The Gold Report: Rick, is this a good time to be buying gold?

Rick Mills: There are three key reasons to have exposure to gold bullion. The traditional reason is to protect against inflation. We’re printing money. More quantitative easing has taken place and inflation looks to be coming down the pike. I buy groceries. I pay for gas. I can see inflation. I firmly believe it’s going to get higher over the coming months and years. Buying gold as a protection against inflation is realistic.

The second reason investors have traditionally bought gold is as a safe-haven investment. There’s a lot going on in the world—from secession talk in the U.S. to turmoil in Israel, Iran, Syria, the South China Sea region and Turkey.

One of the things that most investors don’t know about gold is that adding a gold allocation to your portfolio, especially over the last decade or so, has provided substantial enhancements to the portfolio’s return.

Gold helps minimize the downside deviations in an overall portfolio. In 2002, the S&P 500 was down 23%. Emerging market equities were down 6%. International equities were down 16%. Yet gold was up 25%.

TGR: That was early in the bull run in gold.

RM: Even in 2008, the S&P 500 was down 37%, international equities were down 43% and emerging market equities were down 53%. However, gold was up 8%.

TGR: It felt like the end of the world in 2008. Gold has saved the portfolios of a lot of investors who were smart enough to start collecting it in 2001 and onward. However, there are investors who don’t believe that gold has the multiples now.

RM: It’s true. I believe gold producers have shot themselves in the foot because of their reporting methods. They use cash cost for reporting. In 2001 and 2002, miners were producing gold for below $180/ounce (oz). By 2005, cash costs had risen 45% to $250/oz. Data from research consultancy Thompson Reuters GFMS shows that world gold production costs for the first half of 2009 averaged $457/oz. In 2011, they were $657/oz. GFMS’ Gold Survey 2012 says it’s now $727/oz.

“Buying gold as a protection against inflation is realistic.”

But if investors have been looking at that, they’ve been misled because that’s not really the cost of producing gold. These average cash-cost figures include only the costs directly associated with the production of gold, such as wages, energy and raw materials. The problem is that gold cash costs are not the only costs associated with mines. Investment bank CIBC just produced a complete breakdown of costs. Yes, operating costs are $700/oz, but there is also sustaining capital, construction capital, discovery costs and overhead. CIBC pegs those at an average of $600/oz. Add in $200/oz for taxes on average, and you’re looking at $1,500 to produce an ounce of gold.

TGR: In that environment, many of the gold mining producers would be out of business.

RM: The gold price is $1,700/oz. Companies are not making a lot of money here. The funny thing is that the sustainable costs for gold—the sustainable number gold miners need—according to CIBC, is $1,700/oz. You can see why investors are leery to jump into the space with numbers so tight.

TGR: But you’re a gold bull. You believe that people should be investing in bullion. The bullion has to come from somewhere. What’s an investor to do when he believes in the fundamental reasons for owning gold, but doesn’t understand how the equities can perform?

RM: Historically, the precious metals equities have given investors the most leverage to a rise in gold and silver prices. We need to have a rise in gold and silver price. We need to get into that environment again, like it was from 2001 to 2006 when gold equities went up 900%.

Let’s look at why companies aren’t making a profit. One of the biggest reasons is capital expenditures (capex), which is the basic cost of building a mine and its supporting infrastructure. There are lower grades being mined—down 23% over the last five years and expected to drop another 4% this year—and more complex metallurgy. Companies are increasingly going into more remote areas that lack infrastructure. Environmental regulations are increasing. We are seeing more money-grabbing governments and resource nationalization. There’s a serious shortage of skilled personnel and labor unrest is pretty much everywhere: strikes, protests and unions demanding higher wages. Everything you can imagine is working in a perfect storm to increase costs and risks on mining companies.

Costs are going through the roof, yet gold is stuck in a holding pattern at $1,700/oz. Then, when people want exposure to the sector, they buy an exchange-traded fund (ETF). In the past, a lot of that money would have gone into mining equities.

“Gold helps minimize the downside deviations in an overall portfolio.”

There’s a huge increase in exploration spending—more than $8 billion ($8B) in 2011—but a serious lack of new discovery. There have been very few large, high-grade deposits discovered during the past few years. Barrick Gold Corp. (ABX:TSX; ABX:NYSE) said at the Precious Metals Conference 2012 that of the “super giant” discoveries, those that are more than 20 million ounces (Moz), 18 were discovered in the 1900s. Fast-forward to the 1980s when 14 were discovered. In the 1990s, 11 were discovered. In the 2000s, only five were uncovered.

The number of annual gold discoveries of more than 5 Moz since 2007 is six in 2007, one in 2008, one in 2009, three in 2010 and one in 2011. None is producing yet. A lot of people who think that they’re going to produce are in for a disappointment because of resource nationalism, permitting problems, environmental problems, lack of water, labor unrest and protests.

TGR: Assuming gold demand will continue to escalate due to macroeconomic pressures, will the price of gold continue to increase?

RM: Gold demand is still rising. Five-year average quarterly demand is rising, so that’s correct.

TGR: What do you forecast for the 2013 gold price?

RM: That’s a mug’s game, trying to predict gold prices, but it’ll be higher.

TGR: You believe the price of gold can only go up.

RM: That’s right. Inflation, world events, diversification—gold does offer leverage. So do equities, or at least they will again. I’m not looking at huge mines with billions and billions of dollars in capex. I’m much more comfortable with the smaller mines with lower capex and under-control operating expenditures. I like the lowest-cost producers. That’s where the money is going to be made over the next two years.

TGR: Canada, the U.S. and some places in Latin America are the preferred jurisdictions for risk reduction, infrastructure, rule of law and reliability of government.

RM: Absolutely. Look at the Muslim Brotherhood in Egypt canceling a nearly 20-year-old license for a mining company. In Madagascar, a DJ gets elected president and the first thing he wants to do is cancel permits and do a review. That’s not happening in Canada, the U.S. or politically stable places like Greenland. There is enough risk in this business as it is without intentionally inviting more.

TGR: Given that backdrop, what are some companies you find interesting right now?

RM: Let’s stick with soon-to-be producers or companies that are going to be very low-cost producers. They’re all in geopolitically acceptable countries with superior management teams.

According to a July 2012 research report by Natural Resource Holdings, there are only 164 undeveloped gold deposits globally, with more than 1 Moz of gold in all categories, that are owned by non-major mining companies. The average grade of all these deposits is 0.66 grams per ton (g/t). Since we’re mining +80 Moz a year, that makes these non-major-owned deposits quite valuable.

The total current gold resource on Altair Gold Inc.’s (AVX:TSX.V) Kena property sits at 1.06 Moz. In the Kena Gold Zone, Measured and Indicated (M&I) resources are 300,000 oz (300 Koz) at 0.64 g/t Au, and Inferred are 85 Koz at 0.70 g/t Au. In the Gold Mountain Zone, M&I resources are 249 Koz at 0.71 g/t Au, and Inferred are 428 Koz at 0.60 g/t Au.

“Everything you can imagine is working in a perfect storm to increase costs and risks on mining companies.”

I like Altair Gold because the company has an amazing technical team and they are putting some serious money into their project. Altair put $1.75 million ($175M) into the Kena property in British Columbia this year. The company drilled 7,400 meters (m) and got some results back, but is going to put a comprehensive plan together based on the complete results. That will be exciting. Altair has proven it can raise money. It can run a technical drill program. It can get the word out to investors. With the right results, this management team can take this project all the way to being one of those low-cost producers. Altair could have something spectacular.

TGR: Bob Archer, who has had great success with Great Panther Silver Ltd. (GPR:TSX; GPL:NYSE.MKT), is behind this company, as well as Fayyaz Alimohamed.

Do you foresee a problem with Altair getting permitting due to the rise of the green movement and First Nations issues?

RM: Most of the companies in British Columbia that have had problems with the First Nations created their own problems by not getting the First Nations involved in the projects early. They show disrespect to the traditional ways. A company that engages the First Nations, is willing to work with them and is willing to provide jobs and help them, isn’t likely to be road-blocked by them. The First Nations are not against resource development. They want jobs. Engage them early in a project and you won’t have a problem.

As for the greens, Altair is a historic mining district. There is not really much you can say when you’re in an area of past-producing mines.

TGR: It sounds as if it won’t be an issue.

RM: The next one we’ll talk about is NioGold Mining Corp. (NOX:TSX.V; NOXGF:OTCPK). I like this project, which is a joint venture with Aurizon Mines Ltd. (ARZ:TSX; AZK:NYSE.MKT). There has been some uncertainty surrounding it. Aurizon was supposed to have made a decision to invest in the third phase, but it is going to wait and see the next NI 43-101.

The first NI 43-101 didn’t have phase two results and was very conservative. The phase one report has delineated 2.1 Moz, most of that in the Marban deposit. The goal of the phase one drilling on the Marban deposit was to bring as many surface ounces as possible into a pit shell. The stripping ratio looks pretty high, but the grade is good and that should compensate for the high strip. Now, NioGold is going to look at the open pit, the high grade and strip ratio.

TGR: When does NioGold expect to publish the updated NI 43-101, and how good was the grade in the first NI 43-101?

RM: Next March. Phase two included $5M of drilling, and that is being added to the NI 43-101 report now. The NI 43-101 shows 1.58 g/t and that compares with 1.07 g/t across the road at Osisko Mining Corp.’s Canadian Malartic mine. And the 43-101 report was quite conservative, using a punitive grade capping that discounts the contained metal by as much as 30%. The phase two report will be more detailed, using tighter intervals and high- and low-grade envelopes to more accurately detail the deposit, and this should capture more of the ounces.

TGR: So if the phase 2 report shows improved ounces and grade, what happens next?

RM: This is the best part of the story. Aurizon has already spent $11M and at this stage the company has not earned anything. If it doesn’t continue with phase three, the entire deposit reverts to NioGold and it will have 100% ownership of a 2.1 Moz deposit. Assuming Aurizon continues with the earn-in, then another $9M is spent over 9–12 months. Then a final 43-101 is delivered to Aurizon and it has to make a resource payment to NioGold for half of the gold in the deposit at a rate of $40/oz for Measured and Indicated, and $30/oz for Inferred. This payment is already estimated at $39M, just including the gold outlined with phase one. The payment could easily grow to $50–60M by the end of the program. And that is only for half of the deposit. NioGold gets to keep the other half. Aurizon would then be the operator and it can go to 60% by delivering a feasibility report, and up to 65% by arranging project financing. But that last 5% is at NioGold’s option.

Don’t forget that this deal with Aurizon is for only part of NioGold’s property—about 8% of its land package. The company has several other gold discoveries and showings to follow up on its own.

The stock is trading in the low $0.30s, and with just a little over 100M shares that’s a cap of about $32M. The payment from Aurizon is already going to be bigger than the entire market cap right now.

TGR: What is your third pick?

RM: Terraco Gold Corp. (TEN:TSX.V) has several irons in the fire. Nutmeg Mountain, the Almaden project, is putting out an updated NI 43-101. It has 887 holes that were inherited. They were rotary air blast (RAB) drilling and reverse circulation (RC), but those types of drilling wouldn’t give you the best representation. The company has done 52 core holes and four 4-inch metallurgical holes that it is going to include in the new NI 43-101.

Institutional interest in large-scale gold and copper discoveries has dropped off mainly because every time it puts some money into them, its interest just gets totally destroyed. It gets delay after delay. It gets cost increase after cost increase. These smaller ones, which have low costs to put into production along with low-cost producers, are going to be the way that we’re looking at things as retail investors.

“I like the lowest-cost producers. That’s where the money is going to be made over the next two years.”

Almaden seems to be a perfect example of a low-cost deposit. We’re looking at a new NI 43-101 with better recovery in the cores, and the holes support that. The diamond-drill holes were 20–40% better grade than the RAB and the RC. We’re waiting on metallurgical results that should be out shortly. The biggest knock on this deposit is that it has only been able to recover 63% of the gold. It doesn’t absolutely kill you economically, but it’s not a huge incentive either. However, there are reasons for the lower recoveries, namely that the column tests weren’t leached for a full 90 days. It never separated the sulfide, oxides and the mix into separate columns.

Terraco should have a preliminary economic assessment (PEA) early in 2013. It could come up with some superior numbers that show Almaden as a serious low-cost producer. It’s heap leach. The company has $1.8M in the treasury. Terraco is going to do its PEA and see if it can produce out there.

TGR: Terraco has the benefit of its primary asset being in northern Idaho, where mining is well accepted, and in Nevada, which is a fantastic jurisdiction. What CEO Todd Hilditch has done with his career is impressive.

RM: I was lucky to get in on his company Salares Lithium Inc., which merged with Talison Lithium Ltd. (TLH:TSX). The buyout by Talison was 400% of what I originally bought it. Of course, now we have the bidding war for those who got Talison shares.

TGR: That’s been a wonderful thing for the shareholders of Salares.

RM: Then Hilditch turned around and did something that is almost as impressive—buying the royalty on the Barrick deposit.

TGR: That’s part of the assets in Terraco, right?

RM: Yes, it’s on a project in Nevada, the Spring Valley joint venture (JV) project of Barrick and Midway Gold Corp. (MDW:TSX.V; MDW:NYSE.A). Midway’s Spring Valley deposit is at 3.5 Moz. That’s $40M net present value (NPV to Terraco. After $13M to exercise its option, that’s a $27M NPV, which is $2M more than its current market cap.

TGR: Just on the royalty.

RM: Yes. If it does expand that deposit to, say, 6 Moz, which is certainly not out of the realm of possibility, that’s a NPV of $64M. After exercising its options, it’s a NPV of $51M. That’s double the market cap—just on the royalty.

There is also a lot of blue-sky potential. The Barrick/Midway JV’s best hole is on the north end of Spring Valley. They have in hand a permit to drill toward the north, which is the south end of Terraco’s Moonlight project. If the JV hits Moonlight is in play.

TGR: What’s up next?

RM: My next one for your readers is Northern Vertex Mining Corp. (NEE:TSX.V; NHVCF:OTCQX). This is a company that is fast-tracking its Moss project in Arizona.

In the last six weeks, Northern Vertex has drilled 200 percussion holes and raised $9.1M. Ken Berry just stepped aside as CEO to bring on Dick Whittington, a mining engineer. Whittington took Farallon Mining Ltd.’s (FAN:TSX) project in Mexico to production in four years. He’s also put a voice behind mining interests in Mexico. He gathered together miners and explorers worth $50B in assets and they speak to the Mexican government as a single voice. Whittington is well respected and is very good at what he does. The mission is to fast-track Moss into production. When this happens, Northern Vertex is definitely going to be one of the lower-cost producers out there.

TGR: Tell me about the asset.

RM: Moss is a gold and silver project in northwestern Arizona with all the necessary infrastructure nearby. It has a gold-equivalent (eq) NI 43-101 resource of 950 Koz Measured and Indicated and 266 Koz Inferred gold eq, and it’s growable. It’s got a low strip ratio and is amenable to low-cost, heap-leach open pit mining. It’s a major stockwork vein system that outcrops at the surface for 5,500 feet. It has a unique three-phase plan. The third phase will be paid for by production. It’s a smart plan run by some very smart people. I have no doubt that this one is going to be successful.

TGR: The fact that it was able to raise $9.1M in this environment is pretty impressive. That’s been within the last 30 days.

RM: Exactly. Its management team is extremely popular with investors and institutions for several good reasons. When they say they’re going to do something, they go out and they do it. They’re a no-nonsense team.

TGR: This has been an interesting list. Thanks, Rick.

Richard (Rick) Mills is the founder, owner and president of Northern Venture Group, which owns Aheadoftheherd.com, as well as publisher, editor and host of the website. Focusing on the junior resource sector, Mills has had articles appearing in more than 400 different publications, including the Wall Street Journal, Safe Haven, the Market Oracle, USA Today, National Post, Stockhouse, LewRockwell, Pinnacle Digest, Uranium Miner, Beforeitsnews, Seeking Alpha, Montreal Gazette, Casey Research, 24hgold, Vancouver Sun, CBS News, Silver Bear Cafe, Infomine, Huffington Post, Mineweb, 321Gold, Kitco, Gold-Eagle, The Gold/Energy Reports, Calgary Herald, Resource Investor, Mining.com, Forbes, FN Arena, UraniumSeek, Financial Sense, GoldSeek, Dallas News, VantageWire, Indiatimes, ninemsn, IBTimes, jsmineset, the Association of Mining Analysts and Resource Clips.

Join the forum discussion on this post - (1) Posts

The Gold Report: Paul, your speech at the Hard Assets Conference in San Francisco was titled “Rational Expectations.” You spoke about monitoring the real rate of monetary inflation based on the total money supply.

You take into account everything in your indicator that acts as money, creating a money aggregate that links the value of gold and the dollar. You conclude that quantitative easing (QE) is not resulting in hyperinflation and is not acting as a driver for the continuing rise in the gold price. What then is pushing gold to $1,700/ounce (oz)?

Paul van Eeden: Expectations and fear. It’s very hard to know what gold is worth in dollars if you don’t also know what the dollar is doing. When we analyze the gold price in U.S. dollars, we’re analyzing two things simultaneously—gold and dollars. You cannot do one without the other. The problem with analyzing the dollar is that the market doesn’t have a good measure by which to recognize the effects of quantitative easing.

Since approximately the 1950s, economists have used monetary aggregates called M1, M2 and M3 (no longer being published) to describe the U.S. money supply. But M1, M2 and M3 are fatally flawed as monetary aggregates for very simple reasons. M1 only counts cash and demand deposits such as checking accounts. M1 assumes that any money that you have, say, in a savings account isn’t money. Well, that’s a bit absurd.

TGR: What comprises M2?

PvE: M2 does include deposit accounts, such as savings accounts, but only up to $100,000. That implies that if you had $1 million in a savings account, $900,000 of it doesn’t exist. That’s equally absurd.

“If gold is money, we should be able to look at gold and compare gold as one form of money against dollars, another form of money.”

M3 describes money as all of these—cash, plus demand deposits plus time deposits, but to an unlimited size. One may think then that M3 is the right monetary indicator. But the problem with both M2 and M3 is that they also include money market mutual funds, a fund consisting of short-term money market instruments.

That’s double-counting money because if I buy a money market mutual fund, the money I use to pay for that mutual fund is used by the mutual fund to buy a money market instrument from a corporation. The corporation takes the money it received from the sale of the instrument and deposits it into its bank account, where it is counted in the money supply. I cannot then count the money market mutual fund certificate as money, as it would be counting the same money twice.

TGR: So there is no accurate indicator.

PvE: M2 and M3 double-count money; M1 and M2 don’t count all the money. All are imperfect measurements. That is why I created a monetary aggregate called “The Actual Money Supply,” which is on my website at www.paulvaneeden.com.

TGR: How is your measurement more accurate?

PvE: It counts notes and coins, plus all bank deposit accounts, whether they’re time deposits or demand deposits. This is equal to all the money that circulates in the economy and can be used for commerce—nothing more and nothing less.

TGR: How does that separate out gold from the dollar in value terms?

PvE: I’m a goldbug. I believe gold is a store of wealth and gold is money. If gold is money, we should be able to look at gold and compare gold as one form of money against dollars, another form of money.

Changes in the relative value of gold and dollars will be dictated by their relative inflation rates. If I create more dollars, I decrease the value of all the dollars. If I create more gold, I decrease the value of all the gold.

TGR: The relationship is determined by both quantitative easing and mining?

PvE: Correct. Essentially most of the gold that has been mined is above ground in the form of bars and coins and jewelry. We can calculate how much that is. That’s the gold supply. That supply increases every year by an amount equal to mine production less an amount used up during industrial fabrication. That’s gold’s inflation rate.

“If the Federal Reserve starts to see an increase in price inflation or a rapid increase in loan creation—monetary inflation—it can sell assets back into the market.”

We can also look at the money supply and see how it increases every year. That’s the dollar’s inflation rate. The value of gold vis-a-vis via the dollar will be dictated by these relative inflation rates.

I have data on both gold and the U.S. dollar going back to 1900 and thus can compare the two. By doing that, I can calculate how the value of gold changes relative to the U.S. dollar and what gold is theoretically worth in terms of dollars.

Keep in mind that the market price is not the same as the value. In the market, price is seldom equal to value. Price often both exceeds and is below value. But it will always oscillate around value.

For example, in 1980, gold was trading much higher than value. By 1995, the gold price had sufficiently declined and U.S. dollar inflation had sufficiently increased to bring the gold price back to value, vis-a-vis the dollar. By 1999, gold was substantially undervalued. By 2007, it was again reasonably valued. But in 2012, it is again substantially overvalued.

Gold price and U.S. dollar inflation (blue) 1970–present

TGR: The value of gold is not $1,700/oz?

PvE: No. The value of gold is about $900/oz. Expectations of monetary inflation are keeping gold prices high.

In 2008, after the financial crisis, the Federal Reserve Bank announced the first round of quantitative easing. The gold price started to rally because there was an expectation, with the Fed openly engaging in quantitative easing, that we would see massive U.S. dollar inflation. But that didn’t happen.

“Whether annual mine production goes up or down, it makes no difference to the price of gold.”

When the Fed engages in quantitative easing, it does so by buying assets in the open market, such as Treasury notes or bonds. When the Fed buys a government bond in the open market it creates the money to pay for it out of thin air. The payment is credited against a commercial bank’s account at the Federal Reserve Bank and is not available for commerce in the economy. It’s part of the monetary base, but not the money supply, as the money supply only counts money that can be used for commerce.

Thus, the money that the Fed creates is not in circulation. It’s not part of the money supply because it cannot be spent. The commercial bank in whose name it is credited cannot withdraw it. The only thing it can do is to create new loans against that reserve asset. But the bank can only create new loans equal to the demand for such new loans.

Right now, as a result of QE1 and QE2, there is an enormous amount of excess reserves on account at the Federal Reserve on behalf of these commercial banks. These excess reserves in theory could be used to create new loans. The reality is that new loan creation by commercial banks have proceeded at a very normal pace, and not at all at a rate that should cause fear of hyperinflation.

TGR: Is it that there isn’t a demand or that the banks don’t see creditworthy people to loan to?

PvE: It doesn’t matter; the result is the same. The point is that the marketplace is not creating those loans.

Money that is counted in the money supply is created when consumers and corporations borrow money from commercial banks. When a loan is created by a commercial bank, the banking system creates that money out of thin air just as the Federal Reserve created its money out of thin air.

When a loan is repaid, that money is destroyed. The natural increase of the money supply is the balance between loan creation and loan repayment from consumers and corporations to commercial banks. Their ability to create those loans is dependent, to some extent, on their reserve assets in the monetary base that they have on account at the Federal Reserve. Right now, those reserve assets are much, much larger than what is necessary to account for existing loans of banks. So banks have enormous capacity to create loans, but capacity to create is not the same as having created. We are not seeing runaway inflation in the market. The U.S. money supply is increasing at an annual rate of around 7%, which is high, but not high enough to cause the type of hysteria that the gold price is exhibiting.

TGR: The expectation that banks will eventually loan up to their lending capacity is what is causing the fears of hyperinflation and the gold price to go up.

PvE: That is correct.

TGR: When will banks start lending?

PvE: They are lending, which is why the U.S. money supply is increasing. But they are not lending at a torrid pace—the U.S. money supply is increasing only very slightly faster than the average annual rate since 1900, and slower than it was in the period from 2000 to 2009 before quantitative easing started. It is highly improbable that we will see the kind of monetary inflation the market is afraid of—the fear is misplaced.

The Federal Reserve alone controls the level of money in the monetary base. If the Federal Reserve starts to see an increase in price inflation or a rapid increase in loan creation—monetary inflation—it can sell assets back into the market. When those assets are sold back into the market the money that the Federal Reserve receives for the asset is destroyed. It evaporates.

Just as the Federal Reserve created money, it can destroy money. The Fed can absolutely prevent runaway inflation by selling assets back into the market, therefore constricting the ability of commercial banks to make loans.

TGR: If the Fed-created money isn’t loaned out, will the inflationary expectation in the market eventually disappear? Will the price of gold go to $800–900/oz?

PvE: That’s a possibility. The gold price rallied in response to QE1 and QE2 and when QE2 ended, the gold price started falling.

Prior to the announcement of QE3, the gold price rallied again in anticipation, but since QE3 has been announced, the gold price has been falling.

When the Federal Reserve announced QE1, there was a massive increase in the monetary base. When it announced QE2, there was another substantial increase in the monetary base, but much less than with QE1. But there hasn’t been an increase in the monetary base since the QE3 announcement. The Fed is “sterilizing” QE3 by offsetting sales of assets at the same time it is purchasing assets.

TGR: So the key is how the Fed implements quantitative easing?

PvE: Correct. The question is whether the gold market is rational in expecting hyperinflation or massive runaway inflation. That expectation is not being supported by the money supply, or by price inflation, or any other data. The only place the expectation is being manifest is in the prices of gold and silver.

TGR: If you look at the supply and demand expectations for gold versus the inflated valuation for gold, do you see more gold producers bringing gold out of the ground? If so, is that going to have an effect on the price?

PvE: If the gold price is high relative to production costs then yes, it does bring marginal mines into production, which increases the supply of gold. Incidentally, the increase in production from marginal mines then causes production costs to increase as well.

Does that have an impact on the price of gold? No. The reason is very simple. Approximately 1,000–2,000 tons of gold is traded each day. Annual production of gold is roughly 2,000 tons. If annual gold production increases by 5%, which is a lot, it’s 100 tons. We trade that in a couple of hours.

Whether annual mine production goes up or down, it makes no difference to the price of gold. The gold that’s trading globally is not just the gold that’s being mined; it’s all the gold that’s ever been mined, that’s sitting above ground in vaults and in storage. That’s where the price is set. Not on the margin of incremental production.

TGR: As you’re looking at the gold companies that are out there, are you seeing that we have some good prospects or are you seeing that the producers aren’t able to replace what they’re using and the juniors aren’t able to get the funding to find new sources?

PvE: I agree with your last statement. Producers are not able to replace their reserves. New exploration is not keeping up with reserve depletion and the juniors are not getting the funding to do the exploration.

The reason juniors aren’t getting funding is because the market has become quite risk averse. Junior exploration companies are among the most risky investments you can imagine. When risk aversion increases in the market, the ability of juniors to fund exploration evaporates.

It’s also true that the miners, particularly gold and copper, are having a tough time replacing reserves. Is that something that’s going to cause a calamity in the next 12 or 24 months? No. But, it is a reason why, over the long term, investing in mineral exploration is an interesting business. Without mineral exploration, there can be no mining industry and without a mining industry, our society does not function.

TGR: The last time we spoke to you, you said that you were very scared and that it was a healthy thing for investors to be scared because it keeps them from making mistakes. Are you still scared?

PvE: I’m definitely concerned that the market is going to look worse in 2013 than it looked in 2012. I think risk aversion is not yet ready to be replaced by risk appetite. The big concern I have for next year is further deterioration of the Chinese economy. In particular, a tipping point is being reached in China where its banking system can no longer sustain the bad loans it has created.

If economic growth in China takes a really big hit at the same time the financial problems in Europe have not yet been resolved, I see more risk aversion creeping into the market. That’s not good for junior exploration companies.

What makes me optimistic is that I think the worst is behind us in the United States. I think that slowly but surely the U.S. economy is going to get better and better. With time the improvement in the U.S. economy will bring risk appetite back into the market, but I don’t see that happening in 2013. We’ll have to see this time next year what the prognosis is for 2014.

TGR: In 2008, you told your investors to sell everything. Is that still your position?

PvE: The end of 2007 and the beginning of 2008 was the top of the market for most metals and certainly for mineral exploration stocks. That was the time to sell everything. Now we’re very close to the bottom of the market. It could be a long and drawn-out bottom but, nonetheless, I think that we’re close to a bottom.

This makes it a very good time to be accumulating mineral exploration assets or junior exploration companies. It assumes an investor has the patience and financial ability to wait for the next bull market and stay with the trades. Remember that junior exploration companies don’t generate revenue. If the bear market is protracted, these companies will need several rounds of financings in order to stay alive.

TGR: You also invest in silver, base metals and energy. Are some of these sectors doing better than others?

PvE: Copper, like gold, is very expensive. So is silver. The other base metals, such as aluminum, zinc, lead and nickel, are much more reasonably priced. Oil is also very reasonably priced at $85/barrel. I see less systemic risk in those sectors than I see in gold, silver or copper.

TGR: What specific companies do you like in those sectors?

PvE: I have recently acquired additional shares of both Miranda Gold Corp. (MAD:TSX.V) and Evrim Resources Corp. (EVM:TSX.V). I’m on the board of both of those companies and so I am not at all independent, or impartial.

I also recently acquired shares of a company called Millrock Resources Inc. (MRO:TSX.V). And I continue to scour the market for more opportunities. I intend to be a buyer of mineral exploration companies for the foreseeable future.

TGR: Why do you like those three?

PvE: All three of those companies share one element that is critically important. All have competent, experienced management and they have management that I trust: trust that they’re not going to squander the money that we give them and trust that they will use their best efforts to create shareholder value. It is my confidence in management teams that causes me to invest in mineral exploration. Mineral exploration is a business about ideas. It’s not about assets. And when you’re dealing with ideas, the asset that you’re de facto buying is people—it’s management.

TGR: You say that you’re doing this for the long term. How long do you think that you’ll have to wait?

PvE: Who knows? 5, 10 years? Maybe we get lucky sooner. Maybe we don’t.

TGR: Thanks for your insights.

Paul van Eeden is president of Cranberry Capital Inc., a private Canadian holding company. He began his career in the financial and resources sector in 1996 as a stockbroker with Rick Rule’s Global Resources Investments Ltd. He has actively financed mineral exploration companies and analyzed markets ever since. Van Eeden is well known for his work on the interrelationship between the gold price, inflation and the currency markets.

The Energy Report: You make the case that investors should take a look at small-cap international energy companies. Why?

Darrell Bishop: The main attraction is exposure to high-impact exploration targets. In the international space, a small-cap producer can prove up material reserves with a single well. This compares favorably with the junior space in North America, which has transitioned to an unconventional resource play based primarily on multi-stage hydraulic fracturing technology. The North American juniors are in a lower-risk and lower-reward environment. International companies are inherently more risky, so the potential for higher returns needs to justify that risk.

TER: How do domestic and international projects differ for small energy companies? Is technology a differentiator?

DB: Land acquisition costs in North America can be a huge barrier to entry for junior companies. We see a willingness for teams experienced in North American geology and technology to seek out opportunities in international jurisdictions where they can apply that expertise in a less-competitive setting. The junior international explorers tend to be the first movers in discovering emerging global plays. These projects can generate major shareholder value for investors. That’s why I think investors should look overseas when evaluating smaller energy companies to add to a portfolio.

TER: What geographies do you think are geologically and socially prospective for international energy development?

DB: There are many factors that investors have to look at in the international space. It comes down to a balance between geology, the fiscal and geopolitical climate in the country and the investor risk tolerance. The majority of the world’s reserves are located in less-stable regions. Negative regional headlines can impact the share price of companies that operate anywhere within that region—even if it is in a different country. Much of the time, news will affect share prices for companies totally unaffected by regional political developments. A recent example is Chinook Energy Inc. (CKE:TSX.V), which has operations in Tunisia—the epicenter of the Arab Spring uprising. Despite not experiencing a day of operational downtime through the unrest, the stock traded at a discount to its international peers. With that said, there are a few jurisdictions worth mentioning, although not without risk. Kurdistan and parts of Africa continue to attract investor attention based on recent exploration success, the potential for large reserves and production growth and increased interest from the majors.

On the other hand, once-popular regions in Argentina and Colombia have cooled. Argentina has tremendous shale potential, but investor interest has dried up following the government’s expropriation of Yacimientos Petrolíferos Fiscales (YPF:NYSE). In Colombia, which was once the poster child of international success stories, the risk appetite has fallen off as many of the lower-risk exploration targets have now been identified. That’s forcing companies to step out into more expensive and riskier frontier regions that show a lower chance of exploration success. Production from small international projects can decline steeply, so companies need to be successful with the drill bit in order to backfill potential production shortfall.

TER: You cover some offshore companies in the North Sea. How do smaller international energy companies fit into that market? What’s their niche?

DB: The North Sea has been in production for decades. The consensus is that most of the major fields have already been discovered. At this stage, the focus is shifting to increasing recovery from legacy fields and developing the remaining smaller fields. There are government incentive programs to partially offset the high taxes that are seen in the North Sea. That encourages smaller field development and opens up opportunities for small companies like Iona Energy Inc. (INA:TSX.V). These discoveries are too small for most of the majors to care about (because the majors need scale and large reserves), but smaller companies can build a business out of only a few discoveries.

We cover Iona Energy, which is a pure play on the North Sea. It’s focused on growing production from undeveloped discoveries that were too small for the majors. The majors ignored these deposits because they were not material additions to their reserves. However, for a smaller company, these reserves are potentially very material.

Iona trades at some of the cheapest metrics in our international space. Investors will have to be patient with a stock like this, as the major operational catalyst for the story is the first oil from its Orlando field. That’s currently not scheduled until mid-2013. Although it’s primarily an execution story, many investors have been burned in the North Sea and are cautious. That’s because North Sea projects tend to take longer and cost more than originally planned. With Brent prices now north of $110/barrel (bbl), industry activity and costs are likely to increase in the coming years. Short-term investors won’t pay for development projects that are a year out, but long-term investors may have a good risk-reward opportunity at these levels.

TER: International energy companies generally sell their production at the international price, which is currently at a large premium to U.S. domestic pricing. Will international energy pricing remain robust?

DB: Our thesis is that domestic West Texas Intermediate (WTI) will continue to trade at a discount to the international (Brent) pricing in the near term. That likely won’t change until more domestic production can get waterborne.

TER: What metrics do you use to evaluate smaller international energy companies?

DB: You have to be pretty selective when you’re playing the international space because of the jurisdictional risk. Typical smaller international energy companies are exploration focused. Frontier exploration success is less than 20%. To flip that around, you have a greater than 80% chance of failure on your exploration target. The current market is not paying much for exploration upside. For this reason, we tend to favor companies that have a balance of development opportunities (for cash flow) and exploration upside as a bonus. To evaluate production, look at cash flow metrics. To evaluate exploration prospects, look at the risk basis. Next, you break it down to a present value based on the number of barrels in the ground and the cost of extracting that. Management also is very important—they need a track record of success and in-country connections. A lot of times for junior companies in international jurisdictions, it’s who you know that matters most to help navigate the regulatory approval process rather than who you are. One last point: the international space, especially for small companies, is operational catalyst driven. Investors should watch for drilling events that may drive value.

TER: One of the jurisdictions you follow is unusual —Albania. Can you explain the investment thesis and the current opportunities?

DB: We cover three companies in Albania. The first two are primarily focused on increasing oil recovery from legacy fields—Bankers Petroleum Ltd. (BNK:TSX) and Stream Oil and Gas Ltd. (SKO:TSX.V). Bankers is not a small company; it has a market cap of approximately $800 million (M). The third company we cover in Albania is an early-stage explorer called Petromanas Energy Inc. (PMI:TSX.V). It is an interesting story for many reasons. Earlier this year, Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) farmed in for a 50% interest in two of its blocks, which, combined with cash on hand, basically funds exploration plans through 2013.

TER: Are these offshore explorations?

DB: No, these are all onshore. Shell is interested in these blocks because of similarities to the Val d’Agri and Tempa Rossa fields located across the Adriatic Sea in Italy. One of those fields is currently producing 90 thousand barrels a day (Mbblpd) from fewer than 30 wells. Shell and Petromanas are currently drilling their first exploration well in Albania. That well cost $30M and is carried almost entirely by Shell. The well is a re-drill of an existing discovery that flowed oil to surface about 10 years ago, but the rate was limited due in part to a series of operational issues and poor decisions. Well results are expected by year-end. If successful, we see this as a potential company maker for Petromanas. Additionally, Petromanas has two other wells it is planning to spud before year-end, which means there are several potential drilling catalysts on the horizon.

TER: How about the political and social issues in Albania? For most investors, it must be an unknown.

DB: For the most part, it is unknown to most investors. Albania, up until about 20 years ago, was a Communist society. It’s been in transition to democracy for the better part of the last decade. There are social and environmental issues in Albania. However, the government is pushing to turn things around and be more investment friendly. The country is applying for European Union status, which is a vote of confidence in foreign investment in the country. While the country is still in transition mode and has challenges, the big picture is positive over the longer term.

TER: Is the geology in Albania somewhat complicated compared to North America?

DB: The risks there are primarily a function of geology. To date, exploration and production activity in Albania has focused on shallow formations (less than 2,000 meters) that produce heavy oil. Petromanas is targeting much deeper, more complex sub-thrust structures. There has been limited exploration on these formations to date. With advances in three-dimensional technology and deep drilling, plus experience in geologically similar Italy, the companies feel like they have a better understanding of how to create exploration success in that geography.

TER: Is the major trend for the small-cap international energy sector the application of new exploration and development technologies?

DB: There are a couple of major trends in the industry. The single biggest factor is technology. In most international jurisdictions, expertise and the rate of technology adoption greatly lags that of North America. We see adoption of seismic, drilling and completion technologies that were pioneered and perfected here in North America as the catalyst to advance the industry internationally. In the international jurisdictions, the use of these technologies is just beginning to grow. These technologies have been key to discovering new areas for exploration and production that were not considered prospective or economic until now. One example is the worldwide emergence of onshore unconventional shale plays. Another example is the advance of deepwater exploration technology that is unlocking huge exploration potential in places like Angola, Namibia and Brazil.

The second trend driving the sector is commodity prices. In most international jurisdictions, oil is priced relative to Brent, which as we discussed is at a healthy premium to North American oil. A similar pricing structure is in place for natural gas, which can fetch three to five times more internationally than in North America. This is a significant motivator for international companies, as the potential return justifies riskier exploration targets.

TER: Another underexplored location with complicated geology you cover is New Zealand. Can you give us an overview of the energy investment situation there?

DB: New Zealand has received increasing attention from oil and gas companies because they’re seeking out new regions to explore globally. New Zealand offers a bit of a unique opportunity in our international space. It is underexplored, but also benefits from a politically stable climate with fiscal terms that encourage investment. There are multiple sedimentary basins with known or potential hydrocarbons—both onshore and deep-water offshore. There have been multiple discoveries, even hydrocarbon seeps to surface, which demonstrate an active petroleum system in many of these basins. Currently, all of New Zealand’s oil and gas production comes from the Taranaki Basin on the west side of the North Island. Because of the tectonic setting, the geology is favorable for structural petroleum traps. However, exploration is complicated because of the lack of structural repeatability of these formations. Advances in technology, mainly seismic and drilling, have enabled companies to better focus their exploration efforts. While current production is on the west side of the island, the east coast is where things get interesting. There is tremendous exploration potential in some of the shale reservoirs, which are yet to be tested and estimated to contain billions of barrels of undiscovered resource.

TER: So New Zealand is a frontier—which companies are there now? Are both juniors and larger companies there?

DB: Shell has been a major player in the country for some time, but we’ve also seen some heavyweight companies recently step in, such as Petrobras (PBR:NYSE; PETR3:BOVESPA), Anadarko Petroleum Corp. (APC:NYSE), Apache Corp. (APA:NYSE) and Exxon Mobil Corp. (XOM:NYSE). But there are also a couple of junior, Canadian-listed companies with a presence. Tag Oil Ltd. (TAO:TSX.V) is one we recently initiated coverage on. New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX) is another Canada-listed junior in the area.

TER: Tag has an interesting past—and investors have done well with it. It’s not a smallcap anymore. Is there upside to the stock? What events are you looking for?

DB: I agree, the stock has had a good run the last couple of years, and that’s mainly on the back of success with the drill bit. Two of Tags fields transitioned from discovery to production, but we still see upside from here. The current valuation is supported by shallow conventional development at these two fields. Production is approximately 2,400 bblpd now and set to ramp up to between 5–6 Mbblpd between November and March. That’s entirely from 14 drilled wells that are behind pipe-awaiting infrastructure expansion. It has less than 10% of its production permits explored to date. We see Tag in the early stages of unlocking the potential of these assets from a conventional perspective.

Besides these assets, Tag has three high-impact, liquids-rich prospects that are drill ready. Two of these prospects, Cardiff and Hellfire, are slated to be drilled within the next six months and could add material value to the company. The real game-changer for Tag could come from a carried call option that it has on an unconventional resource in the east coast. Apache farmed in and is carrying Tag for the first $100M in exploration capex to test unconventional shales in the East Coast Basin. If the partners can prove moveble hydrocarbons with an upcoming four-well program, it’s likely going to be all systems go for Tag. On the regulatory front, there are still public concerns over hydraulic fracturing. That’s a hot topic with industry and the government. Tag has been working to dispel the myths associated with hydraulic fracturing. There is a parliamentary report due in November. That could be an important factor in unconventional operations going forward.

The bottom line is that we continue to like the stock at these levels. Tag has a very strong balance sheet, and we see the valuation as being underpinned by significant near-term production given those already-drilled wells. There is additional upside potential from a busy “catalyst-rich” operational calendar over the next 12 months.

TER: What does the New Zealand energy market look like in terms of import/export and pricing?

DB: With respect to oil, New Zealand is a net importer of oil. Current production in the country is approximately 50 Mbblpd. Demand in the country is approximately 150 Mbblpd. With respect to pricing, oil is priced relative to Asian Tapis pricing, which is comparable to Brent. With respect to gas, the situation is similar to North America in that New Zealand natural gas is a landlocked product. Current production is approximately 400 million cubic feet a day (MMcfpd). Pricing is generally between $4–5/Mcf, which is a healthy premium to what North American producers receive.

TER: If New Zealand natural gas production increases dramatically, what happens to the price? It is a small domestic market.

DB: That has been some of the pushback for the story of gas production in New Zealand. Offsetting the small domestic market is the fact that the major gas fields that are in the country have been in steady decline over the last few years. There is talk that demand for gas will increase over the coming years, in part due to the expansion of the Methanex plant in the Taranaki Basin. If existing production drops and there is an increase in demand, then new production can be easily absorbed by the market.

TER: Are there any final thoughts you want to leave with investors who are contemplating how to get into the smaller overseas energy explorers and producers?

DB: Investors need to be selective when they’re playing the international space. There are unique risks in each jurisdiction. Look for stocks that balance development and exploration. The current market does not pay much for exploration, but that may be an opportunity for longer-term investors. Keep an eye on operational catalysts and favor companies with strong management teams.

TER: Thanks a lot for talking with us.

DB: I appreciate the opportunity.

Darrell Bishop is a Research Analyst with National Bank Financial (NBF) covering international oil and gas E&P companies. Based in Calgary, Bishop joined NBF in late 2011 after working as a senior research associate at Macquarie Capital Markets where he focused on international oil and gas E&Ps. Prior to Macquarie, Bishop had 10 years of industry experience with CorrOcean Aberdeen, Petro-Canada East Coast and Devon Canada where he worked in various roles including asset optimization, production engineering and corporate development. Bishop holds a Master of Business Administration from the University of Calgary and a Bachelor of Mechanical Engineering with a specialization in oil and gas from Memorial University. Bishop is a Professional Engineer with the Association of Professional Engineers and Geoscientists of Alberta (APEGGA).