By JT Long (The Gold Report)
Could an infectious disease kill the monster that has been choking gold and silver prices for more than a year? On the heels of a lively Sprott Precious Metals Roundtable discussion, The Gold Report caught up with investor Eric Sprott to ask how a tragedy in Africa could impact the price of precious metals and mining stocks. We also spoke to his Executive Vice President of Corporate Development John Ciampaglia about a new way to gain exposure to gold.
The Gold Report: Deutsche Bank warned in a recent note that the Ebola virus could impact commodity markets, including gold and cocoa, as it spreads to producing countries in West Africa, particularly Ghana and Mali. In a recent article titled "Ebola, The Tipping Point," you mourned the unnecessary loss of life and predicted 5% less global production next year than this year. Could a lack of supply due to Ebola-related closures really cause the price of gold to rise?
Eric Sprott: There is already a shortage of gold and silver in the markets without a corresponding increase in the price. I wrote an open letter to the World Gold Council questioning its data on China. If you believe the Shanghai Gold Exchange data, China consumes more than 2,000 tons (2 Kt). In 2011, it consumed only about 1 Kt. In the last two years, China has bought an extra 1 Kt gold—25% of a 4 Kt market. If any country came in and bought 25% of the oil market, the wheat market or the orange juice market, the commodity price would not go down. Obviously, the physical gold market is not manifesting itself in the price changes.
There is already a shortage of gold and silver in the markets without a corresponding increase in the price.
We also see that in silver. Last year, Indians bought an extra 18% of the silver market, yet the silver price declined. That's because the price is being run by someone who has avoided the physicality of the market. I hope the U.S. Mint will announce that it has to stop selling 2014 silver because the demand has picked up so much. That's what I expect the Mint to do if it's running out of silver. It would be interesting if some of these futures players were to stand up and demand delivery, because I don't think the Mint could deliver.
I'm really focusing on the impact of Ebola on the demand side. The numbers suggest that Ebola will be difficult to contain. The death rate is incredibly high and it is highly contagious. It has already spread to Spain and the U.S. Unfortunately, the powers that be at the Centers for Disease Control (CDC) and the World Health Organization (WHO) have totally misunderstood and understated what's going on. Four weeks ago the U.S. government magnanimously announced it will spend $22 million to build a 25-bed facility in Liberia. What would 25 beds possibly do in Liberia? Sierra Leone has already given up trying to treat people in hospitals. The country could have 100,000 cases in just a few months. The CDC estimated that we could see between 550,000 and 1.4 million cases by Jan. 20 in just those two countries. There aren't enough hospitals or healthcare workers there to deal with those numbers.
TGR: You called the world's response to the crisis "nothing short of underwhelming." Do you think now that there have been cases in the U.S. that the world health community will take it more seriously?
ES: Unfortunately, recent events have suggested that travel protocols, monitoring programs and hospital procedures are not working. It's a mess of incompetence, and it goes back to central planners focusing on the economy and the stock markets and bond yields. They forget about people and their response is wholly ineffective. When Doctors Without Borders was screaming months ago that it needed more help, nothing happened. No one understood the simple equation of numbers that if you let this thing go, you've lost control. We have certainly lost control in Sierra Leone and Liberia. The Ebola virus doesn't know where the border is and the likelihood of it spreading to Ivory Coast and Ghana is very high. The jury is still out on how the developed counties will do.
TGR: How will an explosion in the number of Ebola cases impact the global economy?
ES: Fear of travel and business disruption is definitely going to have an impact on a fragile economy already weakened by recessions in Europe and Japan. An event like this could have serious negative repercussions because it changes people's behaviors. If people worried about the security of bank deposits start pulling their money out, they would logically want to shift to gold and silver. All of a sudden, investors would come back into these markets and push the price up. No one is considering that. The natural Armageddon of disease could cause a financial Armageddon and precious metals are the natural comfort play.
TGR: Do you think that the commodity markets have already baked that into the precious metals prices?
ES: No, they probably haven't. Crisis-induced asset price weakness puts a terrible strain on the banking system and takes us back to 2008 when people realized they were better off putting money in gold and silver than propping up the banks. As a precious metals investor, my biggest concern is what happened to the banking business during that crisis. The Federal Reserve bailed out the banks, but never fixed the problem. The banks are still overleveraged and negative real interest rates aren't giving accountholders a reason to keep their money there. When people come to that realization en masse is when gold and silver prices will return to where they should already be based on the fundamentals.
Closing mines in Africa would just exacerbate the supply problem and cause things to finally change dramatically to the upside in prices as people publicly acknowledge the fundamentals.
TGR: During your recent Sprott Precious Metals Roundtable, Chief Investment Strategist John Embry pointed out that the gold price could go to $5,000 an ounce, but we would still see less gold coming out of the ground in the next five years because in the current low gold price environment companies are depleting their mines through high grading and cutting back on exploration. That means with or without a health crisis, gold mine supply will fall over the next five years, cutting supply and making existing mining inventory more valuable. Sprott US Holdings CEO Rick Rule agreed that investors need to own the mining shares, but warned that not all gold stocks are created equally. He pointed to the Sprott Gold Miners Exchange Traded Fund (SGDM:NYSE) as an example of a basket of gold mining equities that are chosen based on qualitative company factors and not just market capitalization like most other offerings. How are the companies chosen for that basket?
John Ciampaglia: Sprott Gold Miners ETF aims to track the Sprott Zacks Gold Miners Index, which is designed to identify large and mid-sized companies with attractive investment merit. The Index selects 25 stocks from the investible universe whose historical stock prices have high sensitivity to the price of gold.
The 25 companies are then ranked and weighted using two factors—revenue growth and long-term debt to equity. Revenue growth has been a strong indicator of production growth and the long-term success of a gold producer. The revenue growth screen is based on quarterly revenue growth and measured on a year-over-year basis. Companies with the highest revenue growth scores are rewarded with higher weighting in the Index, while slower growers are penalized. A company like Randgold Resources Ltd. (GOLD:NASDAQ; RRS:LSE), which had revenue growth of 41% in Q2/14 compared to the same quarter in 2013, is currently being rewarded in the Index.
The natural Armageddon of disease could cause a financial Armageddon and precious metals are the natural comfort play.
The Index also uses long-term debt to equity as a factor because companies with higher debt levels tend to have weaker balance sheets, and interest payments erode profitability. A high level of debt can also make a company more vulnerable in a downturn. For this reason, a company like Barrick Gold Corp. (ABX:NYSE), which has a high debt ratio, is currently underrepresented in the Index. Conversely, a company like Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) is currently overweighted because it has zero debt.
The process is dynamic, which means that every quarter the Index rebalances its holdings to incorporate the latest company results into its screening process. This ensures that companies with the highest factor scores are represented in the Index on a quarterly basis.
TGR: The Sprott Gold Miners ETF currently holds a mixture of company types at various stages of development. It includes royalty companies like Silver Wheaton Corp. (SLW:TSX; SLW:NYSE), large caps like Goldcorp Inc. (G:TSX; GG:NYSE), along with intermediate producers like Primero Mining Corp. (PPP:NYSE; P:TSX) and New Gold Inc. (NGD:TSX; NGD:NYSE.MKT). Then you have the near-term producers like NOVAGOLD (NG:TSX; NG:NYSE.MKT). What role does each of those company types play in the Index?
ES: You obviously want a cross-section. In this environment, the royalty companies seem to have done the best. They essentially have almost zero cost. All they have is revenue. Now, the revenue goes down because the price of gold and silver goes down, but you're not going to go broke.
However people invest in precious metals I would like to stress what I said in the roundtable: People need to stay the course. I think the returns can be very large if what should happen is allowed to happen in the physical market. I think it will happen very shortly.
TGR: Thank you for your time, Eric and John.
Source: The Gold Report
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