By The Gold Report, on January 10th, 2012
  Despite a pullback in growth for China, copper demand is likely to remain strong in 2012, according to Dr. Michael Berry, publisher of Morning Notes, and his co-author, Chris Berry, founder of House Mountain Partners. Other developing nations, such as Indonesia, should pump up demand, but supply from such regions remains a tenuous prospect. In this exclusive interview with The Gold Report, the Berrys explain how “home-brewed” U.S. copper companies will be an important part of the equation.
The Gold Report: In a recent edition of Morning Notes, you referenced some “sprouting” problems in China. What are those problems and are they likely to affect China’s economy?
Michael Berry: We spent a couple of weeks in Shenzhen, China, and Hong Kong last month. On the surface, there do not appear to be any real problems in China. The infrastructure is fabulous—new roads, tunnels, bridges and stadiums. There are a lot of institutional investors in China with a tremendous thirst for knowledge. But old China hands—and I’ve been there many times since the 1960s—feel that there are serious problems beneath the surface, including inflation, slowing exports, bad loans and overbuilding.
During our visit to China, investment bankers we met with indicated that there are vacancies and see-through buildings in many cities. This is always a precursor of problems to come. China has an export-led economy and the U.S. and Europe, two of its main customers, have slowed down considerably. We may see a recession in Europe this year, which would bode ill for China, which counts the Eurozone as one of its largest trading partners.
An important question is how quickly can China transform itself into an economy with healthy domestic demand? That’s going to take years. There are also concerns about whether China can continue to grow at a breakneck speed of 9% or 10% per year. Most of the forecasts show China’s gross domestic product (GDP) will slow considerably over the next six years; however, it will still maintain growth levels above the Western economies. But problems are lurking in China, no doubt. The best we can hope for is a soft landing in 2012.
TGR: Paul Krugman recently wrote in The New York Times that China is on the verge of a massive real estate bubble. The World Bank recently lowered its GDP forecast for China to 8.4% from 9.1% in 2012.
MB: Growth will certainly slow, but China is better positioned to handle problems with overbuilding and bad debt than the U.S. China has been running huge surpluses for years and has accumulated significant foreign exchange reserves by pegging its currency to the U.S. dollar at artificially low levels. Japan recently inked a deal with China to buy its bonds. The Chinese currency and economy are slowly coming out of their self-induced isolation.
We remain cautious, however. China has a cushion here, but as we said before, there are some lurking issues and Paul Krugman touches on one in his piece.
TGR: How could a slowdown affect copper demand?
MB: Copper is probably the single metal that reflects good times in the world and growth. It is called the metal with a Ph.D. in economics because it’s so necessary for and indicative of economic growth. Expect supernormal growth of 5–7% in a number of emerging economies, which will keep demand for copper strong going forward.
The real question is from where will additional supply of copper come? There are the beginnings of a supply crunch in copper, which is affecting a number of mines worldwide. We are witnessing a combined supply-demand issue, not just a demand issue. Resource nationalism, falling grades and adverse weather are just a few issues affecting copper today. This is troubling but ultimately a good omen for junior mining companies involved in copper exploration.
Chris Berry: China is responsible for about 40% of global copper consumption, and copper is a 16-million-ton-per-year market. If GDP growth in China slows even from 9% to 8%, copper consumption has to fall in line unless other countries can pick up the slack in demand. What countries hold the potential to do this? Looking at demographics, potential demand and infrastructure build-out, several emerging markets come to mind including Brazil and India as well as “second tier” emerging markets such as Indonesia, Turkey or Colombia. If these countries do indeed grow at above-trend growth rates, you must then ask where additional supply is going to originate from—and supply appears tight going forward.
A notable example of a supply disruption is Freeport-McMoRan Copper & Gold Inc.’s (FCX:NYSE) Grasberg mine in Indonesia, where company management recently declared force majeure on copper exports. You can add labor strife to the list of issues potentially curtailing copper supply. Labor issues at mines promise to remain front and center as high metals prices make mining a more financially attractive pursuit. Grasberg is one of the largest copper mines in the world and the employees there have agreed to a 40% increase in pay over two years, however, I don’t believe the strike is fully settled yet, highlighting how thorny labor issues can be. Issues at the Grasberg mine have some very serious implications for copper supply going forward. So to summarize, between supply and demand, I think copper supply is the more important of the two to focus on.
TGR: The junior resource sector had a difficult time in 2011. The Toronto Stock Exchange Venture Composite Index, which is mostly composed of junior resource companies, was at about 2,400 in April, but had fallen to 1,450 by the end of December. Do you think we’ll see a sector rebound in 2012?
MB: There are strong headwinds for a lot of these companies and 2011 was unkind to the junior mining space in general. Very few junior mining companies have escaped the wrath of the pullback in commodities and overall panic at issues that have developed around the world. Investors must now focus on which companies can sustain themselves until we’re over the hump. We’re not there yet. The question will be which stocks can stand the test of time, can sustain their exploration and development activities and raise sufficient capital to fund operations in a difficult environment, to put it mildly.
TGR: Revett Minerals Inc. (RVM:TSX; RMV:NYSE.A) had some potential catalysts coming to the forefront this summer. What’s new there?
MB: Revett produced 3 million ounces (Moz) silver equivalent and earned about $16 million (M) in the third quarter. The company also recently announced a $20M revolving line of credit from Société Générale. It produces the best copper-silver concentrate in the country from its Troy mine in Montana. The mine has a perpetual seven-year life because it keeps finding more copper and silver resources as it mines. It’s building in production and the kind of liquidity and strength it will need to manage any economic downturn.
We visited the company in early September. The management team is very much together. It got a good ruling from the Ninth Circuit Court of Appeals on the environmental impact of Rock Creek on grizzly bears and endangered fish. Rock Creek is a second ore body fully drilled out, and environmentalists have tried to block its development. It has 229 Moz silver and a couple billion pounds of copper in virtually identical geology to the currently operating Troy mine. There’s a good chance the company will be able to mine Rock Creek within the next couple of years.
Revett should prosper and could be the target of a takeout. It’s a very positive situation. The stock trades around $5/share, but it was $0.07/share a few years ago. That speaks well for the management and investors in Revett Minerals.
TGR: The line of credit is at London Interbank Offered Rates (LIBOR) plus 3.5%. Do you think that’s a bit high?
MB: Possibly, but certainly Revett can handle it. It’s producing and selling all the silver and copper concentrate it has, so a revolver is a good deal for it. These are catalysts that you want to see from time to time.
TGR: If Rock Creek moves ahead as planned, when would it reach production?
MB: I don’t think the environmentalist group will appeal to the Supreme Court. Even so, I don’t think the Supreme Court would hear it. It’s probably three to four years away from production.
The Troy mine will certainly sustain the company in the meantime. Management presentations indicate that Troy has perhaps 10 to 15 years of production left.
TGR: Is $5/share a good entry point for that stock?
MB: This stock is fairly volatile. If Rock Creek comes on, yes, I think $5/share will be an incredibly good bargain for investors. I’ve been watching Chief Executive John Shanahan now for several years and he’s completed everything he said he wanted to do.
TGR: In a recent edition of Morning Notes, you discuss some of the recent ups and downs of Quaterra Resources, Inc. (QTA:TSX.V; QMM:NYSE.A). You called the company’s Yerington copper project in Nevada “a company maker” even though Quaterra also has the high-grade Herbert Glacier gold project in Alaska.
MB: Tom Patton, the chief executive of Quaterra, bought Yerington out of bankruptcy for $250,000 in stock. Historically there are about 5 billion pounds (Blb) of copper at the Yerington Bear deposits. This past May, he announced he was exercising Quaterra’s option on it. There is going to be a large copper district there. There are three companies now in the area. Nevada Copper Corp. (NCU:TSX) has a very large, high-grade skarn deposit. Entrée Gold Inc. (ETG:TSX; EGI:NYSE.A) has some properties to the east of Yerington, which include the Bear deposit, a large, partially drilled out porphyry, and the MacArthur, an oxide-chalcocite run-of-mine project with 1.4 Blb of mine-ready, leachable copper. Quaterra drilled out the MacArthur oxide quite nicely and found a fair amount of higher-grade copper averaging about 0.5%. It could be leached directly and brought into production within two to three years for about $250M. The key to the entire district is the MacArthur property that Quaterra owns, in my opinion.
Quaterra has been cut in half in this pullback. We hope management will move to monetize some of its assets, either its Nieves silver property in Mexico, which may have 100 Moz silver in all categories, or even its 35% stake in Herbert Glacier, a high-grade, gold-silver resource north of Juneau, Alaska, which was recently discovered through drilling.
I may be a loner in this regard, but the MacArthur oxide-chalcocite deposit and the fact that it has a huge water resource are the keys to the entire Yerington district. I think the district holds 50–60 Blb copper. When I visited Yerington in September, Quaterra had five drill rigs turning. You don’t have five rigs turning on a property if you don’t think you’re really proving up and increasing the resource significantly.
TGR: Nevada Copper was shopping its project before its share price went down considerably. Which one—Quaterra, Entree or Nevada Copper—is most likely to be taken out first?
MB: Nevada Copper is the furthest along. A company like Antofagasta Plc (ANTO:LSE) might want to take it out. However, whatever company comes into the district is going to want to consolidate it. Having Nevada Copper would be a coup, but it would not help consolidate the district. From a strategic view point, Quaterra’s Yerington pit, MacArthur pit and Bear deposit are really the keys to the district.
There are already some big players in the district. Rio Tinto (RIO:NYSE; RIO:ASX ) owns 25% of Entrée Gold. Ivanhoe Mines Ltd. (IVN:TSX; IVN:NYSE) owns 12%. But Entrée is three years behind Quaterra and Nevada Copper.
TGR: Arizona has some vast reserves of copper as well. Do you see a renaissance in developing copper juniors in Arizona?
MB: I do. On our way to China, Chris and I visited Tucson, where there are several great porphyry discoveries. ASARCO LLC, Rio Tinto and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) are there. One junior miner in particular, Redhawk Resources (RDK:TSX; QF7:FSE; RHWKF:OTCQX), has been drilling and it’s onto something.
Arizona, Nevada and Idaho are great states for mining. Given the unemployment in some of these regions, there is a new lease on life for junior mining companies to work in these states.
TGR: Redhawk is trading at about $0.42/share. Do you like that as an entry point?
MB: The stock is cheap, there’s no doubt about that. Its property, Copper Creek, is quite spectacular. When we visited in December, it had three rigs turning. There are close to 400 breccia outcrops of fairly small tonnage, but very high-grade copper, gold, silver and molybdenum. Red Hawk is looking for deep, but high-grade, thick veins that characterize big discoveries like Butte in Montana. I like the management team. It raised $20M earlier this year and it’s probably going to have to go back to the market again or do a joint venture. There’s lots of interest and it has confidentiality agreements signed with the big boys. There are smelters literally all around it. It’s got great infrastructure. There’s a good chance for a world-class discovery there.
TGR: What about Quadra FNX Mining Ltd. (QUX:TSX)?
MB: Quadra is a great case study. It has done a great job. You want to see that event that monetizes the shareholders. The Polish firm KGHM Polska Miedz S.A. (KGH:WSE) offered $15/share for the company. There is a lot of interest in U.S. deposits now. There’s a new life on mining and exploration, and there’ll be more takeouts in the future.
TGR: Do you have anything to add to that, Chris?
CB: There has been a lot of talk lately about what makes a metal critical. Certainly, copper is a critical metal based on its ubiquitous use throughout all facets of the global economy. Mineral deposits where resource nationalism isn’t a top concern, or a concern at all, like Arizona, Idaho or Nevada, deserve a second look and a premium in share price based on their location. I think we are sure to see more cross-border mergers or take outs like the KGHM/Quadra example as copper’s importance to economic growth is only magnified by an emerging middle class of billions in the years to come.
TGR: You gentlemen are about to launch a new product, the Discovery Investment Scoreboard. Tell us about that.
MB: About 10 years ago, I defined a technique called Discovery Investing because I was interested in discovery. All great wealth creation starts with discovery. I defined 10 rules or factors and continued to refine them over the last decade. Dr. Terry Rickard, a brilliant mathematician and former senior fellow at Lockheed, finally convinced me to put my discovery investing discipline in a software format. We use a powerful mathematical technique that he developed. It allows users to rate stocks in English vocabularies and develop an ordinal ranking. The number of companies that the system ranks, the database, is getting quite large. The most interesting aspect of the database is its ability to build a crowd score. It takes each individual user’s analysis and builds it into a single score, which allows investors to check their analysis against the crowd.
CB: The toughest part about the nano cap space is in trying to evaluate these companies, because traditional metrics don’t work. There are no earnings or cash flows so there is a great deal of guesswork involved. The Discovery Investment Scoreboard (DiS) is designed to take the guesswork out of evaluating these companies. We can rank any one of the companies we mentioned today—it doesn’t even have to be a nano cap.
We might look at the management of a company and you might say it’s average. I might say it’s excellent. At the end of the day, who’s right? Nobody really knows. There are still a lot of open questions. We’re aiming to quantify those opinions. The real bonus for the end users is the crowd score. Investors can see how their opinions rank relative to the crowd. Since I’ve been using the system, it has raised many questions about what I’m seeing that the crowd is not or vice versa. We think it has potential to shine a lot of sunlight on accurate valuations for junior companies.
TGR: Have either of you adopted a New Year’s investment resolution?
MB: In 2012, we hope to make DiS available to everyone who wants to analyze these companies. It’s going to be by subscription but we’re actually looking now for people who want to help us build the database. We’re planning to kickoff the system on Jan. 22 at the Cambridge House International Resource Conference in Vancouver. We haven’t priced it yet, but it will be affordable for the individual user. We’re going to have versions for institutional users that will be more detailed and quite a bit more powerful.
TGR: Jeepers. You might just put some analysts out of business.
MB: Chris and I actually sat with two analysts and two investor relations representatives in China and they loved it. We travel to Denver next week to conduct a focus group on the usage of the DiS.
CB: Once we explained the rationale and the background to them, it became a little bit addictive, because companies start popping up in your head and you think, “Gee, I wonder what the crowd thinks about this company or that company?” The whole idea of finding out what I’m missing or what I know that the crowd doesn’t is key. I think that’s what has a lot of people excited right now.
TGR: Thanks to both of you.
Dr. Michael Berry served as a professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia from 1982-1990, during which time he published a book, Managing Investments: A Case Approach. He has managed small- and mid-cap value portfolios for Heartland Advisors and Kemper Scudder. His publication, Morning Notes, analyzes emerging geopolitical, technological and economic trends. He travels the world with his son, Chris, looking for discovery opportunities for his readers.
Chris Berry, with a lifelong interest in geopolitics and the financial issues that emerge from these relationships, founded House Mountain Partners in 2010. The firm focuses on the evolving geopolitical relationship between emerging and developed economies, the commodity space and junior mining and resource stocks positioned to benefit from this phenomenon. Widely quoted in the press and a frequent speaker at conferences throughout the world, Berry holds a Master of Business Administration in finance with an international focus from Fordham University and a Bachelor of Arts in international studies from The Virginia Military Institute.
By The Gold Report, on January 2nd, 2012
  China has become the $5.88 trillion question in the world financial equation for 2012. In an attempt to gauge the direction of this economic elephant, Cambridge House International is asking two China experts to debate the health of the second-largest economy at the Vancouver Resource Investment Conference January 22. We called the two speakers for a preview of the tactics they will take in this epic debate.
Frank Holmes, chief executive and chief investment officer at U.S. Global Investors, will focus on the upside of massive Chinese modernization and growth. He is the recipient of both Mining Fund Manager of the Year Award from Mining Journal and International Citizen of the Year Award from the World Affairs Council of America and has a long-term investor’s view of international geopolitics.
Author and Commentator Gordon Chang literally wrote the book on why investors should be wary of China’s growth. His book The Coming Collapse of China has attracted attention from the likes of the LA Times and Asia Times and many other publications in between. He has made appearances on Fox News and regularly contributes to Business Insider, Barron’s, National Review and Forbes magazines. When he lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai as counsel to the American law firm Paul Weiss, he saw the ghost cities and environmental challenges up close.
“The debate is a direct response to attendees who need to know if China is on a course to grow, slow or blow,” said Nicole Evans, president of the Cambridge House International Conference Division. The Gold Report called these two experts to find out the numbers behind why they have such different predictions about how this enigmatic country will fare in the coming years.
Frank Holmes: This veteran investment advisor based his positive prognosis for China and its Eastern neighbors on a combination of tacit knowledge learned firsthand through travel and observation of geopolitical conditions along with explicit knowledge of history and the markets.
He studies S-curve patterns, modeled on economist Simon Kuznets’ 20-year long cycles. For example, the world’s population has grown from 1 billion in the 1800s to 7 billion today, which has drastically affected commodity consumption and infrastructure buildout. “Nowhere is this more evident than in the emerging markets, such as China,” Holmes said.
“When governments have invested in infrastructure, there has been a powerful impact on gross domestic product (GDP) numbers.” For example, he pointed to the 1950s, when Eisenhower signed the Federal Aid Highway Act, allowing commerce to expand across the nation, with restaurants including Dairy Queen and McDonald’s experiencing tremendous growth over the next several decades. “Paved roads from coast to coast helped sustain a more than tenfold increase in U.S. GDP,” Holmes said.
“Whereas the U.S. connected 160 million people with nearly 47,000 miles of freeways, by 2020 China will connect 700 million people across 250 cities, spanning more than 47,000 miles of interstate and 18,000 miles of rail,” Holmes explained.
Holmes estimated that over the next 25 years, about $41 trillion will be spent on global infrastructure—$6 trillion has been approved for the 2011 through 2013 timeframe with China projected to spend half of that $6 trillion. He believes these investments will result in rising GDP per capita and trigger a consumption economy.
“Once China connects its super cities, it will enable more Chinese to travel around the country, resulting in a completely different consumption pattern. You will see train stations with 50-story condominiums along with U.S. restaurants that have already been expanding in China, including McDonald’s, Dairy Queen and Starbucks. Major hotel chains, such as Wyndham, Starwood and Hilton, along with luxury goods businesses including Cartier, Hermes and Gucci will compete for market share. Infrastructure will change the face of the economy in China just the way it did in the U.S.,” said Holmes.
“We are big believers that government policies are precursors to change, so our investment team continuously tracks the fiscal and monetary policies of the world’s largest countries in terms of economic stature and population. The G-7 (industrialized) countries are 15% of the world’s population but 50% of the world’s GDP and growing only about 1%. Western countries seem to be focused on cutting back infrastructure spending and raising taxes to pay for entitlements. At the same time, E-7 (emerging) countries comprise 50% of the world’s population with 20% of the world’s GDP. However, these countries are growing at 7% to 8% and include a rising middle class of some 60 million people out of a total 2.2 billion people. But, 60 million people making $30,000 a year is very significant. Think about the movie “Slumdog Millionaire”—this is what is happening throughout Asia. That is why companies such as Gap and GM and KFC are focusing on expanding in China where its residents love American products and pack the stores in Beijing.”
Holmes also saw important policy changes in the works that could improve China’s economic outlook. “Over the past 10 years, we have seen a slow migration of more property rights being given to people in China. The largest transfer of real estate in the history of mankind took place in China seven years ago when more than $500 billion of real estate value was basically transferred to farmers. That was followed by condo building. Additionally, to attract public companies, Shanghai adopted the Hong Kong Stock Exchange listing and bankruptcy systems, which are based on common law. This is significant because if you look at all the countries that have had financial problems over time, no common law system has ever gone bankrupt. Civil law has. China is slowly adopting a rule of law system.”
Not all of the changes have been smooth. “One of the biggest things that China has been wrestling with is the fear of inflation,” Holmes said. “The government raised the minimum wage and that resulted in a big spike in food inflation. Then it had to deal with real estate inflation in Shanghai and the cities along the ocean. It required banks to keep more reserves, up to 20% in some cases, to avoid the problems now occurring in European banks. A tax on speculative real estate slowed the economy and it showed up in the psychology of the stock market.
“The spike is slowly reversing and rates are falling. Because there is so much less borrowing generally in China than in the rest of the world, prices rebound much faster,” Holmes said. “Only 25% of homes have mortgages so the impact of bankruptcies is much smaller. Also, I don’t think they’re going to print money the way they did in 2008. The Chinese government will move slowly to make sure the country doesn’t get hurt by Europe’s slowdown.”
Based on money supply, debt levels and the weakness of the dollar, Holmes predicted economic activity in the emerging countries should double over the next five years. “It is going to be between 8% and 9% this year and it has another 10 years of growth ahead of it,” Holmes said. “Investors need to understand volatility and not be fearful of it. If you are trading futures where your leverage is 10 to 1 and you have a big correction, you can get wiped out. But, if you are a cash business, you understand when these markets go through these corrections. Solid companies paying dividends can be an attractive investment over the long term.”
Gordon Chang: This China-watcher recently wrote an article for Forbes that said what others considered positive November trade numbers—exports up 13.8%, imports up 22.1% year-over-year—was actually an indication of flat consumer demand once the commodities were factored out. His conclusion was that the government was taking advantage of low prices to stockpile things like soybeans, copper and iron ore while domestic demand remained stagnant. “Since September, we have seen essentially flatlining growth,” he said.
“The growth over the last three decades has been absolutely stunning, but that was then, and this is now,” Chang cautioned. “After 35 years of virtually uninterrupted growth, the Chinese economy hit an inflection point, probably in September of this year. I think we are going to see a long-term cycle down. There are a number of reasons for it, some of them short term, some of them long term. The reasons that created this growth either no longer exist or are disappearing fast. Deng Xiaoping’s policy of reform paired with the end of the Cold War and expansion of globalization triggered growth in the 1980s. However, under current leader Hu Jintao, China has seen the reversal of reform, with the government partially renationalizing the economy. Today, we are in the second part of a global downturn, which will be much worse than what started in 2008. A trade-dependent economy like China’s is going to have real problems. Additionally, China was aided by the demographic dividend, an extraordinary bulge in the Chinese workforce, which by most estimates will level off between 2013 and 2016, leaving a demographic tax where one worker supports two parents and four grandparents.”
Chang pointed to stagnant electricity consumption, flat car sales, plunging industrial orders and collapsing property prices. “For example, in October, we saw property prices collapse 30% in places like Shanghai and Beijing, and actually across the country. That has to eventually trigger a negative wealth effect.
“Domestic growth is vital for a sustainable economy,” Chang said. “Last year, domestic consumption comprised less than 34% of Chinese GDP and it has been dropping in recent years. That means China is not restructuring its economy because the problems go to the core of the political model. The government would have to let the Renminbi float, allow banks to offer market rates of interest to depositors and state enterprises, allow workers to bargain collectively to get higher wages and provide a better social safety net, especially in the health care area. These are things that Beijing didn’t do a half-decade ago when it was growing at 9.9% and they’re certainly not going to do so now in a very difficult environment.”
On the manufacturing side, Chang referred to the December HSBC/Purchasing Managers’ Index (PMI). “It showed an absolute, outright falloff in industrial orders domestically. I think that is a really important indication of the problems,” Chang explained. Technically, the Chinese economy went from expansion in October to contraction in November when it crossed the critical 50 line. Any number above 50 shows expansion; any number below 50 shows contraction.
The fact that China is reporting negative numbers is telling in itself, according to Chang, who said often government-issued statistics conflict with reports from other sources. Beijing reported 13.8% export growth in November. However, during that same period factories went bankrupt, factory owners fled because they couldn’t pay their debts and some of them took their own lives. Even more damning are container and freight statistics, including reports from mega-container shipper Cathay Pacific that showed November cargo shipments down 13.8%. “Exports to Europe have fallen off the cliff and the EU was China’s largest trading partner so something doesn’t add up,” he said.
For the final blow, Chang pointed to the actions of the Chinese government. “If China really does have robust, 8–9% growth as everybody says, why is the central government starting to stimulate the economy again? That just doesn’t make any sense. If we look at things like imports and exports, I think the economy is really in trouble.”
Chang warned of political consequences if the country is not growing at least close to a double-digit rate. “I don’t know if China can stand 3% growth—or the other very real possibility, contraction. The American government bases its legitimacy on the nature of its political system. The legitimacy of the Communist Party is primarily based on the continual delivery of prosperity. Already, the number of protests in China has increased dramatically from maybe 70,000 mass incidents a year in 2005, to as many as 280,000 last year. In addition to strikes, riots, insurrections and bombings, the standoff between villagers and the authorities in Guangdong province are threatening the future of the Communist Party.”
One solution is for the Chinese government to continue to spend millions on infrastructure to create growth as it did when it spent $1.1 trillion after the 2008 downturn. “This tactic is of limited usefulness the second time around,” Chang warned. “It may be able to play out the game for 18 months, maybe two years at the outside, but it’s pretty much done. Plus, the artificial stimulus also created a stock market bubble, inflation, ghost cities, banking weakness and property bubbles. Massive spending didn’t avoid problems, it just postponed them and made them bigger and more difficult to solve.”
Chang said that people in China are starting to see the reality of the problem. “There is a sense of pessimism. Starting in October, we saw large, unexplained transfers of money out of the country.”
The bright spot, according to Chang, is that while China will not be able to fuel a global recovery with a consumer-driven middle class, a Chinese meltdown won’t be a major blow to the U.S. either. “We have the world’s largest internal market; 70% of our GDP relates to consumption. Exports don’t really play that much of a role in the U.S. as it does in other major economies. So China can fall off the cliff in a sense, and it would have some negative effect but not very much. In fact, we might benefit from it.”
Chang’s conclusion? “People say the Chinese economy is the global engine of growth, but that’s not true. The engine has been the American consumer because we are taking every other country’s exports, and the Chinese, through predatory and mercantilist policies, have been grabbing growth from other countries. For the last 200 years, China has been a potential source of customers for other countries. Still, domestic demand isn’t that significant. China’s imports lately have been commodities and that is going to fall off because China’s exports of manufactured goods, to Europe and the U.S., are going to be stagnant or lower than they have been in the past. So China really reacts to the rest of the world. If the changes over the next couple of months are as dramatic as they’ve been for the past two, then we’re going to be looking at a very different China. The Chinese economy could fall into a big black hole with 1–2% growth or even contraction. Can the government turn it around as it has in the past? That’s the money question.”
Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. In 2006 Mining Journal, a leading publication for the global resources industry, chose Holmes as mining fund manager of the year. Holmes co-authored The Goldwatcher: Demystifying Gold Investing (2008). A regular contributor to investor-education websites and speaker at investment conferences, he writes articles for investment-focused publications and appears on television as a business commentator.
Gordon G. Chang is the author of Nuclear Showdown: North Korea Takes On the World. His first book is The Coming Collapse of China. He is a columnist at Forbes.com and The Daily and blogs at World Affairs Journal. He lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai, as counsel to the American law firm Paul Weiss and earlier in Hong Kong as partner in the international law firm Baker & McKenzie. His writings on China and North Korea have appeared in The New York Times, The Wall Street Journal, the Far Eastern Economic Review, the International Herald Tribune, Commentary, The Weekly Standard, National Review, and Barron’s. He has given briefings at the National Intelligence Council, the Central Intelligence Agency, the State Department and the Pentagon. Chang has appeared before the House Committee on Foreign Affairs and the U.S.-China Economic and Security Review Commission. He has appeared on CNN, Fox News Channel, Fox Business Network, CNBC, MSNBC, PBS, the BBC, and Bloomberg Television. He has appeared on The Daily Show with Jon Stewart.
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By The Energy Report, on December 28th, 2011
 According to Jim Letourneau, author of the Big Picture Speculator, oil and gas aren’t going away any time soon. Indeed, new technologies offer the industry and investors profitable opportunities. Read more about why Letourneau considers shale gas, shale oil and enhanced oil recovery “game changers” in this exclusive Energy Report interview.
The Energy Report: Jim, in a nutshell what is the big picture in the oil and gas space right now?
Jim Letourneau: Despite a big renewable trend, oil and gas are still critical to world energy markets. We will need both for the foreseeable future, at least the next decade.
TER: You recently wrote about fear paralyzing the market. What effect is fear having on you as a newsletter writer?
JL: When people are scared, they want dividends, U.S. dollars and precious metals. No matter how interesting or exciting the company is, in a really strong bear market it will not matter unless the assets are productive today. People will look at a mine that is in production and has cash flow. A project that involves lots of drilling to build out a deposit is a tougher sell.
Most newsletter writers, myself included, do not like talking about companies whose stocks do not appreciate. Fewer people want to be invested in the stock market because they don’t see why they should be. However, even that can be an opportunity. When people are fearful, sometimes the market can turn and have a really nice run. If we do not have new lows over the next couple of months and the trend changes, we would hypothetically be able to enjoy that for quite some time.
TER: Some oil and gas companies are boosting dividends in an effort to get attention in the market. Do you expect that to continue?
JL: That is a way of showing off, of saying “Look, we are so comfortable with our business model that we can afford to pay out dividends.” If there is a bull market in dividend-paying stocks, there also could be a time when that popularity will end. It could be just a passing phase.
TER: But it does provide a bit of flexibility: A company can increase or decrease its dividend. It is one of the cards a company can play if it has a lot of free cash flow.
JL: Exactly. Some of the major gold producers are increasing their dividends. Everything else being equal, I would rather have a dividend from a gold producer than from a financial institution. Banks will tell you everything is great until the day before they collapse. If people are looking for dividend-paying stocks, at least gold mines or oil and gas companies have productive assets; they produce something of value. That’s where I would concentrate.
TER: That seems to be where the Chinese are concentrating. Sinopec just bought Daylight Energy Ltd. (DAY:TSX) for a little more than $10 a share, more than double the closing price the day before the bid. Do you think China will continue to turn its dollars into hard assets while dollars still have value?
JL: The short answer to your question is yes. China is making acquisitions all over the world every day of anything that is productive.
It tells you something about the state of the market that Canadian investors thought Daylight was worth less than $5/share and China waltzed in and paid $10 without any haggling at all. This was an opportunistic move by Sinopec.
Chinese companies have taken the clever strategy of going for lesser-tier companies. If they go for a bigger one, they will take a minority interest so it is not seen as a takeover.
TER: What did Daylight have that the Chinese wanted?
JL: Daylight has oil, natural gas and high-content natural gas liquids in a few different plays in western Canada. The Chinese are buying companies with the potential for productive assets.
I think China also has a very long-term horizon concerning its energy policies. The country is willing to invest in the long term over a broad portfolio of energy sources. The Chinese know that all the investments may not all work out, but they can afford to do it.
We are still building out the capacity to export natural gas from North America. If that happens, our low-price North American natural gas will be very attractive to China.
TER: At a recent investment conference in Montreal, you told the audience about three “game changers” in the oil and gas space: shale oil, shale gas and enhanced oil recovery (EOR). Can you please give our readers the nuts and bolts of your presentation?
JL: All three of those things involve new technologies that are squeezing more oil out of the ground than we ever thought possible.
In terms of shale oil, the best example is the Bakken in North Dakota and Saskatchewan, and possibly Montana and Southern Alberta. The Bakken really changed the oil and gas landscape in North America to the point of using trains to transport gas from North Dakota to Texas. And there are a lot of other source rocks that have the same characteristics and will be developed over time.
Shale gas was actually the first big game changer. Five years ago we were building natural gas import terminals because we thought we would run out of domestic natural gas. Today, North America has the cheapest natural gas in the world and we are building export terminals. It started in Texas, in the Barnett Shale. For every argument that says shale gas will not work, there are arguments that say it will. A lot of the technical problems that exist today will be solved in the not-too-distant future. That is one of the reasons I am not a huge believer in peak oil; yes, you can extrapolate present-day trends, but you cannot predict what human innovation will come up with to increase supply.
That leads to the third category, which is enhanced oil recovery. Big picture, roughly a third of the oil that has been discovered has been produced. Getting the next third out will take some innovation. There are a lot of interesting technologies in EOR that make it quite likely that the next third will be produced. Recovery factors can move up from 33% to 50% or 60%.
TER: I see your point on shale oil and EOR. But gas prices on the NYMEX are at record lows. Very few companies can make money at that level. The only shale-gas companies seeing an uptick in their share price deal with natural gas storage, and they are running out of places to put it. How can an investor make money in shale gas?
JL: There are two sides to the story. First, abundant, cheap shale gas is good for consumers of natural gas. Second, all commodity bull markets end.
Natural gas is not the best place to invest, but, it does point to the opportunities. The service companies that unlock the shale gas are doing fairly well. I suggest that people look not so much at the producing side but more on natural gas being used as transportation fuel. Some petrochemical industries and the steel industry will benefit from cheap natural gas. So, you have to be a little bit nimble.
TER: Could you give our readers a name or two in the shale-oil space?
JL: I really like Shoal Point Energy Ltd. (SHP:CNSX) because not too many people pay attention to the company. It discovered Green Point, an oil-in-shale play in Port au Port Bay in western Newfoundland. The Green Point shale can be over 2,000m thick, compared to the Bakken, which is typically 30m thick. The extra thickness really changes the amount of oil per section. Shoal Point has an oil-in-place number of at least 100 billion barrels, calculated from volumetrics. Production will be the challenge, but that is just too big a resource to ignore.
TER: The company also has the Ptarmigan oil-in-shale play in Newfoundland and the South Stoney Creek gas play in New Brunswick. How is Green Point progressing?
JL: There was a delay for further testing and Shoal Point had to wait for permits. Investors got a little discouraged because everybody wants results right away, and the share price languished.
Now, the company has the permits and will deepen the well and test it soon.
TER: In other Newfoundland oil projects, the provincial government has wanted a piece of the action. Does the government have a piece of this?
JL: I’m not sure. But, I cannot imagine Newfoundland not having a royalty interest because that is typically how we do things.
TER: Are there other shale oil plays?
JL: There are a lot in the Alberta Bakken, in Montana and southern Alberta, where that play has yet to really ignite and catch on fire. Companies are also looking in the Duvernay in Alberta. That is a deeper, Devonian shale that sourced a lot of the Leduc oil.
TER: Do you have any names in the shale gas space?
JL: Given that the price of that commodity keeps dropping, one way to play shale gas is through service companies. GasFrac Energy Services Inc. (GFS:TSX) has gotten a lot of attention for using gelled propane as the carrier fluid instead of water.
There has been a lot of concern about the use of water in fracking. Very few people realize that most oil and gas production in North America involves about 10% oil and 90% water.
People like GasFrac because it does not use water. But more importantly, in certain types of formations having a liquid hydrocarbon that changes to the gas phase when the pressure drops helps avoid the formation damage and other problems that can happen when you use a massive water-based frack.
TER: In terms of enhanced oil recovery, what names are you following?
JL: There are very few specific companies; usually it is an oil company with a project. One that I have been following for a long time, and worked for, is Wavefront Technology Solutions Inc. (WEE:TSX.V).
All versions of EOR involve injecting a fluid. It could be water, CO2, chemicals or nutrients. The more uniform and evenly distributed those fluids are, the better the process will work. Wavefront has patented an injection process that provides that uniform fluid distribution.
The company is not quite profitable yet, but the growth will come quickly from its Powerwave application for EOR.
TER: Wavefront now has a market cap of around $68 million (M). It would not take long for a major producer to get older assets to market if this technology works as well as you suggest.
JL: The biggest upside for oil companies using the technology is that they can increase their reserves without infill drilling. The oil industry does not just jump and try new technology; it likes to see some proof. Wavefront now has proof. The longest Powerwave installation is over four years old. It has numerous case studies that document how the technology works and how it makes money for the client. It has made the transition from an unproven technology to a proven technology. It is now a commercial technology with a lot of upside.
Wavefront is essentially a technology company that licenses its technology to oil companies. Wavefront will not have a lot of additional expense to sell 100 tools or 150 or 200. The scalability is exciting.
TER: If a major can apply that technology in its old basins, it would not take long to reach perhaps, $70M worth of oil.
JL: Definitely. Of course it depends on the size of its fields, but increasing ultimate production by 5-10% provides some big numbers. More and more people are seeing exactly that. Wavefront could become a takeover target. The company has roughly $24M in cash. It has a lot of staying power.
TER: Jim, what should investors be keen on in the oil and gas space in 2012?
JL: I would still look to oil and gas service companies with the right technology. Shale gas fracking companies are interesting plays to look at.
I would not be too excited about natural gas producers. Those producers who are moving toward liquid rich natural gas are a little more interesting.
Overall in the oil space, the only thing that would move oil prices any higher would be severe geopolitical tension. And I wouldn’t be shocked to see some unpleasant geopolitical tension in 2012. Economic news is creating tension all over the world. When that happens it’s usually pretty bullish for energy prices.
TER: Jim, thank you for your time and insights.
Jim Letourneau is a public speaker, geologist, corporate evangelist, and investor in emerging technologies and discoveries.
By Bron Suchecki, on December 28th, 2011
Mineweb (ex-Reuters) is reporting that “Gold exchanges in China outside of two in Shanghai are to be banned, authorities said in a statement released on Tuesday.”
Looks like the much hyped Pan Asia Gold Exchange is dead. Not sure where this leaves those who claimed that it “will ultimately destroy the remaining short positions in both gold and silver”.
I will come back to this story but for the moment I want to see how the pumpers and hype merchants spin it, or unspin what they said before.
I also find it interesting that this story breaks at the same time as China Daily reports that “China should further diversify its foreign-exchange portfolio and make more gold purchases when the metal’s price dips but is still at a relatively high level, a senior central bank official said on Monday.”
What is China’s game re gold? How can we weave these two stories into a coherent explanation?
By Ajay Shah, on December 27th, 2011
Patrick Chovanec has a fascinating article in Foreign Affairs, titled China’s Real Estate Bubble May Have Just Popped. This is interesting and important from two points of view.
First, bad news for China is bad news for the world economy. We are already in a bleak environment, with difficulties in Europe, Japan, the US, and India. It will not be pretty if China runs into trouble as well. I am reminded of the feeling of carefully watching real
estate in the United States in 2006, with a sense that the future of the world economy was going to turn on how it turned out.
Second, it made me think about real estate in India. As with China, one often sees buyers of real estate in India have the notion that
this is a safe financial asset. This is a questionable proposition. Real estate is perhaps not an asset
class with a positive expected return in the first place; and it is certainly not a convenient asset class with features like liquidity,
transparency, diversification and easy formation of low-volatility diversified portfolios. I find it hard to explain the prominence of
real estate in the portfolios of even educated people in India.
In the article, Chovanec says:
For more than a decade, they have bet on longer-term demand trends by buying up multiple units — often dozens at a time — which they then leave empty with the belief that prices will rise. Estimates of such idle holdings range anywhere from 10 million to 65 million homes; no one really knows the exact number, but the visual impression created by vast `ghost’ districts, filled with row upon row of uninhabited villas and apartment complexes, leaves one with a sense of investments with, literally, nothing inside.
This has not happened in India. So in this sense, the situation in India is not as dire. But his second key message seems uncomfortably
close:
As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some
cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts.
Part of this looks familiar. There is a lot of leverage in Indian real estate development and speculation. Real estate speculators and
developers are finding themselves in a bit of a scramble hunting for credit. One hears about very high interest rates being paid by
developers. Other sources of financing are also weak. This reminds me of the dark days before the global crisis, when borrowing by real estate companies was the canary in the coal mine.
If business cycle conditions and financial conditions worsen, the problems of borrowing by real estate developers and speculators will get worse. How might this turn out? Perhaps the borrowers will merely get uncomfortable. Or, a few firms could really get into trouble, and start liquidating inventory. That would have substantial repercussions.
Suppose there is a situation where there are many people who have speculative positions in real estate, but significant selling of
inventory has not yet begun. The longs would then be nervously looking at each other, wondering who would be the first one to sell, to take a better price and exit his position. The ones who sell late would get an inferior price. In such a situation, conditions could change sharply in a short time.
On a longer horizon, I would, of course, be delighted if real estate prices are lower. This would help shift the supply function of
labour, reduce the cost of setting up new businesses, etc. But that’s more about the long-term policy changes, which would remove barriers for converting land into built-up housing, while rising vertically into the sky with FSI in Indian cities ranging from 5 to 25.
By The Gold Report, on December 15th, 2011
 David Morgan, publisher of Silver Investor, likes the balanced risk and growth that midtier companies provide, but even he can’t resist the pull of having a speculative pick pay off. In this exclusive interview with The Gold Report, Morgan talks about the tenets he lives by when investing in mining companies, be they small-cap or midtier or billion dollar companies.
The Gold Report: David, in August you predicted that the silver price could go as high as $75 an ounce (oz). It was recently at about $32/oz. Where is it along the path to $75/oz?
David Morgan: I don’t see the silver price going above the $50/oz level in 2011. In other words, the top is in for this year, and has been for some time. I do see silver’s price going above $50/oz in 2012. I forecast $65–75/oz silver by the end of 2012. I don’t foresee a big rush into price appreciation for gold or silver in the first quarter of 2012 (Q112), which is seasonal. Typically, there is a very strong boost to the price of metals in the first quarter of every year. However, this year I’m suspect because of what’s going on in the Eurozone and all the paper pushing between the central banks of the world. I’m reserved about what’s going to happen over the next three months.
TGR: What did you think of the recent move by central banks in the U.K. and Canada getting together to boost liquidity in the markets? It seemed to push up the gold price a bit.
DM: It was what I call “old school.” I’m showing my age, but we used to avidly watch the U.S. money supply. When there was a significant increase in the money supply, the gold price would reflect that because it is more dollars chasing a fixed amount of goods. It’s a clear indicator that papering over the problem is not a solution and gold is shouting that loudly. The increase in M1, M2 or M3 (not provided by the Fed anymore) is looked at, but not with the intensity it was in the 1970s.
TGR: In the November issue of Silver Investor, you report that China could become a significant holder of European debt. While any such move would devalue China’s significant holdings of U.S. Treasuries, it would provide leverage for China’s efforts to form a new global currency backed in part by gold. Could you expand upon that idea?
DM: China as a nation has become the creditor of last resort because it has money to recycle. The more debt that it owns, the more control it has over the debt. China would have a lot of leverage in any default negotiations. There was a conference about a gold-backed yuan about a decade ago. The idea about a gold-backed currency is probably going to take place at some point in the future. China has bought more gold all along than they publicly admit, but the amount is far too small at this point to do any real gold backing to their currency. The country continues to buy gold slowly and quietly. It’s hard to say when China would have enough to make a viable gold-backed currency out of the yuan. That’s where the negotiations would come into play.
TGR: Do you think it would take decades?
DM: It would take decades to accumulate enough to make a gold-backed yuan in the fashion China is acquiring gold now. However, if China dumped a significant amount of its money (U.S. debt) into gold at once it would drive up the price thousands of dollars an ounce overnight. Gold would go ballistic. On the other hand, China has the leverage of the debt. In other words, it says, “U.S., you owe us this much money, so what we’ll do is we’ll discount the debt. You send us this much gold and we’ll cancel out part of the U.S. debt we hold.” That is a lot of power. Remember, “The borrower is servant to the lender.”
TGR: You recently reprinted Ron Hera’s “23 Ways to Boost Silver Investment Profits.” It talks about risk versus growth.
DM: The best place to be in this market, after establishing a physical metals position, is on the mining side by balancing risk with growth. I like the midtiers because this is where the greatest growth is along with mitigated risk.
TGR: Hera also tells investors to take a 24- to 36-month time horizon.
DM: All markets move up and down, including the silver market. Investors have to take the long-term view of this market. There is still a major trend to the upside, but there’s going to be more volatility.
TGR: Hera tells investors to be greedy when others are fearful and be fearful when others are greedy.
DM: I was getting fearful while others were getting greedy when silver was around the $35/oz level on its way to $50/oz. I cautioned investors that if they had to buy silver at that level to only buy some because the market was temporarily overdone. I was getting a lot of blowback from even some of the better analysts for being too cautious. I called the top around $48/oz and I’m pleased with that call. In other words, looking from the perspective of this interview my call was a good one, yet you would not believe the flack I took from some in this business.
TGR: Hera also says, “No excuses.” If a company isn’t progressing, just get out.
DM: You have to hold every company’s feet to the fire. Ask what it plans to do next year and if it met its milestones last year. The idea is to strive to do everything it set out to, but if it can’t then it should report it honestly and move on.
I don’t really like the junior sector that much. There are a lot of companies that have gone by the wayside early in the junior mining cycle. There are still some good values out there, but it’s pretty tough to call these days.
TGR: He also advises that investors pay attention to value and don’t pay a premium to get on the bandwagon.
DM: I agree. For example, we did an update on Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ) sometime ago that showed how valuable it was—even at an extended stock price. A well-known Wall Street stockbroker took the time to call me to say it was an over-the-top, great report. That stock has done extremely well while so many have not.
TGR: Hera also discussed the influence of inflation on real wealth. Given the hidden inflation in the market, he argues that to preserve or even grow wealth, investors have no choice but to seek higher gains of a minimum of 25% a year. What’s your perspective on it?
DM: Markets are volatile. They wax and they wane. The market is in a period of consolidation. Very few stocks are reflecting their true value. It’s a good time to gradually get into these stocks. They could go lower over the next few months, but they represent one of the best places to put money right now.
As far as what to expect in the future, let me just state that I agree with ShadowStats.com Editor John Williams’ prediction that we have 10% inflation. There will always be some dogs (stocks) that won’t move, but there should be some real gains in precious metals. If there’s truly 10% inflation, there could be 25% gains in a mining equity, which would be a 15% real gain versus the true inflation rate. Once the sector gets hot again, the gains could be huge.
Presently, stocks are undervalued, which means be greedy when everyone’s fearful. This is the time investors should be buying.
TGR: Some pundits are saying that the market’s going to go even lower before it heads higher. Do you believe that’s the case?
DM: I do, but to think that you can pick an exact bottom is an amateur’s game. A professional tries to get in and accumulate while the getting is good. I’m looking at December through perhaps as late as April.
TGR: If investors are trying to reach 25% returns per year, they’ve got to turn to the small-cap space.
DM: Not necessarily. First, to expect those returns every year is unreasonable. However, investors could make 17% a year just by holding a good company, like Royal Gold, and writing the options on it. The options writers win 85% of the time and the option buyers lose 85% of the time. An investor could rent a stock like that out to people that want to play the options game and smile all the way to the bank—even in a downtrending market.
TGR: Nonetheless, you have some speculative buys on a handful of small-cap silver plays.
DM: Of course. Nothing is more exciting than getting a speculation right. We had Western Copper before it was renamed Western Silver, and eventually bought out by Glamis. Glamis was eventually bought out by Goldcorp Inc. (G:TSX; GG:NYSE). When you get a 4,000% gain on something, you can’t help but smile.
We like some small caps. Silvermex Resources Inc. (SLX:TSX; GGCRF:OTC) is one that we’ve come back to. The stock did fairly well after our initial recommendation. Then we went into this financial situation that clobbered everything and Silvermex had to regroup. We sold it. We came back to it when it was very undervalued. I’ve done that on several companies.
TGR: Silvermex is down about 26% year-over-year right now. Is that just the market or is that fallout from the deal with Genco Resources Ltd.?
DM: It’s both. The Genco deal looks pretty good on paper, but the market is giving a different vote right now.
Sometimes persistence pays off in stocks, however. I’ll give you an example. We owned First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:Fkft) for a very long time. We had it at $4/share, but it was under $4/share month after month. When that stock finally caught on it went like gangbusters. We could have missed a huge move in that stock if we weren’t persistent. Am I always right? No. Am I right on Silvermex? I don’t know yet. Does it look bad at this particular point in time? Yes, it probably does. But I know enough to know that there’s a strong probability that at some point the stock will catch up.
TGR: What’s your view of Silvermex’s management?
DM: It’s one of the better management teams out there. I know Mike Callahan, Silvermex’s president who was formerly an executive with Hecla Mining Co. (HL:NYSE). I also know Art Brown, who was also with Hecla. Silvermex has a strong board. They want to make this company viable. They have something to prove.
TGR: It’s trading at about $0.40/share right now. Is that a good entry point?
DM: We had it earlier than that, but it’s probably OK. Investors could slowly build positions between now and April to take advantage of any further market decrease.
TGR: You’ve done pretty well with some of the midtiers, too.
DM: Pretium Resources Inc. (PVG:TSX) stock is up 20% after it announced a much larger, higher-grade asset. We were into the stock at around CA$8/share. It’s well above CA$10/share, but it’s still undervalued. We love the management. Robert Quartermain has a proven track record. Investors see a stock move and they’re scared to buy it. That’s incorrect thinking. A lot of these stocks that make big moves make new high after new high. How else does a stock go from $5/share to $50/share?
TGR: Pretium is up about 45% so far in 2011. How much upside is left?
DM: I think there’s plenty left. Think about buying $1,000 worth of Coca-Cola stock in 1928. People worry about how much is left, but what if the stock goes up 500% or 5000%? You have to let the stock tell investors how much upside is potentially left. You don’t want to sell your winners. You want to sell your losers.
TGR: What other midtiers still have some upside?
DM: Tahoe Resources Inc. (THO:TSX) is a great company on my watch list with a lot of upside. It’s not very well known.
TGR: BMO Nesbitt Burns has a $26/share price target on Tahoe. It’s trading around $18/share now. Do you think that’s reasonable?
DM: I do, but I don’t like to use price targets because it’s a no-win situation. If it makes a target and it stops at that exact price, you’re a genius. If it’s under that or over that then you get nothing but flack. Do I think Tahoe is undervalued? Yes.
TGR: Tahoe is planning to produce about 316.9 million ounces of silver from its Escobal property in Guatemala over the next 18 years. Do you have any doubts that it will execute on that?
DM: There are always doubts in the mining industry. There’s jurisdictional risk in many South American countries. Am I confident that it’ll happen? No, not today. Investors should spread out geopolitically. It’s very important in today’s financial climate to expect the unexpected.
TGR: The company is run by Kevin McArthur, who was the president and chief executive of Glamis Gold, which was taken over by Goldcorp, and then headed Goldcorp. It’s hard to argue with that kind of track record.
DM: I’m not. You have to put a great deal of credence into that caliber of management. But the best management in the world in the wrong jurisdiction can have problems. Robert Quartermain is one of my favorite examples. He was involved in a project in Russia and got burned slightly.
TGR: Are there any other company stories you’d like to share with us?
DM: Prophecy Coal Corp. (PCY:TSX; PRPCF:OTCQX; 1P2:Fkft) is undervalued. Prophecy Coal was two companies. It’s a coal company, but it also had a platinum group metals company that was spun off. I still like the Prophecy Coal side.
It’s a long-term project with a lot of hurdles to overcome in the uncertain jurisdiction of Mongolia. However, I have been to Mongolia and met with some of the people heading up the project, which will be using the coal deposit to fuel a power plant. I got a pretty good feel for how serious they are. As a speculation, it’s one of the better ones.
TGR: Do you follow 49 North Resources Inc. (FNR:TSX.V) at all?
DM: Yes, it is on my watch list.
TGR: It’s a different kind of play. It’s a little like the Pinetree Capital model where it takes positions in companies involved in many different resources.
DM: What I like about that type of model is that it spreads risk out. These are run by professionals that know what they’re doing. That model is especially good for the retail investors who don’t have the time to understand what they’re buying. It’s a good way to play the market.
TGR: In a response to a readers’ inquiry about the frightening possibility of deflation, you replied, “I do see a deflationary scare and suggest you buy all the way through it—three to six months. These mining stocks are cheap, but could get cheaper. I do not see it as being as bad as 2008.” How bad do you see it getting?
DM: The mining equities market could drop another 10%. But it’s possible that the current market is as bad as it gets. I do not see the financial crisis of 2008 repeating in 2012. But something needs to be done that’s going to really strengthen the financial markets and confidence in the system on a global basis. If that isn’t done, I expect 2008 or worse to repeat at some point. But, again, I don’t think that will happen for a couple of years.
TGR: Thanks for taking the time to share with us.
David Morgan (Silver-Investor.com) is a widely recognized analyst in the precious metals industry and consults for hedge funds, high-net-worth investors, mining companies, depositories and bullion dealers. He is the publisher of The Morgan Report on precious metals, author of Get the Skinny on Silver Investing (Morgan James Publishing, 2009) and featured speaker at investment conferences in North America, Europe and Asia.
By The Energy Report, on November 16th, 2011
 From fossil fuels to fission, growing global demand for power generation offers investment opportunities. Thermal coal is heating up and the uranium junior mining sector is set for development and a wave of consolidation. Geordie Mark, mining analyst with Haywood Securities in Vancouver, shares his thoughts in this exclusive Energy Report interview.
The Energy Report: There have been recent takeovers in the coal sector, including the $1 billion (B) takeover of Grande Cache Coal by a Chinese and Japanese business combination. What should investors take away from that deal?
Geordie Mark: Investors need to be aware that metallurgical coal is intimately related to the steel market. Our expectations for growth in the steel market drive our expectations for growth in metallurgical coal. It is a positive sign that the market sees the value of such a strategic commodity. We’ve seen a lot of activity this year in the space, highlighted by the $4B takeover of Riversdale by Rio Tinto (RIO:NYSE; RIO, ASX) primarily for Riversdale’s metallurgical coal asset base in Mozambique.
TER: Chinese imports of metallurgical coal have grown along with China’s steel sector. Do you see this trend slowing in the near term?
GM: With steel demand increasing, we expect China to have an ever-increasing footprint in terms of metallurgical coal consumption. Long-term, there is still big potential for metallurgical coal, although we may see a plateau in pricing in the near term. China is also the largest producer of metallurgical coal, producing more than 500 million tons (Mt) in 2010, but we are expecting continued importation of the commodity in China, as well as Japan, India and South Korea.
TER: Which juniors with advanced coal projects are likely to see some interest from potential suitors on the heels of the Grande Cache deal?
GM: The first that comes to mind is Xinergy Ltd. (XRG:TSX), a company that produces thermal coal, but which recently acquired two metallurgical coal projects. One already produces high-voltage metallurgical coal and Xinergy aims to bring the other into production next year.
Another name is Corsa Coal Corp. (CSO:TSX), which is in production at its own metallurgical coal projects, both surface and underground, in the U.S.
TER: What about Coalspur Mines Ltd. (CPT:TSX; CPL:ASX)?
GM: To put Coalspur in context, it helps to talk about thermal coal. The company’s Vista Coal Project is a strategic asset as there is still underlying, increasing demand for seaborne thermal coal, especially in Asia.
TER: This is coal that is used primarily in power plants, is that right?
GM: Yes, its predominant use is to provide base-load for electricity generation. Coal remains the largest form of base-load power in the U.S. Almost 80% of power in China comes from thermal coal; Japan and India are also very big thermal coal consumers, and importers.
We see Coalspur being able to introduce itself into the thermal coal space through its Vista Project in Alberta, Canada. Coalspur just tied up a contract through the Ridley Terminals in Prince Rupert for up to 8.5 million tons per annum in export volume starting in 2015. Furthermore, the company also signed a memorandum of understanding with CN Rail to co-ordinate coal transport to Prince Rupert starting 2015. The project is right next to the railroad, so it is ideally positioned to add high-quality thermal coal into the seaborne market over the next few years. The large scale of this project, with such high-quality product, and advanced stage of negotiation for infrastructure support, is unparalleled in Canada. We expect Coalspur to make big inroads over the next few years. We have a 12-month target of $2.80 on Coalspur, and it is trading around $1.80.
TER: There is a lot of negative news about the pollution that coal-burning power plants produce. Are you saying that, despite the headlines, the thermal coal market isn’t going away any time soon?
GM: That is definitely what the projections tell us. The International Energy Agency predicts increases in thermal energy consumption over the next 20–25 years. I don’t see thermal coal—the largest form of base-load power across most economies—going away anytime soon as most of tomorrow’s growth is expected to emanate from the Advancing Economies.
TER: Do you have confidence in Coalspur’s management?
GM: Absolutely. The management team has built and run mines in the coal space in various jurisdictions. I am very comfortable with what they will be able to achieve.
TER: The last 12 months have not been kind to uranium companies, especially juniors. Year-over-year, the share price for Denison Mines Corp. (DML:TSX; DNN:NYSE.A), a mid-tier uranium producer, fell 36.5%; Uranium One Inc. (UUU:TSX) dropped 46.2%, and Paladin Energy Ltd. (PDN:TSX; PDN:ASX), a uranium project developer, lost 63.7%. Over the same time period, the TSX Composite Index slipped a mere 4.4%. How do you pitch uranium equities to retail and institutional investors at this point?
GM: The equities have taken a very big hit over the last year, despite the uranium spot price being around where it was a year ago. This equity market artifact is more related to sentiment, I think.
We still see uranium very much as a strategic commodity, even following the nuclear accident in Fukushima. This view is supported by the acquisition and offer activity in the sector in 2011. The sector’s growth outlook looks solid, driven by expected demand increases in China, Russia, South Korea and petroleum-producing nations such as the United Arab Emirates and Saudi Arabia.
TER: The Australian Bureau of Agriculture and Resource Economy estimates that roughly 107 thousand tons (Kt) uranium will be needed to meet demand in 2016. That is about 20 Kt more than the 86 Kt yellowcake expected to be consumed this year. Is an extra 20 Kt a year enough to drive up the share prices of uranium juniors?
GM: I think we need some other catalysts. We need to remove the negativity sentiment toward this sector. For example, we need to see new reactors being built. We need to see a timeframe for non-operating reactors, say those in Japan, to be put back online. Investors need to see more usage of existing reactors and new growth coming into play.
We’re starting to see new demand. A couple of new reactor proposals got the go-ahead in China recently, with construction for the reactors expected to start next year. Progress is starting to be made, albeit on an incremental basis.
The strategic nature of uranium is highlighted by recent interest shown by Cameco Corp. (CCO:TSX; CCJ:NYSE), the world’s largest uranium-only producer, and Rio Tinto in Hathor Exploration Ltd.’s (HAT:TSX.V) Roughrider asset. Rio Tinto’s involvement in the space is very interesting because that company deals with a range of commodities, and it allocates capital across geography and across sectors. By taking an interest in North American assets, Rio Tinto is increasing its stance in uranium.
TER: As I understand it, Cameco came in with what Hathor considered a low-ball bid. Then Rio countered. Has Cameco countered yet?
GM: Cameco has upped the ante and offered an increased bid of $4.50 per share. Cameco has more operational synergy in the region than Rio Tinto, given Cameco’s infrastructure and expertise in the Athabasca Basin. Ultimately, Cameco could provide a greater offer for Hathor than Rio and still maintain similar future margins on the operation.
TER: Does the bidding war for Hathor tell us that the major uranium producers place a premium on jurisdiction?
GM: Yes, but we also have to be cognizant of the inherent quality of the asset. For Rio and Cameco, it’s about where they see the equity markets valuing assets today versus the long-term outlook. It’s a combination of being comfortable in the jurisdiction and in the sector’s value.
TER: Do you expect takeover offers for more juniors with significant high-grade resources in safe jurisdictions, like Canada and the U.S., in the year ahead?
GM: The other situation that has investors’ attention is the potential bid for Kalahari Minerals plc (KAH:LSE; KAH:NSX) and Extract Resources Ltd.’s (EXT:TSX; EXT:ASX) Husab uranium resource in Namibia. Extract Resources is the world’s third-largest uranium company, based effectively on the valuation of the Husab uranium project, which has more than 500 million pounds (Mlb) uranium.
Right now, Kalahari Minerals, the largest shareholder in Extract, is in negotiations with state-owned China Guangdong Nuclear Power Corp. where a potential all-cash offer of £2.4355 per share is potentially on the table for Kalahari.
TER: Another significant project in Namibia is Bannerman Resources Ltd.’s (BAN:TSX; BMN:ASX) Etango uranium project. China’s Sichuan Hanlong Group made highly conditional proposal to acquire Bannerman, but Bannerman recently announced it must do further due diligence before committing to the financing. Is this an indication that Bannerman needs to continue to derisk Etango or that Hanlong simply wants Etango at a steep discount?
GM: Hanlong’s proposal was at quite a low enterprise value per pound rating, much less than $1/lb. That was already a fairly substantial discount to other acquisition metrics in the space. For instance, Hathor and Mantra Resources Ltd. (MRU:TSX) were north of $9/lb. Bannerman’s management and board were talking to many parties subsequent to Hanlong’s proposal. Bannerman’s board considered it to be a low offer for the company. Time will tell.
TER: Do you think Bannerman will find another bidder?
GM: There is a lot of interest out there in the sector for advanced projects, but I think that there needs to be a resolution with the potential take out of Kalahari, and by extension Extract Resources, before focus may move to Bannerman.
TER: Moving back to North America, are there projects here that you expect to generate takeover interest in 2012?
GM: I think people will wait and see how the dust settles for Hathor Exploration, but consolidation is probably the name of the game in the space for the time being. We’ve seen that in the in situ recovery space in North America. There is synergy between Uranium Energy Corp (UEC:NYSE.A), Uranerz Energy Corp. (URZ:TSX; URZ:NYSE.A) and Ur-Energy Inc. (NYSE.A:URG; TSX:URE). Uranium Energy Corp is in production now. Uranerz Energy is in the construction phases, and Ur-Energy awaits a final permit prior to commencement of construction. Then there is the potential merger of Energy Fuels Inc. (EFR:TSX) and Titan Uranium Inc. (TUE:TSX), announced at the end of October.
TER: What did you make of that deal?
GM: I felt it was a positive move for Energy Fuels, in that it gives the company access to a broader resource base, particularly in the uranium mining state of Wyoming. Energy Fuels has potential access to future production through its planned Piñon Ridge uranium-vanadium mill. The Sheep Mountain uranium project in Wyoming is a moderate-sized, defined resource of more than 30 Mlb uranium, and Titan’s management team has a clear objective of progressing the project through permitting and development over the next several years.
TER: What more can you tell us about Uranerz? Do you think it is undervalued?
GM: Uranerz is fully permitted for construction for Nichols Ranch and its Hank satellite facility. Both are on time and on budget. The company has a rich history of developing similar projects—six times in the U.S. There is a lot of confidence that Uranerz can do this. Production is expected to commence in Q312. That timing would make Uranerz the world’s next uranium producer.
The company is being derisked through the construction phase; moving into next-producer status will be very positive for the company.
TER: Uranium Energy Corp is up and running in Texas, where it is working on a second in situ operation there. Given that the company is recovering significant amounts of uranium, is there a likelihood Uranium Energy could see a bid?
GM: You typically see bids coming in after significant milestones and de-risking have occurred. If a bid were to come in, I think it would be after UEC has permitted, built and started production on its second main project, Goliad. There will be a wait-and-see period in terms of external acquisitions.
TER: Why is Uranium Energy Corp a good buy?
GM: First off, UEC is in production. Second, it has a very clear plan for developing its portfolio of assets to increase its corporate production rate. Goliad is at the mature state of permitting and is expected to enter the construction in H112. The company also has the Salvo Project, which could be Uranium Energy Corp’s third project to come into production in a couple of years. The company has a clear strategy to increase production from an existing plant that is already built, permitted and operating.
TER: Until the last few years, few uranium projects have been developed into producing mines outside of Kazakhstan. Other than the price of uranium, why is that?
GM: The lack of new project development is a combination of the long lead times typically required to mature projects through permitting and construction, as well as fluctuating commodity prices and access to project financing. Lack of project development appears to be also an artifact of sector focus. In the last 10 years, a lot of money was spent on brownfields projects that were marginal in earlier periods of exploration, and less focus was placed on greenfields projects. Greenfields discoveries have the potential to add low cost output to the future production project, but discovery and resource definition can take time. I think that it is interesting to observe that despite market sentiment, acquisitions are still on the table in the sector, and these are focused on the few new discoveries (e.g., Mkuju River Project, Husab Uranium Project and Roughrider Project) made over the last several years.
TER: One new discovery is Strateco Resources Inc.’s (RSC:TSX) Matoush Deposit in Central Québec. Do you think that will ever become a mine?
GM: Matoush certainly has potential with just over 20 Mlb U3O8, at grades and close to 0.6% uranium. Because it is in Canada, the permitting process is known, although it takes time to go through and meet all the requirements. The company is in the permitting phase now.
TER: Geordie, thank you for your time and your insights.
Dr. Geordie Mark, a research analyst with Haywood Securities, focuses principally on iron ore, coal and uranium companies involved in exploration, development and production. He joined Haywood Securities from the junior exploration sector, where he served in an executive role concentrating on exploration across Canada. Immediately prior to joining the exploration industry full-time, Dr. Mark lectured in economic geology in Australia and served as an industry consultant. He completed his doctorate in geology in 1998 at James Cook University’s Economic Geology Research Unit in Australia, specializing in aqueous geochemistry and igneous petrology applied to ore-forming systems.
By Bron Suchecki, on October 31st, 2011
Shall we count how many bloggers pick up on this news item Chinese silver imports decline 39% y/y; exports tumble 44% y/y:
Silver imports in China fell by 39% y/y and 16% m/m to 264.7 tonnes, the lowest level since February, while silver exports declined by 44% y/y to 83.5 tonnes, keeping China a net importer of the metal for two consecutive years on a monthly basis.
On a product basis, silver powder, unwrought silver, semi-manufactured silver, and silver jewelery all declined y/y in September with the latter two products suffering the steepest decline and silver powder only falling by 4% y/y. Indeed, silver powder is the only product that has grown for the year-to-date.
And from the “Chinese love paper more than physical” department, see China’s gold frenzy gives birth to small bourses:
The emerging exchanges offer a lot size as small as one ounce, which lowers the capital needed to begin trading, even though the margin requirements can be as high as 30 percent. With lot size set at 10 ounces and margins at 20 percent, the initial capital requirement to start trading is about half the amount required by the SGE.
Emerging exchanges claim to trade physical gold, but most investors are not interested in taking physical delivery. Some exchanges make it difficult and expensive to take delivery. …
“Who would want to take physical gold? People just want to speculate on price moves and make a profit,” said a customer service representative at the exchange who gave her last name as Chen.
Analysts compared the gold investment spree to the wave of retail stock market investors in the last decade, who rushed to a bull market with little know-how, only to suffer huge losses during later market turbulence. …
Although China’s central government has vowed to open up the market, and has made progress by allowing more foreign banks access to the two Shanghai exchanges, an open market for retail investors is yet to take shape. …
But it was unlikely to happen as long as the country’s foreign currency exchange remains tightly controlled. Until foreign exchange controls are lifted, Chinese gold bugs would continue to need tables to put down their bets. “The Chinese love gambling,” said Hou.
Doesn’t sound like China’s exchanges are any different from COMEX. If the Chinese Government wanted its people to buy physical gold you’d think all this paper gold would be shut down. I suppose we will have to wait until the much hyped PAGE is up and running [sarcasm]. 
By Claus Vistesen, on October 17th, 2011
It was telling that just as the ECRI and other notable research outfits decided to push recession button on the US economy the data flow became notably more positive. This could be a sign of the times that the cycle is just too volatile for even capable analysts to call or it could simply be a blip to the otherwise fundamental issue that economic weakness is here to stay for now.
Risk asset markets however made no mince of the recent stabilisation of the euro land crisis as well as the better news flow from the US economy. Just take the following headlines from Bloomberg and you know exactly what kind of sentiment I am talking about.
Quote Bloomberg
U.S. stocks advanced, giving the Standard & Poor’s 500 Index its biggest weekly gain since July 2009, as retail sales beat economists’ estimates and the Group of 20 nations began discussions on Europe’s debt crisis.
(…)
U.S. 30-year bonds capped the longest weekly losing streak since January as concern eased that Europe is unable to curb its debt crisis and U.S. retail sales climbed, damping bets the country will fall into a recession.
The question is then whether it signals a decisive and lasting breakout or whether it was simply a rally to the top of a choppy range before we start another descend to test the lows. Recent weeks’ market movement will suggest that you sell the current levels as top of a post crash range and I, for one do not think we are out of the woods yet. It is important to emphasize two issues on the US economy when it comes to the likelihood of a recession.
Firstly, the US housing market has never recovered and inventories remain low. This means that there is not much room for the economy to slump even if it does enter a recession. Any recession is then likely to be relatively short. Secondly, all liquidity gauges we are watching are pointing strongly upwards which is likely to provide strong tailwinds for risky assets 9-12 months out. Excess global liquidity, US broad and narrow measures of money are all shooting up.
In addition, we should consider the slow but sure movements by all four major central banks to increase either the short term liquidity or simply re-starting QE.
The BOE put itself at the front of the pack with the recent addition of another bn 75 GBP worth of QE, but likewise at the ECB it was interesting to see that long term liquidity operations was re-instated together with an expansion of the covered bond purchasing programme. Additionally, the ECB has been and will continue to be more or less forced to support bonds in the periphery, particularly in Spain and Italy, in order to ring fence the periphery from the coming Greek default. In comparison, the Fed’s latest much debated Operation Twist looks almost modest since it is, by the letter of the theory, not quantitative easing but rather qualitative easing [1]. Of course, the market is fully expecting the Fed to act aggressively should the economy falter further with a joint financing programme with the Treasury for long duration mortgage products as the most likely initiative alongside the more technical move in the form of reducing interest rates on excess bank reserves to negative.
I think it is important to realise that the Fed, with its latest actions, have its gaze firmly fixed on stimulating a recovery in the US housing market which is seen as the most important missing leg in an already faltering US recovery.
In Japan, the BOJ’s situation is different in the sense that economic has been distorted by first the devastation of the earthquake and then obviously the technical recovery as supply side disruptions have eased off. I take note of the fact that the BOJ has verbally put a lot of promises on the table in terms of stimulating the economy not least, one would imagine, in relation to the ongoing strength of the JPY. Finally, it is worth pointing out that the BOJ’s balance sheet has actually expanded briskly in the past two months.
The main conclusion to draw here I think is that while it is certainly not over yet, developed market policy makers are starting to open the floodgates. The euro zone crisis will remain a severe drag and like an almost chronic illness will continue to flare up. A disorderly Greek default can still not be ruled out and as the euro zone policy makers seem to take comfort on even a second of calm it seems to me that the market will have to push harder before we get a realistic proposal for a Greek default.
The recovery in the periphery (or obvious lack thereof) is still not working. The internal devaluation in the European periphery is alive and well when it comes to nominal wage increases which is getting a beating but in the context of lingering inflation in core and headline it leads to a squeeze in real wages and further depresses the recovery. The problem is that a sharp reduction in living standards through a decline in real wages to restore competitiveness is needed but if it occurs without any form of nominal currency depreciation not to mention in the context of very sticky core inflation, it just becomes counterproductive. Absent a fiscal union to socialise the risks it is difficult to see how the euro zone policy makers will be able to come with a fudge that will satisfy markets. In that regard I agree with Chris Wood here.
Ultimately, GREED & fear’s view on all of the above remain the same. This is that the only coherent end game for Euroland remains a formal move towards collective fiscal responsibility, which would ultimately address the fundamental cause of the present crisis. This is the financial fault line represented by monetary union without fiscal union. Euroland either has to go down this path or it has to confront all the problems associated with a break up since in GREED & fear’s view there is no “middle way”
One positive development on Greece is that the private sector involvement (PSI) proposal originally envisioned seems to have been abandoned for a much more realistic haircut.
But more challenging issues remain.
It was hardly surprising that the S&P downgraded Spain last week which only serves to underline the issue that while Greece may be the imminent worry the real problem lies in Spain and quite possibly Italy. There is a limit to the amount of Italian and Spanish bonds that the ECB can buy as long as it is evidently clear that growth prospects continue to remain difficult.
In emerging markets and touching on the theme I dealt with in my last installment the recent inflation data from India indicate why I continue to think that investors may hold too high expectations for easing in big emerging markets.
Quote Bloomberg
India’s inflation exceeded 9 percent for a 10th straight month in September, maintaining pressure on the central bank to extend its record interest-rate increases.The benchmark wholesale-price index rose 9.72 percent from a year earlier after a 9.78 percent jump in August, the commerce ministry said in New Delhi today. The median of 21 estimates in a Bloomberg News survey was for a 9.75 percent increase.
Elevated inflation in India and China are crimping room for policy makers to ease monetary policy and support global growth amid Europe’s debt crisis and a faltering U.S. recovery. India’s central bank Governor Duvvuri Subbarao said yesterday that a more than 9 percent inflation is above “comfort level.”
Of course, the picture is not uniform here with notable economies such as Brazil and Indonesia already lowering interest rates but all eyes are currently on China (and secondarily India) and here I think that we will have to see stronger signs of a hard landing or a relapse into a more severe global slowdown we can expect policy makers to actively stimulate.
In summary, I think that we are indeed nearing an inflection point at which money printing in the developed world will once again provide relief to risky asset markets but the problem is that the underlying economic backdrop has not improved much. In particular, the ongoing lack of resolution in the euro zone represents an issue but Eastern Europe as well as a housing bubble in Australia (and perhaps even in Denmark) are also potential sources of uncertainty not to mention the unravelling of credit excess in China. As such, “it” is far from over but a tradable bounce in risky assets which goes beyond the current choppy range may soon represent itself.
–
[1] – The distinction between quantitative and qualitative easing is simple. The former refers to an expansion of the balance sheet through the central bank increasing its liabilities and adding a corresponding amount of assets. The latter refers to changing the composition of the asset side of the central bank’s balance sheet and as I am reading the gist of OT the Fed has committed to keep its balance sheet unchanged by selling short term bonds and buying long term bonds. Try this one for a good recap of what QE is and isn’t.
By The Gold Report, on October 12th, 2011
The rare earth sector has seen astronomical gains in recent years as Chinese export restrictions, short-sighted U.S. policy and investor interest combined to make front page news. In this exclusive article for The Critical Metals Report, Chris Berry, founder and president of House Mountain Partners, LLC, argues that a “Great Reset” is changing the face of the sector, rewarding explorers far more selectively.
What Economic Uncertainty Means for the Rare Earth Sector
The competition among non-Chinese junior mining companies to successfully mine rare earth elements (REEs) began as a footrace and evolved into a full-on stampede. That race is now unraveling, thanks to slower global economic growth and the sheer number of exploration companies involved in rare earth exploration. We have seen estimates of over 300 companies involved in this global search, and when you factor in the relatively tiny size of the rare earth market (approximately 130,000 tons produced in 2010, according to the U.S. Geological Survey) we still stand by what we’ve said all along—there is room here for a few major players and not much else. We believe the rare earth industry is in the beginning stages of a phase we call “The Great Reset.” We base this theory on four ideas:
- Everything reverts to the mean. This includes rare earth oxide (REO) prices. While we believe we will see a permanently higher price for select REOs, this is not the case for the entire suite of oxides, and prices cannot continue rising indefinitely. The laws of supply and demand have proven this.
- Demand projections for REOs are being re-evaluated downward due to anemic global economic growth prospects. With a tremendous debt overhang in the United States and Europe and evidence of growth slowing in China (the three biggest economies in the world), lower aggregate demand for finished goods that use REOs is a given. We have seen forecasts for REO demand in 2015 that are higher than they are today, and don’t disagree, but the downward revision is indicative of lower demand for most REOs.
- Companies such as Toyota and General Motors are actively researching substitutes for REOs in their products. This type of research has been in progress for some time and we think that these companies would not be spending the R&D dollars if they didn’t want to avoid high REO prices.
- Demand projections for “green” or “clean tech” applications such as hybrid electric vehicles, wind turbines and solar cells are not factoring in whether or not manufacturers of these goods can ensure a steady supply of raw materials (specifically REOs) to meet their production forecasts. The rare earth industry is a customer-driven business in that the customer needs REOs of a highly specific type and purity. If a wind turbine manufacturer can’t procure a specific purity of neodymium oxide, for example, the wind turbine may get built without neodymium, implying demand destruction. We have seen estimates of the use of up to one ton of neodymium needed to produce one megawatt of generating capacity from a wind turbine. China alone has plans to install 100 gigawatts of generating capacity from wind (up from 12 gigawatts in 2009). When you factor in European and American projections for wind power (not to mention other parts of the world), this begs the question of whether or not there is enough neodymium to go around and if there currently is not, will there be enough to satisfy these growth targets in wind generating capacity? We are well aware of the benefits of neodymium-iron-boron magnets in miniaturization and efficiency, but think that if a product can be manufactured economically without REOs, then the manufacturer will choose that path or abstain from building the product at all.
To be clear—we have not “thrown in the towel” on REOs and the important role they play in certain sectors of the economy. What we are saying is that the role will be different from what many in the sector currently suggest. Like many other facets of life, the rare earth sector is Darwinian in nature and will evolve to equilibrate supply and demand. The gratification that comes along with healthy and growing demand for a product (in this case REOs) will be delayed, to the chagrin of investors and rare earth mining company CEOs alike. This “reset” shapes how we think about the rare earth space now and in the future and in deciding how and where to invest. Below is a price chart of the Bloomberg Rare Earth Mineral Resources Index and its one-year performance.
The One Sector Where Supply and Demand Don’t Matter
There is one area of the economy, however, which we think is immune to the vagaries of supply and demand of REOs: the military. While the potential for substitution exists with consumer products, we believe there is no such “wiggle room” when analyzing a country’s defense capabilities. The neodymium-iron-boron magnets we mentioned above are critical in actuators of precision-guided bombs and are designed specifically around these magnets. Actuators are responsible for control of the bomb, and this is just one of several products (lasers and radar being two significant other products) that must use rare earths to function optimally. Without the magnets in the bombs, performance is reduced—implying an inferior product—something nobody should be willing to accept. The U.S. Military is responsible for a small overall percentage of REO demand in the United States, but it is significant nonetheless.
The Rare Earth Supply Chain: The Key to It All
So at this point, we believe two things: first, demand for most REOs will decrease in the near term, and second, that it will be exceedingly difficult for the majority of the junior mining companies involved in rare earth exploration to achieve commercial production of REOs. Despite this, the singular crucial issue that put the rare earth story on the front page of every newspaper around the world in the first place still haunts us—Western dependence on a critical resource from a strategic adversary. While a seemingly endless amount has been written about China’s control of the supply of REEs, what we think is most important (and most often missed by the pundits) is the fact that China also effectively owns the entire mine-to-magnet supply chain. This is the crucial vulnerability. The mining of rare earths is the easy part. It is the resulting steps where intellectual property is created that really matter. In 2010, the United States Government Accountability Office (GAO) was commissioned to deliver a report on the use of rare earth elements in the Department of Defense supply chain. Regarding military capabilities, the report states (Ed. Note: bold text is ours),
“For example, the M1A2 Abrams tank has a reference and navigation system that uses samarium cobalt (SmCo) permanent magnets. The samarium metal used in these magnets comes from China.”
Whether we’re discussing heavy rare earth elements (HREEs) or light rare earth elements (LREEs), a particular concern is the fact that the West is realistically years away from having a supply chain built that can diminish foreign dependence on REOs. Viewed that way, reduced demand for certain REOs could be a blessing in disguise in that it can give Western policymakers more time to formulate a viable strategy, though based on recent behavior in Washington DC (i.e., the debt ceiling debate), we’re not holding our breath. The chart below shows the supply chain for rare earth permanent magnets used in wind turbines and hybrid vehicle motors, among other products. China is responsible for the entire upstream portion of this chain and has designs through mercantilist export policies on owning the entirety of the downstream portion of the chain as well.
There are myriad issues surrounding China’s trade policies and her seeming inability to “play fair” on the world stage. The World Trade Organization recently found that China was in violation of international trade rules for curbing exports of rare earths. The Chinese government is likely to appeal this ruling, effectively kicking the can down the road and prolonging export curbs of rare earths from China indefinitely. Though one could, based on this factor, infer higher prices for REOs, we still believe that slower economic growth and potential for substitution point to lower REO prices going forward.
To get a sense of how Chinese export quotas of REOs have decreased in recent years and the resulting increases in prices of REOs, see the charts below:
Here are the YTD percentage increases in prices of select REOs. More than anything else, we believe, this makes the case for our thoughts on mean reversion and demand destruction described above:
What to Focus on in the Rare Earth Space Going Forward
There are numerous important factors to consider when undertaking due diligence of a mining opportunity (management capability, grade, tonnage, etc.) that we use in the Discovery Investing Ten-Point Factor Model, but we think that there are three keys one must consider initially before looking further at a given rare earth exploration company as an investment.
Despite the fact that we believe the “easy money” has already been made in this sector, we do believe that opportunities for profit exist. Much has been made in recent months of “critical” or “strategic” metals and what constitutes a metal joining this group. We would certainly include rare earths here and, in fact, take this one step further. We consider rare earths to be “political metals.” In the rare earth sector, geopolitics trumps all, and this is the first factor to consider when investing in the junior mining rare earth sector. It should be clear that we have our doubts about permanently increasing demand for REOs. However, due to the significant enhancements REOs provide in military applications, access to a reliable supply of these metals is now on the radar (pardon the pun) of politicians from Brussels, to Ottawa, to Beijing, to Washington DC. In the United States, Sen. Lisa Murkowski (R-Alaska) has been an ardent supporter of rebuilding the U.S. industrial base and supply chain for critical minerals, including rare earths. Rare earth deposits are of strategic significance. A deposit in a safe and stable political jurisdiction is an absolute must.
Second, when comparing rare earth deposits, a decidedly large slant towards HREE mineralization is also a must. After all, the HREEs are truly “rare,” and forecast to be in deficit going forward. In our opinion, investing in a large LREE deposit that promises tens of thousands of tons of REO production per year, when the Chinese dominate this portion of the market and are set to do so going forward, is not a wise move. In the price chart we printed above, dysprosium oxide and terbium oxide (two of the most sought-after HREOs) have increased in price by 704% and 439% respectively, year-to-date. We do not expect continued triple-digit gains in these REO prices, but do believe that deposits with a high percentage of HREEs have potential to outperform going forward.
Finally, while the geopolitics and HREE content are important, without a solid understanding of the metallurgy of a deposit, you could quite literally be investing in moose pasture. This is one of the ultimate differences between rare earths and other metals. Separating 17 metals from each other is an enormously difficult task both technically and financially. This is also a competitive advantage the Chinese have over the West—they have “cracked” the metallurgy of their primary rare earth deposits. While we don’t expect miracles, we do want to see Western rare earth companies making steady progress into understanding the mysteries of the metallurgy. This is one of the biggest risk factors when analyzing a rare earth exploration company.
The Future Is Never Certain, but There Will Always Be a Place for REOs
It appears to be a rather hazy future for the rare earth sector as slow economic growth, potential for substitution, manufacturers potentially misreading demand for their own products that use REOs and price mean reversion all come together to take some of the “froth” out of this market. We think this is a good thing. Regardless, the big picture issues surrounding the need for REOs in various military and clean tech applications are going to keep the industry front and center, but it will evolve much differently than many expect. The Great Reset will ensure that.
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