Gold Mining Outlook

A guess at what will happen from here, if not when...

AS THE ECONOMIC CRISIS unfolds, writes Olivier Garret of Casey Research, a sense of deep uncertainty has begun to pervade the market in gold miners' stocks, as everything else.

Even dyed-in-the-wool risk takers admit that they don't know what to think anymore. Inflation, deflation, recession, depression, recovery...there are so many vagaries that it appears to be anyone's guess what will happen next.

Despite the current, volatile environment, however, our team here at Casey Research maintain their core prediction: that a highly inflationary cycle is not far off. While we, along with several external experts, continuously review our assumptions and conclusions – and also encourage dissenting opinions and analysis to avoid biased conclusions – so far we keep returning to our views about what's coming.

But the hardest thing to predict remains not what will happen, but when.

The way I see it, the swift, far-reaching and mostly ill-conceived reactions from most of the world's governments under the leadership of two apprentice sorcerers (Ben Bernanke and Hank Paulson in Washington) have until now resulted in a widespread run for an exit to nowhere, a deep credit freeze, and total and indiscriminate mistrust in the market and all of its players.

The fact remains that in the last year, many principles long rooted in the success of capitalism have been thrown out of the window.

• First, market players discovered that the longest-lasting asset bubble in history was made possible by poor regulations (as opposed to lack thereof), plus greed, and the misunderstood and misrepresented risks of credit derivatives;
• Second, we found out the real meaning of "too big to fail". If a business is large enough and has enough clout, it doesn't matter how poorly managed it has been, it will be bailed out at the expense of taxpayers (us) and investors (us again);
• Third, we found that the rating systems the financial markets relied on have been misleading investors and failing to identify the riskiest asset classes. As a result, investors and all other economic agents are left with no means of evaluating risk as they conduct business, hence the credit freeze and rush to cash;
• Fourth, to add to the confusion, the US Federal Reserve and Treasury, followed by many other monetary authorities, have been altering the rules of the game by the minute (buying toxic waste at face value, bailing out certain financial institutions but not others, becoming shareholders of several behemoths in the banking and insurance industry, and trumping all accepted rules of creditors' and stakeholders' priority, prohibiting the shorting of certain classes of assets on a moment's notice);
• Last but not least, the US presidency, weakened by almost eight years of mismanagement, has continued to show total lack of leadership. It has empowered a couple of technocrats to run the country's finances without leadership until a new administration gets in and, hopefully quickly, figures out what to do.
• To make matters worse, the European Union has shown its ugliest face and demonstrated a fact we all truly knew but didn't want to recognize until recently – that economic unity and coordination is easy in good times but almost impossible when the going gets tough.

No wonder economic actors are wreaking havoc as they race for shelter.

Add to this the fact that all natural resources have been hammered by the combination of a credit freeze and lower real and anticipated demand from most industrial nations. Then look at junior Gold Mining exploration stocks – our specialty, which is a very thinly traded asset class and rightfully considered to be higher risk – and how they've been hammered twice as hard as the rest of the markets.

Hence the performance of the TSX-V, which has lost 76% in the last year and 30% in the past 30 days alone. The fact that many hedge funds had to unwind large positions in such a small market – just as they did in Gold Futures – certainly did not help.

But what does this mean for investors in this market?

We all have suffered significant losses in our portfolios, and although our choices may have reduced some of the downside, quality companies have been hit almost as hard as fly-by-night juniors with no future. Several of our favored companies are trading at or below cash value, and they get no goodwill for the significant assets and outstanding management teams they have assembled.

Although there is no way to tell when we will hit a bottom in these markets, we believe that once tax-loss selling season is over and reality settles in, we will see the beginning of a slow recovery process for the best of the juniors.

Investors who have the ability to stay the course and are invested in the highest-quality juniors, we believe, will recover from their losses and benefit from what will eventually be another bull market in commodities.

In our thesis, precious metals such as Gold Bullion – as well as agriculture, followed by certain segments of the energy sector – will lead the way to widespread price increases across the range of commodities. While we daren't predict the exact timing of this run, the fundamentals are in place once the world's economy takes a turn for the better or at least stabilizes somewhat.

Here is why:

1. The current crisis is taking tremendous amounts of needed capacity off the supply pipeline. Whether it be energy, base metals, or agricultural goods, projects to bring online expensive oilfields and alternative fuel sources are being shelved and will take years to get back on track;
2. Mines are closing and projects are being canceled, thereby removing much of the supply; the credit squeeze is cutting down on agricultural investment, and working capital constraints will dramatically limit supply;
3. The world's demographics are not changing, nor are the aspirations of a hard-working, fast-growing middle class in emerging economies. The changes that drove commodity markets up for the last few years are long lasting and real;
4. Peak Oil and peak-everything-else that comes out the ground. There is limited supply for many commodities, and although there are alternatives (curbing consumption and finding alternative sources of energy), it takes large investments to do so. In current markets, many of these investments are going to be put aside until the next crisis/shortage hits – at which point we will have years of a commodities bull run before an equilibrium is reached;
5. We anticipate that China, Russia, and India will take advantage of low commodity prices to secure very large, long-term supply commitments while the Western world licks its wounds and tries to recover. By then, an even larger portion of the world's available resources may no longer be available on the markets, for example oil and gas.

In the last edition of Casey Energy Opportunities, for example, Marin Katusa pondered how the United States plans to replace the supply of uranium when its HEU program with Russia is set to expire in 2013. The answer is that the US will struggle to replace 40% of its needs, and this will benefit a handful of US suppliers with proven reserves. Currently shares of these companies, which have the cash to develop resources or are already producing with positive cash flows, are incredibly cheap – a win-win situation. Eventually similar opportunities will come from copper and strategic metals.

We also expect the world to continue to be a very unstable place, where regional conflicts can quickly spread and spin out of control, with obvious impact on the smooth supply of key commodities (Gulf region, Nigeria, former Soviet republics, to name a few). In fact, a widespread financial crisis could precipitate those events as conflicts are often linked to economic hardship.

Meantime, the unprecedented deficits, a wave of bailouts, and growth in the money creation by central banks in the Western world will eventually lead to massive inflation. In the United States alone, the base money supply has increased by 50% since early September. This will unequivocally reverse the current short-term deflationary pressures and lead to a steep devaluation of the Dollar and other major currencies.

At that point, precious metals and all tangible assets are poised for a strong recovery.

So, if you ask for my opinion, I am still bullish on the resource sector. Indeed, I'm more bullish than ever. Juniors are juniors, and when things go wrong, they get beaten down. The strong ones with great teams and lots of cash will survive and prosper, the others will disappear. When commodities come back with a vengeance, there will be fewer companies, almost all with good projects...and those who are invested in these few companies will see a very sizeable appreciation of their capital as the broader public returns.

It's very hard to be a contrarian investor, especially when all forces seem to be against you, but one thing the markets have taught me is that memory on the Street is unbelievably short.