buy when they cool down
by Robert Cardwell
Director of Equity Research at the Hirsch Organization
"Remember
the deflation story that was such a prominent feature of the
business news just a couple of months ago? Take a look at the
metals charts -- they sure don't look as if inflation were in
the works. Some people on Wall Street (and more important, at
the Federal Reserve) remain quite worried about deflation or
disinflation. As we'll see, that's a good reason why gold and
other commodities should keep going up.
Gold has been a store
of value and hedge against uncertainty for thousands of years.
As such, it moves have major psychological as well as economic
significance. Whether you're a gold bug or a skeptic, ignoring
gold would be foolish.
The metal has made
a convincing long-term double bottom and embarked on a powerful
bull move. After two years, this move shows no sign of flagging
(though we are approaching important resistance in the $400 area).
Gold was supposed to be an inflation hedge but the last two generations
of Americans have never seen inflation as tame as it is right
now. So what's going on?
It's a combination
of simple supply and demand plus rather complicated economics.
On the supply side, the most important immediate factor is the
end of producer hedging. During the long bear market in gold,
it seemed smart (and for a time was smart) for producers to sell
their gold forward. Using the futures market or more complicated
schemes, they would sell gold before they mined it.
That gave them a certain
price and usually a higher price. Of course, that strategy is
a loser in an advancing market and it has been a disaster
for a few companies that got caught with huge short positions.
Hedging is over, and de-hedging (producers buying back short
positions) has been a substantial factor in demand.
Mine production was
down last year. It probably will be up a bit this year, and rising
prices may encourage additional production next year. But there
is a limit, particularly for the large South African mines, some
of which are already on life support. They are running out of
economically mineable ore -- leaving aside the political problems
that also make South African production tenuous.
It's not generally
appreciated that jewelry fabrication alone takes up more gold
than all of the world's mines turn out. So changes in investment
demand, scrap sales and other "marginal" factors make
a big difference in the equation. Central bank sales are down.
They are always unpredictable, but selling hasn't looked smart
lately, an we suspect the bankers won't be anxious to unload
more gold.
Looking at economic
fundamentals, we find reasons that gold is likely to remain strong.
Fighting deflation, the Fed has kept the monetary spigot wide
open. Those excess dollars have not spurred inflation yet, but
they might. In any case, the dollars are there to support commodity
prices.
In the second quarter,
the U.S. current account deficit was $138 billion. We continue
to buy from foreigners at a prodigious and increasing rate that
far exceeds our exports. Thus foreigners must hold increasing
amounts of dollars -- not a comfortable position with the dollar
declining. Among the few alternatives to converting some of those
bucks to gold. The sudden swing to a huge federal deficit exacerbates
the problem, as we have to finance the budget cap.
Economic recovery will
spurt further demand for metals whose supply-demand picture is
favorable already. Platinum's recent record prices reflect growing
use in anti-pollution catalysts, fuel cells and elsewhere. Sister
metal palladium is still depressed but also has a bright future.
Copper demand and production are about matched right now. Even
without global economic recovery (which will happen sooner or
later) the industrialization of China, India and other nations
will create huge demand for copper and other metals.
So investments in mining
can benefit both from things going right and things going wrong.
At the recent New York Institutional Gold Conference we were
able to meet with managements of quite a few junior mining companies,
getting updated on situations we knew and investigating additional
opportunities.
Here is our pick of
stocks we judge to have the best risk-reward ratios. Note, however,
that we want to buy on corrections. Most mining stocks have already
tacked on substantial gains. Further, there tends to be seasonal
weakness in October. This may allow us to get in at favorable
prices.
Orezone Resources
(TSX ORZ) is the only gold stock currently in our portfolio.
It's been good to us; we've already taken our original investment
off the table and we expect to be further rewarded. We were attracted
originally by a very low valuation. Orezone was selling at about
the lowest price per proven ounce of any gold stock. Despite
a big gain, the stock is still not expensive on that basis, and
there is the potential to develop much bigger reserves.
The company can be
compared with Nevsun Resources (TSX-V NSU), a company with similar
but somewhat more advanced projects in Africa that carries a
market cap and almost four times higher. The ultimate goal is
to be another IAMGOLD (TSE IMG), which has just three times the
measured ounces but is in production and boasts a market cap
15 times as large. Orezone has very large and prospective concessions
in Burkina Faso, a stable country as African nations go. More
discoveries are likely.
Reserves can be discovered
or they can be bought. Buying is easier, and if the timing and
deal making are intelligent, the result can be rewarding for
shareholders. Northern Orion Resources (TSX NNO), long
a South American exploration vehicle, recently was transformed
by a change in control, a large financing and the addition of
two key assets.
The new management
bought 12.5% of the Alumbrera Mine in Argentina, a low-cost copper/gold
complex that last year produced 440 million pounds of copper
and 759,000 ounces of gold. In a related deal, Northern Orion
increased its interest in the advanced Agua Rica copper/gold/molybdenum
project to 100%. We believe Alumbrera was bought for a bit less
than present value. Agua Rica's cost was way under net present
value, and if things work out as planned, it will have been a
steal.
Alumbrera has a well-defined
further life of 8 10 years. The large Agua Rica deposit
(7.5 billion pounds copper, 4.2 million ounces gold) is close
enough that ore could be conveyed to the Alumbrera facility when
its ore gives out, or preferably blended with that ore even before.
While developing a full-scale mine and concentrator complex at
Agua Rica would be feasible, using Alumbrera would save $500
million or more in capital cost, a compelling economic case.
There are a couple
of other projects that have been on the back burner. Management
will now have significant cash flow to work with, so if Agua
Rica can't be moved forward soon, we expect to hear about other
developments.
ValGold Resources
(TSX-V VAL) is a small exploration company that's been somewhat
adrift in the last few years. But VAL happens to own 1.8 million
shares of Northern Orion plus more than one million warrants.
With its cash and some other small investments, VAL has liquid
assets worth about 35 cents (Canadian) per issued share. There's
no debt, so VAL is trading at a discount to assets, even forgetting
the rest of the company.
There's also an exploration
project where some good results have been reported recently,
plus some other projects in Canada. With its tiny market cap,
ValGold will be a winner if they find something and the
assets limit the risk.
Manhattan Minerals
(TSX MAN) sells at one-tenth of its former price simply because
its main project has been postponed. The company has a proven
resource in Peru that is ready to be mined, but environmental
and other problems put it on hold. Now the environmental and
local political issues have largely been solved and it looks
like a mine will be built. With expected low-cost production
of 260,000 ounces of gold and 3.2 million ounces of silver a
year, this is a big deal for a company like MAN, even assuming
that a partner will be brought in.
There are other promising
South American projects but the key thing is that Manhattan already
has a very valuable resource. We think the market doesn't fully
realize how much progress has been made toward getting it mined.
European Minerals
(EPM.U) is a similar situation but completely off the radar
screens. EPM has a gold deposit in Kazakhstan with 3.5 million
ounces. Metallurgical and other work has been going forward,
and there is a good change that a mine will be developed. EPM
also has a head start in the under-explored and highly prospective
areas of Eastern Europe. There's an advanced project in Bulgaria
with (so far) about half a million ounces of high-grade gold.
European Minerals is
quite undervalued just on these projects. But the company is
now talking to potential financial allies, and we expect to see
it take on more projects. Note that EPM is listed on the Toronto
Exchange but is one of the few stocks that trade there in U.S.
dollars.
Freegold Ventures
(TSX ITF) offers a lot of exploration bang for the buck with
its market cap of about $5 million U.S. In addition, there's
the proven Almaden project in Idaho with 527.000 ounces of gold
(and probably more) that will be economic at slightly higher
gold prices.
Freegold has been exploring
in Alaska for years. It's found a good bit of gold at its main
project near Fairbanks, but not enough in one place to make a
mine. Recent drilling results have been more promising, and the
company has added several other interesting projects including
a platinum exploration venture that's being financed by Lonmin
(one of the major platinum producers). Freegold will soar if
anything worthwhile is found.
Pacific Northwest
Capital (TSX PFN) is a related company that we have recommended
before. It wasn't particularly rewarding, but I think it will
be sooner or later. PFN continues to advance its River Valley
project, which has a good chance of becoming North America's
third platinum group metals mine. At present, almost all platinum
and palladium comes from South Africa and Russia, so we need
some mines on this continent for strategic as well as economic
reasons.
PFN recently announced
its best hole yet from River Valley 154 feet of 5.02 grams
per ton platinum/palladium. While measured and indicated resources
already are 826,000 ounces, much of the prospective ground has
not yet been drilled. PFN has another platinum project in Ontario
for which Anglo is paying the way, and right now is busy accumulating
ground in Alaska that it thinks is highly prospective. PFN is
cheap based on River Valley alone, and the other projects are
icing on the cake.
Newmont Mining (NYSE
NEM) is being added for those who won't buy speculative or Canadian
stocks. It won't move as far as our other selections, but is
as solid as they come in the mining business and trades on the
NYSE. Newmont is a major gold producer in Nevada, Peru, Australia,
Indonesia and elsewhere. While it's a comparative giant, it is
more leveraged than the other senior producers and should outpace
them in a gold bull market.
The company's 87 million
ounces of gold in the ground offer assurance to shareholders.
Still, the current price is rich and we would buy only on a major
correction.
Except for Newmont,
all these stocks trade in Canada and all are speculative. However,
every one but ValGold is listed on the senior Toronto Stock Exchange.
Eight mining stocks are more than most people want or need. However,
our buy limits are conservative and we don't expect to add all
of them. We'll see what happens in the coming weeks and adjust
our portfolio and buy limits depending on conditions. We are
watching still more attractive resources issues, and will be
commenting on them if they move to reasonable buy levels."
Editor's Note: Robert
Cardwell is Director of Equity Research at the Hirsch Organization.
At press time Mr. Cardwell was long European Minerals, Freegold
Ventures and Pacific Northwest Capital.
