Gold: We've Only Just Begun

The Stealth Bull Market

Gold hit five-year highs amid a slumping US dollar, negative real interest rates, heightened geo-political tensions and an anemic US stock market. Technically, the bullion market is anticipating some profit-taking as gold flirts with $330 per ounce. We believe that this should not be construed as a major setback since a new floor at $300 has now been established. Indeed, it has only just begun. Bull markets do not last one or two months, rather they last years, particularly following a 20-year bear market. In the last ten years the average price of gold was $358 per ounce. Since year-end, gold has rallied 18% while the gold mining index is up 70%. A survey of precious metal funds finds that the majority is still holding significant cash as portfolio managers wait for the pullback. And, the major institutions are still under-weighted to gold. Even those now on the bandwagon are suggesting profit taking and a strategy of "buy on dips". We believe that this cautious sentiment is atypical of bull markets. Gold will climb this proverbial wall of worry which will see a near term target of $375 an ounce and an intermediate target at $510 per ounce.

The market is also looking for signs of traditional leadership from the big cap stocks such as Barrick and Placer, which have lagged the market. The big cap stocks appear out of sync, instead of taking a leadership role. However, this lack of performance is attributable to the fact that these producers are hedgers and investors have sought the unhedged players. Consequently, we do not anticipate the big cap producers to outpace the index; rather it will be more like the tail wagging the dog.

The Big Drivers For Gold

A big driver for gold's move is the dramatically changed supply/demand fundamentals over the last year. Last year, total global demand was 3,800 tonnes, of which jewelry accounted for almost 3,000 tonnes. Total fabrication demand was almost 3,500 tonnes against global mine output of only 2,600 tonnes. Scrap sales, central bank sales and producer hedging filled this deficit. On the supply side, producer hedging has stopped due to the lack of contango and hedging has become like smoking, socially unacceptable. The Achilles heel of the gold industry is hedging and the gold shortage has converted many producers to become buyers instead of sellers. The second, and key driver is that the demand for gold has expanded due to the long awaited collapse in the US dollar. Gold, priced in US dollars is now cheaper in other currencies and an effective safe haven against the decline of the dollar and global crises.

Hedging, The Industry's Achilles Heel

The gold business has divided itself into a world of hedgers and non-hedgers. Hedging is a complex tool, used by companies to protect earnings against volatile movements in the price of gold. Hedgers lock in today's gold price plus a premium by borrowing gold (from central banks) and selling that gold in the forward market. The proceeds are invested and added to the eventual sale price. Simply, they are selling tomorrow's unmined gold at today's prices. For the last ten years this was a profitable exercise and a great many hedgers made more money from hedging than mining gold. Indeed in the last quarter, Barrick made $57 million from their Premium Gold Sales Program versus $47 million mining gold. On the other hand, non-hedgers prefer giving investors 100 % of the upside, implying that investors know better than mining company executives over what to do with their money. Importantly, non-hedgers view gold as an equivalent to money and the selling of gold to create paper gold is considered too risky.

The world has changed. According to GoldFields Mineral Services, total producer hedging has declined, with the amount of gold hedged falling 147 tonnes in 2001. In 2000, total producer hedging dropped 15 tonnes, the first decline since the early 1980s. This year, the global hedge book will be reduced by more than 300 tonnes. The new Newmont focused the world on the differences and swore off hedging. Ironically, the company still has 7.3 million ounces of Normandy hedges. Barrick sensing the turn of the market has declared that it will now only sell half of this year's production at spot market prices. AngloGold similarly has accelerated its unwinding, promising to be below 10 million ounces by the end of the year from 13 million ounces currently. Most companies at least will deliver into their hedges.

Unwinding these hedges is positive for the gold price since it requires purchases of gold. On the other hand, hedging depresses prices because it adds gold to the market. However, the industry just can't seem to get it right. While hedging protects companies from falling prices, they lose if gold prices climb. Left unsaid, hedging only works in declining markets.

Bullion Bankers Create Risks

But there is more. In the last decade, bullion investment bankers bastardized simple hedging techniques and developed toxic or exotic hedges. Widely used spot deferred contracts have floating lease and investment rates. Any adverse change in rates may force a change in the contract. Similarly, gold's move has focused attention on contingent call options that may or may not be triggered, depending on pricing scenarios. "Knock in" or "knock out" provisions are often buried and investors are the last to know. "Knock in" provisions almost sank Cambior and Ashanti a few year ago. Delta strategies and synthetic products were similarly meant to take advantage of time provisions and were used to fund these hedging programs.

We believe these contingent hedges create uncertainty in an era of transparency. Currently, these transactions, conducted directly between companies, are difficult by their nature to regulate and are almost invisible. There is no way to measure counter-party risk. In a post-Enron era, mark-to-market accounting was supposed to allow an effective measurement of risk. However the problems of the energy industry centered on mark-to-market accounting, which allowed the industry to book changes in energy contracts as income. The gold industry also books hedging profits as income.

Hedges Beyond Several Years Are Risky

Hedge books are not created equal. For example, we believe that companies should disclose the cash flow from their hedge books separately, which could then be valued over a period of years. However, companies are reluctant to release this information and the Street is left to deal with mark-to-market books that are overly simplistic and misleading. In the interim, an effective way to analyze hedge books is to compare the amounts hedged against the annual production of that producer. Obviously, companies with the hedges beyond several multiple of years of production lose flexibility when the gold price increases sharply (see Table I). As such, we believe that hedges equivalent to one year or less of total gold production are most desirable since production and reserve risks are manageable and investors can better measure the price cap in a rising market.

Most relevant for the industry is that at the current gold price and exchange rates, the gold industry's hedge books are underwater for the next few years. As described in Table I, the producers have hedged in excess of 2-3 years of production. As the price of gold goes higher, these producers will have to mark-to-market their hedges putting pressure on balance sheets and bank covenants. Even Newmont, the born-again anti-hedger, had $411 million in hedging losses. Consequently, we expect the industry's hedged position to be their Achilles heel and will be an explosive catalyst to the gold price as they're forced to unwind their hedges. Of the global producers, Barrick Gold has the largest hedge position at 18 million ounces, followed by AngloGold with 13 million ounces. Should Placer Dome be successful in its outrageous bid for Aurion Gold, the combined hedge position will be 14.5 million ounces moving Placer Dome to the number two position with 4.1 million years of hedged production.

However, the tip of the iceberg may well be an innocuous press release from Barrick on May 8, 2002. In order to simplify Barrick's Premium Gold Sales Program, the company said that, "It will not renew call and variable price sales contracts, and expects this position to decline by at least 50%, or 3 million ounces this year. Secondly, the Company will no longer invest a portion of its spot deferred contracts in corporate bond funds, and will instead leave all proceeds invested with its average AA-rated bank counter parties." Could the decision been prompted by a margin call? We've only just begun.

The Decline And Collapse of the US Dollar

After two decades of fiscal retrenchment, Washington has created more credit in the months following the terrorist attack than in any period in the history of paper money. The bigger problem is that President Bush's tax cut plan and push for the largest military buildup in twenty years exacerbates the nation's fiscal books. The Republicans generally limit government's role but President Bush has brought back "pork barrel" spending. In addition, with revenues falling sharply because of the recession and September 11, the surge in government spending is the biggest since the Vietnam War. We believe that the twin deficits, the current account deficit and budgetary deficit, will end the US dollar's run, cause higher gold prices, lower markets and a slower economy.

Twin Deficits - The Budgetary Deficit

For some time, we have been concerned that the Bush Administration was following Lyndon Baine Johnson's "Guns and Butter" policies. LBJ fought the Vietnam War and at the same time opted to finance the Great Society without raising taxes. Then the Fed printed more money and twin deficits ensued. LBJ could not defy the laws of economics and double-digit inflation and an $800 gold price soon followed. Today, President Bush's desire to fight the "War on Terrorism" as well as to provide politically motivated subsidies ahead of the November elections sees Bush outspending the Clinton Democrats. In only a few months he signed the largest farm bill in history, a $190 billion gift that subsidizes the American farmers, imposed steel and lumber tariffs, which will leave him with a budgetary deficit of $200 billion. President Bush is having problems increasing the nation's legal debt ceiling. In late '95, the Congressional debt ceiling was $4.9 trillion. The Administration has had to juggle its books in order to pay its bills, using smoke and mirrors to avoid increasing the debt limit beyond $6.7 trillion or a 35% increase. Of course, like most families the government could cut expenditures, but President Bush refuses to eliminate expenditures or raise taxes - he wants both "guns and butter".

Twin Deficits - The Current Account Deficit

The United States owes trillions of dollars of debt it took on to finance its current account deficit. The deficit in the American balance of trade is so huge that is has turned the US from a creditor nation into a debtor nation. The US needs $1.3 billion every day to prevent the dollar from falling and to finance its deficit. For some time we have warned that chronic balance of trade deficits would be the catalyst to cause the US dollar to fall. But now a swelling federal budgetary deficit and interest rates at 40 year lows are keeping rates at negative real rates of return. Thus huge amounts of foreign investment money are leaving the country. The US's net liabilities to the rest of the world exceeds $2 trillion. Unless the Americans can suck in $400 billion of other people's money to finance its spending habit, the consequences of the huge current account deficit, which is running close to 5% of GDP, is a falling dollar. In recent weeks, the dollar has fallen to a 29 month low against the Swiss Franc, a 16-month low against the Euro and a six-month low against the Yen. Low interest rates, trade wars, Middle East difficulties and a slumping market have also diminished the foreign appetite for dollar assets. And its institutions are in decline. Enron, Merrill Lynch, Arthur Anderson have fallen from grace. The under-performing stock market has caused a marked slowdown. The average monthly inflows averaged $14.5 billion in January and February compared to $44 billion into the US last year.

Of concern is the consequences of the Americans pursuing policies that historically have led to higher rates of inflation. The inflationary policies in the 1960s and 1970s were monetary based, and then as now, the problem was not savings and capital formation but of debt. Foreign investors are leaving the United States and that means the Americans must rely on themselves. This is not a good time to be a debtor nation.

A Mountain of Debt

For sometime we have warned that America's debt load is drawing a strong parallel with Japan. With each passing month, the similarities increase. Japan's economic woes are not unique and in fact it appears that the United States is following the Japanese experience lock stock and barrel (only a decade later). In the 1980s, Japan had the most dynamic economy in the advanced world; indeed, many thought that Japan would replace America in its might. In the 1990s the United States held that distinction. Of course the bubble burst leaving both countries with a legacy of debt. Huge deficit spending kept the Japanese economy from experiencing a depression, but could not stop the deflationary forces or extinguish a mountain of debt.

Too Little Savings

As in Japan, balance sheets dictate events. US consumer borrowing hit another record as consumers seduced by low interest rates spend more. Corporate borrowing continues and stands at more than 90% of gross domestic product (GDP), another record high. Household debts averaged 73% of GDP, compared with 63.2% just after the 1990-91 recession. It appears at long last that the chickens are coming home to roost.

Despite the Fed's interest rate reduction, liquidity provided by investors and lenders has dried up. There is a capital shortage. Simply, it is not the level of interest rates that spur corporations to borrow but the availability of money. Until the stock market and other lenders refinance that debt, the Fed's action will do little to turn things around. Ironically, Japan has the highest savings in the world and it is those savings that will help the Japanese. On the other hand, America's savings rate is low and the American recovery is tentative due more to inventory de-accumulation. Business investment that drove the boom in the 90s remains stagnant and the housing bubble looks poised to burst with the next uptick in interest rates. The White House's response is to push for tax cuts and more protectionists subsidies and these programs have left the government with a huge debt load. And that is the crux of the problem. What everybody misses is that the experience of the Japanese in the early 90s shows that repeated bouts of fiscal stimuli results in more red ink. Japan's government debt to GDP ratio is now 125% or double a decade ago. Tokyo, at least has its own savings to fall back on, the United States must depend upon outsiders. Gold might be a good thing to have. Fearful of this debt, we expect investors will seek gold for its traditional safe haven characteristics.

Gold is an effective asset as a barometer of investor anxiety. When the mountain of debt crumbles, when the dollar collapses, when the hedgers stop hedging, gold will emerge as an asset of last resort. We believe that $510 will be next floor for gold.

What Could Go Wrong?

And what of the threat of more central banks selling which could depress prices? The UK government auctioned 395 tonnes in 17 auctions, netting the treasury $3.5 billion at an average selling price of $275 an ounce.However priced today, the UK government has left almost $600 million of taxpayer's money on the table (i.e, it's lost). Meanwhile China increased its gold reserves in the same period, increasing the reserves to over 300 tonnes, buying no doubt some of England's gold. We believe both governments have ironically shown the world that gold indeed has a role to play in monetary history. The Washington Agreement raised the consciousness of central banks and gold producers - both need each other, and sales do no one any good. Gold is still the second largest holding of reserves in central bank coffers, after the US dollar. If the US dollar loses value, what will happen to gold? Gold is a good thing to have.