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Institutional Embrace of Resource MarketRisk, Junior’s, Asia, Emerging Markets, Energy, $600 Gold and $12 SilverBy Keith W. Rabin and Scott B. MacDonald KWR International April 12th, 2006 NEW YORK (KWR) April 11, 2006 – Just over four months ago our article “Waiting for the Sky to Fall?: Asia and Implications of $500 Gold and $8+ Silver” highlighted a positive perspective on gold, silver, industrial metals, energy, uranium, Japan, India and other Asian markets. Of the 69 specific investment ideas included, 63 appreciated in value. If one had placed $1,000 in each selection on November 22nd when the article was released, one would have achieved a return of nearly 40% as of March 31st not including dividends, distributions or transactions costs. That is over 100% on an annualized basis. While this appreciation is no guarantee of future performance, we have been receiving many inquiries regarding our views moving forward and offer the following comments. In addition to the rapid appreciation of many of the sectors and securities that we highlighted, of special concern is the potential for central banks to over-react to the “threat” of inflation by raising interest rates to the point where they kill off growth. Most major central banks, the Fed, European Central Bank, and Bank of Japan, are gearing to reduce the massive amount of liquidity in global capital markets. As one London-based trader recently said to us: “There is still way too much money chasing too few securities.” That would take into account the $400 billion of capital that flowed into Emerging Markets in 2005, a trend that is still in motion. Massive Global Liquidity Has Led to Assumption of Greater Risk and Asset BubblesOne sign of this massive pool of liquidity and rising risk has been little bubbles in “fringe markets” – for example, Iceland, Saudi Arabia and the Persian Gulf. Over the last three years the upsurge in international oil prices have brought a windfall to Middle Eastern oil producers, around $300 billion in 2005 with roughly the same expected in 2006. For many Middle Eastern producers, the first rounds of petrodollars went into rebuilding foreign exchange reserves, infrastructure projects to diversify their economies, and real estate purchases in Europe and Turkey. However, as the petrodollar flow continued, the old venues were inadequate. At the same time, the rise of protectionism in the US and Europe as well as the complications of 9/11 and the US occupation of Iraq made many Middle Eastern investors uneasy with New York and London. Instead they turned their attention to regional stock markets, in particular, Saudi Arabia, Jordan, Egypt, and the United Arab Emirates. Close to home, familiar, and economies buoyed by oil money, these markets looked like a certain bet. The problem is most of these markets lack depth and valuations soon ran away with themselves. Large amounts of capital flowed into these markets in 2005, making them some of the biggest gainers for the year. However, beginning in mid-February, some of the more savvy investors, recognized a bubble, and pulled out. Stock markets in the Persian Gulf took a tumble. (See Table below) Iceland followed in March. International investors earlier in the year borrowed funds in Japan, where overnight lending rates are near zero, to finance purchases of AAA-rated Icelandic bonds paying more than 9%. Speculation the Bank of Japan would begin raising rates (confirmed on March 9) caused investors to unwind these carry trades. What made Iceland especially vulnerable was a massive 16.5% current account deficit in 2005, inflationary pressures, a small, yet somewhat highly leveraged banking system, and an over-valued currency. By the end of March, the Iceland trade was over, the local stock market had taken a tumble, and serious questions are still being asked about the health of the country’s banks. The lessons to take from these fringe incidents are twofold – in an environment of low volatility investors are forced to assume greater risk and at some point that risk materializes. The second lesson is that more bubbles are going to burst. There is talk that Hungary and New Zealand could see the same problems as Iceland, while the hot stock markets of Vietnam, Morocco, and Karachi all look similar to their Middle Eastern cousins – shallow in terms of capitalization and number of blue chip companies. Where Is the Money Going? As of April 5, 2006
Source: Bloomberg What happens on the fringe should be a signal to the major markets – risk never entirely leaves, though it can be hidden by optimistic sentiment. Greater risk is creeping into the market and the process of drying up liquidity is starting. But we emphasize that at the present time, this appears to be a gradual process. That gradual nature is important if the shift to Asia and other engines of international economic growth is to occur without the trauma that generally accompanies more abrupt and sudden transitions. On the other hand, should the US Federal Reserve over-stretch in raising interest rates, it could send an already retreating consumer into a tailspin and the downturn in the housing market into a rapid plunge as opposed to a more orderly retreat. We do not, however, believe this to be the most likely scenario, Despite having far better fundamentals, an erosion in the US is also likely to cause panic and fear in Asia, emerging markets and others believed to remain highly correlated to US performance. However, as we noted, while we do not doubt this sell-off would occur, we believe the surprise would likely be how quickly these other markets recover while the US demonstrates more lackluster performance. Institutional Embrace of Resource Sector Creates Opportunity in Junior SectorPerhaps the greatest change in our past analysis, however -- and where we have been focusing attention in recent months and believe the biggest opportunities lie moving forward -- are within the junior gold, silver, energy and other resource markets. Here we seem to be seeing a major paradigm shift emerging. We base this on a belief the major financial institutions have finally begun to shift their orientation from one that disparaged the resource market as one inhabited by quirky “gold bugs”, survivalists, old-timers and those not wise enough to recognize the unchallenged appeal of technology and other sectors investors came to know and love in the 1990s. Today, these institutions appear to be slowly realizing the rise of commodities, metals and energy is not likely to be a short-term phenomenon, but rather one that will endure so long as global growth and demographic trends continue at anywhere close to present levels. We have seen this change reflected in numerous conversations with fund managers, bankers and other financial professionals in recent months. One can also see a distinct change in rhetoric within institutional research. So, while some US newsletter writers and Canadian firms such as Canaccord, Sprott, BMO, or GMP have been promoting resource markets for some time, only in the past few months are we at least starting to see major firms such as Citibank (“Party not over yet”), Merrill Lynch (“A Red Hot Acquisition Market” and “Gold Poised to Move Higher”) or Barclays (“Seismic Shift”) begin to use language until recently rarely seen outside Gold sites, select retail newsletters and Internet message boards. This movement has many implications. The primary one being large financial institutions do not move quickly. As anyone who has studied Max Weber or taken a sociology class can tell you, once they do -- they try to make the most of their effort. Therefore, as these institutions begin to perceive value in the resource sector, and to augment their staff of bankers, analysts and other professionals with relevant expertise, these people will need to do deals and move the product necessary to justify their existence. Institutional managers and funds, however, cannot buy penny stocks, bulletin board listings and many Vancouver or even foreign-listed companies. If they are to participate -- there is a distinct need to bulk up to build the market caps that provide the liquidity and perceived sense of security needed. At the same time, as analysts such as Donald Coxe of BMO Harris like to continually remind us, the resource sector has been depressed so long and dominated by fears of commodity price meltdowns that the industry has shied away from making investments in capacity. As one senior investment banker recently told us “the major oil companies are very reluctant to make any investment that does not make sense at $30. Will prices decline? If you are Exxon it happened to you in the 1980s”. A key point is that a mine is a wasting asset. Gold, silver and other minerals do not replenish the veins that are mined. Neither does energy once extracted reproduce itself. Therefore, the majors are forced to explore or buy those that do. Whether it is more advantageous to have agreements with junior exploration companies on a percentage basis, to buy emerging producers outright, or to initiate Greenfield efforts is subject to debate. But the fact remains that the supply of gold and many other commodities is forecast to decline for the rest of this decade. And should the marginal supplier, namely in the case of gold, the central bank’s begin to slow or cease their sales -- the valuation of exploration companies must also expand as demand simply overwhelms supply. This same paradigm – in which investors are coming to view these resources as a proxy on emerging world growth is also affecting a wide range of other precious and industrial metals, energy and even agricultural and soft commodities. The problem, however, is that investors have been reluctant to finance exploration activity. Recently, however, there are indications this sentiment has started to change. As firms such as Merrill Lynch begin to ask questions such as “Gold Equities - What if Metal Prices Remained ‘Stronger for Longer’” we are also beginning to see a notable increase in the appetite for junior companies. Merrill notes in its March 27th North American Precious Metals Weekly report that “Since September 2005, there have been 20 significant mergers and/or acquisitions (M&A) in the global gold industry (compared to just 5 in the first half of 2005). Merrill goes on to state only two of these transactions have involved senior gold producers (Barrick Gold merging with Placer Dome and selling off certain assets to Goldcorp) and that “the M&A focus has been focused on development deals … with 12 such transactions ….[and] the balance …. was intermediate and mid-tier producers purchasing companies with mines in start up phases (and usually holding several intriguing development projects)”. It is not clear from the Merrill report whether this list includes transactions such as Glamis Gold’s acquisition of Western Silver, but it is important to note there has been substantial interest in other metals as well – both precious and industrial – and this trend also prevails in uranium, energy and other commodity and resource markets. For this reason it should not be surprising the majors are now realizing the cheapest and fastest way to both bulk up their companies and to possess numerous “lottery tickets” on future exploration opportunities is through acquisitions. That is radically transforming the appetite of investors toward junior companies. Whereas early last year one could not give them away, the slow rise that began last summer has progressed to a more manic phase. Since the start of 2006 many of these firms have risen by several 100% in value. One can see this consolidation within the activities of entrepreneurs as well. The most notable example is perhaps the actions of former Goldcorp CEO Robert McEwen. His use of U.S. Gold (USGL.OB) as a vehicle to create what he hopes will be Nevada's top junior exploration company, was arguably one of the developments that set off the current acceleration of interest in the junior market. It included the acquisition of four firms, White Knight Resources (WKR.V), Nevada Pacific (NPG.V), Coral Gold Resources (CGR.V) and Tone Resources (TNS.V). All are part of the Cortez Trend, a part of the Battle Mountain-Eureka Trend in Nevada. Mr. McEwen also surprised the industry last December when he moved to make a C$10 million investment to buy 23.5% of Minera Andes, a firm that describes itself as one that “aggressively explores for gold, silver and copper in Argentina.” Sharp Corrections Remain Inevitable but the Market Environment has Changed Some analysts believe with this activity we have reached a topping phase in the resource market and committed investors can take little comfort in today’s front page Financial Times headline, which screamed “Commodity prices set to soar”. One should, however, always be prepared for the prospect of ongoing and perhaps brutal corrections. That said, while it is always foolish to say “this time it is different”, and we are sure there will be major scares along the way, there are a number of factors that indicate we may not see the lengthy, multi-month corrections of the past few years for some time. The primary reason we make this claim is that major institutions are just beginning to wake up to the promise and potential of the resource market. As a result, the relentless short selling seen in recent years by large hedge funds, speculators and others who either sought to hedge their commodity purchases, earn trading profits, or some would claim to cap potential price rises, is now far more dangerous. As deep-pocketed asset managers enter this market, short sellers no longer can remain totally confident of their ability to shake out and instill fear among small institutions, die-hard retail investors and others who are unable to withstand this pressure without risk or consequences. Their propensity to cover more quickly is evident in the brevity of corrections over the past few months – compound by the latent demand of those who do not yet have sufficient exposure – and who appear to be moving to buy all dips a few cents higher than their competitors. At the same time as sell-side institutions build capacity and more resource companies list on US exchanges, they will do their best to build and amortize their investments, by enlarging the base of investors with an interest in this sector. Two other factors include the still relatively small size of the commodity and metals market and most importantly the fact that strategically-driven M&A operates under a very different time line and valuation metrics than those employed by hot-tempered traders, who are primarily seeking to load up on whichever chart has broken out and lighten on any sign of weakness. As Barclay’s Capital reported in their recent The Commodity Refiner Report, flows into commodity investments have risen from under $5 billion in 1996 to about $80 billion in 2005. That is a huge increase, particularly on a percentage basis, however, $80 billion is far below the market capitalization of many individual Fortune 500 companies. While not insignificant, it does not seem excessively large given soaring demand and rising interest in the resource market. Obviously, on days like April 5th -- when 39 junior companies on the Vancouver Exchange rose over 10%, and the top one -- Aurelian Resources, experiencing a 240% daily rise to give it a market cap of C$68 million, one cannot say this market is without froth. On the other hand, at least as of this writing three trading days later, Aurelian had sustained this gain, indicating this movement does not appear to be a one-day spike caused by momentum buyers. Given there are numerous examples of junior companies that have experienced 20-30-40%+ daily gains in recent weeks, responsible analysts and newsletter writers who focus on this sector cannot help but shake their heads in amazement, while interjecting notes of caution about the prospects for a correction. For example, Laurence Roulston recently headlined a report “A Time for Caution”, with the subtitle “The Outlook remains extremely bullish … but be prepared for short-term volatility” and the Coffin Brothers write “It is hard to imagine anyone looking at metals markets as they entered the this quarter and seeing anything but an overheated situation. When base metals see 4-5% rises in one day. Overheated doesn’t mean over, however, though we have placed a few companies on hold and will continue to that process in coming weeks.” Are Junior Resource Stocks Exhibiting the Same Characteristics as the Dot-Coms? In some ways the current enthusiasm is beginning to be reminiscent of the Internet craze and junior companies said to be exhibiting some of the same characteristics as the dotcoms. Interestingly, the current rally is benefiting one of technologies primary beneficiaries, Bill Gates. The Microsoft chairman's Cascade Investment is the second-largest shareholder in Vancouver, B.C.-based mining company Pan American Silver. His 3.32 million shares of Pan American are valued at about $85.2 million and have tripled since 1999, when Gates made the investment. In any case, many tend to remember only the speculative excess and pain of the dotcom period, and forget that before ending badly, there was a lot of money made in this sector. That phenomenon went on far longer and showed far more upside on less tangible fundamentals than the resource mania now emerging. In addition, while perhaps the subject of another article, the growth of the Internet has unquestionably had a dramatic impact on our lives and after a long correction we appear to be seeing renewed and profitable activity in that area. This indicates while that era may have gotten severely over-extended it was not without value. In any case, many investors who were around during those giddy days now seem to be recognizing the potential of resource investments and many who did not are likely to try and make sure they do not miss the boat this time around. Nevertheless, in light of the heightened risk factors previously cited and all the exaltation of the present moment -- one has to be really careful making new investments into the juniors. This is especially true if one is not already involved. One also has to acknowledge the illiquidity and speculative nature of this sector of the market. There is indeed risk, and with the appreciation that has been seen – it is substantially larger than several months, weeks or even days ago. We would also caution anyone seeking to get involved to start off small and to spread their capital over a number of names or mutual funds and to consider phasing in over time. While holding some big names as well, UNWPX, USERX and PSPFX, all managed by US Global, qualify in this regard. The reason diversity is so important is that it is very difficult or even impossible to know which junior will hit, announce superior drill results or attract a suitor’s eye. If one remains too focused on individual names or a few choices, the resulting portfolio represents more of a high-alpha gamble on the circumstances surrounding a particular country, firm, mine, or management team, rather than a diversified play on the overall junior market. That said, we believe even though periods of downside volatility are inevitable and likely imminent, the underlying fundamentals remain positive and the best is yet to come. As a result, we would advise investors to keep a closer eye on what is now taking place, to consider phasing in and selling what appears to be overextended and only to risk capital that they can lose and commit for this purpose. Selectivity Important in Evaluating Asia, Emerging Markets & Energy InvestmentsAs for the other sectors noted in our previous article, we would be a bit more cautious in allocating new funds to markets such as India, which have exhibited exceedingly strong performance. Korea has also shown strong growth but not to the same extent. This is not because we have lost confidence in this markets – that is certainly not the case -- but rather we think at this time investors need to be more discerning and should try to think more in terms of specific sectors and securities than broad indices. We do, however, remain confident about Japan, particularly in domestically-oriented plays -- which has continued to show strength, even after the end-of the fiscal year accounting that ended on March 31st,. This we believe is a strong positive indicator. In terms of other Asian markets, we remain positive on Singapore, which started to move later than the others and Malaysia, which has lagged its neighbors. Indonesia, blessed with abundant resources and a government that is moving to address its economic problems also remains a strong contender. Thailand is now again interesting as it moves to resolve its present political difficulties with the resignation of its Prime Minister and China and Taiwan are likely to perform well, particularly so long as global liquidity remains rampant. On the Emerging Market side we prefer Asia to Latin America from the perspective that the political noise in the latter is only going to increase going forward -- elections in Peru, Brazil and Mexico, the populist rhetoric from Hugo Chavez in Venezuela and Evo Morales in Bolivia, and a corresponding de-linkage with the United States -- and more intensified search for alternative poles of influence and trade with China, Russia and Europe. While we remain bullish, we acknowledge that risk is on the rise. This comes in part from the massive amount of capital sloshing around in markets, seeking a place to go to work. The recent follies in Iceland and the Middle East, however, are instructive along this line and demonstrate the need for caution and more selectivity in one’s choices. We also remain positive on energy despite -- or in fact because it has been a laggard over the past few months. Energy fundamentals remain strong and while various analysts continue to make predictions over a retreat to $40-50 a barrel oil or less, that strikes us as mostly wishful thinking. While a post-Katrina consolidation was indeed essential, particularly in view of the warmer weather we had this winter, accelerating momentum in the uranium market is one of many indicators telling us short of a major economic or political dislocation it is very unlikely that millions of newly-enfranchised Indians, Chinese, Southeast Asians, Latin Americans, Central and Eastern Europeans, and other citizens of emerging markets – as well as those within recovering economies such as Japan and Western Europe are going to reverse the trend toward higher consumption they have been exhibiting. In fact, as we pointed out in our previous article, the very health of the global economy depends on a shift from over-reliance on the US to other “locomotives” such as those within Japan, Western Europe and the Emerging Markets. Alternative energy now also appears worthy of more serious attention and consideration. Despite Inevitable Volatility, Opportunities Continue to Abound for Patient Investor In conclusion, while the underlying trends remain clearly positive and we still regard global markets as attractive, in particular Asia, Emerging Markets and commodities, we acknowledge the need for more caution. This is due to risks caused by central bank tightening, the extensive buying and appreciation seen in recent months as well as a range of other factors. Commodities, however, are going through what we regard as a second leg – as a larger pool of more mainstream investors enter this market and related firms. That does not mean we will only experience linear growth moving forward without consolidation or corrections. The interest of these investors, however, is pushing up valuations and acknowledging that current economic and demographic trends – most notably from within the BRIC (Brazil, Russia, India and China) and other consumption-starved economies are likely to strengthen demand for many decades to come. At the same time, as liquidity comes into long-cash starved sectors such as mining and energy, we are likely to see an acceleration of the consolidation now emerging. That is because with larger institutions moving to embrace this sector, larger companies and entrepreneurs now have the funding and incentives necessary to invest in longer-term productive assets that have struggled under less-capitalized players. In addition, investors far more prepared than they have been in decades to allocate capital and reward these firms through higher valuations. In our view, however, one is likely to find the best returns at the exploration and junior end of the sector. Unlike the majors, these companies now seem to be valued more from a corporate finance and M&A perspective than one based on their short term trading performance. Ironically, in some ways at least to date, this seems to be making them less prone to the tendency of the majors to trade up and down with every movement in the price of the underlying metal or commodity price. While these firms remain highly speculative and should only be purchased by investors who can deal with the potential for large losses, this allows the chance for much greater appreciation. In addition to the leverage these investments have always possessed, the heightened appetite for exposure to this sector is leading to greater demand for financial products, the underlying resources themselves and hence assets of this kind. While one can count on heightened volatility, shakeouts and continuing corrections – and one might wait for these opportunities to take on additional exposure -- the underlying trend is likely to remain positive and reward the patient investor for many years to come. We thank all of our readers for their continuing feedback and interest and wish investors all the best of luck in complicated markets. By Keith W. Rabin and Scott B. MacDonaldKWR International April 12th, 2006 For more information on KWR International, Inc. and to register for the KWR mailing list, please click here. Keith W. Rabin is President of KWR International, Inc. and Scott B. MacDonald is Senior Managing Director at Aladdin Capital and a Senior Consultant at KWR International. KWR International, Inc. is a consulting firm specializing in the delivery of research, communications and advisory services with a particular emphasis on economic analysis, trade and investment development, public/investor relations, business development, financial transactions and corporate and marketing programs. Our clients include governments, associations, venture companies and multinational corporations; as well as financial institutions, investment managers and professional service firms. The opinions reflected are those of the authors and not necessarily of KWR International, Inc. (KWR) While the information and opinions contained within have been compiled from sources believed to be reliable, KWR does not represent that it is accurate or complete and it should be relied on as such. Accordingly, nothing in this article shall be construed as offering a guarantee of the accuracy or completeness of the information contained herein, or as an offer or solicitation with respect to the purchase or sale of any security. All opinions and estimates are subject to change without notice. KWR International, Inc. staff, consultants and contributors to the KWR International Advisor may at any time have a long or short position in any security or option mentioned. Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant
Associate Editor: Darin Feldman
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