of share dilution in mining companies and not just opt for the cheapies. Ian Ball was appointed president of Abitibi Royalties ( OTC:ATBYF ) in 2014. Ian worked 10.5 years for Rob McEwen, initially at Goldcorp (NYSE: GG ) and then McEwen Mining (NYSE: MUX ). He most recently served as McEwen Mining’s president where he was responsible for overseeing production, construction and exploration activities throughout North and South America. He was responsible for discovering McEwen Mining’s El Gallo 2 project, scheduled to become one of the 15 largest silver mines in the world and building the El Gallo 1 gold mine that is forecasted to produce 75,000 ounces gold in 2015. www.youtube.com/watch Palisade Radio Host, Collin Kettell : Welcome back to another episode of Palisade Radio. This is your host, Collin Kettell. On the line with us today is a new guest to the program. I am very happy to have him. It is Ian Ball, President and CEO of Abitibi Royalties. A lot of people are probably familiar with the name as he has been around in the industry for quite some time and he has worked in the past – and still does to this day – with Rob McEwen. Ian, welcome to the program. President and CEO, Abitibi Royalties, Ian Ball: Thank you for having me today. CK: Yeah, as we were talking before the interview here, you went through your background that got you into mining. I thought I had started young, but you were saying that your background in mining went all the way back to when you were five years old. If you do not mind just giving a brief overview of that story again, it would be great. IB: Yeah, I would be delighted to. I grew up with mining because my parents were investors in mostly junior mining companies, and they had me looking at mining stocks at the age of five. There is always a discussion around the dinner room table on gold mining, exploration success, and the amount of wealth that it could generate on the back of discovery, so it has always been very intriguing for me. As I sort of went through school, I became very intrigued also in terms of how different mining companies were run and it seemed to me it was quite clear that the best mining company in terms of its management, in terms of its assets was Goldcorp. This was back in 2002, 2003. I was very fortunate to have met Rob McEwen at that time and then have him offer me a job to go and work there. CK: And so from therein you became the president of McEwen Mining, if you can give a brief overview of your time there and what you are doing now. IB: Sure. Well, after Goldcorp, because if you think back to 2005, Goldcorp merged with Wheaton River and the head office was then subsequently moved to Vancouver. Rob stepped down as CEO, which was always his intention. We went out and started a small company called US Gold which then became McEwen Mining. I had started at US Gold and slowly started to move into the exploration’s operational side and started in Mexico with a small exploration budget. We were fortunate enough to make a reasonable size silver discovery that now has almost a construction permit and is scheduled to be one of the fifteen largest silver mines in the world. On the back of that headed up a team that built what is now McEwen Mining, the main operating act of the El Gallo 1 Mine in Mexico. With those two successes then being promoted to president of McEwen Mining and that will have to be about ten years. CK: Great! So now you are working with Abitibi Royalty. I think a lot of our listeners have seen many of the press releases you guys have been doing, what you are calling a royalty search over the past few months. But, essentially, if you kind of outline the concept for potential shareholders behind how you guys see making money. It is quite a unique business model that I do not think has been executed on before. IB: Well, we look at Abitibi as having almost like a number of divisions inside of a company. Number 1 is the royalty search. If you think of any job of the CEO, it is allocation of capital. In a mining company, we have done an absolutely horrible job of allocating capital. When I was working at Goldcorp and then McEwen Mining, what become Rob’s primary themes is that if you do the average you should expect to get the average result. Most mining companies view the same as everybody else. That is why it is mostly we are all in the same position. When I look at the world in terms of mining, oftentimes it is not large sums of capital that generate the highest return; usually it is small sums deployed in a different fashion. We looked at it and said, well, it is a tough market right now. There are a lot of prospectors and junior mining companies that are having a difficult time in terms of financial position. They cannot pay the claim fees that are coming due and, therefore, they are going to have to drop the properties. Then I say, well, would we be willing to pay the property taxes on their behalf, in doing so getting back a royalty? We have also asked that should the properties be sold we would also get 15% of the net proceeds. But we are looking for properties that have certain characteristic. They have to be near a mine site. They have to have good geology and they have to have science and mineralization through previous exploration. I thought if we could build up a portfolio of 25 to 30 of these, we might walk away with two that end up being successful. Today, we have 70+ submissions. We completed eight transactions and we are continuing to review submissions as they come in. We have been pretty happy with what we spent. Today, I think for the first eight we spent $90,000. CK: I want to dig in a little bit deeper on this model behind paying for the claims fees and in turn getting a royalty and some upside on the project. The purest form of speculating in the mining sector is picking up or staking projects and holding them from the cheap point of a bear market into the craze that comes into a bull market, and that is essentially what you guys are doing. I mean I have looked at some of the press releases coming out and the costs to cover these claims fees are quite low and you are ending up with a substantial royalty. But for our listeners that are not as familiar, what is the value of the royalty? I mean some of these assets are not going to become a mine, and even if two of them do it, it is going to be a long time out. If you can explain how these things become valuable just through a bull market emerging that would be great. IB: Well, if you look at some of the royalties that we acquire, couple of them are 200 meters away from an operating mine. They are very, very close. A lot of the geology indicates that the mineralization may trend over where we have the royalty. You are right where even if there is a discovery it could be some time before you see cash flow. But if you look at the industry in the history of mining, the history of royalties, the best royalty ever purchased was by Franco-Nevada (NYSE: FNV ) in the early to mid-’80s on the Goldstrike mine, and that was when Barrick (NYSE: ABX ) then subsequently made the large discovery just like Goldstrike. If you look at Franco, it was not so much the cash flow that was the driver of their share price; it was the exploration success in knowing that cash flows were coming in the future. I think that this way, if the exploration company has a good drill hole, their share price starts to increase because you are building the underlying value. We suspected the same thing would happen initially here as any of these properties was to have a resource, and the value would have continually be increased as they get closer to production. The thing that we like most about these is that they are all right near a mine site and these are not in an area that has no infrastructure. They are 200 meters away, 500 meters away, a kilometer away from where usually substantial mines are operating. CK: For the benefit of our audience, Ian, can you explain how royalty is tied to a project? When a royalty goes away? How it sticks with the projects as long as the project remains in good standing, etc.? IB: Yeah. In that sense, it is a good question because royalties, in terms of their legal standing, they do vary by jurisdiction. You have to know the underlying rules that are applicable. Ontario, for example, in Canada is different than in Quebec. It might seem strange that you are on the same country but one is common law, one is civil law. The rules do change. One thing that we are building into our agreement is saying that once the claims come due again we are putting in a clause that we will be willing to pay the claim fees again for a higher royalty. That is where we can maintain if we like the property that it shows it stays in good standing and does not go to any default status. CK: Okay, thank you for the clarification there. I want to shift gears a little bit and talk to you about the industry that we are in which is, oftentimes, as you pointed out, mismanaged, money is misallocated. Much of your career was started at Goldcorp, and you said that at the time it was extremely innovative, shareholder-friendly. Of course, there was what I believe was referred to as the “Challenge” which was that first online exploration challenge that was a huge success and has now been replicated a few different times. Can you talk about the use of technology and the internet in how you have gone ahead and worked in the mining sector? IB: Well, I think the internet has a lot of uses in terms of its reach to connect people, to bring in new ideas. You did see it with the Goldcorp Challenge. You have to remember that was back in 2000 when the internet really was at the early stage and what you are able to do today versus then has obviously been drastically increased, so there is more we can be doing on the internet. If you think about it other companies have tried it and there is always success. Barrick would be an example where they had a challenge on metallurgy. This was in 2006 where they put up a prize of $10,000,000 I believe it was. But I think the problem there was they did not have an internal champion to keep pushing it ahead. I think without that a lot of these initiatives end up failing where I think Rob was a very good example where he came up with the idea, was the internal champion, and continued to push it so it became a success. I think that is the key. We have tried to use the internet saying that rather than trying to talk to people individually about what claims they want to have in good standing. We have created an online platform where you can submit all your technical data online and you will have an answer within 48 hours. I think that is a much more efficient process. Those are just two examples. In terms of innovation technology as a whole, right now we are seeing a lot of cost cuts in the industry. But it is just cutting cost; it is not innovation. The two should not be confused. To give you an example, two years ago, I went down to the Caterpillar (NYSE: CAT ) factory in Illinois and my question was why are we not developing an electric coal truck? Because according to the work that I had done, mining cost would go from – and this is in Mexico because this is where I was primarily working at the time. Mining cost would go from $2 a ton to $1 a ton if you can move from a diesel to an electric haul truck. I thought, “Okay, well, that would drastically impact the economics of a mining operation.” Caterpillar’s response was, “We do not do electric. We only care about expanding the hours on a diesel engine.” That is the wrong mindset for the mining industry. I think we need to push the suppliers to work harder on the innovation side. CK: Well, that is very interesting. Well, Ian, at 34 years old, you have ridden a couple cycles up and down. I want to talk about where we are at right now in the cycle. I think action speak louder than words. Certainly with you picking up assets under Abitibi and other projects you are working on, it would indicate that you think we are near a bottom. How do you see things developing over the next couple of years? Are we close? Is the bottom behind us? IB: Well, a couple of things. You are right and we launched the royalty search on the back of a very difficult time in the market. Four years ago, when we could not have done the royalty search idea because there was a lot of capital available, the other thing that we have done to sort of show that we think it is the good time to be buying is that we are one of the few companies that have launched share buyback program. Rather than issuing shares, we are buying back our shares currently. The other thing is I agreed to take all my salary in shares versus taking it in cash. That is also my belief that the share prices are going to go up, not down. In terms of where we are in the market, I think kind of pick a spot or a price in terms of where’s a bottom, I think that is a very difficult thing to do. I sort of try to look at it in terms of where are we are in the cycle. This might sound like I am looking at myself a lot as a buffer but I think we are in the bottom twenty to bottom third of this downward trend. If you look at the technicals, which I know, I am not a big believer in technicals, but if you look at the charts you would assume that gold is going to go to a thousand. It is probably going to overshoot a thousand as it typically always overshoots support to some degree. Whether it is $975, $950, $925, I think gold is going to go there somewhere in the next twelve months. Knowing that is very difficult to do deals and markets can turn around quickly. We have looked at it and see we are in the bottom third of the market that is safe enough for us to start deploying our capital, share buyback, asset acquisitions. We think in the next twelve months, we will probably see the bottom, but we do not know where that would be or we do not know how quickly we would recover from there or whether it sort of just tread water for some time. CK: What do your past experiences in bull markets tell you about the type of gains will be made for investors? Obviously, it depends on if you are going to the ground level purchasing assets like yourself or if you are buying mid-tiers or majors. But what will you expect over the next few years? IB: Well, it is an interesting question because I just sort of give you an example. If you go back to 1995, this is when Goldcorp made the high grade zone discovery at Red Lake and the shares did very well off the back of that. Then in ’96 we had Bre-X. We then had gold prices starting to decline making significant declines in ’97, and then they ultimately bought, did a double lot then in 1999 and then in 2001. By the time you got to 2001, Goldcorp, despite having arguably the best gold discovery in fifteen years, was back to the same price they were pre-discovery. If you look at it and say – in hindsight it makes sense and here you have a deposit that ends up being five million ounces of gold at 88 grams per ton gold. Think of it. That is almost unheard of. It is unheard of. Then if you have the nerve to buy at the time the gains were phenomenal going from 2001 to 2005, 2006 where the share price ultimately went from $5 in 2001 to $46. Big games can be had with the announcement of a company of reasonable size. I think that now people should be looking at companies that have good assets, good discoveries, that are trading at fractions of what it even cost to discover those deposits. I think there is a few of them out there right now. CK: Yeah, that is great. Well, Ian, at this point, I want to ask you if you have anything to add. Any suggestions for audience, members, and also if you can give us some more information on the companies you are working with where people can find out some more information that would be great. IB: Well, I would say the thing you will come to appreciate over time is that with a lot of these mining companies, you should be looking at the share dilution. I think that is what has been a killer in this industry and that the cost of capital to finance these companies was quite high, and you are looking at companies that are cheap and that is why we buy shares. But do they have any money? How long will that money take them. If they have to do a financing, how many more shares are to be issued plus the warrant? There’s a bit of a cautionary tale to be had there. In terms of other mining companies, I only invest in one and that is Abitibi. I do not invest in any others. There are specific reasons why and I think Abitibi has a good story in terms of its fundamentals. I do think that there are other companies out there that are doing good work, but it is still a bit of a cautionary tale. Right now, you have an opportunity to probably buy a handful of very good companies at a reasonable price rather than trying to buy companies that are just cheap for the sake of being cheap. CK: Okay, well, Ian, thanks so much for coming on the program. Really appreciate it. We will try and get you back on next year maybe in a better market, maybe not. IB: Okay, that sounds good. Thank you for your time today.

Want To Trade The Interest Rate Swap/Treasury Bond Spread? Think Twice.

The spread between five-year OTC interest rate swap yields and five-year Treasury yields has recently turned negative. In theory, this spread measures the cost depositors charge for bearing the extra credit risk of bank deposits. Should you buy this spread, expecting a return to positive spreads? Trades based on the yield economics are risky in the very inefficient IRS market. The press has awakened to an unexpected development on the long end of the interest rate swap (“IRS”) yield curve. IRS rates for 5-year maturities and longer are trading below Treasury rates for the same maturities. This spread is, in theory , a measure of the difference between the credit risk of Treasury debt and unsecured wholesale unsecured bank debt of the same maturity. But in reality this spread is obviously vulnerable to divergence from the theory. The chart shows the 5-year swap rate against the 5-year constant maturity Treasury curve over the past six months. A few things stand out. The IRS yield exceeded the Treasury yield during most of the period. The problem, if we should call it that, begins with the early-October run-up in Treasury rates, as displayed in the graph below, produced by FRED, the St. Louis Fed’s database. Several issues that distinguish IRS markets from Treasury markets might have come into play at that point. What are the trading implications of this development? With the listing of 5-year IRS futures by the CME Group (NASDAQ: CME ), it is possible for non-banks to trade the expected spread between 5-year IRS futures (CBOT : F1U) and 5-year Treasury note futures (CBOT : ZF). (click to enlarge) But the negative cash market spread is telling us that an analysis of the credit risk of prime banks is secondary in trading this spread successfully at present. There is no assurance that buying this negative spread will return a quick profit. Economic forces will be secondary determinants of this spread until the OTC IRS itself trades in a secondary market. At the moment, determination of swap rates is the dominion of roughly 20 large banks that face a multitude of other problems. On the other hand, if you meet these conditions: You are a non-bank corporate or financial institutions borrower, but not an IRS dealer. You can finance your operations at interest costs tied to 6-month LIBOR for the foreseeable future. You have a productive use for long-term debt. Run – do not walk – to your nearest swap dealer and pay fixed on an appropriately sized IRS at a negative spread to Treasuries. OTC swap dealers do provide long-term interest cost protection. It will take five or more years for the swap to unwind and provide the cheap long-term cost of money that you seek, but if that is consistent with your business plan, very little can go wrong. [But if there is any chance that you will change your mind (as several municipalities have done), do not enter this transaction. There is no more iron-clad commitment than an IRS. It is not a bond. You can’t buy it back.] The IRS/Treasury spread is a close relative of the TED Spread [difference between the Treasury bill rate and the Eurodollar (LIBOR) rate of the same maturity.] The TED spread is thought to represent the cost to prime London banks of the added credit risk their short term unsecured debt represented relative to that of the U.S. Treasury. In spite of the problematic history of LIBOR pricing, the TED spread has been and will remain, positive. LIBOR is indeed problematic. Within months of the listing of Eurodollar futures (CME : ED), LIBOR became something other than a market yield. London offered the services of the British Bankers Association in polling specified bank employees in London branches to form a poll on LIBOR. This was not good news for believers in market forces. Most readers are aware of the sorry history of this “LIBOR fixing,” with billions in legal settlements of lawsuits resulting from manipulation of this poll on a market price. If you are not familiar with the LIBOR scandal, read here . LIBOR, the interest rate index fundamental to the determination of swap values, is an estimate of the market yield on unsecured wholesale bank debt. These bank debt instruments, London branch deposits, are securities in the same sense that Treasuries are. And nobody questions that they are riskier than the U.S. Treasury bills. But as we learned, the LIBOR rate is not exactly the price at which these deposits are traded. For example if, for some foolish reason, roughly 10 of the 18 banks asked on a daily basis to provide LIBOR, undertook to bring three- and six-month LIBOR rates below the Treasury rates at those maturities, they could make that happen without a single transaction. We learned from the LIBOR scandal that 18 large banks have unfortunate employees that have been cursed with the task of providing an answer to the following imponderable question every day. ICE LIBOR Question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?” There is no compensation this side of $1 billion that would entice me to accept this job. The reason is simple. This person is very likely to be sued, perhaps criminally, and will have no credible economic explanation for the values provided. Consider the plight of this person if employed, for example, to produce Citibank’s (NYSE: C ) rate. Of the 18 banks polled each day, 17 know at what price Citibank could borrow under the (poorly specified) circumstances of the question. The only bank that does not is Citibank, which cannot lend to itself. Worse, none of the 18 banks know the minimum rate at which Citibank could borrow, which is the number requested. Yet this Citibank must make this guess every day. Given the disastrous events of recent years and the legal jeopardy described above, I am sure the LIBOR providers do their very best to guess this rate correctly these days. There is little likelihood that LIBOR is anything other than a very good guess at the 11:00 AM cost of bank money in London. The likelihood of LIBOR falling below the Treasury rate is nil. Why is the IRS rate different from LIBOR? Mostly because it is more obscure. Nobody is going to jail because the spread is out of line right now. But it is no less important to the dealer banks. Various authors search for an economic explanation for an IRS rate less than the Treasury rate. Resist this urge. There is no economic answer. The dominant economic explanation in the press doesn’t wash. This explanation posits that these unseemly low IRS rates are the result of the incredibly safe IRS clearing houses. The argument goes that the new OTC clearing facilities are less credit risky than the U.S. government. This dubious notion, it is suggested, is perhaps due to an implicit government guarantee, resulting from exchanges’ designation as “systemically important utilities.” Such explanations are based on a total misunderstanding of the credit risk associated with entering a swap and could not be more mistaken. IRS trades are credit risky. But the credit risk in question has no direct relationship to the IRS yield. The credit risk exists on both sides of the trade. Each party to the trade is at risk to the other. As a result, there is no reason for either side to pay for the credit risk it creates unless its credit risk is dramatically different from its counterparty. This is not the case for the dealer swap transactions upon which market pricing is based. The heart of the matter is that LIBOR swap rates are based on the dealers’ prices in trades with each other. For the specifics of how IRS prices are determined, l refer the reader to a rather terse explanation from LCH:Clearnet , the largest clearer of IRS globally. The root of the pricing problem is that IRS trades, like LIBOR, are not negotiable and thus inevitably guesses. LCH:Clearnet’s methodology does not specify the guesser. I have no reason to doubt that the effort to guess the market price of IRS is as sincere as that for LIBOR. I expect that the negative value of the Treasury/IRS spread caught the dealer’s attention and that the optics did not amuse them, another reason to believe the prices are close to the market’s transaction prices. Here is a short list of market issues that could be leading to the negative spread. (click to enlarge) Liquidity. As the Chart below indicates, the volume of cleared IRS has been falling steadily for the past two years. This suggests fewer dealer trades. JasonC also shows that U.S. dealer notional principal amounts (NPA) have been falling steadily over the same period, another indicator of falling liquidity in this market. The market may have become less efficient, and the dealers’ ability to change pricing as market conditions change may be reduced. Valuation Issues. An IRS (if you set the credit risk between parties aside) is a zero-sum game. Every dollar one trader earns as IRS rates change is lost by another. Since most IRS are trades between the 10 largest dealers, I cannot imagine that the trading community as a whole benefits directly from unchanging interest rates, whether up or down. The same may not be said of individual dealers of course, so the possibility that one or more specific banks is losing value as interest rates rise is real. But I don’t think one or a few banks losing money would slow the rise in IRS long-term rates. Changing rates do have a substantial and important indirect negative effect on all banks. There is a reporting issue associated with changing rates. Bank derivative risk reporting basically involves two measures of performance. Banks report their derivatives NPA and derivatives net asset value (cash value in the case of a hypothetical sale.) A run-up in interest rates has a substantial effect on every bank’s net asset value. It has no effect on the net asset value of the system as a whole, since every dollar earned in the zero-sum swap market is also lost elsewhere. But regulators base their estimates of the risk exposure of the banks’ swap books on this number. And both negative market values and positive market values rise as rates change. Even an increase in a bank’s swap book net asset value is a negative for bank regulators. This factor could create an incentive to moderate changes in swap rates, especially if there were a substantial probability that these increases would be reversed. The Whack-a-Mole Factor. Finally, I think it would not be surprising if individual banks are as reluctant in the IRS market as they are in the LIBOR market to release estimates of market yields higher or lower than the herd’s reported average. IRS estimated rates are no less subjective than LIBOR rates, since there are no secondary market prices. There has not been a scandal in IRS markets analogous to that in the LIBOR markets. In fact, this is one of the few OTC markets in which there has been no such scandal. But who wants to be first? All in all, I do not find this temporary divergence of IRS rates from their theoretical relationship to Treasury rates very alarming. None of my suggested reasons leads to any kind of financial disaster. But the absence of pricing efficiency in the IRS market is another of the gradually collecting indicators that this market is more expensive to operate and less efficient in performing its risk-transfer function than we should expect. And trading this spread based on bank credit risk estimates is dangerous right now. As presently constituted, the IRS market is hazardous to traders other than dealer banks and their customers. And that is its most important flaw.