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Barry Allan: Stage Is Set for Stellar Silver Performance
Source: The Gold Report; interviewed by Karen Roche, Publisher (12/4/09)
The first quarter—historically a tough period for gold—is around the corner. Research Capital's equity team lead and senior mining analyst Barry Allan remains absolutely optimistic about the king of metals' long-term outlook for a variety of reasons, and in this exclusive Gold Report interview talks about some of the emerging companies whose deposits portend the next generation of gold mines. But in the meantime, he says silver will slip into the limelight for what's likely to prove a stellar performance.
The Gold Report: When we interviewed you last March, you were very bullish on gold and silver, partly because demand for gold is being driven by investors rather than jewelry and also by worldwide currency crises, particularly problems with the U.S. dollar. Gold is now approaching $1,200 an ounce, and central banks have shifted from selling to buying gold. What's your impression of where we are in this precious metals bull market now?
Barry Allan: It's fair to say that all the ingredients we talked about in March have really come to fruition and quite dramatically so. I recently saw statistics in our financial Globe and Mail about fundamental purchasing of gold by the average person. We are seeing unprecedented hoarding rates, as far as people putting gold in safety deposit boxes is concerned, but also a continuing evolution in the amount of gold going into exchange traded funds, ETFs. And as you pointed out, we have seen this material shift by central bankers. It's now fashionable to actually to own gold as part of their foreign holdings.
I am a bit concerned that gold is becoming too fashionable, that it is now not only mainstream thinking that you need some gold, but it's actually approaching a point where gold is occupying the forefront of a lot of people's attention. Short term, that worries me a little. Nevertheless, while we might have some short-term weakness, prospects for the U.S. dollar and interest rates still suggest that in certainly U.S. dollar terms, my expectations for gold a year from now are higher than where we are now.
TGR: What do you mean by the short-term weakness?
BA: In the near term we are always cautious about the seasonality element, which basically says that gold gets into a tough environment toward the end of January or February. It certainly has been the case for the last number of years; and I have no reason to suspect that will change. We typically go into the doldrums before the beginning of spring. But with that caveat, we continue to be optimistic on both gold and silver. We don't really see the dynamic of the market changing all that much over the long-term.
TGR: A lot of people who see this current market rally as a bear market rally are calling for a correction; in fact some are even calling for a crash. If the market does crash, will gold and silver decouple or pull back with the general market?
BA: My expectation is to see a certain amount of correction in gold. I do not expect a decoupling. Gold has become fairly tied to investment opportunities and prospects in the sense that if we get into a tough equity market, you're going to see some profits taken in gold as well. The more you say gold is an investment vehicle, the more it will behave like other investment vehicles. If we're having a general contraction in equity markets, I find it hard to believe that we wouldn't have some correction in gold—certainly gold equities, but also in the price of gold itself.
TGR: But aren't the metals often viewed as a hedge against downturns?
BA: Yes, but on a practical basis people will take profits. Gold is certainly a hedge against currencies, but if the market is correcting, why would I sell my equities and go straight to currencies? Wouldn't I go to gold? It's that kind of logic. The practical part of it, though which I have seen over the years, is that any time we've had an equity market correction, we've always had a correction in the commodity price as well. I do not expect that to decouple. It may be less of a phenomenon, but I don't expect a surge in bullion price if equity markets roll over.
TGR: Silver prices have done very well this year, along with gold, but they're still a lot of "silver bugs" who expect it to start to increase relative to gold due to the gold-silver ratio. What do you think will happen with silver?
BA: That's a fair comment. Certainly what we've been tracking and saying is that silver has lagged gold. History has shown us that silver often does catch up and tends to overreact, so we fully anticipate that gold and silver will come back into line. We haven't changed our thesis; we've always argued that the best predictor for silver price is the price of gold. We look at gold as our benchmark. The R-squared value of the correlation between gold and silver is the best predictor for silver prices, with the caveat that it tends to lag and then it tends to overshoot. For that reason, particularly now, we'd be more apt to be in silver than gold.
TGR: Because you're expecting silver to catch up.
BA: That's correct. Yes. And that's based on a little more concern about gold and a little more correction in the ratio.
TGR: Are you looking for silver to have that increase before the seasonality downturn? Or is that more likely to occur throughout 2010?
BA: Probably more in the seasonality period. I would expect the ratio to correct itself with silver holding up a bit better than gold. We'll certainly see silver trying to catch up while we're in this bullish environment for gold, but I really think it's going to be a matter of gold coming more into line with silver, at least for that period. After that, they'll march together again. But again, in a rising gold price environment, silver almost always lags.
TGR: So, even though you're expecting a really nice run up in silver, both silver and gold had a very nice run 2009. With this tremendous increase in metals prices, why aren't most of the mining companies generating a corresponding increase in profits?
BA: That is a really good question, and there is no really good answer. Gold companies have not distinguished themselves in capitalizing on this gold price environment to get earnings to the bottom line. Quite often, we've had disappointments, start-up issues, grade problems, and on and on we go—to the extent that the rise in bullion prices is not translating into bottom-line performance. We have had an immoderate amount of disappointments by our senior gold companies, whereby mines haven't started up as planned or on schedule. There's a long list of woes we could go through—but in short, they just haven't delivered the goods. That's one reason why gold equities have lagged gold commodity prices.
TGR: That's not a bad answer. But are there other reasons?
BA: Another factor is the evolution of ETFs. If you want gold price exposure, you now have a much more liquid way of getting that exposure. An ETF gives you that exposure without exploration exposure or operating cost exposure and other things that go along with owning part of a mining company—and, by the way, these companies have not gotten earnings to the bottom line anyway. The two phenomena together have been the primary reasons that gold equities have underperformed the commodity.
TGR: Why aren't the mining companies successful at getting earnings to the bottom line?
BA: This gets back to the fundamental logic of gold mining. When gold prices rise, gold miners will go to a more marginal ore grade. By virtue of extracting lower cut-off grades, they cannot achieve the same percentage increase in bottom-line performance that they would if they were taking higher-quality stuff. It's a little bit a self-defeating kind of process, but they're looking to get the maximum level of cash flow. Their margin with a poorer-quality ore grades is not quite as large as it would have been, but total cash flow generated is better because they're producing more ounces.
Some of this is going on as we speak. You've seen the evolution of large low-grade deposits, which are classic examples of what I've described. In Canada—it's been more common in other parts of the world—we are now rather uniformly getting one-gram–ore-grade deposits in hard rock, or even less, and that's a direct result of these high gold prices. So high gold prices do have consequences on the bottom-line performance of gold companies.
TGR: Let's continue down that line of thought about the effect of increasing gold prices on ore quality for a moment. Suppose we have a settling out of the gold price or a correction that takes it back to $1,000. In that case, these lower-grade deposits might no longer be attractive from a cash flow standpoint. And if that happens, won't we run into a supply issue?
BA: No, because a good portion of the mines will have been built already. For example, Osisko Mining Corporation (TSX:OSK) is building a very large, low-grade mine with economics based on gold in the $850 area. They've raised all the capital to build this mine, so I expect them to complete construction and operate it. Even if gold were to go as far down as $850, they wouldn't care because the economics are based on the capital required to build the mine plus an acceptable rate of return on that capital. So even at $850 gold, they could say, "We are going to produce. We may not get the return on capital we wanted, but we'll still make positive cash flow."
TGR: At what point would supply become an issue?
BA: You'd see a contraction in gold supply only if you start getting into the marginal cost of production, which probably sits in the high $400s now.
TGR: So as some of these new mines come on board, like Osisko's, we actually might begin to see a rapidly increasing margin in the next year or so.
TGR: As the higher grade ore starts to come up top?
BA: In Osisko's case, a higher grade ore is a bit difficult. Osisko's economics works by economies-of-scale. It's low margin, high volume. That's where they make money. With the gold prices we're looking at now, they'll be rolling in cash. They'll be producing 600,000 ounces of gold annually. They're going to be a very significant gold producer in Canada, and considering their original return on capital was based on $850 gold, they're going to have a wonderful margin if these gold prices hold up and will become a very significant cash flow generator.
TGR: Any other stories like that?
BA: Detour Gold Corporation (TSX:DGC) is a very, very similar kind of proposition. Detour has not raised the funding required for building the mine and has not started construction, but the economics and value proposition are almost identical to that of Osisko. Both of them will be close to being the largest gold producers we have in this part of the world.
TGR: When we spoke in March, you talked about the balance between low and high-beta stocks, with the relative weight in your portfolio depending on whether you were bullish or bearish on the sector. To what extent is your portfolio weighted toward more high-beta stocks now?
BA: In the summer months we'd gone to a high-beta strategy in the sense that we wanted exposure to gold. We continue to be there at this point and—unless something catastrophic happens here in the short term, which I am not anticipating—we'll probably stay there right on into early 2010. We have a technical analyst and I watch charts fairly closely. If we see some rapid outbreak in gold price, even more than we've already had, I might go to a defensive mode a little bit more quickly. By that I mean go to a low-beta strategy in gold stocks—go to low-cost operators; low-debt kinds of companies; away from the smaller market cap companies and into the bigger cap companies—and maybe straight to ETFs as well. If there's an outbreak in gold price, I am going to say, "You know what, I'm going to take profits here, thank you very much."
TGR: More of a profit-taking thing.
BA: Absolutely. Going to a defensive strategy comes back to an overall phenomenon I've observed in analyzing some 29 years' worth of quarterly data. The end of the first quarter is an extremely high-risk period for gold. Better than 45% of the time, we get into a problem at the end of the first quarter. About 30% of the time it will be in the second quarter. It's rarely a fourth-quarter problem; only 5% of the time have we been in an ugly gold price environment in the fourth quarter.
Because of this pattern, I'd need something—something like a very dramatic move up by gold—to really shake my fundamental seasonality strategy and go to a more defensive posture now. Some people are saying we've had it already, but I'm not there. . . yet.
TGR: You've indicated that you're looking for the "next generation" of Canadian gold mines. Why not stick with the ones that are already up and have cash flow and profit margins?
BA: When gold stocks move, you have tiering of companies. The big tier moves first, then the intermediates, then the juniors. Then you see the last tier, the very high-risk stocks—the people who are in exploration mode or in development mode. That's where we've gone to try and engineer our performance. So, for example, in a company like Rubicon Minerals Corp. (TSX:RMX) (NYSE.A:RBY), we see its resource continue to grow. We don't have any idea yet of how big this resource is in terms of a 43-101, but they just continue to intersect gold with more drilling. As they drill more, they intersect more gold. If you take all the intersections and as you get more data, the averages of the intersections become more soundly based. It shows that they have something of significant proportions. It really has nothing to do with gold price, per se, but as I said, it has everything to do with successfully adding to the ounce count. We're looking for value, creation of value, and that's where we see our next generation of emerging gold producers.
TGR: Any examples you could share?
BA: I mentioned Detour. Osisko is the closest and is under construction. San Gold Corporation (TSX-V:SGR) fits that mold as well. This is about exploration, about good-quality exploration, adding good-quality exploration ounces to the ounce count. And in the case of San Gold, they'll be getting some of that to the production curve more quickly than what you'd normally expect because it's all within kilometers of an established infrastructure.
Lake Shore Gold Corp. (TSX:LSG) is another company that is just about to come into production, and there's one in the high north, Comaplex Minerals Corp. (TSX:CMF). Not a lot of people have heard about Comaplex. Their deposit is in Nunavut, near Rankin Inlet. It's a very high-quality reserve. Last year they went underground and took a 25,000-ton bulk sample to test the mining continuity and actual ore grade, and were pleasantly surprised. Underground the deposit is averaging about 21-gram material before dilution. Comaplex is progressing through to feasibility and ultimately production, and it is another one of this generation of companies I've been talking about.
So we do have a number of these companies that are at various stages of exploration, advanced exploration and development, and over the next three or four years they will come into production. The emergence of these very high-quality underground mines and large, lower-grade open pits portends our next generation of gold mines.
TGR: When do you expect some of these companies to start coming out with 43-101s?
BA: In the case of Rubicon, which is probably the one that most people are focused on, the nature of the deposit is such that it is very difficult to prove by just drilling it. Red Lake (Ontario) history has shown the only way operators can prove up deposits and develop acceptable 43-101s is to get underground and take bulk samples.
That's vastly different from open-pit deposits, which you can drill off of with a greater degree of certainty because they are generally uniform and near-surface deposits. The continuities of open-pit deposits are generally in terms of tens of meters, whereas in underground circumstances you're talking to two or three meters. So Rubicon needs to get underground to explore actually continuity of the ore - and they have a plan to do so by the second half of next year. It would only be after that program that they would be in a position to be able to speak with authority about the nature of the resource.
Both San Gold and Lake Shore are also in the high-grade, underground mine camps. Lake Shore has a resource statement already. San Gold has been underground for five months on their new ore zones; so we're expecting its 43-101 by the end of the year. Rubicon is by far the earliest-stage company we've talked about.
TGR: Who are some of other very early-stage, near-production juniors in the next-generation camp?
BA: Osisko is in that category. Generally, when I say "junior," I'm talking about an emerging company or a producing company with a market cap of under a billion dollars or so. A whole bunch of other junior-type companies that are producing gold are not included in my next generation of gold mines because they have been around a while, have less than 100,000 ounces and typically don't generate operating profit. We have a number companies in Canada like that, such as Claude Resources Inc. (NYSE/AMEX:CGR), Richmont Mines Inc. (NYSE/AMEX:RIC), Kirkland Lake Gold Inc. (TSX/AIM:KGI). They're producing gold, but they're very small and have limited prospects for a major expansion.
TGR: One of the ways some investors tend to play in any commodity is with associated services companies. Do drilling company equities, for instance, complement holdings in a metals portfolio?
BA: Historically yes, although the drilling companies are very levered to the exploration cycle, and over the past 12 months the different strategies employed by the drilling companies have dramatically affected their top- and bottom-line performance. The big driller in Canada, Major Drilling Group International Inc. (TSX:MDI), has been the hardest hit, with valuation off fairly dramatically. That said, they are looking at a better position now. In fact, I would say that the drilling industry for 2010 is going to improve overall. We are currently in the budgetary cycle for 2010; in other words, 2010 budgets are being put to boards now and being approved. Early indications we've seen—and it's pretty uniform—is that the next year's exploration expenditures will be much better than what we saw for 2009.
Drilling programs will be heavily influenced by gold price, but generally speaking, metal prices across the board have held up a lot better than what anyone would have anticipated. So there is confidence that we've seen the worst. So I'm fully anticipating that 2010 will be a much better exploration year.
Some of our smaller drillers, though, such like Foraco International (TSX:FAR) and Orbit Garant Drilling (TSX:OGD), continued to do well throughout the cycle. They specialize in a niche, have very good business strategies and focus on a unique type of drilling. For them, it's as if there's been no change in the exploration cycle at all. They continue to generate good levels of operating results and cash flow. They've really had no decline in top or bottom-line performance over the last 12 months. It's been the big guys like Major Drilling and Boart Longyear (ASX: BLY) that have felt the contraction of the worldwide exploration the most. In any event, as I've said, I believe 2010 will change for the better for the drillers.
TGR: Are these smaller companies in a position to ramp up and capitalize on some of this increased budget for exploration?
BA: The reason the smaller drillers have done well and have not experienced decline with exploration expenditures off very dramatically is that they very, very carefully pick their clients and pick what they do well. They're very niche-focused, and one-fifth the size of a Major Drilling in number of drill rigs, market cap and so on. So they're quite cautious about going out and trying to take advantage of this environment. They will tell you point blank that they don't want to get involved with companies that don't match their strategy. That stance has held them in good stead to this point in time, and I don't see that changing all that much. They have nice little businesses, and they're going to continue to grow them organically, but it's not going to be major acquisitions on their horizons.
Consistently ranked as one of Canada's top 10 gold and precious metals mining analysts, Research Capital's Barry Allan has more than 15 years' experience in the mining sector that brings together geological fieldwork, equity research and finance. Before joining Research Capital in 1997, he was a Gold and Precious Metals Mining Analyst with Gordon Capital, BZW and Prudential Bache. Prior to equity research, Barry was a member of the specialist finance group at CIBC, one of Canada's largest financiers of mining projects. Barry earned his B.Sc. (Geology) and MBA degrees from Dalhousie University.
1) Karen Roche, of The Gold Report, conducted this interview. She personally and/or her family own none of the companies mentioned in this interview.
2) The following companies mentioned in the interview are sponsors of The Gold Report: San Gold Corporation, Rubicon Minerals
3) Barry Allan—I personally and/or my family do not own the following companies mentioned in this interview. Research Capital Corporation has been involved in corporate transactions with Rubicon Minerals, Comaplex, and Foraco International.
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