An Interview with Rick Rule, Part IV: Silver and Base Metals
Source: Rick Rule, Global Resource Investments††(3/21/08)
Rick Rule of Global Resource Investments, in the fourth part of our series of interviews with John Pugsley of Stealth Investor, gives his thoughts on silver and base metals. Read what Rick, a legend in the mining, energy, and exploration business, has to say.
Now let us pick up the conversation with Rick Rule from where we left off last issue:
SI: Up to this point in our discussion, Rick, youíve talked about the general outlook for a continuation of the bull-market in natural resources, the prospects for a deepening recession, and gold. Now letís talk about silver.
RR: Itís a different animal. In the 1970s silver went farther than gold. I know from my experience as an investment dealer that while the gold bugs are aggressive, the silver bugs are the equivalent of gold bugs on steroids.
SI: Apparently. In the 1970s silver went from $1.29 up to $50, roughly a 40-fold increase. Gold wouldíve had to have hit almost $1,400 an ounce to match that.
RR: One of the interesting things about silver is that itís impossible to forecast supply. The reason is that most of the silver, and by most, I mean and overwhelming amount of silver produced on a global basis, is the by-product of the mining other metals. If the demand for copper, lead, and zinc stay strong, the supply of silver will automatically increase.
Whatís more interesting about the silver market is that itís impossible to know what the physical inventories are, and itís impossible to know what the demand will be. There are estimates that suggest that 40% of the physical holdings of silver in the world are held by the peasantry in South Asia as a store of wealth. They own that silver because they have a 4,000-year experience with government. They have no interest in holding rupees, they want to hold their wealth physically. Furthermore, they have absolutely no incentive to report their silver holdings in a place where thereís an income tax and a wealth tax. So getting some sense of what the above-ground supplies of silver are is impossible in the first instance, because nobody knows how to talk to all the peasants, and the second instance, because the peasants have a positive incentive to lie.
There are other unknowns. In order to make a correct calculation, you need to know things like what the weather will be like in India over the next 12 months. A good harvest will result in surplus capital, some part of which will be stored as silver. A poor harvest will involve dishoarding, where they sell silver to feed their children.
Itís very, very difficult to forecast the silver price: you canít forecast demand, you canít forecast physical holdings, and you canít forecast the flood. Other than that, no problem.
SI: And moving away from gold and silver, what about base metals?
RR: Base metals are an interesting conundrum. If you believe that the base metals prices will stay at or about their current level, the base metals are actually very, very cheap. Currently, there are no shortages of producing base metals companies that are selling at healthy discounts, say 10% or 12% of the net present values of their cash flows. No shortage of them. There are Australian base metals producers that are yielding 8%, 10%, 12%, and theyíre covering the dividend handily at current metals prices.
SI: The problem becomes, will base metals prices hold in a declining economy?
RR: It is said that copper is the metal with a PhD in economics, because the copper price is very sensitive to the economy. Itís regarded as a relatively accurate barometer of the economic outlook. There are people, and I was in this camp for a while, that have suggested that as the US economy slows down, the global economy will slow down. This school of thought considers the US as the worldís mouth, so if the US consumer slows down, Wal-Mart slows down, and if Wal-Mart slows down, China slows down. Sort of, the economic margin that drives China comes from selling stuff to US consumers.
But there is a different school of thought. Several Chinese that Iíd met recently upbraided me when I suggested that China was prospering because of American demand. They said that the United States and US citizens, myself included, take a somewhat grander view of our role in the world than is deserved.
They pointed out that the PRC has $1.4 trillion in foreign currency reserves. Their intention, apart from diversifying out of the dollar (and thereby cratering the dollar), is to spend the money modernizing China. Their position was that if they took 8 or 10 years spending $1.4 trillion dollars modernizing China, the Chinese economy wouldnít fall, it would become more domestically based and internationally based, which is in fact what the United States is asking them to do anyway.
SI: China is enormous, and although it must have changed since I visited there 20 years ago, Iíd guess they still have a long way to go to catch up with the western industrialized nations.
RR: What these people have told me is that China will start by building the infrastructure that we already have. They need rural electrification, the job that we started to do in this country in the '30s. They are going to build a national highway system like the United States built in the '50s. They need massive, massive improvement in pollution control and water distribution. My Chinese contacts tell me that China will spend the next 10 years, and their surplus, dragging China into the 21st century. If thatís true, they say that while the US economy may slow down, it wonít impact the Chinese economy a bit.
SI: If thatís true, it has bullish implications for base metals prices.
RR: It does. I was interviewed and, in fact, retained by a couple very large Chinese investors to help them make base metals investments. In the context of us mutually interviewing each other, I said, ďI donít do price projections. You guys have to do price projections. That will tell you what I can show you in terms of investment opportunities.Ē The sort of lead Chinese investor said, ďShow me a six-percent real return at US $2.50 copper.Ē
Well, our work has shown that the Canadian junior market is discounting $1.70 copper, so if the ask is $1.70 and the bid is $2.50, thereís a very large disconnect and a lot of money to be made. Iím not sure if the Chinese gentleman is correct or if the Canadian junior market is correct, but certainly the disconnect is large and real. I think there are lots of opportunities in the base metals market for people who subscribe to the point of view that although the US economy and the Western European economy is probably headed lower, that many parts of the global economy wonít be as effected as severely as people like myself had suggested that they would be twelve months ago.
SI: In that light, China isnít the only emerging economy that will need natural resources to sustain growth.
RR: It isnít. I was very recently in the United Arab Emirates, and saw the incredible profusion of building going in there. When I looked around Dubai in particular, what it seemed to me that I was looking at was a bust in the making. Every time I see too many cranes, I think this is nuts.
What I learned is that there is a shortage of rental accommodation. Weíve invested in a financial services firm over there. It has a nice, functional but fairly small office, 1,800 square feet, with people working on top of each other. I asked my host, you know, itís good that weíre frugal, but we donít have enough space. He said, ďWe canít get any more space, our space will be available in 15 months.Ē One of the employees told me that he is renting a villa, which is what they call a detached house in Dubai. Itís a nice house, like a four-bedroom house, and like many of the places there, it has the availability of extra room for a driver, a maid, and things like that. The rent is $10,000 US dollars a month, payable 12 months in advance. There is no rental accommodation available in Dubai.
SI: So the building boom that seemed excessive to you may make sense?
RR: The suggestion of these people is that at $90 crude, the building of new productive infrastructure in the Middle East, things like liquefied nitro gas storage facilities, nitrogenous fertilizer plants, aluminum smelters, will drive Middle Eastern growth, irrespective of US growth. This may or may not be true for the Middle East, but the thing that impressed them more than the growth that was occurring in the United Arab Emirates was the growth that was occurring in India.
My Arab host told me that their building boom is spreading. He said, ďYou should see India grow,Ē and described the same process taking place in India that my Chinese friends described taking place in China. The Indians, as an example, are involved in building something they call a quadrilateral, which is their interstate highway system. They are modernizing and upgrading road transportation in India, and extending rural electrification to the point where 90% of India is electrified. I donít know if the political liberalization in India and China will continue to the extent that has occurred in the last 15 years, but you and I both know that as you allow people more freedom, they become richer. If India and China continue to gradually liberalize, the people will become richer. While economies in the U.S. and Western Europe are slowing down, economies in places that are taking the chains off of individual entrepreneurs and workers are speeding up. The world may not even notice our slow down.
SI: Currently, at least here at the beginning of the slowdown, metals prices seem high enough to reward the producers.
RR: Certainly. The free cash flows for the copper, zinc, iron and lead producers are at superb levels. Moreover, the juniors have delivered a stream of discoveries that would suggest that putting them into production would yield robust investment returns at current prices.
SI: Robust returns providing the price stays where it is. But if and when these discoveries are put into production, what happens to the supply? If supply increases, that should affect the price.
RR: Well, an example would be Northern Peru copper which was just bought by the Chinese. It will require about $1.2 billion to put into production. It wonít impact supply at all for five or five and a half years. If you believe that the US economy and the Western European economies wonít be decidedly worse off five years from now than they are now, it wonít matter. If you believe, like Doug Casey, that the greater depression is coming, then you must have a serious issue with base metals. Your readers need to provide their own economic forecasts. Itís beyond the scope of my expertise to do that. Iím pretty good where the rubber meets the road, or in this case, where the drill meets the rock, but Iím less confident when looking at the big picture.
SI: To summarize your point about the base metals, the world-wide collapse of communism has freed billions of people, and theyíll be out there both producing and consuming. As the underdeveloped world, particularly India, and China, become more free, they will replace the United States as the consumption engine in the world.
RR: Itís proving to be the case. However, the interesting part about that scenario, which affects base metals, is that socialism is a pendulum, and itís coming back. Host governments are less predatory during periods of low commodity prices. John Dillinger didnít bother to go to a town that didnít have a bank. Governments arenít going to steal from a mining industry thatís insolvent. Now that the copper price has increased, host governments around the world are looking to put in place different fiscal regimes than the ones they negotiated with the companies five or six years ago. This is happening everywhere including places that are allegedly friends of the industry, like Chile.
SI: It will always happen.
RR: Of course, you and I are in agreement on that. The basic business of government is to steal. When they asked Willie Sutton, ďWhy do you rob banks?Ē He purportedly replied, ďBecause thatís where the money is.Ē
One of the things that happened is that if the capital is less certain of a warm welcome, it flows less freely, and that goes to supply increases. As an example, one of the most fertile exploration terrains in the world is Ecuador. Ecuador changed its money law to be more friendly five years ago. This stimulated a lot of exploration, and they had two very quick discoveries, Perilya and Corriente. However, the government recently decided to revert back and change the tax regime for these companies, which has really, really slowed up exploratio in a place that rewarded exploration with two extraordinary finds in a very short period of time.
The uncertainty with regard to the fiscal regime in Zambia right now will slow down copper development in Zambia. The entire mining world will be watching how Congo treats its copper mining industry now that thereís new investments in copper mining there for the first time since 1971. Will those governments honor their commitments? If they don't honor their commitments in Zambia and Congo, 10 or 12% of the worldís copper reserves will be off limits. This will have an interesting impact on copper supply.
SI: So far in our discussion weíve covered the natural resources bull market, prospects for a deeper recession, gold, and base metals. Iím aware that your family was involved in the oil and gas business, so from your earliest years youíve had a big interest in energy. Letís take a break, and then talk about the implications of the recession on oil and natural gas.
RR: Good, Iím deeply involved in the industry myself and Iíd love to share my thoughts. (2/15/08)