For several months now, junior resource stocks have been in a highly depressed state. Many juniors are now testing their two- to three-year lows despite the commodity bull market raging strong. As stock prices remain depressed, the financial positions of these junior exploration, development, and production companies are deteriorating. 

Rising production costs, aggressive feasibility study assumptions, a worrisome number of start-up productions problems, and even resource data falsification have all greatly contributed to the credibility crisis in the junior mining sector. At the same time, the credit crisis is exacerbating the situation by making funding for even the best projects unavailable.

Financial institutions in the United States and many other countries are in serious trouble and cheap debt financing is hard to come by. Brokers are reluctant to assist with equity offerings and want better terms for their clients: deeper discounts in addition to attached warrants – both of which are making dilution even worse for the desperate-for-dollars juniors. It is a vicious cycle as this lack of funds caused by depressed share prices is further pushing investors away as they are anxious to become victims of unfavorable dilution.

As a result, the former best-performing group in the gold stock universe, Exploration II companies (26 advanced gold exploration and development companies tracked by Resource Stock Guide), is now close to its two-year low. What’s even more disheartening for investors is that these stocks are now setting eight-year lows relative to gold price.

What about the other “red hot” stocks in the resource sector. Do they look any better? Let’s look at how oil stocks fared compared to the performance of crude itself. The ratio between oil stocks, represented by the S&P/TSX Energy/Oil Index ($SPTEN), and the price of oil, is also setting new lows since 2000.

Looking at silver and copper stocks, it is also apparent that they have underperformed their underlying metal. What could be an explanation for this phenomenon? The answer lies in investors’ and financial institutions’ almost complete aversion to risk.

The culmination of the credit crisis in the resource sector, in our opinion, came with the recent news from Altius Minerals (TSX: T.ALS, Stock Forum), a highly diversified company engaged in many areas of the hot resource sector (gold, uranium, nickel, energy, potash, oil shale, and iron ore).

At the end of June, Altius’ stock suddenly lost over 40% of its value in one day. Altius’ flagship project is Newfoundland and Labrador Refining Corporation (NLRC), a venture to build a new oil refinery in Placentia Bay, Canada – the first refinery in North America in about 30 years. The cause of the crash was the announcement by NLRC that it is seeking bankruptcy protection from creditors as it has been unable to obtain additional financing. 

Existing North American refineries are currently running at close to 90% capacity. The project could not have been timelier as there is limited oil refining capacity worldwide and strong market demand for refined petroleum products. What could be more discouraging today, in the midst of the credit crisis, than a company unable to obtain financing for a permitted refinery?

This failure to obtain financing highlights the main reason for the bear market in the junior resource stocks lasting longer than expected. The credit crisis in the financial sector and the credibility crisis in the junior sector, together with the threat of a serious recession, have caused companies with even world-class size deposits to struggle for financing.

When combined with growing political and environmental risks of putting projects into production, the picture looks even gloomier. The bottom line is: bankers have little capital available for lending and almost no appetite for risk. Investors too are hurting from large losses, with fear and risk aversion becoming the dominating drivers.

Small- and micro-cap resource stocks, now in a midst of a bear market, have become some of the most hated in the entire stock market. This means that instead of burying the whole sector, we are treating this tough time as a period of lucrative opportunities, especially since we are aiming at a two- to three-year investment time horizon.

What is the rational behind this opinion?

1) Gold has shown exceptional resilience, bottoming in May, and is now indicating that the next move will be much higher despite the following negative factors:

     a) Poor seasonality

     b) A sharp drop in India’s imports (down 50% in the second quarter,
         year-over-year)

     c) Large reduction in de-hedging by gold producers

     d) Latest relative stability of the U.S. dollar exchange rate

     e) Chronic, multi-year underperformance of gold relative to other hard
         assets

So, who is buying gold? Investors. Investment demand is actually the most important driver for the gold price in a bull market; growth of inflation, in conjunction with the uncertainty related to the world-wide credit crisis, is creating perfect conditions for this demand to continue to grow.

2) At the same time, many large gold and silver producers are complaining about falling production. Their internal prospects for growth remain limited and they are forced to look elsewhere in order to battle with a decline in metal reserves.

3) With gold, silver, and copper prices rising, profit margins of large gold producers are continuing to increase, making gold majors very cash-rich. There are three ways to spend this cash: buy back shares, increase dividends, or acquire smaller companies with quality deposits paving the way for future growth. 

4) Wealthy sovereign funds from oil states and other “dollar-rich” countries have gotten badly burned in the collapsed western banking sector and are looking to diversify into hard assets worldwide. The developing world will, no doubt, become an important player in acquiring interests in juniors as well as in helping them finance projects into production.

5) The valuation gap between large-cap producers and juniors is widening dramatically (with prices of majors rising and prices of juniors generally falling). The conclusion is clear for us: bargain hunting time is here for senior producers.

At the same time, sentiment among investors in the junior sector is at a decade-low. The market almost disappeared for some of the less-followed juniors, with only a few stink-bids remaining. Any buying interest is met almost immediately with selling pressure. Selling is indiscriminate with the exception of a few high-grade deposit discoverers.

With the credit crisis nowhere close to being over, the best approach for investing in resource stocks is a highly selective one. We are currently focusing on:

• Companies with economically robust projects, high internal rate of return (IRR), and short capital payback period.
• Projects located in politically stable regions of the world.
• Companies that have enough cash to advance their projects or who have strong management and major backers with an ability to obtain equity or debt financing.
• Companies with large enough projects which will attract the attention of the major producers.

Many companies that fit even these stringent criteria are trading at a deep discount compared to large producers. In fact, on average, the market values proven and probable reserve ounces held by senior producers at 10 times the reserves owned by these quality juniors. We do not recall a time when this valuation gap was so wide. For astute investors, who are convinced that the gold and silver bull will continue, extraordinary opportunities abound.

This is an excerpt from a Resource Stock Guide Newsletter dated July 12, 2008.