Leonard Melman: Fiscal Cliff A Boon For Precious Metals

Surveying reality from his perch on Vancouver Island, Leonard Melman is a veritable sage in the world of metal mining analysis. In an interview with The Gold Report, the economic philosopher is troubled about the direction of the global economy. However, there are a few bright spots for eagle-eyed junior metal investors, he reports, and names some of his favorite picks.

The Gold Report: Leonard, what are the most pressing issues facing investors today?

Leonard Melman: Let's start with the fiscal cliff. If America falls into this abyss, the combination of tax increases and spending reductions will slow down economic growth. Interestingly, political leaders in Europe are calling for increasing taxes and decreasing spending in order to solve their problems. I find it amusing that the solution to economic problems being proposed by leaders on the European side of the Atlantic is thought to be the problem on the American side of the Atlantic.

TGR: How do you account for the disconnect?

LM: It is due to a philosophical inconsistency and a lack of economic understanding on the part of the world's political leaders, most of whom are not well qualified as economic thinkers, nor as philosophers for that matter.

TGR: How important is a philosophical stance to making a cogent economic analysis?

LM: Adhering to a strong underlying philosophy can guide leaders through difficult times. Unfortunately, demands by the public for more and more government services are making politicians even more reluctant to come down on the side of austerity, particularly in America. The results are uncontrollable deficits and a massive national debt. The statutory debt limit of the U.S. government is $16.394 trillion. The national debt of the U.S. as of mid-December was $16.337 trillion. Therefore, a mere $52 billion remained before the ever-rising debt reaches the statutory limit.

TGR: What will happen if no measures are taken to change the debt limit?

LM: According to law, portions of the government must cease operations once the limit is reached. Nobody wants to see that happen, least of all politicians. So I believe they will likely agree to increase the debt limit by another couple trillion dollars.

TGR: What will happen if the two-party system fails to agree on tax and spending cuts? How will the market respond?

LM: The market operates in two different directions. The precious metals market historically has regarded instability as a plus. The financial markets have historically regarded instability or uncertainty as a minus. If the parties fail to resolve either the fiscal cliff or the debt limit problem, I believe the financial markets will react negatively, but the precious metals markets will most probably react positively.

TGR: Then why has the price of gold bullion during the last year been so out of sync with the deflated price of junior gold mining stocks?

LM: In late 2007 and early 2008, the price of gold hovered near $800/ounce (oz). It's over $1,700/oz now—more than double the earlier price—and yet the three most popular mining share indexes, the Philadelphia Gold and Silver Index (XAU), the NYSE Arca Gold BUGS Index (HUI) and the Market Vectors Gold Miners ETF (GDX), are all below their late 2007 and early 2008 levels. That is rather astonishing. The reason is that the nature of mining—especially for the juniors—has undergone dramatic changes in recent years, none of which are positive. Increasing energy, transportation, geological and licensing costs make it now more expensive to mine for metals, but the most pressing problem is that the time that it takes to put a newly discovered mine into operation has increased at a rapid rate.

I've been in this business for four decades. In the late 1970s, a mine could anticipate rapid progress from the time of discovery. A junior simply raised money, put the money into the ground, proved up the asset, got construction financing and went into production. Now a series of lengthy bureaucratic processes are making it difficult for mining companies to raise new funds in the financial markets because that causes share dilution.

Share dilution tends to knock down share price, which makes it difficult to arrange the next round of financing, which then makes it even more difficult to advance exploration and development and a most difficult spiral ensues that makes it very difficult for miners to generate revenue from production.

TGR: Are environmental regulations the only cause of slowing timelines for new mine development?

LM: There are other obstacles. In Canada, we have an aboriginal problem. The courts have literally given many aboriginal tribes the ability to interfere in the progress of a mining venture. Companies are required to "consult" with them at various stages of progress. Consultation is expensive, it's time consuming, and it can be interrupted by legal procedures at almost any time.

TGR: Do you see any changes in the near term?

LM: The near term remains very difficult. In the long term, I'm fairly optimistic, because the world needs metals to survive, plain and simple. You can't cook food, you can't drive anywhere, you can't process energy, you can't run computers, you can't have medical instruments and you can't do almost anything that we do in modern life without metals. When genuine metal shortages begin to develop, we will see pressure build for a revision in these policies.

TGR: Are there any North American gold juniors that can weather these difficulties?

LM: There are some. I've developed an interest in Balmoral Resources Ltd. (BAR:TSX.V; BAMLF:OTCQX). A while back, I got to know Darin Wagner, and he struck me as a very competent individual. He successfully sold a company called West Timmins Mining Inc. (WTM:TSX), and now he's the president of Balmoral. He understands the value of obtaining properties with a high likelihood of success. The old adage is that if you want to develop a new mine, acquire property in the vicinity of an old mine. Balmoral is working in the Detour Gold Trend along the Québec-Ontario border, which has four different multimillion-ounce projects. Wagner has a great chance of success there.

Another company that I like is DNI Metals Inc. (DNI:TSX.V; DG7:FSE). It is working to develop black shale deposits in northern Alberta fairly close to the shale oil deposits and those black shales contain an enormous variety of metals. DNI has proven up very sizeable ore bodies at two locations on its properties, Buckton and Buckton South, and its current work involves resolving metallurgical problems. It's obviously a high-risk investment. The shares are about $0.18/share right now, but there could be a very substantial return if the project works out.
TGR: DNI's shares have fallen from a high of about $0.65 a year ago. Why is that?

LM: The same thing we've been talking about: the prolonged period of trying to prove up the resource during which time a firm has to keep raising funds to satisfy all operational and regulatory requirements. And the longer it has to keep looking for new funds, the more shares are outstanding, which tends to dilute the value per share.

TGR: So now would be a good time to buy DNI?

LM: From a risk/reward ratio, I believe it is a good time to acquire the shares—being fully cognizant of the risks and, of course, an investor should always do his own due diligence, but I think the potential gains outweigh the potential risks.

TGR: What about investing in bullion as opposed to investing in gold stocks?

LM: As noted earlier, during the last four years, investing directly in gold bullion would have provided a 112% gain. Investments in a variety of mining shares would have, on balance, stood still. But in the past, the opposite dynamic has applied. Looking forward, if the world monetary situation keeps declining, there could be a truly powerful gold bull market in front of us. That also applies to silver, platinum, palladium and some of the base metals. It is necessary for investors to clearly define their specific goals. If the general motive for investing in gold and silver is safety and preservation of purchasing power in case currencies break down, as they have done before, then one wants physical possession of the metals. But for trading gains, shares can be advantageous. Aside from shares, if a player desires to get in and out of the gold market quickly, exchange-traded funds work well. It depends on the investor's objective.

TGR: What about silver?

LM: I like silver more than gold as a trading vehicle, because when precious metals are rising, silver tends to rise at twice the rate of gold. Of course, when the prices fall, silver falls farther; but if one anticipates a bull market in metals, then silver has real advantages.

There are a couple of silver mines that I truly like in Mexico. Orko Silver Corp. (OK:TSX.V) has a very substantial deposit in Durango State of up to 200 million ounces of Indicated and Inferred reserves. Orko developed the property for about eight years before Pan American Silver Corp. (PAA:TSX; PAAS:NASDAQ) bought into the project. It created a joint venture with Pan American, which provided expertise and at least $18 million (M) of capital for exploration. But then Pan American decided that the project did not fit its needs, so it abandoned it.

The net result is that Orko obtained, at no cost to itself, $18M worth of exploration, which enabled it to publish a resource estimate, and allowed for a substantial increase in holdings. There was a bit of a shock to the share price when Pan American pulled out, but the stock now seems to be moving in an upward trend. The project is huge. Orko can either sell it to a major, or develop it into a very important and productive mine.

NOTE: Immediately following this interview, on December 16 First Majestic Silver Corp. issued a Press Release that announced that it had just concluded a friendly takeover of Orko, which afforded Orko shareholders a 69% gain over the present market value of Orko shares.

SilverCrest Mines Inc. (SVL:TSX.V; SVLC:NYSE.MKT) has a property in production in Sonora State, Mexico, called Santa Elena. It is throwing off a substantial amount of cash flow to further develop the Santa Elena resource, plus another property, La Joya, in Durango State. SilverCrest is expanding resources and increasing production, and doing it thanks to the cash from Santa Elena without suffering from the stock dilution that has been so harmful to other companies. It has managed to create a substantial cash reserve of about $20M.

TGR: Cash flow may be one of the most important things for investors to keep in mind.

LM: Cash flow improves the likelihood of a firm advancing its project by increasing production or discovering new resources without encountering potentially ruinous share dilution.

TGR: The share price of many specialty—or "rare earth"—metal mining corporations has disappointed investors during the past year. What will it take to reverse that trend?

LM: The world of rare earth elements is incredibly complex and potholed with variables. There are an enormous number of elements and each has its own attributes and its own uses. It takes full-time study to get a grip on how to identify demand, and how that demand can be met, given the network of variables. The rare earth miners definitely need to make a better effort to educate the public about the nature of their business.

And there is the same problem, as with all metals, of having to spend money without being on a clear path toward production. Some of the critical metals juniors went up very sharply a few years ago, after the Chinese announced they were suddenly limiting exports. Although the U.S. military establishment requires a stream of rare earth elements and other markets for rare earths are growing, many juniors have made little progress toward achieving production. The reputation of several of these companies has been hurt. The industry must more clearly identify to investors the positive attributes of rare earth elements and step up the pace toward production.

TGR: Are there any names worth watching in the critical metals space?

LM: Commerce Resources Corp. (CCE:TSX.V; D7H:FSE; CMRZF:OTCQX) is unique in that it has two specific projects with preliminary economic assessments. It has the Blue River tantalum-niobium project in British Columbia and a rare earth element project called Eldor in northern Québec. Each project appears to be capable of standing on its own merits; the company is attracting interest from potential end-users and possible joint venture partners. The price of the shares has come down recently, but I believe it's reached the point where the potential rewards truly outweigh the risks.

TGR: Are there any holding companies in the metal mining space that investors should investigate?

LM: I enjoy Zimtu Capital Corp. (ZC:TSX.V) in Canada. Its game plan is to fund early-stage companies with developable projects. By funding and forming new companies, it is able to offer its own investors a chance to participate in early-stage share offerings at an advantageous price before the initial public offering (IPO). When Zimtu funds a project it normally receives a substantial block of shares. If the general market environment goes up, then the asset values of Zimtu go up, and that should lead to increases in its share price. It is a good game plan and if the market environment for the whole junior mining sector improves, then Zimtu stands to profit substantially.

TGR: Returning to the start of our conversation, how do your political and ideological preferences affect how you identify opportunities in the markets that you cover?

LM: I am a deep believer in limited government. There should be simple and easy to understand regulations only where they're absolutely necessary. The current government interferences are a profound negative and worsening. If we can somehow turn the long-standing trend toward excessive regulations around, then profit opportunities within the mining industry should improve dramatically.

I'm normally an optimist, but I have serious concerns about the world's financial stability going forward. Europe in many places is a basket case. Japan is facing enormous problems, particularly demographic problems. Nobody knows for sure what China is doing. America is facing colossal budgetary problems. There's a mess out there and it's hard to see a really clear path to valid solutions to the litany of ongoing serious problems.

It's not that I'm a pessimist. I love life, I love nature and hiking in the woods and mountains, but when it comes to discussing economic matters, I do try to be a realist and look reality straight in the face. Frankly, there have been pleasanter times.

TGR: Thank you, Leonard.

LM: My pleasure, indeed, Peter.

Leonard Melman, publisher of The Melman Report, has been writing about precious and base metals for more than two decades as monthly columnist for California-based ICMJ's Prospecting and Mining Journal and Vancouver's Resource World Magazine. He focuses on how political and financial considerations impact the world of mining and the prices of the metals.

DISCLOSURE:
1) Peter Byrne 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: Balmoral Resources Ltd., DNI Metals Inc., Orko Silver Corp., SilverCrest Mines Inc., Commerce Resources Corp. and Zimtu Capital Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.

3) Leonard Melman: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.