The Good, the Bad and the Ugly

New York Hard Assets Investment Conference 2012 Online Preview

The following market commentary is excerpted from a  presentation at last months’  Prospectors and Developers Association of Canada conference in Toronto. Rick Rule will give a keynote address on “Natural Resource Investing in a Financial Meltdown” on May 14 and also give free workshop and participate in a “Bulls and Bears Panel” on May 15 during the New York Hard Assets Investment Conference.

This year the junior resource sector will present investors and speculators with both unparalleled opportunity and risk. I see a year where unwary sector investors underperform in painful fashion, while discriminating stock pickers perform very well. The following is an overview to put these comments into perspective and to explain our expectations.

Let’s start with the good news for the sector.

The Good

In the U.S. alone, private sector institutions and individuals are estimated to hold in excess of US $8,000,000,000,000 (that’s trillion, with a “T”) in investable cash. Further, as a consequence of artificially low interest rates and rising inflation, savers are turning into speculators as a defense against negative real interest rates. To merely save is to lose money. This is very bullish for speculative equity markets.

Some of this cash should find its way into the resource sector because the resource bull market is still very much intact. In my opinion, we are in a resource super-cycle. Resource supplies are constrained. We are currently witnessing the lingering effects of a twenty-year bear market. Thanks to limited investment in a capital-intensive industry, ongoing dysfunctional credit markets restricting the available project debt needed for large scale resource development, escalating public demand for taxes, royalties, project equity and other forms of social costs, increasing regulatory and political uncertainties, and inflation in wages, energy costs and other inputs, resource supplies are constrained. In the face of tighter supplies, demand is increasing as a consequence of increasing population, rising real incomes and hence rising living standards in emerging and frontier markets. Constrained supply meeting rising demand equals a bull market!

This bull market has generated excellent operating margins for existing participants in most extractive sectors. These margins allow existing participants to reinvest capital to expand operations without diluting current equity holders. Major producers have been depleting their reserves and will need to acquire other companies’ deposits to grow. Issuers are returning capital to shareholders through dividend streams and equity buy-backs, and are also expanding their activities with mergers and acquisitions, all of which are beneficial to resource equity markets. Thanks to volatility and fear, the natural resource sector has lost its luster for the broad investing public. There is lower volume and less buying pressure in many of the stocks, meaning that many stocks are now acceptably priced, and some of them are arguably cheap. The over-valuations that were evident, particularly in the precious metals equity sector have collapsed. Finally, after funding the exploration sector generously for eight years now, I believe that we are at the dawn of a discovery cycle, where new discoveries drive the acquisitions markets and inspire further excitement and investment in the sector as a whole.

The Bad

Despite positive circumstances for the macro resource market trends, the overall economic outlook is poor. The developed markets, especially the US, Japan and Europe, are coming to a “reckoning period,” where they must come to grips with the fact that they have lived beyond their means for three decades, mortgaging their futures. I believe there is precious little unpledged future left to mortgage. As private sector capital becomes unavailable, the government’s response to circumvent a credit crunch has been to engage in what can only be called “counterfeiting.” No matter what it’s titled, (Quantitative Easing, Operation Twist and foreign currency swaps among others) it is the act of printing money, hoping to inflate away the currently unsustainable debt levels and increase interim liquidity. In the US we are taking in less than 40% of what we are spending, borrowing about half the balance, and counterfeiting the rest. Don’t try this at home! The US has in excess of US $12 trillion in on-balance sheet liabilities and an estimated US$65 trillion in off-balance sheet liabilities. It is suggested by the CBO (Congressional Budget Office) that the private (i.e. productive) sector will save approximately US$420 billion or 3% of GDP (GDP estimated at US$14 trillion). Servicing the on-balance sheet liabilities with our saved surplus would be tough enough; servicing the off-balance sheet liabilities is not mathematically possible. And these numbers assume we balance the budget next year…

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