On a daily basis, giant machines and 5000 workers move 600,000 tonnes (metric) of waste rock and ore. Noteworthy is the fact that each tonne of ore contains .028 ounces of gold per tonne. This ratio means that by volume, each tonne contains .000088% of gold. Gold mining of this type is essentially a giant earth moving operation. Each year, approximately 200 million tonnes of ore and waste are displaced. Ore grade material is loaded by 240 ton trucks onto symmetric pyramids of crushed rock called heap leach pads. These pads are sprayed with a chemical solution, which contains, among other things, cyanide to separate the gold from the rock. Environmental compliance is to the highest standard. Cyanide and other potentially harmful chemicals are contained and recycled via closed circuits. Day by day, a chemical solution containing gold and silver trickles to the bottom of the leach pads into collectors, which are then transported to a local refining site. The solution is cast into crude bars called dore, containing more than 90% precious metals.
Yanacocha is the very model of a modern gold mining operation. It is above ground (open pit), capital intensive, and highly efficient. However, much of the world's gold is still produced from accident-prone, labor-intensive underground mines. On a comparative basis, underground mining is generally riskier, especially for those who labor in high temperature stopes with unpredictable rock conditions. Wages in underground operations represent a comparatively high component of production costs. Labor disruptions, including strikes, are not unknown. In the decades to come, even Yanacocha could move to underground mining potential copper-gold deposits now being explored.
The vast operations of the Yanacocha mine produce 2.7 million ounces of gold per year, or roughly 3% of the world total. That works out to revenues of around $1 billon. While the typical gold mine is far smaller, it is safe to say that the lead-time between discovery and date of initial production is comparable. Given the proliferation of environmental concerns and the growing presence of Greenpeace-like interest groups, it is unlikely that these lead times have contracted. In this context, the sharp decline in gold exploration by the mining industry since its peak year of 1997 at the very least suggests a hiatus of several years before the curve of global mining production resumes any semblance of growth. Each year, global mine production removes 90 million ounces of gold from the surface or near surface of the earth. If the industry kept track of its reserve to production ratio, as does the natural gas industry, it would cause one to think that the maintenance of the current rate of world production is in jeopardy.
The dore bars, hard-won treasure from the earth's crust, have only a notional market value at the end of the mining process based on their gold and silver content. They are unsightly, crudely shaped bars of bullion, which bear only slight resemblance to the final products contained within. Therefore, the operators of Yanacocha periodically load the dore bars onto jet freighters at the Lima airport 375 miles away. The bars, representing potential revenue to the mining operation, are shipped to Zurich where they are loaded onto armored trucks. The trucks wind their way south over the Alps and through the Gothard Tunnel to arrive at a non-descript building tucked away between an outlet mall and the railroad tracks in the Italian zone of Switzerland.
The Argor-Heraeus refinery is not a particularly welcoming sight to unannounced visitors. Ringed by a high wall topped with barbed wire, the only entrance is a steel gate devoid of a company logo or much else in the way of identification. In our case, we had requested a visit in order to view the gold bullion purchased for our clients in the past year. Dr. Wilfried Hoerner, a shareholder-manager of the refinery, was our cordial and informative tour guide.
In the ordinary course of business, drivers communicate with internal security to gain access in order to unload their cargo. Trucks bearing dore bars from Yanacocha and other world gold mines are joined by those loaded with the sweepings from the factory floors of Swiss and other European watch and jewelry manufacturers, and scraps of jewelry discarded from the souks in the Persian Gulf, Africa and Asia. The flow of scrap and dore is periodically augmented by high purity 400-ounce gold bars from the vaults of world central banks, as they continue their multiyear campaign to reduce their exposure to this non-earning, albeit appreciating, reserve asset.
Inside, the source materials are ground, chopped, melted, purified, extruded and reconstituted in a series of low and high tech stages. State of the art security is impressive. The combined material flow is recast into new shapes of "four 9's" gold, the highest purity, or alloyed with silver, copper and other metals depending on customer specifications. Final output includes coin blanks, 1 kilo bars favored on the Indian Subcontinent, rods and bars for jewelry manufacturers, and even semi-fabricated watch cases. In this way, central bank gold, once the numeraire for all paper currencies, is decommissioned from its official monetary status so that it may satisfy the growing world appetite for luxury goods.
Twenty-five years ago, the elite mainland Chinese wore mechanical steel wristwatches. Today, the affluent wear Rolexes, Patek Philipe or similar brands. Twenty-five years ago, local moonshine was the adult beverage of choice in many reaches of Asia. Today, first growth Bordeaux is served in the better restaurants throughout the Orient. Perhaps this explains the more than ten-fold price appreciation in first growth vintages over the past two decades. The traditional quick and dirty benchmark for assessing the purchasing power of an ounce of gold, bespoke men's suits, has gone haywire. According to Alan Flusser, renowned author and designer of exclusive menswear, a bespoke gentleman's Saville Row suit could be purchased in the early 1980's for around $800. Today, the number is over $3000. A look at college tuition, exotic sports cars, luxury real estate and other items on the "cost of living it up" index would tell a similar story of scarcity against rampant growth in the global appetite for the finer things in life. Gold stands alone in the bargain dustbin of luxury goods.
The managers of the Argor Heraeus refinery purchased the facility in 1999 along with a consortium that included the Heraeus Group, Commerzbank, and the Austrian Mint (at a later stage.) Their growth plan for the business is to integrate further downstream into "value added" fabrications for their customer base. The refinery is strategically located for "just in time" deliveries to Swiss watchmakers and the Italian jewelry industry in centers such as Geneva and Vincenza. Absent in the company's expansion plan is any provision for the possible needs of those who might be short the metal including Wall Street traders, commercial players, holders of derivatives, or managers of mining company hedge books.
The Argor Heraeus facility is not your typical sausage factory. It is as technologically advanced and environmentally compliant as any precious metals refinery in the world. In their own words, "The Swiss environmental regulations are among the most severe in the world and Argor Heraeus for its part is dedicated to constant research and development in order to guarantee state of the art technology in this field". The entrepreneurial management group focuses on increasing throughput and adding value for their customer base. They are motivated by the desire for profits and growth and therefore pay close attention to matters of cost cutting, efficiency, environmental compliance and process improvement. The monetary and macroeconomic aspects of gold appear nowhere on their agenda. The refinery's exact capacity is classified but it represents between 10% and 20% of world gold output. At periods of peak demand, customer requirements are met thanks only to a supply of 400 ounce bars from central banks.
There was a time when the prevailing opinion of policy makers and individuals alike that gold and money were synonymous. However, times change and opinions with them. Central bankers are not immune to these forces. Today, most have little use for gold and view it as an antiquity. Their collective opinion matters since central bank gold reserves amount to 33,000 tonnes, about 20% of the above ground supply. They are steady sellers of the metal and for that, jewelry consumers, coin collectors, and value investors have much to be thankful. If it were not for central bank distaste for gold, its rarity as a natural element and difficulty of procurement would result in a much higher price. While supply and demand analysis suggest that gold is scarce and would trade at a higher price if not for central bank sales, it is equally important to view gold as just one asset among many in the universe of equities, bonds, real estate, and other commodities. As such, it is in constant competition for capital flows against anything else that can promise to deliver an investment return.
Viewed as a portfolio asset, the supply of gold is not the 2500 tonnes produced by the mining industry each year plus scrap and other recycled metal. Instead, one must consider the entire above ground supply, marked to market, and theorize that at any given moment this quantity could be bought or sold in its entirety. The "market cap" of gold, like the market cap of Microsoft, is subject to daily reappraisal on its investment merits.
As sellers of gold, central bankers came to the realization in 1999 that episodic but relentless attempts to liquidate were depressing the price of the metal. In an attempt to create a more transparent market, but stopping well short of the sort of the promotion and inflated claims often utilized in the investment world to unload a large position, the banks agreed to sell at a measured pace of 400 tonnes per year for an initial five year term. That initial term expires September '04, but seems likely to be renewed as new sellers want to join the action. Most vocal of among these has been the Bundesbank, whose 15,000 employees might regard an ongoing gold sales program as a path to job security against a background of declining relevance for European central banks.
In any investment situation, it is essential to determine whether the seller is right or wrong. To be charitable, it is quite likely that the motivation and mandate for central bank selling transcends the narrow investment exercise of whether a sale at current prices is well advised. As government (and mostly anachronistic) institutions manned by bureaucrats, central banks do not rank particularly high in the realm of investment acumen. It therefore does not require a major ration of courage to suggest that it is better to be a buyer than a seller of gold at this particular juncture in history. The inevitable investment inference is that gold is too cheap and that money, as the modern world has come to understand the term, is over-valued. The same observation would apply to the handmaidens of paper money, i.e. equities and bonds.
It is a truism that all the gold ever mined exists above ground. It is never consumed but forever recycled into different shapes--- artistic, monetary and otherwise. During a recent restaurant experience, I was served an entrée garnished with 24k gold leaf. However, let's assume that the truism is essentially correct. That works out to 140,000 tonnes, which in turn equates to a market cap of $1.5 trillion. Only a small part of that total is represented by monetary gold. Using highly conservative assumptions, monetary gold including coins, bars, and quasi jewelry and central bank reserves account for perhaps 50% of this total. The remainder, which exists in the form of Rolexes, museum artifacts, gold leaf on frescoes, and tooth fillings, is not in play for the sake of this discussion. Neither is most of the central bank gold. However, for discussion purposes only, let's assume that it is. Based on this reasoning, the market cap of financial gold, assuming a $400 price, is a paltry $750 billion.
As an investment, gold has only two things going for it. First, and the one we prefer, is the possibility that it can rise in value, perhaps substantially, against other things, in particular stocks, bonds, and its paper money price. The second, and potentially very appealing feature to a wider population of investment constituencies, is uncorrelated performance. Pension fund investment managers, for example, who oversee multi-billion dollar portfolios of stocks and bonds have a mandate to defend the purchasing power of plan beneficiaries not for tomorrow, or next year, but for generations. Whether gold rises or falls in the short term is irrelevant to such managers, as would be the case in contemplating the imminence of a fire when purchasing insurance. Unlike most alternatives, however, gold generates no investment return of its own. There is no coupon or internally generated rate of return to explain investment appeal. That appeal rests exclusively on the premise that no return is better than a negative return. Gold does well during prolonged bear markets in financial assets.
The market cap of gold today at $750 billion seems pitifully small when measured against world financial assets of $60 to $70 trillion. If only a sliver of that total were reallocated to physical gold, the price impact would be highly disproportionate to the fraction of reallocation. There are numerous ways to illustrate the imbalance. In the following discussion, we use US equities plus government debt including agencies as a proxy for global financial assets since historical data on global financial assets proved hard to come by.
In 1982, gold traded briefly above $800/oz. By subtracting cumulative production since 1982 of roughly 38,000 tonnes, the above ground supply in that year was 102,000 tonnes of which 35,820 tonnes was held in the official sector. Since gold had been a strongly appreciating asset for the previous decade and a half, it would not be implausible that more than today's 50% ratio of above ground gold was held as an investment. We will assume 60%. If so, the 1982 market cap of investment gold at $800 would have been $1.6 trillion. In 1982, according to Morgan Stanley, the market cap of US equities was $1.5 trillion while US dollar denominated debt of all descriptions was $4.7 trillion. At that particular swing of the pendulum, the market cap of gold represented about 25.8% of US financial assets.
In 1934, the Roosevelt administration felt compelled to raise the price of gold to $35/oz in order to restore confidence in the financial system. Federal and non-federal debt totaled $159 billion while the market cap of all equities was $30 billion for a total financial asset proxy of $189 billion. Subtracting the 47,000 tonnes of cumulative production from 1934 to 1982 (World Gold Council web site) suggests that the above ground supply was 55,000 tonnes. Official sector gold reserves in that year totaled 20,172 tonnes, or 37% of the total. Using a 60% ratio of above ground gold supply hypothetically in play, the market cap was $68 billion or 36% of US financial assets.
During these two noteworthy episodes when investors fretted most about the value of their paper assets, they placed a hefty premium on gold's safety. As nearly as we can measure the degree of concern exhibited in those two instances, the safety premium for gold translated into somewhere between 25% and 37% of US financial assets. Today, that fraction is 1.6% ($750 billion over $46 trillion, based on an equity market cap of $15 trillion and total debt outstanding of $31 trillion.)
With stocks trading at 26x trailing earnings and a 1.6% yield (S&P 500), investors in general do not seem to be fretting. However, certain investment world luminaries are beginning to sound downright alarmist. Warren Buffet, in the November 10th issue of Fortune, suggested radical measures to deal with the trade deficit in the form of a complex scheme of import credits to stimulate exports. Whatever its other faults, his proposal is no more than a clever disguise for a substantial devaluation of the dollar vs. other key currencies. Forgoing the social engineering impulse, John Templeton recently advised investors to "get out of US stocks, the US dollar, and 'excess' residential real estate." His sell recommendation was based on the belief that "the dollar will fall 40% against other major currencies….and that this will lead the nation's major creditors, notably Japan and China, to dump their US bonds." (as reported in the Herald Tribune October 16th) The certain aftermath would be a run up in interest rates, a decline in stocks, and "the beginning of a long period of stagflation." Echoes can be found in the musings of George Soros, Bill Gross of Pimco, and James Grant.
What about those non-US creditors who already hold 46% of US treasury debt as well as 20% of all agency debt? A continuation of the status quo means they would end up holding considerably more US paper both in absolute and relative terms in years to come. Maybe it works for them. By so doing, they gain access to the US market and thereby provide jobs, exports, and even the prospect of economic growth for their domestic constituencies. Fiscal prudence has never been high on the agenda of any government, so why would the central banks of our trading partners feel moved to act based on the prospect of a substantial devaluation of their most important reserve assets? We (the US and its trading partners) are all in this together. Dollar devaluation would undermine our collective prosperity. A 26x multiple on stocks and record low bond yields say worries over dollar valuation are misplaced. Long live the virtuous circle!
Thoughtful investors wonder what could ever replace the dollar. The US is still the world's most important economy, beacon of freedom, and strongest military power. No other nation or group of nations have or most likely could ever construe a superior currency. Still, there are the unanswered issues of valuation and capital imbalances. We are reminded of Cisco and similar equities at the top---over-owned and over-valued. As with Cisco, the skeptic is powerless to predict the turning point but quite capable of identifying what is unsustainable. One's inability to imagine an alternative to the current dollar's reserve currency status provides no assurance as to its permanence.
Some small reasons for concern might include China's recent contemplation of a non-dollar peg for the yuan. Zhou Xiaochuan, governor of the People's Bank of China, said in September '03 that there was room for debate on whether the yuan should be tied to a cocktail of currencies. What should one make of the September sale of $3 billion of US Treasuries by China, Korea, and Thailand, as noted by Stephanie Pomboy (MacroMavens 10/24/03)? Was this just a subtle reminder to the visiting US Treasury Secretary Snow of who held the cards in the currency debate or were they just testing the water? It seems inconclusive. With a far smaller stake in the debate, perhaps Russia was able to speak more freely when Deputy Finance Minister Alexi Ulyukayev said "he wants the structure of reserves to change to reflect the structure of the nation's foreign debt and trade contracts." This could be accomplished by reducing the portion of its $63.8 billion reserves held in dollar-denominated assets by 3 to 5 percentage points in favor of euros. However, the Russian stance also seems inconclusive.
Perhaps investors and corporate managers should continue to contemplate business as usual, as did Pravda, until one day before the regime change. In this respect, the managers of the Barrick Gold hedge book can take solace in the company of large numbers. Their view, it may be inferred from their posture regarding their most recent financial statements, would differ from our view that gold is seriously mispriced and unlikely to revisit levels that would vindicate indefinite extension of Barrick's 16mm ounce short position. The company reported a negative mark to market of its hedge position as of 9/30/03 of $1.2 billion, based on a spot price of $385. Since the company's net worth was well above the $2 billion threshold at which counter parties could call for an early close out of hedges and long term debt to net worth was even more distant from the trigger of 1.5:1, financially induced hedge book stress seems remote. Notwithstanding the relative underperformance of ABX shares since the bull market in gold commenced in August, 1999, or repeated investor calls to reduce hedge exposure, the company has elected not to exercise its right "to accelerate the delivery of gold at any time during the life of our contracts." Instead, during the most recent quarter, it exercised its right to defer delivery while the spot price floats substantially above the average of $311/oz that would be realized by satisfaction of its hedge book obligations.
Comex option writers agree with Barrick. They have written call premiums for near term expiration at 400 to 450 amounting to nearly 5.6mm ounces, or more than 160 tonnes of gold, a very sizable bet by historical standards, that these strike prices will go unbreeched. Months ago, when these calls were written, 400 seemed distant and the premium income like easy money. 2.6mm ounces are at nearby strikes, 400 to 420 that expire in early December.
The stance of Barrick and the option writers is consistent with the prevailing financial market view that any foray by gold above $400/oz would likely be a short-lived and anomalous event. Implicit is the thought that the dollar will remain unchallenged as the world's reserve currency. Also implicit is the thought that world financial policy makers, especially the Federal Reserve, possess the wisdom, the skills, and the power to promote global prosperity and stave off contractionary market forces that from time to time threaten global financial stability.
In this view, the Fed's increasingly transparent attempts to manipulate financial markets through barrages of liquidity would be seen as clever adaptation to the realities of the 21st century economy. A contrasting take would be that of James Grant, editor of Grant's Interest Rate Observer, who wrote: "Our age in finance is an age of heresy. Budgets go unbalanced, currencies go uncollateralized, current account deficits go uncorrected, securities go unanalyzed and bubbles go unpopped (until too late)". (10/24/03)
The impressive headline numbers on the economy's recent performance cannot hide a disproportionate dependence on consumer spending and service jobs. For example, despite 7% GDP growth, corrugated box shipments, usually a good proxy for coincident economic activity, were flat during the period. Manufacturing employment continued to decline despite overall job growth. GDP, having moved far afield from the manufacturing sector would be better measured in terms of cell phone traffic, hamburgers flipped, casino winnings, or box office receipts. Traditional measures of economic health such as inventory to sales ratios, the purchasing managers index and similar ratios have become less relevant. To understand the economy, one must comprehend the engine that drives consumer spending. That engine is the wealth effect. Its principal moving parts are financial asset prices, employment levels, consumer sentiment and personal income. Of these parts, financial asset prices are the core, and the others mere derivatives.
In its November 14th Economic Newsletter, the San Francisco Fed asked whether the Fed should "react to the stock market." Fed senior economist Kevin Lansing concluded that "although central banks control only short-term interest rates, their ability to influence longer-term rates and other asset prices is part of the transmission mechanism of monetary policy. Movements in asset prices can have important consequences for real output and inflation."
Over the past several years, the Fed's excursion into extreme liquidity has disembodied financial asset prices from their fundamentals. The Fed wants investors to forget that the invariable precursor to positive equity returns has been bear markets, complete with high dividend yields, low p/e multiples and pervasive skepticism. With bond yields at multi decade lows despite record fiscal and trade deficits, what positive outcome to these historically troublesome issues is necessary to prevent the bloodshed that normally results from overvaluation? If generous bond market valuations cannot be sustained, how can the equity markets continue to flourish? Lack of inflation is essential to low interest rates. The basis for low inflation is high productivity, or outsourcing of manufacturing to Asia by another name.
Factory orders, unemployment claims, capacity utilization and housing starts do not hold the key to the future, celebrated though they may be by the wise men of CNBC. What we need to know in order to peer into 2004 and thereafter is where stock and bond prices are headed, for it is these and these alone that will affect consumer psychology and behavior. Consumer spending held up despite a cyclical downturn thanks to the Fed's aggressive cycle of interest rate cuts, justified by fears of deflation. The desired boom in housing, mortgage refinance, and auto sales kept the cyclical downturn from accelerating. The unintended consequence was a bubble in yield instruments of all types as risk averse investors sought refuge from equities. Now that the refinancing boom has waned, will housing and autos decline and choke off an incipient upturn in business spending? Clearly, the Fed is not waiting for an answer. Their response to the sharp downturn in mortgage refinance has been aggressive expansion of the monetary base.
The Fed has become a prisoner of its policies. It cannot tolerate an economic downturn. Flood upon flood of liquidity has not put to rest long-term issues of solvency. The price for relief from short-term stress has invariably been increased debt issuance. The consequences of a possible protracted bear market in equities and bonds have become intolerable. In attempting to avoid the experience of Japan, it has launched a direct attack on saving and financial prudence. "Under Greenspan, the Fed has evolved into a kind of national financial fire department. It is not merely the lender of last resort but also the damage-control coordinator of first resort…Repeated and predictable acts of intervention can't help but change behavior….. The more dependably the Fed fends off disaster, the bolder and more leveraged investors become." (Grant's-Nov. 7, '03)
The willingness and/or ability of international trading partners to hold US paper defines the limit of the Fed's discretion. While the Fed has demonstrated its capacity to cause financial markets to defy gravity, and in so doing, induce desired real world economic results, we remain skeptical that it can do so indefinitely. The limits of our trading partners to sop up additional spillage of dollar denominated debt cannot be known, but that there is a finite limit to that capacity cannot be disputed. As stated by Morgan Stanley economist Steven Roach, "the model of a sustained US-centric global growth dynamic rests critically on a very stylized depiction of the world economy. It implicitly presumes that ever-mounting current account deficits in the world's growth engine do not trigger a depreciation in the value of the US dollar." He goes on to say that "a still sluggish world is listing increasingly toward trade frictions and the pitfalls of competitive currency devaluation….That underscores the mounting tensions that another bout of US-centric global growth most assuredly produce. For that reason, alone, I believe that the global economy is now nearing the end of an extraordinary seven and a half year period of unbalanced growth."(Sept. 15, '03).
A slowdown in the rate of purchase or outright sales of foreign held treasury and agency debt could easily lead the trade weighted dollar index to a level of, say, 65 or 75 versus the current 92. An index at that lower level would depict a far different world than the one we know. It would be a world of higher interest rates, lower bond and equity prices, inflation, faltering economic activity and permanently higher gold prices. In the words of Roach, "it boils down to flows versus analytics." In other words, it may be difficult to make an abstract analytical investment case for the yen or the euro. However, it is not difficult to imagine, in light of the existing imbalances, that safety-seeking investment capital might flow to liquid alternatives based on convenience and expedience.
In his day, Otto von Bismarck warned the squeamish to avert their eyes from the manufacturing of sausages by sausage makers and laws by politicians. Today, that advice could be updated by including the deconstruction of money by central bankers. Saucissons, in the mining lingo of the early 20th century, referred to the flexible casings used for explosives in mine operations. Numeraire, of course, refers to gold's historical role as the reference point for all paper currencies once used by the entire commercial world including central bankers. The numeraire function, according to economist David Ricardo, was essential if "one wish(ed) to make intertemporal or interlocal comparisons (in the) problem of measuring value." Over the last three decades, it has been the practice of central bankers to demonetize gold, thereby making intertemporal and interlocal assessments of value much more difficult, if not impossible. In theory, a dollar standard might have worked, but in practice it has not. Without a global monetary compass, unrestricted issuance of government and corporate debt, trade imbalances, misallocations of capital, periodic banking crises, and currency turmoil should come as no surprise. It seems more than likely than ever that the world's central bankers will eventually convene to reprice gold to a level sufficient to persuade a world of paper skeptics that the metal must be reinstated as the numeraire. That level will exceed whatever is at that time by a substantial amount. Our guess is the market at the time of an official sector bid will be well into 4-digit territory.
November 19, 2003
© Tocqueville Asset Management L.P.
The views expressed by the portfolio manager in this article are current as of the date of this article, and are subject to change at any time based on market and other considerations.
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