Gold: Neither a Borrower nor a Lender Be
The global financial system is highly levered, with no margin for safety. A leaking sound can be heard. So much for record highs and hopes of prosperity. All bubbles require the availability of cheap credit, but after three rounds of quantitative easing (creating money to buy assets), the beginning of the end of cheap credit has finally begun. Real interest rates are creeping up, currencies are collapsing, $3 trillion of stock prices have been erased, and emerging markets are the first casualty. This exit was never promised to be pain-free.
The problem is that central banks waited too long to end the monetary expansion and return to normalization. Manipulating interest rates by central banks is akin to turning supertankers around in a bad storm - it can only be done slowly. Markets, addicted to cheap money, have been hit with a classic one-two punch.
The Fed has Become Part of the Problem
First, the mistakes that caused the collapse of 2008 and the Great Recession are being repeated again in the form of much more leverage and contagion. We have seen this movie before. In the past, the Fed's easy money created the tech bubble in the nineties, the housing bubble and Greenspan's "irrational exuberant" market. This time, the sequel has rounds and rounds of monetary stimulus causing a debt-fueled stock market boom but little was said of the significant risks. Financial moral hazard was abandoned again as investors believe the Fed will always bail them out by using monetary policy to lift stock prices to shield them from losses. Margin debtrose to all-time highs in search for yield at the expense of quality. However, this time instead of a Lehman or subprime meltdown, we expect debt default fears and concern over the sovereign credit of the most powerful economy in the world. Our logic is that America's repeated rounds of quantitative easing have quintupled the size of the central bank's balance sheet that caused the stock market boom but will end in one of history's biggest financial bust. The world's largest balance sheet has grown from $850 billion to over $4.1 trillion exacerbated by a debt load that has grown from $10 trillion to over $17 trillion. In only five years, Mr. Obama has racked up as much new debt as all the presidents combined in America's 227 years, and his second term is not even over. Even with tapering Mr. Obama will spend $1 billion every year.
Until recently, the US dollar remained relatively strong. However, America's loose monetary policy created an excess of dollars and the dollar has recently lost value. The dollar was supposed to be risk-free but the Fed's unorthodox stimulus policies caused a global fallout, particularly among the emerging markets which depended upon the Fed's largesse to keep interest rates low in order to finance their outsized deficits. The recent uptick in rates has caused a surge in borrowing costs and a looming painful readjustment period, raises the risk of a much feared currency war. A move up against the dollar will hurt a country's exports and a move down will stoke inflation. Ghana just increased its rates two percent to 18 percent. Ukraine's 10 years are 32 percent. The depreciation of Argentina's peso is just beginning. Funds doing "carry trades", borrowing in cheap dollars and buying riskier currencies are reversing the trades, creating big distortions.
The global ramifications of America's fiscal follies threatens then to drag down weaker nations like Argentina as well as stronger ones like China. Fundamentally, the US has become less and less a factor in trade. Exports for example make up less than 10 percent of GDP, while imports make up only 5 percent of world GDP. What the US produces in great amount is money. That is the problem. And what of the consequences of all those dollars that have been printed? With the printing of fewer dollars, it removes a major prop under the value of that dollar. We believe that this uncertainty will weigh heavily on the greenback, particularly since America's financial situation is deteriorating further. Debt on debt is not good. The holder of this debt and America's creditors should beware.
Stealth Inflation is Alive
At the same time, the decline in inflation coincided with the biggest bond boom in history, spawning financial bubbles and even soaring asset prices. Balance sheets became further stretched with investors eschewing risk hedges like gold, convinced that all is well and inflation will remain benign. But that does not seem likely. There is every reason to believe this Keynesian medicine of deficit spending is akin to the casino's mantra that if you bet enough money enough times, you will eventually win. As before, the Fed appears to have lost control over demand. In fact, the second sandbagging punch is inflation, which is a double whammy because the real cost of servicing of debt actually goes down. While the normal value of debt doesn't change, the actual relative amount declines with debtors winning and creditors losing. Rising prices reduces the buying power of fixed interest payments. Inflation is alive, but it is stealth inflation. Third Way, a centrist think-tank suggests that so called big ticket items such as house prices quadrupled between 1977 and 2012. However, during the same period, a "stealth inflation" in personal health care expenditures and college tuition fees rose tenfold hollowing out a beleaguered middle class. Of course taxes too have skyrocketed.
Then there is the jump in farmland which increased 12 percent this year. Wine, classic cars and West Texas oil is up four percent from last year, the highest since 2008. Inflation was exported to emerging markets, such as China and that hot money has become globalized, returning to the West in higher inflation. Paradoxically western governments have been friendly to inflation and their policy responses always too late. The obvious solution is to abandon their profligacy and bring back sound monetary policies but unfortunately that does not appear to be in the cards. Gold is a good thing to have.
Big Government, Big Problems
Markets too have become overly politicized in part because of the need to finance the government's insatiable appetite for debt. Too often, policy interventions have become commonplace. The much delayed Volcker Rule, for example, restricted the behavior of the financial sector but it did much more, it also gave more powers to the central government. The capital markets conveniently became everybody's favourite villain, vilified by everyone from the Pope, to hizzoner of New York led of course by the Obama Administration. Ironically Wikileaks and Mr. Snowdon unearthed the magnitude of the government's involvement, including the day to day involvement in our markets. Since then, benchmarks such as LIBOR rates, the London gold fix and currencies all face regulatory scrutiny because of manipulation and the big banks have been hit with multi-billion big settlements. These benchmarks are the basis for the trillion dollar derivative markets, where Wall Street and others reaped big profits.
Free markets have been demonized and the rationale for the need to control these markets is seen as the cure. US authorities have even requested information on the hiring practices of the big US banks and multi-nationals over whether they have employed certain Chinese for their connections in another subtle slight at China. Yet this much practiced form of cronyism is ironically part of the DNA of the American political scene. We only have to look at the dynastic Rockfellers or Kennedys or the Bushes or even the Clintons to see how family influence can help in high places. Congress itself has joined the White House and big government is seen as the panacea against big business and big labour. Capitalism is actually under fire from within.
Europe, The Weak Link
We believe, the long awaited upturn in the business cycle has caused a conflict between the government and private sector as both must compete for capital, particularly in Europe. The European Central Bank has not sorted out its problems and there is another delay over its long awaited banking union. Solutions are just kicked down the road despite running on razor thin capital cushions. The massive government spending spree left a huge hangover of record debt levels leaving other central banks vulnerable to an uptick in interest rates which could pose catastrophic losses on creditors making them even more reluctant to finance sovereign debt. Of course structural reforms could have eased those problem as would the restructuring of this mammoth debt, but both are an anathema to countries reluctant to go down the path of austerity.
Europe remains the weak link in the chain. Mario Draghi's famous pledge to do "whatever it takes" to save the euro, bought time but policymakers wasted that time avoiding necessary decisions, postponing the inevitable. That pledge has yet to be tested. France and Italy frittered away the time and an extortion-type "Robin Hood" tax policy has become the policy du jour. In the interim gold will be a good thing to have.
America's Fiscal Follies Has Weakened the Greenback
The US dollar has a monopoly as the world's currency but the uncertainty created by the Fed's withdrawal has caused a massive exodus, spilling over into the rest of the world. To be sure many emerging countries question whether the volatility of the dollar is a good bet any more. The thirst for dollars seems to be ebbing among America's trading partners. Some of them are weaning themselves already. Russia, Brazil and South Korea have deepened their local markets as an optional funding tool.
Many emerging countries remember the 1997 Asian financial crisis when their dependence on the dollar caused so much damage that some nations never fully recovered. To be sure, taken together the fallout from the endless rounds of monetary stimulus, Washington's dysfunction and rising debt has prompted many to reassess their reliance on US economic policy and the dollar based international monetary system. China's desire to loosen the dollar's dominance is also because of another threat. Money is power. In the past, America has instituted a financial blockade of Iran and isolated other nations. For that reason, America's exorbitant privilege is ending. Underlying all this is that the average percentage of dollars in reserves peaked at almost eighty percent in the early nineties but has fallen to less than sixty percent of reserves today. Countries no longer are satisfied to have the global currency subject to American politics and a government reluctant to make good choices.
China has some $3.7 trillion of foreign exchange reserves of which $1.27 trillion is in treasury debt. If they sell only a small amount of treasuries, US bonds yields would soar, rattle the market and hurt their own massive holdings. We believe the biggest risk then is that the Fed's unwinding will have an unknown impact on our financial markets - another Black Swan event. To be sure, a weaker dollar would spell calamity and gold as a store of value would be a good thing to have.
China, Today and Tomorrow
While, the Chinese renminbi isn't soon to replace the dollar, other currencies and gold are being used as substitutes. China is now the world's largest trader and the renminbi is increasingly being used for trade. Beijing has loosened capital controls, promoting the international use of the renminbi. China's banks are big, setting up international bases and opening its capital markets. China has also liberalised its government bond markets giving a bigger share to consumers. Much is made of China's debt levels which represents more than 100 percent of GDP. Local government debt levels in China have risen to almost $3 trillion in less than three years, however, unlike the United States, the Chinese debt is owed to themselves. In comparison, about half of America's debt is held by foreigners, with the bulk owed to China and Japan. China's voracious appetite for raw materials and much of their debt can always be financed internally.
What's more the West is more dependent upon financially strapped households and states and rather than address its towering debt, the government prints more money as the solution. This time, Beijing is pursuing a new reform agenda, in part to extinguish its bubbles, something that the Americans have yet to learn. It seems easy to criticize China's mounting debt load but the US should solve its own debt problems before criticizing others.
Neither a Borrower nor a Lender Be
The end is also in sight for fiat gold or paper gold. Derivatives have become a big part of our lives and like chips at a casino, become tools of the capital markets. These "weapons of mass destruction" almost took down the financial system when the edifice of Wall Street's biggest firms imploded and were found to be worthless. The same thing is happening in the gold market where high frequency trading (HFT), algorithms and spoofing have become commonplace. Comex gold contracts which can be printed in unlimited quantities have at least a half dozen times last year, contributed to the drop in gold. Comex is a commodities futures exchange for the buying and selling of future contracts used by everyone from Exchange Traded Funds (ETFs) to the big Wall Street banks but is just another casino for speculators to trade paper futures electronicly as proxies for gold. These products are sold with the promise that all are fungible gold. Wrong. Speculators have amassed huge short positions and these highly leveraged bets must eventually be unwound or covered.
In fact, the synchronised dumping of some 800 tonnes of futures last year created a rush for physical gold such that Asian demand has taken virtually all of the western world's output as well as from the gold Exchange Traded Funds (ETFs). Physical gold in Asia is selling at a premium as well as huge premiums for kilo bars on the Shanghai Gold Exchange. Asian and Middle East demand have dominated the physical delivery markets. Gold jewellery demand alone increased more than a third in the first nine months of last year. Chinese demand is estimated at some 1,200 tonnes of gold, overtaking India as the world's biggest consumer of gold. Gold has shifted from the West to the East. The Commodity Futures Trading Commission (CFTC) releases data every week and Comex deliverable ounces have collapsed from something like 7 million ounces to less than 500,000 ounces. While the shenanigans on Comex have kept deliveries low, something like 30 percent of the gold contracts has been delivered on the Shanghai Gold Exchange raising the spectre of a potential short squeeze akin to the classic "run on the bank". China is also the largest producer of gold, producing some 440 tonnes last year. That production is expected to be added to the People's Bank of China (PBOC) reserves at 1,054 tonnes, last recorded in 2009.
Geopolitical Influences Boost Gold
Meanwhile, central bank demand has also skyrocketed. Germany's Bundesbank for example, requested the repatriation of only 300 tonnes from their 1,500 tonne reserve held by the Americans dating back to reparations. However, only 37 tonnes was returned and the Germans were told that it will take the NY Fed something like seven years to repatriate the balance, which raisies questions whether their gold has actually gone missing or, is it a default?. Venezuela was more fortunate repatriating 160 tonnes of gold lately. Since 2007, Russia has tripled its gold reserves. There is a shortage of gold, physical gold.
The short squeeze will also come a time when the building blocks for the resumption of gold's bull market are falling into place. From a political point of view, the much celebrated Arab Spring removed dictators but instead spawned a new crop of dictators with the possible exception of Tunisia. Without the old-time dictators, the Middle East has deteriorated into clashing sects and tribes. This time, oil is being used to fund the different sectarian groups who have become proxies for the major powers. The geo-political balance has tilted to North America with shale gas and technology lowering gas prices but Europe is still plagued by high gas and electricity prices. Middle East politics are set to change. We believe that the geopolitical conflict over energy will renew tensions and gold will be a good to have.
Gold is a Beneficiary of Tapering
Gold prices perhaps more than other asset depends on market sentiment. In fact, it is a barometer of investor anxiety and often likened to the canary in the gold mine. Demand is only one of many factors affecting the gold price as does the rate of inflation. The World Gold Council reported that total world-wide sales of gold jewelry were up 20 percent in 2013. We believe the biggest factor driving gold prices is the behavior of investors. Gold had a twelve year bull run because central banks pursued an accommodative monetary stance fueled in part by two unfunded wars, Wall Street's bailout and three rounds of quantitative easing. We believe the key driver is that gold is an alternative investment to the dollar for many central banks. Since tapering began, gold has been the best performing asset. Gold has bottomed, technically bouncing off the $1,180 lows three times and has now broken out of its trading range. We expect gold to reach $2,000 per ounce this year resuming its twelve year bull run. Still if the doomsayers are right and, problems do arise such as another Cyprus and Greece, which resulted in the seizure of depositors' assets, gold will ratchet up, not down, as the spike in demand for physical gold will squeeze the paper players further.
Simply, the global financial system is stuffed with dollars , in part due to the rapid money supply growth of 10 percent plus per annum in recent years. The Fed remains the world's largest holder of gold, yet supplies are not growing annually. If gold is a finite currency, its value then against not just the dollar, but other fiat currencies, must rise. And, zero interest rates means the yield on gold matters even less. It may not be an inflation hedge today, but the debasement of currencies, economic stagnation, tapering and record debt levels make gold a better store of value today.
Recommendation: Peak Gold
The gold mining industry is in a funk, after recording more than $100 billion of writedowns. Moreover, gold grades have slipped, falling from 4.6 g/t in 1998 to 1.1g/t. As a result no longer is the industry prepared to pay $1,000 an ounce and instead are focused on profitability. Exploration budgets have been pared back and capital spending has been shelved at a time when a $1,200 gold price approximates the breakeven price for many producers.
The dilemma for the gold mining industry is that the low hanging fruit has been plucked. In recent times, the economics of gold deposits have been constrained by size, grade and lack of capital. Of the fifty or so undeveloped deposits, only seven are in excess 5 g/t or 0.145 opt.
With so few undeveloped deposits on the horizon, we believe that the best ounces are in the gold miners' backyard so we would focus on those producers with ounces in the ground which today are valued at less than $200 market cap per ounce of in-situ reserves. Of note that a review of 100 gold companies' projects with PEAs or PFS stage, with capex and opex of $1,000 an ounce, only 20 possess double digit IRRs.
Thus falling gold prices, squeezed reserves and uneconomic projects are fueling investor demands for profitability and we believe a "harvest" approach would be better off. We also believe there is a need for more consolidation in the mining industry to better reduce costs and shutdown uneconomic projects. Balance sheets will be important. As for the industry, the seeds for its revival has been planted. Less gold is expected to come into the market. We estimate the industry has some 22,000 tonnes of in-situ reserves which is the largest unallocated resource in the world, however those reserves will cost more than $1,000 an ounce to extract.
This Bull Market Has Just Begun
Importantly, the price of gold has fallen to levels that approximate the all-in cost of most of the gold miners. As such, we believe mining stocks reached bottom at the end of last year, just when the bandwagon emptied. Year to date, gold has jumped more than ten percent and gold stocks have increased almost thirty percent. While there are expectations that this is just a dead cat bounce, investors forget that the gold mines not only changed CEOs but also boosted profitability by closing down marginal operations and in some cases, mining higher grades. The gold mining industry has undergone massive change - it is profitable. To be sure, the junior miners were more badly hurt and more than 50 percent of the companies on the TSX Venture have empty treasuries. Importantly, those deposits won't disappear but the companies might. We believe that the mining industry will continue to consolidate because of the growing shortage of reserves. Ironically gold production increased four percent last year, due in part to the billions spent during the hey days. This time with fewer deposits found and fewer being financed, less gold will come to the market. However, the most common question that we've been asked, is what will turn mining stocks around?
We believe that has happened already, and indications are that the huge private equity players are kicking the tires of many of the cast-offs of the senior producers. We believe these private equity funds will even resort to privatizing some of these players because reserves are very cheap, a prerequisite for some of these vulture players. In addition some of the big commodity trading houses have also coveted some of the producers, so we expect that both sets of funds together with sovereign entities will beat many of the institutions at their own game. Gold stocks are too cheap.
The majors all have problems as a legacy of the heyday. Barrick has suspended Pascua Lama, which is a good thing. Cerro Casales and Donlin Creek are on the shelf and won't go away until higher metal prices. Goldcorp is bringing on Eleonore and building out Cochenour which will be part of the Red Lake complex. El Morro in Chile is a non-starter at current prices. Kinross has wound down Tasiast in Mauritania, but even at much reduced pace, Tasiast is a money loser at current prices. Newmont's Akyem construction is well advanced and should be a contributor, but big Conga is a nonstarter. Newmont's Indonesian assets are also a question mark and closer to home, Phoenix is a nonstarter.
We like the senior producers like Barrick because of the belief that the world's largest producer has turned the corner and is in the midst of successfully checking off many of the ticked boxes that caused Barrick to lose some fifty percent of its value. Among the intermediates, we continue to recommend Agnico Eagle who are masters at execution, Eldorado for its broad diversified base and B2 Gold for its growth profile (newly covered). Among the juniors, we like McEwen Mining, St. Andrew Goldfields, and believe that Osisko is a trade in wake of the Goldcorp take-under.
The silver producers have also been badly beaten up and silver has dropped below the industry's cost of production. Unlike the gold market, ETFs sales are not a problem for silver. We like silver's prospects and continue to recommend Excellon, because it is the highest grade silver producer in Mexico, has a great balance sheet and growing production profile.
Agnico Eagle Mines
Agnico's last quarter results were better than consensus. Agnico also reduced its dividend but kept its 31 year dividend record intact. Sean Boyd has reduced both capital spending and operating costs and the company has benefited from execution and fewer problems at Meadowbank which will be a major contributor. La Ronde, La India, Kittila, Goldex and Pinos Altos are the main drivers of the company. Agnico has been aggressively boosting output and a skunkworks of juniors does not stretch its balance sheet but gives Agnico a low cost window on future discoveries. Agnico is a buy here.
Allied Nevada Gold Corp.
Allied reported a solid fourth quarter. Randy Buffington, the new president and CEO has initiated a milling and oxidation study (AAO process) and a game plan to process Allied's massive Hycroft sulphides at a reasonable price tag. The new Merrill-Crowe plant was started in October, boosting output. Allied reported gold output of 190,000 ounces and about 2 million ounces of silver. We like Allied down here and believe the AAO process has merit. This year, Allied should produce 240,000 ounces and 2 million ounces of silver at an adjusted cost of $850 per ounce.
Barrick Gold Corp.
Barrick cleaned house taking another big writedown in the quarter and pared about one million money losing ounces from production. Barrick has gradually checked off all the boxes, restoring balance sheet with the $3 billion offering and in suspending the huge Pascau Lama high in the Andes also gives it financial flexibility. Changes at the board level responded to governance concerns and with Peter Munk retiring in April, we expect further board changes. Barrick has taken $11.5 billion in impairment charges as part of its cleaning house moves. The new broom also swept the sale of six high cost mines and the focus on profitability is constructive. The world's largest gold producer`s costs are now among the lowest cost quartile. Barrick has a long reserve life, improved quality assets and a renewed focus led by soon-to-be Chair, John Thornton. Barrick has turned the corner and is a buy here.
Centerra Gold Inc.
Centerra announced proven and probable gold reserves at 10.2 million ounces down slightly down from 11.1 million ounces last year. Given its ongoing dispute with the government, the decline was not a surprise. The yearend reserves were calculated at $1,300 per ounce. Centerra's flagship Kumtor Mine is in the Republic of Kyrgyz, and reserves declined because the company remains locked in a battle with the government over the ultimate government's ownership stake. We believe that this will be resolved soon. Meantime, Centerra has an excellent balance sheet and the stock is cheap at this level. Centerra has a great balance sheet with $425 million of cash and is in need of an acquisition.
Detour Gold Corporation
Detour updated its mine plan at 100 percent Detour Lake gold project doubling production from last year and reported life of mine (LOM) average annual gold production of 660,000 ounces and a dramatic lowering of total cash cost to $723 an ounce. Importantly, Detour's mine life is almost 22 years and proven and probable reserves stands at 15.5 million ounces. Sustaining capital over the life of the mine is estimated at $1.1 billion which is easily manageable. The company also intends to increase name plate capacity at 55,000 tonnes per day shortly and the process plant could be increased to 61,000 tonnes per day over a four year period. We believe that the new mine plan and new president, Paul Martin is welcome news and with the mine reaching commercial production, we expect that Detour would be an excellent tidbit for one of the majors. Detour is planning a small exploration program since only 17 percent of its lands have been explored. Buy.
Eldorado Gold Corp.
Eldorado continues to do well with development continues at Skouries, in Greece. Skouries will produce in 2016, with a capital cost of $200 million and so far $41 million has been spent. Although Eldorado is the largest foreign producer in China, the country took a $800 million impairment change for China and the company is still waiting for its final permit for Eastern Dragon. Eldorado Gold's production last year was about 720,000 ounces which was an increase over the year before. Gold output will grow at an additional six percent this year and all-in costs are expected to be between $915 to $985. Little is said of Stratoni in Greece which will process grades of 215,000 tonnes of ore with a modest capital cost. At Olympias, Eldorado is processing tailings as part of the cleanup. Eldorado has a growing production profile and a management good at execution. Buy.
Iamgold with six mines continues to disappoint and its development projects are too expensive such as Côté Lake project in Ontario. The company took a $772 million impairment charge due to lower gold prices. Iamgold's production will decline by 20 percent with margins squeezed by Iamgold's low grade mines. Iamgold's acquisition track record is also dubious. Worse, the company recently expanded its stake in Columbia by signing an exploration agreement with Solista Gold. Spending on grassroots might be exemplary but shareholders will have to be patient again. Gold won't be produced from that area sometime - just like Côté Lake which is a non-starter. Meantime, all-in costs keep creeping up despite management's promises to lower costs below $1,200 an ounce (the upper tier of producers). Iamgold's Essakane Mine in Burkina Faso is the only bright light here. The shares are a sell.
New Gold Inc.
New Gold had a good quarter, producing 106,000 ounces and 24 million lbs of copper largely from New Afton in Canada. Mesquite, an open pit operation in California produced 150,000 low cost ounces. Reserves stand at 18.5 million ounces of gold and cash at $414 million. Guidance will increase with lower costs as New Afton is expected to average throughput at 12,500 tonnes per day this year. New Afton's ramp-up was relatively problem free and mill expansion is key particularly from the promising E zone. Rainy River's feasibility study at some 50 km northwest of Fort Francis in northwestern Ontario calls for gold production of 325,000 ounces with an all-in cost of $736 per ounce. The mill head grade is low at 1.44 g/t of gold but the eye opener is the development capital cost will approach of $885 million and production is not slated until 2017. This megaproject while well robust is too iffy at that grade at current prices. Nonetheless, we like New Gold with a solid balance sheet, growing output and solid pipeline of projects.
Osisko Mining Corp.
Osisko received a hostile $2.7 billion take-under bid from Goldcorp. Osisko claims that Goldcorp violated a confidentiality agreement which will be argued in the courts. We believe that Goldcorp's bid is miserly and doesn't give credit for the 10 million plus ounces of resources outside Canadian Malartic. Last year Osisko produced 475,000 ounce at Canadian Malartic at a cash cost of $760 per ounce. Goldcorp will likely raise its offer or its bid may attract other players. We like Osisko as a trade believing Goldcorp will either sweeten terms or a white knight emerges.
Yamana reported a shortfall producing only 1.2 million ounces last year at an all in cost of $950 per gold equivalent ounces and a $672 million impairment charge. Newly opened Pilar experienced problems and flagship El Penon produced less ounces. Yamana produces copper as a by-product and reports on a gold-equivalent basis. Yamana has pared its capital to $150 million this year. Other than El Penon, we believe Yamana's assets are of mediorcre quality and there are better situations elsewhere.
|Company Name||Trading Symbol||*Exchange||Disclosure code||Rating|
|St. Andrews Goldfield||SAS||T||n/a||n/a|