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Commodity Conundrum

The following article was presented on Saturday, December 15th, 2007 for the benefit of subscribers.

Inflationary cycles are always manifested towards the end with rises in commodity prices that become equivalent to a black hole where money gravitates. Increasing the supply of money is the very definition of inflation, with rising prices being a symptom. Interest rate cycles tend to last 20-30 years starting from a decline to a base, followed by peak. Central banks use interest rates as the brakes of an economy and is the primary tool used under fiat currencies. Central Banks could stop printing money, but that would lead to a deflationary collapse, which is not a desirable outcome...so inflation it is. After interest rates rise to cool things on a Cycle Degree, periods of declining interest rates occur which will often see a decline in prices. Money is still being printed in the background, so the general overall theme is inflation, albeit maybe 1-2% instead of 15-20% near the end of the cycle. As economies begin growing with lower interest rates a credit economy emerges where companies and people essentially leverage their ability to purchase goods and pay it back later (a totally different concept than "Pay if Forward").

Towards the end of the credit cycle, inflation begins to grow due to expansion of the money supply and credit (due in part to the fractional reserve system used by banks). Rising interest rates eventually makes borrowing expensive, thereby quashing demand for things and causes scaling back in consumption sectors of the economy. During this phase, there is an increase in the amount of money circling the globe to try and find somewhere to park into something "tangible". Gold and silver and are often viewed as "tangible" items once the economy shifts from a credit economy to a "necessity economy" (paying only for the essentials such as heat, food, fuel for transportation etc.).

Supply and demand dynamics generally see commodity prices rise during the terminal portions of inflation cycles and decline during subsequent periods of disinflation. Once disinflation kicks in, commodity prices historically decline to near or below operational costs, which cause many companies to collapse. Once demand begins to outstrip supply, commodity prices begin to turn around.

The modern age of financial wizardry has caused issuance of paper to somewhat successfully manage or manipulate the price of commodities. This suppression has caused the prices of metals to be far below where many "should be", like gold and silver on an inflation adjusted valuation compared to their 1980 highs. Inflation costs for mining companies are trending around 30% per year and making many new projects economically unfeasible to develop. This was the main reason that NovaGold's Galore Creek project was shelved, which by chance had negative implications for surrounding companies. This created a negative environment, at least in North America for the development of open pit mines that have higher costs due to the lack of available infrastructure and energy costs, but have lower high-grade metal deposits. Given the era of contracting credit, companies that have large bodies of ore with high metal concentrations stand to get developed ahead of those with lower grades.

Companies that rely on credit to develop projects are going to find it harder and harder to get projects to market because much of the speculation will have been removed from the system. Companies that have mines, reasonable grades, infrastructure, good management etc. stand to profit the most with rising commodity prices as profits will hit their balance sheet NOW rather than later. Large cap companies such as Newmont mine 6 million ounces/year of gold that must be replaced in order to keep their reserve indices constant on a year to year basis. For this reason, large companies are going to be forced to go down the food chain to acquire junior gold producers. The number of junior mining companies that have good deposits and a reasonable number of shares are shrinking, so this will be the initial driver in the coming wave III of the HUI.

As many of the small junior companies are bought out, the public will start to jump on board and then the speculation begins. Most of the above information will only be realized when the public has been fleeced, so many will be lured into buying sections of moose pasture. Once the speculative phase begins, there will be a lot of money moving into emerging producers to try and bring things online to meet demand, but the present environment has yet another twist.

Oil shortages of the 1970's were political and today are geological. Societies since the dawn of time have had their growth limited to available energy. The past 100 years has seen unprecedented growth with the assumption that energy derived from oil was infinite. The sad fact is that most mining companies will not see their projects developed due to the coming energy shortages. Skyrocketing costs are going to be prohibitive for projects that are in remote areas and have little to no infrastructure. There is significant infrastructure around areas like Flin Flon Manitoba, Timmins Ontario and Sudbury Ontario so companies with deposits in these areas are likely to be developed ahead of areas with little to not infrastructure. Areas with little to no infrastructure would be locations such as Noront's discovery and NovaGold's Galore Creek. Failure for the Galore Creek to be developed automatically resulted in termination of a transmission line that could have boosted power to many other companies looking to set up shop. There is a feed back loop that often goes deeper than is initially perceived.

At present it is recommended to reduce speculative positions (meaning any company that is an emerging producer 2-3 years from production) or lower down the food chain)) to no more than 10% of an individual portfolio.

Oil sand companies are going to be around 10 years from now because most of the cheap oil has already been found. There will be issues over the course of the next 10 years such as reduced quantities of available natural gas and water (that will physically restrict the amount of oil that can be extracted), but a premium will likely be paid for owning oil in a stable part of the world. The next 5 years will see bull markets in energy (oil sand stocks and Uranium stocks) even though most in these two areas have been absolutely hammered.

Wave V speculation should start at some point in mid to late 2010 and it simply will not matter what someone owns...as long as it has the word "gold" in it. Gold stocks in wave V should be and will mostly be restricted to speculative stocks that have good potential in areas that have available infrastructure for processing ore. Around 40-60% of individual net worth during wave V should be confined to gold and silver bullion, with 20-30% in speculative stocks that have trailing stops.

The next two articles to be released on the web over the coming 2-3 months pertain to peak oil and another piece about inflation versus deflation.

For further viewing of prior work, simply click on the Archive section of this site. I update the AMEX Gold BUGS Index, AMEX Oil Index, US Dollar Index, 10-Year US Treasury Index, S&P 500 Index as well as commentary on market-related issues and new technical analysis findings. Recently, the TNX had positive reversal that failed and has had a significant decline since then. The S&P also had a positive reversal with a measured move to 1612 fail and it was hypothesized the downside move should equal the upside potential, which lies just above 1200 (this is the minimum downside target). A future article will be written about this idea along with 2-3 different editorials, so there will be no updates for the HUI for some time. We follow some 60 stocks, with a focus on core positions and stocks that actually make up our personal portfolio. As well, the keeper of the site, Captain Hook writes 3-4 articles per week discussing macro issues, ratio analysis of various markets and an in-depth study of put/call ratios and shorting candidates.

Have a good day.


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