Where Resource Investors Can Find Value Amid the Turmoil

Where Resource Investors Can Find Value Amid the Turmoil

Monday, September 10th, 2012

Long-time resource sector expert speaks of the distressing macroeconomic picture, and where he sees value for resource investors amid the turmoil.

Rick Rule, founder and chairman of Sprott Global Resource Investments Ltd., spoke with us on August 30th and painted a bleak macroeconomic picture exasperated by what he calls a “backdoor nationalization of the banking industry” in both Europe and the US.

“The policy response in most western democracies has been to mistake a solvency crisis for a liquidity crisis,” said Rule. “We’ve been mortgaging our future for too long, and now there isn’t a lot of future left to mortgage. The response has been to add liquidity and to increase the indebtedness of society, and that doesn’t work. It feels good at the time, but like with any really good party, the drunkenness is followed by a hangover. The central banks are trying to treat a vodka hangover by handing out large servings of rum.”

Rule says that investors need to understand that the current “health” of the bond markets is entirely dependent on liquidity provided to European banks by German and other European taxpayers, which is then used to purchase the sovereign debt of the countries the banks are in. “This is convenient,” says Rule, “because no one in their right mind would buy this debt other than these banks.” If this “daisy chain” erodes, as Rule believes it could, that could lead quite quickly to a very serious disruption. And while the current focus is on Europe’s solvency issues, Rule says, the United States is experiencing the same fundamental issues, and the current strength of the US Dollar is due to the extraordinary weakness of the other currencies. “I like to say that the US Dollar is the worst currency in the world, except for all the other ones,” Rule half-jokes. He believes the only difference between the US and European solvency crises is timing. He points to the growing concern over American municipal insolvencies, due to unfunded pension liabilities and reduced revenues resulting from decreased residential property value.

“This is an undercurrent we really need to pay attention to,” says Rule. “It wouldn’t surprise me if ‘junk’ municipal debt replaced ‘junk’ mortgages as the trigger of a future crisis.”

“It’s important that everybody understands what is really going on with ‘Quantitative Easing’”

Rule, one of the most respected resource analysts and investors in the world, continues to watch the “money printing” at the Federal Reserve with a rueful eye. “I know it’s not technically ‘counterfeiting’ when the money is printed by the federal government, but people need to understand what is really backing this currency. About 40 per cent of the treasury bond sales are being purchased by the government – they are printing money to buy bonds to fund the government’s current account deficit. They are printing money, literally, out of thin air. This is extremely scary.”

It’s all of this short-term liquidity, however ‘counterfeit,’ that is buoying the current markets, says Rule. “While the private sector has been, in some sense, frozen out of the long-term capital markets,” he continues, “there is abundant short-term liquidity available for the very largest banks and hedge funds; the fact that this is counterfeit liquidity has not mattered to the markets. What has mattered to the markets is that the major market economies are stalled. There is very little growth in Europe, the U.S., or Japan.”

Outlook and Opportunities in the Resource Markets

“The long-term bull market in resources is very much intact,” says Rule. “Supply and demand work, and supplies are still constrained by the bear market we had through the 80’s and into the last decade – a 20 year bear market where there was insufficient investment in exploration and construction.” He believes the most important longer-term influence on demand is the developing world, the “three billion people below us on the economic pyramid that aspire to a life more like ours, and who are beginning to be able to afford it and compete with us for resources.”

Near-term, however, he recognizes the drag on the resource markets from the slowed economic engines, pointing to the recent collapse in iron ore, steel, coal and other industrial commodities prices. Another critical near-term factor is the lack of availability of long-term credit for large-scale capital investment. With the exception of the very largest players, Rule says, resource companies are unable to secure long-term financing for the very large expenditures needed to build new projects.

“Here at Sprott, we believe there are some specific investment themes that will be important to keep in mind going forward,” Rule says. “The first, particularly for those who consider themselves ‘traders’ is that consolidation is taking place and will continue to do so, both in the mining and energy spaces. Larger companies trade at better metrics than smaller companies, and as a consequence, they have lower costs of capital. Because of that, larger companies will be buying smaller ones. It is easier to buy reserves and production on Wall Street or Bay Street than it is to go out and find and develop it.”

“We also believe the sector has too many participants and too much G&A,” Rule continues. “The truth is, we need to see these companies consolidate so that we can see the production costs decrease per barrel of oil or ounce of gold produced. You are going to see consolidation across the energy and mining space. You’re already seeing it, and I think it’s going to heat up and be a very important investment theme over the next two years.” Rule believes the smaller companies are stuck due to their inability to access long-term capital, and the larger companies are stuck in terms of how they can grow organically, and that the two will come together to fuel this trend.

The second and perhaps most interesting theme, says Rule, is what he sees as significant under-valuation of many companies by the market. “There is the largest discount I have seen in my life,” Rule says, “between the net asset values as determined by Preliminary Economic Assessments and the market capitalizations of some of these companies. There has been a real shortage of high quality projects in this industry, though not a shortage of projects in general.” One of Sprott’s strategies is to identify smaller, but higher-quality projects with good PEA numbers and play the arbitrage between those numbers and the issuer’s market cap, both in mining and energy, says Rule.

Rule has been “very surprised” at his firm’s inability to attract financing deals with companies that are willing to finance at their current market price and include warrants. “Capital is very short in the industry,” says Rule, “and the industry has an almost desperate need for capital, but is unwilling to acquire that capital at prices that the market suggests. I think time is on our side, as investors, however. The industry is going to have to come to us for capital in the fairly near future, with terms and conditions that existed in the 1998-2002 period – a time when our company had some of our very best performance.” Rule is firm in his conviction to be patient and focus on the very highest quality companies and deals that contain terms that are attractive for his investing clients. “It’s going to be an extremely exciting time,” he says. “Be ready to take advantage of opportunities – it’s in these times of turmoil that the best ones are found.”

For the complete audio version of Rick Rule’s commentary, please visit this page.

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