Low Gold & Silver Prices "Disrupting Mining"
Thursday, 6/19/2014 09:50
Mineable properties will dry up from demise of exploration companies...
MICHAEL BERRY was professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia, and the Wheat First Professor of Investments at James Madison University.
Managing small- and mid-cap value portfolios for Heartland Advisors and Kemper Scudder after that, he now co-edits
The Disruptive Discoveries Journal with his Chris, who founded House Mountain Partners in 2010 to focus on the evolving geopolitical relationship between emerging and developed economies.
Together Mike and Chris Berry analyze the commodity space and junior mining and resource stocks. Here they talk to
The Gold Report's sister title,
The Mining Report, about the importance of disruptive discoveries to help companies beat sideways commodities markets...
The Mining Report: Do you think investing is a skill that is learned or inherited?
Chris Berry: I suppose there's some sort of a gene for analytical ability, but there's no substitute for real-world experience. While my father taught at the Darden School at the University of Virginia, I received a good grounding in theory-based finance and investing. Being out in the investing world for the last 15 years, I've seen what works and what doesn't compared to what you read in a textbook. If the last few years have taught us anything, it's that markets aren't as efficient as academic theory would have us believe.
TMR: Mike, when did you first know that Chris had the knack for investing?
Mike Berry: When I realized that Chris was interested in what I was doing, I sent him to see a good friend to talk to him. I wanted to stand back. Chris came back and said this is what he wanted to do. We have all heard Chris say he loves what he does now. If you love what you're doing, you're going to put a lot of effort into it and you will be successful.
I think it's more environmental than genetic. If you're in a family where everybody's reading The Wall Street Journal all the time, it probably comes more naturally.
In 2000, I came up with the idea of discovery as a different kind of investing discipline. Chris and I have worked together now for four years and he's adapted that into the idea of one of disruptive discovery. This is more defining and in the current market a lot more powerful. We reinforce each other's work. It's a really good relationship in that we're in sync and yet we cover different interests in the destructive or disruptive discovery space.
TMR: You recently changed the name of the publication you co-edit to Disruptive Discoveries Journal. Which industries are being disrupted by macro forces, and how can investors profit?
Chris Berry: A number of macro forces have combined to deliver compelling challenges to the global economy. Globalization has increased trade among countries and benefited many people through higher living standards. The globalization of technology gives a farmer in an emerging market access to the same amount of information that, say, the president of the United States would have had 15 years ago. These two forces are leveling the playing field between East and West. As a result, both challenges and opportunities are presented. This means that as many more people live what I call "commodity-intensive" lifestyles, we're starting to see living standards converge. This has been one of the main factors in stagnant real wage growth in the West in the past decade.
However, the confluence of globalization and technology has begun to raise a number of issues for us in the West. One challenge is an excess of labor. Hundreds of millions of people globally are joining the middle class, which is flattening wage growth. China's middle class is forecast to grow by 200 million in the coming decades. Other countries like India, Indonesia and Mexico are experiencing similar phenomena. Greater access to technology, for example free online education through Coursera or edX, has exacerbated this issue by allowing anyone with an Internet connection to learn what a better life can be. This will continue to have far-reaching consequences for us in the West as the global labor pool expands and can grow at a relatively lower cost of living. Technology, specifically disruptive technology like online education, is simultaneously our best friend and worst enemy. A number of industries are set to be upended and herein lies the opportunity.
We broadened our reach because to thrive in the commodities markets of the future, investors will have to be much more selective about the sectors, the companies and the commodities they look at. I look for companies anywhere along the value chain that have a disruptive technology or unfair competitive advantage. Maybe it's a deposit, maybe it's a technology. These companies offer the opportunities in a global economy awash in labor and capacity.
TMR: Mike, which commodities could benefit from today's disruptive technologies?
Mike Berry: Oil and natural gas come to mind first. Fertilizers and potable water also will benefit. Mineral exploration and recovery will also be revolutionized with new technology. There will be a revolution in energy use, food production, clean mineral production and, therefore, quality of life here and around the world.
It took a decade for hydraulic fracking to take hold, but now it has almost completely restructured the global geopolitics. In the second quarter of 2014 the US produced 8.4 million barrels of oil equivalent, the highest in 26 years. By 2016 the US will produce 12 million barrels of oil a day and will become an exporter of natural gas; it's just a matter of time. That's the best, most recent example of a global disruptive discovery.
It's not about discovering a mine; it's about discovering a technology. I talked recently with someone about plasma torch technology for processing minerals. That technology is still very early in its development, and many in the mining industry don't believe in it, but it has the same potential as fracking has had to oil and gas production to change the economics of the mining industry and impact the geopolitics of the world.
TMR: Many of these technologies are costly. You've said that society needs access to cheap commodities to sustain a high quality of life. Many commodities are now being sold at below the price it takes to produce them. That can't be sustainable. With these new technologies, will prices catch up with the cost of production?
Mike Berry: It takes time to perfect these disruptive discoveries. In the Eagle Ford Shale, the cost of producing a barrel of oil is around $40. The best the Saudis can do using traditional finding and recovery technology is $45 or $50 a barrel. New exploration technologies and recovery technologies in mining will dramatically reduce costs. So the answer to your question is yes.
Chris Berry: Selling commodities below the cost of production is obviously not sustainable. We've seen countless companies either mothball mines or abandon projects altogether in recent months. However, every commodity is different and I think it's important to look individually at the distinct supply-demand dynamic for each. As an example, lithium and rare earth elements (REE) offer different opportunities. Lumping them together and saying ALL energy metals are bad bets now is patently false.
Take uranium, for example. By some accounts, 60% of the uranium being produced today is produced below cost. That can't continue because companies have shareholders who invest based on the capability of management teams to generate profits and cash flow. You can only produce something at a loss for so long before you lose the trust of the markets.
Yet, uranium is a critical component of our energy infrastructure, and it will remain a critical component, despite its challenges. In an environment where the uranium spot price is $28 per pound and the term price is $45/lb, you must find the companies that can exist in low-price environments. Right now, that means in-situ and near-term production plays in the western United States and Kazakhstan. The Athabasca Basin has great grade, but that kind of hard rock isn't economic right now, and won' be until we reach much higher uranium prices.
If you want to invest in uranium right now, I would look at the lowest-cost producers in the industry. Another strategy would be investing in hard rock plays that aren't economic now, but will be at higher uranium prices. I have been discussing this theme of optionality frequently.
TMR: In last year's father-son interview you were sharply divided on the prospect for uranium. Mike, you were adamant that we should be moving to thorium to avoid more Fukushimas. Do you still feel that way?
Mike Berry: One of the great things about our relationship is that we don't always agree, or disagree. We go back and forth. It's a very healthy relationship because you can avoid "drinking your own bathwater." We're still divided on uranium long term.
Uranium is not the best nuclear fuel, thorium is. Thorium is more plentiful and easier to store. The burnt material doesn't give off much plutonium. Its byproducts decay faster and are safer. The problem is that we spent billions of Dollars building and retrofitting uranium-based nuclear plants, as have the Chinese. We're unlikely to move to thorium anytime soon. We'll probably have green energy before we have thorium reactors, although both China and India are working on them.
As to what Chris said about uranium not being ready for a turn, I agree. I don't see a turn for two to five years. That's why we're looking up the value chain for disruptive discovery investment opportunities in technologies, as well as the natural resource discoveries. In the nuclear space small modular reactors provide a disruptive technology. They are in their very early development stages.
TMR: Is that partnership new?
Chris Berry: No. I think it's been overlooked by the market. Lithium Americas is a well-run company with a great asset in a region of the world with history of lithium production. It could be producing a commodity whose demand looks to remain steady and growing. Despite some of the excess in the global economy I spoke about above, lithium has dodged this bullet. Lithium Americas has partnered with one of the more influential multinational companies in the world in the commodity space. It's a really positive story.
Also, as a brief aside, Tesla's recent announcement to not enforce its patents on its Supercharger technology will likely be more revolutionary to the electric vehicle industry in the long run.
TMR: Mike, are you as excited about lithium?
Mike Berry: Yes, very much so, although I'm skeptical about Tesla's plans for its Gigafactory. Battery technology has not yet found its steady-state niche. I am looking for disruptive battery technology today. You can't build a battery factory – or a car factory to use all those batteries – until you're sure you're at the point of sustainability.
Lithium-ion battery technology is clearly important. Whether or not it uses graphite anodes is another issue. It's evolving. We may or may not have the expected demand for lithium and graphite; that's another issue.
I also want to comment on graphene, which is a one-atom thick extract from graphite. In my view disruptive graphene technology is coming but it is a decade or two away from serious cash-flow generation. It will definitely be a disruptive technology when it develops.
TMR: You've emphasized that not all critical metals are alike. There has been lots of volatility among the REEs. Could China's recent announcement of its plan to tax REE producers and require environmental protections be good for non-Chinese companies?
Chris Berry: I hate to sound cynical, but probably not. Every quarter, China makes an announcement about how it's going to change this or that. I don't expect the pronouncements out of China to benefit non-Chinese REE exploration and development plays in the near-term. Remember, this entire supply chain from mining to manufacture now takes place almost exclusively in China. This has been in place for years and we can't expect to change this overnight. Trying to use rulings from entities like the World Trade Organization to get China to dismantle its supply chain in the name of "fairness" is a wrong-headed strategy. Both the private and public sectors in Western economies need to garner the political and economic will to comprise a strategy that can compete with a dominant low-cost Chinese production scenario.
I have a five-year view on the REE space outside of China. That is how long I anticipate it will take an REE junior to achieve commercial production.
An investor has to be very patient and have a long window to make money in the REE junior space.
TMR: Mike, do you agree?
Mike Berry: I certainly agree that the US has given up on supply-chain development. It takes billions of Dollars and lots of time to build a workable and economic supply chain. The Chinese have worked pretty hard at that. They made mistakes, but they learned how to do it. We need to be focused downstream, as well as upstream.
TMR: Mike, you're going to give your biannual talk to the Federal Reserve on the economy next week. What will you say?
Mike Berry: The overriding issue now is the battle among the central banks of the world trying to generate inflation, escape velocity growth and avoid deflation or shrinking of the money supply and their own economies.
I think the world is much more disinflationary or perhaps deflationary than it has been since the Great Depression. The Fed is printing a lot of money. Yes, it's tapering its quantitative easing, but the real money supply in the real economy is not growing. The Fed's money supply is. The Fed has $4.5 trillion of bonds in its portfolio. The real question now is, "How does the Fed raise interest rates without imploding the economy?"
The European Central Bank recently said it was worried about deflation. It instituted a $100 billion program to buy bonds and make loans. So the ECB is now embarking on its own quantitative easing program.
We don't have an economy of robust, sustainable growth. Since 1970 GDP growth has averaged 3.4% coming out of recessions. Here we are 70 months down the road and we can barely sustain 2% growth. Without escape velocity growth, you cannot deal with the amount of debt that was incurred back in 2000-2008. I'm worried that we have three to five years of growth capped by the slow deleveraging process we are in today. That will affect how quickly the capital markets can turn and a new credit cycle evolves to support needed economic growth.
The equity markets are much overvalued. I expect a correction. I think we're facing two to five years of deleveraging. It's not an optimistic presentation in the short term. Longer term, of course, we will recover.
Chris Berry: All of that underpins our disruptive discovery thesis. It's not a viable strategy to hide your head in the sand and not participate in these markets. Rather, you need to find those opportunities that can provide above-average returns in what looks to be a very muted growth profile over the next couple of years. You do this through finding those opportunities that can produce an attractive product either through a disruptive force in their business model or another element. Tesla has done this in the automotive business. Uber (though privately held) has done this in the mass transportation business. Netflix has done this in the streaming video business.
Mike Berry: Remember, there are two kinds of deflation. One comes from excess supply and insufficient demand. That is part of what we're facing now. For example, there is lots of supply of iron, aluminum and copper, but the Chinese have scarfed it all up. Who knows when that will come back and hit us on the head? That's bad deflation: excess supply and stagnant demand. Prices fall, expectations are formed and people start to save, because they can buy the washing machine cheaper next month. As a result, growth spirals into a decline.
The other kind of deflation comes from disruptive discovery. That's where new technological discoveries tend to replace labor or at least cap labor's real disposable income. That's happening in the labor market now. It is struggling to maintain growth in real wages and get people back to work.
The US announced the creation of 217,000 new jobs in May, equal to the number of jobs lost in 2008. Everybody cheered. The problem is there are 15 million more people in this country than in 2008. We still have tremendous excess and underproductive labor. Labor is not being rewarded; productivity, through new discoveries, is being rewarded.
We have both kinds of deflation right now, and we have to clear them out. I just don't see anyone in Washington DC being willing to do what is needed to make that happen.
TMR: A lot of people turn to gold when things are disrupted. The gold price is down from the beginning of the year. What do each of you think of the prospect for gold and silver?
Mike Berry: In terms of the real inflation rate, gold is going to be capped. I think it will test $1200 per ounce, or maybe $1100 per ounce. Wall Street is arrayed against gold right now, and the futures market is the tail that wags the dog in both gold and silver. At $1200 per ounce, we'd be buyers.
I suppose the good news, although it's not really good news, is that exploration is stopping. This will also be disruptive. It's very difficult to raise money for exploration now. There will be very few new gold or silver mines coming on stream. Some of the midtier silver producers will have real problems as silver finds its bottom.
We might have to wait one to three years, but at some point we will run out of mineable gold properties as a result of the demise of exploration companies. I think gold and silver will find the bottom when we start to see marginal costs equal to the price of gold and silver. Then, there will be a bounce.
TMR: Chris, do you agree?
Chris Berry: I still maintain that most commodities will go sideways for a while. It is difficult to say how long this will last, but I can't see many macro catalysts at all auguring for explosive demand in the near-term. You must find low-cost production or disruptive technology stories.
In the precious metals sector, in particular, perception is reality. If you're hearing a lot about disinflation or a lack of inflation, you stop thinking about some of the traditional reasons to buy and hold gold or juniors and producers. That's one of the main reasons they've been pushed down hard and will probably stay there for a while. The perception is that there is no inflation in the economy and economic growth is now stable. The reality is quite different if you've been to a grocery store or filled your car with gas recently.
That doesn't mean gold might not explode to the upside based on world events in the short term. We saw what happened to gold when Vladimir Putin started saber rattling and invaded Ukraine. Gold hit $1380 per ounce, but fell once things calmed down. We are now seeing a similar phenomenon as Iraq devolves into a civil war. I'm unconvinced these singular events can push precious metals prices dramatically higher in the near-term.
You want to watch traditional factors such as supply and demand and exchange-traded funds inflows or outflows.
It's unfortunate that in the past 10 years, gold and silver have turned into asset classes in and of themselves and we've forgotten their traditional roles as stores of value and insurance policies against inflation. As a result, we've seen a lot more volatility with gold and even more with the price of silver.
Mike Berry: In my mind, gold and silver have decoupled. Silver has a huge industrial application; gold does not. With a mere 2% growth rate in the world's economy, industrial uses will shrink until we can get to 3-5% GDP growth.
There are a lot of silver investors out there. Some 245 million ounces of
silver coins and bars were purchased in 2013 – 76% more than 2012 and triple the silver purchased by investors in 2009. When you add in jewelry and silverware purchases, almost 500 Moz silver were purchased in 2013. That does not include industrial usage, investment only. Last year we incurred a 113 Moz deficit in silver supply.
Two years ago, the silver price averaged $35 per ounce; today it is $19 per ounce. Investors must seek companies that can sustain their silver production. They have to be sure that companies can maintain their properties. I think we will find a lot of great silver properties that come free.
We see a lot of private equity players now. They're rolling up properties for pennies on the Dollar when they can. Will silver turn? Yes. When will it turn? I don't know, probably a ways off.
TMR: Chris, in addition to being a son, you're also a father, which, of course, Mike, makes you a grandfather. Is there an investment in a commodity or a stock that you could make now when your children are young that would be worth enough 20 years from now to pay for their college degree?
Chris Berry: I can't think of a single investment or a commodity. You can't control financial markets or the performance of the economy. You have to a have a flexible strategy and a plan in place to weather these storms. Buy and hold is not the only strategy to employ and has been a losing strategy in recent years.
I focus on energy metals and I have a thought process, a timeframe and a strategy for each one of them. The convergence of lifestyles is a real and credible phenomenon. It's not a parabolic boom; it's slow and steady and it will continue. We think that convergence only happens to the extent that people can live more commodity-intensive, more affluent lifestyles. If you're going to invest in the commodity world, whether it's juniors or anywhere along the value chain, you need to have a strategy, a plan and a philosophy that you stick to, but you have to stay flexible enough to adapt when times change. It's not 2006 anymore and you should not be investing as if it is.
The ability to adapt is probably the most important lesson that I hope I can leave to my kids.
TMR: Mike, do you agree?
Mike Berry: One of the things Kate and I did was to make sure that we put stocks in trust for the kids. In the discovery sphere, landing on one major discovery – I'm thinking a world-class Peñasquito, which was one of our big early discoveries – can make you millions. These also increase wealth for everyone. Not all of them work, but you learn so much from every single discovery opportunity, disruptive or not.
I think it is incumbent upon parents to teach their children to understand implications of disruptive discoveries. In terms of a single investment that will put my grandchildren through college, that's a question I would rephrase. What can I teach my grandchildren to focus on as they approach college and life beyond?
The point I would make is the necessity for disruptive discoveries in food production and healthcare. These are areas that we are heavily involved in. Cancer technologies and therapies, stem cell technology and medical device innovations, as well as nutritional discoveries, are of great interest to both of us. (Editor's note: Click here to read Michael Berry's ideas on life science investing).
TMR: Thanks for your time and insights.
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