Gold: The Obituaries Are Premature
Gold collapsed over 14 percent in two days in the sharpest tumble since 1983 raising fears that the twelve year bull market is over. Some blame the collapse on the fear that Cyprus and other weaker European countries would have to dump their gold reserves. Wrong. Under an earlier agreement (CBGA3), all Eurozone countries must seek permission and the sales of gold were limited to 400 tonnes. Others blame the fear of a slowdown in China. China's growth remains in excess of 7.5 percent and its state-owned companies are leading the way. The People's Daily recently noted 54 state-owned companies now rank on the Fortune 500 list of the biggest companies in the world. Only two decades ago, the total revenues of the top Chinese companies were less than that of General Motors. However none of these reasons seem plausible to explain the magnitude and breadth of the decline.
In our view the main reason was an estimated 400 tonnes of gold futures dumped in two tranches on the NYMEX Comex. The sales were worth about $20 billion equivalent to about 15 percent of the entire world's mine production. In fact two years ago, the European central banks took one year to sell that amount of gold. Comex is a market where gold and silver are traded daily as well as stored in warehouses. In one week alone more than a million contracts equivalent to 3,000 tonnes traded on Comex, easily surpassing the annual mine production of 2,600 tonnes. And the volume was unprecedented, exceeding 700,000 lots or 4 times the 30 day average. Comex subsequently raised the margin requirements to 19 percent, making the trade more expensive for both buyers and sellers. Billions of paper derivative contracts are backed by the physical metal (100 to 1) held in the Comex warehouses. Trading of future contracts are leveraged (10 to 1) allowing a buyer to control a fraction of its total value and if only 10 percent of the buyers opted to take delivery, there would not be enough gold to cover the claims. As such, the market is fraught with counterparty risk similar to the AIG or Bear Stearns debacle which showed us that the derivative market is based on not only leverage but confidence in counterparties' promise to pay.
Although 400 tonnes of physical gold did not hit the market, the future contracts (paper gold) were obviously too big for the market to absorb and in fact was the second largest short position ever. The identities of those speculators, of course, are unknown but are likely a combination of the big bullion banks and hedge funds which have been feasting on gold's volatility. To be sure, gold's long term uptrend chart was broken sparking a classic panic investor capitulation, and liquidation from the gold ETFs. Indeed, in over four decades of following the barbaric metal, we have never seen gold more technically oversold. Similarly gold miners which were already beaten up by their non-performance have become even cheaper. However, given our belief that gold's collapse was an orchestrated raid by speculators, the expiry saw the "shorts" begin to cover and the calling of their bluff. We believe the next big move will be up, sparked by the inevitable short covering rally and the unintended consequence of an unprecedented explosion in physical demand.
Bull Market in Physical Gold
The gold market has seen a shift away from "paper" gold (futures, contracts and ETFs) into the physical market. Paper gold has counterparty risk while physical gold is tangible and always fungible. Unlike paper gold, the supply of physical gold is limited. While there was ironically a rush to sell paper gold, there was a bull market stampede to buy physical gold, as government mints, refiners and bullion dealers reported demand as high as in the aftermath of the Lehman Brothers' collapse in 2008.
Certainly much media attention was paid to gold's bloodbath and the 174 tonnes dumped by the gold exchange traded funds (ETFs), however ETFs only represent less than 8 percent of investment, according to the World Gold Council.
Of more importance and to put it in perspective, bar and coin demand accounted for 29 percent of overall gold purchases last year is enjoying strong physical demand. In addition, central banks which hold 17.4 percent of above ground stocks have been monster buyers of gold. Last year 19 central banks bought gold and recently Russia, South Korea and Kazakhstan have been buyers.
In fact, while central banks are the largest institutional buyers, jewelry makes up about 49 percent of all above ground stocks has also seen strong demand. And there are reports that Chinese housewives bought some 300 tonnes in the past two weeks with 60 tonnes bought in Hong Kong over the three day holiday. We believe that central banks and investment are behind the global phenomena of skyrocketing demand for physical gold.
Trading premiums in gold coins have risen more than five percent above the spot price which compares to three percent at the beginning of the year. It is no coincidence that only three weeks earlier there was a dramatic two million ounce drawdown to a five year low from Comex warehouses after the Cyprus "bail-in" which saw the confiscation of depositors' asset to save Cyprus' banks. Simply there is a shortage of physical gold. We believe this premium for physical spot gold is getting larger and larger and the price correction only makes it more appealing. In India more than 15 tonnes was bought in three days and gold imports are expected to rise to almost 900 tonnes. China, the largest gold producer in the world produces 400 tonnes, but its overall demand is expected to be about 800 tonnes after importing 223 tonnes in March alone. The volume on the Shanghai Gold Exchange exceeded 43 metric tonnes the first time ever. Both India and China are expected to purchase 70 percent of world supply. Gold is simply moving from the West to the East.
The largest Dutch bank, ABN Amro ran out of gold, defaulted and was forced to give paper to those holders of gold. The shortage too has been part of a global trend whereby central banks' requests to repatriate their gold have increased including Germany's request to the Bank of England and the State of Texas asking that their gold be moved from New York depository to Texas. By the way, Germany was told it would take up to seven years to get back only 300 tonnes of their own gold. We believe that the huge short position and orchestration was done to not only make money but also to allow those players to build-up their physical holdings. Simply, possession is nine tenths of the law and physical holdings can't be confiscated nor replaced by specie as in ABN's customers' case.
Needed is Fiscal Austerity
We believe the catalyst for this gold rush was the much ballyhooed Cyprus "bail in"which has backfired. The newly fashioned troika (the IMF, European Central Bank and European Community) lost credibility largely because taxpayers have balked at footing the bill for the string of sovereign bailouts. Those unelected mandarins after bailing out other members have resorted to confiscating savings. Bailout weary taxpayers have rejected the inevitable austerity programs and in some cases have turfed out their governments. Short of capital, the EU members have few alternatives. The big surprise was that nothing was accomplished because cutting public spending and wages were offset by increases in state's debts and deficits. Structural reform was quickly abandoned. Budget deficits rose and debt to gross domestic product increased. Austerity is out, and now Rogoff and Reinhart's excellent work has been conveniently discredited because of a simple math error. The turfing out of so many politicians has made central bankers and governments wary about incurring more stringent austerity programs.
The usual Keynesian policy prescription in the past was to spend our way out of problems, adding more debt. Central banks unleashed unprecedented monetary easing over the past several years, using inflation to erode debt. So far the effect is subtle, eroding the purchasing power of currency each day squeezing pensioners and savers alike. And now the European Central Bank seems to have reached its limit because with interest rates near zero, there's not much more they can do to spur the still floundering economies.
Eurozone members are fed up with austerity's dire effects. Spain has a jobless rate of 27.2 percent. Italy is calling for an austerity truce. The Cyprus' "bail in" did not even utilize the EMS fund set up for just that very purpose and the European Central Bank lost further credibility with the introduction of capital controls which goes against the European Union's rules restricting the free movement of capital. By introducing the concept of two types of euro, it is the beginning of the end for that currency. In fact the capital controls by Cyprus harkens back to the dark days of South Africa where the Rand was restricted prohibiting money from going out of the country. Gold mines suffered as well as the people of South Africa. By imposing restrictions on capital, it works both ways. The key point is that capital is like water, and knows no boundaries. Currency controls and capital controls are very much what contributed to the Great Depression in the thirties and of course gold was a beneficiary.
Needed instead is fiscal austerity because governments are caught in a debt trap that is proving impossible to fix. Like a drug, no one dare take the patient off the drug which is having less and less of an impact. And, that debt has to be repaid. The outcry has only just begun and central bankers appear to have hoisted themselves on their own petard as investors question not only the credibility of the central bankers but also the credibility of money. In fact the new crop of political leaders is just like the old ones, except for maybe Beppe from Italy. Politicians are up to their old tricks of kicking the can down the road. The political and government system is unworkable because of the lack of leadership.
Debt Ballasts The US Monetary System
What ballasts the US monetary system is debt. In the third round of quantitative easing, the debt-clogged Federal Reserve buys bonds creating money to pay for the bonds which increases the supply of dollars putting pressure on the exchange rate. And almost four years later, this printing of money appears to have no material inflationary effect yet economics 101 teaches us that doubling the money supply to monetize America's deficits must reduce the value of the dollar. Although the dollar is at three year highs, it is 25 percent lower over the past decade. And four years and trillions later, the largesse has ended up in Asian banks' reserves and corporate America's offshore accounts (some $2 trillion). It hasn't disappeared. That liquidity is the base or fertile ground for inflation. In essence, cheap money caused a massive shift in wealth from declared a defacto war on wealth. Yet another offshore banking destination is closed and ultimately, taxpayers will pay more. Creditors should beware.
The Fed's heavy use of quantitative easing has caused its balance sheet to quadruple in size to $3.2 trillion. Initially much of that cheap money went into shoring up their investment banks' balance sheet after near bankruptcy in 2008, but soon the money went to inflate bubbles in commodities, Asia, treasuries and of course the S&P 500. The cheap money also allowed the Fed to borrow trillions in order to finance the government's massive spending programs. And of course cheap interest rates forced a generation of investors into real estate and riskier investments. Today junk bond issuances are higher than in 2007.
Not only are central banks supposed to be stewards of money they have used their money minting powers to take on the obligations of the private sector by buying long term bonds and mortgage debt, becoming the central figure in the bond markets. Indeed, the Federal Reserve has become the world's largest financial intermediary or a glorified hedge fund raising the risk of big losses when rates go against them. What central banks miss is that the rounds of unorthodox quantitative easing and their massive intervention in the bond market will jeopardize investor confidence particularly when rates increase. Not so outlandish when consideration is given that the Republicans in the House of Representatives are calling for a bill that prioritizes interest payments to foreign holders in favour of US bonds to protect Social Security receipts. Then there is the debt ceiling bill which will be reached on May 18 and should Washington and Congress not agree, the US would again be on the brink of default. The question is who is going to bail out the "too big to fail" central bank?
Inflation Is Imported From China
The recent surge in foreign exchange reserves of the Bank of China to $3.4 trillion was a $128 billion jump in the first quarter, the biggest quarterly increase since the second quarter of 2011. Beijing's strict capital controls have made movement in and out difficult but there is no question that some leakage is flowing into China. Consumer prices are edging up slowly in China, and in other parts of Asia there have been increased activity and the buildup of similar foreign exchange reserves with the ten southeast nations growing at an average 5.6 percent last year. In Indonesia there is evidence of a property bubble. While the pump priming programs are benefitting the US and Japanese banking systems, the unintended consequence is boosting the Far East's inflation rates, supporting our view that the quantitative easing programs are ultimately inflationary since they will show up on US shores in higher cost imports.
As such the Chinese and Asian central bankers have been buying gold. China and Japan already have more dollars then they want and need to diversify their reserves. Gold is an alternative for them, dollar denominated and a hedge against a falling dollar which is expected to fall even further.
Gold's Obituary is Premature
So while gold's collapse in our opinion was technically driven, what is to happen next? It is our opinion that the fundamentals have not changed. The "band-aid" solution de jour remains piling on more debt. For the fundamentals to change, the US dollar would have to be the best investment in the world, and for that the Americans would have to reduce the record amount of debt and stop having a string of trillion dollar deficits every year and pass perhaps a budget in both houses. Unlikely to be sure. Consequently while gold had broken its long term trend with a correction of more than 20 percent, as gold did in 2008 the correction will prove to be a false breakdown and temporary.
Gold is lightly owned. To be sure the bandwagon is empty and this lone bull notes that sentiment is shifting faster. The battle between paper and physical gold will escalate. Strong demand for physical gold, especially from Asia has propped up gold, tilting the scales between paper and physical. The US has a severe debt problem with its deficit and overvalued dollar. Europe has yet to solve its problems. All have sick economies and trillions have not solved the problem, other than inflate more asset bubbles.
The question most often asked of us, "is this the end of the bull market?". Having the good fortune of being around when gold was $35 an ounce and watching it go to $200 an ounce when the Americans were allowed to buy and then watch gold fall to $100 an ounce, we were told that we would never see $200 an ounce again. Gold subsequently went to $850 an ounce and then in 2008, gold fell more 20 percent, before reaching even new highs at $1,920 an ounce. Gold always comes back to post new highs. Gold is an asset which unlike collateralized debt obligations or mortgage backed securities or Bank of Herstatt shares or even Fannie Mae debt, always comes back. Gold is a store of value and the making of new highs in the last twelve years is a reflection of its haven-type characteristics. It is not that gold has done so well, but that the purchasing power of currencies has done poorly. Everybody has it wrong; it is not different this time.
Gold is also a barometer of investor anxiety. Sometimes it moves as a commodity but most times it moves as a safe haven. Gold's twelve year bull run was due in part to a fall in the US dollar and the financial crisis in 2008. The next big move will come as a consequence of the rounds and rounds of quantitative easing which has already led to more bubbles and inflation. Real interest rates remain negative. Governments have been printing money at an unprecedented rate, creating demand for gold as an alternative currency. Indeed, gold has become the defacto currency. It is this currency debasement that provides gold's underpinning as an attractive long term investment, now and in the future.
Gold mining shares have been hard hit by the collapse in bullion prices making some attractive bargains. Many however would face hardship at current prices so selectivity is important. Balance sheets are equally important. At this time emphasis should be on quality ore bodies, experienced management and low geographic risk as some governments view the industry as golden geese ready to be plucked.
It is thought that $1,250 an ounce is the level at which the gold mining industry needs to be cash flow positive. Balance sheets have recently experienced pain with the drop in the gold price. Of concern are single miners, such as Osisko and Detour and high cost producers such as San Gold, Lakeshore, and IAMGold which reported "all in costs" at more than $1,400 an ounces. Multi miners can mine lower cost or richer deposits while single operation miners simply do not have that luxury.
We believe that the gold miners are among the most hated stocks. This cannot last. The top ten producers` market cap per ounce of in situ reserves are trading at less than $300 per ounce. This is cheap. We also believe that the same gold mines are sitting on close to 22,000 tonnes of gold in the ground which is the only free, unallocated supply in the world. Given the looming shortage and the fact that the mines are producing less gold annually in the face of healthy demand, we expect investor interest to return. Gold miners are trading less than 10 times earnings and only need to harvest their in-ground ounces. And yes, rather than emphasize growth in ounces, we believe they will finally show investors the money through dividend increases and buybacks. Gold miners must also realize they produce a defacto currency which involves extracting at a profit and show investors the leverage of producing that profit. Gold investors want just that - gold. We like Agnico-Eagle, Eldorado, and Barrick for a spec turnaround based on compelling risk reward parameters.
Agnico reported earnings of only $0.14 in the first quarter, down from $0.40 a year earlier. Obviously low metal prices hurt earnings. Yet Agnico remains on track to develop its relatively low cost ounces. Meadowbank's and flagship LaRonde's grade should be higher this year. Earlier Agnico wrote down Goldex which resulted in a loss of $2 billion of market cap. Agnico is reopening Goldex but developing instead the satellite deposits around the mine and while we do not expect the restoration of the market cap, Agnico will make money from the reopening of Goldex. Meanwhile Agnico is developing La India project in Mexico, which is ahead of schedule. With operations in Quebec, Mexico, Finland and Nunavut in Northern Canada, we continue to like the shares down here.
Allied Nevada Gold
Back to the future, as Bob Buchan takes over the Chief Executive role from Scott Caldwell. Bob Buchan was a founder and co-founded Kinross Gold. After the sale, he created Allied Nevada in 2007 which has been exploiting the oxides of the Hycroft mine in Nevada. However the much larger sulphide deposit must be financed. Bob has stepped in to expedite the development and the company recently completed a $150 million financing at $10.75 per share. Allied plans a 75,000 tpd facility in 2015 growing to 130,000 tpd. The Company will spend $350 million towards an eventual price tag at $1.24 billion. We like the shares down here.
Barrick probably wishes that 2013 ends quickly. As soon as Peter Munk hinted that he was ready to step down, the skies opened. Today, after spending $3 billion plus in the Dominican Republic, the authorities have stopped gold shipments and ceded $1.5 billion to get a new deal. At Pascua Lama which could be the world's most expensive gold mine, the Chilean courts halted production and to add insult to injury, Barrick's own shareholders have told Peter Munk that he and his directors are paying themselves too much. Sure, there was a paradigm shift, but Barrick has not shifted enough. Barrick's $8.5 billion Pascua Lama project has already seen $4.8 billion spent which is supposed to produce 35 million ounces silver in the first five years of production. Of concern, is that should Barrick shelve Pascua Lama that would trigger an obligation to Silver Wheaton to repay $650 million to settle its obligation.
Barrick is in trouble. Replacing the South American head or tinkering will not help. Barrick has some 140 million ounces of gold in the ground, and even if you eliminate Pascua Lama's rich reserves, Barrick has more than 16 years of reserves. Indeed we believe a paradigm shift would see Barrick eliminating most of the $500 million allocated for exploration, stop Pascua Lama and instead harvest those ounces in the ground. With the combined savings from exploration and capex, they could raise their dividend to at least 40 percent of their earnings and show their beleaguered shareholders some money. Barrick has a portfolio of some 25 mines across five continents with 60 percent of its production from only five mines. Barrick would be better served by eliminating many of those high cost mines and concentrating on the five mines that produce the bulk of those revenues. We believe that such a simple maneuver would revive interest in the world leader in gold - that would be a paradigm shift.
Centerra remains in a dog fight with the Kyrgyzstan government who is pushing for a bigger stake. Centerra has seen this all before and the last fight gave the government a 33 percent interest. The government is pushing for majority control and we believe that Centerra which is the largest revenue producer in the Kyrgyzstan Republic, will unfortunately lose more in order to make peace with the government. As such at current levels, we believe that Centerra has downside from here.
Goldcorp is the second largest gold producer, surpassing Barrick in market cap. Goldcorp reported a disappointing quarter of $0.31 a share although stronger performances came from the huge open pit Penasquito project in Mexico and underground Red Lake Mine in northern Ontario. Of concern is that Argentine's Cerro Negro capital costs are up nearly 70 percent to $1.4 billion which will be delayed until early 2014. The cost of building mines have skyrocketed and Goldcorp has already seen an escalation in its pipeline. We note that however that Eleonore in Quebec cost have increased and Goldcorp will spend in total a whopping $2.8 billion this year. Goldcorp should instead show investors the money and raise its dividend, curtailing the mega projects.
Kinross Gold Corporation
Kinross took its long awaited $3.2 billion repairment charge at Tasiast and has developed a prefeasibility study which shows a disappointing 11 percent IRR. We believe that the Tasiast mine in Mauritania was a mining disaster but a good deal for Red Back shareholders. Kinross` revised mine plans are so iffy that we believe a new plan together with pushing higher output would not be worth the dollars to stretch Kinross's balance sheet further. Kinross has reduced its capex and Paul Rollinson has concentrated its efforts but the task remains tall. Kinross' South American operations like La Coipa,Maricunga in Chile and Paracutu in Brazil currently produces over a third of Kinross's production. However, growth remains elusive.
Newmont suspended $4.8 billion Minas Conga copper/gold project in Peru following violent local protests. While Peru was considered "mining friendly", the local opposition and environmentalist caused Newmont to shelve the project. Conga was a big investment and Newmont is harvesting its 51 percent owned Yanacocha, the biggest operation in Peru. We believe that it makes sense but Newmont's problem is that there is little on the horizon, having written down $1.6 billion at Hope Bay of Nunavut. What makes sense is for the former industry leader to combine with another entity that would not only add growth but serve to consolidate the industry.
|Company Name||Trading Symbol||*Exchange||Disclosure code|
|Barrick Gold Corp||ABX||T||1|
|Centerra Gold Inc||CG||T||1|
|Detour Gold Corp||DGC||T||1|
|Eldorado Gold Corp||ELD||T||1|