More than almost ever before, gold is being used for collateral for loans, hedge funds are borrowing to buy it, and Indians are using it for shadow banking loan reserves. There is a loan against a significant proportion of the world’s gold. 

These are not 30-year fixed mortgages, these are not loans that as long as you pay the interest you get to keep the loans. These are collateralized loans. If you miss a payment, the gold will be sold, if the price of gold drops enough, the gold will be sold, if the rest of your portfolio has an issue, the gold can be sold. 

Before this ship can recover, we need to scrape some barnacles off the bottom, clean the oil tank of water, and buy some new spark plugs. 

The barnacles are the junior exploration companies that cannot pay their rent, don’t have assets worth saving, and fail to understand that six months is not going to save them. Some of the projects we have looked at as an industry are not going to make it. Management should have the wisdom to say, “OK, what is an economically feasible project and what will it take for my project to make it to that stage?”  If their project is NEVER going to make it, they should have the wisdom to kill it--and maybe even the company. 

We are in the season of failure and everything looks bleak.

With that said, it’s important to remember it’s OK to fail. We all have failures, and they define our character. 

This week, someone told me that we go through rough market periods so that we can treasure the times when the market moves in our favour. 

I think it’s different than that.  Not everyone can succeed in any business. The ones who can succeed however are those who have failed in the past and learned from the process. You must be able to admit you don’t have a viable plan, and then plan on the next steps. If you panic and ignore the facts, you are dead.  You have to carefully understand what you have, what you do not have, and what your real options are. 

Global Drivers were produced in 2010/2011. We will be releasing summaries of the reports on our blog, Orenthink.

Introduction

We are excited about zinc because we feel supply is limited due to mine capacity and demand will stay relatively robust in any economic scenario.

In the short term, zinc production will be driven by the shutdown of significant mines like Century and a limited number of new mines being built to replace them. However, market visibility is confused by the fact that there are resources in the world that can be developed, and the market can and will stay in oversupply if any major company’s focus is turned onto them. However, we feel that most majors do not really care about the zinc market even when prices spike.

We believe that there will be a global renaissance due to a supply shortage for zinc from about 2012 to 2016, but supply will equal demand in the longer term. We think zinc assets are attractive because the market has not priced in supply shortage, but metallurgy, location, and permitting are going to be the three major drivers when deciding which assets to buy.

Last month the TSX changed the financing rules for junior companies, creating a special class of capital raises at below five cents per share for companies in trouble.

I had a very interesting conversation with a senior market participant. I argued that in weak markets like the one we are currently in, I prefer to see companies shut down and reverted back into shells. I would like to see 20-30% of the junior companies shut down. He argued the market is so weak that if the exchange did not change the rules, some good companies would die alongside the bad companies.

Four years ago the world felt a shock wave similar to doing a polar bear run into the ocean on New Year’s Day. Lots of people and companies were in trouble and could not swim to safety. However, some were able to make it back to shore and have been muddling along the beach ever since.

At this point, however, the beach has turned into a sinkhole of mud. I am seeing more desperation garage sales and many middle class people who have finally spent all of their reserves.

It seems like big companies have shifted to maintaining cash reserves and will not be faced with the desperation financings of 2008 again, but at the same time the average household is losing its grip and going under. This is all anecdotal of course.

There are two theories on how to run exploration companies. First, keep the cash at a bare minimum; only raise what you need and do not run any reserves. Second, over raise by 40% whenever possible; take the dilution and do not run on fumes. If you think the lucky strike is around the corner, the first option is best. However, if you’re smart you run reserves.

A CEO should do two things from a treasury management perspective. One is to control costs, and the second is to keep 20% in reserves at all times. Junior companies should be able to pay bills for the next 12 months while running on fumes. Going into 2009 or 2012 with no reserves could not have been fun.

It is a strong statement to say there is an oligopoly in the iron ore space, but the Big Three have owned the business since 2000 and will continue to do so for the foreseeable future. Is there enough iron ore in the world? Absolutely. Is there enough independent iron ore that can be profitably produced by new mines at $130 per tonne? Absolutely. The only way to keep the price over $130 per tonne without bringing in new suppliers is to have a couple of quarter-long market flush outs over the next 3-4 years.

The iron ore business is not constrained by operating costs. It is a capital-constrained business. Building large mines with the ability to move millions of tonnes of ore and waste cost at least $1 billion, which requires a stable iron ore market. Every time the price crashes, stability disappears and capital stops flowing to the smaller market players.

An asset can be valued in two ways: option value and net present value (NPV). A marginal project can have significant option value.

If you have a permitted mining project with a 22% or 30% IRR discount, reasonable capital costs, and a decent management team, the project will trade on a NPV basis. It will trade on the concept of what cash flows can be expected.

I am having a hard time balancing record gold prices with the rapid growth in capital costs. On one hand, record gold prices should be able to support new mine development, but on the other hand, the huge expansion of oil & gas development in Alberta and continued development in other Canadian industries have driven costs so high to a point where very little is feasible.

Looking at the stream of new company press releases, the mining industry has gone into a panic-and-shock stage of project development. It seems nothing will move forward unless construction has already been started.