Which Gold Price?

I am taking a break from my normal IMF research to focus your attention on a special situation that has developed over the last 2 months.

Many gold investors are discouraged that the price of gold (POG) has fallen to just above pre-911 attack levels. However, that would depend on which POG you are looking at. If you are looking at the price of gold in terms of the US dollar price, indeed the POG has been a disappointment. This is especially true in light of the current geo-political/economic uncertainty.

A fair number of gold share investors have chosen to stick with North American (NA) based miners, such as AEM, GG, MDG and NEM. Anyone having invested in these companies at the end of 2000 have done very well by any benchmark. Due to the special situation which I am about to show you, sticking your neck outside the confines of NA could prove very profitable for those willing to step up the risk level one notch.

Political Risk

Whenever investing in foreign countries, political risk should be taken into account. This can come in the form of nationalization of mines, mineral taxes or other restrictive forces. Risks however, are present even in the US as well and could come in the form of changes in environmental laws, permitting delays or denials.

I have always preached diversification in gold shares. Who wants to have the entire gold sector of their portfolio wiped out? Not I! It is paramount then, that you approach diversification with prudence and consideration of the risks involved. On the other hand, it is also reasonable to extend your risk level a tad when the reward part of the equation warrants such action. I believe that we have entered such a situation at the present time.

The South African Rand Gold Price

The average South African (SA) rand gold price in the first three months of 2001 was R2,070 per ounce. The average USD gold price was $263.46

The current rand gold price is around R2,650 per ounce while the USD gold price is around $277.

Now, let's put this into perspective.

If gold was trading at US$263.46 and had a gain of 28%, it would be fetching a whopping US$337.22 per ounce. Once again it appears that the rand gold price is stretching out for new highs. The following graph tells the whole story.

PACIFIC Exchange Rate Service

© 2001 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC,
Canada. Permission is granted to reproduce the above image provided
that the source and copyright are acknowledged.

So if you were just sitting around waiting for gold to go up, for SA miners it already has!

True, in USD terms they are receiving only slightly more for their gold than they were at the beginning of the year, but for those who pay the majority of expenses in rand, it is a fat move.

Ore extraction in SA is a very labor-intensive effort, with the majority of expenses going directly to labor costs. Labor costs did go up this year at about an 8% rate, but the good thing is that long-term wage deals were worked out with the miners union prior to the big move. As a result, there are no major labor disputes likely to get in the way.

In my opinion, the best way to profit form this move is through holding shares of SA miners. Miners that have no hedging standing in the way of current profits will have the greatest benefit.

Out of the four large producers in SA there are only two that fit this profile and those two are Harmony (HGMCY) and Gold Fields Ltd. (GOLD). These increases in the rand gold price will be showing up when quarterlies are released early next year.

Placer Dome (PDG)

Many do not consider when factoring South African exposure in their portfolio for PDG to be a part of that. Please reconsider. Fully half of PDG reserves are locked up in the 50/50 deal between Western Areas and the PDG managed South Deep project.

The PDG website lists total reserves of 47 million ounces. The South Deep project is 58million ounces of reserves of which 29 million ounces is the PDG share. That is half in any book. Actually that comes out to 61%!!! They must have adjusted reserves since I looked last year.

Are you paying a NA premium price for SA reserves? Think about it. Why on earth would anyone do that?

Questions and Answers

Q: I have PDG in my portfolio. How should I approach this situation now that I know that 61% of the reserves are in SA.

A: Consider making a change. This would depend on your current percentage of PDG in your portfolio and your view of risk vs. reward.

One method might be to take the portion of you PDG investment that represented your SA exposure and place that directly into SA gold stocks to get the full bang of the rand gold price. The remainder could be placed in the unhedged NA based miners mentioned earlier.

Q: I already own a significant amount of SA gold stocks along with PDG. Now that I understand the PDG situation, I find that my commitments to one country is above my risk level.

A: Your choice of PDG in the first place leads me to believe that you were leaning to a large, cap multimillion-ounce, blue chip producer. The logical replacement for PDG would then be NEM.

Q: Since 61% of PDG reserves are in SA, won't they benefit from the rand gold price?

A: Yes and No. Only the portion of gold mined in SA will get the full benefit. South Deep however is a long life mine with a projected life span of 72 years. Estimated PDG share of South Deep production for 2001 is about 240,000 ounces. Since PDG is a 3 million ounce producer, SA production comes out to about 8% of total annual production. Therefore you get only 8% of the benefit of the rand gold price move in EPS terms.

Q: I am expecting the USD to move to the downside. Won't the rand then become more valuable in USD terms?

A: Yes, but the POG is likely to go up when that happens. A falling dollar will likely generate a renewed interest in gold, putting gold stocks into the limelight. You win.

Q: What if the rand falls back to the pre 911-attack levels and POG does not move or goes lower.

A: You loose. That is what diversification is all about. Even still, by keeping PDG, you are paying too much for SA reserves.

New Developments

On November 14, it was announced that Newmont Mining, Franco Nevada and Normandy are likely to be combined, forming the largest gold mining company in the world. This development is very bullish for the future of gold.

Two things should be noted here. First is that Anglogold had an offer on the table for Normandy and is now left as a number 2 producer. This new development may turn their eyes once again to Gold Fields Ltd. or possibly Harmony to regain their #1 position. While Gold Fields is pricier now than when Anglo was taking a gander at it not so long ago, the current rand gold price should more than offset the higher price.

Second fact is that the Franco boys will be heading up the deal making over at Newmont. Last year, Franco Nevada and Gold Fields proposed a merger. The deal structure did not pass the SA government at the time, much to the disappointment of many. A "vision" was expressed by Franco Nevada that a global gold producer would be formed that would have a makeup of 1/3 NA, 1/3 SA and 1/3 rest of world.

In the event that this "vision" is still in existence, I would expect that at some point in the near future, that GOLD or HGMCY would be a part of that.

David Walker
November 19, 2001
e-mail [email protected]