At the 2014 Vancouver Resource Investment Conference, Lawrence joined Even Keel Media to discuss the ongoing bifurcation taking place in junior resource markets.
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Bullion vs. Silver in the Ground: Assessing the Risks and Rewards
Many companies in the resource sector try to sell themselves to investors as proxies for the underlying commodity. Every company in the industry that has any sort of resource works out the market value of the company divided by the ounces or pounds. The implication is that if you can buy silver in the ground for, say, fifty cents an ounce, then an investment in the company will increase at a faster pace than the price of silver.
In arriving at those measures of value per ounce, of course every company uses the approach that makes them look best against a carefully selected peer group. Some use market value per ounce. Others use enterprise value per ounce. For the number of ounces, they can use proven and probable reserves, reserves plus resources, measured and indicated resources or total resources.
And, in determining the number of ounces, some companies stick with the number of ounces of silver. Most companies with byproduct gold will convert the gold to silver equivalent. A few companies will convert the base metal credits to silver equivalent ounces. I don’t like incorporating base metals into a silver equivalent, because most investors are looking at these companies as a play on precious metals.
It is vitally important that investors recognize that every ounce of silver in the ground is different from every other ounce of silver in the ground. Comparisons against peers are useful only as rough indicators of potential value and should be carefully evaluated.
Let’s look at an example of the share price of a silver company over time compared to the price of silver. Please note that this is not a rigorous analysis. It is intended as a first pass to arrive at some broad observations.
For many years, Silver Standard was a go-to silver equity for investors wanting exposure to the silver market. As expected, the Silver Standard share price rose much faster than the silver price from 2003 to 2007. In that time, the silver price rose three-fold while the Silver Standard share price rose by nine-fold. That is, Silver Standard rose 3 times faster than the silver price.
But, look what happened in 2008. Continue reading Bullion vs. Silver in the Ground: Assessing the Risks and Rewards
Mining Industry Outlook
After a really dismal year for the resource industry, there are finally signs that the market is at the bottom.
Before looking at where the markets are headed from here, let’s have a quick look at a couple of indicators of the junior resource market to show just how bad the destruction has been.
The Toronto Stock Exchange Venture Index is not a perfect measure, with junior resources roughly two thirds of the index, but is probably the best indicator available of the overall junior resource market. The VIXJ declined 66% from its high in early 2011 to the low point in late June.
Continued Turmoil
News that the US Federal Reserve may begin cutting back on Quantitative Easing panicked investors around the world. The mere suggestion that the easy money might be cut back if the economy continues to improve exemplifies how dependent investors have become on what is effectively a government handout.
The sharp drop in the gold price resulting from the Fed comments had a hugely negative impact on resource stocks generally. There may be further downside for many companies as investors globally have taken a decidedly bearish stance on everything related to resources.
At some time, that sentiment will begin to reverse, as prices have fallen to irrationally low levels for many companies. In the meantime, we are looking for companies that are generating news of suitable magnitude that it might impact share values.
Following are some excerpts from a talk that I was invited to present at a conference in Australia. These comments summarize my current view of the resource markets.
The Current State of the Resource Markets
Excerpts from a presentation by Lawrence Roulston to the Africa Mining & Investment Conference, Sydney, Australia, June 24-25.
This Time Is Different
We all know that the market for junior resource companies is in a terrible state. We also know that this industry is cyclical, and no matter how bad it gets, it eventually turns around.
I have experienced a few cycles in the resource industry. In some ways, this is the worst situation that I have ever seen. But, this time is different and it is important to understand those differences to know what to do next.
In 2008, the resource industry was clobbered, along with most investments around the world. That sharp selloff was driven by external forces. Everything went down sharply, but then everything rebounded in tandem. Over the next two years, the TSX Venture index tripled.
If we look back a little further, 1999 through 2001 was considered the “nuclear winter” of the mining industry. At that time, the mining industry was still in the classic era, when high metal prices led to increased production which led to oversupply and declining prices. Several big new mines had just come on stream and demand for metals was sluggish. At that time, nobody dreamed that China and the rest of the developing world would soon begin to take off. Metal prices were down: copper, at $.60 a pound, was at the lowest price ever in real terms; gold hit a low of $252 an ounce. The producing companies were losing money.
Market commentators called mining a “sunset industry”, implying that the world’s need for metals was going to suddenly evaporate.
The Trends and What They Really Mean
Mining industry news of late has been dominated by massive write-downs: $6.5 billion for Barrick; Kinross added $3.2 billion to the $2.5 billion written off last year on its West Africa operations; in total, the mining industry wrote off $50 billion last year.
The write-offs follow a shopping spree over the past few years that saw all of the top-tier majors making aggressive acquisition aimed at growing the size of their businesses. Higher operating expenses in the face of softening metal prices slashed operating margins, emphasizing that the companies had grossly overpaid for those acquisitions. Those deals were done by management teams who were committed to growing for the sake of growth.
Barrick has stated that it has no further mine development plans in the works and the other top-tier majors also assured their shareholders that they have shifted their focus from growth to maximizing return on capital.
The Art of Metal Price Forecasting
Investors in the resource industry are inundated with metal price forecasts, and indeed often go out of their way to seek opinions on where metal prices are headed. Investors, the media and pretty much everybody else with even a passing interest in resource investing obsesses over metal price forecasts. Yet, does anybody ever take a moment to consider whether those projections have any value whatsoever?
A couple of years back, I referred in the newsletter to a study by global consultancy Ernst & Young which determined that, over the previous decade, analysts’ forecasts of metal prices had consistently understated future metal prices.
A recent study by the Bloomberg information service further graphically illustrates the extent to which analysts completely miss the mark in forecasting metal prices. On the enclosed chart: The upward trending line represents the actual gold price while the downward sloping lines to the right of the trend line represents three-year forecasts made in each year from 2006 to 2012. The flat line near the top represents futures prices that could be locked in by investors in 2012.
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Year End Review
The last year was a brutal time to be an investor in the junior mining sector – the worst that I’ve seen in more than 30 years in the industry. After that painful experience, now is a good time to be investing in this sector: BUT, invery selective companies.
We are all familiar with many of the reasons for that broad sell-off: Investors shunned risk in the face of extraordinary global financial uncertainty. The gold companies delivered disappointing operating performances, driving many investors away from the gold sector. The lack of upward movement in the commodity prices and the perception of further downside risk in metal prices have all added to the unfavorable investment climate. The net result has been that shares of nearly all junior mining companies have been clobbered, the good along with the bad.
Another Factor That Is Depressing Junior Resource Stocks
There is another factor that many are probably familiar with, but you may not appreciate its magnitude. During 2010 and 2011, there was an extraordinary amount of new capital coming into the junior mining sector. Just looking at the Toronto Stock Exchange Venture board, there was $20 billion of new primary investment in TSXV-listed companies.
Roughly three quarters of the companies on the venture board are mining related, implying about $15 billion worth of new share certificates were created over a two year period, more than at any other time. That was a period of irrational exuberance, with the Venture index coming off the low point in early 2009 to triple by early 2011.
During that time of exuberance, Fund managers seemingly suspended their judgment and due diligence, making private placement investments into an astounding array of companies, many with questionable geological merit.
Unfortunately, much of that new money failed to generate any real value for shareholders. A lot of it was eaten up by management salaries, head office rent and investor relations activities. A portion of it funded drilling programs aimed at making new discoveries. Very few new discoveries resulted from all that geophysics, trenching and drilling.
There was $15 billion of new money added in those two years. Today, the total value of the TSXV-listed mining companies is $11 billion and still falling.
In my opinion, many exploration and development companies are still trading at share prices well above their fundamental value. The ongoing sinking feeling of so many companies declining in price is creating the impression that the whole market is still declining. Indeed, many share prices still have a long way to fall, even if they are now at a level of a few pennies. Over the past few weeks, tax-loss selling has added to the downward pressure on prices.
Share Prices Are Reacting to Various Forces
There are a number of factors that influence the different trajectories of the various companies.
Some people like to speculate on a new discovery. Finding a big new metal deposit can be enormously rewarding for shareholders: We recently saw GoldQuest go from a nickel to $2 in a matter of weeks. Unfortunately, new discoveries are few and far between.
Many people invest in resource companies on the basis of the expectation of rising metal prices. That works as long as the company actually holds some of the metal in question. You won’t get much leverage to a metal price off a company’s best intentions to make a discovery next week.
Another big pit-fall is to get caught up in the various fads that go through the sector. For example, there is enormous merit in the fundamentals of the critical elements story, or graphite, or lithium or whatever the story. It’s just that most of the companies that get caught up in the flavor-of-the-month fads have little to contribute to the fundamental story.
Looking For Companies Which Are Adding Value
Another approach, and the main driving force in all of the companies listed above, is to seek out companies that have a high-quality metal deposit in hand. In this way, you avoid the discovery risk, yet there is still potential for enormous gains. For example, a gold deposit with widely spaced drilling and which is classed as an inferred resource will be valued by investors at just $10 per ounce of gold in the ground. By the time those same ounces advance to production, the value per ounce has increased by 30 or 40 times.
Finding companies with high quality metal deposits which have the potential to advance toward production requires a great deal of hard work. One must sort through a pool of companies that numbers a couple of thousand to identify those few that have quality assets; and then, it is necessary to do extensive due diligence. Many metal deposits that look attractive on the surface may have metallurgical problems or permitting issues or some other fatal flaw.
This approach continues to have validity because the exploration and development companies are vital to the future of the mining industry. Most of the discoveries and re-discoveries are made by the juniors. The juniors supply deposits on which the mining industry builds new mines to replace depleted mines and enables the industry to keep up with the growing demand for metals.
As important as these companies are, they are presently shunned by investors. There are a number of notions, which are not accurate, that are impacting on investor sentiment.
For example, there is a perception that metal prices aren’t moving. But, that perception is because people are so focused on the near term. If we take a longer term perspective, we see the gold price is up 6-fold in the past decade. The silver price is also up six times in that period.
Some people are surprised that the copper price is up by nearly the same 6-fold ratio as gold and silver. There is a perception that the world economy is in a state of suspended animation and therefore base metals are no longer needed.
The reality is that Europe is using slightly less metal this year than last. America is using slightly more. China, by far the largest consumer of metals, is using more than 7% more metal this year than last. Even at a time of slow growth, demand for metals continues to grow.
Another of the important misperceptions comes from basic economic theory, which tells us that when the price of a commodity increases, the supply of that commodity will expand to bring down the price. The expectation that there will be a jump in production has meant that forecasts of metal prices have consistently understated the actual metal prices.
In the case of gold, the price is up 6-fold in a decade while the production level has barely increased. New mine development over the past decade has barely offset depletion of older mines.
Whether for gold, or nearly any the other metals, actual metal supply growth has consistently fallen short of analyst projections. New projects are nearly always delayed, for a host of reasons: problems with permitting, lack of adequate capital and the like.
The net result is that expanding metal production is much more difficult than just assuming a production increase, as the economists tend to do. Geology doesn’t follow basic economic theory: It is getting harder all the time to expand metal production. The big, high grade deposits that were once sticking out of the ground have long since been developed, and are now largely mined out.
New deposits are lower grade, more remote, metallurgically challenging, and often in places where investors don’t want to put their money. The last year when the gold industry found as many ounces as it mined was in 1998.
Mining Companies Are On A Shopping Spree
While investors continue to shun the junior resource companies, the larger companies are actively shopping. Recently two companies – Galway and Inter-Citic –received takeover offers. Both are cash offers, one worth $250 million, the other $300 million.
A really interesting point is that both offers came from companies in emerging markets. Last year, over half of all M&A activity involved companies in emerging markets. That trend is going to continue.
In Europe and North America we moan about the slow pace of economic growth, and therefore avoid resource companies. In the developing world, people look at what is happening around them and wonder how they will find enough resources. I recently participated in resource investment conferences in China and Hong Kong. There is a feeding frenzy for projects ready to go into production. Investors and mining companies are gaining awareness of the earlier stage projects and beginning to actively shop.
Is This The Right Time?
It’s not hard to understand the longer term fundamentals of the resource industry. The important question at this time: Is now the time to invest in junior resource companies?
The answer is: Yes! But, very, very selectively.
As I noted earlier: Probably the majority of companies will continue to decline in value. Tax-loss selling is further depressing share prices, which can provide good entry points for investors, in carefully selected companies
On the other hand, a few companies are already moving up. Some of the companies with good deposits, strong management and access to cash are being accumulated by knowledgeable investors.
One of the important criteria at this time is to identify companies that are potential takeover targets: That means deposits that are large, advanced stage and well located. Identifying these potential targets for subscribers will remain a priority for me.
By the time someone rings a bell to tell us that we are at the bottom of the market, the better quality companies will already have enjoyed big gains.
It’s Time to Look at Companies, Not Markets
Resource markets remain extremely volatile in the face of global economic uncertainty. After a terrible beating in the first half of the year, resource company shares began to recover in August and September. A reversal of that uptrend in October leaves many companies still priced at irrationally low levels.
On a superficial analysis, the junior resource markets are merely treading water, with the TSX Venture Index barely ahead of the low point in June. A closer examination shows a very different story. Many companies are still losing share value, creating an aura of a flat or declining market. In fact, many companies with little or no cash and without tangible assets are still trading well above their fundamental values and will continue to sink.
On the other hand, a few tens of companies with strong management, good projects and which have cash are appreciating in value. We counted at least a dozen companies that we follow in Resource Opportunities which have appreciated by 50% to 200% in the past six months. Those big gains have come at a time when “the market” has been moving sideways.
While investors in general are not putting much value on the development-stage companies, larger mining companies can see the values, as evidenced by several takeover offers in recent weeks. The bid prices in those offers are well above market prices, with at least a couple of the deals priced at two-times the trading prices before the offers.
Interestingly, many of the takeover offers are coming from companies in emerging countries: Galway is being purchased by a private Brazilian company in a $300 million cash deal; Inter-Citic is being purchased for $250 million cash by a Chinese company.
Several of the companies that we are following are well positioned for takeovers, with large advanced-stage metal deposits. While many investors and analysts cast their eyes over the traditional developed world, for mining companies as the only players in the takeover game, the reality is that many, or most, of the offers in the future will come from rapidly growing mining companies in the developing world. Those companies can see the intense need for new resources and are prepared to pay reasonable prices. Investors in the developed world, taking a myopic view of the short-term issues close at hand, are missing the global picture and are under pricing resource assets.
A few investors, those who can identify the best companies, are coming back into the markets in a big way, quietly picking away at the higher quality companies. By the time that “the market” has turned around, the high quality companies will be trading at prices well above current levels.
The past year has been extremely difficult for resource investors. Looking forward, we believe that the extremely low valuations, the recent takeover offers and the improving global economic outlook provide strong evidence for a rebound in high quality development-stage companies. In due course, “the market” will also begin to move higher. In the meantime, we continue to present high quality companies which can generate big gains in spite of the near-term market sentiment.
Resource Opportunities is a subscriber supported publication dedicated to providing objective commentary on the resource industry.
SUBSCRIBE NOW to gain access to Lawrence Roulston’s initiating company coverage and specific company updates. Your subscription includes access to all of Lawrence’s Resource Opportunities twice monthly newsletters, including instant alerts with information you can use to trade more profitably.
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Life Goes On
Nearly half of American voters are disappointed by the election results. A slim majority of voters are reveling in the success of their candidate. Like it or not, Barack Obama is the president for the next four years. With the House of Representatives still under Republican control, Americans can look to more brinksmanship as the nation hurtles toward the fiscal cliff.
Without compromise and cooperation from both parties, the $600 billion package of spending cuts and tax increases will kick in early in the new year. If the media is to be relied upon, the American economy will instantly hurtle over a cliff when those measures come into effect.
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Investors took the dire threats seriously, with American stock markets today posting the biggest losses in a year. Ironically, investors fled to the safe haven of US government debt. Among the big losers were defense contractors and suppliers, as investors see the fiscal cliff putting an end to the easy money that has been doled out to that sector.
Whatever happens over the coming weeks, it is abundantly clear that no feasible combination of “new revenue” nor spending cuts will eliminate next year’s budget deficit, let alone begin to reduce the $16 trillion debt load and the much larger bundle of unfunded liabilities.
It is a certainty that the dollar will continue to decline in value, being the only possible way out of the financial mess. With Europe, England and Japan also in a mess, it becomes a race to the bottom for the world’s major currencies. Gold and other hard assets will continue to appreciate in price, as measured in dollars or other currencies.
Junior resource companies are not high on any investor’s list of favored investments at this moment – which makes this a good time to buy them. Once the current mood washes through the system, people will again realize that quality companies, adding value to gold and other metal deposits, represent an excellent way to protect against currency devaluation and at the same time gain the prospect of real returns.
James Kwantes is the editor of Resource Opportunities, a subscriber supported junior mining investment publication. Mr. Kwantes has two decades of journalism experience and was the mining reporter at the Vancouver Sun. Twitter: 
Resource Opportunities (R.O.) is an investment newsletter founded by geologist Lawrence Roulston in 1998. The publication focuses on identifying early stage mining and energy companies with the potential for outsized returns, and the R.O. team has identified over 30 companies that went on to increase in value by at least 500%. Professional investors, corporate managers, brokers and retail investors subscribe to R.O. and receive a minimum of 20 issues per year. Twitter: 
