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Archive for March, 2010

25
Mar

JUNIOR MARKET’S TRAVAILS

   Posted by: Mr. Gold    in Uncategorized

I recently had an opportunity to go through an early stage exploration project with the CEO of a promising Canadian junior. The company controls a nice land package in a friendly jurisdiction and has been adding resources at a stable, though leisurely pace. I was a little surprised when the CEO confided that the company, in response to market expectations, had decided to raise the resource base rather than increase the level of confidence regarding the density, shape and other physical characteristics of the deposit. In other words, the company banks on the market’s infatuation with the growing number of “inferred” resources, and postpones project development stage which would hopefully lead to an estimate of indicated resources. Technically, this means that the drill rigs will step out of the currently known mineralization, rather than “fill-in” the most promising zones with narrower and narrower spacing. But it also makes the economics of the project somewhat difficult to “infer”.

One of the reasons for this ‘either/or’ dilemma lies in the fickle nature of junior exploration financing. The junior exploration budgets were halved in 2009. In fact, the junior equity market had been an early leading indicator of the troubles that eventually befell the mining space in 2008. Interestingly, the equity market impact also appears to be strongly correlated with drill results, which, according to Metals Economics Group, also peaked in May 2008 – around the time mining equities turned downwards in London.

The sector is only slowly recovering from the subsequent damage. North American small cap gold companies raised $6.4bn throughout last year, but the majority of the transactions were concentrated in small amounts (up to $25m, with average transaction for exploration purposes at around $18m). According to RBC, as much as 76 of the transactions were closed for exploration purposes (by comparison only 48 transactions were closed to finance feasibility study and construction). The fragmentation of the junior universe means that this relatively high number of transactions yielded mere $1.2bn for actual exploration (or less than 20% of the total capital increase). Indeed, the actual number of what goes “into the ground” could be even smaller. Earlier this month at PDAC in Toronto, Renaissance Resource Partners estimated that only 30% of the money raised by the juniors goes into actual “exploration activity”, as opposed to other exploration expenses. Such estimates are often contradicted by mining companies’ pie-charts purporting that the budgets are invariably drilling-heavy. Indeed, the seasonality of the drilling season in some severe climates shows that a “drilling” month could be 5-6 times more costly than a month without drill rigs on.

Mining companies conveniently divide exploration into two categories – greenfields exploration on new land and brownfields exploration seeking to prove up orebody extensions near the existing operations. The heuristic proves useful to detect long-term trends in the industry. Globally, early stage greenfields exploration pipeline has dwindled in significance, from 40% of overall exploration effort in 2005 to 32% in 2009. It has been largely replaced by the less onerous – and much less risky – brownfields exploration, whose part, as a percentage of overall exploration effort, has grown from 20% five years ago to 27% last year (the remainder falling into “advanced” exploration category). This shift is understandable in uncertain economic conditions; in terms of the total dollar per recovered ounce, successful brownfields exploration is about three times less costly than greenfields exploration. However, from the industry-wide perspective, there is a fallacy of composition here. The known orebodies – like all mines – are finite resources and no mining sector can survive without new discoveries.

How is, therefore, the new year shaping for the junior market? Overall, both the gold equity market, and the financing rate have stabilized since December. However, there are encouraging signs concerning flow-through financing, which allows Canadian investors to lower their taxes by directing funds to exploration ventures. This system provides a buffer for investors when their equity investments depreciate less than the amount of the tax break. Understandably, the interest in flow-through peaks towards the end of the year, but this time, encouragingly, it has continued after the December season.

Following the financing rounds of 2009, there is now expectation that mid-cap and large companies will engage aggressively in equity deals with juniors (as opposed to simple joint ventures or option agreements). This could be particularly true in Latin America and in Canada, where majors frequently neighbor on prospective ground explored by juniors. Other areas of “relative” concentration can be found on Ghana’s three prominent gold belts. But it would be premature to bank your money on a rush to take out early stage gold explorers. Most large gold producers tend to favor acquisitions of companies closer to feasibility study and thus add to production in the near term, rather than swivel the “growth pyramid” with a thin pipeline of intermediate projects. And although there are exceptions to this dominant strategy (Agnico-Eagle comes to mind), investors who bank on majors’ private placements in early stage companies are bound to be locked in a low-delta option game. The gold equity market, and the gold exploration universe, are bound to remain fragmented and in slow recovery mode, for some time.

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18
Mar

WHAT DOES THE FORWARD CURVE PORTEND?

   Posted by: Mr. Gold    in Uncategorized

As the London Bullion Market Association has opened negotiations with London Metal Exchange to distribute its new gold forward curve, the question of the relationship between gold and base metals is again beginning to haunt investors’ minds.

The relative liquidity of the copper contracts, and the presence of this metal on COMEX means that the gold-to-copper ratio is the most frequently quoted comparable between the precious and base metal sectors. And although many gold-rich epithermal systems are found around large copper porphyries, the geological relationship between the two metals does not necessarily extend into the markets. For one, as expounded before on these pages, gold seasonality is quite strongly tilted towards strength in the second half of the year. On the other hand, base metals – and in particular aluminum, zinc and copper – are known to enjoy stronger demand in (northern) Spring, although falling merchant premia since the Chinese New Year seem to suggest that it may not necessarily be the case this year.

Of course, the most notable difference between gold and the base metals has for years lain in the shape of the forward curve. Gold resides in a permanent contango (forward prices higher than spot prices), owing to its abundant liquidity and the fact that storage costs outweigh convenience yield. Base metals, on the other hand, were historically characterized by entrenched backwardation (spot prices higher than forward prices). Until the middle of the past decade, the backwardated forward curve offered fairly predictable gains in the futures market. An investor could buy a futures contract 2 months before expiration and then sell it to avoid physical delivery, while buying another one with later expiration. The price difference offered by the backwardation is commonly referred to as roll yield. Between 1959-2004 investors could earn this way over 10% excess return over risk free rate.

However, just around the time this passive strategy was heralded for its low correlation with the rest of the portfolio, money poured into commodity index funds, increasing the level of offsetting inventories and leading to prolonged periods of contango. Although the interest in the commodity space was initially triggered by the structural shifts in the physical demand, engendered largely by the construction boom in the emerging markets, the appearance of the contango also reflected low financing and storage costs. The problem for investors was that contango left the aforementioned passive futures strategy with a negative roll yield (essentially, what you bought after selling your previous contract was more expensive). This development proved to be particularly damaging at the front end of the curve, which is more volatile and – as in copper – more amenable to twists into a contango.

The base metals experienced rising prices along stock surpluses for the first time between July 2005 and March 2006. Much to the surprise of gold investors, some market participants began to consider copper (rather than gold) as a “hedge against inflation”. In the process, the market cap of the major mining companies for the first time reached levels previously reserved exclusively for oil majors. In May 2006 copper hit an all time high of $8800/t. Later that year the copper/gold copper ratio rose to a record 1.7x (it subsequently collapsed to 0.4x in December 2008). The second “surplus investment” period began in 2009, this time driven by Chinese merchants’, dealers’ and investors’ unprecedented level of stockpiling. For many of these players the red metal constituted a hedge against inflation, broadly anticipated in the credit-swamped economy. And, as in the heyday of gold miners’ hedging, forward sales by the holders of physical inventory could negatively affect the prices. However, long positions accumulated in commodity index funds now significantly outweigh these hedges.

Nowhere is this situation more striking than in aluminum. Between 75% and 90% of aluminum stocks are now tied in financial arbitrage deals, facilitated by low 3-month Libor and low storage costs. The metal is not instantly available for physical consumption and will only be freed either when the forward curve flattens or when the prices go up enough to offset the cost of breaking the warehousing contracts. As in gold, or in early stages of the silver cycle, this “investment” demand is now being associated with stock surplus, not with the deficit.

If the contango persists, it could encourage further over-production, most easily achieved in aluminum and zinc markets. But this is only sustainable for as long as interest rates are low and Chinese “speculators” continue to enjoy access to easy credit. Metal financing deals won’t suffer from a small rise in interest rates because the cost base is very low. Importantly, the $200bn stack of unused corporate loans in China would indicate that the party could go on for longer, regardless of PBOC’s interest rate decisions. The optimistic view is that even if the contango in aluminum disappears, it will take up to 3 years to reduce the stocks currently tied up in financing deals.

How significant are these developments for gold investors? First, regardless of the surplus stock building, the base metals are still a far cry from the investment-related inventory levels supporting the gold contango. Even counting all the exchange stocks, smelter and merchant inventories, Japanese port inventories, physical investment, China’s strategic reserves and whatever generous statistics we can offer to the rumored private stocks of the base metals, they mostly amount to around 15% of annual market. Meanwhile, just the gold ETFs and Comex net long positions correspond to nearly 70% of the size of the annual gold market, and as we know there are many other sources of liquidity, potentially available to this market. In other words, base metals cannot “replace” precious metals as an inflation hedge, not least because the resulting price level would actually feed back into inflation expectations and eventually a higher PPI.

But the eventual disappearance of the contango in base metals could dent investor sentiment vis-à-vis the commodity markets. This is not insignificant for gold, given the level of gold allocation in the main commodity indices – 2.8% in GSCI index and 9.15% in DJ-UBS index. This allocation is only marginally lower than in 2009 and gold retains some sensitivity to broader commodity sentiment.

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11
Mar

BEWARE OF THE IDES OF LIBOR

   Posted by: Mr. Gold    in Uncategorized

Several months ago, I drew your attention to the importance of the shifts in short term interest rates, and in particular in Libor. Libor rates are crucial for the understanding of gold lease rates, which, historically, have been negatively correlated to gold prices.

Gold lease rates can be understood as the difference between Libor and gold swap rate, which is expressed in annual percentage difference between the spot and forward prices. Low Libor usually means low gold lease rates, or even, as has been the case recently, negative lease rates. In a negative lease rate environment, market participants can still borrow gold, but will charge the lender for the operation, largely offsetting the storage costs. The fall in the borrowing costs is, therefore, negatively correlated to gold prices – a unique case among commodities. In base metals, the cost of borrowing increases as price rise because inventories are depleted and the physical metals is at a premium. This could be understood as one of the factors determining the mean-reverting character of “scarce” commodities.

But gold is, famously, devoid of any ‘mean-reverting’ level. There are no liquidity shortages here and low interest rates result from ample liquidity held at Central Banks and among other large holders. This ample liquidity allows jewelers to finance their inventory at the (lower) gold lease rate and avoid currency risk. But when the lease rates rise, the cost of holding this inventory rises as well, and the stock holders push the product into the market, which predictably depresses the gold prices. The relationship can also be illustrated by the legacy of hedging by gold mining companies, which has been progressively shaken off by the corporate boards. In the process, the lending market has shrunken, even though bullion banks offered ever lower lending rates. The de-hedging process has, therefore, been associated with low interest rates and higher gold prices. Note, by the way, that the CEO of AngloGold Ashanti – the holder of the last sizable hedge book – announced earlier this week that the process of dehedging will be accelerated. The market had hitherto anticipated an orderly expiration of the contracts over the next 5 years.

In the conditions of market stress, gold lease rates are a fairly reliable as a near term leading indicator of the gold prices. When the TED spreads pulled up the lease rates to a multi-year high of nearly 2.7% on October 10, gold subsequently dropped a record 22% over the next two weeks. On December 5, 2008, lease rates began their inexorable descent, contracting by 41% by the year end. During this short period, gold jumped up 16% and has not seen sub-$800/oz prices since. On the other hand, the collapse of US Libor in summer 2009 was accompanied by a drop in the lease rates and largely prefigured strong momentum in gold prices, observed between September and December. Three month gold lease rate hit a multi-year low (-0.16) on December 18 and began to climb since.

But the US Libor is not only significant for gold lease rates. The relative level of short term rates determines the choice of the funding currency for carry trades. Thanks to the ultra-low interest rates during the last 15 years, the Japanese Yen has served as the quintessential funding currency. After the Yen hit an all time high of Y79 to USD in April 1995, monetary authorities agreed to prop up the dollar, opening two and half years of the first Yen-carry-trade period. This led to an even stronger current account surplus in Japan and when the Yen strengthened again in 1999, Mr Sakakibara found it very difficult to convince US Treasury Secretary Larry Summers that further interventions to weaken the Yen were in the interests of the global economy (or US economy, for that matter). However, the Yen carry trade resumed in 2001, with unorthodox qualitative easing introduced in Japan for the first time. Against the background of strengthening Euro, Japan could grow again through strong exports and a market of around $1 trillion worth of carry trades evolved, lasting until 2008, when the Dollar and the Yen strengthened suddenly.

Since at least the summer of 2009, there has been much verbal speculation about the size of the new “Dollar carry trade”. Mr Zhu Min of Bank Of China (and now IMF) stated in Davos that, at $1.5 trillion, the size of this trade dwarfed the Yen carry trade of the previous decade. The problem is that we have no robust data to rely on and many commentators argued that the size of this trade could be half of what Mr Zhu Min had alluded.

Why is all this relevant? Because as of last week (March 4), US Libor has notched above Japanese Libor for the first time since August 2009. The Japanese currency is, again, the cheapest to borrow for those market participants who are keen on placing the funds in, say, Australian dollar assets. The Yen tanked on the news and gold wobbled, losing over 3% over the week. Incidentally, if the wall of Japanese money bids up AUD once again, Australian mining producers (including gold miners) will suffer.

Although the trade-weighted dollar has remained stable, the erosion of carry trade pressure on the greenback removes one of the supporting factors for the gold price. Also, since the third week of January, 3-month lease rates are again in the mildly positive territory (albeit trading lower again). All of this exposes gold to near term weakness and the questions are being raised about how far from the physical clearing price we are. Unconfirmed reports cite buyers’ interests at around INR 50’000 per ounce (current Rupee gold price is around 50’490/oz), but March is not a strong market for physical offtake. Beware…

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5
Mar

GOLD’S VIRTUOUS CYCLE – ANOTHER DECADE TO COME?

   Posted by: Mr. Gold    in Uncategorized

If there is one lesson I derive from history, it is that things that have never happened before do occur.  Extrapolation or intrapolation from past trends has led many an investor onto the manure heap of wasted capital.  Looking back at the last decade, there are at least several themes which seem to be enjoying a “stronger for longer” mantra: the emerging market growth, the commodity boom and the (ever more enigmatic) gold story.  But while the emerging markets have seen tangible wealth generation, sound macroeconomic stewardship and a productive combination of savings and investment (pulling, not surprisingly the commodity trade along), the gold fundamentals are poorly understood in this context.  Little attention has been paid to the mechanism of the progressive wealth shift which has underpinned the gold demand through reinforcing feedback loops, with several positive effects on the way.

Let us start with the US market and the introduction of the Greenspan put, recognized sometime after his seminal 1996 speech.  With the exception of 2004, when interest rates were hiked some time after the long-term yield rose (and gold still returned a creditable 6%) the US economy enjoyed a prolonged low-interest rate environment.  This famously fed into the construction boom and supported non-yielding assets, not least gold, whose lease rate (below Libor) is negatively correlated to prices.  But this low interest rate environment also unleashed a hunt for yield.  The emerging markets were among the beneficiaries of those flows, barely 3-4 years after the most recent (“Asian”) crisis.  This time however, the flows were not dominated purely by US-dollar denominated credit, and included capital from equity funds.  Importantly, the growth in wealth affected several economies whose consumers had historically been “positively inclined” towards ownership of gold.  For all the near-universal ubiquity of gold as ornament and as a store of value, the enrichment of Middle Eastern, South Asian and East Asian consumer/investor has had a stronger impact on gold sales than wealth preservation of baby boomers.

Yet much of the capital inflows also triggered a defensive posture by the monetary authorities in the emerging markets, many of which remembered all too painfully the lessons of the Asian crisis.  Beijing consensus began to emerge, with the religion of an open capital account more commonly questioned.  This created a strong upward pressure on the currencies of the economies running a current account surplus over and above the capital inflows.  In extreme cases, sterilization was required to reduce the domestic component of the monetary base.  Elsewhere, the liquidity conditions allowed for a construction boom which appeared commodity-friendly.  Although gold did not participate in this process directly (as metallurgical coal, iron ore and copper did), it has benefited from it indirectly, via commodity indices, where the yellow metal was bought along with the energy and industrial metals.

But the net capital inflow into current account-surplus countries has also led to a massive accumulation of foreign reserves.  Over a decade, the foreign reserves increased from 1.9 trillion dollars to 6.8 trillion dollars, dominated by growth in four Asian countries: China, Japan, India and Taiwan.  Given that the current account surpluses were generated by trade surpluses (with the exception of Japan, where the surplus was more related to income from overseas investments), it is not surprising that most of the inflows were in US dollars.  Understandably, they were also deployed in US dollar vehicles – Treasuries, agency debt and corporate debt.  But this accumulation did generate expectations that after a decade of post-Cold War net selling by (Western) central banks, globally the monetary authorities would now move into a net neutral, or even net positive purchase mode.  Although it is not in the interest of dollar holders to make dollar-bearish statements, there are indications that central banks have indeed shifted away from a strongly negative attitude to gold.

The other gold-friendly element, which has long been occulted by the foreign reserve accumulation, relates to the role of the Euro.  The foreign reserve growth has seen the progressive erosion of the role of the dollar as a reserve currency, though not yet as a currency denominating the global trade (occasional renminbi swaps notwithstanding).  In the effect, some of the accumulated dollar positions have been exchanged into the Euro – whose global role increased significantly over the last decade.  For most of the decade, gold traded with a positive correlation to Euro / dollar pair, a phenomenon disrupted in the first quarter of 2009 and again most recently.  But for the most part, inflows into the Euro were viewed as “bullish gold”.

However strong, the demand for Euro from the monetary authorities has been dwarfed by the overseas demand for US Treasuries, 33% of which are held outside of the United States.  This, seemingly perennial demand has helped the US authorities to keep yields low, fuelling the credit boom until 2007.  But as already noted before, low (real) interest rates are gold’s most trusted friend.

As we can see, this large loop of global capital flows has benefited gold at several junctures – through the interest rates, capital inflows into gold-consuming nations, the commodity boom and resulting index investments, the growth of forex reserves with the potential increase of the role of gold as a reserve asset, and finally through the increased role of the Euro – which has been mostly positively correlated to gold prices.  Which of these factors are here to stay and which are to go away?

The emerging market side of the equation may last longer – despite the current fears surrounding inflationary pressures and higher interest rates (indeed, the related capital outflows could first affect Latin America, rather than Asia).  The Euro story will depend on whether the multiple public deficits are treated via strict – and ultimately deflationary – austerity measures (a near-term negative for gold) or through monetization.  And the US interest rates?  Here’s a tough one.  According to Bernanke, they are low for a “foreseeable future”, and indeed, as long as they trail inflation, gold will benefit.  But does “future” mean 2011?  This is when Bush’s tax cuts (1.6% of GDP) will expire.  The US economy is too brittle to survive an interest rate hike and a tax raise.  Are Washington politicians are as suicidal as Ryutaro Hashimoto was in 1997?  Although it is highly unlikely that Republicans ever vote a tax increase, expiration of old tax cuts is a different story.  Deficit bashers are aplenty today, jockeying now for November elections.  But a tighter monetary policy, coupled with fiscal fundamentalism will smother the US economy and its exports, which will struggle under a stronger dollar.

Would this happen early this decade, gold will suffer, offering spectacular new entry points.  Why?  Because this exercise in macro-economic amnesia will not last.  Nor did Hashimoto.

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