I spent the latter half of last week at
the New Orleans Investment Conference, talking with investors, mining
companies and analysts about the state of the gold industry. The annual
conference falls at an interesting time of the year, as the price of
gold typically corrects in October. In fact, going back 30 years, the
historical seasonality of gold has been to rise during September, with a
subsequent correction in October.
Miners, Show Me the Money!
At the conference, I’ve been discussing the multiple forces squeezing the profits and earnings out of gold miners, causing equity investors to become the Rod Tidwells of the gold world, getting miners energized to “Show me the money!” In my opinion, this phenomenon highlights the importance of selectively choosing among those gold companies that exhibit the best relative growth and momentum characteristics to help obtain outstanding investment results.
My workshop presentation
in “The Big Easy” integrated preeminent thinking from multiple gold
experts, including research firm CIBC, Gold Fields and the World Gold
Council, about how gold companies’ performance has been neither “big”
nor “easy.” There’s been a decline in production per share, an 80
percent increase in the average cost per ton of gold over the past six
years, and a 21 percent decline in global average grades of gold since
2005. Cash taxes per ounce of production have increased dramatically,
and, according to CIBC World Markets, the replacement cost for an ounce
of gold is now $1,500, with $1,700 as a sustainable number. Cash
operating costs eat away the most, at $700 an ounce, while sustaining
capital, construction capital, discovery costs, overhead and taxes eat
up $800. At the October 24 gold price of $1,700 an ounce, only $200 is
left over as profit, says CIBC.
Gold
companies have had their share of challenges in the past. Prior to the
huge run-up in gold prices in the late 1970s, forward price-to-cash flow
ratios crashed from a high of about 22 times to just under 9 times.
Eventually, as gold climbed to its high, multiples spiked back up to 21
times.
Miners also didn’t increase the supply of the precious metal
in the 1970s. Back then, there were only a few major players in the
gold game. South Africa was a significant gold-producing country, as
well as Russia and North America.
However,
following years of a gold bull market in the 1970s, production climbed.
In fact, Pierre Lassonde, chairman of Franco-Nevada and a living legend
in the mining and resource world, says it took seven years for the gold
industry to respond after the rise in the price of gold. Ironically, as
the price kept falling over the next 20 years, production doubled, says
Lassonde.
Beginning
in 2000, gold companies have experienced a similar phenomenon, with
production remaining flat, even declining in some years. In 2008, mine
supply of gold fell to levels not seen since the early 1990s.
Now, after a seven-year lag, the industry has responded as we’re beginning to see some growth in supply.
From
2006 through 2011, production throughout the entire gold industry has
increased about 3 percent, says CEO Nick Holland of Gold Fields. During
his keynote presentation at the Melbourne Mining Club in July, he
indicated that most of the growth was not coming from the major
producers. In more mature markets, such as South Africa, Australia, Peru
and the U.S., annual production decreased by about 5 million ounces
since 2006. Emerging markets on the other hand—China, Colombia, Mexico
and Russia—added about 7.6 million ounces over the last six years,
Holland says.
Of gold finds that contain at
least 2 million ounces of gold, research from the Metals Economics Group
(MEG) finds that there have been 99 significant discoveries between
1997 and 2011. Only 14 of the 26 major gold producers made these major
gold discoveries.
“Today, the major producers and their majority-owned
subsidiaries hold 39 percent of the reserves and resources in the 99
significant discoveries made in the past 15 years.” This amounts to less
than half of the yellow metal needed to replace the gold companies’
production from 2002 to 2011, says MEG.
According
to Lassonde, this is the “elephant in the room,” as new finds have
become elusive. The chart below from CIBC shows that there was only one
major discovery that was more than 3 million ounces in 2011. Over the
past seven years, there have been only nine major discoveries of gold.
Lassonde
doesn’t think we have hit “peak gold,” but believes the gold industry
needs a “3D seismic” event similar to what occurred in the oil industry
before we see considerable finds.
For as
many challenges as gold companies face today, they have rarely
experienced such a well-diversified consumer base and diversified demand
for their product: It’s “the best we could ask for,” says Lassonde.
A newer trend that I’ve discussed is the reemergence of emerging markets central banks as
buyers of gold, as they have been “relearning that all paper currencies
are suspect,” says Lassonde. Today, he says “cash is trash,” with the
value of euro, dollar and yen in question.
He
believes this source of demand could be long-lasting and quite
significant if you look at emerging market countries’ gold holdings as a
percent of total reserves. In 2000, the European Central Bank decided
that the right proportion of gold to own should be 15 percent. Pierre
says if you apply that figure to the potential gold holdings of the
emerging market central banks, they would need to accumulate 17,000 tons
of gold. At a purchase of 1,000 tons a year (or about 40
percent of today’s production), these central banks would have to buy
gold for the next 17 years!
Another
growing source of demand has been from the Fear Trade’s scooping up of
gold exchange-traded funds (ETFs). Eight years after the products were
launched, 12 gold ETFs and eight other similar investments are valued at
around $120 billion and hold 2,500 tons of gold, says Nick Holland.
I believe the Fear Trade will continue buying not only gold but also gold stocks, as the group is driven by Helicopter Ben’s quantitative easing program. In the latest Weldon’s Money Monitor,
Greg Weldon discusses the consequences of the Federal Reserve’s debt
monetization and liquidity provisions, showing the “somewhat frightening
pace” of expansion in money supply.
Weldon
says that over the last four years since August 2008, the U.S. Narrow
Money Supply, or M1, which is physical money such as coins, currency and
deposits, has increased 73 percent, or more than one trillion dollars. This is about as much as it expanded in the previous forty years!
Don’t let the short-term correction fool you into selling your gold and gold stocks.
The dramatic increase in money suggests that monetary debasement will
continue, and in addition to all the above drivers, I believe these are
the positive dynamics driving higher prices for gold and gold stocks.
U.S.
Global Investors, Inc. is an investment management firm specializing in
gold, natural resources, emerging markets and global infrastructure
opportunities around the world. The company, headquartered in San
Antonio, Texas, manages 13 no-load mutual funds in the U.S. Global Investors fund family, as well as funds for international clients.
Source: Don’t Fear a Normal Gold Correction
