As many Europe-bound Indians and tourists trapped in Mumbai or New Delhi have spent the week mulling over increasingly exotic routes back home (Moscow? Rome? Then a car to Scandinavia?), the Reserve Bank of India raised interest rates for the second time in as many months.

As a result, banks’ cash reserve ratio has been raised to 6%, the key repo rate is now at 5.25% and the reverse repo at 3.75%. Yet, with consumer inflation running at close to 10% (and food prices at double that rate), the higher interest rates will still trail the runaway price indices. Indeed, of all the major emerging markets, India is facing the most serious inflation challenge. Its currency peaked in February 2009, but has since lost 15%. Meanwhile, real exchange rates of Brazil, Russia and Indonesia have continued to appreciate, which partly helped these economies stem imported inflation. Indian economy is also radically different from China’s. While the northern neighbor continues to stun observers with its addiction to serial overcapacity generation, Indian demand is chasing insufficient supply of goods, repeatedly triggering administrative measures which negatively impact the country’s trade account.

Such trade wobbles contribute to the fact that, year on year, India’s foreign reserve accumulation has grown by only 5.5% – a pale shadow of the double digit growth in other BRICs and in Newly Industrialized Countries (Taiwan, Korea, Hong Kong and Singapore). These two groupings added 22% and 26% of reserves, respectively. In this context, India’s purchase of 200t of gold, at $1040/oz last September appears a highly significant – if unprecedented – move in the overall reserve management strategy.

New Delhi says it targets 5.5% inflation, but the increase in food prices has already caused political unease, with BJP opposition party trying to exploit the mounting dissatisfaction.

So far this year gold has been range-bound in Rupee terms – testing 52000/oz on three occasions and enjoying a solid support at around 49500/oz. Contrary to uncovered interest parity theory, in practice the exchange rate does not strengthen when interest rates are low to compensate for expected depreciation. But given that India’s capital account is only partly open, nor is the 25bp increase in the main lending rate likely to generate a stampede of foreign capital into the Rupee. In other words, India’s gold buyers may not get a fillip from a stronger Rupee ahead of the upcoming Askhaya Tritya festival.

Askhaya Tritya falls on May 16. According to Indian astrologists’ Mahurata theory any important activity commenced on this date will benefit from its auspicious timing. Hindus consider gold purchase on this occasion as the key to lasting prosperity. No surprisingly, the festival is recognized to be the last significant gold-buying date in the country prior to the monsoon season. One of India’s private banks alluded this week that it expected a 30% increase in purchase of gold coins, compared to last year’s 440kg. This is a bold assumption, given that in Rupee terms gold is hovering some 15% above last year’s prices. But India’s notorious price elasticity could be affected by stronger real income growth and further distorted by money illusion generated by the fast-accelerating inflation rate. This last factor is most relevant in India’s cities. In fact, urban inflation index in India has doubled since last year’s Akshaya Tritya.

All this goes a long way to explain the improving sentiment in this 480tpa gold market. India’s inflation fears feed not only increased interest in gold, but also in silver. Western investors, at least outside Australia and Canada, have been trapped in the recurrent deflationary jitters caused by the seemingly eternal Greece debt fears, slow recovery in service sectors, sluggish investment growth, poor external balances, and – most recently – falling long term yields. Market participants in the developed markets tend to lose from sight that quite a few of the key gold consumer nations are now facing inflation pressures on a scale unprecedented in the last 24 months. This does not necessarily tell us where gold prices may be going in the near term. But stronger demand on the Subcontinent will contribute to a more robust floor under the price, potentially helping to support the gold market during the traditionally weaker summer months.

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Tags: Akshaya Tritya and gold demand, gold prices in Rupee, India inflation, India interest rates

Last week something interesting happened to gold options. The short trading week saw the return of strong investor interest to the gold market, with net long positions on Comex increasing by 4.5 moz. This constitutes the most significant weekly inflow since the 6.4 moz rise during the first week of September, which at that time helped gold break the $1000/oz barrier. Yet, unlike in September, 1 month contracts initially did not experience a pick-up in volatility that usually accompanies decisive shifts in the spot market. In order to understand what this means, it is worth stepping back to consider some unique characteristics of gold’s historical – and implied volatility.

In theory, gold should not be volatile at all. Inventories and storage capacities are a non-issue for this “commodity”. Unlike other commodities, gold volatilities cannot be easily dissected into structural (long-dated prices) and cyclical (forward curve structure) components, as the metal is not mean-reverting and its global inventory is always plentiful. Unlike platinum, or oil, gold is geologically abundant in almost all major regions of the world. And, unlike silver, gold is usually produced and accounted for predominantly as the main output of mining operation. Consequently, it does not suffer from low elasticity of supply.

Secondly, for the purposes of the investment and jewelry markets as we know them today, the supply from mines, scrap and, if need be, central banks is sufficient to satisfy demand. Finally, gold storage is not a big deal. Ultimately, people carry this stuff on their bodies. This is probably why gold is notorious for being the least volatile of all commodities, bar livestock. Indeed, long-term comparisons show that commodities difficult to store – such as power – are the most volatile. The long-term annualized daily return volatility of power rates (say, US PJM West Hub) is over ten times gold’s.

But there is another unique characteristic of gold’s volatility. During bouts of strong momentum buying, as during the last quarter of 2009, gold’s volatility surges. And while, at that time, implied volatilities of the VIX index continued to fall in the broader market – almost in synch with the bullish sentiment in equities, gold’s volatility increased in line with spot price gains. It eventually peaked some two weeks after the metal notched its all-time high level in dollar terms.

According to World Gold Council, over the last 20 years, standard deviation of positive returns for gold is above 3% (compared to 2.3% for S&P500). Typically, in the broader equity market, negative returns are associated with higher volatility, yet gold’s standard deviation for negative returns is actually lower, 2.5%.

How does volatility correlate with gold prices? The last three years provide an interesting lesson. During the year separating the “subprime” fallout in Sep 2007 and the Lehman debacle in Sep 2008, the correlation was positive and high (0.8). It dropped precipitously, as gold prices reacted negatively to the potentially deflationary shock of the banking collapse. Gold volatilities shot up, in synch with other asset classes, and the correlation between gold prices and gold volatilities reverted to negative. The relation remained negative until late summer 2009, but since October, the correlation has turned positive again, although less decisively so than in the preceding period (currently at around 0.15). As a result of new inflows into the market (both Comex and ETFs), over the last week we have observed the lowest ever ratio of volatilities to gold prices. In other words, during the recent quarters it has paid off to be long gold, but short gold volatilities. Unfortunately, in order to have more confidence in this trade going forward, it would be helpful to have a slightly higher implied volatility than it is the case now (old adage goes that shorting volatility is best when the implied volatilities are significant, but historical volatilities are unimpressive).

Gold options, including options on gold equity products, such as ETFs, differ in volatility skew from the rest of the market. Implied volatility of calls and puts has a forward skew (volatility is higher for higher strike options). This is not only the case of gold, but also of most other commodities, many of which have experienced much stronger swings in long-dated prices than the yellow metal. The most liquid SPX options, on the other hand, have a reverse skew (higher implied volatility at lower strikes). Not surprisingly, the options on gold mining companies, and on GDX index, have the volatility skew more akin to the broader equity market.

In the near term, if gold continues to notch up regardless of USD/EUR direction, I would expect volatilities to pick up and the record price/vol ratio ease in the short term. If not, we are in uncharted territory. But shouldn’t we get used to it by now?

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Tags: Comex gold, correlation between prices and volatility, gold ETF options, gold price volatility, volatility skew

As the memory of colorful eggs and chocolate rabbits is now ebbing, the market is resuming its pre-Easter strides with a fury. Nowhere has it been more evident this week than in Sydney. Prior to the long weekend break, Newcrest’s management announced the long-anticipated takeout offer for Lihir. The target jumped over 30% on the impact, and the prospective acquirer closed up on the day as well. Back from the fattening Easter spell, the investors shifted gears, dropping Lihir by 6%, but buying even more of Newcrest, pushing up the latter by 3%. Importantly, the volumes of Lihir’s stock were three times Newcrest’s. This pattern has been sustained ever since.

Waking up to the announcement (and Lihir’s instant rejection) of the deal on April 1 one could not shake off the disbelief. The pair touted for consolidation for the better part of the last decade, and often arbitraged against each other is finally taking the vows… Or is it? Indeed, in order to understand where Australia’s two largest gold producers are today, it is necessary to step back a couple of years.

Lihir was incorporated in 1995, after the discovery of the large deposit on a remote and geothermally endowed island of New Ireland archipelago. Initially staffed by Rio Tinto’s management, the company was never destined to shake off the blessing – and the burden – of the difficult, unique project which gave it its name and 700koz of gold p.a. The company was eventually weaned of Rio’s involvement as investor and operator in 2005, when new CEO Alan Hood took over. Understandably, he drove the process of risk diversification for what was perceived as a value company over-exposed to a very long life mine located in a poorly understood environment. Listed in Australia and US, the management was keen to reduce investor resistance and closed its hedgebook in April 2007, but at a price of A$1.2bn equity raising. The management also commenced to talk about “growth”.

This was, however, easier said than done. “Corporitization” boosted the size of Brisbane office. The first attempt at corporate activity was the unfortunate purchase of Ballarat in early 2007, a company based in a historic gold district of Victoria. The eventual sale of the mine, for mere A$4.5m, was announced earlier this year.

When I met Lihir’s CEO in 2008, the management was still willing to talk up M&A, yet it was the flagship operation that suffered from recurrent issues with the oxygen plant, crusher accidents, heavy fuel oil pricing and low grade sulphide ore. The company continued to target prospective 200koz p.a. and soon enough it announced a A$1 merger with Equigold. The combination of Queensland and Cote d’Ivoire assets has fulfilled the initial criteria, and allows Lihir to flag creditable production growth from 2011 onwards. However, unable to digest the Ballarat glitch, the company was effectively without the CEO since January this year. When the newly appointed CEO, former BHP metallurgist Graeme Hunt walked into the office on April 1, he found his new house under a takeover offer from Newcrest.

This is Newcrest’s maiden voyage. The company is unique in the gold mining universe as it has always generated its growth internally. Indeed, it is perfectly possible that its management is serious stating that the deal costing 9/1 scrip + Ac22.5 is “not vital”. This could partly explain the relative share price fluctuation between the two companies this week (Lihir’s short interest ratio on the North American market is only 1.5). Still, one could argue that, given Lihir’s five year long independence, it could have happened before. However, Newcrest’s combined Telfer and hedgebook problems at reduced the probability of the takeover between 2005 and 2007. The embedded premium began to grow again in 2008, but by then the name of the game was cash conservation, especially in the copper-heavy NCM.

The company has always been regionally focused and controls some 17% of Australia’s proven and probable gold reserves. Its entry into Papua New Guinea is fairly recent. In August 2008, Newcrest entered into a 50/50 joint venture with strategically challenged Harmony Gold to gain access to a highly prospective area in PNG’s Morobe province. It included Wafi/Golpu area, which I remember being discussed at length among geologists during my trips to this wonderfully mysterious country. Wafi/Golpu represents today hidden value embedded in Newcrest, with copper-rich intercepts shown repeatedly in the results.

If there is a risk to Newcrest, it lies in its overdependence on the success of Cadia East porphyry – a huge panel-caving underground mine, which will soon represent over 30% of company’s earnings. Newcrest has a track record of overhyping otherwise promising projects to the market (e.g. Telfer) and too much focus on Cadia East could be detrimental in future, its relative merits and contribution to ca 15% annual cash flow growth notwithstanding. This alone could explain the sudden willingness to pounce on Lihir, regardless of the lackluster market response to Newcrest’s stellar results recently.

Lihir is now clearly at play. Indeed, with U$470m in cash at the end of 2009 and rudderless for months, the company was “asking” for it. But it is also worth remembering that every single mining company and her Easter Bunny had done the numbers on Lihir’s assets many times over. If it had not happened before, it is because of the unique mining, power, community and environmental challenges on the remote, volcanic island. The ultimate decision is now down to Blackrock, Fidelity, Commonwealth and First State, which hold together between 21% and 39% of either company.

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Tags: ASX gold stock arbitrage, Cadia East overdependence, Lihir's growth programme, Lihir's shareholders, Newcrest's offer for Lihir

As much as the last quarter of 2009 showered gold investors with no shortage of excitement, the first quarter of 2010 has brought little more than tired yawns. And that is despite the gold price hitting a nominal all-time high in both Euro and British Pound. Indeed, gold’s resilience has been remarkable since the beginning of the year.

In light of the well-publicized Euro-Mediterranean troubles, it could have been anything but. During the quarter, the dollar has gained 7.2% against Euro and the broadly measured, trade-weighted dollar has advanced by nearly 4%. And yet, in dollar terms, gold has added its 6th straight quarter of gain (around 1.7%), even though the momentum has definitely ebbed (50-day moving average is now below the level attained at the beginning of the year).

Things have been more exciting for Euro-denominated investors. Having peaked in May’06, March’08, October’08, February’09 and December’09, gold has again offered an all-time high for the troubled denizens of the Eurozone. This time, gold peaked at EUR 840 (intraday) on March 4 and returned 7.8% over the quarter, proving its asymmetric resilience to USD/EUR correlation. As the global capital flows continue to be dominated by two structurally weak currencies – USD and EUR – opportunities abound in gold, not only in terms of long-term capital preservation, but also to occasionally take profits from the combined forces of competitive weakening of the public-debt plagued currencies, and their shifting correlations with gold. Interestingly, the picture in British Pound appears very similar.

But in this world of weak currencies – is there anyone on the other side of the counter? Certainly not the Swiss Franc. Swiss investors have enjoyed a creditable 3.7% gain in gold during the first quarter, partly due to the looming (and recurrently implemented) menace of SNB’s intervention in the currency markets. The Japanese investors, who have not seen an all-time high gold price since December, have also enjoyed a decent quarter, with the return staying positive at 1.6%. This leaves the titans of the currency market – the Australian dollar (negative gold returns of about 1%) and the Canadian dollar (negative 2.7%). Interestingly enough, these shifts affect negatively gold miners’ returns – a topic worth investigating (again) in more detail.

The ETF community has had a net positive quarter, ending the holdings of the 12 major ETFs at 57.7moz. Comex positions neared 24moz, after some long liquidation towards the end of March. As the longs are less extended, there is little evidence of new shorts coming in. These trends have contributed to the relatively quiet quarter.

The Canadian stocks-dominated gold equity market has had a disappointing quarter, despite the initial expectations of a strong response to 4Q09 returns. The GDX index lost 6.4% and the 50-day moving average has now fallen to the level of the 200-day moving average. The month of January was particularly damaging to the stocks, with the HUI index losing nearly 8% over the quarter. Interestingly, the (imperfectly) Junior market-tracking GDXJ index lost only 4.29%.

Equity-wise, the strongest performance came from a selection of West Africa-focused mid-tier producers – Red Back, Semafo, Golden Star and High River Gold among them. Elsewhere, the winners have been among operators in the Former Soviet Union (Highland, Petropavlovsk and Centerra). Finally, Oceana Gold and Anatolia (both long punted by sell-side analysts) have strongly outperformed the competition. On the other hand, copper-heavy gold stocks (e.g. Newcrest and Yamana) have disappointed again despite 4.67% increase in the copper price over the quarter. They now appear relatively cheap, with Newcrest seeing better cash flow growth – unless smothered again by AUD appreciation. This question is becoming even more prominent in light of Newcrest’s offer for Lihir this morning. Interestingly, Newcrest was slightly up on the announcement.

With the exception of Newmont, this has been a poor quarter for the North American majors. Kinross, in particular, has continued its 2009 losing streak. Newmont has now emerged as the only major company with positive spread of returns over its cost of capital. One can only hope that the full addition of Boddington (copper-heavy, in AUD environment) would not turn the long-hatched blessing into a curse, in disguise.

Elsewhere, expected volume increases are positively correlated with economies of scale and resulting near-term cost performance (e.g. Goldcorp, ElDorado and Randgold), though they come at a price. It is the South African majors that continue to represent a value entry, yet not without hitches down the road, as previously discussed on these pages.

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Tags: currency markets, ETF, first quarter performance, gold equity markets