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 Fri Jan 26, 2007
Excerpt: Bottom-Fish Action Report - A lurching stairway to hell or a modulated stairway to heaven?
    Publisher: Kaiser Research Online
    Author: Copyright 2007 John A Kaiser

 

Excerpt Bottom-Fish Action Report Jan 14-20, 2007

January 16, 2007

A lurching stairway to hell or a modulated stairway to heaven?

Losers marginally outnumbered gainers on the TSXV for most of the week of January 14-20, 2007, but daily new highs climbed above 30 while new lows remained below 20. Trading volume reached the highest level since mid December, hitting 198 million shares on Thursday January 18 in advance of the 2007 Vancouver Resource Investment Conference held on January 21-22. This was the biggest and most successful show put on by Joe Martin's Cambridge House. Although there were more than 400 exhibitor booths in a seemingly endless series of rows that were substantially wider than those of the IIC gold show in San Francisco, the floor was so crowded with delegates on Sunday that it took one a rather long time to navigate from the Speaker Hall to the Workshops at the other end. The Speaker Hall was full from the early morning talks right through the last one in the evening both Sunday and Monday. On Sunday people were camped out on the floor in the Speaker Hall next to chairs like some sort of sixties be-in. According to Joe Martin 8,200 people pre-registered and a large number showed up for on-site registration. Exhibitors who have historically grumbled that they were not getting quality traffic, and who had been wringing their hands in advance of the show because of the record number of fellow exhibitors, were pleasantly surprised by the attention they got. Should we be worried by what seems to signal the top of the bull market? As in the past couple years when we saw record turnouts, there still was not present that sense of "I'm missing the boat" panic which characterizes a true market top. The audience is bigger than it has ever been, but it is cautiously interested and surprisingly knowledgeable rather than panic-driven and grasping for bandwagon tips. This was apparent in the market on Monday and Tuesday as stocks which had been recommended from the podium by speakers received only a moderate short-lived increase in action. None of that, of course, has any impact on the eventual outcome in the battle between the structural bulls and the cyclical bears which continues to rage as base metal prices correct from the 2006 peaks.

The recent rebound in the price of gold was given a boost on Thursday January 18 when the US Department of Labor reported that the Consumer Price Index had climbed to 201.8 in December, an increase of 0.1% from November, and an increase of 2.5% from a year ago. This is the biggest month over month jump since April 2006, but it comes after 0.5% declines in September and October, and no change in November. Key sectors responsible for the increase are housing costs, which are calculated on the basis of rent rather than purchase cost, and energy, which experienced higher gasoline prices even though crude oil prices were at the bottom of the 2006 range. Commentators were mixed in interpreting the increase as a sign of inflation which would justify higher interest rates later this year, or as a meaningless blip which in the context of weak home sales left open the possibility of lower rates. The gold bug fringe, of course, dismissed the overall low inflation rate as a product of manipulation by the Federal Reserve to hide the true inflation rate which supposedly is substantially higher than posted. Currency markets paid no attention and bid the US dollar slightly higher even as gold crept higher, confirming that for the moment at least the old inverse relationship between the price of gold and the US dollar is not at work. Resource sector speculators who appreciate that this is a good thing for the economics of gold projects controlled by juniors shook off the early January blues.

Copper continued to have difficulties as LME warehouse inventories nearly breached 200,000 tonnes, but by the end of the week the worst seemed to be over as inventories retreated to 193,000 tonnes. Reports circulated that copper mine capacity utilization had jumped sharply during the last quarter of 2006, exceeding 90% as producers hustled to take advantage of high spot prices before they disappeared. While the weakening spot price constitutes a bearish market trend, the move by producers to full capacity has bullish implications. By now copper producers will be close to exhausting their grade flexing opportunities. Grade flexing is a mining strategy which targets higher grade ore during periods of weak metal prices and shifts to lower grade ore during high prices. Copper's sharp price rise since mid 2003 has been accompanied by a strong bearish sentiment evident in the persistent backwardation in the futures market. During the first couple years copper producers were heavy forward sellers of future production, but such hedging activity by producers has shrunk as management responded to shareholder criticism over all that cash left on the table. At a time of record prices even in the futures market you would think the copper producers would be locking in high prices for the next couple years (you can still get $2.25 per lb for copper 27 months down the road). During the copper price ascent the producers would have been inclined to mine higher grade ore because of their anxiety over the longevity of high prices and because of the desire to compensate for forward selling so much at prices that turned out substantially lower than spot prices. Eventually, however, you have to switch back to mining lower grade ore, and that time has come, which partly explains the move towards full capacity. While the surge in supply has cooled the spot price, the producers may very well lack the capacity to boost supply further in the near term. In other words, further downward pressure on the spot price will have to come from weakening demand.

Conundrum: what to do during the 3-5 years it will take for the Veneroso style cyclical bears to be right?

The conditions for the classic collision between a lagging supply cycle peak and a business cycle related fall-off in demand that creates a price devastating glut do not seem to be in place. The stalling of the copper sell-off is linked to reports that Chinese demand has started to climb again, giving hope to the structural contention that the new low for copper will be in the $2.00-$2.50 per lb range. Cyclical bears like Frank Veneroso, who for the past three years have been predicting the imminent collapse of copper prices, have stepped up their bearishness, pointing out that record price spikes have historically always spawned a glut of new mine supply that has crashed base metal prices. But with capacity utilization exceeding 90%, and global demand on the rise again as the US residential construction slump bottoms out and the Chinese embark on a restocking campaign, this price crashing glut seems to be something to worry about 3-5 years down the road, the time it takes to mobilize new supply by permitting and developing new mines. So now that we are half way through the 7-8 years it will take for Frank Veneroso and his fellow cyclical bears to finally be right about a crash in metal prices, what are investors and the mining industry to do now? If the mining industry wholeheartedly agrees with Veneroso, and resists putting new mines into production, he will be horribly wrong. If everybody chooses to ignore him, he will be terribly right. The deep pessimism implicit in the persistent backwardation in the base metal futures market suggests that the mining industry has sided with Veneroso for the past three years, helping him be wrong, and creating the psychological conditions which will encourage the mining industry to ignore him for the next five years, thus ensuring that Veneroso will eventually be very right. From the standpoint of somebody who speculates in resource juniors, this creates a conundrum. Do I focus on the eventual outcome and miss a huge profit opportunity created by the majority choosing to ignore the eventual outcome, or do I ignore the eventual train wreck and participate in the greater fool spiral with the hope that I will manage to bail out before it collapses?

Plan A Strategy: upgrade and expand existing resources

The uncertainty created by this conundrum is one reason the audience at last weekend's conference is not yet in panic buying mode. It is the reason that the market is refusing to plug current metal prices into the cash flow models appropriate for the advanced base metal deposits owned by many juniors. At the Cambridge conference I recommended a strategy of focusing on juniors which own advanced base and/or precious metals deposits with $1 billion or more gross value of metal in the ground at current prices and a rock value well above the operating cost associated with the mining plan appropriate for the deposit. I offered juniors such as Lithic Resources Ltd (LTH-V: $0.59) with its Crypto zinc deposit in Utah, and Geodex Minerals Ltd (GXM-V: $0.50) with its Sisson Brook tungsten-molybdenum-copper deposit in New Brunswick, as prime examples of juniors that would be trading a lot higher if there were widespread confidence that the current metal prices were here to stay. Both companies have embraced a "Plan A" strategy of drilling these projects to upgrade and expand resources. Upgrading the existing resource will put the company in a strong position to make a production decision if current metal prices do hold, and if the company is successful in expanding the resource, the accompanying economy of scale related reduction in operating cost could allow a production decision to be feasible even if metal prices settle down at lower prices.

Do metals face a descending staircase?

The Plan A strategy hopes that this time is different, that the long term downtrend in inflation adjusted metal prices has reversed and that we face a long period of elevated prices well above past cyclical lows. In this scenario juniors like Lithic and Geodex would see their deposits eventually go into production and sport valuations 10-20 times what the market is willing to assign now. But even if this optimistic metal price scenario never comes to pass, the Plan A strategy could still deliver huge gains to speculators. There is a good chance that we may see another major spike in spot metal prices during the next couple years which shoots past recent record highs, something we are now seeing in nickel which had a price peak in 2005 before pulling back in the face of a supply surge. Now we have nickel pushing at a record $19 per lb due to static supply and growing demand. Nickel juniors have done extremely well, even though everybody knows that when major new nickel mines come on stream in 2010-2012 the price of nickel will get clobbered. My expectation is that base metals will all spike to new highs after the current pullback has bottomed out this year. For cyclical bears like Frank Veneroso and Paul van Eeden to look good in the eyes of the market, we need to see a descending staircase pattern develop from here onwards. In other words, after copper spends 6-8 months building a base at $2.50 per lb, puffing up the structural bulls with optimism, the next move is a sharp downward lurch to the $2 per lb level, where copper spends another 6-8 months building a base through which it also breaks to, say, $1.50. This continues for the next 2-3 years until copper is back to $0.60 per lb. This slow motion bear cycle possibility is a realistic risk, and it is the reason only fools dismiss Van Eeden and Veneroso as a bunch of broken clocks who will be right long after it matters.

Or an ascending staircase with valleys at successively higher elevations?

The alternative scenario where metals spend the next 3-5 years creating a series of new highs with interim lows that are higher than the previous pullback's low, and eventually collapsing in the way the dot-com bubble burst in 2000, will ironically draw sustenance from the badly timed pessimism of cyclical bear naysayers. The longer the cyclical bear pessimism proves unfounded, the more the masses will become disinclined to pay attention to those bearish warnings. That is when the market will substitute "permanently" for "temporarily" in the famous "this time is different" phrase that blossoms whenever a cycle's amplitude and duration exceed all past cycles. Then woe the bear who digs in his heels while market valuations shoot far beyond rational valuation limits.

What good is eventually being right if in between you are on the wrong side of a mania?

Two past examples of this phenomenon in the resource sector were the nickel-copper Voisey's Bay discovery of Diamond Fields and the Indonesian gold Busang discovery of Bre-X. During 1995 analysts such as myself did the math and concluded that the Ovoid was worth about $1 billion or $36 per Diamond Fields share pre-split. Well, we promptly looked stupid as Diamond Fields sailed to $160 pre-split and got bought out by Inco for about $4 billion. Three years later in 1998 Inco wrote Voisey's Bay down to $1 billion even before it had to factor permitting delays into the net present value calculation. I don't recall anybody thanking me for getting my back of the napkin calculations right. I did get thanked by a friend for pointing out in early 1997 that even if Bre-X had 20 million ounces, it did not justify a $4 billion market valuation because at the reported grade it was not possible to build a mining operation for a single deposit such as the Southeast Zone large enough to churn out the cash flow at prevailing gold prices needed to justify a $4 billion net present value. That observation coupled with efforts by a former prime minister of Canada and the children of Indonesia's dictator to wrangle title away from Bre-X prompted the friend to give up on Bre-X before that guy hopped out of the helicopter without a parachute. At the time John Felderhof was waving his arms about 80 million ounces while accepting his Prospector of the Year award, and had the hoax not unraveled shortly after my comments, the thanks from my friend would have been loaded with sarcasm. Once a mania takes hold its momentum is so powerful that the market will resist evidence that the foundation for the mania has disappeared, which is exactly what happened when Freeport McMoran first reported that its twinned holes at Busang did not come anywhere close to the results reported by Bre-X. "The gold is there!" and "The hoax is the hoax!" are the memorable pronouncements by a couple prominent boosters of Bre-X who made a staggering amount of money for their followers before the mania dissolved.

China will do everything it can to make the 2008 Beijing Olympics the dawn of a new age

The mania we might see evolve for this market cycle would not be linked to a particular discovery, and thus will take much longer to dissolve. If we see a pattern of ascending metal prices with valleys at successively higher elevations, rather than a descending staircase from here onwards, we will see a resource sector mania develop that draws in a global audience. This is what I call the third leg, and in retrospect we will likely pinpoint its start in October 2006. The third leg will be drawn towards its climax by the 2008 Beijing Olympics which will focus enormous attention on the Rise of Asia. The Chinese will do everything within their power to prevent negative momentum in its economy from developing until after the Olympics. The more the western media trashes China while metal prices are rising, the more aware will become the general public about how the global economic landscape is both shifting and expanding. That we are in the middle of an unprecedented raw materials bull market will become a household idea, and a huge untapped pool of retail and mainstream institutional capital will flood into the resource sector and cascade down the entire food chain. This flood of capital will guarantee that way more new mine supply is mobilized than demand can handle even if China's growth rate continues unabated for many years. A metal price crash will come, but not before a mania has swept the resource juniors to the moon.

Hey, we too can knock satellites out of the sky!

The moon, and certainly the space surrounding the earth, has become dear to China. On January 11 China successfully used a medium range ballistic missile to destroy one of its aging weather satellites in orbit about 525 miles above the earth. Apparently this was the first "space weapons" test in 20 years by anybody, and it raised considerable concern that a new arms race to control space had begun. China confirmed on January 23 that it had conducted the test, but denied that it signaled China's intent to become a player in the militarization of space. China and Russia have pushed for an international treaty on the military use of space which the United States has resisted because it already has effective military control of space. The American "eyes in the sky" not only provide global surveillance for the United States, but the satellite network provides the navigation system that enables American missiles to take out any target on the planet. Whatever other reasons may have been behind the invasion of Iraq, one intended consequence was to use the success of the remote controlled "shock and awe" attack to demonstrate to the world that the United States can disable anybody's infrastructure without landing a giant army on that country's shores. Although the United States has not conducted any tests during the past 20 years on destroying satellites, that has been because it already has the technology to destroy "enemy" satellites. The implicit threat by the United States to the rest of the world is that if push came to shove, the United States could eliminate everybody else's satellites and then use its surviving satellite network and fleet of aircraft carriers to dominate the oceans and destroy everybody else's stationary (land base installations) or slow-moving (ships) infrastructure. The United States does not have the capacity to land an army on the shores of any major country, but it can paralyze that country by disrupting its energy, communications and transportation infrastructure, which are essential to economic activity. The only deterrence is the existence of intercontinental missiles with nuclear warheads whose whereabouts are not fully known, and submarines, which could launch a militarily futile but destructive retaliatory nuclear attack on the United States. This rules out that the United States would ever launch an infrastructure attack without provocation, but it does not change the fact if a another country such as China embarked on a military expansion campaign in its neighborhood, such as annexing Taiwan by force, the United States could inflict serious infrastructure damage on China through the use of technology alone. Because nobody has effective missile interception technology, it is a very big deal for China to demonstrate to the United States that it too has the ability to pop satellites out of orbit. And why is this development important to speculators in the resource and energy sector? It is one more signal that the status of the United States as the sole global military superpower after the collapse of the Communist Soviet Union is subtly eroding as the Rise of Asia carries on. And this is relevant to the ongoing debate between the structural bulls and the cyclical bears where the cyclical bears contend that China is the tail wagged by the American dog. It reveals the strength of China's ambition to become America's equal, and perhaps eventually its superior.

No crash, just a staircase descending from great heights a few years from now

The strong possibility that China will embark on a long term strategic campaign of stockpiling raw materials is one reason I think the eventual "metal price crash" will resemble the descending staircase the cyclical bears are expecting (hoping for?) now rather than the calamitous crash associated with a failed rocket launch. Right now the metal price charts do resemble a rocket launch, encouraging anxiety-ridden metaphors such as my "Sword of Damocles" image. But if an ascending "valleyed" staircase pattern emerges, the chart will lose its scariness and inoculate the market with confidence. Because of political uncertainty in many parts of the world, and permitting unpredictability in politically stable countries, we will not see a wave of new mines come on stream all at once and glut the market. New supply will come on stream in stages while global demand grows. When the latest valley bottoms at a lower elevation than the prior valley a few years from now, the market will scale its perspective and compare the most recent valley to a much earlier but lower one. We will not see the sort of collective realization that "it's over" as we did when the dot-com bubble peaked in March 2000. We will see what we are seeing in the real estate market where prices have retreated somewhat, but are not showing signs of crashing back to where they started five years ago.

After the third leg comes the discovery oriented fourth leg of the bull cycle

You might think that once a descending staircase pattern emerges for commodity prices the resource juniors will be in serious trouble. If it happens now, then I agree, it will become difficult to make money in the juniors. But if it happens a couple years from now, such as after the 2008 Beijing Olympics, manic conditions will have enabled the speculators presently in the resource junior market to make an enormous amount of money. They will be aware that the metal price cycle has peaked, and while the newcomers in the market may interpret the downtrend as just a bigger valley within a long term bull cycle, those that rode the cycle from its 2003 bottom will be back to plugging lower metal prices into their cash flow models. The structural bulls will become cyclical bears, but they will not exit the market. Instead, they will fuel the fourth leg of the resource junior bull cycle by bankrolling exploration plays. Instead of betting that high metal prices will hold for the longer term, turning the advanced deposits of the juniors into mine development acquisition targets, they will bet on juniors making brand new discoveries that are economic at substantially lower metal prices. We are not yet in a market where juniors can readily raise capital to explore geological targets. But the conditions for discovery style speculation of the sort we saw during the nineties are improving. For example, a year ago a pure exploration junior called Aurelian Resources Inc (ARU-V: $27.35) was flat-lining after spending more than $15 million on exploration in southern Ecuador without much to show for it. With only about $1 million left management drilled a blind geophysical target buried beneath conglomerates. Even after Aurelian reported strong epithermal mineralization in mid March the market did not care. When the results came out in early April, the stock gapped from $0.60 to $3 and within a couple weeks Aurelian had raised $20 million. The stock has since been as high as $42 as follow-up drilling confirmed an extensive medium grade gold system with potential in excess of 10 million ounces.

The market's response to Serengeti's visual description of core

That the market has started to warm up to discovery potential became evident in December 2006 when another pure exploration junior focused on porphyry targets in central-northern British Columbia called Serengeti Resources Ltd (SIR-V: $1.62) published a juicy geological description of a hole drilled in a copper-gold porphyry target on its Kwanika project. Within a week the stock had jumped from its $0.15-$0.20 bottom-crawling range to the $0.60 level where it stayed until January 9, 2007 when it reported an intersection of 111 metres grading 0.69% copper and 0.54 g/t gold. The copper grade is double that of similar copper-gold deposits in this region such as Kemess and Mt Milligan, and the market has responded strongly to this new discovery. What is important is not that Serengeti has made a new discovery, but that the market saw fit to respond to intersection visuals and the geological context by tripling the stock price before it had the benefit of confirmatory assays. The commodity price boom based resource junior cycle has pulled enough capital into the resource juniors to spawn what will be a rising number of new discoveries during the next couple years which will rebuild the Cinderella foundation needed to justify speculation in exploration plays. When the bloom finally does come off the commodity bull cycle, the resource juniors will continue to boom for another couple years as speculators shift their attention to the potential for world class discoveries.

Leeward a sign of the market warming up to geological concept plays

A further sign that an appetite for conceptual geological plays is evolving is evident in the ease with which Leeward Capital Corp (LWC-V: $0.19) was able to raise $1.2 million late last year for its Nithi Mountain molybdenum project in central British Columbia after I described in layperson terms the geological target Leeward's Jim Davis had developed. The truth machine has been working away on the Gamma and Gamma West targets since January 3 and the stock has started to creep up even though everybody who cares is already long and on their knees praying to mother nature to forgive Jim Davis for badmouthing her. When the on-site geologists started yanking the Man from Missouri's chain about what they were seeing in the core, Davis had to hustle off to the property himself to offer a stern lesson about how visuals lie and assays don't. When I told him that the Blue Pearl crowd is telling people that Endako doesn't need Nithi, Davis laughed that Nithi might not need Endako. That could mean either of two things, so I think I'll wait for the assays. But I am encouraged by signs that discovery oriented speculation is making a comeback.

Plan B Strategy: exploring for bluesky discovery

Returning to Lithic and Geodex with their Plan A strategy of upgrading and expanding an existing resource which could become a valuable mine if metal prices do not retreat to their bear market lows, what I like about these juniors is that they also have a Plan B strategy of exploring projects with bluesky potential for a discovery that is economic even at bear market metal prices. In the case of Geodex the junior hopes to make a rich indium discovery on the land it has assembled surrounding the old Mt Pleasant Mine in New Brunswick. In the case of Lithic the junior hopes to make a Buchans or Bathurst style polymetallic VMS discovery on its Stoke Mountain project in southern Quebec. On their own these Plan B exploration plays strike me as a little risky, but in conjunction with the Plan A advanced deposit exploration plays I see the potential to have my cake and eat it too. Lithic is already a KBFO bottom-fish buy recommendation in which I have a modest position, and in the case of Geodex, it did qualify for a bottom-fish buy recommendation, but I decided to simply load up on it at cheap prices and avoid the conflict of interest created by also recommending the stock. If Frank Veneroso and Paul Van Eeden are wrong, both stocks will do very well with the Plan A plays, and if these cyclical bears are right sooner than later, these stocks could still do very well if they get lucky on their Plan B exploration plays.

International Enexco a perfect example of the Plan A-B combo working

One bottom-fish recommendation similar to Lithic and Geodex which has already done so well that even my modest position has turned into a pleasing contribution to my net worth is International Enexco Inc (IEC-V: $3.24), first recommended December 5, 1995 as a bottom-fish buy in the $0.30-$0.49 range, and confirmed as a Spec Cycle 100% Hold on March 17, 2006 as the stock hit $0.65. (Yes, Kaiser also can take a very long time to be right, though that tends to apply more to stocks going up than down!) What is driving Enexco are two Plan A and B style projects which the company has held since the late seventies. The Plan A project is the Contact copper deposit in Nevada which hosts a 400 million lb plus copper resource at 1% or better which Enexco hopes to be exploiting by 2009 through a small scale underground mine. The Plan B project is a 30% interest in the Mann Lake uranium project in Saskatchewan's Athabasca Basin where JV partners Cameco and UEM have been diddling for the past 30 years. Things started to look good last year when drilling nipped 0.25 metres of 7.12% of U3O8 and 0.4 metres 5.53% U3O8. Now you might think with such short intervals the Mann Lake discovery might be suitable for mice wearing lead suits and not much else. But these unconformity associated style uranium deposits are hard to find, and with an $11,000 rock value at $72 per lb U3O8 it does not require a lot of tonnage to create huge in situ gross value numbers in the billions. The intersections were in the right geological setting just above the unconformity and Cameco plans to follow up with additional drilling in 2007 which could demonstrate that this mineralization is the tip of a tiny needle in the haystack worth billions. With just under 25 million shares fully diluted, a 30% net interest, and a $3.24 stock price, the implied project value of Mann Lake is already $260 million. At the same time the implied project value for the 100% owned Contact project that has about $1 billion worth of copper and silver in the ground at current metal prices is a modest $78 million. Enexco is conducting an 18,000 metre drill program on Contact to upgrade and expand the existing resource. Since March 2006 Enexco has raised nearly $15 million and is in excellent shape to pursue its goal of completing a prefeasibility study in 2007. Even though Enexco is up more than than 500% from its bottom-fish buy limit of $0.49, the fundamentals of this junior are so strong I am declaring a Spec Cycle 100% Hold for International Enexco Inc with the expectation that the stock will hit $5-$10 this year, higher if drilling at Mann Lake produces thicker intersections that confirm a major new uranium discovery in the Athabasca Basin.

*JK owns shares of Lithic, Geodex, Intl Enexco and Leeward

 
 

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