Interview: Market insights from Sprott’s Rick Rule

At the Sprott/Stansberry Natural Resource Symposium — held in Vancouver in late July — Rick Rule, chairman of Sprott U.S. Holdings Inc., spoke with The Northern Miner about the state of the mining industry and its future.

The Northern Miner: When will the bear chew the juniors right to the bone? When is that point of no return?

Rick Rule: I would’ve told you 2014, but I was wrong. What I didn’t anticipate about this market is that I didn’t take into account the strength of the bull market. Bear commodity markets end one of two ways: either through demand creation or supply destruction.

Demand creation occurs when the price of the commodity gets so low, the utility to consumers is high enough that demand returns, and there’s economic recovery.

The other is supply destruction, the same kind we had at the turn of the century. We destroyed resources through the 1990s and ate through production capacity to the extent that when demand came back a little bit, the industry couldn’t supply, and we had those price spikes in 2002 to 2006.

But what happened in the 1998 to 2002 bear market is that the juniors went into it already weak, whereas now they went into it incredibly strong. Juniors today had gorged on cash in the last decade and the amount of destruction they could absorb was greater than what I had anticipated.

TNM: What are some things this bear market has taught us?

RR: Those who run the juniors, from worst to best, are characteristically entrepreneurs and are extremely optimistic people. And the mistake that they made — and the mistake that I made on their behalf — is that they confused the optimal capital market conditions with being normal.

And the juniors believed the market conditions would normalize, but these are normalized market conditions.

Capital-raising markets for the extractive industries in the last 40 years have been more often bad than good. And the very hope that is occasioned by confusing optimal market conditions with normal market conditions is what’s given these people the intestinal fortitude to prevail or attempt to prevail against all odds.

It’s my belief that there are probably 1,500 superfluous listings in mineral and energy exploration. It costs us somewhere between $1 million to $2 million a year to maintain a small company, which is a different way of saying that the exploration industry is leaking somewhere between $1.5 billion and $3 billion a year in needless general and administrative expenses.

So in one sense, the bear market we’re in is the bear market of the juniors’ own making, because we have wasted an enormous amount of investors’ money. And this winnowing would be the healthiest possible outcome for the industry, though this would be highly unpleasant for the folks that work in those superfluous companies.

TNM: So, what’s the game for investors now?

RR: It’s necessary for the industry and investors to understand that the junior industry as a whole is an enormous destroyer of capital … it’s hugely inefficient because it’s based on the narrative, it’s a story.

The best 10% or 20% of that industry generates so much performance that it adds legitimacy and sometimes lustre to the whole sector.

The game, both for the industry and particularly for investors, is to differentiate between the good, the bad and the ugly. Because one Ross Beaty can undo the damage of 800 schmucks and schmoes, who are the ones that pollute most of the industry.

The job that The Northern Miner does, as an example, in helping investors understand the difference between good and bad deposits, people who are attempting to mine air rather than grade, or highlighting the accomplishments of individuals like Ross Beaty — that’s what needs to happen.

We need to be more efficient at knowing the difference, and we have to do it ourselves. The brokerage firms won’t do that for us because they get the same commission for A- to C-grade stock.

And the whole idea that government can protect people from their own stupidity is a bad idea, because it’s fraud.

The Enron incident would be a good American example, where investors lost $100 billion and the government ushered in legislation called the Sarbanes-Oxley Act in 2002.  But the excess compliance cost American shareholders $80 billion a year, so we institutionalized the same loss on an annual basis that we instituted the law to avoid in the first place.

I’m not a lawyer, but before the Enron incident, fraud was already illegal. The idea that the U.S. Securities and Exchange Commission (SEC) can protect American people from fraud is the cause of most of the fraud in the U.S. — people believe they’re being protected.

But the SEC doesn’t protect people, they don’t do the hard investigative work and neither do the Canadians — they react to complaints. And the whole circumstance suggests that people aren’t responsible for their own financial future, that they don’t have to investigate before they invest. That’s the cause of the fraud.

At Sprott we have a whole team of technical people to do due diligence, and we spend a lot of time understanding the projects. It puts us at a pleasant advantage because for some reason, many of our competitors don’t feel the need to understand the truth.

Investors should take it upon themselves that if something appears too good to be true, then think it through.

TNM: Many of the Canadian producers are maintaining positive cash flow because of the strong U.S. dollar, but what’s your forecast on that? 

RR: Certainly in the global mineral production industry, if the cost in denominated currencies goes down and you sell the product in a currency that’s strong, then it’s a wonderful delta to maintain.

But I would urge producers not to count on that. I would urge people to consider that conditions might normalize, and even consider the use of financial hedges.

I think the U.S. dollar strength is more due to weakness in other economies than the incipient strength of the U.S. economy. Investment analyst Doug Casey describes the current situation of the U.S. economy as being the “prettiest mare at the slaughterhouse” — we’ve benefitted more by weakness in terms of competitive currencies than we have by incipient strength in the U.S. economy, and I would agree with that outlook.

TNM: What changes might we see in the future?

RR: I know that eventually people of my era will be replaced by the younger generation, and that will bring a fresh perspective on valuations.

In my era, valuation perceptions were set in the 1970s, and the defining event back then was the incredible escalation in the price of commodities. For example, gold went from U$35 to US$850 per oz., and silver rose from 80¢ to US$50 per oz., and that warped the perception of an entire generation of financiers.

What was rewarded in the 1970s was leverage to commodity price, and so for the past 40 years we have asked companies to demonstrate leverage to commodity prices.

So what companies have the best leverage to commodity prices, or are the most marginal? The high-cost producers enjoy better unit margin escalations in price escalation. As a result, my generation of financiers has asked the younger generation of technical people to become marginal. And the mining industry has become extraordinarily marginal.

My suspicion is, when my generation either dies or goes broke, we’ll be supplanted by people in industry and finance who never experienced the escalation of commodity price
s in the ‘70s.

My hope is that this younger generation will ask the industry to increase things like free cash flow per share and treat the mining business the same way as automobile manufacturers.

If so, the world industry would be better for it.