Gold's Plunge Ultimately Healthy For The Sector: Michael Gray

Market volatility sets the stage for price upswings as well as dips, according to Michael Gray, equities analyst of Macquarie Capital Markets, and the recent gold price drop should be seen as a "pause" in the bull market. Management teams are pausing as well, to focus on earnings and shareholder return rather than growth. In this interview with The Gold Report, Gray says this is the time to buy the best companies you can while they are discounted to fire sale prices, and he offers several names in jurisdictions from South and North America in the junior explorer space.

The Gold Report: On April 15, gold dropped to a two-year low as panic selling set in across many mined commodities. Was this the larger players showing the retail market who is in control or was it inevitable?

Michael Gray: Several firms have been predicting a mid-cycle correction for gold; it just happened faster and with more volatility than expected. It also seems to be a very well-timed short-selling trade, especially on the back of the positive gold price correlation with quantitative easing (QE) breaking down and reversing post-QE3. In addition, there was no response in the gold price to the debt crisis in Cyprus or political concerns with North Korea. This was an opportunistic time for the shorts to come in, and they did, forcefully.

TGR: Does this indicate that investors prefer equities to gold?

MG: Not necessarily. The gold equities have moved sharply down and most are now pricing gold at an implied gold price of $1,000–1,200/ounce ($1,000–1,200/oz) or less. There is some fear that the gold bull run is over, which explains why many institutional investors have been abandoning their gold equity positions.

TGR: Gold equities fell in lockstep with the fall in the gold price. Why?

MG: Gold equities have had an inverse correlation of share price: net asset value (P/NAV) versus the gold price since late 2009. Historically the senior gold equities have traded +1.2x P/NAV. Now we are looking at an average of 0.65x P/NAV among our senior gold producers. Essentially, investors are pricing in a much lower gold price on the forward curve.

As the gold price goes down, we believe investors will expect that the future gold price will drop as well. That is why the equities are trading in lockstep with the decline and have a much weaker response on the upside.

TGR: Has the drop in precious metals prices fundamentally changed the market?

MG: We have not seen this magnitude of volatility in this bull market up until now. It sets the stage for other big moves and for a more volatile market, perhaps including price upswings of similar magnitude. We think this volatility is ultimately good for the bull market.

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TGR: Will it result in less gold being produced?

MG: The deferral of major capital projects and the number of projects that will be shelved because they cannot stand up to the stress test of a $1,200/oz gold price will limit growth among the senior companies. As that happens, we expect significantly less growth in the gold sector over the next five years if prices continue to lag or go sideways.

TGR: A JPMorgan Chase report dated April 16 said 10 years remain in the commodity supercycle and that the April 15 price drop was only a pause in the overall cycle. Do you agree, and what positives do you see as a result of the price drop?

MG: In general, we concur that this is a pause in the supercycle for metals in general, including base and bulk metals. China's growth being lower than expected shocked the market, at least in the short term.

The positives are that management teams are now less focused on growth and more focused on earnings and returns to shareholders—this could instill more investor confidence. It will take a few years, but having CEOs whose interests are more aligned with shareholders will impose more discipline among the producers.

TGR: In early April, Barrick Gold Corp. (ABX:TSX; ABX:NYSE) once again delayed development of its Pascua Lama gold project in Chile. What are the likely ripple effects for Barrick and the sector?

MG: This is one of those situations where a company believed it had earned its social license after a long dialogue with the government and various nongovernmental organizations (NGOs). Barrick likely felt it was crossing the finish line. Barrick is not alone in this situation.

For the gold sector it means management teams will have to look at large capital expense (capex) projects through a lens that captures extreme capex creep risk, in the case of Pascua Lama from less than $3 billion ($3B) to north of $8B. Going forward, project scale and social license risk will be key issues—only the best projects will be built.

TGR: Is Chile still on your list of preferred mining jurisdictions?

MG: It was until recently. Canada, Mexico and the U.S. are at the top. Recent developments in Chile and elsewhere in South America with community relations and NGO protests are cause for concern.

TGR: If Mexico, Canada and the U.S. are your top jurisdictions, what is the next tier?

MG: The next tier would include Chile, Peru and Turkey. In particular, Turkey is embracing foreign investment, has attracted a significant amount of capital and has a successful track record of mines being permitted and put into production.

In South America, Brazil can be also be an attractive jurisdiction, depending on the state. In Central America, we like Nicaragua, where we cover B2Gold Corp. (BTO:TSX; BGLPF:OTCQX). Nicaragua has been very politically stable in the past decade and is one of the few countries in Central America that has a stable mining policy and royalty regime. In Africa, Namibia, Tanzania and Botswana would lead our list.

TGR: Let's look at management teams. Cash is king for junior mining equities right now, yet some junior mining executives are collecting big cash salaries. Some shareholders think the C-suite is overcompensated. What do you consider a reasonable salary for a junior mining CEO?

MG: Management compensation has been a blind spot for investors in the exploration sector during this bull market, given that many management teams have created tremendous value for shareholders. The compensation matrices among peer groups have been driven by market capitalization: The more you could grow your company, the more you could convince your compensation committee to pay you.

The problem is that juniors with undeveloped resources trading at $1B market caps in 2011 paid dearly to attract talent or retain talent. Their base salaries in some cases exceeded $400,000 ($400K) plus similar size annual cash bonuses. Now those same companies have market caps of $200–300 million ($200–300M), yet the compensation levels have not changed. The G&A burn rate related to these salaries is significant.

To evaluate compensation, we look at where the company is in the exploration cycle and how much skin management has in the game. The $80–150K/year salary range has the right ring for a very early-stage explorer with no assets of retained value. Companies that have more advanced assets probably need to pay in the $200–250K range, plus bonus.

TGR: How do people find out that information?

MG: It is all disclosed in the annual financial statements and in the Management Information Circular on here . I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.

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Written By: The Gold Report