Gold Refulgent

For more than twenty years the correct investment strategy, or rather the strategy which has brought the greatest return, has been to ignore gold, trust in the good faith of the United States of America, and buy U.S. financial assets. And, until last year, the riskier the assets, the higher the return has been! The price of gold during that long period has continued to slide against the US Dollar, so that, although it has proved a safe haven for many an investor against his own Government’s bad faith or bad management, it has been a poor performer measured against the wonder of compound interest in a hard currency. It should not come as a surprise, therefore, that those who believe that gold will remain, permanently, as a store of value, just as it has done globally throughout known history, are extremely few.

What is surprising, however, is that the gold mining sector has been amongst the best performing sectors of the stock market during the last six months. Furthermore, a glimpse at the long term charts of major producers, such as Newmont, (see fig 1.) will confirm that the build up of volume over the last three years suggests that this has been no speculative binge, as in 1987, but rather that substantial capitulation by long term holders, who have finally lost faith, has been well absorbed by investors who are prepared to bet that the fundamentals of the gold market are about to change.

Fig. 1

Shares in the gold mining sector, generally, bottomed in November of 2000 and, interestingly, the shares which have outperformed their sector since then have been those which have minimal forward sales contracts in place and which, as a result, are barely, or not at all, profitable at the present gold price. Thus, Homestake Mining has seen its share price rise from a low of US$3.50 in November to as high as US$8.15 last month against a 60% increase in the Philadelphia Gold and Silver Index during the same period. Homestake recorded earnings per share of 3 US cents last year and is not expected to do much better than break-even in 2001. Barrick Gold, by contrast, rose from a low of US$12.31 in October last year to a high last month of US$19.38. Barrick earned 84 US cents per share in 2000 as a result of its very substantial forward sales programme initiated at much higher gold prices.

In addition, a brief look at the present fundamentals of the gold mining industry will immediately reveal that the vast majority of companies in the industry are destroying capital. There are very few companies which, at today’s gold price, can earn enough money to cover operating costs, depreciation of their plant and amortisation of their reserves in the ground far less fund the exploration necessary to replace those reserves or pay shareholders a dividend. During recent years, most companies have strained to reduce operating costs and have largely ceased exploration in a struggle to survive so there is little hope of relief from further cost cutting. Indeed, with energy prices rising, most miners’ costs will actually rise this year.

In aggregate, the global gold mining industry had costs of production of US$246 per ounce of gold last year (and it can be argued that slick accounting enables many to understate their true costs) and these costs are set to rise. At today’s price of US$267 per ounce, the margin is totally inadequate to provide a return on the present market capitalisation of the industry of approximately US$40 billion. Why then are investors willing to pay 275 times last year’s earnings to own Homestake when costs are likely to rise? Only one scenario can justify such behaviour - a dramatically higher price of gold.

Why then is the market willing to bet that gold prices are going to go much higher?

Last month I attended the London Bullion Market Association conference in Istanbul in the vain hope that someone might provide the answer clearly and succinctly. Gold rose $25 an ounce during the 24 hours trading before the conference opened but, almost to a man, the speakers saw further gloom ahead. I left the conference little the wiser but more than ever convinced that gold was at the beginning of a long and sustained bull market. Although the conference was well attended with over 350 delegates, the vast majority were bankers, of one hue or another, and almost all convinced that Central Banks will continue indefinitely to oversupply the market with physical gold and that only the producers faced problems. To those who concur with Jefferson’s statement that “commercial bankers are more dangerous than a standing army” their complacency would go a long way to explain why investors are buying gold shares. To those who are the wrong side of fifty years old, there is little need for an explanation because you have been here before – for the situation now is not dissimilar to that which prevailed at the time of the collapse of the London Gold Pool in 1968. At that time many gold producers were on the verge of closure as production costs were rapidly approaching the official price of US$35.20 per ounce. Then again, the United States was running a current account deficit and the Federal Reserve had persuaded the leading Central Banks of Europe, as far back as 1962, to form a “selling consortium” whereby the Europeans would provide some of their gold to a pool, which the US Federal Reserve would match, and which the manager, the Bank of England, would be able to draw upon in its attempts to prevent the price of gold from exceeding US$35.20. This scheme worked well for some years but free market forces are inexorable and so the Bank of England found itself supplying ever- increasing quantities of gold from the pool. Finally, in 1968, France withdrew from the pool, and, after Federal Reserve Chairman, McChesney-Martin’s statement that the US Government would defend US$35 per ounce “down to the last ingot” proved but a red rag to the bulls, the London gold market was closed for a fortnight. During that time, gold traded in Paris and Zurich at up to $44 per ounce. Central Banks had sold almost 2,000 tonnes from the pool in their hopeless attempts to contain surging demand. Further attempts were abandoned, and, although the fiction of US$35.20 was maintained for transactions between Central Banks (although this had to be abandoned too a few years later), the free market was once again left to set the price of the Dollar against gold. By 1975, the price had risen to US$200 per ounce and many of the gold mining companies, which had been on the verge of closure, had seen their share prices rise twenty-fold. Of course, as free markets always do, they went too far the other way, and, as confidence gave way to foolhardiness, the Central Banks and IMF stopped all sales, and gold finally peaked at US$840 an ounce in 1980.

“But Central Banks are not conspiring to contain the price of gold today” you might argue.

Certainly there is no overt agreement to do so but individual Central Banks have sold substantial quantities of gold from their reserves, purportedly, and there is no reason to doubt their statements, in order to obtain better returns from paper assets. More importantly, since the 1980’s, again in order to obtain better returns, Central Banks have allowed the bullion banks to borrow their gold reserves in ever increasing quantities. In ever increasing quantities, these bullion banks have either acted as intermediaries for gold mining companies wishing to sell future production forward or acted for the leveraged speculating community, or their own proprietary desks, in playing gold from the short side. As most gold transactions take place out of public view, it is impossible to give much credibility to even the most earnest appraisal of supply and demand, and so, by extension, to estimates of the extent to which the bullion banks and/or their clients are holding naked short positions against gold. They all, of course, deny that there are any such positions but, if one considers the known facts, it would be truly amazing if there were not!

Since 1996 (gold leasing really started in the 1980’s but expanded dramatically in the second half of the 1990’s) each million ounces of gold (31 tonnes) sold short has provided, on average, US$16 million per year in income and US$20 million in capital gains. This is an impressive return on an outlay of nothing except one’s credibility! On the 5,000 tonnes of borrowed gold, which is the “official” estimate, this would provide annual income of US$2.58 billion and capital gains of US$3.22 billion. The “official” estimate is drawn from the statistics of the gold producers and their disclosures of their forward sales and from the assurance of the bullion banks that there are no substantial naked short positions taking advantage of the “gold carry trade”. However, some gold analysts have estimated that the extent of bullion lent may exceed 10,000 tons. Given the size of the sums involved, the motive, and the opportunity, it would be truly amazing if there had been no takers. It is unlikely that anyone knows the true extent of the short position that might be out there, but recent developments in lease rates for gold do suggest that the Central Banks are concerned that there is a short position, and that they are going to remove the motive element by rendering the gold carry trade unprofitable.

Fig. 2

As the chart (fig. 2) of the 12 month gold swap rates shows, since 1996 anyone entering the “gold carry trade” was able to obtain a running yield of approximately 4% per annum. This, in any case, was so until October 1999. Then, under what has come to be known as the Washington Accord, the European Central Banks announced a limitation of the gold they would sell or lend during the next five years. The effect of this announcement was to convince producers to limit forward selling (as Ashanti and Cambior were forced to the verge of bankruptcy by their aggressive hedge positions) so that during 2000 there was a net reduction of producers’ forward sales. Higher interest rates during 2000 also led to enhanced returns on the carry trade but, by February this year, the combination of sharp reductions in US Dollar interest rates and higher lease rates all along the curve have meant that the annual return now on the trade is 1.9%. If, as expected, US rates continue to fall and gold lease rates continue above 2%, any participant in the carry trade must look to capital gains for his return.

However, without Central Bank selling and without increasing forward sales from the producers, the physical market is in short supply. New mine production is 2,500 tonnes and re-cycled scrap a further 600 tonnes whereas annual demand is estimated in excess of 4,000 tonnes. If the mining companies are alert to the message emanating from the stock market, that it prefers producers that do not hedge, and there is no longer a premium to be obtained from selling forward, not only will they cease to sell forward, but may seek to cover existing forward sales. Theoretically, Central Banks can prevent momentum from developing behind such a move by reducing the lease rates and again enticing the producers to sell forward but, in the face of declining US interest rates, there is much less room for manoeuvre.

If the various gold analysts who would have us believe that there is a substantial naked short position are correct, then it will be difficult to maintain an orderly market in gold once the trend is reversed for it would be clearly impossible for the market to enable shorts to cover over 5,000 tonnes at prices which would leave the participants solvent. The facts, therefore, are clear. The mining industry is making no returns on operations at the present price and is therefore expecting production to decrease from 2003. With only a marginal premium on forward sales, producers are unlikely to be providing gold beyond their annual production to the market. Therefore, only a decision by all the Central Banks to liquidate their remaining holdings of gold will enable the supply to meet market demand at present prices. Governments have always stood firmly behind their currencies with statements and assurances but when the market has asked for their gold they have balked. Once again, Central Banks have succeeded, perhaps unintentionally, in manipulating the price of gold. The myriad of attempts to do so throughout history have all ended in failure and there is little reason to believe that our present batch of Central Bankers are any smarter than their predecessors thirty years ago. Gold will always remain the proxy for value in the free market. Central Bank selling below production cost might make sense for a brief moment but ultimately will be seen to be as wise as the sales from the Gold Pool were seen when the price rose 1000% seven years later. The stock market is correct – gold prices will rise!

Assuming the stock market is correct and the price of gold is going to rise, how should one participate?

As always the answer to this will depend upon how much risk one is willing to accept. One can participate in the gold market in a half-hearted manner by buying Barrick Gold (where its forward sales have largely reduced risk but equally curtailed expansion of margins from rising gold prices) and hope that general improvement in sentiment will take the stock higher. At the other end of the risk curve, a rising gold price will produce spectacular increases in profits, and, by extension, share prices in those companies which, at present prices, are just marginally profitable, have virtually no forward sales, and have large reserves or resources that are presently sub-economic. Some of the South African producers such as Harmony fall into this category.

However, if history is any guide, the manner in which the bull market is likely to develop is that the large capitalisation stocks will make the initial running as that is where the liquidity is. This has already begun to happen and, true to form, it is happening without anyone being able to justify it because the price of gold is stagnant. Present stock valuations are discounting US$325 gold so that buyers are climbing the proverbial “wall of worry”. However, as gold prices fulfil the market’s expectations and worries subside, buyers will be willing to switch from the highly valued leaders and seek better value in the second line stocks. This trend will continue as confidence grows until, finally, all manner of speculative ventures will be floated off on the public.

For those seeking the comfort of a strong balance sheet, certainty of margins, good management, and minimal political risk, then Franco Nevada and Barrick Gold will probably be as far as you need to look. Given my conviction that the gold price will rise, and rise substantially, I prefer to concentrate on those companies that will be the greatest beneficiaries of rising prices. Needless to say, if gold prices do not rise, look out below! That is not to say that the companies will cease operations, for they have substantial cashflow, but it is the result of depreciation and amortisation and not of profits, so that, without an increase in the gold price, these companies are steadily destroying capital. Following the surge in share prices this year, the market is certainly not going to tolerate destruction of capital for long.

For those willing to accept South African risk, companies such as Anglogold, with resources of 364 million ounces and total production costs of US$245 per ounce, or Gold Fields Ltd, with 150 million ounces in resource category and costs of US$240, both have huge potential earnings growth and are providing good dividend yields even today. In North America, Homestake Mining has resource ounces of 32 million but after exploration expenses made small losses last year. Similarly, Kinross with 25 million resource ounces, made operating cash-flow but accounting losses last year. These two companies are prime examples of the stock market telling us that the bullion market is wrong. (see Figs. 3 and 4)

For those who will feel that they have missed the boat, it is wise to step back to the weekly charts of those same two companies :-

Despite the large gains in gold mining shares listed in North America, there has been little interest in the Australian listed gold miners. There is good reason for that. In aggregate, the Australian producers have been the most determined “hedgers”, with some companies selling forward almost their entire reserves. Indeed, one of the reasons given for a recent spurt in the bullion price was that Australian company, Centaur Mining, was going into bankruptcy as a result of problems at a nickel mine and that it had substantial forward sales of gold outstanding. Australian producers at December 2000 had 49 million ounces sold forward at an average of Aus.$470 per ounce. ( Spot price today is Aus.$520 per ounce!) Having sold forward almost the next six years of production at prices that are now below spot, if the gold market moves to a zero contango basis , i.e. where interest rates on deposit less the lease rate of gold is zero, for any length of time, the Australian gold mining industry will be under severe threat! It is essential, therefore, to select companies that have minimal forward sales. Of the larger companies, only Lihir and Normandy Mining have limited forward sales ( Normandy only recently qualifies as a result of a transaction with Franco Nevada whereby it acquired a producing mine from Franco Nevada without forward sales attached! ). However, if one is prepared to accept the political risks of Fiji or Georgia, one can find real bargains in Emperor Mines, which has huge operational leverage and a market capitalisation per resource ounce of US$3, or in Bolnisi Gold, which trades at less than one year’s cash flow, produces gold below US$140 an ounce, has more than 500,000 ounces of attributable reserves, and has excellent exploration potential. Both of these companies should be major eneficiaries of higher gold prices.

There is little doubt that there remain large quantities of gold which can be brought into production when higher gold prices prevail, particularly in South Africa and the Former Soviet Union. However, these resources will take years to finance and bring into production. Gold exists in almost every corner of the world, (one of the reasons it has been universally accepted as a store of value), and there will doubtless be a myriad of geologists with promises of Eldorado emerge to separate us from our savings when everyone is convinced that gold prices can only continue to rise. But that will be another temptation to resist. The one to resist at the moment, is to believe the bankers who tell us that gold can only go down!

« More News & Articles