The
BIG Picture Transcript
March 22, 2008
Part 1 Real
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Part 2 Real
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Part 3 Real
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Part
1
Credit
Market Turmoil: Liquidity vs. Solvency
FSN
Follies: Andy Looney
Other
Voices: William Pincus, Director, President & CEO Esperanza
Silver Corp.
Part
2
The
Big Disconnect
Other
Voices: Allen V. Ambrose, President & Director Minera Andes Inc.
Part
3
Q-Calls
Credit
Market Turmoil: Liquidity vs. Solvency
JOHN: Well, here we are, another boring week in finance. Finance is so boring, Jim. I think there has been so much going on in the last, well, what would we say? Since a week ago Thursday is when the thing really ratcheted into high gear. It started a little earlier than that but it’s been there. We saw a good old-fashioned run on a bank. That’s what you saw happening. And as far as financial news in reality, there is no shortage of headline stories. It makes it fun to be in this business at this time. The fall of Bear Stearns and subsequent pseudo-bailout I guess we would call it, emergency rate cuts by the Fed, a falling dollar, roller-coaster stock market, recession; it’s everything that makes for a great drama and a great movie just to name a few.
Now, this was supposed to be a short show this week. Remember that? We told people you’ve got a wedding and it’s Easter weekend for a lot of people so we’re making a short show. Well, we really have to tell you given the dramatic events over the last two weeks…So what we’re going to try to do here for this part of the Big Picture is to frame the issue, put things into perspective. And before we do, I want to review an issue we discussed several weeks ago and try to put that back into perspective as well, as we go from Wall Street to Main Street on the credit crisis.
JIM: If I was to summarize this, the key issue to understanding what’s going on here is you have to understand the concept of leverage. And then of course, the second factor is real estate because that’s behind all of this. Real estate has now gone from a boom to a bust. But unlike the technology bubble that we saw in the 90s, when it comes to real estate, it directly impacts the financial system because it involves the banking system, both money center banks and investment banks which repackaged and sold these mortgages in the form of asset-backed securities in all their forms and variations. But the most important factor to focus on right now is leverage. The world’s financial system rests on a pillar of leverage which innately makes it very unstable. Several weeks ago, John, you remember we talked about how leveraged the system has become with today’s structured finance which includes derivatives. [2:31]
JOHN: Well, just a few weeks back we were talking about the degree of leverage in the system. It was really quite shocking. And you really need to explain leverage to people. And the average investor right now really has very little knowledge of exactly how leveraged the financial system is today and what that really means. So do me a favor, review or refresh our memories because I believe this has got a lot to do with what we’ve seen unfold over the last couple of weeks.
JIM: When I talk about leverage factors here, I’m going to discuss this in what I call generalizations for financial institutions. Some of the institutions may be more or less leveraged than their peers within their group. But as it stands today, in generalities, it pretty much looks like this. Commercials banks are leveraged 10-to-1, meaning for every one dollar of equity they have 10 dollars of debt. If you take a look at savings institutions, they’re leveraged 8.4-to-1. Credit unions are leveraged 8.4-to-1.
Now here’s where it gets scary. Brokerage firms and hedge funds are leveraged about 32-to-1, meaning that for every 32 dollars of debt they only have one dollar of equity to back it up. And then government sponsored entities such as Fannie and Freddie are on average leveraged let’s say 25-to-1. If you take all institutions combined, the system is leveraged over 12-to-1. Now, these are general figures and if you add derivatives to the equation, then those numbers could be even higher than what I just told you. For example, James Turk wrote a piece on our site this week, it was called Will Citibank Survive? And if you look at Citibank’s stated leverage on their balance sheet, Citibank is leveraged 8.2-to-1; but because Citibank has gone on a lot of acquisitions and they’ve bought other banks, which means they’ve added a lot of goodwill to their balance sheet, if you take out the intangible assets such as goodwill from the balance sheet their real leverage is about 42-to-1, meaning that they have really 42 dollars of debt backed by only one dollar of equity. And if you take a look at the trend on Citibank’s leverage, it has nearly doubled from about 21 ½ to nearly 42 in a little over just 2 years. That’s how crazy and how ramped up this market was getting during the real estate boom. [5:08]
JOHN: It’s always fun to tell people that, Jim, because in essence what this means is that for every dollar in equity – their eyes get big like pike lights – for every dollar in equity that the bank has, it has 40 dollars of debt. And what that means is it doesn’t really leave very much wiggle room at all if their investments or their loans go bad; they have nothing to fall back on, they’re hanging over the ragged edge.
JIM: Exactly. And that’s why you’ve seen for example, at the end of the fourth quarter before they get around to reporting losses they went out and got capital infusions in order to rebuild their balance sheets because the losses were so sizable in relation to their balance sheet. You would have had an absolute outright panic when you start seeing an institution write off 16 and $18 billion of losses when you know they have equity of only roughly let’s say 100 billion, and if you subtract intangibles from that equity it’s probably even less than that. [6:13]
JOHN: Well, why don’t you review the example of how leverage works - this is what I was talking about before because when you use the world leverage people sit and go, “what does that mean?” And especially in the area of investments and loans. And how the banks actually got into this mess in the first place; why there aren’t more safeguards to this whole thing?
JIM: Most investment institutions, financial institutions, have an investment policy where they keep a certain leverage factor. And because this is radio and we’re not doing television I don’t have a chalkboard to draw this out. I’m going to use some very simple numbers here but I think they’ll illustrate the point. In the case of banks, that leverage is around 10-to-1. So let’s say as an example, a bank has $100 of assets, they have $90 in debt and they have about $10 in equity. So roughly almost a 10-to-1 leverage factor on the amount of assets they have.
Now, let’s say, either through appreciation of the assets they own or the earnings that they make, their equity increases by another dollar. So instead of having $10 of equity they now have $11 of equity. Well, their equity just increased by a dollar. If they want to keep the same leverage factor they’re going to go out and expand their balance sheet by another $10. So now because their equity increased $11 they increase their assets to $110 and they increase debt by another $9 – once again, trying to keep that $10 ratio. Now, since debt increased by another $9, during asset booms what you see (and this is what you saw, for example, in Citigroup where their leverage doubled) are financial institution balance sheets expanding as asset values increase. And look at it this way: if the amount of assets that you own go up in value, whether it’s stocks, bonds etc., that increases your equity; your net worth goes up – and equity increases due to let’s say an increase in profits or an increase in asset values. However, just as you leverage up during the boom when prices are rising, this scenario reverses when the asset booms go bust such as we have seen here over the last year with real estate – actually, the last couple of years.
So in boom periods as we saw from let’s say 2002 to 2007 in real estate, asset prices lead to greater demand for assets driving up their prices. It also leads to bigger and stronger balance sheets with rising equity. I mean your stock portfolio is going up, your bond portfolio is going up, the value of your real estate is going up, your equity is going up.
Reverse that now: When an asset category goes into a bear market such as we’re seeing in real estate, what happens? Prices fall, this leads to contracting equity and as a consequence contracting balance sheets. So what happens is assets begin to fall in value, their price goes down, the firm begins to deleverage in order to keep their leverage ratio controlled. In that example where I said we start originally with $10 of equity and let’s say $100 of assets, $90 of debt, equity increases by one dollar to $11, the balance sheet goes up to $110 and debt goes from $90 to $99. On the way down, if your equity contracts by let’s say a dollar in that example, you would get rid of $10 worth of assets, getting rid of $9 worth of debt to bring your debt to equity ratio back to a 10-to-1 factor. [10:05]
JOHN: It’s interesting when you talk about it like this because you realize this thing is like a giant leveraged balloon and so there’s a multiplier effect here, both going up and coming down which is why the comedown is so dramatic. And then that would explain what we’re seeing today in asset markets as firms sell off their assets, whether that’s stocks or bonds or mortgage securities; in an effort to reduce leverage they have to maintain their solvency, so the whole thing just collapses in reverse order. That’s all you’re saying.
JIM: Yeah. And that’s exactly what is happening here. It is estimated, for example, UBS which is extremely leveraged is reducing its balance sheet of assets by over $500 billion. So as these assets decline in value to maintain their debt-to-equity ratios and their leverage factors, they’re deleveraging their balance sheet meaning that they’re going to unload almost half a trillion dollars of assets. So since financial institution reserves have to be priced according to market values, a lot of these financial institutions have to sell off their assets. So whether it’s corporate bonds, or mortgage bonds or even stocks simply because they’ve been going down despite the fact they may not want to sell them. They may have to sell good stocks, good bond portfolios that they know are worth a lot more than the current market value. But because of the amount of leverage that they have they’re being forced to sell assets at below market prices because they have no other choice. [11:40]
JOHN: How is this impacting then say, for example, like Bear Stearns, the investment banks and the hedge funds that we’ve seen go belly up.
JIM: Well, as banks reach their regulatory limits of their lending based on their reserves, the banks have no other choice but to rein in the amount of leverage that they have. And as it does, many of these firms that they’ve lent to such as hedge funds – what happens is the bank calls in their loans from the hedge funds, the hedge funds are forced to sell in an illiquid market and unfortunately this forced selling spreads to other markets. If you have one asset category you’re unloading, and because many people are doing the very same thing you may look at, “okay, what else can we sell that’s liquid that we don’t have to take a beating on right now; or for that matter, what else do we own that is liquid where there are buyers.” So this forced selling spreads to other markets, it’s triggered by the tighter prime brokers. In other words, these investment banks their prime brokerage business to hedge funds, as investment banks pulled in the reins they pulled in the reins on the hedge funds, this forced selling spills over to other markets. And you can see this especially in the debt markets from corporate bonds, it even spilled over into the municipal bond market as well as actually high grade mortgage securities. And what happened is the asset markets begin to seize up if there is too much forced selling because what happens when there are few buyers – because you know, buyers get skittish, they’re scared – the value of the quality of debt can drop precipitously. And so what we have unfolding is basically a liquidity crisis. And if it was left to extremes it can lead to a solvency crisis which is what we saw with Bear Stearns. [13:43]
JOHN: You’ve used two terms there that we need to distinguish between each. There is liquidity and solvency. If liquidity dries up and you’re leveraged then this would lead to a solvency issues, but what is the different between the two?
JIM: Liquidity in terms of banks and business companies means the ability to convert wealth or assets into, let’s say, money. So you know, it might be a stock, it may be a bond, it could be a money market fund, it could be a CD at the bank, but basically liquidity means: I have these assets, how can I turn them, or how quickly can I turn them into cash. And if you look at a balance sheet from modern accounting methods, we try to distinguish the difference between the two. We have short term securities less than one year, meaning they are more liquid than what you would see than most securities and then assets held over one year which are less liquid.
On the other hand, solvency in contrast is the entity’s ability to pay off or dissolve its outstanding debt. So if you’re leveraged and you may have corporate debt outstanding, loans to a bank, it’s your ability to pay off those bills. So in a solvency crisis, creditors or investors are going to suffer permanent loss and economic value because the firm that is insolvent in some cases does not have the ability to pay off or discharge its debt. And in some cases, as we’re seeing today, it’s actually the government and the taxpayers that come in as the debt is liquidated at a fraction of its value and so what happens is the taxpayer or the government in the end ends up absorbing some of the loss. [15:34]
JOHN: So then what do we really have today, is it a liquidity issue or a solvency issue when you boil it down?
JIM: And when I boil it down, it looks to me more like a liquidity issue. What originally started out last year has now spilled over into other markets – more of this contagion. Remember they told us it was contained? Well, no, it isn’t. It turned out to be a contagion. Even high grade mortgage paper such as Fannie Mae, Freddie Mac, municipal bonds have plunged in value. Once again, this gets back to deleveraging because forced selling has reduced asset prices at a time buyers have become scarce because of fear essentially. So Bear Stearns collapsed because of what happened to the value of their higher grade securities. We had a couple of hedge funds – the collapse of Carlyle Corp, Peloton, which specialized in buying government sponsored entity debt such as Fannie and Freddie with incredible – and I mean incredible! – amounts of leverage. Remember, I referred back to those leverage ratios of 30-to-1, some were 40-to-1.
When they were unable to roll over their short term loans with their investment banks, because of the unwillingness of these banks to accept these GSE bonds and other Triple A rated collateral at 100 cents on the dollar, those bonds had to be sold into the market in huge quantities into what still is an unreceptive market. This caused the prices to collapse. I mean just picture people fleeing a stadium all at once and you know, somebody yells fire or something like that, there was panic that came into the market so there was more selling coming into the market and that selling overwhelmed the market driving down the price well below what these actual bonds or securities were really worth. And remember, these leverage ratios that I spoke about earlier, as those asset values collapsed it wiped out the remaining equity. I mean if you’re leveraged 10-to-1 and your assets dropped 20% your equity is wiped out. And so that’s what happened – as these asset values fell in value the remaining equity of these financial institutions were wiped out. [18:01]
JOHN: So how did the hedge funds going under then impact Bear Stearns? It seems like a cascading effect here.
JIM: That’s exactly what was going on, because as these hedge funds dumped their government sponsored paper onto the market in a fire sale, the market value of these bonds plunged. And with the market value of these assets falling, Bear Stearns’ lenders and counterparties demanded even higher levels of collateral which the firm was basically unable to offer. So as lenders demanded more capital or collateral from the firm, Bear Stearns had basically exhausted its capital and was at the point of defaulting on its outstanding loans. In this case, it was actually a lack of liquidity which turned into insolvency. The problem that you now have in the financial system today is that a lot of prime assets are suffering from lower liquidity. In other words, if everybody is selling all at once you just don’t have people buying; you don’t have buyers out there and so what you thought was a very liquid asset turns out to be not that liquid. [19:10]
JOHN: There’s this impression on the part of people out there that the government stands behind everything. It’s like the FDIC in banking deposits. How far is there backing behind all of these assets?
JIM: There is no way that big government would let Fannie and Freddie go under. There is an implicit backing by the government. Once again, I don’t believe this is a solvency issue. It’s more an issue of the liquidity of these bonds. In normal markets, and I put a caption around that, in normal markets the bonds would remain highly liquid; however, in the situation that we have today where markets are seized by fear and a lack of confidence then there are more sellers than buyers for the bonds and those bonds in essence become less liquid. This issue has also, for example, impacted the municipal bond markets where markets seized up, liquidity dried up and you had the Port Authority of New York, for example, having to offer double digits in interest rates in order to entice investors to come in and buy their bonds. I mean it’s absolutely amazing what has happened here with the fear gripping the markets. [20:22]
JOHN: So once everybody realizes that there’s a fire and that they have to get out of the theater, confidence turns to panic, literally, in a relatively short amount of time. It goes pretty fast once the Street catches on to what’s happening. And last year everyone thought the crisis would quickly blow over, especially when the Fed for example began to cut rates. Now the crisis has claimed another victim which as you’ve been talking about always occurs when the Fed goes through rate-raising cycles; they keep raising the rates until something breaks. We’ve talked about that forever here on the program. And it breaks either in the economy or in the markets. And this time, well, it looks like we’ve sort of broken the economy a bit and the financial markets – we got a two-for-one on this one.
JIM: Yeah. And what really has gripped the markets recently is confidence went out the window when the rating agencies it turned out that they were pricing a lot of this garbage as Triple A. So people say, “oh my goodness, we can’t trust the ratings agencies.” And then I think one of the other factors that came in here was these monoline insurers that insured a lot of the municipal bond market. The credibility of bond rating agencies and the possible solvency issues of these monoline insurers that insured these bonds changed the sentiment in the credit market landscape completely. Up until recently it was thought that, well, maybe the issue is of liquidity only impacted the risky assets such as subprime mortgages; but basically that changed when the monoline insurance crisis hit. And when you take the monolines which were threatened with downgrades (which means the bonds they insured were downgraded) municipal bond prices began to collapse and many muni bonds became illiquid forcing sellers into the market where actually there were no bids. And after the muni-bond crisis, investors began to question even government sponsored entities such as Fannie and Freddie, and what this produced is the forced liquidation of these mortgage-backed government sponsored entities and it led to the collapse of a hedge fund in London – Peloton – and the Carlisle Capital Group. And as the liquidity of Fannie and Freddie Mac dried up, in essence these insolvencies were caused not by credit quality but by the illiquidity of the underlying assets when the credit markets seized up and that’s what happened to these institutions. [22:52]
JOHN: Well, so does this mean that we have actually hit the bottom or is this more like a plateau that we’re going to slide off again and there is more to come?
JIM: Well, the latest Fed plans – and believe me, they’re not done yet – to open up the discount window to primary dealers – I mean if they were to have done this probably a week earlier Bear Stearns wouldn’t have been in the problems that enveloped it. But the fact that the Fed is now swapping paper with financial institutions – basically they’re taking their illiquid assets, whether it’s Fannie or Freddie, that if you had to sell them now you would take a huge loss and drive the prices down; what they’re basically doing is the Fed is taking this paper onto their balance sheets. Congress is working on additional bailout plans and so is the Fed. There are going to be more bailouts and possibly additional failures. Eventually, the crisis is going to subside; the markets will stabilize and we’re going to get closer to that creamy filling inside the Oreo.
I mean right now there is an ocean – and I mean an ocean – of money that is sitting in cash today which is seeing returns lower by the day – especially with each Fed rate cut; remember they cut the discount rate a ¼ point on Sunday and they just cut it another 75 basis points on Tuesday – there are massive short positions in the market. That’s why you see, when you have these announcements, these explosive moves on the upside which is mainly short covering. But there are massive short positions in the market that are going to be forced to be unwound. You take the stimulus helicopter drop from the rebates that are coming around the corner here, that is going to hit consumers somewhere around May and into June. So I expect at some point we’re going to see explosive rallies in the stock market as cash comes off the sidelines, as short sellers are forced to cover. And when it begins it is going to start out very quickly. You get the first 10% move in a blink of an eye and it’s going to take the markets by surprise. So overall my best assessment is that we’re getting closer to that creamy center of the cookie. [25:04]
JOHN: And you can see politically where this is going in an election year because suddenly there will be proclamations of “hurray, we dodged the bullet, hurray, it’s all over, the crisis has gone.” Breathe a sigh of relief, we’re back to prosperity as normal.” That’s going to be it through the election. And you can see this one coming right now. But the other side of this creamy center is another hard chocolate crust on the other side, which will probably be when? After the elections, so it won’t even be an election factor.
JIM: Yeah, I think you’re going to see probably higher interest rates and higher inflation rates. And that’s going to put the central bank in a lot more difficult position. [25:43]
JOHN: Well, I know you’re a card carrying Austrian economist…
JIM: Wait just a second, I need to pull out my card. Yes, it says so officially.
JOHN: It says so there? You know, you don’t look that. That doesn’t look like your picture. You’ve got to stop using that photo that’s 30 years old, Jim.
JIM: Actually, I’ve got hair down to my shoulders, I wear sunglasses and sandals.
JOHN: Ha ha, I remember those days. And surfing a lot. Anyway…
All of these bailouts, tax rebates, rate cuts are going to come at a cost because there is no free lunch and although everybody is saying we’re bailed out, somebody has got to pay for this at the end of this so there is a dark side. The other side of the Oreo. And so should the Fed have just have stood its ground and done nothing? I mean in a perfect world if you did what was wise, would that have been a wise move for the Fed?
JIM: You know, John, at the point that we are right now unfortunately the financial system is too far gone. There is way too much leverage in the system. Had they not stopped there would have been a chain reaction between all of the various counterparties. I mean, I forget what the figure is, 5-, 600 trillion in derivatives and the counterparties to backing those derivatives you can probably count on two hands. And there would have been a chain reaction between the various counterparties that would have brought down the entire world’s financial system. I don’t think people realize that’s how close we were last weekend. I don’t know if you saw Paulson’s picture in the press on Monday and Tuesday, the bags around his eyes, I mean these guys were definitely in a crisis mode. So we were at the point of risk of a systemic collapse which has now risen to probably uncomfortable levels.
I want to use an analogy if I can. Everybody probably saw the movie Titanic with Leonardo DiCaprio and Kate Winslet. Well, just picture yourself, you’re on the Titanic, you’re watching this movie, okay, and Leonardo and Kate are on the top of the ship – in this case we’ll call it Bernanke and Paulson – and they’re looking, oh my God, the ship is so big we can’t turn it, we’re about ready to hit an iceberg. We hit the iceberg. Water starts to come into the ship in the front compartment. And you know, John, how they build ships with what they call bulkheads. [28:08]
JOHN: Yeah, they have to be water-tight bulkheads that can support that so they can close it off and try to restrict leakage to one part of the hold.
JIM: Yeah, the problem that we had, the water was rushing in so quickly in to the first one or two compartments had they not shut down some of those compartments water would have spilled over into the other bulkheads, collapsing the bulkheads. It would have just been a daisy chain, domino effect. The bulkheads would have collapsed and the ship would have gone down. We were literally teetering on the edge last weekend. That’s how close we were. [28:44]
JOHN: You know, I’m trying to actually picture Ben Bernanke actually standing on the top railing at the bow of the ship with his arms outstretched like that.
JIM: Music in the background.
JOHN: So what you’re saying really though is…true, I’ve been telling people that in various places. I said you know, you don’t understand how close we came to disaster but all we did is we skated over the edge, dangled over the edge for a bit but in reality you really believe we’re going to wind up skating out there at some point and over. That’s almost inevitable. So we’ve only delayed the inevitable right now. And so ultimately this dovetails to something which if we go back to one of your articles back in – was it 2000, or 2002 I can’t remember?
JIM: Actually, it goes back to the fall of 2000.
JOHN: And it was basically talking about a day unlike any other day. In other words, that day is coming when we will go over the edge financially and then that will be it.
JIM: When I wrote this…because when these big events occur, whether it’s a 9/11 or the multiple failures of large financial institutions it comes on a day, you don’t expect it. It’s unlike anything else that you’ve seen up until that time. It emerges out of nowhere. I mean one day you wake up and say, “we’ve got a crisis.” It comes at a time when nobody expects; nobody – not even the most knowledgeable experts anticipated – I call it my Rogue Wave thesis. It’s an exogenous event out there that happens that people just say “where did that come from?” And I still think we’re going to see major rogue waves and you just take a look at the structure of the way things are today. I mean I still think we’re going to see major rogue waves, bigger than what we’ve experienced before.
At some point and I will admit, I don’t know, nor do I believe anybody else knows at this point the financial system is not going to be capable of withstanding further failures. It may be a single event, it could be a series of contiguous events but it’s going to bring the system down. I mean we’ve been building a giant edifice of debt that now looks like, picture this, an upside down pyramid. The derivative markets are becoming far too large to contain. I mean the sheer nominal value of over 500 trillion in derivatives and the limited number of counterparties. Remember, there are a handful of people to back all of this stuff; it is almost becoming uncontrollable. Eventually it’s going to collapse from its own weight; it could boil down to one rogue trader making a wrong way bet. It could be a wrong way bet by a firm. It could take place at a wrong time, at a time when tensions are high, fear is high and quite honestly the whole structure of debt and derivatives is going to collapse. You’ve heard it said often and people quote Warren Buffett is derivatives are “financial weapons of mass destruction.” The point I’m trying to make here is the financial system has become way too highly leveraged and it rests on a very unstable financial structure. And John, this is not going to last no matter what the models of the math whiz kids tell you. Fat tails are much, much more common today than what the financial experts are willing freely to admit. [32:25]
JOHN: So I believe ultimately that’s probably why you like gold because it carries no liabilities, it has no counterparty risk. That’s also why you’ve invested in tangible assets like food, water, energy and metals – things people need to have to live. You know, you hear people talk about when we talk about metals, Jim, this came up this week, I like to talk to people out there, it gives me a pulse on what’s going on; they’re always talking about, “well, we need to have like junk bags of silver because there’s coming a time when we’re going to go back to barter and etc. etc.” Even if we had that type of a major breakdown the powers that be – meaning the Fed and the government here – couldn’t just allow the whole thing to totally implode. Something would have to happen because civilization has to go on; right?
JIM: You could get into a severe crisis mode and as I’ve pointed out here on this show boom and bust cycles are natural. We see them come and go. And you go from a boom to a recession, or a boom to a bust but what happens unfortunately when you go through this bust period and you try to adjust, people say, well, you don’t want to interfere with the markets cleansing system. We use the analogy of somebody going on a drinking binge and then all of a sudden, you know, you get a hangover which is your body’s way of getting rid of the toxins. We don’t want to do that. What I fear most and especially with some of the policies I’m seeing advocated on the campaign trail this year, is it really takes a politician and policy mistakes to turn a recession into a depression and that’s what I fear they’re going to do. Rather than letting the system cleanse itself over a period of time they will interfere continuously and turn a recession into a depression. [34:17]
JOHN: You’re listening to the Financial Sense Newshour at www.financialsense.com.
I’m Andy Looney. Did you ever have your kids ask you one of those difficult questions that you can’t possibly answer without embarrassing yourself and them. I did. My kids Candy and Randy asked me why all the grown-ups were worried about a bunch of stern bears running around Wall Street. I decided to take a page from the Children’s story book and I told them about the goldilocks economy and the Stearn Bears. It went something like this.
Once upon a time – you know, you have to start kids’ stories out that way. I did. Didn’t you. I did. Anyway, once upon a time there was a goldilocks economy. It wasn’t too hot and it wasn’t too cold. It was just right. The goldilocks economy was skipping down the road to prosperity – not the yellow brick road because that’s a different economy, kids. And everything was going just fine but the big, bad subprime wolf frightened the goldilocks economy into the recessionary woods. Boy, she was scared. Goldilocks economy wandered through the recessionary woods until she found the house with the stern bears. She knocked on the door but the bears were out foraging for financing. So goldilocks went into the house, opened the door wide where she saw three bowls of bailout porridge. She looked at Papa Stern Bear’s bowl but it was too big, and then she looked at Mama Stern Bear’s bowl and it was too small. But when she saw Baby Benny Bernanke’s bowl of bailout porridge, it was just right. And she ate it all up. About that time all the Stearn bears came home. They tried to give her a bear hug but goldilocks economy is afraid of bears too and she ran away. Thank goodness for me Randy and Candy didn’t wait for me to say, “and she lived happily ever after.” Because I don’t think she’s going to live happily ever after. Do you? I don’t. Anyway, try to keep your kids away from news programs. It will save you from having to explain embarrassing stories.
For Financial Sense I’m Andy Looney.
Other
Voices: William Pincus, Director, President & CEO Esperanza
Silver Corp.
Joining me on the program is Bill Pincus, he’s President and CEO of Esperanza Silver.
And Bill, before we get into some specific questions I’d like to ask, why don’t you give our listeners a bit of a background about the company, your origination and tell us about the projects that you’re working on.
BILL PINCUS: Sure, and thanks for the opportunity. The background of the company is we were started in 2002, a group of geologists and explorationists, we found ourselves some funding and our original idea was that we were going to go out and be the classic prospect generator. We started with a number of projects over time. Two of them have evolved into what are now our principal projects and ironically, despite our name Esperanza Silver, both of our projects have become primarily gold projects. Quite honestly, there’s not a whole lot of difference prospecting for gold or prospecting for silver, they obviously occur together and as luck would have it our projects have become more gold rich than silver rich. Our two projects – and I would characterize these both as advanced stage in the sense that discoveries have been made and quantified and now we’re moving towards feasibility with both projects. Our San Luis project which is a joint venture in Peru with Silver Standard, and Cerro Jumil which we own 100% and that one is in Mexico.
The San Luis project which has been one which up until recently has gotten us quite a bit of attention is a high grade vein system where we defined a small and what we hope will be growing resource. In terms of the grade I’m talking about overall we’re looking at close to 700,000 tonnes of 12.2 grams of gold and 330 grams of silver. That’s very high grade rock and that’s going to be very valuable rock. This project now is being operated by Silver Standard and we’ve drilled about 30,000 meters on it. We hope to as soon as we get the permits –which should be in the very near future, I’m hoping in the next couple of weeks actually – we’ll begin mobilizing for an underground development and the purpose of this development is to evaluate grade continuity as well as to you know collect more material for metallurgical testing. Silver Standard has told that their hope is to get this into production by late 2009, 2010. It’ll be a relatively small tonnage operation but at these sort of grades should be producing significant amounts of gold and silver.
Now, at the same time and what has got us very excited on the same claim block, it’s part of the same joint venture, when we first discovered this I made the statement that we had discovered not a new deposit but a new district. And I think that is now being borne out by some of the new discoveries that we have made within the same block, the joint venture area, but outside of the main vein area. And what’s most exciting is something called the BP zone which has a lot of the earmarks of a porphyry – base metal porphyry system which are giant ore deposits. Now, it’s very early days and there’s quite a bit of work yet to be done but we have a number of drill holes into it which have been very encouraging and we hope once the rainy system ends in Peru which should be in the next month or two to begin drilling and more active exploration there as well.
Our other principle project is Cerro Jumil which is 100% owned by us. It’s in Mexico. It is south of the city of Cuernavaca. This is a new discovery by ourselves as well, and we’ve now completed – we have three rigs just winding up a drill program of roughly 35,000 meters and what we’re looking at here we believe is a large bulk tonnage gold deposit. We’ve done some metallurgical test working on it and we believe it will be heap leachable – certainly the test work has come back and given us very positive heap leach test results. And so right now at this point in time we’re looking at it as an open pit heap leach operation. Where we’re going with this project right now is as I say we’re winding up a drill campaign. We have got the qualified person contracted and has begun the resource evaluation. So we hope by some time this summer we’ll have a resource announcement and you know, we’re hoping for a significant resource. We’ll see what it comes out to be. At the same time, we put together the team to begin a permitting and community relations effort. Obviously we’ve been dealing with the local community but now we’re getting into the point where we have to increase our efforts. We had to start buying land rights – surface land rights as well as water rights. We’ve begun that effort and I am also now interviewing various groups to begin the scoping study or prefeasibility if you will, which we could begin as soon as we have the resource. So you know this one we also are moving towards production, you know, we have the people on board to help us do that; we think this is going to be a significant project. [42:30]
JIM: If you were putting this into a timeline frame assuming all things go well without a glitch, you’ve got your San Luis project going into production possibly next year; where do you see Cerro Jumil?
BILL: I think Cerro Jumil will definitely be a longer term project. If we live in a perfect world and all goes well I would see Cerro Jumil going into production most likely in late 2010, early 2011. [43:03]
JIM: How’s your cash position?
BILL: Right now we’re doing fine. We have about $14.5 million in the bank, at least as of the last time I checked which was recently. Up at San Luis we’re not spending any money, it’s – to complete their earn ins Silver Standard has to provide all the funds to put us into production. We have been spending quite a bit at Cerro Jumil, but as the drilling winds down that burn rate will also drop. So you know, I think we’re well funded to certainly take Cerro Jumil through – if not full feasibility, most of the way there. Certainly through the prefeasibility. [43:43]
JIM: Now, when San Luis goes into production and Silver Standard has a right to earn up to – what is it? – an 80% interest by funding the property through to production, the cash flow that will be thrown off, will it be enough to fund your exploration activities or will you have to tap the financial markets for additional funding?
BILL: No, we anticipate that it will be certainly enough to fund our corporate and our exploration activities. Now presuming of course that the feasibility studies at Cerro Jumil are positive, we would have to tap new financing sources for that project development. [44:22]
JIM: Okay, so to take it into production?
BILL: For production. But we believe once again if we live in a perfect world that the cash flow from San Luis should be enough to maintain our activities without any new equity financing. [44:38]
JIM: If you take a look at this being a new year, what are your goals? What do you hope to accomplish and achieve for shareholders this year?
BILL: Well, the first thing is we have to – and this of course is being controlled by our partner at San Luis – but the goal here for 2008 is to go underground and by the end of the year I would like to see a production decision. And if we’ve gone underground and we’ve come and made significant advancement with the underground development it should be easily converted into a production facility. Obviously we would have to build a small processing plant. But I would like to come out with production decision by the end of this year for San Luis.
And Cerro Jumil, what we would like to achieve is first our resource by the end of the summer and then in the latter part of the year we would like to at least be able to complete a scoping study which would allow us to more accurately value the project and of course carry it forward.
And then one third thing that I didn’t mention you alluded to, we have other exploration activities. We are actively drilling on new projects now in northern Mexico. And we have seven projects we’ll be drilling between now – you know, that are now underway and between June of this year. And we’d sure like to make another discovery. I think we have good targets; we’re drilling those targets and obviously if we do have news of a discovery you’ll be the first to hear about it. But we would love to make another discovery.
So those I think are our three major goals for 2008. [46:15]
JIM: And what is your business plan to help you achieve that? What’s your strategy?
BILL: Well, you know, once again at San Luis we partnered up with Silver Standard who’s a great partner. You know, it’s been a very successful company. So in that case it’s to let our partner do the work. Other than that, we’ve matured over time as a company where five years ago, as I said we started as a classic prospect generator, well, now our prospects are maturing and we now have the opportunity to develop them. And so we have got to make the evolution into a development company. And we have the wherewithal both financial but more importantly the human capital within the corporation to take the projects – you know, we have taken projects through development into production as individuals working for other companies, so we feel like we have that expertise – and we have the projects. So as we move forward we’re looking at moving our projects forward into feasibility and then into production. [47:18]
JIM: Looking at your company, you’ve been achieving your goals as you have stated them. Your stock like many stocks and juniors have fallen by the wayside as most investors have been chasing the large cap stocks, what is your plan to get your company marketed. In other words, how are you going to get your story out to other investors? What’s your plan?
BILL: Well, we approached that on really three fronts. The first as you well know, there a number of investor shows during the course of the year and we always have and will continue to participate in those and they reach both the retail and the institutional audience. So that’s one effort.
The second effort is we have hired – it’s called Roth IR – investor relations firm. And roughly once every six weeks we’re going out on a road trip. As a matter of fact, I’ve got one planned for early April, we’re going back to New York and once again we’re meeting with largely institutional but to a lesser degree retail brokers. And we just keep telling our story. We’re meeting new people, we’re telling our story. You know, we’re getting I think a fairly positive reception. I think we’re getting in front of the right audience. Most people that we speak to do generally go into the market and start buying. And then the third prong of our attack is we’ve just recently updated our website. I think we’re doing a better job of that and maintaining our mailing list.
Let me say right out there to your listeners, we welcome calls from investors. I’ll handle the calls. If you have a question, call in. Please let us know and we will respond to you. We think that ultimately the investor, the person who bought our shares, that’s who we’re working for and we will respond to our bosses. [49:09]
JIM: Looking at the shareholder structure of your company, you’ve got minimum shares out there. Let’s talk about it appears to me that your company is tightly held. Silver Standard own roughly about 14%. Talk about management ownership of the company.
BILL: Sure. Management – I’m not exactly sure of the number but it’s roughly about 7% of the company is controlled by management and the directors. As you mentioned, Silver Standard is another 14% roughly. Other institutional holding probably would add up to another 15 to 20%; and then the rest is fairly widely held by retail investors. [49:53]
JIM: Early in our discussion when we talked about your goals to take San Luis into production eventually; resource by the end of summer for your Mexican property, Cerro Jumil. And we were talking about a perfect world. As we all know, we don’t live in a perfect world. What are two or three things that can go wrong with your business plan, number one? Number two, what are you doing to monitor or anticipate these problems? And number three, if these problems surface what would your plans to mitigate the problems?
BILL: Okay. I think the first group of problems I would say are always technical issues, particularly at the stage that we’re in. We have – you know, we’re continually modeling and reviewing our drilling results and evaluating what they mean in terms of resources and what not. I’ve been accused of being promotionally challenged by some people. We take a very conservative approach to resource evaluation and engineering, including multiple layers of review. But clearly we’re drilling a project. At Cerro Jumil I’ve got an idea in my mind that we’re looking at a significant project, but until it’s modeled, until it’s been independently verified, you know, I could be wrong. That’s one place we could go off the wheels. There’s no doubt there’s an ore deposit there. The question is how big it’s going to be. But we are continually, on an internal basis, modeling this and to come up with a fairly good idea. So we don’t really anticipate major surprises there.
At the same time even though Silver Standard is the operator at San Luis and the same issues could always apply, we know there is something there. How much more is there is yet to be determined. But we constantly monitor what they do. This is one of our contractual rights and I think one of our contractual obligations. So if we start going off the tracks we’ll identify it early.
The other big area of problems – and this is true of any mining project are of course the social issues. In the areas that we work, we’re largely dealing with indigenous populations, small communities. It’s always very complicated and as soon as you think you have things figured out they change on you. The way we deal with this issue first to identify the problems and then to of course mitigate them is we by and large we’re working in Mexico and Peru, we largely work with national geologists; geologists who are familiar with the cultural aspects of the areas that they’re working in. In the case of Peru some of our assistants not only speak Spanish but they speak Quechua which is the local language which is often spoken up in the mountains of Peru. And you know, we’ve put together a guiding set of principles on how we’re going to approach things and I think we have a pretty good feel for what’s happening on the ground, you know, where the rumblings are coming from, where people are happy. And so I think we have a very good early warning system. When those issues arise we just have to confront them and we have to confront them with transparency and we have to confront them with honesty and flexibility and sensitivity to the situation. And we also have to be very clear about what we can and cannot do vis à vis the local communities; that they have to have a real understanding of what our capabilities and limitations are. And so far we’ve been managing all of that, but clearly that’s as I say in any mining project a real area of concern. So I would classify those as the two major areas. [53:38]
JIM: Now you talk about taking San Luis into production, eventually Cerro Jumil. What is the infrastructure that surrounds your project; roads, access to power, energy, etc?
BILL: San Luis is a pretty isolated area. Since we’ve begun working there and in the last year with Silver Standard as the operator, the road infrastructure has improved significantly. But nevertheless power will have to be most likely generated onsite – whether that’s by diesel generators or I think there’s potentially the chance of actually developing hydropower. It’ll need to be developed and that’ll be part of the cost structure.
Cerro Jumil quite the opposite. We have very good road infrastructure; a power line passes within kilometers of the likely mine site and plant site, so there I see infrastructure development as being far less of an issue. [54:38]
JIM: If you were to put your own money, Bill, into some of your competitors, what companies would you be buying personally?
BILL: Well, not surprisingly I do have some of my own money into some of my competitors and I really don’t see them as competitors. I think that someone else’s success is not at my expense – at least in the mineral exploration and development game. I make my evaluations based on my sense of the project but as importantly my sense of the management of the company. And two I particularly like right now are Orezone I think is a very good company; I also am invested in a company called Oceana Gold. You know, they’re developing a new project in the Philippines and they also are mainly in Australasia and they’re developing a new project; they’re operating mines in New Zealand and very good operators and very good projects. So those are two I like. [55:37]
JIM: And is there anything, Bill, that I have not asked you that you feel is significant or important?
BILL: Well, I would like to reemphasize a little bit about, we do have two advanced projects that are moving forward and we’re quite proud of those. We’ve made these discoveries and we recognize discovery as our best way of growing the company. We are quite active on the exploration front. We have I believe right now, it’s something like 16 or 17 properties in Peru and Mexico, we’re actively – we’ve got two drill rigs turning right now on properties in northern Mexico, we’re trying to permit another couple of properties in Peru and we think that you know, our best chance for growth if we’re really adding significant shareholder value is by making new discoveries. We’ve done that in the past and we believe we can do that in the future. [56:30]
JIM: And Bill, if our listeners would like to get more information about your company, why don’t you give out your website and tell them how they could do so.
BILL: Well, the website is very easy, it’s www.esperanzasilver.com. You’ll see on the homepage there’s – we try and keep an updated PowerPoint presentation. There’s also an easy way to join the mail list and we’ll be glad to send you news releases and any other information we send out that way. And you’ll find an 800 number on that website and as say, we will answer the phones. We would love to talk to you. [57:08]
JIM: All right, well, the name of the company is called Esperanza Silver. Its ticker symbol is EPZ and it’s listed on the Canadian Venture exchange.
Bill, I’d like to thank you for joining us on this week’s program.
BILL: My pleasure as always, Jim.
JOHN: Well on the day that we are recording – we did this a little earlier this week which is Wednesday – it’s obvious that gold and oil and silver by the way are pulling back. Everybody thought that they might go to the moon, but…things rarely go to the moon in the stock market and we notice that there is shrinking demand. There’s an imbalance in the system – it’s really obvious to see that – that are really basically structural in nature and that are simply there, and simply happen regardless of what’s going on. Commodity prices are up, but stocks are not going down. This leaves you with an either-or decision; either commodities are ahead of themselves or the stocks are actually undervalued.
JIM: You know, as I look upon this and you and I have discussed this issue over and over until I think we’re blue in the face over the last six or seven years – every time these commodity prices hit new higher levels everybody says: “That’s it! The Fed is raising interest rates, they’re going to go down. The US economy is heading into a recession, they’re going to go down; the Chinese economy is slowing down, they’re going to go down.”
With prices hitting this level they’re always telling us for the last probably what, eight years, why it’s going down. And it still goes up. So the way I look at it, I think there is a major, major disconnect between what we’re seeing going on with the stocks and this divergence that we see between lower stock prices and the rise in commodity prices. I mean I’m looking at…even with this pullback with oil and gold, oil prices are still up 10%, we have natural gas prices up 27%, coal is up 19%, we have gold prices even on the day you and I are talking where gold fell $60 an ounce, we’re talking about gold prices up 12, silver up 22, palladium up 21, and platinum up 24%. You get the base metals; remember the demand was going to slow because the US economy was in a recession and Asia’s economy and the global economy would slow down; we have Aluminum up 24, copper up 24, lead up 12, nickel up 16, tin up 25.
Then we get to the ags; we have corn up 20, we have soybeans up about 7, sugar up 8, and cotton up 8.
So they’re not going down, so there is a very, very big disconnect. [2:38]
JOHN: The next obvious question to ask here is why do you think this disconnect is there.
JIM: I think it relates more to the topic that we were covering in the first hour which is this deleveraging of balance sheets. If you look at what has been the strongest performer over the last couple of years in the market, probably the last four years running, it’s been energy and the precious metals. And so if you are an investment bank, if you’re a hedge fund, if you’re a money center bank and you’re deleveraging your balance sheet, you know what, you’re going to be selling off what you can find that’s liquid. If you can’t get rid of your mortgage bonds or some of your more sophisticated credit products like CDOs and others, then you say, “okay, what do we have left in the portfolio that we can ditch and get liquid.” So I think that is what has contributed to a lot of this forced selling that has caused the producers that actually make this stuff, their company shares have been going down while the commodity prices have been going up. So this whole concept of deleveraging that we’ve been talking about. [3:43]
JOHN: Well, here comes one of these little quizzes we like to throw by everybody; here we have a financial crisis in the world. Now what would you do? You’re Johnny Investor out there – I guess I’m Johnny Investor. We have noticed in the last week or so a major counterparty investment bank goes insolvent; the Fed cuts rates in an emergency session and then cuts rates two days later again. The world financial system looks like it’s skating right over to the edge; it almost went off the edge of the world, teeter-tottered for a bit and managed to stagger back from that. So you as an investor do which of the following? And there will be a little quiz on this after the show.
1) You invest in financial stocks;
2) Buy Treasuries when the Treasury rate is at one half the inflation rate, meaning you’re paddling backwards;
3) Get into homebuilders stuff;
4) Sell gold and commodities;
5) Do 1, 2, and 3 but not 4; or
6) Do 4 but not 1,2 and 3.
So which way does it go?
JIM: Sell gold and commodities, buy financials.
JOHN: See! I told you. You were laughing but…
JIM: You know, it’s almost like a Pavlovian response that if this would have been probably 30 years ago, John, and we would have been in this mess as we’re in today and the Fed would have been doing what it was doing, you would have had the bond market getting hammered, the dollar falling and gold would be skyrocketing. What they do now is they get people to sell gold prior to a Fed rate hike as the Fed prints more money to bring interest rates down. And it’s like, okay, we sell our gold, they’re printing like I said, we ought to invest in chainsaws and we’ll go and buy financial stocks. It’s absolutely amazing to me the disconnect between what is behind and what causes inflation and what financial participants do when these events erupt. You know, I go back to the last hour with the analogy of the Titanic. We just struck an iceberg and people are arguing the placements of deck chairs on the Titanic. [6:07]
JOHN: But this is basically caused by a fundamental difference of financial world view really, isn’t it? I mean if you look at the world through certain parameters then even when the world is going the other way, you still keep trying to sort of stuff it down through your little old parameter there and make it work. And that’s why you wind up doing that.
JIM: I think unfortunately there’s a lot of noise out there. I mean as I have commented in the past, you have a whole industry that has risen over the last decade or so and especially with the plethora of cable channels. I mean let’s put it this way, we didn’t have this kind of information 10, 15 years ago. When something happens it’s instantaneous; a billion eyeballs around the planet are watching the same thing on their computer screens. The unfortunate thing is there is simply a lot of noise out there, like one of the comments made, “gold sold off today because even though the Fed raised interest rates on Tuesday, two Fed governors dissented and said they’re worried about inflation.” That was taken to mean the Fed is going to be fighting inflation. It has just created a big disconnect. But actually these are the times that we are probably the happiest because we tend to be more value investors. And I hate buying things when things are going up. Gold was down 60 bucks; I hope they take it down into the 800s because if they do I’m just going to buy more bullion, I’m going to be buying more silver. [7:33]
JOHN: It’s a better time to do that.
JIM: Yeah. And that’s the thing that we’ve always tried to emphasize here on the program. Don’t go chasing these things when they’re going up when everybody else is piling in. Buy them unless something has become so incredibly mispriced where for example maybe you can find a mining company that’s selling for gold in the ground at 25, $30 an ounce at a time when gold is over 900. But outside the mispricing what you really want to do is you want to wait for the pullbacks. And more importantly, your most important objective in this gold bull market, and remember, we’re in the eighth year yet and we’re just getting warmed up because when this bull market ends probably at the end of the next decade, what is going to be most important to you is how many shares of a mining stock do you own, how many ounces of gold do you own, how many ounces of silver do you own. And what you do is you don’t panic, and what you start thinking of – I want to buy more of these things and when they pull back it enables me to buy more of these things. And that’s the way you approach this market. And if you take a look at Wall Street right now they’re like a bunch of chickens running around with their heads cut off. It’s like, “oh, that’s going up, okay, we’ll pile into that.” Or “gosh, that’s going down, we’ll sell that and what’s next is going up we’ll pile into that.” And they’re just going to and fro – one day they’re buying, the next day they’re selling without a lot of, in my opinion, some commonsense in terms of what’s going on. [9:12]
JOHN: If you remember, Jim, back in the 1980s, 1990s say if people were going to go into mutual funds, for example, we would tell them, I mean instruct them, do dollar-cost averaging. And today you’ve got this whole crowd running around chasing tops and bottoms of the market. Remember what I said about gold going to the moon. Well, it didn’t go to the moon, it came down $60 today. And who would have thought that just yesterday and that’s the way it’s sort of run. And the trick is just stop watching this top and bottom nonsense and just watch your long term fundamentals and positions.
JIM: I want to tell a story that sort of illustrates this point that we’re making here. It’s a true story and it will probably have a lot of relevance to what we’re talking about here. But we’ll call this individual Mr. X, and we’ll call the company, Company A. Well, about three or four years ago there was a company out there that was headed up by an all-star geologist. This gentleman had been very successful, very well-noted in his field, great reputation and the company he was involved in had made a major discovery. They raised capital, they went public and they began to drill out the property and came out with their first resource estimate and people got excited when they first saw the initial drill results and test results because it was a rather substantial property. And they got excited – as the price of the stock went up the company was very smart, they did a financing at a level that would give them sufficient capital to carry on their drilling program for a good two to three year period. So very astute management on part of the owners of the company that were running the company. And we got into a situation in to 2004 and you probably recall this; in April of that year there was a big story that circulated at the end of April that China was slowing down and there was a huge sell-off in gold shares and the price of bullion and commodities in general. It hit the gold market, it hit the oil market, it hit commodities, the CRB went through a severe correction and that correction lasted for quite some time – did not even begin to recover until you got into the fall. Well, it turned out as we got into the fall Chinese economic growth did not slow down it actually accelerated, but who knows how that rumor got started.
But anyway, to continue with this story this Mr. X saw the price of these shares fall and the company continued to put out good press releases, they were doing their job so he began accumulating shares. Following year, the gold market began to recover, had a nice uptick, but this company went against the grain and it continued to fall. This Mr. X continued to add to his position and then the following year once again, gold takes off in the summer of 2005, the stock that he was buying continued to fall. He continued to buy, add to his position, dollar-cost average. What he saw was a phenomenal development that was taking place that was being ignored by the market. In fact, the marketplace was actually ditching the shares and this company, even though things were going very well for the company in a period of about 2, 2 ½ years, the stock price fell by over 80%. During the entire period of this 2 ½ year downturn this particular Mr. X continued to buy these shares, adding to his position. Well, let’s make a long story short; that company was a company called Aurelian and the shares that he purchased in the 2s, in the middle $1.50s, in the 60, 70 cent range and eventually in the 40 cent range, well, it went from 40 cents to $40. And so this is just a good example of when you find something that is being ignored by the market, if you understand the fundamentals of the company, you understand the people that are behind it, their track record, that is what you do, you add to your positions, you dollar-cost average, you bring your cost structure down. If it falls and offers you a better buying opportunity then your money buys more shares. Well, to make a long story short this Mr. X is a very wealthy individual today. [13:50]
JOHN: The prerequisite for him here is that this mysterious Mr. X understood, first of all, the fundamentals and they understood the company and its management. And the one thing he didn’t do, and here’s the intestinal fortitude in this, you have to have the convictions of what you’re doing here. He didn’t waver in his patterns as each time it became appropriate he increased his position in that particular company. He went ahead with that on that plan, he was not watching necessarily what was going on on the Street and what everybody was saying.
JIM: Exactly, and that’s one of the points that we’re trying to make here. It’s our belief because of the deleveraging of the balance sheet you’ve seen this disconnect or divergence between the shares of the companies that produce the commodity and the price of the commodity itself. And the problem here is, as we’ve been discussing, is we’re in an inflationary environment, just look at what the Fed has been doing, look what central banks are doing, and just look at the environment that we operate today: politically, economically, and just resource-wise. And there is a major disconnect between what’s going on in commodities and the companies.
There’s a lot of news out there that they’ve topped out; I’ve read study after study and everything I read tells me fundamentally what is going on is just the opposite. Most commodities, even though they are at record highs or near record highs, I see no reason why these commodity prices can go meaningfully higher. I don’t care if you’re looking at gold, silver, oil, corn, soybeans, aluminum, copper because one point, we’ve been talking a lot about peak oil and it’s not confined to oil. We have done a lot of extensive research on this. And what has happened is it is spread across a broad commodity complex as policy driven investment constraints. We're not seeing with higher prices the typical supply response that you would see with greater demand. I mean look at the decision by our government to divert almost 25% of our corn crop over to ethanol, which we know is inefficient. I mean, think of what that has done to drive the price of wheat, soybeans, the price of dairy products up, the price of chicken up, the price of beef up because corn is an important feed stock over 52% of our corn production goes to feed stock. Well, if you start diverting corn to produce fuel for your tank instead of food, it's going to have an impact, so there has been political policy restrictions. There is also geopolitical concerns. There are a lot of areas in the world today that are exceptionally resource rich that countries that own these resources, either one, because of Marxist ideology are not developing it or they are nationalizing it. I mean just take a look at what has happened to Venezuelan oil production. It's fallen about 40%. So there aren't a lot of incentives for a lot of these governments who own the commodities today to go out and say, “look, let's try to develop this, produce as much as we can to drive the price down.” So there are a lot of constraints that didn't exist today and this has very serious long term effects global implications in terms of investing and for economic growth. [17:25]
JOHN: Well, if these things are sought, I mean if this is what is going to be, what is really most salient, I would say, from your own research that we should talk about?
JIM: Probably, I would just say one thing that stands out and certainly we've seen this all across the spectrum is going to be record profits for most commodity producing companies. It doesn't matter if you're producing energy, gold, copper, whatever it is, you're getting prices that you would have never dreamed of before. I think another thing is that for a lot of manufacturing companies, they are going to see expense pressures and to some extent, these companies are going to have to start passing along a lot of these cost increases. I work in a stress environment, and one of the ways that I try to relieve stress is through physical exercise. We had a show here in San Diego with all the top sports equipment companies who are in town with all of their equipment, and one of the things that I heard –it didn't matter what company you were talking to – prices of steel were going up 20% next month because a lot of sports equipment home gyms or individual machines are made in China and China just had their iron ore prices go up by 65%. So these companies were anticipating and are now starting to say, “look, we're going to have to raise prices nearly 20%.”
I think another thing that there is a great opportunity, and this is what why we've often talked about infrastructure here is any company that can help relieve some of the supply constraints, especially in energy or in mining equipment as a result of the massive capital expenditures that we're seeing in the mining industry and also the energy sector, are the commodity-related infrastructure. I mean there are going to be fortunes. We're looking at companies that have back logs that go out two or three years. So there are a lot of things that are taking place here and in my opinion, I think the market is dramatically underestimating the potential upside to commodity prices. And furthermore is the durability of those price increases. In other words, yes, they are at higher levels, but I think these high levels are sustainable. [19:49]
JOHN: The one thing we are seeing here is if we look to Asia and China especially, we're seeing rising demand in the Indian subcontinent, so industrial demand is rising there, but supply has not increased on that side of the equation, so at some point there is an exchange that happens here.
JIM: As I just mentioned, one thing we have not seen is we have not seen a supply response that is commensurate with the degree at which demand is growing. And typically in past bull markets, that's what you saw. As a result of higher prices, a lot of supply and expansion came online, John. Today it's very difficult. You know, with the environmental movement, with nationalism, with the good majority of these natural resources lying in countries that are nationalistic, these mining companies, these energy companies don't have access to a lot of this. So we're almost at a tipping point right now. And despite what you think are high prices today, believe it or not, I think these prices can double. I don't care if you're talking about grains, if you're talking about base metals or you're talking about that energy or precious metals, I believe that you can see over the next year or two that you can see these commodity prices double as we enter this next phase of structural commodity bull market. We're sort of that quiet phase right now, but we're seeing all over the place in one commodity after another, we're seeing supply disruptions to one market. And then they have knock on effects throughout broad commodity complex. I mean we talked about a month ago the supply disruptions in power in South Africa, how that is impacting the gold market and the platinum and palladium market there. And on the day we're doing this Big Picture segment, we interviewed Jeff Christian from Johannesburg and they had several power disruptions while he was there. And we see this common place in California whenever we get a heat wave or there is extra demand put on the grid system, we got rolling black outs. We saw it in Florida with a nuclear power plant. We've seen it with refineries. So everywhere that you look abroad across the commodity spectrum, there are supply constraints, John, and you and I know these are things that aren't solved very quickly. [22:05]
JOHN: So basically right now we're in this period here where at least from the point of view of the US, we're operating on somewhat a myopic basis, almost what you would call US-centric type of thinking, but that's not going to last forever.
JIM: No. And I think we're going to enter another phase here. Remember, John, in the new economy in the 90s and oil prices were coming down and they were saying, “you know what, energy is less important to the world.” A lot of the commodity prices were in a very long trending bear market that lasted two decades, and they are saying this is less relevant. But what happened during that period of time, we consumed all of our excess supplies and it's amazing here we are with modern technology, with IPods, satellite communications, the internet, high speed computers, and it's almost like what's doing well, it's like the old economy – natural resource producers. And it's been absolutely fascinating to see price rises in gold mining stocks, silver mining stocks, energy stocks, commodity stocks, food stocks go up every single year and reach record levels and it still is dismissed. Like I said, they sold off energy stocks this week. They sold off the gold stocks this week. They bought the financial stocks based on the Fed rescue and what were the real implications on what the Fed just did? They are inflating. [23:43]
JOHN: Well, what we are seeing here is a – there is always a long time, a lag before supply begins to respond to market demand, and that's what we're seeing right now, which obviously tightens things up, puts constraints on everything. And so then from an economic standpoint, what do you see in that?
JIM: What you're going to have is the markets are going to be regulated. In other words, prices are going to have to rise to such a level that it brings the markets in balance, and the only area – I've seen this written about oil, but I think it's on commodities in general. Demand is going to have to fall in the Western part of the world to offset the rise in the eastern part of the world. I've read studies that over the next couple of years, oil consumption in Western countries is going to have to fall by nearly 4 million barrels a day in order to offset the demand that is coming in areas like OPEC, within OPEC countries, where demand is subsidized or in Asia and India. And remember, in a lot of these countries, that's where the fastest growth is, and within OPEC itself, energy is subsidized much as it is in China, so that's why demand keeps going up. I mean energy demand last year was up over 12% in China. It's up this year. Well, what is going to offset that? It's going to have to be falling demand in what is a resource constrained world, and that means conservation. It's going to mean substitution. It's going to mean innovation. And in many areas as supply will affect economic growth, it could mean stagnation, or in this case in the United States, stagflation. [25:28]
JOHN: Yeah. So as we go through these – you're going to see this period where we have these sort of blow offs and pull backs and knowing that the trend is still going to go in a particular direction when you see them, that's time to scoop up more. Just add to your position, sit back, let it go through these things. You don't have to go chasing them.
JIM: Yeah. And that's really what you want to do. You want to accumulate on weakness, and you're getting an opportunity here and I've been pounding the table. I don't know when it's going to be whether it be by summer when the stock markets are taking off and they've cooled down the crisis. Will it be in the fall when gold prices are higher and inflation is higher? But we've been pounding on the table of juniors are the cheapest things out there in relation to the price of gold. And what has happened is there has been a play in the market place that's probably taken place probably last fall, and that is the hedge funds and many of the investment banks have gone long the producers –the big companies: the Barricks, the Newmonts, the Agnico's, the Yamanas, the Goldcorps – and they've gone short the juniors. I mean some of these juniors have had massive short positions, and as they started to go up with this rally that we've seen in metals, the short positions in many cases got even larger.
And for people like ourselves that are wanting to accumulate and especially since we're operating more at the institutional level, I mean we just took one million shares off a short seller in the last week off a company that we've been trying to buy but as volume came in with heavy selling, which was basically the shorts were almost doubling their position, those are a million shares in a tightly controlled company that are now put away in a lock box. I don't know how these guys are going to cover short positions. But you see this all across the board today, and when you're looking at these companies when they are doing that and driving the price down, this is just one area where I think it's gone to extreme levels, John, and it's like the Street is on the wrong side of the trade. Just as they were on the wrong side of the trade with the mortgage-backed securities, and now look at the damage that is being done to these firms; one firm is no longer going to exist as a result.
And that I predict is the day of reckoning coming to a lot of these people that have been going out and shorting because just as the day you and I are talking where the price of gold dropped 60 bucks, you're going to see multiple days on the upside to levels you've never seen before and everybody is going to be scrambling and wanting to go into the sector. And it's like they are going to look at the large cap stocks and they are going to say wait a minute, these are so high priced, what else is cheap out there and that's when this connection is made and that's when money spills over and it trickles down the food chain; and probably the best bargains out there in the food chain are a lot of these juniors. And the nice thing about it, and even for the little guy is they are not selling at 40, $50 a share. They are selling at a dollar a share, $10 a share, $3 a share, 50 cents a share, five bucks and so you could buy 100 shares, you can buy 200 shares, and so here is a