Gold and base metal plays: Jerome Hass and Jimmy Chu

Toronto-based hedge fund managers Jerome Hass and Jimmy Chu of Lightwater Partners discuss their strategic approach to taking long positions on gold, zinc and tungsten opportunities around the world. In an exclusive interview with The Gold Report, the Lightwater principals reveal several precious and base metal plays in which they have purchased stakes and define their criteria for limiting risks when taking on junior mining investments.

The Gold Report: Does Lightwater Partners have a regional bias when looking at precious and base metal equities?

Jerome Hass: Yes, we do have a preference for Canada- or U.S.-based investments, largely because of the political stability and the rule of law. By that, we mean a stable legal jurisdiction, which is important if things go wrong—as investors are discovering currently in places like Mongolia or Argentina. That said, not all of the North American states and provinces are equally mining friendly. We are cautious about gold companies based in British Columbia or Montana. We look far more positively on projects located in Ontario, Québec or Nevada.

TGR: Do you favor junior mining firms that are directly engaged in exploration and operation, or enterprises that buy and hold properties until it becomes feasible to sell them to more practiced developers?

Jimmy Chu: We rarely look at exploration plays, because we just don't find the risk-adjusted return to be attractive. We prefer to look at near-term developers, but not at those that are actually building a mine. For us, the value-added proposition is in proving up the economic case for a mine, but not in construction or operation. However, we will look at a company that has already built a mine, is operating it and is exhibiting good management skills.

TGR: How do you assess management skills?

JC: We meet directly with the managers. We look at management's track record and at how it has delivered against investor expectations.

TGR: Do you have a strategy for hedging on gold and precious metals and base metals?

JH: Hedging is tricky for most junior mining or gold companies. There are a number of options available. One option is to use physical gold as a means to short a position. The problem with that strategy is that positions in physical gold and equities rarely move hand in hand. Another option is to short the equities themselves. But, this is a real problem when the entire junior gold industry views itself as a potential takeout. That's a big risk when you're a short seller.

Large-cap stocks are easier to short as there is less of a takeout risk. Of course, large-cap and small-cap stocks can react differently depending on market conditions.

Another option is to use a proxy for junior gold ore on the Toronto Venture Exchange, such as a Canadian stockbroker, because a lot of its profitability and revenues come from junior mining issuance and corporate finance. We tend to use all four approaches to hedging, although no one of them is perfect.

TGR: What gold ventures excite you today?

JH: We rarely look at exploratory ventures. We do focus on companies with near-term catalysts. For example, we like Oromin Explorations Ltd. (OLE:TSX; OLEPF:OTCBB). It is more of a developer than an explorer. In fact, we recently met with Oromin's managers. They said that acquisition negotiations are ongoing for its joint venture group in Senegal.

Interestingly, Oromin is only covered by one analyst on the Street. Its story is not well known. It should receive its environmental approval in Senegal within the next couple of weeks. And, once that is done, its project will be construction-ready. Given that Oromin has access to 3.3 million ounces (Moz) gold, as indicated in an NI 43-101 compliant document, we think it's quite attractive.

Also interesting is a nearby property held by Teranga Gold Corp. (TGZ:TSX; TGZ:ASX). Teranga operates a gold mine equipped with an underutilized mill. There are obvious synergies between Oromin and its potential mine and Teranga and its existing mill. On top of that, IAMGOLD Corporation (IMG:TSX) and Randgold Resources Ltd. (GOLD:NASDAQ) operate gold mines in the same region.

TGR: What about Oromin's Canadian ventures?

JHs: Oromin's main asset is in Senegal. The Canadian operations are minor, and we attach zero value to them.

TGR: How do the costs of mining production in Africa, including environmental and labor costs, compare with those in Canada?

JH: The operating costs are lower in Africa. Of course, the cost of capital is the same, given that Canada is the principal financial center for mining and mining capital.

TGR: What junior gold mining firms interest you in Canada?

JH: Auriga Gold Corp. (AIA:TSX.V) is revving up its Maverick gold project in Manitoba. That is a very safe jurisdiction—a mining friendly province. Maverick is an advanced stage project, with infrastructure already in place from a past-producing mine. Auriga is restarting Maverick's mill, which is in good condition and worth $25 to $50 million (M). That alone translates into $0.50 to $1.00 per share, and compares to a $0.25 share price.

But even if there were no ore body to exploit, Maverick is still an attractive deal strictly from the perspective of the mill. Adding value is a shallow open pit with a very low strip ratio at surface. The combination of the existing mine and the very shallow ore body makes Maverick a highly economic project. It should be up and running by early 2013 at a cost of only $18M.

I can't think of another project around the world that can get up and running for only $18M in capital expenditure. The payback is only 20 months, and the cash flow is projected to be $130M over the mine's projected life of 7 1/2 years. The internal rate of return on the initial phase of the project is 88%, which is extremely nice.

TGR: Who do you favor among mid-cap gold stocks?

JH: Looking for near-term catalysts, we like Seabridge Gold Inc. (SEA:TSX; SA:NYSE.A). Surprisingly, it has an $636 million market cap and 38 Moz gold in reserves, yet there's not one analyst that covers it on the Street. The reason for that is the business model: Seabridge hasn't had to raise equity. Consequently, the Street's not paying attention to it.

In 1999, when gold was $300/ounce in 1999, the Seabridge principals saw opportunities where the capital markets just weren't interested. Seabridge scooped up gold properties knowing that when gold rose in value it would benefit. The Seabridge business model is to develop these properties to the stage where they should be built, but they don't build them out themselves. What we find attractive is that Seabridge has clearly recognized its own management strengths: drilling and proving the economics of a mine.

By way of catalysts, in mid-May, Seabridge is scheduled to produce an updated pre-feasibility study on its Kerr-Sulphurets-Mitchell (KSM) project in British Columbia. KSM is probably the largest undeveloped ore body in the world. The study is the second to last stage before putting the company up for sale. Seabridge intends to find a joint-venture partner within 12 months of the release of the updated prefeasibility study. The final catalyst before going up for sale is approval of the environmental application. That will probably happen in September. At that point Seabridge will have a mine plan ready for a major buyer.

TGR: What about the local mining infrastructure? Can it handle KSM?

JH: KSM is close to cheap power and close to a highway. It has year-round port access, a very low strip ratio and a projected long mine life. All the things you want to see in a mine. The problem is that it's so huge that there are a limited number of players who are big enough to develop it. Pulling this off will require a firm along the lines of Barrick Gold Corp. (ABX:NYSE; ABX:TSX), Newmont Mining Corp. (NEM:NYSE) or Freeport McMoRan Copper & Gold Inc. (FCX:NYSE).

TGR: What about base metal mine development? Does that sector fit your risk-adjusted portfolio?

JC: We tend to shy away from base metals, with the exception being a small company that is a pure play on zinc. That's Tamerlane Ventures Inc. (TAM:TSX.V). It owns a zinc-lead mine called Pine Point in the Northwest Territories. It's a restart of a mine that was operated by Cominco Ltd., which is now owned by Teck Resources Ltd. (TCK:NYSE; TCK.A:TSX).

TGR: Pine Point was closed, but it is now being revitalized? How so?

JC: Teck had shut down the mine because it had developed its Red Dog mine, which is one of the world's most prolific high-grade zinc mines. There's no question that Red Dog is the better ore body, but Pine Point is also attractive based on its fundamentals and valuations. It will provide an independent source of zinc concentrate, which is very much in global demand by both smelters and traders.

TGR: Does Lightwater invest in other metal commodities?

JH: We like tungsten. Its fundamentals are attractive from a supply and demand point of view. China stopped exporting tungsten concentrate in 2000; at the same time demand for tungsten increased. The tungsten fundamentals have improved for non-Chinese producers globally.

Tungsten is used as a composite material because of its hardness—it is second only to diamonds. Because tungsten is heat resistant, it's used in high-speed cutting tools, jet engines and light bulb filaments, as well as a replacement for lead in certain applications. Overall, there is a nice combination of increasing demand and tightening supply.

It is worth mentioning that Warren Buffet's Berkshire Hathaway has recently invested in the tungsten space. That has focused investor attention onto this rather obscure market.

TGR: Are there any companies that you're attracted to in tungsten?

JH: We like a pure play on tungsten through a company called North American Tungsten Corporation Ltd. (NTC:TSX). It has the Cantung mine in the Northwest Territories. It's small, but it accounts for 4% of world tungsten production. Its output is improving due to the purchase of Caterpillar equipment, which has really helped operational reliability because it is located in a remote region, and temperatures can plunge to minus 40 degrees.

TGR: What is the quality of the Cantung tungsten?

JH: The Cantung grade is very high by global standards: about 1.1% on average. The global average is about 0.3%. American Tungsten tested the mine's old tailings and found a grade of about 0.3%. That means that the company can enhance Cantung's mine life by processing those tailings. But, what's even more exciting is North American Tungsten's new development project called the Mactung deposit. It's one of the world's largest undeveloped high-grade tungsten deposits. Permitting is ongoing.

TGR: That's all good information. Do you have any names to add, Jimmy?

JC: A company called Orbite Aluminae Inc. (ORT:TSX) has patented a new technology to extract alumina from aluminous clay deposits. There was a lot of controversy surrounding certain overstated claims in Orbite's preliminary economic assessment in late March and trading was briefly suspended. But those issues seem to have been resolved. We have met with Orbite management on numerous occasions and we flew out to Gaspé, Québec, to see their pilot plant. It's potentially a game changer.

TGR: Thank you for your time.

JH: Thank you.

Based in Toronto, Canada, Lightwater Partners is an asset management firm specializing in alternative investments. Partner Jerome Hass has 16 years of experience in the financial industry. He joined Lightwater from Epic Capital Management. Previously, he was a portfolio manager and head of international equities at Montrusco Bolton Investments, where he managed $450 million directly, co-managed large global funds and oversaw $1 billion in private wealth. Partner Jimmy Chu has 10 years of experience in hedge and investment funds. At Lightwater he focuses on developing detailed financial models for existing and potential equity investments, which are used as a tool for making investment decisions.

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