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Archive for October, 2010

28
Oct

WILL BASE METALS ETFs FOLLOW THE GOLDEN TRAIL?

   Posted by: Mr. Gold    in Uncategorized

The nature of investment in commodities has been transformed in the last 5-6 years. Until around 2004, commodity futures, benefiting from predictable backwardation used to enable investors to buy the futures one or two months before expiration and then sell them at a price difference called the roll yield. At which point, one could (and usually did) buy futures with later expiration. From natural gas to copper, it was an easy ride. Gold, incarcerated in its contango, did not quite participate in four decades of the futures spree. But just around that time, the gold ETFs made their appearance. Having accumulated over $100bn in assets under management over the last seven years, precious metals ETFs now represent a very considerable portion of commodity investment universe. Broader commodity indices, despite spot price rises, remain in doldrums.

Surely, important structural changes are affecting the base metals. First, there is China with its mercantilist attitude to stockpiling. Just like the US has strategic oil reserve, China’s Strategic Reserve Bureau has been sitting on 1.5% of the global copper, zinc and aluminum market since 2009. Local governments in China mimic this behavior, accumulating inventory for… the rainy day? For an inflation day? For a 2008-style collapse in trade financing? For a war in the Pacific?

The second structural shift is occurring in the contango investment. Unlike in gold, contango in, say, aluminum, is unusual as the commodity is by definition scarce – utilized, embedded in the infrastructure, vehicles, power lines and scrapped for secondary supply with a considerable lag. And yet, contango did develop in several scarce commodities in 2009. In aluminum traders found a means to turn profit by holding physical metal and selling forward into the contango, benefiting from low storage costs and low borrowing costs. This “inventory financing” ensured that prices have remained high and the margin could be offset to the cost of carrying excess inventory. This metal will be liberated one day, either when the curve reverses or when the prices go up to offset the cost of breaking the warehousing contracts.

But this is not the game available to the Joneses and whatever is left of their baby-bummer wealth. And so, banks, traders and producers are now rushing to offer a whole array of base metals ETFs – first in aluminum and copper, later also in zinc, nickel and other LME metals. The excited buzz is understandable, given gold ETFs past and current success, but is this reasonable?

Other than onerous regulatory filings, gold benefited from several advantages at the time of the launch of the first products. First, storage costs are around 1/50 of what one has to pay for much lighter (less dense and therefore more expansive in terms of floor space) aluminum. Secondly, gold has a unique characteristic of being quite plentiful for investment purposes. When the word came out that a Swiss bank was planning a platinum ETF, opponents raised precisely this argument: the relative scarcity of platinum would defeat the purpose of the investment vehicle, leading to higher volatility in the prices of the white metal. There is little evidence so far that this has been the case.

What the PGM ETFs did show earlier this year, however, is that the initial enthusiasm for the new product is no guarantee for the sustained success of the tracker. Indeed, skeptics point out that after the initial phase, base metal ETFs will simply constitute an additional inventory, unavailable for consumption – in some ways just another version of those Chinese stockpiles, except more visible to market participants.

But what the ETFs phenomenon does is confirm the observation that investors purchase commodities in times of inventory surplus, a phenomenon first observed in early 2006, when copper hit an all-time high. These market conditions have returned in late 2009, likening base metals to gold and, especially, silver, whose prices tend to rise with the onset of physical surplus. This investment demand – an old leg in gold, but a brand new feature of base metals market – will durably affect the price expectations of these commodities, adding to structural (production cost) and cyclical (inventories and demand fundamentals) factors.

It is unlikely that the base metal stocks will suffer from the introduction of ETFs and the resulting equity crowding out to the extent that the gold companies did between 2005-2008. Neither Lundin nor Century Aluminum nor countless others benefit from the market premium offered by the nature of the variable cost of capital – an important differential of the gold stocks. The market ripples of these new products may be less perceptible than many observers fear.

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21
Oct

IT’S THE DOLLAR, STUPID

   Posted by: Mr. Gold    in Uncategorized

The effervescence in commodity markets has been barely checked by China’s 25bp interest rate hike this week. Gold bugs, silver bugs, LME complex bugs – have all espoused a worldview buttressed by the stories of a ‘supercycle’, ‘the collapse of the global monetary system’, ‘currency wars’, and now even rare earth wars. This year’s price charts – in gold as in other metals – seem to bear out this enthusiasm, although one wonders how positive for the rest of the developed nations such trends are.

What these commodity punters and casual observers seem to share is pervasive currency myopia. Until mid-October, most metals, including gold, notched multi-year nominal highs. Silver, gold, copper and tin were particularly hot and seemed hotter by the day in an incessant drive redolent of the heady days of Spring 2008. But peek under the cover of the US dollar’s weakness, and the story is much less compelling.

The Fed first alluded to what has now commonly been dubbed “QE2” in late August. In a classic ‘triple waterfall’ effect, further confirmation of impending purchase was delivered on September 21, and then again sealed with FOMC’s minutes, released last week. At every turn, the dollar responded by abseiling ever deeper against traded emerging market currencies, against the Yen, and most importantly against the Euro. FX markets simply assume that increased liquidity will impact long term interest rates in the US, eventually driving the greenback further down.

When the trend reverses, as it did briefly last Tuesday, comments abound about “commodity selling”. But how relevant are Chinese interest rates for the global liquidity binge, other than potentially sucking even more illegal capital flows into the country? China remains the marginal buyer of the last pound of copper and the last ton of iron ore, but it is not (yet?) a similarly dominant source of physical demand for gold. And yet, gold responded to this short-term reversal with southbound conviction.

There is no mystery to it. Most of gold’s “gains” since last June are a matter of nominal adjustment to the denominator’s value. The denominator (i.e. the dollar) has fallen nearly 13% on a trade-weighted basis, a measure still flattered by the untradeable nature of the renminbi. During the same period, gold has gained only slightly over 8%. Looking at gold in other currencies, we may have a hunch that the stories of “buying” (most of time) and “selling” (as on Tuesday) are, most of time, suspect. On any given day, one has to look for gold to rise in a cyclically weak (currently the dollar) and a cyclically strong (right now the euro) currency to draw a solid conclusion about gold’s popularity or lack thereof. And to understand the underlying trend, it is advisable to adjust gold prices for the trade-weighted dollar, however imperfect even this measure is.

Viewed from this perspective, we notice that gold has not made any gains since the heyday of European panic buying in May-June. Most of the nominal gains that the metal has registered since then simply reflect the dollar’s losses.

gold adjusted for trade-weighted dollar

Interestingly, similar story appears when we analyze copper prices, adjusted for the dollar weakness/strength. The red metal has not made any significant gains since as far back as March. The copper bullishness, which marked the LME week in London, should, in short term, translate into dollar bearishness and little else. While no one denies the well-documented problems of the slow replacement of the current mining production and supply challenges going forward, the spot premiums on Asia’s physical markets are falling and near-term copper demand appears to be slackening.

copper adjusted for trade-weighted dollar

In theory, low value of the dollar should be good for commodity purchase, as it makes them more affordable for Yen, Pound, Euro and other currency holders. China, the marginal consumer, has a structurally driven demand. The bill it foots for, say, iron ore, is bound to generate much hand-wringing among steelmakers, but the client must eventually relent, despite the artificially low value of its currency. Likewise, large trade imbalances driven by oil imports lead to increase in the supply of dollars against other currencies whenever oil prices rise. Yet none of these commodity/currency mechanisms are present in gold, which is economically inert. Weak dollar is not, per se, “good” for gold because the metal is predominantly an investment good today and its demand relies on the perception of its future value. A much stronger Rupee, or a much stronger Renminbi, against the dollar, could yet drive copper, molybdenum and metallurgical coal into a bubble territory, but in the local markets they might trigger negative price expectations and actually depress future demand for gold.

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14
Oct

ELEGY TO HEDGES

   Posted by: Mr. Gold    in Uncategorized

Only gold market veterans still remember the jovial hectoring socked onto gold mining executives by the late Julian Baring of Mercury Asset Management. Baring – in his days the most successful gold investor – spent the late 1990s castigating gold mining companies for selling gold forward. Baring’s tirades fell mostly on deaf ears but the miners soon rued their studious indifference. Famously, Ashanti – the chief victim of Baring’s verbal prowess – soon caved in under the weight of the margin calls when the sudden spike in the gold prices squeezed their positions.

AngloGold Ashanti’s closure of the hedgebook last week ends the nearly 20 years’ legacy of mining companies’ activity in the gold lending market. Skeptics believe that this could be a contrarian signal for the gold market and that the lack of accelerated buying from the miners closing their hedgebooks will remove one of the key supports under the physical flows. Arguably, net de-hedging did help to provide additional demand for gold since the last quarter of 2001, or roughly since the 10-year long bull market began. Yet the hedging and de-hedging decisions are about producers’ expectations of the future demand for their product – and the environment today could not be more different from the 1990s.

The mechanics of gold hedging was simple. Producers would borrow gold today against future production expectations. This borrowed metal was sold and the proceeds were reinvested into risk free rate instruments. To close the contract, the miner had to deliver the borrowed bullion back to the lender and the risk free instruments (e.g. Treasuries) were sold. The receipts from these instruments were effectively the revenue for the mined ounces. Naturally, this only made sense when the sovereign interest rates were way above the expectations of future gold prices. Today, this feels like stone age. But it was the market reality of the roaring 1990s.

Historically, there were three reasons why gold producers’ output was partly hedged – in reverse order of importance: acquisitions, project financing and strategic revenue security. First, during the ongoing consolidation, many smaller producers were acquired by larger rivals. Although the larger players could more easily diversify their risks, small and mid-size companies often could not secure the financing without the commitment to sell the product at a predictable price. These legacies soured revenues of companies which eventually acquired Ashanti or Bema. The other type of hedges was, precisely, related to project financing. Banks could de-risk support for capital-intensive projects in frontier markets if at least part of the future cash flow was guaranteed. Yet the timing and structure of these hedges oftentimes clashed with the strategic planning of the mining companies and their treasury departments. This is because the latter engaged in the third – and much larger – form of program hedging. Since the gold price was fixed, the value of these products depended on the combination of the interest rates and gold lease rates. The former were usually fixed, the latter most often floating – at least since the new accounting standards were introduced in 2001, pruning interest in hitherto successful spot deferred contracts.

Options were also used extensively. Less abstruse than the negotiated forwards, options focused investors’ attention on the so-called “committed” and “protected” ounces. There was, supposedly, more comfort with the latter than the former. Yet the complexity of the hedgebook’s overall architecture flummoxed even sophisticated analysts. I often found that a combination of short puts and forwards was not adequately appreciated as a cost-efficient alternative to close out parts of the book. In response, miners endeavored to concentrate the market’s attention on the delta of the hedgebook, rather than committed/protected ounces. Unfortunately, this measure of the book’s near term sensitivity to gold price’s movements was dependent on too many variables (spot prices, interest rates, volatilities) for most investors to be able to project the marked-to-market value of the book.

At the antipodes of Julian Baring’s principled harangues, there was the fragmented Australian mining industry. Aussie executives did not engage in the debate about hedging. They simply did it, without much pressure from the local, somewhat isolated investor base. On the other hand, Barrick’s wiz-kids embarked on roadshows trying to educate investors about the more arcane aspects of the book, which peaked at 20m ounces in 2001. Newmont famously dipped a toe into the hedge world at all-time low gold prices. And AngloGold – whose hands were tied by the commitment to pay dividends to Anglo American Plc – had to insist on the maintenance of revenue security, and endure investors’ wrath or indifference as a result.

All of this is now a closed chapter. Barrick bit the bullet in 3Q2009, charging $5.7bn to its earnings in the process. AngloGold Ashanti has now accelerated the demise of its one hedge, at a cost of $2.7bn. Both transactions were, arguably, accretive on NAV basis. Among the majors, only Kinross still has to battle with the legacy positions inherited from Bema’s takeover.

The end to net growth of gold hedging ushered us unheralded into a new gold market in 2001. It will be worth considering whether the end of de-hedging also marks the beginning of a new era.

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7
Oct

STOPPING ‘DRANG AUS OSTEN’

   Posted by: Mr. Gold    in Uncategorized

Last night, Premier Wen Jiabao sent EU packing, rebuffing any attempts to “pressure” China over its inflexible currency policy. It is well-known that Beijing holds EU institutions in disdain, partly because Brussels does not command anything like the 7th Fleet, and partly because of Europeans’ own failure to craft a properly articulated, common foreign policy.

Yet, hubris may yet prove to be China’s undoing. Beijing’s propaganda regards international clamor over its mercantilist policies as a sort of a dark conspiracy, a view expressed already in last year’s bestseller, Song Hongbing’s “Currency Wars”. And indeed, think tanks around the world are beginning to roll out less accommodative strategies. To be effective, they may require Heinz Guderian-style skills transposed into capital markets, rather than Charles Schumer-like cheap populism. Until some solution is found to Beijing’s intransigence, gold has a ball.

This is a tough time to be optimistic about the peaceful, orderly solution to competitive devaluations and uncoordinated liquidity injections. Yet, one remains hopeful that the world’s biggest trader will blink in the face of its inability to redeploy the earned dollars into Treasuries overseas (a credible threat to this effect is one tool the developed markets have at its disposal). As Naoto Kan stated last month, there is something perverse in a global system, in which China is allowed to buy JGBs, but Japan cannot purchase Chinese Treasury bonds.

What would a coordinated approach mean for the gold market? Unlike unilateral interventions occasionally adopted by Tokyo, most multilateral efforts in support of specific currencies had lasting effects on the FX market and, by extension, on gold prices. The magnitude of these effects depended on the depth of the negative correlation between gold and trade-weighted dollar, a measure which is currently back at its strongest level since April.

The most clear-cut cases of direct influence on gold market can be traced to the hallmark agreements of the 1980s. In the year following the Plaza Accord of September 1985, dollar weakened 35% against the Yen. Eerily, gold (in dollars) strengthened by exactly the same rate. The negative DXY/gold correlation was very strong, at -0.76. The February 1987 Louvre Accord, organized to stem dollar losses, was famously unsuccessful when Germany raised interest rates. Remarkably, over the following year, the dollar lost a further 16% to the Yen, while gold gained 14.5% in dollar terms. The negative correlation between the trade-weighted dollar and gold was still strong (negative -0.47).

The effects of the interventions in the following decade were less straightforward. Between January and April 1995, Japan and US coordinated efforts to stop Yen’s strengthening. Over the following year, the dollar gained 35% to the Yen, but gold performed better than expected and remained flat, in dollar terms, at 394/oz. In fact, by early 1996, gold’s correlation to the dollar reversed and stayed in positive territory for several months. The opposite intervention in June 1998, aimed at strengthening the Yen, did send the dollar down by almost 20% over the following year. This time gold did not enjoy the party. Saddled by legacy sales from central banks, the yellow metal fell 9% over the period. Finally, the joint intervention in support of the Euro, in September 2000, helped the common currency to gain over 8% during the following 12 months. Again, gold did not benefit from this effective dollar weakening, and the correlation between the two reversed to positive by June 2001.

What are the lessons of history for the optimists who still expect Beijing to relent and enter a global debate on a more orderly currency system? First, the dollar gold price seems to shadow the dollar depreciation when the intervention is publicly known – regardless of its ultimate success. Secondly, the initial conditions count. A very strong negative correlation between dollar and gold represents a risk of (low probability, but high impact) reversals, such as those in early 2009 and in Spring 2010. This could still be good news for European and Japanese investors, but not for dollar-gold holders. Finally, assuming the correlations do hold, gold’s response in the first days after the intervention is likely to evolve into a trend over the mid-term.

Yet in the context of the collapse of Brussels-Beijing negotiations this week, a more plausible scenario today is one of partly closed capital accounts. In such a world, to keep long term yields low, central banks may need to continue or even increase the purchase of domestic Treasuries to palliate against the disappearance of Chinese demand. Maybe global capitalism needs to take this step back in order to ‘advance’ in a less disorderly fashion. How gold performs in this ocean of liquidity will depend on how successfully sterilized the interventions would be.

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