Here’s some sad commentary about the current set of grads:
Seven in 10 of these recent graduates said they would need more education if they were to have a successful career. Despite their belief in the value of post-secondary education, though, only 38 percent definitely planned to attend college to get more education in the next five years. Barriers included skyrocketing tuitions and family obligations.
These grads are, of course, entirely correct in believing that college credentials are generally necessary to having, if not a good career, at least a decent one. What’s sad, though, is how many of these grad think they need a higher education in order to succeed. In essence, 70% of current grads are not willing to make their own success; they are relying on others to do it for them.
I know that not everyone can self-employed entrepreneurs that go about making new businesses and products, but it is pathetic that so many won’t even consider such an option. People can’t work at Microsoft or Apple without their first being a Bill Gates or Steve Jobs. Unfortunately, not many seem to want to be Gates or Jobs.
Of course, given the current economic climate, this isn’t altogether unexpected. The current regulatory regime very much favors established big businesses, and generally hamstrings small businesses (assuming they operate within the bounds of regulation). The taxes accompanying success aren’t encouraging, either. Really, it is easier to rely on others to provide some small measure of success for you than to fight for it yourself.
And really, there is no better sign of a declining society than its youth’s lack of desire to take risk. Quite simply, young people in the United States have bought into the notion that they need to have a higher level of education to succeed in their career. That they are so concerned with conforming to the desires of economically privileged in order to have a tolerable life is saddening. That the current state of affairs actively encourages this mindset of dependency is simply sick.
Graphite is the “it” mineral of the moment, but as an investment space it remains largely misunderstood. In this exclusive interview with The Critical Metals Report, Glen Jones, executive director for the Western Hemisphere at Intierra Resource Intelligence, suggests investors research extensively to protect against loss, and names some of his favorite projects that may serve as a jumping-off point for the graphite-curious.
The Critical Metals Report: In a May 31 press release, your firm said, “If China’s approach to rare earths was applied to graphite, the impact on global demand, supply and prices would be significant.” Do you believe China will establish export quotas on different types of graphite?
Glen Jones: If the demand for the different products in which graphite can be used—for example, lithium-ion batteries—actually comes to fruition, then yes, I believe China will establish export quotas, because it will need graphite for its own internal production.
“Rare earths and graphite are not as cut-and-dry as gold or copper. Thus, my advice is always, ‘Research.’”
TCMR: Is the growth in graphite demand from current applications like refractory and lithium-ion batteries enough to support the 40 companies now seeking economic graphite deposits?
GJ: If this growth comes about, there could be a shortage of graphite. Not all of these companies will find deposits, but it is necessary to have 40 companies exploring—it increases the chance of discoveries.
TCMR: Graphite demand is growing at a rate of about 5% per annum right now. That’s reasonably healthy, but not extraordinary. What catalysts are going to get investors excited?
GJ: Green energy initiatives: fuel cells, solar electricity, new-generation nuclear power and pebble-bed nuclear reactors. When some of those technologies will be perfected and when greater graphite demand will come still remains to be seen.
TCMR: You’ve said the graphite mining business is misunderstood. What is the source of confusion?
GJ: Investors are overwhelmed about the various types of graphite, flake or vein. The variations in grade, prices and the sources for each type make graphite a very confusing market, and a lot of investors are just jumping on the graphite bandwagon because they don’t want to be left out. I compare it to the early days of rare earth elements (REEs). REEs, like graphite, are not as cut-and-dry as gold or copper. Also, graphite just kind of popped up, and investors wonder why it’s suddenly in such demand. All of the numbers about the future use of graphite and how much supply will be required are still just estimates. Even if the numbers were more certain, they still depend on the fluctuating economy.
That’s what’s misunderstood in the business. Thus, my advice is always, “Research.” With the Internet, there’s such a huge amount of research available. Most companies have PowerPoint presentations you can access. There are also many government sites, such as the U.S. Geological Survey, that you can consult to boost your technical knowledge.
TCMR: Canada is home to 71% of the graphite projects currently being developed. Graphite is relatively abundant throughout the world, so why are so many projects located in Canada? Does it hurt the sector to have so much of the work happening in one country?
GJ: For investors, it’s not bad to have so much supply concentrated in Canada. The country is blessed with great geology for resources, not only for graphite but many other commodities, including gold, copper, nickel and lead zinc. About 45% of the world’s listed mining companies, over 1,600, are listed on the TSX and TSX-Venture exchanges. Most of these companies are experienced. They know how to raise money. They know how to explore. Plus, Canada has great infrastructure and is mining friendly.
TCMR: Within the last year, roughly 40 companies specifically seeking graphite were listed on various Canadian exchanges. Does this almost-overnight increase trigger any alarm bells?
GJ: I’m not concerned with the number of companies jumping in. It happens in the exploration business. Of the 140 projects in the world that these companies own or have acquired, about 80 are grassroots projects, which Intierra classifies as having no previous drilling. This leaves about 40 properties that are at various advanced stages. Of that group, maybe half a dozen will get to the feasibility stage. I think it’s good to have so many companies in there right now.
TCMR: Within those 140 graphite projects, only one graphite mine is being built. Should that concern investors?
“Canada is blessed with great geology for resources. Most of these companies are experienced. They know how to raise money. They know how to explore. Plus, Canada has great infrastructure and is mining friendly.”
GJ: I don’t think so. Within the next couple of years, two or three other mines will likely come into production. One is the Kearney mine in Ontario, currently privately owned by Ontario Graphite, which I think will go public. It’s a past producer of graphite, and it should open in Q312 or Q412. It will produce about 20,000 tons per year (t/a), which is a decent size. Total world production in 2010 was about 925,000 metric tons graphite. The Lac Des Iles mine is in Québec and owned by Timcal, which is a division of Imerys (NK:PA), produces about 25,000 t.
Another upcoming mine is the Kringel mine, owned by Flinders Resources Ltd. (FDR:TSX.V) in Sweden. It was a past-producing mine and is currently under care and maintenance. It’s permitted with a mine and a mill just sitting there. The company should produce up to about 13,000 t/a graphite and hopes to be producing by 2014.
The Lac Knife deposit, which is owned by Focus Graphite Inc. (FMS:TSX.V), is in Québec. Construction there should begin in 2013, and it will probably produce about 25,000 t/a. It’s supposed to be one of the largest high-quality and high-grade deposits in the world. Focus raised $20 million ($20M) as of April 11 to continue exploration and development of Lac Knife and various facilities there. That’s impressive, given the current economic climate.
TCMR: It’s not all that far from the Lac Des Iles mine you referenced earlier. Will that be useful to the new project?
GJ: The closeness means there’s good infrastructure in place already, so a new project doesn’t necessitate a new railway or more roads.
TCMR: Another company that’s done a couple of financings in the last year and raised over $12M is Northern Graphite Corporation (NGC:TSX.V; NGPHF:OTCQX).
GJ: Northern owns the advanced-stage, flake-graphite Bissett Creek deposit in Ontario. It’s completed a preliminary economic assessment and started its bankable feasibility study and environmental and mine-permitting process. It hopes to fast-track it and begin construction late this year.
TCMR: Could you see an offtake partner coming into that equation?
GJ: Probably. That’s certainly something that’s happened with many companies in the REE sector, which is similar to the graphite space in a lot of ways.
TCMR: You have said that only four graphite companies, Focus Graphite, Northern Graphite, Archer Exploration Ltd. (AXE:ASX) and Flinders Resources, have raised more than $2M since January 2011. Did you think there would be more companies reaching that level?
GJ: Yes, I was surprised. I thought that there would have been a lot more companies in there, and I thought there would have been a lot more raised. At Intierra, we only track anything over $2M. That’s our bottom line.
TCMR: What are some commonalities among those companies that did raise over $2M?
GJ: They all had advanced projects. A lot of the juniors with early-stage projects are having trouble raising capital now.
TCMR: If you were investing in a graphite play, would you be more likely to invest in an advanced-stage play or in one of the early stages of exploration, where you can see those quick run-ups?
GJ: You have to know your investment appetite. Do you want less risk or more risk? With more risk come better gains. I invest in both.
TCMR: What are some of the early-stage plays that have some potential?
GJ: I like Energizer Resources Inc. (EGZ:TSX.V; ENZR:OTCBB). It has the Green Giant project in Madagascar. Its vanadium property is already at the prefeasibility stage, and the company has found 17 graphitic zones on the property. Investors get vanadium and graphite in one.
TCMR: That’s a sizeable resource in a country that has seen very little exploration. How much of an advantage is that?
GJ: There are advantages and disadvantages. Virgin territory is more open for discoveries. But because the country has not had significant exploration, companies could possibly run into permitting, infrastructure and labor issues.
TCMR: What other early-stage plays do you like?
GJ: Strike Graphite (SRK:TSX.V) has two interesting projects in Saskatchewan. The Deep Bay East project is a historic property with significant exploration in past years. It’s very close to the Deep Bay West graphite mine, which is also being ramped up. The Wagon graphite property is near the Lac Des Iles mine, and it’s had numerous amounts of historical exploration on it as well.
TCMR: It’s going to have an NI 43-101-compliant resource estimate by Q412. Will that be a catalyst for the share price?
GJ: Definitely. A lot of investing is about anticipation.
TCMR: Tell us about IntierraLive and how it could help investors in graphite.
“You have to know your investment appetite. Do you want less risk or more risk? With more risk come better gains. I invest in both.”
GJ: IntierraLive is the largest global mining database, but unfortunately we do not have a package for retail investors. However we are also famous for our maps. They show where a company is exploring, that region’s infrastructure, its mines and deposits, et cetera. We hope to have a graphite map out in a month or two. It’s going to be a Canadian graphite map, focused on Ontario and Québec. Investors will be able to pick one up at a conference or call the company they’re interested in to request one. A number of companies put portions of our maps on their websites.
TCMR: Do you have any thoughts you’d like to leave our readers with on the graphite space?
GJ: Do your research. Look at a company’s cash position. These days, that’s really important, and if a company doesn’t have cash, it’s really hard to raise it. Look at the company’s management. Have the members been involved in other commodity plays? Have they been around the business for a while? Does the company have the technical expertise to move their company’s projects forward? Sure, you could just put your money in a company and hope that the stock will double or triple, but if you’re a serious investor and you do not want to lose your money, then you do have to do the research.
TCMR: Thank you.
Glen Jones started his career in the mineral exploration industry over 35 years ago, mapping underground stopes and logging drill core. He founded Mineral Information Maps in 1980, and in 1992, he developed the “Hot Play” map concept and began publishing maps that showed rapidly developing area plays around the world. He merged his company with Intierra Resource Intelligence in 2003, which developed a web-based application for bringing together all levels of technical, financial and spatial data. Jones is the executive director for the Western Hemisphere at Intierra, where he oversees all aspects of the business for the Americas.
At 8:30 AM Eastern time, the monthly Personal Income and Outlays report for May will be released. The consensus for Personal Income is an increase of 0.3% over the previous month and the consensus Consumer Spending index change is 0.0%.
At 9:45 AM Eastern time, the Chicago PMI Index for June will be announced. The consensus index value is 53.1, which is 0.4 points higher than last month, and is still above the break-even level at 50.
At 9:55 AM Eastern time, Consumer Sentiment for the second half of June will be announced. The consensus is that the index will be at 74.1, which is the same as the value reported in the first half of the month.
So it really has been more than just decades since we would have even been considered for a ranking in something like this. Count in score at least. Area Development magazine (always a link there on the right btw) has us ranked near the top for Prime Workforce Growth. Seriously, I am not making it up.
Why you may ask. You may read the news today of the latest labor force news for the region and conclude the situation is quite dour. Yet it is now 66 months that the local unemployment rate has been below the nation’s, 68 months since Pittsburgh’s unemployment rate was actually above the nation’s.
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Josh Young, founder of Young Capital Management, sees big opportunities in out-of-favor oil and gas juniors. Many relatively unknown U.S. companies are trading at huge discounts, and Young’s picks have underappreciated growth potential. In this exclusive interview with The Energy Report, he discusses several companies that are smartly growing production and cash flow, even in a range-bound market.
The Energy Report: It’s been a tough market for energy stocks since your last interview. What is your take on the state of the market?
Josh Young: It’s been a tough few months for energy stocks. Over the last few years, there have been risk-on and risk-off cycles. Commodities and smaller energy stocks have done well when the world economy appeared to be recovering; last November through March was one of those periods. Beginning in April, the market turned down. Investors got more cautious, oil and natural gas prices came down, as did energy stocks.
This is an interesting time because it is not clear what will happen next. Unless there is a big, unforeseen global event, commodities and energy will continue to trade in the wide range that we’ve seen over the last few years.
TER: What companies can succeed in this environment? Gale Force Petroleum Inc. (GFP:CVE) is one that you’ve talked about in the past. How do you evaluate them?
JY: I’ve found that companies achieving the highest valuations are not just cheap based on cash flow and reserves. They are also rapidly growing. Growth can be organic or by acquisition, but there needs to be the potential to grow rapidly and economically. Any capital spending must lead to high growth. Highly valued, large companies such as Southwestern Energy Co. (SWN:NYSE) or Cabot Oil & Gas Corp. (COG:NYSE) are rewarded with a premium multiple in the market after having achieved years of economic, high production growth. I look for companies that are smaller and are in the process of economically growing production, but that aren’t necessarily showing the results just yet in their financials, and where people don’t yet believe there will be consistent growth. That transitional period when companies are growing and drilling with high rates of return is the sweet spot for an equity holder.
Unlike most oil and gas stocks, Gale Force is up for the year. It is well financed, growing rapidly and trading at a discount to the value of its cash flow and reserves. Gale Force recently announced production guidance in excess of 800 barrels per day (bbl/d) by the end of the year versus 275 bbl/d at the start of the year. It is possible that the company could get to 1 thousand barrels per day (Mbbl/d) by the end of the year. With a current enterprise value of around $20 million ($20M), it is undervalued relative to its peers and relative to the liquidation value of its assets. Gale Force is in the process of drilling to prove undeveloped locations and recompleting three producing wells. Production could exceed 600 bbl/d by the beginning of August. These projects have a very high rate of return—a triple-digit internal rate of return in many cases. It should create a lot of value over the next year or so through this capital program. Over time, the equity price will begin to reflect that. If Gale Force traded to a normal industry multiple of $100,000 (100K)/flowing barrel, with 1,000 bbl/d production by the end of the year, that could make for a $100M market cap versus the current $20M market cap. There is a lot of potential upside.
TER: Does this multiple apply to junior producers or is that more for mid-tiers and majors?
JY: That’s a great question. It’s not really still applicable for really small companies, but what Gale Force is doing will make it very applicable. Gale Force has been looking at royalty trusts that have been spun off by companies like SandRidge Energy (SD:NYSE), Chesapeake Energy Corp. (CHK:NYSE) and the management of BreitBurn Energy Partners L.P. (BBEP:NASDAQ). Once production exceeds 1,000 bbl/d, Gale Force will stabilize production with continuous drilling and workover programs. Those assets are being evaluated for spinning out to a royalty trust. The valuations on royalty trusts are well in excess of $100K/flowing barrel. Even now, after a few months of weakness in energy stocks, most of the royalty trusts are trading in excess of $250K/flowing barrel. There’s a capital expenditure requirement, but even netting the capex requirement, 1,000 bbl/d of stabilized production could be worth more than $200M. In general, a $100K/flowing barrel metric is more appropriate for a larger company, Gale Force does have a near-term monetization plan. I think the $100K is fair. As a potential royalty trust offering becomes more of a reality, the stock could price it in.
TER: Have other small companies successfully spun off or converted into a royalty trust?
JY: Absolutely. Recently, the management that runs BreitBurn Energy had a private company that was smaller and grew over the last few years. They spun it out as Pacific Coast Oil Trust (ROYT:NYSE). The initial valuation was about $300K/flowing barrel. Production was approximately 3,000 bbl/d. Gale Force produces less but is higher margin. I don’t think there’s necessarily a size requirement beyond the 1,000 bbl/d Gale Force will achieve. A spinoff needs to be a certain size for investors to want to participate and for liquidity, but I don’t think it should matter too much if it’s 1,000 or 50,000 bbl/d as long as the yield is similar and the cash flow per unit is similar.
TER: It’s good to go down a path that’s been traveled successfully.
JY: Gale Force has always been on the XTO path, which is a little different. Many juniors will lease a bunch of land, then try to raise money on the back of it. Next, they drill wells and try to raise money on the back of those well results. Gale Force has done it the other way around. First, they buy production at a low price. Next, they rework the wells to increase production. Lastly, they borrow money, hedge production to protect the debt and repeat. Gale Force also raises equity, but it has been on the back of production, not because of large land positions. Most of Gale Force’s production has a stable decline rate. That’s why the royalty trust model could work well, whereas for a lot of smaller companies, it’s not really an option.
TER: Is Gale Force mostly active in Texas?
JY: Most current production is in East Texas. Royalty trusts are best if geographically concentrated—it helps to have fields in just a few areas. Gale Force has a field in South Texas, but it is close to current production. It helps to have one center of operations. The company looks at additional acquisitions and drilling, but it’s all within that small area.
TER: When you look at other companies, is it important to you that they have established fields in drilling-friendly jurisdictions like Texas?
JY: Yes, it’s obviously helpful, but I care more about the field being highly economic than I do about location. I also care about political risk. In New York, you can’t drill horizontally and do hydraulic fracturing. Internationally, there are all sorts of political risks that I generally avoid, although occasionally I’ll participate for the right risk-reward ratio.
A position I recently added is AusTex Oil Ltd. (AOK:ASX). It is traded in Australia, which is unusual for a small energy stock with most of its assets in the Mississippian play of Oklahoma and Kansas. That could be why it trades at a discount to its asset value and to its peers. AusTex is next to Range Resources Corp. (RRC:NYSE) on the Nemaha Ridge. Range has drilled more than 100 vertical wells in the area. Many have had more than 100% rates of return. More recently, Range has drilled eight horizontal wells within two miles of AusTex’s position. AusTex was in one of those wells from which they expect a 30-day average rate of 1,000 bbl/d or more. With a well cost of less than $4M and production of 1,000 bbl/d, the well could pay out in a few months. AusTex is a minority working interest partner in that particular well, with approximately 14–15% interest. AusTex has 6,000 net acres adjacent to that well. The company has drilled a few vertical wells on the land with well costs around $600K and 30-day rates in excess of 100 bbl/d. Those are very high rates of return.
Another AusTex neighbor is Apache Corp. (APA:NYSE), which just had its analyst day. Apache has hundreds of thousands of acres in the Mississippian in Kansas, where it envelops AusTex’s position in Kansas. Apache is going to drill wells all around AusTex. It is possible that AusTex is in the center of a newly discovered oil field. It’s exciting, but too early to give it too much credit in my valuation.
TER: Your valuation on AusTex is based on production and cash flow plus a big growth component?
JY: Yes. There will be a lot of growth from the 6,000 acres next to Range. AusTex will be able to drill hundreds of vertical wells or dozens of horizontal wells that will each have net present values well in excess of the cost of the well. You can more than double your money every time you drill a well. The market cap right now is just above $30M. It’s a small company, but if it drills a few wells, it can ramp up production and cash flow significantly. It will be able to internally finance the drilling and get payback in approximately six months for each well.
TER: AusTex stock has been pretty hot this year—tripling up to a few weeks ago and then selling off. Is the word getting out or is this still somewhat under the radar?
JY: I think one or two investors in Australia figured it out. In February and March, people got excited. Prior to that it, it was stable in the $0.08–0.11 range for a long time.
The stock started to move after announcing excellent vertical well results. Range’s results were also great. Based on both companies’ results, investors were comforted that it was not a “one-off” well. Recently, the stock has declined with the sector as a whole. With additional drill results, the stock could rebound and head higher. Competitors like Red Fork Energy Ltd. (RFE:ASX) and a few other Mississippian-focused companies have higher per-acre, per-flowing barrel and cash-flow valuations. It has a lot of room to the upside. I have bought this dip.
TER: What other companies are you following?
JY: Gastar Exploration Ltd. (GST:NYSE) has positions in Texas and West Virginia. It is executing on its plan, growing rapidly and generating high rates of return on its wells. Its financing is lined up. Last year, it doubled proven reserves and it’s likely to do so again. The stock is down 50% since the beginning of the year, and it has far underperformed its peers. Exposure to natural gas and natural gas liquids didn’t help. Despite that, Gastar’s wells are highly economic on a new, mid-continent oil play. A partner has drilled a number of highly economic wells that cost $3–4M and came on at 30-day rates of 600–800 bbl/d. It also has a historic natural gas field that it hasn’t been active in but still holds the land by production. EOG Resources Inc. (EOG:NYSE) recently drilled an Eaglebine shale well nearby with reports of stabilized production of approximately 1,000 bbl/d. Encana Corp. (ECA:TSX; ECA:NYSE) drilled a well nearby with an initial high production that flattened out at around 200 or 250 bbl/d. The company recently announced several others at similar production rates and is now drilling a longer lateral well, which it expects to produce at substantially higher rates.
TER: But how do you value that?
JY: Gastar’s West Virginia land is probably worth more than the current enterprise value. In addition, it has 15–20K acres that are prospective for the Eagle Ford that EOG may have just delineated. Encana is also drilling around it. It also has the mid-continent oil play that looks like it’s going to be highly economic. Gastar is participating in the first one of its wells in a few weeks. I believe the stock is cheap. Apparently, so does the CEO, because he bought $100K of the stock a couple of weeks ago. He said he got some flack because he only bought $100K. He told me that almost all of his personal net worth is already in the stock. When you go from 90% of your net worth in the stock to 91% of your net worth in the stock, even if it’s a small dollar value, it’s a big deal because obviously it’s further concentrating your wealth. I think he was joking, but he said he was rummaging through his couch seats for change to go and buy a little bit more. Hearing that made me go through my couch seats to pick up a little more stock myself.
TER: It’s really been beaten up over the past year on the price chart.
JY: Yes, it’s gotten beaten up. It’s tough as a current holder. I’ve owned the stock for a while. But it’s also a great opportunity. I bought a little bit more recently. I may buy some more going forward. I see opportunity in stocks that are beaten down, executing well but are unloved for some reason. As they go back into favor, they have the opportunity to outperform.
TER: Does Gastar look like an acquisition target?
JY: Yes. The CEO has talked about getting inbound calls from private equity. I’m not sure that the whole company is for sale. However, the Marcellus asset is probably worth more than the whole company. Half could be sold for $100–200M to pay down debt and the balance re-deployed elsewhere. Such a scenario could double the stock.
TER: Are there other special situations that you are watching?
JY: I like companies that are cash rich. Neither Gastar, AusTex nor Gale Force have a lot of cash on hand. They have sufficient liquidity to execute their plans, but they don’t have a ton of excess cash.
I follow two companies that have more than 50% of their market cap in cash and no debt—Sonde Resources Corp. (SOQ:NYSE) and Molopo Energy Ltd. (MPO:ASX). Both happen to be selling international assets. Molopo is selling a natural gas field in Australia that could be used for liquefied natural gas transport. Sonde is selling a North African oil field. Both companies could have negative enterprise values if their sales happen at the management-guided prices. They’re special-situation investments, and they theoretically shouldn’t be very high beta. Oddly, they have traded in line with the market over the last few months. As their asset sales proceed, the stocks should diverge from trading with the market. Both should be able to create value through stock buybacks and maybe even distress acquisitions.
TER: Molopo has a large portfolio of different types of projects all over the world. Would it make sense to focus on its best prospects?
JY: Yes. It has a lot of valuable assets, but the company is hard to value because not all its projects are generating cash. Molopo needs to focus. Ironically, even if it gave away some assets, it could go up in value because it would be easier to understand. Its South African holdings are an example. It has hundreds of thousands of acres there that may have shale gas or other assets. How do you value that? My estimate is that it could be worth $10–20M or more in the future. For now, Molopo is not selling the South African holdings, but the asset has value. Molopo is selling an Australian asset, but it’s also hard to value. Hopefully, proceeds will be used to buy back stock because the market is having trouble valuing the company. Buybacks would help to resolve the issue.
TER: Are there any other interesting companies that you would like to mention?
JY: Yes. The last one is unusual for me in that its only asset is offshore West Africa and it has no production or cash flow. It has a very low valuation based on the oil that could be underneath its leases. It is in Namibia, and it is called Westbridge Energy Corp. (WEB:TSX.V). Southern Namibia has a known offshore field. Chariot Oil & Gas Ltd. (CHAR:LSX) recently drilled an exploratory well. That well was uneconomic, but it showed a petroleum system in the area. That well looks to be on the side of the same reservoir as Westbridge. There is a lot of activity in the area, with many wells located and permitted offshore by a number of different operators. It will only take one economic well to get numerous buyout bids for Westbridge. For now, Westbridge is starting at a low valuation and taking a more pragmatic approach, which starts with coming in early, paying little for acreage and building relationships. Westbridge has attractive back-ins with Namibia. As an investor, their low-cost approach mirrors my own. A large, inexpensively acquired land package with lots of exploration activity should result in value creation that someone will pay well in excess of current market valuation.
TER: That is a lot different from your other picks, but it fits a different portfolio need.
JY: It’s a flier—but it’s a cheap flier. I know management well and I like how they work. If Namibia heats up, Westbridge could sell a portion of current holdings for a substantial profit to fund ongoing exploration. That would ensure that early investors are rewarded. Management recognizes that West Africa is a high-risk prospect and they are acting to maximize gains for themselves and early investors.
TER: How would you sum up your advice for our readers?
JY: It looks likely that we’re going to get some quantitative easing and bailouts in the U.S. and Europe, particularly running up to the U.S. election in November. If so, energy stocks could run. Investors should consider the international dynamics for oil prices, especially with regard to Russia’s role. I want to be on the same side of the table as Russia in this regard. The current Russian regime has strong incentives to maintain a high oil price. Their finances need $110 Brent. There are many strong geopolitical incentives for Russia and oil exporters to maintain the high oil price. That’s part of why I feel comfortable maintaining exposure to oil, despite all of the geopolitical and economic turmoil. People with the power to maintain high oil prices are doing so. I expect a reasonably high price of oil over time, even if there is an economic downturn.
TER: Thank you for your time, it has been interesting.
Josh Young is the founder and portfolio manager of Young Capital Management LLC, which launched Young Capital Partners L.P. in 2010. He previously served as an analyst at a multibillion-dollar single-family office in Los Angeles. Prior to that, he was an investment analyst at Triton Pacific Capital Partners. He was also a corporate strategy consultant at Mercer Management Consulting and DiamondCluster. He holds a Bachelor of Arts in economics from the University of Chicago.
At 8:30 AM Eastern time, the U.S. government will release its weekly Jobless Claims report. The consensus is that there were 385,000 new jobless claims last week, which would would be 2,000 less than the previous week.
Also at 8:30 AM Eastern time, the final GDP report for the first quarter of 2012 will be announced. The consensus is an increase of 1.9% in real GDP and an increase of 1.7% in the GDP price index. The real GDP estimate is the same as the preliminary value for the first quarter of 2012, and the GDP price index is the same.
Also at 8:30 AM Eastern time, the monthly Corporate Profits report from the Bureau of Economic Analysis will be released.
At 9:45 AM Eastern time, the weekly Bloomberg Consumer Comfort Index will be released, providing an update on Americans’ views of the U.S. economy, their personal finances and the buying climate.
At 10:30 AM Eastern time, the weekly Energy Information Administration Natural Gas Report will be released, giving an update on natural gas inventories in the United States.
At 11:00 AM Eastern time, the Kansas City Fed Manufacturing Index for June will be released. The consensus is that the index will be at 4, which would be a decrease of 5 points from the previous month.
At 3:00 PM Eastern time, the Farm Prices report for June will be released, giving investors and economists an indication of the direction of food prices in the coming months.
At 4:30 PM Eastern time, the Federal Reserve will release its Money Supply report, showing the amount of liquidity available in the U.S. economy.
Also at 4:30 PM Eastern time, the Federal Reserve will release its Balance Sheet report, showing the amount of liquidity the Fed has injected into the economy by adding or removing reserves.
Sometimes more than others media coverage really befuddles me. I mentioned this a couple weeks ago, and now the Philly Inquirer has now looked into it a little. But the changes in public pension accounting just enacted are at least metaphysically a big deal… and if local actuaries don’t follow them, then that is a story as well.
Just look at the table in the Inky’s article there. You would think that just out of sheer curiosity someone would want to know what local pension funds’ status would be if similarly recalculated. And note the discussion of ’smoothing’ which happened in Pittsburgh the last actuarial reporting cycle for the first time and which was pretty much unmentioned anywhere.
Anyway… anyone want to guess what the best funded large public pension fund is in the region if not the state?
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Taking part in the Cambridge World Resource Investment Conference, geologist and minerals maven Brent Cook, who also serves as Exploration Insights president, CEO, publisher and author, said he found more investors there looking for reasons to sell than to buy. In this exclusive interview with The Gold Report, he suggests that those who postpone buying decisions for too long risk missing the boat on some real “gems.” Finding gems in the garbage takes serious due diligence; he advises investors to evaluate potential juniors the same way the majors do when they’re hunting for companies whose assets will help replenish their dwindling reserves.
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The Gold Report: The Market Vectors Junior Gold Miners ETF (GDXJ) hit a low on May 16, and some pundits and speakers at the Cambridge World Resource Investment Conference earlier this month said they felt we’d hit the bottom. You are dubious, though. In your June 10 Exploration Insights, you wrote:
China continues to slow, Korea and Japan even more so. India looks to be hitting a wall, and Europe is in a slow-motion disaster. The copper price is declining as are iron ore and base metals in the world that, overall, seems to be deleveraging, with consumption declining. More succinctly, as my Uncle Coyote puts it, “They’re all just swirling ’round the drain.”
Would you share more about your general impressions of investing in mining stocks in this market?
Brent Cook: I don’t typically guess bottoms or play with technical charts. I just look at what I’ve seen happen and make what is hopefully an educated guess as to what is coming. Over the past two years, in excess of $10 billion (B) has come into the junior resource sector via the Venture Exchange alone. During that time, we’ve seen more than 300 new companies listed and probably 3,000 financings. Despite the mad rush of money into the sector, not much of it has actually produced returns as measured by the GDXJ, the junior miner index.
“So what I see happening here as part of the global deleveraging is the people who jumped into the junior miners without looking are now jumping out without looking.”
So what I see happening here as part of the global deleveraging is the people who jumped into the junior miners without looking are now jumping out without looking. They jumped into companies that had resources without digging deep enough to see that they have other issues that complicate the value of those resources. In my opinion, they were willingly led astray by banking analysts touting questionable resource estimates and economic assessments. A lot of money has been lost in the process, and until that works its way out of the system, I think it gets uglier.
TGR: Investors who have been burned are skittish about getting back into the fire.
BC: Indeed. If I were told some company’s 8 million ounces (Moz) was going to be worth several billion dollars and then the stock falls by 75% when a prefeasibility study comes out showing it ain’t, I would have to conclude that I had no idea what this industry was about nor do I have any business ever investing again. That said, there are certainly a few experienced funds in the industry that are still interested in investing and probably relishing the current disaster. eRetail money, which doesn’t tend to be very selective, has been hit pretty hard, too, over the past year and a half. So I don’t see where the new speculative money comes from.
In fact, I see a lot more money exiting than entering as the volatility and chaos being played out in the real world of investing drives people to stuff their remaining cash under the bed where it’s safest. Over the rest of this year, I think we’ll see a lot more junior companies go out of business, hibernating or financing at prices highly dilutive to current shareholders. Junior companies with average or below average projects and management are in trouble and, keep this in mind, most projects are below average despite claims to the contrary.
TGR: In a lot of your presentations, you juxtapose the very dramatic visual of the Carlin Trend’s enormous gold pits with the idea that we are mining the equivalent of the entire Carlin Trend’s production to date every year. You do the same visual using the Bingham Canyon Mine’s massive open pit for copper. Considering what you just said about investing sentiment on the one hand and the need to find more ounces and pounds to meet demand on the other hand, there must be opportunities for the astute investor.
BC: That’s exactly right, and that’s the second part of my presentation. I lay out the bad news, that a large percentage of these companies will go out of business because they don’t have a chance in hell of finding anything of value and they can’t finance. On the flip side, major mining companies are producing 19 million tons/year copper and 83 Moz/year gold. In order for a mining company to stay in business, it obviously needs to replace what it mined with new reserves. Fortunately for us, it can’t do this internally and will need to buy whoever finds the reserves it needs. It’s very, very difficult for them to replace that much, and it’s getting even more difficult for a lot of reasons I go into detail about in my letter. For that reason, legitimate profitable deposits are going to command a serious premium, and people who own stocks in those early-stage exploration companies that pull it off will make a lot of money. But there’s no room at all for error because as suggested earlier, the dumb money has all gone to money heaven and I think it unlikely anyone will bail out mistakes in judgment.
TGR: So investors who want the cream of the crop in terms of mining assets need clarity as to what those assets are. You’ve talked about having to replace the equivalent production of a Carlin Trend every year to satisfy demand for gold. That’s a mind-boggling amount for anyone who knows how big the Carlin Trend is. Where are some of the areas the seniors expect to find so much gold to replenish their reserves?
BC: Their first choice is to find a deposit near where they have operations, be that in Nevada, Peru, Brazil—somewhere they’re comfortable. Quinton Hennigh, a geologist who works with me, went into a lot of detail on this in the June 10 Exploration Insights and again in an interview The Gold Report published June 18. Because he used to review potential acquisitions for Newmont Mining Corp. (NEM:NYSE), he knows the process. Number one, companies are obviously looking for deposits that are profitable. A major mining company that looks at a junior’s project doesn’t just use the third-party resource estimates and preliminary economic assessments (PEAs). The majors do the detail work themselves. You’d be surprised how much their evaluations of a property differ from a third party’s prepared for the seller.
TGR: Are you saying that most juniors’ PEAs are useless to seniors that are seriously doing due diligence on a junior company?
BC: No, certainly not most, but a lot are not to the level a mining company needs to make a major investment decision. I’ve seen too many studies that didn’t quite match reality in costs, and particularly in resource estimates. In my view, too much sloppy work has been going on in terms of resource estimates. We also typically lose a lot of ounces of gold and pounds of copper when converting a resource to an actual mineable reserve. My point is that majors do their own due diligence and their analyses often come up with far less of a resource and valuation than the PEA would suggest.
Think about all the companies that have announced massive resources out there, and then think about the fact that we’re hardly seeing any acquisitions. That tells us they’re looking at a lot more detail than the junior companies do and coming away unconvinced. It’s not that the seniors aren’t hunting. As I say, they have to replace 83 Moz/year of gold production. That’s not an easy task at any gold price.
TGR: Does the slow rate of mergers and acquisitions also indicate that the majors are nervous about deploying their cash? Or that they’re just being more diligent?
BC: I think the latter. They go through a lot of detail. They have to weigh in the risk as well. As I mentioned, they’re looking for something close to where they’re operating, in a stable environment, something that doesn’t have a huge capital expenditure with a low margin—that’s one of the big issues right now. Then political jurisdiction, social issues and the increasing government take all enter into the decision.
TGR: Quinton outlined that—location, location, location—very clearly in Exploration Insights. He also talked about metallurgy and the importance of having accurate testing and assessment of what projects really will produce, and whether there’s potential for higher production as time goes by. In terms of minimizing risk, he pointed out, too, that majors look at the state of the junior’s infrastructure. Has it put in roads and power lines? Has it developed relationships with the locals that are positive and encouraging?
BC: They need people, too. There is a real shortage of qualified people in the mining industry. So when they look at a project or a company to acquire, they look to see if they can get some good people with it. A friend of mine running a midsized Australian gold company recently told me of losing six months of production when two key underground miners were poached to work at the iron ore mines. So people are a key consideration to mining companies these days.
TGR: With that whole mix of criteria as a backdrop in choosing companies, could we talk a little bit about some specific names?
BC: I just completed a field trip to Gold Standard Ventures Corp.’s (GSV:TSX.V; GDVXF:OTCQX) project on the south end of the Carlin Trend. Its recent drilling suggests that it may be on to a significant deposit, a new one. That’s certainly worth keeping an eye on, and as we all know, the Carlin Trend is one of the world’s richest gold belts.
TGR: With a market cap of $200 million, Gold Standard just started trading on the New York Stock Exchange on June 12. Is this stock overvalued at this point based on drilling results and such?
BC: It’s way overvalued. This is pure speculation, but I’ll tell you, we bought it in Exploration Insights when the first big drill hole was announced and I still own it and I’m not selling it because the risk-reward is massive. A major high-grade discovery on the Carlin Trend could be worth billions of dollars. I think Fronteer Gold Inc. (FRG:TSX; FRG:NYSE.A) sold its Carlin style Long Canyon gold deposit to Newmont for $2.3B.
TGR: And obviously, you don’t feel Newmont overpaid for Long Canyon.
BC: No, I don’t think so. If Gold Standard can find a significant deposit on the Carlin Trend, it would be worth a lot. Bear in mind, Goldcorp Inc. (G:TSX; GG:NYSE), Barrick Gold Corp. (ABX:TSX; ABX:NYSE) and Newmont are all active in the district—that’s where the guts of Barrick’s and Newmont’s operations are. Their roasters and autoclaves scattered around the state are desperate for ore, so capital and infrastructure costs there are considerably less than if you found a similar Carlin-style deposit in the middle of nowhere. Miners are right there, roads are there, it’s maybe an hour’s drive from gas stations, brothels and a cold beer. What more could you want in a gold discovery?
TGR: What about other companies in Nevada?
BC: Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX) is interesting. We own that one as well, and bought it as soon as I saw that it had staked claims over what used to be part of Coeur d’Alene Mines Corp.’s (CDM:TSX; CDE:NYSE) Rochester silver deposit in Nevada. This is basically a play on Coeur having to buy its claims back. That comes down to the General Mining Act of 1872. If the law holds true, Rye Patch owns those claims and Coeur, to continue its mining operations into the future, needs those claims. So there’s a deal there somewhere, and I think that deal is going to be struck at above the current share price.
TGR: It will be interesting to see how that gets resolved. Any others you want to talk about?
BC: In central Idaho’s old Yellow Pine District, up in the mountains east of McCall, Midas Gold Corp. (MAX:TSX) consolidated the district and has been very successful in proving up gold, silver and antimony resources. It has a resource in excess of 6 Moz in all categories in three main deposits, grading almost 2 grams/ton, open pittable. The antimony and silver scattered through it provides an extra byproduct. Permitting is likely to be a long endeavor, but probably doable, because of this area’s long history in large-scale mining operations. Midas is doing some intelligent things, environmentally speaking.
This area is in the headwaters of one of the forks in the Salmon River. Salmon spawn in the river below, but can no longer get up the river because the old pit stopped them. So Midas plans to reroute the river so the salmon can continue up above the mine. Also, because the metallurgy is more complex, Midas probably will produce concentrate and may truck it to the Snake River Plain for processing. As a result, no cyanide will be used onsite.
TGR: Have you stomped around on this property yet?
BC: Not since Midas came in. I looked at it probably about 10 years ago as a consultant and in fact in my teens I used to run around Yellow Pine fishing and causing trouble. Another positive is that Midas is now led by Stephen Quin, who’s been very successful growing and selling companies in the past including Miramar Mining Corp., which was sold to Newmont, and Sherwood Copper Corp., which was combined with Capstone Mining.
TGR: What’s Midas’ next big step?
BC: It is currently drilling now and working on its prefeasibility study. That’s probably the next big thing.
TGR: Mexico is a fantastic mining address despite what some consider jurisdictional risk. But again, we’re seeing more and more discoveries there, surprising some but probably not you.
BC: Mexico is a fantastic place to explore, although it has become more dangerous, particularly in the Sierra Madre. But it’s still a great place to look, and there are areas that I have no problem going to. Almaden Minerals Ltd. (AMM:TSX; AAU:NYSE) is on the top of my list in Mexico. I like big, big geothermal or hydrothermal systems because they produce big deposits and big companies like big deposits and pay big bucks for them. Almaden’s Ixtaca property in Puebla is a very large system. So far, the company has defined one zone that’s looking pretty good. Almaden hasn’t produced a resource estimate, but it certainly has good grade and, more importantly to me, the property has the potential of producing a very large precious metal deposit.
“Mexico is a fantastic place to explore.”
In my view, Ixtaca is just a piece of what eventually will be found there. It’s complicated. It’s covered, so you’re drilling blind, but that’s a really interesting system run by a competent group of people. And with $25M in the bank, Almaden isn’t going to be diluting us right away.
TGR: What about other companies in Mexico?
BC: Riverside Resources Inc. (RRI:TSX) has a number of joint ventures with different groups on projects scattered in reasonably safe areas throughout Mexico. Riverside is one of the prospect generators that turns up ideas and brings somebody else in to spend the high-risk dollars. If you consider studies by various groups showing that maybe one out of a thousand prospects actually turns into an economic deposit of some sort, it makes good sense to generate targets and then vend out the high-risk, high-cost part to somebody else. That way, as shareholders we maintain our piece of the business as opposed to losing it when the project gets drilled and probably fails.
TGR: Almaden is also among your project generators, and isn’t MAG Silver Corp. (MAG:TSX; MVG:NYSE) like that in some ways?
BC: MAG Silver is different. MAG is drilling in tandem with Fresnillo Plc (FRES:LSE) on the Juanicipio project, and just put out a solid PEA on that. It is also drilling its Cinco de Mayo project and ventured into one other project that it has been drilling as well. So, no, MAG Silver spends its own money. It is also earning in on its deal with Canasil Resources Inc. (CLZ:TSX.V) and has put out some decent results, although I haven’t watched it closely. To me, it’s all about the Juanicipio silver deposit and how and who develops it.
TGR: Let’s get back to your prospect generators.
BC: In addition to Riverside and Almaden, we have Lara Exploration Ltd. (LRA:TSX.V), Virginia Mines Inc. (VGQ:TSX) and Altius Minerals Corp. (ALS:TSX.V). A few weeks back, I reviewed the whole portfolio, and among those five companies we’re involved in 88 potential discoveries, 88 projects being drilled and worked by somebody else. A free ride on 88 chances of a discovery at minimal financial risk to us—that’s pretty good odds.
TGR: Especially when you think about the brain trust that’s behind those companies.
BC: That is an important aspect, for sure.
TGR: What other companies should we talk about?
BC: Lydian International Ltd. (LYD:TSX) has an oxidized gold deposit in Armenia. We’ve owned this one since I visited a few years ago. It is now in the final stages of putting out a feasibility study that I think will show it’s worth quite a bit. Lydian has advantages in that the cost of recovering oxidized gold is fairly low and with the deposit on a hill, the cost of mining also is fairly low. This will be the type of low-cost operation I think a midtier company would be interested in taking over.
TGR: Is the Armenian government supportive and a good partner?
BC: Yes. The government has been very, very supportive and keen to bring in foreign development leading to jobs and taxes. I’ve been there, been through the country and met government officials. Armenia is a great country to explore in—desperate for development that will bring in some tax revenue. The government has been as helpful as you can imagine in expediting all the permits Lydian has needed. In fact, its contract with the government requires Lydian to advance the project at a certain pace.
TGR: Lydian apparently is doing a lot of things socially in the community, which seems quite unusual for a junior company.
BC: Precisely. That’s one of the points Quinton made as well. When a major looks at a junior, if the company has the groundwork in place, the environmental studies out of the way, the social issues settled and the people on board who build schools, put up hospitals, support soccer teams, those sorts of things—if the dirty work, as Quinton calls it, has been taken care of ahead of time, it’s much easier for a major to acquire that company.
TGR: Let’s talk a little about other countries you like. You’ve been to Colombia many times. We saw a swelling in investor interest in Colombia in 2010 and 2011, but not much progress in juniors advancing their projects there this year. What’s behind that slowdown?
BC: Geologic reality rarely matches the hype. Colombia is a well-endowed gold province. That’s both good and bad. It’s good in that there certainly are some major deposits. Ventana Gold Corp. (VEN:TSX) was taken over. Continental Gold Ltd. (CNL:TSX; CGOOF:OTCQX) has made a great discovery and AngloGold Ashanti Ltd. (AU:NYSE; ANG:JSE; AGG:ASX; AGD:LSE) has made a few. On the other hand, there’s so much gold in Colombia that everybody and their dog rushed in, staked a claim with a gold vein on it and raised money. But 99% of those gold veins will amount to nothing of any significance. That’s the reality. People went there, took some samples, had some good grades and promoted it as if it were the next Ventana, when in fact that’s not the case. Most of what will be found down in Colombia will be small veins or low-grade, small porphyries.
TGR: And the garimpeiros are doing their best to drag out a few ounces from those small veins and porphyries. A lot of artisanal mining persists in Colombia.
BC: Exactly. Not geologically but in terms of gold distribution, it’s not that different from the Yukon. We saw the same thing in the Yukon, with 200 companies going there and staking claims, each with a soil anomaly and a vein of some sort on it. But concentrating that geologically into something that makes a lot of money is a very rare situation. So we’re seeing the reality in both the Yukon and Colombia that most of the gold will be of no economic significance. Gold doesn’t sell for about $1,600 an ounce because it’s easy to find.
That said, Continental Gold and AngloGold Ashanti are working there, and I’m certainly keeping an eye on Miranda Gold Corp. (MAD:TSX.V), which follows the joint venture model. The president of Miranda, Ken Cunningham, has a project ventured out to Red Eagle Mining Corp. (RD:TSX.V), has staked quite a few claims and it is in discussion with other groups to come in and work its projects.
Red Eagle also has a big drill program going on its own property in San Ramón, a potentially interesting project that I’m also watching. It has just completed two drill holes into the San Ramon vein. They are encouraging, but it’s drilling along the whole strike length, so until we see a long section that provides an idea of what continuity looks like, we’ll just keep watching.
TGR: Do you have any parting thoughts you’d like to add about investing in the market now, beyond the obvious need to be very, very careful in choosing the companies we invest in?
BC: I think we’re approaching an excellent time to be investing in this sector. It’s down. People hate it. But there are some real gems out there. By identifying those companies or projects that really offer the potential to turn into a major discovery, something that a mining company will want to buy and put into production, I think a lot of money will be made on investments people make over the next six months. But as I pointed out, you must be very selective because no one’s left to bail you out and you have no room for error. Due diligence is key. Talk to the people. Read the reports. Get outside advice from someone who knows what they are talking about. It’s really important. After all, it’s your money, do everything you can to improve the odds of success.
TGR: Thank you, Brent.
[Fresh from the Cambridge World Resource Investment Conference in Vancouver—where Brent Cook gave a "Turning Rocks into Money" presentation that provided tips and tricks for navigating today's turbulent stock market, served on an exploration panel with Eric Coffin, Thom Calandra and Jay Taylor, and conducted a workshop to answer investor questions about junior mining companies—Cook suggests that Cambridge Conferences give investors access to resources that can help immensely in doing their homework. In Exploration Insights, he points out that these conferences "are free to the public and always a good place to get a 'feel' for market sentiment as well as to visit many companies in a short period of time."—Editor]
Brent Cook, a world-renowned exploration analyst and geologist, is the author of the weekly Exploration Insights, a mining and exploration newsletter that selectively covers junior mining and exploration investment opportunities. Cook has 30-plus years of experience providing economic and geologic evaluations to major mining companies, resource funds and investors. He has worked in more than 50 countries on virtually every mineral deposit type, being involved in projects from the conceptual stage through detailed technical and financial modeling related to mine development and production. He served Global Resource Investments through 2003, providing analysis to retail brokers and in-house funds.
The Mortgage Bankers’ Association purchase index will be released at 7:00 AM Eastern time, providing an update on the quantity of new mortgages and refinancings closed in the last week.
At 8:30 AM Eastern time, the Durable Goods Orders report for May will be released. The consensus is that there was an increase of 0.4% from the previous month.
At 10:00 AM Eastern time, the pending home sales index for May will be announced. The consensus is that the index increased 1.2% last month.
At 10:30 AM Eastern time, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.
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All of us are aware of India’s inflation crisis. It is very disappointing, how we lost our grip on stable 4-to-5 per cent inflation which was prevailing earlier. From February 2006 onwards, in every single month, the y-o-y CPI-IW inflation has exceeded the upper bound of 5 per cent.
All of us agree that there is something insiduous when 10% inflation effectively steals 10% of the value of my wallet or fixed income investments. In India, however, we often hear the argument “Yes, this is bad, but if high inflation is the way to get to high GDP growth, let’s get on with it”. It is, then, important to ask: Why is low inflation valuable?
Nominal contracting is very important
Complex organisation of economic life involves myriad written and unwritten contracts involving households and firms. The vast majority of these contracts are written in nominal terms, i.e. in rupee values that are not adjusted for inflation.
Every society needs to adjust all the time, in response to changes in tastes and technology. When tastes or technology change, the structure of production needs to change, which involves renegotiation of (written or unwritten) contracts. These adjustments are costly. Contracting is costly, and renegotiating contracts is costly.
It is useful to think of a finite supply of adjustment as being available in the country. We should devote that full power of adjustment to the beneficial adjustments associated with changes in tastes and technology. In a place like India, where GDP doubles every decade, the requirement for adjustment is (in any case) large.
Inflation is an acid that corrodes all nominal contracts. Two people may have agreed on a contract two years ago at Rs.100, but that contract is thrown out of whack because of 10% inflation per annum. That contract has to be renegotiated. Bigger values of inflation corrode personal relationships also, given that there are many financial ties within friends and family.
Contracting is costly. Almost everything that senior managers do is to arrive at complex deals that create and sustain complex structures of production. This work is continually torn down by high inflation which makes the deals of last year break down today. Managers are able to build sophisticated edifices of contractual arrangements under low and stable inflation. These webs of contracting are harder to build and hold up when the acid rain of inflation is continually tearing these down.
Inflation messes up information processing
To continue on the theme of adjustment, the essence of a market economy is adjustments to relative prices, reflecting changes in tastes and technology. Firms learn about the viability of alternative investments by watching relative prices change. Inflation messes up this information processing. It increases the `background noise’ by making a large number of prices change at once. This makes it harder to discern which price change is fundamentally driven, and merits a response in terms of increased or decreased production.
Building a sophisticated market economy is all about making long-term plans. When a firm decides to build an airport or a highway, this involves making NPVs over the next 20-40 years. This requires having a fair idea about future inflation. If inflation will fluctuate in the future, then firms will err on the side of caution when making plans about the future, i.e. investment will be reduced. I will stress that long-term investment, in projects such as infrastructure or heavy industry, relies critically not just on a long-term bond market (which, in turn, critically requires low and stable inflation) but also on the calculations happening in a spreadsheet about the NPV of the investment project, which involves projecting all revenues and all expenses for the next 20-40 years (which also critically requires low and stable inflation).
Impact upon pre-existing nominal savings
For a person at age 60 who expects to live to age 85 or 95, fixed income investments are absolutely crucial in the financial planning of these 25-35 years. These calculations can be destroyed by a short bout of inflation.
A civilised society is one in which people can make plans for the deep future, and trust in financial instruments. It is simply cruel on the elderly to inflate away their nominal assets. The possibility of even one bout of high inflation over the coming 25-35 years forces people to drop back to other mechanisms of protecting themselves in old age. What is needed is not just inflation control right now. What is needed is the environment of mature market economies, where outbursts of inflation are fully ruled out for decades to come.
Impact upon relationship with banks
In India, banks pay very low interest rates. While many interest rates have been deregulated, the interest rates paid by banks are held back by factors such as low competition and financial repression (i.e. forced purchases of government bonds).
When households expect inflation will be 12%, they will see a 4% interest rate paid by the bank as yielding -8%. This has many consequences. On one hand, households and firms expend excessive (wasteful) effort on minimising their holdings of low-yield cash. In addition, households tend to shift away from fixed income contracting with the formal financial system. Both these distortions are caused by inflation, and exacerbated by flaws in the financial system.
If the financial system were regulated sensibly, then with high inflation we would immediately get higher nominal interest rates since buyers of 90 day treasury bills would demand higher interest rates to pay for inflation. This would reduce the damage caused by high inflation. In India, we suffer from bigger negative effects because of a faulty financial system.
These may seem to be small things but they actually are fairly large effects. Towards an understanding of the costs of inflation — II, by Stan Fischer, 1981, argues that perfectly anticipated 10% inflation induces a cost of 0.3% of GDP on account of only one factor : excessive efforts by households and firms to hold less cash.
The rising prominence of gold
Gold is a barbarous relic; it is the investment strategy of choice for uneducated people. It is also a vote of no confidence in fiat money. Our failures in creating a capable central bank, which delivers sound fiat money, are taking Indian households back to their old ways. Many decades of progress in getting households to engage with the modern financial system is being undone in this inflation crisis.
A classic quotation
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become `profiteers’, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.
From Chapter 6 of The Economic Consequences of the Peace, by John Maynard Keynes. Source: Who said “Debauch the Currency”: Keynes or Lenin? by Michael V. White and Kurt Schuler, Journal of Economic Perspectives, Spring 2009.
But is there not a tradeoff between growth and inflation?
For a brief period, the empirical evidence in the US suggested that there was a tradeoff between inflation and unemployment. Here’s the classic picture, for the 1960s in the US:
which shows a nice relationship where higher inflation has gone with lower unemployment. This evidence has led many people, particularly those concerned with the plight of the unemployed, to advocate higher inflation.
A look at the same evidence for the US, over a longer time period, shows no such tradeoff:
The idea that there is a tradeoff between inflation and unemployment is thus an artifact found in the minds of people who studied economics in the 1970s. This proposition was pretty much dead by the late 1970s. One by one, as central banks moved to inflation targeting, aiming and delivering 2% inflation, unemployment went down, not up. Hawkish central banks are the central story about how the stagflation of the 1970s was broken.
In the empirical literature, it is quite clear that by the time we get to double digit inflation, this has a discernable and negative impact on growth. This generally means that at a 95 per cent level of significance, you can reject the null of no effect, in conventional datasets. The conceptual reasoning above gives no reason for believing that there should be a threshold effect, that inflation above 10% should hurt growth but below 10% things should be fine. It could well be the case that when you get to smaller values for inflation (e.g. 9%) this effect size is not detected with conventional datasets at the 95 per cent level of significance.
It is interesting to look at the target inflation rate set in the numerous countries which have setup either de facto or de jure inflation targeting. The median value chosen has been: 2%. If people were convinced that inflation below 10% is not damaging to growth, inflation targets may have been higher. But instead, the typical inflation target in the world is 2%. This underlines the universal consensus in favour of targeting low inflation — more like 2% and far below the 10% that we’ve got stuck with in India.
In the West, some people with a weak grip of economics, and strong sympathy for the unemployed, have argued that high inflation is a good thing because it helps reduce unemployment. In contrast, in India, economists have consistently found that the poor are adversely affected by inflation. There has not been a left-of-centre lobby that is soft on inflation, here.
There is no tradeoff between inflation and growth.
High inflation damages growth.
One element of India’s growth crisis is India’s inflation crisis.
It is important to think carefully about the accountability of the central bank. RBI is not in charge of India’s welfare. RBI is in charge of India’s fiat money. The one thing that RBI should be held accountable for is delivering low and stable inflation, i.e. for holding CPI-IW inflation within the 4 to 5 per cent range.
Low and stable inflation is an essential ingredient of the foundations of high economic growth in India. RBI can lay that platform. They can do no more. If they try to reach into other objectives, they damage this core.