Turning Rocks into Gold

You would think that rising Gold Prices mean rising Gold Mining output. But no...

GEOLOGIST Brent Cook, editor of Exploration Insights newsletter, has examined mining properties in more than 60 countries over his 25-year career, learning the investment side of the business from legendary master Rick Rule.

Cook has earned a reputation for recognizing which Junior Gold Miners have the best chance of beating the odds, and where rocks have the greatest potential for producing profit.

In this exclusive interview with The Gold Report, he shares some of his insights into Gold Mining output, the junior sector, and the investment landscape today.

The Gold Report: Brent, as we look at the various programs that Barack and the Congress are going to put in place, what's your feeling for Mr. Obama's first 100 days and how will that impact the markets?

Brent Cook: I've probably got a bit of different view on Obama than lot of the hard money crowd. I'm not as jaundiced about him – I think he's very intelligent, insightful and, in the overall picture of things, I see him bringing a lot more credibility to the United States.

I believe the Rule of Law, transparency, shutting down Guantanamo and so are are very important to setting America in the right direction on the international scene. This is positive and more in line with America's core values.

In terms of the economy, I don't know that anyone really has a chance of fixing that in 100 days or a year or two years. We've got serious problems out there. We're looking at a $6 trillion public deficit, and up to another $2 trillion more in various bailout packages and stimulus packages someone has to loan us the money for. That's a 30% increase in debt this year. The massive increase is happening as tax revenue, which was about $2.5 trillion in '07, is headed south. The US deficit was $168 billion in 2007, a prosperous year, and this year it's projected to be $400 and something billion. So expecting any sort of fix in 100 days – it just ain't going to happen.

I think Obama realizes that, and he's going to prepare the rest of us for the reality of this. My plan, if elected, would have been to give every individual taxpayer one year of no taxes. Anyway, neither he nor anyone is going to fix this quickly.

TGR: If that's true, what would be the impact on the market?

Brent Cook: I think people are still under the impression that the government, Ben, Hank and whatever new guys or gals who show up, can save us, which is ironic given they're the same folks – and Greenspan – who essentially drove us into this ditch. They were completely blind driving into it and now we're expecting them to drive us out? Give me a break. The public still doesn't realizing how bad the situation is or how long it is likely to last.

I think short term we may get a rally here, but six months from now, nine months from now, a year from now, I think it's not going to look better and the market's going to reflect that.

TGR: So with that said, there's still demand for certain materials such as base and precious metals. Will certain sectors come out of this with some type of buoyancy?

Brent Cook: Looking at the metals market, which is what I know best, we've had – just by my count – on the order of 125 base metal mines shut down, suspended and put on hold over the past six months. On top of that, we've got dozens of companies that are in the process of proving up resources, converting the resources to reserves or in the permitting stage, but are now completely halted. I don't see base metal prices increasing much over the next few years, at least. Basically, all the discoveries for the next bull market are sitting idle right now. As base metal prices slowly increase as the global economy rights itself, all the pent-up supply will act as a cap to rapid price increases – barring another speculative binge. So I don't see much hope for base metal prices, certainly on an inflation-adjusted basis. In terms of exploration, the world doesn't need another porphyry copper or VMS deposit [volcanogenic massive sulfide ore].

TGR: So you're saying once the base metals price comes back, those projects will come back on line. So until then, that's not a sector to look at investing in.

Brent Cook: No. If someone's positive on base metals – and I think it's more important to act on your read of the data than mine – now would be a great time to buy the producers with the lowest production costs and low debt. Those are the companies that will survive and buy the assets they feel offer value. But I am not focusing there.

TGR: What about precious metals?

Brent Cook: That's a different story. I think precious metals will be entering a new era of respect over the next few years at least. Gold is going to do quite well over the long run and silver, which to some degree mirrors the gold price, will also do well.

Gold is real money. Silver is often lumped into that category as well by investors. I do think the fundamentals for silver are going to improve just because 70% of silver production comes out of base metal deposits. With these base metal deposits being shut down, the silver supply or production is going to drop off and that should be positive for the silver price.

TGR: But if silver goes up high enough, wouldn't that justify keeping those projects going?

Brent Cook: It's on a case-by-case basis. Let's look at what people call silver mines, the silver companies. There are very few pure silver companies. Almost every silver company is really a lead, zinc, and silver production company and they need this lead and zinc credit to make these things profitable. I look at a lot of the mines and companies operating in Mexico and Peru. By and large the so-called silver companies are underground mining silver grades in, say, the 150 to 275 grams per tonne range with decent zinc and lead credits. That's not a very good deposit, really. It's marginal at best and these things don't make money, especially if you add in exploration and forward development costs.

These mines generally produce a lead-zinc-silver concentrate that then gets shipped to a smelter and the smelter pays you X amount for the lead, zinc, and silver in that concentrate. When zinc was $1.50 to $2.00, you made good money. Now at 50 cents, you can see what the problem is.

Plus, because there's such a low demand for base metals, the smelters are paying even less for the zinc in concentrate. It used to be they'd pay, let's say, 70% of the spot zinc price back to the mining company. Now I've seen them only getting about 50% of the value of zinc in their concentrate. If zinc's 50 cents, which is low, they're only getting 25 cents once the smelter takes their cut.

TGR: So regarding silver, you're saying because the base metal mines are shutting down, the production of silver is decreasing, at the same time the demand will increase because of the financial situation worldwide?

Brent Cook: I think so.

TGR: And gold is a slightly different story, though. Is Gold Mining production increasing?

Brent Cook: No. This is interesting. Since about 2001, gold production has been declining slightly. Yet, starting in 2001, the price of gold up till now has increased about $600. That's counter intuitive. You would think that as the Gold Price rose, gold production would rise. That hasn't happened.

The reasons behind that are that it's getting harder and harder to find good deposits. We've got mining companies decreasing their reserves by 78 million ounces a year coupled with dearth of new gold discoveries coming online. We've got mining companies trying to increase their production and unable to do so, so their production profile is falling off.

TGR: So if the lack of new discoveries and the current projects don't have the capability of scaling up, we are facing almost a finite amount of gold right now.

Brent Cook: Yes, finite amount of economically viable gold deposits. There is no shortage of uneconomic gold deposits out there. Trust me, I have looked. Here are some interesting statistics. Historical world gold production comes to about 4.4 billion ounces. That's worth about $3.5 trillion today. Interesting number, given the deficits the US is looking at of $8 trillion.

Over the past 100 and some odd years, the gold inflation rate, which is essentially the amount of new gold that's been produced and brought into the market, has averaged around 2.2%. That's across that whole time frame. So we've got gold inflation of about 2.2%, which now is only in the order of 1.5%, due to the declining production. Compare that with the global monetary inflation, which averages – depending on the country and such – considerably more than that. So right now we're looking at a declining gold production or a declining inflation rate of gold, and rapidly increasing monetary inflation. Those two things alone are going to be very positive for the Gold Price.

TGR: This has been true for the last five months. Why hasn't gold taken off?

Brent Cook: My suspicion is that what we've got is a massive global deleveraging and what that means is people are selling everything they possibly can to get liquid. Gold is one of the most liquid instruments out there, so I think we're seeing people, or more likely funds and countries, selling gold to raise cash. And, on top of that, the most liquid currency is the US Dollar, so people have been buying the US Dollar because it's perceived as safe.

TGR: So as we look at Gold Bullion increasing in value – and I think that's pretty much what everyone's saying – there are basically three ways to get in if you're Ready to Buy Gold. One is to buy physical and hold it, to buy a Gold ETF, or to buy the production companies. What's your thought on those?

Brent Cook: I personally don't own any physical gold to speak of. I guess because everything else in my net worth is so linked to the Gold Price – my newsletter, investments and life, I don't need it sitting in my basement, too. The Gold ETFs and leveraged instruments on top of that make a lot of sense to me. I have done some of that and I will do more.

I personally believe we're going to see gold get whacked again in the near future as the realization of what's happening to the banks in Europe and across the world starts to take effect and people grasp that things are not going to get better very quickly and that we've got serious problems. I think that'll drop the Gold Price for the very reason I gave you before, that people need to get liquid and they run to the dollar. That's what I'm looking for to jump in a lot harder into the Gold ETFs and the leveraged instruments.

Gold Mining companies have not performed as well as they should have and I think it's because of the deleveraging that's been happening, as well as they really haven't provided much shareholder value. As the gold price has gone up, the production costs have gone up. So margins aren't increasing that much, even though the Gold Price is going up.

So I would selectively be buying some gold mining companies, very selectively, and make sure those companies are not big base metal producers. Actually, that's something that the large companies have done in order to keep their production up. They bought or brought base metal deposits like porphyry copper-gold systems into production because of the gold credits. When copper was at $3 to $4, it lowered their perceived gold production costs and increased their profitability. With copper at $1.50 or less, their profitability is down a lot. So make sure it's a pure gold company with decent margins.

TGR: So what level of Gold Prices do you think would make these stocks turn?

Brent Cook: Until we see a real sustained increase in the price of gold, it's hard for me to see big investors – the big funds and generalist funds – come into the Gold Market. These guys need to see profit margins or at least a sustained trend. That said, there is a fair bit of money just waiting for a five-day gold rally to jump in feet first. How quickly people forget.

TGR: But Gold Prices could still go up and the stock could still go down.

Brent Cook: Yes, definitely.

TGR: Do you think the real big investors are waiting to see the stock prices stabilize or are they watching the Gold Price?

Brent Cook: I think they're watching gold and the margins. They need to see that these companies can actually make money as a business. Most of the usual investors in the gold sector don't really look at it as a business that you're supposed to make money in. I think they look at it more in terms of what they think Spot Gold is going to do.

I think that you need to look at these gold companies as a business. What are the margins they're going to make on producing their gold going forward?

TGR: On top of being a geologist, I believe you also look at the financial health of the companies that you're recommending and look at.

Brent Cook: Yes. Mining and exploration are very capital-intensive businesses.

TGR: Do you have any companies that are both the pure gold plays and also have margins?

Brent Cook: I don't spend a lot of time on the big cap mining companies. There's too much to really understand to get an edge over the competition. You need an edge in this business and for me that is understanding the fine geologic details that will either show up a fatal flaw or indicate a true discovery. So I stick pretty much to the smaller cap gold companies and, in fact, mostly the exploration-stage companies. Not many people put the time in to figure these early stage companies out.

I was very, very cautious last year and I will be again this year. I think it's going to be very tough out there. The problem we've got is that it's no longer a market where someone's going to buy your mistake. You're going to live with your mistakes. There's a lot I'm following, a lot of things I look at and keep on my radar screen and watch, but there's not that many companies I actually buy. Over the whole of last year, we purchased 13 stocks in the portfolio and right now we own 10. Just to plug myself here, I was down 12% on the year.

TGR: Brent, thank you so much for your time.