Pricing the Golden BullFirst let me make the usual disclaimers. Everyone must do his or her own due diligence. Nothing in this note should be considered investment advice. I am long gold and silver in the mining shares, options on futures, as well as physical. Although the information contained in this document is intended to be an accurate representation by this author, no guarantee can be made due to the opaque nature of the market being discussed. Official numbers may indeed differ from those presented. As such, let me emphasize that everyone must determine the accuracy of the claims for themselves.
Gold - The Metal
Let's start with some assumptions. Note that these are assumptions rather than facts because of the purposeful lack of transparency in this market (although, there is an increasing amount of circumstantial evidence to support them).
CB's around the world are short 15K tonnes even though they carry this short position on their books as an asset. Thus, of the roughly 30K tonnes reported, only 15K is truly in their vaults.
The demand is 3500 tonnes per year and growing. The mined supply is roughly 2500 tonnes and shrinking. Scrap is roughly 500 tonnes per year and flat? This leaves 500 tonnes per year that the CB's have been supplying.
A further word about the assumptions: Round numbers were chosen for simplicity. Each individual number may be disputed but we have tried to present an overall picture which is fairly close to the mark.
Now, the movement in gold from 250 to 350 signals there has been a change in CB policy (as they are the only real variable in the physical supply market). Thus it is reasonable to conclude that in the least the CB's have significantly curtailed their supply to the market.
Let us look out five years in the future for the sake of argument. It seems likely that much of the 15K tonne position will be forgiven. Let us assume that only 2.5K of the 15K tonne short position needs to be returned and that in net, the CB's are no longer suppliers. Further let us assume that the supply reduction amounts to an average over the next five years of 2250 tonnes and the demand (not including the new CB net demand) is 3750 tonnes.
Note that the CB demand is 500 tonnes per year added to the 3750 tonne per year demand netting a demand of 4250 tonnes. Since we have assumed that the annual supply will have decreased to 2250 tonnes, there is an annual short fall over the next five years of 2000 tonnes per year.
The only variable not discussed over this future five year period is scrap (which includes "dishoarding" of prior investment purchases in this discussion).
Granted we have presented a static (in the sense of averages) argument as a representation of a dynamic process. This latter was done in order to get some sense of where the fundamentals in the gold market are leading us.
OK. Is there going to be a massive (investor "dishoarded") supply of physical to meet the 2000 tonne per year deficit at a gold price of $350? My opinion ... not likely. Maybe at an equilibrium price upwards of $750 to $1000 per ounce.
Gold - The Mining Shares
Much discussion of the value of the mining shares has been taking place over the last few months in the internet discussion forums. Several years ago I presented a method that valued the HUI and XAU indices as a function of the gold spot price. These essays can be found here. They are titled "Looking for Leverage" and "Finding Leverage in the HUI" respectively.
In these essays the linear trend lines for the data series were approximated by simple analytical rules. For the XAU, the result was that XAU = POG*(1/4). In like fashion, the HUI linear trend line (LTL) was approximated by HUI = POG - 200. During last year's stellar performance of the shares in the December to May time frame of 2002, these historical valuation norms represented good approximations. Of late, the shares are underperforming the norms. Why?
Well no one knows for sure and there has been much speculation but one might consider the following. In the HUI index, if NEM's price was adjusted higher, the value of the HUI would be correspondingly higher. This latter adjustment would be perfectly reasonable as it is fairly evident that Normandy's hedgebook has been a drag on NEM's share price. Currently the HUI is about 145 with the POG at 355. Thus, the approximation to the LTL would imply an HUI of about 155. I have not crunched the numbers but it seems that this analysis implies in an admittedly rough way, that the unhedged shares are not priced too far from historical norms. Further, what the analysis suggests is that large amounts of new money has not yet found the mining sector (as this would cause a significant premium to historical NAV evaluations - eventually similar to the outrageous PE expansions seen in the internet bubble). Said another way, the best may be yet to come.
The XAU contains not only NEM, but also the significantly more toxic hedges of ABX, PDG, and AU (listed in descending order of toxicity - in this author's opinion). The approximation to the LTL for the XAU implies a price for the XAU of 88 for a related price of $352 for the gold spot. The XAU is clearly lagging historical norms with its current valuation. History may show that this significant underperformance by the XAU was a warning to investors who hold positions in the hedged mining shares.
20 January 2003
Last year I was toying with the idea of a newsletter on gold, silver and their related mining shares. I received several hundred interested responses and I wish to thank each and every one of you. While this idea has been "tabled" for the time being, I may reconsider a weekly letter with email alerts in the future.
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