The Silver and Gold
Train Wreck: Part Two

By James J Puplava CFP, January 12, 2004

Gold prices are up 2 this year after rising 20% last year. Gold prices have advanced 66% since reaching their nadir on April 2, 2001. The price of the precious metal is up but it is going higher, much higher than anyone can now imagine. Right now gold is acting as it should in the early stages of a new bull market. It is climbing a proverbial "wall of worry" as traders, professionals and gold bugs sell off their shares mindful of times past when gold would break down after reaching the $400 level. To many in the gold camp this has been too much too soon. Everyone would like to believe this is a new bull market, but their mindset is steeped in the bear market past. When prices rise this quickly there is a tendency to get cautious and retreat from the market battlefield settling for nickels and dimes when big dollars are at stake.

This is a time to be bold; not a time to be timid. In a new bull market you hold your positions and accumulate on any pullbacks. You don't trade in and out of your investments or keep flipping your holdings going for singles and doubles when there is a chance to hit a home run with the bases loaded. Forget the charts. In the beginning stages of a new bull market, new chart patterns are being laid down which means an investor is better looking forward rather than looking back through the rear view mirror. The biggest mistake is trying to time in and out of your trades instead of taking a long-term investment position. Several large traders I talk to have told me they regret selling out of their positions. One pro I know of sold out of his position in September missing out entirely on gold and silver's explosive advance. As a guideline going forward, I would ask the reader to examine the two Eric King charts of the networking sector and Cisco if they want to get an idea as to where we are heading.

There are a number of reasons to be bullish at the moment. The monetary environment has never been this conducive to pushing gold prices higher. Central bankers around the globe are in the process of reinflating their economies. Paper money is everywhere and the smart money is buying what is real. Smart money is buying, holding and accumulating because they can read the monetary fine print. If you think gold prices are too high in this environment then look again at the money supply.

The money supply was less than $2 trillion when gold reached its peak of $850 on January 21, 1980. Today the money supply is at $8.956 trillion with gold prices at only $424.45. As mentioned earlier, gold prices are heading higher, much higher from where they are today.

Supply and Demand Imbalance

There is another fundamental factor that I believe will exert a more powerful influence on the price of gold and silver going forward and that is the supply and demand imbalance which appears to be worsening. Gold, like silver, has been running a supply and demand imbalance for well over a decade. It has taken central bank sales, gold leasing, and forward selling to balance out the books. In the case of silver, above-ground stockpiles of silver are being consumed at an alarming rate. Industry forecasts for gold and silver mainly focus on industrial demand. Investment demand for precious metals has been small and mainly confined to the coins. However, demand for the metal is increasing from the size of open interests on the COMEX, the introduction of gold ETFs, to demand for gold and silver mining shares. As demand increases the supply is ready to fall. Both gold and silver production should be declining over the next few years at a time when the demand for the precious metals is accelerating. Unfortunately for the industry, the supply of gold and silver can’tincrease at the flip of a switch. It takes time to explore for and develop a gold or silver mining deposit. From the time of discovery to the time a new mine is brought into production may take as long as 5-7 years.

Even if prices head higher and demand continues to increase, the supply will not be there to meet this demand unless central banks are foolish enough to unload their last remaining gold reserves. Even if they were to pursue such a course, there are large Asian and Russian central banks and Middle Eastern nations who would be there to buy any large central bank sales.

In all of the bearish discussions of central bank sales, I have heard very little about the buy side. During the heyday of central bank selling and leasing in the late 1990s there was very little discussion on who was buying. Just as there were big sellers, there were also big buyers at that time mainly coming from Asia. Gold is under-owned in Asia as far as central bank reserves are concerned, an issue that looks like it is being remedied, especially now that the dollar has begun its sharp descent.

Coming back to the issue of supply after a long-term consolidation trend that led to today's VLGPs (very large gold producer) the major gold mining producers will have a very difficult time of replacing each year's production. This issue becomes paramount as demand increases. Where will the new supplies come from and how will this new gold and silver be replaced? Because of the very nature of gold and silver mining deposits being dispersed and more difficult to find, it is going to be very difficult for major producers to discover and replace each year's production with new reserves.

An issue every investor needs to be asking about every mining company they own today is if 3, 4, 5, 7, 8 million ounces are going out the front door each year is the same amount coming in through the back door? I can tell you from what I read in company reports and industry surveys, it isn't.

	Past Production		Company Forecast Production
	2001	2002 (mil)	2003	2004 (mil)
AngloGold	6,983	5,940	5,820	5,800
Barrick	6,065	5,695	5,450	4,900
Goldfields	3,660	4,110	4,334	3,930
Harmony	2,668	2,668	2,992	4,000
Newmont	5,430	7,632	7.350	7,200
Placer Dome	2,756	2,832	3,800	3,600

Outside a few South African producers there are no major production increases foreseen for the VLGPs. Most of the production increases over the next few years are going to come from the small and mid-tiered producers. The majors are going to have a difficult time going forward replacing their reserves. Outside making a major acquisition the VLGPs are more likely to shrink in size. An acquisition may increase production in the short-term, but it does very little to increase reserves. Unless the company being acquired has a longer reserve life than the company doing the acquiring, the reserve life remains unchanged. Higher prices and the application of new technology may serve to make more of existing reserves accessible, but it is doubtful if it can increase reserve life significantly. Over the last 8 years the annual increase in global mine production has averaged only 2% since 1995. Industry forecasters are now predicting a flattening if not declining production curve over the next few years. More recently, we are seeing forecast production declines coming from the majors with Placer Dome announcing that its gold output will decline 5% this year.

In addition to production declines, the majors are also experiencing rising costs for production. While overall costs can be reduced through mergers, such as the reduction of head office staff or exploration activities, the cost of actually mining the metal is going up. The exploration staff at most majors face a formidable task of replacing reserves. There are very few new large deposits to explore. There are even fewer existing deposits that will allow the VLGPs to keep current production at its present rate and then replace those ounces that are extracted. Even if new deposits were discovered, the time required to bring these new projects on line and into production can take years. The exploration and development process has become much more difficult with the environmental movement which is making every effort to shut down many mining projects. The time required to permit projects in North America continues to get longer each year with 5-7 years now becoming the norm.

Train Wreck

While I expect that the acquisition game is getting to ramp up as exploration staffs at the majors face very few promising prospects, I believe that the acquisition game will be played out much differently this time. Instead of buying production future acquisitions, the majors will focus on buying reserves. Buying smaller gold producing companies will not ameliorate the majors' reserve problems unless the acquired company has a longer reserve life.

Once again if a 9-year reserve company buys out another 9-year reserve company, the reserve life of the company remains the same. The company's production may increase in the short run but the acquisition has done nothing to increase reserve life. In fact it has made the situation even worse because the company now has to replace a larger production base.

Therefore, the future course of acquisitions will be focused almost entirely in the junior sector. It is the junior exploration companies that have been doing most of the exploration. They are more nimble and aggressive with their exploration programs. The majors are just now ramping up their exploration budgets. I believe there has been very little acquisition activity in this area because of price increases in the junior sector. Only a few companies such as Wheaton River have been willing to pay up to own reserves or producing properties. The majors are still acting as if we are still in a bear market. With the price of gold and silver rising and the shares of many junior mining companies exploding, the majors have been reluctant and hesitant to buy. For almost a decade most juniors were sitting at the front of the majors' table looking for any scraps from the big boys just to stay alive.

A bear market in precious metal prices and a major mining scandal with Bre-X made for very difficult times. The majors would take a 10% position in a company with first right of refusal. In effect they would control the rise in the price of the stock. When they bought, it was usually at $25-$30 an ounce in the ground. That's the way it remained until recently when companies such as Glamis were willing to step up to the plate and pay as much as $100 an ounce. The majors are going to have to pay up to own resources and they will have no choice if they are to maintain production and maintain their present size. Even at higher prices many juniors with sizable reserves may decide to go into production rather than sell out. They would do much more for their shareholders if they did. In a bear market, you sell. In a bull market, you go into production. You make much more money for your shareholders by becoming a producer in a bull market and this bull market is going to be a bull market major.

You can throw the old prices out the door. We're in a new bull market that is only in its beginning stages and has much, much further and longer to go. The majors will either pay up for reserves or see their production decline. The odds don't favor the likelihood of the major producers finding 5 or 6 elephant (5 million ounce) size projects each year just to maintain present production. Over time I expect that their annual production will decline. This same problem is facing the energy industry where the large international oil companies face declining production and reserves. We saw signs of this last Friday with Royal Dutch Shell Group. Shell cut its reserve estimates by 20%. The announcement by Shell is putting pressure on the oil giants to disclose and prove their reserves, an issue that may soon confront the gold industry.

Therefore in my opinion the best way to play this major bull market is to invest in high quality juniors and in the small and mid-sized producers. These are going to be the growth companies in this new bull market. Owning the majors will be like owning stogy old blue-chips. You'll make money, but that is not where the fortunes will be made. The juniors and the small and mid-sized producers have greater growth potential especially those with prime properties and long-life reserves. You can either own the gold equivalent Ciscos in this major bull market or you can play it more conservatively by owning the majors which is a lot like owning the IBMs. During the tech bull market, the shares of Cisco went up 1640-fold. The shares of IBM went up 12-fold. That is still a good return, but I prefer the returns of a Cisco versus an IBM which is why I like juniors.

The monetary environment is going to increase the demand for gold and silver bullion and equity shares. It will become a major driver of this bull market as central banks globally depreciate their currencies in a repeat of the 1930s. However, just as monetary games will provide the fuel for this rally, the gold and silver train wreck is what will take this market to unbelievable heights. If you think prices are going higher, you haven't seen anything yet. You need to focus your mind on the fundamentals and become an investor. As to thoughts that this market has become a mania, nothing can be further from the truth. Gold newsletter writers are decisively bearish as is much of the gold camp. The monetary environment continues to deteriorate strengthening gold and silver. The supply and demand imbalance continues to worsen with central bank vaults now half full. Prices are going higher, much higher, which is why you buy and accumulate. There is simply not enough bullion or precious equity shares around to handle demand which is why prices are heading to the moon.

The market cap of the Amex Gold Bugs Index is only $53.6 billion. The market cap for the Philadelphia Gold and Silver Index is $75.7 billion. By contrast the market cap of the SOX is $548.5 billion. The Amex Networking Index has a market cap of $263.4 billion and the Nasdaq has a market cap of $3.6 trillion. The value of the entire gold and silver mining sector is only $100 billion. When the mania and the silver and gold train wreck hits, this sector we'll be talking trillions, not $100 billion.

James Puplava

© 2004 James Puplava

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