Gold: Bull Markets Climb Walls of Worry

By: John Ing | Thu, Jun 8, 2006
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Conspiracy theories, self-doubt, testing 2,000 years of history? The Da Vinci Code? No. Gold. Gold bullion's performance continues to defy conventional wisdom. Gold broke $700 an ounce to its highest price in a quarter of a century before retreating in profit-taking. Nonetheless, gold has risen more than 250 percent in the past five years, outperforming stocks, bonds and cash. Gold's move is due to the fact that the US has become the world's largest debtor in history. Gold generally has an inverse price relationship to the US dollar. As global rates inch up, there has been a major realignment of interest rates making non-dollar assets more appealing. The renewed flight from the dollar has been fast and furious, losing 6 percent against the euro in only a month.

Wall of worry

Bull markets climb walls of worry. With gold pulling back almost 13 percent, conventional wisdom is skeptical about gold's rise and sustainability. Such uncertainty has caused many investors to shun gold. Commodities have recently touched new records, reaching levels not seen for nearly two decades. However, when adjusted for inflation, commodities in real terms are even cheaper with crude oil and gold less costly than they were in the 70s. While most analysts are calling for the "pricking" of the commodity bubble, few have "drilled down" for the real cause of the price moves.

Simply, we believe that a commodities super-cycle has just begun. Two decades of neglect and inventory rundown sparked the upturn. We are experiencing a fundamental imbalance between constrained supplies and exploding demand. South Africa, the world's largest gold producer produced almost 11 percent less gold in the first quarter despite higher prices and will produce less then 300 tons this year, an eighty year low. South African production has fallen 40 percent in the past decade. Copper has done even better. The surge has been driven by concerns that China would vacuum up existing supplies, whilst hedge and pension funds have targeted copper and other commodities, seeking better returns than underperforming stocks and bonds. Commodity producers have simply failed to produce new sources of production.

In January 1980, gold hit $700 an ounce. Today there are parallels between then and now. In the seventies, inflation was rising for more than two years and was not seen to be a problem despite a credit expansion to pay for a war and higher oil prices. Inflation subsequently jumped to 13 percent. Gold? Starting at $50 an ounce it peaked at $850 an ounce on January 1980. Today like then, inflation has been creeping up. In April, the US consumer price index reached an annualized 5.3 percent up from 2.2 percent for all of last year and we are again told this is not a problem. Gold also traded at $700 and like then, the rise is also due to a lengthy period of easy money. Oil prices have tripled since 2003. In our view, gold is simply in the midst of multi-year secular bull market accompanied by a boom in commodities not seen since the 70s. Déjà vu.

Too much fiat money, too little gold

Gold is one of the oldest forms of money and a logical alternative to the US dollar. We have a bear market in financial assets and a bull market in hard assets. Gold is a constant or static while the dollar is a variable. Gold is priced in dollars. The price of gold is rising. Yes. But only because the value of the dollar is declining against gold. The greenback has lost more than 40 percent in the last three years and is still overvalued. Commodities too have become the new mainstream asset class and investors are diversifying from underperforming bonds and equities, seeking a hedge against the declining dollar.

In our view, gold's recent rise is all about falling confidence in the dollar, its debasement and the dollar's decline as the world's reserve currency. Gold has inherited the dollar's status as a safe haven. Gold's current run is driven by the wall of liquidity of cheap money and expectations that the central banks and governments will continue to inflate to avoid the damaging effects of higher interest rates.

America has flooded the international monetary system with dollars and dollar denominated securities to finance an enormous current account deficit to go with its massive budget shortfall. Their lack of savings and a policy of devaluing the dollar has caused record indebtedness of almost $9 trillion as well as and an explosion in liquidity. Once upon a time, hot money might have been playing internet stocks. Today this hot money poured $200 billion into the commodity markets. While these billions could disappear as quickly - newer money arrived with the introduction of ETFs, exchange traded funds with holdings at 443 tonnes for a value of about $9.3 billion.

Super-sized economy has to go on a diet

America's massive current account deficit puts an enormous burden on its trading partners, particularly China and Japan. The US trade deficit at $900 billion last year was a reflection that America is living way beyond its means, spending far more than it earns. Since 2001, Mr. Bush's spending has increased 7 percent every year. This super-sized economy has to go on a diet.

To pay for this deficit, the United States has to sell stocks, bonds, and goods to foreigners. American households' savings rate went negative for the first time since the Thirties. Alarmingly the Americans owe foreigners more than $5 trillion since 1999. The current account deficit at seven per cent of GDP is more than twice than that of the mid-eighties. That gap put another way, represents how much more America consumes than it produces. And the recent drop in the dollar will not cure these global imbalances.

The Americans are deeply in debt and are still talking about tax cuts and to solve the energy crisis, hand over $100 bills to their citizens to offset the high cost of gasoline. Amazingly, the lawmakers were happy to go deeper into debt and borrow even more from foreigners. That increase in debt and the resultant abundance of cheap money is a prescription for a weaker dollar and higher gold prices.

With rising global interest rates, the greenback faces competition as investors seek higher yielding currencies elsewhere. The stock markets of countries with even larger current deficits such as Iceland and New Zealand have been decimated this year. Since May, the Indian market has fallen a record 20 percent with a current account deficit at only 3.6 percent this year. The United States is not immune to the risk of a comparable sell off. And, with the Asians intervening less and less in the markets, the greenback no longer enjoys the benefit of the flow of funds, the interest rate gap narrows further.

Growing dependence weakens and isolates America

And that is the problem. The United State's huge and growing foreign indebtedness and its reluctance to curb its appetite for cheap oil and cheap debt is causing a huge global imbalance reinforcing the commodity super-cycle. The world's superpower is being financed by foreigners of which many are also its competitors for ever scarcer national resources.

Rather than browbeat China for its success in growing its economy, Bush should be looking for ways to solve this made-in-America problem such as the development of energy sources, conservation or fiscal policies that are not dependent upon others but on its own productivity.To blame China is easy but also misleading since the increase in China's trade surplus since 1996 is only one sixth of the increase in America's deficit.

President Hu's first official visit to Washington was noteworthy more for its symbolism rather than resolving both countries' complaints. President Hu for example visited Seattle before Washington, sort of business before politics. At the White House "welcome" ceremony, the well-staged introduction was interrupted by a Falun Gong supporter, of all things. And, President Hu's next destination was Saudi Arabia, sending a message to the Americans that oil is the real issue. The Americans blew their chance. Instead of a recipient of a $16 billion shopping spree of American goods and a book, "The Art Of War", President Bush should have tackled the real issue, energy and the interrelationship between both countries.

China bashers also raised the issue of China's banks' indebtedness of $900 billion despite the success of the Bank of China's $10 billion IPO. Built up over two decades, The Chinese bank debt was due to reckless lending. While myopic, the US Treasury and Western institutions are focusing on the absolute amount. In recent years however, China has restructured and reduced their banks overall liabilities. Few realize that under the Chinese banking system, the Government of China stands behind their Chinese banks. A failure would not be only a "loss of face" but cause a massive bank run. That could not be said for other jurisdictions such as Germany when the Herstatt Bank was closed in 1974 or in the United States when many savings and loans in Texas failed.

US dollar loses its status as a reserve currency

Sweden's central bank recently reduced its dollar holdings to 20 percent from 37 percent, putting the proceeds in euros. US Treasury data showed a decline in capital inflows to $69.7 billion and foreign purchases of US Treasury notes and bonds falling to a three year low to $3.1 billion. And that is not all. Foreign institutions, including central banks sold a net $6.3 billion of treasury notes and bonds in March, the largest amount of selling in a year. The Arabs recently have shifted part of their reserves of dollars into other currencies, particularly the euro and of course gold. Japanese holdings of US Treasuries have fallen by $74.5 billion since December. Asian central banks have been buying gold instead of dollars and rumors persist that China will diversify its reserves from dollars into gold. That said, the Chinese hold a large portion of their reserves of almost $1 trillion of reserves in dollar denominated securities. China has about 1 percent of its reserves in gold, compared with 15 percent in the European Community. Even Russia having surpassed Saudi Arabia as the world's largest producer of oil and with reserves of $243.3 billion, has not only questioned whether the dollar should retain its status as the world's main reserve currency, but pledged to raise its gold reserves from 5 percent to 10 percent of foreign reserves. Oh yes, Russia will accept only rubles for its oil and natural gas and will have the world's third largest reserves, surpassing Taiwan.

Not since 1984-1987 when dollars were dumped has there been an alternative to the dollar. Newly appointed Treasury Chief Paulson will bring much needed creditability to the financial markets and also offers expertise in dealing with China. Yet he is unlikely to alter an already weakening currrency. Indeed he is expected to welcome it, allowing the Americans to pursue a new weak dollar policy. Yet with Americans cheapening their dollar as part of a competitive devaluation policy, investors are losing faith in Washington's ability to finance its deficits and with their inflation fight wanting, what is the alternative? That alternative is gold. That is why gold hit a twenty-five year high and is to go higher.

America's insatiable appetite is its Achilles Heel

Thanks to America's insatiable appetite for energy and cheap money, the geo-political balance has shifted from the spenders to the savers, and the consumers to the producers. As prices rise, the balance of power has shifted giving more leverage to America's competitors many of whom give lip-service to democracy preferring instead to follow autocratic and anti-west policies.

The shoe is on the other foot. Former "have not" countries have grown richer by America's appetite for cheap oil and propose to grow richer by nationalizing the reserves held by the private sector many of them American companies. While the state governments appear to have found a new weapon, lost on these politicians is that foreign capital and expertise has underpinned the increase in reserves and production. For example, Iraq has yet to regain prewar production levels. The same could be said for Venezuela and of course Iran's output is nowhere near pre-1979 levels. There is a pattern here. Tearing up contracts, nationalism or bashing oil companies however is not exclusive to developing countries. In the United States, lawmakers too are talking of a "windfall" tax and similarly in Newfoundland, of all places, Premier Williams is threatening to nationalize offshore reserves.

Statism, nationalization or xenophobia will not bring on more oil and gas reserves or production. History shows that oil and gas is a cyclical business. When oil inevitability retreats, will these same governments invest the needed billions to maintain output? We think not. Where will they find the billions of capital and the technology needed to develop reserves? Governments do not have the know-how. Without capital and investment, this golden goose will have been cooked. Higher prices will ensue. That same pattern is occurring in the gold industry where the goose has been cooked in formerly hospitable jurisdictions like Venezuela, Chile, Peru and now Mongolia. Gold is a good thing to have as political risk everywhere increases. Higher prices too are in the offing.

Conclusion: it's a new world after all

Americans' financial profligacy and deepening geopolitical tensions have ushered in a new era. To be sure, America's flirtation with low long term interest rates has drawn to a close. Global commodity prices have risen sharply, and the surplus of liquidity in the East ushers in a new era of high prices. Global growth appears immune. Despite sixteen rate increases and crude oil hovering near $70 per barrel, the US economy grew a whopping 5.3 percent in the first quarter, the highest in two years. Japan's will grow 2.75 percent this year ending almost two decades of deflation. China grew by 10.3 percent in the first quarter. Higher interest rates and rising oil prices have not curtailed demand because governments have allowed even bigger increases in credit. The monetary excesses have simply led to the rapid expansion of hard assets from oil to real estate to copper and to gold.

The inflation in money will continue unabated, particularly since Helicopter Ben once described the Fed as a "printing press", able to "produce as many US dollars as it wished, at essentially no cost." Mr. Bernanke is off to a rocky start as Fed Chairman has abolished the Fed's publishing of monetary targets (M3). Few remember that inflation is a monetary phenomenon. Investors have already added a "Bernanke premium" in the marketplace. Mr. Bernanke is about to learn a lesson - that gold will do better than those dollars created by the printing press.

Investment Strategy: Go for per share growth

How high can gold go? For over two decades, many gold mines closed down as reserves were depleted and/or the economics of staying open were untenable. Some such as Barrick, took advantage of decades of under-investment, consolidating by acquiring others. And, because gold was in a funk, Barrick and others sold forward, to the extent, that for many years, companies made more money hedging than mining. But over the past couple of years, the price has sky-rocketed and Barrick and others were forced to buy back those expensive hedges, pushing up the gold price.

While gold recorded a twenty-five year high, gold stocks have not. Part of the reason is that gold companies are only now just making decent money. On average, gold stocks are trading at more than 30 times this year's earnings and about 100 times last year's earnings. Obviously investors have built in a growth multiple. But, worrisome for the industry is that meaningful production and revenue growth is not in sight. Given the lengthy lead time to bring new mines into production, many producers are only now pouring gold from the deposits found in the eighties. Consequently, there has been a surge in merger and acquisition activity since is cheaper to buy ounces on Bay Street than to spend the money in the ground. In addition, by using their paper as currency, gold companies are able to maintain a "growth" profile. However on a per share basis, that growth is not so evident. Of concern is that should growth not be forthcoming then what is to move share prices? To date, as gold hits new highs, gold stocks have been dragged kicking and screaming upward. We estimate that investors are only discounting a $400 gold price.

Some of the big cap companies have not been able to solve the problem of declining reserves in coming years. Some share prices will suffer as a result. We again recommend the intermediate players because of their superior production profiles, per share growth and advanced development projects. We recommend Agnico-Eagle, Meridian, Goldcorp and Kinross. IAMGOLD, Cambior and Northgate could be utilized as sources of funds because of their relative mediocre growth outlook.

As such, we believe that a move beyond the old highs of $850 will eventually drive gold stocks higher fed by investor greed and euphoria. But to maintain higher levels, the industry must show growth particularly per share growth and for that they are going to have to spend money on exploration to offset declining mining reserves and escalating operating costs. So far, despite increased exploration budgets there have been no major new grassroots gold discoveries nor even a fraudulent discovery. History shows markets tops are often associated with not only euphoria and greed but a discovery of a major find (albeit many of them unreal). The peak of 97 for example ended with the bust of Bre-X. The eighties ended with the bust of New Cinch.

For that reason, we still think that volatility and even higher levels are ahead of us. Gold will outperform currencies and stock markets. It is an alternative to the dollar for investors and central banks. Our thesis for higher prices is dependent upon a new wave of inflation. This year gold will surpass its 1980 high at $850 an ounce and $1,000 gold will look cheap. Every peak in gold is higher then the previous - and that is Da Gold Code.


Agnico-Eagle Mines Ltd

Agnico benefited from its diversified commodity exposure and reported a strong quarter due to strong byproduct credits. Agnico produced 64,000 ounces in the first quarter and 47 million pounds of zinc which meant that the flagship LaRonde mine was producing gold at zero cost. Indeed in the quarter, the byproduct sales of zinc, copper and silver alone caused Agnico to report a cash costs at a negative $241 an ounce.

Agnico will produce about 250,000 ounces this year and raise $250 million to fund its growth pipeline. This mid-sized producer's balance sheet is strong with no debt, $155 million of cash and a $150 million bank line. Agnico unveiled a pipeline of growth with a targeted 750,000 ounces of production and in the next few years. Agnico also gave the go-ahead to develop the LaRonde II project in northwestern Quebec. At an initial capital cost of $210 million, this deep seated polymetalic deposit is expected to average 320,000 ounces of gold annually with ramp-up expected by 2011. While LaRonde II is further off, the Goldex mine, approximately 50 kilometres east of LaRonde is well advanced Goldex should produce 170,000 ounces of gold per year, beginning in the second half of 2008. Similarly, the Lapa project, 10 kilometres east of LaRonde is expected to produce 125,000 ounces of gold, with initial production in late 2008 (shaft sinking at Lapa is at 700 metres). At Suurikuusikko in Northern Finland (Kittila gold project), Agnico will build Europe's largest gold mine with production beginning in 2008 at 150,000 ounces annually at a cost of $135 million. The study calls for an open pit and underground operation with a 3,000 tonnes per day processing plant. There are eight diamond drills turning, with five conducting infill drilling to expand the 3 million ounce resource. A mine tour this month should remove some skepticism. At Pinos Altos in Mexico, the company has released more information. Initial indications suggest a 3,000 tonnes per day open pit with underground operations, each supplying 1,500 tonnes per day. Capital costs are projected at $150 million and a feasibility study is expected next year. Agnico-Eagle does not hedge and we continue to recommend the shares here, particularly for one of the most ambitious growth profiles.

Barrick Gold Corporation

The world's largest producer released a sensational first quarter and surprised the street by spending nearly $1 billion to reduce newly acquired Placer Dome's hedge book by a whopping 4.7 million ounces. Barrick pledged to reduce the hedge book further, which was timely and might have helped the first quarter run-up in gold. Production was 1.96 million ounces at a cash cost $283 and guidance is unchanged at 8.6 million ounces of gold for the full year. At Barrick's annual meeting, it unveiled a pipeline of projects, including Cortez Hill and Pueblo Viejo. Barrick has efficiently consolidated and pruned the Placer Dome people, hedge book, and operations. Barrick's cash flow benefited from approximately 35 million pounds of copper produced at cost between 75 - 80 cents per pound. We expect Barrick to further reduce its portfolio of mines and problems such as South Deep will likely be sold. Barrick's balance sheet, cash flow and pipeline of projects makes it the leader in the industry and the "go-to company". However, even Barrick will find it will be difficult to maintain its growth, particularly on a per share basis. We expect further reductions in its hedge book and expect Barrick to further harvest the Placer Dome acquisition. Unlike other senior producers, Barrick mines possess relatively low geo-political risk.

Bema Gold Corp.

Bema has increased the size of Kupol by 15 percent following drilling and using a higher gold price. The Kupol gold/copper deposit in northern Russia is a major asset for Bema and operation is expected to begin in mid-2008. Current resources of Kupol stand at 11.3 million ounces, grading a whopping 17.2 grams per tonne and 220 grams per tonne for silver. The company has begun negotiations for the return of the Cerro Casale deposit located in the Andes mountain. Bema and Arizona Star had reached an agreement with Placer Dome to reacquire ownership of one of the largest underdeveloped resources of the world. Barrick has offered the huge gold-copper porphyry deposit of almost 23 million ounces gold and 2.7 million tonnes of copper back to Bema and Arizona Star. Some deposits are meant to be developed and others are meant to be kept in inventory. It looks like Cerro Casales with a $1.6 billion price tag will be inventory for a while, primarily due to the hefty capital cost. Meanwhile Bema has been searching for a South African partner to lessen Bema's exposure to Petrex. The newly reopened Refugio mine contributed in the third quarter. We recommend Bema for its growth potential and potential quadrupling of output.

Cambior Inc.

Cambior shares have been in a funk due in part to a strike at Rosebel in Suriname and ongoing production problems at Doyon in Quebec. Cambior is a mid-sized producer that should produce 523,000 ounces of gold this year, down 638,000 ounces due in part to the winding down of Omai in Guyana. Cambior's cash position is also winding down and the company will need new financing if it wants to develop Camp Caiman in French Guinea. Cambior's outlook is mixed since Camp Caiman is further off and Rosebel is producing at its peak. The company has been mum on the takeover battle for Aurizon which owns the other 50 percent of the Sleeping Giant mine that Cambior holds. Cambior once had a chance to take in Aurizon but preferred to leave it to somebody else. That might be a decision they will regret given the opening of the Casa Berardi mine in November and Northgates' premium bid. There are ongoing rumours that Cambior is worth more dead than alive and that it might be an ideal takeover candidate. The non-gold assets are interesting but Rosebel is really Cambior's main asset. At current levels, we prefer other vehicles even though Cambior may be better off dead than alive. Sell.

Eldorado Gold Corporation

Eldorado is at long last showing improved results due to the commissioning of the Kisladag heap-leach gold mine in Turkey which began operations in April, achieving its multi-mine gold ambition. In addition, the Tanjianshan mine in western China is expected to begin in the fourth quarter of this year. Eldorado could be producing better than 220,000 ounces, up from 64,000 ounces last year. Eldorado will close down the Sao Bento mine in Brazil by mid 2007. In 2007, however, contributions from China and a full year of operation at Kisladag will see Eldorado producing almost 500,000 ounces. In addition, Eldorado is permitting the Efemcukuru gold project in western Turkey which could be in production by 2008 at 90,000 ounces annually. Eldorado shares look attractive inline with its growing production profile and improved profit picture. We continue to recommend purchase here for Eldorado's rising reserve profile, unhedged position and solid management.

Glamis Gold Corporation

Glamis closed its whopping big purchase of Western Silver and the company intends to spend $52 million at the Penasquito gold/silver/zinc/lead property in Mexico. Glamis is making a big bet. Its current gold mines are relatively modest with problems at Marlin gold/silver deposit in Guatemala and Marigold in Nevada. Until the acquisition of Western Silver, El Sauzal was Glamis' main mine. The Penasquito project is a major bet and while Glamis has been successful at bringing open pit gold mines into production, Penasquito will be a challenge management wise, capital and geology. However, with a capital cost in excess of $330 million, Penasquito could be one of the major silver producers. While drilled off, construction and metallurgy will prove to be a challenge for Glamis. We expect Glamis' premium will shrink with the company in the construction phase and thus we recommend switching into Goldcorp, Meridian or Agnico-Eagle at this time.

IAMGOLD Corporation

IAMGOLD has been a mediocre performer due in part to a flat production profile. In the first quarter, IAMGold produced 123,000 ounces at a cash cost of $271 an ounce excluding the Gallery Gold contribution which closed at the end of the quarter. The company also released encouraging preliminary scoping results at Quimsacocha in Ecuador. At an initial capital cost of $270 million, the company could be producing 280,000 ounces from an open pit.

IAMGold has non-operating interests in four gold mines in West Africa and thus the acquisition of Gallery Gold in Australia is its first operating mine. Gallery Gold will be a test for management and its skills. In addition 100 percent owned Quimsacocha gold/silver/copper deposit in Ecuador is an attractive development situation but geo-political risk may dampen investor enthusiasm. IAMGOLD is in need to show growth since investors appear to be impatient over its inability to grow its resource and production base. We prefer Meridian or Kinross at current levels.

Kinross Gold Corporation.

Kinross finally reported first quarter's results which were inline with estimates. The company's main mines at Fort Knox (Alaska), Round Mountain (Nevada) and Paracutu (Brazil) performed in line with expectations and the company released more information on the Paracutu expansion. Kinross also benefited from the reopening of Refugio (Chile). Tye Burt, the new president has effectively changed all the managers this year, sort of a new broom sweeps clean. We note however that the new players possess little industry experience. Nonetheless, we expect that Kinross will do more deals, now that its regulatory problems are behind it. Most likely is a consolidation of some of the interests that it shares with Goldcorp, such as La Coipa and the Porcupine Joint Venture. We continue to recommend the shares here more for its takeover potential and excellent leverage to the gold price. With ten operating mines, Kinross is an attractive tidbit for the majors since it has more than 1.5 million ounces of unhedged ounces and a solid balance sheet.

Northgate Minerals Corporation

Northgate shares have picked up in response to drilling news from the Young-Davidson property in the Kirkland Lake gold belt in northeastern Ontario. Northgate has had good results but now must go underground to expand the 1.5 million ounce resource base which will take time. Meanwhile Kemess North is plodding along drawing attention to Northgate's main problem and that is its uncertain future growth in reserves and production. As such, Northgate has launched a hostile takeover for Aurizon Mines which is scheduled to produce 175,000 ounce a year at the 100 percent owned Casa Berardi development in northwestern Quebec. Unless improved, we do not expect Northgate to be successful despite offering a 30.5 percent premium because the bid undervalues Aurizon. Consequently, Northgate would be left at the altar and expect the company to be dead money for a while. We would switch into Bema or Eldorado at current levels.

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Analyst Disclosure
Company Name Trading Symbol *Exchange Disclosure code
Barrick Gold ABX T 1
Bema Gold BGO T 1
Crystallex KRY T 1,5
St. Andrew Goldfields SAS T 5
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John Ing

Author: John Ing

John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040

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