Gold Market Update

August 6, 2002

The summer correction continues, while the volatility picked up in July. Gold saw its largest weekly decline in recent memory at the tail-end of a massive two week sell-off in the general equity market that took the Dow Jones Industrial Average down 1677 points, or 17.9%. Fund redemptions and margin calls forced money managers and investors to raise cash amid the market sell-off. As one of the only sectors with gains on the year, profit-taking and portfolio re-balancing caused gold and gold shares to take it on the chin. We pointed out in our last update that gold stocks were nearing peak valuation levels as compared to past gold bull markets. This situation has corrected substantially with the aggressive sell-off in gold equities. In fact, the last time the XAU Gold Index traded at current levels, bullion was around $290 per ounce. The price action late last week was particularly encouraging for those looking for a bottom in the current gold correction. Thursday morning, after trending downward in the Asian markets, bullion opened in New York down about $5.00 to $299 per ounce. The gold price began with a "2" for exactly one hour before aggressive buying moved bullion to a gain for the day. The positive momentum continued on Friday amid weak jobs data and gold finished the week at $307.00. The chart below lends perspective to the summer decline in bullion as compared to the bull markets of 1985 to 1987 and 1993 to 1996. As can be seen from the chart patterns, gold remains within its upward trend of the last 16 months and the correction is not unusual in terms of magnitude.

The relentless downtrend in the dollar finally broke in mid-July, as the trade weighted dollar index ended the month in the midst of its first rally of the year. The rally may be short-lived, as there was an unexpected increase in the May U.S. trade deficit (released July 19th), which followed on a record $35.9 billion deficit in April. This, combined with the continuing drop in foreign investment in the U.S. this year, indicates that there is a chance the current account deficit will increase to reach a new record of around 5% of GDP. In order to correct this imbalance, a weaker dollar is needed to slow imports and make U.S. products more affordable abroad. One side effect of a weaker dollar is an increase in pricing pressure (or inflation), which is positive for gold. The high annual rate of growth of the money supply could also eventually lead to inflationary pressures. During June M2 grew at an annual rate of 7.6%, while the Monetary Base grew at 10.5%. However, with unused plant capacity currently of around 24%, and talk of further cuts in the targeted federal funds rate, it seems the greater worry at the moment is deflation. As many corporations struggle to make a profit, the last thing the economy needs is a drop in prices that would make debt service even more onerous and further delay any rebound in capital spending. That is why consumer spending is now such a critical component of the economy. Underpinning this spending is the buoyant real estate market, but signs of weakness in what many have described as a bubble are beginning to appear. Existing home sales fell 11.7% in June, the biggest fall since April 1995. In a related development, according to the Wall Street Journal, demand for office buildings is actually rising at a time when rents are declining and the national vacancy rate for office space have climbed to the highest level since 1994. Just like the residential housing market, there is a disconnect between the economy and office building investment. This disconnect has been caused by the multi-year lows in interest rates and cheap credit. While the Fed intended for the rate cuts of 2001 to spur demand and business investment, instead they promoted a real estate bubble. A deflationary scenario becomes a palpable threat if there is a collapse in demand for real estate. During the last deflationary period in the U.S., the price of gold increased from $20.67 to $35.00, a 69.3% rise.

Many who follow the mining sectors were alarmed at news leaked from the South African government regarding a Charter that will be added to the Minerals Bill, which was passed earlier this year. The Minerals Bill is a work in progress that sets out the framework for the future of the South African Mining industry. The bill allows the government to take control of the mineral rights of the nation. Although this may sound extreme, it basically brings South Africa in line with the rest of the world, as mineral rights are generally held by the state. This is so in developed nations like Canada, the U.S., and Australia, as well as lesser-developed nations, such as Mexico, Mali, or Indonesia. Under the new South African bill, private owners of mineral rights will be granted the same rights by the government. When a company is finished mining, it will reclaim the land, move on, and the rights will remain with the government. One aspect that is still being negotiated in the Minerals Bill is the subject of Black Economic Empowerment (BEE). BEE promotes participation in companies and projects by black companies, groups, or partners. BEE has been an unofficial policy within the gold mining industry for a number of years. The most proactive company in this regard has been Harmony Mining. Harmony is 9.8% owned by a BEE group. One of their core assets is in the Free State, a 50/50 joint venture with a BEE company. The BEE entities have taken these positions at market rates. Their sources of funding range from loans provided by quasi government agencies, inter-company loans, or market financing of debt or equity. The Harmony example shows that BEE can be accomplished in ways that do not dilute the interests of existing stakeholders. What got the market riled a couple of weeks ago was the leak of an internal government "discussion document" that proposed that the applicant of a new mining license must have a BEE partner with at least a 30% equity interest in existing operations and at least 51% equity in new operations. This caused general weakness in the South African mining sector and a nasty sell-off for the platinum companies. The platinum industry is expanding and will develop many new projects in the coming decade, whereas the gold industry continues to mine deeper and farther on existing deposits, with little prospect for expansion. The emphasis in the gold industry has been expansion outside of South Africa. If one believes that this discussion document will become law, then the apocalyptic warnings in the press of expropriation are valid and the selling is justified. We believe it's a tempest in a teapot and that in the end the South Africans are certainly smart enough to enact legislation that will keep their domestic mining industry strong while promoting black empowerment. Several key points on this issue:

  • The government is apologetic and has stated several times that the discussion document does not represent its position on the matter. Meetings with government, industry, and the unions have taken place to come to a mutually agreeable position sooner rather than later.
  • The numbers stated in the document are laughably unrealistic. Estimates of the funding needed for such levels of participation are excessive and clearly out of the reach of the BEE community.
  • We believe that this process is akin to union negotiations in South Africa. Every couple of years as contracts expire, the unions take positions that ask for astronomic increases in wages. Months later when it comes to a vote, the actual increase is but a fraction of the original. Such negotiations are customary.

South Africa has a mining culture that is a century old. That culture is dynamic and changing to meet the modern challenges of global competition, aids, environmental stewardship, and black empowerment. The country has a first world infrastructure and an experienced work force. Mining is a vital element of the economy, it brings in foreign exchange. We believe it is one of the best places in the world to operate a mine and will remain so as long as there is ore in the ground.

The term “carat” comes from “carob seed,” which was standard for weighing small quantities in the Middle East.

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