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Oil and Gold:

Where do we go from here?


With Eric Sprott, Rick Rule, and Marc Faber
Published February 13, 2015

A Recovery with Soft Oil Demand and Low Wage Growth?


Positive economic data has helped fuel the US stock market over the last year. In January 2015, the US economy added 257,000
jobs according to the Department of Labor.1 New jobs have increased by over 200,000 each month for the lasts 12-months. The
US economy grew at an annualized rate of 5% from July to September 2014, according to the Bureau of Economic Analysis, and
continued at a clip of 2.6% from October to December.2
With that backdrop of economic growth, oil prices have done something straight out of left field. They got cheaper by half
over a period of only about six months. Oil was selling for over $100 per barrel globally last summer. West Texas Intermediate
crude, a benchmark for US oil prices, was above $90 per barrel this summer3 and was below $55 per barrel as of late
December 2014. As of early February, oil remains below $60 per barrel.4
The oil price is falling while stock prices are reaching all-time highs. That is what you call an elephant in the room. On the
one hand, an economic recovery should mean that oil will be in higher demand, as manufacturing, housing starts, and other
energy-consuming industries pick up.
And yet, the recent price action suggests that oil is becoming less appealing. What should you make of it?
There is evidence that part of the reason for lower oil prices is an increase in supply due to higher oil production, particularly
in the US. Global oil production rose from 84.9 million barrels per day in 2009 to 90.1 million barrels per day in 20135. As you
can see, worldwide oil production has increased steadily over the last 3 years.
CHART 1: GLOBAL CRUDE OIL PRODUCTION DEPARTMENT OF ENERGY

10000

1000 Barrels of Oil

8750

7500

6250

5000
2010-01-29

2011-01-07

2012-01-06

2013-01-04

2014-01-03

2015-01-02

Source: Bloomberg

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Why did this three-year old trend suddenly spook the market?
Many analysts and economists have suggested that a lower oil price will not last, as consumers will take advantage of lower
prices to use more oil and thus dispatch with excess supply. So far, we have yet to see this occur.
Oil traders view the oversupply as so severe right now that we have entered a situation known as contango. The price of
oil for delivery a few months from now is higher than the current spot price. As a result, traders buy oil to stockpile, which
they immediately sell on the futures market to lock in a profit. Partly thanks to the contango trade, oil stockpiles in the US
have skyrocketed.
CHART 2: US CRUDE OIL INVENTORIES EXCLUDING STRATEGIC PETROLEUM RESERVES DEPARTMENT OF ENERGY

420000
410000

1000 Barrels of Oil

400000
390000
380000
370000
360000
350000
Jan 04, 2013

Jan 03, 2014

Jan 30, 2015

Source: Bloomberg

So far, neither the boost to consumption expected from a lower price, nor the reduction in current supply due to US stockpiling
appear to have firmed up the price of oil very substantially.
While the oil price decline has been blamed on surging supply, production growth has been steady over three years, and was
of little concern for most of that period as prices remained comfortably around $90 to $110 per barrel. Meanwhile, the global
economy and particularly the US are supposed to have improved. If so, why isnt oil in higher demand?

A Lower Oil Price Confirms What Interest Rates Suggest


Low interest rates support the idea that the world economy is slowing down. In a real boom, consumers and investors around
the world tend to deploy more capital into assets like businesses or new housing starts, a move that drives up interest rates.
Yet, lower and lower interest rates suggest that these investors are hunkering down, instead of ramping up.
The Federal Reserve offers a feel-good take on low interest rates that they help the economy. This might be true, if there
were substantial demand for credit and places to re-invest using this huge supply of capital. In the absence of beneficial
uses for this cheap credit, low interest rates are more a symptom of a tepid economy, rather than an aid to an economy that
appears to have little use for them.
An important misconception among analysts and economic observers is to suggest that low interest rates are set by the
Federal Reserve, and that other aspects of the economy depend on these interest rates. Remember, though, that the market
exerts a strong force on interest rates one that might very well be overwhelming. The Fed is certainly taking advantage of
weak credit demand to help fund the government cheaply, but the reasons for low interest rates may be more deeply-rooted
than the Feds policies.

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In fact, interest rates might go even lower if the Fed did not discourage holding cash by producing heavy amounts of new
dollars and expanding their balance sheets.
In other words, low interest rates may simply be caused by much lower demand for capital and debt. Along with a weak oil
price, weak interest rates suggest an overall sluggish economy, not a broad recovery.

Weakness Around the World


The oil price is driven by the same dynamic that underpins the case for most commodities, such as copper, uranium, or iron ore.
As people get richer, especially in emerging markets, they tend to consume more metals with which to build houses and cars,
and more fuels to generate energy and power machines.
Yet commodities have been flat since the Great Recession ended, suggesting, once again, that economic growth is slowing down.
The price of copper is at a four-and-a-half-year low of $2.60 per pound6. Uranium sells for $36 per pound today, down from
around $65 in 2011.7 Iron ore for delivery in 2015 trades for below $60 per tonne on the futures market, down from over $180
per tonne in 2011.8
The price of oil, meanwhile, had not declined substantially over the last three years. Perhaps its recent price collapse is not
as sudden and inexplicable as many believe. Indeed, a low oil price is consistent with the price action weve seen in other
commodities. It also dovetails with economic data were seeing from around the world, which suggest that global growth
rates are simply decreasing.
The Eurozone is trudging along more slowly than the US, according to statistics from the European Central Bank.9 In the third
quarter of 2014, its GDP was nearly flat at 0.3% in growth. Inventories were being dis-hoarded, falling by around 15 billion
euros over the last 6 months. This suggests that fewer goods are being produced and stockpiled a response to weak demand.
Employment grew by 0.2% over the quarter, meaning that unemployment levels are still high for the developed world, and
industrial production increased by only 0.1%.
The situation is similar in Japan. Despite sustained ultra-low interest rates and activist policies meant to stoke growth, the
country is mired in what isnt far off from being a depression. Its GDP shrank 0.5% in the third quarter of 2014, right on the
heels of a more than 1.5% contraction in the second quarter.10
Developed-world economies are not the only ones that are experiencing weakness now.
Chinas annual growth rate has slowed from around 10% in 2011 to around 7.5% as of the third quarter of 2014. 11 Its
domestic consumer market appears subdued. In the third quarter of 2014, the Consumer Price Index (CPI), which measures
the average change in the prices of consumer goods and services, was its lowest since February 2010. The real estate market
has been weak and domestic investments in fixed assets which includes new building projects grew by only 16.1%. That
number was above 21% in early 2013, and has been declining steadily ever since.
Weak economies around the world offer weak demand for commodities and for capital. The effect is to keep interest rates
extremely low and to push commodity prices down.
The same logic applies to oil, which has long been priced with the expectation of ever-increasing demand and ever-declining
supply. We can therefore view the oil price as a symptom of poor global economic growth, which is a long-term problem and
not just as a short-lived consequence of a slight oversupply of oil.
Falling oil prices are yet another sign that the world economy may be more fragile than before the Great Recession.
Why is this important? Well, many write off the oil price drop as merely the machinations of Saudi Arabia to throw a monkey
wrench in the wheels of the US shale industry or perhaps a market thats over-reacting to a slight supply and demand
imbalance. You would then naturally expect a quick recovery after the market worked through the problem of oversupply, or
once OPEC and Saudi Arabia had adequately bludgeoned its rivals. On the other hand, if you attribute the oil price decline to a
more significant underlying issue within the world economy, then the oil price drop starts to look like the harbinger of a more
long-term trend.

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Why the Recovery Story Is Widely Believed


For now, there have been a few main indicators that suggest that the US is in an economic recovery. The first is the positive
economic data were seeing in the US. However, the data is still mixed. Even though it suggests that the GDP is growing and
that unemployment is going down, household incomes are stagnant, and often decreasing in real terms. The chart below, from
the Federal Reserve, shows real median household earnings from 2008 to 2013.12
CHART 3: DECREASING REAL WAGES SINCE 2007 IN THE UNITED STATES US BUREAU OF THE CENSUS

2013 CPI-U-RS Adjusted US Dollars

57000

Real Median Household Income in the United States

56000
55000
54000
53000
52000
51000

2007-01-01

2008-01-01

2009-01-01

2010-01-01

2011-01-01

2012-01-01

2013-01-01

Source: Bloomberg

Eric Sprott, Chairman and Founder of Sprott Inc.


Markets at a Glance, July 2014

How can we have an economic recovery when there is barely any


discretionary disposable income for 40% of the population? As
we have shown above, those that have seen their incomes grow
are not the ones most likely to spend, while the bottom 40% of
households still rely heavily on government assistance, have had
stagnant incomes and have been faced with increasing inflation
for non-discretionary goods that constitute a very large share of
their incomes.
There is clearly no recovery

The second important reason that many believe in a recovery is the broad boom in both US stocks and bonds. As you can see
in the chart below, almost anyone who got into a broad basket of US stocks over the last 5 years, and stuck with it, would
have made money. Those that got in in early 2011 would have practically doubled their money by now.

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CHART 4: MARKET VALUE OF S&P 500 ($ BILLIONS)

20000
18000

Market Value ($ Billions)

16000
14000
12000
10000
8000
6000
4000
2000
0

2008-09-30

2009-06-30

2010-03-31

2010-12-31

2011-09-30

2012-06-30

2013-03-31

2013-12-31

2014-09-30

Source: Bloomberg

If you look at how unlikely a rally in the US stock market seems when you consider all the other indicators suggesting a
weakening economy, you begin to look for what may have tipped balances in favor of US stocks in the midst of a tepid
economic environment.
Ultra-low interest rates are the usual suspects. They allow large corporations those big enough to borrow large amounts of
cash to re-finance their outstanding debt at lower rates, and to re-purchase their own shares using borrowed money. This
results in higher share prices and increasing earnings per share, which in turn help fuel optimism for the stock market.
As you can see in the chart below, about $1.4 trillion of new debt was accumulated between 2011 and 2014.
CHART 5: CORPORATE DEBT RESUMES CLIMB AFTER PAUSE FROM 2008 2010

7600
7400

Nonfinancial Corporate Business; Credit Market Instruments; Liability

Billions of US Dollars

7200
7000
6800
6600
6400
6200
6000
5800
5600

2007-01-01

2008-01-01

2009-01-01

2010-01-01

2011-01-01

2012-01-01

2013-01-01

2014-01-01

Source: Board of Governors of the Federal Reserve System (US)

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Thats eerily similar to the amount of corporate buybacks over the same period. Companies were buying back around $105
billion of their own shares each quarter during that time period, which amount to over $1.7 trillion over the same time frame.
CHART 6: BUYBACKS AND BUYBACKS + DIVIDENDS FOR THE S&P 500 ($ BILLIONS)

300
250

Buybacks + Dividends ($ Billions)


Buyback ($ Billions)

200
150
100
50
0

2008-09-30

2011-09-30

2014-09-30

Source: S&P 500 Dow Jones Indices

The Wall Street Journal reports that in the first half of 2014, about $315 billion of corporate bonds had been sold in the US to
repay or refinance existing debt.13 That amounts to around a third of total worldwide corporate debt issuances of $995 billion
during that period just to re-finance debts of US companies.
Record US corporate debt issuance is suspicious when businesses are not even re-deploying their existing cash-flows into their
own businesses. In 2014, S&P 500 companies are expected to have spent 95% of profits on buybacks and investor payouts.14
It looks like this new debt is acquired for buybacks and that the stock market rally is in large part a product of cheap credit.
Its possible that the US economy really is back on track and that the oil price drop is just an outlier incident. However,
considered in conjunction with weak commodities overall, weak household earnings growth, and persistently low interest
rates, the alternative explanation that we are living in a period of slowing global growth appears more compelling. This
framework also gives us an explanation for the lower oil price that doesnt depend on speculating about the obscure
machinations of the countries that make up OPEC.

What Wall Street and Russias Oil Oligarchs Have in Common


For the US, Treasury debt markets dwarf oil sales. Since the US produces around 9 million barrels per day, thats 3.2 billion
barrels per year. If prices fall 50% from $100 to $50, thats $160 billion less in annual revenue.
In contrast, the US issues around $1 trillion worth of Treasury debt each year.15 That does not include the trillions in corporate
debt outstanding.
And yet, just as abundant oil production has soaked the world economy in ample supplies of oil, so too has the US
governments profligacy, and the Feds acquiescence, flooded the worlds monetary system with US Treasuries.
Russia capitalized on strong oil prices when they were there. Natural gas, crude oil, and petroleum products exports brought in
$356 billion in 2013.16
The problem in Russia is that a massive portion of the economy had become dependent on energy exports.
Similarly, the Federal government in the US has been able to divert the benefits of ultra-low interest rates to pay its bills and
continue to keep its commitments.

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The US Treasury has accumulated debt at break-neck speed over the last 5 years, totaling around $17 trillion.17 This doesnt
even take into account all of the governments other liabilities. The total number has been estimated at around $70 trillion.18
Add to that the stock markets reliance on cheap debt to fund buybacks and re-finance debts, and it is clear that much of the US
economy now revolves around ultra-low interest rates expensive bonds. The economic destruction weve seen in Russia may
forebode events to come in the US if the US Treasury bond ever comes under the same pressure as a barrel of Russian crude.

Gold and gold mining stocks


Today, the demand for US Treasuries is unrelenting,
but bear in mind that an increase in interest rates will
have profound implications for the US economy when it
occurs. A rise in interest rates would likely damage US
share prices, as well as the financial solvency of
the Federal government.
Precious metals companies have hardly received their
share of the stock market boom but thats a good
thing. While turbulence in the bond markets may
damage most stocks, precious metals stocks are not
like the others.
Rick Rule, Chairman of Sprott US Holdings Ltd., July 2014

Most developed economies have consumed and borrowed at


worrying levels. The US federal government has on-balancesheet liabilities of over $16 trillion and off-balance-sheet
liabilities estimated at about $70 trillion.

For one, gold miners also have the backing of the


physical gold that they own in their deposits. While
other companies will be paying your dividends in
dollars, miners may be able to accumulate physical gold,
silver, platinum, or palladium.

These numbers do not include state and local government


liabilities, or the likely liabilities from underfunded private
pensions. Not to mention increased costs associated with
more comprehensive health care and an aging population!

The events in Russia confirm that gold can serve as a


hedge against currency disasters. When the oil fall-out
threatened the Russian economy, the price of gold in
Rubles surged.

CHART 7: 60 DAYS GOLD PRICE (FIX)


RUB/oz

85000
80000
75000
70000
65000
60000
55000
50000

2014-11-07

2014-12-05

2015-01-05

Source: S&P 500 Dow Jones Indices

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Trends in Gold, Mining, and Exploration

Gold Mergers and Acquisitions May Increase in 2015


The gold mining sector is seeing adjustments to a gold price in the range of $1,100 to $1,300 per ounce, down from over
$1,900 in 2011. These are healthy adaptations to a lower gold price.
When investors expected the price of a metal to rise, companies responded by acquiring mines, even if they did not stand to
produce a profit right away. A rise in the price of the metal could render the mine profitable at a later date, while holding off
until metals prices rose may have meant paying more for the acquisition.
This explains why mining companies as a whole went on a buying spree during the years leading up to 2011, when everyone
expected gold to keep going up.
What has happened to those acquisitions in the meantime?
The mining industry saw massive amounts of write-offs from mergers and acquisitions from 2011 onwards. Well-known
billion-dollar write offs include the Alaskan Pebble mine and the Fruta del Norte deposit in Ecuador.
We are now entering a new phase of mergers and acquisitions, since many of the worst and least efficient projects from the
last cycle have been dumped.
In 2014, big miners mostly switched from shedding deposits to acquiring new ones. Big acquisitions include Osisko Mining
for over $3 billion by Agnico Eagle and Yamana Gold.19 Another example, Cayden Resources, received a takeover offer from
Agnico Eagle of around $205 million.20 Bloomberg reports that $11.2 billion in new mergers and acquisitions in the gold mining
sector have been proposed or completed in 2014.21
We expect more takeovers of companies with potential or producing mines to occur in the next 12 to 18 months.

Cash Is King
Juniors that are looking to bring an asset into production require capital for exploration drilling and acquiring the data that
may make the project attractive for an acquirer.
Exploration companies make high-risk ventures for investors. They can quickly drop in price if their projects fail to stimulate
interest. For geological reasons, most exploration projects are destined to end in failure. The good thing is that bad projects
can go out of business fast because they usually have no source of income other than issuing new shares. This culls the herd
for investors and eliminates wasteful uses of capital.
The chart below clearly shows that, as a whole, a culling is imminent for many juniors, unless they can raise more cash. Cash
held by junior gold miners listed on the TSX Venture exchange, the main marketplace for US and Canadian exploration stocks,
is less than a third of its level from early 2012. In just three years, cash on these companies balance sheets has dropped from
C$3.5 billion to around C$1 billion.
This means that cash is king and becomes more important the longer this trends keeps going.
CHART 8: CASH HELD BY JUNIOR GOLD MINERS ON TSX VENTURE ($CAD BILLIONS)

4
3
2
1
0

2012-03-01

2012-06-01

2012-09-01

2012-12-01

2013-03-01

2013-06-01

2013-09-01

2013-12-01

2014-03-01

2014-06-01

2014-09-01

2014-12-01

Source: Bloomberg

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Some of the large miners may benefit from this trend. Because they have stronger balance sheets, they can absorb projects
cheaply especially when those companies are out of cash and their managers are worrying about their salaries.
Royalty and streaming companies could also swoop in to benefit from this trend. These companies offer financing to big
miners and to junior exploration companies in exchange for a share of future production or discovery potential. They typically
pay for the royalty upfront, but can end up with a very long-lasting stream of cash flows, at no additional cost.
Franco Nevada, the leading royalty and streaming company in the mining space, recently raised $500 million, which it has
re-deployed into streaming agreements with mines owned by the Lundin Group.22
The share price action of the three largest royalty and streaming companies suggests that this business model is increasingly
popular with investors. The three largest royalty and streaming companies, Franco Nevada, Silver Wheaton, and Royal Gold are
up 68%, 19%, and 27% respectively over the five years ending December 31, 2014. The GDX, which tracks major mining stocks,
is down 63% during that period. The GDXJ, which tracks the junior miners, is down 78%.23

Pitfalls of Acquisitions
It is highly possible that this time around mining companies that are making acquisitions will focus on low-risk projects.
Perhaps they will swallow up smaller mining companies to get their hands on an asset that is producing already.
Over the last ten years, miners have suffered from failing to operate mines optimally or underestimating costs. That has been
reflected in their share price.
One example in recent memory: in 2006 a major miner acquired a gold-silver-zinc project in Mexico, promising shareholders it
would be a huge multi-decade profit-generator.
The major paid over $6 billion to acquire the project, expecting to spend around $900 million to build the mine and forecasting
production to start just two years later in 2008.
After reviewing the project, the company said it would produce about 30% more ore per year than initially estimated, though
expenses to build the mine would nearly double. They also pushed out the start date for the mine to 2010 from 2008. For good
measure, it added an extra $190 million in sustaining expenditures and pre-operating costs.
When all was said and done, the mine cost $1.7 billion to build, almost twice the initial estimate of $900 million, on top of the
$6 billion purchase price. Production was two years late. When it actually started in 2010, the mine lost around $100 million. In
2011, the mine was still well below full production. Recently, they ran into issues with water availability, and the mine will not
likely reach full production until 2017 at the earliest.
In 2013, the major cut its initial estimate on the total size of the reserves, reducing the life of the mine to 13 years down from
around 20 as originally forecast. On top of these issues, the miner announced litigation against them by the local community.
It isnt a stretch to call the entire acquisition and mine development a corporate disaster. Miners sabotaged themselves with
projects like this one.
They will likely be looking for safe projects.
In the case of Osisko, the company owned a producing mine when it was taken over. For Agnico Eagle and Yamana Gold, who
acquired the company, this eliminated a lot of uncertainty compared to taking over an asset at the exploration stage.

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- Marc Faber, Board of Directors of Sprott Inc., February 2014

This is the second longest bull market in the last 100 years.
I wouldnt buy shares here. Im not interested.
Now can the market go up another 20 percent? I wasnt interested to
buy the NASDAQ in late 1999, but between January 2000 to March 2000,
the NASDAQ went up another 30%. Afterwards people were crying
when they realized their losses.
The markets go up and down. I think that the upside potential now
for the general stock market is very limited and there is considerable
downside risk. Probably more downside risk than investors realize.

Outlook for 2015


Cash is king and thats good for speculators involved in financing small exploration companies. It is also good for mining
companies that want to acquire assets and for royalty and streaming companies that provide financing to the sector.
If you have the ability to analyze specific takeover targets for potential acquisitions, these opportunities may offer outsize
returns over the coming year.
However, a more general approach requiring less technical expertise may be to accumulate a position in the miners and
royalty and streaming companies that stand to make acquisitions at bear market prices. Whether you invest in exploration
and development stocks, or in relatively low risk royalty companies, there are always risks to investing including possible
loss of principal.
To many people, the oil price drop looks like a wrinkle on otherwise smooth water. Taking a closer look, though, we can see
that it doesnt come out of nowhere. In fact, commodities as a whole have been weak for several years now. Low interest
rates and stagnant household income numbers also suggest poor economic conditions, leaving us to explain how we could
see an epic stock market rally at the same time.
The mining industry is consolidating, which is a natural and positive occurrence. They are also not part of the pack that has
participated in the ongoing rally. Thats partially because their weak balance sheets didnt allow them to issue new debt in
large amounts.
There is reason to be positive for gold and silver mining stocks because of improvements that are intrinsic to the industry.
Precious metals stocks have been unloved for the last three years and consequently are at long-term lows. In contrast, we
believe that most US stocks are teetering near all-time highs, on the shaky premise of a broad recovery.

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Bureau of Labor Statistics New Release. February 6, 2015.[http://www.bls.gov/news.release/empsit.nr0.htm]


Bureau of Economic Analysis New Release: National Income and Product Accounts; Gross Domestic Product: Fourth Quarter and Annual 2014.
January 30, 2015
3
Bloomberg
4
Bloomberg
5
International Energy Statistics online: Petroleum: Production [www.eia.gov]
6
SkyNews online: Copper price hits four-and-a-half year low. December 29, 2104
7
Infomine online: Historical Uranium Price Chart
8
Infomine online: Historical Iron Ore Fines Prices and Price Chart
9
European Central Bank Eurosystem: Euro area economic and financial data [www.ecb.europa.eu]
10
Moodys Analytics Dismal Scientist online: Key Economic Indicators for Japan [www.economy.com]
11
KPMG Global China Practice: China Quarterly Report. Third Quarter 2014
12
Economic Research: Federal Reserve Bank of St. Louis: Real Median Household Income in the United States. [research.stlouisfed.org]
13
The Wall Street Journal online: U.S. Bond Issuance Nears $1 Trillion. August 21, 2014
14
Bloomberg online: S&P 500 Companies Spend 95% of Profits on Buybacks, Payouts. October 06, 2014
15
TreasuryDirect online: Historical Debt Outstanding Annual 2000 2014 [www.treasurydirect.gov]
16
U.S. Energy Information Administration: Today in Energy: Oil and natural gas sales accounted for 68% of Russias total export revenues in 2013. July 23, 2014
17
U.S. Treasury website [http://www.treasurydirect.gov/NP/debt/current]
18
The Wall Street Journal online: Cox and Archer: Why $16 Trillion Only Hints at the True U.S. Debt. November 28, 2012
19
Forbes online: Agnico Eagle, Yamana Gold and Osisko Mining Strike $3.6 Billion Friendly Deal to Sidestep Goldcorp Takeover Bid. April 16, 2014
20
News Release: Agnico Eagle to Acquire Cayden Resources. September 08, 2014
21
Bloomberg online: Gold M&A Pickup Boosts Prospects for Seabridge Project. August 21, 2014
22
News Release : Franco-Nevada To Buy Candelaria Gold & Silver Stream From Lundin For $648 Million. October 06, 2014
23
Bloomberg
1
2

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