We are approaching an inflection point in the economy and the metals markets favorable to precious metals and mining equities. Moving beyond 2008, investors long in mining and metals equities are no longer burdened by the combination of redemptions and tax loss selling. While producers appear less risky, we see mining and metal equities with development potential as offering the greatest leverage for appreciation in the new year.
Increasing operating costs in 2007 and declining metal prices in 2008 have increased development risk and squeezed operating margins. Turmoil in the credit and housing markets have reduced access to capital, exacerbating a lengthy decline in both precious and base metals mining equities to the lowest level in several years.
Slower levels of economic growth worldwide have led to higher than anticipated inventories, declining base metal prices, and shelving base metal projects. As we anticipated, this has produced increased availability of labor and equipment leading to moderating operating and development costs. While in many cases, base metal prices have declined to below required levels for production, precious metal prices remain above real long-term price levels.
Investment Thesis Transitioning: Defensive Strategy for Liquidity Trap from Commodity Super Cycle
We suspect that these trends may remain in place until global economic growth resumes. This includes stable or increasing precious metal prices and moderate to declining operating costs. Also, considering the decline in supply of available viable precious metal projects to finance, we anticipate a relative increase in supply of available credit and capital. Despite the aggregate decline in the market capitalization of mining and metal equities, and the reduced supply of bankable projects and available credit, the amount of precious metals in the earth remains constant. While the availability of metal in the ground is an issue, this characteristic increases its scarcity and value which is at odds with the money supply, which is made scarce only by the moral fiber of the government and monetary authorities.
Real Gold Price Chart
Source: Analyst
We base our outlook on Irving Fisher’s Equation of Exchange, or MV=PQ. In general terms, the velocity of the money supply will be reflected in inflation and GDP. The left side has been adequately discussed in the investment and national media. Losses in the financial industry have reduced bank capital and bankers’ ability and willingness to lend, thereby retracting available credit and reducing both the supply and velocity of money. On the right side of the equation we have seen both declining commodity prices (oil, base metals, housing) and slower economic growth (lower sales, bankruptcies, layoffs). This suggests a deflationary environment including a strong dollar and low interest rates, where holding cash starts to look like making an investment.
Expected Inflation Chart
Source: Laffer Associates
The national media has documented the monetary authorities’ response to increase GDP by reducing interest rates. The government has also increased the money supply through the financial and auto industry bail outs. The incoming administration has also pledged to spur the economy through historic investment in infrastructure. The government appears sanguine regarding bankers’ willingness to lend and is making a strong effort to increase the money supply. There is skepticism as to whether these actions will produce the desired result.
Monetary Base Chart
Source: Laffer Associates
It is accepted that the government is increasing the money supply, and should banks begin to lend, the combination based on the Fisher Equation should lead to inflation or an increasing GDP. Optimistically, it may take years for infrastructure projects to commence or for the economy to grow. The only remaining variable to balance the equation is inflation. As monetary policy is more art than science, the ability to manage the money supply is suspect. (In our opinion, the optimal path is to allow the market to manage the economy to equilibrium by reducing taxes and regulation, leading to higher levels of productivity and production, none of which is regarded by the government as a solution). We question the Fed’s ability to smoothly reduce the money supply commensurate with an increase in lending by bankers (increasing velocity) resulting in volatility at best and inflation at the worst.
Precious Metal Production and Development Should Hold Value in 2009
These factors are favorable to junior precious metals equities. Gold and silver prices are correlated to inflation, suggesting stable or higher precious metal prices. Slower economic growth should increase the supply of labor and equipment for moderating operating expenses. The combination of increased prices and lower costs may expand margins, increasing the attraction of precious metal equities by investors. Though investors may recognize the importance of production and cash flow, the most attractive returns may be in development and exploration of precious metal resources. We believe that investors will look for leverage and screen precious metals companies by size (or resource) and probability of development. Our short list for consideration includes the following.
NovaGold Resources Inc. (NG) has nearly 22 million ounces of gold (plus 4.5 billion pounds of copper and 62 million ounces of silver) in the Measured and Indicated classification. Barrick Gold Corporation (ABX) should complete a Feasibility Study on the Donlin Creek project, in a 50-50 joint venture with NovaGold, in early 2009, which should advance much of the 32 million ounces of in-pit Measured and Indicated resource into reserves. Donlin Creek is one of the world’s greatest undeveloped gold deposits. In 2007, drill hole DH-1556 intersected 299 meters grading 5.26 g/t (1,573 gram-meters) and DH-1564 intersected 308 meters grading 4.60 g/t (1,417 gram-meters). NovaGold’s other assets include the world-class Galore Creek polymetalic project and the Rock Creek gold mine. Based on NovaGold’s share of Donlin Creek alone, at $45 per ounce (less than one half previous conservative acquisition levels), NovaGold may be valued at more than $6 per share not including its other assets.
Seabridge Gold Inc. (SA) continues to advance its KSM gold-copper project in British Columbia. KSM is one of the world’s largest undeveloped gold-copper-silver projects with a 19.7 million ounce Indicated gold resource (plus 5.3 billion pounds of copper and 64 million ounces of silver). Seabridge’s total gold resources total about 49 million ounces, or over 1.25 ounces of gold per share. Seabridge reported $11 million in cash on its balance sheet at the end of its third quarter. On December 15, 2009, Seabridge announced the closing of its Noche Buena project in Mexico for $25 million in cash. This should fund additional drilling and study at KSM, which we expect will lead to an increase in the resource and improved economics by converting waste to ore.
Exeter Resource Corporation (XRA) continues to advance its Caspiche gold-copper porphyry project in northern Chile. The project is well situated between Kinross’ Refugio mine with 6.2 million ounces of gold and the Barrick/Kinross Cerro Casale project with 25 million ounces of gold (grading 0.69 g/t gold and 0.26% copper). Exeter recently announced drill hole CSD023 at a depth of 102 meters intersecting 603 meters grading 0.89 g/t gold and 0.32% copper (under an oxidized cap of 0.65 g/t gold). Caspiche is open, and with the current footprint the eventual resource could exceed ten million ounces of gold. (Barrick acquired 51% of Cerro Casale for $775 million in October of 2007, roughly eight times the market capitalization of Exeter). They have three drills on site and are scheduled to produce a resource estimate by April of 2009. Exeter has one of the largest land positions in Argentina and Chile, with about $22 million in cash on its balance sheet as of the end of its third quarter.
South American Silver Corp. (SOHAF.PK) is rapidly advancing one of the largest silver resources in Bolivia. The Malku Khota silver-indium deposit has an Indicated Resource of 144.6 million ounces of silver and 845,000 kg of indium (an important industrial mineral used in flat screen televisions). The deposit has good exploration upside as the resource covers only 3.5 km of the project’s 15 km strike length. Malku Khota could be one of the largest silver discoveries in South America, if not the world. Given the change in administrations in the U.S., and an upcoming election in Bolivia, there are also good prospects for improving international relations which should become clearer in January. Currently, South American is trading at close to cash per share.
Alexco Resource Corporation (AXU) is scheduled to make a construction decision at its high-grade silver and base metal Bellekeno project (inferred resource of 537,000 tonnes containing 1,016 g/t silver, 13.5% lead and 10.7% zinc) in its wholly owned Keno Hill silver district in the Yukon Territory. Construction should be fully funded by the transaction with Silver Wheaton Corp. (SLW). Bellekeno is anticipated to be a modest but high-grade and highly profitable operation fueling development of the district. Keno Hill may be early in its production history, producing over 217 million ounces of silver between 1921 and 1988, and having been explored to depths of only several hundred meters. We believe the district has the potential to rival Idaho’s Silver Valley, which has produced over a billion ounces of silver, and mined to depths of over 5,000 feet.
Etruscan Resources Inc. (ETRUF.PK) has exceeded anticipated gold production levels at its Youga project in Burkina Faso. Youga has good potential for resource expansion at its Ouare´ satellite target, which may lead to reserve expansion with increased capacity or mine life. The current price environment is conducive to funding exploration. As Etruscan focused on West Africa early in the metal cycle, they acquired the largest land position of any mining company in the region, and consequently may be best positioned for exploration. We also believe Etruscan is ahead of the curve on diamonds and rare earth development in southern Africa. Etruscan has a gold resource of over three million ounces and recently produced a Feasibility Study for its Agbaou project in Côte d’Ivoire.
Looking Forward to Increasing Demand for Developers in 2009
We believed that 2008 would favor investment in emerging producers assuming stable metal prices and moderating operating expenses. These companies appeared to have proportionally less risk than metals and mining equities on the exploration end of the spectrum. We see higher metal prices and moderating costs already increasing the attraction of mining and metal equities. As exploration companies have declined more than most, we see these now as potentially having the greatest upside potential. Moving out of a period of tax loss selling, equities in general may see a real bounce. Developers may enjoy the greatest appreciation from stable or increasing precious metal prices, moderating operating or development costs, and increasing availability of credit or profitability of major producers.
Disclosure: The author is long NG, SA, SOHAF.PK, AXU and ETRUF.PK. An affiliate of the author's employer provides corporate advisory services to NG, AXU and ETRUF.PK.
