Gold: The Sky Is Falling
What a year 2005 has brought - hurricanes, tsunamis, earthquakes, terrorism and now Paris is burning. Aside from the sorry scenes of destruction, innocent deaths and economic disasters, the common denominator was the lack of government preparedness. And in the richest nation of the world, the Federal Management Agency (FEMA) was found particularly lacking. What's next? A bird pandemic or an earthquake in San Francisco? To ask these questions is not to spread panic (there is enough already) but to focus attention on an even greater disaster that is to befall us - a financial disaster. This time though, it will hit Main Street.
David Walker, US Comptroller General warned that the US would face a "fiscal hurricane". He said, "We face a demographic tsunami" that will "never recede". The top budget chief explained that ageing baby boomers will present fiscal challenges as benefits swamp future budgets. Former Fed Chairman, Paul Volcker warned that America's deficits cannot persist forever, "The United States is absorbing 80 percent of the net flow have their fill of dollars... so I think we are skating on increasingly thin ice."
Is anyone listening?
The Warning Signs: Fear of Inflation is Back
America's deficits are a global problem. Lacking savings, the United States has no choice but to import offshore inflows creating massive imbalances. These imbalances are giving rise to inflation when too much money chases too few goods. Without a cutback in spending or an increase in savings, the outcome spells deficits as far as the eye can see. Gold is a finite commodity which is not the case for the US dollar. For thousands of years, gold has represented a store of value and is a better protector of wealth than any fiat currency backed by political promises. Gold's rise is a warning.
The story of Chicken Little is a cautionary tale. Disney's remake has been modernized but the message is still the same. The sky is falling. The Fed's lax monetary policy stance will push inflation higher. And no matter how much the Administration "disneyfies" the message, the future outcome is the same. Deficits are inflationary.
HC Wainright & Co, in a recent study calculated that gold is a better leading indicator of inflation than the much revised watered down or "properly adjusted" Consumer Price Index (CPI). Since 1951, the correlation between gold and consumer price inflation one year ahead is 0.37 and with the CPI, it is 0.5. Gold's recent move is the harbinger of inflationary problems to come.
Inflation is a dynamic animal. After being declared extinct, inflation is back. History shows that inflation is a monetary phenomenon. The experience of the 90s is that easy money initially flows into asset price inflation but eventually flows into traditional cost/push inflation. The threat of rising inflation is spooking the markets with yields rising and bond prices tumbling. Yields on 10 year government bonds are now at 4.5 percent, compared with 4 percent in June. Inflation today is higher than when that great inflation fighter, Alan Greenspan took office. In October, it doubled over the previous 12 months to 4.3 percent. In the UK, it too has doubled to 2 percent and in the G7 countries, it stands at 3.7 percent. Inflation this time is more of a "cost-push" type reminiscent of the 70s when commodity-specific supply shocks triggered double digit increases.
Alan Greenspan is retiring. When he first joined the Federal Reserve, gold was at $470 an ounce. Seventeen years later, after presiding over a speculative tech, stock market, and now housing bubble, he leaves behind a horrendous legacy of growing debt and renewed inflation. And he too worries about the future. In an outgoing message he warned that the mammoth US trade deficit "cannot persist indefinitely". He also warned "at some point, investors will balk at further financing." Incoming Fed Chairman, Ben Bernanke is expected to be more relaxed than Mr. Greenspan about deficits particularly since he believes the current trade account will eventually take care of itself. Oh yes, gold today is near an eighteen year high at $500 an ounce.
The Twin Towers of Debt
In 1964, President Lyndon Johnson pursued a "guns and butter policy" in the belief that he could afford both the Vietnam War and his Great Society without raising taxes. He was wrong. Too much money was created chasing too few goods. Shortages occurred, prices skyrocketed and inflation rose to double digit levels. Forty years later, another President is pursuing the same "guns and butter" route. Now like then, the Americans are told they can fight both a war and grow their economy. His domestic budget is a tide of red ink. Today's shortages? Now like then, its energy. Oil prices have more than tripled since 2001 and copper has reached new highs. And despite a decline in popularity, Bush continues to bring in large tax cuts without reducing government spending or the war effort.
The US current account with other world economies will climb over 7 percent and threatens to reach $1 trillion next year. The US deficit almost mirrors the surpluses of China, Germany, Japan, and Canada. The deficits are needed because the personal savings fell to -0.6% in July, the lowest in 46 years. The housing bubble propped up both the economy and the stock market, as the consumer upgraded from shoes to new homes. In 1992, US household indebtedness represented 85 percent of disposable incomes. Today that ratio is closer to 130 percent. In September, the personal savings rate as a percentage of disposable income was negative for the fourth month in a row. During the 80s, the personal savings rate was 9 percent. During the 90s, the savings rate averaged 5 percent and since 2000 averaged less than 2 percent.
China's trade surplus with the United States will top a record $200 billion this year. Despite revaluing the Chinese yuan against the dollar in July, there is renewed pressure for further adjustments. This is a red herring. The main cause for the trade deficit is America's insatiable demand for cheap oil and cheap credit. The Americans have now soaked up the combined savings of Japan, China and Germany and have very little savings left, while Asia has more. Ironically, while China has become the world's locomotive, it too is heavily dependent on US consumer spending. The US structural deficits are caused by overspending and monetary laxity of its central bank and these deficits are contributing to major imbalances with the rest of the world, fueling global inflationary pressures.
The Dollar Meltdown
The Americans have flooded the world with liquidity pursuing a policy of currency debasement. According to the Bank of International Settlements (BIS), central banks hold 75 percent of the US current account deficit and the Chinese and Japanese have become the biggest offshore investor in US securities. At the end of September, China's foreign exchange reserves stood at $711 billion of which $252 billion were held in US Treasuries. Japan is the largest holder of US Treasuries at $687 billion and the UK holds $182 billion. America's outsized spending requirements require a net inflow of more than $3 billion per day. In September, international capital flows reached a record $101.9 billion which was due more to a race among US companies to repatriate funds under the Homeland Investment Act rather than indications of foreign confidence in the US economy.
The world's largest debtor's growing dependence on the savings of Asians and Europeans is a reflection that America spends more than it earns, consumes more than it makes and imports more than it exports. As Greenspan warned, this cannot persist forever.
America's reliance on foreign savings has only two outcomes; either foreigners will decide one day to keep more of their money and force the US to replace their money with higher interest rates or they will keep lending to the US but use those dollars to buy more and more US companies. Either way the greenback will go lower. This may already be happening. In the second quarter the dwindling appetite for dollars saw the US receiving only $1 billion of net overseas investments contrasting with $36 billion in total last year.
What Will Hedge The Derivative Market?
Meanwhile by flooding the world with liquidity, the Americans also helped the credit derivative market to expand rapidly as more and more complex financial products were created. According to the International SWAPS and Derivative Association, outstanding credit derivatives contracts reached $12.4 trillion in June 2005, a 48 percent increase from January and 108 percent from a year earlier. The credit derivative market barely existed five years ago but it has exploded as investment banks created ever new complex and toxic products to move risk off everybody's balance sheets to investors. It is for that reason that the New York Federal Reserve and regulators in the UK asked the industry to better expose and make the sector more transparent.
Of concern is that the financial reverberations from Hurricane Katrina, a GM bankruptcy or Refco failure will cause one of the big users of these complex instruments to be caught on the wrong side. Two-thirds of the credit derivative contracts are traded by only 10 firms, according to Fitch Ratings. Fitch estimates that hedge funds today control 30 percent of the trading volume in global credit derivatives. The collapse of the hedge fund, Long Term Capital Management (LTCM) in 1998 illustrates that no institution is too big to fail. Risk has gone from financial institutions to the unregulated hedge funds. The price tag only gets bigger. Gold is the only effective hedge against a derivative financial meltdown. Gold is a good thing to have.
Gold to top $700 an ounce
History shows that gold's biggest move occurs when it not only outperforms currencies but other asset classes. And that is what is happening today. The impact of higher oil prices and the after-effects of two devastating hurricanes have caused a sharp increase in the CPI which ironically excludes life necessities, energy and food. And, the recent strength in base metal prices suggests higher economic growth and a resurgence in inflation.
Gold is a beneficiary of the move to "hard assets" as investors shun financial assets which are vulnerable to higher interest rates. Oil, real estate, platinum are near historic highs. Gold is next. Meanwhile, gold's supply and demand fundamentals remain tight. Demand is strong and supplies are weak. Jewellery demand rose a whopping 15.4 percent in the first half of the year due mostly to the demand from the Middle East and China. The supply of gold will be constrained due to lower gold production and central banks sales which are capped at 500 tonnes per year. South African gold output will fall to an 80 year low to 300 tonnes, down from 346 tonnes produced last year. South African output has fallen by over a third in the past decade. The European central banks have extended their agreement to 2009. Russia wants to recycle its petro-dollars and double its reserves to 10 percent by 500 tonnes. If the Russians increase their reserves, can the Chinese be far behind? China currently holds 700 tonnes and would need six times that amount to match the Russians.
While many think gold has risen against currencies, the stock and bond markets, these asset classes are falling in terms of gold. Gold is a storehouse of value. Gold is inexpensive in an overvalued world. It is an asset, unaffected by what ails the dollar and unlike fiat currencies cannot be printed. It is also a classic hedge against inflation and the recent spike to $500 an ounce, is due to concern about higher energy and commodity prices, which will add to inflationary pressures. It is the Chicken Little of the global financial market. Gold's recent rise is a warning signal.
As such, we believe that gold will at long last reach $510 an ounce this year and top $700 an ounce next year. However, we believe the ultimate target will exceed $850 per ounce. In our view, gold's bull market has only just begun.
Investors have been frustrated by the lack of performance of gold stocks while gold bullion records new highs. Indeed, the chief executive officers of many of the gold producers are equally frustrated. A review of gold producers' last few quarters tell the story. Simply, gold producers cannot make money with gold below $500 an ounce. Rising energy costs, ever deepening mines, labour and equipment shortages have all contributed to an escalation of mine costs. In addition, the lack of discoveries and years of high grading during the nineties contributed to poor profits. As a consequence, exploration spending has been flat resulting in few gold discoveries. Instead, the industry has dusted off previously known discoveries and only under a new price deck have old development programs been accelerated. Thus in order to replace production and reserves, gold producers have found it cheaper to buy ounces on Bay Street than to spend money in the ground.
For example, Barrick Gold, already Canada's 800 pound gorilla has decided to make a hostile US$9.2 billion bid for Placer Dome creating the world's largest 800 pound gorilla edging out Newmont Mining Corp., who may or may not enter the fray (we think the odds are small). Nonetheless, we believe that if either Barrick or Newmont absorbs Placer, M&A activity will be even more hectic as they will want to divest some of Placer's assets. Consequently, we expect the midcap producers to be active participants in this next wave of consolidations. We continue to favour Agnico-Eagle, Kinross and Meridian and expect the third tier group of companies such as Bema, Eldorado and even Crystallex to be part of this process. Already South African mining giant Gold Fields Ltd, the fourth largest gold producer has made a $330 million bid for Bolivar Gold for the Choco mine in Venzuela.
While gold stocks have been underperforming we believe that once gold breaks above $500 an ounce, stocks will outperform bullion. Our next target is $700 an ounce in 2006, so gold stocks still have significant upside. A review of our clients' portfolios show that the majority have less then a market weight in gold stocks. We thus expect an avalanche of money to go into the gold stocks as part of the secular trend to "hard assets". Technically, many of the gold stocks have reversed their downtrends and have only just emerged from long bases. As such we continue to recommend an overweighted position to the mid-tier gold companies with rising production profiles and reserves.
Agnico-Eagle Mines Ltd.
Agnico-Eagle will organically triple its gold production and double its gold reserves by 2009. Agnico is among one of the biggest spenders on exploration and is expected to announce the exercise of the Penoles $65 million option to acquire the Pinos Altos project in Mexico. Six drills are in operation and results to date have confirmed multiple high-grade gold and silver deposits. The property is adjacent to infrastructure and a scoping study is in progress. Agnico-Eagle was also successful in acquiring the expanding Suurikuusikko project in Finland which might be in production in 2008. Plans are for an autoclave and open pit. Agnico's third mine in the pipeline is the Goldex mine which is under construction. The low-grade project is really an earth moving exercise with a design capacity of 7,500 tonnes per day. Startup is expected in the second half of 2008 with an average annual production of 170,000 ounces at an average cash cost of $200 per ounce. Agnico's fourth mine, Lapa which is only 7 miles east of LaRonde is a high grade deposit. A bankable feasibility study should be completed by the end of next year. Lapa's potential production at 1,500 tonnes per day would yield 125,000 ounces per year with a total cash cost of under $200 per ounce. Startup is scheduled in 2008. With $124 million of cash, Agnico-Eagle is well placed to undertake this exciting expansion and has room for more acquisitions. We recommend purchase here.
Bema Gold Corp.
Bema's quarter was disappointing, but the company has made progress. The Refugio mine in Chile has been restarted and will contribute 125,000 ounces to production next year. At Kupol (75% owned) in Russia, development work continues and the company continues to expand the resource. Kupol is a company builder and Bema has arranged the debt financing and should be in production by mid-2008. Bema has also reacquired Cerro Casales from Placer for a nominal price. The price tag might have scared Placer Dome, but Barrick has hinted that it might revisit the deal because of Cerro Casales' proximity to Pasqua Lama. However, Bema's South African Petrex mine remains a drag. Nonetheless, we recommend purchase here because the company has an excellent inventory of projects that one of the majors would covet. Buy.
Crystallex Gold Corp.
Crystallex shares have been on a roller-coaster ride as investors wait out the granting of the environmental permit that was filed April 2004. Crystallex's management has patiently pushed forward the development of the huge Las Cristinas 12.5 million ounce gold project in Venezuela. Wit a twenty plus mine life, the company has modeled a 20,000 tonnes per day expanding to 40,000 tonnes per day. The economics remain attractive and production in the first five years could average 550,000 ounces a year. However, Crystallex is dressed up and ready to go to the party but her date hasn't arrived.
Hugo Chavez's musings and his government's procrastination has knocked off more than 40 percent of Crystallex's value on fears that Chavez would cancel or revoke Crystallex's mining permit soon. But, politicians never really should be trusted for their musings (particularly during election years) and the government has (to its credit) abided by their laws. We expect Crystallex to receive its environmental permit. After all, who better to exploit one of the world's largest undeveloped gold deposits than Crystallex who has been developing, financing and engineering this deposit since 2002. And with strong hints in the air, it appears a resolution is at hand. Moreover, Gold Fields $330 million investment in Bolivar's Choco 10 deposit, offsets concern that Venezuela is not open for business. Crystallex shares are a good buy here, particularly from a risk/reward point of view.
Eldorado Gold Corp.
Eldorado shares have picked up due in part to the expectation that the Kisladag project in Turkey will be producing 144,000 ounces to Eldorado's book next year. Kisladag is on target and Eldorado announced that it will begin the feasibility study on the Efmçukuru project also in Turkey. The Sao Bento mine, in Brazil had a decent quarter due to better grades. The company also offered guidance at its Tanjianshan gold deposit in China which is an advanced development project scheduled to be production late next year. Eldorado shares have picked up recently and we continue to recommend purchase.
Glamis Gold Corp.
Glamis reported disappointing results due to escalating cash costs at all three mines in Nevada, Honduras and Mexico. Also production at Marigold in Nevada is expected to be lower due to lower reserves next year. Glamis is building the Marlin mine in Guatemala, a gold/silver mine that will be a small contributor this year. Glamis had a problem free start-up at the El Sauzal Mine in Mexico. While Glamis Gold has grown through acquisitions, it has only $20 million in cash so the company's balance sheet is ill prepared take on another infill acquisition. For some time the shares have traded at a premium and so could use its shares as currency. The time has passed. We recommend the sale because of the shrinkage of this premium and the potential for problems at its acquisitions. We view the shares as a source of funds.
Kinross Gold Corp.
Kinross Gold has finally gotten out of jail and restated its results. As expected, there was a huge writedown of the 2003 TVX/Echo Bay merger but nobody really cared. Now that the company can finally release its results, we expect Kinross to be active in the acquisition and divestiture front (Kinross has rights of first refusal on three mines with Placer). Kinross should produce 1.6 million unhedged ounces over the next several years. While the production profile is flat, we expect that among its dozen mines, production will increase at Paracutu in Brazil, Kettle River in Washington and Round Mountain in Nevada. Reserves at Paracutu were increased to 13.3 million ounces, an increase of 4.8 million ounces following a drilling program which shows that deposit is still open at depth and along strike. With no gold hedges the company is an ideal remedy for the heavily hedged senior producers. In addition with its Russian base of assets, Kinross remains an ideal candidate to take on Norilsk's Polyus Gold in a friendly reverse takeover when that spin-off is created next year. For these reasons, we strongly recommend the shares of Kinross here.
Meridian Gold Inc.
Meridian reported excellent results from its main low cost 100 percent owned El Penon mine in Chile. Meridian shed new light on yet another structure and the company has four drill rigs turning, focusing on the Fortuna, Dominador, and Providencia vein structures. Meridian continues to pile up the cash and the company is debt free and hedge free. Hidden but not forgotten is the 3 million ounce Esquel project in Argentina which is in a stalemate with the local town over development. We recommend purchase here for conservative oriented accounts.
Placer Dome Inc.
Placer Dome is toast. In defending itself by describing rival Barrick Gold Corp's hostile US$9.2 billion takeover as an "on the cheap" bid, it only drew attention to its own failings. Like Barrick, Placer's hedge book is also underwater. Peter Tomsett defended Placer commenting that, "Large gold companies should be buyers of quality assets, not sellers." This is one of the reasons that Placer is being acquired on the "cheap". Placer acquired Getchell which was a dud and acquired South Deep, another dud but it sold Omai, which was a success. Placer has a dysfunctional record from a revolving executive suite door to acquisitions.
As for the white knight. It's Newmont or nobody. However there are compelling reasons for Newmont to not make a bid. First on price, Barrick has bid a fair price given Placer's warts and the fact that Barrick has Goldcorp's cash as a sweetener. We believe Denver-based Newmont would be reluctant to use most of its $2 billion cash hoard for a counter bid. Second, deal completion would be an important factor to the arbs who are now Placer shareholders. Barrick has already mailed its circular and has unless extended, its deal closes at yearend. This raises a big problem for Newmont since a circular and its bid would require SEC approval, which could take a long time. It took Newmont over a year to get SEC approval to acquire Franco-Nevada. SEC oversight is almost as good as a "poison pill" today. Barrick on the other hand, is a Canadian registrant so will not have to go through as many regulatory hoops (although it too will require SEC review). And that brings the third point - Barrick as a Canadian company can take advantage of tax synergies not available to Newmont.
So what to do? Placer shareholders, should wait and then tender under an inevitable "top up" sweetener by Barrick. Goldcorp shareholders however should take the money and run. While in the long term, the Red Lake acquisition is a plus, the piling on of debt will mean another big tranche of equity to come. Sell.
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