On The Greenback, Gold And Global Growth

Global economic growth will be weak next year and commodity prices will remain under severe pressure. The consensus among many in the mining industry seems to be that metal prices won’t recover until mid-to late 2009 or early 2010.

The Northern Miner has assembled a group of experts to participate in its outlook for 2009. Our panel includes: Patricia Mohr, vice-president economics at Scotiabank; David Coffin, the Vancouver- based co-founder of HRA Advisories newsletter service, which focuses on mining and related markets; Jeffrey Christian, managing director of CPM Group, a commodity consultancy based in New York; and California-based Brent Cook, editor of a weekly newsletter on junior mining stocks, Exploration Insights.

TNM: What does the future hold for the U. S. dollar and gold?

Patricia Mohr:We think that the U. S. dollar, which has rallied in recent months, could well retreat again. It could decline on a trade-weighted basis later in 2009 because of financial concerns over a growing U. S. budgetary deficit. If that happens, gold prices will probably do quite well. Just in recent days, gold has rebounded back over US$800 per oz., so gold is really maintaining its value quite well in these turbulent economic times. It is maintaining its role as a store of value.

There have been a few weeks when the price moved below US$800 per oz. due to concern over the potential for deflation — not a positive development for gold. And, of course, the U. S. dollar has recently been stronger because of the flight to the safety of U. S dollar-denominated Treasury securities. But the price of gold has maintained its value better than base metals, so in that sense gold has performed well for investors.

David Coffin: The greenback is strong right now in large part because various carry-trade and related hedges that require using it are being unwound. It does not make sense that the economy with the weakest mid-term prospects should continue to show this strength, but it is equally unclear which other paper currency has both the volumes and strength to replace it right now. On that basis, gold is likely to gain ground as a store of wealth that is neutral to any specific underlying economy.

Jeffrey Christian: We expect the U. S. dollar to trade in a broad, volatile sideways fashion over the next year, with a slight upward bias. Longer term, the consensus would be for a drop in the dollar given the massive debt built up within the U. S. economy. That consensus may not prove out, however. For one thing, for the U. S. dollar to decline, the exchange rates of other countries would need to rise. Internal economic and political issues within the countries that issue potential alternatives to the U. S. dollar as the numerator of the world’s economy trade may preclude that.

Furthermore, as was demonstrated in the 1990s, the U. S. economy has a tremendous capacity to generate wealth, which if husbanded properly by political leaders could be used to rectify the U. S. financial imbalances in a surprisingly fast time (decades, instead of centuries). Were that to happen, the dollar might stave off a long-term decline. The potential for such financially political leadership on the part of the United States government for an extended period of time might render such a long-term outlook as purely hypothetical, if not fantastical. However, the experiences of the 1990s, in which the U. S. government reversed a quarter century of budget deficits and managed to pay off US$560 billion of its long-standing debt over a four-year period, combined with the potential that other countries may not provide suitable alternatives to the dollar as the reserve currency of choice, must be considered.

The CPM Group expects gold prices to rise in the short-term, as investors worldwide continue to turn to gold and silver as alternative assets. Prices may reach new highs in the first half of 2009. Beyond that, gold prices may come back to somewhat lower levels. We expect gold prices to remain elevated by historical standards, however, for a variety of reasons. First, economic, political, and financial conditions are likely to remain unsettled for a time. Even after the world emerges from the current recession, as it will, investors should be expected to remember the stringencies of the current period and continue to seek to put a portion of their assets into gold on an ongoing basis. Given the small size of the gold market and the pool of investable gold, even a miniscule shift in investor attitudes toward gold is likely to have the effect of keeping prices high, perhaps above US$800, over the coming decade. Additionally, parts of the world gold mining industry will be hard pressed to expand production, adding upward pressures and supporting gold prices from declining too much. Much of these declines will be offset by growing output in other countries, however. There will be growth in the gold mining industry, especially in emerging producing nations such as China.

Brent Cook:My suspicion is that the dollar does far better than most of the people involved in the gold sector believe. We have experienced near-total global economic failure, two wars, Bush and the emergence of gold-centric societies like China and India. How good can it get? Yet none of these “positive” events has managed to keep gold above US$1,000. I will be basing my gold investment recommendations on US$750-850 gold through 2009.

TNM: What Commodities Have The Brightest Future In The Next Few Years? Which Ones Will Suffer?

PM:Gold will continue to perform fairly well, but I think potash prices are probably going to hold in well too. Spot prices for potash at the Port of Vancouver in November are still at record highs. Potash prices averaged US$869 per metric tonne in October and are at that level in November. So prices have not gone down at all.

The good news is that Canpotex — the marketing arm for overseas sales by the Potash Corp. of Saskatchewan (POT-T, POT-n), Agrium (AGU-T, AGU-n) and Mosaic Co. (MOS-n)– has recently negotiated several term contracts for South Korea and Japan at US$900 CFR (in the case of the contract in Japan, US$200-220 higher than this year). While spot potash prices may move down a little in 2009, prices should stay high and profitable. Potash will maintain its value very well, probably better than gold.

Uranium prices have recently lifted off the bottom, and probably will move up a little further in 2009, because of the resumption of imports by India. And there is a lot of interest in uranium by Asian utilities.

DC: Gold looks brightest, for the reasons already noted, plus limited scope for supply gains despite healthy increases of demand. Some of the specialty metals with alternative energy profiles could do well, and as a sense of recovery sets in we expect copper to pick up, as it usually does. As for suffering, that applies to everything right now and we are really more focused on what can recover.

JC: In the near term, by which we mean the first half of 2009, gold and silver should be expected to outperform industrially oriented commodities. Longer term, from the perspective of 2010, 2011, and beyond, most commodities may see rising prices. The longer-term secular increase in demand for goods and services, globally, has been interrupted, not destroyed. Assuming governments do not mishandle the economic outlook, by 2010, already we may see sharp increases once more for metals including steel, copper, molybdenum, and other ferroalloys. The platinum group metals all are poised for strong increases in prices, as supply will be constrained by the recent freezing up of financial markets. Oil prices also should be expected to rebound strongly beyond the first half of 2009.

BC: They all look tough until the global recession nears its end. Both uranium and gold offer the best underlying supply/demand fundamentals.

TNM: What countries or regions should investors focus on, and which should be avoided?

PM: Africa has a lot of potential in terms of new resource discoveries. However, there are geopolitical risks in some areas and I think for the average retail investor focusing on companies with resource plays in Canada, the U. S., Australia and Chile is probably the safest bet. It is interesting that the new state government of Western Australia is willing to allow new uranium mine development and there are quite a number of potential projects of interest to investors.

DC: Focus on areas with well-established tenure and legal systems for the sector, and ideally with strong existing infrastructure. Conversely, avoid those that don’t have this or that are perceived as being risky because of more general economic concerns or histories of corruption.

JC: I am loath to single out individual countries or regions as focal points for investments, since doing so suggests less than strong interest in other countries and regions. That said, Mexico will remain one of the best places to invest in mining. Australia, China, other parts of Asia, parts of Scandinavia, and Greenland also stand out as particularly interesting targets. I attended a Raw Materials Group conference on mining and exploration in Stockholm in November. While I have followed some of the developments there from a distance, I was truly impressed by the scope for interesting metals mining development opportunities in the region.

BC: Risk in the resource sector is at an extreme, regardless of province. I would focus on regions in which major mining companies are already successfully operating.

TNM:Will the recent trend towards resource nationalism continue or will the difficult economic times discourage it?

PM: I actually think resource nationalism in the mining sector will continue.

DC: I think calling resource nationalism a trend may overstate what has, or at least had, been happening. There have been instances of government taking back tenure that had been gained through legitimate channels in places like Ecuador, Russia, Mongolia and the Congo. Difficult economic times will make this less likely only if commodity prices crash back to old levels, but most instances of expropriation were in areas that had flags attached to begin with. The broader concern of governments calling for higher government revenues in light of high prices will be lessened by these weaker prices, but they will resume as prices strengthen again and probably without enough regard for increased costs. That happens in any economic sector that is doing well, and has to be dealt with on a case-by-case basis.

JC: Resource nationalism is one of the biggest threats confronting both mining development and real economic development in countries around the world. It will continue to be a problem for both the people of these countries and companies seeking to help them develop and exploit their natural resources. It might grow worse in the near term. Unfortunately, potentates through the ages have proven that they are willing to ignore their own best interests, let alone those of their populations, and impoverish their nations even in the face of both difficult economic times and compelling evidence that they should seek to efficiently exploit their natural resources. I have not seen any evidence to suggest that this flaw in human nature has ended.

BC:We may begin to see actual investment incentives in countries that last year were considering increased taxes and state ownership.

TNM: In the mining sector, will it be junior or senior companies that prosper more in the next few years?

PM: The senior companies are usually better positioned in more challenging economic times because they have stronger balance sheets and credit is probably more available for them. Unfortunately, when credit conditions tighten it is usually the junior companies that find it more difficult to raise bank credit or equity capital. Sometimes M&A activity picks up with lower equity values, so you may find that there is stepped-up interest by senior mining companies in acquiring juniors.

DC: Most senior producers in the sector are cashed up and have been shutting down marginal operations until commodity prices come back, and these should rebound with commodity prices. Junior producers don’t all have that luxury, and it really depends for each on what debt they have and how it is structured; new producers with low-cost operations that have been badly hammered in the market could generate some strong gains from these new low levels, but caution is required in picking them. Explorers with strong discoveries at scale and cash in the bank will begin to gain as the best of them are picked off and anticipation returns for those in similar shape — and this process is already under way and will gain ground as the current broad assets sell-off abates. But those who need cash or are still at conceptual stages will remain wounded for a while yet.

JC: It depends on how one defines prospering. Overall, senior mining companies should do well. In the junior sector, there always is a greater risk and reward. Some juniors should be expected to do spectacularly well, offering returns to investors that are disproportionate to anything larger companies might be able to generate. Others, however, will have a more difficult time.

Financing growth will remain problematic across the sector, which will restrain the profitability of all mining companies from what it could be were financing for development purposes more readily available.

Senior mining companies should prosper over the next few years in that the prices of their products should rebound from currently depressed levels, to levels that will offer well-run, efficient mining companies good returns on their investments. They also should expect to see large institutional investors considering them as investment targets, which should be reflected in higher equity prices.

One thing large mining companies will need to do, in our view, is focus on profitability, and growing profits. Too many companies seek to expand through acquisitions, partly to have a size sufficient to attract the largest institutional investors. Too many measure success in terms of tonnes or ounces produced, instead of the better measures such as profits and returns on investments. We hope to see management at senior mining companies focus more on profitability and less on size.

BC: When the tide turns, the seniors will lead the way. That said, there are a number of very selective opportunities in the junior space that are trading at a considerable discount to NAV.

TNM:What does an individual mining company need to do from a corporate standpoint to survive the current economic crisis?

PM: Many companies are obviously focusing on the best prospects for development that they have, while the more marginal projects will probably be put on hold. Efforts on cost control will be redoubled.

DC: Avoid or reduce debt and have cash to work with, much like any other company or individual. Those with strong deposits but limited cash reserves can still get by, but it will be difficult for them to gain ground until there is a turn in perceptions about the resource economy.

JC: Husband financial resources, think clearly, not panic, focus on retaining their quality personnel, and prepare for a recovery in the mining sector. Also, they should hedge. I happen to feel strongly that hedging always makes sense, especially if a mining company uses a participatory structure that provides a floor price, allows for participation in rising prices, and has been structured so that it has minimized credit risks and no potential for nasty surprises buried in the terms and conditions imbedded in the language imposed by their trading counterparts. Unfortunately, for those of us who invest in mining companies, many managers have fallen victim to the anti-hedging fervour perpetrated by those who do not know. With low prices and stringent credit markets now, hedging is that much more important. However, just as in all other times, hedging that provides a floor while offering participation in rising prices and a predetermined risk profile is just as important as it always has been.

BC: Make more money than it spends.

TNM: Do you believe the current financial crisis will prompt more mining companies to take a harder look at their executive compensation packages and take measures to either reduce salaries or cut bonuses?

PM: Boards of directors are likely to look at executive compensation and bonuses more critically in the coming year.

DC: Yes. There is also a process of going to contractors and consultants and having them redo their cost structures before contracts are renewed or extended, and for some companies the process could include more junior employees. Conversely, there could be an uptick in low-priced share options, which become bonuses only if the company recovers.

JC: No.

BC: Definitely. Folks should also consider seeking their next mining stock tip from the greeters and clerks at Wal-Mart. That’s where many industry professionals will be.

TNM:Does the current financial crisis present a buying opportunity for the majors? If so, which juniors do you see as potential targets?

PM: Senior mining companies that have good cash flow and strong balance sheets, could well be interested in acquiring mineral resources or reserves through acquisition rather than through exploration.

DC: A great many juniors have been sold down to cash levels with little regard to the deposits they have been working on, so yes there is very much a buying opportunity. For the most part it will be explorers with more advanced and larger-scale deposits that will go first, and generally those who are active in expanding these deposits will garner the first attention since they are the ones who can regain price as they report new results. That said, a takeover requires sufficient data to assess both capital and operating costs be on the table, either through deposit- specific work having been done or possibly because an exceptional discovery has been made with sufficient attributes similar to those of established ore-bodies in the same area to garner an early take-out.

JC:The current financial crisis has driven the prices of virtually all assets far below their reasonable long-term values. I have joked that while the conservative voters in the U. S. were worried about socialism under the incoming president (after he quoted Adam Smith’s Wealth of Nations almost verbatim), they have been witnessing the largest forced redistribution of wealth in the history of mankind, far larger than the Communist takeover of Russia after 1917. The fact is that many investors have been forced to liquidate assets, including mining shares, at prices that are unsustainably low from a long-term perspective. This is true across financial assets, and it certainly is true in the mining sector. Additionally, the drying up of financing has put many smaller mining companies in peril unnecessarily. Many of these companies will be absorbed by majors in the months ahead.

BC: The opportunities for major mining companies to acquire juniors are the best they have been in years. Unfortunately, the major mining companies are contending with a serious collapse in mine margins and decimated share prices. For a mining executive to stand up to a board and take responsibility for buying a junior in this market takes more guts than most of them have. Although opportunities abound, I suspect actual deals will be few and far between. This is, however, one of my three investment theses in Exploration Insights. Two companies on the possible acquisition list include MAG Silver (MAG-T, MVG-x) and Hathor Exploration (HAT-v). I think we will see more opportunistic mergers and acquisitions at the smaller end of the sector. There are a number of cashed-up smaller companies with very intelligent management that will be quicker to recognize and act on opportunities. Altius Minerals (ALS-t) and Sprott Resource (SCP-t) are two that come to mind.

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‘Explorers with strong discoveries at scale and cash in the bank will begin to gain as the best of them are picked off and anticipation returns for those in similar shape — and this process is already under way.’

— David Coffin

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‘Too many companies seek to expand through acquisitions, partly to have a size sufficient to attract the largest institutional investors.’

— Jeffrey Christian

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‘Folks should consider seeking their next mining stock tip from the greeters and clerks at Wal-Mart. That’s where many industry professionals will be.’

— Brent Cook

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‘Boards of directors are likely to look at executive compensation and bonuses more critically in the coming year.’

— Patricia Mohr