Untitled Document
Coins & bullion since 1973


More Faith, Still Hope and Less Charity
More ruminations on gold mine company forward-selling

by Julian Baring

Printable Version

Luncheon Speech to the
European Gold Mining Investment Forum
June 26, 1998
Geneva, Switzerland

You may recall that when I spoke to you last year, I urged all who have the welfare of the gold industry at heart, to redouble their efforts to hasten the transfer of gold out of the hands of those who didn't need it (like the gold-mining companies and the Central Banks) and into the hands of those who actually want to own it.

I suggested that this could best be achieved by all of you continuing to do whatever you were doing at the time to achieve a lower gold price. Such heresy caused a number of you to choke on whatever you were eating and seemed certain to ensure that I would not be asked to speak again! The fact that I am here, either tells you that people in the gold industry are masochists, or demonstrates -- too closely for my comfort -- that in these hard times you will endure anything for a free lunch!

The fact that the gold price is nearly $50 lower than it was when we met, is a powerful demonstration of the grim determination of all concerned to make gold more affordable. I congratulate you on this considerable achievement, made almost regardless of cost!

The 14% fall in the gold price from $344 on 10th June last year, to around $295 today, has wiped about $50 billion off the value of Central Bank gold reserves. I don't know exactly how much of their reserves are lent, but I have heard a figure of 12%. With the gold lending rate of 1.5%, they might have clawed back some $647 million in interest. Bully for them!

Mining industry profits have declined by some $3.3 billion and the market capitalisation of the gold-mining industry has been reduced by $14 bn to a mere $44 bn, less than a quarter of the market capitalisation of Coca Cola! Let no one say that those who have contributed to the cause of a lower gold price have done so without sacrifice.

Having achieved so much, I am sure that you are expecting me to proffer a more digestible message on this occasion. I regret to inform you, however, that the people who live East of Suez and who had been benefitting so greatly from your selfless behavior, encountered a little local difficulty on the financial front themselves! The Asian crisis, which was not predicted when we last met, has reduced the purchasing power of those who wanted to buy gold, by more than the gold price has fallen. To them, gold has become more expensive and they have less money with which to buy it. Some of them have even had to sell it! Others, patriotically, handed theirs over to their Governments, who did not have enough of their own when they needed it! In the circumstances it is remarkable that the gold price is not lower than the $276 it plumbed in January.

The good news this year is that there are signs that the patient will eventually be restored to health. The bad news is that to achieve this more tablets have to be taken.

So what was it I was urging everyone to continue to do last year and how have they matched up to expectations? What would an examiner's report say about the industry's performance over the past 12 months?

Apart from selling their gold at ever lower prices, Central Bankers have helped the cause greatly by continuing to lend their gold at pitifully low rates of interest to others -- mainly mining companies and speculators -- who then sell it. During the year the opportunity was taken at the World Economic Forum's conference in Davos, to introduce the CEO's of some of the world's leading gold-mining companies to some of the world's foremost Central Bank governors. They had previously never met. I am sure their meetings gave birth to a better understanding between the two major seller of gold as to the consequences of their actions. Let us hope that contact can be maintained behind the scenes, because, although you would not think so from the way they act, both parties surely have a common interest in getting the best price for their gold.

No one denies the Central Bank's right to do whatever they want with their reserves, but the wisdom of lending their gold to others who then stuff the market with it, is debatable. For years, most miners argued that forward selling did not harm the price. Fewer take that view today, but that does not stop them doing it! It enables them to go on digging, which, after all, is a miner's raison d'être!

Presumably Central Bankers also believe, if indeed they ever give it any thought, that lending gold for others to sell does no harm to the value of their gold reserves. This belief, in my opinion, has been the most important single factor in securing a lower gold price. Add to that the uncertainty created by keeping the market guessing as to their intentions regarding the ECB gold and you have to give the Central Bankers high marks, I'd say 10/10, for their contribution to the cause last year.

Next year I would be surprised if they score so highly. This time next year we will be approaching the millennium. Central Bankers may well be starting to consider the risks of having their gold lent out to the market over the year end. Not only will they be worrying about millennium bugs in their computers, but if ever there was an occasion when the enduring beauty of gold is likely to find favour with the public, it is surely as a gift to celebrate the start of the new millennium. A glimpse at the periodicals of those days will convince you that it fulfilled that role 100 year ago. And then they were only celebrating a new century! By the middle of next year we could well be witnessing the mother of all bear squeezes for the precious metal.

Many Mining Companies, believing that a bird in the hand is worth two in the bush, have continued to take advantage of the Central Banks' willingness to lend gold cheaply and to sell today what they will not produce until tomorrow. It makes one wonder how they get away with calculating their reserves and resources at a higher price than that at which they have so recently sold forward. We must presume that gold-mining companies value their reserves at $350/oz because they believe the current price to be unsustainably low. If that is the case, they should surely be buying back their forwards at current prices, rather than selling more. Another such elephant trap awaits the unwary investor in gold shares, namely the danger that during periods of currency upheaval, mining companies can so easily undo any benefits they derive from selling forward, by failing to hedge the currency correctly. If you want the gory details, ask the Australians here present.

Some, however, have encouragingly taken the view that to be short gold at these very depressed prices will be asking for trouble when the gold price rallies. They have used recent weakness in the gold price to cover their forwards, Examples of such mining companies, with leadership qualities, are Newmont, Homestake and Western Mining.

A few mining companies are beginning to question whether real value is added by bringing mines into production, simply to boost the number of ounces they produce. Some are even starting to question whether they will earn an adequate return on the money invested to produce the extra ounces at the current gold price. We are all guilty of willing the gold price to go up, but too much money has already been torched on new mining ventures, financed in the belief that they will make money at the higher gold price, which is bound to be ruling when the mine eventually comes into production. this triumph of hope over experience has resulted in investors becoming thoroughly disillusioned.

The Mining industry's contribution to making gold more affordable was a little patchy compared with the previous year. Some seem less than convinced that a low gold price is really in their best interests! If you ask executives of gold-mining companies which have sold forward heavily whether, as they spring out of bed in the morning, they hope the gold price will go up, down or stay the same, some of them find it difficult to give a coherent reply! Whatever they say, the market does not differentiate between the hedgers and the non-hedgers, because nobody knows how badly the hedgers will be caught when the market turns.

I know it is cruel to single out a company for special mention, but I cannot resist citing Ashanti as an example of how unkind the market can be, even to hedgers. Ashanti was listed in 1994 at a price of $20. At that time the gold price was $375. Ashanti put hedges in place which four years later have resulted in them receiving a price if $406/oz. Production has risen 40%, yet the share price has fallen to $8!

Let's give the gold mining industry 7/10 for their contribution to a lower gold price last year.

Conference Organisers continued to do their bit by providing a platform for producers to tell investors about their plans for expansion of production as well as reserves, if not of profits. In fairness, I do detect a slight change of emphasis in the presentations this year compared to last. Mining companies are still very shy about showing charts of their earning record or their share price performance (in case investors may not have noticed that they are not very good), but some of them are starting to talk about EVA. Whoever she is, I am keen to meet her! She sounds attractive from what I hear. I'll give conference organisers 8/10 for persistence.

Investors in gold-mining shares have suffered so greatly for the cause in the past year as to have become an endangered species -- in real danger of being wiped out! Without investors, mining companies will find it difficult to finance the "ambitious expansion plans" and "aggressive exploration programmes" they love speaking about. In the medium term, this could seriously damage the cause of making gold more affordable. Once bitten twice shy, this generation of investors will be hard to convince that they should reinvest in a sector which has treated them so harshly. They will surely insist that if they are to be persuaded to invest in gold-mining ventures, they must be persuaded that they have a reasonable chance of securing at least as good a return on capital employed in the gold-mining business at the current gold price, as is offered by other asset classes.

The body of professional gold-mining investors has become so emaciated that it can no longer be looked upon by the mining industry as a serious source of capital. The mining industry will have to look elsewhere for investors, but those investors don't know our "rules". Little do they know or care about "market cap per resource ounce" or "relative percentage premiums over assets". They will want to see a return on their money which compares favourable with what they expect to get elsewhere.

There are two ways of getting the gold price to rise. One is to increase demand, which was what last year's theme was all about. The other is to reduce supply which is what this year's effort should be about. There was not much investors could do last year about increasing demand for gold, apart from helping to finance uneconomic production. this year they can help reduce supply by insisting that the mining industry earns its cost of capital. In the interests of not hitting a man when he's down, lets give the remaining investors in this sector 6/10 for fortitude last year.

The contribution that the Brokers made last year to the cause of making gold more affordable, started well but tailed off as their clientele were blown away by the market. It must now be virtually impossible to make a living if you are a mining broker, unless you are lucky enough to have corporate business. For years the brokers were able to ignore the fact that the Emperor wore no clothes and convince their clients that gold shares offered value, just as brokers in the Japanese market used to look with pity on those who simply did not understand how Japanese shares were valued. With gold and natural resource funds in an emasculated state, it will be hard for the brokers to target the owners of gold shares, so we will give the 7/10 for their past, if not their future contribution.

Speculators against gold have had a ball which has lasted almost uninterruptedly for the past year and is still continuing. At one moment when it was thought that the European Central Bank might have more than 20% of its reserves in gold and before the onset of the latest Far East currency crisis, the speculators actually cashed in their chips and ran. But they are back, as short as ever, exaggerating the trend set by others without taking too much risk, as is their wont. It would be churlish to give them less than 10/10.

Looking back on the year, all the participants, in their various ways rose splendidly to the challenge. Much gold has passed from the hands of those who no longer think they need it, onto the necks, arms and noses of millions of Indians who, over the centuries have learned that gold looks better on them than in a vault. We must pray for their continued prosperity, uninterrupted by Asian flu or a poor Monsoon. As for the rest of Asia, we must hope for a speedy recovery in their fortunes so that they too may resume their love affair with gold.

It may not have escaped your notice that people in the West have become richer as stock markets in the western world have made lots of people feel good. The "feel good" factor affects discretionary expenditure and encourages generosity. The last thing most people think about, when they buy a bauble for their loved one, is its investment merit. As with other forms of discretionary expenditure, people buy things made of gold for fun, for beauty or to celebrate something. The richer they feel, the more they have to celebrate, so the stock market boom in the West is helping to offset the reduced demand for gold in the East.

Over and above all the things the industry did to depress the gold price in the last 12 months, the metal has had to contend with the greatest enemy of all markets -- uncertainty. When we look back at the events of the past year, I would not mind betting that the last two months of last year and the first two months of this year will turn out to be the months of the greatest uncertainty and therefore the months of the greatest downward pressure on the gold price. Things are bad now, but less uncertain than they were then.

Six months ago, it was impossible to judge the likely effect on the gold price of the financial crisis in the Far East and furthermore the market was susceptible to the wildest rumours as to the part gold would play in the reserves of the ECB. At lest we now know that in the interests of diversification, gold will comprise between 10-15% of the ECB reserves. If 10-15% is a sensible diversification for them, perhaps we should ask ourselves why most investors find no merit in holding any gold at all! We still do not know what will happen to the 12,000 tons of gold which will be left in the hands of Central Banks which comprise the ECB, but since stability is of paramount importance to the guardians of the new currency, it would be surprising if the ECB looked kindly on one of its members undermining the price of its gold reserves by disorderly selling. It is also possible that the ECB, having decided on the proportion that gold should represent of its total reserves, might buy or sell gold if the percentage actually held got too far out of line.

One last point needs making. You will recall that when forward selling became fashionable, it was explained to the shareholders that the companies were taking out an insurance policy to tide them over a period of weakness in the gold price. As time went by, more and more companies saw their forward book as a balance sheet item lending support, not to their mines but to their share price. Mines which do not cover their cash costs are either being closed or sold, rather than risk eroding the value of the forward book.

Some companies like Western Mining, as I have mentioned, closed out their forwards rather than run the risk of incurring shareholder wrath by allowing an asset then valued at more than A$300 m to be eroded by a rise in the gold price from a very low level. No one asked how many years it would have taken Western Mining to make A$300 m from mining the stuff at current prices. I am told it would have taken more than 12 years!

Perhaps Western Mining recognised that the mining industry is now so short that they could not buy back their forwards even if they wanted to. Many companies will be reluctant to see such a valuable asset in their balance sheet being eroded as the gold price rises. Their shareholders would not thank them for that.

So although things look grim at the moment I am not so pessimistic as I was a year ago. I see the seeds of better times to come. This bear market has already lasted longer than most of its predecessors and the fall in share prices have been just as severe as in the past, with the exception of the major North American producers. Most gold share investors have given up all hope by now and thrown in the sponge. The recent retreat in share prices representing the final straw for the faithful.

With mining shares you often get a second chance to buy at the bottom. The FT Gold Mines index is 4% from its year-end low, but the gold price, particularly in the Australian dollars and Rends, is well above its year-end lows due to the weakness of those currencies. Gold-mining profits, bearing in mind that cost savings will be starting to come through, will probably surprise on the upside for a change. The first few percent rise in gold shares will come from bear covering, thereafter, however unlikely it may seem now, bargain hunters will emerge from the woodwork.

I said last year that I would not recommend anyone to buy gold shares until they saw the gold-mining industry unwinding its forward positions. I said that would be as good a sign as any that the pain we are suffering is nearly over. Last year the gold miners were increasing their forward positions, but recently a few mining companies have been cashing in the profits on their forward sales. Three or four swallows do not make a summer, but at least the birds we have seen were flying in the right direction!

So now I expect you will think I have finally taken leave of my senses! But I don't really mind, because this is my Swan Song, and I would prefer to be remembered for singing the praises of gold shares after they had fallen 61% from their high, as they now have, rather than after they have risen 275% from their low and they have, on average, in the six bull markets since 1972.

Thank you so much for your attention.

This article reprinted at USAGOLD with permission.


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