What Happened to Gold?

Fri, Aug 3, 2012 - 12:00am

Here we are on the brink of another global financial meltdown (at least according to the popular press) and the gold price is not moving. This lack of action in the gold market in the face of pending disaster troubles some people. They are concerned that gold may no longer be the ultimate safe haven.

In fact, $9 trillion worth of gold has been stashed away by consumers, investors and governments to be called upon at some time in the future. Only a tiny portion of that gold horde is actively traded. The rest is being held tightly for the long-term.

The price of gold, like any other commodity, is determined by the daily trading activity, which reflects only a very small portion of the total holdings of gold. The price is set by those who go in and out of the market. The majority of gold holders, who hang onto their gold, are not counted in the daily price setting. On any given day, the balance of sellers versus buyers, reacting to daily news headlines, determines the short-term price.

It is far more instructive to look at the longer-term trends. Gold has appreciated 6% since the start of this year, and is up 8% from a year ago. At this moment, gold sits at the bottom of a short-term dip. In the last decade, gold has appreciated at an average annual pace of 19%. There have been wild fluctuations along the way, but the trend is clear.

Perhaps the most important factor in the short-term gold market is that investor expectations are pushed well beyond realistic levels. That is, people are told to buy gold because the price will be going to the moon next week. As a result, when the gold price rises, investor demand increases, contrary to rational analysis or the patterns for most other goods.

People buy gold as it is moving higher, on the expectation that this just might be the beginning of the big move. Demand and media attention is most intense near the short-term peaks. Once the gold price is no longer moving higher, it falls back quickly as disillusioned investors bail out. These cycles have become intensified as speculators have learned to play the game: They pile into the market as it begins to rise, hoping to sell before the market turns.

For many people, the only reason to own gold is to benefit when the price finally takes off. After a decade or so of projections that are consistently out of line with reality, a certain degree of skepticism has come into the gold market. Many investors know gold on the basis of its failure to reach the lofty targets set by goldbug commentators.

Nothing has changed to disrupt that decade-long pattern. Gold is going to continue to bounce around, notching higher over time. For those who buy on the dips and take advantage of the spikes (that is, go counter to the herd) gold offers a long-term store of value and the potential for trading profits.

At this moment, investors prefer the certainty of negative returns on US Treasury Bills or German government bonds to the near-term uncertainty of gold or most other assets. That could change quickly. From this level, there is a great deal more upside potential than downside risk.

Gold Equities – Will the beating ever end?

While the gold price has gained 8% over the past year, gold equities have lost enormous value, in some cases being down as much as 80%.

The collapse in the value of gold companies, at least in part, is a follow-on from the growing skepticism with regard to gold. Many people bought gold equities on the expectation that there would be a big move in the gold price. In the absence of that big move, they concluded that there was no reason to own gold or gold companies.

The dismal profit performance of the gold companies contributed in a big way to investor resentment. From 2006 to 2011, the gold price increased by $1000. However, across the gold industry, real cash margins improved by only $100. Much of that meager gain was given back in the first quarter of this year.

The cash cost and margin figures reported in the highlights section of gold company financial reports reflect only the operating costs incurred in the most recent quarter to extract gold from the ground. Those figures do not include the cost of finding and/or acquiring gold deposits and bringing them into production. Those costs are capitalized and then amortized or depreciated. As such, they do not show up in the quarterly cash cost figures.

The total cost of finding or acquiring, developing and then mining gold is not a lot less than the current gold price. One has to question the wisdom of owning a gold mining company. In fact investors have been doing that in droves, as evidenced by falling share prices. The share prices of gold mining companies at this time are about 20% less than net enterprise value. As always, the market has over-reacted, pushing the share prices well below the rational value. The gold companies are profitable, just less so than investors were expecting.

After years of disappointment from mining companies, investors are seeking safer bets, such as the ill-fated initial public offering of Facebook. The biggest destination for investors at the moment is the guaranteed negative real return offered by US Treasury Bills. (The interest rate is lower than the rate of inflation.) In effect, people are paying the government to look after their money.

One important implication of the low profitability in the gold mining industry is that it provides a level of support to the gold price. Just remember that gold is unlike any other commodity. In silver, for example, the production level is an important determinant of the price. Most of the gold that has ever been produced is available to come back onto the market. Annual gold production represents about 2% of the total holdings of gold.

It is very instructive to look at the reasons for the disappointing level of profitability among the major gold mining companies. Clearly, rising operating costs have been a major factor. Energy represents about 40% of the operating cost of the typical mine. Energy costs have been rising at the same pace as gold. A lack of skills across the mining industry has increased the labor price at all levels. Increasing political demands have seen taxes and royalties rising almost globally.

One of the most important and least understood factors in the rising cost structure is grade. The average gold grade a decade ago was about 2.5 grams per tonne. Today, the average grade of a gold mine is 1.3 grams per tonne. That implies that nearly twice as much rock must be mined and processed to get the same amount of gold compared to a decade ago.

Some analysts attribute the declining grade to an expansion of the gold mining industry in response to a rising gold price. That assessment is half right: the gold price has risen. During the time that the gold price has increased by six-fold, gold production has grown by a mere 8.9% a year. The gold mining industry has spent enormous amounts of money to develop new mines, but those new mines have done little more than offset the depletion of older mines.

As an illustration, let us look at the reserves and resources for Barrick, the largest gold producer. The average grade for the company’s reserves is 1.3 grams per tonne. The average grade for the company’s resources (beyond the reserves) is only 0.7 grams per tonne.

Simply put, the gold mining industry is developing the best available deposits. As far as I can see (and I have looked long and hard) there is nothing in the exploration/development pipeline to suggest a reversal of this downward trend in the average gold grade.

Investors and analysts are out of date with regard to their expectations of grades for gold deposits. Projects are heavily discounted by investors who apply metrics that were meaningful a number of years ago but are no longer relevant. A similar story applies to most of the other metals.

At this time, with investors fleeing global financial uncertainty, investors have little or no interest in undeveloped gold deposits, whatever the grade. (There are companies with gold deposits which are trading for less than cash value.)

Even if investors do not appreciate the value of those deposits, the mining industry will undoubtedly continue to acquire exploration and development companies in order to develop new gold mines.

Where is the bottom?

In April, we referenced a study by the brokerage firm Canaccord Genuity. That study concluded that large and mid-sized gold producers were trading at a share price that represented only 75% of the net asset value of the company. The latest figures show the share prices have rebounded slightly to 80% of net asset value. This suggests that the market, at least for the producing companies, has bottomed.

Some of the higher quality exploration and development companies have also started to rebound.

For the overall market for junior exploration and development companies, there is still a lot more downside. Many of the companies in this sector, perhaps the majority, are still trading for share prices well beyond their fundamental values. A company whose only asset is the hope that someday they will make a discovery will have a difficult time raising money in this market, at least at prices that make sense to existing shareholders.

To clarify that statement: Nearly any company with a listing will find somebody to invest in it. However, for many of those companies, the financing prices will be far lower than the price paid by most of the present shareholders. With share structures increasingly numbering in the hundreds of millions of shares outstanding, it gets harder and harder to imagine a payoff in line with the risk of holding these companies. In other words, those companies with the bloated share structures will have to make phenomenal discoveries if there is any hope for a payoff. Of those companies that do make a discovery, most will fall far short of the “phenomenal” level. With a mediocre discovery and hundreds of millions of shares out, it is hard to see a big upside.

Under the rules of the Toronto Stock Exchange and the Venture Exchange, financings cannot be done for less than a nickel. For many of the companies trading below that level, the only hope of doing a financing includes a share consolidation or “roll-back”.

Only those companies with exceptional management teams and exploration projects will find money on terms that allow for suitable upside potential.

Making the situation worse for the juniors is the fact that many hedge funds and other institutional investors are still liquidating positions in order to satisfy redemptions.

We all know that the market will eventually hit bottom and rebound. But, it is vital to understand that not all companies move in sync with “the market”. By the time that somebody rings a bell to tell us that “the market” is at the bottom, the higher quality companies will already have rebounded substantially, in some cases by multiples.

Investors who wait for the ringing of the bell as a signal to come back into the markets will pay substantially more for the high quality companies and/or will be forced to buy the second or third tier companies.

Why the rich get richer

NetJets, one of Warren Buffett’s companies, has ordered 425 new airplanes valued at $9.6 billion. The expectation is that the American and European economies will be much stronger by the time the airplanes are delivered. Mr. Buffett did not become one of the wealthiest people in the world by reacting to headlines. He made his fortune by acting in anticipation of what will come.

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