Gold: House Of Cards

Everything is rosy, or is it? The Dow is flirting with 18,000 again but stocks are overvalued. Positive economic news is not so positive because it means that the Fed will push up rates. Bad news is just bad news.

Domestically, Barrack Obama has been a disaster. Take for example, ObamaCare which is inefficient, expensive and unpopular as ever. Or that a record number of Americans have dropped out of the labour force with almost 100 million jobless. And of course despite printing trillions, economic growth remains tepid. The Nobel Peace Prize winner’s Middle East agenda is in tatters. His credibility was again tested in another wrestling match with Congress over America’s debt limits. And unsurprisingly, then, he leaves an economy worse than he inherited and even in worse shape than it looks.

Since 2009, the Fed has purchased almost $4 trillion of Treasuries and mortgage backed debt, funding over half of the government’s federal debt load. Post crisis debt monetisation and quantitative easing has poured trillions into the global financial system, creating credit bubbles. Yet despite rounds and rounds of quantitative easing, the world economies remain in a funk, laying the ground for another pump priming exercise. In fact, a “dithering” Fed has even lost credibility with the biggest beneficiary of its stimulus policy – Wall Street who feasted on the cheap credit. The world is simply addicted to this money creation exercise and cannot get off the treadmill.

Credibility on the Line

Despite the United States only accounting for 23 percent of global GDP, 60 percent of global foreign exchange reserves are in dollars. Seven years after the Lehman collapse, the US has added nearly $8 trillion of debt, doubling its debt-to-GDP ratio. But now that gap has created problems among the cartel of central banks because most currencies are linked to the dollar. Central bankers were once bankers to the banks, however those stewards of money have become creators of money. Those imbalances also triggered a return to a currency war, reminiscent of the Thirties with a race to the bottom as each country sought a competitive advantage. The world’s financial system has become more unstable. China was the last to join the currency war and will soon pass the United States to become the world’s largest economy. That emergence, we believe will reshape America’s financial hegemony.

Much of America’s obligations are owed to foreigners which represents a clear and present danger for the dollar. America’s trading partners’ patience is wearing thin with America’s hegemonic power and use of its financial clout as a political tool. The dollar payment system has allowed America to impose financial sanctions on its adversaries, bully developing countries, close tax havens and dominate the financial world with its big Wall Street institutions. Today, most trade and transactions are conducted with dollar payments either directly or indirectly. As such global banks are largely American. Indeed this “exorbitant” privilege of owning the world’s reserve allows America to borrow in dollars, pay for spending, and finance a growing debt and huge deficits in a currency that it prints.

No Respect

The biggest worry is that America has become the centre of global disorder. The United States, the world’s largest borrower has become increasingly dependent upon its creditors. America’s debt holders have noticed and some like China are dumping dollars as China discovered that quantitative easing reduced returns on its massive dollar denominated reserves to near zero. China has already unloaded $100 billion in a move to support the renminbi. Saudi Arabia too has unloaded dollars as it dipped into depleting reserves to prop up spending and hedge the impact of falling oil prices. Russia unloaded dollars to offset the impact of sanctions and finance gold purchases. Brazil, Norway and Taiwan sold dollars having tapped out their rainy day reserves. In time, these sales will push up rates, with or without the Fed’s acquiescence.  Never mind that the dollars created are worth less and less, yielding diminishing returns such that the markets have become complacent because debt service costs are low. Traders are hoping for just one more bubble and another fool willing to pay even more. Despite Europe’s near death experience with fiscal recklessness, debt has exploded and is well above gross domestic product (GDP). Debt doesn’t seem to matter. It does. Debt must be paid off. Failure to pay not only leaves future generations the responsibility, but failure or even a hint of default damages the credibility of all debt.

The failure of the Fed to wrestle these problems has eroded trust in America’s ability to act as a financial steward of the world’s reserve currency. The dithering and politicking over a much overdue rate hike has increased volatility, undermining respect in the dollar. Still to come is the unwinding of America’s extraordinary monetary policy and the eventual symbolic first interest rate increase in a decade. The dollar has entered a paranoid moment, involving respect. Every move is about the loss of respect. Take China’s move towards globalising the renminbi. Or take Europe’s latest moves. Or the perennial debt ceiling discussions which brought the US to the brink of debt renunciation only just avoided in 2011 and 2013. The whole concept of respect was waged before with Britain in the Thirties experiencing the decline of sterling. The dollar is the world’s currency. However, because the US consumes much more than it produces and owes much more than it owns, the creditors of America’s debt have a vote. This time there is no lender of last resort.

China’s Calling

China introduced a platform of financial reforms to liberalise the renminbi as a global currency and part of the foundation for a Sino-centric financial system. China also unveiled a package overhauling its gigantic debt ridden state-owned sector and targeted bureaucratic paralysis and corruption.

To revive its economy, the PBOC cut interest rates for the sixth time in a year. China recently shocked the world by devaluing and loosened the peg from the dollar joining Switzerland making the value of the renminbi more market oriented. In turn, the IMF will include the renminbi as a component of the Fund’s Special Drawing Rights basket (SDRs) of reserve currencies after the Americans dropped their resistance. China launched a cross border renminbi payment system with some nineteen banks encouraging the use of renminbi as a unit of settlement for trade in the West. China’s deep pockets have also created international lending institutions as part of the global architecture. Beijing sponsored the Asia Infrastructure Investment Bank (AIIB) which has the backing of more than 50 countries. Already China has set up North America’s first currency swap hub in Toronto, solving infrastructure problems and facilitating cross border transactions. As a result, the renminbi has become the fourth most used currency for global payments.

Among its many moves to globalise the renminbi and displace the dollar monopoly, China has been accumulating massive stocks of gold, accounting for one fifth of global investment demand. Today the US has about 8,000 tonnes of gold. China has purchased major supplies for the fifth month in a row and holds 1,722 tonnes, an increase of 668 tonnes from the 1,054 tonnes reported last in 2009. China’s purchases of gold, makes it the fifth largest holder of gold, moving ahead of Russia and Switzerland. We believe Beijing is increasingly viewing America’s profligacy through a lens of distrust, reminiscent when the baton of financial superpower was passed before. For now, the world’s largest bullion hoarders are building a new system, gold backed and beyond the reach of American hegemony.

At the same time on the geopolitical front, Russia’s escalation of the Syrian conflict blindsided the West, crossing multiple red lines filling a vacuum left by America’s stealth departure from the Middle East. In the process, it appears that the partition of Syria is inevitable, tearing to shreds Mr. Obama’s Middle East plans leaving its allies on the beach. By calling the West’s bluff, Putin has slowly extended his reach from the Ukraine to the Middle East in a Catherine the Great type move. For allies, America’s world power is now in line with its ebbing financial power.

Monetary Reform

Needed is tough monetary reform. The Federal Reserve was created in 1913. Money was then linked to gold. Central bank reserves held only gold but in 1922, at a conference in Genoa, they decided to also hold currencies like pound sterlings and dollar IOUs. The gold standard morphed into a gold exchange standard with currencies elevated to money and dollar-based claims became equivalent to gold as part of central bank reserves. Subsequently and not surprisingly, the world soon was awash with printed liabilities with the postwar Bretton Woods system of fixed exchange rates existing from 1946 to 1971.

The system became flooded with more liabilities. In 1971, Richard Nixon was forced to end the dollar’s convertibility into gold to stop a run on America’s gold reserves as creditors demanded gold instead of dollars forcing the Americans to ultimately print yet more dollars. There followed a system of floating rates and soon dollars officially replaced gold. Of course, the world dollar’s base increased by quantum percentages. For seventy years, the dollar was the keystone of the world’s financial monetary system, allowing America to live beyond its means, financed largely by debt monetisation, a vastly expanded shadow banking sector and too big to fail financial institutions. Since the financial crisis, the tide of recovery has not lifted all boats equally.

Today what ballasts the US monetary system is debt. The potent challenge is that the world’s central banks have built up enormous hoards of each other’s debt with newly printed money as part of unorthodox quantitative easing. After two decades of financial globalisation, global foreign currency reserves are now pegged at a whopping $12 trillion or a fivefold increase since 2004 while the US has accumulated the world’s largest international debt at $18.5 trillion, excluding trillions of unfunded mandatory obligations.

The conundrum for the Fed is that rising rates will firm up the dollar at a time when the global economy is struggling and American exports are already hurting from a strong dollar. The United States may be faring poorly, but the rest of the world is doing even worse, it is the least ugly duckling. Ironically, while the Fed is sensitive to the impact of dollar, the currency will likely fall. Not because the Fed is objectively tight but because of its “helicopter money” policy, printing money to pay for spending. That too will be good for gold, but bad for the dollar.

Out With the Old

Pointedly, while central banks removed convertibility, physical gold never went away. China sits on the world’s largest pile of foreign exchange. Russia and China have been buying gold and central banks from France to Germany are repatriating their gold, from New York and London vaults back to their domestic vaults. We believe the underlying trend of course is the distrust in currencies after the global economies aggressively printed fiat money, devaluing its value. At the same time, there is concern about those dollars. The price of gold is both a rival and linked to the value of the dollar and it lies outside the dollar denominated banking system. Of concern, is that eras of large-scale, uncontrolled financial booms and busts have been seen before, in the Thirties, late Seventies and of course 2008. Gold was always a good hedge to have.

But what about the widely held bearish view that because of the lack of inflation, today, gold will underperform. We recall the great inflation of the seventies when persistent growth in money and credit plus a war led to borderline hyperinflation. Subsequently gold reached $850 per ounce. Today, despite rounds and rounds of similar credit expansion, we are told again that inflation is not a problem. In 2011, core inflation was not a problem and actually was declining yet gold rose 24 percent that year. The lack of inflation today is just a red herring. In fact, gold in renminbi, rubles or South African rand has moved up, in line with inflation.

Another popular bearish argument is that since the Fed will eventually raise interest rates to “normalize” monetary policy, that will be bad for gold. Indeed in recent weeks gold fell through $1,100 per ounce in the wake of the Fed’s hawkish statement after years of procrastination. However in the seventies, rates rose sharply from 4 percent to 20 percent’, yet gold went from $200 to over $800 per ounce. Another red herring here. Nonetheless, we also believe the market has priced in the initial round of interest rate increases, whenever they come. A key concern is that rising rates will hurt the bubble-like stock and bond market causing a flight into what? Gold will be a good thing to have. No red herring here.

For all that, money is largely paper. Markets have become casinos with high-frequency traders and their algorithms the new croupiers. The Libor rigging scandal, billions of dollars in fines and foreign exchange price fixing have become normal business practices. Our financial institutions, central banks and money have lost trust in recent years and with it legitimacy. Iceland recently sentenced 26 bankers for a combined 74 years in prison for their role in the meltdown in 2008. However in the United States, not a single banking executive has been charged relating to the 2008 collapse.

The greatest anxiety is not that money is made of paper but its lack of substance or store of value and the supply is elastic. That said, central banks, investors and Chinese grannies are buying gold as a safer bet than the dollar. For three thousand years, gold has retained its value. Gold’s value is derived from investors’ perception of what it is worth and which no country can control. Moreover, gold is a barometer of investor anxiety. To be sure, in a world of zero interest rates, the low yield on gold matters little, particularly, when interest rates in most countries are negative. Experience indicates that gold’s rise this summer shows investors are nervous, particularly when so much fear stalks the world.

Recommendations

Despite the move in bullion, gold stocks remain in a funk. The last few quarters show that margins remain tight despite increasing production. Again, the mining industry seems divided along a barbell shape with producers such as Barrick, Agnico-Eagle, and Goldcorp making money in the quarter on one end, Eldorado and B2Gold breaking even in the middle and on the other end of the barbell, Kinross, Yamana and IAMGold continue to lose money.

While the majors bit the bullet by deferring multi-billion marginal projects, many fully funded developers persisted with Darwinian results. Some issued too much paper for dubious projects lacking feasibility studies or even PEAs. Other surprises will come from those projects with too much debt or in vogue “streaming” deals which remove much of the profitability, particularly from short-lived projects. Yet, the swamp is still draining. IAMGold reported another loss with lower production from three of its four mines and production costs at $1,750 an ounce at its recently commissioned Westwood Mine. Largely ignored are the development disasters like Timmins Gold having to shutdown San Francisco Mine in Mexico and the second shoe dropped when Rubicon shelved its $400 million mine when it discovered the lack of reserves.

In all, we believe that the gold miners’ main asset are reserves, in-situ reserves. Commodities are boom and bust markets. We’ve certainly experienced the bust. Reserves in the ground are everyone’s asset. The industry has not replaced reserves so those with in-situ reserves will in time command a premium. Low share counts and technically experienced boards are also important qualities.

Most significant is that, while producers focused on costs, positive exploration results should not be ignored. After all exploration is the lifeblood of the mining industry (Eskay Creek, Fruta Del Norte, Brucejack). Agnico for example has 12 drills turning at El Barquero in Mexcio and an initial resource is expected in the first quarter of 2016. Barrick has good results at Gold Rush in Nevada. Pretium keeps expanding Brucejack. To be sure, the lack of new deposits and results only means that the in-situ reserves of the gold miners will command premium valuations despite trading at the lowest market cap per in-situ ounce in history.

Agnico Eagle Mines

Agnico Eagle reported excellent results revising production guidance upward. Agnico generated free cash flow and in the quarter produced a record 441,000 ounces at an AISC of $759 per ounce due to a 20 percent improvement in output and efficiencies. Agnico also reported strong results at Kittila in Finland, higher grades at Meadowbank, and plans to release exploration updates from El Barqueno in Mexico. Also expected are results from Amaruq in Nunavut which will extend the life of Meadowbank. Noteworthy was that Agnico paid off $200 million of debt while 50 percent owned Canadian Malartic set new records for milled quarterly tonnes and ounces produced (153,206 ounces on 100 percent basis). Agnico has almost 20 million ounces of in-situ reserves. We like the shares here, particularly for its growing reserve and production profile.

B2Gold Corp

B2Gold had a breakeven quarter with the ramp up from Otjikoto in Namibia a healthy contributor to results. La Libertad in Nicaragua increased 30 percent due to higher grades. An illegal blockade at El Limon in Nicaragua temporarily halted production. B2Gold’s next mine is Fekola in Mali where $100 million is to be spent this year. A feasibility study shows that Fekola will produce 350,000 ounces per year for the first seven years at a cash cost $418 an ounce. Preproduction costs are estimated at $400 million. The company has a solid balance sheet and should have no problem financing Fekola. We continue to recommend B2Gold as an emerging mid-tier producer with a steady pipeline of projects and a management team known for execution.

Barrick Gold Corp.

Barrick announced positive operating and financial results confirming the much advertised turnaround. Credit should go to John Thornton for quickly refocusing Barrick, flattening the organization, identifying and selling noncore assets as well as reducing debt in moves that are so popular today among its peers. Barrick will meet its debt reduction target of $3 billion and announced the sale of additional noncore assets including Round Mountain, Spring Valley, Ruby Hill, and Golden Sunlight of which Kinross is a logical buyer for the other half of Round Mountain. Of note, there was heavy interest in Barrick’s noncore assets reflecting the quality of those assets. Meantime, Barrick’s core mines continue to grow with higher output from Cortez in Nevada producing 320,000 ounces. At Goldstrike, the thiosulphate circuit ramp-up is on schedule and full production is slated by mid-next year. Barrick costs continue to come down with full year AISC between $830 - $870 per ounces, among the lowest of the industry. Having “walked the talk”, we expect a Street reassessment of Barrick. Still to come are development news from Gold Rush, Cortez underground, Turquoise Ridge in Nevada and Jabal Sayid in Saudi Arabia. Barrick’s biggest asset is the largest in-situ reserves and resource base in the world. We like Barrick here.

Detour Gold Corp.

Ontario based Detour Gold will produce about 525,000 ounces in 2015 despite an unplanned shutdown in the quarter. The company continues to improve mill throughput and plans an updated mine plan next year which will concentrate on higher grade reserves in the initial period and the likely exploitation of Block A reserves. Detour is exploring 6 km south of the main mine picking up slightly better grades. Less than 20 percent of Detour’s ground has been explored so there is blue sky potential. Detour has 15 million ounces of reserves. Detour produced 128,000 ounces in the quarter and AISC is projected at $1,050 or so. Profits, however are elusive and Detour needs to process higher grade material.

Eldorado Gold Corporation

Eldorado reported a paper loss of $4 million in the quarter on production of 180,000 ounces. The results were expected and the company upgraded guidance to 710,000 ounces from 680,000 ounces at an AISC of $870 per ounce. Eldorado reported that their Greek operations has resumed after the Greek Supreme Court overturned an injunction on Eldorado’s mining license. Eldorado’s flagship Kisladag operation in Turkey produced less gold due in part to a planned mining phase. At Eldorado’s other Turkish mine, Efemcukuru, output was higher. Eldorado’s Chinese operations output was lower at Jinfeng and White Mountain but output was higher at Tanjianshan due in part to a cleanup of its gold circuit. Eldorado is optimizing production at Kisladag and the installation of a substation was completed. With a go ahead at Eastern Dragon, work continues now that they have received project approval from the NDRC. Production at Eastern Dragon is expected next year and permits are to be filed before yearend. Eldorado has reduced its capital spending significantly to $225 million down from $400 million although the company is well funded with a $375 million undrawn line. We like this well-funded producer here.

Goldcorp Inc.

Goldcorp reported a whopping $192 million loss in the quarter which was largely non-cash items. Goldcorp’s production was up 42 percent to 922,200 ounces but the loss was a shock and erased almost a billion from Goldcorp’s market cap. Goldcorp lowered its production from newly commissioned Eleonore mine in northern Quebec due to dilution problems. However, the mill achieved capacity at 7,000 tonnes per day, with 2,000 tonnes from lower grade stockpiles on hand but dilution hurt costs. Recoveries were also lower than expected. Goldcorp expected Eleonore to produce between 250,000 to 270,000 ounces this year, less than earlier estimates. Nonetheless, Goldcorp has maintained its overall guidance at 3.6 million ounces. Although, Eleonore is in a start-up mode, the mine is an excellent addition to Goldcorp’s portfolio. Goldcorp also delivered better results from Cerro Negro in Argentina, Musselwhite, Pueblo Viejo and Penasquito in Mexico. Despite the disappointment, Goldcorp has a healthy balance sheet with $3 billion of liquidity, sufficient to finance $1.2 billion of expenditures. We prefer Barrick here.

McEwen Mining Inc.

McEwen Mining reported nine month production of 116,000 gold equivalent ounces with the major part from the El Gallo Mine in Mexico. El Gallo produced almost 20,000 gold equivalent ounces in the quarter on track to producing 62,000 gold equivalent ounces. The 49 percent owned San Jose Mine in Santa Cruz, Argentina also met guidance and will produce 46,500 ounces this year. McEwen also announced a positive feasibility study at the Gold Bar open pit project in Nevada. Gold Bar has a low capex cost of $60 million, will produce 65,000 ounces at a cash cost of $728 with a reasonable 20 percent IRR (3 years payback). McEwen has cash and cash equivalents and bullion of approximately $36 million. We like the shares here.

New Gold Inc.

New Gold has a portfolio of four mines which produced 123,000 ounces of gold and 25 million pds of copper at AISC of $788 per ounce. Results in the quarter were breakeven and a clean-up at Mesquite and Cerro San Pedro helped the quarter. Higher grades were realized at Peak and New Afton. New Gold’s Rainy River is fully funded with a streaming deal of $175 million completed with Royal Gold and sale of El Morro to Goldcorp. Rainy River should be in production in 2017 at a $500 million price tag. So far 58 percent of total capital has been spent or committed to date. Rainy River will almost double New Gold’s production.

Yamana Gold Inc.

Yamana has projects in Brazil, Argentina, Chile, Mexico and Colombia. Yamana produced almost 326,000 ounces reflecting increases from fifty percent owned Canadian Malartic, Chapada, Minera Florida and Jacobina. Brio Gold is a non-starter as a spin off with cash costs of $700 per ounce. Flagship El Penon produced less gold in the quarter due to a falloff in grade. Yamana reported a loss of $15 million due to higher taxes and tighter margins. To alleviate the Street’s balance sheet concerns, Yamana announced a streaming deal which will net it $150 million and while the deal monetizes Yamana’s assets, it removes the future profitability of Chapada and Cerro Moro in Argentina. The cash will be used to reduce a debt laden balance sheet and Yamana must now focus on financing Cerro Moro in 2017. We would avoid the shares.

John R. Ing

416-947-6040