The Gold Report: When you last spoke with The Gold Report in early March of last year, gold was trading around $1,420/ounce (oz) and silver was around $36/oz. Silver peaked about $49/oz in late April and then gold hit around $1,900/oz in September. Now we’re back up above $1,700/oz on gold and about $33/oz on silver. Where do you see these prices going this year, after it appears that they have likely bottomed out?

Matthew Zylstra: We’re long-term bulls on both metals. Gold has been correcting since September and it looks like it bottomed out around $1,500/oz. We believe the recent decline is a normal pullback in a longer-term uptrend where nothing has really changed to the outlook. We see a perfect environment for the metal—concerns over our currency debasement, negative real interest rates, geopolitical friction, etc. I expect gold will reclaim the 2011 highs and could reach $2,000/oz.

For silver, the picture is less clear. Silver is, in part, an industrial metal accounting for around 50% of demand and less of a currency. Silver peaked at almost $50/oz in April 2011 and the price has been very volatile. We think the move is a correction, again, in a longer uptrend going back to 2003. I expect silver will trade around the mid-$30/oz range this year.

We actually feel platinum has a lot of potential. South Africa, Zimbabwe and Russia account for about 90% of platinum production and there’s a scarcity of good platinum metals group (PMG) projects outside those countries. We expect increased investment demand and believe that supply disruptions, as well as resource nationalization concerns, will drive the price higher. We note that Sprott Asset Management has formed a physical platinum and palladium trust, which could boost investment demand.

TGR: So, what really happened to the platinum market? Historically, platinum traded at a 30–40% premium over gold. Does it have to do with industrial demand or what happened to cause it to trade below gold?

MZ: The main industrial use for platinum/palladium is automotive catalysts. With fears of a global slowdown, their prices came off. But our view is that supply is not going to be able to meet the demand going forward. And, as you mentioned, platinum has historically traded at a significant premium to gold but the value is now only about 95% of the price of gold.

TGR: Getting to the actual equities, the gold and silver stocks certainly didn’t track the metals prices very well the last year. What’s been the problem?

MZ: Gold stocks have performed poorly compared to the metals. We believe this has to do with investors being leery about another period similar to what occurred in 2008 when credit markets froze. Exploration and development companies, in particular, are sensitive to what’s going on in the capital markets since they require capital to continue exploration. Take, for example, Trade Winds Ventures Inc., which was acquired last year by Detour Gold Corp. (DGC:TSX). Shares of Trade Winds traded down to $0.03 in the 2008 crisis. Trade Wind shares were later bought for cash and stock, which at the time amounted to about $0.45 a share. My point is that people are nervous but that creates opportunity especially with what I believe will be a catch-up in equity prices.

TGR: I hope with metals prices staying up, the credit markets will be a little more optimistic and will loosen up a bit.

MZ: We certainly don’t expect another period like 2008. I think that was an aberration.

TGR: So, I hope the stocks start picking up here and not continue acting like gold is $800/oz and silver is $15/oz.

MZ: That is what we expect and the precious metals stocks could really get a boost on QE3 or other stimulus programs.

TGR: So, what do you think is going to be some sort of catalyst to get people more excited faster? Or is this just going to have to be a gradual progression and we are going to have to wait for $2,000/oz gold and $50/oz silver for people to really get into this market?

MZ: The disconnect between gold/silver prices and mining company equities has grown considerably. The sector is cheap by historical standards when you consider the price of gold miners’ shares relative to the price of gold. The Philadelphia Gold and Silver Index (XAU), which is an index of 16 precious metals and mining companies, is close to the lowest level it has been since the 2008 crisis relative to gold. We expect this ratio to gradually work its way back to the average. If we see gold mining stocks move up to even the low end of their historical range versus gold, it will mean a significant gain for many of these companies.

Increased merger and acquisition (M&A) activity in the sector will get people interested in a lot of these companies. As the price of gold and silver continues to rise, the economics become very compelling, especially for large- and mid-cap companies to acquire smaller players.

More interest in precious metals will help too. With what I see as a developing currency war—a race to devalue—I think more investors are going to turn to precious metals and related equities.

TGR: It certainly seems like there are a lot of smaller companies out there with some interesting looking projects that may be sitting ducks for being taken over. If they have to keep going back to the market to raise more money and create more dilution, that could be a problem. What’s your thinking on that?

MZ: Small exploration companies are going to continue to need funds to advance their projects, and costs have been increasing. That’s a major problem. The need to raise capital isn’t going to change but we are seeing alternative ways of financing such as gold and silver streams, alternative debt arrangements and joint ventures, which mean less dilution.

TGR: A lot of companies that were able to load up with plenty of cash at reasonable prices are obviously happy in this market. Do you think they’re going to get pushed to go out and do acquisitions?

MZ: I think what we’re seeing now are mining companies with the ability to acquire languishing juniors taking advantage of the environment. The seniors and intermediates, which have filled up their treasuries with robust gold and silver prices, certainly have the ability to do the same. At the end of the year we saw companies like Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) acquiring Grayd Resource Corp, AuRico Gold Inc. (AUQ:TSX; AUQ:NYSE) acquiring Northgate Minerals, and New Gold Inc. (NGD:TSX; NGD:NYSE.A) acquiring Richfield Ventures Corp. and Silver Quest Resources Ltd. We see this trend intensifying, especially if mining company valuations don’t keep pace with rising metals prices.

TGR: That brings us to a little follow-up on some of the companies that you talked about last time. A couple of the junior producers you talked about were Barkerville Gold Mines Ltd. (BGM:TSX.V) and Orvana Minerals Corp. (ORV:TSX). Can you tell us what’s going on with them?

MZ: The market has been disappointed with production from both companies. Barkerville recently got a boost after receiving a permit for its Bonanza Ledge property, which is a high-grade open-pittable gold resource. The delay in getting that permit meant that production was not what we had originally expected. Updated resource calculations for the company’s Bonanza Ledge, Cariboo Quartz and B.C. vein zone in the first half of 2012 could be a positive there.

Orvana has two properties that were both put into production in 2011. In Spain, the company’s El Valle-Boinás/Carlés is an operating gold mine, which is not seeing the head grade we had expected. Grades are slowly increasing from around 2 grams per tonne (g/t) to an expected 3.5 g/t. Its other project in Bolivia, the Don Mario mine, has a different problem. It’s an open-pit, copper-gold mine where recoveries have been less than expected—around 50% versus 70–80% for copper. We look for recoveries to improve and think a lot of the bad news has been priced into the shares. We’re also encouraged by the fact that Bill Williams has now taken the helm of the company. Bill has exceptional operational technical expertise.

TGR: So you feel both of those are reasonable values at this point?

MZ: On Barkerville we’re taking a wait-and-see approach and have the stock rated as a hold. On Orvana we believe the negative news has been priced into the shares and valuation looks compelling.

TGR: So, how about some of the near-term producers that you follow, such as Canadian Zinc Corporation (CZN:TSX; CZICF:OTCBB)?

MZ: Canadian Zinc is a situation where the valuation has not kept up with the project. The company recently passed the major hurdle for environmental approval of its Prairie Creek mine. It’s a really interesting story—an old Hunt Brothers mine that could be in production in 2014 or maybe even as early as 2013. For readers who don’t know the history of the Prairie Creek mine, it is in the Northwest Territories and was just a few months away from going into production when silver prices collapsed in the early 1980s and the Hunt Brothers went bankrupt. It’s a high-grade silver-lead-zinc mine with much of the infrastructure in place that we think has a lot of potential. We actually believe this is an ideal time to own shares of the company since fundamentals have improved and the share price has drifted lower with the sector.

TGR: So that’s another one to watch closely and this may be a good time to be picking some up. What about some of the other junior explorers that you like and have talked about in the past?

MZ: For very near-term production I have followed but do not cover Armistice Resources Corp. (AZ:TSX). The company expects to produce 25,000 oz gold in 2012. At around $0.22/share, which is about 50% less than last year, valuation looks interesting. Two that I cover, which are exploration stories, are NioGold Mining Corp. (NOX:TSX.V; NOXGF:OTCPK) and Prophecy Platinum Corp. (NKL:TSX.V; PNIKD:OTCPK; P94P:FSE). NioGold continues to drill at its Marban project in Val-d’Or, Québec. This is a joint venture with Aurizon Mines Ltd. (ARZ:TSX; AZK:NYSE.A) where Aurizon is funding $20 million for exploration. We think the resource could grow fairly significantly from the current 960,000 oz to 1.4–1.5 million ounces (Moz). We actually think Marban could give Aurizon’s other project, Joanna, some competition. I think the valuation looks fairly attractive here, trading at about 60% lower than our calculated net asset value.

We’re also excited about the potential of Prophecy Platinum. Prophecy has the Wellgreen deposit in the Yukon, which contains 12 Moz of combined PGMs and gold plus 2.4 billion pounds (Blb) of nickel and 2.2 Blb of copper. The in-situ value is around $50 billion and we think a preliminary economic assessment due out in Q112 will show some strong economics for an optimized open-pit. The company is carrying out other work to derisk the project, including metallurgical studies and additional infill drilling for which we’ll start seeing results early this year.

TGR: So, that one is well priced at this point and a buy as far as you’re concerned.

MZ: Absolutely. The price drifted down after the excitement over the updated resource estimate, but it’s come down to a level where we think it offers very good value. We have a $6.40 target price.

TGR: So then, let’s look at some silver juniors. One that you follow is Cream Minerals Ltd. (CMA:TSX.V; CRMXF:OTCBB; DFL:FSE). What’s going on with that one?

MZ: Cream is a company I cover and which I visited late last year. It’s an exploration company with a 41 Moz silver deposit called Nuevo Milenio. It also has about 300,000 oz gold. We believe the company has the potential to really expand the current resource. Cream completed about 20,000 meters (m) of drilling in 2011 and we expect an updated resource out late Q112. This should actually upgrade a fair amount of the Inferred resource to Indicated and could add about 30% to that resource. We also see it doing another round of drilling of 20,000–30,000m in 2012, which we think has the potential to more than double the current resource.

TGR: That sounds promising.

MZ: Another one I don’t cover but I think is very interesting is Oremex Silver Inc. (OAG:TSX.V; OARGF:OTCBB; OSI:FSE). This is a small-cap silver exploration company with assets in Mexico. The company recently moved up on good initial results on its Chalchihuites project. The project is in the same area as First Majestic Silver Corp.’s (FR:TSX; AG:NYSE; FMV:FSE) Del Toro project, and we understand First Majestic is aggressively acquiring property in the area. The company’s flagship property, Tejamen, has a defined 51 Moz silver deposit. We think the president and CEO is also a real asset for a company with a market cap of around $20M. He’s been manager of exploration and development for Barrick Gold Corp. (ABX:TSX; ABX:NYSE) in South America.

TGR: So, are you expecting that 2012 is going to be the year that mining stock investors finally wake up and smell the gold and realize it’s time to get into this market?

MZ: I think this is the year! Investors have been cautious and focusing just on the downside, holding their money in cash. I think investors should be opportunistic and look for well-run companies with strong management and great assets.

TGR: Well, we’re certainly hoping for that also. We appreciate your joining us today and look forward to talking with you again.

MZ: Thank you and I appreciate the opportunity.

Analyst Matthew Zylstra joined Northern Securities in 2010 after having worked at Sprott Resource Corp. and investment counsel firm Foyston, Gordon and Payne Inc., a unit of Affiliated Managers Group Inc. He is focused primarily on junior precious metals producers and also follows some base metals miners. Zylstra has worked in the finance sector since 1999.

The Gold Report: Whatever form the Federal Reserve’s economic stimulus takes, do you believe it will prove to be a boon to the junior resource sector, much like it was in late 2010?

Chris Marchese: It’s going to be exponentially more this time around. With gold at $1,800/ounce (oz.), it is taking the reserve status away from the dollar. And with the announcement of Quantative Easing 3 (operations twist, etc.), we could see $2,500/oz. or $3,000/oz. gold very quickly.

Jason Burack: People who have courage and conviction and are willing to continue to average into their positions over the next 12–18 months will benefit. Established producers of gold and silver have humongous cash flow, and they’ll add more juniors. They are going to want to add near-term producers. The juniors are where the majority of wealth is going to be created.

TGR: A few weeks ago, precious metals expert Eric Sprott said silver will be “the investment of this decade.” Did that spur a change in your investment strategies?

CM: Artificially suppressing a commodity for a prolonged period, which in this case has been 30 years and counting, leads to shortages. So Sprott just reaffirmed what I was thinking, which is definitely a good boost of confidence.

JB: The Silver Institute projects industrial demand to grow by 35% by 2015. Investor demand now is really starting to rocket, especially in the developing countries. You are seeing tremendous amounts of investor demand in China and India, where normally they would have bought more gold. Sprott’s been tracking the capital inflow of each dollar of gold relative to each dollar of silver invested and they are equal on a dollar for dollar amount for both metals in most cases; for some bullion dealers a lot more money is being invested into silver, and there is no way the gold:silver ratio is going to stay this much in favor of gold if this continues.

TGR: Are you more bullish on silver or gold junior equities?

JB: I like the companies that are hybrids, like Minefinders Corp. (MFL:TSX; MFN:NYSE) and Coeur d’Alene Mines Corp. (CDM:TSX; CDE:NYSE).

CM: The quality just isn’t there in the primary silver juniors. Of the ones that are, most are 60%–70% silver. First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:Fkft) and Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) are over 90%. The hybrids are a good way to play it. The gold:silver ratio will go into the single digits. That will also help control byproduct cash costs for a lot of the hybrids, such as AuRico Gold Inc (AUQ:TSX; AUQ:NYSE), Minefinders and Gold Resource Corp. (GORO:NYSE.A; GORO:OTCBB; GIH:Fkft).

TGR: What did you make of AuRico, previously Gammon Gold Inc., and its CAD$1.4 billion (B) bid for Northgate Minerals Corp. (NGX:TSX, NGX:NYSE.A)?

CM: I love the acquisition. It gives the company some geopolitical diversity. It’s in Australia, Canada and Mexico now. Starting with the acquisition of Capital Gold Corp. earlier in the year, AuRico set itself up so that it won’t have to acquire any more property or smaller companies for the rest of the cycle.

TGR: Has AuRico worked out all the issues with its Ocampo silver-gold mine in Mexico?

CM: There was a nine-month strike at El Cubo, but it will be at full capacity next year. Ocampo is doing phenomenally. The preliminary economic assessment for Guadalupe y Calvo, its next flagship (excluding Young Davidson—pending the close of the Northgate acquisition), is due in September. It has a nice blend of gold and silver. It is one of the better turnaround stories for this year.

JB: For the gold production companies right now, this is a perfect storm–type of scenario. The energy prices are staying in a relative trading range or they’re trending downward, so their energy input costs are under control. The price of the gold they produce is going up, so their profit margins are expanding rapidly. Pretty much in every other sector of the economy, everyone’s trying just to maintain profit margins and keep their heads above water. Maintaining current profit margins in this current macroeconomic environment is the goal of most companies; this is not the case for gold and silver producers. In the silver and gold sectors, there is a rapid expansion of the profit margins, which is super bullish.

TGR: Do you think that gold and silver hedge their production too forward, given that a number of analysts are looking at long-term gold prices of around $1,000/oz.?

CM: I think companies should do that if they don’t believe in their product. As opposed to the 1960s and 1970s, it is not just the U.S. this time—it’s the whole Western world. So I can understand something like Barrick Gold Corp. (ABX:TSX; ABX:NYSE) hedging because it doesn’t seem to believe in its product that much. That’s why it went out and bought Equinox Minerals Ltd. (EQN:TSX; EQN:ASX), a copper company instead of one of the numerous gold companies trading at gross undervaluations.

TGR: Barrick spent $6B to dehedge.

JB: I think it did start hedging its silver. And Equinox is a primary copper company. So Barrick has some tremendous issues there. I’m not buying stock if the company is hedging its primary production. If it is a primary gold producer and it is hedging gold, it’s not a gold company. The reason for buying these shares is to get the leverage to the higher gold prices, and if a company is hedging its gold production, then you’re not getting that.

CM: Junior miners can hedge to ensure that they’ll have the funding to bring on more projects, that they’ll have the necessary capital requirements. I have no problem with that, going one or two years out.

JB: That’s what Revett Minerals Inc. (RVM:TSX; RVMIF:OTCBB) did to keep itself alive 18 months ago.

TGR: A couple of companies mentioned in your report “Treasure Hunting for Precious Metal Stocks” have forward-sold their production. One is Alexco Resource Corp. (AXR:TSX; AXU:NYSE.A), which sold 25% of its silver production to Silver Wheaton.

CM: That’s a different case. Silver Wheaton is almost like a bank. It provides financing in exchange for a certain amount of the production at a given price. Alexco (one of my personal favorites) was in need of capital and went that route, avoiding shareholder dilution and taking on potentially dangerous amounts of debt, making it the most logical choice at the time.

TGR: It was the earliest stage that Silver Wheaton had bought into a precious metals play.

JB: The grades for Alexco are spectacular. It has the highest grades of any primary silver production company that we’ve looked at.

TGR: Do you expect those grades to continue at the Bellekeno mine?

CM: Definitely. It’s starting to rehabilitate Lucky Queen and Onek. This district is great because Alexco can bring on these other deposits in about 12 months with very low capital expenditures. I was talking to a geologist and he was estimating $13 million (M) for one of them, which is nothing, especially given Alexco’s cash on hand of more than $40M coupled with positive operating cash flow. This whole district is filled with numerous, very high-grade deposits. There are six identified so far.

TGR: The AuRico and Northgate deal comes on the heels of Trelawney Resources Inc. (TRR:TSX.V) taking over Augen Capital (AUG:TSX.V). Are we seeing the beginnings of a fresh wave of consolidation in the small- and mid-cap resource sector?

CM: Prior to the Northgate proposal, Northgate was going to acquire Primero Mining Corp. (PPP:NYSE; P:TSX). Goldcorp Inc. (G:TSX; GG:NYSE) acquired Andean Resources Ltd. (AND:TSX, AND:ASX), Kinross Gold Corp. (K:TSX; KGC:NYSE) acquired Red Back Mining Inc. (RBI:TSX) and then AuRico acquired Capital Gold. So there’s been a constant flow. It will accelerate once the whole market is convinced that higher precious metal prices are here to stay.

JB: Coeur d’Alene made lots of acquisitions in a short time span to get the Palmarejo mine, and it took on debt, it diluted shareholders and it struggled when the markets collapsed. The other companies look at Coeur d’Alene as a cautionary tale. They don’t mind paying a little bit higher price for the assets that they’re bringing in as long as their producing mines are actually cash flowing a good amount more. Silvercorp Metals Inc. (SVM:TSX; SVM:NYSE) is buying private companies. Fortuna Silver Mines Inc. (FVI:TSX; FVI:Lima Exchange) bought Crocodile Gold Corp.’s (CRK:TSX; CROCF:OTCQX) silver property in Peru. Some juniors over the next 12–36 months will get taken out by the really high-quality juniors, producers looking to replace depleted reserves and/or expand their production profiles and growth pipelines, like Argentex Mining Corp. (ATX:TSX.V; AGXM:OTCBB) and Revett Minerals.

CM: Consider Seabridge Gold Inc.’s (SEA:TSX; SA:NYSE.A) KSM project. That’s an enormous gold deposit in Canada, but it’s going to cost $3B–$5B just to construct. I’m surprised Barrick or someone else hasn’t come in and bought it yet. That’s telling me that the seniors don’t have that much conviction at this point in time.

TGR: One of the issues there is Pretium Resources Inc. (PVG:TSX).

CM: I would assume it would be a joint deal.

TGR: So you wouldn’t just be taking out Seabridge—you’d have to take out Pretium, too. There’s a study under way as to whether or not it is feasible to combine these projects.

CM: Another example being Detour Gold Corp. (DGC:TSX), which has the ability to produce upwards of 1 million ounces (Moz.) annually. Someone like Newmont Mining Corp. (NEM:NYSE) or Barrick could easily acquire a company such as Detour, allowing it to both increase production growth profiles and replace reserves.

TGR: Detour seems to have pretty much the same plan that Osisko Mining Corp. (OSK:TSX) had. I wouldn’t be surprised if it pulled it off without a takeover, if it actually made it into production without a major coming into play.

CM: Yes, because I’m guessing Detour will acquire Detour Lake Block A, owned by Trade Winds Ventures Inc. (TWD:TSX.V). It’s adjacent to the main deposit. That could become well over 1 Moz. per year after all the mill and optimization.

TGR: In your research report “Treasure Hunting for Precious Metal Stocks,” you list what you consider to be the top 15 undervalued precious metal stocks.

JB: We issued the report a couple of months ago, but there are still a lot of amazing values. We really like Aurcana Corp. (AUN:TSX.V), because we think it’s going to be the next Great Panther Silver Ltd. (GPR:TSX; GPL:NYSE.A) in terms of the momentum play and the pop, over the next 18 months as the Shafter mine comes on-line. If management can deliver the construction of the mine and production starts on time and hits the numbers, Aurcana is going to have a humongous amount of production growth, more than any other silver junior in the next 18 months, and that is going to translate into large earnings growth. Management is planning on up-listing the stock to the regular TSX and then to a major American exchange. That is going to create a big pop in the stock for Aurcana. Longer term, Shafter also has a really good exploration upside and a lot of silver relative to the base metals.

In terms of the other juniors in the report, Revett Minerals and Argentex Mining are two of the top. Revett has a pretty large institutional interest, and it has an equity position from Silver Wheaton. Silver Wheaton owns about 15% of the total shares outstanding for Revett. The reason that Silver Wheaton is interested in the stock, and the reason that pretty much everyone is interested in the stock, is because of Rock Creek. It is one of the top 10 undeveloped silver projects left in the world, and it is arguably the best undeveloped silver project left in the U.S., and in North America for that matter.

For those not familiar with Rock Creek, this deposit has been in the legal process since the early to mid-’90s, and it is almost through that. There’s already some production there from Revett Minerals, through its Tory Mine, which produces about 1 Moz./year silver production and 11 million pounds (Mlbs.)/year copper production. That is hedged right now, but those hedges are expiring at the end of the year. The local government, the state government and the people there all want the jobs that the mining would create as long as it is done environmentally responsibly. Rock Creek already has an NI 43-101 resource of well over 200 Moz. of silver and a couple billion pounds of copper resource. That is for a project that it hasn’t been fully explored yet. If the company were to spend another year or two fully drilling out the property and then add the expanded resource into a new mining production plan for when Rock Creek gets built, it is not out of the realm of possibilities that the silver resource could double.

Mines Management Inc. (MGN:NYSE.A) has its massive Montanore deposit right next to Revett’s Rock Creek deposit and the Montanore deposit already has a similar-sized resource to what Rock Creek is listed at. Revett has a large land package to still explore at Rock Creek, too.

For someone who is willing to let things play out while Argentex releases the new resource estimate upgrades and all the preliminaries—the prefeasibility and the feasibility—I think Argentex is going to be a potential tenbagger in three to five years with patience. The Pinguino deposit is a complicated deposit, but in a good way. If Argentex fast tracks things, it can put a near-surface, open-pit mine into production in the next three years for its lower grade silver and gold part of the deposit. It already has a nice preliminary economic assessment on 5 Moz. of silver resource that the market is not valuing anywhere close to fair value. It also has and a little bit of gold. It is obviously expanding that resource quite a lot by the end of the year. The resource calculations are going to be a significant expansion. That is going to get cash moving quickly. But the real home run for the company is in the polymetallic, the sulfide, part of the deposit, although that will take more time to get into production.

It is quite a bit deeper, so production costs are going to be quite a bit higher. But with these grades on the silver, there will be a massive amount of more than 2,400 grams/ton (g/t) in a 250 meter (m) long x 400m deep x ~6m thick ore shoot. Since it is polymetallic and there are great grades of indium along with solid grades of gold, lead and zinc mixed in with the high grades of silver and indium, it’s very valuable rock. There is a lot of indium in there with the silver at good grades. The U.S. Geological Survey is saying there is only 10 years left of indium supply at current production and demand levels. Indium is primarily used in thin-film solar panels and flatscreen TVs. So there could be growth in demand for indium as long as this current technology continues to expand.

AngloGold Ashanti Ltd.’s (AU:NYSE; ANG:JSE; AGG:ASX; AGD:LSE) Cerro Vanguardia mine is right next door to Argentex, and it is in production. The Pinguino deposit shares the Tranquilo trend. Anglo is exploring their deposit further and now hitting drilling hole results at this deposit at more than 3,000 g/t silver and more than 9 g/t gold at pretty good strike lengths. Pinguino shares the same fault line. The polymetallic part of the deposit, the sulfide part, shares the same fault line.

TGR: So it is a long strike?

JB: Yes. The fault line is pretty massive around there. Anglo used to own the Pinguino deposit and the land package as well but it realized that there wasn’t going to be enough gold for it to turn Pinguino into an economic primary gold deposit. But Anglo realized there would be enough silver there for Pinguino to be a primary silver deposit so it sold the property off to a junior like Argentex to develop as a primary silver mine.

TGR: Are there any other names you want to talk about?

CM: I’ll talk about a few larger ones. I am really into the streaming and royalties companies because of the fixed cost structure, which will prevent margin contraction should input costs start to rise. One is Silver Wheaton. Another is Franco-Nevada Corp. (FNV:TSX), which is trading on the TSX. It’s larger than Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ). The federal government just accepted a refilling for the necessary permitting of one of its streaming acquisitions, Prosperity, that didn’t get permitted initially. It will be run by Taseko Mines Ltd. (TK:TSX; TGB:NYSE.A), and it will add 66,000 oz./year attributable to Franco, which is pretty large for a streaming company at a $400/oz. ongoing purchase price. It’s up-listing on September 8. The good thing about it is it has a monthly dividend, so you get the compounding effect as opposed to the quarterly dividend.

Fortuna is also a good play. Its San Jose mine just came on-line. One of my favorites for the last two years has been Sandstorm Resources, which split into two companies: Sandstorm Gold Ltd. (SSL:TSX.V) and Sandstorm Metals & Energy Ltd. (SND:TSX.V). Sandstorm Gold is headed by the former chief financial officer of Silver Wheaton. It spun out a sister company with metals (base metals) and energy, so it is the first to apply the streaming concept into the base metals and energy sector. In one year, it has already managed 10 legitimate streams.

TGR: Is that fraught with more risk, given the base metal crisis?

CM: Sandstorm Metals & Energy only has one base metal stream to date, but its purchase price is $0.80/lb. of copper, and if the price of copper drops below $2.75/lb., the purchase price per pound drops to $0.55/lb. Sandstorm has guaranteed minimum cash flows negotiated in several of its streaming agreements. It has met coal, thermal coal, oil and gas, copper and natural gas streams, and is looking to add uranium, iron-ore, geothermal and other base metals. Sandstorm Metals & Energy recently did an equity offering, and is currently suffering from the equity offering hangover, but it gives it plenty of ammunition if lucrative deals present themselves. Nolan Watson was the one who pioneered the streaming concept (along with Peter Barnes and others at Silver Wheaton), so this management is just incredible. Sandstorm Gold and Sandstorm Metals & Energy both have fewer than 15 people working. They have low selling, general and administrative expenses and pay minimal income tax. They have found high-quality assets that have already shown a lot of exploration upside. Sandstorm Gold is the only 100% gold royalty/streaming company aggressively seeking additional gold purchase agreements on top the seven already in place. In other words, they have figured out how to create companies highly involved in capital intensive industries without the heavy capital requirements, making them free cash flow machines, which will translate into dividend juggernauts within a few years.

TGR: What are your parting thoughts on the precious metals sector as we head into the fall?

CM: I think it is going to be typical, another bullish run in the metals. This time I’m actually expecting the miners to play catch-up instead of lag bullion.

JB: Gold will touch $2,000/oz. probably, at least test $2,000/oz. by the end of the year, and then it will correct a little before blowing through $2,000/oz. For silver, we are going to see silver at least test $50/oz. in the next two to three months, and $50/oz. is a very tough resistance point for silver. It is the old nominal Hunt Brothers high. It might not pass through $50/oz. on the next try, but once it does, we’ll see it make a run pretty quickly into the $66–$67/oz. range.

If people take a longer view, two to three years out, it is really not going to matter if the miners underperform bullion in the short term. I hear a lot of people complaining that “my mining stocks haven’t done this or that.” But if you hit a couple tenbaggers or 400% gains on say two to three stocks out of every 10–15 stocks you pick, and you are doubling your money every 18–24 months on some of these stocks, you can’t complain if they are lagging for six, seven or eight months. I’ve been investing in this sector for quite a few years now, and it is just not something that you can worry about in the short term. It might definitely underperform in the short term, but the numbers are going to be so good. The profit margins are expanding. The fundamentals are there, and they’re improving. All we are waiting for now is the psychological, fundamental paradigm shift when more fund managers, more mutual funds and more pension funds say, “Hey, these gold stocks are all raising their dividends. Profit margins are expanding rapidly, production and earnings are rising and we see increasing potential for both capital gains AND dividends from producers. We’re going to buy and hold more of these. We’re going to continue to add positions and accumulate these shares because this sector is going to outperform the rest of the market in a major way for the next few years at the very minimum.” We are nowhere near the late stages of this secular, bull market for mining stocks, but we will be in a couple of years. This is going to make the tech bubble look faint once things are finally up and running, because many of the producers will actually have the earnings to justify much higher valuation multiples.

TGR: Thank you for your insights.

Jason Burack is an investor, entrepreneur, financial historian, Austrian School economist, and contrarian. Jason co-founded the startup financial education company Wall St for Main St, LLC, to try to help the people of Main Street by teaching them the knowledge, skills, research methods, and investing expertise of Wall Street. You can also find Jason’s work at his blog website at http://www.jasonburack.com.

Chris Marchese is currently a portfolio strategist for the Vishni Fund LP of Vishni Capital and as a contributor to the Morgan Report. For anyone interested in learning more about the Vishni Fund, which is entirely focused in the precious metals industry, visit Vishnicapital.com or email him at marchese.chris@gmail.com.

I put custodian in inverted commas because unallocated metal, even if backed 100% by physical, is not the same as a true custodial service, commonly referred to as allocated metal. With allocated, you hold title to the physical metal and the storer is just a safekeeper of your metal. It is off the balance sheet of the storer and control of it is a very simple process: run listing of how many bars your are holding for a client, do a count of the bars in the vault, the two should equal.

Unallocated metal, on the other hand, is on the balance sheet of the storer. This is why it is so important that debits equal credits, from an ounce point of view. At first you may think that the controls around keeping track of allocated should apply to unallocated – if you owe 100oz to clients, then you should have 100oz of physical gold on site. What this article hopefully reveals is that it is not necessarily that simple and an appreciation of the need for stronger controls.

The Golden Table

Let me start with an imperfect analogy for the manufacture of precious metal products: making a wood table. Looking at your plans, you go down to the hardware store and buy some wood and nails, say it costs $100 all up. It is not likely that you will get the exact lengths you need, so some sawing is involved. Whack a few nails in and you have your table.

If I asked you what the table cost, you look at me strangely and say $100 and wonder why I was so stupid. Your answer, however, has made one assumption: that your “by-products” of the table making process are worthless. What are these by-products? They are the wood offcuts and sawdust and your assumption is most likely correct.

Now consider that you are making the same table out of gold. Lets assume the same $100 purchasing cost for the raw gold (it would have to be a really small table) and same process – you have to cut up the gold planks. When I asked what the cost was, would you still say $100? Of course not, you aren’t going to sweep up the golddust and throw it and the gold offcuts in the bin like you would with the wood. You would melt them down and sell them to a refinery and the money you would get back would reduce the initial cost of $100. It is like the hardware store giving you a refund for the wood offcuts and sawdust.

This is what makes precious metal manufacture different from normal manufacture and is a function of the high value of precious metals and the fact that you can melt the by-products and reuse them without any or much loss of “utility”. My first exposure to this was when I looked at a stocktake count summary and saw a line called “sweeps”. It was literally the amount of gold after refining from the sweepings from the factory floor. That plus the fact that the counts were done down to 1/1000th of an ounce that was my first indication that this minting business was just a little bit different.

The existence of by-products introduces our first complication in precious metal control – estimations. To help illustrate the issue, let us first complicate our gold table process. As your local hardware store doesn’t sell gold planks, you have to buy standard size gold bars from your local refinery. You therefore have to melt them and pour them into a mould for the legs of your table.

To melt and pour gold, you have to heat it to above its melting point. The reason for this is that gold cools very quickly and if it is just at its melting point it will go solid before you can finishing pouring it. However, this creates a problem because when something is above its melting point (but not yet at its boiling point), some of the liquid is evaporating. Now you might think how much gold would really evaporate and I don’t know the technical answer to that. But what I do know is that it must be enough because above any gold furnace I’ve seen there is a hood that sucks in the fumes, taking it to a “scrubber” that collects the gold particles. However much gold is evaporated, it must be worth enough to go to all that trouble. Consider also that the crucibles in which the gold bars are melted also, over time, absorb amounts of gold.

Estimations

So how do you do a precious metals stocktake? First step is working out your “theoretical” or book inventory. Say you received 100oz of raw gold and recorded shipments of 90oz of coins. 100 minus 90 equals 10oz. Second step seems simple enough, go around and count all the physical gold and it should add up to 10oz. Easy.

OK, lets say there are 5 x 1oz finished coins on the shelves and 3 ounces of “offcuts”. But what about the gold in the sweeps, embedded in the crucibles, in the scrubbers? This is where one has to estimate the gold that is onsite, but not measurable – for example you don’t want to crush up and refine your perfectly good crucibles just because it happens to be a stocktake date. Introducing estimations, however, introduces room for human error. This is minimised by keeping historical records of the usual gold recovery from spent crucibles, scrubbers etc, so that there is a reasonable basis or justification for the estimated “onsite but not measurable” gold. Lets say this is worked out to be 1 ounce.

We are still missing 1 ounce. At this point consider that not all “recovery” controls are 100% effective. Scrubbers still let some gold evaporated gold out, for example. I’ve only described a few of the many recovery type controls in a precious metal factory, there are many more and over high volumes of manufacture bits of gold can be lost. The use of the word “loss” is often interpreted as “theft” but it is more accurately described as a “production” loss. It is a sort of known unknown. But this is not really fair, because production managers, again from historical stocktakes, know that there is a certain ratio of production losses to volume manufactured, which enables them to calculate and expected production loss.

Lets say in our example that the production loss ratio is 1% (our production manager would get fired if that was an actual loss). The estimate loss is therefore 0.950oz (1% of 95 coins made). This leaves us with a stocktake result of 5+3+1+0.95 = 9.950oz against theoretical or book inventory of 10oz. What happened to the 0.050oz? In a precious metals stocktake this is the key question.

First thing that is looked at is the accuracy of the count of measurable/countable physical gold. Second the production manager reviews the by-product estimations. If these two look OK, then third is to consider the effectiveness of the recovery controls. For example, maybe there was a hole in the ducting to the scrubbers and thus more gold was lost to evaporation. If controls are OK then it only leaves two possibilities:

1. Your production loss ratio is not correct. Maybe for every 95 coins made you lose 1oz?
2. Maybe your production loss ratio is correct. Therefore, someone in the factory has managed to secrete 0.001oz out every week over the past year.

The problem is that it is not easy to answer the question, because the stocktake result relies on estimations. This is why mints have one other “recovery” control – physical metal detection of staff as they leave the factory!

The above discussion is simplified, of course. There are many more processes involved in a refinery or mint and many more opportunities for production losses, necessitating many more controls. This is where accurate historical records and experienced staff come in to keep account of precious metal.

There is one thing we have missed. In our example, we only have 9oz in physical metal. Whether the 1oz is 0.95oz of production losses and 0.05oz of theft, or 1oz of production loss, doesn’t change the fact that we have lost 1oz. If the 10oz book inventory was funded/acquired from clients holding unallocated with us, then we only have 9oz of physical against 10oz of liabilities.

This is why this article was titled Metal Accounting I. In Metal Accounting II, we will discuss how the 1oz loss is dealt with and introduce yet more opportunities for gold to get lost.

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