A Melman Minute
By: Leonard Melman
The strange world of financial markets rising
despite a barrage of “bad news” continues uninterrupted this morning as reports
from the petroleum and American home sales fronts hit the newswires. Regarding
oil, not only have prices been able to hold firm and sustain the new record
levels just under (all prices US$) $123 per barrel, but new trouble spots in
Nigeria and diminishing production from Russia were recently added to the upward
pressure on prices. Regarding U.S. home sales numbers, the situation continues
to worsen as the U.S. National Association of Realtors reported March sales down
a further one percent from February’s already record-low levels.
However, despite the continued bad news, financial markets followed their recent
pattern of falling in early trading, then reversing themselves and rising as the
day progresses. In this morning’s trading, the Dow Industrials were down by as
much as 35 points, but then rallied and were near +15 just before 8:00 AM PDT.
(See last paragraph for updated information)
However, we believe all is not quite well with the recent rally in the Dow.
Despite what appears to be a powerful gain from a low of near 11,700 to about
13,000, it can be noted that the rally has been labored and, by historic
standards, has progressed at a very slow pace, particularly compared to the
rapid decline that preceded it.
We hate to be the bearer of bad tidings about our mining industry, but it is
better to face reality than to ignore it - and one of the harshest realities
facing the industry is the rapid escalation of costs. They not only affect
junior, exploratory and development corporations, but also negatively impact
results for the major miners as well. Two cases in point are mining giants
Goldcorp and Barrick, both of which just announced their first quarter 2008
earnings.
Despite receiving an average price of $932 per ounce for its gold in the First
Quarter, up from about $650 during the First Quarter 2007, Goldcorp’s comparable
earnings fell somewhat short of expectations, with production problems and
sharply higher costs being the culprits. Some of the per-ounce production cost
changes at their various projects were astonishing.
For example, those per-ounce costs at their largest mine, Red Lake, rose from
$228 last year to $369 this year. At their Porcupine Mine, the comparable
figures were $419 per ounce last year and a shocking $634 this year, while at
Goldcorp’s Musselwhite Mine, the increase was even more dramatic, rising from
$458 last year to $746 this year!
It must be pointed out that production at these mines declined in
quarter-to-quarter comparisons and therefore, all the fixed production costs had
to be allocated to fewer ounces of production, but that only partially explains
the numbers.
Even seasoned market analysts were surprised by the both the production and
per-ounce cost figures. Greg Barnes, an analyst at TD Newcrest, was quoted in
the Globe and Mail as stating, “…Goldcorp’s Canadian operations underperformed
his forecast by a wide margin.: Mr. Barnes had been forecasting Canadian
production for Goldcorp of 296,000 ounces at an average cost of $418 per ounce,
but the reported figures came in at 234,100 ounces at a production cost of $507
per ounce.
Barrick’s numbers were also cause for concern regarding the escalation of
production costs. Although they did rack up sizeable profits of C$500 million
for the quarter, they also reported that per ounce production costs had risen
sharply from $309 last year to $393 per ounce this year, an increase of more
than twenty-five percent year-over-year.
Our own opinion is that some of the important factors which have been driving
costs higher are not likely to abate. Fuel and energy costs continue to soar at
an accelerating rate; professional and technical personnel shortages which drive
costs higher continue to occur in the mining industry; transportation costs are
surging; and the entire government regulatory apparatus continues to inflict
punishing extra expenditures far beyond normal exploration and production work.
Peter Monk, Barrick’s acting CEO, did mention two facts which could have
positive implications for the junior mining industry, particularly in Canada,
the USA, Mexico and Australia. First, Monk noted that Barrick planned to
increase annual production in coming years to about ten million ounces of gold,
up from the current level of near eight million. However, he added that there
has been a dearth of new, large discoveries. We interpret this as an indication
that any junior which is able to prove up a substantial new ore body will have
willing buyers waiting in the wings.
He also noted that projects in many foreign areas faced unprecedented political
and environmental opposition, noting in particular Zambia, Argentina, Venezuela,
Ecuador, Congo and others which have recently been making negative headlines. In
our opinion, this would put a premium on quality projects being developed in
politically sound countries which have histories of court-supported corporate
contract law.
There is one other chart that is worth watching closely. We are referring to our
old friend, the long-term bond interest rate Index known as TYX. There is, in
fact, an interesting but opposite comparison to action in the Dow Industrials.
Just as the Dow has been able to climb despite a veritable tidal wave of bad
economic news, in an opposite manner, long-term interest rates are showing
surprising strength in the face of perhaps the most concerted effort to drive
all interest rates lower in the entire litany of monetary history.
As can be readily seen on the chart, long-term bond rates - which directly
influence the home mortgage markets - have increased from 4.10 to 4.66 percent
since late January 2008. Our interpretation is that this increase is being
caused by investors’ unwillingness to take positions in long bonds without
greater interest returns to compensate for the risk of rising future inflation.
We are not alone in this concern.
CIBC’s Chief Economist and strategist, Jeff Rubin, just informed the National
Post that he expects long bond rates to move upward by 100 basis points - or one
full percent - in the coming year, due to rising inflationary expectations. Bank
of Nova Scotia’s senior international economist, Erik Nilsson, also noted that,
“…inflation was becoming more evident in manufacturing, labor and consumer
data.”
We believe a break above 4.75 percent on the TYX chart could be a signal that
the Fed and other central banks will have entered a world of being caught
‘between a rock and a hard place.’ At one and the same time they would be forced
to continue the loosest monetary policies possible in order to stimulate the
economy while simultaneously adopting policies of severe monetary tightening in
order to control rising inflations. It will be interesting to watch.
As of about 8:30 PDT this morning, gold is down about eight dollars while silver
and platinum are also lower, base metals have fallen sharply, crude is holding
near $122 per barrel and the U.S. Dollar is showing strength in international
currency markets. After interim rallies, both the Dow Industrials and the TSX
have turned lower in what is turning out to be a ‘roller-coaster’ session in the
financial markets.
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