The Coming Bull Market in Gold
Part 1

In short, it is not politically correct to have anything good to say about gold.

We live in a world where everything is just about right and gold seems to have the power to speak up and say, "wait a minute, if I'm still around, maybe there is some risk out there". So gold must be denigrated, denounced, discarded, disowned and at the very least disliked. We also live in a world of new era and revisionist thinking to insure that there can be no negative thoughts.

The Holocaust did not happen.

The Japanese were victimized in WorId War II by U.S. imperialism.

Bear markets are over forever.

Traditional share valuation methods are obsolete.

Inflation is dead and buried.

There can be no systemic banking crisis.

Foreigners will continue to buy, or at least hold, U.S. treasuries forever.

EMU is a certainty.

To make the fantasy complete we need only add that gold, the traditional store of value which people have used as currency since civilization began and to buy their way out of danger, is now obsolete, demonetized and a relic. It has been replaced by paper, and if you are such a heretic as to believe that paper may have a slight risk to it, all risk can be eliminated through derivatives, which are, of course, more paper. The paper asset mania requires that the principal alternative, gold, be thoroughly discredited. Whether you call it greed, irrational exuberance or whatever, there have been few times in history where at least the temporary accumulation of wealth has been this easy and where risk has been so disregarded. These few times are well chronicled in the book "Extraordinary Popular Delusions and the Madness of Crowds".

I only mention the wonders of paper to offer an explanation as to why gold is in the doghouse.

The "sirens" call to the financial markets are irresistible until fear sets in and then things change rapidly as we all know that fear generates behavioral change faster than greed.

ActualIy, the gold story is compelling even without the catalyst of fear.

I got interested in gold about five or six years ago when I looked at the basic supply/demand equation, that is jewelry and industrial demand versus mine supply.

It was evident then, as it is now, that billions of Asians with rapidly rising discretionary incomes and a history of purchasing gold and gold jewelry as a form of savings would accelerate the demand for gold. It was also obvious that mine supply, due to environmental constraints, capital intensiveness and long lead times between finding a deposit and actually producing gold, would grow at a much slower rate than demand. This has proven to be true and a substantial deficit exists in the market today.

The basic supply/demand equation is extremely bullish with a gap between supply and demand of around 800 or 900 tonnes per year last year and much larger this year.

Projected Deficit (tonnes) in Gold Market
	1996	Growth Rate	2000
Physical Demand	3,850	5.5%	5,032
Mine Supply	2,330	3.0%	2,701
Scrap	620	5.5%	810
Total Supply	2950	3.5%	3,511
Deficit	900		1,520

Producers cannot replace their reserves in line with production. The industry needs to find 100 million ounces per year which is about equal to the total reserves of Barrick, Newmont and Homestake. The only chance of doing this, even once, was through Bre-X whose 100 million ounces turned out to be a complete fraud. Mine supply is growing slowly without considering any impact from the depressed price of gold. At current prices many projects have been delayed, especially in view of the difficulty in obtaining the necessary financing at the current gold price. In addition, there have been a significant number of mine closures announced with Barrick recently announcing the closing of five mines. Finally, in South Africa, where the average full cost of producing gold is now above the spot price, the mining industry is in crisis.

As you can see, at the current gold price 25% of the western world's gold production is unprofitable on a cash basis. On a full cost basis, 50% are unprofitable.

The demand side continues to be extremely robust with fabrication, i.e. jewelry demand, growing at 13% in the latest quarter. For the six months ended June 30, Goldfields Mineral Services reports gold demand up 18%, with fabrication demand up 15% and bar hoarding up 67%. On the supply side, mine output rose just 1.4% and gold scrap declined 27%. Goldfields Mineral Services supply/demand numbers show a large deficit of about 600 tonnes for just the first six months of 1997. This was with gold at an average price of $347, about a $40 drop from the beginning of the year. With gold now at $325 price elasticity plus seasonality should result in an even larger deficit in the second half. The deficit will also expand in the second half due to mine closures. Thus a deficit estimate for 1997 of a record 1,200-1,500 tonnes is reasonable. With producers heavily hedged and shorts having large positions which have already pushed up lease rates, that is the cost of borrowing the gold they sell short, it is likely that neither of these groups will have a significant impact on filling the deficit going forward. That means that gross central bank sales of probably 1,500 tonnes or more are needed to keep gold at the current low level. This is highly unlikely especially since central bank net sales for the past decade only averaged 250 tonnes per year, and even if it were to occur it would quickly bring us to the end of central bank net sales.

Actually the market may be able to absorb even more than 1,500 tonnes of central bank sales since the deficit does not fully reflect Chinese purchases. In China there is huge latent demand which goes unsatisfied because of the extremely limited number of jewelry outlets and also due to the significant premium above the spot price which the government charges the public. Nevertheless, surveys in China show that the wish list among Chinese is first a refrigerator, second a television set and third, gold jewelry. We believe that the official gold consumption numbers used for China may be much too low as they are out of line with other countries having comparable GDP per capita. It is likely that the high state markup and limited distribution system results in "unofficial" sales. This could mean that the overall deficit is actually 200 or 300 tonnes higher.

Nevertheless, while the basic market structure is in a record deficit, gold differs from other commodities in the magnitude of the above ground supplies and in the ability of short sellers to borrow the gold they need to deliver against their short.

The basic question then is to what degree above ground sellers will be able to fill the deficit. Let's look first at the central banks. While potential gold investors are paralyzed by the fear of the central banks aggressively selling their holdings, the reality is quite different.

In fact in 1996, 19 central banks bought gold while 16 sold and of the 16 who sold, only 5 sold 10 tonnes or more. Furthermore, over the past decade, over 70% of all central bank sales came from just three central banks: Belgium, Netherlands and Canada. That means that all the other central banks combined sold only a minor amount of gold each year. Nevertheless, there is a perception and some reality to the concept that many central banks are "mobilizing" their reserves.

Over the past year there has been much discussion about sales and "mobilization" of Western central bank gold reserves. Mobilization is the lending of reserves to enable producers to sell future production into the market today, effectively a short sale, and to provide actual short sellers with the bullion to deliver to the purchaser of their short sales. I should also mention that we suspect that dealers and others are using this mechanism as a form of financing, i.e. borrow gold at a low rate, sell it and use the proceeds for whatever. We are also told that there is a "carry trade" in gold where gold is borrowed, sold and the proceeds invested in government bonds. The currency risk of borrowing in yen and buying U.S. bonds has been partially replaced by the obviously less risky program of being short gold, which according to most observers, can only go down. For the risk of lending out their gold these central banks typically receive about 1.5% interest per annum.

As I have mentioned, a large and growing deficit exists between the supply of gold from mines and demand, which in the absence of central bank sales and lending would result in a much higher gold price, perhaps over $500 per ounce. In an attempt to earn a small return on a portion of their gold, central banks have, in fact, lost hundreds of billions of dollars in the reduced value of their gold holdings and have caused losses far in excess of that amount to gold investors worldwide.

Just as an example, which is probably not far from the actual figures, assume that Western central banks last year sold 500 tonnes of gold, loaned 500 tonnes to facilitate producer forward sales and loaned 500 tonnes through dealers to short sellers. Assuming that they earned 6% on the proceeds of the gold sold and 1.5% on the gold loaned, the centraI banks would have earned about $500 million on their gold sales and loans.

But central banks and official agencies own 33,000 tonnes of gold, the price of which has declined 20% from its recent highs entirely due to central bank activity. This has resulted in a decline of approximately $80 billion in the value of their gold holdings. In addition, if one believes that without these sales and loans of gold, the price of gold would be over $500/ounce due to the imbalance of basic supply and demand, then the central banks have given up an additional $90 billion. In sum, they have earned $500 million and lost $170 billion in the process. How's that for shooting yourself in the foot?

Furthermore, as the central banks lend out more and more of their gold, they are effectively allowing a reserve asset, which is the only asset that is no one else's liability, to be replaced by a note from a dealer. In addition, the loaned gold ends up being sold into the marketplace by the dealer on behalf of short sellers, producers, etc. and much of it is fabricated into jewelry. The loaned gold has, in large part, permanently disappeared. If one central bank wants its gold back, the dealer can borrow gold from another central bank. But if many or most of the central banks want their gold back, for whatever reason, then lease rates would skyrocket, there would probably be a default and gold would go into backwardation where the spot price was higher than the future. This would wreak havoc with producers who sold forward, short sellers and dealers, all of whom could suffer huge losses. There is increasing evidence that the amount of gold on loan is much greater than generalIy thought and thus the risks in the market are increasing. Nevertheless, certain bullion dealers with their "chicken little" story of the sky is falling have been successful in spreading the fear story that the central banks will sell all their gold. This has brought them the producer and short seller business since the declining gold price is enough verification of the story and the facts are ignored. The producers and short sellers selling at today's prices are probably the weakest and most gullible of the lot. This will enable the brokers to fulfill the old axiom which says, "client's money and broker's experience soon becomes broker's money and client's experience".

As a result of all this borrowed gold the risks in the gold market are very real. No one anticipated the palladium market going into backwardation as the Russians were expected to continuously supply metal to the market. This key assumption failed which could happen in the gold market where the key assumptions are that central banks will continue to lend their gold, and in such amounts that lending rates remain at low enough levels to keep the market in contango. If lending central banks withdrew from this activity or if physical demand for gold is substantially increased by other central banks or investors becoming aggressive buyers then lease rates would become so high that the market would go into backwardation and the spot price would rise dramatically as in the case of palladium. Lease rates have recently soared, perhaps indicating that the limits of gold lending are being reached.

We have not touched on yet another form of central bank gold mobilization which is the sale of calls. These calls are sold by central banks, primarily to dealers who then delta hedge the call with short sales. This is unmeasurable but probably a significant factor. Since the decision to selI calls is probably made by a trader at a central bank, it is unlikely that the same trader would have the authority to deliver the national gold reserves in case the gold price rose and the call was exercised. Most likely the call would be repurchased adding fuel to a rising market.

On the positive side, however, are the central banks who have been buying gold and the huge underweighting of gold among Asian central banks due to the enormous increase in their holdings of U.S. dollars.

With only 5 or 6% of their reserves in gold Asian central banks need to buy $6 billion worth of gold for each 1% increase in gold reserves. Thus, even a small increase of a few percent would overwhelm the gold market. In discussing central bank purchases of gold during the first half, Gold Fields comments: "But a larger element appears to reflect several institutions diversifying their reserves away from what they perceive to be an excessive reliance on the dollar, an asset which under certain circumstances could conceivably be open to political interference from the U.S. authorities".

The chart on shows that central bank net sales and producer net forward sales are really not so great relative to the market deficit. The additional gold needed to fill the deficit and keep gold from rising comes from short sellers. There are estimates of producer forward sales being in the 2,000 tonne range and outright shorts possibly equal to that. These figures are in line with estimates of borrowed gold in the 3,000-5,000 tonne range. The key point, of course, is that with the market in deficit, above ground sales must continue at these high levels to prevent gold from rising since without above ground sales the deficit would result in a much higher price for gold.

Now I run through a little recent history of the gold market to show how we got to the current point and a possible future scenario. An acceleration in producer hedging was followed by some central bank sales. The weakness created by these two selling groups encouraged outright shorting of gold.

Current State of the Gold Market

1. Large and expanding deficit. 2. Producer forward sales, speculator shorts and some central bank sales fill the deficit. 3. Overwhelmingly bearish sentiment promoted by bullion dealers in an attempt to capture flow from producers, short sellers and central banks. Their "bear" story: A. Central banks 'will sell all their gold. B. Producers should sell forward at any level as the gold price is going lower. 4. In fact: A. In 1996, 19 central banks bought gold versus 16 that sold. Of the 16, only 5 sold more than 10 tonnes. B. Mines are closing and many projects are being deferred at the current gold price, further expanding the deficit.

Now, producers have large gains on their forward position. Barrick has a $600 million unrealized gain and Normandy, the largest gold company in Australia, has an $800 million unrealized gain. It is now much more likely that forward positions will be bought back rather than additional shorts initiated by producers since hedging at current levels for many producers would just lock in a loss. By the way, while these producer hedges in retrospect seem wise as industry hedge gains are probably $2-3 billion, the market capitalization of the gold companies was reduced by $15-20 billion in part due to the effect of their forward sales on the gold price. Producers are also good at shooting themselves in the foot.

When gold looks as if it has made a solid bottom, it is likely that a flurry of acquisitions will take place as virtually all the majors must make acquisitions to replace reserves since exploration will not find the reserves fast enough, if at all. An important asset in these acquisitions would be the unrealized gains many companies have on their hedge positions. For example, Barrick could acquire Normandy for cash, raising all the needed money from the reversal of both company's hedges. In the process they would have to buy back 13 million ounces which would initiate a breakout to the upside in the gold price.

We believe that in addition to producer hedge reversals we will soon see evidence of significant central bank buying. If borrowed gold is 5,000 tonnes or more, someone has been buying all this gold and rumors of Asian central bank purchases will probably be verified.

Finally, we expect investment demand to pick up as paper markets falter, the Asian currency crisis spreads, EMU has problems or there is a "clean up" of any central bank overhang.