Deflation Is Coming: Jay Taylor

Source: Brian Sylvester of The Gold Report  (12/5/11)

Jay Taylor Jay Taylor believes the biggest challenge facing the U.S.—deflation—could mean a better year, or even decade, for junior gold stocks. Taylor, editor of Jay Taylor’s Gold, Energy & Tech Stocks, has ridden some equities to the bottom of this punishing market and is ready to pile more cash into small gold companies. In this exclusive interview with The Gold Report, he explains why market sentiment hasn’t shaken his faith.

Companies Mentioned: American Bonanza Gold Corp. – Aurvista Gold Corp. – Calico Resources Corp.Crocodile Gold Corp.Great Panther Silver Ltd. – IAMGOLD Corporation – Meadow Bay Gold Corp.Merrex Gold Inc. – Metanor Resources Inc. – Nautilus Minerals Inc. – Pretium Resources Inc.Prodigy Gold Inc.Rye Patch Gold Corp. – Sandstorm Gold Ltd. – Silver Wheaton Corp.

The Gold Report: In the Nov. 4 edition of Hotline, you note that America’s ratio of debt to gross domestic product (GDP) is north of 350%. Our total debt as a society is somewhere around $57 trillion (T). That’s worse than Greece. Is deflation America’s biggest economic threat?

Jay Taylor: I believe it is, however, most of my goldbug friends wouldn’t agree. It is important to realize that the U.S. is not a third-world country. It still has the world’s reserve currency. The central bank, the Federal Reserve, doesn’t put money into the hands of the masses. It puts money in banks. It’s all about credit extension. That is very difficult to do now. With the debt-to-GDP ratio as it is, it’s unsustainable. The markets are telling us that—not only in the U.S., but clearly in Europe as well. We are undergoing one of the largest debt-deleveraging periods in a long time, which may be much larger than what we went through in the 1930s.

TGR: You believe there should be no more bailouts, let this debt wrench itself out of the system and let bankruptcies occur.

JT: Absolutely. Most people don’t understand the reason we’re in trouble is because the good times that we had were false. They weren’t based on savings and investment. They were based on money creation through credit extension. The nice homes, the big office buildings, fancy cars, everything—it wasn’t earned, it was based on debt. Now that the debt cannot be repaid, the expansion goes into a contraction. That process has a long way to go.

TGR: Bob Prechter of the financial forecasting firm Elliott Wave International is predicting that gold and silver “should decline in conjunction with the stock market selloff. Gold should work down toward $1,300 an ounce (oz), while silver should fall into the low $20/oz area.” What’s your position?

JT: If you believe that we’re in a deflationary environment, the nominal price of gold could go down and the purchasing power of it could go up a lot. The real price of gold is most important for gold mining companies. Before the Lehman Brothers failure in July 2008, an ounce of gold would have bought only 17% of the Rogers Raw Materials Fund. It rose to 44% by March 2009, but came back a bit to 30%. It was recently up to a new high of 47.5%. Gold’s purchasing power is rising much more dramatically than its nominal price. Gold has fallen off its highs and is around $1,700/oz. As Ian McAvity has said, an ounce of gold is an ounce of gold. A barrel of oil is a barrel of oil. What is a dollar? It’s a meaningless measure because Federal Reserve Chairman Ben Bernanke can create trillions of dollars out of thin air.

TGR: Silver’s purchasing power on the Rogers Raw Materials Fund hasn’t experienced quite the same gain. In June 2008 it was just below 1%. Now it’s just below 3%.

JT: Silver has done very well, but it’s much more volatile. It has outperformed gold in general since Lehman Brothers’ collapse, however.

TGR: The International Monetary Fund (IMF) has agreed to throw the Eurozone countries a lifeline of about $0.5T. Will that be enough?

JT: My view on Europe is the same as on the U.S.—the kindest, gentlest thing to do would be to allow the debt to implode immediately. We’re allowing sick entities to survive and eat up resources. It’s contrary to free market capitalism. It’s really fascism. Large corporate interests are being protected because of their cozy relationships with government. A half trillion is not going to be enough. Where does the IMF get its money? Is the U.S. going to be asked to pony up more money for Europe? Probably. Are they going to sell the rest of the gold they have? Perhaps. That’s what the Soviet Union did before it collapsed.

TGR: You’re biased toward credit market deflation, but you continue to be partial toward gold and gold mining stocks. What are the reasons for that?

JT: Margins are widening. There is an explosion of profits for major mining companies in production before 2008: Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE), AngloGold Ashanti Ltd. (AU:NYSE; AU:JSE; AGG:ASX; AGD:LSE), Barrick Gold Corp. (ABX:TSX; ABX:NYSE), Goldcorp Inc. (G:TSX; GG:NYSE), Kinross Gold Corp. (K:TSX; KGC:NYSE), Newmont Mining Corp. (NEM:NYSE) and Yamana Gold Inc. (YRI:TSX; AUY:NYSE; YAU:LSE).

In 2008, those companies recorded $5.77 billion (B) of earnings collectively. In 2009, that jumped to $7.05B. In 2010, it jumped to $13.62B. The analyst consensus is that it’s going to go to $20.22B in 2011 and $28.28B for 2012. Margins have increased in this deflationary environment because the real price of gold has risen relative to the cost of mining it.

Bob Hoy, a technical analyst in Vancouver, figures we are in the sixth large credit contraction in the last 300 years. In every case, the real price of gold has risen over 15 to 20 years. The real price of gold started to rise in 2007. We could be in the early days of a super bull market for gold mining shares.

TGR: Those majors probably average $500/oz in cash costs. However, you have a buy rating on small Australian producer Crocodile Gold Corp. (CRK:TSX; CROCF:OTCQX), which just reported a loss of about $6 million for the quarter. Its cash costs are above $1,400/oz and its stock is down about 80% this year. Why on earth would you still have a buy rating on Crocodile Gold?

JT: I believe in the long-term prospects of this company. It’s had a lot of problems. Its costs were $250/oz higher than projected this year because of lower-than-expected grades from its open-pit projects. Clearly, that’s a black eye for management because something went wrong. But I still believe that this company has extraordinary exploration potential and will get costs under control.

TGR: For example, silver producer Great Panther Silver Ltd. (GPR:TSX; GPL:NYSE.A). As of Nov. 18, it was up 355% since you took your initial position. Great Panther is down almost 20% this year despite a strong Q311, however. What’s your outlook for Great Panther?

JT: Its decline is in line with the general market decline. It keeps improving on a fundamental basis and expanding its resource. It’s a fine operation that’s earning money.

TGR: What other smaller gold and silver miners are you interested in?

JT: My favorite might be Sandstorm Gold Ltd. (SSL:TSX.V), which is a royalty play. It has one of the best looking charts in a horrible market. Sandstorm provides the capital to get companies into production and then it gets a royalty. It usually gets the chance to buy maybe 15% or 20% of a project’s production for the life of that project at cost. It has several properties that are producing now. Its projects are getting bigger and production is growing. This is a company that’s going to continue to earn more and more very rapidly. There are fewer risks involved in this model than if it was an operator, too.

TGR: Its production forecast for this year is from 16–18 thousand ounces (Koz). However, that will increase to more than 50 Koz by 2014. That’s certainly strong growth.

JT: The gold price, where it is relative to the cost of mining and the expansion of production, means that earnings are going to grow very rapidly, if not exponentially.

TGR: Do you think that too many royalty plays kill the goose?

JT: That could be the case. With increased competition, they might be paying too much for the deals that they strike. However, I’m not concerned about that with Sandstorm at this point. Royalty plays, like Sandstorm, Silver Wheaton Corp. (SLW:TSX; SLW:NYSE), Royal Gold Inc. (RGL:TSX; RGLD:NASDAQ) and others, generally sell at much higher multiples than mining companies because there’s less risk involved. An operator can have any number of things go wrong and have to put in more capital to get things moving again.

TGR: It’s more of a matter of vetting these projects and being sure the geological model works and the metallurgy is good.

JT: Yes. I have a high regard for the management of Sandstorm. They’re really sharp. They get involved in projects that have enormous upside potential. It’s not just the ounces that might be in a bankable feasibility study. They look at the exploration potential and the expansion of production, too.

TGR: Let’s move down the food chain to the explorers. The portfolio scorecard in each edition of Hotline doesn’t paint a very kind picture of gold and silver exploration plays lately.

JT: Nope, not this year.

TGR: As of Nov. 18, only 8 of 50 exploration companies on that list, or 16%, were up: American Bonanza Gold Corp. (BZA:TSX), Metanor Resources Inc. (MTO:TSX.V), Prodigy Gold Inc. (PDG:TSX.V), Aurvista Gold Corp. (AVA:TSX.V), Meadow Bay Gold Corp. (MAY:TSX.V; MAYGF:OTCQX), Pretium Resources Inc. (PVG:TSX), Nautilus Minerals Inc. (NUS:TSX) and Rye Patch Gold Corp. (RPM:TSX.V; RPMGF:OTCQX). You still have buy ratings on the other 42 companies, however. Why are you still recommending small-cap companies exploring for precious metals?

JT: I believe in the sector. I can’t explain why the markets have treated the sector badly this year. The majors’ profits are up very sharply, yet the share prices haven’t even begun to keep up. It tells me that most of the players in the equity markets don’t recognize this as a gold bull market and they don’t see the potential for turnaround. They don’t realize, as Bob Hoy points out, that there’s probably another 15 years to go.

Gold is going to be strong for a long time because the financial sector, deleveraging and the loss of confidence in fiat money is going to keep the real price of gold and real earnings high. I told my subscribers when things started to turn that they should build some profits and keep some cash on the sidelines because the entire sector is likely to decline in price along with the general market.

The gold sector is being hurt badly and that’s an extraordinary opportunity. Why would I sell companies that I believe in even if, like Crocodile Gold, they’ve lost 80%? It would be a stupid time to sell. It would be a great time to take some of that cash that I suggested investors put aside and start to buy some of these companies as they decline. I don’t see any reason to jump ship now because I believe so firmly in the fundamentals of this industry.

TGR: The biggest gainer on the list of the companies that are up this year is American Bonanza Gold. It’s up about 70% this year, but about 232% since you took your initial position. Why is that junior performing so well?

JT: It’s on the verge of production at the Copperstone gold mine in Arizona. There were a lot of skeptics and the stock was extremely cheap. The costs are very low. It’s not a big mine and the production levels are fairly small, but it has really good exploration potential that can be built into a much bigger mining operation over the long term.

TGR: When is initial production expected?

JT: I believe in Q112.

TGR: American Bonanza should be generating some cash flow at that point.

JT: It should, with the caveat that more often than not startup operations have some kinks to work out. However, this was a previously producing mine. That reduces some of the metallurgical risk and other risks of a new startup. I’m confident it’s going to get the job done.

TGR: You recently interviewed management from Merrex Gold Inc. (MXI:TSX.V; MXGIF:OTCQX), which is not doing too badly this year. What did you learn about Merrex?

JT: Merrex is exploring the Siribaya deposit mine in Mali with IAMGOLD Corporation (IMG:TSX; IAG:NYSE) as its 50% joint venture partner and largest shareholder. IAMGOLD is there because it believes this is going to be a multimillion ounce deposit. And IAMGOLD is committed—it spent about $10 million to earn a 50% interest.

It has about 460 Koz from a relative high-grade open pit at a quarter grams per ton. However, that’s based on less than 5% of the total strike length of two major zones, plus another zone was discovered, too.

Moreover, some of the assays recently from the south end of the zone that was drilled have been much higher grades. The average grade may be even higher than 2.25 grams.

The only real downside is that the company has to rely on diesel fuel for now. There’s some vulnerability to spiking oil prices.

TGR: IAMGOLD is effectively using Merrex as an exploration arm.

JT: IAMGOLD is the operator of the project. It has a joint committee that decides on the strategy and drill programs. In fact, one of the management members of Merrex who I was with in Switzerland was going to Toronto on his return to talk to IAMGOLD about the next drill program.

TGR: You also have a buy rating on Calico Resources Corp. (CKB:TSX.V; CVXHF:OTCQX), which is drilling the Grassy Mountain gold project in Oregon. Oregon is generally not considered the most mining-friendly state. Why does Calico make your scorecard with a buy rating?

JT: Washington is probably considered one of the most difficult states in the country for mining. California had been very difficult, but it’s getting tougher everywhere. Calico management discovered by doing research that Oregon is no more difficult than any other Western state.

Politicians with common sense know the local people want jobs. Where are the jobs going to come from? Mining is a wealth-creating activity. It’s not going to be easy. Getting permits moved through the pipeline can be difficult, but I have confidence in the management team at Calico led by Chairman Buck Morrow, for whom I have a high regard.

Grassy Mountain was worked on during the last gold bull market. The potential there is extraordinary. It has gotten some really nice assays back.

TGR: What are some other precious metals explorers that you’re following closely and remain excited about?

JT: I love Rye Patch Gold in Nevada. It has 3.1 million ounces (Moz) gold, but it has 3.9 Moz gold equivalent including silver. Rye Patch clearly has a shot at building something much bigger than that with its good management and miniscule market cap.

I also like Metanor Resources a lot. Since Sandstorm provided capital, the company has been focusing on its underground Bachelor Lake mine in Le Sueur, northeast of Val d’Or, Québec. Bachelor Lake is going to be put into production within the next six months to a year. It should do very well with that. It also has the Barry deposit, which has the potential to be a very large deposit similar to Osisko Mining Corp. (OSK:TSX).

Québec is one of the best provinces in which to run, explore and develop projects. Aurvista Gold in Québec has 2 Moz and huge exploration potential. Pretium Resources also has a huge deposit up there next to Seabridge Gold Inc.’s (SEA:TSX; SA:NYSE.A) gold-silver deposit. Pretium is headed by Bob Quartermain and a very strong management team. It’s actually been one of the winners this year.

TGR: Do you have any parting thoughts?

JT: It’s painful sitting with stocks in this kind of a market, but that’s the nature of the beast. You hold a junior mining company and all of a sudden it takes off. You just don’t know when. You have to believe in the fundamentals of the story and the chance to come up with something big. A couple of times I’ve walked out of a stock and a day or two later the company made a great discovery—that is really painful.

TGR: How would you respond to someone like Rick Rule who says it’s not about the 80% you lost, it’s about what you do with the 20% that you have left?

JT: I suppose that’s right. Rick is a very conservative investor. He really likes to buy stocks when they’re cheap. He’s a very disciplined trader. You want to protect that 20%. When you get a market that’s on the upside, you can make that 80% back very quickly if you’re in the right stocks.

Of course, I’d never recommend that investors back up the truck and bet the farm on any one company. I have a lot of companies on my list because I believe in diversification. These little penny mining companies, the miniscule market-cap companies, can be tenbaggers in a hurry if they’re successful. Whenever you invest in a deal, you can lose 100%, but you can’t lose 1,000%. The upside is limitless.

With 20/20 hindsight I should have sold everything and waited until now to buy, but I didn’t know for sure how the markets were going to treat gold stocks this year. But I’ve been telling investors to build some cash for this kind of environment. Now is the time to be buying.

TGR: Thank you.

As he followed the demolition of the U.S. gold standard and the rapid rise in the national debt, Jay Taylor’s interest in U.S. monetary and fiscal policy grew, particularly as it related to gold. He began publishing North American Gold Mining Stocks in 1981. In 1997, he decided to pursue his avocation as a new full-time career—including publication of his weekly Gold, Energy & Tech Stocks newsletter. He also has a radio program, “Turning Hard Times Into Good Times.”

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1) Brian Sylvester 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: Calico Resources Corp., Crocodile Gold Corp., Goldcorp Inc., Great Panther Silver Ltd., Merrex Gold Inc., Prodigy Gold Inc., Pretium Resources Inc., Meadow Bay Gold Corp., Royal Gold Inc., Rye Patch Gold Corp.
3) From time to time, Streetwise Reports LLC and its directors, officers, employees or members of their families, as well as persons interviewed for articles on the site, may have a long or short position in securities mentioned and may make purchases and/or sales of those securities in the open market or otherwise.