In this special issue…
|Publisher’s note: We asked Diggers and Drillers editor, Alex Cowie – just back from the equivalent of two round-the-world trips in seven days – to summarise for readers the four most important ideas from the commodities market, in light of recent events and the long-term supply-and-demand stories he’s tracking. Here’s what he wrote…|
On Monday I stepped back onto Aussie soil after flying 37,000 km through the US and South America in just one week. You’ve got to travel a long way when you’re hunting ‘recession-proof’ commodity investments. My head is spinning. And I’m exhausted. But the trip was completely worth it.
Aussie miners can be anywhere in the world these days. You have to be willing to travel to get the real story. And you just can’t get a real feel for a company until you go and meet all the people on the ground, look at the set-up, its settings, the infrastructure, and the country it is in. The real acid-test is actually taking a look at their project with your own eyes.
I came away with four observations I think could lead to useful investment ideas for the rest of 2011. I’m talking about gold and silver mining stocks, potash, and coal. Let me share with you what I saw last week and why I like these four commodities for the rest of the year.
Two of the projects I visited last week have the right people, the right location, the right commodities, and potentially huge, high-grade deposits. Both stocks are at the stage where everything is in place. But the shares are still at bargain prices thanks to the fear gripping financial markets.
One is a gold explorer that is still fairly unknown. It appears to be sitting on a deposit large enough to compete with the world’s biggest gold companies. Which, perhaps not coincidentally, are right next door. I’ve been tipping gold stocks since gold was selling for $900 an ounce. As you know, it recently it hit $1900.
High prices have not deterred central banks from adding to their reserves (central banks are net buyers this year). The central banks of Mexico, Russia, Thailand, and South Korea have bought a combined 183 metric tonnes of gold this year alone.
Yet gold stocks in general haven’t yet responded to gold’s recent price acceleration. I believe they have to – and soon. The more the gold stocks lag the gold price, the more value they offer. This value can only exist for so long.
You can see from the chart below that gold stocks (the blue line) have badly lagged the move in the gold price. But a higher gold price will mean greater cash profits for low-cost gold producers.
gold stocks (blue) need to explode to catch up
The other precious metal I think you can make a lot of money from is silver. I have been buying silver myself for a year, and am buying more when I can.
Since D+D first recommended it, the silver price has run 138% from $16 to $38 per ounce. I see it running much further yet. (I think it can easily get into the hundreds within two years.) In fact, I’ve made a comprehensive case for silver in recent months. (Click here to read my most recent research)…
We may not have long to wait for the next jump.
Elements within the US Federal Reserve chairman are hinting that they are ready to give the market another dose of stimulation as soon as next month. Federal Reserve Bank of Chicago Charles Evans recently told CNBC, “I would favour more accommodation…I am in favour of some of the most aggressive policy actions of anyone on the [Fed’s policy making] committee.”
Gold will fly again if the money printing comes, as more stimulation will weaken the US dollar and make it more of a laughing stock than it already is.
The last bout of ‘fed nitrous’ – QE2 – also forced investors to invest in riskier assets. By buying medium-term bonds, the Fed forced interest rates down. This forces investors to take more risk to get higher yield.
Because silver is riskier than gold we saw silver rise faster than gold the whole way through the QE2 program. The gold/silver ratio fell steadily from 65 to 32 in less than year as investors took on more risk.
What does this mean?
Silver did twice as well as gold during the last episode of QE. In other words:
Don’t get me wrong. I like gold. And gold stands to fly for reasons of its own. But if Bernanke does turn the monetary taps on again next month, we would see silver take off faster still. (I expand on the argument for higher priced silver here)
As well as buying physical silver, I recently recommended two silver plays to profit if silver prices rise as I expect. One stock is just weeks from full production. This means it will be tapping into high silver prices immediately.
The other recommendation is still in its early stages. Early-stage shares haven’t been “de-risked”. This makes them riskier in the sense that more could go wrong with exploration, finance, and the commodity price. But there’s an upside.
Earlier stage plays could make big gains for longer-term investors. This particular company has the longest planned mine life of all Aussie silver stocks. The Chairman of Kingsgate, a gold producer with a one billion dollar market cap, recently joined the board as well. This suggests to me it could have a big future.
In a world where paper money seems to be returning to its intrinsic value of zero, it is easy to make the case for gold and silver.
They provide the perfect hedge against a falling currency. As one ounce of gold today will still more or less buy you the same as it would have 5000 years ago.
But what about the other commodities? Where else do you invest when the world is staggering its way into a double-dip recession?
Fertilisers will be in demand whether the global economy slows or not.
The global population – 6.75 billion mouths and counting – increases by the day. People need to eat, even if they can’t find work. Potash is a potassium-rich rock that is used to help farmers increase crop yields.
Urbanisation and the expansion of cities are colliding with the need for arable farm land all over the world. With less land to grow from each year, farmers need all the help they can get. Potash prices are climbing again, after the big crash in 2009.
Thermal coal is another commodity that is fairly recession proof.
It doesn’t really matter how you feel about coal. The fact is it is used in power stations to produce most of the world’s energy. Demand is rising; driven mostly by China and India, which are constructing an army of coal-fired power stations.
The China case for coal has been well made. But did you know that India approved plans for 173 new coal-fired power stations last year? 37 of those new plants are slated to be built in the state of Andhra Pradesh. It has a population of 84.7 million. The new coal plants will increase electricity production by 800%.
Demand like this is staggering. It’s also why most of the mergers and acquisitions in the market recently have been for coal producers.
For the last few years, thermal coal has risen in price from September to January as the Northern Hemisphere moves into winter. This price rise takes thermal coal stock prices with it, so this is a good time of year to invest in these kinds of stocks.
Finally, no matter how good the company or the commodity, don’t forget the cash!
When I tip a stock, I make sure it has enough to cash in the bank to weather a storm. At last count, the explorers that I have recommended have more than 16 months worth of cash in the bank on average. So they should be well protected if things do go south and the equity markets seize up.
Equity market volatility can be terrifying. But what I’ve found is if you get out there in the world and have a look at what’s actually going on, you can come back with some very useful ideas.
Looking into the past can be just as useful…
The History of the Gold–Silver Ratio
You might be wondering why the gold–silver ratio is always quoted as being 15:1.
Wonder no more!
Back in medieval times, silver made up most of England’s coinage. There was a bit of gold, but silver was top dog.
Then, something strange began happening in the 17th century.
You see, silver and gold were used in continental Europe as well. But on the continent, silver was worth more relative to gold than it was in England. The silver in English coins was actually undervalued to the real price of the metal.
The profit motive kicked in. Enterprising traders shipped silver from England across The Channel to the French, Flemish, Spanish and Portuguese. It was pure arbitrage. Traders could buy silver in England at face value and sell it a higher price – the price of silver – in Europe.
It was a lucrative trade. In fact, English silver coins started dwindling in number alarmingly. Coins were also getting smaller and tattier. This was a result of small pieces of silver being “clipped” from them.
Coin clipping became endemic. And it wouldn’t surprise me if this was the first example in history of a currency arbitrage trade, which is where a difference in value between two markets is exploited.
Enter Isaac Newton, who – as well as coming up with the basic laws of physics – was Warden of The Royal Mint.
Newton calculated that in the major economies on the European continent, there was an average of 15 times more silver in circulation than gold. In other words, Newton concluded that in economies where both gold and silver were fairly valued, the effective ‘gold-to-silver’ ratio was 15.
His logic was sound. Newton suggested that the English government establish the same ratio in its own gold and silver coins.
Newton meant to close the arbitrage window and stop English traders from selling the country’s silver overseas. But like most government intervention, it fell afoul of the inescapable laws of the market.
The market didn’t care what the government said. There was still profit to be made by selling silver from England in Europe. So silver kept disappearing from the country – until gold took over completely as the currency of choice.
Thus, by accident, England adopted the Gold Standard.
When you look at how much silver bullion is available today, it is incredible. It suggests there’s a huge shortage of silver relative to gold, using Newton’s 15:1 historic ratio. How much is there?
Well, Canadian fund management company, Sprott Asset Management calculates there are about one billion ounces – just half as many ounces of silver as there are ounces of gold available today.
More generous estimates reckon there is eight times as much silver bullion as gold. Even this suggests there’s just half as much silver in the world as Newton’s gold–silver ratio suggests!
This small amount of physical silver is what could power its prices far higher in the coming months and years. Taking the more conservative of these figures – which implies a gold-to-silver ratio of 8:1 – silver would need to be closer to $225/ounce to reflect the relative scarcity of silver.
Now, there may be plenty of silver awaiting the markets in old silver mines – or from melting Granny’s antique candlestick holders and cutlery – but it will take many years to add meaningful amounts to current circulation from either of these sources.
In the next few years, the inevitable money printing from the Fed, and other central banks, is going to trigger investors to move into precious metals. And they will be surprised how little silver is available to them!
And, just as in medieval times, this silver bullion will naturally migrate to whichever buyer values it more. In other words, the highest bidder. Today, India and China are strong contenders. Silver imports into these countries are going – and there is no other word for it – ballistic. Indian silver imports have doubled in just three months.
By some estimates there is less than half an ounce of silver bullion available per Indian and Chinese citizen.
It doesn’t take much imagination to see where this is going!
To learn more about my two favourite silver investments right now, click here.
Dr. Alex Cowie
Editor, Diggers and Drillers
Publisher’s note: Alex spends practically every waking moment scouring the globe for Aussie miners with truly great stories that have yet to be told. He publishes his research, analysis and investment recommendations each month in Diggers and Drillers – Australia’s leading resource stock advisory.
You may not realise this, but right now, you can take a 30-day risk free test-drive of Diggers and Drillers and receive a 55% discount on a 12-month subscription… To find out more about this special deal – and to read Alex’s latest research on what he believes are the two best silver plays on the Australian market right now, click here.