Dave Forest Explains Why Trillion-Dollar Infusion May Not Produce Inflation—or Drive Gold Up
Source: The Gold Report 07/07/2009
Where is the aggressive inflation that was supposed to follow the government's tremendous expansion of the money supply? Why hasn't the new money propelled the price of gold higher? Pierce Points author Dave Forest shares his answers, which counter traditional theories, in this exclusive Gold Report interview. He also talks about some of the companies he likes no matter which way the pendulum swings. Juniors with plenty of project options to choose from are among the equities Dave favors. In his view, those with a strategy for discovery and the cash to do it are good protectors of investment that will do well regardless of what happens on Wall Street—in either an inflationary or deflationary environment.
The Gold Report: Your weekly Pierce Points newsletter has been looking at popular investing theories and providing additional perspectives for these theories or, in some cases, basically busting some of those theories—such as the theory of the money supply. A lot of other newsletter writers and analysts say that with the money supply expanding we should expect aggressive inflation, if not hyperinflation. Can you give us your perspective on whether that's necessarily true?
Dave Forest: The assumption is that because we've increased the U.S. monetary base by close to a trillion dollars over the last nine months that inflation is guaranteed. We're locked in, that's a certainty—we're heading toward higher prices for most of the things we buy.
But just because you increase the money supply does not necessarily guarantee inflation. Certainly when you create a trillion new dollars, you raise the possibility of inflation, but the real key lies in where most of that money goes. The most telling statistic is that even though we've increased the monetary base by a trillion dollars, 90% of that money—about $900 billion—sits in the vaults of commercial banks around the U.S. as excess reserves. So we're in a situation where most of the new money has gone straight into bank vaults.
It's not out roaming the streets, buying things like food and fuel and bidding up prices. We've seen this movie before. It was called "Terror in Tokyo." Back in the '90s, the Japanese government created the yen equivalent of about $400 billion in an attempt to reinflate its economy and the exact same thing happened. Most of that money sat in bank vaults and failed to inflate anything, with the result being that prices for almost everything in Japan fell for the next decade.
TGR: But won't the money in the bank vaults eventually come out and bring on inflation? Or is there some timing scenario that totally avoids inflation?
DF: The real key is when and how that money gets released from banks and goes out onto the street. It's almost like we have a dam and we're pouring all of this money, all of this liquidity, into the reservoir behind the dam. Then we're waiting to see whether it will be released and flow downhill. For the most part, the release valve is bank lending and consumer and business borrowing.
The theory of stimulus would be that you give money to the banks and the banks lend it to individuals and to businesses, which then go out and spend it and put it into the real economy and start helping to reinflate prices. We're not seeing that.
All of the data shows bank lending in the U.S. for businesses and individuals is down by about $100 billion over the last nine months. That's the largest drop in borrowing we've seen in the last 10 years. So the message is that consumers are not borrowing and banks are not lending. Banks are having trouble finding people creditworthy enough to borrow. You don't want to lend money to somebody if you're not sure that they can pay you back.
TGR: If we added $1.2 trillion to the money supply and lending is down only $100 billion, where is the rest of it?
DF: Most of that has ended up in the banks in the form of excess reserves. A large amount also went abroad in the form of currency swaps to help foreign governments provide U.S. dollars to people in those countries who need them. Those currency swaps will notionally be swapped back at some point, which means that money will be returned and retired. All of these factors mitigate or moderate the impact of the trillion-dollar increase in the monetary base.
TGR: This whole discussion started with the fact that increases in the money supply don't necessarily mean inflation because a lot of this money is trapped within the banking system. Is there a scenario in which we would just continue in a deflationary environment because the money never comes out of the banks? Or at some point in time will it come out and drive inflation?
DF: That's the key question. Will it come out and when? That's why we say inflation is not guaranteed just because of the increase in the monetary base. It's certainly a possibility. And, again, the mood of the business community and the consumer are key. If U.S. consumers and businesses—borrowers—suddenly become happier about prospects for the economic future in the U.S., they could indeed start to borrow and banks will start to lend and we'll see that money starting to move out into the wider economy. At that point, we certainly could get a dramatic increase in inflation. But if they don't and if borrowing continues to decline, that money will sit in the banks and we certainly could have deflation despite the increase in the monetary base.
The other consideration there, of course, is that the government is now trying to bypass the banks and put money directly into the economy through stimulus spending. If they are successful in injecting large amounts of money into the real economy by paying for bridges and roads, that's another situation where the money does start to get out onto the street and we could see inflation.
TGR: Many people who follow gold are predicting an enormous increase in the gold price because of this pending inflation. If the new money is trapped in the banks, though, do you suppose gold will remain in its current range?
DF: That's been the experience so far. A lot of people say, "Wow, the monetary base is increasing, so this has to be bullish for gold." But here we are a trillion dollars later and gold is still trading between $900 and $1,000. The event that everybody expected to drive gold to the moon has happened, and gold hasn't gone to the moon. If that money does start to get out into the economy, it certainly will be good for gold, but we're not seeing that at the moment.
TGR: Canada's Metal Economics Group Report—the MEG Report—findings indicate that replacement reserves are increasingly difficult to find for producers and in essence this will decrease gold production as we look forward. Can you speak a little bit to that and the implications on the price of gold?
DF: The idea is basically that producers are having a more expensive time replacing their gold reserves. Major gold producers are very sensitive to their reserves replacement ratio, so if they produce a million ounces a year, they want to see a million ounces a year or more added in reserves so the tank isn't running dry. In places like South Africa, for example, you can add reserves by looking for gold at deeper levels, but the problem is that that gold becomes more expensive to mine, so you pay more to discover and produce those reserves. There's a movement afoot amongst producers to try to find lower-cost sources of new reserves, which is taking the form of looking into new technologies and new countries.
TGR: Given that we're still looking for new technology and looking at new countries, the fact that buying the reserves is increasing and mining reserves are increasing, why shouldn't we see gold increase just due to supply and demand factors?
DF: That's an interesting question. The shorter answer is we should, because in several countries the strategy has been for producers to move toward lower-grade deposits where they can add tens of millions of ounces to their book. Those deposits are available in many parts of the world; they'd been passed over because they weren't profitable to mine in the past. So as producers move towards those lower-grade reserves, yes, we should see an increase in the cost of gold because it costs more to produce those deposits.
The mitigating factor there would be that, generally, when the price of a commodity rises, there's the opportunity to make a lot of money. When you can make a lot of money, you usually attract a lot of smart people and those smart people tend to ruin it for everybody by finding better and cheaper ways to do things. In the mining industry we've seen that in the past with the development of technologies like heap leaching. So in the '70s when we had a rapid rise in the price of gold, we did a lot of work on developing heap-leaching technology. That basically enabled low-grade gold deposits to be produced relatively cheaply and brought the production price push on the gold price back under control. So we expect that to happen and be a mitigating factor if gold prices do rise.
TGR: To what would they have to rise to really influence these smart people and new technologies to come in?
DF: Even now we're seeing gold as one of the few sectors that's shown much life in the investment community over the past nine months. I think in the first four months of this year there was something like $4 billion raised globally for gold projects. So, even at a $900 gold price, we're seeing a lot of interest. I suspect that even if gold rises by a few hundred dollars to $1,000 or $1,100 or $1,200, we would still see a lot of interest around the world in gold projects.
TGR: A lot of things seem to be influencing the price of gold, though. We're in a deflationary environment. We may not see inflation for a year or more until that money comes out of the banking system. We have increased mining costs. With all these factors at play, what's going to cause the price of gold to go up?
DF: Conceivably, it may not go up. We could have a situation where gold stays range-bound between $750 and $1,000, the way it's been over the last couple of years, especially in a deflationary environment where you'll have some selling of gold as people try to raise money and some buying of gold. That's been our investment thesis; you can't bank on a rise in the gold price as your underlying argument for stock selections. If you're counting on a rising gold price to lift all boats in the gold stock sector, you may be disappointed.
TGR: Another thing that you've written about in your newsletter is that deflation, while it's bad for a lot of companies' performance and probably for the general stock market, it could actually be good for gold companies. Can you explain that?
DF: Gold stocks are sort of in a win-win situation. If we get inflation and the gold price goes up, obviously gold stocks do well and that's the scenario that everybody expects when they buy gold stocks. The other scenario that's interesting is that historically, during periods of deflation, gold stocks are one of the few assets that do well. That's because during deflation things are getting cheaper and you can sort of win by not losing or not losing as fast as everything else. The historical evidence is that gold tends not to lose as fast as everything else. Because there's some demand for gold, it's a store of value.
So the gold price tends to go down more slowly than the price of things like oil, labor, chemicals—all of which are used in producing gold. The end result being that for a gold producer, the sale price of your gold stays relatively high while all of your costs come down considerably—the costs of your mine workers, your process chemicals and the fuel to run your machinery (particularly in an open pit gold mine). So margins tend to improve. The experience in past deflationary periods is that gold miners' margins improved, and improving margins mean improving cash flow and generally improving stock performance.
TGR: But if the replacement reserves are lower grade and more expensive to mine, are we looking at a wash, where the margins are about the same? Or are you expecting, even at $900 an ounce gold, new technologies will come in to make those lower-grade replacement reserves more economically viable?
DF: Usually what happens when we have a period of profitability in the gold sector, there tends to be a lot of exploration for new gold deposits. That usually results in the discovery of some major world-class gold deposits, which are the highest grade, the most profitable gold deposits around the world. Those tend to be the cost setters for the entire industry. They're usually the cheapest to mine and the highest quality. So if we get a period of intense interest in gold stocks, we can probably expect one or two major discoveries that will help to offset the rising costs at other gold deposits because they'll be high grade and large and low cost to produce.
TGR: Given we've got all these factors, what do you see as a good investment strategy through the next 12 months?
DF: Gold stocks are sort of hedged both ways. If we get a deflationary scenario, we'll probably see margins improve for the producers and that eventually will translate into interest in the more junior gold stocks. If we get inflation, then obviously the gold price rises and all of these gold stocks do well. So we like gold stocks, particularly those that have cash.
One of the problems at this point is many of these companies are struggling for survival. They've run out of money, and raising new money in the equity markets has been tough. So good gold companies, companies that have a strategy for discovery and the cash to do it, are good protectors of investment in that they'll do well regardless of what happens on Wall Street.
TGR: Do you have a preference for those that are in production or near production?
DF: No, We like both sides. We like juniors that have a good strategy for identifying new projects, doing some early-stage work and then bringing in a larger partner—a major or an intermediate—to do some of the work in proving that up. We like that model. We also like development-stage companies that have a deposit where there's potential to add significant value by doing a relatively moderate amount of work. And we like the seniors, too. The seniors will benefit from a rising gold price in inflation or from rising margins in deflation. So, across the spectrum, I think gold stocks are going to be a good investment.
When you look at the stages of the exploration cycle, the lifecycle that a project goes through as it grows up from being a piece of land in the middle of nowhere in Alaska or Papua, New Guinea or wherever, to being a mine, it goes from early exploration to advanced exploration to drilling to development and then to mining.
The interesting thing is that the potential to add the most value for the least money is at the earliest of those stages. When you go out and stake a piece of land somewhere, it may only cost $25,000 or $50,000 to hold that land. Then by applying some fairly inexpensive work, by going out and doing some field mapping, taking a helicopter out for a day, having a look around, perhaps doing a bit of geophysics, maybe spending $50,000 or $100,000, if you can show that there's a decent chance that that piece of ground may have a large deposit beneath it, you've now added a considerable amount of value. If a company does that kind of work, we may see a major company come in and commit to spending maybe $5 million or $10 million to earn an interest in the property. Any time you can attract an investment of that magnitude for a payment of $50,000 or $100,000 on your own, that's a very good return on capital.
TGR: Can you share with us any companies that are particularly interesting to you?
DF: Absolutely. We tend to be a little more focused on the junior side. A company like Golden Arrow Resources (GRG-TSX.V) is an interesting one because they have a stream of cash flow, which is unusual for a junior. They own a royalty on a producing gold mine and, because of that, they expect to receive about $2.5 million a year in payments from the royalty. That's a significant amount of cash coming in for a junior. You can buy a lot of exploration for that amount of money. So, because of that, we expect them to be around and exploring for quite some time; and management has a good track record of sourcing new projects and finding new areas to explore. So we like that one.
Another one would be Riverside Resources, Inc. (TSX:RRI) . The management team there has a very interesting strategy for developing new exploration projects. They own a proprietary database of projects in Mexico and they use that to constantly generate new project ideas, and then bring in partners to pay much of the bill in exploring those properties. As such, we expect them to be around exploring for a long time. The more lottery tickets you buy, the more chances of success you have.
TGR: Has the proprietary database for these project ideas panned out? Are they getting good signs?
DF: They've had some. Some of their more advanced projects, the ones that have been drilled, have had some decent gold intercepts. The issue in exploration is really more longevity than results. The rule of thumb is that one exploration project in 1,000 turns out to be a viable mine. So the object as an exploration company is to stay in the game and to explore as many prospects as possible. You may have 10 or 20 or 50 that you look into that don't pan out before you have one that does.
I think the most important thing with the Riverside team is that they're selecting projects that, at the outset, have a chance of being a large deposit. They know what to look for in terms of screening what does and does not have the potential to be a large deposit that would be of interest to a major mining company. And then at that point, you put the drill in the ground and you hope for the best and try not to spend much money doing that. Riverside is succeeding on all of those counts.
TGR: Any others in that category?
DF: ATAC Resources Ltd. (ATC:TSX-V) is another one that we like that's done a good job with a similar strategy. The management team has been active in the Yukon for half a century and they've used their knowledge of the area to likewise generate a large number of projects. They've used some of their own money and some of partners' money to come in and explore those projects. Because of their knowledge of the area, they're constantly generating new project ideas and are well-financed to keep exploring those projects.
TGR: So the three companies you mentioned, Golden Arrow, Riverside and ATAC, are all multi-project companies.
DF: Yes. They all have numerous projects and, more importantly, they all have a strategy for constantly generating new project ideas, which becomes important as you move on and drill more and more of your projects. One of the major problems that junior mining companies run into is that they run out of ideas, and then they spend money on projects that don't deserve the money because they simply don't have anywhere else to spend the money. You don't want to end up in that situation. You want to have enough on your table that you can look around and select the best places to spend your money. And if you don't have good places, then you go out and you look for new ideas.
DISCLOSURE: Dave Forest
I personally and/or my family own the following companies mentioned in this interview: Golden Arrow Resources, Riverside Resources, ATAC Resources
I personally and/or my family am paid by the following companies mentioned in this interview: None
A professional geologist, Dave Forest currently writes the free weekly e-letter, Pierce Points (piercepoints.com), which covers global commodities markets. He also serves as Managing Director of Notela Resource Advisors' Vancouver office. His analyses have been featured on BNN, Kitco.com, Financial Sense and The Daily Reckoning. Dave, who worked in the mining and oil/gas sectors for a decade, previously managed Casey Research's Energy Research Division.
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