Basic Points

Hard Rocks and Hard Shocks

February 19, 2009

Published by Coxe Advisors LLP
Distributed by BMO Capital Markets

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Don Coxe THE COXE STRATEGY JOURNAL

Hard Rocks and Hard Shocks

February 19, 2009
published by

Coxe Advisors LLP Chicago, IL

THE COXE STRATEGY JOURNAL Hard Rocks and Hard Shocks
February 19, 2009 Author: Editor: Don Coxe 312-461-5365 DC@CoxeAdvisors.com Angela Trudeau 604-929-8791 AT@CoxeAdvisors.com

Coxe Advisors LLP. 190 South LaSalle Street, 4th Floor Chicago, Illinois USA 60603

www.CoxeAdvisors.com

Hard Rocks and Hard Shocks OVERVIEW
This is the month for the BMO Nesbitt Burns Resources Conference, a major event for global mining companies, and for institutional investors in mining stocks. It is our tradition to prepare an issue of our journal that will be of particular interest to the attendees at that great gathering. This meeting will also be the eighth anniversary of our keynote speech to the 2002 meeting (sparsely attended compared to this year, which should be a record). Back then, we audaciously proclaimed “The Birth of the GreatestEver Commodity Boom.” As we began thinking about our keynote address for this year’s meeting, we have been reviewing what we said at earlier meetings, and are struck by how much the outlook has changed for the hard and soft rock industries, because of the two great dramas of recent years: first, the emergence of China and India as the driving forces of the global economy, and secondly, the international financial crisis and recession. We remain bullish on the longer-term outlook for commodities and the shares of the commodity-oriented companies. But the fragile financial state of many major governments and banks means that we must consider the implications for investment assets at a time when investors—and such basket cases as Fannie Mae and Freddie Mac—are beginning to look forward with trepidation to the time when the flows of what we call “financial heroin” will slow down before drying up. We are leaving our cautious Recommended Asset Mix unchanged. The powerful equity bull markets have, since last March, driven many valuations to levels that make scant allowance for further systemic shocks. Most commodity stock prices are held back by the mixed messages of recovery in Europe and the US, while China has switched from expansionary to restrained liquidity policies. Within the US, there are some hopeful recovery signs—notably the recent strong performance of the US regional banks in the KRE Index (despite reports of rising problems with commercial real estate loans)—but volatility, as measured by the VIX, is rising anew.

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Hard Rocks and Hard Shocks
I The Base Metal Miners
When we spoke in 2002, the Canadians—and most of the Americans—in the audience were focused primarily on the outlook for copper and nickel, because Inco and Falconbridge were the core base metal investments in Canadian—and Canadian-oriented—portfolios. Naturally, our enthusiasm was greeted with skepticism and, (we have since learned) some outright scorn—particularly from the mining analysts and from mining executives. We explained the importance of Triple Waterfalls for macro-financial analysis by listing the three within our experience: in each case, a decade of bullishness ended in mania, followed by two decades of collapse: Commodities: The asset class of the Seventies, ending in January 1980, followed by two decades of decline, disappointment, and despair. Japan: The real estate and stock market stars of the Eighties, ending on the last trading day of 1989; we predicted that Japan’s plunge still had many years to run. Technology: The asset class of the Nineties, ending March 2000. We predicted that most technology stocks would be underachievers until late in the following decade. (Note: Google wasn’t public at Nasdaq’s peak.)
Copper January 1, 1986 to February 18, 2010
450 400 350 300 250 200 150 100 50 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10 320.25

Commodities: The asset class of the Seventies, ending in January 1980, followed by two decades of decline, disappointment, and despair.

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My entry into portfolio management in 1972 came just in time for the horrendous stock market crash of 1973-75. Commodities then became an inflation hedge class, driven initially by gold, silver and oil, but later by base metals when the big oil companies began redeploying into mines some of the billions of dollars of their proceeds from the nationalization of their major Mideast oil fields. One of the historic Dow Thirty of that era—Anaconda—was bought by a member of the club still known as Big Oil. Its purchaser explained that its skills in extracting wealth from the ground were equally applicable to metals. That was a sign of mania driven by desperation. (The investment was later written off.) The peak came in 1980. Commodities entered their Triple Waterfall collapse, and 20 years of despond and despair ensued, as the capex born of the mania was slowly and painfully absorbed or sold for scrap. By 2002, with the mining industry shrunken and disbelieving, the stage was now set for a boom—which would be driven by demand from Asian industrialization. China and, to a lesser extent, India, had embarked on what would become “the largest-scale efflorescence of human economic liberty in the history of mankind.” Buy what China needs to grow, we had been telling investors since 1999. By 2002, most investors seem to have forgotten their enthusiasm for the new millennium, which had arrived with two shocks: the Technology Crash, which spread into an overall equity bear market, followed by 9/11, which meant we were collectively at risk from attackers based in some of the most primitive regions of the world. Yet, we were telling them their biggest investment opportunity was coming from nations that had not long ago been considered so economically backward as to be mere footnotes to any global investment strategy.

...“the largest-scale efflorescence of human economic liberty in the history of mankind.”

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A chance meeting in Australia months previously had confirmed our suspicion that good times would soon be returning for the ravaged base metals companies: After touring the famous desert massif sacred to the Aborigines as Uluru, our group was supplied a desert dinner. I asked the gentleman next to me what he did, and he replied that until a few weeks ago he had been a mining executive. Since I had long been a follower of that industry I asked which one. “I ran Rio Tinto’s operations in Australia.” I explained that I was an investment strategist and had been negative on mining companies for years. Was the outlook changing? He explained that, for twenty years, the industry was driven by men who sought to prove their virility by opening bigger new mines than their competitors’. That strategy may have been good for their testosterone, (he allowed), but it was terrible for shareholders. Stock prices were so beaten-up that managements finally learned their lesson: from here on, they wouldn’t be betting big on big new mines. (Reflecting on that, I later coined a maxim: Invest in an industry where “Those who know it best, love it least, because they’ve been disappointed most.”) We asked, “What could create the shortages that would get them to reopen closed mines and open new ones?” “China,” he said. “They’re going to need a lot of metal to meet their growth promises to their people, and they will soon have trouble getting it. Metal prices will have to go up eventually.” That, I figured at the time, was the single most prophetic speech I was likely to hear for years. I knew from having studied economic history that large-scale industrialization created huge demand for metals, whereas mature economies’ modest annual growth in consumption could be met—in considerable measure—from scrap. By 2002, I was convinced the Prime Mover for the global economy in coming decades would be Asia—not Europe and North America. Invest in an industry where “Those who know it best, love it least, because they’ve been disappointed most.”

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The Boom Begins, and Has Its First Pause
BHP Billiton (BHP) January 1, 2002 – February 17, 2010
100 90 80 70 60 50 40 30 20 10 0 Jan-02 May-03 Sep-04 Jan-06 May-07 Sep-08 Jan-10 74.25

BHP Billiton relative to S&P 500 January 1, 2002 – February 17, 2010
900 800 700 600 500 400 300 200 100 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 739.68

Vale (RIO) March 23, 2002 to February 17, 2010
50 45 40 35 30 25 20 15 10 5 0 Mar-02 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09 27.78

Vale relative to S&P 500 March 23, 2002 to February 17, 2010
1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 Mar-02 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09 1,336.96

Rio Tinto (RTP) January 1, 2002 – February 17, 2010
550 450 350 250 150 50 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Rio Tinto relative to S&P 500 January 1, 2002 – February 17, 2010
600 550 500 450 400 350 300

215.25

250 200 150 100 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

284.23

Xstrata (XTA) (London) March 23, 2002 to February 17, 2010
3,000 2,500 2,000 1,500 1,000 500 0 Mar-02 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09 1,062.50

Xstrata (XTA) (London) relative to S&P 500 (currency adjusted) March 23, 2002 to February 17, 2010
900 800 700 600 500 400 300 200 100 0 Mar-02 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09 362.91

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These are the diversified base metal giants that operate around the world, and their collective performance is driven by demand and pricing for copper, aluminum, iron ore, coal, nickel and zinc. (BHP has substantial oil and gas production, and others have precious metal exposures in varying degrees, but they trade on investors’ outlook for the key base metals and coal.) Copper—“King Copper” serves a wide range of industrial markets, as does aluminum. The others are tied directly into global iron and steel production.
Copper January 1, 2002 to February 18, 2010
450 400 350 300 250 200 150 100 50 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 320.30

These are the diversified base metal giants... they trade on investors’ outlook for the key base metals and coal.

Aluminum January 1, 2002 to February 18, 2010
1.60 1.40 1.20 1.00 0.80 0.60 0.40 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 0.83

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Nickel January 1, 2002 to February 18, 2010
60,000 50,000

We had, in effect the Anorexic Index— a few analysts too scarred by years of grim news to issue enthusiastic Buy stories.

40,000 30,000 20,000 10,000 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 20,066

Zinc January 1, 2002 to February 18, 2010
5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 2,276.75

In 2002, and each speech thereafter, we outlined the key financial and political principles for successful commodity stock investing: First: invest in an industry that has completed its Triple Waterfall Crash, whose companies are led by battle-scarred executives and whose shares are followed mostly by analysts who, like those executives, “know it best, and love it least, because they’ve been disappointed most”. Secondly, invest in companies whose strength is “unhedged reserves in the ground in politically-secure areas of the world”. As time went on and the stocks began to move, we added another maxim: “The Obesity Index.” Avoid investing in stocks where the weight of analysts on the Street is heavy in relation to that group’s weight in the stock market,” In 1980, there were more oil analysts than tech analysts on Wall Street: you should have sold oil and bought technology. Now the reverse was true, even after the first stage of technology’s Triple Waterfall collapse. We had, in effect the Anorexic Index—a few analysts too scarred by years of grim news to issue enthusiastic Buy stories. 8 February
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By the late 1990s, most of the big base metal miners had virtually shut down their exploration departments, firing their geologists, and hunkering down. Why explore for new mines when you’re losing money on the ones you’re operating—which are probably higher grade than what you might find in some bush, jungle or mountain top—and face strenuous opposition from local residents and global greens? University geology departments had been shrinking or closing for more than a decade, and many geologists had taken up careers outside their industry. (A friend who was Chairman of Geology at a major university once told me that one big reason they were able to keep the department going during the bad times for exploration was demand from students who had no intention of working for mining companies. They wanted to learn about the industry so they could get jobs with Greenpeace, environmental NGOs, and law firms that sue to prevent mines from operating. Some of these enthusiastic demonologists doubtless got gloriously satisfying work on Avatar.) Such exploration as was being undertaken was mostly by the smaller companies, who took advantage of the lack of competition from the biggies to stake claims around the world. That meant that the contract drillers which had somehow survived the Triple Waterfall Crash were getting more demand for their services than they could fill. Once the China story took hold with risk-oriented investors, smaller mining and exploration companies were able to raise funds through equity offerings, and they filled the gap left by the bruised biggies. Result: one of the great winners from the mining boom has been contract drillers:
Major Drilling Group January 1, 2002 to February 17, 2010
70 60 50 40 30 20 10 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 23.47

Why explore for new mines ....which are probably higher grade than what you might find in some bush, jungle or mountain top...

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In keeping with “Those who know it best love it least,” big mining and oil companies, having slashed exploration and capex to the bone, did not boost their exploration budgets in line with rising revenues as metal demand climbed. A study in 2005 reported that global mining exploration expenditures were roughly equal to what the industry had spent a decade earlier. The managements of those companies and the few surviving analysts who covered them looked at each uptick in prices of their production as selling opportunities. It took a while for copper prices to respond to the rapidly-rising demands from China (and, to a lesser extent, South Korea). One big reason was the determination of the management of Phelps Dodge, one of the world’s four biggest producers, to lock in higher copper prices by selling huge amounts of production forward in what was (falsely) called hedging. At the 2005 Conference, I was asked during Q&A, “How high can metal prices go?” I had heard Phelps’ management’s presentation that morning, in which they insisted that analysts should use 85 cents per pound for their long-term earnings estimates. I replied, “Why not use $2.00 for copper and $9.50 for nickel?” The Phelps team got up, and noisily marched out. In contrast, Inco’s CEO was quite complimentary about the speech, and grinned, “I loved your $9.50 nickel.” Phelps had locked in 85-95 cent copper on huge long-term contracts. They doubled up with more sales in the $1.25 range. Insiders exercised stock options and sold heavily with copper prices trading not far from $1. Result? In 2006, with copper prices soaring to $3.00, the honchos of the Arizona desert found themselves under water and were bought out—at a bargain price for their superb assets—by Freeport McMoRan. The management of BHP, led by the shrewd “Chip” Goodyear, had a different view. The giant continued to expand production, eschewed hedging, and shocked the industry by buying Olympic Dam, which had the largest known undeveloped reserves of copper. At the Society of Economic Geologists Convention in 2006, Rio Tinto people were smiling about “the very large sum” BHP had paid for Olympic. In his speech the next morning Mr. Goodyear noted, “Yes, we paid ‘a very large sum’ for those copper reserves. But we also got the world’s largest known uranium reserves for free. That is the optionality that builds great mining companies.” He further explained “optionality” with reference to Freeport’s giant Grasberg mine—the world’s biggest gold deposit and one of the three biggest known copper deposits.

In 2006, with copper prices soaring to $3.00, the honchos of the Arizona desert found themselves under water...

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When the mine was being readied for production in 1988, its reserve life was estimated at 20 years, but the geology in the region was extremely favorable. He said that its current estimated reserve life was many decades. That approach to “optionality” should, we felt, be used by investors in mining stocks. Look for companies owning properties with great, unhedged, proven reserves, and with indicated geologic potential for massive additions to those reserves, including—in some cases—the likelihood of proving economic quantities of other minerals. That approach to “optionality” should... be used by investors in mining stocks.

The Crash: Was That The End of the Greatest-Ever Commodity Boom?
As the stock charts show, the big miners took bigger hits during the Crash than most other big non-financial companies. Naysayers who had dismissed the commodity boom as another 1990s bubble were gleeful. “So much for the China story! How will China continue to buy copper and coal when its exports collapse and it falls into recession? Those big mine expansions in Australia and Asia will probably go bust.” However, as those charts also show, the mining stocks came roaring back. Their cash flows are once again robust, and the only one of the majors with a modestly worrisome balance sheet is Rio Tinto, which leapt late into the acquisition game, buying Alcan right at the top. But RTP’s earnings are powerful, and it is having no difficulty in raising money. Meanwhile, Freeport, which borrowed to expand Grasberg and buy Phelps Dodge, could be debt-free by next year, if copper and gold prices stay near current levels. BHP announced its earnings for the first half of fiscal 2010 last week—$6.1 billion, up from recession trough $2.6 billion. Of perhaps more importance were its announced capex plans—up 17% in this year, not including $5.8 billion for its joint iron ore venture with Rio Tinto that still awaits final government approval. The company had earlier advised the it was now seeing “strong price recovery driven by demand in China and restocking in the developed world.” This optimism was confirmed in a Wall Street Journal report last week which asserted, “The prices of ingredients to make steel— iron ore and coal—are rising sharply.”

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Contrast that powerful recovery in prices of minerals and stocks from recession depths with the anemic GDP outlook for the US and Europe. On the evidence, “The Greatest-Ever Commodity Boom” remains intact. What the Crash and subsequent events have demonstrated is that these companies have far less endogenous risk than most macro-analysts realize. Many “deep cyclical” US stocks that rely on US economic activity have barely recovered from the Crash, and their futures depend on the success of the Obama-Bernanke-Geithner programs. The miners are true global companies, and the strong recoveries across Asia more than offset sparse demand from American and European customers.

“The Greatest-Ever Commodity Boom” remains intact.

China’s “Second Long March” Goes Global
As metal prices—particularly iron ore—continued to climb to record levels, “The China Story” took a new turn. Stung by the iron ore cartel—BHP, Rio Tinto and Vale—China began sending its minions across the world looking for metal reserves. When BHP tried to buy Rio Tinto, (which had recently bought Alcan), the Chinese were alarmed that the merged company would have the properties, production, and cash flow to have a lock on Australia’s production of iron ore. Chinalco leapt in, buying sufficient RTP shares within 24 hours to put a hold on the merger, which was already in trouble because of anti-trust claims by Australia and the European Economic Community. This year, China made its next move to lock in control of major Australian properties that produce what China’s steel mills need: the Export-Import Bank of China is putting up $5.6 billion of the estimated $8 billion cost of developing Clive Palmer’s huge Resourcehouse coal project in Queensland, which will be built by Metallurgical Corp. of China. China is investing almost everywhere—including in Quebec, where Wuhan Iron and Steel has taken a $240 million stake in Consolidated Thompson Iron Mines. Stung by governmental intrusions into attempts to buy major commodity companies such as Rio Tinto and Unocal, what is happening is that Chinese state-owned or controlled companies are buying minority and controlling stakes in companies with mineral properties across the world—and opening mines in hellhole countries backed by their own security personnel.

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Although the Crash was devastating to the miners’ stockholders, it may have accelerated the emerging competition for ownership of resources from government-owned mining companies and Sovereign Wealth Funds. These cash-flow-rich organizations tried buying up mining and oil companies, but found that Western governments were unhappy about losing “national treasures.” The situation was asymmetric: it was difficult—or impossible—for resource companies to buy control of Chinese, Brazilian or Indian companies, but the government-controlled companies were able to hymn the virtues of free markets as they made major acquisitions abroad. Vale bought Inco, and, (as we bitterly complained at the time), the Canadian government sat by as the EEC bureaucrats took geologic time to consider the implications for European steel mills of Inco’s planned merger with Falconbridge. That merger would have prevented a takeover of Inco, and would have blended the giant Sudbury operations of the companies. As a result of Brussels’ stalling, Xstrata was able to pick up Falconbridge, while Inco was left virtually defenseless against Vale’s big bid, at a time hedge funds were huge holders of Inco shares. We believe that the government-controlled companies and Sovereign Wealth Funds will eventually dominate the world’s base metal industry unless investors collectively revise their appraisals of mining’s risks and rewards, and governments in the countries where the miners are incorporated change their purist views about takeover rights by government-controlled companies. Five years ago, for example, Falconbridge and Inco were jewels in Canadian portfolios and RSPs. After the dust had settled, a Brazilian-governmentcontrolled company owned Inco, and a company of shadowy origins that was partially spun-off from the Marc Rich group owned Falconbridge. Those outcomes are dubious tributes to the glories of capitalism and free markets.

Those outcomes are dubious tributes to the glories of capitalism and free markets.

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The Next Eight Years
What now? ...resource companies still suffer from what could be called G-SevencentricEvaluations. The mining industry has long been loathed by environmentalists. It is relatively friendless among G-7 governments as a polluter and a big contributor to global warming. Nobody wants a big smelter upwind. Nobody wants any runoff of toxic chemicals into local rivers and bays. The industry, fortunately, has devoted billions to research and construction to make it a clean air, clean water producer of what the world needs now—and in the future. Global warming is a different kind of challenge (as will be discussed in the Investment Environment). Cleaning up air and water pollution from sulphuric and other acids and metal dust is something that is being done at costs the industry can bear. But its smelters are CO2 producers, which the warmists have been opposing with all their connections and might. One reason why so many investors consider the mining stocks to be high-risk is that resource companies still suffer from what could be called G-SevencentricEvaluations. For the early years of the boom, skeptics regularly dismissed these stocks as terrible investments: “They’ve been that way for twenty years, and, apart from the inflation boom, they’ve been deep cyclicals that can’t deliver good long-term returns. They don’t fit the stable grower model made famous by Warren Buffett, and they have, in most cases, no control over the prices of their output. They finally get around to opening big new mines late in one cycle, and then a recession arrives, prices collapse, and they have to keep pumping stuff out for whatever they can get. They are their own worst enemies.” Dare we say it? It’s different this time. Despite the worst Crash and recession since the Depression, prices of key industrial commodities, such as copper and crude oil, are trading at highly profitable levels for efficient producers. The S&P is up by one-third in eight years but copper is up 192% and crude is up 130%.

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One reason is that known economic reserves in politically-secure areas have not increased, despite heavy capex in recent years. Costs of finding, developing and producing are up sharply, which means the small and mid-cap entrepreneurial companies that in earlier booms supplied substantial new production (either by themselves or through being taken out by majors) have not been able to fill those roles to the same extent this time. Why? Mostly because of politics. Robert Friedland, a respected giant among mining promoters, is a modern Gulliver, beset by Lilliputians. His superb Ivanhoe copper mine in Mongolia, which could increase that poor nation’s GDP by one-third, is finally going forward after years of politically-driven delays. Just when it looked as if he was on the verge of getting full financing, the Mongolian government announced punitive new resource taxes. It has taken three years for him, and his new partner, Rio Tinto, to get the government to repeal those minekilling levies, but investors are naturally wary that once many billions have been invested and the ore flows, the cash-strapped government will enact big tax increases. His vision, guts and smarts have outlined potentially gigantic reserves in the Congo. They once looked secure because he had negotiated rights with a government backed by the UN. Alas, as of now, his guts haven’t brought glory. The Congo has reverted to its pre-Belgian pattern of bloody tribal warfare. Where is it safe to bring on new mines? If there aren’t major environmental challenges, and if local native tribes don’t claim veto powers while they sort out among themselves who has the historic rights, then most provinces in Canada—and particularly Quebec— remain safe for miners. (Mining exploration in remote regions, as we have been told by one of the leading contract drillers, is in Quebecois’ genes dating back to Les Coureurs de Bois who lived, hunted and trapped in the wilds. Their descendants are, he said, among the world’s best and most reliable workers in the bush or jungle.) Perhaps the best place for mining in North America is Nevada, because the local governments are friendly and Congress has been unable—despite decades of effort—to come up with a royalty scheme for federal lands. Result: companies only pay regular corporate taxes. The miners have strong support in Washington with Harry Reid as Senate Majority Leader, and he gets help from Senators in other states with substantial federal lands.

Robert Friedland, a respected giant among mining promoters, is a modern Gulliver, beset by Lilliputians.

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Conclusion
The base metals and coal are the purest “Chindia” plays among the four commodity asset classes (base metals and coal, precious metals, energy, and agriculture). Among those metals that trade on the exchanges, the China influence is powerful; for those steelmaking ingredients that trade by overseas contract—iron ore and metallurgical coal—China is the price-setter. We underweight these stocks within our recommended commodity stock portfolio because they have the highest economic risk of the four classes, and have the most to lose if the global economic recovery falters when the “financial heroin” supply dwindles. China’s inventory policies are opaque, and base metal contangos in the metal futures—most notably in aluminum— stimulate speculative activity that makes valuations vulnerable to major selloffs. However, the base metals may well have the best upside potential of any group when—or if—overall global economic growth resumes and investors no longer have reason to worry about metal price bubbles. We expect to boost our recommended exposure to the base metals sharply this year, as our concerns about a double-dip US economy fade.

China is the price-setter.

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II The Latest Chapters in the Financial Crisis
The best moment for us, in our continuous coverage of the debate about the financial crisis was Obama’s response to the Massachusetts “Tea Party” shock, in which an obscure, centrist-conservative state senator named Scott Brown won the Senate seat that had been under Kennedy family control since 1952. Within hours, Obama announced that he was endorsing Paul Volcker’s banking reform proposals (which we endorsed enthusiastically in our last issue). Then we heard that Barney Frank and Chris Dodd would be proposing the reforms in their respective committees. The surprise at being on the same page at the same time with Obama, Frank and Dodd recalled for us the time we absentmindedly wandered into the wrong restroom at O’Hare. The worst moment for us was to come two days later. Mr. Volcker appeared before the Senate Banking Committee, whose members are the objects of Wall Street’s tenderest attentions and most generous gifts. The Democrats were, in the words of Wodehouse “not exactly disgruntled, but they weren’t gruntled either.” The Republicans were more openly hostile. Republican Senator Richard Shelby of Alabama became the Brutus in this latest Capitol drama. As The Wall Street Journal described it, “He questioned Mr. Volcker in a fashion that suggested the utmost respect for a great hero of economic crises past and the patronizing condescension one would give an 82-year-old suspected of being out-of-touch with the modern financial world and, perhaps, a bit senile….. Mr. Shelby has taken $2 million from financial interests, more than double the contributions from the next leading industry….But that’s how it is in Washington these days. Unlike the Congress of the 1930s this body is more beholden to politics than to reforming a broken system that has put the American economy in a hole so deep the competitiveness of every American industry is now in question.” After Shelby announced his opposition, other Republicans rushed, GadareneSwinishly, to join him, and the Democrats quietly withdrew from the scene, unwilling to mount a fight that their biggest donors opposed. Shelby may well be remembered as the Capitol killer who destroyed the rescue program offered by the man who could reasonably be regarded as a short-list candidate for “the noblest American of them all.” Prior to shafting Volcker, he was best-known for holding up 70 federal appointments of all kinds because he demands approval of a big tanker deal for his state.

After Shelby announced his opposition, other Republicans rushed, Gadarene-Swinishly, to join him...

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Other Developments
The Big, Bad Bonused Bailout Banks (aka the B5) are having a remarkably easy time in Washington these days. They have even managed to convince the Republican Right that defending them against what Obama calls “Reform” is standing up for Free Enterprise and The American Way of Life. These were the financial organizations that brought, with more than a little help from Fannie, Freddie and their overlevered counterparts abroad, the Crash and Recession and added more than $2 trillion to the National Debt. Investors are learning more about the B5 as hefty books are published about the tense days of 2008. We recently read Andrew Ross Sorkin’s impressive Too Big to Fail. There are very few laughs in the book, but to our taste, there is a deliciously hilarious quote from Vikram Pandit, the ex-hedge fund manager within Citigroup who was paid more than $120 million to become CEO of that multi-strategy hedge fund that wants to be viewed as a bank when it’s seeking deposits from the public: At the point in the crisis when it looked as if even Goldman could fail, the overstressed Hank Paulson and Tim Geithner briefly tried to convince Citigroup to merge with Goldman. Pandit’s explanation to Geithner of why he turned down their plea could be one of the two great quotes of our time, along with Homeland Defense Czar Janet Napolitano’s assurance after Mutallab’s crotch bomb failed to explode over Detroit, “The system worked well.” “This is a bank,” Pandit announced. “And a bank takes deposits and a bank has a prudency culture.” As he spoke, Citi was still trying to unwind hundreds of billions of dollars’ book value in off-balance sheet SIVs, and, from its grotesquely overlevered balance sheet, even a small part of its humungous collection of perfumed CDOs. The stock price of what had recently been the biggest bank in the world with “a prudency culture” was on its way to 99 cents from its fifty-ish level 15 months earlier. But Pandit and his Wall Street allies had enough money left over from the bailouts to shower donations on Shelby and the other key Congresspersons who blocked Volcker’s reforms.

The stock price of what had recently been the biggest bank in the world with “a prudency culture” was on its way to 99 cents...

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Another of the central figures in the book, JP Morgan’s Jamie Dimon, who is one of the most vociferous and powerful of the Wall Street barons, was upset with Volcker’s proposals. He defended the Street, saying that a crisis comes every five to seven years. Really? Will that go into history as the Morgan equivalent of Chuck Prince’s memorable, “As long as the music is playing, you’ve got to get up and dance?” The Crash wasn’t some Seven-Year Hitch. And even after nearly two years of multi-trillion spending, 8.5 million Americans are unemployed, and the stock market is where it was twelve years ago. Nor was all this misery necessary. Had the B5 and their bankerly brethren not pigged out on their fancy, impenetrable CDOs and CDSes, that Buffett and Volcker had routinely derided as socially useless and outright dangerous, there would have been no Crash, and no recession. In general, Wall Street’s words of repentance and its acceptance of meaningful reform are as impressive and reliable as the investment quality of the average sub-prime CDO that they’d love you to buy. That doesn’t bode well for the financial recovery on which the nation depends. On the other hand, the KRE is looking better in recent weeks. If its relative strength continues through a stock market correction, we would be looking for the time to give the “All Clear” signal to investors.
KBW US Regional Banking ETF (KRE) relative to S&P 500 January 1, 2009 to February 18, 2010
110 100 90 80 70 60 50 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 69.25

Wall Street’s words of repentance and its acceptance of meaningful reform are as impressive and reliable as the investment quality of the average sub-prime CDO...

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III Turning of the Tide?
When the financial markets and economies imploded, Leftist publicists and politicians could barely conceal their satisfaction: at last the era of greed that began with Reagan and Thatcher and spread across the world so obscenely after the collapse of Bolshevism was over. Voters everywhere would now, finally, demand socialist-oriented policies. Leftist parties would transform the political landscapes of the world. Greed is dead! Government is no longer the problem, it is the solution! Except that it hasn’t been turning out that way. Consider Europe: Apart from Greece and Spain, two of the Mediterranean’s members in the Eurozone’s family of PIIGS (Portugal, Ireland, Italy, Greece and Spain), elections have been going for center-right or conservative parties. Admittedly, in Latin America, the tide toward the dictatorial Left in Venezuela, Ecuador, and Argentina, which began even as most of that region was turning to the Right, is continuing. But even in those dens of political stench, the caudillos are now having trouble holding down political discontent. The most important confirmation of this trend toward normalcy came in last year’s election in India, in which the center-right Congress party of Manmohan Singh was returned with a larger majority. We have commented on these reassuring trends previously. Now we must take note of something that could be even more momentous: the tide in bond risk appraisals away from sovereign credits toward high-quality corporate bonds. As voters seem to be moving away from reliance on Big Government and looking to the business community to revive their economies, bond investors have begun to migrate from the debt of hideously over-indebted governments to the debt of well-managed companies that will be part of the economic progress of future years. If, as we expect, this trend continues, it would be one of history’s greatest sea changes in bond investing. Harvard’s Kenneth Rogoff may have helped set off this swing among bond investors with the publication of a remarkable history of debt defaults over six centuries. He shows that the list of countries which have never defaulted on their own debt is a handful. (Canada, by the way, is a member of that virtuous group.) The record of European, Asian and Latin American countries is enough to make a moralist weep and a sovereign bond investor consider hemlock as an alternative acquisition. Rogoff asks why sovereign credits are,

The record of European, Asian and Latin American countries is enough to make a moralist weep and a sovereign bond investor consider hemlock as an alternative acquisition.

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according to banking system rules, always ranked higher than any corporate credits. He shows that many of the biggest corporations have never defaulted. He is, in effect, challenging the Basel rules which provide that a bank holding Greek bonds does not need to allocate capital for that investment, whereas if it holds Exxon Mobil bonds, it does. As Mr. Bumble would say: “The law is a ass.” The new doubts about sovereign credits are based on the rapidly-unfolding evidence that governments’ unionized employees’ salaries, pensions and health care have created a huge new class of winners—and few governments can afford what previous governments promised to the privileged. Watching the striking unionized government employees screaming threats in Athens, we realized that those people—who retire as early as 58 or no later than 63 with great pensions—may have more to argue about with most of their fellow citizens than the Greeks had with the Trojans. (Our favorite rioter quote, “We gave the world democracy: now it’s time to pay us back.”) Athenian democracy disappeared 23 centuries ago, and only returned when Truman intervened after World War II to prevent the USSR from taking over. Greece’s democratic performance since then suggests that the genes of Pericles and Solon are extinct. In other words, many—if not most—governments are struggling under the piled weight of all the sweetheart pension and union promises of the past, while the economies on whose taxes they rely are forced to compete in the present—and face a future of increasingly formidable competition from economies that were deemed irrelevant when those costly promises were made. To add injury to destiny, they have to bail out bad banks and insurers. Why buy the paper of sovereign issuers that keep going deeper into debt and have no realistic programs for doing better? (Although the dollar currently benefits from the Greek-driven rush out of the euro, the IMF’s calculation of current deficit to GDP ratios puts the US in Greece’s league. Only the US’s reserve status allows Washington to keep boosting wages and benefits to government employees while the private sector languishes. According to one study, the number of Federal employees earning more than $150,000 per year has doubled in the past 18 months.) If people are collectively beginning to mistrust Big Government and Zero Interest Rates, then it should be no surprise that investment-grade nonfinancial corporate credits gain on governments almost every week.

Greece’s democratic performance since then suggests that the genes of Pericles and Solon are extinct.

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Until recent months, the United States seemed to be an exception to this rule that governments were moving from the Left toward the center-right. Mr. Obama ran as a centrist against the record of a faux conservative who had added a huge new entitlement (Prescription Drugs) and a major federal intrusion into school systems (No Child Left Behind), and drove the US into a war based on botched intelligence about WMDs. Result: a big rise in fiscal deficits and the national debt. Bush also failed dismally by kowtowing to the Fannie Mae and Freddie Mac backers in Congress who kept legislating reductions in down payments and credit ratings for mortgagors. Despite strong support from Congressional Republicans and Allan Greenspan, he caved in to the Congressional Democrats who kept insisting that Fan and Fred posed no risk whatever to the financial system. Inheriting “this mess” and a full-blown financial crisis, Obama proceeded to surprise many of his supporters by introducing massive, costly new federal programs in health care and global warming. The result: deficits—in both the short and long-term—far above earlier estimates and the kind of rising political discontent that opens the doors to populists. As early as the Midterm elections, if current polls hold, the US will have rejected dreamy progressivism, and will, at least superficially, more closely resemble the political trends abroad. (Whether the new winners in November will prove to be sensible centrists and moderate conservatives remains to be seen, and the auguries at this point are hardly encouraging.) Obama has had one big stroke of luck recently. The Euro-turmoil about Greece and the other PIIGS has forced China and other central banks to reconsider their reduction in Treasury buying in favor of buying Eurozone bonds. Major investors had been warning of a coming crisis—with sharply rising interest—as projections for US deficits kept climbing. The White House Budget office minions kept grinding out reassuring figures about global demand for Treasurys. Those geeks should thank the Greeks.

The White House Budget office minions kept grinding out reassuring figures about global demand for Treasurys. Those geeks should thank the Greeks.

Conclusion
If the big bosses of the Big Government trend are losing public confidence, then, at some point, private investors and pension funds will decide to build some longer-term protection into their funds against worsening economies and the rapidly-deteriorating quality of federal and state bonds. There’s a four-letter word for the clear alternative to all these machinations and program and deficits and bad bank paper: gold.

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IV The Precious Metals
Gold January 1, 2002 to February 17, 2010
1,400 1,200 1,000 800 600 400 200 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

1,120.10

Silver January 1, 2002 to February 17, 2010
2,500 2,000 1,500 1,000 500 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

1,609.80

Platinum January 1, 2002 to February 17, 2010
2,500 2,000 1,500 1,000 500 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 1,537.10

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This is the commodity stock group that, as of now, seems to offer the best risk/reward opportunities for equity investors. (We remain ardent advocates of agriculture stocks on a longer-term basis, but with the dollar and euro both facing major near-term challenges, gold’s haven status makes its appeal impressive even to investors who are instinctively averse to commodities.) It is also the group that offers greedy dreamers the best prospects for price increases arising from accumulation by central banks and foreign exchange funds. All other commodities’ prices are constrained by the willingness of current users to pay any price increases. Not so with bullion. Gold went to new highs after jewelers and Indian ladies—for long the major buyers—had gone on strike. Contrast that behavior with what would happen to prices for iron ore and metallurgical coal if half the Chinese steel industry were to shut down. Although there are numerous experts on gold prices who issue wellreasoned forecasts, nobody really knows what it’s going to be worth in six months—let alone six years. Gold has one unique characteristic: since the beginning of time, it has always been one of the accepted alternative asset classes to consider in wealth conservation and building. A Giacometti statue of a skinny walker can be the current rage among nouveaux-riches, and set an alltime auction price record, but its weight in gold could well be worth more than the statue fifty years from now when the fashionable love of the lean has soured.
Barrick Gold (NYSE: ABX) January 1, 2002 to February 17, 2010
55 50 45 40 35 30 25 20 15 10 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 37.86

All other commodities’ prices are constrained by the willingness of current users to pay any price increases.

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Goldcorp (NYSE: GG) January 1, 2002 to February 17, 2010
60 50 40 30 20 10 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 38.65

Newmont (NYSE: NEM) January 1, 2002 to February 17, 2010
70 60 50 40 30 20 10 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 47.24

Kinross (NYSE:K) January 1, 2002 to February 17, 2010
30 25 20 15 10 5 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

18.50

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Among the biggest metal stories since the last Resources Conference have been the dramatic run-up in gold prices, and the announcement of Barrick’s unwinding of its hedges. Gold finally broke through that magic barrier last September, and has remained in The Promised Land since then... Barrick’s hedging program was the right big thing during the years of gold’s Triple Waterfall collapse—and the wrong big thing once gold had entered a new long-term bull market. The Barrick volte-face helped drive gold prices to new heights. For decades, many gold companies’ executives and promoters spoke longingly of the coming Golden Age when gold would trade at $1,000 an ounce. Gold finally broke through that magic barrier last September, and has remained in The Promised Land since then, but gold mining stocks (as measured by the XAU) peaked out weeks ago. As we wrote in December (Financial Heroin), when gold broke into Four Digitland, it suddenly began to look less like a store of value and more like a speculator’s plaything. Why was gold running wild? We cheekily suggested, as historians, that this moment in metal history could be driven by dates of the past. According to this dubious hypothesis, gold’s first target should be 1066 (The Battle of Hastings), the next 1215 (Magna Carta), with a nearterm peak of 1258 (The Provisions of Oxford) and a one-year target of 1345 (Onset of The Black Death, which began to fade away by 1350). Bullion bounced all the way to Magna Carta before the mini-bubble burst and gold plunged briefly back, bottoming out—at 1066. What converted so many skeptics into chrysophiles was (1) Barrick’s capitulation to market forces, and (2) word that the Government of India was buying 2,000 tonnes of gold from the IMF for its foreign exchange reserves. Analysts also noted that the list of European central banks who were not taking advantage of their gold selling rights under the Washington Agreement seemed to be gaining new members. The new elixir for gold investors and gold bugs alike: what happens if (1) all the central banks in the Washington Agreement stop selling and start buying and (2) China and other heavyweights decide to put a meaningful percentage of gold into their forex reserves? As gold broke through $1,000, that kind of buzz began to spread, and, after thirty years in which gold bugs talked of “Gold at a thousand,” suddenly the new target was $2,000. The wise Pope (Alexander, that is), would understand: Hope springs eternal in the human breast. Man never was, but always to be blest.

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Aaron Regent, Barrick’s market-savvy new CEO, comes from a base metals background at Falconbridge. He helped fuel the flames of desire (after he had shrewdly convinced Barrick to pull in its huge hedges) by touching and stroking a hitherto-undiscovered erogenous zone in gold bugs: peak gold— which could be the latest Big Thing since peak oil. He noted that new-mined production of gold has been declining for a decade, and suggested this could prove to be the equivalent of what has been happening to major oil fields (such as the North Sea, Cantarell, and Alberta’s sedimentary basin). During that decade, gold’s price trebled, yet the feared and revered “Iron Law of Commodities” did not re-appear to spoil the fun. (“The cure for high commodity prices is high commodity prices. When prices climb, new production appears and prices fall back: always has happened; always will.”) Another “law” was cited in some quarters during the later stages of gold’s long run-up: the Stupid Central Banker Rule: “As for gold, do the opposite to what central bankers are doing: they’re nearly always wrong.” These self-styled sophisticates noted that central bank buying helped drive gold to $800 an ounce thirty years ago, and their selling helped drive it to $250 at the end of the past decade. Since then, they’ve continued to sell into a rising market. This is one of those “rules” that makes its proponents look smart, but has a hidden problem: since central bankers have apparently stopped selling and are now buying, shouldn’t we be rushing to the exits and buying something more secure—like Treasurys or Citigroup debt? The longest-established “Golden Rule” is that “He who has the gold makes the rules.” It was cited with relish month-in, month-out, from 1974 through 1982. It stopped working in January 1980, but its hordes of true believers kept relying on it for years thereafter. Much of the recent commentary on gold (and, to a lesser extent, the other precious metals) is that Obama’s deficits, coupled with Bernanke’s money-printing, could produce either a Depression or runaway inflation. To us, this is an argument investors really should take seriously.

...a hitherto-undiscovered erogenous zone in gold bugs: peak gold...

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We have advised those who, terrified by soaring global fiscal deficits and global liquidity, talk of a rush to cash by selling most or all their equities that gold could be the optimal investment under both extreme outcomes. If gold were back at $250, total mineable gold reserves might be barely adequate to meet the collective bling demands of all Grammy winners. Since we regard cash as an unattractive asset for investors who fear Depression most (they should own long-duration high-quality bonds instead), we argue that a holding of gold and gold stocks offers excellent protection under both extremes, and attractive potential under a regime of moderate inflation and modest recovery. Gold was the best investment during the Rooseveltian 1930s and the Carteresque 1970s. Mr. Obama seems at times to be a blend of those two Democratic Presidents. The first was a confident, charismatic interventionist, whose economy was actually rescued by World War II; the second was a wellmeaning, yet inept, President who seriously weakened America at home and abroad. Nothing became him in his Presidency as the leaving of it—first, by giving the world the gift of Paul Volcker, and then by losing to the reformist Ronald Reagan. While on vacation, we spent some time watching Obama on TV. We found him even more impressive than we had thought previously. What he’s peddling may well be the wrong answers to our problems, but his charm and energy are infectious. Such bad news as there has been about gold recently has been confined to disappointing news from some of the major gold mining stocks that unleashed big selloffs. We have held some of these recently-wounded companies in our Fund (The Coxe Commodity Strategy Fund) because of our belief that long-duration unhedged reserves in politically-secure ground meant they were better than bullion in a bull market for gold. Why? Because all mining (and oil) companies report reserves on the basic of economically-recoverable minerals. If gold were back at $250, total mineable gold reserves might be barely adequate to meet the collective bling demands of all Grammy winners. Conversely, were it $2,000, new-mined gold production would surge past current levels—but it wouldn’t double: There ain’t enough gold in them thar hills. Miners report three kinds of mineral reserves: proven and probable reserves, and resources. The latter category is generally lower-grade, has not been drilled out in detail, and may have been estimated primarily by geophysical and geochemical techniques.

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One reason a big boost in bullion prices has not meant a big jump in gold production—but was actually accompanied by declining output—is that the kinds of mining companies in which you should invest are those who recognize that each ton of ore taken out of the ground brings the mine closer to closure. A mine’s closing is painful for stockholders and management, but is usually a disaster for a community. Therefore, responsible mining means mining some lower-grade ore during periods of high metal prices to expand mine lives. This not only serves the community, it protects the value of the company’s biggest asset—the mine. This was illustrated a while back when Freeport McMoRan announced a slight reduction in its copper and gold output, which meant earnings came in modestly below the estimates of some Street analysts. Some of these responded with criticisms of management’s “failure to execute,” and argued that shareholders should reconsider their approach to the stock. These criticisms bespoke not sophistication, but ignorance. When copper and gold prices soared, that gave Freeport the chance to mine some lower-grade sections of its Grasberg mine, thereby extending its life and smoothing its earnings growth. The idea of steady, uninterrupted, and predicted growth in per-share earnings is a construct of modern portfolio theories about what makes good investments. It doesn’t work with commodity companies, because the prices of their products are subject to wide swings over time. As applied to mines, that valuation technique makes as much sense as giving the Academy Award to the actress whose facial expressions are the most predictable. That’s one reason why we do not recommend giving the highest recognition to mining analysts who make the most accurate short-term earnings forecasts. We rely most on those analysts who have real understanding of the nature and challenges of each of the mines a company is operating or is planning to open (or re-open), and the management’s longer-term strategies. Nevertheless, rising metal prices will almost always mean increased ore reserves—and in some cases, the results can be dramatic. There are huge ore-bodies in politically-secure areas of the world that are virtually worthless at $1.25 copper and $600 gold but can be bonanzas at $3.00 copper and $1100 gold.

...that valuation technique makes as much sense as giving the Academy Award to the actress whose facial expressions are the most predictable.

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We have argued that investors should overweight the gold mines and underweight the bullion if they are bullish on the metal, and reverse the strategy if they turn bearish on the metal. Quite simply, higher gold prices not only mean more profits from existing reserves, but likely mean major additions to published reserves. You win—or lose—two ways on a significant move in metal prices. There is one other alternative form of precious metal investing that we have employed in the Coxe Commodity Strategy Fund: the royalty and streaming companies. The pioneer in this field was the original Franco-Nevada, which was merged away, but has since been reincarnated. It has acquired some imitators and competitors, but the field doesn’t yet look so overcrowded that investors’ returns will shrink. These companies don’t operate mines: they buy percentage shares of the output, either on an overall basis, or one component part of the production—usually a precious metal. A relatively recent entrant to this entrepreneurial sector—Silver Wheaton—illustrates the most impressive feature of the concept: According to The Northern Miner, the company has the highest market capitalization per employee on the New York Stock Exchange—23 employees for a $6 billion company.

...investors should overweight the gold mines and underweight the bullion if they are bullish on the metal, and reverse the strategy if they turn bearish on the metal.

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Conclusion
The latest published estimates for global fiscal deficits this year and last are $14 trillion. Dennis Gartman quotes a friend who explains a trillion by saying that a pile of US $100 bills totaling a trillion dollar would be 800 miles high. Conversely, all the gold on earth could be held within a few bank vaults. It is less than a century since all major currencies became non-exchangeable into gold (or, the case of US, silver). That is, in human experience terms, a brief interval. During that time there have been two World Wars, many lesser wars, one Great Depression, many recessions, and many localized depressions. The purchasing power of the greenback—the global store of value—declines year in, year out. Since the invention of paper money and the development of foreign exchange markets, there has never been a time when the central bank of almost every industrial nation in the world that matters is pumping out money at nearzero nominal rates—and government deficits continue to explode, while demographies in the G-7 countries continue to erode. Long before the fiftyyear bonds of some European countries mature, the workforces of their issuing countries relative to retirees will have plummeted to levels that are insupportable under almost any economic theory. When the sum of existing debts, present deficits, and future projected deficits is so far beyond human experience, investors should go back to the Old Reliable: There may never have been a time where Gold had a better claim to inclusion in all portfolios dedicated to wealth conservation. What has long been the popular metaphor for a sure-fire money-making idea of almost any kind? “It’s a gold mine.” Exactly.

What has long been the popular metaphor for a sure-fire money-making idea of almost any kind? “It’s a gold mine.” Exactly.

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V Is a Fertilizer Producer a Mining Stock or an Agricultural Stock? Or Does It Matter?

...it’s positively poetic: Yara bought Terra.

For months there had been growing speculation that the big mining companies were going to add fertilizer to their product mix. Then, within weeks, Vale bought Bunge’s Brazilian fertilizer operations, and BHP bought a small Saskatchewan fertilizer wannabe, Athabasca Potash. BHP has long held rights to potash permit land around the main producing properties of the giant Potash Corporation, and is developing a potash mine (Jansen) that adjoins Athabasca’s leases. (Not that the miners are the only buyers: the world’s biggest fertilizer company, controlled by the Norwegian government, bought a US nitrogen producer this week. It’s not only a big deal, it’s positively poetic: Yara bought Terra.) Several brokers have been flatly predicting that BHP will buy Potash, a company whose stock has recently languished in response to disappointing earnings:
Potash (NYSE:POT) January 1, 2002 to February 17, 2010
250 200 150 100 50 0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 115.20

The CEO of Potash, the messianic Bill Doyle, who is almost never ruffled, recently complained that “BHP is trying to buy fertilizer companies on the cheap.” Why did BHP move into agriculture? Answer: it’s so big it has to think big. Since BHP was frustrated in its attempt to buy Rio Tinto, it has what most companies would consider a lovely challenge: how to reinvest its powerful cash flow.

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How? Buying a basket of little mining companies would probably be little more than a managerial nuisance; however, buying big mining companies producing what BHP also produces can unleash a sea of antitrust troubles —from the multitudinous tiers of Brussels Snouts, and the US Justice Department, recently aroused from somnolence with the kiss from Prince Obama. Potash and phosphorus are mined, although the techniques have little in common with hard-rock metal mining. The big mining companies’ experience with farmers has tended to be of the unpleasant, pitchfork variety, because of alleged or actual injury to the farmers’ air, land, water and livestock. Diversifying into agriculture therefore is not, at first blush, the basis of a sound business model. It arouses memories of what happened to Big Oil when it bought base metals. However, BHP naturally covets POT’s reserves in the ground in politicallysecure Saskatchewan—possibly the longest-duration reserves of any mineral asset on Planet Earth. (Potash Corp. people enthuse about their “thousand years of reserves,” but even if they’re out by 25%, that means they’ll be pumping out potash for more than a half-millennium after the last drop of bitumen has been drawn from the Alberta oil sands.) As clients are aware, we have always included the fertilizer stocks within the Agriculture component of our Recommended Asset Mix (and within our Fund, where they have nearly a one-third weighting in Agriculture and a 9% overall weighting). If BHP is as serious about taking a run at Potash as Wall Street believes, we suggest the managements of both companies consider the arguments about mega-mining takeovers we adduced after the Falco-Inco-Fiasco. (Basic Points, May 2007). In brief, we believe that takeovers of companies with large mineral operations in a Canadian province are not, primarily, a question for Ottawa but for the legislature of that province—under Section 91 of the British North America Act, which became Canada’s constitution. Provinces have jurisdiction over mineral resources within their territory, except for pipelines and other forms of interprovincial trade. We are virtually certain that Quebec would take that position if there were a foreign takeover attempt at Agnico-Eagle’s mines in that province. In the case of Potash, the Saskatchewan government’s veto power may be stronger, because the company operated for many years as a provincial Crown Corporation, until Bill Doyle and friends arranged that historic privatization.

...the US Justice Department, recently aroused from somnolence with the kiss from Prince Obama.

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Canada’s federal Cabinet was only slightly more involved in the Falco-Inco takeover battles than were the Commissioner of the National Hockey League and the artistic director of the National Arts Centre. So Ottawa should not be considered the premier player if Potash is the prey. The Saskatchewan government, one of Canada’s most quietly competent, should, in our view, set up an informal committee within the Department of Agriculture or the Department of Finance to prepare a position paper on the province’s response to any future takeover bid. We greatly admire the management and ethics of BHP, but we feel that the people of Saskatchewan should be heard if Potash Corp—a true national treasure (even though its top management resides near Chicago)—control is at stake. A thousand years is a long time for remorse.

Canada’s federal Cabinet was only slightly more involved in the Falco-Inco takeover battles than were the Commissioner of the National Hockey League and the artistic director of the National Arts Centre.

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Hard Rocks and Hard Shocks INVESTMENT ENVIRONMENT
For investors worried about anemic growth in the G-7, industrial commodities and commodity stocks may look highly risky, after their dramatic snapbacks from the Depression fears of a year ago. We talk from time-to-time with pension funds about the attractions of commodities, and frequently find great willingness to consider new or increased allocations to this sector despite all the worries about deficits and unemployment in the developed world. In the US, many pension fund managers and consultants cite a paper recommending commodity investing published four years ago by two Yale professors—Gary Gorton and Geert Rouwenhorst. The Financial Times last week interviewed them about how their forecasts had worked out, given that “prices in the years following the report’s publication moved in tandem with other asset classes…As stock markets plummeted worldwide in 2008, commodities fared just as badly.” The academics seemed unruffled, still maintaining that “Over a long period, commodity futures returns match equities but with a negative correlation.” Their work tends to confirm our friend David Rosenberg’s cogent analysis that commodities and equities move in different long waves—and that equities are still in a long-term bear market, whereas commodities are still in a longterm bull market. What does that imply for commodity stocks? Can they be in a long-term bull market while the major equity indices are still in bear markets? We believe that well-managed commodity companies offer investors the opportunity to position themselves in the industries that are performing more strongly than the global economy, while under-exposing themselves to shares in companies whose market caps reflect the way the advanced economies used to be when the industrial world was still industrializing rapidly—as was its supply of citizens under age 25. That was before the combined impact of negative demographies, disastrously engineered financial behemoths, and overburdened governments brought the developed world’s global economic leadership to an end. Car drivers drive by watching the road ahead, with frequent checks to the rearview mirror. Northrop Frye, one of Canada’s most renowned intellectuals, argued that the best way to travel across Canada by train was to ride seated backward—watching where you have been.

...equities are still in a long-term bear market, whereas commodities are still in a long-term bull market.

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The major equity indices offer that vista—you know the companies, you know their competitive positions, and you know which products and services have been their growth engines. This is ordinarily comforting, compared to the neck strain from trying to peer into the landscape ahead. These economies are the Global Olympians— young, competitive and optimistic. Commodity stocks are the asset class that should be priced mostly by appraisals of the future of the global economy. They are the pre-eminent global asset class because the materials the companies produce are priced internationally, and are tied to rising demand in the fastest-rising economies. These economies are the Global Olympians—young, competitive and optimistic. The advanced industrial economies are rapidly becoming the equivalents of the high-end golf and country clubs where the successful people who’ve already made their wealth come to retire, play and drink with their own kind—and where they don’t have to compete with aggressive young upstarts. Governments’ debts are the accumulated buildup of cumulative spending growth above GDP growth—the underpayments made by earlier generations for the rewards their politicians showered on them. They are an ever-present reminder of past budget fantasies. Investors have begun the momentous process of re-evaluating the endogenous risk in the pre-eminent backward-looking asset class—OECD government bonds—compared with high-grade corporate debt, which is priced the way drivers drive cars—looking forward most of the time, with occasional shoulder checks. But, you ask, don’t government bond prices reflect perceptions of future deficits? Yes, governments, economists and investment firms routinely publish projections of future public debt situations. However, apart from basket cases like Greece, those longer-term guesstimates seem to have little or no effect on bond prices today. Else why would 30-year Treasurys offer a nominal yield of just 4.6%, when the range of future US national debt estimates is from the deeply worrisome to the utterly terrifying? Obama’s own forecasts are for endless deficits, even though they predict strong economic growth forever, no real increase in inflation, and only a one percent rise in long Treasury yields. The nation’s debt/GDP ratio is widely predicted to be heading –within a very few years—into the Mediterranean Eurozone—the Twilight Zone for risk-conscious investors.

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In contrast, blue-chip corporate debt sells based on the current balance sheet and on assumptions about managements’ commitments to restrain future bond issues in line with—or less than—actual earnings growth. Were IBM to announce it expected to lose money for the next decade, but by then it would dominate the computer service business, the yield on its outstanding bonds would skyrocket, and it would be effectively priced out of the bond market. So, what about the evaluations of commodity stocks? The good mining companies should be priced three ways: the past, the present, and the future: The past is there in the form of the existing mines and reserves; The present is there in the form of earnings and new discoveries. The future is there in the form of expectations about the growth of “Chindia” and other emerged and emerging economies, and the companies’ abilities to position themselves for even greater future profitability as hundreds of millions of new consumers vie for the products that will come from the manufacture and use of commodities. We place the greatest emphasis on the future, whereas the Street tends to downgrade it, posting long-term base metal price forecasts that plunge to levels last seen in 2005 or thereabouts. We disagree strongly with those future earnings projections and question why any smart investor would want to pay up for mining stocks that supposedly face grim years later in this decade and beyond. Peddling stock with a forecast of future sustained gloom rarely works—except for selling box seats for Wrigley Field. The endogenous risk for the well-managed mining companies compared to the broad stock market is much less than most backward-looking conventional strategists assert, and the future profitability is greater than most analysts dare to predict.

Peddling stock with a forecast of future sustained gloom rarely works—except for selling box seats for Wrigley Field.

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Hard Rocks and Hard Shocks
The Global Warmists’ Crisis
Global warming began to emerge as the new challenge to the economies of the industrial world after the Fall of the Berlin Wall and the subsequent implosion of Bolshevism. The devastated global Left found a new cause that, by attracting support from across the political spectrum, could give Big Governments even greater power than they exercised before Reagan and Thatcher made capitalism fashionable. Crucial to warmism’s rapid rise to power was its insistence that the science of global warming was settled. Dissenters within the scientific community found themselves marginalized and ridiculed, and their access to publications restricted. The Nobel Peace Prize awarded to the UN’s Intergovermental Panel on Climate Control (IPCC) and Al Gore sanctified the cause. The Copenhagen Conference was to be the occasion at which the industrial world would not only pledge itself to imposing strict controls on its practices, but would pledge up to $100 billion in payments to the Third World in reparation for the damages to emerging economies from Western industrialization, and to assist its members in achieving climate-sensitive economic growth. Then the settled consensus began to become unsettled: First came “Climategate”—the thousands of hacked emails that showed the extent to which the scientific dogmatists went to cover up embarrassing data and discredit their opponents. Second was Copenhagen. TV viewers across the world saw rioters in the streets and socialists like Hugo Chavez getting standing ovations when they demanded the end of capitalism. No deal was reached. Third was the revelation that the IPCC’s headline claim that the great Himalayan glaciers would disappear within 35 years was as scientifically based as reports of conversations with a Yeti (The Himalayan Bigfoot). The one scientific paper used for that scary claim had actually talked of the possibility they would disappear by 2350, but the basis of the IPCC assertion was anecdotal reports from a few enthusiasts at the World Wildlife Foundation (WWF), which had long ago morphed from saving pandas to fighting warming. Fourth came the report from Swiss glaciologists that the Davos Glacier, the most influential ice sheet on world opinion, had not shrunk because of global warming but because of eight years of far-above-average sunlight.

...the IPCC’s headline claim that the great Himalayan glaciers would disappear within 35 years was as scientifically based as reports of conversations with a Yeti...

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Fifth came “Amazongate.” The IPCC had leapt into the cause to save the rain forest by claiming that a huge percentage of forestland faced destruction from warming. Now it was revealed that the only basis for that scientific alarmism was an article written by a pair of youthful global warmists with scanty scientific credentials—one of whom worked for the WWF. Sixth came the saving of Holland. The IPCC had reported that, because of rising oceans, 55% of the Netherlands was below sea level. Dutch scientists showed that the part of its landmass protected by dikes was a small fraction of the nation—and it hadn’t shrunk recently. Seventh came the confessions of Phil Jones, the former head of the East Anglia climate institute whose emails had been hacked. He had been put on leave after the scandal broke. He admitted that their studies showed “no statistical evidence” that the world had been warming since 1995, and that the historical records showed the world was warmer 1,000 years ago than now. He said that what was needed in coming years was a return to peer-reviewed research. More and more confessions and revelations come out each week. This week, the big business alliance that had been backing Obama’s Cap and Trade bill began to unravel, as BP, Caterpillar and Conoco Phillips pulled out. Its biggest remaining member is General Electric, which has built its business model on building alternative energy devices. The legislation is stuck in the Senate, and it now looks as if that will be its tomb. The record snowfalls across the Southern and Eastern US cheered the opponents of global warming, but the warmists point to the problems for the Vancouver Olympics to argue that, as they said all along, warming meant wild weather swings, so a snowbound Washington is actually proof of their claims. On balance, those snowfalls were further bad news politically for warmists—because of their impact on ordinary people’s perceptions—but they certainly weren’t decisive. What matters most is the week-to-week accumulation of evidence that the “science of warming” has to go back to the drawing boards. There is no chance now that voters in the developed world will support governments that impose heavy burdens on their own economies, while sending billions in reparations to the newly industrializing nations that have become such formidable competitors—and formidable polluters.

What matters most is the week-to-week accumulation of evidence that the “science of warming” has to go back to the drawing boards.

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Hard Rocks and Hard Shocks
The investment implications are immense: • Coal is coming back, and Warren Buffett’s bet on BNSF will pay off. The business model of Blood & Gore may have to undergo some revisions. • The Canadian oil sands will probably never get support from the environmental elites, but the odds that the US will ban imports of Canadian heavy oil now range between slim and none. Moreover, the supposed global consensus demanding the shutdown of the oilsands soon will be history. Suncor and the other producers can start breathing more easily—and investors who dumped their shares to prove their green virtues may begin to reassess their decisions. • The US Environmental Protection Administration’s carte blanche to involve itself in business decisions across the economy will probably not outlive the US Midterm elections. That is good news for the US economy—and particularly for transportation and industrial companies. • The business model of Blood & Gore may have to undergo some revisions. No one has proved that man-made global warming does not exist. But, week by week, more and more people across the world will come to believe that no one has proved beyond reasonable doubt that it does. The game has changed.

Is Bernanke Running Out of Heroin?
As we were going to press, Bernanke announced a boost in the Discount Rate—the fee for short-term emergency loans to banks. He also announced there would be no change to the fed funds rate. Commodities—particularly gold—were hit hard. We see this as central banker’s cosmetology---not surgery. He doubtless would love to abort the commodity recovery, which was confirmed by a big surge in the Crude Goods component of the PPI. As an economic historian, he knows that indicator was the one that, in the 1970s, first flashed powerful evidence of the stagflation to come. The only capital punishment open to him is closing down bad banks. He can’t shoot the inflation messenger.

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Hard Rocks and Hard Shocks RECOMMENDED ASSET ALLOCATION
Recommended Asset Allocation (for U.S. Pension Funds)
US Equities Foreign Equities European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Bonds US Bonds Canadian Bonds International Bonds Long-Term Inflation Hedged Bonds Cash Allocations 17 5 2 11 14 12 8 11 10 10 Change unch unch unch unch unch unch unch unch unch unch

Bond Durations
US Canada International Years 5.25 5.00 4.50 Change unch unch unch

Global Exposure to Commodity Stocks
Precious Metals Agriculture Energy Base Metals & Steel
We recommend these sector weightings to all clients for commodity exposure—whether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

33% 30% 22% 15%

Change unch –3 unch +3

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Hard Rocks and Hard Shocks INVESTMENT RECOMMENDATIONS
1. This is assuredly an inopportune time to increase equity exposure—and an opportune time for profit-taking. Major stock indices are breaking down. For the S&P, it would take only an 8% retrenchment from its current level to break the 200-Day Moving Average, and take the index to late summer levels. 2. Maintain a strong overweighting in commodity stocks within equity portfolios. 3. Maintain high exposure to gold bullion and the gold miners whose production comes from politically-secure areas. The core belief system for gold is that governments can’t be trusted. Investing in miners dependent on the sustained honesty and wisdom of conspicuously dubious governments may work out for a time, but the principle behind that strategy is oxymoronic. 4. Investors should overweight base metal miners within the cyclical component of their equity portfolios. The base metal miners’ earnings have come back faster than all but the most optimistic would have predicted when the world’s crisis managers were engaged in panic-driven ad hoc strategies to avert a Depression. Few investors grasped the significance of the fact that the new players on the global block—China and India—weren’t even in recession. Result: metal inventories never mounted to levels that would have imperiled major miners. 5. Here is a strategy for corporate clients to consider: borrow—don’t buy—debt denominated in euros. The Eurozone, justly renowned for its liberal dispensations of pork, barely emerged from the Crash before being faced with a big PIIGS (Portugal, Ireland, Italy, Greece and Spain) problem. Germany has a veto on any form of bailout for the big spenders, and German voters were never given a chance to vote on whether they really wanted to swap their beloved Deutschemarks for euros. Canada recently demonstrated its smarts by borrowing heavily in euros.

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6. The Saudi Oil Minister has said that $70-$80 is the “perfect” price for oil. In an imperfect world, this looks like a reasonable price for valuing oil producing companies—and the contango in the futures curve is a reasonable basis for valuing the companies’ Reserve Life Indices. 7. Underweight natural gas-related stocks within energy portfolios. Overweight the oil sands companies, whose managements should be among the loudest of laughers at the warmists’ implosion. Despite El Niño, it has been a challenging winter for most of the USA. But it hasn’t been enough to get natural gas prices up to interesting levels. 8. We remain bullish on the leading agricultural stocks. Food price inflation is hitting consumers in many emerged and emerging economies. The reasons vary, but the Beijing bosses and their counterparts in other important economies have to be concerned that prices could be so strong, even though prices of corn, wheat, soybeans and rice are not. 9. Canadian bonds and stocks should be heavily overweighted in global portfolios. As you watch the Vancouver Olympics, don’t focus too much on the Canadian committee’s high-risk decision to schedule many downhill events on the coast in what turned out, unfortunately, to be the year of a giant El Niño. Look at the beautiful city and countryside, and look at how Canada’s economy is performing compared with its Southern neighbor. 10. Overweight investment grade corporates in bond portfolios. Would you rather hold long-term debt from a government that cannot manage its finances or from a great company that manages its money very well? Remember that those smart people who rate leading governments’ bonds AAA also gave that rating to trillions of face value in complex “bonds” that are heavily weighted in the worst of residential mortgages. If the US stock market rolls over and falls sharply, the impact on the US economy is likely to be profound. Such improvements in consumer and business outlooks as the pollsters find are heavily based on the strong equity markets. Those ebullient markets helped corporations rebuild their finances through debt and equity issues. A bear that emerges from hibernation could be dangerous to more than equity investors.

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