The Commodities Bull Market: Insights on Gold, Energy and Agriculture

MAY 7, 2012
BY PETER KRAUTH, Global Resources Specialist, Money Morning

Despite the setback caused by the 2008 financial crisis, the commodities bull market rolls on. A short four years later, many commodities are trading at or near all-time highs.

And thanks to huge swaths of the developing world moving up the ranks, the current bull market in commodities promises to be one for the history books– both in time and size.

After all, the wants and needs of 7 billion people are an irresistible and monumental force.

Soon virtually every substance vital to modern life will become enormously expensive − and profitable for investors who know how to play it.

In fact, today’s scarcity and soaring costs could spur history’s biggest gains.

It is one of the reasons why I recently sat down with resource investor extraordinaire Rick Rule.

A leading American retail broker specializing in mining, energy, water utilities, forest products and agriculture, Rick has dedicated his entire life to all aspects of the natural resource industry.

Rick is without question something of a heavy hitter.

At Sprott Global Companies, he leads a team of professionals trained in resource-related disciplines such as geology and engineering. Together, they work to evaluate commodities-related investment opportunities.

I think you’ll enjoy what Rick had to say during our recent Q&A.

Insights on the Commodities Bull Market

Peter Krauth: What is your general outlook for commodities – the commodities market over the next, say, one to three years and even beyond that?

Rick Rule: I think my outlook is quite good and quite good for simple old economic reasons: supply and demand. Supply is constrained because in the period sort of 1982 to 2002, we had a 20-year-long bear market in commodities, and the bear market constrained new investments.

These are long lead time, capital intensive businesses, and taking 20 years out, with, figuratively speaking at least, not very much investment in natural resource and commodity-specific production facilities: oil fields, mines, things like that, you greatly constrain your ability to produce over time.

Secondly, in terms of the constraint side -constraint to production, so lack of supply side, the incidents beginning late 2007 -2008 rocked the worldwide credit markets. That’s constrained the availability of debt finance for large-scale natural resource projects. This is a capital intensive business and without capital, you don’t have a business.

Finally, at least in the oil and gas side, but increasingly in the mining side, a lot of natural resource exploration and production activities don’t take place in the private sector but rather take place with things like national oil companies, and these national oil companies have now, for 15 years, diverted way too much of the free cash flow from the national oil businesses, to politically expedient domestic social spending programs.

And so there’s been insufficient sustaining capital investments in the oil and gas business to sustain current levels of production; which is very worrisome. So on the supply side, we have real supply constraints. On the demand side, the equation’s really Malthusian.

We have 7 billion people in the world now and at least in frontier and emerging markets, as those societies become a little more free, they become a lot more rich. And as they become rich, the things that people at the bottom of the demographic pyramid buy are very much resource intensive; while when you and I get more money we tend to buy more services or things with higher value added from technology.

When people at the bottom of the demographic pyramid get more money, they develop as an example a more calorie-intensive diet, a more energy-intensive lifestyle, and a more materially-intensive lifestyle, and so on both sides of the equation you have constrained supply and you have increasing demand, which is very good for the natural resource business.

Insights on the Growing Markets in Gold, Energy and Agriculture

Q: When we compare it to commodities in general, it looks like either gold has gotten relatively expensive or the commodities have gotten relatively cheap compared to the gold price in U.S. dollars. Which individual sectors do you think have the best risk/reward setup right now in terms of commodities?

Rick Rule: I suspect that what you’re seeing really is deterioration in the denominator that is the U.S. dollar over time. I certainly believe that gold has outperformed other commodities as a consequence of the fact that gold acts in many capacities, but seldom as a commodity itself.

Gold is viewed, I think, historically and traditionally as both the store of value and the medium of exchange. And so the gold price, I think, has been relatively strong as a consequence of people’s renewed preference of it to other mediums of exchange.

You have to go back to sort of the old gold bug tenets. Gold, unlike other mediums of exchange, is simultaneously a store of value. It isn’t a promise to pay, it’s payment in and of itself, and as a consequence of that and as a consequence of the fact that you’re seeing on a really global basis, debasement of other mediums of exchange be it euro, U.S. dollars or Renminbis.

I think the gold price is going to continue to do well, simply because it’s denominated in a fiat sea of currencies, and those fiat currencies are engaged in sort of a competitive debasement.

The other commodities that I like are the grossly oversold commodities. I think in the energy complex, North American natural gas, if you have a two- or three-year time horizon, is astonishingly cheap.

And buying companies that are solvent that have lots of proved, undeveloped locations that aren’t worth anything at $2.50 per thousand, but would be worth something at $4.00 per thousand are really good speculations. I like the uranium business. I think the world needs more energy of all kinds, but in particular it needs the energy density of uranium and the ability to generate 24/7 baseline load economically.

I like the agricultural minerals, meaning potash and phosphate. One of the things that we’re learning with 7 billion of us on the planet is that increasing food supplies by increasing the amount of farmland that we have under cultivation is increasingly a difficult proposition. And what we need to do is increase the yields per acre and the best way to increase the yields per acre is through the intelligent application of potash, phosphate and nitrogen.

I’m not talking about the profligate use of it like we used to do in the 60s, but the intelligent application of nutrients is the only way that we can feed 7 billion people — particularly when 1.2 billion of them are increasingly able to better their substandard diet in terms simply of calorie concentration than they had in the past.

So, I’m attracted to the potash business, I’m attracted to the phosphate business and those businesses have gotten very cheap. The potash and phosphate quotes have fallen pretty dramatically in the past 12 months, but I think that they are probably unsustainably low on a going forward basis.

Longer term, not in the near term but longer term, I’m still attracted to the crude oil business. Because despite the impact that high crude prices have, rising crude prices have had in Western Europe and the North American atmosphere, you can’t get over the fact that in the next 20 years at least, we’re extremely oil dependent.

In the context of vehicular transportation and the problem that we talked about earlier in the call, which is these national oil companies not reinvesting substantial amounts of sustaining capital in their business, means to me that in the fairly near term, perhaps as near as three years, perhaps as near as five years, several major exporting countries, particularly Mexico, Venezuela, Peru, Ecuador, Indonesia, and probably Iran, cease to be petroleum exporters.

If that happens, about 20% of the world’s export crude comes off the market. With crude demand on a worldwide basis growing at 1.5% compounded, you could imagine what would happen if 20% of the world’s supply came off in the face of fairly steady increases in demand.

When those supply/demand lines converge and then cross, the price experience can be pretty explosive, and I think that we could see, you know, three years out $150 crude in real terms which could mean $160-$170 crude in nominal terms if the depreciation of the U.S. dollar continues.

Insights on Gold Stocks

Q: The World Gold Council has just indicated that gold’s risen in all major currencies in the first quarter this year. But as you no doubt well know the equities have lagged considerably. What’s your opinion, is this justified or is it at this point exaggerated?

Rick Rule: I think it is at this point exaggerated, but I do think it was justified and this is an important topic, too. You know, the first thing in terms of the metals outperformance of the equities, I think is due to several factors. One, in the period five years ago to three years ago, the equities outperformed the metals fairly substantially, so there was a catch up to do.

The second thing that happened was the increasing acceptance of equity-like vehicles for bullion participation: things like the Sprott Physical Gold Trust (NYSE: PHYS), the Sprott Physical Silver Trust (NYSE: PSLV) and the gold ETFs. It’s become easier for equity investors and people with brokerage accounts, you know bond buyers and things like that, to buy bullion without having to go down to, you know, a bullion dealer and put it in the safe deposit box but rather to have it in securities accounts or in retirement accounts.

And that made bullion relatively easier and hence relatively more attractive to buy. The third factor was really disgusting corporate performance for the last decade by the gold mining companies themselves. You would have expected that when the commodity you produce increases in price from $250.00 an ounce to $1250.00 an ounce, that your cash flows wouldn’t merely increase, but they would in fact explode.

And for much of the past decade that didn’t occur. In fact the mining companies, rather than returning capital to shareholders, continued to raise capital to build up capital projects.

And I think the final factor was simply that people misunderstood the nature of the junior of the markets and many people got invested in the junior markets as a sector rather than understanding that all of the value in junior markets is controlled in about 10% of the listings.

So you had a situation that led to overvaluation of gold equities and led to a collapse of gold equities. What you have now, however, is an entirely different set of circumstances. In the first instance, the overvaluation of the equities relative to the metal is over. The equities are fairly valued, or in some cases undervalued relative to the metal. So the attractiveness offered up by the ETFs other than convenience has disappeared.

Importantly the corporate performance in the last 18 to 24 months has turned around, too. Finally, the impact of the capital expenditures made through the decade by the gold industry and the impact of the higher gold prices is flowing through on the income statements of the major mining companies.

If as an example one were to look at the income statement of Goldcorp or Barrick in the last six quarters — what you see stripped away of all the accounting subtleties, if you look at cash at beginning of period and cash at end of period and also expensed and capitalized, sustaining capital investments; these things are generating literally tons of cash.

The cash that is starting to flow through the gold mining industry really at all the producer levels from the super majors like Barrick all the way down to the 100,000 ounce producers is starting to be truly spectacular.

Understanding that if you look at the whole junior market, with 4,000 companies, there is no aggregate value in the junior sector. There is superb performance among the top 10% of juniors, but it’s really a stock pickers market and as investors and speculators come to understand the nature of the junior market, the junior market will be less able to disappoint them, simply as a consequence of the fact that they’ll be more judicious in the application of capital.

One factor that’s more pronounced in gold is that we’re really in a discovery cycle now. We have funded the exploration industry and funded it lavishly for 10 years.

And people are disappointed in the results that have come from the exploration expenditures, but that disappointment reflects a lack of knowledge of the industry. It takes a long time and consistent application of capital to have successful exploration efforts.

And it’s my belief that we are on the cusp now of a discovery cycle of the type that we enjoyed in the late 70s and early 80s in the gold sector. And there is nothing that drives both, if you will, liquidity and greed, like a discovery in the junior sector.

I remember the excitement that followed as an example: the Diamond Fields discovery where the stock went from $4.00 a share to $180.00 a share, or Arequipa that went from thirty cents a share to $30.00 a share. Big discoveries like that do two things: they add lots of liquidity to the system and they add hope, or even greed, to the sector.

Those are the type of things that can ignite a whole sector, and I really think that we’re going to see a convergence of valuation, cash consolidation and discovery. And I think it’s going to be a pretty exciting market. Doesn’t mean it’s going to happen tomorrow, but my outlook for the next one, two, and three years particularly in the precious metals sector is pretty bright.


So there you have it. One of the sharpest minds in the entire resource business sees tremendous opportunities in the years ahead in a number of subsectors.

From undervalued junior mining companies to major producers gushing cash, there’s a potential area for every commodities investor.

Perhaps most interesting is Rick’s view of the prospects for a major discovery cycle that could ignite a huge wave of excitement.

But remember, if you’re going to invest in resource companies, consider carefully what you don’t know. Read, research, and get expert opinions before you dive in.

The key is that the commodities bull market still has plenty of room to run.

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