Gold: Sequester: Part Deux?
Although this is the first time in the Fed's 100 year history to use Quantitative Easing (QE), it is not the first time the Fed used the printing presses as fiscal policy. Money printing was attempted in the seventies, thirties and even during the Civil War (although the Fed was not in existence then) with inflationary consequences after each episode. Still, while the Fed's balance sheet has quadrupled, nothing has been done to address the underlying causes of the disease. America has not addressed a tax system that hobbles businesses. They've done little to address dysfunctional Washington. Little has been done to rein in entitlements. And even less was done to address government spending. Instead, policymakers pushed for more spending, and of course more taxes to pay for that spending. They've wasted trillions on Wall Street making its members too big to fail and yet most are holding a paltry percentage of less than 10 percent of their capital against total assets.
Despite the fact that they now have a debt to GDP ratio of over 100 percent, the solution de jour is more inflation, at least a little. But as the last inflation fighter, former Fed Chairman Paul Volcker once said, "All experience demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse." As with Mr. Volcker who was forced to raise interest rates to almost 20 percent to clean up the inflationary mess caused by excess money printing under his predecessor Arthur Burns, the next Chairman will be asked to clean up an even bigger mess.
For too long, the Fed's experimental policy has been a source of distortion of risk, capital flows, credit and currency values. The problem as Volcker warns is that it's very difficult to stop easy money, once started. The threat of Fed tapering has sparked divisions in the US Congress and even the selection of the next Fed Chairman is being fought openly with name calling rather than in the conclaves of the White House. Today's debts and deficits have accumulated as the Fed bought trillions of dollars of government bonds in order to keep interest rates low. The debt overhang plaguing the economy since the financial crisis has been a major drag on the economic revival. The Fed's balance sheet is topping $4 trillion of debt with over $2 trillion of government debt making it vulnerable to the inevitable interest rate swings. Unwinding this portfolio will be left for the next Fed chairman and neither Yellen nor Summers are a match for Paul Volcker. Both candidates are considered "insiders" when an "outsider" is needed to take the unpopular steps to clean up Bernanke's mess.
Then there is the continuation of the Eurozone's problems with their splintered banking system, rising debt loads and tendency to postpone needed reforms. Germany is balking at loosening the purse strings any further to bailout the debt-laden sovereigns like Greece again. The underlying problem is that central banks have printed trillions to buy time but problems remain and the crisis of 2007-2008 was only postponed. Overnight the twenty biggest emerging market currencies tumbled against the greenback on fears that the effects of the Fed's "tapering" plans will tighten credit and crimp growth. India's rupee slumped to an all-time low.
Finally, there is the looming third round of the debt ceiling debacle. In the first round, the Republicans demanded one dollar of spending cuts for every dollar of new borrowing. Obama refused and we ended with the so-called sequestration. During the second round of debt ceiling negotiations, the Democrats passed a budget but the Republicans balked and sequestration was invoked. Now the third round of the debt ceiling discussion looms this fall with the Republicans calling for a repeal of Mr. Obama's healthcare legislation. The federal debt limit must be raised, but this time it raises the threat again of a government shutdown or worse, default. Even after raiding the government's piggybank, the debt ceiling will be reached and the government faces a partial or complete shutdown if there is no agreement, sequestration: part deux? The US dollar has already lost 5 percent. Gold will be a good thing to have.
Conflicts of Interest
Quantitative easing and the trillions of dollars have benefited the financial players who leveraged their own operations into monsters of mass destruction. The revelations that the banks control everything from Libor interest rates to the London gold fix to commodity prices is not surprising but that regulators are only now focusing on them is a surprise. The holding companies of the banks used their excess capital to leverage the derivative products of their customers, the miners, oil producers and farmers who have discovered that the banks helped drive up their costs. Indeed those inventories were the basis for which the banks or financial players leveraged or used as collateral for the multitude of structured derivative products which have become the main profit centers for these financial players.
As a result, regulators are focusing on the banks and other financial players for their investments in commodities and related markets. The ownership of the commodity warehouses and also the infrastructure such as oil tankers and pipelines are being scrutinized in response to a barrage of criticism over the banks' activities. Not only are there obvious conflicts of interest but consumers are complaining about the lengthy delays to get their commodities from the warehouses. In fact, the gold mining industry has seen a dramatic drawdown in physical gold stored in vaults and Comex warehouses such that there are fears there is insufficient physical metal to back demand should a small percentage of those outstanding futures ask for immediate delivery.
Last year the 10 largest banks generated about $5 billion from commodity-backed derivatives. Banks today control most commodities, and also store, transport and trade materials. Goldman Sachs, JP Morgan, Chase, and Morgan Stanley held $35.2 billion in physical commodities at yearend according to Fed data. In 2003, regulators opened the door allowing the deposit-taking banks to trade physical commodities. Five years ago they were given a grace period that expires September 2014. The looming deadline and increased scrutiny comes at a time when regulators are considering bringing back the Depression era Glass-Steagall Act which split the banks into banking and commercial activities. The Act was scrapped in 1999 and the merger of the two led to big profits, an explosion of derivatives and a phenomenal increase in systemic risk. Regulators are concerned that the inherent conflicts and growing financial volatility could endanger the financial system - you think?
In our view, the scrutiny is coming at a time when the leverage of the bullion banks is being tested by the markets. Too many paper derivatives have been created and at long last, the derivative swamp is being drained. Only the problems remain. To be sure, counterparty risk which surfaced in the Lehman bankruptcy in 2008 has not been resolved by Dodd-Frank (the SEC still has not enacted major amendments). Some initiatives at Wall Street reform recently received a Presidential nudge but the major bills remain untouched, including the Volcker Rule.
But it is not only over commodities that the big US banks are facing problems. The Basel Committee has proposed boosting the capital behind the huge $7 trillion REPO market where financial institutions borrow against government bonds. JP Morgan alone has said that such a change would cost the banks at least $180 billion of additional regulatory capital. That the bank recently put their physical commodity business up for sale, signals a retreat after paying a whopping $400 million to settle a dispute with US power regulators over alleged market manipulation. The same regulators casted a wider net asking for records and emails of the big European banks raising a regulatory turf war with the EU. US regulators have been clamping down on everything from laundering to privacy laws on both sides of the ocean, and the Europeans have not sorted out who's in charge.
The common denominator however is the powerful US banks, the lynchpin of the global monetary system, have lobbied hard pushing the regulators to soften their stance. We believe the industry is poorly capitalized notwithstanding their protestations and leverage remains problematic. The industry to date has resisted shoring their balance sheets and since governments depend on them to finance their debt problems, lawmakers are stymied on how to put the genie back into the bottle. Gold will be a good thing to have.
The Piper Must Be Paid
Detroit's bankruptcy is symptomatic of America's fiscal prolificacy. While everyone focuses on Detroit's $20 billion debt and declining population, few recall that Detroit's problems was due simply because it was spending more than it was bringing in. Spending was fueled by giving its workers and paid pensioners big healthcare benefits and annual increases to buy labour peace but now the pensioners find themselves in the same position as Cyprus' bank depositors with only claims. Detroit is proposing to treat pensioners and bondholders alike which will be a test of America's bankruptcy laws. But in truth, Detroit's bankruptcy symbolizes America's problem today, in that they continue to believe that they could spend more than they earn and promise more than they can keep. And issues such as the "debt ceiling", "fiscal cliff" or "grand bargains" can just be set aside until the future. But, as Detroit has found, like Cyprus's depositors, the piper must eventually be paid. In Cyprus, the depositors bailed out the banks. However with pensioners' liabilities so large on both the federal and municipal level, are pensioners' savings and their obligations from the state to be used to bailout America's profligacy? They already do, the Federal Reserve has purchased 40 percent of government issuances.
Ironically Detroit's bankruptcy follows that of General Motors which recently emerged from Chapter 11. Of interest, is that derivatives played a major role in the demise of Detroit. The amounts involved are hundreds of millions of dollars or maybe billions. For example at the end June, Ernst & Young calculated that the value of Detroit's derivatives was a negative $300 million. By the time the city pays off the $1.4 billion of borrowings, the total bill from 2013 and onwards, will have been more than $2.7 billion, almost double the original debt of which $770 million are derivatives. (Detroit took this step in order to avoid $502 million in interest payments). The question arises however, who owns the derivatives. Dexia Group, the big Franco-Belgium bank recently took a $59 million euro charge to cover potential losses on $305 million of Detroit's debt. Now that Detroit has gone bankrupt there is a little left but those big unfunded liabilities. In fact the fight over Detroit is likely to be a prelude to the unfunded liabilities showdown over the social security liabilities of the Federal government. Like the Cyprus bail-in, innocent parties are being dragged down by the fiscal ineptness that has allowed this financial crisis to grow.
In the wake of a slowing economy and Beijing's crackdown on corruption, China's central bank (PBOC). briefly sent interest rates surging to 30 percent in order to exert more control over the economy and the shadow banking system. Until now local government financing entities were given free rein to finance growth but now those debts are coming home to roost. China's National Office conducted research on 15 provincial capitals incorporating 36 municipalities found that 14 cities were found to have debt ratios higher than 100 percent. To be sure China's gross debt is somewhat higher than the estimated 22 percent of GDP but no one knows.
The PBOC move caused the Shanghai Stock Index to lose 15 percent in a month which was a warning shot to wrest more control over the shadow banking world comprising of local government entities, guarantee companies and trust entities. The shadow banking world complemented the financing of the banking system but was left largely unregulated, financing many dubious projects raising the risk of contagion. The PBOC liberalised interest rates and removed the floor on bank rates which allocated credit more freely as they got more control over the shadow banking system. In addition the PBOC was concerned over the explosion in lending which went to prop up property projects and other local government pet projects outside the influence of the central bank's purview and thus regulation. In taking control, the PBOC is ensuring no bank will go under and that the state supported system is as good as gold, something the Americans can't claim. Beijing in contrast is making the hard decisions, confident in their growth outlook. Gold will be a good thing to have.
Recommendations- Gold Moving From UK to Switzerland to China
Large-scale selling triggered an 18 percent slide in gold since yearend, falling to a three year low of $1,180 an ounce in June. The collapse triggered a huge increase in demand from Asia, particularly China with a surge in physical bullion buying offsetting the outflows of the metal from the popular exchange-traded funds (ETFs). Comex records show that in the last month, buyers are paying premiums for physical metal because of low physical inventories. The metal three months out is trading at a discount. Gold was last in backwardation in 1999 and 2008 which marked market bottoms. Gold has risen almost $200 per ounce from the lows and is still in "backwardation".
We believe the rush for physical gold is the beginning of gold's second leg to record highs. Amazingly despite gold's collapse in the second quarter, there were not tonnes and tonnes of gold offered to the market. Instead, gold supplies actually fell by almost 6 percent according to the World Gold Council. And despite glaring commercials for "cash for gold", the amount of gold from recycling fell to its lowest levels since 2007. Meanwhile demand for physical gold exploded - the making for a significant bottom. The UK's gold exports surged nearly tenfold to Swiss refineries at almost 800 tonnes in the first half. London is the center of the physical gold market with some 10,000 tonnes held in the City's vault. The UK is not a gold producer, so most of that gold came from the ETFs. Where did that gold go? Swiss refineries melted those bars into smaller products preferred by Asia. In fact, despite being the world's largest producer of gold, China will overtake India as the world's biggest gold consumer buying more than 1,000 tonnes this year alone which compares to China's central bank gold holdings of only 1,000 tonnes.
In the nineties, the big banks were behind a hedging scheme that cost the gold industry billions to unwind. Then the banks borrowed gold from the central banks and sold that gold on behalf of the gold industry as part of the banks' ill-fated hedging programmes. We believe the powerful banks were swamping the bids at the time. The gold ETFs sold 400 tonnes in the second quarter, more than double South Africa's production, which ironically was bought by the Chinese, Russians and South Koreans. The bullion banks drew down their inventories to replace the growing physical bullion demand causing one of the banks to declare force majeure.
Gold has since rallied on this short squeeze and strong demand from Asia as well as a weaker dollar fueled the current rally, setting the stage we believe for new highs this year. The ingredients that pushed gold to $1,900 in ounce are still in place.
The cost of building new gold projects has escalated into the billions, hitting a cost wall. And now the world's biggest producer has run into trouble, sinking $5 billion into Pascua Lama when there is no certainty that it could be finished by the end of the decade, because of cost setbacks, and a price tag approaching $10 billion. In addition most gold producers spent billions in takeovers with expectations that the price of gold would go higher and higher. But billions of dollars were wasted chasing after growth, instead of profitability and only the investment bankers were happy. No wonder then that gold stocks' values were cut in half.
Today, gold costs more than $1,200 an ounce to extract. Older producers like Barrick and Newmont have the good fortune to harvest "old" ounces but the cost of "new" ounces after billion dollar takeovers or expenditures will ensure a floor of $1,200 an ounce. Until this year, growth or the illusion of growth kept stock prices high but investors have been disillusioned over some $20 billion of writedowns. The industry's mea cupa comes too late. Peak gold has arrived, supply flattened last year and will fall this year. We believe demand, not supply will increase. The industry is spending more and more money to produce the same ounce of gold, which was fine when the gold price went up. But that has changed. That means producers are digging deeper and geology is forcing them to frontiers or emerging areas which have become hostile and revenue hungry. We continue to prefer the mid cap producers like Agnico-Eagle and Eldorado. We would avoid higher cost producers such as IAMGold. Barrick is even a trade down here. We would also look at the beaten-up juniors down here.
As expected, Barrick the world's largest gold producer wrote down $8.3 billion due largely to Pasqua Lama. Barrick to date has taken almost $13 billion in writedowns and its net tangible worth has been halved from $12.3 billion to $6.3 billion giving it little room under the minimum $3 billion debt covenant under its $4 billion loan facility. Barrick currently has $14 billion in debt but recently extended some of that debt repayment to 2015. With $2 billion of cash and the facility, Barrick has financing options. Barrick also has other options with respect to its mines with 60 per cent of its production from five mines. Barrick has finally addressed some of those higher cost mines and could sell or close some dozen of its mines, thereby improving results. African Barrick itself took a $700 million impairment charge. African Barrick, of which Barrick owns 74 percent, is currently producing gold at a $200 loss for each ounce produced. Barrick tried to sell African Barrick earlier but harsher medicine is likely needed. Barrick recently divested its energy division which was supposed to be a hedge against higher energy costs but instead resulted in a $500 million loss in the quarter. We believe Barrick will not disappear and the Company's 127 million ounces of reserve in the ground are its biggest asset. Barrick is a trade down here.
Eldorado Gold Corporation
Eldorado had a relatively good quarter and despite five development projects was one of the first to pare capital spending and push to reduce costs. Production increased from its five mines slightly to 177,300 ounces with cash costs under $500 an ounce. Guidance was intact at 745,000 ounces up from 2012. Eldorado has a strong balance sheet. Eldorado, a midsized producer remains a buy here with production from Turkey, Greece and China.
Goldcorp reported a loss of almost $2 billion in the second quarter, taking big writedowns for cornerstone Penasquito mine in Mexico. This time the problems at Penasquito were water and the mine still has not operated at design capacity. We think there is still more bad news ahead. The writedowns are not surprising and Penasquito has become Goldcorp's Pascau Lama. Operating earnings also fell below expectations due in part to lower production at its flagship Red Lake Mine in northwestern Ontario. Despite a contribution from newly opened Pueblo Viejo, all in costs for the quarter increased to almost $1300. Goldcorp will defer spending at Cerro Negro in Argentina, Eleonore and Cochenour. Goldcorp is too expensive here and like Barrick is in need of a consolidation of its mines. Red Lake remains the crown jewel but Penasquito still has more shoes to fall. We remain concerned about Goldcorp's capital intensive growth profile.
New Gold Inc.
New Gold is an intermediate producer that went against the trend, acquiring Rainy River Resources in northwestern in Ontario for $370 million. Rainy River is an advanced development prospects and will offset declining output from Cerro San Pedro in Mexico and Mesquite in United States. New Afton in Canada is New Gold's main asset and is operating at designed capacity. Peak Mines in Australia has surprised and remains a main contributor. New Gold's balance sheet is decent and management is experienced. New Gold produced 102,000 ounces in the second quarter and all in costs are below $1,000 per ounce. New Gold will produce 450,000 ounces this year and Rainy River could add 255,000 long life ounces.
Newmont Mining Corporation
Newmont took $1.5 billion of writedowns on its Australian assets. Production at Boddington declined five percent because of lower mill output but costs increased 38 percent with an all-in cost at $1,500 in the quarter. Yanacocha's output in Peru dropped 25 percent. Newmont the world's second largest gold producer missed its earnings estimate reporting an operating loss of $0.10 a share compared to $0.56 a year earlier. Still Newmont will spend $2 billion this year. Newmont's 44 percent owned La Herradura in Mexico output fell in the quarter due to lower leach recovery. And the ongoing disposal of seven percent stake in its Indonesian subsidiary is still embroiled in local politics. The government has been eager to buy a 7 percent stake in Newmont's Batu Hijou mine worth some $250 million but neither the local nor central government has come up with the money. We prefer Barrick here.
Yamana Gold Inc.
Yamana reported disappointing results and although producing 250,000 ounces of gold, the company reported an operating loss of $7.9 million. Yamana pointed to the losses at 12.5 percent owned Alumbera in Argentina, but it appears that Yamana's Brazilian mines like Chapada and Jacobina reported dismal results with increasing costs. Yamana has significant by-product and is sensitive to copper. In the quarter, copper cash costs increased to $1.76 from $1.34 a pound. Flagship El Penon however boosted output 16 percent. Yamana halved its exploration expenses and lowered its guidance to 1.3 million ounces for the year. Yamana has cash of about $380 million, yet recent results show that Yamana will be eating into that cash. We prefer Eldorado here.
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