Gold: The End of Cheap Money
The Fed's subsidization of the American economy is over. The era of cheap money is at an end. Interest rates have ratcheted up again in England, following increases in Australia and China, so the long overdue rate increase in the United States was no surprise. With interest rates at the lowest in recorded history, America's net national savings rate dropped to less than 2% of GDP as they borrowed with wild abandon. For three years, US interest rates have been in negative territory as the Americans pursued a cheap money policy. As such, further rate increases are inevitable which would expose the vulnerability of America's financial center causing a further large devaluation of the dollar. And with the election looming in the fall, a cheerleading Fed reluctantly removed the punch bowl.
A Flood Of Red Ink
For some time now we raised concerns about this environment of unsustainable low interest rates, believing that the glut of dollars would eventually feed rising prices. Record household debt together with record government twin deficits have made the US economy highly sensitive to the impact of higher interest rates. The United States is the world's biggest capital importer and net debtor. And now, even a small uptick in interest rates were enough to cause both the stock market and housing markets to swoon on concerns about the overly indebted consumer and financial institutions that financed this orgy of spending. Questions are asked of even the "too big to fail" Fannie Mae and Freddie Mac. Of more concern, is that while the consumer has retrenched, the Federal Government has not, and is still running huge budgetary deficits.
The deficits are the dollar's Achilles heel. To date, the dollar has lost 15 percent of its value. The US current account deficit widened to $145 billion in the first quarter and a record $55.8 billion in June. The current account deficit, a broad measure of how much more the US is spending than taking in, is over 5 percent of GDP rising to over half a trillion dollars. The deficit reflects the fact that Americans are spending more than they earn and their robust economy is sucking in imports at a greater pace. Under President Bush the budget has swung from a surplus to a deficit in only one term - a swing of 700 billion.
To balance its books, the US depends on the largesse of foreigners and must attract more than $2.0 billion of net investment each day to cover the current account shortfall. In the past, foreigners were piling up US assets at a huge pace led by Asian economies intervening to prevent their currencies rising further against the US dollar. In 1993, foreign holdings accounted for 20 percent of US debt today. Foreign investors own almost half or $1.75 trillion of the $3.76 trillion of marketable treasury debt.
Recent data shows overseas interest in US equities waned but after four consecutive monthly declines, purchases picked up slightly in June. Lacking the necessary pool of savings, the Americans are dependant on massive lending from the rest of the world. The monstrous US trade deficit must be matched by a corresponding surplus elsewhere.
Central banks also slowed their dollar purchases in the latest quarter and there was a collapse in demand for treasuries. In May, foreign purchases of US securities were down 26 percent from April, the fourth consecutive monthly decline. Japan, holding 16 percent of US Treasuries, bought $20.1 billion of Treasuries in the months of April and May in contrast to average monthly purchases of $25 billion last year. We believe this outsourcing of the financing of the US economy is over, with perilous consequences for the dollar.
And now, the US dollar beset by global security concerns, spiking oil prices and the crushing weight of the twin deficits, has come under renewed selling pressure as the increase in the current account deficit and jobless numbers sent foreign investors scurrying into other major currencies and gold. The bulk of the selling came from hedge funds reversing their "carry trade". We believe the declining inflows will ripple across the globe.
The Implications Of Living In A China-centric World
The deteriorating trend in net US inflows suggests a growing reluctance by foreign private investors and central banks to shoulder this burden. Until now, Asian central banks were " the lenders of last resort". That has stopped. And, foolish politically inspired duties on China's furniture manufacturers is due to spark a reciprocal action. China has an increasing imbalance of trade and financial surpluses, piling up more than $400 billion in US Treasuries and has made moves to diversify into euros and more recently gold. In June, China purchased a net $700 million of treasuries, down from $3.1 billion the previous month.
China's voracious appetite for raw materials has caused huge price spikes raising concerns whether the price moves are sustainable. China has become a major player, with total trade expected to top $1,000 billion up from $851 billion last year, surpassing Japan as the third largest market. Indeed, the threat of a slowdown in China was enough to cause the global stock markets to selloff. As outlined in our last report, The China Syndrome, we believed the fears of a slowdown were greatly exaggerated. China is on the path for another 9% plus growth - it's not even a speed bump. China's imports are up a whopping 50 percent in the first half of this year due to a 40 percent increase in crude imports to 2.45 million b/d. Bank lending in June rose 16.3 percent. Industrial production rose 15.5 percent in July. While the world is focusing on China's growth prospects, investors appear to have missed the implications of this growth. China has accumulated large surpluses and a major part of US indebtedness, making it a world player in the financial markets.
Dollar Blocs, Euro Blocs, and Yuan Blocs
China's emergence as a superpower has not only helped Japan pull out of its ten year doldrum, it has been the driver for the emergence of the Far East as a super economy. And there is talk of a common Asian currency like the Euro to facilitate trade and investment. In essence, a common Asian currency would reduce currency risk and the dependence on US dollar, further undermining the greenback.
China's efforts to go from a state-owned and run enterprise to a more market economy has come at a cost. For example, its banking sector is in need of restructuring and there is still much to do about corporate governance. Nonetheless, the world is now discovering what it is like to live in a China-centric world. In 2003, China consumed 7 percent of the world's crude oil, 31 percent of its coal, 30 percent of its iron ore, almost 20 percent of its steel, 25 percent of its aluminum and 40 percent of its cement. No wonder foreign investment surged into China, making it the largest recipient of the funds in the world, exceeding the United States. China is now one of the world's twin economic engines, alongside the United States. While a new superpower has emerged, the old superpower, the United States is ageing.
For three years, a mixture of cyclical and structural factors has influenced the US dollar. A major part of the decline is due to the imbalance of Chinese production on the supply side and American consumption on the demand side. China is a powerhouse of exports, until their consumers take up the slack, the Chinese are dependent on America's insatiable appetite for goods. Here is the rub. Once the Chinese become confident in their own markets and the Asian countries begin to learn to rely on themselves and their markets , there won't be a need for America. Why then, will they need all those reserves of depreciating dollars?
The Golden Constant
After reaching a 16 year high, gold retrenched into a narrow trading range between $380- $410 an ounce, as the dollar recorded a "dead cat" bounce against other currencies. Gold is negatively correlated with the dollar. Is the party over? Not yet!
Investors are concerned that higher rates to prop the dollar will also hurt gold. A weak dollar goes hand in hand with higher rates. But higher rates and a weaker dollar also are inflationary. Three years after the business cycle peaked, the US economy is growing in fits and starts with an inflationary bias. Inflation has reared its head, due to the tremendous amount of liquidity injected into the system, in part to get the economy on track in time for the November elections. Until recently, inflation was low and falling. The oil price hit yet another peak at $46 a barrel reflecting a combination of strong demand, tight supplies and increased risk premiums. Commodities have turned around as tight inventories and strong demand have caused another spike in prices. Inflation is back.
In the past there was another parallel period, between today's deficits and the deficits of the seventies. In the seventies, the deficits surged with a war in Vietnam, an oil crisis and a surge in global inflation. The Fed Fund rate increased a net 14 times from 4.5 percent to 20 percent. Inflation soared to 20 percent and the dollar fell 70 percent. Gold moved from $35 an ounce to $850 per ounce. Today, the deficits are even larger and we have only begun gold's second leg. The dollar has fallen only 15 percent so $510 per ounce continues to be only an interim target.
Gold's bull markets are normally underpinned by a pickup in investment demand, then finds support from fabrication demand. Fabricators, build their holdings during corrections. Through the 1996 to 2001 bear market, fabricator demand picked up. When gold entered the bull market, fabricated demand actually declined because fabricators expected gold prices to pull back. But instead investment demand picked up due to heightened geo-political tensions, Chinese buying and large gold derivative inflows. Meanwhile industrial demand exceeded the western world's mine production. Central bank selling also slowed down and the new pact will limit central bank sales to 500 tonnes a year for another five years. De-hedging was also a big factor. Barrick, Placer and Cambior reduced their hedges in the latest quarter. Both Placer and Barrick have more than three years sold forward so they are expected to continue to deliver into their hedges. De-hedging has a positive impact on prices and producers are expected to continue to be among the biggest buyers of gold as they reverse their bloated hedge books.
Gold is unlike other commodities in that it cannot rust, deteriorate or spoil. Gold does not inflate like paper currencies. The supply of gold worldwide increased by about 2 percent per year, or about the same rate as the increase in the world's population. Compare that against the dramatic increase in the supply of US dollars. It is no wonder that gold as a discipline for central banks went out the window in 1971. In 1971, President Nixon severed the final link between the dollar and gold. The global monetary base grew by 55 percent between 1949 and 1969 - an average of 2.2 percent a year. Since 1969, the monetary base has grown four times by 1900 percent or 9.7 percent per year.
Gold does not pay interest. As such, misguided central bankers have been loaning or selling gold reserves in order to generate income. The gold bears have calculated gold's value over a hundred years versus treasury bill and found gold lacking since it pays no interest. However, those same analysts should look at the Seventies, when gold increased from $35 an ounce to $850 an ounce. Gold increased about 24 times or 2400 percent for an annual increase of 34 percent. To be sure there were no bonds during that period that returned 34 percent. Gold is indeed the ultimate hedge asset. Don't look now, but gold is rising. To repeat, $510 an ounce is only an interim target. Gold is a good thing to have.
Agnico-Eagle Mines Ltd.
Agnico-Eagle recorded a second quarter of $0.11 per share up from $0.05 per share due to higher production of 65,233 ounces versus 60,157 ounces. The LaRonde gold producer in northwestern Quebec has shown the street it has turned the corner with its third impressive quarter. In addition, the mill ran at a record 8,300 tonnes per day, up 8 percent and the company is on track to produce about 295,000 ounces this year. More importantly, the company is spending about $30 million on the underground development at its Lapa property about eleven kilometers east of LaRonde. Lapa will be in production in 2008 producing 125,000 ounces of gold at a cash cost of $175 an ounce. Agnico-Eagle is also carrying out studies at Goldex in order to bring that deposit into production. And finally, Agnico-Eagle has seven drills working underground at LaRonde as part the largest exploration program in Canada. We continue to like the shares here.
Barrick Gold Corp.
Barrick Gold reported second quarter earnings of $0.06 per share in line with consensus estimates. However, a large part of those earnings were due to a tax credit and derivative gains. Barrick produced less gold in the quarter due to falling production from Pierina and Goldstrike. Barrick also unwound 850,000 ounces at a cost of $26 million and now has 84 percent of its reserves unhedged. However Barrick still has more than three and half years of production hedged. At the end of June, the hedge book stood at 13.9 million ounces with a negative mark-to market value of $1.4 billion. To offset a flat production profile, Barrick provided more clarity on the development of five new mines in Argentina, Chile, Peru, Tanzania and Australia. However the big "on again and off again" Pascua price tag went up and the project is not expected to come on stream until 2009. Barrick now estimates that the capital cost of Pascua at almost $1.5 billion and that is before taxes and other fiscal arrangements including environmental. More promising in the near term is production coming from Alto Chicama, Veladero and Tuluwaka. Nonetheless, the problem with Barrick, like most senior producers - is how to replace quickly depleting reserves. The senior producers are stuck on a treadmill and cannot quickly replace their reserves due to the shortage of world-class deposits. As such, we prefer the more growth oriented middle-sized producers who are potential targets themselves.
Cambior reported earnings of $0.01 per share reflecting a major contribution from the new Rosebel mine in Suriname, which came on stream of February of this year. Cambior produced 193,000 ounces in total with Gross Rosebel producing 74,100 ounces at a cash cost of $160. Significantly, Cambior also reduced its hedges by 281,000 ounces in the second quarter leaving a balance of only 207,000 ounces or 5 percent of reserves. Cambior is expected to continue to reduce its hedges. Cambior is consolidating its assets and excess cash flow will likely be directed towards smaller acquisitions. While acquisition of the balance of Aurizon makes sense, Cambior does not appear to want to do that and in fact may sell its holding. We view Cambior as a hold at this time.
Crystallex International Corporation
Crystallex unveiled its second phase expansion that will double the output from 10.2 million ounce Las Cristinas project in Venezuela to 500,000 ounces. The base case of 20,000 tonnes per day would produce 311,000 ounces at a cash cost of $144 per ounce in 2006. Detailed engineering and environmental work is being carried out by SNC Lavelin Engineering & Constructors. The revised 40,000 tpd model lowers cash cost to $190 per ounce and raises the capital cost to $266 million. Crystallex is currently drilling an 18 infill hole program, which could add about 2 million ounces to its proven and probable reserves as it drills more closely spaced holes in the proposed pit. Having been granted the "land" permit, Crystallex expects to receive the final permit before the end of this year and financing will be in place by the same time. Consequently we expect the company to break ground by the end of this year, which would attract investor interest. We continue to recommend this undervalued producer. Buy.
Goldcorp has one of the strongest balance sheets with $365 million of working capital, no debt and over 117,000 ounces of gold in inventory. Goldcorp has so far delineated almost 6 million ounces of reserves and the flagship Red Lake mine expansion in northwestern Ontario is expected to cost over $100 million. Goldcorp has the balance sheet to handle this expansion easily and is expected to spend about $30 million this year. Goldcorp reported earnings of $0.05 of per share with production in the second quarter totaling 138,000 ounces at a cash cost $116 per ounce. Earnings were below estimates due to the retention of 33 percent of Goldcorp's production. Goldcorp is comfortable stockpiling gold believing both gold is money and confidence in the gold price. At Red Lake, Goldcorp is spending more than $50 million but the shaft development is going slow. The shaft is currently at 1250 feet and is expected to reach total depth at 7150 feet by 2006. By then, Goldcorp should be producing over 700,000 ounces. Goldcorp has also taken some of its excess cash flow and made investments in strategic juniors giving it exposure to potentially large exploration plays. For example, Goldcorp has accumulated about 14 percent of White Knight Resources, which is the second largest player surrounding Placer Dome's Cortez Hill discovery (see report: Placer Dome Has A New Discovery With A White Knight In The Wings). We continue to recommend Goldcorp for the Red Lake mine, its astute management and rock solid balance sheet.
Kinross Gold Corporation
Kinross reported an excellent second quarter of $0.02 a share versus a loss last year. In addition, Canada's third largest gold company will produce 1.7 million ounces from its twelve mines at a cash cost of $230 per ounce. Kinross has $200 million of cash with a working capital position of $270 million at the end of June. The company has recently acquired positions in Cumberland, Anatolia Minerals and White Knight giving it excellent exploration potential. Kinross expects to explore around key mines Fort Knox, Round Mountain and Kubaka. Kettle River will come on stream this year extending Kinross reserve life. Kinross is hedge free and is well levered to the gold price. Buy.
Meridian Gold Inc.
Meridian reported exceptional earnings of $0.10 a share due to the El Penon mine in Chile which produced 82,000 ounces of gold in the quarter up from 78,000 ounces. Total cash cost was at $50 per ounce and the elimination of a drag on earnings from recently sold Jerritt Canyon helped results. Mill through-put at El Penon reached record levels in June. The exceptional high grade Dorada vein was extended to 1.2 kilometres in strike length and underground access to Dorada was initiated. Meridian should be mining Dorada high grade material within a year and a half. Meridian has cash of $210 million and should produce 310,000 ounces of gold at a cash cost between $50-$60 an ounce. We like Meridian shares at current levels and believe there is nothing in the shares for Esquel which is stalled at this time. Meridian continues to work with the local community to reverse its stance. We believe that a thawing in the relationship is inevitable and thus there is interesting upside to Meridian shares if there is a move towards putting the Esquel project into production. Buy.
Miramar Mining Corporation
Miramar shares were hard hit following disappointing news that the permitting process with the Nunavut board has delayed bringing on the Doris North project. There is only a twelveweek window and the need to assemble and bring equipment to the north afforded little opportunity for another delay in the permitting process so construction cannot begin until 2005. Consequently, Doris North won't be brought on stream until late 2006 pending at the earliest. Meanwhile Miramar closed the Giant mine because every ounce Miramar produced was at a loss. Consequently, the loss of production is a plus since Miramar will have more cash flow to work with. From an exploration point of view further news from Hope Bay and Goose Lake this summer should result in limiting the downside.
Placer Dome Inc.
Placer Dome reported second quarter results of $0.08 per share on gold production of 908,000 ounces at a cash cost of $229 per ounce. For this year, Placer Dome is in line to produce 3.6 million ounces of gold and 400 million pounds of copper at a cash cost $230 per ounce. Like other senior producers, Placer's problem is the replacement of reserves. Development work at Getchell's Turquoise Ridge is slower than the company expected. South Deep in South Africa continues to be a disappointment producing only 51,000 ounces at a cash cost of $399 per ounce. South Deep remains an albatross for Placer and the South African rand is going the wrong way. Noteworthy is that until the shaft is deepened there will be no impact on production which is a problem since the bulk of Placer's reserves are in South Africa.
On a positive note, however, Placer released an update on Cortez Hills in Nevada, which could be a company maker. Placer boosted reserves at Cortez Hills from 3.2 million ounces to 4.5 million ounces and the company expects to complete a feasibility study by year-end. The Cortez Hill discovery is close to the Pipeline facility and this high-grade deposit can be brought on stream fairly quickly. As of June 30th, 94 holes were completed with assays received from 72 holes. So far the high-grade zone is open to the west and down depth and the company has yet to define the limits of this discovery. Of interest is that there is a possibility that this deposit can link up with nearby Pediment, which would add to the reserve picture. While it is still early days, we believe Cortez could add about $2.00 per share to Placer's NAV. At Pueblo Viejo in the Dominican Republic, Placer also gave clarity to its program. Pueblo Viejo is a refractory deposit and the company expects to produce a prefeasibilty study by the end of this year. Placer like Barrick has reduced its hedges but the company still has almost 10 million ounces under hedge, which is three years of production hedged - too high. The mark-to-market loss is $307 million. With the exciting Cortez Hills discovery and the prospect of bringing Pueblo Viejo on stream, Placer has offset the difficulties in South Africa and we recommend the shares at current levels.
Richmont Mines Inc.
Richmont has started the ramp at East Amphi in Quebec at a cost between $6-$7 million. The ramp should be finished by early fall and thus development work could begin. East Amphi will provide 250,000 ounces to Richmont's book. In Newfoundland, the company has begun drilling at Valentine and a 2,000 foot program will look for additional reserves to be processed at Richmont's facility. Richmont's shares have corrected and with only 16 million shares outstanding, the company is well levered to the gold price. Richmont should produce between 65,000 and 70,000 ounces this year and in 2006, a doubling of output is expected. With a working capital position of $30 million, no debt nor hedges, the stock is undervalued with earnings expected to be $0.32 this year. We like this junior producer here.