Gold: Texas Hold'em
The gold market has been behaving as if inflation is back. Investors who believe otherwise need ask themselves: is past prologue? Gold has doubled in the past five years and is trading at the highest in a quarter century. Amid a breakout to levels last seen in 1981, most market pundits are saying that the gold market must be wrong this time. Yet, after missing the run-up in gold, they are missing the message.
There has been an influx of physical buying from both institutional and individual investors. Last year cash did better than currencies, the US stock market and bonds. Gold was a better investment, outperforming them all last year. In four days, StreetTracks Gold Trust (NYSE:GLD), the largest exchange traded fund (ETF) accumulated almost 21 tonnes of gold and now holds more than 280 tonnes of gold. And, in Japan, investors have been buying gold as protection against a sinking yen. Gold was also purchased by Middle Eastern investors, whereby protecting their massive hoards of petrodollars, left their funds in gold instead of US dollars.
Secular Change In Our Financial Markets
What investors are simply missing is a secular change in the financial markets and gold. As long as assets go up, there's no worry. Wrong. Most assets have become overvalued. We live in an unbalanced world where gold has become the prime beneficiary.
We believe gold's recent move is due to its alternative role to global currencies which have sunk in value relative to bullion. Indeed gold historically served as the currency of last resort. Gold is money, it is the Chicken Little of the financial markets, it is the universal safehaven and a hedge against what ails us.
As in the game "Texas Hold 'em", the US once held all the winning cards but in the past few years has succeeded, by bluffing. Simply put, America's insatiable demand for cheap oil and financing has placed it in a vulnerable position, depending on its very competitors for financing. That cannot continue for too long. The US has gone "all in" before the "flop" card. Gold is a surefire winner when Uncle Sam has such a losing hand.
Today, most economic pundits believe that inflation is dead. Investors are too complacent about inflation. They forget inflation was and is a monetary phenomenon. Copper is trading at all time highs. Oil prices remain high and inflation has doubled in the last year. The Labour Department reported that in December, the Producer Price Index jumped 0.09 percent, the largest increase in 15 years. Rising prices are a symptom of inflation. Greenspan raised interest rates thirteen times to prevent a rerun of the 1970s, when high oil prices and a loose monetary policy resulted in borderline hyperinflation. Ironically, the Fed continues to provide liquidity to the system through a policy regime of large deficits and very low interest rates. Monetary base (MZM) continues to grow at double-digit levels. By refusing to burst the asset bubbles, Greenspan's manic monetary creation has ensured the return of inflation.
Ben Bernanke is so confident of this lack of inflation that he proposes to replace money supply targeting. By abolishing the monetary targets, it allows the Fed to print as much money as it wants providing even more liquidity to a world already awash with liquidity. In November 2003, when Mr. Bernanke joined the Fed, he told a group in Washington that the Fed possesses a marvelous deflation fighting machine - the "printing press". He said that the government can "produce" as many US dollars as it wished, at essentially no cost". In 2002, he said that in a time of crisis, the Fed could add liquidity to the financial system by dropping money from helicopters. Gold's recent move coincided with the expectation that Helicopter Ben is about to embark on a whole new round of monetary expansion or debasement.
Poker Game - doubling up the bet
As in "Texas Hold 'Em", investors appear ready to double up their bet, calling America's bluff. America is the world's biggest economy but also its biggest borrower. Despite Mr. Bush's rhetoric, the federal government is awash in a sea of red ink with US government debt at $4.6 trillion, or almost half of GDP. America's twin deficits, a negative savings rate, and record indebtedness have caused its creditors to look for alternatives and to reduce their stake in the American economy.
The Asians have accumulated large reserves of foreign exchange. The growth in reserves has been fueled partly by China's growing bilateral trade surplus with the US which is likely to top $200 billion in 2005. China has almost $820 billion, up 50 percent from a year ago. The Middle Kingdom's reserves this year will reach $1 trillion making it the world's largest single holder of official reserves. Next year, it will be larger still. The Asians already have too many dollars so they are under pressure to diversify their reserves. About three quarters are believed to be dollar-denominated assets. China is now spending its money, becoming the fastest growing investor in Africa. To lessen its currency risk, China is expected to make changes in its reserves. Gold is a good thing for central bankers laden with excess dollars and falling values.
China: Banker to the world?
China's desire to increase its gold reserves would reduce currency risks and change asset allocation - a potential shift with major implications for the global financial and commodity markets. The Chinese State Agency has recently stated its intention, "to optimize the currency and asset structure and to actually boost investment returns of the country's foreign exchange reserves". That set off alarm bells and a doubling of the bet.
Central banks limited their gold sales due to the extension of the Washington Agreement limiting gold sales to only 500 tonnes annually. The European central banks reluctance to sell more gold was due partly to the misguided Bank of England's sale of 300 tonnes near the bottom of the market at $275 per ounce. On the other hand, Argentina, South Africa and Russia are looking to boost their reserves of gold. Awash with petrodollars, Russia has expressed an interest to double their reserves to 10 percent. China has about 600 tonnes of gold, less than 2 percent of their reserves and thus would need to increase its reserves by eight times just to get to the European level. The coming New Year is the Year of the Dog and a good year for weddings according to Chinese tradition. Gold will be a good thing to give during the year.
We believe the Asians have winning cards this time and are no longer waiting for the "turn" card. If they decide to buy less paper, the US current account deficit could not be financed at current exchange and interest rates, since the American savings rate is near-zero. America's problem is a "made in America" and not in Asia. And with a burst housing bubble, it has been estimated that over $2.5 trillion in mortgages will come due this year and next at carrying values twice what they were when they were originally written.
The dollar is the world's currency. The massive US current account deficit is now more than 6.4 percent of GDP and is unsustainable. In the 80s, when current account deficits were less than 4 percent of GDP, the greenback fell 40 percent. The US budgetary deficit widened to $83.1 billion in November, the largest deficit of any November. The deficit is expected to top $400 billion up from $318 billion a year ago, for the third year in a row. Debt service payments represents 15 percent of the deficit. America's reluctance to curb its insatiable appetite for cheap energy is causing it to import more and more expensive oil, raising its indebtedness further. Concerns over the ability of the US to finance their deficits has led to a loss of confidence in dollar assets and the beginning of a spiraling down in the value of its currency and its assets. The US must import more than $2 billion of capital from abroad every day or 80 percent of the world's savings - truly unsustainable.
Because the US owes abroad much more than it owns, consumes more than it produces, there are too many dollars. Foreigners are converting those dollars to Euros and to gold. We believe that gold will trade beyond its last peak of $850 as these global imbalances are poised to come home to roost. Gold will continue to outperform dollar assets. Gold's bull market has only just begun.
Energy - the new world order
America's current prosperity is at the cost of a record account of debt. The United States lost its economic independence once its deficits were financed by foreign investors.
The American economy is so overstretched and its reliance on foreign money gives them leverage over America. America is no longer the superpower it once was and is vulnerable to either natural or in fact, financial disasters.
As a consequence of energy politics and America becoming the world's largest debtor, the centre of economic activity and power has shifted to the East. "Chindia" has reshaped the global economy, becoming the fastest growth area with the combined economies of China and India poised to exceed that of the rest of the world. America's downfall is similar to others when those economies could no longer support higher taxes or soldiers due to insufficient savings or production. America now must depend upon the old cold war political order of "détente" to continue its profligacy. But that "détente" has been changed over energy politics on the principle that he who owns the gold makes the rules. Two and half year ago, under pressure from the United States and threats of sanctions, Iran placed seals on its nuclear reactors. Iran's removal of the seals reflects how much that international order has changed. Today lacking leverage, the United States is hoping that Russia and China, two permanent members of the UN Security Council will do what the Americans can't.
Energy has become the new currency of the world and Russia's flexing of its energy muscle is a reflection of America's growing vulnerability. America went to war to protect its supplies but under its very nose, Russia and China have secured supplies at America's expense. With a third of the world's gas reserves, Russia is becoming the central player in Europe, breaking a 65 year hold on the American and European alliance. Russia and China have signed numerous oil deals to gain their support and secure markets. China and India have agreed to co-operate in securing offshore reserves.
A Tilt to the East
On the same day that Russia assumed the chairmanship of the Group of Eight, they cut off natural gas supplies to its neighbour. The Russian-Ukraine standoff exposed the vulnerability and caused panic in Europe since they are so heavily dependent (as much as 50 percent) on Russian energy supplies. America could not deliver gas to Europe. Thus Russia's use of energy as a political weapon is no surprise.
Indeed, the reality today is that energy has become a geopolitical football and control of strategic supplies have become paramount among the superpowers. China for example has aggressively secured its supplies, shunning the United States. The newly opened Kazakh-China oil pipeline is an example. Since it will take time for the 190,000 barrels a day pipeline to fill with oil from Kazakhistan, Russia will be providing more than half of the oil, furthering strengthening its relationship with China. And China is strengthening its relationship with Iran. Iran provides some 14 percent of China's oil today. China is not only securing its supplies but proving to be a key player in that part of the world, much to Moscow and Washington's chagrin.
Where does that leave the US? The US has traditionally depended upon Middle East imports, but as we have seen over the last few years, going to war to secure its supplies, was not a riskless proposition. And, $300 billion later, the US is still mired in a war and oil supplies have not increased from that area. Indeed quite the reverse, as it appears that not only will it take time and more money to build up supplies, but Saudi Arabia, America's traditional ally, is also having problems boosting its own production. Consequently, the US has become increasingly dependent on imported oil from the very countries it has had a falling out with (including Venezuela) or countries that are politically unstable.
And that is the Achilles heel of American foreign policy. US influence will continue to wane as others secure their energy supplies. China's blatant attempt to challenge the Americans in its backyard was thwarted when CNOOC pulled out of the bidding for Unocal. Americans should realize is that this is a foretaste of what is to come. Right now, gold is a good thing to have.
Recommendation: Peak Gold
For twenty years, the gold industry was in a bear market and the lack of new discoveries meant less gold was produced. And to survive the bear market, gold miners high-graded, shortening many of their mine lives. Now with strong physical demand there are insufficient supplies. Gold production is falling as mines mature and costs escalate. Peak gold. For example, South Africa the world's largest producer is expected to produce 300 tonnes in 2005, an eighty year low. On the demand side, gold is being bought as a physical alternative to currencies which are falling in value. The US dollar has resumed its downtrend and the dollar/gold inverse relationship has been reestablished. Gold mining shares have finally begun to perform due to the fundamental reason that these companies need a $500+ gold price in order to make money.
While Barrick gobbles Placer Dome, consolidation continues with Goldcorp spending half a billion dollars to acquire Virginia Gold mines for its promising Eleonore exploration property in James Bay Quebec. IAMGold announced a $274 million deal to buy Australian-based Gary Gold Ltd and Yamana Gold announced a $28.5 million bid to buy RNC Gold which has a mine in Honduras.
Surprisingly gold stocks did twice as better as bullion last year. The improvement was due to the fact that a higher bullion price will help improve the profitability of an industry which has been squeezed with falling grades, maturing mines, higher energy costs and volatile currencies. Last year was a tough year for the gold producers but this year will be much better.
Average Price Forecast Revised to $600
We also believe the recognition of a new floor price ($500) will stiffen the
resolve of many of the producers and we expect new players to join the poker
game. A survey of our institutional clients shows that many clients are underweighted
towards gold stocks due in part due to fears of a pullback, worries over its
volatility and the widespread view that gold stocks are overvalued.
Bull markets climb walls of worry, so we believe that the gold price and gold stocks will go higher before they correct - there are still too many skeptics and not enough buyers. We also have revised our average price forecast this year to $600 per ounce from $550 per ounce. The combined market capitalization of he gold miners remains less than the value of Apple Computer and a fraction of global wealth today. A shift of just a fraction would cause gold and gold stocks to skyrocket.
In our opinion, the key drivers for gold stocks will be higher gold prices, a year-over-year improvement in earnings, an upward reevaluation of reserves allowing the gold companies to bring former uneconomic resources into reserves and yes, exploration news.
Gold reserves have been dwindling due in part to the lack of exploration spending and the resultant lack of discoveries. Many of the projects coming on stream were discoveries found in the eighties. It is only in recent months that companies have boosted their exploration spending. We believe that portfolio managers and analysts should value gold companies on the life of their reserves in the ground (similar to oil companies) rather than cash flow or P/Es. The high cost of bringing on reserves today (let alone finding them) dictates that existing reserves will trade at a premium. Indeed we believe that is the reason Barrick Gold acquired Placer Dome, boosting Barrick's production by 53 percent creating the world's largest gold producer, ahead of Newmont Mining. Goldcorp solidified its role by acquiring Placer's Red Lake mine and other Canadian assets, reinforcing the old adage that it is cheaper to buy ounces on Bay Street than to look for gold in the ground. We believe that this trend will continue, particularly in the mid-tier category where we expect companies like Agnico-Eagle Mines, Kinross Gold, Meridian Gold, Glamis and Goldcorp to be among the active players this year.
With the lack of exploration and few dollars going into grassroots exploration, we believe that the market will focus on the more junior companies which have yet to be developed projects or those in development mode. Consequently we believe that the shares of Eldorado Gold, Bema Gold, Northgate and Crystallex could be accumulated. Among the junior exploration plays, we like US Gold (McEwen's new entity), and St. Andrew Goldfields.
Agnico-Eagle Mines Ltd.
Agnico-Eagle has significant byproduct credits for zinc, copper and silver at the LaRonde mine in Quebec. Sky-high prices for these commodities will allow Agnico to mine 250,000 ounces of gold this year for "free". Consequently on an earnings per share basis, Agnico-Eagle will surprise many.
More significantly, Agnico is expected to continue its string of acquisitions through the exercise of the option to purchase the Pinos Altos gold/silver project in Mexico. The company currently has six drills turning and a resource estimate and scoping study is expected, once Agnico takes up its option. Now that Riddarhyttan has been completed, Agnico is expected to release a revised scoping study on Suurikuuikko in the next quarter. We continue to recommend the share for its rising production profile and expectation that over the next few years, Agnico-Eagle will more than double its output. Agnico-Eagle also a debt-free balance sheet and an aggressive exploration budget.
Bema Gold Corporation
The key for Bema is bringing on the high-grade Kupol gold/silver deposit in Chutkoka in far eastern Russia. Financing was arranged in the last quarter and since this is a seasonal operation, Bema is on target to develop Kupol. The company has been converting inferred resources to reserves and we believe that this project is a company builder. With a new owner of Placer Dome, we expect some progress on the huge Cerro Casales in Chile since that project is close to Barrick's Pasqua Lama. Refugio in Chile is onstream within budget. Cerro Casales has more than 23 million ounces of gold and almost 6 billion pounds of copper but the capital cost is huge. Buy.
We have been negative on Cambior because of the lack of a growth profile. Problems at Rosebel hurt the stock, but modifications to the circuit have cleared up the problems and the Rosebel mine will produce 340,000 ounces this year. Cambior is Canada's fourth largest gold producer, but the high cost Doyon division in Quebec is a problem asset. Cambior's mines are short-lived and with hedges still on its books, the company is hard-pressed to show any improvement. Production this year will fall 17 percent with the closure of the Omai mine in Guyana. We believe that there are better uses of funds than Cambior.
Eldorado Gold Inc.
Eldorado Gold announced the discovery of almost 9 million tonnes of iron ore at the company's Vila Nova iron ore project in Imapa state, Brazil. A few years ago we would have said "ho-hum", but given today's iron ore prices, Eldorado appears to be on to something. Eldorado expects to continue to develop this deposit in northern Brazil and with infrastructure close by, it can easily be developed. Eldorado has also brought Kisladag in Turkey into production which should produce almost 150,000 ounces this year. The feasibility study on the Efemcukuru project in Turkey has begun and that mine could be in production in late '07 at a rate of 90,000 ounces per year. In the interim, the Chinese Tanjianshan gold mine could be on-stream by late '06. With a rising production profile and one of the best management groups, Eldorado remains a buy here.
Glamis Gold Ltd.
Glamis results were disappointing in the quarter due in part to rising costs at its three mines in Nevada, Honduras and Mexico. The new Marlin gold/silver mine in Guatemala came on-stream but results were affected by the hurricane. El Sauzal's costs in Mexico were higher due to higher energy costs but that will be offset by the better bullion prices. Glamis shares have performed well but the company lacks meaningful projects in its pipeline. The lack of growth will cap the performance of the shares and we expect Glamis to be on the prowl.
Kinross Gold Corporation
Kinross is about to release its 2005 results, following the issuance of the 2004 and restatement of the 2003 financial statements due to the SEC review of the TVX/Echo Bay goodwill. As expected, the accounting review was a brouhaha over nothing and Kinross shares have improved with the long awaited release of its results. More relevant the company has not been idle and Refugio was brought into production within budget. In addition, mining of the Buckhorn deposit will help results. The key however has been the aggressive development at Paracutu in Brazil which has been expanded. This mine is a company builder. Proven and probable reserves increased to almost 14 million ounces and the mine is still growing since it is open at depth and along strike. Paracutu would produce 350,000 ounces and production could double.
Among its twelve mines, a higher gold price will help Kinross' three major open pit mines, Fort Knox (Alaska), Round Mountain (Nevada) and even in Kubaka (Russia). Kinross sold the Aquarius assets that was inherited from Echo Bay which gave it a strategic 14 percent stake in St. Andrew Goldfields, giving it major exposure in the Timmins camp. Kinross will produce 1.6 million unhedged ounces and the company remains as an antidote for the hedged super-producers who are underwater on their hedges. Buy.
Virginia Gold Mines
Goldcorp made a stunning bid for Virginia shares, presenting an interesting arbitrage opportunity. Virginia shareholders are expected to vote and ratify the deal in February, so Virginia is a proxy to play Goldcorp as well as the gold price. In addition, the stub is expected to attract attention given Virginia Gold's management track record. "New Virginia" will have attractive exploration "moose pasture" potential in the Eleonore area, a balance sheet of $30 million plus and a 2 percent NSR which makes the stub an interesting spec.
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