Putting Faith in Holding Physical Metals: Eric Sprott

New York Hard Assets Investment Conference 2012 Online Preview

BY PHILIP BURGERT
May 15, 2012 • Reprints

Long-time investor Eric Sprott, the chairman of Sprott Inc., chief excutive officer, chief investment officer and senior portfolio manager for Sprott Assett Management LP and chairman of Sprott Money Ltd., stirred up a lot of interest he when issued a “Call to Action” to silver producers to limit sales until prices increased and put their convert their cash reserves to physical silver. He’s still pushing that argument, as Resource Investor found when we interviewed Sprott for Futures magazine recently.

Resource Investor: How would you characterize your relationship and that of Sprott Asset Management to the futures industry and futures trading?

Eric Sprott: I would suggest that we don’t have a great relationship to the futures industry per se, because we don’t get involved in trading of futures and never have been involved that way. We tend to be buyers of physical metal whether it’s for our accounts here at Sprott Asset Management or whether it is for the two trusts that we have listed on the New York Stock Exchange. Obviously our actions in the physical metals might have some impact on the futures markets because we have been a significant buyer of silver on a relative basis but I don’t actively trade those contracts.

RI: Is there a reason that you stay away from futures?

ES: Well the reason is that when you buy a futures contract you are taking on a counterparty risk and there are those of us who think that the Comex trading is incredibly erratic relative to the physical market. I might describe Comex as primarily a paper market where somebody with deep pockets can affect the price of the metal notwithstanding that there is absolutely no relationship to the physical market. So for the reason of counterparty risk and the fact that it bears no relationship to what’s going on in the real world metals, in my mind I don’t get involved.

RI: How did your open letter to silver miners on their potential role in determining pricing in the market develop?

ES: I think it opened up a number of inquiries at metals companies. We have seen a number of examples recently. One very small company literally said they were buying some of our silver trust in support of our call to action. First Majestic Silver also bought 10 million of our most recent tranche of the Silver Trust in recognition of that, I believe. Endeavor Silver didn’t sell some silver in the fourth quarter thinking that the Comex price was an inappropriate price and that things were going on that shouldn’t have affected the physical market. Of the roughly 1.2 million ounces they produced in the quarter they only sold 400,000 in anticipation getting a better price when the Comex market was somewhat more rational. And of course that was a very, very wise decision on their part.

The only other change I’ve noted is that McEwen Gold, I think, figured that they put a third of their cash into gold and silver. Now Rob McEwen had been a strong proponent of owning physical gold when he was CEO of Goldcorp. He had a very large position that he maintained in gold. So that is not a new theme for him but it was interesting that they recently stepped up their gold and silver positions.

We are still trying to convince more people in the silver business that the paper market, rather than the physical markets seem to determine the price and continually suggest to them that they should be a little more proactive in their dealings in their silver trade and that instead of owning cash they should own silver. So it’s an ongoing movement that hopefully will get better response from larger organizations.

But I would think that anybody who has their eyes open to what happens in the commodity market (would look at what we’re doing). It’s so darn volatile when you think that silver goes from $49-$50 to $27 and when we had that Feb. 29 smash this year where it fell by $3 or $4 or close to 10% in literally a day – which rarely ever happens in any commodity market. That’s questionable particularly when there wasn’t any announcement of any change in the physical market whatsoever that would make people do that. So we’re still working very hard at trying to get the producers to realize that it’s in their best interest to take matters into their own hands because I think they are being disadvantaged by the paper market.

RI: I think there were something like 17 companies cited in your letter original and three or four have now had some response. Is that right?

ES: Right. We still have a lot of work to do, though.

RI: How did the idea of this develop in the first place – of getting miners to have this type of role?

ES: There are two fundamental reasons for it. The first is that the paper markets are way too volatile relative to what’s going on in the physical market. And the second one is simply a statement that if they would regard silver as a currency – which many, many times over humankind it has been and I suspect will become a currency again – that they would be much better positioned to – rather than have their money in a leveraged counterparty bank – have it in silver. So those are the two things. It’s trying to fight off the action in the paper market and at the same time recognize the fragility of the financial system and not own cash.

RI: Do you think that there is anything that the futures markets themselves might be doing to change the way they work as paper markets?

ES: Well, there have been lawsuits filed against JPMorgan and HSBC saying that they manipulated the price of silver in 2008. Those are in the public record. Either the CFTC or the CME – Chicago Mercantile Exchange – have had an ongoing investigation into manipulation of the silver market for three and a half years now with no results. There has been the Dodd-Frank suggestion that there are position limits which keep getting pushed out. So I would say that of those – I mean some resolution that means the CME or CFTC getting involved in the ’08 suggested manipulation, the current investigation with some results or instituting position limits – would all be beneficial to proper trading in the futures markets.

RI: Do you see any sign of changes in the way the exchanges are orchestrating their margin requirements?

ES: None. In fact I’m always surprised they keep pushing these times when the dealers have to report their positions. No, there has been absolutely zero positive response from the regulators.

RI: On all of the things you are citing here, there has been no positive response?

ES: And I might even go on to say we’ve also had this MF Global situation but there’s been absolutely zero transparency. Nobody seems to know where the money is. Nobody seems to discuss that a lot of the owners of gold and silver were sold out of their positions in the fourth quarter as part of the bankruptcy situation. So no, I would say it’s gone in reverse. It’s just a closed door and now nobody has any idea what’s happening.

RI: And as far as the investigation you don’t see any sign of action on that – the extended ongoing CFTC investigation?

ES: There’s been no sign of anything other than delaying it.

RI: Do you think there are any prospects for improvement on that?

ES: There’s no tangible evidence of it. If I saw some tangible evidence of it I might say, “Oh boy, things are changing here.” But as I mentioned, we have the whole MF Global thing where I think the CME essentially tried to wash their hands of the whole thing. So no, I would say there is no suggestion that the CFTC or the CME is likely to have any resolution with respect to the concerns we have.

RI: I saw this quoted somewhere else that you had indicated that 143 times the amount of silver is traded in the markets versus mine supply. Is that an accurate quote?

ES: I think it’s probably way, way, way worse than that and I would go back when the price of silver was $49-$50. I think that day – when it was about to break out on the upside – there was something like a billion ounces of paper silver traded that day – over a billion. And for investment purposes there’s less than about a million and a quarter ounces – maybe – that would be available per day to trade in the physical market. So if you want to compare a billion to a million you had a thousand times more paper trades than was available physically.

RI: And what are the implications of that?

ES: The implications to me as a guy sitting back looking at [it is], I say who is it that’s selling the billion ounces and what possible relationship would that have to possibly supplying silver? We only mine about 750 million ounces a year, so whoever sold a billion ounces that day obviously had not a hope in hell of supplying that silver. It’s just become a paper market and/or a high frequency trading market, both elements are in there. And really there is no purpose for high frequency trading. We don’t need to trade a billion ounces of silver in a day to say that we have liquidity in the market. I mean you could probably trade 10 million ounces a day and it would be more than enough liquidity to deal with the daily transactions that are truly necessary in the physical market.

RI: Are there any other arguments other than liquidity that are floated up to justify these positions?

ES: There are no other arguments and, in fact, I think everyone realizes that with high-frequency trading the net result is the bona fide investor makes less. That’s the net result of it all … It’s kind of funny that exchanges should be trying to encourage people to earn money on your exchanges – not lose money on their exchange – but we have the opposite situation.

RI: You are Canadian but you’ve also urged miners to store part of their reserves outside of the banking system. Do you include Canadian banks among those that you feel are at risk?

ES: I characterize all banks as levered financial institutions. We all know every bank is levered. Most of them are levered at a minimum of 20 to one. Just stand back and say to yourself that if there is a 5% decline in something with paper assets there is no capital at the end of the day. We’ve probably had a 4%-5% decline in the stock market in the past week. We might have a 2% to 3% or 4% decline in the European bond market last week. So you have to realize that there is a lot of risk when you are levered and your capital can be impaired rather quickly. I’m a chartered accountant and I just don’t believe that financial institutions should be that levered. Obviously it was the leverage in the financial institutions that brought us the ’08 crisis. It’s the leverage in the financial institutions that brought us the G6 creation of unlimited swap lines. It’s leverage in the financial institutions that brought us the LTRO in Europe. It’s an ongoing issue that people take deposits to the banks. The banks have to sell an asset which they don’t want to sell because it’s probably at a loss and/or there are no buyers. So the only reason that banks ever need to borrow is because some depositor wants his money back. When you’re earning a spread every day, other things being equal you should have more money than last time. And when you’re having principal repayments every day at the end of the day you should have more money than last time. Why do you need to borrow? You shouldn’t need to borrow. You should have positive cash flow all the time. Well obviously because they have to borrow it means that the deposits are moving around.

RI: So are Canadian banks in the same situation as other banks?

ES: I think there is a hierarchy in banking and, of course, if we imagine somebody living in Greece, do you leave your money in a Greek bank or do you try to upgrade to a stronger bank? I think it is obvious what you might do if you were a thinking person and I would say to the good fortune of the Canadian banking industry they’re pretty high up in that hierarchy and therefore not at risk as much as some other sovereign banks.

RI: How do you see the silver market and other metals developing in the next few months and beyond?

ES: You know, a lot depends on how this financial crisis, which seems to be ongoing, plays out. I’ve always been a great believer that the ultimate true price generation will be a function of fear of the financial system where people see it as I would much rather have my money in gold in my hand than I would have it in the bank. And if the European situation continues to deteriorate – and I’m only saying it’s begun to deteriorate literally within the last two weeks again, I mean it’s already deteriorated once and then we had the LTRO come along and everyone seemed to be calm and now it looks like it might be rearing its ugly head again – that to a great extent will determine what the fate of gold and silver are. That and is the US in a recovery or not in a recovery? Do we get another QE? If we get another QE3 I think that is a signal that gold and silver will rise. A lot of people are asking, “What’s your target for gold or silver” and I say, “Well, you tell me what the money supply is going to be ongoing.” And that’s a tough question to answer because you have the Bank of England, the Bank of Japan, the ECB, the Fed – they all keep coming up with these money printing schemes and goodness knows how much is going to be printed. But the more that’s printed I think the higher price of the gold and silver go. So it’s a moving target. But obviously we’ve printed enough money already in the last four years since we had the beginning of the financial crisis in the developed world that one could see gold and silver prices being well beyond where they are today with the amount of money that we have floating around the world. In fact I wouldn’t call it money, I would call it fiat currency floating around the world.

RI: There are some people who are suggesting that are right now some of the factors for gold are not quite the same as they have been in that the there is some weakness developing in trading. You don’t see any of that?

ES: I think at all came out of the theory that the US was in recovery mode and therefor there was no need for QE3. I’ve never been a believer in the recovery. I’ve always that we’ll get some data that would suggest that it’s not recovering as we have expected. In fact we wrote our last article in the Markets at a Glance on that: “The Recovery Has No Clothes.” And of course I feel somewhat justified … I think there were some very strong headwinds in the first two months of the year, including the very benign weather we had, the fact that February was a Leap Year and January had an extra business day. It may not sound like much but you know what? It’s 4% more business days, so you might expect factory orders would be higher in February this year than last year, you’ve got an extra business day. So I think as some of these events transform into a situation where we are comparing apples to apples, that the comparisons will not look as good and it’s a very simple thing for me to imagine that we wouldn’t get recovery and I think almost anyone would imagine that we wouldn’t get a recovery if you simply look at that 99% and the fact that wage increases are very muted. Costs are going up well about CPI and you have to know that that disposable income, discretionary disposable income, must be going down. How do you get a recovery off declining discretionary disposable income? It’s very, very difficult.

RI: So that continues to bode well for precious metals?

ES: Well in our view, the situation we’re in where the financial situation is still at risk – it never was really out of risk. It gets bailed out temporarily but once the medicine runs out every time – the QE1 ended and the market tanked, after QE2 ended the market tanked, LTRO looks like it might have run its course here in the sense of the optimism that it generated, now with European markets declining reasonably quickly and we’ve got bond yields going back up, even Operation Twist which would suggest that they buy the long end of the bond curve – literally bond rates have gone up since Operation Twist started. We’re not really seeing the fruits of what the market might have anticipated with these funding operations. And I should point out that none of it goes to the 99%. In fact if you look at Europe they say we’re going to lend the banks an unlimited amount of money and by the way we want you to put in an austerity program. So the banks get helped and the economy gets nothing – the 99%.

RI: Which metals do you see as being the best investments now?

ES: I distinguish between precious metals and commodity, cyclical metals. I’ve not been a bull on the commodity metals because, let’s face it, there’s a recession in Europe. There’s a big slowdown taking place in Asia. People debate what China’s GDP is going to be this year, but the fact is – I was just looking at the HSBC manufacturing survey – it’s gone down for five months and it’s been in negative territory for five months. Manufacturing in China has been negative for five months based on that survey, so as far as commodities go I would say the outlook is very challenging.

RI: So what about other investments like energy?

ES: I don’t feel that I’m an expert on natural gas and I haven’t really been a buyer of energy securities for some time now. Even energy – even though it’s about the most inelastic of the cyclically sensitive of commodities in a world slowing economy – there will be a time when oil price comes under pressure here. It won’t be long-lasting because you’ve got to keep drilling and I’m a believer in the peak oil thesis. If you get a market selloff I think energy would go with it, whereas I hope if there is another market selloff that we may see gold rally into the that selloff in this particular case.

RI: What are you doing in terms of equities?

ES: We’ve actually been a seller of some of the physical metals – I’m talking within Sprott Asset Management now, not the trust. We’ve been a seller of some metals to buy equities because we know they’ve massively underperformed the price of gold and that they’re likely to snap back. If we could imagine gold and silver going to new highs this year, I think the stocks would significantly outperform the commodities.

RI: Are you talking about precious metals equities?

ES: I’m in precious metals, yes.

FM: Do you do anything beyond precious metals in equities?

ES: Not much these days because I have this fear, you know, that the financial system is at risk that we’re going into a recession or that we’ll have very modest recoveries, and I don’t really want to be involved in any economically sensitive area.

RI: So in terms of the precious metals are you talking about mining equities and royalty companies?

ES: Well, I think the royalty companies are OK. It hasn’t been a big feature with us, but I can see the merits of it for sure. I’d much rather try to find a producer who can increase his production significantly over the next two years and therefore you might get a double whammy if the price of the metal goes back up and the production goes up. You can have a pretty dramatic impact on earnings and therefore valuation.

RI: Do you have a timetable that you see for turnaround in mining stocks?

ES: I don’t have a timetable and turnaround because one thing about the markets, they can go off on a tangent for a while. Imagine that certain things are going to happen only to find out that they don’t happen, or they don’t happen as expected… if the market’s forced to change the mood – let’s say we’ve got couple of reports that suggested that the economic strength was nonexistent, well then I think the market would come under some pressure and people again be forced to say, “What works in a bear market or a cyclical downturn?” And I think history has proven that gold works because if there is a cyclical downturn of course it puts even more pressure on anyone who’s running a levered balance sheet and of course I’m referring to the banks in that case. And then again the fear of the banking business comes out and people opt for safety of gold and silver.

RI: Your company’s portfolio managers describe your investment approach as being built around the idea of making money by not losing it first. How can investors avoid losing money today?

ES: That’s sort of been our modus operandi ever since 2000 and we could see, “Oh, my goodness this Nasdaq is back to mania and look what could happen when we all come to our senses. And of course it did happen quickly. And then, of course, we’ve tried to avoid what should have been a normal secular bear market by interference by central banks and governments, whether with a zero interest rate policy or cash for clunkers or new home buyers tax credits — all the TARPs and TALFs and things that we had never heard of before – to try to prevent the market from going its natural way. And actually for the most part they probably have prevented a lot of what otherwise might have happened. God forbid that we didn’t get a TARP or TALF or QE or LTRO because I think when the LTRO was announced or the G6 came in – more the G6 – and said we’re going to have unlimited swap lines there were institutions that were going to go down – very obviously and they stopped it, they stopped what was going to happen from happening. That doesn’t mean it’s not going to happen in the future because you don’t stop a deleveraging by creating more debt. In fact that’s the opposite of where you really want to be. You want the banks to really replenish capital not start reinstituting dividends and stock buybacks and things like that. It’s ridiculous. I think the one case where we had a bank issue in Europe, UniCredit, they probably lost more in market cap by announcement of the issue than they even raised in the capital raising. It’s a bit of a statement about how ready the market is to refinance the banks. We just have an ongoing problem here that we haven’t solved. I don’t see the problem going away to be honest.

RI: So you have been operate on the basis of not losing money since 2000.

ES: And the way to avoid losing money is to own the metals. As you know they’ve gone up 500 percent since then. We’ve probably been the extreme beneficiary of reckless monetary and fiscal policies, which one might not have anticipated back in 2000 when we got involved in it. But that’s transpired. If you go to your Economics 101 textbook you won’t read about zero interest rate policies, you won’t read about conservatorships, you won’t read about long-term refinancing operations, you won’t read about quantitative easing. These are all new things that are meant to stabilize a very fragile system. In lots of cases they have stabilized it for a time, only to find out that the gradual deleveraging that must take place takes place. In terms of economics, I think our central bank governor, Mr. Carney, explained it best when he said at a speech in Toronto about three months ago we’re at a “Minsky moment.” There was an economist by the name of Hyman Minsky who prophesied or had a theory that when you expand your GDP by increasingly relying on debt there comes a time when the productive resource that must support the debt becomes totally unable to support the debt, it’s just not big enough. The classic example is Greece. They had so much debt, it became obviously apparent that these 11 million people and their GDP could not support the debt. Then you have debt forgiveness, which is exactly what he predicted and exactly what happened. And I would make the comment that there are many economies in the world that are well into the Minsky moment where the debt keeps going up but the production doesn’t. When you think of the US, back in 2000 we probably had 1.5 million new homes, now we’ve got 300,000, we probably sold 18 million cars, now we sell 14 million. For a decade or 12 years we’ve accomplished nothing. Meanwhile the debt has exploded. So you have this productive capacity that has to support more and more and more debt and we don’t even produce as much, which creates a big problem.

RI: So the precious metals are a way to protect the wealth?

ES: Because there is no counterparty risk. If you own a coin in your hand you don’t have to worry about some institution, such as Dexia, which over a weekend suddenly had to get bailed out by three governments. Just out of nowhere. It was so instantaneous it was unbelievable. Imagine if they didn’t bail them out. The depositors had to fear for their deposits. That’s what the fear is that we’ve expended so much money trying to support the financial system and it’s very debatable whether the powers that be will win in the end. I suggest they will lose.

RI: So the precious metals don’t have the counterparty risk and they don’t have the risk of the banks or paper financial instruments?

ES: They don’t have the counterparty risk, they’re rare, they have a 2,000 year history of preserving value, so in a bad market the most important thing is to try to preserve capital. You’re not even trying to make money, you’re just trying to hold yourself there.

RI: Your web site says you employ a mixture of philosophies. Can you talk about your different investment philosophies. Why is it necessary to have more than one?

ES: I think the first philosophy is to try not to lose the client’s money. That’s by far the most important thing. And the second thing is try to have your money grow. Even though we have people in the bond business and balance funds and things that have a little disadvantage over gold and silver, that portfolio manager has the flexibility to deal totally with the situation at hand. In other words if a bond guy can short this bond and buy that bond, there is a survival mechanism that is available. That’s the approach we take. We wouldn’t just start a bond fund and say we’re going to buy government bonds and then just see how the wind blows. We want to be in a position where we can deal with the vulnerbilities of the world’s financial system and at least hold our own.

RI: Do you have a bond fund that buys government bonds?

ES: Luckily they don’t buy government bonds. One of the things I said when we hired the guy was does this guy like government bonds. “No he doesn’t.” Good, we can hire him. He would buy corporate bonds, higher yielding instruments where he has analyzed the company and realizes there’s a way to survive and prosper. So that’s essentially what they’ve done or trade those bonds against a government bond or… there are various strategies that they employ that try to generate a positive return.

RI: You operate out of Canada. What differences are there in US and Canadian regulations about investors?

ES: I don’t know that there are many. The fundamental regulation should be all rules should protect the investor. No, I wouldn’t say that. There might be different reports you have to file but I don’t think that the theme of the regulation is different by any extent. I don’t think it’s easier here versus in the US. No, I would say that the theme is exactly the same.

RI: In analyzing investment in energy and metals stocks, how much do you base your outlook on the underlying market and how much is based on the actual company?

ES: We’re long run bulls on energy because it is very tough to replace energy as we all know and the world just continues to use more and more and more. In effect its stunning what ultimately is going to happen if you take a longer-term view. As I mentioned before, on a shorter-term basis if there is some kind of economic decline here, then energy even though it’s the least elastic of products, will probably come under a little bit of pressure. So I haven’t been adding to positions in energy. I see way more upside in precious metals.

RI: So you are long-run bulls on energy but do you anticipate getting back into more energy at some point with more elasticity?

ES: You have to watch events unfold. I mean who knows? You could imagine a situation where the dominoes start falling here and it wouldn’t be pretty. Therefore it depends on how things flow going forward, right? I mean if let’s say two weeks from now we start discussing some kind of bailout for Spain…oh my goodness. Who know what happens to energy or anything economically sensitive. So you have to kind of play it by ear. I just don’t see a situation there with our view of where the economies are going that I would want to participate in a cyclical commodity.

RI: And as far as the precious metals go, do you see a point at some place down the road – I guess when all this debt is possibly brought under control, which is hard to imagine – do you see prices falling again at some point?

ES: They’ll fall someday for sure. But we might be 10 years from that day and many multiples higher than today’s price. That would be my view. Just as it’s gone up by five times in the last 12 years who knows, maybe 10 years from now it will be up another four times, which would create an astounding number by the way.

RI: So you don’t actually forecast where it is going to get to?

ES: Not really, because it’s a moving target. I mean what if they announced QE3 in three weeks, right. Well then you’ve got to up your gold target and if the Bank of England keeps buying and the Bank of Japan keeps buying and the LTRO does another tranche two months from now it just keeps telling you more and more people have to put their money into things that will maintain their value. It’s a very difficult thing to predict. I do believe both metals will hit new highs this year, but where they go from here is a very open question.

RI: Is there anything else you want to add?

ES: No, I think you’ve covered it pretty good there. Thanks a lot.

RI: Thank you.

Eric Sprott will give a keynote address to the New York Hard Assets Investment Conference today at 10:30 a.m.

Phil Burgert is managing editor of ResourceInvestor.com. He can be contacted at pburgert@resourceinvestor.com.

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