Mike Niehuser: Mining stocks not reflecting record gold prices

Mike Niehuser: Based on gold’s recent price history, it looks like we were a little conservative. Our forecast for 2011 included the price of gold ranging from $1,300/oz. to $1,500/oz. with the potential in the wake of a catalyst to go over $1,600/oz. by year-end.

TGR: With gold prices at record levels, do you attribute weakness in mining stocks to seasonal weakness or is the market forecasting lower gold prices in the near to midterm?

MN: The accuracy of the forecast is not as important as providing a more or less arbitrary gauge for assessing the buoyancy of mining stock prices against the primary metal underlying these companies’ assets. Considering sustained gold prices and softening mining stock prices, we can draw a number of conclusions: One, that gold prices are ahead of themselves and ready for a seasonal correction, or two, markets are signaling lower prices, implying that higher metal prices may not materialize in later years when projects accelerate production. On the contrary, we remain confident in our earlier forecast and see few forces mobilizing to take gold prices lower in the mid to long term.

TGR: Why are you bullish on gold prices?

MN: In normal times, if there is such a thing, we might see a seasonal correction in the spring or following a period of excitement, much like we recently saw with silver approaching record levels a couple months ago. I find it interesting that gold has long since moved through record levels of the late 1970s but has yet to produce a price chart like silver peaking just a couple months ago. Gold prices have been remarkably resilient and appear to be setting a new normal. Considering the excitement for gold at half the price just a couple years ago, and gold stabilizing at record levels, it is somewhat amazing that investors seem almost indifferent.

TGR: What do you credit for breaking seasonal patterns?

MN: We are living in historically uncertain times. A populist uprising against the banks has not taken place in Europe, as banks appear more willing to restructure debts and kick the can down the road, rather than discipline member countries’ loose financial behavior. China appears to be facing both inflation and limits to growth, a new concept for them in recent history, and it’s unclear how they will deal with a discontented population if they increase interest rates. It would appear that the strategy here in the states is to manage interest rates and inflation, at least as they are measured globally, but high commodity prices, high rates of long-term unemployed and anemic growth expose the limits of monetary policy and increasing regulations. In all three instances, government intervention is likely to increase misallocation of resources that will lead to a more extreme correction.

TGR: Are higher gold prices inevitable?

MN: Not necessarily, despite loose monetary policy. With weak demand for credit and investment, and QE2 ending, in the near term we see interest rates declining and unemployment increasing. An uncertain regulatory and tax environment may reduce the velocity of money leading to lower gold and commodity prices in the near term. But the only tool at the Federal Reserve’s disposal, the only one that they appear to understand, is loose monetary policy. It is hard to see how they can back away from a QE3 with indifference toward deficit reduction and the willingness of the Chinese to continue to buy Treasury bonds.

TGR: So you see modest increases in gold prices until inflation becomes a concern?

MN: Yes, as long as low-cost imports from China, financed by Treasury purchases, continue to roll in, deflation rather than inflation remains a concern. Lower growth or production in the United States is eventually inflationary without free trade or allowing wages to fall. “Money illusion” temporarily placates the masses, but only temporarily. In the meantime, should legislators cap the debt or foreign investors require higher rates on Treasuries, the blindfolds will drop from their eyes. Systematic risk and moral hazard have gone global and we are all now “Too Big To Fail.” Gold prices measure the progress of political and market economies. Sustained higher gold prices suggest global failure to maintain confidence or to protect the essential element of currency to be a store of value. The direction of gold prices appears inevitable so it is only a matter of time and severity.

TGR: If gold prices are, on average, ahead of your forecast and in your opinion moving higher, what accounts for the recent softness in demand or prices of mining stocks?

MN: Good question, the easy answer is uncertainty. Not only do we have excessive government intervention, but the world almost daily appears more unstable. Pollsters used to ask people if they felt less secure after 9-11. Now the question is do people feel more secure after Bin Laden’s death? Democracies are inherently unstable. In the nuclear age, lessons may be final. Whether in the Middle East or in the United States, it is not the outcome, but an uncertain journey that increases the risk premium component of interest rates. This clearly decreases the present value of future cash flows. While this may push stock prices down, at some point they bottom and reach equilibrium, and investors may expect abnormally high returns for risk taking. Investors buying in early 2009—deep value investors and true contrarians that held through the spring of 2011—have been richly rewarded. It is starting to feel a lot like the fall of 2008.

TGR: What do you mean?

MN: In the second half of 2008, it seemed like fundamentals didn’t matter. Management teams that executed on guidance for developing projects or production seemed to be punished for any news. Following silver peaking in April, most mining companies have taken a significant haircut. This appears to be from a lack of demand or buying, rather than fundamentals or investors liquidating positions. This has created a similar buying opportunity, not as extreme as 2008, but possibly quite significant. Should gold prices strengthen through the end of the year, lower stock prices should increase the demand for industry consolidation, acquisitions, stock repurchases or value investors. Major mining companies or the Chinese wanting to secure pipelines of production may set off a rally in 2011.

TGR: What are you recommending investors consider when analyzing a company’s prospects?

MN: We believe markets should eventually recognize value and investors should focus on companies with potential to build value that may be recognized. This would include competent management and a balance sheet sufficient to execute on its strategy. Should metal prices provide for positive margins—and $1,500/oz. gold is arguably sufficient for projects to be economic—advancing projects up the value curve should lead to higher stock prices. Because the market may favor production or exploration, we look for companies with near-, mid-, and long-term upside. We believe this may provide the greatest opportunity for companies to gain recognition and secure and retain a shareholder base—in other words, build market capitalization. This characterization of near- to long-term upside fits the full range of producers, advanced development and exploration companies.

TGR: What companies fit this profile?

MN: Minefinders Corp. (TSX:MFL; NYSE:MFN) provides a good example of a producer that has rewarded patient investors by moving into production of gold and silver in Mexico. The company has capable management and has consistently improved the balance sheet by creating additional opportunities. This includes planning to build a mill at their Dolores project, which will increase recoveries and expand the resource, leading to production growth in the near to midterm. The company is also moving closer to a decision on constructing a low-cost La Bolsa gold project and exploring La Virginia. The company is progressing down the path of building near-, mid- and long-term value.

We also were on Brigus Gold Corp.’s (TSX:BRD; NYSE.A:BRD) analyst day visiting their Black Fox gold mine and mill near Timmins, Ontario. Management has succeeded in eliminating the hedge book and reducing debt. Brigus has about $29M in cash and expects to produce over 73 Koz. of gold in 2011 at about $625/oz. As the company ramps up underground outputs with higher grades, production is expected to increase to over a 100 Koz. in 2012 and costs should drop. In addition to this scheduled upside in the near term, the area is known for deep underground gold mining. Brigus has had great exploration success near surface down the trend in the Contact and 147 Zone. Together, this indicates good potential to increase production and the life of the mine. Improving prospects in the near and midterm should lead to Brigus achieving an entirely new investment profile.

While on the subject of producing mines, I would like to mention one interesting deep value company, Kent Exploration Inc. (TSX.V:KEX; OTCPK:KXPLF), which is putting into production its Flagstaff barite mine north of Spokane, Washington. Barite is used as a weighting agent for drill mud. This is important for preventing blow outs like in the Gulf of Mexico. It is really a simple crushing operation of high-grade barite for operations in Canada. The company anticipates cash flow of over $2M/year. Cash generated from this operation should be deployed in advancing the Alexander River gold project in Reefton, New Zealand. This project has a potential historic resource of over .5 Moz. gold. Kent plans to upgrade and expand the resource, which may provide feed for depleting mines in the area. Here again, we see near-term value and mid-term upside. Cash flow reduces dilution typical of exploration companies, and the resource in New Zealand appears to have little recognition in the market.

TGR: What advanced development companies fit your profile?

MN: Geologix Explorations Inc. (TSX:GIX) is rapidly advancing its gold-copper project in Mexico. The company has established a 3.8 Moz. gold equivalent resource supporting an 18-year mine life and has $20M in the bank. It has seven drill rigs turning, which are likely to lead to upgrading the resource classification, if not resource size and grade. It will take about $8.5M to bring the project to prefeasibility in the spring of 2012, and feasibility by year-end. In addition to this near-term upside and expansion of the existing resource, the company has only explored 15 square km. of a 172 square km. land package. It appears to us that they are well positioned to locate additional low-cost gold oxides at surface, which should lead to higher production in the mid to long term. If investors believe in copper along with gold, the substantial amount of news flow coming out over the next 12 months should increase the visibility of the company.

We also think Inter-Citic Minerals Inc. (TSX:ICI) fits this growth profile. The company is advancing its 3.4 Moz. Dachang gold project in Western China to feasibility in late 2011. China has been in the news a lot lately, but Inter-Citic appears to have strong backing from two significant Chinese investors and is well aligned with the largest gold producer in China. Inter-Citic has a long history of development in China, and a manageable political risk. We see good likelihood that the Dachang project will advance to feasibility with low operating and capital costs. There is a good opportunity the company will establish a central operation that could scale with discoveries and other potential mines on their 279 square km. land package. Inter-Citic plans to complete at least 15,000m of exploration drilling, again combining near-, mid- and long-term upside.

TGR: Lastly, what exploration companies do you see having both near- and long-term upside?

MN: These are typically companies with historic or modest resources or with large land positions. Kiska Metals Corp.’s (TSX.V:KSK) Whistler project is about 150 km. northwest of Anchorage, Alaska. Kiska has established a copper-gold resource of over 5 Moz. gold equivalent at its Whistler target and has about $20M in the bank. This could be the first of several copper-gold porphyries discovered on its large 527 square km. land position. We think Kiska is well underway to doubling the resource, is well into a 35,000m drill program, and is approaching the project as if it was a major mining company. The company continues to organize the camp for ongoing exploration, and we suspect that by the end of the day it will be competing with other large gold deposits in Alaska and British Columbia.

Antioquia Gold Inc. (TSX.V:AGD) also is pursuing a rather large land position in Colombia like an experienced mine builder rather than a junior explorer. Antioquia controls over 37,000 hectares in Colombia, but the focus has been on Cisneros, which is about 5,600 hectares. Antioquia has methodically explored Cisneros with mapping soil samples and geophysical surveying that has led to ongoing drill success. The company has also taken on a strategic investor with extensive gold mining experience in similar host rock in Peru. Altogether, Antioquia should enjoy near-term exploration success at Cisneros, as well as other targets over the wider Cisneros project. Over the long term, Antioquia will work to establish strategic partnerships over the balance of its properties.

We also recently visited Revolution Resources Corp.’s (TSX:RV; OTCQX:RVRCF) project in the Champion Hills Trend in the Carolina Slate Belt near Greensboro, North Carolina. Revolution is exploring in an area of the U.S. that is known for the first gold rush, first silver mine and the primary producer of lead for munitions in the Civil War. The project follows the success of Romarco Minerals Inc.’s (TSX:R)4.2 Moz. Haile gold project in South Carolina. Revolution’s land position of 7,500 acres is second only to Romarco with 9,700 acres. Revolution’s land position is also on private land with similar host rock. The area is economically depressed and is surprisingly welcome to mine development. While relatively early, it appears that Revolution is well positioned to repeat Romarco’s experience, now about a $1B market cap, and may become an integral part of Romarco’s growth strategy.

TGR: Thanks for sharing your insights with us, Mike.

Mike Niehuser is the founder of Beacon Rock Research, LLC, which produces research for an institutional audience and focuses in part on precious, base and industrial metals, oil and gas and alternative energy. Previously a vice president and senior equity analyst with the Robins Group, he also worked as an equity analyst with The RedChip Review. He holds a B.S. in finance from the University of Oregon.

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DISCLOSURE:
1) The following companies mentioned in the interview are sponsors of The Gold Report: Minefinders Corp., Brigus Gold Corp., Kent Exploration Inc., Geologix Explorations Inc., Inter-Citic Minerals Inc., Kiska Metals Corp., Antioquia Gold Inc., Revolution Resources Corp.
2) Mike Niehuser: I personally and/or my family own shares of the following companies mentioned in this interview: Minefinders Corp., Brigus Gold Corp., Kent Exploration Inc., Geologix Explorations Inc., Inter-Citic Minerals Inc., Kiska Metals Corp., Antioquia Gold Inc. Revolution Resources Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None.