John Kaiser: Best Leverage in Ounces-in-the-Ground Plays
Interview

The Gold Report: John, you were recently at a mining conference in Toronto where you told the audience you could see gold spiraling well into the thousands/oz. without worldwide financial Armageddon. Other gold pundits think such prices can be attained only with global financial ruin. Tell us how gold investors can have their cake and eat it too.

John Kaiser: I regard gold as a special asset class, whose specialness is derived from the fact that gold is very rare, hard to bring above ground and generally useless due to its high cost, unlike silver, which is more abundant than cheap and gets fabricated into all sorts of industrial applications. Gold would be a wonderful conductor for electronics, too, but it's just too expensive. We have just over 5 billion oz. (Boz.) scattered around the world in safes, vaults and jewelry boxes not doing much at all.

Because gold has limited utility, its price is irrelevant to ongoing economic activity. As a comparison, if oil shoots to $500/barrel that means that your paycheck would allow you to drive just one-fifth the distance it allows you to drive now. Such a move in oil would have drastic implications for the global economy. But if gold shoots to $5,000, what happens? Well, the gold stays in my teeth. Jewelry demand goes down even more, but nobody makes any decisions to substitute out of gold because it really isn't being used for much. In other words, it really should not affect the economy.

TGR: Then why are people buying gold?

JK: People buy gold because it's a very exchangeable asset class and one that can't be forged, counterfeited or multiplied like paper or digital assets. Gold is an asset you want to own because the world is changing in terms of its geopolitical and economic center of gravity; it's moving from West to East and that shift will be turbulent. The East, to some degree, is still communist. We really do not know how financial and other assets and currencies will play out over the next 20 years.

TGR: But what's driving the demand? If it's not an economic collapse, what is it?

JK: It's the conversion of money into a different asset class because investors are concerned about currency gyrations; they're concerned about equities. Imagine a corporation that sells lots of widgets but no longer has access to the rare earth elements (REEs) needed to make them. Well, the company dies.

We're entering a period of massive change in the viability of businesses as new players from China enter the global stage and as new technology undermines yesterday's technology. Then you have all these financial entities and investment banks. They have thrived because they've engaged in a systematic looting of other people's wealth. Ultimately, the crash of 2008 will usher in a dramatic decrease in the lucrative fees collected by the financial sector. What are these Wall Street entities worth when they no longer make these extraordinary trading profits? They're not creating any real wealth. The market value of all these entities is under siege. You also have a boomer generation that owns all this paper, either directly or through pension funds. But the boomers need income. Everything is geared toward capital-gains growth, yet the current generation has few real jobs that would enable it to accumulate the capital needed to buy this paper from the retiring generation. This means companies are going to shift from a capital-gains model to a dividend-based model where pricing is based on the dividend they're able to pay. As these industries mature, carve out their niche and cease to be grow-forever entities, their stock prices will stop going up. Share prices may even have to go down, so they're worth owning for their yield.

All of these things potentially undermine the value of other asset classes. So it's just common sense to park 5% or maybe 10% of your wealth into gold and let it sit there, because gold is unlikely to go down in relative terms.

Gold investors don't own gold because they want to sell when it's up 300%. They want a sense of security; when everything goes haywire like it did in 2008, at least they have one portion of their asset base to convert into other assets when the dust settles.

TGR: How did we get to the point that gold is now a preferred asset class?

JK: This shift comes after a 30-year bear market in gold caused by the 500% real gain that happened in the span of less than eight years in the 1970s. This, in turn, unleashed 2 Boz. of new mine supply.

The mining industry said: "Wow, gold's at $350/oz. and these low-grade deposits are economic and these exploration targets are worth chasing because we can develop them as bulk tonnage deposits." We've had to digest all of this. But if you inflation-adjust $350 forward over the last 30 years, gold should now be at $1,000. That means gold is currently about 30% higher than it should be in inflation-adjusted terms. We're facing a real gain in the gold price because this period of Central Bank liquidation is over. The mining industry has exhausted the available pool of gold that was easy to exploit at $350 and rising all the way to $1,000. We actually need a higher real gold price to mobilize new supply.

Do we need new supply? Well, global GDP in 1970 was $3 trillion. Today, global GDP is around $50 trillion. While the world has grown much wealthier during the last 30 years, gold has remained a small percentage of that GDP. Now, more and more people want to own it, and those that own it are reluctant to sell. I think we're facing a period where, as gold starts to move, it could rise to the $2,000–$3,000 level. People will worry and there'll be all kinds of end-of-the-world hysteria. But then gold will pull back, maybe 20%–40%. And that's fine. This will happen without currencies collapsing and without inflation going through the roof, which also means that the cost structures identified by prefeasibility studies (PFS) of junior miners with gold ounces in the ground will still be the same tomorrow as they are today. Thus, when you mine the gold, you will have HUGE profit margins. In my view, the big gains will be in gold juniors that are advancing ounces-in-the-ground deposits in anticipation of a real move in the price of gold.

TGR: That sounds a lot like what other people are saying, but just not to the same extreme.

JK: That's exactly why I am a gold bug in a sense; but I'm not what I call an apocalyptic gold bug. What you'll find hidden beneath a lot of the gold bug thinking is an intense bitterness about how they feel the world has turned out. People on the left and right are bitter; they're both experiencing the same thing—the compression of the middle class—the crushing view that, in the West, we are dealing with the contraction of our standard of living. That makes us sort of diametrically opposed to China and, to some degree, India, where they have a small light at the end of the tunnel that is growing. In percentage terms, it's not huge; but on their perceived level, it's extraordinary—they are optimistic about the future. They want to own gold because they don't trust their communist or half-communist leadership, which could screw it up.

In the West, people see that their leadership has screwed it up and it's not going to get better. But you've got both groups wanting to own gold.

TGR: Let's get to some gold producers. If gold rises to the levels you mentioned and major producers are still operating at the same inflation-adjusted cash costs, then we're going to see some big earnings increases. Tell us about some of the names in that space.

JK: Obviously, the big producers like Barrick Gold Corporation (NYSE:ABX; TSX:ABX) and Newmont Mining Corp. (NYSE:NEM) will benefit because they've all made huge capital investments in massive deposits. Suddenly gold goes up and they will experience the same thing copper producers experienced during the last decade when they stopped forward-selling copper into the futures market for delivery at a price lower than spot. It took them several years to figure out this was really dumb.

The gold producers have realized these hedging strategies are not good as gold demand adjusts to a new reality. Of course, they'll bring them back in once gold stabilizes at a new level; but right now, they're all prepared to sell their gold at the spot price. The big game, though, is in the intermediate sector where you have companies, such as Goldcorp Inc. (NYSE:GG; TSX:G) and Kinross Gold Corp. (TSX:K; NYSE:KGC).

TGR: You wouldn't list Goldcorp as a major?

JK: Well, I guess Goldcorp has made it into that category; but companies like Goldcorp and Kinross have been on a mergers and acquisitions (M&A) tangent. The really big gold producers aren't taking out the juniors much anymore because they need 3–4 million ounces (Moz.) in the ground even to get their attention.

But we're seeing intermediate companies starting to consolidate smaller companies. Companies like Eldorado Gold Corp. (TSX:ELD; NYSE:EGO); Alamos Gold Inc. (TSX:AGI) is another one and potentially, Jaguar Mining Inc. (TSX:JAG; NYSE:JAG) down the road.

Then there is another set. Take for example Minefinders Corporation (TSX:MFL; NYSE:MFN), which is a single-project company. What is it going to do? Will it be taken out by a bigger company, or will it start taking out other companies? Same thing with Golden Star Resources Ltd. (TSX:GSC; NYSE:GSS) or a Gammon Gold Inc. (NYSE:GRS; TSX:GAM). These are just the Canadian-listed ones. There are also Australian companies and a few European ones in there, too. But the area most interesting to me is non-producers. That's where the game is—the ounces-in-the-ground juniors that aren't economic at the prevailing gold price. If we shift to a higher real price, then the money will follow the ounces in the ground. For example, one of the companies I've followed is Chesapeake Gold Corp. (TSX.V:CKG). Its Metates project is huge—15 Moz., but it requires several billion in infrastructure and that's not something a junior can do. The problem is they have no place to put infrastructure and they have an asset-drainage problem, so Chesapeake has come up with a plan to pipe a slurry concentrate 140 km to a better suited location.

TGR: You mentioned El Dorado Gold. Goldcorp trumped its bid for Andean Resources' El Morro gold-silver deposit in Chile. El Dorado offered $3 billion for Andean. If it had the money for that and didn't get it, the company must be looking elsewhere. What other targets might El Dorado be looking at?

JK: Without actually having thought about what they're interested in, it would just be random stuff. There might be companies like Guyana Goldfields, Inc. (TSX:GUY), which is in Guyana and has a multimillion-ounce resource.

Once it becomes generally accepted that gold is in a long-term uptrend, you'll see excessive pricing in the more-advanced companies. They'll be able to use their paper as currency to acquire smaller companies or standalone deposits for a fraction of their market cap, and then put their internal capital resources to work to develop these projects.

You have growth by acquisition in an uptrending market, so the whole is worth more than the sum of the parts. That type of logic drives the M&A business during an uptrend. We've already seen Osisko Mining Corp. (TSX:OSK) take out my favorite gold junior—Brett Resources—and grab the 6–7 Moz. there because it's the same sort of bulk tonnage, low-grade system as Osisko's Canadian Malartic Project in Quebec. We're going to see these kinds of projects disappear as the whole M&A business moves down the food chain and gobbles up all the ounces-in-the-ground companies that don't have serious permitting, environmental or technical problems. One example of such obstacles is Gabriel Resources Ltd. (TSX:GBU) in Romania, where there's political opposition to development.

TGR: What are some ounces-in-the-ground companies you like?

JK: Well, one that's still quite cheap and my replacement for Brett is Spanish Mountain Gold Ltd. (formerly Skygold Ventures) (TSX.V:SPA). It has just 3–4 million low-grade ounces in the ground, but it's in the process of completing a preliminary economic assessment (PEA). Once we know the cost structure, then we can start penciling in different gold prices to see what happens to the bottom line.

Spanish Mountain was once perceived as a high-grade quartz vein system, and then somebody realized that the black shales hosting these quartz veins were also mineralized with low-grade gold. That's when they started measuring the entire package and doing the metallurgy to see if the whole thing could be mined as an open pit. That's how a crumby little 200 Koz. high-grade deposit suddenly became a 3–4 Moz. bulk-tonnage operation.

Another example of a company that's mutated from being an alluvial saprolite mining entity is Sandspring Resources Ltd. (TSX.V:SSP), which did a reverse takeover just a year ago when the Canadian brokerage industry and backers realized these guys had been wasting their time on the saprolite when beneath it was a major gold-copper deposit in the bedrock system. Those are examples of companies whose basic geological premise was rethought.

TGR: John, you understand geology better than most geologists. What exploration plays do you like?

JK: In terms of exploration potential, one of the areas I'm very keen on is hybrid base/precious metals deposits. Copper-gold porphyry projects intrigue me a lot because I'm a bull on the continuing growth of China and demand growth for copper. And I've already talked about how high I think gold could go. We need to develop lower-grade copper deposits, which require higher copper prices. I think strong copper prices in the $3–$6 range are the new reality.

One of the juniors I've got a strong open recommendation on is Geologix Explorations Inc. (TSX:GIX), which acquired the Tepal gold-copper porphyry project in southern Mexico from a company that got caught in the financial meltdown. Geologix itself had its major project taken away during the meltdown but used its remaining cash to acquire Tepal, which has just below 100 million tons (Mt.) of copper-gold mineralization.

Geologix is now doing two things: 1) Working on a PEA to figure out what it takes to mine the existing resource as a modest copper-gold open-pit operation; and 2) Bringing geological talent to bear and using geophysical surveys on the surrounding area to see how this system actually works. There is potential to expand the resource through exploration, perhaps even double it. That would mean they could scale up the mining plant.

Right now, the market is pricing Geologix as though it will be unsuccessful with further exploration. By buying Geologix, you're placing a bet on gold and cooper trending higher and a favorable PEA making it worth $100M or so down the road. That means the stock might go to $1 and get taken out by another entity looking to add a copper-gold producer to its portfolio. On the other hand, if exploration is successful, you could see this thing turn into a $200M–$300M asset, which, of course, would put the stock in the $2–$3 range—a 10-bagger from the current level.

TGR: Nice. Heading in a different direction, the hottest play in the junior market is the Yukon. That area play has gotten more coverage than anything else since Kinross took out Underworld Resources earlier this year. What are some companies you like in the Yukon?

JK: Well, the one that I've been following since it hit $0.60 last year is ATAC Resources Ltd. (TSX.V:ATC). This is a classic toiling-geologist company, which had flatlined in the $0.15-–$0.30 range for years. ATAC specialized in generating projects in the Yukon, farming them out and never getting lucky. But then its Rau Project started to click a couple of years ago. This is a property that's been expanded to cover more than 100 km. of carbonate rocks that bear a striking similarity to the host rocks in Nevada's Carlin Trend.

The company found several zones of gold mineralization that it had treated as a sediment-hosted gold system. This year, at the far end of the belt, it made the Osiris discovery through old-fashioned prospecting and systematic exploration. Here ATAC has a geological setting that is a dead ringer for the host of the Carlin-style mineralization; it's even gone from calling this a sediment-hosted gold system to a Carlin-style hosted gold system. The company has published just one drill hole so far, but the footprint is enormous. The stock has gone to from $0.60–$6; ATAC now has a rather extraordinary market cap of $600M. There are no ounces in the ground yet, but this is the type of story that could be a real home run. If it discovered a Carlin-style system in the Yukon with the same sort of 50–100 Moz. gold endowment, a stock like that, pardon the expression, could go to the moon. Now, because the company has 100 million shares out, it's not like the old days where the moon was really high. But a stock like this could go to $30 or even $50 if drilling confirms that Osiris is a multimillion-ounce discovery and that the entire belt is prospective for similar gold hot spots.

What the junior market has lacked for the last 10 years is this sort of 'holy-mackerel' score where old-fashioned exploration leads to a jaw-dropping discovery and everybody who bet on it makes an enormous amount of money. Aurelian Resources Inc. (TSX:ARU) came the closest to doing that, but it chewed through $19M in exploration funding and, basically, scored with a Hail Mary pass. Then the Ecuadorian government decided to re-jig its mining law, and Aurelian was taken out for just $1 billion. Retail investors really never had a chance to participate in that. We have been in a skeptical market for gold exploration, but the attitude is changing, helped in part by record-high nominal gold prices and successes in the field. As this glass switches from half empty to half full, retail investors will flood back into the resource exploration sector.

Interest in exploration is making a broad comeback because the ounces-in-the-ground number crunchers are good at figuring out the upside limit based on their gold price of choice. But with a new discovery like ATAC's Osiris, where do you put the limit? Until they've done all the exploration work, you don't know what's not there. On existing deposits a lot of the work has already been done and you know what's not there, so the speculative upside is muted.

As gold grinds higher, these ounces-in-the-ground companies get absorbed, cash enters the system and then you add in a 'holy mackerel'-style gold discovery and you wind up with an all-out crazy bull market similar to what we had in the mid-1990s. What happened in the mid-1990s was far more exciting than in the last decade, when more than $60 billion worth of takeover bids was handed to the junior sector. There was all this money but none of the absolute excitement that characterized Dia Met Minerals Ltd.'s (now owned by BHP Billiton Ltd. (NYSE:BHP; OTCPK:BHPLF)) discovery, which became the Ekati Diamond Mine in the Northwest Territories; Aber Diamond Corp.'s discovery, which became the Diavik Diamond Mine; Diamond Fields International Ltd.'s (TSX:DFI) discovery, which became the Voisey's Bay nickel mine in Labrador in the 1990s and Arequipa Resources, whose Pierina gold discovery in Peru was bought by Barrick for $1 billion. I think we're heading back to something like those heady days.

John Kaiser, a mining analyst with 25-plus years of experience, produces the Kaiser Bottom-Fish Report. It specializes in high-risk Canadian resource sector securities and seeks to provide investors with a framework for intelligent speculation. His investment approach integrates his "bottom-fishing strategy" with his "rational speculation model." After graduating from the University of British Columbia in 1982, John joined Continental Carlisle Douglas, a Vancouver brokerage firm that specialized in Vancouver Stock Exchange listed securities, as a research assistant. Six years later, he moved to Pacific International Securities as research director and also became a registered investment adviser. Not long after moving to the U.S. with his family in 1994, John cast his own line in the water, so to speak, with publication of the premier edition of the Kaiser Bottom-Fish Report.

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DISCLOSURE:
1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Goldcorp, Minefinders, Geologix, Guyana and Sandspring.
3) John Kaiser: I personally and/or my family own shares of the following companies mentioned in this interview: Spanish Mountain and Geologix. I personally and/or my family am paid by the following companies mentioned in this interview: None.