SNN: Can you review what happened in the natural resources market in 2015?
RR: Well that’s easy to sum up in one word: we had a DISASTER. On a global basis, I think it’s safe to say that there was a lack of demand for anything anywhere. There are discussions in the resource market that we suffer from over supply. The truth is that the supplies haven’t increased that dramatically in the last five years. What’s happened is that we have a sort of synchronous global decline, the relative strength of the U.S. economy notwithstanding. As a consequence of a lack of demand particularly for industrial materials, things like oil and gas, base metals, iron, coal, uranium, but also, of course across the whole soft commodities complex, the agriculture commodities which are uniformity off 30%-50% in price. On a global basis, we had very very very soft demand. The consequence of very weak commodities prices is that we had weak cash flows to natural commodity producers and some of those producers have an awful lot of debt, which means that both debt, i.e. bond prices and equity prices, in natural resources businesses from the very largest like Anglo American which has fallen by almost 80% in 3 years to the very smallest as are characterize by the TSX-V that’s a resource index which is also astonishing 88% in nominal terms, has been a rout.
SNN: Is there a point in time when markets are so beaten up, investors so distraught, that it just makes sense to be a buyer?
RR: The answer to that question is fairly nuanced and I think there’s three parts to it but I think the first over riding answer is ABSOLUTELY YES. The truth is that when you view the higher natural resource complex from the largest Oil and Gas company to the smallest viable development company on the TSX-V, five years from now you will look back to the end of 2015 to the beginning of 2016 as the “Good ‘ol Days” when things where cheap and in some senses absolutely, idiotically, insanely cheap. And you will say five years from now what was I thinking that I wasn’t buying. So, the first answer to the question is if you have a five-year time frame the answer is YES, YES, and YES. If, however, you have a twelve-month time frame or more problematically a three-month time frame, the answer to that question may very well be NO. It’s important that people understand that you come out of a commodities bear market one of two ways: either through demand creation, which rises price, or through supply destruction. And let’s talk about both of those. Demand creation itself happens one of two ways: either there is a broad base economic base recovery in response to the business cycle. Although I’m no economist, I see no broad base recovery taking place in the world today; the relative strength of the U.S. economy notwithstanding. The other way that demand can be created is because ultra-low commodity prices increases utility for a commodity so that the demand for the commodity increases irrespective of underlying economic conditions. We are beginning to see some evidence of that today. Examples would be gasoline consumption in the United States which is doing extremely well despite the increasing prevalence of things like electronic cars or duel powered cars, despite the sales of more fuel efficient cars. The truth is that gasoline demand in the United Sates is very strong relative to forecast, and I think that has lot to do with low gasoline prices. The second example would be natural gas demand in the U.S which is increasing, although manufacturing capacities isn’t increasing in the U.S. It’s happening because low natural gases prices discourage consumption and encourage the utilization of natural gas for things like feedstock chemical production and also to displace coal and other things in the power grid. So we are seeing a bit of demand creation in the natural resource business, but not enough in my experience to cause a recovery. The other way you come out of a natural resources bear market is by supply destruction. We are just coming to see that now. You will remember from previous interviews that my buzz word in resources because of its cyclicality is that you must be a contrarian or you will become a victim and that same cyclicality has to do with supply destruction. You see right now across the spectrum in natural resources in Oil and Gas, Uranium, Coal, Copper. At least the median part of the industry is producing at a loss. In Uranium, as an example, estimated cost to produce a pound of Uranium, including the cost of capital is about $65/lb. So you buy the stuff for $65 a pound and sell for $35 a pound or $37 a pound, losing $30 a pound trying to make it up on volume, this doesn’t last very long but it can last to 2-3 years. Remember that producing at a loss is a way of cannibalizing the capital that you built up in the good markets. Fortunately for the industry, but unfortunately for the recovery, the natural resource industry has built up an awful lot of surplus capital in the bull market that occurred in the period of 2002 thru 2012, and we need to eat through that capital before we have wholesale shut downs of supply. Wholesale shut down of supply is coming: they are coming in the iron business, they are coming the coal business, they are coming in the oil business, they are coming in the gas business, they are coming in the copper business, and when you shut the productive capacity down its very difficult, very time consuming, and very expensive to restart it. So what that means is when you have a price recovery, you don’t have a price recover up to the marginal cost of the production you have price recoveries that are dramatic because people can’t bring back supply as quickly as they could shut down supply. Those of you who were students of the resource market and remember the recoveries we enjoyed at the beginning of the last decade will see the dramatic nature of the price recovery that has happens over the consequence of supply destruction. Prices move like from Uranium $8 a pound to $130 a pound, natural gas moves from $1 per/NCF to $15/NCF, copper from $.75 to $4.50. You get the drift. Ironically the longer this bear market in resources lasts, the more the dramatic ultimate recover will be, and here’s why: at $40 as an example most oil production in the North Sea is uneconomic. The North Sea produces between 1.5 and 2 million barrels year. If this $40 price last for two years/two and half years, you start to shut in most of the North Sea production. 2 million barrels a day is the gap worldwide between supply and demand for oil. Just the North Sea itself coming out of production would put production in fact in balance with regards to demand, but $40 oil wouldn’t just shut in the North Sea, $40 oil would be terminal for most of the marginal for production most of the places like Mexico or Venezuela. Ironically, if two years from now oil is at the $60 level five years from now oil would only be at the $75 or $80 level. If two years from now you have oil at the $40 level my suspicion is that that five or six years from now you would see oil at the $100 or $125 level. I know it seems counter intuitive and I know that it’s ironic, but that’s the way the market works. The consequence of what I have just told you is that really in terms of where and when you participate in the natural resource market it has to do with your own sense of timing and your own willingness to endure risk.
SNN: What catalysts should investors look out for in changing metals markets?
RR: In this case one needs to segregate between base metals and precious metals. The catalyst for the increasing precious metals prices crisis is simple: a weaker U.S dollar. If the FED is able to make a 25 basis point interest rate ride stick and if they are able to get away with another couple of small interest rate rises that is if U.S debt markets, equity markets, and the U.S economy don’t respond negatively to an increasing interest rate. The U.S dollar will continue strong and precious metals will continue weak. If by contrast, this 25 bases point increase can’t be made to stick and the subsequent interest rate hikes can’t be made to continue, then I would expect the U.S dollar to roll over, similar the way it rolled over in 2002, and in that case with a weaker U.S dollar the game will certainly be on in precious metals. With regard to base metals the question is trickier. You will recall we talked about the need for supply destruction in the answer to the previous question, and my suspicion is that supply destruction in base metals will take between 18-24 months to start to have some impact on metals prices, and hence, on equity prices of metals producers.
SNN: Despite the overall negative sentiment in metals and natural resources, what are some key characteristics investors should look for in MicroCap natural resources companies at this time?
RR: Interesting question; some of your readers will remember the depth of the 1997 to 2002 bear market. In the summer of 2000 we experienced an event that I call an issuer capitulation. Issuer capitulation is where the very best companies in the junior business, the very best promoters, the Ross Beedie’s, Bob Quartermain’s, Robert Friedland’s, Locos Londen’s, the best of the best, come to the realization that they cannot save their way to prosperity but they have to build their way to prosperity and that takes money. At that point in time the issuers come from the market despite how painful it is for them, and raise the money to advance their projects. Ironically despite the perceived illusion this does two things: you see in the first instance people are leery about buying stocks when they know they need to raise money because they are afraid that the process of raising money itself will dilute their interest. Ironically, after the money raising takes place, the worry goes away. The circumstances that everybody was afraid of disappears and the reason not to buy the stock also disappears. More importantly the companies that have the courage to raise money in the bad market begin to do work and generate news in a news vacuum. It’s one thing to get the market’s attention when there are 1000’s of people clamoring for attention. It’s very different to be a part of group of 15 that are clamoring attention. So in the year 2000 in the middle of the last bear market the companies that came into the market doubled in 12 months and doubled again in the next 12 months. We had a 400% price rise in the select group of companies - a private bull market in a massive bear market. What I think the key characteristics that people should look for in this bear market are Issuer Capitulations, from the very very best investors in the market.
SNN: In 2016, there will be a US Presidential election. Will that have any notable effect on the metals markets?
RR: I would say almost certainly not. The only way it could have an impact on the metals markets is if the economy and the electorates discussed at the process and the discussion by the candidates offered up by both parties was so complete that it damaged confidence in the U.S dollar. In other words, the idiocy that we see on the television screens around the world of the U.S political process was so extraordinary that it began to cause people to fall off the dollar. Or, if the FED response to the politics of the 2016 election cycle would be yet easier money and to forestall an interest rise in an attempt to generate yet another for a short term fix of the economy, in other words, if the U.S. Presidential election, or the politics around the presidential cycle were so extreme that they damaged faith in the U.S dollar and began to damage the credibility and hegemony of the U.S dollar and U.S federal debt markets that would of course be very very bullish for gold.
SNN: Can you discuss the relationship of metals markets to the overall economy?
RR: Leaving out the precious metals markets, the rest of the metals are extremely economically sensitive. An example of the effect of the overall economy in the metals market can be seen the third quarter report from Caterpillar tractor, which I consider to be a bell whether for basic goods manufacturers on a global basis, and it was a catastrophic quarter by any measure. The top line number, the bottom line number, but most importantly, the evaporation of the work back log at Caterpillar. That tells us that there is no life in the capital goods sector, which suggest the prognosis of the private sector for growth and demand is very very tepid. The consequence of that is people aren’t buying steel they aren’t making stuff out of steel, people aren’t buying copper because people aren’t making stuff from copper. So those part of the metals markets are extremely economically dependent. Although I am not economist I don’t see any near term recovery in any meaningful market on a global basis.
SNN: What do the experts predict for the resource markets in 2016?
RR: Now this is the one part that makes me bullish because everybody’s expectations of the 2016, those people who care enough to even make a prediction are overwhelming bearish. My experience has been that when people are this overwhelming bearish they have already made decisions with their funds in other words everybody who needs to sell has probably sold. The experts’ predictions for 2016 are so dire that you would expect the 7 billion people on Earth would stop procreating, and don’t want to eat and don’t want to drive cars. The most bullish part of resource markets for 2016 is that the overwhelming negative consensus of the experts which is as of itself a very bullish phenomenon.
SNN: What guidance are you giving Sprott clients for 2016?
RR: Well, many. Value-oriented clients will probably be able to buy the best names in the middle of 2016. Income-oriented clients can begin to buy the infrastructure stocks; the pipeline stocks, as an example, which are up by 40% in the last 18 months right now. Speculators can buy the really good speculations; the guys who don’t need to raise money for next two years. Right now it’s amusing and I am not going to use any names, but there is a mining company out there a junior mining company that is selling at about a 200 million dollar premium to the cash it has in the treasury that generates about 200 million dollars in cash flow a year in other words enterprise value is about 1 times EBITDA with 10 year mine life and there is a 6% yield. This is like picking up a 6% bond for free this is an astonishingly good value, and they exist out there but there is no way of saying it won’t get better. In terms of other specific pieces of advice, with regards to speculators, pick your spots now but save a lot of dry powder for issuer speculation when you can participate in private placements and pick up warrants. And finally in the junior oil and gas space expect a blow up in quarter 2 or quarter 3 of 2016, where the annual reports come out with third party calculations of net asset value approved developed producing reserves. This will catalytic because the companies renew or don’t renew their bank facilities or lending facilities based on these net present values the fact that they haven’t been able to continue to invest this year means most of the production that they have gotten cash from this year hasn’t been replaced by drilling. At the same time the future value of those reserves is depressed by today’s low commodity prices. I will expect you will see real blow ups in the junk debt market in the bonds for oil and gas producers. You will see blow ups with regards to loans being termed or loans foreclosing and you will see extraordinary blow ups I think in the sub $300 million dollar market cap oil and gas space. These blow ups will scare investors about the whole sector, in other words, they will behave irrational and they will throw the good companies out with the bad ones simply because they are oil companies. This seems to happen once a decade. I remember it happening in 1984, I remember it happening in 1992, I remember it happing in 2002 and 2003 and it’s with us again it is something that happens once a decade and in my experience it has generated a once in a decade opportunity. So ironically I am looking forward to more chaos, more carnage in my businesses because like I said at the beginning of this discussion, five years from now you will look back at 2015-2016, if you are a buyer you’re going to say boy those were the good ole’ days I can’t believe how cheap stuff was. If you view today a year from now you probably won’t have that same opinion but if you view five years from now you will absolutely, positively from my point of view, you will have that opinion.
For more information about Rick Rule and Sprott Global, please visit: www.SprottGlobal.com
Rick Rule Bio:
Mr. Rule has dedicated his entire adult life to many aspects of natural resource securities investing. In addition to the knowledge and experience gained in a long and focused career, he has a worldwide network of contacts in the natural resource and finance worlds. As Director, President, and CEO of Sprott US Holdings, Inc., Mr. Rule leads a highly skilled team of earth science and finance professionals who enjoy a worldwide reputation for resource investment management.
Mr. Rule is a frequent speaker at industry conferences, and is interviewed for numerous radio, television, print and online media outlets concerning natural resource investment and industry topics. He is frequently quoted and referred by prominent natural resource oriented newsletters and advisories. Mr. Rule and his team have long experience in many resource sectors including agriculture, alternative energy, forestry, oil and gas, mining and water. Mr. Rule is particularly active in private placement markets, having originated and participated in hundreds of debt and equity transactions with private, pre-public and public companies.
Sprott US Holdings, Inc. is a holding company made up of three separate and distinct companies: Sprott Global Resource Investments, Ltd., a FINRA Registered Broker/Dealer; Sprott Asset Management USA Inc., an SEC Registered Investment Adviser offering managed accounts; and Resource Capital Investment Corporation, an SEC Registered Investment Adviser managing partnerships. These three companies make up the US Subsidiaries of Sprott Inc. and are active in securities brokerage, segregated account money management and investment partnership management involving both equity and debt instruments, across the entire spectrum of the natural resource industry.
