Signs Of A Bottom

As things go from bad to worse for so much of the mining and exploration sector I thought it was time to collect up some anecdotal evidence of bottoming. This won’t be based on charts or tables (though I might toss in a couple later) but from empirical observation.

I’ve spent most of my life in and around the mining sector either as an analyst, exploration or financing consultant or child of a mining executive who bounced around a few mining camps in his youth. I have seen a lot of cycles come and go.

I’m the first to admit this is one of the strangest cycles I’ve seen but there are some predictable behaviors near cycle bottoms that are beginning to appear.

As was noted in these pages about 10 years ago, the dominant theme of this cycle was the rise of emerging economies that had exponentially growing demand for raw materials— the “BRICS”. China in particular can be thanked (or blamed) for extending the current part of this cycle. Unlike every other major economy China went Keynesian—big time—in 2009. It chose to buy stuff rather than buy collapsed mortgage bonds and kept up demand for metals and energy. Prices, especially base metals, would have gone soft much faster without this intervention.

China was aided and abetted by hedge funds that were just in for the trade. Hedge funds are a pretty bipolar bunch, not given to moderation. They are either all in or all out. Exit of the commodity markets by hedgies and non-growth for most developed economies exacerbated recent swings in metals prices.

The price movement has all been to the downside in the past year or so. The world is full of unresolved fiscal calamities and no one should assume the risks are low going forward. The apparent demise of the BRICS and falling metal prices have led market generalists to opine the mining sector will be “a goner for longer” this time.

It’s assumed we have moved to a secular bear market. Hard commodities are considered a bottomless pit; no one but diehards and unemployed geologists will hear the faint thud when they finally hit bottom.

I’m not sold on this idea yet. Yes, it’s a very large correction. Two of the BRICS (Brazil and Russia) are quite resource dependent themselves so their economies are pro-cyclical with commodities. Oil and gas prices are helping Russia out and Brazil has internal political issues its needs to deal with. The same is true of China.

China is making the moves it should be to diversify and balance its economy but it doesn’t look to be falling off a cliff. We should be happy leadership is being proactive and recognizes the issues. India isn’t helping much but it never really did. The corruption and the “license raj” have to go before India is the contributor to world growth it should be.

As these issues are sorted out there should be some increase in metals demand. There will also be growing demand from the next group of high population countries moving up the ladder like Malaysia, Indonesia, the Philippines, and several others in Southeast Asia and Africa. These changes don’t happen overnight but I will be surprised if we don’t see higher metals demand and new highs in some prices before the longer secular cycle is over.

Times are tough right now though, no doubt about it. Times have been tough many times before in this heavily cyclical sector. Many outside the mining business - and even more within it—assume it will be a decade before things improve.

I doubt it. I’ve seen this movie before. Recent headlines are very similar to what appeared during previous lows in the cycle, to wit:

Tons of write downs. Many of the world’s largest miners are taking big hits to their P&L statements and balance sheets. It’s similar to what we saw in the financial sector in 2008-2009. Management's view is something like “the market hates our guts so we might as well get all the crap off our balance sheet. It’s not like we’ll get hit much harder in the market place anyway”.

Earnings impairments like this gets the bad news out there and, not coincidentally, allow these companies to carry much smaller depreciable asset totals going forward. This helps them set up to deliver stronger bottom lines when and if things get better. They have smaller depreciation deductions in good years.

Don’t think this is just accounting gimmickry though. Many of these large projects will be put off for a long time, decades in some cases. It’s no coincidence these write offs often occur after management shake-ups. New executives get themselves off the hook by taking the hit and blaming it on the last guy.

If a new executive doesn’t have to wear the failure he or she will be much harder to convince the project has to be completed. A lot of very large projects are now in limbo. I saw the same thing happen in the late 1990’s and many of the deposits downgraded then still haven’t seen the light of day.

We’re Outta Here! — Companies exit sketchy jurisdictions.

No doubt you saw the news concerning Kinross walking away from the Fruita del Norte project it acquired when it took over Aurelian a few years ago. I’m not outing Kinross here. They got caught in a country determined to demand such high returns that there was nothing left for the company undertaking the risk. It would be nice to know the specifics of the deal they walked away from, though.

The only good news is that former Aurelian shareholders can stop hating on management. The deal they took turned out to be a smart one. That dislike did spawn a hilarious YouTube video so it wasn’t a total loss. (you can see here: http://www.youtube.com/watch?v=TDKRLfeo6N8 Apologies to Patrick Anderson who gets dissed pretty hard though he does have a sense of humor and probably laughed at it too)

Kinross’s plight is being repeated in many other jurisdictions by other companies. This is classic cycle bottom behavior by governments. When metal prices rise, countries start feeling like they are not getting enough out of the deal.

Politicians ignore the fact that miners spend tens of billions each year looking for deposits and that the small number of successes ultimately has to carry all that other spending. All they see is potential for high margins and a populist points to be made attacking nasty foreign investors.

The problem is magnified in a state that also has oil and gas resources. Governments try to apply the same payback rules to mining as oil and gas. That just doesn’t work. The sort of royalty arrangement that works on a high volume oil field make all but a tiny handful of hard rock mining projects uneconomic.

Political backlash can come and go but it usually reaches its peaks right about when metal prices are falling. This helps ensure even more projects come off the drawing board.

I think it’s time miners’ outed governments that cannot be dealt with or just can’t be trusted because they rewrite deals after the fact.

In some countries issues will go away after the next election but many countries fall into this trap over and over. It’s tough on shareholders but its time companies walked away from places that can’t be trusted, no matter how good the geology might be. I think this is quietly happening already.

It’s happening in the update section of HRA this month too. You’ll see several companies listed as sells due mainly to the country they are operating in. I’m not happy to be doing it near a market bottom but it’s time to stop supporting exploration in countries that won’t allow a return on investment. In some cases the situation will improve but I don’t feel like waiting for it.

The list of countries that have gotten inhospitable is long. A few that come to mind are Indonesia, the Philippines, most of Central America, Venezuela, Ecuador, Russia, Zaire and Zimbabwe. I could go on but the list gets the point across and leads directly to the next point, namely.

Look at all these deposits coming on stream! We’re all gonna die!

I’ve been the recipient of a number of emails in recent weeks that include huge lists of deposits “on the shelf”. They are usually distributed by commodity or precious metals bears as “proof” that metal prices will just keep falling as this avalanche of new production arrives.

The only thing most of these lists prove is that the sender is clueless about the mining business. I looked at a list of 160 gold “deposits” that could swamp the gold market. I imagine many of you have seen versions of it.

The first problem is that most of the list are Resources—not Deposits. Deposits have proven economic viability and many of the projects in these lists certainly can’t lay claim to that. A large percentage of them are in countries you can’t deal with or have terrible logistics or locations near national parks or other cultural landmarks that make it unlikely they will be permitted.

A large number of the remaining projects have grade or metallurgical issues or geometry or topography that make them impractical. I didn’t bother to go through the list name by name but I recognized many of them.

I would hazard a guess that something like 70-80% of these projects are non-starters at current prices. Even if I’m wrong and, say, 30-40% of these projects are viable you still need to factor in time to production. In short, the resources on this scary list would only replace existing mine depletion, if that.

There might be a last gasp bump up in gold production this year though even that is doubtful as there are a lot of small marginal producers throwing in the towel. If we have hit bottom on gold this time that would obviously help but the die still seems cast when it comes to the multibillion dollar megaprojects. It will take more than a $100-200 increase in the gold price to restart most of those projects.

Outsiders constantly underestimate how fast the production pipeline in the mining business flushes out when things get tough. A lot of the projects listed in estimates of 2% or 3% or higher production growth for the gold and base metals sectors have already been shelved. Many large companies have already cut exploration budgets and we all know how exploration in the junior sector has collapsed. I don’t expect “peak” anything, but I’m not worried about huge oversupply either.

Gold Catches a Bid

After the last few months we’ve all learned to be hesitant when it comes to the gold price. It looked for a little while like we had a bottom when gold was smashed in April but that didn’t hold. We saw a new low last month and then a new rally. We can thank Ben Bernanke for both.

Gold was hammered as traders interpreted comments by Bernanke and other FOMC members after the last Open Market committee meeting. NY equities and the Treasury market were also getting whacked.

This led to some rapid backpedalling by Fed governors, particularly Bernanke himself when he addressed the US Congress during his semi-annual testimony last week.

While there was an initial selloff during Bernanke’s comments they were actually much more dovish than his post FOMC meeting address. Bernanke went back to using 6.5% unemployment as a potential benchmark for tapering rather than 7% used last month. It will take a long time for the US to get down to 6.5% unemployment and even that doesn’t deal with the issue that many jobs being created now are part-time, low paying or both.

The biggest negative for gold recently is continued attempts by the Indian government to throttle gold imports. This could be an issue later in the year. It’s not an issue now because China has been more than making up for slackened Indian imports. I suspect India’s black market will fill a lot of the gap but it will be difficult to measure this.

The Chinese have been trading an impressive amount of gold on the Shanghai futures exchange. Even more impressively, traders have demanded delivery of gold when contracts expire. This is very unusual, almost unheard of in the West. Only a tiny fraction of futures contracts traded on Comex or Nymex result in delivery.

Also interesting is that gold ETFs recently launched in China are faring poorly, with initial demand a fraction of the amount hoped for. The message seems to be that Chinese demand is holding up but they want bullion, not paper contracts.

Demand for delivery in Shanghai, and reportedly higher demand in North America may help explain why gold has gone into “backwardation”. Backwardation occurs when the spot price for a commodity exceeds the near term futures price. While this isn’t that unusual for strongly seasonal agricultural commodities it’s rare for “financial” commodities like gold.

Backwardation implies strong spot and physical demand, something many gold followers have already noted. It’s a bullish sign. If it continues and strengthens we could see delivery bottlenecks as sellers scramble to deliver the actual product.

This is precisely the sort of situation that should make a short seller very nervous and it looks like it is.

Gold just swept through $1300 fairly easily. As you can see above it’s currently sitting at the 50-day moving average. The one year chart shows what a glass ceiling the 50 day average has been for gold. If bullion can clear it and surpass the next big resistance level at $1350 we could see short covering really accelerate.

In my non-technical view, the current situation looks far more dangerous for the shorts than any time in the recent market. This is doubly true if the Fed sticks to its new dovish stance.

Backwardation is a warning that there is a danger shorts will be asked to deliver on gold sold forward. That is something a futures trader rarely worries about. It can be avoided, but only by taking out the offer. A few large traders doing that could finally generate a large step up in price. Stay tuned.

By Eric Coffin