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Mike Niehuser: Precious Metals Investment Strategy for 2011
Source: Mike Niehuser and The Gold Report (1/5/11)
As we start the new year, Beacon Rock Research Founder Mike Niehuser has doubts about growth and believes that inflation may spook stocks and bonds. In this exclusive interview with The Gold Report, Mike recommends looking for leverage to the metal price through investment in exploration and development metal stocks with large world-class assets, and names a few of his favorites.
Mike Niehuser: At the end of 2009, gold was at a 52-week high of about $1,100, and we forecast gold to range from $900 to $1,200 per ounce, with the potential to reach $1,500 should some catalyst emerge. With gold over $1,200 for a good part of 2010, we were a little conservative. On average, we feel vindicated as gold and other precious metals were not in the bubble that others thought them to be a year ago. The Wall Street Journal pointed out last week that gold was up 26%, with silver and palladium up 74% and 86%, respectively. This is a broad statement that investors are looking to hard assets for a store of value relative to currencies and other intangible assets like stocks and bonds.
In our opinion, we would not be surprised to see gold holding within $1,200 to $1,500 through 2011, with a potential breakout to $1,600. This again is a somewhat conservative perspective that lends itself to a barbell investment strategy of selecting low-cost producers with ramping cash-flow surprises in the near term and exploration and development companies with highly leveraged assets to production in the long term.
TGR: Do you see a bubble now or are you still bullish on precious metals for 2011?
MN: Taking into account deficits for as far as the eye can see, it is hard not to be bullish on precious metals. It really looks like Federal Reserve Chair Ben Bernanke is between a rock and a hard place. I keep rewatching Bernanke's "60 Minutes" (12/5/2010) spot on YouTube. If you mute the moderator and listen to what Bernanke is really saying, it may provide some real insights into 2011. I can't help but think the interview on media like a talk show somehow degrades the prestige of the Fed, but it is useful as it may be historic.
We may be seeing the Great Maestro being replaced by a Great Magician who is able to dispel myths of not turning on the printing press while grossly expanding the monetary base. Increasing the monetary base and proposing to buy an additional $600 billion in Treasuries while claiming to have 100% control over inflation confirms that the Money Illusion trick is now a card up the Fed's sleeve.
Bernanke seems more concerned with his opinion that deflation was the cause of The Great Depression, and less concerned about inflation. I don't agree. In any event, while claiming that quantitative easing 2 (QE2) is a means of reducing unemployment, it appears that this is his means of keeping real estate prices from falling. This redistribution of wealth may actually be a redistribution of responsibility for the financial crisis away from politicians and policy makers. It is disturbing to see that the systematic risk of banks and others deemed too big to fail has been upstreamed to the government and the taxpayer.
The point here is that by not allowing the housing market to bottom and inventory to clear, the Fed may actually be inflating the currency and pumping up the real estate market to keep what looks to be an increasing number of banks from failing. While the Fed is charged with keeping money stable and full employment, they have also been tasked with maintaining the soundness of the banking system, and they are not looking very good at this point. There seems to be more self interest in Bernanke's comments than may be evident.
TGR: Are you saying that we are or are not experiencing a rise in inflation rates?
MN: Higher sustained metal prices and an uptick in mortgage rates suggest that inflation expectations are increasing. I really question what the real rate of inflation may be. Having put two kids through college, I can tell you that higher education is not getting cheaper; and getting sick or taking care of older folks is also not cheaper. Energy prices are creeping up as the economy appears to rebound. All of these are certainly highly regulated or subsidized, and it does not look like they are increasing the supply or reducing the demand in these areas. Clearly we are seeing lower costs and higher productivity in other areas. The reduced costs and higher product offering of technology is hard to keep up with. The power and reach of mobile electronic devices or the reduced costs of large-screen high-resolution televisions is remarkable. We may have China to thank for our low CPI, at least for now. In any event, I really don't have a high degree of confidence that it is all properly accounted for in the CPI's basket of goods as a useful measure of domestic inflation. Like the switch to GDP from GNP, maybe we need a new price index. What's more, it is not clear to me how any of this relates to what the Fed should or should not do.
The real problem is with the dual role of the Fed for stable prices and full employment. This is rooted legislatively in the Humphrey-Hawkins Act and philosophically in an unwavering devotion to the Phillips Curve that asserts that inflation and unemployment growth are mutually exclusive. The concern here is that Bernanke may have the narrow perspective that both unemployment or economic growth, and inflation, can be managed by the blunt instruments of monetary policy: open market operations, the discount rate and reserve requirements. This is troubling because it is an academic perspective, which inevitably requires big thinking supported by big macroeconomic equations that can only be made understandable by holding variables constant. This reinforces a closed system excluding outside influences, which they assume do not matter possibly because they are outside their control. For example, they may assume the government balances the budget or that deficits do not matter, or likewise they may fail to take into account unpredictable consumer and investor expectations and behavior, both in the U.S. and globally. When Bernanke claims to have 100% control over inflation by being able to change interest rates in 15 minutes to slow the economy, I get really nervous.
TGR: What do you mean nervous?
MN: I get nervous when I am confused by apparently contradictory statements that may lead to a negative event, but like my college economics professor Dr. Watson used to say, "If you are not confused, you are not informed." On the one hand, Bernanke said it could take four to five years to reduce unemployment to 5% or 6%. To do so, he apparently has no problem today buying $600 billion in Treasuries, and more if warranted. On the other hand, he claimed that this way of stimulating the economy was not "printing money." In addition, while not inflationary, should inflation occur it could be dealt with in 15 minutes by crushing inflation expectations by raising rates and slowing economic growth. While this sounds reassuring, I thought the justification for the stimulus was, after all, increasing growth. This comes across to me like a shell game of sorts where additional stimulus is necessary for growth to be self-sustaining or maybe it is personal employment insurance.
TGR: If Bernanke succeeded in avoiding another depression, isn't that a good thing?
MN: While Bernanke is confident that the Fed's actions avoided a depression, we should recognize his comment is an opinion, or at least it is too early to tell, or that he is simply too close to the question to be objective. The important decision for investors today is to ask themselves where they think we are and what they should do. Right now, the U.S. seems to be trying to decide whether it wants to go the direction of Europe or Asia. At the moment it looks like Europe is the more likely choice. If we are looking for historic parallels, I think we are revisiting the specter of stagflation of the '70s following the growth and turmoil of the '60s. Open market operations, buying Treasuries, fund the growth of government's aggressive actions to increase regulations, thereby curbing innovation, devaluing the currency, and discouraging saving and investment in private enterprise. I would agree with Bernanke that the tax code needs to be more efficient, hopefully flatter, but for him letting up on the stimulus accelerator is now out of the question.
TGR: Some economists are talking 4% growth in 2011 and 2% to 3% inflation over three to five years, with improving consumer confidence. How does that fit in with your perspective of stagflation?
MN: Just as it is hard to say inflation is under control when witnessing higher energy, education and healthcare costs, it is hard to be impressed with growth coming off the bottom of 2008. Bernanke noted that 8 million remain unemployed, and that 40% of them have been unemployed for over six months, making return to the work force problematic. Also, with graduating high schoolers pushed into college, what jobs are awaiting students when they graduate, and what about the 8 million unemployed? Clearly, the housing market is not out of the woods and neither is the banking system. For the gainfully employed, this remains an anxious concern, and despite increasing confidence, I would expect doubts about growth and inflation may spook stocks and bonds in 2011 and even the employed may see a correction in their asset base. While some may move late into commodities seeking diversification, they may experience a correction in metals.
There is a potential that with higher interest rates in the U.S. or even China, specifically higher real interest rates, we may see metals prices hold at these levels or even decline. Having offered that warning, on the present course of stimulus with anemic real growth, we could see signs of growth in the near term concurrent with higher metal prices, the economy stalling in stagflation in the mid-term, and a scramble to commodities in five to ten years, just like in the late 1970s.
TGR: What are you suggesting to investors, given this murky outlook?
MN: It is reasonable to diversify with some exposure to commodities. In the past, precious metals linked with demand for jewelry have increased in the fall through winter season with a correction in the spring. As investment demand has become a larger factor, an increase in interest rates may trigger a correction in commodities should growth pickup.
In the meanwhile, if investors are of the opinion that metal prices may hold at current levels, move higher, or even decline in the near term, they may look to low-cost producers with the potential to positively surprise investors in 2011. Likewise, if investors are concerned about a correction in commodities and an overall pullback in stocks, but are still concerned about significant inflation and much higher commodity prices in the long term, they may look for leverage to the metal price through investment in exploration and development metal stocks with large world-class assets.
The producers provide a more immediate exposure to higher production margins today, while developers able to keep their projects on schedule may advance to production potentially corresponding with higher metal prices on the more distant horizon. This is a barbell approach that looks for value and cash flow in the near term with more speculative growth in the long term.
TGR: Which low-cost producers meet your requirements for value and cash flow in 2011?
MN: I am fascinated with companies that were constructed during periods of lower metal prices, based on even lower, more conservative long-term metal price assumptions. These companies with only relatively increases in costs may have exceptional operating margins. If these companies execute as scheduled, they may produce positive cash flow surprises. Even if metal prices stall or decline, or if costs increase, there appears to be plenty of operating margin to provide a return and remain viable, which should provide some protection if the general market or sector corrects. This may provide an element of value that has not been seen in the mining sector for some time.
Alexco Resource Corp. (TSX:AXR; NYSE.A:AXU) is now shipping concentrate from its Bellekeno mine at its wholly owned Keno Hill silver district in the Yukon. Bellekeno has exceptional high grades and recoveries, which should make it one of Canada's most profitable primary silver producers. Management should be applauded for putting the mine into production in about three years from discovery with minimal dilution. This was made possible by selling one quarter of the district's silver stream to Silver Wheaton Corp. (NYSE:SLW; TSX:SLW) at $3.90/oz. The first mill processes a modest 250 to 400 tons per day (tpd), but with silver grades of up to about 50 ounces per ton (oz/t) plus lead and zinc with some gold and indium. At modest production levels project risks and operating costs are manageable. The challenge for Alexco is two-fold. They need to execute on stabilizing production and they will need to expand the resource beyond the current identified four-year resource.
Alexco just completed a $41 million equity offering, and with cash flow from Bellekeno, is more than adequately capitalized to aggressively pursue exploration or develop another mine in the district. Keno Hill has historic production of about 217 million ounces (Moz.) of silver and has never been mined much beyond a couple hundred meters from surface or comprehensively explored with modern mining methods. Exploration at and around Bellekeno has provided plenty of opportunity for expanding resources and extending mine life, but management is intent on discovering another 90 to 100 Moz. silver mine at Keno Hill. While this may seem optimistic, I suspect it was this kind of opportunity that led Silver Wheaton to make a significant investment as early as they did.
I also think 2011 will be the year for Minefinders Corporation (TSX:MFL; NYSE:MFN). Minefinders has stabilized processing at planned capacity at their Dolores mine in Mexico and has begun leaching higher grades gold and silver from its second leach pad. They are poised to execute on increasing production of gold and silver in 2011 relative to 2010. At current metal prices, they should see additional leverage to fixed operating costs, and with declining costs on a per-ounce basis, we should see rapidly increasing cash flow.
Minefinders also recently completed an equity offering of about $151 million and is also adequately capitalized. This should provide financial flexibility to make decisions on completing a mill to increase capacity and recoveries at Dolores, or maybe even construct a modest mine at its La Bolsa gold project. Minefinders also has an opportunity to increase its resources at Dolores or at its Dolores look-alike La Virginia gold-silver project. In either case, both Alexco and Minefinders are poised to exceed expectations in 2011, are well capitalized and have good long-term prospects to expand resources and mine life.
TGR: Can you give a few examples of companies for the longer term whose assets are highly leveraged?
MN: These types of companies may be years away from production and often are large enough that their assets sell at a significant discount to their smaller peers or to the underlying metal base. These companies' stocks often trade with the underlying metal and often with greater volatility, which may provide liquidity for traders or larger blocks appealing to both retail and institutional investors. The logic here is that as they advance toward production or a construction decision, they move closer to a full value of the underlying asset, providing potential for above-average returns if acquired early in development and assuming success in reaching production or being acquired.
NovaGold Resources Inc. (NYSE.A:NG; TSX.V:NG) is a 50-50 partner with two major operators in what they believe to be two of the most significant mine projects of this century. This includes the 42 Moz. Donlin Creek gold project in Alaska in partnership with Barrick Gold Corporation (NYSE:ABX; TSX:ABX), and the world-class copper-gold-silver Galore Creek project in partnership with Teck Resources Ltd. (NYSE:TCK; TSX:TCK.A, TSX:TCK.B) in British Columbia. Donlin Creek is the most advanced and known to investors. NovaGold is scheduled to complete an updated feasibility study by mid-2011, with a natural gas power option that should reduce operating costs, and submit permit applications by year-end.
NovaGold is also scheduled to complete a pre-feasibility study on its Galore Creek project in the first half of 2011. The Galore Creek project has not received as much attention as Donlin Creek, and we don't think NovaGold has gotten much value in its stock price for this large copper-gold project. As both of these projects advance through 2011, NovaGold may get an additional lift from Galore Creek, and again as both projects advance to a construction decision in the years ahead.
Seabridge Gold Inc. (TSX:SEA;NYSE.A:SA) is developing the KSM gold-copper project in British Columbia. KSM has a 30 Moz. gold reserve with 7 million pounds (Mlb.) of copper, 133 Moz. of silver plus 210 Mlb. of molybdenum. The project is likely to increase in size in 2011. Seabridge added a fourth deposit, Iron Cap, and will be coming out with a new resource estimate in January and an updated pre-feasibility study early in the second quarter, which is expected to increase reserves. With over $30 million in cash at the end of the third quarter, and having recently sold the remaining interest in their Noche Buena project providing an additional $10 million, they should be adequately funded for 2011.
Seabridge also has another very large gold project that may be off investors' radar. The Courageous Lake gold project in Canada's Northwest Territory has a gold resource of about 10 Moz. They drilled an additional 33 core holes in the project and are scheduled to complete an updated resource estimate in January and a preliminary assessment in the first half of 2011. Both NovaGold and Seabridge have large projects that are highly leveraged to the price of gold, and additional projects that should gain additional recognition by investors in the new year.
TGR: Mike, we appreciate your time today. Thanks.
Metals and mining Analyst Mike Niehuser is the founder of Beacon Rock Research, LLC, which produces research for an institutional audience and focuses in part on precious, base and industrial metals, oil and gas and alternative energy. Named after what Mike describes as the largest monolith in the western hemisphere, Beacon Rock Research is an independent investment research firm committed to helping investors "attain an uncommonly better understanding of opportunities and risks, enhancing the possibility of timely and informed investment decisions." Its work is designed to withstand the "torrential flows of contrary and fickle opinions and beliefs" and go beyond the "cramped conventional wisdom (that) often spoils natural curiosity and optimism, the attributes fundamental to learning, understanding and making the intuitive connections that help us perceive what might be around the next bend." Previously a vice president and senior equity analyst with the Robins Group, a registered broker dealer, Mike also served as an equity analyst with The RedChip Review, where he initially followed bank stocks but expanded to a diverse industry range. A graduate of Pacific Coast Banking School—where he now serves on the faculty—Mike spent 18 years with U.S. Bank, with expertise in all areas of real estate lending and valuation. A life-long learner, he earned his B.S. in finance at the University of Oregon. He has written hundreds of research reports and related articles on investing in small cap companies.
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1) The following companies mentioned in the interview are sponsors of The Gold Report: Minefinders and NovaGold.
2) Mike Niehuser: I personally and/or my family own shares of the following companies mentioned in this interview: Minefinders, Alexco and Seabridge. I personally and/or my family am paid by the following companies mentioned in this interview: Alexco. CGF9SSQS8ZD