Strategies for Success in a Bloody Market

The Gold Report: John, early this year you predicted that as many as 500 companies listed on the TSX Venture Exchange would go under by the end of 2013. Do you stand by that?

John Kaiser: I think at least 500 companies are endangered; I doubt they will disappear by the end of the year. The critical time will be next summer, when their audited financials are due and their annual meetings will be held. If we have not had a turnaround by then, many management teams will hand the keys over to the stock exchange and abandon their companies.

Of the 1,800 companies we follow, 761 as of June 28 have less than $200,000 ($200K) in working capital left. That is the bare minimum needed to merely exist as a publicly listed company.

TGR: Is capital on hand one of the first things that you look at when deciding whether to invest?

JK: Yes. If a company has no working capital, we look at whether management owns sufficient shares to make it worth its while to salvage the company and whatever resource assets it still owns.

"Our ideal company has working capital of at least $3 million and a management team that holds a reasonable equity stake."

Our ideal company has working capital of at least $3 million ($3M) and a management team that holds a reasonable equity stake and has well-rounded exploration and development expertise. We want a company that is working its property. Too many companies, despite being well endowed with cash, are hunkering down, waiting for metal prices to turn around.

That is the deadly danger we face: companies with cash going into hibernation. No money gets spent on exploration. No new discoveries emerge. Existing deposits are mothballed because they require heavy capital spending to advance them. The entire sector goes dormant.

TGR: In your chart of 1,788 resource sector companies, 73% are trading below $0.20/share. The percentage trading below $0.10/share jumped to a seven-year high of 53% in late 2008, dipped to 12.6% in February 2011 and is back up above 58% this year. What is causing those swings?

JK: While equities in general are near record highs, the resource sector has been targeted for a massive selloff. We are now more than two years into a serious bear market. Two things are driving this. One is the perception that the supercycle has run its course and that the global economy will, at best, grow at a very modest rate. At worst, we may end up in a global recession or depression. The other perception is that the main narrative for gold has not really delivered what was promised: a substantially higher gold price.

The mining sector has also seen substantial cost escalation over the last five years. Now we get the extra whammy of declining metal prices. Investors see the mining sector as just one big way to lose money.

TGR: In April, you attributed blame for falling gold prices to the goldbug narrative that took pleasure in bad news. Is a good economy good for gold?

JK: The apocalyptic goldbug narrative posits that if fiat currencies are debased, the gold price will rise. However, that is just a mathematical adjustment to inflation; it does not create a profit margin for existing gold mines.

"I disagree with the conventional goldbug view that a strong American economy is bad for gold."

An alternative argument is that much of the demand for gold in the last decade has been purchases made possible by the prosperity created through the emergence of China as a major economic engine. The private sector now owns 82% of all the gold that exists; central banks own about 18%, the lowest since 1910.

If the global economy were to keep growing, emerging market economies would grow at a greater rate than mature Western economies, eventually eclipsing them. The resulting shift in the balance of economic power to these new kids on the block would introduce anxiety over what the world might look like 1015 years from now, when the U.S. economy no longer dominates.

It would be prudent for the private sector to park some of its growing wealth in physical gold and for central banks, particularly in countries with emerging economies, to accumulate gold in preparation for a period of instability when the U.S. dollar no longer serves as the single reserve currency. A reviving American economy would benefit the global economy, which should boost demand for gold. I disagree with the conventional goldbug view that a strong American economy is bad for gold. The market, however, has for now taken their view, which creates a bottom-fishing opportunity.

TGR: June was tough for gold and mining stocks. Physical gold dropped through the $1,200/ounce ($1,200/oz) barrier, and the Market Vectors Junior Gold Miners (GDXJ) basket of miners sank to new lows. Let's talk about some of the companies that could survive in this new reality and their strategies.

JK: A number of strategies can help a company survive and investors can do well if they ride out this downturn.

Probe Mines Limited (PRB:TSX.V) is a junior with a new, low-grade gold system discovery in an Ontario greenstone belt where no significant gold had ever been discovered and mined. The company did not publish an expected preliminary economic assessment (PEA) in Q1/13 based on its 4 million ounces (4 Moz) 1 gram/tonne gold. Instead, its drilling last December discovered a new aspect to the existing gold zone. This opened up the potential for underground gold mining at a higher grade and may indicate that the low-grade gold system is part of something much bigger and richer.

Probe gives you a dual hedge. If gold turns around, the low-grade, open-pittable resource becomes very valuable again. Or if we have a brand-new discovery play on our hands, nobody will care about the gold price because the grade will work at even lower gold prices.

TGR: When do you expect a PEA?

JK: At the end of 2013, with a resource estimate issued in September 2013. Probe Mines is closing some property agreements to consolidate ownership of the land position. The stock is in a holding pattern. Once these loose ends are tied up, the stock will stand out.

TGR: Could Probe be a takeover target for Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE)?

JK: Agnico-Eagle has bought just below 10% already. Probe still owns its Borden project 100%, but Agnico-Eagle has an equity foothold and is in a position to provide technical advice. When a takeover bid becomes justifiable, Agnico-Eagle would have a head start on any competitors, but it would still be an auction among any interested producers. Incidentally, Probe Mines has $39M in working capital.

TGR: What is another strategy and company?

JK: Midas Gold Corp. (MAX:TSX) has the Golden Meadow project in Idaho, a gold-and-antimony story for which a PEA was published in September 2012 that envisions an open-pit mine producing 5 million ounces gold and 90 million pounds antimony. It recently sold a royalty on the gold to Franco-Nevada Corp. (FNV:TSX; FNV:NYSE) for $15M, giving Midas $25M in cash. On July 2 Teck Resources Ltd. (TCK:TSX; TCK:NYSE) bought a 9.9% equity stake for $9.8M, boosting working capital to about $35M. That puts Midas Gold in a strong position to complete a prefeasibility study during the first half of 2014.

"Look for stories that can stand out in a sideways metal price market."

Last year Midas Gold was a $45/share stock, now, it is trading $0.700.80/share. The company has good management. Significant exploration potential exists beyond the zones it wants to put into production as an open-pit mine. Idaho is perceived as a difficult place to permit a mine, but this is a former mining district, where tungsten was produced during World War II. That left behind a mess, which developing Golden Meadows as an open pit would clean up. Still, management estimates permitting will take three to five years.

The antimony component presents a security of supply aspect, given that 85% of global antimony supply comes from China. While antimony's main use is as a fire retardant, it has potential new applications in battery storage devices. This could become a strategic reason to accelerate development at Golden Meadows.

TGR: Do you look for a variety of metals to balance and diversify the risk?

JK: When the metals are very different it can be helpful, especially when the demand cycles are not correlated. It used to be good to have gold and copper in a system because copper is traditionally strong during an economic boom when gold is weak.

But today, the destinies of gold and base metals are pretty much twinned. If there is a major global downturn, gold and copper prices will be weak. In an upturn, both will be stronger. Byproduct credits go up and down roughly in tandem these days.

However, during the past decade we have seen supply volatility from regions such as China that are well endowed with certain metals such as zinc, molybdenum, rare earths, tungsten and antimony. In the case of rare earth, supply was curtailed, resulting in a price bubble during 2011. But in the other cases China has ramped up supply, the sustainability of which is in question. South Africa with regard to platinum is another example. Byproduct metals whose primary supply has a geographical skew, such as is the case with antimony, do interest me.

TGR: How about another strategy and another company?

JK: Clifton Star Resources Inc. (CFO:TSX.V; C3T:FSE) has the Duparquet project in Qubec. This was a high-flying stock promotion several years ago, which was mismanaged. The regulators halted the stock until the company brought on new management.

Clifton Star is an example of a junior looking to change its mining model to mitigate heavy upfront costs. The market perceives it as a relatively high-cost open-pit gold mine that would produce 1.5 Moz over a 10-year period. Based on the PEA published in December 2012, the project as envisioned is marginal at the current gold price. Management is rethinking its mining model, moving from a pressure oxidation unit to simply producing a concentrate for shipment to China for smelting. That could eliminate substantial capital costs and reduce operating costs.

The company still has $9M, which it deems sufficient capital to deliver a prefeasibility study in Q1/14 that incorporates these changes. Clifton Star will not have title until it has made a series of balloon property payments totaling $52M that come due between December 2014 and the end of 2017.

The market is pricing companies like Clifton Star on the premise that current or weaker gold prices will prevail in the foreseeable future. Such companies need to find an audience willing to take the view that within a year gold will be back in an uptrend underpinned by a sustainable narrative that promises higher real gold prices. Once gold has stabilized, these stocks with an overhang should be accumulated at incrementally higher prices that cleans out the hostile, angry shareholder base without attracting algo traders. This is why another year of bear market could be healthy for the sector. It would allow rotation of the audiences for these stocks, so when the uptrend starts, they will accelerate quickly.

TGR: Under that scenario, what other name could do well?

JK: Shifting to silver, a junior called Maya Gold Silver Inc. (MYA:TSX.V) is returning the Zgounder mine in Morocco to production on a fairly small operating scale of 200 tons per day (200 tpd), producing 1 Moz/year. In itself this mining plan is not very interesting, especially with silver now below $20 per oz, but it is part of a substantial company-building exercise. Noureddine Mokaddem, who was a heavyweight in the Moroccan mining industry, has put together a group of projects for this Canadian junior. Several are owned by the Moroccan government's mining entity, which is privatizing them.

Part of the deal in earning an 85% interest in this project is that the company must put Zgrounder back into production. The cost is relatively modest. It only needs to spend another $3.5M to commission by the end of the year.

The real game here is that this system could be similar to Morocco's Imiter silver mine, which also started as a small, underground, 1 Moz/year operation. Then management realized that the material between the high-grade lenses was also mineralized and went into production as an open-pit mine. Imiter now produces 10 Moz/year, has already produced 100 Moz and has 100 Moz to go. As part of restarting the underground mine Maya must conduct exploration drilling, which will be done at an angle that will make or break the hypothesis that it is vesting for 85% of another potential Imiter.

TGR: How about another name?

JK: Diamonds are a commodity whose price is not only difficult to track, but whose price comes in hundreds of variations based on the crystal shape, color, clarity and carat weight of individual diamonds. Peregrine Diamonds Ltd. (PGD:TSX) is in a holding pattern while it waits for De Beers to make a decision by the end of 2013. Thirty-five percent of the stock is owned by Robert and Eric Friedland. Its 100%-owned Chidliak project has a significant diamond resource on Baffin Island. In the last four years, with the help of BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), Peregrine has found six high-grade pipes within a field of many more diamondiferous pipes.

In April, rather than just wait for De Beers to make up its mind, Peregrine took a 500-ton surface sample at its own expense from the CH-6 pipe, where it estimates the presence of 20M carats. If the 3 carats/ton global grade holds up in this sample, the resulting 1,500 carat parcel would be large enough to allow valuation.

TGR: Do you look for different fundamentals in a diamond company than a gold company?

JK: Yes. The fundamentals for diamonds are trickier. With gold, as soon as you have an intersection, you know the value per ton of the material. With diamonds, you need to spend many millions to get a large enough parcel to assess the value. Diamonds are a statistical game. There is a big spectrum of quality related to size, crystal shape and color.

If the diamonds turn out to be valued at more than $100/carat on average, that would set in motion a prefeasibility study on CH-6. The hang-up is the deal Peregrine did last year that allows De Beers to acquire 50.1% by spending $52M, of which $38M would be a firm commitment. DeBeers has until the end of this year to make this election. Anglo American Plc (AAUK:NASDAQ), which owns 85% of De Beers, has its own problems these days.

Whether De Beers walks away or elects to earn 50.1%, Peregrine Diamonds will process the bulk sample, and the market will finally know how to quantify the potential economic value of the diamond pipes on Baffin Island. It will not do so until De Beers is in or out. In either case Peregrine will have saved its shareholders a year waiting for that crucial information, the value of the diamonds at Chidliak. If the quality is high, Peregrine will benefit from two Friedlands as major stakeholders.

TGR: How about rare earths?

JK: Rare earths are still trying to find a bottom. With Mountain Pass and Mount Weld coming onstream this year, there will be meaningful supply of light rare earths outside of China. End users are waiting to see a stable, non-Chinese supply of rare earth elements before they start incorporating rare earth oxides (REOs) back into their products. Meanwhile the arrival of non-Chinese supply will weigh on rare earth prices.

The heavy rare earth (HRE) problem has not been solved. Some of the more advanced companies with large deposits, such as Quest Rare Minerals Ltd. (QRM:TSX; QRM:NYSE.MKT) and Tasman Metals Ltd. (TSM:TSX.V; TAS:NYSE.MKT; TASXF:OTCPK; T61:FSE), are doing costly metallurgical studies. Their projects will probably not come on-line until late this decade, assuming they can clear the pilot plant studies and fund what are likely to be high capital costs.

Namibia Rare Earths Inc. (NRE:TSX, NMREF:OTCQX) is an interesting alternative. The company owns the Lofdal carbonatite complex in Namibia. It has developed a small, low-grade, HRE-dominated deposit that could provide a bridge supply over the next 510 years. This fills a space that neither Lynas Corp. (LYC:ASX) nor Molycorp Inc. (MCP:NYSE) is able to fill.

Namibia Rare Earths has $20M in working capital. Its shareholder base recently changed when Endeavour Mining Corp. (EDV:TSX; EVR:ASX:TSX) sold its block to a couple of venture capitalists. Namibia Rare Earths has a solid management team and a supportive shareholder base. It is looking for rare earth elements and other specialty metals within this carbonatite complex. More metallurgical studies will tell us whether it will can process and produce HREs from the Lofdal deposit.

TGR: When do you expect that?

JK: We expect news on that front in Q3/13. The key will be the ability to remove the radioactive thorium from the heavy rare earth concentrate so that it can be shipped to processors in Japan or Europe. The next step would involve spending $5M on a PEA expected some time in 2014.

TGR: What about another name?

JK: Southern Arc Minerals Inc. (SA:TSX.V; SOACF:OTCQX) has been working in Indonesia for the past decade and has $14M in cash. The company expects to produce an NI 43-101 resource estimate for its primary project. Once it has delivered its resource estimate, the company plans to stop working in Indonesia and to seek farm-out partners for its more advanced assets. It is looking for opportunities to acquire a distressed asset, perhaps in a different jurisdiction with fewer political issues. The company has a decent management team, including John Proust and Mike Andrews, and substantial backing from the Qatar Sovereign Wealth Fund. On June 28 Southern Arc announced that it had spent half its treasury to acquire a 26% equity stake in another junior, Eagle Hill Exploration Corp, owner of the high-grade Windfall gold deposit in Quebec. That is not my preferred way for a cash-rich junior to deploy its capital, but it is an example of opportunism at work in a distressed gold equity market.

TGR: Another company?

JK: Golden Arrow Resources Corp. (GRG:TSX.V; GAC:FSE; GARWF:OTCPK) just produced a resource estimate for a silver-zinc-lead deposit that has more than $3B worth of metals, the Chinchillas project. Its black mark right now is that it is in Argentina. Golden Arrow's exit strategy is that its project is near and similar to Silver Standard Resources Inc.'s (SSO:TSX; SSRI:NASDAQ) Pirquitas mine. The company will continue basic work and, hopefully, be bought out by Silver Standard.

Golden Arrow also has projects in Peru, $10M working capital, not a lot of shares outstanding and an experienced, well-rounded management group. It is the sort of company that I would expect to survive and possibly deliver a windfall sometime in the next few years.

TGR: In addition to silver, this is zinc-lead play. Is that a good thing?

JK: Yes. Zinc is one of the few base metals where, because mines are shutting down and new mines are slow to come onstream, zinc will be in deficit in the next three to five years. Today, there are mountains of zinc in warehouses, but zinc consumption is also much higher and increasing.

Zinc is one of the few metals I expect to rise over the next couple of years regardless of the macroeconomic trends. We could see stronger zinc prices in the next year or so. That would attract capital to zinc plays, of which there are very few.

TGR: Golden Arrow plans to release a PEA early next year. What do you hope to see from that?

JK: We hope to see a positive net present value (NPV) and reasonable capital and operating cost estimates.

The market does not trust many of the cost numbers used in PEAs. That is one reason that even though these companies show significant NPVs at trailing average metal prices lower than spot price, the market has been unwilling to assign anything near the value implied by the economic study. The recent bad press about the quality of cost assumptions in economic studies will hopefully make future economic studies more reliable.

TGR: What number do you use for the gold price when you look at feasibility studies?

JK: I use the whole range: the trailing average, lower and higher numbers.

I treat juniors as leveraged options on the future price of the metal. If you plug in $2,000/oz gold, some projects end up being 10 or 20 times more valuable than they are now. If gold continues at its current price, these companies may have an intrinsic value of zero. I like to see at what gold price the internal rate of return drops below 15%, and the net present value drops to zero. I prefer using a 10% discount rate rather than the 5% rate favored by many analysts.

Painful as this market has been to my picks and portfolio, it has a certain beauty. The valuations of the juniors are so cheap, that if we did get a positive outcome or if the economy started to grow again and metal prices rose for reasons that are perceived as sustainable over the longer term, these companies would see very rapid price increases. And there is an abundance of information available through the 400+ economic studies we have picked apart.

But you have to buy these stocks without knowing when the metal price will turn up. Once it turns, there is no stock available. If you want to bottom fish, you have to take the timing risk.

TGR: What topic excites you most?

JK: Nevada remains my favorite topic. Nevada has produced 250 Moz gold since 1970, and 100 Moz of medium-grade gold remain in the ground, largely controlled by Newmont Mining Corp. (NEM:NYSE) and Barrick Gold Corp. (ABX:TSX; ABX:NYSE). But every outcrop in Nevada has been explored, and the perception is that if there is anything more to be found, it is under cover and probably on ground controlled by Barrick and Newmont. My contrarian view is that this perception is wrong, that hundreds of million gold ounces remain to be found in shallow bedrock covered by gravel on land not controlled by the majors.

Nevada Exploration Inc. (NGE:TSX.V) has collected more than 5,000 groundwater samples, mainly from gravel-covered basins in northern Nevada. The company identified at least 80 gold-in-groundwater anomalies along with Carlin-type pathfinder elements outside the main trends controlled by Barrick and Newmont. It has at least 20 targets that it regards as high priority. This suggests dozens of gold deposits are to be found under the gravels. These targets are interesting because of the nothingness that sampling has revealed about the surrounding area. This junior has the keys to their locations. It will still take conventional explorationgravity, seismic and other geophysical surveys and stratigraphic drillingto map the bedrock geology and home in on these systems.

Nevada could well experience an exploration boom$200M of grassroots exploration capital to deliver an additional 200300 Mozin the next 5 to 10 years, driven by juniors exploring these anomalies. This could become a distributed area play attracting risk capital. Given what Carlin-type deposits are like, the gold price will not matter.

TGR: Has the gold-in-groundwater sampling method been proven?

JK: The science behind it is sound. It is the basis for the Environmental Protection Agency's water quality monitoring rules. A 20-Moz deposit called Twin Creeks had a study that showed a gold-in-groundwater anomaly associated with that deposit's location under basin gravels, along with other Carlin-type pathfinder elements deemed as poisonous to humans. Nevada Exploration sampled nearly 30 known deposits and established halos that correlate reasonably well with a deposit's location. What it has not done is deliver its own significant discovery using its methodology.

The ability to measure gold at such diluted levels has only existed for 10 years. Nobody has had an opportunity to apply gold-in-groundwater sampling on a large scale except Nevada Exploration.

TGR: Will there be a moment of truth when we will know if this approach works?

JK: Nevada Exploration has one play, Grass Valley, poised for a $600K three-hole stratigraphic program. If this program gets done and it intersects lower plate hosted gold mineralization within the context of the anomaly and the other data sets that have been built up, that would kick off the next great gold rush in America.

TGR: Does it have enough funding to do that drill program and report on it?

JK: The project is 70% owned by McEwen Mining Inc. (MUX:NYSE), which is responsible for all exploration costs, but which is now losing money on several smallish gold and silver projects thanks to the recent drop in gold and silver prices.

Does Rob McEwen have the courage to divert some of his shrinking capital into drilling high-risk, high-reward discovery holes? It appears that McEwen Mining does not want to risk spending money on any exploration. It is now concerned with keeping its ship afloat. On the bright side, if we see a further deterioration in gold and silver prices, McEwen Mining may have no choice but to swing for the fences with a wildcat drill program on a company-maker scale target.

TGR: What did you think of the Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX) settlement announced recently?

JK: The settlement disappointed the market. Rye Patch will get $10M cash, and the net smelter royalty at $20/oz silver is worth about $2630M. It will kick in at the start of 2014. At that point, Rye Patch could probably sell it to a royalty company at a discounted price that would leave Rye Patch with $2530M in working capital.

Rye Patch, headed by Bill Howald, has a number of other exploration projects in Nevada. Its approach is old-fashioned: We have a target, we're going to drill for it and make a discovery.

I like the company and its situation, though I am not so keen about the Oreana Trend properties in the current gold-silver price environment. Rye Patch is active in the Cortez-Battle Mountain Trend, which is where I am hopeful it will start exploring aggressively rather than just sit on the cash.

Rye Patch has changed from a company with $700K in working capital, a number of projects and a fair number of shares outstanding, into a cash-rich junior with motivated management in a position to deliver discoveries during a bear market.

TGR: Any final advice for investors trying to keep their own ships afloat?

JK: In the resource sector, you need to consider whether a company can survive a potential two- to three-year bear market. You want to have a mix of companies in different commodities, companies that have determined management, money or at least a story that can raise money, assets, ounces or pounds in the ground and do not have a high carrying cost for the company to keep title. Also look for stories that can stand out in a sideways metal price market, either because of a unique twist or because of a compelling exploration target. When a junior is willing to fire its bullets at a target knowing that the bullet factory is on strike, that is a reason in itself to look a little closer.

TGR: John, it is always a pleasure and an education talking with you.

John Kaiser, a mining analyst with 25+ years of experience, produces Kaiser Research Online. After graduating from the University of British Columbia in 1982, he joined Continental Carlisle Douglas as a research assistant. Six years later, he moved to Pacific International Securities as research director, and also became a registered investment adviser. He moved to the U.S. with his family in 1994.

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1) JT Long conducted this interview for The Gold Report and provides services to The Gold Report as an employee. She or her 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: Probe Mines Limited., Franco-Nevada Corp., Clifton Star Resources Inc., Tasman Metals Ltd., Namibia Rare Earths Inc., Southern Arc Minerals Inc., Golden Arrow Resources Corp., Silver Standard Resources Inc., Rye Patch Gold Corp. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.

3) John Kaiser: I or my family own shares of the following companies mentioned in this interview: Peregrine Diamonds Ltd., Rye Patch Gold Corp., Tasman Metals Ltd., Nevada Exploration Inc. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.

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