Britannia Radio

Dear Daily Crux reader, 20%... That's how far the widely-followed CRB commodities index has fallen in the past few months. Many individual commodities have fallen even farther: Copper and crude oil are down 30% from their highs this year... Silver is down 40%... Even gold has fallen over 15%. To help make sense of these moves, we sat down with our friend Rick Rule, founder of Global Resource Investments. Longtime readers know Rick is one of the smartest, most successful resource investors in the world. In this week's interview, Rick shares his latest insights on the resource markets, including why you should expect more of the insane volatility we've seen this year, what he thinks of gold and silver now, and which commodities he thinks are a great buy today. Regards, Justin Brill Managing Editor, The Daily Crux www.thedailycrux.com –––––––––––––––––––––––––––––––––––––––––– The Daily Crux Sunday Interview What one of the world's best commodity investors is thinking now... The Daily Crux: Rick, we've seen some incredible moves in commodities over the past few weeks. What's going on here? Rick Rule: Well, I think we've entered a period of volatility the likes of which most investors – even those who have been doing this as long as I have – have never seen. I expect we'll see the VIX – the volatility index – stuck above 30 for extended periods of time. Commodities markets are already extremely volatile and risky in their own right, and take place in emerging and frontier markets on the fringes of liquidity. So these effects will only be magnified. On the bullish side, it is an absolute truism that emerging markets are slowly becoming freer at the same time the Western markets are becoming less free. So wealth is increasing for the first time in a couple generations in places like the People's Republic of China, India, Mali, and Brazil. Here in the west, when folks earn more money, they might buy an iPad or an iPod and load it up with 1,000 songs... There's no commodity intensity there. But when folks in emerging markets earn more money, the things that they want to buy – that add the most utility to their lives – are commodities dense. The first thing they might do is increase their family's caloric intake from 1,500 or 1,600 calories a day to 2,500 or 2,600 calories a day. They might replace a thatch hut with one made of cinder block and a tin roof. They may upgrade from walking to a bicycle, or from a bicycle to a motor bike. The point is that demand for commodities per capita in emerging and frontier markets is increasing very rapidly, and that's spread over billions of capitas. So the underlying demand for commodities is undergoing an undeniable secular change. There are 2 or 3 billion people in the world who aspire to your standard of living, and increasingly have the means to compete with you for some of it... for much of the commodities. ---------- Advertisement ---------- Gold prospector reveals #1 opportunity in gold right now His latest gold find could pay you 390% this year. Most importantly, the location is one of the most isolated and cutoff regions in the world, so not many folks are aware of this opportunity – yet. Click here for more information. --------------------------------------- On the other hand, the bear case is that world markets – particularly western markets – are heavily over-indebted. And there are structural problems in the world's banking systems. There are going to be big credit contractions – and commodities businesses can't exist without project finance and credit – at the same time the major markets are experiencing both credit volatility and perception volatility. So you are going to see corrections, market failures, and credit failures in resource markets – debt, equities, and commodities – at the same time you see very strong underlying demand for commodities in emerging markets. You can think of it as two great weather systems colliding... one positive and one negative. When two big systems collide, of course you get some extremely turbulent and stormy weather. So that's exactly what you should expect over the next two or three years in the commodity sector. For those people who have an understanding of value, and have the courage and the capital to take advantage of the sharp down moves and the sense to monetize some of the sharp up moves, these will probably be the best speculative times in a generation. But there will be enormous transfers of wealth from the people who play the game poorly to the people who play the game well, and those who play the game poorly aren't going to like it at all. Crux: You mentioned China as one of drivers of the bull case... But do you see a downturn in China playing a role in the bear case as well? Will a slowdown there cause commodity demand to dry up? Rule: I think demand from China may well hit a hiatus. I'm no China expert, but my understanding is that the balance sheets in Chinese banks are extremely opaque. There is a suggestion that the special purpose vehicles set up by some of the Chinese regional and municipal governments have the same "sound" financial structure that WorldCom or Enron had, and an awful lot of credit has been consumed in speculative real estate development that, in certain forms, has far exceeded demand. The other side of China, however – even though it's a Communist country – is that there is no social safety net. As a consequence of that fact, workers in China save... otherwise they would starve. The personal savings rate in China is 30% or 40% of total incomes. The surplus capital thus far has been in some measure allocated by the center, which is always dangerous. But what's healthy in China is the fact that there is both societal and political pressure to save and invest, as opposed to consume. China is a bit of a wildcard. There is the risk of centralized political and social control and the consequent misallocation of capital, which I suspect has been happening and will continue to happen. On the other hand, you have incredible mobilization of capital as a consequence of individual savings and the hard work and tenacity of Chinese people. Perhaps the most important variable is the understanding on the part of the political elite that they need to continue to deliver growth and increase opportunity for the Chinese citizenry. They're terrified of political and social discord, which will inevitably result if they fail. So whether you agree with it or not, the central authorities are spending massive amounts of money on infrastructure. And while I'm no fan of centrally directed economies, one must note the economic growth that was stimulated in the United States with such initiatives as the expansion of electric power to rural areas and the development of the interstate highway system. Those same types of efforts are underway on a massive scale in both India and China now. In the near term, of course, those big infrastructure spends are bullish for resources, because things like asphalt and concrete and copper get consumed as a consequence of building out transportation and electrical infrastructure. At the same time, they stimulate regional economic growth, and greatly increased demands for things like oil to produce the gasoline that gets used on the highways, and natural gas, coal, and uranium to meet the increased demand for power as a consequence of rural electrification. So I think Chinese commodity demand is likely to be constrained, perhaps significantly, in the next 18 months as a consequence of them sorting out the opaque balance sheets of their banks, and dealing with the consequence of real estate overdevelopment. But in the longer term, I think Chinese demand – like other emerging markets generally – will do well because people are becoming a little freer, and hence, a lot richer. Crux: After the big moves of the past couple weeks, I'm sure readers are interested in your thoughts on gold and silver. What do you expect from precious metals going forward? Rule: Well, I have to say I'm not a traditional gold bug, but I do subscribe to the thesis that most gold bugs describe... namely, the bankruptcy of fiat currency. It's important to remember that gold and silver are denominated for trading purposes in U.S. dollars. In a period where the denominator is declining fairly rapidly, the numerator becomes less relevant. So I think that the nominal prices of gold and silver will trend higher. Of course, they won't do it in a straightforward way. I also think it's also safe to say that the easy money in those trades has been made. They went from being distinctly out of favor in the 1990 to 2002 timeframe, to being somewhat more in favor. So I don't think that their rise will be as rapid as it's been in the past, but I think it will be consistent simply as a consequence of the decline in the purchasing power of fiat currency. One thing that adds value to any commodity is scarcity, and it's very difficult to say that the euro or the dollar or any of the fiat lies that we use as currency trading units, are becoming scarcer. They're becoming much, much, more plentiful. The process we've seen a great deal of recently – by which the government issues debt, which it then buys itself – is described politically as quantitative easing. But the traditional phrase for that activity was counterfeiting. It's my own belief, and I think this has been explained well by a couple of your editors, that quantitative easing isn't actually about providing liquidity and stimulus for the economy. It's about the fact that they otherwise couldn't sell this stuff to the people. It truly is counterfeiting, from my point of view. One of the jokes I've made at conferences for years and years is that the U.S. dollar is probably the worst currency in the world, except for all the others. So what I see happening in the currency business is really a race to the bottom. For many years, places like Switzerland and the United States were losing that race. But we Americans, in particular, are extremely competitive. And we've decided at long last that we're going to win every race, including the debasement race. Of course, the Europeans are stout competition in that regard. Unfortunately, as a consequence of this, I think one must be bullish on gold and silver for the intermediate term. That isn't to say of course that they couldn't fall significantly from their current prices. In the 1970 to 1981 bull market in gold – when the gold price went from $35 an ounce to $850 an ounce – I was early in my career and very involved in the markets. In the midst of that gold bull market, in 1975, the gold price fell by half. Of course, it didn't stay down, but the fact is people who were overleveraged and didn't have the cash or courage to hold on could go broke... on the right side of the trade in the biggest commodity bull market in history. That's a sobering lesson. Is there some law written by God, or nature, or Congress – depending on who you believe in – that the price of gold can't fall from $1,600 to $900? None whatsoever. What you need to consider in the context of that price action is, why did it happen? What caused the volatility and what are the likely outcomes? People who were shaken out of gold in 1975, after the price fell from roughly $200 an ounce to $100 an ounce, missed out on a move from 1976 to 1981 from $100 to $850 an ounce. Like I said... there are very sobering lessons there. Despite the volatility, I must say that I'm bullish on gold and silver over the intermediate term, merely as a consequence of the fact that they're denominated in fiat currencies which can be counterfeited. I intend to actively use the volatility to build my physical and paper positions in gold, silver, and precious metals stocks. Crux: You're bullish on gold and silver... Are there any specific commodities that you're intermediate term bearish on? Rule: I'm still bearish on the base metal sector. I think copper probably still has a ways to fall. I am less bearish now on the oil market than I was four weeks ago, because the market took care of some of my bearishness in the near term. I think metallurgical coal is stable to down in the next two or three years. It's had a tremendous run and is due for a rest. It really depends on your timeframe. If you're thinking about the three-month timeframe, I'm probably bearish on all of them... But I don't think in three-month timeframes. People need to understand that commodity prices are essentially the margin between buyers and sellers, and with less credit available and less liquidity in the market, all these things trade lower. Crux: Are there any commodities you're especially bullish on right now? Rule: Absolutely... we're actually building some positions now. For the first time in three years, the outlook for gold and silver stocks in the market is now perceived as bad. As a consequence, they're plummeting in price. Ironically, for the first time in probably six or seven years, we think they represent reasonable value relative to the commodity prices. So we are actively buying gold and silver stocks across the quality trail… from the promising explorers all the way up to the largest producers. We are particularly attracted to the sub-$1 billion market cap companies – the junior producers and advanced explorers – and we are particularly attracted to the ones exploring in West Africa. They've really been beaten up. There's a perception in the west that West African markets are far riskier than major markets, but I think they're less risky than their price action would suggest. West Africa is an exploration terrain that is extremely promising for gold discovery, and importantly, it's an area that's being explored for really the first time in history with modern techniques over the last 10 years. So we think we're in a discovery cycle in West Africa, and the industry will consolidate. We are also very attracted to both the oil and gas sectors over the next five years. The oil sector is attractive because most of the oil that's currently produced worldwide is produced by national oil companies. In other words, it's produced by entities as efficient and well-managed as the post office. For 10 years now, the national oil companies have been diverting sustaining capital from their oil and gas industries to politically expedient domestic spending programs. Unfortunately, in capital intensive businesses like this, if you deprive them of capital, you wreck them. So we have a set of circumstances before us now where we see it as inevitable – not probable, but inevitable – that Mexico, Venezuela, Peru, Ecuador, Indonesia, and perhaps Iran cease to be oil exporters in the next four or five years. This is incredibly profound. That means between 20% and 25% of the world's export crude comes off the market at a time when import demand is growing at 2% compounded. We see sharply higher oil prices five years out, not as a consequence of increased economic activity, but rather as a consequence of production declines that occur because there isn't sustaining capital being put into those oil and gas businesses. This is a very important point. We see a pricing umbrella in natural gas as a consequence of this, as a substitute in North America markets in particular for newly-unavailable imported oil. This is a phenomenon that investors absolutely need to pay attention to, and they need to pay attention to it not in the three-month timeframe, but rather in the three-year, four-year, and five-year timeframe. We think this is very important for both investors and speculators. A third area we like is uranium. Uranium is deeply out of favor and whether people like it or not, it will be an incredibly important part of the world's energy mix for the foreseeable future. Uranium at $42 a pound spot is marginally economic. It would be wise to take note that only about 15% of uranium trades take place in the spot market. The other 85% takes place in the long-term market, and the contractor long-term market is currently at $65 or $70 a pound. Uranium stocks are being priced off the $42 a pound level, but they're drawing their revenues in the $65 or $70 a pound market... So there's an interesting arbitrage there. I think both quotes go higher because the price leader in energy is crude oil, and crude is going to have supply constraints going forward. I have also beaten the drum loudly – and thus far wrongly – for geothermal and hydro. One of my faults as an investor is that I'm almost always early. I think that all forms of energy trade higher in the future, but I think it's important that alternative energy investors understand these are long lead-time, capital-intensive businesses, which have worn out many speculators. But importantly, if you look at a typical seven- or eight-year product cycle in geothermal, we've now gone through about four-and-a-half of those seven or eight years. In other words, a lot of the time risk has been taken out of these stocks. Meanwhile, some of these stocks are trading at 20% to 40% of tangible book, which means that although the businesses are capital intensive, most of the capital has already been spent. Even if you're buying a 6% or 7% internal rate of return business, if you're buying at 25% of book, the rate of return on your investment is in the high 20s. Buying a utility-style business at a 20% rate of return is about the most fun a speculator can have with his or her clothes on. Those are just wonderful trades. Crux: That's a great point. Is there anything else you like now? Rule: It's a bit difficult to play, but we also like the agricultural sector and the agricultural input sector. By agricultural input, I mean things like potash, nitrogen, and phosphate. Like I mentioned earlier, as the world becomes richer, the first thing everyone wants to do is feed their children better. In the west, feeding them better might mean, ironically, feeding them less, but higher-quality foods. In emerging markets –where 1.5 billion people live on less than $1 a day – it typically means more calories and increased protein consumption. That's an extremely important trend on a global basis. Although it's very difficult to buy agricultural stocks – because agriculture has been in such a long-term bear market – paying attention to agricultural investments and paying attention to input investments is something that will do well for people. Finally, I think the most undervalued commodity of all – particularly in the U.S. west or southwest – is probably water. But it's very difficult to play water and it isn't suitable in all regions. Because water is a local business, a good water investment has to happen in a place that's water-scarce. Here in Vancouver, the challenge with water is to make it go away. So having a good source of water supply in British Columbia is not necessarily a valuable thing, but where I live in California, it's a very different matter. In addition to lack of supply, however, people have to be able to afford to pay for it. Unfortunately, although water is in very short supply in Eritrea and Ethiopia, the citizenry there can't afford to pay for it. So you have to have areas where the supply is needed and people can afford to pay for it. I'm talking places like Texas, Arizona, New Mexico, Nevada, California, or outside the U.S. in places like Australia, Chile, and Spain. Water has been supplied politically for the last 40 or 50 years, meaning the price hasn't been set by the market, but rather by political means. Increasingly, what is happening is because we have underpriced water, demand for it has grown faster than supply. And because it's been allocated politically, there hasn't been a rationing mechanism. There's been competition not in the market, but rather competition in the legislature. As I see it, the market has been so totally destroyed and disrupted that when we have a period of water scarcity, particularly in the U.S. west or southwest, we're set for absolutely cataclysmic and explosive price dislocations. This won't happen this year or probably next, because in most of the west – I'm not saying Texas or New Mexico, but in most of the west or southwest, the mountain states, and California – we have a water surplus this year. But for long-term speculators, it's a theme that is certain to play out over the next five or 10 years. Crux: Thank you for talking with us. Rule: You're welcome. Editor's Note: Rick and his team at Global Resource Investments invite all Cruxreaders to take advantage of a no-obligation "buy, hold, and sell" review of your current portfolio. They are available on the web at www.sprottglobal.com , or by phone at 800-477-7853 (or 760-943-3939 outside of the U.S.). Please ask for Anthony Marsh when calling.