It’s not altogether hard to see why. As is the case for many markets, developments are best understood in hindsight. Commentators, particularly financial journalists, know that it pays to naively react to a price chart as a continuous breaking news event, rather than a complex amalgamation of shifting forces. Within those constant snap-reactions, broader themes can get missed. And when it comes to both oil and gold, a far bigger story may have just flown under the radar.
Last month, Investors Chronicle sister title Nikkei Asian Review reported that China is on the cusp of launching a crude oil futures contract priced in yuan and convertible into gold. According to the report, the futures contract will be open to “foreign companies such as investment funds, trading houses and petroleum companies”, who can sell oil in yuan, and convert the underlying contract into gold on either the Hong Kong or Shanghai exchanges.
The implications are enormous. The first is geopolitical: theoretically, such a contract would allow oil-exporting nations such as Russia, Iran and Venezuela to bypass US sanctions, by avoiding any exposure to a dollar trade. Circumventing the greenback could therefore reduce the impact of one of the key economic weapons in the United States’ foreign policy reach.
An option to convert the contract into gold may also prove enticing for sellers reluctant to receive payment in renminbi, which is not as widely traded or liquid as the greenback, and whose rate is set by Beijing. And although volatility in the gold price may dissuade some, others may be prepared to look past those short-term swings as a hedge against a weakening dollar – which is on course for one of its worst years on a trade-weighted basis since 1973, according to Bloomberg. Plus, although gold is not cash, it is still liquid.
On the other side of the trade is China, which has long sought to sidestep or reduce the dominance of the US dollar in commodities markets. Put simply, the world’s second-largest economy does not want to continuously pay for its imports with its largest rival’s currency. That’s increasingly true in the oil market, where the People’s Republic has become the largest net importer in the world.
Paradoxically, America’s growing self-reliance on domestically-sourced crude production means China’s international buying power has stepped up. That has led to a strategic opening: according to the Asian Review, China’s suppliers have been informed that if they accept payment in yuan, they can expect a greater share of the 7.6m barrels of oil the country must import each day.
One beneficiary of this push has been Russia, which in the process of accepting the ‘petroyuan’ has become the largest exporter to China. Interestingly, the two countries’ central banks have consistently been the largest buyers of gold in recent years, as part of long-running efforts to diversify their reserves, and leverage their gold holdings to stabilise their own currencies.
There is reason to believe that the contract might be successful. Apart from Russia’s acceptance of yuan in oil trading, the Asian Review reports that trade in yuan-denominated gold futures contracts on both the Shanghai and Hong Kong gold exchanges have been “moderately successful” since their respective launches in April 2016 and July this year.
The implications for gold are fairly bullish: the contract’s adoption would likely increase demand for the yellow metal, and could open up the possibility that the sale of other commodities could soon be priced in gold. Conversely, the rise of the petroyuan could do serious damage to the long-term strength of the dollar. For decades, the US has benefited from the current pricing system, as the widespread conversion of petrodollars into US treasuries has helped fund the country’s enormous deficit expenditures. A long-term drop in demand for dollars could therefore present a serious challenge to the hegemony of the world’s reserve currency.
Lower demand for dollars could also have the long-term effect of raising the price of both gold and oil – both of whose spot prices are quoted in US dollars.
Desert storm
These tensions might have already found a flashpoint. For the last decade, Beijing has steadily reduced the share of business it gives to Saudi Arabia, instead awarding larger contracts to Russia and Angola (which in 2015 adopted the yuan as its secondary currency). Getting squeezed out of its largest potential market will not have pleased Riyadh, as it raises the risk of a build-up in excess oil inventories that might have to be sold on the cheap, thereby depressing prices.
This means there is pressure on Saudi Arabia to accept yuan. At the same time, Washington is unlikely to welcome or even accept the large-scale circumvention of petrodollars. Saudi Aramco’s proposed initial public offering, in which China has been touted as a potential cornerstone investor, could therefore be seen as a test of the likely direction of travel. Chinese state backing for the flotation, which Saudi Arabia hopes will raise as much $100bn (£76.5bn), is likely to carry a requirement that sales to China are made in yuan rather than not dollars. If those payments can be converted to gold, the Kingdom may have fewer reservations about a pivot eastwards.
Gold equities targeted
News of China’s plans will undoubtedly have featured in the private discussions of attendees at the recent Denver Gold Forum. But the limelight was stolen by activist investor Paulson & Co, which gave a lacerating presentation on the performance of gold mining equities since the start of the decade.
Gold miners around the world have routinely played their get out of jail card: the gold price, and the perception that miners are at best a leveraged play on the yellow metal’s gyrations. As Paulson & Co’s intervention showed, this sorely misrepresents the reality. As of 20 September, gold had returned 20 per cent in dollar terms since the start of 2010, compared with a negative return of 45 per cent for the GSX, a popular ETF that holds positions in the world’s largest gold stocks.
Those miners can hardly blame their overheads. The currencies in which large gold miners’ costs are largely incurred have collectively underperformed the dollar by 16 per cent. Energy costs have fallen sharply over the same period.
This brought the firm to an alarming discovery: this decade, the gold mining industry’s return on capital has been lower than the cost of capital. Investors would have been better off holding onto their cash, let alone buying real gold. An analysis of the 13 largest listed gold producers contained further painful reminders for their shareholders: cumulative impairments have reached $85bn so far this decade, with a mere $12.8bn returned in dividends. Around 80 per cent of the transaction value of the eight largest mergers or acquisitions have been written off, suggesting the industry cannot be trusted to do deals. Despite this, CEO pay has been staggering. All but four of the group’s constituents have shelled out at least $30m for their top executive since 2010.
Interestingly, the only two companies in the group to achieve both a positive return on capital and total shareholder return were the only two London-listed stocks: Polymetal International (POLY) and Randgold Resources (RRS). Furthermore, the latter’s strategy – which assumes gold will stay at $1,000 an ounce and targets a 20 per cent internal rate of return – was the only one which came in for praise.
However, the presentation went beyond simply suggesting others adopt Randgold’s approach, and instead trained the focus on shareholders themselves. Throughout the decade, investors have behaved “like sheep being led to slaughter”, concluded Paulson & Co, which has taken it upon itself to form a coalition of “significant” gold mining shareholders, who will press for board representation and make recommendations on appointments, pay packages and corporate transactions. One of the primary goals of the Shareholder’s Gold Council will be to aggressively petition boards to align executive pay with shareholder returns. In light of the evidence, it’s hard to contest the solution.
