Gold: The Sole Levee Against The Floodwaters of Financial Disaster
Gold pulled back last month but held above the critical support level at $430 an ounce. We are now getting a rally triggered in part by Hurricane Katrina and Koizumi's election victory. The real question is whether or not this is the end of the decline or the beginning of the resumption of the bull market that will see gold surpassing the last peak at $850 an ounce.
We believe that gold will rise over $500 an ounce this year as investors dump US assets in response to a falling dollar, economic woes following the clean-up of Katrina and America's growing indebtedness. The once powerful locomotive has become the little train that can't. Gold has surged 43 percent over the past three years while the greenback has lost over 50 percent during the same period. America's problems and vulnerability will boost gold's appeal as a haven in uncertain times.
And like oil, gold supplies are tight. Gold production in South Africa, the world's largest producer, is expected to decline again this year due to increasing production costs and a strong rand. South African output fell 12 percent in July and this year will fall to 300 tons down from 342.7 tons, the lowest in 74 years. Meanwhile, the World Gold Council reported global demand in the second quarter for gold jewellery totalling 949 tones, up 14 percent form a year ago particularly from India. Demand from China increased 12 percent. Gold's fundamentals can't get any better.
New Orleans is sinking
America's worst natural disaster exposed its vulnerability. There were not enough helicopter, soldiers or National Guardsmen to save New Orleans from becoming Atlantis. Why? The generals were right - America's resources are tied up in Iraq.
Just as a benign event as the "missing anchovies" off the coast of Peru, heralded the great inflation of the 70s, so will Katrina usher a sea change in the financial landscape. When the Peruvian anchovies went missing, the Japanese became big buyers of soybeans touching off a chain reaction that saw a big increase in agricultural prices, which led to the double-digit inflation surge. Inflation never showed up at once. It was first seen in the runup in gold, the anchovies went missing, commodities moved up, then oil quadrupled. Gold surged to a record peak at $850 an ounce. Today, gold prices have resumed their three-year climb. The CRB future index is at another record high. Oil has tripled in price. Every commodity has a tight supply/demand bias. Oh yes, it is the peak harvest season and farmers must ship their crops down the Mississippi...but how and when? Katrina's effects will touch every aspect of the US economy.
An ill wind blows
Hurricane Katrina's continuing disruption of the Gulf Coast refineries, pipelines and ports raises the prospect of a 1970s energy crisis. And unlike, the 70s, this does not involve just oil. New Orleans is the largest energy hub for refining, natural gas, pipelines and electricity. Energy prices have already spiked, long gas lines have been reported and there is talk of heating oil shortages this winter. Its only going to get worse with at least 5% of US refinery capacity still shutdown at a time when there is no slack in the world's refining system nor new capacity to bring on stream. There has not been a single refinery built in the United States for more than a quarter of a century.
Even before Katrina, oil was high, not because of supply shortages but because of excess demand and the flow of hot money, betting on even higher prices. A supply shock will now be more damaging. While in the long run, the laws of supply and demand will take hold as more supplies are found, $40 oil is now part of our past. To be sure, the spike in oil prices will ensure higher energy and food prices, and the core rate of inflation has already risen to 3.7% in July up from the 2%. Inflation is a dynamic beast, once released from the bottle, it cannot go back in.
Global Bubbles, Toil and Trouble
Ten years ago, the tech boom exploded with internet stocks reaching the sky only to collapse with a handful of survivors. Today retiring Fed Chairman Greenspan, missing the stock market bubble, is now warning about the end of housing market's five-year run. That these bubbles are Greenspan's creations are lost on most advisors. Mr. Greenspan's easy monetary policies has created the biggest housing bubble ever, leading to a huge increase in consumer spending as people borrowed on the equity of their houses. And because of the US savings shortfall to finance these deficits, Mr. Greenspan sold debt to foreigners.
Amid this increase in debt, investors missed a new bubble formed, oil. Oil prices have slipped to $63 a barrel, not far from the record $70.85 after the storm. Investors appear buoyed by the lack of an oil shock owing to the underlying resiliance of the American economy. Wrong. We believe that the current run-up in crude oil prices in the aftermath of storm will cause that oil shock. History shows that following the last two oil price spikes of the 1970s, discretionary spending contracted, setting the stage for consumer-led recessions. And America's indebtedness has made it more vulnerable to not only financial shocks but also oil shocks. What happens when you combine both?
Achilles Heel - Billions in spending
After Katrina, the US budget deficit will hit a record $400 million despite an improvement in tax revenues. Billions in spending are planned and rebuilding will cost more than the Wars of Afghanistan and Iraq combined. The US had outsized spending requirements before Katrina, needing to attract more than $3 billion in net inflows in each working day, to cover the large and growing current account deficit. The spiralling deficit is being matched by growing current account surpluses in Asia and oil exporting countries. And with few signs of narrowing, the current account deficit could reach $1 trillion in 2006. History shows us that this is not sustainable.
So far the capital inflows have allowed the Americans to live beyond their means since domestic savings are near zero. As a consequence the US economy is suffering from twin imbalances. Domestic spending has caused the budgetary deficit to grow again, fueled by tax cuts, the Iraq war and now Katrina and with the huge trade deficit as far as the eye can see, how are they to be financed? By foreigners again?
Foreign central banks are buying fewer dollars, rebalancing the reserve portfolios by diversifying and buying more non-dollar denominated assets. Japan, the biggest overseas holder of US treasuries, holds more than $700 billion, while the Chinese hold $250 billion. The UK holds more than $140 billion of treasuries. However, in the first quarter of this year, foreign investors raised their holdings of British government bonds by $18 billion, financing over one quarter of outstanding issuances. China and Malaysia abandoned their dollar pegs and are managing their currencies to a basket of currencies tied to their trading partners. The Russians are considering lessening their dependence on the dollar. Shortly after the death of King Fahd, the dollar plunged in part to rumours that the Saudi Arabian monetary authority was swapping dollars for euros, purchasing billions of euros. The move was rumoured to be a prelude of a plan to follow China and shift from a dollar peg to a basket arrangement, diversifying out of dollars. Ominously, US data shows that in June, overseas investors only bought $7.9 million of US treasures, the lowest level since September 2003. So far the diversification has been orderly but dollar flights are never that.
The financial world just had a margin call
After Katrina, the financial world just had a margin call. Katrina will be the most expensive national disaster ever. We believe the economic fallout will reverberate well into the future from the property and business insurers to the commodities traders to the hedge fund manager, all of whom are the big users of these credit derivatives.
Hurricane Katrina is such an example of how life can upset the best laid plans, projections and hedging strategies. Left unsaid is following the aftermath of Katrina, what will happen to America's financial markets? This natural disaster will turn into a financial one as well. Preliminary estimates suggest that insured losses from the storm could exceed $60 billion with actual damage to be three times that. The hurricane will lead to billions of dollars in liabilities making the storm the most the industry has paid for any other natural disaster in the country's history. While the prevailing view is that there is little systemic damage to the stock markets, Katrina has hit the insurance industry at its most vulnerable period since that industry is still paying off claims from earlier storms as well as dealing with the SEC and Mr. Spitzer. Reinsurers to hedge risk are major users of the complex financial derivative market. And, a number of hedge funds attracted by the returns entered the reinsurance market.
Over the past decade, credit derivatives were issued as products that allowed investors to hedge themselves against risk. This "funny money" market exploded in use as financial conglomerates, especially larger global banking institutions accounted for more and more of the derivative market. Never have so few controlled so much, concentrating risk reminiscence of the "too big to fail" institutions in the "go-go" period.
The amount of financial derivatives traded rose 11 percent in the second quarter to total $372 trillion or more than 10 times the global economy. It is these financial instruments that were supposed to be the" levees" against the floodwaters of financial disaster. The derivative market provided the hedges against financial losses for many financial conglomerates. With housing and oil in a boom phase, the derivative bubble has grown even faster. On September 15th, the Federal Reserve of New York invited 14 of the major participants in the credit derivatives market to a meeting concerning $8.4 trillion in "unconfirmed" trades. And, the Financial Services Authority, the main UK Securities regulator has requested similar information from UK banks. It seems that regulators on both sides of the ocean are assessing the growing risks of the infrastructure of the credit derivative market. Backlogs, unconfirmed transactions, delayed settlements are part of the back office problem but now total billions in risks.
Gold - Hedge against declines in other investments
We believe that gold is an excellent alternative as a hedge against declines in other investments, particularly as the series of aforementioned bubbles pop. Gold historically has been an effective hedge against inflation, a prudent hedge in portfolios against the systemic unwinding of the dollar and a barometer of financial stress.
Mr. Bush has become the biggest spender since Lyndon Johnson's "gas and butter": spending for the Great Society and the Vietnam war which touched off the 1970s inflation. Investors have become concerned about the United States, its fiat currency and now its financial system. And just as the missing anchovies were the benign event that ushered in the Great Inflation in the seventies so will Katrina trigger a sea change in economic activity. So amid a vulnerable financial system beset by rising deficits, bloated government expenditures, low savings, sky-high housing prices, a falling dollar and a lack of confidence in other currencies, gold will be the prime beneficiary and is the sole levee against the incoming floodwaters.
Gold stocks were again disappointing performers in relation to bullion, due to poor operating results as result of rising costs. Despite a decline in hedging, the mark-to-market positions plunged further into the red with the higher bullion price. More importantly, most producers have not been able to successfully replace reserves and thus are stuck on a treadmill. For some time, we have recommended the intermediate group of players because of their superior production profiles together with advanced development projects. We continue to recommend Agnico-Eagle, Meridian, Goldcorp and Kinross.
We also believe the industry itself will continue the trend towards consolidation because of the lack of reserve replacement. We are about to embark on a re-run of mergers and acquisitions. In addition, there has been a dearth of exploration news as companies continue to spend on development rather than for exploring for gold. Analysis of the industry's capital spending shows that they are spending more on development prospects and not enough real grassroots exploration. Until the industry spends money on exploration they will have to content themselves by eating their own and ultimately that is even more bullish for the gold price but not for the companies.
Agnico-Eagle Mines Ltd
Agnico-Eagle's bid for all of Swedish miner Riddarhyttan Resources AB appears dead in the water since a significant minority have rejected the $130 million paper bid. Agnico-Eagle has said they will not increase its bid for the Finnish deposit. We believe that should Agnico-Eagle be unsuccessful, the shares will ironically perform better due to the lack of paper dilution. Agnico-Eagle has enough on its development plate with the advanced development of Goldex, Lapa and of course LaRonde. At LaRonde, the company is benefiting from higher by-product prices. We like the shares here.
Bema Gold Corp
Bema announced a $119 million bought deal and $400 million debt financing and to develop the high-grade Kupol gold/silver project in Russia's Far East. Bema released a feasibility study outlining positive economics in line with expectations and production will start in mid 2008. With the bulk of value of Bema in 75 percent owned Kupol, every burp will be important to Bema's stock price. Refugio in Chile will contribute a full year's production next year offsetting the drag of Petrex in South Africa. Consequently with the bulk of Bema's asset tied to Kupol and Julietta, Bema has a very attractive Russian base and we recommend purchase.
Eldorado Gold Corporation
Eldorado shares have been acting better as the opening of the Kisladag open pit mine in Turkey gets closer. While the start-up is delayed till the new year, construction of this huge mine is on track. Eldorado's Kisladag mine will produce 164,000 ounces, paving the way for Eldorado to develop the Efencukuru deposit with almost 1 million ounces of reserves in western Turkey. With mines in Brazil and Turkey, Eldorado has added a third leg through the acquisition of Afcan Minerals whose principal asset is the Tanijianshan gold project in northwest China. We recommend purchase of this junior producer.
Goldcorp reported excellent results due in part to the sale of the bullion inventory accumulated by former CEO Robert McEwen. Also, the company unfortunately will no longer stockpile its production from the Red Lake mine. The new management's task is to concentrate on existing production as well as bring Amapari in Brazil into full production. The sale of the bullion inventory and various stakes in junior gold miners boosted Goldcorp's results, masking potentially negative news such as increasing operating cost and additional delays over the sinking of the Red Lake shaft. However, with a broad asset base and a rock solid balance sheet, Goldcorp is well placed to pursue its 2 million ounce per annum production goal.
Kinross Gold Corp
Kinross was able to report its quarterly production in the second quarter but financials were again withheld due to the SEC review. Kinross has submitted a letter to the SEC in response to the Comment Letter, and thus daylight is in sight. We suspect that once the SEC gives the green light, Kinross will be able file its results following a re-statement of its historical earnings and goodwill. There is no question that there will be a hefty restatement of the goodwill portion relating to the TVX and Echo Bay acquisition, however, such a statement would not impair earnings or cash flow. More importantly Kinross will be able to file its financials and complete the acquisition of Crown Resources.
We believe that SEC approval will be a catalyst for a jump in the shares allowing management the time to look at other acquisitions in particular the merger with Polyus, the Russian gold subsidiary of Norilsk. As for operations, Paracutu in Brazil continues to perform well. Kinross will likely boost its reserves at Paracutu, following an expanded exploration budget. Paracutu is a company builder. At Round Mountain, the Company has successfully boosted reserves. Kinross has excellent leverage to the gold price and a higher gold price would allow Kinross to boost reserves at Round Mountain and Fort Knox in Alaska. We recommend the shares here.
Placer Dome Inc
Placer Dome's results were a disaster as the company reported a second quarter $7 million loss due to increased costs, hedging losses and non-cash charge with respect to the company's Australian assets. At the Porgera Mine, Placer's share of a production in the quarter dropped 11 percent and costs were higher.
In South Africa, the South Deep/Western Areas joint venture continues to be hit with delays and higher costs - the development bill keeps on rising. Its partner Western Areas recently announced an 18 percent drop in reserves or 10 million ounces to a total of 45 million ounces due to the fact that the reserves are not mineable. Amazingly, Placer Dome has remained quiet on this expected reduction but its share is 5 million ounces. For sometime we warned that too much of Placer Dome's value and reserves were based in South Africa and the stock should trade at a discount to its peers. With an expected reserve reduction, rising costs and ongoing disputes with its partner, we believe that investors would be pouring good money after bad money here. For example, phase I was supposed to cost $500 million and phase II was to increase reserves but would cost a whopping $1.2 billion. So far the project is two and half years behind schedule and the South Deep joint venture has not performed up to expectations.
Meanwhile, at the Cerro Casale open pit project in Chile, the company has not disclosed how it proposes to finance the $1.3 billion price tag for its partner, Bema. Amid all this bad news, Placer also downplayed the exploration potential at Cortez Hill with a lack of definitive news and released very little on the Pueblo Viejo project in the Dominican Republic (it is our understanding that the price tag has increased). The Cortez Hill play could be a company builder for most companies but somehow Placer Dome is closed lipped on this. Placer Dome is going to need huge capital outlays and we are not confident in its ability to spend this wisely.
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