The Paradigm Shift Has Begun - This Isn't Going To Be Pretty

Jun 11 2013, 08:03

by: Joseph Stuber

There's ample evidence of late that the Fed is trying to talk investors into moving back away from the edge of the cliff. My personal opinion is they are a little late and that opinion is based almost entirely on the structural flaws in the market today that leave very little dry powder left - in other words, there isn't enough money on the sidelines to backstop a high volume sell-off.

We have witnessed the impact to price when an overbought and overleveraged market starts to sell off - most recently with the Nikkei. We've also seen this phenomenon occur in gold and Apple (AAPL). I think we may be very close to seeing the same thing occur in the broad market in U.S. equities.

First, to the point of the Fed's messengers - here is an excerpt from a speech Jamie Dimon gave in China last Thursday as reported here:
"It's a different world when central banks are managing interest rates," Dimon said, referring to the Federal Reserve's orchestrated effort to keep long-term rates low. He reminded the audience that 10-year bond rates haven't been set by the Fed since World War II, and rates didn't normalize until around 1950. "Until it gets back to normal [this time], it's going to be scary and volatile."

Here's my question - do you think Dimon's comments were purely spontaneous? Please - don't be naïve - Dimon's comments were framed to send a message to the world and that includes investors. The message - things are about to change so be prepared. Anyone who honestly believes this statement wasn't reviewed and approved by the Fed is truly naïve.

If Dimon's comments on Thursday didn't get the job done, here is what the Fed's messenger - John Hilsenrath - said on Saturday:

"Federal Reserve officials are likely to signal at their June policy meeting that they're on track to begin pulling back their $85-billion-a-month bond-buying program later this year, as long as the economy doesn't disappoint. 
"A good-but-not-great jobs report Friday ensured officials wouldn't want to act right away and would instead want to see more data before taking a delicate step toward winding down the program.

Do you get it or not - the Fed is telling investors to back off. Whether the Fed actually does curtail asset purchases is really not the point. The point is they are trying to ease investors back away from the edge of the cliff in a way that doesn't create instant panic. Good luck with that one - investors are usually "all in" until they are "all out".

So what do normalized rates look like? Here is the yield curve today and compared to the yield curve before the Fed's failed QE experiment in 2007 for those who have forgotten what normal looks like:

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Here's a look at the 30 year:

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To develop my thesis, I need to explain what has happened that creates a structurally flawed market. It has to do in part with the amount of leverage employed by traders and investors but also leverage that has been implemented by the primary dealer banks. This leverage is almost impossible to measure, but it is real and I believe that when that leverage is factored into the over leveraged position that exists in the rest of the market, we probably have leverage at levels that far exceed anything we have ever seen before.

This is an incredibly dangerous and potentially devastating situation if the markets continue to be volatile and move lower. As Jamie Dimon so aptly stated ". . .it's going to be scary and volatile. "

Here is a definition of carry trade from the Financial Times Lexicon and it is important to this discussion:

A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return. This strategy is very common in the foreign exchange market. For example, in the period up to 2007 many investors borrowed in Japanese yen or Swiss francs, taking advantage of very low interest rates in Japan and Switzerland, and used the money to take long positions in currencies backed by high interest rates, such as the Australian and New Zealand dollars and South African rand. 
This strategy relies on relative stability in asset prices, as an adverse exchange rate movement can easily wipe out the returns from the underlying interest rate differential. This leads some to refer to the carry trade as akin to picking up pennies in front of a steamroller. 
The yen carry trade reversed sharply in 2007 as global interest rate differentials narrowed, causing the yen to rally against currencies such as the antipodean dollars.

The definition accurately defines what I think has gone on for some time now with the primary dealer banks. Here is how it works. The Fed prints money by purchasing assets - Treasuries or mortgage backed securities - from the primary dealer bank. The bank then has cash which it uses to buy another bond at the long end of the curve where returns are higher. Here is where the leverage is ramped up - the bank then hypothecates that bond to a third party and gets cash in return on a short-term arrangement. The bank then has off balance sheet cash which it uses to buy stocks.

Think that isn't happening - take a look at this chart:

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Here is the point - Bernanke's "virtuous circle" theory was ramped up dramatically in December of last year with QE4. The other big proponent of failed QE policy - Japan - has done the same. The correlation to the Fed's balance sheet expansion dating from the start of QE4 is almost perfect suggesting that the thesis set forth above is true. The Fed's money has moved directly into stocks in an unprecedented form of a double down carry trade play.

And has it worked - stocks are up 14% to 15% in 6 months and on highly leveraged plays via hypothecation strategies that result in big off balance sheet gains. But what now as the Nikkei and the U.S. equities markets seem to be stalling - well in the case of the Nikkei - crashing?

Keep in mind the leverage employed in today's market is very high by historical standards but my guess is it's even higher than the chart below suggests since it fails to take into account the leverage employed by the primary dealer banks.

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How much extra and unaccounted for leverage are we talking about here? Well, if my thesis is correct, it could be well in excess of the number reflected above. Here is why - the primary dealer banks who are buying stocks are doing so on borrowed money - i.e., through the hypothecation of securities they have purchased equities with depositor funds.

The Fed has expanded their balance sheet since QE4 by roughly $600 billion and that sets up the case for arguing that almost all that money has gone into equities - at least that is the extreme case. Consider also that if that is the case the historically high level of margin debt - at roughly $380 billion - is dwarfed by the potentially massive leverage being employed by the primary dealer banks under my hypothecation scenario. The number just since QE4 was announced could be as high as $600 billion. And we don't know how much of the QE money prior to QE4 was employed in the same manner, but we do know however much it is, it doesn't show up in the numbers anywhere.

The dire consequence of a structural imbalance in the markets
"This leads some to refer to the carry trade as akin to picking up pennies in front of a steamroller."

It can't be said that a 15% gain with the Fed's money produced by borrowing against bonds to invest in stocks is "pennies" but the "steam roller" part is likely to be true. Here is the important point - there may be no dry powder left to prop the markets.

It is reasonable to argue that we are moving very close to a margin call crisis and any further sell-offs will precipitate that crisis. Don't summarily reject that point please. Instead look at gold or Apple or the Nikkei. As stocks move lower in a highly leveraged environment, the amount of available credit shrinks and eventually turns to a negative number. What happens then - investors must address the problem by selling assets.

What happens when everyone is selling and no one has any money to buy with? The bid side of the trade disappears. That is where we are based on what we know, but we don't know where the primary dealer banks are or do we? I think we do and I - like most traders - assume that the big banks are the "smart money" and wouldn't make a dumb move like over leveraging and putting the whole system in peril but on further reflection that is sheer nonsense.

Didn't JPMorgan (JPM) do just that a while back? Isn't that why they were called to task in hearings before the Senate back in March? Of course it was and the problem - their VaR model was flawed but according to testimony it has been fixed - yeah, right, and isn't that a load off your mind?
Here is how Paulo Santos explains the VaR models response to volatility:

Now imagine that for some reason, volatility increases for a while. This will in turn show up as an increased level of risk in all those institutions using VaR. A higher level of volatility will mean that the loss that can happen on any given day will be higher. The natural reaction will be to reduce overall exposure. 
This means that an increase in volatility can breed selling and thus more volatility. Worse still, if the selling happens over the whole portfolio, this will increase pressure in several assets at the same time, also increasing correlations between them. This explains how in times of volatility, correlations also usually go up. 
Now, both the increased volatility and the increased correlations between assets again increase VaR. This leads to more selling, which in turn leads to more volatility and higher correlation between assets. And that is the mechanism which can easily make volatility feed on itself.

That should be enough said, but consider what we have seen of late in the various asset classes that make up a typical investment portfolio - bonds, stocks and precious metals.

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Bonds as represented here by (TLT) are down 6% or 7%. Gold is down 17% or so and equities as represented by the S&P (SPY) are up roughly 14%. But on Friday look what happened to bonds and gold:

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I don't know where the tipping point is on U.S. equities, but my guess is we don't have far to fall before reaching that point. We got a brief reprieve on Thursday and Friday, but if we fail to hold those gains and move below the 50 day MA at this point and gold and bonds continue their slide, I would suggest that may be the tipping point.

A look at the Nikkei and the S&P 500 show some similarities, but the Nikkei is well ahead of the S&P. The next two charts show the close of the Nikkei and SPY with the 90 day mean and the +/- 2 standard deviation bands included:

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The Nikkei has a very similar pattern to the S&P. They both peaked on the same day and they both were in overbought territory above the +2 standard deviation band for several days prior to peaking and moving lower. Additionally they both hugged the +2 standard deviation band for a number of weeks before extending into overbought territory and finally peaking and reversing trend.

The only difference in the two charts is that SPY's fall has been more subdued and indicates it is lagging the Nikkei. That said, the probability of both moving to the -2 standard deviation level in the next few weeks is now very high. In particular, the Nikkei which has now moved below the 90 day mean value has an extremely high probability of moving back to the -2 standard deviation level at 10,204.

If SPY follows the same pattern it will bottom out at 146.90. Here's a look at the daily OHLC charts for the Nikkei and SPY:

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The Nikkei is now in the kind of structurally driven negative feedback loop that I think we will see in U.S. equities in the next two weeks.

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Concluding thoughts

I've given a lot of thought to how this Fed driven bull market might end and what might be the cause. I've given some consideration to an unforeseen "black swan" type event and that may still occur, but I think the more likely cause will be the Fed's loss of control of the bond market.

In a market that is not structurally imbalanced, a sell-off in bonds wouldn't imply a similar sell-off in stocks, but there is nothing at all normal in the structural flaws the Fed has created. The logic some might use is that as bonds fall, traders will exit bonds in favor of stocks but in a highly leveraged and overextended situation that may not be possible. My guess is all assets fall at the same time and create a negative feedback loop where selling begets selling.

June 9, 2013

The Ghosts of Europe Past



CAMBRIDGE, EnglandTHE cheerleaders of the European Union like to think of it as an entirely new phenomenon, born of the horrors of two world wars. But in fact it closely resembles a formation that many Europeans thought they had long since left to the dustbin of history: the Holy Roman Empire, the political commonwealth under which the Germans lived for many hundreds of years.       
Some might take that as a compliment; after all, the empire lasted for almost a millennium. But they shouldn’t. If anything, today’s Europe still has to learn the lessons of the empire’s failures.
The similarities with the Holy Roman Empirewhich at its greatest extent encompassed almost all of Central Europeexist at many levels. Today’s European Council, at which the union’s member states gather, reminds one of the old Reichstag, where the representatives of the German cities and principalities met to deliberate matters of mutual concern.
And like the European project, which originated in a determination to banish war after 1945, the “modernHoly Roman Empire, which was reformed by the 1648 Treaty of Westphalia, was intended to defuse the domestic German antagonisms that had culminated in the traumatic Thirty Years’ War.
But most similarities are less flattering. Both the European Union and the empire are characterized by interminable and inconclusive debate. The German phrase for delay, which translates as “shoving something onto the long bench,” stems from when imperial bureaucrats pushed their uncompleted paperwork farther and farther down a long bench in the Reichstag council chamber.
And like the European Union, which is rived by tensions between larger and smaller states, the Holy Roman Empire proved too weak to contain over-mighty members like Prussia and Austria. Fears of partition and collapse abounded. The Reichstag was paralyzed; the emperor was hamstrung by rival princes.
Granted, in a world of increasingly absolutist neighbors, the empire stood out in its respect for the law and a high degree of personal freedom. But the truly powerful states of the 18th and 19th centuries were those that learned from the empire’s mistakes.
The German experience was a cautionary tale for the American colonies after the Revolutionary War. They, too, were profoundly divided over how to defend themselves, and above all on the question of how the huge debt accumulated during the war should be repaid.
The existing Articles of Confederation were too weak for the task, and the founders cast about for alternative models. In the Federalist Papers, James Madison and Alexander Hamilton looked at the federal system of the Holy Roman Empire, but they found it to be “a nerveless body, incapable of regulating its own members, insecure against external dangers, and agitated with unceasing fermentations in its own bowels.”
Instead, the patriots embraced the model of the Anglo-Scottish Union of 1707, when the two kingdoms, formerly so divided, had come together by merging their debts, parliaments and collective efforts on the international stage.
The resulting American Constitution created a powerful executive presidency and a representative legislature and made possible the creation of a consolidated national debt, a national bank and eventually a strong military, all of which in time turned the United States into the superpower it is today. The Holy Roman Empire, by contrast, failed to reform and disintegrated after it was defeated by Napoleonic France in 1806.
Some 200 years later, this history has been forgotten. Today’s constant round of European summit meetings and reform initiatives remind one of nothing so much as the interminable and futile Germanimperial reform debate,” and they are likely to have a similarly unhappy, if less spectacular, end.
Like the old empire, the union has become preoccupied with legality and procedure at the expense of participation and effectiveness. This renders the euro zone cumbersome in the face of competition from the east and causes the bond markets to doubt its creditworthiness. Indeed, everything that Madison and Hamilton wrote about the empire then is being echoed today in Washington, albeit sotto voce.
Fortunately, there is a solution from history. The euro zone faces the same choice as the Holy Roman Empire and American patriots of old: how to overcome discredited forms of confederation. Rather than digging themselves into a deeper recession and democratic deficit through austerity measures, the states in the common currency need to form a full and mighty union on Anglo-American lines.
They must create a strong executive presidency elected by popular vote across the euro zone, a truly empowered house of citizens elected according to population and a senate representing the regions.
The existing sovereign debts should be federalized through a “Union Bond,” with a strict subsequent debt ceiling for the member state governments. There will have to be a single European military and one language of government and politics: English.
This is the only framework that will endow the euro zone with the democratic legitimacy to reassure the bond markets, underpin the implementation of good financial governance across the entire union and defend its interests and values on the world stage.
More than 200 years ago, the choice was between the Holy Roman Empire and Britain. The Americans opted wisely and prospered; the Germans continued to muddle through only to see their empire extinguished. History thus holds out both a great opportunity and a terrible warning for the euro zoners.
Brendan Simms is a professor of history at Cambridge University and the author, most recently, of “Europe: The Struggle for Supremacy From 1453 to the Present.”

miércoles, junio 12, 2013



Once In A Golden Moon: Luna Gold

Jun 9 2013, 13:00

by: Itinerant

Luna Gold (LGCUF.PK) is a junior gold mining company with listings on the Toronto and Lima Stock Exchanges and trading in the US via the pink sheets. The company controls an extensive land package in Northern Brazil and has succeeded in bringing the Aurizona gold mine into commercial production in February 2011. Last year the mine yielded over 74,000 ounce of gold which transferred into $103.1 million of revenues and a gross profit of $39.5 million for the year 2012.

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The Aurizona gold mine is an open pit mine with a gravity and CIL processing plant. Ore for the mill is currently sourced from the Piaba deposits. Additionally, the company has four near mine deposits with defined resources and is testing over a dozen near-mine targets. The first phase of an expansion plan has been initiated which is scheduled to be completed later this year lifting 2013 production to 95,000 to 105,000 ounces at a cash cost of less than $715, or all-in cash costs of around $1,100.

Once fully operational this Phase I expansion will deliver annual average output of 135,000 ounces over a 15 year mine life at current reserves. Remarkably, this expansion has been financed from cash and debt exclusively without dilution of existing shareholders. Further expansion is presently considered with a pre-feasibility study for Phase II expected in Q4/2013.

Luna Gold holds a significant land package of 235,000 hectares around the Aurizona Mine and reports several very promising green field targets. In fact, the company states that they have only just "scratched the surface" of their property in a prominent Greenstone belt location.

At the time of writing the market capitalization sits at just under $200M and shares are trading for $1.88 resulting in a P/NAV ratio of less than 0.5. The share registry is tight with only 105M shares outstanding and insider ownership of 14.4%. At present institutional ownership is negligible setting the share price up for growth once the company attracts wider attention with institutional investors. Luna Gold had a moderate long-term debt of $30M and $20M of cash and finished goods at the end of Q1/2013.

In 2009 the original construction of the Aurizona mine was partially financed by Sandstorm Gold (SAND), a streaming company that provides up-front capital for mining ventures in exchange for a streaming agreement. In the case of Luna Gold the streaming agreement entitles Sandstorm Gold to purchase 17% of the gold production at a strongly discounted price of $400. In October 2011, the State of Maranhao and the Brazilian Federal Government awarded Aurizona with a SUDENE tax benefit which reduces Aurizona's effective tax rate from 34% to 15.2% for the first ten years of operations. Luna Gold finds that the SUDENE tax benefit neutralizes the stream on a gross margin after tax basis. In our opinion this streaming agreement with Sandstorm represents a considerable tick of approval from a savvy and knowledgeable mining investor.

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Business seemed to be ticking along very well for Luna Gold. The share price outperformed the Market Vectors Junior Gold Miners ETF (GDXJ) during last year's brief gold price rally; and the share price did not budge when the spot price turned back south in October 2012 instead reaching a high of $3.85 in mid-March. In early April the quarterly report for Q1/2013 was released indicating production below the initial guidance, due to severe drought conditions in January and February 2013 (which had been alleviated through seasonal rains at the time of the quarterly release). The company had foreshadowed this issue but nevertheless, the share price was punished severely which was compounded by the drop in gold price in April. Luna Gold suffered disproportionately compared to the sector and the share price is currently finding a base at 50% of March highs as shown in the chart above.

We believe that the market has over-reacted and the recent correction was exaggerated by fear and a weak gold spot price. Assuming that management will continue to deliver as has been the rule so far, we suggest that the present situation could represent an attractive investment opportunity. The chart below shows the ratio of Luna Gold's share price and the GDXJ illustrating the described developments since August 2012. The depicted ratio has dropped from 0.25 to 0.15 with the 200dMA sitting at .171. All things equal, we would expect this ratio to return to the moving average once the short-term dust has settled and this chart has bottomed out. Additionally, with all the described catalysts pending and keeping in mind that management has maintained 2013 guidance we would not be surprised if Luna Gold returns to outperforming the GDXJ once again in due time. Quite possibly, a window of opportunity has opened for an entry into this stock during the upcoming summer months.

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We emphasize that this is a relatively high risk/reward situation and we suggest that interested investors should make themselves familiar with risks associated with junior mining stocks. However, in order to gain additional confidence with our investment thesis we decided to contact the company and ask some questions. Mark Halpin, Vice President Corporate Development of Luna Gold, was kind enough to respond in great detail for which we are immensely grateful. Below are our questions and his answers.

Q: Mark, Luna Gold has just released the latest Reserve and Resource update for the Aurizona mine. Could you please give some salient details of this report and explain the significance of this report for the company?

MH: On April 9, we announced that our Proven and Probable Reserves at Aurizona's Piaba deposit had increased by 222%, relative to an earlier statement in July of 2010. Piaba now has Proven and Probable mineral gold reserves of 2.36 million ounces, including 55 million tonnes of ore with a life of mine average of 1.32 grams of gold per tonne. At a processing capacity of 10,000 tonnes per day, a level we'll achieve once Aurizona's Phase I expansion reaches completion, this will allow for an expected mine life of roughly 15 years at the Piaba deposit given the current Reserve. The average life of mine gold production at Aurizona, post Phase I completion, is now estimated at 135,000 ounces per year. The total Aurizona property contains 3.63 million ounces of Measured and Indicated Resources and 1 million ounces of Inferred Resources.

Q: Phase I of the expansion program to 135Koz per year seems to be well on its way. Are you still on time and on budget?

MH: Aurizona's expansion remains both on time and on budget. As of the conclusion of the first quarter, we had approximately $5.8 million of the project's contingency allowance remaining, and had completed roughly 85% of the necessary engineering and 5% of construction. Our latest technical report targets 2014 gold production at approximately 110,000 ounces based on the completion of the Aurizona Phase I Expansion during the fourth quarter of 2013. We are currently optimizing our latest reserve and Luna will have a better understanding of targeted 2014 gold production once the 2014 budget is set in late 2013.

Q: The pre-feasibility study for Phase II of the Aurizona expansion plan is expected to be released later this year. Will the present operating pits support an annual 200Koz-300Koz operation, or will you need other deposits nearby to be mined for Phase II to be an option?

MH: At a processing rate of 10,000 tonnes per day, which Aurizona will achieve following completion of its current expansion, our mine life will be roughly 15 years at our Piaba and Tatijuba deposits. Phase II of Aurizona's expansion, which we're currently considering, could potentially double that processing rate to 20,000 tonnes per day, effectively halving the life of mine. We have three additional deposits with defined resources that we are currently evaluating to convert into reserves. Furthermore, with continued drilling at Aurizona, it is likely that we significantly extend the life of mine beyond its current duration.

Q: Will Luna Gold aim at financing a possible Phase II expansion from cash flow and debt like you did for Phase I?

MH: It's a little too early to provide an accurate reply to that question, given that we have yet to announce the potential capital requirements of Aurizona's Phase II expansion. However, it is fair to state that our preference would be to first obtain funding from our existing cash flow and then through debt, if possible avoiding any dilution to our existing shareholders' positions.

Q: Are you anticipating for Sandstorm Gold to play a role in financing Phase II?

MH: It's possible, as they have been great partners to date. The existing Sandstorm arrangement covers any production at Aurizona. If we elected to further develop an underground mine at the property, which would be separate to a Phase II expansion, then Sandstorm would have the right to purchase 17% of the gold produced by that mine at a price equal to the less of $500 or the prevailing market price. In exchange, Sandstorm would be required to contribute 17% of the capital necessary to both analyze the economic viability of and build the underground mine.

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(all photographs taken from company website)

Q: The results for the first quarter this year showed a distinct reduction in output compared to previous quarters. Can you elaborate on the reasons for this development?

MH: While our first quarter gold production of 17,203 ounces was slightly higher than our production in the same period in 2012, it did represent a decline from both the production levels we had risen to during the latter half of last year and our original first quarter guidance of 21,000 ounces. This was due to the drought conditions we experienced at Aurizona during January and February 2013. These conditions resulted in a shortage of process water that reduced ore processing through the mill in January and February of 2013.

Fortunately, the rains arrived in late February, and water supply has since returned to normal.

Q: Are you still confident in achieving your 2013 guidance of 95Koz to 105Koz?

MH: We are. More than 9,000 ounces of the first quarter's production was generated during March, and we're confident that we can make up the first two months' shortfall over the second half of the year.

Q: Full year guidance for all-in cash cost is around $1,100/oz. Are you still confident to achieve this goal?

MH: Like the production guidance, we are confident that we will be able to achieve our targets for 2013.

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Q: The reserve pit shell at the Piaba deposit is calculated for a gold price of $1,350/oz. The spot price has dipped below this design value twice now in recent weeks. Are you worried about the possibility of gold falling below $1350/oz for any prolonged periods of time in the near- to mid-term?

MH: I think it's fair to say that any gold producer is worried about that possibility, but I don't believe we'll see it. If we do, we'll be prepared. The reserve pit shell price has been applied on a long term basis. Should the spot gold price fall below $1,350 over the long term, we can take steps to re-optimize the pit. Again, however, I don't think we'll find ourselves in that position. History suggests that we'll encounter a long term upward trend in gold prices from its current position, and we also believe current global macroeconomic conditions support an increase in the medium term.

Q: Have you considered changing your mine plan in response to the drop in gold price? Have you implemented any other measures, yet, due to the reduced gold price?

MH: We are prepared to make changes should the price continue to decline, but don't feel they are necessary at this point. We have implemented some other changes, though, reducing our remaining 2013 sustaining capital by 50% and this year's exploration expenditures by 35%. We're also reviewing our corporate expenditures. The gold price decline hasn't forced us into this position, but we felt that taking prudent, precautionary measures made sense until some greater certainty over gold's future begins to emerge.

Q: Has Luna Gold been mining higher grades due to the price pressures? And will this mean lower head grades in the future?

MH: Our recent mining of higher grades was primarily due to the drought conditions we experienced during January and February. The drought and lack of additional tailings dam capacity during 2012 resulted in lack of processing water, effectively reducing the throughput of our processing plant.

During the first quarter we successfully completed raising the tailings dam walls to ensure operations would not be affected in the coming dry seasons.

The current low gold price did play a minor role in this decision. Mining higher than average head grades now will decrease the average head grade for the remaining life of mine. That said, the life of mine is currently 15 years, so the brief time period that has seen us mining higher grades shouldn't have a significant impact on the life of mine average grade.

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Q: Luna Gold has switched to reporting all-in cash cost in the latest quarterly report, even providing a detailed break-down of the cost. In the Q1/2013 quarterly news release the average all-in cash cost is quoted as $1033/oz. In the most recent company presentation the all-in cash cost for the same quarter is given as $1278/oz. Can you please explain this apparent discrepancy?

MH: The $1,033 calculation presents the all-in cash cost for Aurizona based upon expenses. The $1,278 all-in cost number given in the presentation considers any costs for the entire company that wasn't attributed to the Aurizona Phase I Expansion - for example costs included in the presentation but omitted from the Q1/2013 Management Discussion and Analysis include corporate expenses and capitalized expenses.

Q: The presentation mentions decreased costs due to switching from contractor mining to owner-operated mining. Can you elaborate on the advantage of owner operated mining?

MH: This switch is one of the principal reasons that we have been so successful over the past twelve months. Our operational team is experienced, capable, and we believe one of the best in the business. By giving them total and direct control over site operations, we have been able to increase both the pace and efficiency of our production and have seen mining costs per tonne material moved decrease from above $3 to $1.40 in four quarter 2012.

Q: Luna Gold has 23Koz hedged $1567; that must be very satisfying at the moment. Are you planning to increase your hedge book in the future?

MH: We don't have any immediate plans to develop our gold hedge book further. However, we're constantly evaluating this option as the market fluctuates. It is, as you point out, a move that has proven wise so far.

Q: By when can investors expect a NI 43-101 report for one or more of the Luna Greenfields deposits? Could you elaborate on the potential of the Luna Greenfields targets?

MH: In January we announced the positive assay results from our drilling at Luna Greenfields' Touro target. These results have led us to begin work on the definition of an initial NI 43-101 estimate at the property. We'll announce a second round of drilling results during the second quarter of this year and seek to define a NI 43-101 compliant resource by the end of 2014.

There is no question that this property, which is nearly fifteen times the size of Aurizona, has incredible potential. It contains more than 100 artisanal gold workings, and we believe presents a very strong possibility of a multi-million ounce gold deposit.

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Q:Inflation in Brazil is high compared to the Western World and the Central Bank has just increased lending rates. What are the implications for Luna Gold?

MH: The majority of Luna's costs are incurred in Brazil and are paid in BRL. In general, the price of construction materials, supplies, and consumables has remained consistent or has slightly decreased from 2012 to 2013. In theory, inflation is baked into FX rates, and as a business we sell gold in USD. As a result of increasing inflation resulting in the devaluation of BRL against USD, when we convert USD into BRL to pay our operational and capital costs, each US dollar nets us more BRL. This helps to offset the increase operating and capital costs resulting from inflation. Nonetheless, we pay strict attention to minimizing our operating and capital costs, especially in the current gold price environment. Our business model is based around maximizing cash flow.

Q: What are your experiences in general operating a gold mine in Brazil?

MH: We've found it to be a very supportive environment. The best evidence of this is the SUDENE tax benefit. This incentive commenced in October of 2011, and allows for a 75% reduction of Aurizona's corporate tax rate of 25% for the first ten years of operations. Brazil and the State of Maranhao have also proven their friendliness to mining by streamlining a good deal of the permitting processes.
On a gross margin after tax basis we find the SUDENE tax benefit neutralizes the effect of the sandstorm stream.

Q: The share price has held up well during the initial phase of the ongoing gold price correction, but has dropped quite significantly more recently. What are your expectations with regards to the share price for the rest of the year?

MH: There are three major factors that will dictate the strength of our shares over the course of 2013. The first, obviously, is the price of gold, but that's beyond our control. The second will be our ability to make up the production shortfall we experienced at the beginning of the year, and succeed in achieving our annual production guidance. Finally, it will be vital that we keep Phase I of Aurizona's expansion moving forward and reach completion by the end of the year.

Q: Where do you see Luna Gold in five years?

MH: We believe our company has a clear path towards 400,000 to 500,000 ounces of annual production. Aurizona's second phase of expansion could add 125,000 ounces, while moving underground at that property could add another 80,000 ounces. Greenfields' potential is still being determined, but we believe there is at minimum a 125,000 ounce per annum target at that property. Of course, the ceiling could be far higher.

Q: What will need to happen for investors to expect a dividend from Luna Gold?

MH: When the risk adjusted return on investing cash back into our business no longer exceeds our weighted cost of capital.

Q: What is your best guess with regards to the gold price at the end of 2013?

MH: Given the global macroeconomic environment, I expect gold to be north of $1,500 per ounce by the end of the year.