-- Posted Friday, February 13 2009 | Digg This Article | Discuss This Article - Comments:

Founder Brian Tang and the Fundamental Research crew are back this week, offering a value-based perspective on natural resource investment. In this exclusive interview with The Energy Report, FRC provides its macro view on mining, oil and gas and recommends an up-and-comer in the uranium space.

The Energy Report: Brian, could you give us a summary of your firm and its business model? You have strong opinions about how individual investors should approach paid-for research.

Brian Tang: Sure. I founded the firm in 2003. At that time, a lot of the investment banks were being scrutinized for producing research that was tied to corporate finance and I was also in corporate finance—but more on the debt side. On the debt side, all research is paid for. Firms like Moody’s and Standard and Poor’s will charge firms money, and then issue a credit rating on them. So given that the corporate finance model was being scrutinized, I thought why not apply the debt model simply to the equity side, where we would charge a fee to issue a rating on the equity of companies?

Of course, there is the potential for a conflict in that type of situation. What we’ve done is instigate policies to mitigate those conflicts; for example, we only charge our fees flat and in advance and we don’t accept stock, so the companies have to pay in full before we get started. We sign agreements with the companies that basically relieve us from any liability for negative reports. They agree that they will not sue us for negative comments. Once we’re engaged, we have to finish the contract. They cannot prevent us from publishing further research. And, if you look at the distribution of our ratings—where 25% of our ratings are hold, sell or suspend—I think you can get an idea that our analysts are truly independent. We’ve issued sell ratings right off the bat, and that company has paid, we’ve done our due diligence, and we didn’t like the company; so we initiated coverage at a sell. So that is the business model. Also, if you look at our performance on Investars, you will see we have done quite well in the past.

In terms of our focus, we focus on small and micro cap companies that aren’t widely followed by brokerage firms. We think by focusing on companies that no other analysts are following, we can add value by discovering these undervalued companies.

Currently, a lot of our coverage is in the natural resource sector—mining, oil and gas—and the other two sectors that we cover are industrials and healthcare. From time to time, we publish special reports, industry reports, on topics of interest that we think investors would like to read about.

TER: In the research you do and provide to subscribers, do you give specific sell-hold recommendations and pricing?

BT: Yes. We have three ratings: buy, hold or sell recommendation. We don’t call it a target price; we call it a fair value, and we also issue a risk rating from very low risk to highly speculative. We’re registered as a securities advisor with the BC Securities Commission.

TER: What’s your outlook on oil, considering today’s oil price and the more macro picture with oil and gas?

BT: I have always been bullish on oil. I started following oil when it was $12 a barrel; and, when it went to $24, we thought, wow, 100%, and then it shot up to over $100.

In general, I’ve always been bullish on oil, basically it’s because oil is a finite resource. It’s being burned every day, supply is getting lower; and, to me, it just means that the price has nowhere to go but up. Of course, it will experience volatility day to day but I think, in the long term, the trend for oil will always be up. When you look at oil compared to other commodities, oil is unique because it’s consumed. You actually burn it, and then it’s no longer around; whereas, for gold, whatever’s been extracted in the past 100, 200, 300 years is still around. So, in that way, I think oil is different.

The second main sort of “big picture” theme would be the increasing finding and development costs, where people are having to drill deeper and deeper to extract a barrel, so it’s costing more and more. These are long-term issues supporting oil. In the short term, the factors that will affect oil are GDP growth and OPEC production, and that will cause short-term volatility. But, again, in the long term, I don’t see it going anywhere but up.

We did a study and looked at the correlation between changes in global GDP and the changes in oil consumption. We found that the correlation was 58%, which is quite a significantly high correlation. When we looked at OPEC, we wanted to see how important OPEC is and how much of an impact they actually have on oil prices. Our research showed that OPEC is still important. It currently accounts for about 40% of the world’s oil supply.

We found a much stronger negative correlation between OPEC production and WTI (West Texas Intermediate Oil) prices. For example, from 1973 to 2008, the correlation between OPEC production and WTI was -.13 vs. non-OPEC production to WTI with a correlation of -.04. Because .04 is nearly zero, the statistics are saying, basically, for non-OPEC producers, the correlation is almost none. And when you look at a chart of the oil prices vs. production of OPEC and non-OPEC, you can clearly see that when OPEC cuts production, the price tends to respond by going up. Whereas, the non-OPEC production tends to just trend up. Since 1973, there’s volatility in it; but, in general, it just goes up.

In the short term, OPEC’s spare capacity is tight, but they’ve announced recent cuts. Spare capacity averaged 2.8 million barrels per day from 1998-2008. Spare capacity is basically what they could produce on top of what they’re already producing, so it’s kind of like if a factory was producing at only 80%, they have a spare capacity of 20% to increase production. But we think this spare capacity will increase, which means they’re going to cut back supply. Spare capacity of OPEC is forecast to increase to 3.95 million barrels per day in 2009, and 4.56 million barrels per day in 2010 vs. the historical average of 2.8 million barrels per day.

Finally, for our short-term outlook—because of the GDP growth that’s expected to decline in 2009—we also think oil prices will stay around current levels for 2009. However, as OPEC responds with the production cuts and, as the economy recovers, we believe that the long-term price of oil will be about $80 per barrel, and we expect this to start around 2010. That’s our long-term forecast: $80.

When you look at the current and long-term outlook for oil prices, they’re still going to be much higher than what oil has averaged historically. So you might not see a return from ’07 levels, but definitely the prices are still higher than they’ve been historically. And at these prices, a lot of projects are still economic.

TER: With these new ETFs, people can really kind of play oil as a commodity. As you look at micro cap stocks or just plain oil as a commodity, what advice would you give investors?

BT: Siddharth Rajeev, our head of research, can talk about the investment demand for ETFs because he looks at that when he’s making his supply-demand forecast. But one interesting use of these ETFs, or investing in oil directly or oil stocks, which are correlated to oil prices, is to hedge.

For example, a lot of people complain when gas prices are high, but I think one of the benefits of having financial markets is that you can actually offset your risk from high gas prices. And, although the price of gas and the price of oil stocks, or even oil, don’t move 1:1, if you can adjust your position, you can actually offset your risks. For example, if you go long in an oil company that had a high positive correlation with gas prices, when gas prices go up, you’re going to lose money at the pump but then your stock portfolio is going to go up; so, in theory, they should offset each other. And that’s the definition of a hedge—to remove all risk. If the correlation was 1:1, you would remove all risk. So in terms of a risk reduction strategy to minimize your exposure to energy prices, that’s one way to think about how to use hedging other than just to profit. Sid will now talk about investment ETFs.

Siddharth Rajeev: If you look at silver ETFs, silver ETFs were introduced in April 2006 and then if you see the statistics, the total amount of ounces held by the ETF increased by about 1,000% since then. Currently, the ETF holds about 230 million ounces of silver, which is like a 43% year over year increase. So there is a big demand for such products, and we believe that it gives you direct exposure to commodity prices.

TER: If we’re looking at oil, and we’re thinking long-term oil’s got to be going up, why wouldn’t we go directly to the commodity rather than going through Exxon?

BT: That’s actually been a long-term dilemma. Also, for example, there was one classic case people debated: If a mutual fund company is outperforming the market and it’s publicly traded, should you invest in the mutual fund or just buy shares in the mutual fund company? So there are a lot of factors involved that would go into this decision. You could make a case a lot of ways.

For example, if you invest in an oil company, the oil company has professional management. So, if oil prices decline, the stock might not decline as much because they can do things like cut costs and diversify into other industries; whereas, in oil, you’re just 100% exposed to oil. So it would depend on somebody’s risk tolerance, and it would also depend how that asset interacted with other assets in your portfolio. I can’t really give you a straightforward answer on that. There are a bunch of different factors.

SR: If I could add to that, if you’re holding oil and gas equities, oil or gas prices are just one of the inputs for valuing it. There are a lot of other inputs that are going to the valuation of those equities. So, basically, it reduces your exposure to oil and gas prices if you hold equities relative to holding an ETF.

TER: Very good. We appreciate your time. This has been great.

Brian Tang, BBA, CFA, founded Fundamental Research Corp in 2003, and has successfully led the firm to be recognized as one of the fastest-growing companies in the province of B.C. Prior to Fundamental Research Corp., Brian was an analyst in the corporate banking group of one of the world's largest international banks where he performed fundamental analysis on Financial Post 500 companies (the Canadian equivalent of the Fortune 500). Prior to this, he worked at a financial advisory firm where he analyzed and published research on Canadian equity mutual funds.

Fundamental Research provides institutional quality equity research coverage on small and micro cap companies through its extensive distribution network. Its major institutional delivery channels include institutional sites such as Reuters, retail sites such as Stockhouse, and subscribers. Fundamental Research’s performance has been highly ranked in the past by Investars.

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-- Posted Friday, February 13 2009 | Digg This Article | Discuss This Article - Comments: