Richard Gray: The Fear Trade


It's been a dollar vs. gold story ever since the economy ran into trouble last fall, according to Blackmont Metals and Mining Analyst Richard Gray, who sees inevitable inflation down the road. "The trouble is there are no real applicable precedents we can use," he explains, noting the prodigious amount of stimulus money flooding the economy. In this exclusive interview with The Gold Report, Richard discusses major drivers behind gold's price rise, attributes of successful juniors and why he thinks gold's upside scenario is "maybe $1,100 or $1,200."

It's been a dollar vs. gold story ever since the economy ran into trouble last fall, according to Blackmont Metals and Mining Analyst Richard Gray, who sees inevitable inflation down the road. "The trouble is there are no real applicable precedents we can use," he explains, noting the prodigious amount of stimulus money flooding the economy. In this exclusive interview with The Gold Report, Richard discusses major drivers behind gold's price rise, attributes of successful juniors and why he thinks gold's upside scenario is "maybe $1,100 or $1,200."

The Gold Report: Gold's on a roll. What's your take on what's driving the gold and precious metals sector right now?

Richard Gray: I believe there are two real drivers behind the gold price: the fear trade vs. the U.S. dollar, and the potential for inflation. I tend to minimize the overall impact of supply and demand. Given what we've seen over the course of 2009, investors are looking for an alternative investment to the dollar. If you go back to when the overall economy ran into trouble last fall, ever since then it's been more of a dollar vs. gold story and that's still true today.

As the economy recovers and there's a scenario where inflation is an issue, then there's a case to be made that gold will do well then, as well. But for the time being, it's just people worried about where their money is today and using gold as a safe haven vs. where it could go with their other investments. What we've seen in the last six weeks is that gold has broken through some historic levels because there's increased worry that maybe the U.S. dollar isn't the world currency anymore and the U.S. economy is really not as stable as we've been led to believe.

Investment demand, whether from funds or individuals, has been a major, major driver, taking gold from $700/oz through to where we are today. And this investment demand is simply investors just looking for a safe place to put their money.

TGR: Do you think there's a high probability that once we start to recover we will hit inflation?

RG: The trouble is there are no real applicable precedents we can use. With all the stimulus money that's been injected into the system, it would seem inevitable that inflation will be an issue down the road.

On the other hand, you could also argue that all the value that was destroyed (particularly in the last 12 months), won't be regained by all the stimulus money in the world. That's the argument for people who say inflation's never going to be an issue because the stimulus money isn't anywhere near what was lost in the last 12 months.

Personally, what I've been telling clients is that gold around $1,000 is probably a reasonable place to be looking long term. I don't think gold's going to take off and go to $1,500 or $2,000. I think the upside scenario is maybe $1,100 or $1,200 and then somewhere in a range between $900 and $1,100 is probably where the gold market is healthy and where the economy, as it compares to the gold market, is also reasonably stable. The fear trade is going to be here for a while and inflation might have an impact later on. But in the meantime we are not calling for a dramatic move up or down.

TGR: Gold has gone up about 21% this year. Silver has gone up 61%. Is silver being driven by other elements?

RG: Yes. Silver is somewhat of a unique metal. The simplest way to put it is when the economy is good, it trades closely with the gold price—usually on a 50:1 ratio. During these times it is treated more like a precious metal, a metal you invest in to protect your money. When the economy is weak, like the second half of 2008, it trades more like a base metal, where supply and demand has more of an impact. We saw the ratio rocket up to 80:1 last fall. Right now we're at 65:1, which is right in the middle of the bull market and bear market scenario here and that probably fits as well.

On the supply-demand aspect of silver; it is consumed (whereas gold is typically not) and it is usually mined in deposits that are primarily lead, zinc and copper. So it's got a bit of a two-headed look to it. While the increases of 61% this year for silver and 21% on gold are true from January 1st, if you go back to July 31, 2008, that's when things really just fell off a cliff. From July 31, 2008 to today, gold is up 20% and silver is basically flat. So picking a time horizon, silver has outperformed, but also if you go back to where things were fairly stable and normal, the last time gold-silver traded at around a 50:1 or 55:1 ratio, if we ever get back to that, silver hasn't really done much since then. For all the same reasons you can say gold could go to $1,500 or $2,000, you could also say silver could go to $30 or $40; but I just don't see it because silver mines will start popping up all over the world if silver goes through $20, and you're going to get an increased amount of supply—more so than gold. A lot of silver is going to hit the market, and I don't think the demand side can really take it all up and keep that price high.

As with the current price of gold, I think the silver market at $17 or $18 an ounce is quite healthy. I just don't see these kinds of runs because there are a lot of silver deposits out there, whether they're part gold-silver, part silver-lead-zinc. They get built or they get turned back on, and it becomes more of a supply-demand issue for silver anyway. So, you're right—silver has outperformed. Is it overbought here? I don't think so. I think it's probably right where it should be given the uncertainty of the overall market.

TGR: If we're looking at a relatively flat market for silver and gold in the same timeframe—and I'm referring to gold stocks here (as the gold equities have, in many cases, doubled, tripled, quadrupled)—did we miss the boat on these or is there more upside to be gained?

RG: On the big cap gold and silver stocks—there are probably 10 to 15 of them in North America—they've generally traded on about a 2.5:1 beta to the underlying metal, which is typically where it should be in a good, upward market on gold and silver equities.

Where we haven't seen that performance and where we're starting to now is with the smaller cap companies, the more speculative gold and silver companies. I think there's more money to be made in the smaller caps junior companies right now because we're seeing a movement of capital from these big, solid companies down to the more speculative names. I think as gold's gone through $1,000/oz there's a new level of interest in the smaller cap companies. Having said that, if gold has a correction and goes back below $1,000 even for a week or two, there will be a lot more downside on these junior companies because they're the ones that will trade on much higher beta to the gold price than the seniors.

A ratio I look at is the HUI Gold Index divided by the gold price. The HUI Gold Index is really one of the best proxies for gold stocks in North America. Right now this ratio is around 0.42 and what does that mean? It got as low as 0.20 last fall. That's as bad as it got. So since then they have kept pace and outperformed to a certain degree over the last nine months. However, we're still far below the 0.50 to .55 range we saw in 2007 and early 2008. So that's a pretty far way to go for the equities to outperform the gold price to get back to that level. I don't think we're going to get back there because there's still that fear element in equities. The 0.42 level is close to the high we've seen so far this year of 0.44. I don't think the equities are fully valued. But they're close to being fairly valued, and you're going to get more uptick on the smaller cap companies—but you're also taking on more risk. The stocks have done very well and I would just say that, on a one-off basis, they can outperform; but general speaking I think they'll trade in tandem or at least maintain that similar kind of ratio with the gold price.

TGR: Going back to the seniors, are they rebounding because the overall market has rebounded or is there some specific correlation with the price of gold?

RG: Yes. These senior companies are the ones producing gold, and actually have production and cost and revenue and profit. Last year, Q3 of 2008 was really the high watermark for costs. That was the highest costs have ever been and that's because oil increased significantly and because labor and all the inputs to mining were at all-time highs. At the same time, gold was coming off from its highs. The margins hit their peak, and then started to compress from Q3 '08 right through Q1 '09.

In addition to all the other risks that come with equities, the companies' margins were being squeezed enough that they were making less money, so they underperformed the gold price. Since Q1 '09, we've seen a gradual increase in margins as costs have stabilized and gold has continued to trade higher. Gold was $910 in Q1, $920 in Q2 and it averaged $960 in Q3.

So that's the general trend of the gold price, and costs on average for the industry have been fairly flat over the last three quarters. So you could see that delta on the gold price is really providing the expanded margins. That's why people are moving into these equities more so—they're making more money and they're healthier companies and, thus, they deserve higher multiples than they did a year ago. It's not across the board, but generally speaking, the big companies—which constitute a big chunk of the annual global production for gold—their margins are improving every quarter, and that really hasn't happened for a long time. People are finally realizing that these gold companies are healthy and viable investments. Not just gold investors, but generalists in the stock market are looking at gold companies for the momentum and returns over the last little while.

TGR: What about the juniors? They've seen some spectacular gains.

RG: The beauty of it, looking at the juniors, is that most people look at year-to-date performance and it's off the charts because the junior market was essentially dead last December. The juniors that survived through November-December of 2008 just barely did so, thus the January returns on these things have been spectacular simply because they survived long enough to get financing from the equity markets. The junior market has really just been rejuvenated in the last four to five months.

I think there's still more upside because now these companies won't just batten down the hatches and shut down all their drilling. They don't have to go to the banks for loans. They can go to the equity market, which is traditionally where the money does come from. They can expand their drilling. They can do all the speculative things that they're supposed to do—discover deposits and build new mines—which is why investors like them, because that's where you get more of the return. So these companies doing well is really just a function of the overall health of the markets funding them. They have money to do what they're supposed to do, which is find and develop new deposits.

TGR: When you're looking at juniors in your role as an analyst, what are the key elements that you're looking for now?

RG: Whether it's a good market or bad market, I think the two big things for juniors are location and management. You've got to be sure a project is in a place in the world where you're going to get rewarded for success. Canada, U.S., Mexico, most of the Americas are all pretty good.

Once you get over to Africa, parts of Asia or Eastern Europe, there's more risk with finding deposits because there's NGO involvement, there's nationalization risk from the government and things that just happen in those countries that you don't usually see in safer parts of the world

The second thing is a capable management team, especially on the operating side of things. If there's a track record there, all the better. If they have the ability to not only find and develop deposits but also fund them, those are the two most important things. And usually those two things will bring in decent deposits that can get built.

TGR: Do you have some companies you can share with us that have both the location and management you look for?

RG: Yes, one at the top of my list is Jaguar Mining Inc. (TSX:JAG) (NYSE:JAG). I think Brazil is one of the best places in the world to be gold mining. It's got a very stable framework for finding and developing gold deposits. The tax code is very straightforward; the permitting process is extremely black and white. If they tell you it's going to take six months to get a permit; you get your permit in six months. It's somewhat undercapitalized in terms of money being spent in the country if you're looking for gold deposits. It's just traditionally been a tricky place to set up shop for whatever reason. So there aren't a lot of companies down there exploring for gold vs., say, those in Nevada, Northern Ontario or Quebec.

Jaguar's also good because they have a management team in the U.S. that runs things corporately—but it's the management team down at the mine sites that is very impressive. They're guys who have been mining down there for 30 or 40 years and they get it. They know how to do it. Those are the things that attracted me to Jaguar, initially. Since then good things have happened; they now have three producing mines, a fourth on the way and the valuation has followed such that it's poised to be the next mid-tier producer, in my mind. So that's a good example of decent management, good country, good assets and it's worked so far.

First Majestic Silver Corp. (TSX:FR; OTCQX:FRMSF), a silver company in Mexico, is very similar to Jaguar in that they have a specific focus. They have several mines. They built them, they delivered. They've been able to build mines and grow them. First Majestic is an attractive silver producer poised to make the jump up to the bigger peer group.

TGR: And they're currently producing?

RG: Yes, First Majestic has three mines in operation and a couple of other projects that will be brought in to production in the next couple of years. They're not going to stray away from Mexico because that's where their expertise lies. And, like Jaguar, they have management that gets them the money—but it's really the guys in Mexico that build and operate the mines that are key. Once you trust that they're going to be able to do it, that's the biggest hurdle you can overcome. Then you know the guys doing the actual work are good.

Also, on the list of ones I cover, New Gold Inc. (TSX:NGD; NYSE Alternext: NGD) is a fairly new company in the mix. New Gold management is really a "who's who" in the Canadian mining market—the executive chairman is Randall Oliphant, a former CEO of Barrick, and the board includes several of the big names in Canadian mining like Ian Telfer and Pierre Lassonde. These are guys that have had success in the past and they know how to build a company. New Gold has focused on acquiring mines in safe parts of the world such as Canada, the U.S., Mexico, Brazil and Australia.

They started the company by merging three companies a couple of years ago and then they made another acquisition this year. It's likely they're going to continue to make more acquisitions because they want to be a million-ounce producer in the safe parts of the world within the next three years. Given what that management team has done already and can do, I think it's a pretty safe bet that they're going to be able to deliver on that target. They make you want to buy the company just on what they've been able to do and the people behind it. It's an easy one to feel comfortable about.

TGR: Do you have any that are emerging that we can discuss?

RG: Two that I cover that are small, but could become something bigger. The first one is Apollo Gold Corp. (TSX:APG). Their main focus is the Black Fox mine in Northern Ontario in the Timmins District, which is one of the world's most prolific gold mining regions over the last 100 years. They've built the mine and it's producing; it's going to produce over 100,000 ounces next year. And the beauty of Black Fox and Apollo is that it's not well followed. It doesn't have a lot of coverage from the investment community. As they show that they can run Black Fox at the rates that they've indicated they can, it's going to be one of the better gold investments out there in terms of return on your money. I think it's very, very cheap now and as they deliver on what they can do, that's the upside for investors. So Apollo is one of my favorite juniors. They have some obstacles to overcome, of course. The balance sheet's fairly weak right now. They had some startup difficulties with the mine, but nothing that's really that significant. So I think within the next three or four months they'll be well on their way to showing that they're an attractive new Canadian junior producer.

TGR: When they get their production ramped up, will that also offset their slightly weak balance sheet?

RG: Absolutely. It all works together. The more gold they get out of their pits, the more money they make, the easier it is to pay off their debt simply is the way it works.

TGR: You mentioned there were two smaller ones that you are following.

RG: The other one is Nevsun (TSX:NSU; NYSE.A: NSU). I'll be the first to admit it doesn't really fit with the low political risk criteria, but it's a name I've covered for quite a while. The reason I covered it initially was the world-class discovery —the Bisha Project—they made about six years ago in Eritrea in Africa. They are now building the mine, which has gold, silver, copper, and zinc. The first couple of years of production are gold and there's three years of primarily copper production and then five years of zinc production. It's not a pure play gold company, but it's going to be gold to start. Quite frankly, it's one of the simplest and most attractive ore deposits in the world.

The risk with Nevsun and the reason the price is probably half of what it should be is Eritrea, which is a very young country with an uncertain risk profile. Over the last five years, Nevsun and the government have established a very good partnership where now the government is essentially a 40% partner in the mine. They have a vested interest to make the mine survive and be a successful operation because they're going to make money off it, too.

It's an extremely robust project and I think the country risk is overdone right now. They are building this mine, they have a $235 million project loan from several European and South African banks, and it's a great time to be buying Nevsun because you can buy it now for something that'll be a lot higher a year from now when they start producing.

TGR: How interesting. Are there any other companies that you can share with us?

RG: One other junior that I think merits attention right now is a company called B2Gold (TSX:BTO). The management team behind B2Gold is from Bema Gold, which was taken over by Kinross Gold Corp. (K.TO; NYSE:KGC) four years ago. They basically started a new company that has a focus in several parts of the world that aren't really high profile yet. They have projects in Colombia that are joint ventures with Anglo Gold (NYSE:AU, JSE:ANG, ASX:AGG, LSE:AGD) that are in the exploration development stage. They also have a joint venture in Russia with Kinross that is right beside the high grade Kupol Mine, which is what they found originally and sold to Kinross four years ago. So those are the two large scale exploration focuses. But their production focus, where they're producing gold right now, is in Latin America, mostly Nicaragua. And they did an acquisition last year of Central Sun Mining. So in Nicaragua they have a small mine that's producing now and they have a second project that will be producing within the next two months.

B2Gold has been under the radar. They're at that awkward stage where they're not able to report on or release any details yet on what they're doing. They're still doing the work. So I think B2Gold over the next six months as they get this mine in Nicaragua built and as they have some results out of Colombia and Russia is really one of the most intriguing juniors out there. Management's done it before and it's an asset base that could be quite spectacular if things work out the way they could.

IAMGOLD (TSX:IMG) is another one I follow. It's one of the best performing stocks this year—it's had a very good run and I'll be the first to admit I didn't see it coming. I was fairly neutral to negative on the stock up until a couple of months ago, quite frankly. My concern originally on IAMGOLD was they had assets scattered over West Africa, Suriname, Guyana and Quebec—a mish mash of assets that didn't look like they were going to grow. Then they bought a company called Orezone right off the scrap heap and with them got this asset called Essakane, which is a large project in Burkina Faso, West Africa. IAMGOLD was able to use cash and its operating team to build Essakane, which will be producing August 2010. It's going very well for the company and that really kick-started the interest in IAMGOLD in terms of it ended up being quite a good acquisition. In the meantime they've also developed and discovered a lot of ounces at Westwood, which is a project in Quebec, which is a great place to be mining or exploring. Interestingly, the other asset that has really emerged as one of their best is a niobium mine. Niobium is a real specialty metal. There's not many niobium deposits in the world, but they have one. It's not gold, obviously, but it is a money making operation for them such that it is important to them now because it's one of their best cash flow producers. And the niobium market has improved over the last year as well. IAMGOLD was a bit of an ugly duckling about a year ago. No one really thought much of it and now it's one of the better followed, well owned companies in the gold space in that kind of peer group in Canada. Credit the management team.

In terms of the seniors, Goldcorp (TSX:G) (NYSE:GG) and Agnico-Eagle (TSX:AEM) are two of my favorites in that space. Those are just extremely well run companies, with high quality assets in the safest parts of the world—basically, Canada, U.S., Mexico. They're not cheap, but they are also the highest quality of the senior stocks in North America.

TGR: Are there any additional thoughts you'd like to share with our readers?

RG: It's easy to get carried away when you're looking at the gold prices. A rise is ahead. I think it's definitely a very fun market, but you've got to look at where you've come from, too. If you're up 50% or 60% on a good investment, it's never a bad idea to lock in those profits because it's been a very unpredictable market the last 12 months. I don't think you'll ever get fired for doing that and that's what I tell clients. You're never going to get fired for taking money off the table and locking it in on returns.

DISCLOSURE: Richard Gray
I personally and/or my family own the following companies mentioned in this interview: None

I personally and/or my family am paid by the following companies mentioned in this interview: None

Metals and Mining Research Analyst Richard Gray, joined First Associates (now Blackmont in September 2004. He has 12 years of investment research experience in the Precious Minerals sector, seven of them as an analyst. He was previously employed as an analyst at Westwind Partners, where he provided coverage on junior and emerging gold producers. Richard provides research coverage on the gold sector, including senior, intermediate and junior producers, as well as the silver sector.

Richard became a CFA in 2005 and earned his Bachelor of Applied Science (Geological and Mineral Engineering, 1997) from the University of Toronto.

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