Gold: Deal or No Deal
John Ing
Oil has become the symbol of worldwide demographic, economic, environmental and geopolitical stress. The economic order is being remapped. Indeed, the possibility that the oil boom was over sparked a huge rally in Wall Street stocks. But, in fact, that was due more to the dampening of expectations than the fundamentals themselves. Further, the surprising peace in Lebanon has reduced the fear premium in oil. After doubling between 2002 and 2005, oil seems to have stabilized.
Commodities have also pulled back, largely due to profit-taking and the elusive hope of a slowdown in the Chinese economy. Mainstream pundits overlook the fact that the global economy is growing for the fourth consecutive year. And although the U.S. economy may be slowing, Europe continues to gain momentum and Japan's economy has recovered. The lull in the geopolitical cross currents was due more to the November elections than a turn for the better. Indeed, the prospects are good that with the change in the US Congress, this could trigger political gridlock and enough uncertainty to hurt the U.S. dollar. To be sure, a slowing US economy will also erode the value of the dollar.
It is our view that the commodity boom is just taking a refreshing pause. Trees do not grow to the sky. The fundamentals remain in place. Low prices and the lack of capital 20 years ago are today reflected in shortages and sky-high prices. Chronic supply-side problems - from labour to tires - have led to tremendous structural cost pressures. And Asia's economic growth continues to outpace that of the Western economies, driving up prices but also holding back inflation through efficiencies. Consumers in China and Japan have replaced consumers in the U.S.. China alone has accounted for more than half of the global increase in demand for metals over the past three years. Zinc and lead have doubled this year because the sheer scale of the consumer demand means that the use of metals for cars and appliances will be high.
All Roads Lead to the Middle Kingdom
Not only is growth intact in resource-hungry China, but the extraordinary flow of petro-dollars into commodities and other currencies at the expense of the U.S. financial market and the greenback is continuing apace. Another element is that tanker rates continue at near-record levels due in part to the huge appetite for raw materials. And finally, analysts have forgotten that there are simply no new global commodities supplies - from grain to copper to oil - to satisfy demand. With demand growth of least five to eight years, supplies are unlikely to close the gap. Iron ore prices are expected to advance another 10 percent next year and nickel remains three times above the cost of production. Commodities have become a legitimate financial asset class. There is no question that a correction was needed, but the super-cycle remains. The bull market has only just begun.
The state of the commodity markets hinges on China. We live in a China-centric world, whose growth has powered the current boom despite 10 years of dire Western forecasts of a slowdown. Today, China accounts for more than half of the world's total annual capacity for galvanized steel of 80 million tonnes. China's growth is expected to exceed 10 percent for the fourth year in a row, with India growing at a robust 8.3 per cent. China has developed into the world's fourth biggest economy and the third largest trading nation.
A Political Chess Game Has Begun
China's oil consumption has almost quadrupled to 7.1 million barrels a day, making the country the No. 2 consumer behind the United States and ahead of Japan. Until 1992, it was actually self-sufficient in oil. For now, that country's white-hot growth has resulted in the need for more imports, placing it on a collision course with the United States. For America and its democratic allies, a geopolitical chess game looms. In the build-up to protect its energy interests, China has built a network of partnerships and alliances, establishing military and foreign policy relationships.
It is all about oil. In the 1970s, it was about the enrichment of a few Middle East sheikdoms. Hundreds of billions of dollars were spent on protecting this Middle East oil. Ironically, though, U.S. oil security and influence are today less than they were 30 years ago. And if this were not bad enough, the spike in oil prices has not only allowed the Middle East to benefit, but other less-developed countries as well. So rather than the biggest U.S. energy crisis fostering increases in nuclear power or alternate energy sources, it has created an axis of nations opposed to the American way of life. Those petro-dollars have triggered an evolution from nation-state conflicts to ideological conflicts, inflaming existing hatreds and affecting traditional power relationships.
The United States has been neutralized by its own insatiable appetite for energy. America is still the world's largest consumer of oil and, despite the threat of $100 oil, cannot break its oil addiction and its dependence on OPEC.
By contrast, the Chinese are not as selective about where the energy comes from, importing more oil from Angola than Saudi Arabia, for instance.
China has courted Iran, Venezuela, Sudan, Angola and others that oppose the United States. China will buy 150,000 barrels of Iranian oil at market rates for 25 years. The Iran agreement follows an agreement with Moscow that will provide China with billions of dollars in gas that at one time was destined for Europe. Still, China's appetite has enabled these newly empowered nations to thumb their noses at Americans, who no longer possess big leverage, big dollars and big markets. Meanwhile, the United States and Iran are in a Mexican standoff and the interlocking conflicts could cause an eventual retreat - disguised as a victory - from Iraq that would further lessen America's influence in that oil-rich region. As such, the breaking apart and remaking of the Middle East landscape has only begun.
The rise in the oil price has also resulted in a dramatic increase in state-owned enterprises as countries take tighter control over their resources. For example, in Russia, President Putin dismantled privatized Yukos and shuffled its assets to state-owned Rosneft. In Venezuela, Chavez has gutted and hollowed out the private sector by increasing his government's control through state-owned entities. And in Iran, state control over the oil industry has become crucial because the petro-dollar bonanza allows it to champion Islamic hard-line religious positions, further its nuclear ambitions and forge an axis of anti-West players.
China - Banker to the world?
China has built up a huge foreign currency stockpile of US$1 trillion, which is 40 percent of gross domestic product and an amount greater than the combined reserves of Germany, France, Italy and Canada. China is running an annual surplus of almost US$200 billion with the United States, which not only has an insatiable appetite for oil, but for cheap money, too. How China manages this growth and its growing pool of wealth has major implications for the financial markets because the U.S. dollar accounts for the bulk of its reserves and is heading for a fall. Moreover, China's gold reserves total only 600 tonnes - or less than two percent of total reserves, compared with 26 percent for the European Central Bank. This cannot last.
The U.S. economy is tiring, but Europe's and Asia's economies have uncoupled from the slowing American locomotive. Today, more than half of
global economic output is from emerging or
developing economies that also hold almost
half of the world's foreign exchange reserves.
Flushed with petro-dollars, Russia, the third
largest holder of reserves, continues to map
out an independent policy, aligning itself
with China and others. And as these
developing economies grow, they are already
buying half of the combined exports of
America and Japan.
In an ironic reverse foreign-aid program,
the Asian economies have been happy to
finance American deficits. This flow of capital
from developing nations to the richest economy
is coming at a time when capital is becoming
scarce. The meltdown of hedge fund
Amaranth LLP and the commodity markets
has caused increased volatility and liquidity.
Meantime, fears of a slowdown are raising questions as to how long those emerging economies will continue to finance America's spendthrift habits. Nonetheless, the giant U.S. trade deficit has generated a huge outflow of dollars to the East, rather than West. More important, if the greenback continues to fall, the value of China's and others' huge holdings will decline.
While many feel the United States and China are co-dependent because America provides the market for China's exports, only one-fifth of China's exports actually go to the United States. China's main trading partner is Japan. While the United States is important, China's relationship with South Korea, Taiwan and Japan are more important from a currency point of view. And equally, China's 16 percent household savings rate is in sharp contrast to the negative savings rate in the United States.
That said, we no longer live in a U.S.-centric world. This matters because America's creditors have begun to worry about the U.S. financial system. The United States, the world's largest debtor and borrower, is simply living beyond its means. The country's enormous budgetary and trade deficits require almost US$3 billion a day from foreigners to prevent the dollar from collapsing under its own weight. Debtors should always be nice to their creditors.
Casino of Derivatives
Washington's dollar policy has generated a huge outflow of liquidity to the global economy, thereby fuelling a frenzy of investment. America's spendthrift habits created a global rush of excess domestic liquidity, transforming its markets into a casino of derivatives and creating new players such as hedge funds and private pools of capital. Easy money is a sign of the times. After investing in movies, distressed companies and art, the pool of funds are now plowing into commodities. The commodity boom, similar to the tech stock boom, produced an explosion of newly created commodity hedge funds. The hedge fund business is now estimated at US$1.2 trillion, taking a bigger share of the world's investments and growing at a rate of about 30 percent a year.
Private equity firms are also buying up Wall Street at an unprecedented pace, piling more debt on to companies at the expense of their targets' financial health. Debt has exploded, with almost half a trillion dollars worth of deals so far this year. Private equity funds typically buy a company through a leveraged buyout, overhaul its operations,
and then use the cash flow from the improved
business to pay down debt. The private equity
fund then cashes out when it takes the
company public. Too often today, the private
funds are short-circuiting this process. They
use financial engineering to leverage the
balance sheet to pay back their initial
investment through dividend recapitalizations
schemes, management fees or advisory fees.
Sure, there have been big benefits and
exceptional performances, but few ask
about the added debt bombs.
This is when it becomes interesting. When
those cash-rich private equity funds run out
of targets to sustain their above-average
returns, they will resort to paying healthy
but riskier premiums. In a herd-like manner,
they are already co-investing in
monster "club deals" such as HCA and Harrahs. Bigger is not always better. Like any bubble, this one is poised to burst. Caveat emptor.
But there are other changes. The housing collapse means that Americans can no longer use their homes as giant ATMs, financing their spending by withdrawing their home equity. Two years ago, specialty mortgages were the rage. About $2.5 trillion of mortgages are to come due over the next 18 months and homeowners are due for a balance sheet shock. But the bigger shock will come from China and others who invested in the debt of those financial lenders such as Fannie Mae and Freddie Mac, which are saddled with a huge tranche of adjustable-rate mortgages.
The lenders thought they were immune because they were able to offload their risk through the use of credit derivatives by transferring that risk to the system as a whole. The private equity and hedge funds feasted on the indebtedness of the financial markets through a process of creative engineering, designing exotic new instruments such as zero coupon mortgages, credit swaps or CLOs. Investment bankers packaged the mortgages or obligations into a pool, creating different securities and sold them to the funds and even some central banks. Private equity funds alone invested more than US$300 billion in the first half of this year. Alternative investment vehicles and new exotic instruments have attracted trillions, due in part to the lack of performance of the traditional players, such as mutual funds and pension funds. This time, the size and scope of the buyouts raises concerns about the potential wave of defaults.
The Telegraph newspaper reported that one of Treasury secretary Paulson's first task was to reactivate the Policy Protection Team ("PPT"), a working group of the heads of the Treasury Department, the Federal Reserve and the Securities Exchange Commission. This group will meet on a regular basis to prevent an October 1987-like meltdown. Treasury secretary Paulson asked this group "to examine the systemic risk posed by hedge funds and derivatives," and "the government's ability to respond to a financial crisis". Does Paulson know something that we don't? Gold will be a good thing to have.
A Game of Musical Chairs
But who are the bag-holders? Well, existing bond holders are undoubtedly hurt. Asian central banks are worried too. The new financial system has become a game of musical chairs. At some point, the music will stop and someone will be left without a chair. Troubled Amaranth? Not this time. However, next time it will be one of those big investment banks. In the pursuit of performance, private equity and hedge funds appear to have taken on higher return risky assets. But, as we have seen, they have simply transferred that risk. The ultimate bag-holder, the Fed is the lender of last resort. And there is no $300 trillion for a backstop when the music stops. Then, the markets will cry "no deal".
Reflecting a diversification out of the U.S dollar, more than 40 central banks now use euros as part of their currency peg. According to the Bank of International Settlements (BIS) in Basel, the growth in derivatives has vaulted the US$4.7 trillion euro-zone debt securities market past America's US$4.2trillion market There has also been an explosive growth in global derivatives to more than $300 trillion, with this non-traditional source of liquidity growing at about 20 percent a year. As an example, South Korean stock-index options trading rose 71 percent to US$12 trillion, surpassing U.S. volumes for the first time. Equity derivatives have become a big revenue producer. France's Sogen and BNP Paribas are reported to be among the biggest players. It works both ways, since Credit Suisse Switzerland's second-biggest bank, lost US$120 million on South Korean derivatives in the third quarter.
In creating new derivatives, Wall Street is sowing the seeds of the next financial crisis. Booms always turn into busts. This excess of global liquidity - outside the purview of regulators - is the bread and butter of private equity and hedge funds, which are also largely unsupervised. However, by creating these products out of thin air and leveraging at a greater pace, the funds will leave America's indebtedness without a chair. We believe that the systemic risks embedded in the financial markets have increased and the excesses of this imminent global liquidity cycle will have a cost. Gold is a good thing to have when the markets cry, "deal!".
Gold - The Real Deal
European central banks did not sell enough gold under the 500-tonnes, five-year pact. The shortfall is the second year in a row and is an indication that the banks have pretty well sold all they wanted to. For example, Germany, the biggest owner of gold, has not sold any of its hoard because of a dispute between the Bundesbank and the government over the disposition of the proceeds. The shortfall of central bank gold sales has been neutralized in part by the drop in demand for jewelry, which is sensitive to higher gold prices. De-hedging has also contributed to demand (gold miners bought back 2 million ounces in the third quarter) and overall investment demand is expected to outpace supply as producers again fail to replace the decline in output from existing mines.
Meanwhile, the U.S. core inflation rate hit 3.5 percent last month, the fastest pace since 1995, despite 17 consecutive rate increases. Of more concern is that the U.S. Commerce Department reported that prices of imported goods rose 6.6 percent in August, due in part to higher oil prices and the fact that the U.S. dollar has fallen almost 6 percent this year. And how do we explain that the New York Taxi Commission is to increase cab fares by 12 percent? And while it has become more expensive to drive your car or even taking a taxi, tire-makers are increasing the price of tires by 8 percent. What we have is "stealth inflation".
However, gold is not a bet on inflation or China, but a bet against the U.S. dollar. The dollar is poised for a drop. The United States is bankrupt - financially and economically - and powerless to deal with the consequences of its own indebtedness. America's addiction to cheap energy and cheap money is also responsible for the creation of a newly empowered ideology that has mutated into an anti-democratic, anti-West and
anti-U.S. theme. Gold is the beneficiary.
Since the end of 2005, gold had a close
correlation to oil. Bad days for oil tended
to be bad days for gold. Yet the drop
in oil prices has not helped the dollar,
and gold is running again. Oil is down
and gold is up. The disconnect is over.
Currency traders are beginning to
sense that the beleaguered greenback
is on the brink of collapse. The dollar
is the key. We believe that America's
spendthrift habits have left the financial
markets without a rudder. It is our view
that after a five-month correction, gold's
major move has just begun. Gold will rise as global investors realize the scale and inevitability of the dollar's collapse. Gold is not only a hedge against geopolitical tension and inflation, but the ultimate store of value against increasing U.S. indebtedness. As such, we continue to believe that gold, having broken out at $610 an ounce, will surpass $850. That is the old 1980 high and would only complete gold's first leg. Gold, then, is the next big deal.
The Gold Producers
With a growing list of companies disappearing, private equity groups are searching for the next big opportunity. We believe that the buyout groups, hungry to get hold of companies spinning off excess cash flow, will plow into mining companies that are sitting on bags of cash and trading at less than 10 times earnings. While few expected the extended boom in commodity prices, we believe that the private equity groups are ready to auction off Canada's few remaining mines. And after the Aurs, Inmets and Breakwaters disappear in a M&A frenzy, we think that the gold producers will be the next fat targets. Their market capitalizations are only a fraction of the global markets.
Gold has outperformed cash, bonds, stocks and, of course, the U.S. dollar. Since 2001, gold has gained every year, more than doubling in the past five years. However, gold funds, by and large, have lagged despite the improved bullion price. Mainstream opinion is that investors today have too many alternatives such as ETFs, hedge funds and derivatives. We believe the lack of performance is due more to the fact that the gold miners have become serial diluters, issuing incessant rounds of equity. Further, we believe that gold miners are not making much money due to the rising costs and, for some, the heavy cost of hedging. And, gold companies have not been growing on a per share basis.
The good news is that we expect a better performance from now on. The ridiculous premiums being offered for companies such as Glamis and NovaGold reflect a growing shortage of reserves. Mining companies are having difficulty showing growth and are buying ounces on Bay Street, forgetting that those ounces must eventually come out of the ground. And that is the problem. Many of the projects possess multibillion-dollar price-tags and require heavy capital. Further, the inevitable six- to eight-year lead time to bring a new mine into development is a major obstacle, making CEOs cautious in spending a billion dollars in such a volatile market. Consequently, we believe that the industry will continue to gorge on itself in cannibalistic fashion. Indeed, were investors to add the acquisition cost together with capital cost and operating cost, today's transactions would require an $850 an ounce gold price.
We believe that gold is the best hedge against geopolitical stress, inflation, U.S. dollar weakness, economic and financial woes. Gold stocks offer superior leverage and ownership of ore bodies that are particularly attractive at current levels. ETFs do not.
The Next Ten Baggers
The smaller cap miners continue to possess the most upside in comparison the majors. We continue to favour Eldorado, Crystallex and Aurizon for example. While the miners benefited from the higher gold price, we believe that the next 10-baggers are in the smaller junior gold companies. Five years ago, we recommended a package of 10 junior producers. Since then, that group is up 217 percent, in contrast to the gold price, which is up 119 percent, and the Dow Jones, which is up only 14 percent. Today, we have identified another group of precious metal companies that will not only benefit from higher precious metal prices but also some are likely takeover candidates.
Agnico-Eagle Mines Ltd.
Agnico-Eagle reported a sensational quarter reflecting the sale of its stake in Contact Diamonds and particularly strong zinc and silver prices. The cash cost for the quarter was -$709 per ounce versus $33 per ounce last year. The majority of revenues at LaRonde in Quebec comes from zinc which allows Agnico-Eagle to produce its gold for zero cost. No longer is Agnico-Eagle a one mine company. Agnico-Eagle is piling up the cash and is well financed to develop its three domestic gold projects, Lapa, Goldex and LaRonde II. At Pinos Altos in the Sierra Madres region of Mexico, Agnico-Eagle could be producing 125,000 ounces of gold and almost 2 million ounces of silver beginning in 2009. A feasibility study should be completed in the first half of next year and there is still attractive exploration upside potential with four drills currently operating. At Agnico-Eagle's Kittila mine in northern Finland, development is on schedule and this mine could produce almost 500,000 ounces to Agnico-Eagle's book in 2008. Agnico-Eagle has no debt, a rising production profile and young management. Buy.
John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040
jing@maisonplacements.com
8 November 2006
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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