After the extreme volatility of gold in the last few weeks, OCM Gold Fund Manager Greg Orrell is more convinced than ever of the necessity of owning gold assets. In this interview with The Gold Report, Orrell lays out the rationale for buying these cheap gold stocks around the world, including California of all places.
The Gold Report: How has your bullish view on the gold sector evolved as a series of crises has jolted both the international stock market and the price of gold?
Greg Orrell: First off, my belief in gold as a monetary asset has not wavered. Japan basically admitted that it is bankrupt with its intention to aggressively debase its currency. Normally such actions would invoke, and may still, a race to the bottom as each country engages in economic warfare to deal with its debt issues. At this juncture the fear of global deflation among the G7 crowd remains its worst nightmare, especially as additional stimulus by the Federal Reserve is showing diminishing returns. With high debt levels in both the private and public sectors around the world, stimulating economic growth is proving elusive. These alarming events are setting the stage for the next leg up in the dollar gold price, in my opinion. The fiscal and monetary crisis is ongoing and underscores the necessity of owning gold assets.
Though agonizing, the past 18 months have been nothing more than a consolidation for gold from the September 2011 highs of $1,900/ounce ($1,900/oz). The recent decline in gold prices below $1,500/oz is not the end of the bull market in gold, despite the barrage of negative commentary by those wanting to dance on gold’s grave. The destruction of currencies is in full bloom, but it is not a straight line. The problem for many gold investors is that they can see the endgame. Gold prices rise in a straight line at the end of a monetary system, but we are not there yet. It takes some patience to hold the course while the establishment fights tooth and nail to keep the dollar system from failing.
TGR: The years 2009 and 2010 were better for gold stocks. Can you talk about how things changed after that and how investors can best respond to the precipitous drop in market value?
GO: A number of factors go into the poor performance of the gold shares over the past couple of years besides the gold price. We have seen investor rotation out of defensive posturing and then the gold miners ended up being their own worst enemy. Gold share investors became concerned, and rightfully so, with rising operating and capital costs, poor capital allocation and growing resource nationalization. This in turn made bullion exchange-traded fund (ETF) products more attractive and prompted a trend of shorting the miners versus long gold positions.
Let’s look at the world’s largest producer, Barrick Gold Corp. (ABX:TSX; ABX:NYSE). It incurred cost overruns at the Pascua-Lama project in Latin America. And it overpaid for a copper asset in Africa after spinning off its African gold assets a couple of years earlier. Each of these instances led to contraction of cash flow and net asset value multiples for the whole sector, and set a theme for the industry. At this point, the pendulum has swung too far, with the shares basically discounting everything that could go wrong and more. Therefore, if an investor is not in the gold sector, now is an opportune time to take advantage of the significant decline in share values as there are signs of positive change taking place within the sector.
TGR: Can you provide any insight as to why longer-term investors, and also new gold investors, should buy into the current gold market?
GO: The rationale for owning gold assets remains simple: global deterioration of sovereign credit and a growing need to debase currencies in order to meet future obligations, whether it’s here in the U.S., Europe or Japan. The policy of socializing risk with monetary and fiscal policy has destroyed the balance sheets of the Western world. We are in a phase of experimental central banking, which I believe is going to end badly due to the dislocations of capital it has caused through prolonged periods of negative rates.
In the event economic growth were to take hold, an unleashing of built up reserves in the system would set off inflation with a corresponding rise in rates. Just imagine the effect of a change in the direction of interest rates and the collateral damage that will create in the bond markets and the interest rate derivative markets after all of these years of managing a zero interest rate policy. The cost of funding the U.S. deficit will rise exponentially. More quantitative easing begets more quantitative easing. Investors need to have some type of asset to balance their portfolios. Policymakers who got us into this mess are unlikely to navigate us out of it. History tells us that only gold is a good place to be.
TGR: Is now a good time to be looking at the gold miners, including the juniors?
GO: Absolutely. With current sentiment negative on the miners, it is an incredible opportunity to buy gold shares and recapture lost value. A major problem for the mining industry is that its business model is flawed. Gold investors are not strictly interested in taking money from one hole in the ground and putting it in another. Investors want participation in cash flow through dividends and earnings leverage to higher gold prices along with the potential for increased shareholder value through discovery . Not paying dividends was great for management, geologists, engineers and everyone but the investor who was locked out of the cash flow.
Now falling share prices have put the onus on management to compete with the ETFs for investor dollars. A number of CEOs are being shown the door. Marginal projects are being shelved. Dividends are increasing. Management is beginning to understand that the needs of shareholders must be prioritized. Granted, the decline has been painful, but in my 30 years in the business, this is exactly what needed to happen.
TGR: Has the balance in your portfolio between bullion, large caps, mid caps, small caps, ETFs, royalties and cash changed over the last five years?
GO: Because production is cheap, we are weighting toward the large- and mid-cap producers. They are poised to recapture value as sentiment turns around in that space. The smaller, macro-cap exploration and development companies are bombed out, and a number of companies are trading where market cap per resource ounce is down to $10 or lower. Those companies are interesting as long as they have a balance sheet and they’re not diluting their shares to keep the lights on. Royalty companies have outperformed along with bullion over the last five years because of all the negative factors that I mentioned previously. But I’m not adding to the royalty companies right now because the operating companies offer better value.
TGR: You’re not adding to bullion?
GO: Not at this time. We’re keeping bullion around 5–6%. The miners, in my opinion, offer tremendous value at this point with gold reserves in the ground.
TGR: Who are some of the companies you think are attractive in the middle and small spaces?
GO: Endeavour Mining Corp. (EDV:TSX; EVR:ASX) is interesting right here. The share price has been washed out because it is a higher-cost producer, around $900/oz. Its market cap is down to under $400 million ($400M) with 300,000 oz (300 Koz) of annual production in West Africa, but is slated to grow to 450 Koz over the next couple of years. That’s a 50% increase. Endeavour is driving expansion mostly from internally generated cash flow.
Esperanza Resources Corp. (EPZ:TSX.V) is cashed up with over $70M and with experienced management is developing a couple of attractive heap-leach projects in Mexico. One project can put up 35 Koz/year and another one can do 110 Koz/year. Pan American Silver Corp. (PAA:TSX; PAAS:NASDAQ) is a major shareholder. Esperanza could be an early day Alamos Gold Inc. (AGI:TSX).
Avala Resources Ltd. (AVZ:TSX.V), 50% owned by Dundee Precious Metals Inc. (DPM:TSX), is trading down at dirt prices. The company has an entire Carlin-style belt tied up in Serbia where it has outlined close to 3 million ounces (3 Moz) so far. The company’s market cap is $12–15M, with $9M in the bank; it’s not a bad option—the market will appreciate the optionality value on the company’s assets at some point.
TGR: Are you a fan of the royalty model?
GO: I am a fan of royalty companies. The revenue comes right off the top so royalty holders have no exposure to increases in costs and typically have exposure to increases in reserves. Royalty companies often acquire the royalties from the original property owners. Another form of royalty is the creation of a gold or silver stream: the royalty firm helps to finance the project and receives gold or silver in return. We have seen a pick up of companies selling either net smelter royalties or streaming deals on projects as a way to finance in a marketplace where equity capital has become expensive.