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What's Next For Oil And Gold: Thoughts From Eric Sprott, Rick Rule And Marc Faber

 

“ How can we have an economic recovery when there is barely any discretionary disposable income for 40% of the population? As we have shown above, those that have seen their incomes grow are not the ones most likely to spend, while the bottom 40% of households still rely heavily on government assistance, have had stagnant incomes and have been faced with increasing inflation for “non-discretionary” goods that constitute a very large share of their incomes. There is clearly no recovery…

   -  Eric Sprott, Chairman and Founder of Sprott Inc., July 2014

 

“ Most developed economies have consumed and borrowed at worrying levels. The US federal government has on-balance-sheet liabilities of over $16 trillion and off-balance-sheet liabilities estimated at about $70 trillion. These numbers do not include state and local government liabilities, or the likely liabilities from underfunded private pensions. Not to mention increased costs associated with more comprehensive health care and an aging population!”

   -  Rick Rule, Chairman of Sprott US Holdings Ltd., July 2014

 

“This is the second longest bull market in the last 100 years. I wouldn’t buy shares here. I’m not interested. Now can the market go up another 20 percent? I wasn’t interested to buy the NASDAQ in late 1999, but between January 2000 to March 2000, the NASDAQ went up another 30%. Afterwards people were crying when they realized their losses. The markets go up and down. I think that the upside potential now for the general stock market is very limited and there is considerable downside risk. Probably more downside risk than investors realize.”

   - Marc Faber, Board of Directors of Sprott Inc., February 2014

 

Below are some further perspective on what may be next for oil and gold from Eric Sprott, Rick Rule and Marc Faber.

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Weakness Around the World

The oil price is driven by the same dynamic that underpins the case for most commodities, such as copper, uranium, or iron ore.

As people get richer, especially in emerging markets, they tend to consume more metals with which to build houses and cars, and more fuels to generate energy and power machines.

Yet commodities have been flat since the Great Recession ended, suggesting, once again, that economic growth is slowing down.

The price of copper is at a four-and-a-half-year low of $2.60 per pound. Uranium sells for $36 per pound today, down from around $65 in 2011. Iron ore for delivery in 2015 trades for below $60 per tonne on the futures market, down from over $180 per tonne in 2011.

The price of oil, meanwhile, had not declined substantially over the last three years. Perhaps its recent price collapse is not as sudden and inexplicable as many believe.

Indeed, a low oil price is consistent with the price action we’ve seen in other commodities. It also dovetails with economic data we’re seeing from around the world, which suggest that global growth rates are simply decreasing.

The Eurozone is trudging along more slowly than the US, according to statistics from the European Central Bank. In the third quarter of 2014, its GDP was nearly flat at 0.3% in growth. Inventories were being dis-hoarded, falling by around 15 billion euros over the last 6 months. This suggests that fewer goods are being produced and stockpiled – a response to weak demand. Employment grew by 0.2% over the quarter, meaning that unemployment levels are still high for the developed world, and industrial production increased by only 0.1%.

The situation is similar in Japan. Despite sustained ultra-low interest rates and activist policies meant to stoke growth, the country is mired in what isn’t far off from being a depression. Its GDP shrank 0.5% in the third quarter of 2014, right on the heels of a more than 1.5% contraction in the second quarter.

Developed-world economies are not the only ones that are experiencing weakness now.

China’s annual growth rate has slowed from around 10% in 2011 to around 7.5% as of the third quarter of 2014. 11 Its domestic consumer market appears subdued. In the third quarter of 2014, the Consumer Price Index (CPI), which measures the average change in the prices of consumer goods and services, was its lowest since February 2010. The real estate market has been weak and domestic investments in fixed assets – which includes new building projects – grew by only 16.1%. That number was above 21% in early 2013, and has been declining steadily ever since.

Weak economies around the world offer weak demand for commodities and for capital. The effect is to keep interest rates extremely low and to push commodity prices down.

The same logic applies to oil, which has long been priced with the expectation of ever-increasing demand and ever-declining supply. We can therefore view the oil price as a symptom of poor global economic growth, which is a long-term problem – and not just as a short-lived consequence of a slight oversupply of oil.

Falling oil prices are yet another sign that the world economy may be more fragile than before the Great Recession.

Why is this important? Well, many write off the oil price drop as merely the machinations of Saudi Arabia to throw a monkey wrench in the wheels of the US shale industry – or perhaps a market that’s over-reacting to a slight supply and demand imbalance. You would then naturally expect a quick recovery after the market worked through the problem of oversupply, or once OPEC and Saudi Arabia had adequately bludgeoned its rivals. On the other hand, if you attribute the oil price decline to a more significant underlying issue within the world economy, then the oil price drop starts to look like the harbinger of a more long-term trend.

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Gold Mergers and Acquisitions May Increase in 2015

The gold mining sector is seeing adjustments to a gold price in the range of $1,100 to $1,300 per ounce, down from over $1,900 in 2011. These are healthy adaptations to a lower gold price.

When investors expected the price of a metal to rise, companies responded by acquiring mines, even if they did not stand to produce a profit right away. A rise in the price of the metal could render the mine profitable at a later date, while holding off until metals prices rose may have meant paying more for the acquisition.

This explains why mining companies as a whole went on a buying spree during the years leading up to 2011, when everyone expected gold to keep going up.

What has happened to those acquisitions in the meantime?

The mining industry saw massive amounts of write-offs from mergers and acquisitions from 2011 onwards. Well-known billion-dollar write offs include the Alaskan Pebble mine and the Fruta del Norte deposit in Ecuador.

We are now entering a new phase of mergers and acquisitions, since many of the worst and least efficient projects from the last cycle have been dumped.

In 2014, big miners mostly switched from shedding deposits to acquiring new ones. Big acquisitions include Osisko Mining for over $3 billion by Agnico Eagle and Yamana Gold. Another example, Cayden Resources, received a takeover offer from Agnico Eagle of around $205 million. Bloomberg reports that $11.2 billion in new mergers and acquisitions in the gold mining sector have been proposed or completed in 2014.

We expect more takeovers of companies with potential or producing mines to occur in the next 12 to 18 months.

Cash Is King

‘Juniors’ that are looking to bring an asset into production require capital for exploration drilling and acquiring the data that may make the project attractive for an acquirer.

Exploration companies make high-risk ventures for investors. They can quickly drop in price if their projects fail to stimulate interest. For geological reasons, most exploration projects are destined to end in failure. The good thing is that bad projects can go out of business fast because they usually have no source of income other than issuing new shares. This culls the herd for investors and eliminates wasteful uses of capital.

The chart below clearly shows that, as a whole, a culling is imminent for many juniors, unless they can raise more cash. Cash held by junior gold miners listed on the TSX Venture exchange, the main marketplace for US and Canadian exploration stocks, is less than a third of its level from early 2012. In just three years, cash on these companies’ balance sheets has dropped from C$3.5 billion to around C$1 billion.

This means that cash is king – and becomes more important the longer this trends keeps going.

Some of the large miners may benefit from this trend. Because they have stronger balance sheets, they can absorb projects cheaply – especially when those companies are out of cash and their managers are worrying about their salaries.

Royalty and streaming companies could also swoop in to benefit from this trend. These companies offer financing to big miners and to junior exploration companies in exchange for a share of future production or discovery potential. They typically pay for the royalty upfront, but can end up with a very long-lasting stream of cash flows, at no additional cost.

Franco Nevada, the leading royalty and streaming company in the mining space, recently raised $500 million, which it has re-deployed into streaming agreements with mines owned by the Lundin Group.

The share price action of the three largest royalty and streaming companies suggests that this business model is increasingly popular with investors. The three largest royalty and streaming companies, Franco Nevada, Silver Wheaton, and Royal Gold are up 68%, 19%, and 27% respectively over the five years ending December 31, 2014. The GDX, which tracks major mining stocks, is down 63% during that period. The GDXJ, which tracks the junior miners, is down 78%.

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Outlook for 2015

‘Cash is king’ and that’s good for speculators involved in financing small exploration companies. It is also good for mining companies that want to acquire assets and for royalty and streaming companies that provide financing to the sector.

If you have the ability to analyze specific takeover targets for potential acquisitions, these opportunities may offer outsize returns over the coming year.

However, a more general approach requiring less technical expertise may be to accumulate a position in the miners and royalty and streaming companies that stand to make acquisitions at bear market prices. Whether you invest in exploration and development stocks, or in relatively low risk royalty companies, there are always risks to investing including possible loss of principal.

To many people, the oil price drop looks like a wrinkle on otherwise smooth water. Taking a closer look, though, we can see that it doesn’t come ‘out of nowhere.’ In fact, commodities as a whole have been weak for several years now. Low interest rates and stagnant household income numbers also suggest poor economic conditions, leaving us to explain how we could see an epic stock market rally at the same time.

The mining industry is consolidating, which is a natural and positive occurrence. They are also not part of the pack that has participated in the ongoing rally. That’s partially because their weak balance sheets didn’t allow them to issue new debt in large amounts.

There is reason to be positive for gold and silver mining stocks because of improvements that are intrinsic to the industry. Precious metals stocks have been unloved for the last three years and consequently are at long-term lows. In contrast, we believe that most US stocks are teetering near all-time highs, on the shaky premise of a broad recovery.

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Much more in the full note below (link)