The conference season is upon us. The luckiest of us are now trekking to Denver, then onwards to Berlin and then to London. As it happens during yet another period of heightened interest in the gold market (as increasingly frequent calls from generalist and multi-strat – oriented friends testify), the collective cerebral power of pundits is weighing, yet again, the bullish and bearish arguments both from the cyclical and structural perspective.

It was not different this week at the Denver Gold Forum. 13 years after I joined this caucus for the first time, it was yet another opportunity to refresh the dusty capacity of face recognition. This was not too much of a test, as most of the gold market insiders look happy and youthful these days. Undoubtedly, happier and youthful-er than investors in many other sectors.

During the conference, the Denver Gold Group organized a “debate” in which two well-known commentators sparred verbally in what was an occasionally entertaining, but largely unsubstantiated exchange. As a result, I left the proceedings intellectually puckish, rather than fully satisfied.

The bear’s argument boiled down to a cautionary story centering on the sustainability of the investment binge. He countered the highly publicized view that gold remains “underinvested” if compared to other asset classes by pointing to the fact that all gold is homogenous while credit products are not. Therefore, in comparison to specific classes of, say, treasury, muni, corporate or other yielding assets, gold is no longer a tiny niche market awaiting discovery. More ominously, the gold market now depends fully on new and sustained flows of investment demand. The moment the growth of investment flows stops, there will be little, if anything at all, to stop a sudden slide of the gold price. Naturally, any hint of higher interest rates could provide such a signal (the debate was held a day before FOMC’s allusion to new asset purchases).

The bull then made his thesis, based on well-known macro observations (unresolved imbalances, lack of exit strategy from the liquidity binge, further liberalization of gold markets around the world, central banks’ attitude towards gold). There was little novelty to these arguments, widely shared among the audience.

The bear’s long-term vision was one of a re-invigorated US growth and central banks re-establishing credibility by linking today’s consumption with future consumption via a more realistic interest rate regime. This would raise the opportunity cost of holding gold and change price expectations of Indian traders, who would react by liquidating inventory. Eventually, other asset classes would return to favor.

On balance, I found the bear’s views more attractive. It is undeniable that no market ever moves in perpetuity in one direction – and nor should gold. It is also true that the underlying jewelry demand is fragile. However, one could have issue with the argument concerning the alternative asset classes. Most US and European investors are constrained in what they can purchase strategically with attractive cash flow profile. Farmable land, high risk private equity in frontier markets, scarce (illiquid) commodities, Renminbi-denominated bonds – may be available to some sovereign wealth funds and alternative vehicles, but will not address the concerns of the ageing baby boomers. Essentially, the post-2008 obsession with capital preservation leads to a binary market in put options – protection against deflation (hence the record-low yields) and against inflation (gold for most of us, copper for the Chinese).
As FOMC proved yet again this week (and BOJ last week), the fear of deflationary vortex entices monetary authorities to lean towards inflation risk. This is understandable for as long as bank reserves remain high and the entrenched output gap protects the developed economies against inflationary pressures. As I have argued on these pages previously, gold provides a good litmus test for what increasingly appears as a series of competitive currency debasements – either through direct intervention in the FX market, or through ultra-accommodative, unorthodox monetary loosening.

These underlying conditions are unlikely to go away any time soon. There is something fundamentally broken in the US job market, which, coupled with the staggering number of yet-to-be foreclosed properties feeds back into the consumption loop making a mockery out of “lagging indicator” from economic textbooks. Still, the short term indicators for the gold market are not encouraging. As the market is testing $1300/oz, much of the action is concentrated in the US dollar (and in Canadian dollar). Unlike last June, this month no other major currency has registered an all-time low against gold. The unhelpful exception is the Indian Rupee. Although one Swiss bank mentioned robust buying from India at $1270/oz, the record prices in local currency terms are unlikely to support the floor under the market as we are moving to a weaker seasonal period on the subcontinent. The impending holidays in East Asia and recovering lease rates are also mitigating against a stronger support for the prices. But the anticipation of a return to aggressive QE on Nov 3, the uncertain timing of AngloGold Ashanti’s hedge book buyback and political outliers (e.g. Beijing rocking – a Japanese – boat) could ensure that any such correction could be shallow and short-lived. Neither bull nor bear, and even broncos need some rest.

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Tags: alternative investments, Denver Gold Group, gold bear, gold bull, gold investment, Indian gold demand, monetary policy

As the record-setting gold market (and the very sympathetic gold equity market) are reminding us, we have now entered the seasonally friendly environment for the investors who patiently tread through two and half months of relatively uneventful lull.

The seasonal theme inevitably brings us back to the question of demand and Indian demand in particular. After all, late August to mid-September period is known to have brought positive returns in every year except the sadly memorable 2008. We have previously devoted these pages to the misunderstandings surrounding the changing nature of Indian demand seasonality. In light of the summertime reports heralding the alleged “end” to Indian infatuation with gold, it is worth reviewing the recent ebbs and flows in the context of the changing Rupee price of gold.

We have looked at the last three years, using the western (Gregorian) calendar. We do realize that many (though by no means all) of the gold purchasing patterns in India are related to the lunar calendar, but we have elected to reflect the fluctuating nature of Indian demand with respect to Western investors’ seasonal perceptions.

We delved into the demand patterns both from the perspective of the jewelry and investment market in India. We cross-checked these data with average intra-period Rupee price levels, price volatility and volume changes. The investment demand, dominated by retail bars, medallions and recently also small 24-carat coins (worth around $20 each) represents between 20% and 30% of the overall demand. The investment component peaked in 2007 – 2008 and has yet to recover to the levels prior to the massive dishoarding that occurred in early 2009. The circumstances of the first quarter of 2009 went well beyond the traditional “seasonality” and were associated with drop of incomes, mainly due to the sudden fall in exports and remittances.

Overall, as could be expected, Indian investment flows are inversely correlated to the Rupee prices of gold. No such inverse relationship can be detected in the case of the jewelry demand. Although the correlation is not statistically significant (0.16), it is nonetheless positive. The functional characteristics of the Indian demand ensures that the jewelry flows slow down, but do not reverse during the periods of high prices. Interestingly, this caps the potential for further increase in scrap supply. Again, the first quarter of 2009, which was marked by massive re-melting and volume-neutral jewelry exchanges, constitutes an outlier.

The old adage goes that in India it is the volatility of gold prices that counts, rather than the level of the gold prices itself. Even a cursory overview of the last 12 quarters bears out this popular thesis. Jewelry volumes have a negative -0.25 correlation to price swings in Rupee terms. Investment volumes seem to be less sensitive. The picture is again reversed if we compare the price volatility with inter-quarter changes in volumes. High volatility appears to have a strong negative correlation to changes in jewelry purchases (-0.5) and an even stronger negative relationship to the rate of change in investment flows (-0.62).

What does all this mean for the gold market in the near term? As we get closer to Pitru Paksha period, when many Hindus give Shraddh offerings to honor ancestors, the demand is bound to slacken a bit, as this two week period (starting late September) is considered inauspicious. This means that even lower levels of price volatility could dampen demand, especially in the South and West of the country. The “modernization” of India notwithstanding, it is prudent not to underestimate the traditional drivers of (and brakes on) the gold demand. For example, the second quarter this year saw a slight drop in both jewelry and investment purchases even despite the marketing efforts surrounding Akshiya Tritya festival. This slowdown could be associated with the addition of the extra month in the lunar calendar (Adhik Vaishak Maas), which is not considered auspicious for gold purchase (sweets are more commonly offered). Luckily for gold investors, Adhik Maas is added to the calendar only once every three years.

Beyond mid-October, as move towards the second wedding season, things will clear up again. This year in particular, the demand should be robust, thanks to plentiful monsoon. 70% of Indian gold demand is still rural-based and the growth of rural incomes in excess of local gold prices is critical for further demand. Only very high volatility of Rupee gold prices could snuff out this opportunity. Let us hope the gold prices do not accelerate too fast before Diwali on November 5.

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Tags: gold price volatility, gold seasonality, Indian investment demand, Indian jewelry demand, Rupee

Last week we briefly illustrated the complexity of the issues facing decisions of an investor in gold mining stocks.  Luckily, not all dilemmas are as intractable as the eternal notion of risk and the premium demanded for risk exposure.

In fact, many technical questions that can be asked are of binary nature.  This is not unlike the process of physical investment into a mining project.  The executives and the board have to first determine the strategic issues (open pit or underground, mill or leach pad, combinations thereof), followed by tactical pre-feasibility considerations (shaft or ramp, selective mining or bulk, mechanized or conventional) and operational decisions.  As the production rate and fleet size are determined and the cut-off grade is known, the investor may start to run her own numbers on the costs involved in the production.  These will differ for even comparable technologies depending on the location of the project.  Finally, the currency exposure has to be taken into account, as Brazil-focused miners have painfully experienced recently.

In the Western world, a successful small-scale gold project will have taken about two years from the discovery to reliable level of measured and indicated resources that could trigger bankable feasibility study.  A Chinese company would probably be able to halve this timeline.  For anyone else, it will be another two years before the commissioning of the mine and preliminary production.  An investor following an exploration story from the first discovery will have by then spent four years observing the company’s progress.

These four years can be a frustrating experience for anyone but the most ardent supporters of the mining entrepreneurs.  During this time, the development company undergoes several overlapping cycles and its market cap reacts accordingly.

First, we will have the 4 full cycles of previously discussed gold “monsoon” seasonality.  Chances are that they will affect significantly the market value of the company.  Secondly, as the company moves forward with the financing schedule, through a combination of bought deals and project financing, it may be subject to adverse (or beneficial) fluctuations in risk aversion and occasional liquidity clouds.  A bank-enforced decision to hedge a portion of future production could have lasting consequences for the company’s capital structure.  Finally, and most importantly, the company will be subject to a tsunami of investor interest around the time of the deposit’s discovery, but the influx of capital will subsequently peter out until the completion of the feasibility study.  How painful this process is will depend on where the feasibility takes place against the patterns of the financing and gold seasonality cycles.  Note that the seasonal consequences differ depending whether the project is located in deep Canadian north or in the Southern Andes.  Post-feasibility, the company is likely to get a boost from the announcement of construction.  Down the line, the project will be valued on the basis of future cash flows (rather than call optionality) and will fall in line with high-growth competitors.

From this point on, comparables can be run with existing projects of established companies.  The grades, continuity of the orebody, contaminants and their impact on processing, the tonnage, the dilution (how much unwanted stuff is mined), the recovery (how much desired stuff is left in the ground), changes to stripping ratio and flexibility, prospects for further resource upgrade and resource-to-reserve conversion, brownfields potential, mining, milling and G&A costs, fleet and circuit optimization initiatives, depreciation, taxes and voila!  A meaningful relative value comparison is possible, with applicable sensitivity analysis.

If all these considerations are adequately factored in, and the investor remains sanguine about the prospects for the gold market, then the last hurdle is the build-up of a sufficiently diversified portfolio.  The difficulty with shorting many of the new names and the unavailability of traded options means that the portfolio will have a strong long bias and possibly some unsystematic risk included.  There are time-tested ways to steepen the security market line leading from the risk-free level: combine the subportfolio of tier II tickers with large companies (which are cheaper to short), spread the risk geographically, ride the wave of the market value cycle (mentioned above), include gold companies domiciled in markets with low correlation to the dominant (North American) gold equity market.

Such a portfolio requires active management, which, of course, incurs some costs.  However, it offers a valuable enhancement for portfolios dominated by directional gold positions.

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Tags: active gold portfolio management, cost assessment, gold stock market cyclicality, project development timelines

The gold miners’ season is upon us.  Out of the summer doldrums and through the usually disappointing (for most) margin squeeze reported after the second quarter.  As we are eagerly awaiting the annual gold stock party (and, at the same time, the annual Denver Gold Group’s show), it may be helpful for the readers to understand in what way investment in gold mining companies differs from investment in physical gold.

It is well-known that gold prices are fairly stationary.  Over long time, they represent a form of insurance, whose price is the non-existing yield (if we forget for the moment the return that could in theory be earned by lending bullion at rock-bottom lease rates).  Gold mining companies are not like that.  They do not “hold” gold – they sell it.  They currently dig out gold at an average cash cost of $490/oz and, depending on the total cost, pocket the difference with the spot price or some combination of spot and forward sales.

A self-respecting gold investor should hold a portfolio combining the insurance value of gold or gold-backed instrument, a position in companies that sell gold for a good profit and a sub-portfolio for derivative trades enabling her/him to benefit from changes to the volatility of the metal.  The problem is that the three subportfolios require very different skills and time horizons.  Physical gold requires a long-term macro vision (and wealth to preserve in the first place).  Investment in gold mining equities – long or short – requires a level of knowledge of the complex industry which can only be gained by actually working there; a privilege few of us mortals will have.  Finally, dynamic option trading requires both experience and a fairly good orientation in what other large derivative desks are doing.

We shall focus here on the second element of such an ideal portfolio – investment in gold mining companies.  Four years ago, during the height of private equity activity, someone made an interesting observation that unlike oil and gas industry, mining attracted very little in way of leveraged long-term investment.  In many scarce commodities – from lithium to uranium – it is theoretically possible to take a controlling position in an early stage company against the future offtake of the product (assuming that the private equity firm is appropriately positioned further down the value chain).  But in gold, the intermediary bullion banks have been in the business for decades and the product is never “scarce” by any conventional measure.  In addition, the complex knowledge necessary to analyze a mining investment is a hurdle that few non-operating companies undertake.  Those who can do this, are successful royalty businesses.

Why is it so difficult to switch from analyzing, say, retail or machinery sectors to analyzing mining?  There is one underlying conceptual difference.  Your clothing stores and your factories will be differentiated by the product they churn out.  But the process of a factory based in Mexico or in China may be exactly the same.  In mining, the opposite is true.  The product is essentially an undifferentiated commodity, with specific qualities and standards determined by decade-long interaction between producers and users.  But it is the process of obtaining this commodity that differs in every single operation.  The combination of geology, metallurgy and engineering makes each and every one mine a unique operation.  In order to understand the process fully, nothing replaces the actual visit to the site.  And the sites tend to be off-the-beaten track.  As my former boss would quip – “God had a sense of humor when he decided where to put gold”.  From the Arctic Circle to breath-taking heights of 12000 ft and equally suffocating depths underground, from deep jungles to parched deserts, gold just does not happen to be easily accessible.

The 19^th and early 20^th century gold rushes in California, Alaska, Australia, Brazil and South Africa show that God’s sense of humor was somewhat less acerbic at that time.  But much of the easily accessible land has now been scoured for prospectivity, a process that accelerated in the 1980s.  Parts of Australia and Nevada are now drilled out like Swiss cheese.  No wonder that the most prospective gold and copper porphyry-rich Tethyan belt snakes through Burma, Tibet, parts of Afghanistan and Iran, and into Pakistan, where Barrick & Antofagasta’s Reko Diq project is located.  In addition to the challenges posed by the difficult terrain, it is the above-ground factors in these countries that have considerably raised the operating risk.  Such an adverse environment requires the deposit be highly prospective – either rich in grades (which is preferable), or very large.  In the latter case, the operation may incur high development cost or extend way into the future, making the value of the project highly vulnerable to discount rates used to value the cash flows.  The question how to reflect the risk of low-frequency but high-impact events is a huge topic with bankers insisting on somewhat arbitrary adjustments to the discount rate, and operators seeking to reflect the hazards directly in the cash flow profile.  Either way, the shareholders purchase the associated risk, most often with little knowledge of the applicable probability distribution for the potentially damaging events.

This is just one example of the complexity involved in the decision to invest in a mining venture.  Even though the rewards can be considerably higher than in the case of defensive holding of physical gold, the homework concerning the intangible notions of risk takes a bullion-hoarding investor way out of his comfort zone in the Swiss vault.

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Tags: gold vs gold miners, ideal gold portfolio, risk assessment, unerexplored ground