GOLD - UK SALES TO HIT SENTIMENT MORE THAN REALITY
Salomon Smith Barney
Monday, May 10, 1999
----------
--SUMMARY:-------------------------------------------------------------- * Friday's announcement that the United Kingdom Treasury plans to sell 125 metric tons (mt) of gold in 1999-2000, eventually cutting its 715-mt hoard to 300 mt, came as a complete surprise to the gold market and pulled prices sharply lower. * The timing of the announcement, ahead of proposed (but not approved) sales by the IMF and Switzerland, is also perplexing. * We expect the sale to hurt near-term sentiment, but not the metal's physical supply/demand balance. The sale will fill only about one-sixth of the 800-mt commodity deficit for 1999. * In light of emerging concerns about reflation, speculators likely will be less aggressive in adding to short positions. * We recommend purchase of selected gold shares. --OPINION:------------------------------------------------------------------ The United Kingdom, which is not yet a member of the new European Economic and Monetary Union (EMU), shocked the gold market Friday when it disclosed plans to sell 125 mt of its gold reserves in five bimonthly auctions beginning in July. Over the next several years, it will divest 415 mt of its current holdings of 715 mt. The announcement came as a surprise for several reasons: (1) The UK, home to the world's leading market for physical gold, has not been thought of as a likely seller of the metal. The country was the first to establish the gold standard in 1717, and gold bears will certainly view the sale as a watershed event, signaling the likely capitulation of other central banks in ensuing months. (2) The timing of the announcement suggests that the UK intends to front-run potential sales of gold by the International Monetary Fund (IMF) and Switzerland. The IMF has been considering the sale of some of its gold to help fund relief for highly indebted nations for several years, and the UK has been a vocal proponent of the sales. After several years of opposition by key members Germany and Japan, it appears that most finance ministers now support the sales. A go-ahead decision could come later this year to sell between 150 and 300 mt of metal over a multiyear period. The U.S. Congress may yet derail the IMF sales, as its approval is needed before the U.S. can officially sanction the sale, and the U.S. accounts for 18% of the 85% weighted average vote required for the sales to take place. In Switzerland, the link between gold and the Swiss franc was severed in a recent national referendum, with another public vote required before any gold sales could take place. The Swiss Government is recommending the sale of 1,300 mt of its gold over several years. (3) It is highly unusual for a central bank to announce plans to sell gold ahead of the event. Instead, sales in recent years have been announced after their completion, even for forward sales that take one or more years to achieve. (Indeed, we are still awaiting announcements of central bank sales that apparently were conducted in 1997-98 but have not yet been disclosed.) We expect that the UK announcement will have an adverse impact on gold market sentiment in the near term - perhaps over the next several months. Nonetheless, we believe that investors will be better served to view near-term weakness as a buying opportunity, not a time to join the central banks in capitulation. Our supply/demand estimates for 1999 conservatively project that gold's supply/demand deficit will approximate 800 mt - all of which will have to be filled by central bank sales or lending (the latter providing liquidity for producers to hedge and for speculators to take short positions). The effect of the UK sale will be somewhat diminished, in any case, by the fact that its central bank already is a lender of gold into the market - which means that the country effectively has monetized a portion of its gold holdings. Our view has been that it is increased central bank gold lending, rather than outright gold sales, that have kept the gold price mired below $300 per ounce. There is increasing evidence that total central bank gold loans outstanding may exceed 10,000 mt - more than twice the amount recently estimated by Gold Fields Minerals Services Ltd. in its latest gold update. (This equates to almost one-third of all central bank gold holdings.) While not much comfort in the near term to those of us who have maintained a positive outlook toward the metal, such levels of lending raise the likelihood that when the price of gold eventually climbs out of the cellar, the ensuing rally may be much more dramatic than our published price estimates suggest. The high-risk deri vatives-based hedging strategies in place by many gold producers only add to the upside potential. To date, the recent rotation of investor interest into cyclical names has buoyed the gold shares but not the gold price. Typically, gold prices change direction ahead of other metals, but that obviously has not been the case in the current rotation. While the UK announcement has brought the metal back toward its cycle lows reached last August, we would not be too complacent about gold's ability to rally from these depressed levels. It is possible that producers may be more likely to add to hedging positions in the aftermath of the UK announcement, particularly if they buy into the premise that it will be followed by further wholesale divestiture of gold by other central banks. However, we doubt that speculators will be as aggressive in building substantial short positions as they were in the last two years, simply because of the strength of the interest in cyclicals generally. Gold's supply/demand fundamentals are positive, even with our conservative assumption that fabricated demand will weaken this year. We will revise our demand estimate higher if the first-quarter demand numbers released by the World Gold Council (within the next two weeks) show the same degree of strength as the fourth quarter did. Our favorite names in the gold sector remain Newmont Mining, Freeport-McMoRan Copper & Gold, and Agnico-Eagle Mines - all of which we rate Buy. Our outperform recommendations include Barrick Gold, Homestake Mining, Placer Dome, and Kinross Gold |
