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We
are approaching an inflection point in the economy and the metals markets
favorable to precious metals and mining equities.Moving beyond 2008,
investors long in mining and metals equities are no longer burdened by the
combination of redemptionsand tax loss selling. While producers appear less
risky, we see mining and metal equities with development potential as
offeringthe greatest leverage for appreciation in the new year.
Increasing
operating costs in 2007 and declining metal prices in 2008 have increased
development risk and squeezed operating margins. Turmoil in the credit and
housing markets have reduced access to capital, exacerbating a lengthy
decline in both precious and base metals mining equities to the lowest level
in several years.
Slower
levels of economic growth worldwide have led to higher than anticipated
inventories, declining base metal prices, and shelving base metal projects.
As we anticipated, this has produced increased availability of labor and
equipment leading to moderating operating and development costs. While in
many cases, base metal prices have declined to below required levels for
production, precious metal prices remain above real long-term price levels.
Investment Thesis Transitioning: Defensive Strategy for Liquidity
Trap from Commodity Super Cycle
We
suspect that these trends may remain in place until global economic growth
resumes. This includes stable or increasing precious metal prices and
moderate to declining operating costs. Also, considering the decline in
supply of available viable precious metal project to finance, we anticipate a
relative increase in supply of available credit and capital. Despite the
aggregate decline in the market capitalization of mining and metal equities,
and the reduced supply of bankable projects and available credit, the amount
of precious metals in the earth remains constant. While the availability of
metal in the ground is an issue, this characteristic increases its scarcity
and value which is at odds with the money supply, which is made scarce only
by the moral fiber of the government and monetary authorities.
We
base our outlook on Irving Fisher’s Equation of Exchange, or MV=PQ. In
general terms, the velocity of the money supply will be reflected in
inflation and GDP. The left side has been adequately discussed in the
investment and national media. Losses in the financial industry have reduced
bank capital and bankers’ ability and willingness to lend, thereby
retracting available credit and reducing both the supply and velocity of
money. On the right side of the equation we have seen both declining
commodity prices (oil, base metals, housing) and slower economic growth
(lower sales, bankruptcies, layoffs). This suggests a deflationary
environment including a strong dollar and low interest rates, where holding
cash starts to look like making an investment.
The
national media has documented the monetary authorities’ response to
increase GDP by reducing interest rates. The government has also increased
the money supply through the financial and auto industry bail outs. The
incoming administration has also pledged to spur the economy through historic
investment in infrastructure. The government appears sanguine regarding
bankers’ willingness to lend and is making a strong effort to increase
the money supply. There is skepticism as to whether these actions will
produce the desired result.
It
is accepted that the government is increasing the money supply, and should
banks begin to lend, the combination based on the Fisher Equation should lead
to inflation or an increasing GDP. Optimistically, it may take years for
infrastructure projects to commence or for the economy to grow. The only
remaining variable to balance the equation is inflation. As monetary policy
is more art than science, the ability to manage the money supply is suspect.
(In our opinion, the optimal path is to allow the market to manage the
economy to equilibrium by reducing taxes and regulation, leading to higher
levels of productivity and production, none of which is regarded by the
government as a solution). We question the Fed’s ability to smoothly
reduce the money supply commensurate with an increase in lending by bankers
(increasing velocity) resulting in volatility at best and inflation at the
worst.
Precious Metal Production and Development Should Hold Value in 2009
These
factors are favorable to junior precious metals equities. Gold and silver
prices are correlated to inflation, suggesting stable or higher precious
metal prices. Slower economic growth should increase the supply of labor and
equipment for moderating operating expenses. The combination of increased
prices and lower costs may expand margins, increasing the attraction of
precious metal equities by investors. Though investors may recognize the importance
of production and cash flow, the most attractive returns may be in
development and exploration of precious metal resources. We believe that
investors will look for leverage and screen precious metals companies by size
(or resource) and probability of development. Our short list for
consideration includes the following.
NovaGold Resources Inc. (AMEX: NG) has nearly 22 million ounces of gold (plus
4.5 billion pounds of copper and 62 million ounces of silver) in the Measured
and Indicated classification. Barrick Gold Corporation (NYSE: ABX) should
complete a Feasibility Study on the Donlin Creek project, in a 50-50 joint
venture with NovaGold, in early 2009, which should advance much of the 32
million ounces of in-pit Measured and Indicated resource into reserves.
Donlin Creek is one of the world’s greatest undeveloped gold deposits.
In 2007, drill hole DH-1556 intersected 299 meters grading 5.26 g/t (1,573
gram-meters) and DH-1564 intersected 308 meters grading 4.60 g/t (1,417
gram-meters). NovaGold’s other assets include the world-class Galore
Creek polymetalic project and the Rock Creek gold mine. Based on
NovaGold’s share of Donlin Creek alone, at $45 per ounce (less than one
half previous conservative acquisition levels), NovaGold may be valued at more
than $6 per share not including its other assets.
Seabridge Gold Inc. (AMEX: SA) continues to advance its KSM gold-copper
project in British Columbia. KSM is one ofthe world’s largest
undeveloped gold-copper-silver projects with a 19.7 million ounce Indicated
gold resource (plus 5.3 billion pounds of copper and 64 million ounces of
silver). Seabridge’s total gold resources total about 49 million
ounces, or over 1.25 ounces of gold per share. Seabridge reported $11 million
in cash on its balance sheet at the end of its third quarter. On December 15,
2009, Seabridge announced the closing of its Noche Buena project in Mexico
for $25 million in cash. This should fund additional drilling and study at
KSM, which we expect will lead to an increase in the resource and improved
economics by converting waste to ore.
Exeter
Resource Corp. (AMEX: XRA,TSX.V: XRC, Frkt: EXB) continues to advance its Caspiche
gold-copper porphyry project in northern Chile. The project is well situated
between Kinross’ Refugio mine with 6.2 million ounces of gold and the
Barrick/Kinross Cerro Casale project with 25 million ounces of gold (grading
0.69 g/t gold and 0.26% copper). Exeter recently announced drill hole CSD023
at a depth of 102 meters intersecting 603 meters grading 0.89 g/t gold and
0.32% copper (under an oxidized cap of 0.65 g/t gold). Caspiche is open, and
with the current footprint the eventual resource could exceed ten million
ounces of gold. (Barrick acquired 51% of Cerro Casale for $775 million in
October of 2007, roughly eight times the market capitalization of Exeter).
They have three drills on site and are scheduled to produce a resource
estimate by April of 2009. Exeter has one of the largest land positions in
Argentina and Chile, with about $22 million in cash on its balance sheet as
of the end of its third quarter.
South American Silver Corp. (TSX: SAC) is rapidly advancing one of the largest silver resources
in Bolivia. The Malku Khota silver-indium deposit has an Indicated Resource
of 144.6 million ounces of silver and 845,000 kg of indium (an important
industrial mineral used in flat screen televisions). The deposit has good exploration
upside as the resource covers only 3.5 km of the project’s 15 km strike
length. Malku Khota could be one of the largest silver discoveries in South
America, if not the world. Given the change in administrations in the U.S.,
and an upcoming election in Bolivia, there are also good prospects for
improving international relations which should become clearer in January.
Currently, South American is trading at close to cash per share.
Alexco Resource Corporation (AMEX: AXU) is scheduled to make a construction
decision at its high-grade silver and base metal Bellekeno project (inferred
resource of 537,000 tonnes containing 1,016 g/t silver, 13.5% lead and 10.7%
zinc) in its wholly owned Keno Hill silver district in the Yukon Territory.
Construction should be fully funded by the transaction with Silver Wheaton
Corp. (NYSE: SLW). Bellekeno is anticipated to be a modest but high-grade and
highly profitable operation fueling development of the district. Keno Hill
may be early in its production history, producing over 217 million ounces of
silver between 1921 and 1988, and having been explored to depths of only
several hundred meters. We believe the district has the potential to rival
Idaho’s Silver Valley, which has produced over a billion ounces of
silver, and mined to depths of over 5,000 feet.
Etruscan Resources Inc. (TSX: EET) has exceeded anticipated gold production
levels at its Youga project in Burkina Faso. Youga has good potential for
resource expansion at its Ouare´ satellite target, which may lead to
reserve expansion with increased capacity or mine life. The current price
environment is conducive to funding exploration. As Etruscan focused on West
Africa early in the metal cycle, they acquired the largest land position of
any mining company in the region, and consequently may be best positioned for
exploration. We also believe Etruscan is ahead of the curve on diamonds and
rare earth development in southern Africa. Etruscan has a gold resource of
over three million ounces and recently produced a Feasibility Study for its
Agbaou project in Côte d’Ivoire.
Looking Forward to Increasing Demand for Developers in 2009
We
believed that 2008 would favor investment in emerging producers assuming
stable metal prices and moderating operating expenses. These companies
appeared to have proportionally less risk than metals and mining equities on
the exploration end of the spectrum. We see higher metal prices and
moderating costs already increasing the attraction of mining and metal
equities. As exploration companies have declined more than most, we see these
now as potentially having the greatest upside potential. Moving out of a
period of tax loss selling, equities in general may see a real bounce.
Developers may enjoy the greatest appreciation from stable or increasing
precious metal prices, moderating operating or development costs, and
increasing availability of credit or profitability of major producers.
DISCLOSURES:
Beacon Rock Research, LLC provides information and analysis on selected
companies, with a focus on small-cap and micro-cap companies. This report has
been written in accordance with current SEC regulations and the Standards of
Practice developed by the Chartered Financial Analyst Institute (CFAI). Our
research has been conducted by employing analytical practices generally
accepted as standard within the analytical industry. In this instance, a
comparison of financial strength, a bottom-up earnings projection based on a
recovery in the U.S. economy, and relative multiples, were employed. Target
prices are calculated on comparative EPS, sales and book value multiples, and
our knowledge of small-cap markets when enjoying both a sector and a cyclical
rebound. Our conclusions are, by the very nature of forecasting, speculative,
but are also reasonable, supportable and consistent.
Key to disclosures:
1. The research analyst or a member of the research analyst’s household
has a financial interest in the securities of NG, SA, SAC, AXU and EET in the
form of a long position.
2. NG, EET, and AXU have paid SLB Equity Research, LLC., one of its
affiliates, for research coverage, institutional introductions, or other
awareness building services.
3. The
research analyst principally responsible for preparing this research report
received compensation based upon various factors, including SLB Equity
Research, LLC total revenue.
4. This report was prepared exclusively for the benefit of institutional
investors and may or may not receive compensation directly or in soft dollar
arrangements. The analyst, Mike Niehuser, hereby certifies that the research
conclusions and recommendation contained herein accurately reflects his
personal views about the industry, company and shares and also hereby
certifies that no part of his research compensation was or will be directly
or indirectly related to the earnings estimates, target price or
recommendation about the security. The research provided herein should not be
considered a complete analysis of every material fact regarding the
companies, industries or securities named above. The opinions expressed
herein reflect the analysis and judgment of the author on the date of
publication and are subject to change without notice. Facts have been
obtained from sources considered reliable but should not be construed as
complete and are not guaranteed to be accurate. Beacon Rock Research, LLC;
its members; employees and their families may have positions in the
securities covered within the research material above and may make purchases
or sales while this report is in circulation. Additional information on the subject
companies is available upon request.
EQUITY RECOMMENDATION SYSTEM:
Strong Buy Immediate purchase is recommended. The security is expected to
outperform the market over the next six to 12 months. Buy Immediate purchase
is recommended. The security is expected to outperform the market over the
next 12 to 18 months. Hold Holding the stock is recommended because the share
price’s appreciation potential is less than or equal to the market.
Sell The stock has reached the target price objective and/or conditions have
changed sufficiently to alter the outlook for the stock.
EQUITY RISK SYSTEM:
High The security is more volatile than the market and/or the company is more
leveraged than its peer group. Moderate The security has about the same
volatility as the market and/or the company carries a level of leverage in
line with its peer group. Low The security is less volatile than the market
and/or the company is less leveraged than its peer group.
DISTRIBUTION OF RECOMMENDATIONS:
At this time, there are an insufficient number of companies under coverage to
generate usable distribution information or draw any conclusions regarding
biasabout the research methodology. Prospective companies are screened and
evaluated by sales personal and research analysts with the investment thesis
and overall research recommendation developed before the commission is
established.
Mike Niehuser
Beacon Rock Research.com
Mike Niehuser is the founder of
Beacon Rock Research, LLC which produces research for an institutional
audience and focuses on precious, base and industrial metals, and
substitutes, oil and gas, alternative energy, as well as communications and
human resources. Mr. Niehuser was nominated to BrainstormNW magazine's list
of the region's top financial professionals in 2007.
Mr.
Niehuser was previously a senior equity analyst with the Robins Group where
he was a generalist and focused on special situations. Previously he was an
equity analyst with The RedChip Review where he initially followed bank
stocks but expanded to a diverse industry range from heavy industry to
Internet and technology companies.
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