-- Published: Tuesday, 14 October 2014 | Print | Disqus
Source: JT Long of The Mining Report
What if the goldbugs are wrong and fiat currency isn't going to throw the world into hyperinflation? What if instead, a steadily growing economy and a new awareness of the importance of having security of supply for critical metals along with a big exciting discovery that heats up the resource sector are what pull sinking gold and silver prices and their related mining companies out of the muck? If so, John Kaiser tells The Mining Report what the future may hold for the resource sector given the current economic conditions.
The Mining Report: At the Cambridge House Canadian Investment Conference in Toronto, you talked about escaping the resource sector swamp. Why do you call the current market a swamp?
John Kaiser: There are four key narratives that dominate the resource sector, in particular the junior resource sector. One is the supercycle narrative where a growing global economy catches the mining industry off guard with the result that higher-than-expected demand results in higher real metal prices. That then unleashes a scramble to find deposits that work at these higher, new prices and put them into production. The juniors played an extraordinary role during that cycle in the last decade; however, global economic growth has slowed. Therefore, we are looking at a period of sideways, possibly weaker, metal prices for a number of years, which puts the supercycle narrative on hold. That is one factor keeping the sector in a swamp.
Another important narrative is the goldbug narrative, where a soaring gold price is going to make deposits much more valuable. We did see that play out. Gold reached $1,950/ounce ($1,950/oz) briefly, but has since retreated 40%. Even though that's still 400% off the low from just over a decade ago, it has turned out to be a wash in real prices. Now, growth projections in the U.S. are having negative implications for the prevailing apocalyptic goldbug narrative. That does not bode well for an escape from the quagmire.
A third key narrative is security of supply, which we saw manifested in the rare earth (RE) boom in the past five years. However, the RE prices have come back to earth as substitution and thrifting has kicked in. The anxiety that China is going to eclipse the U.S. anytime soon has diminished, and the concern that there will be supply squeezes around the world has diminished.
The fourth narrative, which has dominated the junior sector for two of the past three decades, is that of discovery exploration. Unfortunately, there have not been many very good discoveries in the past decade that have inspired confidence in the retail sector. Add to that the structural changes in the financial services sector that make it increasingly difficult for junior public companies to source retail investor capital.
These are the forces that are keeping gold—and junior mining equity—prices bogged down.
TMR: Let's look at each of those narratives a little bit closer to determine what they mean for junior mining companies. If China's growth is slowing and the U.S. recovery remains hesitant, what does that mean for base metals—copper, nickel, iron and zinc?
JK: In the last decade, juniors have made a career of picking up deposits found in past exploration cycles and discarded as marginal because the grade wasn't high enough. The juniors did a tremendous job of reevaluating their potential based on new prices and technology. That led to $140 billion ($140B) worth of takeover bids, compared to the $5B per decade in the 1980s and 1990s. These deposits now sit as inventory in the big mining companies.
That means when we get another price boom, the big mining companies will develop these projects to supply the demand surge, not acquire juniors that claw a new batch of discarded deposits out of the closet. Investors interested in juniors with advanced deposits will have to focus their attention on an existing pool of juniors that will shrink as they disappear through buyouts or mergers with very modest premiums off cyclical market lows.
TMR: Would you apply that scenario to all of the base metals?
JK: Copper and iron are the ones that are faced with oversupply in the next couple of years. Nickel is a special situation because it was being oversupplied until Indonesia imposed an export ban on raw laterite ore. The Philippines is contemplating doing something similar. Should this come to pass, then we will have temporary shortages of nickel, and we could see nickel prices going higher. But if Chinese capital builds the capacity to smelt the nickel laterite ore in Indonesia and the Philippines, then we will see weak nickel prices.
The one metal I think will realize higher prices in the next few years is zinc. That is because major mines have started to shut down, and what is coming onstream is considerably less capacity than what is shutting down. Normally, that doesn't really matter because China has been the elephant in the room, the largest zinc producer. China has nearly doubled its production in the past decade. The prevailing view is that if we get a higher zinc price, China will move quickly to put more mines into production. However, I believe, due to a new environmental focus, the country could actually shut down some of its capacity, worsening the supply situation.
TMR: Let's go back to your themes. The second one was the goldbug theme. The Federal Reserve is betting that the U.S. economy is good enough to handle rising interest rates as part of a push to jumpstart the global economy. What could this mean for the supercycle we talked about and the apocalyptic goldbug narrative and the companies in the metals space?
JK: If the Fed successfully finesses the transition from quantitative easing and low interest rates to an economy based on positive real short-term interest rates, then we will see the consumer start to feel more comfortable with the future and spend money. Businesses would then start spending the trillions of dollars they are now hoarding or spending on share buybacks to prop up stock prices.
If they shift to building stuff again for the long run, which employs people with quality jobs and signals optimism about America's economic future, then the banks become happy and will start lending money to consumers. It creates a virtuous circle where the economy grows organically rather than artificially. This is also good for the rest of the global economy because it will enable emerging markets to hitch their wagon back to the U.S. as a primary export destination and, ultimately, as a flow of capital back to their own economies to fund self-sustaining economic growth.
A smooth transition to real growth is bad news for the goldbug narrative because if we have higher interest rates and, thus, better yields, that makes gold—which yields nothing—not very competitive. A strong dollar also clashes with the idea that everything is falling apart and, therefore, gold is going to go up due to resulting hyperinflation and fiat currency debasement. But if the Fed is wrong and it merely succeeds in popping a stock bubble and the Dow Jones drops more than the 10–15% that would qualify as a healthy correction, unleashing another asset deflation spiral similar to 2008, then we end up in a very negative scenario for the global supercycle narrative and for the goldbug narrative because gold goes down in a liquidity crunch. Either outcome creates an argument for gold dropping through that $1,180/oz resistance level and touching $1,000/oz on the downside.
TMR: Are you predicting $1,000/oz gold?
JK: I see $1,000/oz as a temporary aberration except in the worst case scenario of a global depression. Today 1980's $400/oz gold adjusted for inflation is $1,120/oz, so $1,200/oz is just a 9% real gain. That is sobering when you consider the mining industry extracted 2.3 billion ounces over the last 30 years on the back of gold's big move during the 1970s. As this low hanging fruit got harvested, mining costs rose, even more so than general inflation during the past five years.
All-in cost estimates average $1,350/oz for new gold, partly due to higher mining costs, but also due to lower grades, more difficult metallurgy and social license costs. A gold price in the $1,000–1,200/oz range implies that the world going forward will be content with the existing 5.4 billion ounce aboveground gold stock plus the billion extra ounces existing mines will produce as they deplete over the next decade.
As an optimist about global economic growth, I find that hard to believe. If the end of quantitative easing and the arrival of higher real interest rates gives the American economy organic growth legs, rather than sending it into a tailspin that requires the Fed to put it back on life support, it will pull the global economy back into an uptrend with resource-hungry emerging economies with large population bases as the long-term growth engines.
While your typical North American goldbug owns gold to hedge against catastrophe and a possible capital gain trade, new wealth in emerging nations seeks gold ownership as a form of saving and wealth insurance. This gold is not generally for sale. In my view, global economic growth is a plausible driver for higher real gold prices. The question is how long can gold hang around at price levels where it does not make economic sense to mobilize new gold mine supply?
What would jumpstart an uptrend in gold is China announcing its actual reserve holdings, which were last reported in 2009 as 1,054 tonnes. Since then China has produced about 2,000 tonnes and because the central bank is the official buyer of domestic gold production, China's official gold holdings are likely over 3,000 tonnes, just behind Germany at 3,384 tonnes. China has also been a heavy importer of gold since its breakdown in 2013, possibly over 1,000 tonnes. That would put China in second place, halfway to America's official holdings of 8,134 tonnes. China sees as the long game the eventual end of the U.S. dollar as the world's single reserve currency.
For now China is more than happy to see weak gold prices and is unlikely to harm its gold accumulation agenda by updating its official reserve holdings. But if it did, that would make investors think twice about selling the gold they already own and increase demand for more, which would lead to a higher gold price. A shortage could push gold to $1,500/oz without excessive inflation or fiat currency debasement. It would also underpin a new bull market in the juniors, especially if the American economy is back on track and the dominant gold narrative is no longer one that just promises higher gold prices without enhanced mining profitably.
TMR: We've talked before about the fact that during this downturn, a lot of companies were going to either disappear or be reduced to walking dead on the Toronto Stock Exchange and the TSX Venture Exchange. Is one of the bright spots of the market today that it's easier to tell the good companies from the bad?
JK: Yes and no. Just under 600 companies out of 1,700 have more than $500,000 working capital and aren't in the big mining company league. Some 300 have between $0 and $500,000 working capital, and about 700 have negative working capital of about $2B. The negative working capital ones are pretty much dead in the water because no one wants to give them real money to replace money that's already been spent. You may find a few companies among them with interesting stories that are worth salvaging. But most of the indebted companies are going to wither away and disappear.
That leaves about 900 companies with potential to survive. Among those, I gravitate toward the ones that have real management teams—technical personnel who know something about exploration—and projects with a story indicating that the brains of management are actually at work and that they are not just going through the motions of pretending to explore. Some companies are sitting on piles of money where management is collecting big salaries but because they have large shareholders who are treating the company simply as a keg of dry power for extremely bad times, they do not have the go-ahead to do anything along the lines of serious exploration that would risk the capital but also put the company in a position to deliver a substantial reward. One also has to be careful about those companies because they represent opportunity cost.
But, in general, it is now easier to see companies that are doing something and distinguish those from the rest because the inability to finance and the poor financial condition of most of the resource juniors make it very clear that they have nothing and are doing nothing. There is no reason to invest even a penny in such zombie companies.
TMR: Thank you for your time.
John Kaiser, a mining analyst with 25-plus years of experience, produces Kaiser Research Online. After graduating from the University of British Columbia in 1982, he joined Continental Carlisle Douglas as a research assistant. Six years later, he moved to Pacific International Securities as research director, and also became a registered investment adviser. He moved to the U.S. with his family in 1994.
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-- Published: Tuesday, 14 October 2014 | E-Mail | Print | Source: GoldSeek.com