Golden Opportunity

By: Sean Corrigan | Wed, Jun 19, 2002
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They almost avoided all the woes.

The Brussels Conference, held despite the refusal of the US Treasury to co-operate, had it down pretty much pat.

Governments, the report enjoined, were to reduce expenditures to match their revenues, impediments to international trade were to be scrapped and attempts at exchange control were to be eschewed.

The policy of deflating the excessive build-up in credit was to be undertaken gradually and disbelief was expressed at the idea that any attempt be made to stabilize the price of Gold. Rather, central banks should conduct themselves solely on the basis of 'prudent finance'.

But, alas, the opportunity was missed and, two years later in Genoa, the insidious principle was incorporated that not only was the use of Gold to be 'economised upon' by allowing deposits of one central bank with another to be substituted for transfers of the metal, but that co-ordinated credit policies should be maintained between them which would stabilize the value of gold itself.

Thus, in the two brief years between the first meeting in 1920 and its disastrous follow-up in 1922, was the world set on the road to the 1920s boom, its culminating Crash and the wholesale destruction of wealth which the widespread implementation of statist nostrums and crank - inflationary - monetary remedies occasioned in the Great Depression.

That shift - from the true, classical Gold Standard, to its malign parody in a Gold Exchange Standard made worse yet by being a bullion standard anywhere the UK's influence could reach - was indirectly responsible for all the economic upheaval, political turmoil, and many of the tens of millions of fiery deaths, suffered in the world in the 80 years since.

Those who deride Gold 'bugs' as primitive cabalists, or as strange, wild-eyed necromancers, miss this last point entirely even though generations of wise men like Webster, Jefferson and Burke - to name only a few - had made plain the dangers posed by unbacked paper money to the liberty and prosperity of all.

Gold is the only sound basis for money because it has always emerged as the instrument of choice when the preferences of free men have been allowed to hold sway and - more to the point - it has always been the money that has provided the best guarantee that the State cannot wholly extinguish those preferences and replace them with the diktats of its elite and their court lackeys.

Gold's virtue, though, is seen by today's planners and collectivists as its irremediable vice for the simple reason that it cannot be created at will by the State and its bankers, as a means of allowing them and their favoured clientele to take ownership of what they have not first earned.

Why else would the IMF - the One World Ministry of Finance in waiting - ban it from having any role in international monetary management? Not discourage it, mind you, but actively forbid it. Why else would the BIS - the central bankers' central bank, cloaked in its extra-governmental Swiss cloud of secrecy - seek to manipulate its value and to finance the great Bear raid of the Bubble years?

Why else would the Fed and the Bank of England act to keep its price from rising, by selling it, leasing it and writing call options against it, the better to protect their friends in the short camp?

Why would the US authorities tell dealers in the 1999 panic not to insist on physical delivery? Why would they rush an emergency generator into the smouldering rubble of the World Trade Center in order to fire up the trading systems at the NY Mercantile Exchange and its COMEX gold-trading subsidiary?

Some would also voice mutteredĀ  - but unanswerable - questions about whether the 1998 bail-out of Long Term Capital Management was really due to their unrecoverable bullion positions and the risks therefrom to their Money Trust counterparties.

But though governments and central bankers can work to ban or subvert much economic activity, in the end, Men's own subjective valuations have a way of expressing themselves as we continually expound as visit to our site - http://www.capital-insight.com - will reveal.

Moreover, it is almost a given of sound economic reasoning that by acting to force the price of something below its true worth, it eventually becomes scarce - either because it is hoarded by the wise, or because it is dissipated by unthinking fools.

Gold may well be a case in point.

Let us look at a few of the facts one more time.

Central Banks ostensibly have around 32,600 tonnes in their vaults - though whether they have (a) physical and (b) effective control over these is a matter of some conjecture after their long years of manipulation.

At today's market prices, this amounts to around $330 billion worth of bullion.

Compare this to the fact that there are around $38 trillion in domestic and international debt securities in existence and $135 trillion in derivative instruments constructed around these (and pretty much anything else from which a contingent cash-flow can distilled).

Thus, we can see that, in the event of a crisis, or even just a marginal alteration in the prevailing economic 'wisdom' (something which is never wise and very rarely prevails), which resulted in a portfolio shift out of bonds of the order of 1-2%, this would be enough to add new demand equivalent to all the gold in the monetary authorities' hands.

In the gold market itself, there are signs that such a sea-change is, indeed, underway.

Estimates have the total forward sales of the top nine producers-hedgers at something like 70 million ounces - around 2,300 tonnes, roughly equivalent to a year's global mine output, while a figure of 95 million ounces in total has been mooted.

This has not been without its costs. Only last month, The Mining Web suggested that mark-to-market losses on these hedges amounted to some $1 billion - real money, by anybody's standards.

This, is of course a seesaw game because the real thrust of much of this hedging is that, starting from relatively straightforward forward sales programmes in the mid-90s, via the fairly innocent wrinkle of smoothed cash flow swaps to assist corporate planning, we now have all manner of financial wizardry foisted upon some of these miners by the sons of F.I.A.S.C.O. - the investment bank whiz-kids - too-clever-by-half men in braces who don't know a mine from a Yours! and have never been closer to a pit than when selling 10,000 lots in the Bonds on Chicago.

This means valuations are highly non-linear - which is a phrase a mathematician would use to describe the likely outcome of playing hopscotch blindfold in a minefield.

As a case in point, consider that Newcrest Mining has recently had to satisfy new FASB regulations on derivative accounting by booking a A$80 million write-down due to surplus gold currency-linked hedges.

What was more revealing was the statement that the miner only realized a paltry A$1.3 million in profit in the March quarter because its hedge book was bleeding so badly, allegedly the fault of knock-in call options written on the A$ price of gold.

Now to buy puts to protect one's investments is a defensible strategy, a form of term assurance. Even to sell puts, in order to have the opportunity to buy back cheaply resources one had already sold at full value - at a new, lower price one firmly believed was below all reason (and which might be below the cost of one's own production, so effectively replenishing reserves) - is more dubious, but understandable.

But, to enter a strategy, whereby a RISE in the price of the commodity one is devoting scarce capital to producing will COST one money, is patently a serious dereliction of fiduciary responsibility.

In addition, this exposure to knock-in calls (so-called because they only become active after a price touches a certain level and are therefore, in some regard, options on options) is doubly censorious since they are not only difficult to neutralize, but their double-optionality means they carry a lower premium than plain vanilla options, so their sale probably did not raise that much cash, in relation to the risk, in the first place.

To see how insupportable this is, ask yourself if you could imagine Exxon-Mobil or BP managing to lose money in this manner from a rising oil price?

But the mood is changing. With investors now wanting full exposure to the rising price of gold, they do not want to find that CFO's have taken all the bottom line juice out of the trade.

That in turn is becoming a virtuous circle, for as non-hedgers' share prices rise more than their peers, so the hedgers are being forced to announce policy changes, taking supply out of the market.

Moreover, so the World Gold Council reckons, the pace of this repositioning is accelerating. Hedge books, it says fell, for the first time in over 12 years in 2000, by around 15 tonnes. In 2001, that increased to 147 tonnes. Provisional estimates for QI 2002 suggest this years' total could already have amounted to another 100 tonnes, or more than 2 1/2 times last year's rate.

This is, of course, helping fuel the very price rise in the metal that justifies the unhedging (as well as giving the lie to the Bobby Godsells and Randall Oliphants of this world who have always attempted to maintain that their previous heavy forward sales and synthetic shorts were not affecting the gold price adversely).

Incidentally, all this helps miners in an indirect fashion by rescuing them from the clutches of the bullion banks, since their greater equity valuation is allowing them to tap the convertible bond market, to issue stock and to look for non-recourse financing, rather than having to enter into the Faustian bargain of depressing the future value of their output and often of failing to maximize their reserves through the pernicious practice of high-grading (taking out the easy pickings and leaving the rest to lie fallow in the ground).

In the process of doing this, as Newmont CEO Wayne Murdy told the San Francisco LBMA conference, tremendous value has been lost:-

'The average cost of capital in our industry is plus minus 10 percent. Looking at the returns in 2000 when gold averaged $279/oz, for the 17 largest producers and removing the hedge gains for those who used them, not one single company came close to its cost of capital. The industry has destroyed shareholder value utilising the investment decisions of the 1990s.'

This is an overdue awakening, but, in a world where accounting chicanery is no longer seen as admirable, where people have begun to rediscover the difference between 'investment' and 'trading', where the realization is dawning that wealth is not created, only transferred, on Wall Street, it is a start.

In the wider world, it may be too much to hope that high-minded statesmen will emerge to restore probity and accountability to government, but it is evident that even as the era of a somewhat lighter hand on the sceptre is rapidly passing, people's faith in policymakers and their instruments is also under serious review.

Equity returns, too, will be firm specific henceforth, not the prize of blind indexation, and that alone will cost them much of their allure.

As Warren Buffett said recently, the same people who spend time and effort in choosing a car, expect to pick a stock in minutes, so the need to do work will limit the involvement of the unthinking herd and hence, perhaps, the worst speculative excesses.

The return of Big Government and its introduction of a raft of anti-capitalist and illiberal initiatives like steel and lumber tariffs, proposed restrictions on foreign ownership of companies, cynical, money-grabbing, legislative assaults on drug companies, the increased surveillance of all private undertakings, together with frantic money pumping by the major central banks, can only serve to heighten risks.

This goes for debt instruments as well.

Either the current swelling rises in price of things other than assets will continue (as it will certainly be an unspoken policy goal) and the inflation component of bond yields will go up, or else a debt collapse, as soaring liabilities overpower straggling production, will send risk premiums soaring (exacerbated no doubt by that other derivative minefield of credit transfer instruments, already the subject of much official hand-wringing).

The mailed fist of Princes and the foolish alchemy of their Chancellors is not conducive to the well-being of financial assets or capital in general.

It is a hell of an argument for the continuation of the Great Bull Market in Gold, though.


 

Sean Corrigan

Author: Sean Corrigan

Sean Corrigan
Capital Insight

Sean Corrigan is a principal of www.capital-insight.com, and a co-manager of  the Bermuda-based Edelweiss Fund.

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