Gold Grows As Growth Slows
Investors buying gold in the wake of the September 11 terrorist attacks are doing the right thing, but for the wrong reasons.
In fact, three of the world's most successful gold analysts and investors contend that a bull market was locked in well before the terrorist attacks.
By Brien Lundin, October 2001
Introduction:The price of gold bullion hit a multi-year low in April of this year at $259 per ounce - at the same time that share prices for many gold producers were on their way to doubling. One of the reasons for this apparent contradiction is that many people in the industry - and investors - were calling a bottom to the five-year decline in gold prices. Sentiment, they said, was turning from overall pessimism to cautious optimism.
But how justified was this view? Even after the terrorist attacks on America, the price of gold cannot escape above a lid of $300.
To get a better understanding of what has been happening in the gold market in recent years, and what may happen in the coming two years, I asked three knowledgeable industry insiders for their views on the future of gold and gold mining stocks. You can rest assured that recent developments have made these gentlemen more bullish than ever.
Pierre Lassonde is President and co-CEO of Franco-Nevada Mining Ltd., one of the largest gold companies in the world. One of the most respected executives in the industry, Mr. Lassonde has helped guide Franco-Nevada to achieve record revenues - and increase shareholder value - in the face of steadily declining gold prices over the last several years.
Martin Murenbeeld is one of the most respected gold analysts in North America. His clients include many of the major and mid-tier mining companies of the world, which rely on his advice for the best way to maximize their gold-sales revenue.
Ian Telfer has taken two companies from zero to several hundred thousand ounces of gold production over the last two decades - no mean feat in a volatile market like gold. He is now Chairman and CEO of Wheaton River Minerals Ltd.
Lundin: Thank you, gentlemen, for contributing your views. Martin, let's start with you. You recently published a report saying you are now cautiously optimistic about the price of gold for the first time in a couple years. Why have you turned positive now?
Murenbeeld: For several reasons, but the quick answer is lower U.S. interest rates. But that needs some explaining.
It was expected in the wake of the Central Bank Agreement on Gold in September 1999 (CBAG - also called the Washington Agreement on Gold, or WAG) that lease rates would rise. This is because the 15 European central banks (including the European Central Bank, or ECB) agreed not only to limit their collective gold sales to 400 tonnes per year, but also to cap gold lending at the then outstanding amount. With a cap on gold lending, any increase in demand would raise the lease rate.
But as it turned out, the year 2000 saw a decline in lease rates as producers backed away from hedging their gold production forward. With U.S. interest rates rising, furthermore, the decline in lease rates opened up a substantial contango, or premium on the forward price of gold. Speculators and "hedge" funds were quick to pounce on the widening contango - by selling borrowed gold and depositing the proceeds in the U.S. credit market. This gold "carry trade" was profitable as long as gold did not rise. And since gold didn't rise, "speculators" were generally short gold for all of the year 2000.
Recently this situation has changed. Central banks, in an effort to improve their return on gold lending, have moved out on the yield curve, lending gold for longer periods of time. Less lending for shorter periods has meant a higher short-term lease rate. As well, the available pool of lendable gold seems to have dried up as the cap on lending has been reached. This has also helped to raise the lease rate.
On the other side of the equation, the U.S. has been lowering interest rates quickly this year in an attempt to forestall a recession in the aftermath of the technology "bubble."
Ergo, higher lease rates on the one hand and lower U.S. dollar interest rates on the other has meant that the contango for gold has narrowed. This has reduced the incentive underlying the gold "carry trade." Indeed, with gold showing more signs of life, there is a disincentive to be short the market. Not surprisingly, therefore, speculators are now playing gold on the long side; CFTC data show that "speculators" have taken on the largest net long position in gold since February 1996, when gold last rose above $400.
Lundin: But nine consecutive interest rate cuts in the U.S. over the last eight months finds the price of gold still below $300. As yet, I would suggest this hasn't been much of a spur to the price of gold.
Pierre, you are on the front lines of the gold industry, managing one of the larger companies in the sector. Do you think we are going to see a significant rally soon?
Lassonde: I had been negative on the price of gold for several years, but we have never been more confident on the gold price than we are now. Our view is in the next two to three years, all the gold that the hedgers, the big guys, have borrowed, they're going to have to pay it back. That is going to take 500-800 tonnes a year of supply offline, which means that your supply to the market is going to be reduced by 25%-33%. That is going to have a major, major impact on the gold price.
And if you look at all the mining companies, we think production is about to fall off a cliff, creating a huge drop in supply. Production was down last year, and it was down this year.
Lundin: One of the bullish factors we've been stressing in Gold Newsletter has been the declining dollar.
Murenbeeld: And rightfully so. I believe the U.S. dollar is overvalued, and gold tends to have an inverse relationship with the dollar - if one is up, the other is down. They are competing against each other to be a "reserve" currency, or a currency of safe haven when stock markets get volatile or turbulent. The U.S. dollar has been very strong for the last few years as the American engine fueled the world's economy. But now as the economy appears to be slipping a few gears, many market watchers - including myself - believe the greenback is poised to fall in value.
A falling dollar also lowers the price of gold in those currencies against which the dollar is declining, stimulating demand for gold in those countries.
A final factor is Chinese demand. China is allowing its citizens to own gold, which could create a powerful new source of demand. India's gold consumption almost doubled when the government opened up the gold market for its population.
Lundin: OK, well Martin, what could prevent the price of gold from going higher in the next two years?
Murenbeeld: Central banks hold a lot of gold! They want to sell this gold; the IMF has "demonetized" gold, and governments want a better "return" on their reserve assets. When the UK announced its intention to sell gold, it noted that it would convert the proceeds to euros, dollars and yen.
Research suggests that over the very long term, the return on holding gold is less than the return on holding dollars. The interest rate on the dollar includes an inflation component and a "real" component, whereas gold returns only an inflation component. Given that central banks, and their respective governments, do not appear to value gold's "neutrality" - gold, remember, is not another central bank's liability - the suggestion is that they will continue selling.
It follows from this desire to sell gold that the CBGA could break down, be revised, or modified in a way that will lead to more gold sales after 2004. In the event of a breakdown, the market will anticipate more competitive selling, as each central bank attempts to sell its gold before the next one does. And gold will plummet as a result. There are some 33,000 metric tonnes of gold held by all official institutions in the world.
Lassonde: Perhaps, but I compare gold price to a rubber band - as long as the current period of gold price stays where it is, when it snaps up it will go even higher.
Lundin: Pierre, were you surprised the price of gold didn't go over $300 an ounce after the terrorist attacks on New York, or now with the war in Afghanistan?
Lassonde: Was I surprised, not really. Two things drive the gold price - monetary policy and the U.S. dollar. Politics doesn't have much more than $5 or $10 effect on price - it's 90% solid fundamentals. The reality is that there is no money in Afghanistan. The demand for gold in that country is minimal. During the Gulf War in 1990, that war dealt with people who had a lot of money. In 1980 and the Iran situation, Iran had a lot of money then - people in those countries buy gold to hedge their bets on their political situation.
Lundin: It's easy to increase the share price of companies if the commodity price goes up. But what if the price gold doesn't improve - why should investors buy any gold stocks if the commodity price goes nowhere for a couple years? Where is there value?
Telfer: Value can accrue to shareholders by merging mines or companies together, especially smaller companies, because general and administrative expenses are a higher percentage of revenue compared to the bigger companies. At Wheaton River, when we had revenue of $17 million a few years ago we had overhead of $2 million. When revenue reached $45 million, we still have overhead of $2 million. You can manage a larger volume of business with the same G&A.
The stock market valuation of small gold projects is incredibly low right now. This gives management teams very little room to maneuver when they need to finance an expansion or an upgrade. This creates a huge opportunity for acquisition minded companies with cash and/or an ability to finance.
Consolidating smaller mines or assets into larger entities improves access to capital. Ten years ago there were few analysts or institutional buyers interested in companies producing less than 100,000 ounces of gold a year. Now this threshold has risen to 250,000 ounces a year. If a company can consolidate production from a number of different sources that total a quarter million ounces, it will attract coverage from analysts, and attract institutional investors. That will increase liquidity in the stock.
Right now, all that dispersed production is being discounted in the market. Investors are nervous that small gold companies won't have sufficient cash flows to maintain the mine, expand their operations and acquire new projects. Single projects are more difficult to finance.
When one of the smaller gold mining companies discovers a viable deposit they require significant amount of cash to develop it. There are very few sources of capital for these producers in the current gold market. Big gold mining companies don't want to be adding 50,000 ounces at a time to their current production. It just doesn't mean that much to them.
Lassonde: Now is the time to consolidate, when assets are the cheapest. Any increase in the price of gold will increase the valuation given to a company's assets, making an acquisition even more attractive to shareholders.
Lundin: Pierre, your company, Franco-Nevada, has been among the leaders in consolidating the gold industry. After your proposed merger with Gold Fields was canned by South African regulators, you proceeded to buy 20% of Normandy Mining, Australia's largest gold producer.
Lassonde: Another example is Barrick Gold Corp, which just acquired Homestake Mining, the oldest listed company on the New York Stock Exchange. Homestake shareholders earned a quick 30% premium from the buyout bid.
Lundin: Pierre and Ian, you're both also actively involved in a consolidation play in the junior end of the gold market - Wheaton River Minerals, a junior producer that saw its stock price double when it announced it intended to consolidate a lot of the small gold mines around the world.
Telfer: That's because, consolidation of smaller assets provides more shareholder value than the amalgamation of major players like Barrick and Homestake.
Lassonde: It's true - there are few companies well positioned to consolidate the smaller assets in what is a very capital intensive industry.
The vision for a company like Wheaton River is to create another mid-size company. Look at the mid-tiers today - a Goldcorp, a Meridian Gold, an Agnico-Eagle - these companies all have market caps in the $500 million range. You look at the tier below that, they're all around $50 million. So if you're able to take one or two projects and put them in a company and create the same kind of assets that you have in a Meridian Gold, for example, you can create 10 times the value that you currently have in a company like Wheaton River.
Lundin: And I wish you the best of luck with it. Gentlemen, that's all the time we have today, thank you for your time.
Conclusion: There Are Fundamental Reasons To Buy Gold
Should all or any of the factors he mentions come into play, Murenbeeld says gold has a very bright future. And almost every actor he cites has now been exacerbated with the terrorist attacks in the United States. The economy continues to slump, which at some point could put pressure on the US dollar. Interest rates continue to decline - the "contango" he talks about is now non-existent. There is no incentive for producers or speculators to sell gold short. And the money supply in the United States is increasing, making inflation a strong possibility in the New Year.
A rising gold price is the easy answer for management teams like Lassonde and Telfer to create shareholder value. Meanwhile, regardless of the gold-price forecast, they continue to focus their attention on acquiring assets with profitable production, and promise.
Note: Brien Lundin is the editor of Gold Newsletter, the oldest and most respected publication on the precious metals markets, and is president and CEO of the famed New Orleans Investment Conference, (www.neworleansconference.com).
For more information on Wheaton River Minerals go to wheatonriver.com
For more information on Franco-Nevada go to franco-nevada.com
For more information on Murenbeeld Associates go to murenbeeld.com |
