Gold Producers in the catbird seat
The Gold Report: Jay, in the June 20 issue of your newsletter, you made the case that gold has broken away from the downtrend that started in late 2011. Why is gold a better investment now?
Jay Taylor: At the time, I was convinced we were looking at a breakthrough in the junior gold index on the Toronto Stock Exchange (TSX). Now, it seems it may have been a false breakthrough.
The S&P/TSX Global Gold Index was as high as 450 back in September/October 2011, dropping to 270 by May 2012. Today, it is around 282. I see the junior gold index as a barometer of the industry as a whole. Although I was getting optimistic, I remain concerned about the possibilities of much lower levels in gold shares as a whole.
The companies that have to raise capital and put money in the ground are my greatest concern. I am less concerned about companies that are in production and generating cash flow from operations, many of which are doing extremely well.
TGR: In that newsletter, you wrote that the value of gold, "vis-à-vis. . .the Rogers Raw Materials Fund. . .had a rocket ship trajectory following the credit deflationary Lehman Brothers event and has remained on a gradual uptrend."
JT: I was referring to the real price of gold, not its nominal price. I am absolutely bullish on gold's real price. There is a distinct uptrend since Lehman Brothers in terms of what an ounce of gold will buy. That, not the dollar price, is what matters.
The recent record highs in the real gold price reflected the anxieties caused by the European crisis. To give you an idea, in July 2008 an ounce of gold would have purchased only 17% of the Rogers Raw Materials Fund. By March 2009, it had skyrocketed to 44%. After quantitative easing 1 and 2, commodities, stocks and gold all rose. Then gold fell back to 30% of the Rogers Raw Materials Fund until the first Greek crisis. It rose again to 44%, and then got worse as Europe seemed to be falling apart. Recently, it has come back a bit.
The anxiety about the world monetary system is driving gold prices. Forget about jewelry or about gold as a commodity. Gold is money, and that is driving its real purchasing power higher and higher.
I am much less confident in the dollar as gold continues to rise. Gold could actually break below the $1,550/ounce (oz) support level.
TGR: Will it drop beneath the 52-week low of $1,480/oz set roughly a year ago?
JT: It could in nominal terms versus the dollar. If that happens, I would expect oil, copper and other commodities to fall even more. I think the dollar could be surprisingly strong for a number of years, which would make gold weaker relative to the dollar, but not relative to other commodities.
I am bullish on gold and especially gold mining in a deflationary environment because the cost of producing tends to go down more than the metal does. Contrary to most public opinion, a severe deflation is historically extremely bullish for gold mining.
TGR: The biggest threat seems to be the euro, which is trading at about $1.20 to the U.S. dollar. A euro in the $1.15–1.16 range could be a big hit to the gold price.
JT: I agree, and I think it is a strong possibility that the dollar could get stronger relative to other currencies. But the strength of the dollar is itself driving up the real price of gold; growing numbers of people do not trust the dollar as the ultimate currency.
As long as there is faith in the dollar and fiat money as a whole—and by and large there is—I see the system holding together for quite a while. I think it's Ian McCavity who calls the dollar the prettiest horse in the glue factory; in other words, the dollar is the least worst of all the manipulated currencies.
In the long run, the dollar could be stronger because it has the most debt. When there is a credit deflation, the margin clerk calls and wants the debt paid. So people have to sell and buy dollars to pay the margin clerk. Because the dollar has the most debt, it stands to have the most short covering against it when the margin clerks call.
The world is not short of liquidity; it is insolvent. Debt has grown so much more rapidly than the income to service it that there will be forced fire sales for years to come. The central banks will keep pumping in liquidity, but that money is made out of debt, not out of gold dug from the ground.
I am not saying the nominal price of gold will not rise. It may ultimately reach unbelievably high levels. But for now, I watch the real price of gold. It is such a macro statistic, very important in terms of my confidence in the mining industry and the producers.
TGR: Even though the real price of gold seems to be rising, will equity prices follow? Over the last year, they have trailed gold's performance significantly.
JT: Equity prices have trailed the price of gold bullion and company earnings. The producers' equity prices have been compressed. We are seeing lower price-earnings ratios (P/E) for the producers.
Increasingly, people are buying exchange-traded funds (ETFs), not equities, for exposure to gold. Getting exposure through an ETF is easier than analyzing a mining company that has all kinds of inherent risks.
Another bigger-picture reason is the increasing insolvency and, therefore, illiquidity of the world at large. You see that in the compression of P/E ratios and not only in the gold sector.
When people grasp that it is gold mining companies, not the Federal Reserve, that are creating real money, the P/E ratios of the gold mining companies will go to the moon. But until that confidence barrier is broken, a lot of mining companies will struggle.
Adding to the problem for juniors is that money is not flowing down the food chain from the big guys to the juniors.
TGR: True. The majors were the flag bearers, and they were consistent. But majors like Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE), Goldcorp Inc. (G:TSX; GG:NYSE) and Barrick Gold Corp. (ABX:TSX; ABX:NYSE) all have issues, from Goldcorp's lower production estimates to Barrick's management turnover. Is this an issue of investor confidence?
JT: Yes. Mining is an extremely difficult business, very capital intensive. The majors have to find and produce more ounces, but where? The low-hanging fruit was picked decades ago. It is increasingly difficult to keep the reserves at levels that would allow continued production.
Most CEOs of gold mining companies do not understand their product; Rob McEwen, founder of Goldcorp, being an exception. They do not understand that they are minting real money. They do not talk about their product that way. Granted, it probably would not be politically feasible to talk that way, but many are comfortable paying the promoters of gold jewelry to promote gold as jewelry. Gold gains its value from being a monetary asset, not from jewelry.
Boom-and-bust periods are a problem for the industry as a whole. We had a 20-year bear market in gold, during which very little production or exploration was done. Now, when I visit gold mines, I find guys are coming out of retirement because they are the only ones who have the skills and knowledge needed.
I like companies that might not be the biggest, but that can grow organically. I like the 100,000-oz (100 Koz) producers that have a chance to grow up to 3–5 Moz producers and do it organically.
TGR: Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE) recently offered $4.26/share for Extorre Gold Mines Ltd. (XG:TSX; XG:NYSE.A; E1R:FSE). A year ago, Extorre traded around $14/share. Will we see more cherry-picking takeovers like this?
JT: Yes, indeed. This is one reason I am so much more bullish on the producers. They have the cash flow and they can buy it. The explorers are losing their share prices and are being cherry picked.
I wish it were otherwise, because my focus has always been on the juniors and the explorers. This is not a good time for companies that need to raise high-risk capital so they can put holes in the ground to see if they have gold or not. I am guessing there will be a lot of dead bodies littering the landscape, many more than in 2008 and 2009.
TGR: In mid-March, you exited 75% of your equity positions to build a cash position. How did you decide which companies to keep, and what did they have in common?
JT: I have a hypothetical model portfolio, and I just reweighted it and sold a few shares.
It is hard for me to sell these stocks because I think they are intrinsically good. But the market is no longer willing to pay what it used to for these companies. The price Yamana got for Extorre is a good example.
TGR: How do you rank the companies in your portfolio?
JT: I re-weighted the portfolio toward what I call my A-1 companies. These are companies in commercial production. Almost all of them are cash-flow positive and have growth prospects. We keep about 50% of the gold share portfolio in the A-1 companies.
My A-2 companies have done feasibility or scoping studies. They have a deposit that appears to be economically viable and are second tier in terms of risk versus reward.
My A-3 companies have delineated a deposit and have an NI 43-101 resource or a measurable, historical resource, but have not done the economics. There is no high level of confidence that the A-3 companies can produce gold profitably.
The A-4 companies have not yet measured a resource, but have some geological promise and probably some drill holes or surface samples that suggest something real.
We look at the liquidity of A-3 and A-4 companies every quarter. Do they have enough working capital to keep the lights on without more capital? Can they raise that capital? How close are they to outlining a viable deposit? If an A-4 can move up into A-3, it becomes less risky.
There are best-of examples in each category. I like Sandstorm Gold Ltd. (SSL:TSX.V) a lot. It is a streaming company that provides startup capital for companies to get into production. It then buys a percentage of the output at the cost of production at the time the mine goes into production, factored through the life of the mine. Sandstorm Gold and its long-term warrants were my No. 1 pick this year.
My favorite company in the A-3 or A-4 category would be Eurasian Minerals Inc. (EMX:TSX.V). With $30 million in the bank, it has major prospects and a very strong management team. It is supposed to be closing on a royalty company acquisition on some Newmont Mining Corp. (NEM:NYSE) production in Nevada that would throw out $6M. That would give Eurasian cash flow, plus, one of its gold projects in Australia looks huge.
TGR: What are some A-1 companies you like?
JT: Petaquilla Minerals Ltd. (PTQ:TSX; PTQMF:OTCBB; P7Z:FSE) is my top pick right now. It is very undervalued; selling around $0.38/share. It expects to produce 100 Koz this year, mostly from growth in its Panamanian project. It also has high-grade deposits in Spain and Portugal.
Petaquilla expects to spin off an infrastructure subsidiary that will build roads and operate power plants in Panama. That is a little dividend for investors, but I just like its long-term growth prospects.
TGR: Management owns about 12% of the company, and Eric Sprott is an investor. Those are usually good signs, but why is a gold producer selling for $0.38/share?
JT: There is some short-term debt on the balance sheet. Petaquilla has produced about 50 Koz gold/year. If it gets to 100 Koz, as it projects, and maintains its quarterly reports, I think Petaquilla can do extremely well.
TGR: It projects 70 Koz gold in its guidance for 2012.
JT: It has bigger numbers in mind for 2013, and has the projects to make it happen in Spain and Portugal, as well as expansion in Panama.
TGR: Any other names?
JT: I would call Sandstorm my No. 1 pick among producers because of its streaming model. It has several companies going into production, and the projects it has financed are producing larger amounts of gold on a regular basis. You will see some very substantial growth in earnings without the risk. Because of its streaming model, unlike most mining companies, Sandstorm does not have to pile a certain amount of its capital back into sustaining capital.
I also like OceanaGold Corp. (OGC:TSX; OGC:ASX), a New Zealand producer. It is starting production at a gold-copper project in the Philippines, using the copper to offset the cost. Right now, it is below zero in terms of production. I believe it is projected to produce 100 Koz/year at less-than-zero costs, which will offset its cost of production in New Zealand, bringing down the overall cost to the company to much lower levels.
Dynacor Gold Mines Inc. (DNG:TSX) is another favorite. It got hit pretty hard when it was unable to explore its Tumipampa project in Peru because of more stringent environmental controls. Its cash-flow projections for 2012 are north of $0.15 and it has been selling at around $0.50. It has the cash flow to explore its skarn target at Tumipampa, which could be a very, very large gold-copper deposit.
TGR: Some of the people at Sandstorm Gold also started Sandstorm Metals & Energy Ltd. (SND:TSX.V), which has performed very poorly. Why is its management team having so many problems?
JT: I think it is because the macro conditions warrant extreme bullishness for gold mining producers and bearishness for base metals producers. If you believe as I do that the global economy is going into a depression or a recession, this is not the time to own base metals companies.
TGR: What do you think about Allied Nevada Gold Corp. (ANV:TSX; ANV:NYSE.A)?
JT: I bought Allied Nevada at $5/share and sold it somewhere in the $30s. I am looking to buy it back.
This company has done everything it said it would; it under-promises and over-delivers. If it continues to do that, especially when it gets to the sulphide part of its project, it will be an enormous success. The oxide production is already successful. Allied Nevada could produce more than 1 million ounces a year gold equivalent (Moz Au eq) from its Hycroft project at lower costs than it is producing now.
TGR: Can Allied triple production at Hycroft by late 2013?
JT: Judging from its recent press releases and its track record of exceeding its promises—yes.
The one risk is that there is very little room for error if anything is wrong with its science or its feasibility work. It is a low-grade deposit, but producing the 1 Moz/year Au eq, it works out to be close to 25 Moz/year silver. The scale is massive. If you come in with just a fraction of a gram less than you expect, you could see a big variance in cash flow and profitability.
TGR: Any A-3 and A-4 names?
JT: My favorite A-3 name is Eurasian Minerals, a project generator company with projects in Haiti, Turkey, Alaska, Arizona and Nevada. It works with major mining companies, most notably Newmont, and with a number of new guys who are spending millions to earn into those projects.
Paramount Gold and Silver Corp. (PZG:NYSE.A; PZG:TSX) has deep pockets and lots of money in the bank. It has AMAX Gold Inc.'s old Sleeper mine in Nevada and some very promising gold and silver projects in Mexico.
Aurvista Gold Corp. (AVA:TSX.V) in Québec has on the order of 2 Moz in an open pit. I like the management and some deep pockets are behind the company.
Esperanza Resources (EPZ:TSX.V) also looks really good. It is a gold-silver company in Mexico, with strong management behind it.
In Brazil, Magellan Minerals Ltd. (MNM:TSX.V) looks good. Sandstorm recently came in and is providing some capital to move it forward.
I like Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX) a lot, although it is in dispute with Coeur d'Alene Mines Corp (CDM:TSX; CDE:NYSE) over claims that Coeur d'Alene failed to keep up and Rye Patch grabbed.
Pretium Resources Inc. (PVG:TSX; PVG:NYSE) has strong management and a super-big, world-class gold deposit in northwestern British Columbia. This is an extremely good story.
Victoria Gold Corp. (VIT:TSX.V) has about 2 Moz in the Yukon. Pelangio Exploration Inc. (PX:TSX.V) is an A-4 company in Ghana. It is outlining an open-pit deposit and a promising underground target that is more elusive and difficult to prove up the ounces on.
I like NioGold Mining Corp. (NOX:TSX.V; NOXGF:OTCPK) because Aurizon Mines Ltd. (ARZ:TSX; AZK:NYSE.A), one of my A-1 companies, is spending a lot of money to develop an underground deposit nearby in Québec.
I wish I could be more bullish on the A-3s and A-4s. They are doing good work and have a lot of good prospects. But this environment of illiquidity and insolvency issues is hard on them.
TGR: Clifton Star Resources Inc. (CFO:TSX.V; C3T:FSE) is on your A-3 list. Its Duparquet project has 3.38 Moz, and it recently upgraded some of the reserves from Inferred to Indicated. Is there is room for further expansion there?
JT: Absolutely. In another timeframe, with its deposit and new CEO, Clifton Star would be selling at much higher levels. It has a good amount of cash on the books. It needs to develop confidence in the market by continuing to develop and move the project forward, which Michel Bouchard is very good at.
There are some metallurgical complexities that make the project a little more difficult, but nothing that cannot be resolved. This is the kind of company that we will have to watch because if it can prove up, it will be a tempting takeover target. If that happens, we hope there will be some competitive cherry picking going on.
TGR: Urastar Gold Corp. (URS:TSX.V: URNRF:OTCQX) is on your A-4 list.
JT: While not denying this is a speculative stock, there are four factors that lead me to consider it to be a very worthy speculation for investors who can afford to tie up capital for an undetermined length of time and who understand the risk/reward tradeoff for junior exploration stocks. First, key personnel form the foundation for a strong management team. Second, I believe there is a fairly high likelihood that the company's Antimonio Property in Mexico can host a near-surface multimillion-ounce gold deposit. Third, I believe that various people who informally stand behind this project have deep pockets and as such increase the probability that "the lights will be kept on" even if market conditions become even more strained. Last, the current market cap makes this a very low-cost speculation. Yes, it could go lower. It could be cut in half with continued harsh market conditions. But the upside could be a factor of 10, 20, or 30 times the downside risk with exploration success and a turn in the markets. It's difficult to find better A-4 risk/reward opportunities than Urastar Gold Corp. at this point.
TGR: What would you advise investors holding a portfolio full of underperforming junior mining equities?
JT: You want to be able to take advantage when you see some strength as we saw starting in the middle of May. Sell a portion of your holdings and deal in cash. My thesis is that we will go lower, that we will see an insolvency that will require more debt liquidation. People will want their money back from the hedge funds to keep the roof on the house or put the kids through college.
I have faith in gold as the ultimate money. The real price of gold has risen dramatically, which has led to real, strong profits for the producers. That makes me confident and is why I believe we are in the gold bull market of a lifetime even though the guys at the bottom end of the food chain are struggling.
TGR: Jay, thank you for your time.
A baby boomer born in Ohio, Jay Taylor was drawn to the world's financial capital in 1973, when he went to New York to work for Barclay's Bank International after earning his master's degree in finance and investments. As he followed the demolition of the U.S. gold standard and the rapid rise in the national debt, Taylor's interest in U.S. monetary and fiscal policy grew, particularly as it related to gold. This led to his first investments in junior gold shares toward the end of the 1970s. Sometimes called "the buy and hold guy," he began publishing North American Gold Mining Stocks in 1981. He was involved in the first modern-times gold loan made in the U.S. (to Amax Minerals, a 250,000-ounce loan facility led by Citicorp). To better understand the potential of the mining stocks he researched, Jay added a bachelor's degree in geology to his C.V. in 1988. Pursuing his interest in researching and writing about mining companies as a sideline, Taylor maintained his full-time banking career for nearly 10 more years. In August 1997, he left his position in the ING Barings mining and metals group to pursue his avocation as a new full-time career—including publication of his weekly Gold, Energy & Tech Stocks newsletter.
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1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Extorre Gold Mines Ltd., Petaquilla Minerals Ltd., Allied Nevada Gold Corp., Rye Patch Gold Corp., Pretium Resources Inc., Aurizon Mines Ltd. and Clifton Star Resources Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Jay Taylor: I personally and/or my family own shares of the following companies mentioned in this interview: Petaquilla Minerals Ltd., OceanaGold Corp., Sandstorm Gold Ltd., Eurasian Minerals Inc., Dynacor Gold Mines Inc., Paramount Gold and Silver Corp., Rye Patch Gold Corp., Pretium Resources Inc., Pelangio Exploration Inc., Clifton Star Resources Inc. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
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