Thoughts About the Current Bear Market Among Junior Miners

For several months now, junior resource stocks have been in a highly depressed state. Many juniors are now testing their 2-3 year lows despite the commodity bull market raging strong. As stock prices remain depressed, financial positions of these junior exploration, development and production companies are deteriorating.   

Rising production costs, aggressive feasibility study assumptions, a worrisome number of start-up productions problems and even resource data falsification have all greatly contributed to the Credibility Crisis in the junior mining sector. At the same time, the Credit Crisis is exacerbating the situation by making funding for even the best projects unavailable. 

Financial institutions in the United States and many other countries are in serious trouble and cheap debt financing is hard to come by.  Brokers are reluctant to assist with equity offerings and want better terms for their clients: deeper discounts in addition to attached warrants – both of which are making dilution even worse for the desperate-for-dollars juniors. It is a vicious cycle as this lack of funds caused by depressed share prices is further pushing investors away as they are anxious to become victims of unfavorable dilution.  

As a result, the former best performing group in the gold stock universe, Exploration II companies (26 advanced gold exploration and development companies tracked by Resource Stock Guide), is now close to its two-year low. What’s even more disheartening for investors is that these stocks are now setting 8-year lows relative to gold price. 

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What about the other “red hot” stocks in the resource sector. Do they look any better? Let’s look at how oil stocks fared compared to the performance of crude itself. The ratio between oil stocks, represented by the S&P/TSX Energy/Oil Index ($SPTEN), and the price of oil, is also setting new lows since 2000.  

 

Looking at silver and copper stocks, it is also apparent that they have underperformed their underlying metal. What could be an explanation for this phenomenon? The answer lies in investors’ and financial institutions’ almost complete aversion to risk.  

The culmination of the credit crisis in the resource sector, in our opinion, came with the recent news from Altius Minerals, a highly diversified company engaged in many areas of the hot resource sector (gold, uranium, nickel, energy, potash, oil shale and iron ore).

At the end of June, Altius’s stock suddenly lost over 40% of its value in one day. Altius’s flagship project is Newfoundland and Labrador Refining Corporation [NLRC], a venture to build a new oil refinery in Placentia Bay, Canada – the first refinery in North America in about 30 years. The cause of the crash was the announcement by NLRC that it is seeking bankruptcy protection from creditors as it has been unable to obtain additional financing.   

Existing North American refineries are currently running at close to 90% capacity. The project could not have been timelier as there is limited oil refining capacity worldwide and strong market demand for refined petroleum products. What could be more discouraging today, in the midst of the credit crisis, than a company unable to obtain financing for a permitted refinery?  

This failure to obtain financing highlights the main reason for the bear market in the junior resource stocks lasting longer than expected. The Credit Crisis in the financial sector and the Credibility Crisis in the junior sector, together with the threat of a serious recession, have caused companies with even world-class size deposits to struggle for financing.  

When combined with growing political and environmental risks of putting projects into production, the picture looks even gloomier. The bottom line is: bankers have little capital available for lending and almost no appetite for risk. Investors too are hurting from large losses, with fear and risk aversion becoming the dominating drivers.  

Small and micro-cap resource stocks, now in a midst of a bear market, have become some of the most hated in the entire stock market. This means that instead of burying the whole sector, we are treating this tough time as a period of lucrative opportunities, especially since we are aiming at a 2-3 year investment time horizon.

What is the rationale behind this opinion?  

1. Gold has shown exceptional resilience, bottoming in May, and is now indicating that the next move will be much higher despite the following negative factors:

1. Poor seasonality
2. A sharp drop in India’s imports (down 50% in the second quarter, year-over-year)
3. Large reduction in de-hedging by gold producers
4. Latest relative stability of the US dollar exchange rate
5. Chronic, multi-year underperformance of gold relative to other hard assets

So, who is buying gold? Investors. Investment demand is actually the most important driver for the gold price in a bull market; growth of inflation, in conjunction with the uncertainty related to the world-wide credit crisis, is creating perfect conditions for this demand to continue to grow.  

2. At the same time, many large gold and silver producers are complaining about falling production. Their internal prospects for growth remain limited and they are forced to look elsewhere in order to battle with a decline in metal reserves.

3. With gold, silver and copper prices rising, profit margins of large gold producers are continuing to increase, making gold majors very cash-rich. There are three ways to spend this cash: buy back shares, increase dividends or acquire smaller companies with quality deposits paving the way for future growth. 

4. Wealthy sovereign funds from oil states and other “dollar-rich” countries have gotten badly burned in the collapsed western banking sector and are looking to diversify into hard assets worldwide.  The developing world will, no doubt, become an important player in acquiring interests in juniors as well as in helping them finance projects into production.

5. The valuation gap between large-cap producers and juniors is widening dramatically (with prices of majors rising and prices of juniors generally falling). The conclusion is clear for us: bargain hunting time is here for senior producers.

At the same time, sentiment among investors in the junior sector is at a decade-low. The market almost disappeared for some of the less followed juniors, with only a few stink-bids remaining. Any buying interest is met almost immediately with selling pressure. Selling is indiscriminate with the exception of a few high-grade deposit discoverers.  

With the credit crisis nowhere close to being over, the best approach for investing in resource stocks is a highly selective one. We are currently focusing on:  

• Companies with economically robust projects; high Internal Rate of Return [IRR] and short capital payback period;
• Projects located in politically stable regions of the world;
• Companies that have enough cash to advance their projects or who have strong management and major backers with an ability to obtain equity or debt financing;
• Companies with large enough projects which will attract the attention of the major producers.

Many companies that fit even these stringent criteria are trading at a deep discount compared to large producers. In fact, on average, the market values Proven and Probable reserve ounces held by senior producers at 10 times the reserves owned by these quality juniors. We do not recall a time when this valuation gap was so wide. For astute investors, who are convinced that the gold and silver bull will continue, extraordinary opportunities abound.  

This is an excerpt from a Resource Stock Guide Newsletter dated July 12, 2008.

Comments

[GMiki]

Shorts and naked shorts are a big factor in this sector. Listen to Jim Puplava's series on the Crime of the Century. And Jim and trader Eric King still believe *very* strongly in the junior sector, where the chance to make a large multiple return is great. I hold a lot of juniors and have definitely lost money in them--good thing I also hold, bullion, bullion in accounts, and GLD and SLV.

However, I've seen these markets move very fast. Today ANO is already up 23 cents--quite a bit for a small (but mighty) stock. ANO is a platinum stock that will do quite well. (I spoke to someone in headquarters and their energy situation is fine because they have generators.) I hold shares of companies with great drill results and I know they're going to have (or already have) private investors or be bought out.

[iman]

There is a more risk in the jr's but I'm buying companies with good resoruces that have JV's with majors or jr's that are in production.

[PastTense]

Where do you go to find out about these stocks?

[whidbey]

Great article and I could not agree more, it is time for the producers to shop the juniors for capacity. I have my list and some are starting to move. Demand over all will continue to grow as it becomes evident that the USA is a hollow shell financially with a pair of presidential candidates that have not any idea about what is driving the economy. Obama thinks it is fairness, and McCain is sure it is political deportment and friendship for non-nationals. Can you say "trouble"?

[GMiki]

PastTense, Look at the news at Kitco.com and at the press releases for company names, but then research the companies. Some people will say to buy the newsletters, but I don't. The analysts have their own opinions and they aren't always right. Diversify a little. Hold on even if the stocks go down. Eventually you'll make money. I also like a few juniors in the oil and gas sector.

[garfunkel]

one tip: SLGLF

[wearmanyhats]

This news is disconcerting. The jr producers that I hold could suddenly run out of funding and I'd be left holding a worthless stock? No telling if big companyies will buy them now. Better to let them go through bancruptcy and get them for a song first. Hmm. Another part of the "perfect storm" in the financial world.

[paultaut]

Try Kitco.com or Mineweb.com for a worldwide view on miners.

The Junior Producers have encountered a wall, Costs.

In the past 5 years, projects which seemed feasible have been tabled due to cost increases in the range of 150% or more. Toss in the current credit crunch and the results favor only those with current production.

[jt]

GMiki...I certainly wonder who the shorters are. I've believed that the anti-gold cartel is primarily involved (the Fed and other Western Central bankers and their bullion bank lackies, such as GoldmanSuchs--who also seems to perennially own the Secy of Treas position...talk about insider info!!, and JPMorgain4Elites, and the hedgies they control). They've had patterns that they've created to get the other commercials to come in alongside them in their manipulation / "management" of the gold and silver markets (COMEX esp). One such signal is a takedown of the PM equities on a day that the metals are moving up and they can't take them down...that's been a signal that the next day WILL be a forced takedown (the investment banks involved simply pull all the bids and let the price plummet) day for gold and silver...like the takedown we had this AM @10:45. I truly believe they are involved to try to keep interest away from the PM equities and in the stock market at large and in treasuries.

But I'm also wondering what part the gold and silver bigboys (or even China for that matter) might have in it. They need to replace assets in the ground and they haven't been finding much...and with the ratio as you've just described being a mere 1:10 for Jr compared with the Sr gold/silver in ground...the cheapest way would certainly be to buy up the juniors with significant inground resources.

And for those who just automically blow off any and every "conspiracy" you hear, understand that I'm not saying that ALL moves in the market are manipulated. But...those who manipulate understand the markets...they understand TA and where the stop losses are placed for example...after all, they have ultimate and intimate insider info on ALL stocks/markets (the SEC and the CFTC are also members of the PPT--PlungeProtectionT... / President's Working Group On Financial Markets). All they have to do is tip a price below certain TA or wave numbers and they know the black boxes will do the rest...and they have.

But manipulation will finally be overcome, as it always has been, by physical supply and demand...and the demand is going to be investment demand. Make sure you have some real money...gold/silver coins/bullion. I'd strongly advise AGAINST the SLV and other PM ETFs. Ted Butler has shown that the SLV is being shorted bigtime...probably b/c the shorts can't come up with the physical on COMEX. That should be and probably is outright illegal, as the prospectus states that the fund will hold 10 oz silver / share, and the shorts certainly aren't holding 100M oz silver (at least 10M shares short, if not more). Buy physical. Start nibbling on Jr producers and the BEST of the explorers. But have physical...what you want to have when this whole mess explodes. It'll never be cheaper...esp silver. jt

[User 30121]

ANOTHER MOUTHFUL of WISDOM from JT! BUY SILVER (and gold), take possession, and wait!

[The Vet]

Great insight, but of course this failure for the banks and the markets to commit to any risk is the same reason that commodities, metals, food and oil are in such demand right now. In the dot com days and before, paper projects and paper investments were short term, quick return and had a degree of certainty... until they failed!

Now commodities are high, costs are high and the time, expenditure and risk involved in getting a new mine off the ground is even higher than before, right at the time that the traditional risk taker, the small investor is feeling the pinch.

The need to get starter projects going so that the world will have adequate supply of commodities has never been greater, but investors time horizons have never been shorter, so where will it end.

IMO the solution lies with the few majors who are doing well with their high cash flows and diminishing reserves. They have to step up and start aquiring and investing in the junior sector. Only then will we get the investor interest returning. The majors are not doing themselves an favours with their current "just in time" mentality, as they well know that new projects always take longer and cost more the longer they delay commencement...

Once they start to lose production as mines become depleted, they will lose their income and the currency of their high stock price regardless of the current spot price of their production. Gold at $5000 an ounce is of no help if production has dropped to a pittance.