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Gold Mining and Economic Philosophy

Europe's medicine is America's poison...apparently...

LOOKING at the world from his perch on Vancouver Island, Leonard Melman is a veritable sage in the world of metal mining analysis. In this interview with The Gold Report, the economic philosopher is troubled about the direction of the global economy. However, there are a few bright spots for eagle-eyed junior metal investors, he reports. 

The Gold Report: Leonard, what are the most pressing issues facing investors today?

Leonard Melman: Let's start with the fiscal cliff. If America falls into this abyss, the combination of tax increases and spending reductions will slow down economic growth. Interestingly, political leaders in Europe are calling for increasing taxes and decreasing spending in order to solve their problems. I find it amusing that the solution to economic problems being proposed by leaders on the European side of the Atlantic is thought to be the problem on the American side of the Atlantic.

TGR: How do you account for the disconnect?

Leonard Melman: It is due to a philosophical inconsistency and a lack of economic understanding on the part of the world's political leaders, most of whom are not well qualified as economic thinkers, nor as philosophers for that matter.

TGR: How important is a philosophical stance to making a cogent economic analysis?

Leonard Melman: Adhering to a strong underlying philosophy can guide leaders through difficult times. Unfortunately, demands by the public for more and more government services are making politicians even more reluctant to come down on the side of austerity, particularly in America. The results are uncontrollable deficits and a massive national debt. The statutory debt limit of the US government is $16.394 trillion. The national debt of the US as of mid-December was $16.337 trillion. Therefore, a mere $52 billion remained before the ever-rising debt reaches the statutory limit.

TGR: What will happen if no measures are taken to change the debt limit?

Leonard Melman: According to law, portions of the government must cease operations once the limit is reached. Nobody wants to see that happen, least of all politicians. So I believe they will likely agree to increase the debt limit by another couple trillion Dollars. 

TGR: What will happen if the two-party system fails to agree on tax and spending cuts? How will the market respond?

Leonard Melman: The market operates in two different directions. The precious metals market historically has regarded instability as a plus. The financial markets have historically regarded instability or uncertainty as a minus. If the parties fail to resolve either the fiscal cliff or the debt limit problem, I believe the financial markets will react negatively, but the precious metals markets will most probably react positively.

TGR: Then why has the price of gold bullion during the last year been so out of sync with the deflated price of junior Gold Mining stocks?

Leonard Melman: In late 2007 and early 2008, the price of gold hovered near $800/ounce (oz). It's over $1,700/oz now—more than double the earlier price—and yet the three most popular mining share indexes, the Philadelphia Gold and Silver Index (XAU), the NYSE Arca Gold BUGS Index (HUI) and the Market Vectors Gold Miners ETF (GDX), are all below their late 2007 and early 2008 levels. That is rather astonishing. 

The reason is that the nature of mining—especially for the juniors—has undergone dramatic changes in recent years, none of which are positive. Increasing energy, transportation, geological and licensing costs make it now more expensive to mine for metals, but the most pressing problem is that the time that it takes to put a newly discovered mine into operation has increased at a rapid rate. 

I've been in this business for four decades. In the late 1970s, a mine could anticipate rapid progress from the time of discovery. A junior simply raised money, put the money into the ground, proved up the asset, got construction financing and went into production. Now a series of lengthy bureaucratic processes are making it difficult for mining companies to raise new funds in the financial markets because that causes share dilution. 

Share dilution tends to knock down share price, which makes it difficult to arrange the next round of financing, which then makes it even more difficult to advance exploration and development and a most difficult spiral ensues that makes it very difficult for miners to generate revenue from production. 

TGR: Are environmental regulations the only cause of slowing timelines for new mine development?

Leonard Melman: There are other obstacles. In Canada, the courts have literally given many aboriginal tribes the ability to interfere in the progress of a mining venture. Companies are required to "consult" with them at various stages of progress. Consultation is expensive, it's time consuming, and it can be interrupted by legal procedures at almost any time.

TGR: Do you see any changes in the near term?

Leonard Melman: The near term remains very difficult. In the long term, I'm fairly optimistic, because the world needs metals to survive, plain and simple. You can't cook food, you can't drive anywhere, you can't process energy, you can't run computers, you can't have medical instruments and you can't do almost anything that we do in modern life without metals. When genuine metal shortages begin to develop, we will see pressure build for a revision in these policies. 

TGR: Are there any North American gold juniors that can weather these difficulties?

Leonard Melman: There are some. They understand the value of obtaining properties with a high likelihood of success. The old adage is that if you want to develop a new mine, acquire property in the vicinity of an old mine. 

TGR: What about investing in bullion as opposed to investing in gold stocks?

Leonard Melman: As noted earlier, during the last four years, investing directly in gold bullion would have provided a 112% gain. Investments in a variety of mining shares would have, on balance, stood still. But in the past, the opposite dynamic has applied. Looking forward, if the world monetary situation keeps declining, there could be a truly powerful gold bull market in front of us. That also applies to silver, platinum, palladium and some of the base metals. 

It is necessary for investors to clearly define their specific goals. If the general motive for investing in gold and silver is safety and preservation of purchasing power in case currencies break down, as they have done before, then one wants physical possession of the metals. But for trading gains, shares can be advantageous. Aside from shares, if a player desires to get in and out of the gold market quickly, exchange-traded funds work well. It depends on the investor's objective.

TGR: What about silver?

Leonard Melman: I like silver more than gold as a trading vehicle, because when precious metals are rising, silver tends to rise at twice the rate of gold. Of course, when the prices fall, silver falls farther; but if one anticipates a bull market in metals, then silver has real advantages. 

TGR: Cash flow may be one of the most important things for investors to keep in mind.

Leonard Melman: Cash flow improves the likelihood of a firm advancing its project by increasing production or discovering new resources without encountering potentially ruinous share dilution. 

TGR: The share price of many specialty—or "rare earth"—metal mining corporations has disappointed investors during the past year. What will it take to reverse that trend?

Leonard Melman: The world of rare earth elements is incredibly complex and potholed with variables. There are an enormous number of elements and each has its own attributes and its own uses. It takes full-time study to get a grip on how to identify demand, and how that demand can be met, given the network of variables. The rare earth miners definitely need to make a better effort to educate the public about the nature of their business. 

And there is the same problem, as with all metals, of having to spend money without being on a clear path toward production. Some of the critical metals juniors went up very sharply a few years ago, after the Chinese announced they were suddenly limiting exports. Although the US military establishment requires a stream of rare earth elements and other markets for rare earths are growing, many juniors have made little progress toward achieving production. The reputation of several of these companies has been hurt. The industry must more clearly identify to investors the positive attributes of rare earth elements and step up the pace toward production.

TGR: Returning to the start of our conversation, how do your political and ideological preferences affect how you identify opportunities in the markets that you cover?

Leonard Melman: I am a deep believer in limited government. There should be simple and easy to understand regulations only where they're absolutely necessary. The current government interferences are a profound negative and worsening. If we can somehow turn the long-standing trend toward excessive regulations around, then profit opportunities within the mining industry should improve dramatically.

I'm normally an optimist, but I have serious concerns about the world's financial stability going forward. Europe in many places is a basket case. Japan is facing enormous problems, particularly demographic problems. Nobody knows for sure what China is doing. America is facing colossal budgetary problems. There's a mess out there and it's hard to see a really clear path to valid solutions to the litany of ongoing serious problems.

It's not that I'm a pessimist. I love life, I love nature and hiking in the woods and mountains, but when it comes to discussing economic matters, I do try to be a realist and look reality straight in the face. Frankly, there have been pleasanter times.

TGR: Thank you, Leonard.

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