Gold: Unsustainable Developments
Gold has finally broken out of the narrow trading range between $640 and $665 an ounce, that has frustrated both bulls and bears alike. Gold bounced off the 200 day moving average but for most of the Spring failed to break through the $670 resistance level due to an increase in central bank selling, a bounce in the US dollar and selling from the ETFs. In addition, seasonal demand is typically low at this time which was not enough to offset the increased buying from the hedge buybacks by Barrick, Anglo and Newmont. We view the recent breakout as another purchase opportunity and remain convinced that gold will trade at $1000 an ounce before yearend.
Gold's physical demand remains strong, particularly from Asia and the Middle East. The latest CFTC Gold statistics shows a dramatic reduction in sentiment which is bullish for gold. Particularly promising is the improved technical action of the gold stocks which until recently have been laggards. Gold stocks have shown signs of strength outpacing bullion and we believe that this a key signal for a major move to the upside. However, the key driver will be the strong crosscurrents across the world's financial markets. It is our belief that the gigantic global speculative credit boom which has already created asset price inflation is a move to hard assets and a prelude to higher inflation. Gold's turn is next.
Sustainable development is the rage among politicians, my daughter and environmentalists alike. Yet, more people watched the soccer match between Argentina and Peru on cable than Al Gore's Live Earth on prime time NBC. What is unsustainable are developments in the economy.
Since 2002, asset prices have skyrocketed around the world and bubbles have popped up everywhere from stocks to Chinese paintings to uranium to debt. The CRB Commodity Index is at a 42 year high. The explosion is rooted in the expansionary global monetary policy that has flooded the financial system with liquidity. It involves the United States, the world's biggest economy, continuing to live beyond its means, running up huge deficits which have resulted in the creation of record amounts of debt. According to the Bank of International Settlements (BIS), "the strategy depends on the availability of cheap funding". The liberal use of leverage and the increasing array of financial instruments made debt easier to pile up. Cheap debt has underwritten a global "carry trade arbitrage" enabling the acquisition of higher yielding equity, companies and real estate with cheaper paper.
Of course this is an unsustainable development.
The liquidity cycle has turned. Fears of the Chinese flu caused a contraction in liquidity. The uptick in rates and liquidation of the subprime debt markets also wiped out the "carry trade", further lessening the level of liquidity. Finally, with piles of American treasury bills losing value, foreign investors have converted some of those piles into other asset classes causing a further contraction in liquidity. The unwinding of the global "carry trade arbitrage" is at hand with an increase in borrowing costs.
Almost at the same time, global interest rates have increased sharply. Bond prices crashed and yields on European and Japanese bonds climbed. The backup in yields follows the European central bank maintaining its main interest rate at 4.0 percent, the highest level since September 2001. The yield on US ten-year government bonds registered its biggest jump in years hitting 5.30 percent before settling back to 5.1 percent. The increase in rates, at long last is a wake-up call for a complacent market used to stable economic news, low inflation and massive US deficits.
Competition For Money
There are fears that the sharp rise in yields was driven by a trend towards central bank tightening. Wrong. We believe that interest rates are rising because the global trend of excess liquidity has pushed up the value of assets. Central banks have been on an inflationary money printing binge- witness the asset inflation of today. As measured by M3, money is being created at double-digit rates world-wide. For money to have value, it must be ‘dear" and limited in supply.
The move in interest rates then, is a competition for money, particularly by weaker currency jurisdictions. For example, the central bank of New Zealand has increased rates to 8 percent, the highest levels in a decade. At the same time, New Zealand is pushing money growth as measured by M3 at a 14.6 percent annual rate in April. New Zealand is not the only one with exuberant monetary growth. Brazil's M3 is growing at 16.1 percent, Australia's M3 at 13.7 percent and even South Korea's M3 growth at 12.3 percent. Although the United States does not measure M3 growth anymore, M3 growth is between 13 to 14 percent range.
The Emperor Has No Clothes
Hit by US sinking subprime loans, the near collapse of Bear Sterns' subprime hedge funds exposed investors to the harsh mispricing of the $850 billion mortgaged backed CDOs or collateralised debt obligations which back subprime mortgages. Merrill Lynch, to realize its collateral, attempted to force the fire-sale of $850 million of CDOs but could only find sufficient bids for $200 million. In addition, it was disclosed that up to $2 trillion of debt was falsely priced and bids for "A" rated securities were placed as low as 30 percent of face value and not the 85 percent for previous "A" rated paper. So far there have been 87 players that have failed in the wake of the subprime implosion. Bear Stearns, the biggest broker to the hedge funds is now locked in a battle with other investment banks. And there are concerns that the Bear contagion would spread to junk bonds and the red hot leveraged loans. Risk premiums have increased, spreads have widened and with it excess liquidity has been extinguished overnight. In any case, investors are demanding greater protection, higher premiums and less leverage in an attempt to close the barn door. Amazingly, the subprime mortgages are less than 11 percent of total outstanding securitized debt. With the credit markets closed, hedge funds, private equity and the big investment banks just had their portfolios revalued downward and there is not enough protection or capital.
What is then to hedge investors from the over-extended institutions sitting with bloated mispriced inventory? The emperor has no clothes and rather a value of $850 billion, the underlying value of the CDOs on the books of the hedge funds, investment banks and insurers may be something less than $300 billion. Indeed, the mark-to-market losses exceed the capital of the big investment banks that underwrote the CDOs. Are the defaults the tip of the iceberg? No. Titanic has already sunk. With access to credit becoming tight, the big investment banks must also handle the bridge financing requirements of the big private equity buyout boom since the buyers are on strike. Credit markets are not ready for the big bust. Losses are projected to be even higher because of the "slicing and dicing" of risk by Wall Street has left buyers illiquid assets. We believe that the inevitable unwinding of this debt binge will cause a credit crunch implosion that could easily turn into a harbinger of crisis. Gold is a good thing to have.
This is Why Gold is a Good Thing to Have
Once upon a time the greenback was good as gold. Under the Bretton Woods Agreement, the dollar was exchangable into gold which lasted from 1946 to 1971. During the Bretton Woods era, America's large deficits and prolificacy was sustained by external borrowings. Gold rose to over $40 an ounce and the Bank of England together with the Federal Reserve were forced to sell their gold reserves to maintain a price at $35 an ounce. This gave way in early 1961 to the creation of the Gold Pool to maintain the price of gold at $35 an ounce. Each time however, the Americans continued to run significant deficits and US gold reserves declined. Gold creeped higher. The Americans also fought a war that they could not afford. The Vietnam War resulted in massive budgetary deficits and by 1968, the Gold Pool was disbanded (US gold reserves had fallen some 50 percent). For much of this time, the US dollar was supposed to be as good as gold.
Inflation of course was in double digits for a decade and unemployment not far behind - an unsustainable development. Bretton Woods fell apart when the dollar problems began to mount and countries opted for gold instead of dollars. As a result in August 1971, President Nixon went off the gold standard to avoid a run on the dollar. Ever bigger deficits ensued, the dollar was devalued and gold peaked at $850 an ounce in 1980.
Déjà Vu, All Over Again
Since its peak five years ago, the dollar has lost about 35 percent against the major currencies. America has become the largest debtor in the world. With record debt loads, and the reluctance by its creditors to invest in more dollars (there is no gold convertibility anymore), we believe the dollar will lose another 35 percent. Like the Johnson and Nixon Administrations in the 1960s and 1970s, the Bush Administration continues to run up huge budget and current account deficits. Each time, Johnson and Nixon had been forced to revalue the dollar. Bush has no choice. A sharp fall in the dollar is in the offing. The worst case scenario? With no savings and credit, the government's access to borrowing will be cut off, creating a cash crisis throwing our financial markets into chaos.
Gold is a good thing to have; it is also a barometer of currency fears. The US government cannot continue to pursue a policy of fiat money inflation. If people believe the greenback is overvalued and there is no alternative. Gold is a natural safe harbour. Gold has risen from a low of $255 per ounce for a 150 percent increase in the past four years. History shows that gold is money. Gold acts as the world's only true currency. Gold cannot be created like fiat paper currencies. Because gold's supply is limited and central banks cannot flood the market; gold represents the ultimate store of value.
A New Currency?
With the dollar so badly flawed, we believe the market will look to alternate replacements like the euro. After the collapse of the dollar in the mid-eighties, the Europeans established the European Monetary System as a prelude to the creation of the euro. The European Monetary System was established following the breakdown of the Bretton Wood system. The euro today is backed 15 percent of gold and about 25 percent of all global foreign exchange transactions now involve the euro.
Despite having trillions of dollars of foreign exchange reserves, the Asian financial crisis of 10 years ago is still fresh in many Asian central bankers memories. Today, Japan, Korea and the Philippines maintain flexible exchange rates, while Hong Kong, Thailand, and Singapore and of course China have managed floating rates. Unfortunately, all these units are pegged to the greenback and the pool of dollars is growing at $1 billion a day. At a recent meeting, finance ministers from ten Asian nations agreed to set up a regional reserve pool, augmenting a current pact.
The fact that the US borrows entirely in dollars makes its deficits safer for itself but riskier for its creditors. In essence with growing pools of foreign exchange reserves, a desire to lower risk, and to avoid a repeat of the Asian crisis, Asia is expected to establish a common currency unit similar to the European monetary system with an Asian central bank. Central banks in South Korea, China, Taiwan and Japan have announced plans to buy other asset classes with higher returns than low yielding and risky US debt.
More relevant, by establishing another currency bloc, central banks have more alternatives to the once favoured US dollar. Asian central banks have already lost their appetites for US treasuries. Despite the increase in yields, a recent auction of US 10-year bonds attracted only 11 percent of foreign buyers. Beijing was a net seller of $5.8 billion of US treasuries in April, the first drop in holdings since October 2005. Gold is a good thing to have since the new unit will have a gold backing similar to the euro.
Yet, another protectionist measure was introduced by Congress which might make good electioneering politics but has little to do with anything to force China to change. Not only is this another impotent form of China-bashing but while the renminbi has strengthened in the past year, America's deficits continue to worsen. To resolve the imbalances between China and the United States, America must look to domestic fiscal policy rather than a shift in the renminbi. America has allowed politics to prevent a reduction of the federal deficit and its policy of China-bashing only serves to mask their real problem. The Bush Administration's proposed defence budget is also a problem. Bush expects to spend $647 billion including $142 billion to cover the anticipated costs of the wars in Iraq and Afghanistan. Meanwhile, China's military budget has increased to modernize its forces and to back its economic muscle with military muscle. However, this has raised new tensions with the United States. China's military spending is expected to increase 17.8 percent this year, but its defence budget is estimated at only US$45 billion. Noteworthy, is that China's defence budget is still smaller than Britain's, France's and Japan's. Nonetheless xenophobia has been raised, particularly when China announced the destruction of a satellite in space with a ground fired missile.
It has been calculated that a 20 percent appreciation of the renminbi would reduce the US deficit by only $150 billon or so, a rounding error. Instead, if Americans spent less, saved more, used less energy and consumed less, the savings of billions would more than offset an increase in the renminbi. Indeed were the renminbi to increase by 20 percent, it would result in increased import costs and higher export prices. America has benefited from low import prices, and that is the problem. America's insatiable appetite for cheap imports and cheap energy and its reliance on borrowing from the rest of the world. America needs to borrow $2 billion a day to finance it deficits.
To be sure, an unsustainable development.
Be Careful of What You Wish For
America's position as the world's sole superpower is being challenged by not only China, but others like India. There are signs that the establishment of sovereign-wealth funds or clubs with hundreds of billions of dollars is a reverse form of nationalism or globalisation. However, it puts debtor-nations such as America at a disadvantage since many of its competitors are also its creditors. As a result fears of "hollowing out" are prevalent. Moreover, wannabe superpowers like Russia, flush with petrodollars hope to capitalize on America's weakness. China already has the fourth largest economy in the world and in the next decade is projected to be bigger than every G8 member, except the United States. Economic size invariably translates into political power and with one of the world's largest economies together with the largest source of cash, China is expected to rival America's position on the world's stage.
Ironically while China has $1.33 trillion of foreign exchange reserves, China's financial system has not kept pace with its industries. China is now the world's largest source of capital. China's current account surplus has exploded from $26 billion to $250 billion last year, outpacing that of Japan. China's problem is that the trade imbalance has resulted in an inflow of dollars due in part to swelling trade surpluses and the piling up of dollars due foreign exchange activities. These surplus dollars has represented a problem in that the securitization or the lack of immunization has resulted in excess liquidity. But this time, much of this liquidity has flowed into its stockmarkets which have been making daily highs. China's capital markets are still in their nascent stage with needed market reforms. Beijing's $3 billion investment in Blackstone is a first step in establishing a more sophisticated capital market capable of recycling the trillion dollars in surplus savings. The liberalization of China's financial markets will likely be part of the upcoming 5-year Communist Party Congress that is due in October. America should be careful for what they wish for.
Meanwhile, flush with petro-dollars Middle East investments have increased in size surpassing the cash hoards of the seventies. Two decades later, the Persian Gulf's $585 billion current account surplus is bigger than that of China and Japan. The Abu Dhabi Investment Authority has used its oil largesse to build up a portfolio of international equities with debt and money markets estimated between $300 and $500 billion overshadowing China's. Instead of high profile US investments like trophy buildings and Tiffanys, this time, Middle East investors have instead become more sophisticated, taking lead positions in hedge funds, big private equity funds as well as participating as joint-venture partners. The global liquidity pool has a new player.
Investment Strategy - Beneficiary of Hard Asset Investing
China's breakneck growth continues in a vortex-like fashion to suck in raw materials, especially base metals. China's prodigious appetite has created supply bottlenecks and helped cause the shift to hard assets, like gold. The ETFS have also sucked up surplus gold generated by the hedgers. Gold is tight due to demand from both the hedgers and ETF players. Finally, with global savings shifting towards China and the Middle East, these nations prefer to invest in hard assets such as gold rather than paper dollars. For more than twenty years, the gold industry was stuck in the wilderness due to low prices which caused a lack of capital spending and exploration. The deposits of tomorrow have yet to be found simply because the industry itself has not boosted its exploration budgets enough, preferring to harvest yesterday's deposits. Hence gold prices are expected to head even higher.
We continue to suggest an over-weighted position in gold stocks with the expectation that gold will surpass the old high of $850 per ounce this year. The end of the twenty-year bond market, credit implosion and a major drop in the US dollar will underpin gold's long term bull market - Indeed we have only just begun. We also expect a continuation of M&A activity as the seniors scramble to replace depleted reserves by buying ounces on Bay Street. The flattening of the industry's gold hedges is a reflection of the long awaited turn in senior management psychology and the acknowledgment that we are in a gold bull market. Consequently, we prefer the mid-tier and junior companies with improving production profiles, blue-sky reserve upside and active exploration programs. To date there have been few exploration successes and thus the industry is ripe for surprises on the upside. We would emphasis those juniors with large land packages, strong management and soundly-based exploration programs. Among the mid-tier we continue to recommend Kinross Gold, Meridian and Agnico-Eagle. We also like Crystallex International, Eldorado (particularly in light of the recent weakness), High River, and Aurizon(which has brought the new Casa Berardi mine into production). And again we like the junior package of Contintental, Etruscan, Excellon, St. Andrew Goldfields, Philex, Unigold and recently added MAG Silver.
AgnicoEagles Mines Ltd.
Agnico-Eagle had another terrific quarter, as the company benefitted from by-product credits for zinc, copper and silver which resulted in a negative $332 per ounce cash cost for mining gold. Agnico will produce 240,000 ounces this year but will boost production to 1.2 million ounces by 2010, once the five new mines currently in construction come on stream. The newest, Cumberland Resources in Nunavut will produce 400,000 ounces in the first year alone. Agnico recently released drilling results from Pinos Altos in Mexico, where four drill rigs are turning. In addition, Agnico is sinking an underground ramp which will give it access to deeper zones in Santo Nino and Cerro Colorado. Pinos Altos currently has a resource of almost 2 million ounces of gold and 56 million ounces silver. Further drilling is expected to be boost the resource. We continue to recommend Agnico-Eagle shares because they are among the few that are spending aggressively and hence possess the best blue sky picture among the intermediate term players. Buy.
Aurizon Mines Ltd. Aurizon has begun pre-commercial production at its Casa Berardi mine in the latest quarter. Aurizon produced 32,000 ounces of gold and is expected to produce about 175,000 ounces this year at a cash cost of about $275 an ounce. Aurizon plans to boost the mill from the 1600 tonnes to 2,200 tonnes per day which would allow it to boost production. Aurizon is also conducting an active drill program in the Kipawa Basin in the Quebec area for uranium where it possesses the largest land holding. We continue to recommend Aurizon as a developing mid-tier candidate.
Barrick Gold Corp.
Barrick reported a first quarter loss of $159 million due to the buyback of its hedges. Noteworthy is that Barrick is still not hedge-free since it continues to maintain a 9.5 million ounce position to offset the production cost at billion dollar Pascua-Lama. We support Barrick's buybacks but believe that they should also flatten the Pascua-Lama hedges, because the company still maintains an excessive mark-tomarket potential loss. Of more concern, is that Barrick shares have been underperforming not only because of its hedging policy but also because despite another round of acquisitions, the company has not been able to show per share growth. Part of the reason is that mining for gold is an expensive exercise and Barrick has seen its cash cost increase from $177 an ounces in 2002 to $350 today. Barrick's gold production profile over the next couple of years is flat and projects such as Pascua-Lama, Pueblo Viejo and Donlin Creek possess billion dollar price tags and thus investors are concerned about Barrick's intermediate term profitability.
Crystallex International Corp.
Crystallex has fulfilled all the necessary requirements for the issuance of the long awaited final Environmental Permit for the Las Cristinas property in Venezuela. The Company has even posted a bond and paid taxes and has diligently purchased everything from hospitals, to roads to equipment in anticipation of receiving the Environmental Permit. The Company expects to be in production within 16 months of being granted the Environmental Permit. Crystallex is probably the answer to a lot the majors' problems of lack of reserves. In our view, Las Cristanas is one of the most important undeveloped gold deposits in the world and with reserves in excess of 15 million ounces, an enviable target. The question is when and how the bidding will begin. We believe that a major is already well positioned and expect at least two other suitors to the table once the permit is granted. Consequently give the potential risk/reward, we believe Crystallex shares are undervalued and a buy here.
Eldorado Gold Corp.
Eldorado Gold successfully brought the Kisladag mine, Turkey's largest gold mine into production and reported first quarter production of 76,000 ounces. Cash costs have increased slightly partly due the Chinese Tanjianshan mine which also came into production. Eldorado is an emerging second-tier gold producer and should produce 400,000 ounces in 2009, up from the current 250,000 ounces. However, a court injunction to halt operations at the Kisladag mine until the court rules on an appeal of a lower decision to confirm the legality of Eldorado's environmental impact assessment shocked the markets. We believe the shares have over discounted what maybe a ‘tempest in a teapot". The decision is only expected t take only 30-90 days so the closure might prove to be short. We continue to recommend the shares particularly on this pullback as the assets remain in place.
Gammon Gold Inc.
Gammon Gold is still in the construction phase at the Ocampo gold project in Northern Mexico. The company plans an ambitious combination heap/leach underground operation, but rain created havoc with the heap/leach operation. The company has recently changed personnel and while the property is well drilled off, we are concerned about the execution risk and note that production guidance continues to be ratcheted down. While the company is well financed, our model suggests there is room for disappointment and thus we believe the company is way ahead of itself. Gammon is an expensive stock and the shares are vulnerable to disappointment. Sell.
Goldcorp reported a disappointing first quarter of $0.18 per share versus $0.27 per share. While Goldcorps's gold production nearly doubled, cash costs increased and the company is plagued by "hardening" assets at this stage and maybe one deal too many. The acquisition of Glamis added four new mines but resulted in whopping dilution. The company took a loss on the sale of the Peak mine in Australia which was a good idea since the Peak mine had already peaked in production. Goldcorp's problem is that like the majors, it cannot show near term growth in ounces on a per share basis. Long term projects such the Peñasquito gold/silver/zinc in Mexico are too far off, as well as Éléonore and Pueblo Viejo. Peñasquito's price tag keeps going up and we question if billion dollar projects makes much sense or even money today. There is still need for a further consolidation and the pruning of assets, including Goldcorp's Porcupine, Musslewhite and La Coipa interests. Sell.
Newmont Mining Corp.
Newmont like Barrick spent more than $500 million to buy back 1.85 million ounces to flatten their hedge book. The company has already decided to unscramble the omelette and will sell the merchant banking assets, Newmont Capital which was a key part of Franco-Nevada which was bought five years ago. Newmont will take an asset impairment charge of $1.7 billion which is really part of the goodwill portion of the Franco acquisition. In sweeping out the old, newly appointed president Richard O'Brien is taking away a key asset generator that actually created value. While we concur with the elimination of the gold hedge book, we think it is a misguided decision to sell the merchant banking portfolio, which ironically may end up in the hands of the original creators - déjà vu? Neither the sale of Newmont Capital nor the flattening of the hedges will solve Newmont's problem and that is to replace reserves and a flat production profile. Newmont will still have to spend heavily at Yanacocho in Peru and is in need of much better mines than Leeville and problem prone Phoenix which recently came into production. Because of the permitting time line and problems with power in Ghana, Newmont is need of a fill-in acquisition. The $1 billion plus convertible debentures will do little for the balance sheet but hurt the common. We continue to prefer the mid-cap producers despite the long-term value. We would be sellers here.
MAG Silver Corporation
MAG continues to add to the growing resource of the Penoles/MAG Juanicipo joint venture (almost 8,000 ha)in Zacatecas, Mexico. The Company recently extended the strike length beyond 1 km and drilling to date has outlined about a 1.3 km of strike length. Most recent results show wider widths and bonanza type grades continue to be recorded. Juanacipo is about 5 km from the world's largest silver mine at Fresnillo. Penoles has three drills working on the site and plans to commit two more and is fast tracking the exploration program. We believe that Penoles will ultimately takeover the 44 percent they do not own at a healthy premium but MAG has seven other projects in Mexico including the promising Batopilas in Chihuahua state. Of interest is that MAG also has a carbonate replacement deposit in Cinco de Mayo in Northern Mexico similar to our favoured Excellon's Platosa play. Buy.
Meridian Gold Inc.
Yamana Gold has made a hostile bid for Meridian using the cash from Northern Orion Resources. Yamana plans a three-way merger with Northern Orion and is making a part cash/part share bid for Meridian. The shareholdings on a performa basis would give Yamana shareholders 53.4 percent, Meridian shareholders 34 percent and Northern Orion 12.6 percent. Meridian owns the world class El Penon mine in Chile and we believe the ratios are out of whack. Also despite Yamana's spin, Meridian shareholders will likely look at other potential merger candidates. In addition, Yamana is paying nothing for Esquel in Argentina, which we believe is promising, with 3.8 million ounces of reserves in place. Hold for a higher takeout price.
Rob McEwen continues to add value to the gold sector and his newly created USGold has outperformed the seniors. With an excellent land position in Nevada and the consummation of the takeover of Nevada juniors, US Gold has the land position of a senior and the exploration budget of a senior without being plagued with the growth profile of a senior, proximity to major deposits of the seniors. US Gold plans to spend over $30 million over the next 2 years, testing an array of targets whose focus is to acquire another Cortez Hill or Pipeline deposit. We like US Gold here.
|Company Name||Trading Symbol||*Exchange||Disclosure code|
|High River Gold||HRG||T||1,5|
|St. Andrew Goldfields||SAS||T||1,5|