Rick Rule: “We Haven’t Seen Capitulation In Natural Resources Yet”
During a period of polarizing precious metals and industrial commodity pricing, Rick Rule, Chairman of Sprott U.S. Holdings was kind enough to share a few comments—opining on global counterparty risk, resource capital markets, capitulation, and more.
When I asked for his expectation of a final capitulation sell-off in resource markets, Rick noted that, “We came close last October. There were some moments of absolute panic…but we didn’t follow through with a capitulation… Capitulation usually follows a protracted period of diminished volume… [and] I have never seen a bear market in the juniors end without [one].”
“[But] just because I haven’t seen it doesn’t mean it has to be that way,” he further added.
Opportunities found at the extreme lows of capitulation, “[Are[ truly stupendous,” Rick explained. “I remember in the summer of 2000 that some stocks declined from $4.00 to $.40 cents, and were going ‘no bid’—changing hands at $.07 or $.08 cents...That’s what happens at the end of a capitulation, because every last available seller is gone.”
Commenting on tightening resource capital market availability, Rick said, “The cost of capital for commodity producers is high and is going higher… [credit markets are] more constrained than at any time in my career [with exception of the early 80s]… [and] I think you’re going to see – and I’m putting it mildly – a very interesting market in oil and gas-related junk debt for the first six months of 2015.”
Here are his full interview comments with Sprott Global Resource Investment’s Tekoa Da Silva:
Tekoa Da Silva: Rick, I’d like to ask you about some of the currency turmoil we’re seeing in the foreign exchange markets, starting with the Russian ruble, and more recently—the Swiss franc. For a person new to the circumstance of the story, can you give us your perspective on what happened with the Swiss franc and what caused it?
Rick Rule: Well, the Swiss franc is an interesting set of circumstances. I think it’s pretty obvious that a year and a half ago, a coalition -- or cabal if you will -- of Swiss manufacturers that were concerned about their export competitiveness in Europe caused the Swiss government and specifically the Swiss Central Bank to peg the Swiss franc to the euro. They wanted to make sure that export goods were competitive in the rest of Europe and so there was a peg set at 1.2 euros per Swiss franc.
From a practical point of view that meant the Swiss Central Bank had to print more and more Swiss francs to buy more and more euros to maintain the peg. What that meant for the Swiss citizen, is that their purchasing power was unnecessarily constrained or unreasonably constrained and their collateral for the decline in purchasing power, the euro, was in fact depreciating. It was a depreciating asset. In other words, the Swiss taxpayer and the Swiss citizen were subsidizing the Swiss export manufacturer.
For the first time in a long time, a central banker acted in a correct fashion and of course, the idea that a central banker would so something right took the market completely by surprise. There were billions of euros in carry trades where big banks were borrowing in Swiss francs at low interest rates and purchasing euro securities at higher interest rates. Of course when the Swiss franc ran up 40% against the euro, many of those people were wiped out.
So we are going to see in the near term some capacity constraints in Europe as some of the bond investors recover from the wounds they incurred as a consequence of their willingness to borrow in a strong currency (the Swiss franc) and lend in a weak currency (the euro).
TD: What are your thoughts, Rick, on the solvency of ‘money center’ banks (banks which are involved in international financial markets, such as Wells Fargo and Citigroup), and investment banks that have exposure to these kinds of currency adjustments? I’ve seen a number of articles pointing out the losses that have now been experienced by banks and traders here, especially as a result of the franc, as you point out.
RR: Certainly the fiscal policies adopted by Western nations have been a copy of the Japanese technique over the last 10 or 20 years of making banks more solvent following currency crises. The Japanese, in effect, invented quantitative easing.
The fiscal regime that has been in place since 2008 is one where the political class has decreased the interest rate artificially, allowing the very large money center banks to borrow at extraordinarily low costs both from their retail deposit banks but also from their central banks and lend the money back to sovereigns.
In effect what happens is that the central governments loan the banks money at .75% or 1% and borrow the money back from the banks at 2.5% or 3%, giving them a 1% or 1.5% interest rate carry at very, very, very low risk.
That’s the way the Japanese subsidized their banks and made their banks solvent again after their currency crises. It remains to be seen whether or not the assets that the banks have bought -- the sovereign credits -- actually pay off. If a European bank was once again borrowing Swiss francs or borrowing euros, but loaning to a sovereign creditor like Italy or Greece and the sovereign credit ultimately became problematic, the leveraged nature of the transaction is dangerous from my point of view.
A second problem, of course, concerns derivatives. The 2008 financial crisis did not trigger widespread counterparty risk. But it could have. The banks, many of the large banks and many of the large US investment banks hold stupendous quantities of derivatives.
The nominal value of these derivatives is in the trillions of dollars. The banks argue, of course, that they have agency positions, that they have offsetting long and short positions and that the real value of the positions relative to the notional value of positions (the total amount of assets in play through a derivative contract) is really small. That explanation doesn’t hold water if there’s a counterparty crisis. If one side or the other doesn’t pay, the banks are liable.
If I’m going to be concerned about money center bank solvency, it really revolves around a couple of issues.
One is the quality of assets they have on their balance sheets. According to Basel III (a set of global banking standards established in 2011), and I’m paraphrasing, if a money center bank makes a loan to a private party or a private counterparty, they need to have reserves in place to be well-capitalized. You need about a 7% equity slice on your balance sheet.
But if a bank buys a sovereign credit (a government credit), and they intend to hold that credit to maturity, they don’t have to mark the credit to market and they don’t have to reserve against it. So the bank balance sheets are becoming swollen with assets that their regulators say are no-risk assets – i.e., sovereign credits.
People following this discussion need to decide for themselves whether they regard some of these sovereign credits, particularly the longer-dated sovereign credits, as being ‘no risk.’ I myself have some concerns with that.
A second issue, of course, is the fact that very large money center banks in effect don’t have any owners. The employees who are making the credit decisions are for the most part not large shareholders in the bank and their stake in the outcome has to do with their bonus. The idea of making a bonus during the quarter irrespective of the outcome five years or six years later is commonplace in large financial services institutions. Compensation to the individual is not derived from the health of the institution, but rather from the cash that employee generates during the quarter.
The third issue I would have is, of course, the issue of derivatives, particularly in volatile markets like we experienced in the last six months of last year, and certainly the first two weeks of this year.
TD: Rick, what are your thoughts on the availability of capital going forward in the context of these currency gyrations when it comes to the production and distribution of real things—like commodities?
RR: I think the cost of capital for commodity producers is high and is going higher for several reasons. Commodity producers’ equity prices in the context of markets we’ve seen in the last 15 years are very, very high. So the cost of equity (where available) is high and this occurs across the commodity spectrum.
Increasingly, senior bank debt, particularly limited recourse or non-recourse project debt, is less available. Again, as a consequence of Basel III, banks are required to provision and reserve intelligently for private sector debt including commodity-related debt, while they’re not required to provision at all for sovereign debt. The consequence is that banks are incentivized – and in fact subsidized -- to purchase sovereign debt, while being penalized for purchasing private debt.
So the credit markets I grew up in with regards to large-scale extractive industry – oil, gas, and mining projects -- are more constrained than at any time in my career with the exception of the first half of the decade of the 1980s.
Of course the third source of capital for larger resource issuers has been the subordinated debt or junk debt market. The junk debt market for resources began to be constrained in June or July of last year. My suspicion is that the vast majority of the US issuances of junk debt have been to second-tier oil and gas companies, and since the oil price has declined precipitously, reducing the value of their collateral, I think you’re going to see – and I’m putting it mildly – a very interesting market in oil and gas-related junk debt for the first six months of 2015.
The fact that the lenders will get spanked in the next six months will make them much less generous with lending over the next couple of years. So I suspect the cost of capital from equity (issuing and selling new shares) will rise, and the cost of capital from debt (by issuing bonds) will rise. Access to the junk or below-investment-grade window will also become constrained.
I suspect that overall the next two or three years will be quite capital-constrained for extractive industries.
TD: Rick, what are your thoughts when you look at the different segments of the oil and gas business, going from early-stage exploration to development, and then larger, diversified producers? Does each of the different segments have its own “moment” in terms of opportunity being most present?
RR: That’s a great question Tekoa and the answer is yes. The oil industry in terms of its investment products and investment efficacy in a portfolio isn’t one industry. It’s very, very segmented. Not only does each segment have its time but each has its place within the portfolio, depending on the investor’s needs, willingness to take risk, and time frame.
It is a large industry and overall it’s a very good business. But like all extractive industries, it’s cyclical. The difference between it and the other extractive industries such as mining is that the oil and gas business is so large and so multifaceted that there is an opportunity in every phase of the cycle.
TD: Rick, we recently attended the Cambridge House Vancouver Conference, and one of the things I heard from a number of attendees at that show was the question, “What is Sprott Global Resource Investment’s favorite commodity here as an organization? Is it gold? Silver? Oil or gas?
What are your thoughts as you look across the different commodities? Do you have a favorite for any particular reason?
RR: Well, as long as you’re asking Rick Rule and not Eric Sprott, I have a class of favorites. The guy whose name is on the door, Eric Sprott, is a hugely directional investor and if you ask Eric, the answer would clearly be silver. Eric has been a directional speculator and a stupendously successful speculator for a long time by attempting to be right when the rest of the world is wrong.
I don’t have Eric’s courage and as a consequence of that, I’m a little more muted in my response. I think the stars are probably best aligned for platinum and palladium. I think precious metals will do relatively well because I think the supremacy of the dollar over precious metals will be less extreme going forward than it is now.
But I think platinum and palladium will do better than the rest of the precious metals because of simple supply and demand factors, which you and I have talked about in the past.
I am a little less positively oriented towards uranium than I was a couple of years ago. That is a consequence of the fact that electricity demand I expected to see in East Asia and South Asia is not extraordinary. The reason for that I suspect is that the much wanted global recovery seems to be merely a recovery in financial markets rather than a recovery in economies that would lead to increasing demand for consumer goods and hence, a more buoyant economy in producer countries.
The second thing, of course, is the precipitous decline we’ve seen in oil prices recently is and will continue to be reflected in seaborne liquefied natural gas prices, which is the Japanese alternative to nuclear. The fact that the seaborne liquefied natural gas price was cut in half has meant that uranium’s advantage over seaborne liquefied natural gas has decreased as well.
So I think I’m less attracted to uranium -- although still quite attracted. I’m less attracted to uranium than I would have been had you asked me the question this time last year.
TD: Rick, one of the things that I observed personally in my first year with the group at Sprott Global Resource Investments Ltd. was the emphasis I saw on two things, when it came to a deposit or a development-stage company. One was ‘internal rate of return’ (a measure of the expected return from the project) and the other was project quality.
Would you say those two metrics can transcend a tough fundamental picture for a commodity if a specific deposit or a specific company has a competitive advantage?
RR: Absolutely. Speculators tend to be too commodity-specific and speculators tend even in the exploration phase to let commodity focus rather than deposit focus drive their activity.
I have learned in my career that I am ambivalent as to whether I make money in sand, gravel, or gold. Free cash flow is free cash flow, and certainly deposit quality is very important.
It’s interesting and understandable that investors’ perceptions on how to invest in natural resource-based businesses, particularly mining businesses, were developed in the 1970s when the gold price ran from $35 an ounce to $850 an ounce.
The consequence of that ten-year period is that the investment community has asked the mining industry to exhibit one overriding trait -- leverage to the gold price. Ironically, the companies that produce the best leverage are the high-cost ones, the less efficient ones, the ones where the margin increases most rapidly as a consequence of the fact that the starting margins are very poor.
As investors, we have asked the extractive industries and particularly the gold industry for 40 years to be inefficient. It’s a perverse ask and the industry has, in fact, complied very well. It has become an extraordinarily inefficient industry. The industry is just now beginning to heal itself. We’re beginning to see the market recognize that leverage to the commodity price should be free. It isn’t something that you should pay for. You shouldn’t pay for somebody to be marginal.
In fact, we’re now beginning to see in the gold and silver markets that the equities that are being rewarded by the market are those that generate free cash and increasing revenue, not merely the hyper-leveraged companies.
The reflection of that is the success in the market of the Sprott Gold Miners ETF (SGDM) which is an active beta trust focused around companies that generate free cash and generate growing revenues, as opposed to the competing funds which simply reward market capitalization.
The truth is that last year, the efficient companies grossly out-competed the leveraged companies in the market for the first time in a long time.
TD: Rick, what are your thoughts on capitulation in natural resources, taking into context the continued selling pressure in oil and copper? Do we have more pain ahead in your opinion?
RR: I don’t know. I have never seen a bear market in the juniors end without capitulation. Just because I haven’t seen it doesn’t mean it has to be that way. The markets don’t listen to me. I listen to them.
Without capitulation, my suspicion is that 2015 will look something like 2014 did. Higher highs and higher lows, but a saucer-shaped bottom with all kinds of volatility in the middle, which at one point in time elates and another point in time terrifies speculators. Certainly we are near or past the bottom in the juniors. But the recovery can be very much saucer-shaped unless you get that spasmodic capitulation sell-off, which we haven’t seen yet.
I think we came close last October. There were some moments of absolute panic in the market which perversely I welcomed, because it signifies the beginning of the end. But we didn’t follow through with a capitulation.
TD: Rick, I think it was on October 16th of last year that you issued a specific capitulation commentary. In the following week or two the market just tanked.
A lot of the stocks we follow closely were down 30% to 50% during that period. I thought to myself at the time, “There it is. This is what Rick was talking about.” Then it turned out that a more severe capitulation did not happen.
So for the person reading, can you define ‘capitulation’ based on those few times you’ve seen it in your career? What were people doing and what did you see happening in the market?
RR: Capitulation usually follows a protracted period of diminished volume. The buyers are exhausted and the sellers are exhausted. The stock charts look like the electrocardiogram of a corpse, and that’s followed by some event or series of events that renews ‘enthusiasm,’ if that’s the right word, for the sellers in the absence of buyers.
I remember in the summer of 2000, that some stocks declined from $4.00 to $.40 cents, and were going ‘no bid’—changing hands at $.07 or $.08 cents. The period of time when that occurs is usually very brief, two or three weeks before a couple of people wrap their heads around the fact that for $.08 cents, you can probably buy something that’s worth $.90 cents, and will go to $3.00 in a bull market.
That’s what happens at the end of a capitulation, because every last available seller is gone. Capitulation is truly a wonderful thing. The second thing that happens in capitulation, and this is actually a better thing—is that the issuer community and the financial services community, the so-called ‘smart money’ (by the way it’s not the smart money) – capitulates too.
I remember in the summer of 2000 getting calls from the absolute A-leaguers in the issuer community; Robert Friedland, Adolf Lundin, Lukas Lundin, Ross Beaty, Bob Quartermain, all of these guys were saying, “Listen, there’s nothing to wait for. We have to raise money in this market. Tell us what it will take. Even if we have to dilute our company by 25%, the investments that we make right now will return 400% or 500% in the next five years. We understand that we can’t save our way to prosperity. We can only save our way to solvency.”
That concept is important because you can’t excite a market with the prospect that a company is going to survive. You excite a market with the prospect that a company is going to make a discovery or put something into production. You have to move forward and this is a capital-intensive business, so if you don’t have any capital, you don’t have a business.
The whole idea is that issuers capitulate too and say, “Damn it, let’s get back to work.” That’s what turns the market around, and we haven’t seen that yet.
TD: Rick, do any specific examples come to mind in terms of individual stocks you saw that went no bid during that period in 2000?
RR: Oh, so many. I remember one that I was talking about in a different conversation today, which is why I will bring it up. Tenke Mining was a company run by the Lundin family, who have been serially successful resource developers for 40 years. Tenke Mining was named after a deposit in Congo called Tenke Fungurume, which was then far and away the highest-quality undeveloped copper deposit in the world, in my opinion.
I think it is one of the highest-quality copper deposits in the world today, but now it’s in production. Suffice it to say the ‘first family’ of mining, the Lundins, controlled the deposit and it was the best available deposit in the world. It had been financed in 1996 or 1997 first at $2.50 a share and then, I think, at $4 a share.
It was trading in the market at $.19 cents a share and had $.30 cents of cash per share in it. So you got the best copper deposit in the world (not hyperbole), the ‘first family’ in mining, $.30 cents cash, and you got all that for $.19 cents a share.
That’s what you see in capitulation. It’s truly stupendous.
I don’t remember exactly when, but Ross Beaty also decided that the copper price was too cheap around that time. He went out and formed Lumina Copper and was able to buy very high-quality copper deposits from very intelligent sellers, like Rio Tinto as an example.
Ross was able to buy copper in the ground for half a penny per pound. He was able to buy deposits that had $120 million spent on them for $3 to $5 million. At the time he bought them, they couldn’t make money at the prevailing price for copper and even if they could, he wouldn’t have been able to raise the money to put them into production. But these are deposits that would have made an awful lot of money had copper gone to $2 a pound, which it did.
The consequence of that is that Ross Beaty raised money from us at $2.00 a share, I think in 2000, and Lumina Copper ended up returning to shareholders (who had the good sense to hold their shares the entire time) – I was not one of those – an 80-fold return in nine or ten years.
That’s what’s available in capitulation, when the very best people say, “The opportunities that I can get for deploying cash overwhelm the fact that the cost of capital in a market decline like this is high.” They take the money on market-clearing terms. They go to work and they make fortunes.
TD: Rick, how does the person reading this take action? How do they get started if they’re new to commodities, or new to precious metals?
RR: Well, the fact that they’re reading this demonstrates that they’re doing the most important thing first. An investor or speculator must educate oneself. You’ve heard me say before that people focus on a panoply of risks -- political risk, business cycle risk, market risk, commodity risk…
The greatest risk of course is located to the left of your right ear and to the right of your left ear. You are your own greatest risk and the speculator who is reading this article and educating himself or herself is taking the most important first step.
The second is simply attitudinal. I probably say this every time we have these visits, but the truth is that natural resource markets are extremely capital intensive and hence they are extremely cyclical.
An investor can only survive cyclical markets (let alone thrive in them), if that investor is a contrarian. You have to buy low and you have to sell high. A market bottom is not a time for selling. It is a time for buying.
It’s difficult to buy when all of the recent experiences you’ve had have been negative. It doesn’t make you an aggressive person. It makes you a cautious person. But this is precisely the time when you have to discipline yourself to buy the best of the best, and buy it in the context of the fact that you’re not going to be rewarded in April. You’re not going to be rewarded in May. You may not be rewarded in 2015. You might be rewarded in 2017. But the nature of the rewards you might enjoy are, in my opinion, predictable and large, and those are both good things.
TD: Rick Rule, Chairman of Sprott US Holdings. Thanks for sharing your comments with us.
RR: Thanks for the opportunity Tekoa.
For questions or comments regarding this article, or on investing in the precious metals & resource space, you can reach the author, Tekoa Da Silva, by phone 760-444-5262 or email firstname.lastname@example.org.
For more information and disclosures on the Sprott Gold Miners ETF, please visit www.SprottETFs.com. Our affiliate, Sprott Asset Management LP, is the sub-advisor to the Sprott Gold Miners ETF.
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