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Golden bulls

Despite Fed tapering, there are reasons to be bullish on the gold price over the long run, although speculative mining plays remain out of fashion
May 2, 2014

If there's a lesson to take from the performance of the gold market over the past 10 years it is that taking an equity stake in a gold miner shouldn't be conflated with holding physical gold. Contrary to intuition, the share price performance of many gold miners bears a weak correlation to the price of the metal - as investors found to their cost during the metal's lengthy bull run.

Gold producer indexes outperformed physical gold in only a handful of instances since the gold price (which had been moribund for the best part of a decade) started its ascent in 2000. And the years of outperformance came towards the beginning of the millennium, well before the US Federal Reserve switched on the printing presses. Over the past eight years, however, the gold miners have remained laggards despite increased anxieties linked to currency debasement.

The FTSE/JSE Africa Gold Mining index hit a 10-year low last December, and although it has subsequently staged something of a recovery, it is still down by a third on its average value over the period. Last year, the price of physical gold fell by 27 per cent, while the index value contracted by 58 per cent. This bears out an unhappy reality for investors: since 2005, the share price performance of many gold mining companies has come up short even as gold prices were rising, but their falls have been magnified whenever prices have retraced.

 

 

Downside risks

Relatively poor capital returns on the upside, with disproportionate risk on the downside is hardly an ideal combination. But this is at least partly a consequence of the high levels of gearing taken on by mining companies that bought into the notion that gold prices would keep rising. Admittedly, given the unprecedented scale of the post-Lehman monetary intervention, it is understandable why this view might have taken root.

However, six years on and there are probably more deflationary risks to the global economy. And it's expected that during 2015 the US Federal Reserve is likely to start paring back its bond-buying programme in earnest. These aren't the only factors that could weigh on the gold price. The Indian government repeatedly increased taxes on gold imports over the past year in a bid to rein in the country's current account deficit. It has been partially successful in this regard, but it's unlikely that the curbs now in place will be eased until the rupee stabilises and domestic economic growth becomes more robust.

 

China and other price levers

February's sell-off in emerging markets equity positions provided some support for gold prices through the month, but a subsequent weakening in the Chinese yuan rendered dollar denominated gold a more expensive option for Chinese investors. Last year, China replaced India as the world's biggest market for gold, so any near-term fall away in demand will feed through into prices. Longer term, however, prospects for Chinese gold consumption remain as bullish as ever. The World Gold Council (WGC) expects that demand from the People's Republic will rise by a quarter over the next four years; a forecast that needs to be tempered by the WGC's role as principal tub-thumper for the metal. Nevertheless, it's undeniable that Chinese retail demand - in a relatively short space of time - has become one of the principal levers of the price. So, perhaps the WGC's forecasts should be seen in light of reports that gold is being widely used for collateral in China's shadow banking system.

One of the other main price levers is linked to demand from physically-backed derivatives, or exchange traded funds (ETFs). Theoretically, they provide investors with a way of gaining exposure to gold price movements without the need to take delivery of physical bullion. These types of instruments proved a hit with investors during gold's lengthy bull run, but it has been argued that they're one of the reasons why listed gold miners did not benefit to the extent they should have during the top of the market. And back in April 2013, when the gold price recorded its worst two-day loss in over 30 years, it was blamed on capital outflows from the SPDR Gold Trust - the world's largest gold-backed exchange-traded fund. The fact that demand didn't flag sooner is somewhat perplexing, given that - relative to earnings - they were among the most expensive contracts on the market.

 

Write-downs and lead times

So, where are we now? Gold ETC outflows have continued for the fourth straight week, an indication that negative sentiment has taken hold in western markets despite ongoing anxieties over the political impasse in Ukraine. A succession of asset write-downs from some of the world's biggest gold producers certainly haven't helped. Subsequent to last year's price falls, Newmont Mining Corp (US: NEM) booked a $1.77bn (£1.05bn) impairment on the value of stockpiles and two Australian mines. Newcrest Mining (AUS: NCM) followed suit with a $6.2bn aggregate write-down on the Lihir mine and Hidden Valley in Papua New Guinea, Telfer in Western Australia, Bonikro in Ivory Coast, and its stake in Evolution Mining. In August, Canada's Barrick Gold (CAN: ABX) revealed an $8.7bn post-tax charge, relating principally to its delayed Pascua-Lama project in the Andes. Barrick's problems mightn't end there; the company has just been named in a proposed class action lawsuit by shareholders who are seeking $6bn in damages because the company allegedly failed to make timely disclosure of problems at Pascua-Lama.

However, we shouldn't read too much into widespread write-downs. Early-stage development projects - no matter how promising - are now of limited appeal to an investor base weary of prolonged lead times towards production and capital that moves inexorably in one direction. For now, a miner's reserve base is of secondary importance to its ability to generate cash flow. As for prices, Jeffrey Currie, head of commodities research at Goldman Sachs, reckons the gold price could fall to $1,050 an ounce by the year-end as the US economic recovery gathers momentum. But even if that was to transpire, we think that the fall would be short-lived.

 

IC VIEW:

Last year's price falls have already taken a toll on production. Miners have shelved development projects and cut back on greenfield exploration. Add in the general decline in ore grades, together with a likely return in consumer demand, and it points to a probable supply shortage. Even with last year's price collapse, gold - currently at $1,294 (£768.33) an ounce - is still only 7 per cent down on its five-year average. And it is worth noting that most 'all-in' industry cash costs (cash costs plus exploration expense, head office costs, and sustaining capital) are being quoted at around $1,250 an ounce. Which begs the question: can gold mining (and, by definition, current production levels) be maintained at a price below this level for a sustained period? We think it improbable based on forecast demand trends.

 

FAVOURITE:

Mexico's Fresnillo (FRES) enjoys benefits of scale linked to volume growth and low-cost production. Although Fresnillo is the biggest primary silver miner in the world, the group's gold output has become an increasingly important generator of revenues and profits. Last year, it produced 425,900 ounces of gold, but that figure is forecast to rise to 500,000 ounces by 2018. As a result, the miner does have some fairly heavy capital commitments over the next couple of years. But it is net cash-positive, and anticipates that projects will deliver internal rate-of-returns of 13 to 26 per cent at $1,100/oz gold and $18/oz silver prices. If new gold mining projects across the globe continue to be either scaled-back or cancelled, then Fresnillo is among the most likely of precious metals miners to benefit.

 

OUTSIDER:

Mark Bristow's Randgold Resources (RRS) is reasonably well-placed to counteract last year's price falls by driving up production through the impact of its Kibali mine in the Democratic Republic of Congo. But the miner now trades broadly in line with its historic enterprise value to operating profit multiple (EV/EBIT). Highland Gold (HGM), a Russia-focused miner (co-owned by Roman Abramovich), is another producer that has partially mitigated the price falls through rising volumes and falling unit costs. And unlike many sector peers, Highland seems intent on establishing a track record of returning capital to shareholders. It currently offers a more than worthwhile yield of 7.3 per cent, but there are near-term pitfalls linked to possible trade sanctions on Russia.