An Interview with Rick Rule, Part III: On Gold
Source: John Pugsley, Stealth Investor (3/6/08)
Rick Rule of Global Resource Investments, in the third part of our series of interviews with John Pugsley of Stealth Investor, gives his thoughts on gold. Rick's success is legendary in the mining, energy, and exploration business. There is simply no one who is more knowledgeable, in Pugsley's opinion.
In the last two articles you’ve heard Rick’s insights on the prospects for natural resources in light of the slowing economy, and he shared his out-of-the-box perspective on the recession itself. His key point relating to the size and depth of his recession was that there is an ocean of sub-prime debt other than just that in the residential real estate market. Credit card debt, leveraged-buyout debt, auto-loan debt, are but a few. And all types of these have been “securitized,” that is bunched into packets that are then bought and sold as financial assets.
These assets, and in fact, all monetary assets, by definition, are someone’s IOU. This holds true for everything including currency, bank checking and savings accounts, CDs, mortgages, Treasury bonds, and all other debt instruments.
The only financial asset that isn’t also someone else’s liability is, you guessed it, gold.
SI: Last week you opined that the U.S. economy is in recession, and it will be another 18 months before we can know just how deep it may go. Prior to that, you described the effect this slowing of demand would have on industrial commodities. We didn’t, however, get to your thoughts on gold.
RR: Gold is an important piece of the puzzle. In nominal prices, as the U.S. dollar goes lower goods priced in dollars go higher. Since gold is a “good,” it should rise as the price level rises. During the gold boom in the 1970s, the metal did fairly well against the dollar through the middle part of the decade, but when it started to go up against all currencies, the move went hyperbolic.
SI: There were some differences between then and now. In 1946 the Bretton Woods agreement gave foreign central banks the right to convert dollars they held into gold at $35 an ounce, thereby fixing the world price at $35. In 1971 Nixon abrogated Bretton Woods, closed the “gold window,” effectively devaluing the dollar against not only gold, but the other strong currencies like the Swiss franc. My point is that because of Bretton Woods, the dollar became wildly overvalued not only against gold, but against all other things, including currencies. Isn’t it a question of how each country deals with the U.S. dollar? The more the Federal Reserve creates, the lower the dollar goes, and the cheaper U.S. products become. No one can predict the future, but give me your guess as to where it goes from here.
RR: I think the probability is that as the U.S. dollar goes lower, other currencies will also devalue to maintain their ability to export to the U.S. market, and simultaneously to avoid becoming a sump for exports from the U.S. This could lead to a round of competitive devaluations.
SI: When you speak of the competitive devaluations, what you are referring to is a situation in which central banks crank up their printing presses in an attempt to stimulate exports and curtail imports, correct? That happened in the 1930s, when a round of competitive devaluations led to catastrophe.
RR: It could happen again, and it will have an effect on the gold supply. The resource business is a capital intensive business, and therefore any credit contraction hits natural-resource based businesses hard. They are profligate users of debt and the availability and price of borrowing have a direct impact in terms of bringing new productive capacity on stream. The novel debt instruments that have benefited the natural resources business on the debt side, in many cases have been just as egregious and just as speculative as the debt instruments that other sectors and consumers have used. A contraction in credit availability and a change in cost of borrowing will certainly impact companies on a global basis that are attempting to add productive capacity.
SI: Gold is currently around $900 an ounce, and we hear pundits claiming that this is a historic high. That’s malarkey, of course. At its bubble high in 1980 it hit $850, but consumer prices have risen about 2.7 times since then, so the price of gold today measured in 1980 dollars is a modest $330. Hardly a historic high. With that in mind, what’s your perspective on the gold mining industry and on the gold price?
RR: Wall Street is currently betting Bernanke will follow through on his threat to cut US interest rates by one percentage point or 100 basis points. [This interview was conducted just before the recent cuts. Ed.] A one-percent cut would effectively lower the return to savers by 20%. If the utility of saving currency falls by 20%, it would make sense that the value of the currency would decline by 20%. So just as a ballpark guess, it wouldn’t surprise me in that set of circumstances to see the gold price increase by 20%. That estimate could change upwards if other countries followed through and lowered their currencies so that the utility of any fiat currency was reduced relative to holding gold.
SI: That would be a point at which we might expect gold to spike again.
RR: Right. The second thing about gold that’s interesting is that the gold market is one of the few markets impacted by both of the primary trading instincts: greed and fear. In the 1970’s market, which is where I cut my teeth, I watched that occur. The gold price would go up, so people would buy gold because they were greedy. There was another set of people who bought gold because they were afraid of the erosion of their store of wealth in other forms, and as the gold price rose, it made those people more fearful, it thereby reinforcing gold’s utility to them. Then the fear buyers would buy. As the fear buyers bought, it generated a further price rise, which then caused the greed buyers to buy more, which would provoke the fear buyers to buy more, etc., etc.
SI: And fundamentally, when money loses value, savers turn to something that will hold value. Gold becomes a safer, more rational way to beat inflation.
RR: But gold can move for psychological reasons that are completely unrelated to fundamentals. But gold has risen dramatically over the past three years, but something odd has happened. What’s been frustrating to a lot of my customers, and I suspect a lot of your readers, has been the disconnect between the gold price, and the price of gold shares. Most observers, certainly myself included, had thought that a move in gold above the $500 level, never mind the $800 level, would provoke a much more pronounced move in the gold equities.
Think about it. If a company was making gold for $300 an ounce, and selling it for $260 an ounce, their margin was negative. As the gold price went from $260 to $400, the industry should be making $100 margin per ounce where they had a minus $40 margin before. With the gold price increasing from $260 to $900 the increase in profit margins that you would expect should be almost infinite.
It hasn’t occurred. I’ve thought about this at length, and with regards to the senior gold companies, I think most of them have been very poorly managed. The margins should have increased for these producers, and though I’m not certain as to all the reasons for this, I believe one of the reasons is that during the days when the industry reported a $300-per-ounce cash cost, they were in fact high grading, that is, mining the richest parts of their deposits.
SI: And they didn’t disclose that?
RR: If they had reported the grade that they were mining relative to the average grade of their reported reserves, they would have had to report higher depletion charges than they did. Profits wouldn’t have appeared as high, and their share price would have gone down, and the cost of capital would have gone up. If I’m right and they did high-grade, they’re left with, if you will, rump or rind deposits, what’s left when you take all the good stuff out.
Second, since the move in the gold price in the late 70’s, mining company managements have been rewarded for exhibiting leverage to the gold price. The marginal producer is more leveraged, and hence more highly valued. So, in a sense, the finance industry has asked the gold mining industry to become marginal, and in other words to become non-efficient. And the mining industry’s obliged them. It’s a lot of fun not to have to worry about costs. Bottom line, they’ve been very poorly run businesses.
And third, there are factors beyond their control. There have been incredible increases in the price of inputs to build mines and inputs to operate mines. For example, an oil price at $15 yields lower diesel costs than an oil price at $90. The price of cement has tripled. The price of heavy tires has quadrupled. Labor prices (when you can get good labor) have tripled. So the input costs are higher.
SI: That would be the case. Consumer prices have almost tripled since 1980, so it makes sense that production costs would rise in tandem.
RR: No, I wish they had only risen in tandem. These costs have tripled in the last five or six years. Prices have soared because of supply constraints. Right now, as an example, the lead time to get a tire for a 300-ton ore haul truck is in the range of 20 months. If you are out of tires, you have a $12 million piece of equipment that sits idle. You pay whatever you it costs to get the tire.
SI: So this is true for the majors, what about the juniors, such as the almost unknown prospect generators that appear regularly in The Stealth Investor. These companies don’t buy ore-haul trucks.
RR: What has happened in the junior sector is somewhat more pernicious. Gold observers are keenly aware of central bank currency inflation, in other words, printing false paper. As you know, the private sector does everything more efficiently than the public sector.
SI: Including printing paper?
RR: Exactly. The Canadian dealer network has printed more phony gold shares in the last five years than in all of recorded history. One might think that the only thing that stands in the way of their printing is the resource needed to make paper, the standing inventory of timber between the Atlantic and the Pacific. We bought it all.
Shares of individual junior gold stocks may not have increased, but the market capitalization of the sector has gone crazy. By some estimates, in the period of 2000-2008 the population of junior mining companies issuing shares has grown from about 800 companies to about 5,000 companies. So while the share prices of the individual companies have not increased as markedly as one would expect with the gold price increase, the number of participants the market capitalization of the junior sector has increased dramatically, and the shares outstanding per participant has increased. It is really amazing. The important part for your subscribers to remember is that not all these exploration companies are created equal. In a universe of 5,000, there are probably no more than 600 worth considering.
SI: If that many. So in your view, the disconnect between share prices and the gold price is related to the profligacy of issues from the Canadian dealer network.
RR: Clearly. But there is more. Both retail and institutional investors in the junior sector have made a fairly fundamental mistake. The idea that because the gold price goes up, the shares of exploration companies ought to go up doesn’t make any sense. The exploration company doesn’t have any gold. They’re looking for gold. If the price of something that you don’t have any of increases dramatically, it shouldn’t make any difference. But people don’t get that very basic disconnect. You shouldn’t buy an exploration company because you think the prices of gold might go up, you buy the company because you think you’re going to find some gold, and those are very different equations.
SI: That would seem to bodes true for all natural resources.
SI: OK, there’s been a dramatic increase in costs of gold production in the last five years. Is this the result of the rising gold price, and therefore exploration activity increased? It seems that this would lead to more demand for all the components of production…things like drill rigs, heavy equipment, and so forth.
RR: The demand for the factors of production wasn’t only triggered by the rising gold price. Some inputs, like labor costs in the state of Nevada, are related to the gold price, and led to a tremendous increase in gold mining in Nevada. But we’ve had an increase in the demand for capital goods on a global basis, primarily driven by third world growth. China and India are the poster children. We need steel in the mining industry and so do they. They need a lot of cement, and they need a lot of oil. Input costs have increased dramatically for all industries, not just the mining industry.
SI: Finishing up on gold, at its current price around $900, is it low, about right, or high?
RR: Evidently a lot of people think its about right or low, as the $900 gold price is stimulating an awful lot of capital input to the mining industry. Personally, I don’t know the answer. I suspect that the price is high enough that it will stimulate some increase in supply. On the other hand, gold doesn’t react as well to the supply and demand imbalance as other metals do. I think what will really determine the price of gold will be the performance of other financial instruments.
SI: Now we’re back to the big question about the economy. On one side we have entered a recession and on the other side inflation is rising. Consumer prices jumped 4% last year, a very high rate indeed.
RR: Truly. Remember that Mr. Nixon imposed price controls when it was only 3 %.
SI: So, were back to Mr. Bernanke. He is wedged between the proverbial rock and a hard place. Thanks for your insights, Rick.
RR: My pleasure. Next let's talk about copper and zinc...