Gold Market Update

Gold closed the week ending April 6th at $260.00. The bears have been out in force, as evidenced by the steep 1.8 million ounce increase in net short position on Comex. On March 30th gold tested its 20-year lows by dropping below $255 intraday. This is the second time this year bullion has successfully rebounded from these low levels.

Gold royalty company Franco-Nevada Mining is in the news again. Following their attempted merger with Gold Fields Ltd., which was denied by the South African authorities late last year, Franco has cut a deal with Australian producer Normandy Mining to exchange a profitable high-grade mine in Nevada and some cash for 19.99% of Normandy's stock and a royalty. Franco is a staunch anti-hedger, while Normandy is heavily hedged, so, how can this combination work? While Normandy may not quite fit the mold Franco is looking for, the key here is the timing rather than the vehicle. In a broader context, Franco's management has made no secret of their belief that the gold cycle has bottomed. Their increased corporate activity is aimed at preparing the company for the up cycle at an opportune time. Normandy has one of the highest debt levels of the major gold producers, and a stable of developing properties that become quite interesting at somewhat higher gold prices. Franco, with their substantial cash position and no debt, is undoubtedly seeing opportunities here to gain more unhedged gold exposure.

Gold lease rates have remained above normal levels since early February. The three-month rate has been bouncing between 1.75% and 3.25%, which is more than double the normal range of 0.75% to 1.0%. Similar rate rises have occurred in the past, but typically toward year-end, supposedly when Central Banks curtail their lending to square the books. Many market watchers believe the Central Banks are moving to more conservative gold lending practices. High lease rates going into the spring is definitely an anomaly, and it would not surprise us to find that this represents the early days of a change in the way the Central Banks do business. During the 90's, an investment psychology developed in which leverage and the expectation of above average returns and quick profits became the norm. This psychology became ubiquitous and in some cases pervasive among Wall Street analysts, corporate CFO's, individual investors, and fund managers as it reached its climax with the rise of the day-trading phenomenon. Central Banks do not normally come to mind when reflecting on the extravagance of the 90's, however, the Central Banks were not immune to the same psychology, engaging in their own brand of reckless investing. Central Bankers established a new mandate in the 90's in which they no longer saw themselves as simply guardians of the monetary reserve. Instead they decided to manage reserves as a portfolio that would generate the highest return within the investment vehicles available to them. Superior U.S. interest rates and an abundance of willing bullion borrowers made gold leasing and U.S. Treasuries the investments of choice. According to Gold Fields Mineral Services Ltd. data, cumulative Net Central Bank lending and sales of gold from 1981 to 1990 was 846 tonnes. From 1991 to 2000 that number ballooned to 5,519 tonnes. Meanwhile, U.S. Dollars as a percentage of total foreign exchange holdings held by Central Banks increased from 58% in 1990 to 78% in 1999. By seeking the highest returns, the Central Banks moved toward putting all their eggs in one basket during the 90's, paper eggs that is, not golden. The bursting of the tech bubble and the more recent break-down of the Dow have caused investors of all stripes to question the way they view investing, it is conceivable that the Central Banks are doing the same.

In another matter, the January 29 Gold Market Update presented the idea that the U.S. economy may be unable to reach its potential in the future due to an infrastructure that is rapidly becoming inadequate, resulting ultimately in a prolonged period of U.S. Dollar weakness. While such problems are certainly fixable, two recent court cases in New York demonstrate why solutions will be difficult to attain. Eleven relatively small gas-powered turbines at seven locations in- and around New York City are under construction to avert power shortages that are forecasted for this summer by the New York Power Authority. Last Thursday a state judge ordered the Power Authority to stop building on two of the sites. Then in a separate case on Friday, another judge ruled the Authority could continue building on the other five sites. Appeals are likely in both cases. Local community groups are opposing these projects on the grounds that the Power Authority violated state environmental review laws. These are small-scale plants aimed at providing a short-term fix to a looming energy shortage that is developing in the Northeast. Unfortunately, this causes one to wonder whether the bankruptcy declaration by California's largest utility last Friday is the tip of the iceberg.