Gold stocks sold off less than other types of stocks but the truth is that gold stocks are stocks and the gold stocks sell off.
Recorded: March 9, 2020
INTERVIEW TRANSCRIPT (EDITED)
Albert Lu: On the call to help make sense of this is Rick Rule, president and CEO of Sprott U.S. Holdings. Rick, how are you?
Rick Rule: I’m fine, Albert. I must say, like the Chinese curse, we live in interesting times. But the truth is you play the cards that are dealt you. This will be an interesting conversation, fit for an interesting market.
AL: Let me set the stage for the viewers because a lot has happened since you and I last talked. [Then] I’ll get your thoughts on what’s going on. Last week, on what was already a very challenging week for the markets, we had the OPEC+ group, that is OPEC plus non-OPEC large producers, meet in Vienna to try to negotiate what was going to be a 1.5 million barrel per day production cut, to try to cope with the supply surplus we have as a result of coronavirus. Apparently, that didn’t go well. Russia was kind of caught off guard. They didn’t agree. They all walked away and, so, not only did we not get the 1.5 million cut, but apparently the existing arrangement they have in place is set to expire and we have nothing on that. That sent oil markets into a downward spiral overnight.
Rick, I saw last night before I went to sleep, $27 a barrel. It’s up that from there, but that’s caused a chain reaction that has sent markets in a tailspin. Japan closed down 5%. Europe is down 5-7%. Futures for U.S. equities actually stopped trading. They halted on the downward limit overnight. It resumed this morning when trading opened in New York but soon closed again as they hit the 7% downward limit on the S&P 500. So they paused. They reopened. We’re now 6% down as I speak here, Rick.
So that’s, in a nutshell, what happened overnight. This is the biggest hit oil prices have taken since the Gulf War apparently, and this has a chain reaction potentially. That’s what we discussed last week. If that was a problem last week, it’s definitely going to be a problem this week.
So let’s pick it up from here, Rick. What do you see?
RR: Well, you packed a lot of questions into a week of events, so let’s try and make some sense of some of it.
Your recitation of events, I think, is accurate. OPEC and the Russians attempted to meet to cut oil production enough to stabilize the price. The price, as we have discussed several times, has declined because it would appear that the impact of the coronavirus worldwide, but particularly in China, has reduced oil demand by about 2.5 million barrels a day. Resource investors know that prices are set on the margin. Their net [is] not set across 95-100 million barrels a day of supply or demand but rather where supply and demand meet. A reduction in demand by 2.5 million barrels a day, that is by sort of 3% of supply, was enough by itself to kick the oil price down 25% or so.
The news with regards to the showdown between the Russians and the Saudis did two things in the very near term. It eliminated, probably, the possibility of any coordinated supply cuts, but the Saudis also decided to use, or at least have announced that they’re going to use, their ultimate weapon, which is to increase their production at the same time that they reduce the quote for Saudi crude in the European market — a strategy designed specifically to hurt Russian export crude into Europe.
Now, my suspicion is that, other than psychological economic impact, this is actually beneficial — a big decline in oil prices — unless you happen to be, like myself, an oil stock investor. [This] is all positive. It acts like a tax cut, i.e., the bills to industry and to consumers for petroleum products decline, which is a very good thing. [It’s] not necessarily so good if you’re an oil stock owner. I’ll get to that later but the actual economic impact of an oil price cut is probably a good thing.
The problems, I think, come in a couple of shapes. But one problem has to do with the impact of low oil prices on the wealth of pension funds and people who invest in oil equities. The other is on the impact on banks that have lent large amounts of money to oil companies based on a $60 price deck. Remember that if the price of oil goes from $60 to $40, it all comes out of operating margin. In fact, at $40 many, many, many companies are negative — that is generate negative free cash flow rather than positive free cash flow across the whole oil price deck — and the impact both on oil producers, particularly leveraged oil producers, and also on the banks that lend to them if these prices continue will be, not could be, will be severe. When I say the banks, I’m talking about major U.S. banks, oil center banks, Canadian banks, and also European banks that lend to the European oil and gas industry.
Another impact that could be felt in the short-to-intermediate term will be, or could be at least, on the non-investment grade or junk bond markets, in particular the junk bond ETFs. I read today, I don’t know if it’s true but I read today, that 16% of U.S. publicly traded, sub-investment grade credits, junk credits, were issued to the oil and gas businesses. The problem becomes that the largest investors in these junk bonds are income ETFs [and] junk bond ETFs, and the problem here is that if you begin to see large-scale retail redemptions of the ETFs, the ETF managers will need to sell bonds that may be highly illiquid themselves.
When you have a liquid top structure, an ETF, owning a whole bunch of illiquid assets, the need by the managers to sell illiquid assets to fund redemptions could, I’m not saying it will but could, provoke real panic in the junk bond markets, and that panic could, I’m not saying that [it] will, spread over into other speculative asset classes, including equities. That’s one nervousness that we have in the near term.
I hope I packed as many answers into that as you had packed question.
AL: They weren’t questions, Rick, but they were options, and you addressed quite a few of them. Thank you for that.
Let’s stick with this junk bond theme for a second, Rick. Would you expect to see trading in these ETFs, particular individual ETFs, halted if that happened? How does that work?
RR: I don’t know. I really don’t know what happens. It may be that there are provisions in place [or] where provisions could be put in place to gate these ETFs, that is, to constrain investor’s ability to exit them. I don’t know what psychological impact that would have on markets, other types of ETFs, where investors believe that they had a highly liquid option to buy and sell classes of securities. Remember all of this that I’m saying now is highly speculative. I just look at, what I suspect, could be the outcome from current events, one, two or three months hence and that’s one of the things that I see as being possible on the horizon.
AL: Rick, one of the things I’ve been wondering since last week, since the news broke on Friday of the disagreement and the failure to reach an agreement with OPEC and Russia, was who is the instigator, who is the targeted victim and who was collateral damage here?
Is it Russia inflicting pain on the Saudis? Is it the Saudis inflicting pain on Russia? Are they [both] looking at U.S. shale and saying, this is going to be very disruptive to shale and financial markets?
Any thoughts on that? Do you wish to speculate on that at all?
RR: You know, it’s a little above my paygrade, Albert. I would suggest that the companies have different interests and each company, each country was pursuing its own interest. The Saudis have traditionally been seen, if there is such a thing, as a leader within OPEC and the Saudis were attempting to enforce pricing discipline and price stability, that is to say, a [production] ceiling.
The Russians were interested in having the Saudis establish a [production] ceiling so that they could [undermine it] and export oil into Europe. I guess, at least, the popular explanation is that the Saudis got sick of providing protection for Russia to take market share from them in critical European markets. This is the popular explanation, and I don’t see any reason to doubt it.
The collateral damage is certainly the U.S. shale industry. The U.S. shale industry has a high degree of capital intensity and has been very, very, very reliant on a low cost of capital. The problem is that this lower oil price environment takes the margin out of the shale production and makes this highly geared capital structure look extremely wobbly. It’s both the Russians and the Saudis, I think, [that] would suggest that the most destabilizing player in terms of world oil supply has been the United States as a consequence of the shale production.
One impact of $35 or $40 crude will certainly be to stop most of the capital programs in the shale industry in their tracks. Another interesting thing to look at in the oil industry, Albert, and I don’t know how this plays, but both the Saudis and the Russians have announced $100-$150 billion capital expenditures in their own domestic oil and gas industry. I don’t think either of these projects are economic at $40 oil so we have a very interesting circumstance where the squabble between these two parties has probably impacted their own capital spending schemes and has acted, as one might suspect it would, to actually limit supplies in the future.
Remember our very common if unpleasant theme, Albert, that the cure for low prices is low prices. At $35 or $40 oil, the first thing that companies do is that they reduce their sustaining capital expenditure, which over a year or a year-and-a-half leads to production declines. But beyond limiting their sustaining capital investments, they also postpone, defer, or sometimes cancel the very heavy capital expenditures in long-lived projects. Among long-lived projects, one could lump in most of the capital-intensive shale projects that are taking place right now but [one] could also lump in Exxon’s plan in Guyana, about 5 billion barrels recoverable, and one could certainly lump into that, in terms of long-term capital spending programs, $150 billion that Russia proposes to spend in Arctic Siberia and a $100 billion program that the Saudis had planned to spend in their own shale capital expenditure programs.
So what happens, ironically, is that the current pain that the oil industry and oil stock investors, and it will be severe, experienced in a $35 to $40 pricing environment almost certainly leads to higher, and perhaps dramatically higher, oil prices four to five years from now as the capital spending deferrals that take place now reduce production, which they certainly will, in the intermediate and longer-term future.
AL: So this is one scenario where these prices persist and the various players have to react accordingly. What if this is just a little game that they’re playing right now and, when the pressure mounts, they are motivated to come to an agreement and we see 1-2 million barrels a day go off the market, prices return to, I don’t know, $40-$50 range. I’m wondering if that happens, how would you prepare for that scenario?
We talked about a company like Exxon last week, which you were interested in but didn’t like at, you know, a $50 price. What if that price is, as it is now, in the low $40s or if it dips below $40 into the $30s? Do you like it then?
RR: I think you probably do like Exxon on a longer term, but I think in a market where panic is the norm, which is certainly where we are now, the way that you acquire the higher quality names is probably by selling puts. You probably take advantage of the panic in the market, and certainly the volatility in the options markets, to sell 90 to 120 day, out-of-the-market puts on high quality names, [such as] Exxon.
Either you grab the put premium and walk away with the money or else you are put a very high quality stock. I wouldn’t play this game if you didn’t want to own Exxon for the longer term, by the way I do, and if you weren’t prepared to see the price fall substantially below the so-called bargain price that you acquired it for. As a consequence of selling the puts you can be right in the 3-4 year time frame and be terribly wrong in the 6-12 month time frame. While you are wrong in the 6-12 month time frame, you feel like an absolute moron for jumping in early. Although, oftentimes, your feelings improve substantially in the 3-5 year time frame buying a high quality company like Exxon.
This is not, by the way, investment advice.
AL: Rick, let’s switch gears now. Let’s talk about precious metals and safe havens. So you look at the ten-year U.S. Treasury; it fell through the half percent mark. Gold held up well, was up, and then retraced a little bit.
I’m wondering, when you look at, for example, companies in the GDX, the GDX is down today. A lot of those components are down, if not all of them. How have they been fundamentally affected by what we’ve seen over the last couple days?
RR: Well, we have to look a little further back to answer that question, Albert. Stocks are stocks, and when you have a panic sell-off and when you have liquidity concerns, which you’re certainly having in the market right now, what you realize is that all stocks sell off. Gold stocks sold off less than other types of stocks but the truth is that gold stocks are stocks and the gold stocks sell off.
Gold itself would be expected to do well as a consequence of the policy response to what we’re seeing right now. The turbulence that you see in financial markets, major equity markets as an example, if past is prologue, will likely produce a policy response where our central bank and other central banks increase liquidity and depress already depressed interest rates on a global basis — that is to say, debasing various currencies, which would of course ultimately be good for gold. When I say ultimately, [I mean] the response might take 3 or 6 months like it did in 2008, but the response likely would be good for bullion and ultimately likely good for gold stocks.
It’s important to note in the midst of all the panic that we’re experiencing, Albert, that the current circumstance is extraordinarily good for gold. It doesn’t mean that in the very, very near term the price will reflect the outlook. Remember Buffett famously saying, in the near-term markets are voting machines. They measure opinion, an opinion [that] is in panic. In the long term, markets are weighing machines rather than voting machines and when you look at the arithmetic around gold’s “weight,” the arithmetic is very attractive.
You mentioned the U.S. 10-year Treasury yielding about one half of 1%. While I suspect that the cost of living will go down a little bit, not as a consequence of any political maneuvering but rather as a consequence of markets reflecting lower energy prices, I still suspect that the real interest rate offered up by the U.S. 10-year Treasury is negative.
To repeat once again that great Jim Grant quote, the 10-year Treasury offers a return-free risk. This is the U.S. government finally in a position to keep its promise. They promised to give you back less money than you gave them if you buy a U.S. 10-year Treasury. That’s the competition that gold bullion faces so I think the bullion does very well. How long before the equities reflect the relative, and then absolute strength, of the bullion? I don’t know. But, I suspect, for speculators the risk of being out of the stocks is higher than the risk being in the stocks, which isn’t to say that they’ll turn around in the near term. That’s not the way markets work.
I know the listeners to this want a simple declarative statement. They want me to say that, you know, next Friday this will happen, this will happen and this will happen. The truth is, I have no idea, in the near term, what will happen. Life isn’t about certainties. It’s about a range of probabilities and it’s important to remember that when there’s panic all about you as there is today.
AL: Rick, so [for] companies like Wheaton Precious Metals and Franco-Nevada that are taking a hit right now, you’re saying that has more to do with liquidity and panic than any fundamental information that’s come out over the last 24-48 hours. Is that correct?
RR: Absolutely the case, absolutely the case. These are very, very, very high-quality companies. I’m not trying to say that they were cheap before but they are, certainly, the lowest-risk equity ways to play a recovery in gold prices and a consequent recovery in the gold mining industry.
AL: One thought, this is me speculating right now about gold. Gold responded but it’s pretty much flat now, which is interesting because the New York Fed announced that they were going to increase their overnight repo facility to 150 billion I think, from 100 billion, and gold does not respond to that. It seems like gold is not responding very much to the, let’s call monetary band aids that the Fed is applying for the liquidity issues, but what I think it’ll respond very strongly to is when the fiscal stimulus comes and there are calls for hundreds of billions, if not a trillion — one popular economist on CNBC called for a trillion dollar package — I certainly think that gold would respond very strongly to that.
What are your thoughts?
RR: I agree with you absolutely, and in each of your statements. Remember that the policy responses that you’re seeing now from the Fed will take a little while to kick in and investors will take a little while to recover from their panic before they invest in anything other than cash. So we could see a response in a month, two months or three months.
The second part, which is the spending that is likely to be a consequence of the circumstance that we see now, would almost certainly destabilize an already unstable currency and cause some people to go into gold. You’ll remember President Obama’s former domestic policy adviser Rahm Emanuel talking about the fact that governments can never let a good crisis go to waste, and this gives the governments a wonderful chance to experiment and seize further controls of all of the levers of the economy, from deficit spending to overnight liquidity issuances to artificially lowering interest rates.
There is absolutely no amount of foolishness that the government wouldn’t be able to entertain that wouldn’t enjoy a high degree of popularity from the electorate. It’s difficult to see a circumstance that comes out of this that shouldn’t be good for gold. The sole exception to that would be if somehow the mood of the investment community became so starkly pessimistic that confidence in the Fed put disappeared. If the Fed were to give a Treasury auction and nobody came, that is, if the Fed was forced to buy the entire auction themselves and the Fed lost control of interest rate markets — by the way I’m not saying that this is going to happen but if that happened — if the market itself reasserted control over interest rates, then I think what you would see is a real financial panic and that financial panic would consume gold.
AL: Jeffrey Gundlach was on CNBC last week and he said that the dollar getting weaker is essentially an unstated policy at this point. Do you agree with him on that?
RR: That’s above my paygrade. I think, irrespective of what they want to do, that great big markets like currency markets sort of work. I don’t think that we’ve had a strong dollar policy in the United States for several years but I think that we have been outpaced in the race to the bottom by our competitors.
I think the U.S. dollar strength hasn’t been due so much to strength in the U.S. society in the U.S. economy as it has been due to greater weakness in places like China and Japan and the European Union. In other words, I think that our strength has been relative strength.
I think this has given some room to U.S. policymakers to continue their stupidity, but one wonders how much room for stupidity there is left [at] all.