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The Global Coal Shortage

A few months ago the upward trend in the price of coal already appeared to be firmly entrenched due to inflation, China's shift from being a net exporter to being a net importer of coal, the high oil price (the higher the prices of other forms of energy the more cost-competitive coal becomes), and the inability of coal miners to quickly ramp-up production in response to rising demand. The outlook for the coal market has since become even more bullish, however, due to a confluence of factors that are restricting global supply of the energy source at a time when global demand continues to rise.

First, coal production and transportation in Australia have been disrupted by heavy rains in Queensland. Refer to THIS recent article for details. Additionally, the quantity of coal leaving Australia's shores is being limited by inadequate port facilities. The upshot is that Australia's largest coal producers are not being able to take full advantage of the surge in the coal price.

Second, an important contributor to the recent power shortages in South Africa has been heavy rain in that country's coalfields. The rain has reduced both the quality and quantity of coal being transported to power stations, leaving coal inventories at dangerously low levels. A likely consequence is that South Africa's coal exports will decline as domestic requirements take precedence.

Third, China's power stations are experiencing a serious shortage of coal due to the effects of severe winter weather on transportation and heating demand. Actually, the weather is just exacerbating a coal-supply problem that already existed thanks to the government's price controls. The issue, in a nutshell, is that the government caps the price of electricity whereas the price of coal is largely determined by the international market. This has led to the slashing of power companies' profit margins as the coal price has moved sharply higher, causing these companies to buy less coal than they need in order to mitigate their losses. The government's solution? Ban coal exports, order the coal producers to deliver more coal to the power companies, and chastise the power companies for not being prepared to lose money in the public interest. This is not only a totally ineffective solution to China's power shortage, it will create a problem for countries such as Japan, Korea and Taiwan that were banking on receiving coal from China.

Fourth, Indonesia, the world's largest coal exporter, is building new coal-fired power plants at a rapid rate to meet the needs of its growing economy. It is therefore unreasonable to expect that Indonesia will be able to plug the gap caused by reduced coal exports from China, Australia and South Africa.

Large increases in the coal price make the in-ground resources of exploration-stage companies such as Red Hill Energy (TSXV: RH) much more valuable, but investors/speculators should not be totally focused on coal-mining companies that are still years away from production. Small-cap coal miners with large in-ground resources -- RH, for example -- are good speculations because at some point in the future they will very likely be acquired at multiples of their current prices by major coal producers or consumers (there's a chance that coal consumers from countries such as Japan will begin purchasing in-ground resources as a way of guaranteeing future supply); however, it is important to also have exposure to companies that see immediate bottom-line benefits from a higher coal price. In this regard we continue to like Patriot Coal (NYSE: PCX). PCX produces and sells within the US, and as the price of coal rises on the international market the price of coal in the US must follow because US-based consumers compete with consumers elsewhere for the available supply. PCX was dragged down to the low-30s during last week's stock market panic, but is still good value near Wednesday's (30th January) closing price of US$39.81.

Given coal's worldwide supply/demand situation and the likelihood that the price of this major energy source will remain at elevated levels for a long time to come, it is not surprising that the Dow Jones US Coal Index (DJUSCL) has a bullish-looking chart.

Fiscal and Monetary Follies

Plenty of money, but not enough credit

The Stock Market

We speculated in last week's Interim Update that the S&P500's initial rebound from its 22nd January panic low wouldn't get any further than former support (now resistance) in the 1375-1400 area. As noted on the following chart, Wednesday's upward spike took the index to the middle of this range.

We have no idea if the initial rebound ended on Wednesday or if there will be some additional upside over the coming weeks. What we do know is that the historical record clearly points toward a (successful) test of last week's low at some point over the coming three months.

The recent sharp rebound in the banking sector relative to the broad market, as evidenced by the following chart of the BKX/SPX ratio, is a positive sign. It is consistent with our expectation that last week's lows in the senior stock indices will, for all intents and purposes, hold during the first half of the year. Note, though, that the BKX/SPX ratio is unlikely to embark on a lengthy advance because a few months after the debt crisis ends or becomes fully discounted in the share prices of the major banks, the banking sector should again come under pressure due to rising bond yields.

Gold and the Dollar

The Dollar

The Dollar Index's daily chart suggests that a drop to the low 70s has a better-than-even-money chance of happening in the near future. It is interesting, however, that over the past fortnight the currency market has been forced to deal with a deluge of dollar-bearish news, including idiotic "economic stimulus" plans and 125 basis points of rate cuts, and yet the Dollar Index remains above its November-2007 low. When a market refuses to make new lows in response to a barrage of bearish news it is time for the bears to be wary.

Our view is that the dollar's downside risk has increased due to the Fed's recent behaviour, but it remains fairly low. At the same time, it is difficult to imagine the dollar doing anything more than bounce by 2-3 points prior to the ECB commencing its own rate-cutting campaign. Our expectation is that the ECB will cut its interest rate target several times this year, but probably won't make its first cut before March.

Gold Stocks

Getting clues from history

There were more than 1100 new lows on the NYSE on Tuesday 22nd January, something that had only happened on four previous occasions over the past forty years. Last week we looked at how the broad US stock market performed during the months following this rare event. Today we will do the same for the gold sector of the stock market, with the aid of the charts displayed below.

The first chart compares the performances of the Dow Industrials Index (Dow) and the Barrons Gold Mining Index (BGMI) during 1973. Notice that:

a) The BGMI rallied for about two months after the 1100+ new-lows day and hit a short-term peak just prior to the Dow completing the final successful test of its panic low.

b) The BGMI then consolidated for about two months while the Dow rallied.

c) The BGMI resumed its upward trend at around the time the Dow reached the peak of its counter-trend rebound.

The second chart compares the performances of the Dow and the XAU during the 12-month period commencing 1st June 1987. Notice that the XAU rebounded strongly from the time of the panic low (the 1100+ new-lows day) to just prior to the Dow's successful test of its panic low. The XAU then became very weak as the Dow returned to its long-term bullish trend.

The third chart compares the performances of the Dow and the XAU during 1998. Notice that, as was the case in 1987, the XAU rebounded strongly from the time of the panic low (the 1100+ new-lows day) to just prior to the Dow's successful test of its panic low, and then became very weak as the Dow returned to its long-term bullish trend.

The fourth of the historical cases of 1100+ new NYSE lows occurred on the 16th of August last year. The gold-stock indices were very strong for almost three months following that event.

The bottom line is that over the past forty years the gold sector has always rallied for at least 5 weeks following a panic that resulted in the number of new lows on the NYSE exceeding 1100. Moreover, when the gold sector has been in a secular bull market, as it is now, it has rallied for at least two months following such an event. Bear in mind, though, that the historical sample size is very small.

Current Market Situation

As noted in Sunday's commentary, the continuing upward trend in the gold/SPX ratio points to new highs in the HUI within the next few weeks.

There's a lot of concern and frustration amongst the holders of exploration-stage gold stocks due to the failure of most of these stocks to respond in an appropriate way to the last six months of gains in the price of gold bullion. During this period the value of aboveground gold has risen substantially while the value of belowground gold has barely moved.

We plan to discuss this issue again in the next Weekly Market Update, but we'll note right now that it isn't just the juniors that have failed to perform as expected. For example, five of the world's six largest gold stocks remain below their May-2006 peaks despite the fact that the gold price is now almost $200 higher than it was back then (of the six largest gold stocks, only Barrick Gold has exceeded its 2006 peak). As we've noted in prior commentaries over the past several months, the gold-stock indices have been propelled to new highs by an unusually small number of gold stocks.

SA Power Outage Update

It looks like the South African gold miners that were forced to shut-down their operations last Friday will move back to full production levels over the coming week or so. However, the longer-term issue of power-supply reliability has certainly not been resolved.

The following chart shows the rapid advance in the Rand-denominated gold price since the beginning of this year. At this stage it looks like the average gold price, in South African Rand terms, will end up being at least 20% higher during the first quarter of this year than it was during the preceding quarter. If this proves to be the case -- it very likely will be the case because there doesn't appear to be much chance of the Rand strengthening relative to gold -- then all the major unhedged SA gold miners will become very profitable if only they can obtain a reliable power source.

Update on Stock Selections

(Note: To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question)

First Majestic Silver (TSX: FR). Shares: 63M issued, 77M fully diluted. Recent price: C$4.39

As a result of the updated resource estimate announced on Wednesday for its La Parrilla silver mine, FR now has a total silver resource across its three main Mexican projects of 175M ounces, 106M ounces of which are in the "measured-and-indicated" category (the remainder are "inferred"). Using the fully diluted share count of 77M, this means that FR is trading at around $1.93 per in-ground silver ounce. This would not be particularly low if FR were an exploration-stage company, but it is low for a primary silver producer with current production of around 5M ounces/year.

    New Stock Selection: Northgate Minerals (AMEX: NXG). Shares: 255M. Recent price: US$2.96

This is what we wrote about NXG in the 31st October 2007 Interim Update:

"In the past we've looked at NXG as a trading opportunity from time to time, but haven't thought it was suitable as a longer-term investment because:

a) Its main producing asset (the Kemess South gold/copper project) was going to be depleted by 2010 and there was considerable doubt that the company would be able to obtain the environmental permits needed to bring its main development-stage asset (Kemess North) into production

b) Its other development-stage asset (the Young Davidson gold project) was too small to make up for the depletion of Kemess South

c) The company's senior management has routinely locked in low prices for its copper production by forward selling at inopportune times

The probability of Kemess North ever being developed into a mine has since dropped to almost zero, but NXG now has investment potential assuming that its recently-announced friendly takeover of junior Australian gold miner Perseverance (ASX: PSV) gets completed as planned.

PSV traded above A$0.40 earlier this year, but the shares subsequently slumped to as low as A$0.08 because the company ran into some operational issues and didn't have the financial wherewithal to sort them out. Moreover, it had forward sold its gold production, so it was in the absurd position of being a gold producer that was getting HURT by the rising gold price due to the increasing mark-to-market losses associated with its hedge book. This was an unfortunate situation because the company appeared to have good assets and production-growth potential, and was achieving some excellent exploration results.

It seemed that for PSV to survive it would have to issue a huge amount of new equity at very cheap prices, thus greatly reducing the value of the existing shares. Enter the cash-rich NXG.

NXG has offered to pay a grand total of US$275M in cash to purchase all outstanding PSV shares at A$0.20/share, close-out the gold forward sales positions and pay-off PSV's debt. For this $275M NXG will get the Fosterville and Stawell gold mines in Victoria (Australia).

The combined in-ground resource of PSV's two mines is 3.8M ounces, 1.4M of which are classified at proven-and-probable reserves. NXG's cost per reserve ounce is therefore quite high, but the exploration results achieved by PSV suggest that the in-ground inventory is substantially greater than the current official estimate. Of greater importance, though, is the fact that the acquisition will immediately add about 200K ounces/year of gold production to NXG at a cost of only US$1375/ounce. This is around one-third the industry average.

With the addition of PSV's assets NXG is expected to have annual production of around 430K ounces at a cash cost of US$184/ounce and enough cash left over to develop Young Davidson into a 175K ounce/year operation. Assigning a value of $3000/ounce (about 25% below the current industry average) to this production results in a valuation for NXG of around US$5/share. 

NXG offers reasonable value at the current price and is a potential future addition to the TSI Stocks List. We will probably add it to the List if it pulls back to the low-$3 area."

Since writing the above the NXG stock price has dropped below US$3 and there have been two significant positive developments. First, the PSV takeover has been completed as planned. And second, the company has eliminated its forward sales.

However, there has also been a negative development in that NXG has been caught-up in the credit market problems due to the $72.6M the company has invested in Auction Rate Securities (ARS). As we understand it, these securities have maintained their AAA rating and are continuing to make interest payments, but the market has become illiquid. The lack of liquidity means that NXG currently isn't able to sell these securities.

NXG may not lose anything on its ARS investment, but the worst case is that it will lose 100% of its investment. A 100% loss would equate to around $0.30 per NXG share, which is significant but not a 'deal breaker' in our opinion.

Given that the Kemess South mine will be fully depleted in 2010 and that the Young-Davidson mine will probably be brought into production by 2010, we think it is reasonable to base our analysis of NXG's prospects on the assumption that it will maintain a gold production rate of around 400K ounces/year for the next several years. This means that the US$5/share figure mentioned in our earlier commentary remains a valid back-of-the-envelope valuation.

Further to the above, we will add NXG to the TSI List at Wednesday's closing price of US$2.96. Ideally, readers who are interested in this stock will accumulate a position in the $2.70-$3.00 range.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/
http://bigcharts.marketwatch.com/