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By Sumit Roy
Rick Rule is director, president and chief executive officer of Sprott US Holdings. He leads a highly skilled team of earth science and finance professionals who have deep experience in many resource sectors including agriculture, alternative energy, forestry, oil and gas, mining and water. Rule is a contributor to Sprott's Thoughts, a free educational resource for investors. HAI Managing Editor Sumit Roy recently caught up with Rule to discuss the outlook for commodity markets, particularly gold.
Hard Assets Investor: Would you tell us about the consolidation that's been going on in the mining space? Is there anything investors should take away from the recent hostile takeover attempt by Goldcorp of Osisko, or is it an isolated event?
Rule: It's a precursor. We would have seen many more of these except that the mining industry's track record in M&A over the last 10 years is so despicable. The industry as a whole -- both precious metals and base metals -- wasted $65 billion or $70 billion over the last decade in fruitless overpriced M&A, which resulted in most of the senior managers at the major money companies being fired.
The consequence of that failure, and the consequence of the subsequent sacking of so many CEOs, has made existing CEOs very reticent with regard to new M&A activities. The value offered up by Osisko, which we think was extraordinary, and the fact that Chuck Jeannes at Goldcorp hadn't participated in too many ill-fated acquisitions, is what allowed Goldcorp to throw the first punch in what we see as a two- or three-year consolidation phase.
And make no mistake, the industry needs to see more consolidation. One difficulty that the industry faces is the incredible leakage of revenue going to general and administrative expenses. We need fewer management teams. And that will be accomplished by M&A.
Beyond that, what the Osisko transaction signals to the market is very positive. It says, first of all, that even if the traditional source of after-market support, liquidity and capitalization for the mining business -- which has been generalist mutual funds, specialist mutual funds, and small hedge funds -- is gone, there are other sources of capital like the industry itself, like private equity players and like sovereign wealth funds.
The second thing it says -- and this is important, this has happened four times before in my life -- when we go into an M&A cycle, these acquisitions do two things, both of which are superb for equities markets. One, they add cash and liquidity to the system; they get money moving around. And two, they add hope.
When people have experienced a 20 or 30 percent premium, or whatever the ultimate premium for Osisko ends up being, the money that comes out of that will almost certainly go back into the gold sector as people hunt the next acquisition candidate.
Making 20, 30, 40 percent, in fairly short order is a lot of fun. And it encourages the sort of speculative activity that gives you the momentum that you need to change a bear market paradigm into a bull market paradigm.
HAI: You mentioned that this M&A cycle could go on for a few more years, and there could be other takeover candidates out there. How can investors identify which companies those are?
Rule: I would say that what you look for right now is a trouble-free operation like Osisko was. Osisko was an ideal candidate, because Goldcorp, if they're successful taking them over, won't have to fix anything. Osisko has low debt and decent free cash flow. There are probably six of those available on a global basis. They are very rare.
The next thing you will see get taken over will be the stuck development assets. That is, development assets that haven't been able to go forward because the corporate vehicles that control them don't have the balance sheet strength to attract project finance, while a larger competitor with a better balance sheet would be able to finance the projects. We think those two sectors of the market are both particularly attractive.
We think there may also be horizontal mergers in the junior producers-the sub-400,000 ounce producer category. We don't see the majors coming down to this space because the junior producers generally have more marginal assets.
And we don't see the major producers coming down to spend the time and attention to fix those assets. But we see an increase in the horizontal amalgamation in the sort of 150,000-400,000 ounce producer range.
HAI: I recently read that Eric Sprott was talking about potential 10-, 20-baggers in some of these smaller miners. Is that possible?
Rule: Eric is of the belief that we have passed a pivot point in precious metals prices and that the strength of gold and silver markets to the upside will surprise almost everybody in the world, with a certain exception of himself. He believes that this is not only inevitable, but more importantly, it's imminent.
And Eric believes that for people who can afford to make a speculative bet, buying shares in the marginal producers that generate little, if any free cash flow, at $1,300 gold, but would generate massive amounts of free cash flow at $2,000 gold, will net massive returns. Potentially 15-fold or 20-fold increases.
He thinks you're going to have a market-cap response of the type that he was fortunate enough to experience in the 197-1980 time frame, where you had many emerging producers that were tenfold or 20-fold gainers.
Now, I need to caution your readers: Don't try this at home, folks. This is for money that you can afford to lose half of if the thesis is incorrect. And it requires very serious due diligence.
Eric is supported in his macro call at Sprott by a dedicated team of financial analysts, engineers and geologists. This is not the sort of thing that retail mas and pas who have a life and don't pay real attention to the fundamentals should attempt to do without help.
HAI: Do you like the resource space in general? Or do you see one particular commodity doing better than the rest? I know we've talked a lot about gold, but is there anything else out there you like?
Rule: We're coming into the second half of the natural resource supercycle that began in 2000. I believe that the decline we saw was precipitated by the financial collapse of 2008, and a subsequent reduction in demand growth on a global basis.
But we're coming into a second part of this resource supercycle, just as we experienced a decline and a recovery in the midpart of the decade of the 1970s. I'm bullish on the whole resource space, but I'm particularly bullish on commodities where the total cost of production exceeds the selling price of the commodity. In other words, I'm particularly attracted to industries in liquidation.
It has been my experience that, if there is ongoing demand for a commodity -- in other words, if society needs it and can't substitute something else for it -- and if the commodity is priced in the market below production cost, that either the commodity ceases to be available, or the price goes up. And this has served me extraordinarily well for 35 years of investing in natural resources.
Commodities that exhibit those characteristics right now include platinum group metals-platinum and palladium -- which are my personal favorites among the precious metal suites. Others I like are uranium, water, and zinc.
HAI: Those are some commodities that aren't getting a lot of headline attention right now.
Rule: It's very important for your readers who intend to participate in these markets, particularly ones who are new to the sector, to understand that natural resource markets are very volatile, and very cyclical. And whatever commodity is hot is about to be not hot and vice versa. The slogan I use to educate my own clients is that in natural resources, you will either be a contrarian or you will be a victim. Those are the two choices. And those choices are yours.
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