Sprott On Oil and Gold Where Do We Go From Here
Sprott On Oil and Gold Where Do We Go From Here
Sprott On Oil and Gold Where Do We Go From Here
10000
8750
7500
6250
5000
2010-01-29
2011-01-07
2012-01-06
2013-01-04
2014-01-03
2015-01-02
Source: Bloomberg
Why did this three-year old trend suddenly spook the market?
Many analysts and economists have suggested that a lower oil price will not last, as consumers will take advantage of lower
prices to use more oil and thus dispatch with excess supply. So far, we have yet to see this occur.
Oil traders view the oversupply as so severe right now that we have entered a situation known as contango. The price of
oil for delivery a few months from now is higher than the current spot price. As a result, traders buy oil to stockpile, which
they immediately sell on the futures market to lock in a profit. Partly thanks to the contango trade, oil stockpiles in the US
have skyrocketed.
CHART 2: US CRUDE OIL INVENTORIES EXCLUDING STRATEGIC PETROLEUM RESERVES DEPARTMENT OF ENERGY
420000
410000
400000
390000
380000
370000
360000
350000
Jan 04, 2013
Source: Bloomberg
So far, neither the boost to consumption expected from a lower price, nor the reduction in current supply due to US stockpiling
appear to have firmed up the price of oil very substantially.
While the oil price decline has been blamed on surging supply, production growth has been steady over three years, and was
of little concern for most of that period as prices remained comfortably around $90 to $110 per barrel. Meanwhile, the global
economy and particularly the US are supposed to have improved. If so, why isnt oil in higher demand?
In fact, interest rates might go even lower if the Fed did not discourage holding cash by producing heavy amounts of new
dollars and expanding their balance sheets.
In other words, low interest rates may simply be caused by much lower demand for capital and debt. Along with a weak oil
price, weak interest rates suggest an overall sluggish economy, not a broad recovery.
57000
56000
55000
54000
53000
52000
51000
2007-01-01
2008-01-01
2009-01-01
2010-01-01
2011-01-01
2012-01-01
2013-01-01
Source: Bloomberg
The second important reason that many believe in a recovery is the broad boom in both US stocks and bonds. As you can see
in the chart below, almost anyone who got into a broad basket of US stocks over the last 5 years, and stuck with it, would
have made money. Those that got in in early 2011 would have practically doubled their money by now.
20000
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
2008-09-30
2009-06-30
2010-03-31
2010-12-31
2011-09-30
2012-06-30
2013-03-31
2013-12-31
2014-09-30
Source: Bloomberg
If you look at how unlikely a rally in the US stock market seems when you consider all the other indicators suggesting a
weakening economy, you begin to look for what may have tipped balances in favor of US stocks in the midst of a tepid
economic environment.
Ultra-low interest rates are the usual suspects. They allow large corporations those big enough to borrow large amounts of
cash to re-finance their outstanding debt at lower rates, and to re-purchase their own shares using borrowed money. This
results in higher share prices and increasing earnings per share, which in turn help fuel optimism for the stock market.
As you can see in the chart below, about $1.4 trillion of new debt was accumulated between 2011 and 2014.
CHART 5: CORPORATE DEBT RESUMES CLIMB AFTER PAUSE FROM 2008 2010
7600
7400
Billions of US Dollars
7200
7000
6800
6600
6400
6200
6000
5800
5600
2007-01-01
2008-01-01
2009-01-01
2010-01-01
2011-01-01
2012-01-01
2013-01-01
2014-01-01
Thats eerily similar to the amount of corporate buybacks over the same period. Companies were buying back around $105
billion of their own shares each quarter during that time period, which amount to over $1.7 trillion over the same time frame.
CHART 6: BUYBACKS AND BUYBACKS + DIVIDENDS FOR THE S&P 500 ($ BILLIONS)
300
250
200
150
100
50
0
2008-09-30
2011-09-30
2014-09-30
The Wall Street Journal reports that in the first half of 2014, about $315 billion of corporate bonds had been sold in the US to
repay or refinance existing debt.13 That amounts to around a third of total worldwide corporate debt issuances of $995 billion
during that period just to re-finance debts of US companies.
Record US corporate debt issuance is suspicious when businesses are not even re-deploying their existing cash-flows into their
own businesses. In 2014, S&P 500 companies are expected to have spent 95% of profits on buybacks and investor payouts.14
It looks like this new debt is acquired for buybacks and that the stock market rally is in large part a product of cheap credit.
Its possible that the US economy really is back on track and that the oil price drop is just an outlier incident. However,
considered in conjunction with weak commodities overall, weak household earnings growth, and persistently low interest
rates, the alternative explanation that we are living in a period of slowing global growth appears more compelling. This
framework also gives us an explanation for the lower oil price that doesnt depend on speculating about the obscure
machinations of the countries that make up OPEC.
The US Treasury has accumulated debt at break-neck speed over the last 5 years, totaling around $17 trillion.17 This doesnt
even take into account all of the governments other liabilities. The total number has been estimated at around $70 trillion.18
Add to that the stock markets reliance on cheap debt to fund buybacks and re-finance debts, and it is clear that much of the US
economy now revolves around ultra-low interest rates expensive bonds. The economic destruction weve seen in Russia may
forebode events to come in the US if the US Treasury bond ever comes under the same pressure as a barrel of Russian crude.
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80000
75000
70000
65000
60000
55000
50000
2014-11-07
2014-12-05
2015-01-05
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$1 billion.
This means that cash is king and becomes more important the longer this trends keeps going.
CHART 8: CASH HELD BY JUNIOR GOLD MINERS ON TSX VENTURE ($CAD BILLIONS)
4
3
2
1
0
2012-03-01
2012-06-01
2012-09-01
2012-12-01
2013-03-01
2013-06-01
2013-09-01
2013-12-01
2014-03-01
2014-06-01
2014-09-01
2014-12-01
Source: Bloomberg
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.22
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%.23
Pitfalls of Acquisitions
It is highly possible that this time around mining companies that are making acquisitions will focus on low-risk projects.
Perhaps they will swallow up smaller mining companies to get their hands on an asset that is producing already.
Over the last ten years, miners have suffered from failing to operate mines optimally or underestimating costs. That has been
reflected in their share price.
One example in recent memory: in 2006 a major miner acquired a gold-silver-zinc project in Mexico, promising shareholders it
would be a huge multi-decade profit-generator.
The major paid over $6 billion to acquire the project, expecting to spend around $900 million to build the mine and forecasting
production to start just two years later in 2008.
After reviewing the project, the company said it would produce about 30% more ore per year than initially estimated, though
expenses to build the mine would nearly double. They also pushed out the start date for the mine to 2010 from 2008. For good
measure, it added an extra $190 million in sustaining expenditures and pre-operating costs.
When all was said and done, the mine cost $1.7 billion to build, almost twice the initial estimate of $900 million, on top of the
$6 billion purchase price. Production was two years late. When it actually started in 2010, the mine lost around $100 million. In
2011, the mine was still well below full production. Recently, they ran into issues with water availability, and the mine will not
likely reach full production until 2017 at the earliest.
In 2013, the major cut its initial estimate on the total size of the reserves, reducing the life of the mine to 13 years down from
around 20 as originally forecast. On top of these issues, the miner announced litigation against them by the local community.
It isnt a stretch to call the entire acquisition and mine development a corporate disaster. Miners sabotaged themselves with
projects like this one.
They will likely be looking for safe projects.
In the case of Osisko, the company owned a producing mine when it was taken over. For Agnico Eagle and Yamana Gold, who
acquired the company, this eliminated a lot of uncertainty compared to taking over an asset at the exploration stage.
This is the second longest bull market in the last 100 years.
I wouldnt buy shares here. Im not interested.
Now can the market go up another 20 percent? I wasnt 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.
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