The Drums of War Beat For Gold
This time it will be different. Just as the countdown has taken months, the actual war and its impact is likely to be protracted with huge political risks (conflict spreading throughout the Middle East) and economic risks (oil, currencies and global recession). Unlike the last war when the allies only had to push out Saddam's troops from Kuwait, this time the Americans must replace his regime, which will take longer. Mr. Hussein has nothing to lose and he might very well use the odd scud or unconventional weapon to destabilize America's allies. Sure the Iraqi army is not a match against the Americans, but it has fought the Iranians for eight years. And, this time the battleground will not be the desert but the cities of Tikrut and Baghdad. Equally worrying is the fragile state of the global economy and the risk of a double dip recession in the United States should the war spread. So far, a built-in war premium has caused higher oil prices crimping growth at the very least. The drums of war must be paid for and gold is a good thing to have.
This has been a terrible year for the stock market and the US dollar. The Dow Jones, for example, is down 24 percent since year-end amid Wall Street scandals, a war discount and intensifying geopolitical tensions. For many years, foreign investors rushed to dollar-denominated investments such as US Treasury Bills, when war or bad economic news made the world seem dangerous. But this year, the US dollar fell 8.4% in the second quarter of this year on a trade-weighted basis, the sharpest decline since the fourth quarter of 1987. The main reason for the decline was the loss of appetite for US assets and dollars at a time when the current account deficit was widening and the stock market was dropping. This time many investors, including foreigners bought gold instead. Gold during this period went up 18% to a three year high. The need for foreign money is important since for two decades, the Americans bought and consumed far more than they produced. According to the International Monetary Fund, the United States absorbs 6 percent of the world's savings to finance its deficit. Foreigners now control 43 percent of the outstanding US debt, and almost 25 percent of all corporate debt. Net direct equity investment dropped to $8.6 billion in the second quarter and the Commerce Department said the current account deficit hit a record high of $130 billion in the same second quarter, up from $112.5 billion for the first three months of the year.
At gold's peak almost 23 years ago, the Dow and gold once sold at the same price. Today the Dow/gold ratio trades at about 23 times the gold price. In 2000 at the top of the bull market in paper asset, the ratio peaked at 45. Historically, that ratio has been 10-12 times. The Dow/gold ratio was at 1 in 1897. A reversion to historic patterns would either see gold go up or the Dow down. At 10 times, the Dow would be 5000 and gold at $500.
The bursting of the US stock market bubble has led many to draw parallels with the Japanese situation at the end of the 1980s. But are the Americans to suffer a decade of lost growth, just as Japan did during the 1990s? Both Japan and the United States have lost control over real short-term interest rates. For Japan, this is because nominal rates are near zero. For the US, rates are poised to fall again, also to near zero levels. Both enjoyed asset price booms fueled by excess credit but are now unable to kickstart their economies, despite an accommodative fiscal stance. And the financial sectors in Japan and the United States are similar, insofar as both banking systems are laden with too much debt leftover from their respective bubbles. Like the Bank of Japan, the Fed is in a state of denial and avoided the blame game explaining the Fed can't anticipate bubbles, it can only soften the impact when they pop. But there are differences and the main one is that foreigners own a greater portion of US debt than they own Japanese debt and that is a problem. The other difference is that the drums of war might exacerbate the trend in the United States.
Twin Deficits
Against the backdrop of war, Fed Chairman Greenspan is again warning that twin deficits call for the need for fiscal discipline since a failure to reign in a rising budget deficit would drive interest rates and borrowing costs higher. The ever-expanding budgetary deficit, particularly in the wake of an Iraqi war, together with the bloated current account deficit is one of the major factors behind our bearish outlook for the overvalued dollar. The fundamentals remain weak. The stock market slide is now almost three years old, and there is little incentive for foreign investors. Wall Street's accounting scandals have also fueled the negative tone in the equity markets and investor confidence is at a low. The other war, the War on Wall Street also does little to bolster confidence in American capital markets. The US dollar has lagged the trend in the US equity market, and therefore it is expected the dollar will experience a similar long-term slide - a slide that we believe has just begun. Mr. Greenspan, having accommodated the bubble, now appears more than willing to accommodate the inevitable repercussions, with an easy money policy. And, that is good for gold.
Countdown To War
But what about this Iraqi War? How bad is it for the economy? The Street recalls the short-lived Persian Gulf War, which only helped the arms manufacturers and had little impact on the US economy or gold. We believe it is different this time and that the situation is more like the protracted Vietnam War rather than the short-lived Gulf War. In the 60s, Lyndon Johnson financed huge social programs as part of his "Great Society" while fighting a lengthy war in Vietnam, which added to the twin deficits triggering the devaluation of the dollar and an $850 gold price. Today, the Afghanistan War and a War on Terrorism has crowded out other spending and comes at a time when Americans are again faced with twin deficits. The White House National Economic Council has estimated that the price tag to fight Iraq could cost between 1 percent to 2 percent of US GDP or $200 billion (the Persian Gulf War only cost $50 billion, which was paid by the Gulf States). However, this time, the Americans must pay for this spending, which will add to an already bloated deficit. The indirect impact could easily be more far reaching if the battle spills beyond Iraqi borders. To date, a war premium is built into oil prices and the war itself will almost certainly push prices higher, undermining an already weak economy. At the very least, the market uncertainties will only lift when the last bullet from Iraq is fired. War was not cheap then, nor is it now. Gold is a good thing to have.
Bubble, Bubble, POP!
America is short on savings and long on debt, and with the stock market collapse, the sagging US dollar is likely to impact the housing and consumer bubbles. History shows that the Fed will have no alternative but to eventually raise interest rates to attract investors and prop up the dollar. The Americans have little room to maneuver. When the stock market was booming, foreign investors had a strong appetite for American investments. The economy was so strong it acted like a vacuum cleaner, sucking in billions of dollars every year. The US did not need high interest rates to attract outside money. The current account deficit has surpassed 5% of gross domestic output and is expected to hit a new record for the year as a whole, requiring an inflow of as much as $2 billion of capital to finance it. If $2 billion does not come in, the dollar must weaken. The IMF has already warned that if a country's current account deficit exceeds 4% of output, it puts that country in danger of triggering a sequence of exchange rate and interest rate problems. Confidence and demand for dollar based assets has dropped and with it the dollar's value. It is our concern that Americans will need to offer higher interest rates to continue to attract investments, which will of course, pop the aforementioned bubbles.
With a $200 billion budgetary deficit at 2% of GDP plus the prospect of another $200 billion spent for the Iraqi War, a new bubble may be forming - the government bond market. To date, corporate bonds have been shunned because of credit worries. The US treasury is now a regular in the markets and there are hints of a resumption of the thirty-year treasury bonds. Mr. Greenspan seems to forget history that treasury offerings often displace other issues and thus a new bubble and liquidity squeeze may be forming. The markets should take heed from the recent Japanese lesson when there were not enough buyers for the Bank of Japan's sale of 10-year bonds, for the first time in its history. While it is unlikely that Japan would be incapable of financing its own debt, Americans ought to realize that debt markets are not finite. We thus expect a steepening of the treasury yield curve and a widening of the credit spreads as lesser quality credits get squeezed out. Quality bonds could only fill the resulting vacuum, but as we saw in Japan, even treasury issues are no longer a sure thing. History shows that gold often fills this vacuum as investors seek protection against falling asset values.
Hedging
Hedging is a fact of life in the gold mining business. Hedging was used successfully by gold producers to reduce risk and provide for predictable earnings and revenues. Hedging also allowed the industry to finance capital projects. Hedging allows producers to sell tomorrow's production at today's prices using the futures or forward markets. If the price of gold falls, earnings are protected and the producer could always buy back production. If the price of gold rises, then some of the profits are given up to the market. However over time, bullion bankers created exotic instruments. Spot deferreds for example, allowed Barrick to rollover a contract for up to 15 years without margin calls. Such tactics were successful while gold prices were sinking, but have since been undermined by the rise in the gold price.
The supply/demand situation in the gold market has improved in part due to the unwinding of hedges. Gold companies are under pressure from investors demanding 100 percent of the upside. When miners close out their hedges, they generate demand for gold.
Investors no longer believe that they need protection from a weak gold price and, ironically, are unwilling to accept that hedging is risk-free. First there was the near death experience of Ashanti and Cambior in 1999 that showed that hedging did not necessarily limit a gold miner's risk. Second, virtually all gold producers have a negative mark-to-market value on their hedge books. And the world has begun to hate off balance sheet transactions. The Washington Agreement has focused attention on the key role of central banks in the derivative market. Central banks, in the interest of transparency, have curtailed their lending activities and no longer appear to be as willing to accept miniscule interest rates in exchange for lending their gold. Even at higher prices of gold, we expect the central banks to renew their agreement since they receive higher prices in transparent transactions versus the former free-for-all, which not only netted them lower prices but harmed the major gold producing economies such as South Africa and Russia who are dependant on income from gold mining. While the Germans and French are likely sellers, the Chinese and other Asian investors are natural buyers.
While hedging was designed to remove risk from the gold market, recent events appear to magnify the risks. For example, an unattractive contango (the amount by which future delivery exceeds the price of spot delivery) has made hedging less attractive. And, when a gold contract or spot-deferred contract is renewed, there is actually an interest rate risk, since backwardation or when short rates are higher than long rates might occur (negative contango). Given the volatility in interest rates, there is no certainty that at the time when a contract is to be rolled over, that the interest rates could be rolled over at the previously fixed price. While high gold lease rates might initially appear favourable, it may come at time when other interest rates are equally high and thus rolling over, might prove to be too expensive.
Of more concern is that the massive hedging market is based on the central banks lending out to creditworthy counterparties and the doctrine of "too big to fail". There is in effect, no ultimate lender of last resort if there is a problem. Transactions are done on a one-to-one basis. Obviously central banks deal and lend only to financially strong institutions. However the recent collapse of the financial markets has shrunk the pool of AA-rated financial institutions. JP Morgan and CIBC for example recently lost one of their As, following losses in the latest quarter. The Comptroller of the Currency reported JP Morgan held gold derivative notes outstanding of a little more than $40 billion, considerably in excess of the bank's book value and market capitalization.
Citibank, Goldman Sachs and JP Morgan (the largest) are the dominant players in the gold derivative market. The shrinking pool of creditworthy counterparties is of concern to a market needing liquidity. When a gold producer decides to defer or roll over a spot deferred contract, the counterparty must hedge that transaction. What if there is a change in that counter parties' financial position? For example, the central bank might decide not to lend gold against the contract, in effect triggering a force majeure. At that time, the gold producer cannot roll over, the counterparty cannot facilitate the trade and a cash settlement is required.
Consequently, we believe that the unwinding of hedges causes an upheaval in the derivative market, which is based on a liquid and abundance of financially strong players. So far recent deliveries against accounts have not had an impact as central banks get repaid. This time, the central banks might not be so anxious to lend gold at nominal interest rates given the shrinking pool of AA-rated counterparties. The prospect of an upheaval in hedge books has raised the risk profile significantly. Consequently, the battle of the hedgers might have already been lost. Hedging, as we know is a financing vehicle of the last spent bubble. What must be unwound are the hedging mistakes of yesterday and it is no coincidence that the unwinding of hedges has coincided with the rally in gold prices. We believe that the unwinding of the gold hedges will not be an easy event. Consequently, we see dramatic volatile moves as producers attempt to unwind their "risk-less hedges". We continue to recommend avoidance of most hedgers.
Recommendations
Much has been made of shrinking consumer demand for gold because of high prices. Gold Fields Mineral Services noted that consumer demand fell 23% in the latest half. However, left unsaid is that the impetus for higher prices is investment demand. In the first half, that demand has skyrocketed to 182 metric tons from 93 tons a year earlier. In Japan where a shaky Japanese banking system has fueled higher prices for yen-based gold, it's not a coincidence that Japanese gold consumption jumped 100 percent to 86.9 tonnes in the first half, reflecting Japanese woes. In North America, demand too has increased in the wake of falling stock prices.
Investors are disappointed with gold and the gold stock's lackluster performance in recent weeks. Gold has actually done well and outperformed relative to the slumping stock market. Gold has an inverse relationship with the dollar, which has stabilized in recent weeks. Our view of the dollar sees a resumption of the downtrend, which will further help to support gold prices. Finally, our work suggest that gold's volatility will pick up once it moves above $330 per ounce, a level of resistance.
We continue to believe that we are in the second upleg for gold with a $375 per ounce near-term target likely when the first cruise missile is dropped on Iraq. Next year, we see a $510 per once target supported by Middle East tension, strong investment demand, a hedging debacle, a sharp depreciation in the US dollar and favourable supply/demand fundamentals. Our gold recommendations remain focused on those producers with potential to grow production and reserves. In addition, balance sheets and quality of plays are important. Among the senior producers, we like Newmont but continue to prefer the mid-cap producers like Agnico-Eagle, Meridian Gold and Goldcorp. We recommend investors buy the new Kinross, which will fill the senior vacuum of unhedged producers. The above producers are virtually unhedged. In addition, we continue to recommend our portfolio of Top Ten Juniors, which includes Crystallex, Eldorado Gold, Claude Resources, High River Gold, Iamgold, Miramar, Repadre Capital, Northgate Exploration, Philex Gold and St. Andrews Goldfield. This group continues to outpace the market.
C o m p a n i e s
Barrick Gold Corporation
As part of its growth initiative, Barrick plans a $2 billion expansion to build four new mines, which will boost output by 1.2 million ounces to 6.9 million ounces by 2008. Barrick will fund this expansion using free-cash flow and its balance sheet. Since Barrick's gold production is expected to decline next year, growth and low cost ounces are needed to offset the decline. Barrick gave more guidance on the newest mine at Alto Chicama in Peru. Again, Barrick dusted off Pasqua, but the project's price tag remains above $1.1 billion. Left unsaid, is that Barrick's pursuit of "organic growth" also closes the door on some of the more expensive acquisition targets such as Newcrest, Placer Dome and AngloGold. While these companies are possible merger partners, we believe that Barrick in the near term will continue to beat the organic growth drum. We view Barrick positively since it has one of the best balance sheets, brand name and array of long-life excellent assets.
The step towards reducing the hedge book is positive, but Barrick still has more than two years of its production hedged and that is too much for today's gold market. Over the next year Barrick would have delivered almost 3 million or so ounces making the reduction more attributable to attrition rather than a buyback. Nonetheless, the symbolism has not gone unnoticed since Barrick has tenaciously defended its unfashionable hedge position.
However, shortly after unveiling its growth story, Barrick shocked the Street. It gave an earnings warning on its third quarter results due to operating problems at its North American and African mines. When the predictable becomes unpredictable, it raises more questions. The production problems at its mines have raised the cost of production, despite affecting less than 1% of its total output. While Barrick has described the problems as short term and expects to produce a targeted 5.7 million ounces of gold this year, next year it will only produce 5.5 million ounces at a cash cost of $175 an ounce. Barrick's sterling reputation has lost some of its luster and its creditability will have to be re-established. In fairness, Barrick's difficulties are a reflection of the mining industry's problem. For the past five years the low gold price has forced an industry, starved for capital, to replace diminishing reserves, slow development and high grade. For that reason, gold miners found it easier to mine the marketplace rather than to mine for gold. Barrick's organic growth kick may not last too long given its new problems. An acquisition may be the logical answer.
Cambior Inc.
Cambior released new data from the Gross Rosebel project in Suriname, South America. Cambior has downsized the original capital cost to $95 million through the usage of equipment from the Omai operation, which runs out of ore in 2005. Financing is dependent on Cambior's banks, which will be asked to put up more debt and give way on cash flow in order to get the project going. The banks should support the plans because without Rosebel there is no future for the company.
At Omai, output is declining, but cost should go down, since less stripping is needed. At Doyon, the company has signed a new labour contract with its workers and this mature underground operation should produce a steady 225,000 ounces. Niobec which is 50 percent owned with Mazarin, is a steady cash flow producer and an excellent asset. Sleeping Giant is the smallest of Cambior operations and is 50% owned with Aurizon. Cambior expects to deepen its shaft, which will cost $3 million and will allow development and extend its mine life. Cambior has some ground near Alto Chicama, which could attract some exploration dollars.
Importantly, Cambior has reduced its hedge book, which currently stands at 1.4 million ounces down from 1.9 million ounces at year-end. Cambior expects to reduce further its hedge book to 1 million ounces by year-end, through purchases and deliveries into the book. However, Cambior will still have more than two years of production hedged. Cambior must deliver 50,000 ounces for the next three years at $235 an ounce to fulfill a sale commitment. With over 154 million shares outstanding and debt of $26 million, excluding the prepayment of $45 million and cash of $32 million, Cambior has certainly escaped its near death experience. However, the financings have allowed the company to redress the balance sheet but it has come at a huge dilutionary cost. The good news is that Cambior does not expect to finance Rosebel with equity, and hopes to finance the project through debt and cash flow. With the financing needed for the low-grade deposit of Rosebel, a still too high hedge book and declining production profile, the shares are suitable only for speculators.
Crystellex International Corporation
Amid much skepticism and following a tireless pursuit, Crystallex was awarded the 12 million ounce Las Cristinas gold property in southeastern Venezuela by the government's Corporacion Venezolana de Guayana (CVG). Crystallex has pooled its rights for concession 4 and 6 and the Venezuelan Government has vended in their concession 5 and 7, as well as drill data and other sundries. Crystallex has a formal operating agreement that grants it 100 percent of the reserves and resources of the project subject to the payment of a 3percent fixed royalty to the Ministry of Energy and Mines and a further royalty to CVG based on the gold price capped at 3 percent. The agreement has an initial term of twenty years, with two renewals, each for a term of 10 years.
Crystallex will now go ahead with a feasibility study. Initial plans call for a three-phased approach with the first phase comprised of a 10,000 tonnes per day operation, producing 250,000 ounces. Phase I will involve mining the saprolite material, which has a seven-year life. Phase II will involve a copper circuit and a 15,000 tonnes a day operation. The capital costs for Phase I and II is only $135 million, so the project is financable. We expect Crystallex to aggressively develop the deposit and at the same time build up its management team and balance sheet. Currently Crystallex operates mines in Uruguay and Venezuela and should produce about 110,000 ounces this year. While Crystallex's shares reacted positively, the shares have lagged our $5-$6 valuation. Consequently, we continue to recommend the shares as an undervalued junior with the potential of being a major. With the Las Cristinas title problems resolved, we expect interest from some of the majors who have in the past expressed interest in Las Cristinas but were deterred by the title problems.
Goldcorp Inc.
Goldcorp released additional drill results at the Red Lake gold mine in northwestern Ontario. Recent holes expanded the prolific High Grade Zone. The drilling results confirm the company's model and raise the possibility of another deposit at the Far East Zone. The company's ambitious drilling program should allow the doubling of resources at year end. At the same time, Goldcorp added to the sulphides, but sulphides are not in Goldcorp's immediate plans. Meanwhile, the company reports that the mine grade continues to be better than projected and is on track to meet its production goal of 500,000 ounces at a cash cost of $65 an ounce at Red Lake. With its debt free balance sheet, Red Lake exploration growth prospects and healthy cash reserves, the shares are attractive at current levels. Buy.
Kinross Gold Corporation
The merger of three mid-sized Canadian gold producers to create the seventh largest gold mining entity in the world should be completed in November. The company has filed documentation with the SEC, and when approved will mail a dictionary-sized information circular to its shareholders. Production at Kubaka (54% owned) increased to 60,000 ounces in the second quarter. Exploration continues at Birkachan where the company is working on a feasibility and development plan. However, the ongoing dispute with the governor of Magadan continues and it seems this problem is coming to a head. A court has frozen one of Kinross' bank accounts, which has made operations cumbersome. Nonetheless, Kinross has the leverage of a fairly extensive operation, revenue generation, and the central government is anxious to resolve this local dispute with the largest gold producer in the country. Consequently, while the Birkachan deposit would normally be brought on stream quickly, resolution with the government is needed before that project is given the green-light.
The merger of Kinross with TVX and Echo Bay, will produce a senior excellent gold investment vehicle for investors who have a limited number of investment options in this category. The elevation of Kinross to senior producer status has been welcomed warmly by institutions. Significantly, the unhedged production of 2 million ounces also makes the new Kinross an excellent acquisition target. Over 65% of its production will come from North America, while 86% of the new production will from the Americas. And unlike comparable-sized Placer Dome, the new Kinross will not have any South African exposure. We believe Kinross shares will become strategically important as over-hedged producers figure out a way to unwind their hedge books without tearing apart their balance sheets. Consequently, the takeover of Kinross is likely in 2003 for its two million ounces of unhedged production. We recommend the shares be aggressively bought.
Newmont Mining Corporation
Newmont will produce almost 7.8 million ounces at a cash cost $176 this year, with the bulk of that production from North America. Next year, Newmont should produce about 7.5 million ounces with increased output from Yanacocha expected to offset the decline in production from Kori Kollo. Carlin gold production should remain at a stable 2.6 million ounces with a slight pickup from the Boddington expansion, which is expected to have an impact in 2004. Newmont has aggressively unwound Normandy's hedge book and will be unhedged next year. After a year of bringing down costs, developing synergies, and pruning assets we expect Newmont to become an acquisitor next year. Like Barrick, Newmont's problem is to replace its reserves and production by spending $85 million on exploration annually. Newmont has benefited from the merger, with debt no longer a major problem, due to Franco Nevada's excellent balance sheet and royalty revenues. The addition of Normandy's mining assets, more than offset its hedge book. Overall Newmont is well placed with proven and probable reserves at 87 million ounces of gold. For every $25 in the price of gold, Newmont picks up $160 million in incremental after tax cash flow and $110 million flow-through to the bottom line in net income. Consequently, Newmont is attractive as a senior producer, giving excellent leverage to the expected higher gold price. Buy.
John R. Ing
416-947-6040
October 10, 2002
The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.
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