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Jim Cook



Every once in a while I switch the TV channel from Fox to CNBC to see what the liberals are saying.  After listening awhile I get a deep sense of hopelessness and foreboding for our country.  The most important thing for the left is giving money to people.  They are happy to see the growth of food stamps, disability payments, housing subsidies, free healthcare and all the other welfare benefits.  They utterly fail to see the damage it is doing to the recipients.  Whole cities that once flourished have deteriorated into rotting eyesores populated with shambling hulks of chemically dependent drones.  These people are no longer employable.  They have become incompetent and helpless and the liberals can’t see that it’s their doing.

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The Best of Jim Cook Archive

Commentary Of The Month
January 23, 2006
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Digital Reserves vs Real Metal

Mark J. Lundeen

The big story since the stock market top in January 2000 has been in metal and energy. Gold and silver prices are not walking but running to new highs since 2001. Crude oil, copper and other vital basic materials have hit all time highs and for the good reason that supplies of vital basic materials has gapped behind global demand. This state of affairs in basic materials is going to stay this way for more years than anyone currently knows. With all that said, what needs to be understood by investors is that there is more to the current natural resources situation than just a supply and demand imbalance. Minerals and mineral exploration companies are currently priced at artificially extreme, never again to be seen in our lifetime low share prices.

During the high tech bubble years of the 1990’s, Wall Street promoters sold the world the idea that computers linked together on the internet were the solution to all of the world’s problems. Capital poured into high tech and everybody was going to get rich on software code and semiconductors. Investment money gave little thought to coal, oil or finding new supplies of metal ores. Basic materials seemed trivial and mundane to the digitally inclined. Products from the Earth left dirt under the finger nails and harkened back to the 19th century while everyone buying stocks during the recent stock mania had their mind’s eye firmly fixed on the coming digital 21st. Century.

The informed opinion of the best and the brightest in high finance and government knew that energy and metals were important at some level to the economy, but they saw no major place for them in the coming digital world.

Wall Street for over a decade paid no attention to the state of major mining companies’ shrinking ore reserves. So seductive was the idea of the coming digital future that even the major mining firms themselves made little effort to replace their depleting metal and energy reserves.

Real world metal mining is an expensive, low-profit margin operation. In the coming digital world it seemed only logical that major mining companies should sell digital copper, gold, silver and anything else that is traded in a futures exchange. In New York, a promise to deliver something is as good as the actual delivery of something in the price discovery mechanism called the COMEX futures exchange. In this digital world, what was carried on a mining company’s hard drive could became better for a company’s bottom line than its in ground reserves and actual metal production.

Expanding production of actual metal for the spot market only adds to global supply and so tends to lower market prices. As actual mining has fixed production costs, a company could go out of business producing too much metal as profit margins disappear due to oversupply of metal. Not so with digital metal. Expanding production of digital metal, (meaning the promising to deliver something, sometime in the future ), also increased supply on the COMEX exchanges and so lowered prices, exactly as would delivering real metal. The wonder of digital metal was that the over supply of this fictional metal actually made money for the commercial digital producers and their investment bankers.

The promise to deliver metal sometime in the future, produced a short position on a commodity contract, and short positions increase in dollar values as prices go down. Millions of ounces of digital gold and silver could be produced at no cost - so lower metal prices could never squeeze profit margins of the commercial digital producers. The following logic applied for the past ten years.

- over produce real metal = decrease profit margins

- over produce digital metal = increase profit margins.

I have no doubt that there were mining companies that actually made more money selling digital metal in the futures markets than they did selling real metal in the spot market – as long as the price of metal kept going down, because with higher prices:

- higher prices for real metal = increase profit margins

- higher prices for digital metal = decrease profit margins

I am not advocating the abolishment of commodity contracts, or COMEX hard drives. I am all for allowing mining companies and their investment bankers being allowed to make their profits as best they can. However, when a major mining concern’s board of directors and their investment bankers, mismanage their company’s shareholders interest by devising a profitable suicide of their own industry; there is something very wrong. The point I am making is that real market prices are not arbitrary. If excessive sales of fictional digital metal sets the price of real metal below the cost of production, then honest producers profits are penalized or become nonexistent and so place at risk the stream of metal into the economy. Rational people understand that at some future point, the very availability of vital materials will become a critical issue to the real economy. This is the wisdom of limiting a speculator’s ability to sell in a futures market. If it stands that the commercial metal producers and large financial trading houses that dominate the COMEX exchanges are the perpetrators of this economic mortal sin, it will not alter the inescapable future consequences.

Did digital natural resources also have a perverse relationship with the digital US "monetary policy?" Never in the history of money has such an explosion of money as the United States experienced under Alan Greenspan’s administration of the Federal Reserve, has there been no corresponding explosion in aggregate prices. That is what the US Government’s own CPI statistics would have us believe as seen in the chart below.

How did the US "monetary policy makers" get around the laws of supply and demand? Basic economic laws apply to money too! I don’t have the data to support the following, but I suspect that the increase in digital dollars was matched with an increase in digital natural resources in the commodities exchanges to support US monetary "price stabilization operations." This would keep basic materials prices down even as wage inflation pushed up the cost of production until mining operations actually became impossible. At first the marginal mines would go under: the gold mines in South Africa, the old Homestake Mining operations in South Dakota, and the Sunshine Mine in Idaho. I suspect base metal mining suffered too. The better mines would eventually have to high grade their ore deposits until they too became marginal operations slated to be mothball or abandoned. In 2006 we discovered that Gresham’s Law: "bad money drives out good money," applies to minerals too.



There is also good reason to be suspicious of the CPI data. Official US Government data would have us believe that aggregate consumer prices did not so much as double since 1987. Is there anyone over forty years old living in the US or elsewhere, who pays rent, owns a home, has to pay for energy or buys food that believes that? But that is what the US Government’s economists who compile CPI data and publish its dubious numbers month after month would have us believe. I think the CPI statistics are people’s "Exhibit A" of the incestuous relationship between the US Government, The Federal Reserve System, and the Economic department of any significant university in the United States. Is CPI used as the basis for cost of living increased for the economists compiling data for CPI? I hope it is, but suspect it is not.

There are some (many?) that will take issue with everything I have said up to this point. However, it is indisputable that the businesses of actual mining and exploring for new sources of metals from the Earth fell into a deep and long lasting depression by the end of the digital decade. Mining companies laid off their entire exploration divisions. Geologists became former geologists who now do something else for a living, assay labs closed their doors for lack of business, schools of mining and geology saw student enrollment shrink to unthinkable levels. The commercial traders of digital metal prospered in New York, but those who offered actual expertise in mineral production saw only poor employment prospects in this dying industry. As the business of producing real minerals to the real economy ground down to dangerous levels, the skilled labor force needed in mining eventually were laid off or retired. Young people as a group, currently see the sector as a dead end for the upwardly mobile. Still, compared to the exploration industry, the people in mining were lucky. The exploration companies really had it bad.

But those were the bad old days. Things have certainly changed in the past two years for the little guys, who like the grizzled prospectors of old, seek out and find new sources of metal for the world. In the next ten years, more money will be made chipping at rocks and examining drill core samples than finding new ways of processing data. And most importantly for investors, the companies doing this work are starting out with their share prices at below Great Depression levels. That means that today it is possible to buy for less than ten cents what should be going for a dollar. In the summer of 2006, this may not be true any longer as there are great changes coming in mining and exploration.

In choosing between the energy or metal sectors, I personally prefer the metals. Energy, as a rule, is the domain of huge companies. Yes, there is money to be made in buying well financed hugeness that is destined to become two to five times as big. Think of IBM during the high tech boom. But we know that the real money made by investors in technology was by finding a Steve Jobs or Bill Gates early in their business cycles. This is why I currently like the gold, silver and copper junior exploration companies as they currently offer the same prospects for superior above-average performance.

A note on exploration companies – no modern prospector limits themselves to gold, or silver. Exploration companies today benefit from high tech as much as anyone else. They also typically have claims to several "targets" that may contain anything from gold to uranium. I really don’t care what an exploration company’s field geologists find, everything from the Earth is currently in shortage.

These are companies that have market capitalizations of millions that * may * be sitting on billions of dollars of metal reserves. As metal prices rise, and above ground inventories of actual metal shrink, the former COMEX producers of digital metal will have to decide if they are still in the business of producing actual ingots of metal. In the years to come, we will witness a desperate struggle by many major mining companies, to obtain new in ground ore reserves.