Gold News

A Deep, Liquid, Transparent Lie

Protecting your portfolio from the ravages of the Currency Wars...
RICK RULE began his career in the securities business in 1974, and is now CEO of Sprott US Holdings Inc, a leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture.
Porter Stansberry founded Stansberry & Associates Investment Research, a private publishing company based in Baltimore, Maryland, in 1999. Together, Stansberry and his research team do exhaustive amounts of real-world independent research, visiting more than 200 companies in order to find what they believe offer the best low-risk investments.
Here they speak to The Gold Report about the upcoming Sprott-Stansberry Vancouver Natural Resource Symposium, and share their strategies for picking good companies no matter what happens on the political front.
The Gold Report: One of the themes of the Sprott-Stansberry Vancouver Natural Resource Symposium at the end of July is "the global currency war". From your perspectives, who are the major stakeholders in this war and what can investors do to protect themselves?
Porter Stansberry: The three major stakeholders in the currency war are the United States, China and Europe. The volatility in those currencies over the last 18 months has been historic. It has resulted in even greater volatility in more minor currencies, including the huge moves that have occurred in the Swiss franc. I expect to see China and the Yuan join the International Monetary Fund (IMF) currency basket, which will lead to a very significant and large move of reserve currencies into the Chinese Yuan. That will definitely have the impact of weakening the Euro and the Dollar.
TGR: Do you expect the Yuan to replace the US Dollar as the world's reserve currency or will there be a dual reserve currency?
Porter Stansberry: I do not believe that the US Dollar will be replaced in the short term. What is significant is that the amount of Dollars held as a reserve around the world has been reduced and continues to decline dramatically. Twenty years ago, US Dollars made up more than 80% of all reserve currencies around the world. Today, that number is closer to 60%. I think after the inclusion of the Yuan, we're going to see the Dollar drop below 50%. This means at the margin it will become harder for the United States to borrow abroad and it will become more difficult for the US to finance its debts.
Rick Rule: I agree with Porter. It's difficult for the Yuan to replace the US Dollar. The Yuan could, however, challenge the hegemony of the US Dollar. I think that the Chinese are making efforts to make their markets more transparent, but the Chinese central government's need for control will make it difficult for the Chinese debt markets to rival the US Dollar's role.
I will tell you why. I questioned an Asian investor at one point about the size of his US Treasury portfolio and commented that I considered the US Treasury to represent return-free risk. He looked at me, smiled and said, "What you say is true, but we still trust you more than we trust each other." When I referred to the US 10-year Treasury as being sort of a fiscal lie, the same man smiled and said, "Yes, but a deep, transparent, liquid lie." I think that's illustrative of where we are in the market now.
Porter Stansberry: Any country whose currency is used as a reserve enjoys tremendous benefits because those currencies gain a significant discount to financing costs. They're able to float huge amounts of credit around the world. Today, almost all currencies are traded primarily in Dollars. The fear is that if the Dollar falls below 50% of the currency basket held by commercial and central banks and insurance companies, there may be a democratization of the way currencies are priced. The huge growth in bilateral trade agreements between Russia and China or China and Australia foreshadow a time where there will be no need at all for those economies to deal in Dollars. That will significantly reduce demand for Dollars held overseas.
TGR: As commodities move to trading outside US Dollars, will we see more volatility in prices?
Porter Stansberry: We are going to see unprecedented volatility in currency values. This has already happened. It makes no sense whatsoever for the Euro to have declined 40% against the Dollar in the last 18 months. These are the two largest economic zones in the world. How can the global economy function if the weights and the measures between these two trading blocks are constantly in such flux? It becomes impossible for producers and consumers to hedge the currency risk because of the volatility and the cost involved in hedging. These are big impediments to global growth and enormous opportunities for speculators. That's great for newsletter publishers and retirees who can trade currencies successfully, but it has a terrible impact on growth and the increasing value of wealth around the world.
TGR: How will this currency war end?
Porter Stansberry: That's the $64,000 question, isn't it, Rick? Currency regimes in the past were always destroyed by volatility. So sooner or later, people desire a currency that is stable. Of the three major players in the currency wars, which currency do you think is most likely to become the most reliable? Do you think it's the Euro, which is falling apart by the seams as the world watches? Is it the Dollar, which supports unfunded liabilities of $200 trillion? Or do you think it's the Yuan, which has a massive labor pool, tremendous domestic savings, giant trade surpluses and huge natural resource capability? I don't think it's very hard to figure out which of those currencies over the long term is going to be the most stable.
TGR: What does that mean for natural resources and the attendees at your conference?
Rick Rule: The currency wars are particularly good for precious metals, which have traditionally fared well in times of fear. It's worth noting that precious metals, unlike most other commodities, respond to both greed and fear. But in my experience, fear has usually been the catalyst that begins to move precious metals higher. The volatility that Porter talks about, particularly downside volatility associated with currency, is what motivates people to store part of their wealth in precious metals.
This connection between currency values and natural resources is evident historically. The increase we saw in natural resource prices in 2001, 2002 and the beginning of 2003 had more to do with the rollover in US Dollars than it did with actual increases in resource prices in other currencies. In 2000, the gold price performed very well in all currencies in the world with the exception of the US Dollar. In 2001, we began to see gold rising in tandem with the US Dollar, and as the US Dollar rolled over, we saw a commodities bull market get underway in earnest. There were fundamental factors associated with the bull market in resources to be sure, particularly emerging markets' demand, but the beginning part of that bull market really was the rollover in purchasing power of the US Dollar. The scenario Porter described will benefit natural resource prices and, by extension, investors who are prepared for the coming shift.
TGR: With the devaluation of the Euro we have already seen, why hasn't fear of further currency erosion resulted in higher gold prices so far?
Porter Stansberry: I don't believe we're likely to see a rise in the gold price in periods where the Dollar is radically strengthening. It has occurred from time to time. It happened in 2005, 2006 and 2007 as inflation heated up in the US and the Dollar was still relatively strong, but it is certainly a very unusual circumstance. I think it's far more likely to see gold rally when there is uncertainty in the currency markets, volatility and a falling Dollar.
Rick Rule: The only explanation I have is that people became very nervous as a consequence of the global financial crisis. The fact that the world as they knew it didn't end caused them to put inordinate faith into the "big thinkers" of the world, the Yellens, Obamas and Merkels, and eased that sense of fear, even if that trust is misplaced.
Additionally, the manipulation of interest rates by what those big thinkers call quantitative easing (QE) – Porter and I call it counterfeiting – has led to a transfer of income from savers to spenders. It has forced savers into riskier means of maintaining wealth and created an equity markets recovery that generates no real jobs.
George Soros famously said that he became a billionaire by finding broadly held public precepts that were wrong and betting against them. It took two and a half years for him to be proved right about the British Pound. After billionaire hedge fund manager John Paulson realized the US mortgage securities markets were doomed in 2005, he spent two years on the bad side of the trade before his intuition paid off. I consider the confidence associated with global debt and the equities market to be a similar anomaly, where sentiment is temporarily stronger than arithmetic, but I can't tell you how long it will take for arithmetic to prevail.
TGR: The TSX Venture Exchange (TSX.V) is off about 90% in real terms. Rick, you have said you are starting to see a bifurcation. Those companies that have strong financials are starting to appreciate, and the many more weak companies are languishing, thus hiding the "recovery" in the natural resource equity market. What needs to change before investors can realize a recovery?
Rick Rule: Three things. First, equities markets and commodities markets generally are cyclical. A market that's down by 90% is exactly 90% more attractive than it was before.
The second thing is the bifurcation I have been talking about. A purging is taking place on the exchange. It's also taking place in the minds of investors and speculators. There is beginning to be more concentration on the best names and a total lack of attention to the worst names, which is healthy. The circumstance that existed in resource markets between 2005 and 2011 was a complete non-acceptance of the concept of risk. People just wanted to be in the market, and they were willing to take any sort of chance. They got what they had coming to them and ran for cover. Now, there is a return, a gradual and begrudging return to be sure, to the TSX Venture.
The third factor is what we have been discussing today, the impact of currencies on commodity prices. We believe that if the economy is fundamentally bad and something happens that calls currencies into question, then the natural resource business, in particular precious metals, will do well. And even if we are wrong and the big thinkers are right, and a real economic recovery is taking place, then resources will do well too, but they'll do well as a consequence of demand. In that case, it won't necessarily be precious metals that will do well, but the energy and the base metals complex will flourish.
When the global natural resources business doesn't earn its cost of capital, which is basically what is happening now, one of two things can happen. Either real resource prices go up or the stuff of civilization – copper, fertilizer, food and energy – ceases to become available. I think that investors should ask themselves which of the two outcomes is more likely.
TGR: What will happen to the energy and mining companies on the down side of that bifurcation? Will they go bankrupt or be consolidated?
Rick Rule: Yes and yes. Bankruptcies are very good. I think another important function of the conference will be to bring home to attendees that probably 80% of the companies on the TSX.V are worthless. If you took every public resource junior in the world and merged them together to form one company called Junior Explore Co., in a very good year that company would lose $2 billion, and in a bad year it would lose $5bn.
So the question becomes: What is the industry worth as a whole? Is it worth 6 times losses, 9 times losses, 15 times losses? That pessimism ignores the fact that the best 10% of the companies on the exchange generate such fantastic performance that they add legitimacy and occasionally luster to a sector that is overall a massive loser. The conference is focused on discriminating between the good, the bad and the ugly. Most investors, including institutional investors, don't take enough time and don't have enough expertise to segregate.
The good news is that companies exhibiting at the conference are all either a Stansberry recommendation or a Sprott fund position. The fact that we have money and reputation at risk doesn't mean that they're all going to be successful, but it sure means that we've studied them and we believe they're a decent opportunity. That makes the job of segregating much easier for attendees.
TGR: How important is political risk and jurisdiction to your decision about adding to your coverage list or fund?
Rick Rule: It's fourth place for me. Quality of deposit; quality of management, particularly management experience specifically correlated with the task at hand; and financial capability all come ahead of political risk.
TGR: Do you look at the same factors in the same order when it comes to energy companies – quality of deposit, quality of management and quality of balance sheet before political risk? Or do geopolitical factors impact supply and demand more in oil and gas?
Rick Rule: Many of your readers will remember the old Purolator oil filter commercial with a greasy mechanic holding up an oil filter with the message, "You can pay me now," pointing to a $10 oil filter, "or you can pay me later," pointing to a $5,000 blown engine. That's where the entire commodity markets are now. If you could keep the oil price in the $65-75 per barrel range, producers would adjust and the oil industry could earn its cost of capital. If the oil price were to fall to $45 and stay there for three years, it would destroy productive capacity and the oil price would go to $150 five years out. It is very much a "pay me now or pay me later" scenario for commodities.
Porter Stansberry: Rick knows me as a long-time energy bear. I have believed since 2007 that we were very likely to have a secular increase in production of hydrocarbons because I saw the crazy increases to capital spending that were going on across the industry. I didn't understand anything about fracking or horizontal drilling until about 2010, when I first learned about the Eagle Ford. So I didn't know how exactly companies were going to discover it, but I knew they were throwing so much money at it that it was inevitable that they would find it, and when they did they would produce too much.
Rick Rule: I would argue that it hasn't been so much an increase in production that's pushed down the oil price. The increase in production is more an American and Canadian phenomenon largely offset by decreases in Mexico, Venezuela and elsewhere. The real reason for the decline in oil prices has been maintaining steady production in the face of declining demand as a consequence of a world economic recovery that didn't occur.
Going back to the capital-intensive nature of shale, I think there are two things that you need to consider. One is that the economic shale deposits are much less ubiquitous than is commonly believed. Six or seven counties account for most of the economic shale production in each of the deposits, Bakken, the Eagle Ford and the Marcellus.
The second thing is that capital is a constraint to technological innovation, and both equity capital and debt capital may not be as available to the North American exploration and production industry as it has been in the last eight years. I believe that capital will be less available and, hence, more expensive. That will be an important determinant in future production decisions. I don't think that we have to pay that piper yet because my understanding is that there are as many as 20,000 wells that have been drilled to hold leases and still need to be completed. So we have some pretty good fairway.
Most people also fail to consider the production tail. The production profiles associated with artificial fracturing are hyperbolic, meaning that the flow rates decline by 60 or 70% the first year and then by 50% the year after. So effectively all the net present value happens in the first two years, then you have a very long tail, which is of course free. But when you slow down the pace of drilling, the pace of decline production relative to conventional oil and gas is extremely stiff.
Investors also need to understand that the competitive nature of 50 or 60 operators trying different fracking methods in North America will continue to result in technological advances not possible in a country like China, where one state agency is charged with following the protocol to meet a quota. Plus, the advanced capital markets in the US and Canada make increased production possible at a rate not imaginable in other places.
TGR: I just interviewed Marin Katusa and he suggested looking to the US and Canada for uranium investments. He believes the fact that US imports 94% of the uranium it needs to power its nuclear facilities is dangerous and an opportunity to develop domestic supplies. Do you share his same concerns?
Rick Rule: I disagree when it comes to US supplies. Uranium is extremely fungible. The biggest supplier of US uranium for a substantial period of time has been Russia and I suspect will continue to be Russia. US utilities hold an average in excess of four years' uranium supply. It could be that capital markets reward US production better than they reward production in other parts of the world as a consequence of the ethnocentricity, but the opportunities to invest in the US in the uranium business are constrained by deposit size.
I agree with Marin on the importance of Canadian uranium opportunities. The Athabasca Basin is the Persian Gulf of uranium. While US in situ leach deposits may be 3 or 4 million pounds, Athabasca Basin deposits are consistently in excess of 100 million. Athabasca Basin grades are measured in%s rather than parts per million. But I wouldn't constrain myself as a uranium investor geographically in response to political concerns.
TGR: What is the one thing you hope readers will take away from this interview?
Porter Stansberry: I think now is a fantastic time to build expertise in the resource space. The best way to do that is to meet the people involved in it. If you're serious about putting some capital to work in resources, the key is to know the people and know the cycles. That's exactly what you're going to learn if you come to the Sprott-Stansberry conference.
Rick Rule: I would hold out just one tickler. Porter and I are working on a joint project, which assuming we get regulatory approval, we will unveil at the conference. That's all I'll say.
TGR: Gentlemen, thank you for your time.

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