The Maven Letter goes out every Wednesday, which meant that last week I published the day Janet Yellen announced the decision to raise interest rates. It has been an interesting few days since.
After gaining in anticipation of the news, US markets spent two days falling. Gold lost US$25 an ounce in a day, then regained more than that. The US dollar climbed for a day, then declined for two.
Is it volatility? Is it real reaction to the impact of a 0.25% rise in rates? Was the rate raise already priced in, minimizing the reaction? Does it matter?
A little of each, I would say. As for whether it matters…yes and no. Yes in that it adds more reason for US dollar strength, which works against commodity prices. No in that 0.25% does not actually have an impact on its own. What will matter is whether the Fed continues to raise rates through 2016, as its outlook chart suggests it will.
In the short term, I think the rate raise will help gold’s seasonal gains. The price was overly depressed in anticipation and now gets to recoup, while also rising on seasonal strength. Since seasonality and specific corporate news events are about the only ways to make money in mining right now, I’ll take it.
Now for this week’s snippet from the Maven Letter. I hope you enjoy. To test drive a subscription, sign up for a free trial.
In The News
It was an icky start to the week for miners. On Monday the metals and mining group of the TSX plunged 6.5%, far outpacing both metal prices and the rest of the market. The loss brought the group’s 2015 decline to 28%.
Of course, at some point losses and unprofitability will create the recovery. It may be unoriginal to say that the cure for low prices is low prices, but it is still very true. And some very bottom-esque developments are taking place.
One such development is the creation of a new Chinese state fund to take on bad debt from struggling miners. In a move akin to the ‘bad bank’ concept in the US, this Chinese fund will support miners like China Minmetals, the country’s biggest metals traders, which is more than US$9.3 billion in debt.
The potential here is deep. China is the major unknown in so many price forecasts, from zinc production to copper stockpiles. State support could mean sustained production for the sake of GDP and jobs, which would be bad for a metal like zinc. But the Chinese are smart and will walk a fine balance between supporting the economy and blindly bolstering miners.
Also, China has a pointed goal in the mining world: to produce the commodities it needs to continue developing. To achieve that, bigger is often better. That is why it was unsurprising to see Zijin Mining president Wang Jianhua quoted saying his company is planning for “bigger transactions…a deal could be as big at US$5 billion” only days after China announced its save-the-struggling-miners fund.
What I see in the comparison is big picture thinking. China needs metals and needs to know its future metals needs are covered. To that, it is willing to make big deals to gain control of significant assets, while also supporting struggling miners. I do not think the same thinking extends all the way down to small-scale zinc operations (which is where much of China’s idle zinc capacity lies) because (1) they do not offer scale and (2) they are environmental liabilities in a country facing catastrophic air quality problems.
There is not going to be a Chinese economy growing at double digit rates propelling the next mining bull market. We had that in 2004-2008 and it was great. At some point, India will be ready, but not tomorrow. But even without massive GDP growth, China will remain a major player in the mining world. For that reason it is great to see it supporting its miners, in acknowledgement that the industry is so weakened right now.
Millrock Resources (TSXV: MRO) is a prospect generator backed by a crew of successful mining investors, including Brent Cook, Rick Rule, and John Tognetti. The company has long been focused on Alaska, where it currently has eight projects. It also has a suite of Mexican assets, acquired through a 2014 takeover.
Now Millrock is stepping south from its head office in Anchorage, with a deal for three big projects in northwest British Columbia. The deal was not easy, involving eight separate agreements to acquire the properties and consolidate royalties.
That challenge is part of how Millrock got the assets. As a small company with much experience negotiating deals, Millrock had the right combination of skills, patience, and focus to make it all happen.
Now the plan is to organize and assess the exploration data to date, which has been done in incoherent fits and starts. This too is something Millrock knows how to do: take a mess of data and find within it a strong exploration story. Then they will shop that story around to potential joint venture partners.
And partners might well be interested. The projects are all in an area known as the Golden Triangle, which is home to some two dozen gold and copper projects – some of them very large, like Galore Creek, and some very high-grade, like Brucejack – and a few mines.
Millrock is actively using the bear market to create opportunity, taking advantage of what president Greg Beischer describes as “tremendous bargains we’ve been able to pick up in the last year and a half.”
Those include the Mexican portfolio of 12 exploration projects and two past-producing gold mines in Alaska.
Millrock just raised $1.33 million, so it will end 2015 with $2.5 million in the bank. The company has 31.7 million shares outstanding. This is a company using its expertise to negotiating deals, assess data, and find new opportunity in a bear market.
News from another prospect generator: Arena Minerals (TSXV: AN). I touched on Arena a few months ago, describing how in 2013 the company optioned a large land packaged from Chilean industrial mineral major SQM. SQM had controlled the land for ages, producing nitrate and iodine from surface layers but never exploring for metals.
Arena has made big strides this year, inking three joint venture deals covering three-quarters of its project. Collectively, the deals should produce 60 to 100 drill holes over the next year, making the Atacama property one of the busier exploration projects in the world. Moreover, partner expenditures and payments will cover Arena’s earn-in requirements, which total US$4.5 million in exploration and US$2.25 million in payments over four years.
The partners are B2 Gold (TSX: BTO), JOGMEC, and Teck Resources (TSX: TCK.B). All three are interested in finding big copper-gold porphyries. In this part of the world – the Atacama Desert northeast of the city of Antofagasta – a surface layer of limestone gravel blocks all geophysics. As a result you have to explore blind, punching a grid of holes through the limestone to see what is underneath.
You might find something big. Mines within 15 km of Arena’s ground currently produce almost 800,000 tonnes of copper annually. This is elephant copper country.
And JOGMEC’s first set of results just returned exactly what they wanted: intercepts showing they might be close to copper.
Mineralized porphyries are surrounded by alteration halos and finding mineralization starts by hitting a halo and then vectoring in. Just today JOGMEC reported that hole 39 intersected a pyrite halo, of the kind found around many known porphyries in the area. It started with a strongly silicified lithocap, which was followed by altered andesites and then intense pyrite mineralization. The hit came from grid drilling, with holes 1.5 km apart.
Now Arena and JOGMEC are working to permit another 241 holes in the area around hole 39.
To the west, B2 Gold started by testing a different kind of target, an epithermal gold vein system, and got some interesting hits. Highlights included 8.13 g/t gold and 29 g/t silver over 2.1 metres and 7.7 g/t gold and 47 g/t silver over 3.8 metres. Combined with earlier trenching results, the drilling defined 800 metres of mineralized strike length.
B2 likely went to that gold-silver target first because the joint venture deal required it to spend a certain amount fairly quickly and the Pampa Paciencia target was defined and ready to go. In the new year B2 plans to return and start probing porphyry targets via grid drilling.
And a week ago Teck also started drilling, with a 3,000-metre program with holes spaced 1.5 km apart in a grid pattern.
Ross Beaty put a nice chunk of cash into Arena. His current holdings represent 12% of the stock and Ross knows what it takes to find copper in the Atacama. The majors partnered with Arena on the property know too.
I like prospect generators because well-negotiated deals provide cash payments and project advancement, enabling these companies to survive in good markets or bad. Arena is an interesting take on the model, what with really only offering one land package, but locking in three majors as partners shows (1) Arena can negotiate and (2) the property has potential. Arena is one to watch.
Almaden Minerals (TSX: AMM) updated the preliminary economic assessment (PEA) for its Ixtaca gold-silver project in Mexico and the new numbers look good.
The PEA needed re-doing because Almaden took advantage of the bear market and bought a mill. For US$6.5 million Almaden picked up a 7,000-tonne-per-day facility (three-stage crushing, gravity, ball mill, flotation circuit, leaching facilities, assays labs, and more), with a deal where most of the cash isn’t due until delivery.
For that US$6.5 million, Almaden has shaved US$70 million off its development costs. I like that kind of cost-reward balance.
The new study also focuses on the high-grade, near-surface, limestone-hosted portions of the deposit, generating a smaller plan (half the throughput) with better returns. Should metal prices improve, the plan could be expanded.
Here are the results, listed along the same parameters as per the old PEA.
Life of mine average annual production
202,000 oz. gold equivalent
108,000 oz. gold equivalent
US$1,200 per oz.
US$1,150 per oz.
US$18 per oz.
US$16 per oz.
Note that the new PEA uses lower gold and silver prices, but yet generates a much stronger post-tax IRR.
The operation would churn through 36 million tonnes of ore averaging 0.76 g/t gold and 47 g/t silver to produce 724,000 oz. gold and 49 million oz. silver over a 13-year mine life. It is not a huge operation, but big enough to interest a mid-tier miner I would think, especially because the larger mine plan is also viable.
On The Macro: It’s Done. Now Can We Pay Attention To Other Things?
She did it. Janet Yellen raised interest rates, lifting the federal funds rate by 25 basis points to 0.25%. It is the first increase since 2006 and happened because Yellen and her colleagues believe the United States is healthy enough that inflation down the road is concerning enough to require action today.
Oh wait. That isn’t how the argument went…
“The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen.”
So went the Committee’s statement. But it is talking around the issue.
You raise rates to limit inflation. By making debt more expensive, higher rates discourage borrowing and encourage saving. The result is slower economic growth and fewer new jobs, instead of high employment, lots of spending, and inflation.
Slower growth is not what the United States needs today. Nor is inflation control.
Inflation is currently 0.2%, nowhere close to Yellen’s target of 2%. Yes, monetary changes render their effects only slowly so you have to raise rates before inflation starts to run away, but no one is the tiniest bit worried about rampant inflation right now.
Employment is a slippery fish. The headline unemployment rate has fallen to 5%, but things look a lot worse when you consider the number of Americans working part time because that’s all they can get or no longer looking for work because their searches have been futile. The full picture is actually pretty tepid.
So neither of the fundamental reasons to raise rates pertains today. Instead, the Fed is raising rates to create breathing room – via the ability to lower rates – should the economy stagnate again. That’s a different reason, one arguably valid but not one Yellen actually mentioned.
Reasons aside, it is done. And what will happen next is anyone’s guess.
The Federal Reserve itself will only say – repeatedly – that rates will increase “gradually”. Seriously, if you had to take a shot every time Yellen said gradual or gradually, you would have been wasted halfway through her press conference.
All that aside, the dot plot showing what the various members of the Federal Reserve Committee believe should happen with rates going forward still suggests four rate hikes in 2016, to reach 1.4% by this time next year. Even the most dovish participant expects a federal rate of almost 1% by the end of 2016. That’s not particularly gradual.
The FOMC dot pot. Each circle shows a member’s rate target for the end of each year
I could pontificate on all the rate hypotheses, but there is little point. Instead, let’s look at how markets reacted today and what it might all mean for gold going forward.
Stock markets around the world had risen in anticipation of the raise. In the US, they rose again on the news. The Dow Jones Industrial Average added 224 points or 1.3% on big volumes while the S&P 500 and the Nasdaq each added 1.5%. European and Asian markets were already closed.
The dollar rose slightly against the euro and the yen. Gold bounced around, dropping initially only to rebound before dropping again. By the end of the day in New York the yellow metal was off only slightly.
In other words, not a lot happened. The next few days will be very interesting. I think the US dollar will try to run; it may or may not succeed. I think gold will do little for a few days while things settle, and then it will rise. I think US markets will bounce up one day and slide back the next, as traders try to outmaneuver the response to a rate increase that was already priced in and therefore will actually make little impact.
And I think that, with the rate increase done, investors might finally start paying attention to other important factors.
Like limited market breadth, incredibly low prices for oil and natural gas, a greenback so strong it is strangling US manufacturers, and rising debt costs for lower quality companies.
That last point is really about junk bonds, which is one area getting increasing attention – and for good reason. There are a couple parts to that story.
First, two small junk bond mutual funds closed up last week; a third shut down on Monday. Third Avenue, Stone Lion, and Lucidus Capital Partners stopped redemptions and started liquidating their holdings to distribute cash to unitholders, because they could no longer sell units at prices that made any sense.
Why? Because the risky assets that made up Third’s units are hard to trade even when times are good, and times are not good for junk bonds. As a result a fifth of Third’s portfolio was illiquid assets that trade so infrequently they don’t even have a price.
We’re talking about bundles of subprime loans dating back to the credit crisis and bank loans to distressed oil and gas companies.
There are lots junk bonds around: in 2009 junk debt issuance totaled $147 billion but it has been above $300 billion every year since. With ultra low interest rates keeping yields on quality bonds low, investors have been drawn to junk bonds for their yields. And to date defaults have been minimal, so the risk has felt reasonable.
Now that is changing. Yields are ramping up as weakness in the energy sector, the strong US dollar, and the anemic global economy increase the risk that issuers will default on these junk bonds. JP Morgan expects the default rate among energy companies to triple in 2016, pulling the overall junk bond default rate to 3% and perhaps 4.5% in 2017.
With junk bond yields pricing that risk is as high today as it was during the 2011 Eurozone crisis, we’ve passed the risk-reward tipping point. After high yields drew investors to junk for several years, investors are now net redeemers from junk bond funds. Hence Third’s struggle with a lack of buyers and liquidity.
In response to Third’s closure announcement, famed investor Carl Icahn tweeted “unfortunately I believe the meltdown in High Yield is just beginning.” In an interview a few hours later he described the junk bond market as “a keg of dynamite that sooner or later will blow up.”
What does it matter to average investors? Several reasons.
First, your portfolio may include mutual funds invested in junk bonds. Like I said, the yields have been very attractive within our ultra-low interest rate reality.
Second, a crisis in junk bonds could spread. The 2008 crisis started as a housing market collapse.
Third, it’s not only junk bonds that are getting more expensive to service. Higher-grade bond yields are getting pulled up too and that means all those companies out there on the lower half of the quality spectrum that wanted to access debt next year simply won’t be able to. Perhaps they planned on a debt issuance for share buybacks (which have been instrumental to the bull market) or to make an acquisition. Not any more, now that debt costs almost twice as much.
Third-and-a-half, the oil sector is hurting and there are plenty of oil patch companies carrying high-yield debt – and more that might need debt to survive until this oil war ends. Expensive junk bonds are going to make a tough year a lot tougher for that lot.
I don’t know how significant the junk bond question will become over the next year. It could rise up as a real issue. It could fade away. But by understanding what is going on and why, we are better equipped for either option.