There is a tendency for some resource company boards to assume capital will be available when they need it, and thus sometimes run their companies a little too relaxed on the cash side.
There is a wise business saying, “Almost every business error is correctable, but when you run out of cash, they take you out of the game.”
Assuming cash will be there is a dangerous game, here’s why.
High structural risk in the global economic system
How to come close to blowing up the global economy
Wrap together various layers of credit rated mortgage assets. The risky or lowest grade layer are nicknamed “Toxic Waste”. Then, assume US property prices will never decline more than 12% in a year. Call these derivative products Collateralized Debt Obligations (COD).
Banks trade these products in the Over-the-Counter derivatives market (OTC).
Risk offsetting by banks pushes up the notional value of this market into the trillions. The only problem is that in the event of default in the chain, Notional Value will move closer to Value-at-Risk (VaR). This causes a formerly manageable VaR to expand exponentially.
Other banks know this and stop dealing with each other in the overnight Interbank market, freezing the entire global credit system.
We have already lived this, back in 2008, when it became known as the Global Financial Crisis.
If you understand the above explanation, you have the basics of one of the most complex markets in the world.
So, what did authorities do to make sure this situation never happens again?
There were cursory efforts to place trades on a clearinghouse model, the effect of which is questionable. If you ask most participants about what was done to stop it occurring again, many will answer “Not Much”.
Today, the Notional Value of the OTC Market is above $630 trillion. To put this into perspective the, annual Global GDP is $86 trillion.
The OTC shark is still out there, little changed from 2008.
Current banking pressures a whole new shambles
Over the last 14 months or so, the US Federal Reserve has lifted the Federal Funds interest rate from 0.25% to 4.75%, still a historically relatively low rate, but the overall percentage rise in rates has been huge.
A fundamental principle of bond investing is that market interest rates and bond prices move in opposite directions. When market interest rates rise, prices of fixed-rate bonds fall.
This is unfortunate as banks globally loaded up on AAA-rated US Treasury Bonds when interest rates were very low and are now holding huge losses on their Bond portfolios.
This is less of a problem if the Bonds are held to maturity, say 10 to 30 years. However, it is a very big problem if people want to get their savings out of a bank all at once. The bank has to sell bonds to raise the money required, realizing a huge bond loss.
This is potentially a bigger problem than the GFC, however, it will depend on what depositors decide to do next.
Inflation, money creation, meets lack of product supply, meets a war
Finally, the cash could be available, but it could buy a whole lot less than anticipated.
The official inflation rate is 6.8%, but realistically it is closer to 16%. Doubt that?
A year ago, I was buying recycled bricks for a home extension at $1 each the price today is $1.70 each, 2 litres of paint is $64.50, steel is through the roof, and one of the best trades I did last year was buying forward and storing Tasmanian Oak floor timber in my roof, which by the end of the year was twice the price.
The point here for resource companies is that $1 million doesn’t buy as much drilling or dump truck as it used to, and it’s likely to get worse, as war, money printing and product and labour supply shortages are likely to push the ‘real world’ inflation rate even higher.
We have only touched on some of the structural risks in the global economy. There are of course others.
The point is, there is enough risk out there in the global economy that resources companies should raise cash early and raise more than enough. As the saying goes “When the ducks are quacking, feed them.”
The global economic system suggests management should have a greater focus on risk management when it comes to obtaining the required cash in a capital raise.
Andrew Quin is a former Macroeconomic Strategist for Australia’s largest full service stockbroker, HNW fund manager, and published Author. He holds a Masters in Mineral Economics.