Tuesday, March 10, 2015

Allied Nevada Gold Files For Bankruptcy Protection

Allied Nevada Gold's bankruptcy offers many layers of insight.

I experienced the boom/bust cycles of other commodities and its collateral effects.  With DRAM semiconductors, during the so-called allocation phase when capacity was constrained, prices of memory chips went through the roof.  Shortages were rampant.  Of course, this invited competitors to increase supply capacity, which later produced plummeting prices.   In other words, supply more than caught up with demand within a few months.

Efficiencies during the boom phase yielded faster throughput and fewer defects, resulting in higher production.  The problem was as more fabs came on line, the scales tipped the other way, as supply would exceed demand, which caused the bust in prices and eventually production shutdowns and fab closures.  These volatile conditions caused huge dislocations in the industry, and associated side effects such as unemployment, currency collapses, company write-downs, bankruptcies, etc.

The same is true today in the precious metals industry, although plummeting prices of the underlying metals has nothing to do with market supply and demand, but everything to do with central bank manipulation.  Bullion banks work as agents for said western central banks in their surreptitious price suppression schemes, manipulating prices far below their production costs.  Eventually, mining companies dissolve into bankruptcy, as they attach dollars with every shipment.  This, in turn, results in closure of mines.

However, the impact is far greater and longer in duration relative to other industries--like semiconductors, for example.  Semiconductor fabrication facilities can be built relatively quickly.  With mines, once shut down, it could take many years to re-start them after they've been moth-balled.  Supply won't come on stream overnight.

And with market prices far below production costs, the most chilling effects rest on the explorers, as the incentives to find new mineral fields are removed.  Exploration is a dicey proposition with high failure rates.  Unlike manufacturing industries, the precious metals exploration industry is fraught with risks.  This will ultimately drive precious metals prices much higher in the future. 

Another point to glean from the current toxic environment of investing in mining shares is becoming self-evident.  With the prices of the underlying metals low, the short-term prognosis for the mining industry is precarious--even if the future for the precious metals themselves is still bullish.  Hence, a balanced portfolio should include physical gold and silver.  That's the fear trade, as precious metals still provide the best hedge for financial catastrophe and/or currency debasement.

The greed trade is investing in mining companies, as rising precious metals pricing results in rising shares of mining companies at much higher orders of magnitude.  In other words, when gold and silver prices rise, the mining shares rise even higher.  But the reverse is also true--in the other direction.  Since the peak in prices in 2011, mining shares have plummeted even more, with some even going out of business.

Long-term, some mining companies will flourish, perhaps appreciating over 10-fold.  But that's only if they can survive the current severe downturn.  The herd will be thinned.  When investing in any equities, the investor takes on company risk, industry risk, financial risk, management risk, governance risk, jurisdiction risk, political risk, and with mining shares, many other risks specific to the extraction industries--the suppression of prices being the most obvious.

Hence, a prudent speculator (because let's face it--investing is calculated speculation) should include physical precious metals in their portfolio.  For high beta (high risk/high reward) investors, a small allocation of mining shares may be appropriate.

The next nuanced point is government and central bank intervention in industries certainly causes unintended consequences, most of them negative.  Markets are distorted and price discovery is destroyed, resulting in industry dislocations.  Livelihoods are destroyed.  But the high priests of central planning insist they know what they are doing, despite evidence to the contrary.


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