We are approaching an inflection point in the economy and the metals markets favorable to precious metals and mining equities.Moving beyond 2008, investors long in mining and metals equities are no longer burdened by the combination of redemptionsand tax loss selling. While producers appear less risky, we see mining and metal equities with development potential as offeringthe greatest leverage for appreciation in the new year.
Increasing operating costs in 2007 and declining metal prices in 2008 have increased development risk and squeezed operating margins. Turmoil in the credit and housing markets have reduced access to capital, exacerbating a lengthy decline in both precious and base metals mining equities to the lowest level in several years.
Slower levels of economic growth worldwide have led to higher than anticipated inventories, declining base metal prices, and shelving base metal projects. As we anticipated, this has produced increased availability of labor and equipment leading to moderating operating and development costs. While in many cases, base metal prices have declined to below required levels for production, precious metal prices remain above real long-term price levels.
Investment Thesis Transitioning: Defensive Strategy for Liquidity Trap from Commodity Super Cycle
We suspect that these trends may remain in place until global economic growth resumes. This includes stable or increasing precious metal prices and moderate to declining operating costs. Also, considering the decline in supply of available viable precious metal project to finance, we anticipate a relative increase in supply of available credit and capital. Despite the aggregate decline in the market capitalization of mining and metal equities, and the reduced supply of bankable projects and available credit, the amount of precious metals in the earth remains constant. While the availability of metal in the ground is an issue, this characteristic increases its scarcity and value which is at odds with the money supply, which is made scarce only by the moral fiber of the government and monetary authorities.
We base our outlook on Irving Fisher’s Equation of Exchange, or MV=PQ. In general terms, the velocity of the money supply will be reflected in inflation and GDP. The left side has been adequately discussed in the investment and national media. Losses in the financial industry have reduced bank capital and bankers’ ability and willingness to lend, thereby retracting available credit and reducing both the supply and velocity of money. On the right side of the equation we have seen both declining commodity prices (oil, base metals, housing) and slower economic growth (lower sales, bankruptcies, layoffs). This suggests a deflationary environment including a strong dollar and low interest rates, where holding cash starts to look like making an investment.
The national media has documented the monetary authorities’ response to increase GDP by reducing interest rates. The government has also increased the money supply through the financial and auto industry bail outs. The incoming administration has also pledged to spur the economy through historic investment in infrastructure. The government appears sanguine regarding bankers’ willingness to lend and is making a strong effort to increase the money supply. There is skepticism as to whether these actions will produce the desired result.
It is accepted that the government is increasing the money supply, and should banks begin to lend, the combination based on the Fisher Equation should lead to inflation or an increasing GDP. Optimistically, it may take years for infrastructure projects to commence or for the economy to grow. The only remaining variable to balance the equation is inflation. As monetary policy is more art than science, the ability to manage the money supply is suspect. (In our opinion, the optimal path is to allow the market to manage the economy to equilibrium by reducing taxes and regulation, leading to higher levels of productivity and production, none of which is regarded by the government as a solution). We question the Fed’s ability to smoothly reduce the money supply commensurate with an increase in lending by bankers (increasing velocity) resulting in volatility at best and inflation at the worst.
Precious Metal Production and Development Should Hold Value in 2009
These factors are favorable to junior precious metals equities. Gold and silver prices are correlated to inflation, suggesting stable or higher precious metal prices. Slower economic growth should increase the supply of labor and equipment for moderating operating expenses. The combination of increased prices and lower costs may expand margins, increasing the attraction of precious metal equities by investors. Though investors may recognize the importance of production and cash flow, the most attractive returns may be in development and exploration of precious metal resources. We believe that investors will look for leverage and screen precious metals companies by size (or resource) and probability of development. Our short list for consideration includes the following.
NovaGold Resources Inc. (AMEX: NG) has nearly 22 million ounces of gold (plus 4.5 billion pounds of copper and 62 million ounces of silver) in the Measured and Indicated classification. Barrick Gold Corporation (NYSE: ABX) should complete a Feasibility Study on the Donlin Creek project, in a 50-50 joint venture with NovaGold, in early 2009, which should advance much of the 32 million ounces of in-pit Measured and Indicated resource into reserves. Donlin Creek is one of the world’s greatest undeveloped gold deposits. In 2007, drill hole DH-1556 intersected 299 meters grading 5.26 g/t (1,573 gram-meters) and DH-1564 intersected 308 meters grading 4.60 g/t (1,417 gram-meters). NovaGold’s other assets include the world-class Galore Creek polymetalic project and the Rock Creek gold mine. Based on NovaGold’s share of Donlin Creek alone, at $45 per ounce (less than one half previous conservative acquisition levels), NovaGold may be valued at more than $6 per share not including its other assets.
Seabridge Gold Inc. (AMEX: SA) continues to advance its KSM gold-copper project in British Columbia. KSM is one ofthe world’s largest undeveloped gold-copper-silver projects with a 19.7 million ounce Indicated gold resource (plus 5.3 billion pounds of copper and 64 million ounces of silver). Seabridge’s total gold resources total about 49 million ounces, or over 1.25 ounces of gold per share. Seabridge reported $11 million in cash on its balance sheet at the end of its third quarter. On December 15, 2009, Seabridge announced the closing of its Noche Buena project in Mexico for $25 million in cash. This should fund additional drilling and study at KSM, which we expect will lead to an increase in the resource and improved economics by converting waste to ore.
Exeter Resource Corp. (AMEX: XRA,TSX.V: XRC, Frkt: EXB) continues to advance its Caspiche gold-copper porphyry project in northern Chile. The project is well situated between Kinross’ Refugio mine with 6.2 million ounces of gold and the Barrick/Kinross Cerro Casale project with 25 million ounces of gold (grading 0.69 g/t gold and 0.26% copper). Exeter recently announced drill hole CSD023 at a depth of 102 meters intersecting 603 meters grading 0.89 g/t gold and 0.32% copper (under an oxidized cap of 0.65 g/t gold). Caspiche is open, and with the current footprint the eventual resource could exceed ten million ounces of gold. (Barrick acquired 51% of Cerro Casale for $775 million in October of 2007, roughly eight times the market capitalization of Exeter). They have three drills on site and are scheduled to produce a resource estimate by April of 2009. Exeter has one of the largest land positions in Argentina and Chile, with about $22 million in cash on its balance sheet as of the end of its third quarter.
South American Silver Corp. (TSX: SAC) is rapidly advancing one of the largest silver resources in Bolivia. The Malku Khota silver-indium deposit has an Indicated Resource of 144.6 million ounces of silver and 845,000 kg of indium (an important industrial mineral used in flat screen televisions). The deposit has good exploration upside as the resource covers only 3.5 km of the project’s 15 km strike length. Malku Khota could be one of the largest silver discoveries in South America, if not the world. Given the change in administrations in the U.S., and an upcoming election in Bolivia, there are also good prospects for improving international relations which should become clearer in January. Currently, South American is trading at close to cash per share.
Alexco Resource Corporation (AMEX: AXU) is scheduled to make a construction decision at its high-grade silver and base metal Bellekeno project (inferred resource of 537,000 tonnes containing 1,016 g/t silver, 13.5% lead and 10.7% zinc) in its wholly owned Keno Hill silver district in the Yukon Territory. Construction should be fully funded by the transaction with Silver Wheaton Corp. (NYSE: SLW). Bellekeno is anticipated to be a modest but high-grade and highly profitable operation fueling development of the district. Keno Hill may be early in its production history, producing over 217 million ounces of silver between 1921 and 1988, and having been explored to depths of only several hundred meters. We believe the district has the potential to rival Idaho’s Silver Valley, which has produced over a billion ounces of silver, and mined to depths of over 5,000 feet.
Etruscan Resources Inc. (TSX: EET) has exceeded anticipated gold production levels at its Youga project in Burkina Faso. Youga has good potential for resource expansion at its Ouare´ satellite target, which may lead to reserve expansion with increased capacity or mine life. The current price environment is conducive to funding exploration. As Etruscan focused on West Africa early in the metal cycle, they acquired the largest land position of any mining company in the region, and consequently may be best positioned for exploration. We also believe Etruscan is ahead of the curve on diamonds and rare earth development in southern Africa. Etruscan has a gold resource of over three million ounces and recently produced a Feasibility Study for its Agbaou project in Côte d’Ivoire.
Looking Forward to Increasing Demand for Developers in 2009
We believed that 2008 would favor investment in emerging producers assuming stable metal prices and moderating operating expenses. These companies appeared to have proportionally less risk than metals and mining equities on the exploration end of the spectrum. We see higher metal prices and moderating costs already increasing the attraction of mining and metal equities. As exploration companies have declined more than most, we see these now as potentially having the greatest upside potential. Moving out of a period of tax loss selling, equities in general may see a real bounce. Developers may enjoy the greatest appreciation from stable or increasing precious metal prices, moderating operating or development costs, and increasing availability of credit or profitability of major producers.
Beacon Rock Research, LLC provides information and analysis on selected companies, with a focus on small-cap and micro-cap companies. This report has been written in accordance with current SEC regulations and the Standards of Practice developed by the Chartered Financial Analyst Institute (CFAI). Our research has been conducted by employing analytical practices generally accepted as standard within the analytical industry. In this instance, a comparison of financial strength, a bottom-up earnings projection based on a recovery in the U.S. economy, and relative multiples, were employed. Target prices are calculated on comparative EPS, sales and book value multiples, and our knowledge of small-cap markets when enjoying both a sector and a cyclical rebound. Our conclusions are, by the very nature of forecasting, speculative, but are also reasonable, supportable and consistent.
Key to disclosures:
1. The research analyst or a member of the research analyst’s household has a financial interest in the securities of NG, SA, SAC, AXU and EET in the form of a long position.
2. NG, EET, and AXU have paid SLB Equity Research, LLC., one of its affiliates, for research coverage, institutional introductions, or other awareness building services.
3. The research analyst principally responsible for preparing this research report received compensation based upon various factors, including SLB Equity Research, LLC total revenue.
4. This report was prepared exclusively for the benefit of institutional investors and may or may not receive compensation directly or in soft dollar arrangements. The analyst, Mike Niehuser, hereby certifies that the research conclusions and recommendation contained herein accurately reflects his personal views about the industry, company and shares and also hereby certifies that no part of his research compensation was or will be directly or indirectly related to the earnings estimates, target price or recommendation about the security. The research provided herein should not be considered a complete analysis of every material fact regarding the companies, industries or securities named above. The opinions expressed herein reflect the analysis and judgment of the author on the date of publication and are subject to change without notice. Facts have been obtained from sources considered reliable but should not be construed as complete and are not guaranteed to be accurate. Beacon Rock Research, LLC; its members; employees and their families may have positions in the securities covered within the research material above and may make purchases or sales while this report is in circulation. Additional information on the subject companies is available upon request.
EQUITY RECOMMENDATION SYSTEM:
Strong Buy Immediate purchase is recommended. The security is expected to outperform the market over the next six to 12 months. Buy Immediate purchase is recommended. The security is expected to outperform the market over the next 12 to 18 months. Hold Holding the stock is recommended because the share price’s appreciation potential is less than or equal to the market. Sell The stock has reached the target price objective and/or conditions have changed sufficiently to alter the outlook for the stock.
EQUITY RISK SYSTEM:
High The security is more volatile than the market and/or the company is more leveraged than its peer group. Moderate The security has about the same volatility as the market and/or the company carries a level of leverage in line with its peer group. Low The security is less volatile than the market and/or the company is less leveraged than its peer group.
DISTRIBUTION OF RECOMMENDATIONS:
At this time, there are an insufficient number of companies under coverage to generate usable distribution information or draw any conclusions regarding biasabout the research methodology. Prospective companies are screened and evaluated by sales personal and research analysts with the investment thesis and overall research recommendation developed before the commission is established.