Written by Henry Bonner, Sprott Global Resource Investments Ltd.
Late summer saw, to the relief of some investors, some price improvements in precious metals and precious metals stocks. We asked Sprott USA Holdings Chairman Rick Rule if he thought this might indicate that we’ve seen the bottom in this sector.
“There’s a key element still missing from the picture,” Rick stated in a recent update to investors. “In past bear markets in natural resources, we witnessed a wave of capitulation selling that marked the end of the bear market. That capitulation allowed the next bull market phase to begin. And we haven’t seen that kind of capitulation occur in this market.”
Rick added that previous corrections lasted three to four years. Since the current bear market started in 2011, he believes it could be another one or two years before things turn around:
“The excesses of the bull market from 2003 to 2010 are nowhere near done being wrung out of the system.”
As Rick has said before, this means that the least able participants in the sector – among both investors and professionals working in the natural resource sector – must be expelled in order for the market to return to growth.
Quality projects must get into the hands of those most capable of creating shareholder value. Bad projects and poor management must go, which means a number of junior resource stocks could still be headed for their intrinsic value – zero.
What about the actual commodities? What about precious metals like gold and silver? Could they be on their way up, leaving mining companies behind?
“In the past three months, we have seen gold move from weak hands to strong. Western central banks have been selling gold to frontier and emerging market banks,” said Rick.
“Another major change has been the collapse of the ‘paper’ market and the rise of the physical market. During the bull market for gold, institutional investors borrowed money – often in Yen – and used it to buy gold on the futures exchange. That worked fairly well until the momentum left the gold market.”
“Then the paper market collapsed because those money managers unwound the ‘carry trade.’ But the physical market grew. Instead of leveraged institutions, these are living, breathing individuals buying real gold instead of futures.”
The rise in precious metals prices could delay consolidation among exploration and mining companies, Rick warns. Investors might hold onto bad equities because they believe that the price of the underlying metals will rise.
“Although prices are low on the equities side relative to the period from 2003 to 2010, they may remain low or go lower. The situation is still messy,” said Rick. “It is very possible that more write-offs will arise in addition to the $75 billion in write-offs that major mining companies have incurred over the past seven years.”
“Meanwhile many junior mining companies with little hope of generating value for shareholders are doing capital raises just to afford their management and administrative expenses. This is very obvious when a company raises only 200,000 or 300,000 dollars. That money only serves to cover salaries and rent, not to do exploration. I believe money that goes into these equity raises will almost surely be lost by investors.”
In contrast, some companies that own legitimate projects and are run by credible management teams are selling at fractions of the highs they reached in the past ten years, Rule explains.
“There are certainly opportunities with regards to these companies for those of you who are able to accept the risk,” Rick said.
Commodities and precious metals, meanwhile, are a different picture, he explained.
Rick cites the rising cost of mining gold, especially when taking into account exploration costs, as a main reason he believes the price of gold must rise. In particular, big miners have struggled, and, he says, “spent their entire market cap” on new mining projects, but have only managed to maintain their current production levels.
In addition to the argument that gold provides a hedge against fiat currency risk, production issues may help push the price of gold up, according to Rick.
Meanwhile, platinum and palladium mining has seen severe labor disruptions. A large number of platinum mines no longer meet their cost of capital, and recent strikes in South Africa ended with workers obtaining a raise of around 8% across the board1, which will only exacerbate the problem posed by unprofitable mines. As mines close, supply will shrink, which should push the prices of platinum and palladium higher.
So even though precious metals may be set to continue higher, Rick believes the equities sector may still have some pain to endure.
Rick also believes that there is a strong case that the oil market is awaiting a supply shortage (but not the gas market).
Over the past ten years, he says, political authorities in many countries have increasingly diverted capital generated by domestic oil production for politically expedient purposes. This has deprived the oil industry in many countries from the sustaining capital investments needed to maintain production levels.
“In the last five or six years, some countries, such as Mexico and Venezuela, have witnessed substantial declines in their production. We are also beginning to see it in Ecuador, Peru, Indonesia, and Iran.”
We’ll expand on these comments in a future update.