Last time we heard from commodities omniscience Rick Rule, it was last November, prior to his appearance at the San Francisco Metals & Minerals Conference, when Gold prices still had a stretch to go before settling at the present $1,200 per ounce support level. It was the tail-end of uniquely brutal bear-market year, a downturn so spectacular in nature that financial pundits and central bank policy the world over seemed to question, if not outright challenge, the metal’s function as a safe haven during times of economic uncertainty.
While the relationship between fiscal politics and the junior exploration space is by no means a straightforward one, however, gold was not the only metal to struggle, as the second half of 2013 saw an increasing amount of bearish sentiment being expressed by a number of big financial institutions (many of whom, it should be added, were in the midst of retreating from their involvement in a variety of physical commodities markets with as little to-do and as much gracefulness as possible). This was the case especially with regard to the supply-demand balance for key metals such as iron ore and copper that is now widely expected to lean in the direction of oversupply in the coming year, if not longer.
But for companies purporting to be looking for the actual metal that eventually gets pulled out of the ground, capital investments have been shrinking since at least 2011 if not before, and as Mr. Rule noted in our November conversation, the mood on the conference circuit was one of thorough demoralization. Rule’s well-known contrarianism has seen him through a few decades of bull-bear cycles though, and he found himself quite at home amidst the helplessness and hand-wringing, as the situation from his perspective looked much better than it has in some time.
Indeed, even back then, there were clear signs that the junior market was bifurcating, with the truly valuable companies already beginning to break away from the deadweight. With the ongoing capital crunch, everything looked like it had a “For Sale!” sign in front of it, and all that was left was for a bottom to be put in place.
When we recently caught up with Mr. Rule, there were no signs that the fundamentals of the market had changed in any significant way. Another thing that hadn’t changed, however, was the market’s indecisiveness with regard to when and where it will finally decide to bottom-out. In terms of last month’s Vancouver Resource Investment Conference (VRIC), this search for a bottom expressed itself in a curious little burst of optimism on the part of companies that have recently benefited from relatively modest cash infusions.
But "modest" is the key word here, and Mr. Rule was not the only conference participant to speak of the notable lack of serious cash on the table in Vancouver.
EQ: Before we get into the nuts and bolts here, I just wanted to spend a brief moment with the industry’s biggest companies, like BHP Billiton (BHP) and Rio Tinto (RIO) . The consensus seems to be that the Chinese economy will slow down to some extent in 2014, enough so that copper and iron ore prices are likely to take a substantial cut. Judging by some recently-released fourth-quarter production reports, however, these two metals, especially iron ore, remain the focal point. Do you think this is a strategy on their part? In other words, do you think they’re confident about the growth of the Asian middle class over the coming years, or do they just have no better options?
Rick Rule: That’s a big question, and I’ll do my best to get to most of it.
With specific reference to BHP and RTZ, they are of course the lowest-cost suppliers of iron-ore on the planet as a consequence of their Pilbara operations; the nature of that rock, and the shipping distance, or rather lack thereof, to Asian markets. It is also the business, along with copper, that generates the best margins for them. Certainly, if you look at the track record of the major mining companies, including BHP and RTZ, over the last ten years, there are a lot of investment mistakes that they need to exorcise from their operations and balance sheets, but their Pilbara iron operations are not among them. They will win the last man standing contest with any supplier on the globe, including the Brazilians. I think a focus on the Pilbara makes absolute sense for those companies.
I also believe the rise of the Asian middle class, in fact the rise of the global middle class, across emerging and frontier markets, is a story that’s very much intact. It wouldn’t surprise me at all to see a hiatus in Chinese growth, as the Chinese came to grips with the incredible credit expansion that has occurred in that country in the 2008-20014 timeframe. We don’t know much about the nature of that credit quality because the Chinese banking market is so opaque, but if the credit expansion in China results in the same sort of circumstance that the credit expansion in the US occasioned, then there will be some indigestion.
But the theme of poor people in emerging markets becoming gradually more free, and as a consequence of that becoming rapidly more rich, and increasing their demand for physical assets, is very much still intact.
EQ: As an aside, since we are talking about BHP, what do you think about their attempt to get into US shale? They ostensibly disappointed investors by not having produced as much natural gas and oil as they were expected to in their most recent production report.
RR: Over 20 years, BHP has proven themselves a shrewd full-cycle oil and gas investor. They have technological capabilities, and an exploration and process focus in oil and gas that has stood them well.
I believe they did overpay for the shale assets, because I believe that BHP has a need at the corporate level for materiality, and one of the few occasions where they had the ability to acquire materiality in a mature market, and in a market where they understood the political ethos, was on the US shale side. I think they overpaid for that asset, but I think that the fact that they overpaid for that asset, and other assets, has come to be reflected in their share price.
I am also, as I have said before, very impressed with BHP in the oil and gas business in general. It isn’t often that a mining company can succeed in a different business, and I’ve never watched the oil companies succeed in the mining business. BHP would appear to be the crossover. They have a viable oil and gas business, and they have proven to be extremely competitive in various oil and gas arenas, in particular the US gulf coast.
EQ: They’re a fascinating company, and that has been my impression as well. But people often react to an earnings report or a production report in an overstated manner, when, for instance, output doesn’t match with prior forecasts.
RR: I think there’s zero doubt with regard to BHP, in the context of the gas acquisition and some other acquisitions that were made at the end of the last decade, that they themselves got caught up in the China story. That they looked at the free cash flow they were generating as a consequence of the run-up in commodities prices, and they became a little too generous with regards to the prices that they were willing to pay for those assets. One could say the same in certain sets of circumstances about myself, though I didn’t have the same level of resources to squander as BHP did!
EQ: A company like BHP can surely absorb some of these fiscal indiscretions, especially if other core operations are running smoothly. Now, you’ve just been at the VRIC, where you were a speaker, as you typically are. What was your sense of the mood there? It seems like there might be more cause for optimism in the exploration space than there has been of late.
RR: I came away disappointed, perversely, because I thought the mood was too optimistic. The level of self-satisfaction, smugness, if you will, among the exhibitors, and the sense among the attendees that it was game-on, I think, belies the fact that although I think we have put in a bottom in this market, we are still going to have 18 months of tough sledding. Management teams are going to have to be extraordinarily prudent and investors are going to have to be extraordinarily prudent.
The general level of optimism associated with that conference makes me wonder whether or not the upturn we have seen in the juniors is a temporary head fake or not. I’m noticing, as an example, a plethora of $400,000 financings going through in companies that have $250 thousand in working capital deficits.
What that means is that $150,000 is actually going into the till, which is enough to keep the company alive for about four months. Whoever is putting up that money is pathologically stupid, and you know, the fact that dumb money is returning to the market, albeit in small slugs, is disappointing to me.
EQ: It could be putting off the bottom that we need to get to here, and that leads into the next question I wanted to ask. We are still seeing bifurcation, there’s a small chunk of juniors off to a strong start this year, but the bottom is somehow not materializing.
RR: Well, there’s zero doubt that the bifurcation is taking place, and that’s something your listeners and readers need to understand. The best of the juniors are off the bottom, in fact came off the bottom in July, and that’s very clear from the charts. If you look at an 18 month chart of the TSX Venture exchange, what you see in the first part of the that chart, as I said at the conference, represents the topographic map of a ski-hill: a steep descent from the upper left to the lower right, which is a consequence of total buyer capitulation and forced selling. The middle part of the chart goes sideways, it’s horizontal, resembling as I said there the electrocardiogram of a corpse.
But really since July forward, and accelerating a lot more in November, you’re beginning to see bifurcation, where the better juniors cut bids, not big bids, but what happened there was the sellers were exhausted. There were no more sellers. So fairly small levels of buying interest led to disproportionate increases in share prices, and among an albeit sort of small, subclass of the juniors, but this is precisely what happened in July of 2000, which I believe to be the time of the turn of that 1998-2003 bear market.
So it’s a very, very useful sign, and I do think in that regard a bottom has been put in, which doesn’t mean that people can’t still conspire to lose vast amounts of money in the ensuing 18 months if they’re not careful.
EQ: It’s amazing what denial will do. We’re still working to get there to the bottom, before we can see a real rebound.
RR: You know, from an investor’s point of view that’s really good. It’s not so good from an issuer’s point of view.
From an investors point of view that means that the “For Sale” sign is going to be out for another 18 months. In order to sell high, you have to have bought low. Many people have been effectively shaken out of this market, because they don’t have money to invest, or because they’re unwilling to take the losses on positions where they’re down 80 or 90 percent, in order to redeploy that money to better companies. Investors need to understand that they need to take advantage of the next 18 months if they are going to enjoy the gains that should occur to them in the three to four year time frame. You cannot sell paper if you don’t have paper to sell.
EQ: This is all happening against the backdrop of Ben Bernanke’s final performance last Wednesday. Since we last spoke, the treasury is spending $20 billion less per month, which I suppose fits the definition of “hawkishness” these days. Is this going to have any discernible effect on junior companies, or can the market just keep minding its business?
RR: There is too much focus on global macro with regard to juniors, and not enough focus on what the juniors themselves are doing. The global macro question is fascinating from the point of view of everybody’s personal financial circumstances, but there’s too much attention paid to it in the context of the juniors, so let’s segregate the question.
You mentioned Bernanke’s performance, which was an excellent, perhaps unintentional choice of words. The language that he uses is well chosen, and fraudulent. Quantitative Easing is not solely about adding near-term liquidity to the market, it’s also about artificially depressing near-term interest rates. But it’s much more about the fact that the US government runs a $1 trillion dollar deficit. They are able to borrow about 750 billion of that deficit on market, that is to say US buyers and foreign buyers, which leaves them spending $250 billion more than they either take in or can borrow. That they have to print, and they call that Quantitative Easing, but if you and I did it, it would be called counterfeiting, and it’s very important from the beginning that we understand that what Bernanke is doing is in fact a performance.
He is trying to cause the market to believe that QE is about introducing near-term liquidity into a market that is awash in near-term liquidity. What he is doing is counterfeiting. So think about what you said, his performance in the context of the fact that he has convinced both the electorate and the markets that counterfeiting is a good thing.
EQ: It certainly seems to be what everyone wants them to keep doing these days.
RR: I think that’s right. On Wall Street, he has given them in the near term a riskless carry-trade. You can borrow from the Fed at 65 or 75 basis points, and you can use that money to buy the US 10 year treasury at 270 basis points, so you’re getting 150 basis point arbitrage, with a time risk built-in. It’s the same sort of thing that the Fed engineered years and years ago with the savings and loan crisis. I hope it doesn’t have the same sort of ending. But obviously Wall Street likes the situation where they borrow at 75 basis points and lend it back to the government at 275 basis points. Who wouldn’t like that trade? So Bernanke has them on his side.
For the part of the population that is more involved in spending than in saving, artificially low interest rates are a very good thing. And certainly in a democracy there’s always going to be more takers than producers, so that is of course popular too.
So, while what he’s doing I don’t think is the right thing, it certainly is a popular thing. Most of the US population was very, very supportive of the very accommodative stance that the Fed and Congress took with regards to mortgage rates and mortgage qualifications until it blew up. So the fact that something is popular in the near-term doesn’t make it either sustainable or right, and I think that looking at counterfeiting and the manipulation of interest rates in the political context, juxtaposed against a history of the mortgage market in the US, is very illustrative.
EQ: What they’re doing, in AA language, might be characterized as enabling, in other words?
RR: You’re really on today! Between “performance” and “enabling”, you should work for the Fed. You’re as good a word craftsman as Bill Clinton was!
EQ: I suppose I’ll have to take that as a compliment, inasmuch as I can at least! What’s the next big appearance you are making that folks need to pay attention to?
RR: The Oxford Club, which is a private part of Agoura, is doing a high-end conference in Carlsbad, CA which is extremely easy for me because I can actually attend that conference while sleeping in my own home, which is a very good thing. We think that will be useful. The Cambridge folks themselves are doing another conference down in Palm Springs, CA, which, although I can’t stay at my own house, I can at least drive to, which is also a useful thing.
There’s an awful lot going on right now, but what is important for your readers to understand is simply that, although the message that our community was delivering in 2009-10 was more palatable because it was supported by price action - prices didn’t have to go up because they were already at high levels - right now, while prices are down, the message is unpalatable as a consequence of peoples’ portfolio performance after the last three years.
While the message is unpalatable, however, it’s no less valuable, so irrespective of where you get the information, this is the point in time where you need to be assembling information and acting on it with regard to juniors, not when it feels good.
EQ: You said something interesting in a recent interview, about the juniors market not being for folks who can’t stomach volatility or cyclicality. It speaks of a need for getting used to the notion that “down” doesn’t equate to “bad”.
RR: On the contrary, it correlates to good!
Listen, if these were physical assets and not financial assets, if there was a sign out there that said “75 percent off sale!”, and we were selling shoes, dresses, or tuna fish, there’d be a line up out the door. It’s only financial assets where people are idiotic enough to want to buy assets when they’re marked up fourfold.
And frankly, it’s a market inefficiency that people need to take advantage of.
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