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A New Paradigm For The Old Economy

by John Hathaway

The recent surge in natural gas prices signals an important change in the economic outlook. The paradigms that fueled the market mania during the Clinton years must be thoroughly re-examined. They include the perpetually strong dollar, the myth of the goldilocks economy, the faith in central bankers to manage that economy, and especially faith in the Alan Greenspan Fed.

Chronic under investment in the resource and basic commodity sector coincided with excessive investment in technology, media and telecommunications. Both conditions will take many years to correct. Investors looking for attractive returns in the winners of the past five years will be sorely disappointed. Manic excesses take decades to unwind, as was the case for the hard asset boom fostered in the 1970's. In the frenzy of an investment bubble, mistakes are made that take years to discover and even more to work out. The new economy is a bust, and will stay busted for the investment time horizons of most. The real excitement will be in the revival of the old economy.

The explosion in natural gas prices is a precursor for physical resources in general, including gold. For many years, it was evident that North American natural gas reserves were running down. Declining reserve to production ratios, accelerating field decline rates, and dwindling investment were just a few among many signs of an impending crisis. Despite these warnings, natural gas consumers abandoned secure long-term purchase arrangements that would have incentivized gas producers to increase exploration. Even though persuasive arguments to the contrary were well understood by producers and consumers, they behaved as if a glut of natural gas would persist indefinitely. Utilities, pipelines and industrial users increased their reliance on the spot market, even for deliveries of predictable, long-term base load requirements. Producers were intimidated by the bearish psychology of the market and skewed exploration investments towards quick payback drilling programs that would accelerate cash flow at the expense of reserve life.

The entire independent power producing industry is premised on the assumption that natural gas will remain plentiful and cheap. The billions that have been invested in gas-powered turbines will cause a permanent increase in natural gas demand of more than 10%. Despite record drilling activity, North American gas production is still languishing. Natural gas production is unlikely to increase before 2007, at the earliest, when frontier areas such as Canada's MacKenzie Delta can be brought to market through pipelines that are still on the drawing board.

Is the natural gas example just an isolated incident, a freak occurrence, or a case of bad luck? On the contrary, it is among the first and most visible outcroppings of systemic miscalculation fostered by the myth of a "goldilocks" economy. The result of these errors, built upon ignorant and shortsighted behavior by consumers, producers, and investment bankers, is an imbalance between supply and demand that can be resolved only by substantial and permanent price increases. Initially, these developments will be viewed as isolated and abnormal. Denial of reality is already evident among those caught on the wrong side of the natural gas trade, and there is much wishful thinking for a return to "normalcy".

At a recent New York investors meeting, senior management of a blue chip utility and a major player in the construction of new power generating capacity fueled by natural gas, admitted to being puzzled as to why natural gas supplies had not increased given record drilling activity. Management's take was that it was just a matter of "slow connections" to new supplies. They appear to be totally unaware of the poor prospects for incremental gas supplies over the next six years.

Today's price deck in natural gas represents the new reality. The new paradigm for the old economy is: prolonged under investment in new capacity together with profligate consumption of scarce resources will trigger substantial price increases. High prices will "crowd out" traditional users until new supply is attracted.

The recent sharp increase in the price of palladium illustrates the new paradigm. Palladium prices have increased from around $150/oz. ten years ago to nearly $850/oz. today. How did this happen? In the early 1990's, proposed new clean air standards meant that automotive manufacturers would need to install catalytic converters to remove emissions from the exhaust. At the time, a choice between platinum and palladium existed, since both provide similar catalytic properties. Because the price of palladium in the early '90's was substantially less than platinum, designers of the new catalytic converters chose palladium. Palladium was cheap compared to platinum because disposal of Russian palladium stockpiles accounted for one third of annual supply. With their newly capitalist economy in a shambles, the Russians were prone to sell anything that wasn't nailed to the floor to generate foreign exchange. What the manufacturers of catalytic converters failed to anticipate was a reversal in fortune for the Russian economy. That change was caused by a rise in the price of oil and other commodities that substantially improved Russia's balance of trade. The palladium stockpiles are no longer in weak hands. If they still exist, (the amount is a state secret,) the Russians have figured out that by withholding material they can maximize prices.

Imbalances similar to natural gas and palladium exist in virtually every natural resource and basic material sector. The current generation of senior management in base metals, paper, oil and gas, and other basic industry owes its ascendance to avoidance of the principal error of the generation it replaced: over investment in new capacity. The previous generation, whose heyday was in the 1970's and early 1980's, earned their stripes by persuading their investor constituencies to spend heavily on growth. The ever-present unwritten assumption was that higher product prices would always bail out shareholders and lenders. After years of poor returns on capital, the race to build was overtaken by a race to rationalize capacity in the 1990's. Current leadership flouts a penny-pinching mentality. Pricing expectations are conservative, if not skewed by bearishness. Cost cutting, rationalization, merger activity, and focus on returns to shareholders have wiped out the "bigger is better" posture.

This change in attitudes and behavior is not a sudden development. One set of miscalculations has replaced another. What originally made good sense as a remedy to the previous mistakes has become irrational because it has been overdone. The current generation of management is conditioned to distrust higher product prices. Major international oil companies, such as Shell and BP Amoco, are still using long term assumptions of oil prices in the low to mid 'teens for planning new investments, even though oil prices continue to hover at twice those levels. Paper industry executives are taking expensive downtime during periods of economic weakness to maintain prices. There has been no significant capacity expansion for years and there is none in the planning stage. Only a few will realize initially that higher prices represent a secular change rather than a cyclical or abnormal development, and that the real opportunities lie in growth and expansion rather than pinching pennies.

Chronic under investment in resources in recent years is explained only partly by the composition of senior management and the evolution of corporate strategy. Their thinking has been profoundly shaped by the over valuation of the US dollar. The over valued dollar created the illusion that the supply of cheap goods and services from abroad would keep a perpetual lid on pricing power of domestic producers. The record balance of trade deficit contributed significantly to the under investment in the resource and basic materials sector by creating a rationale for inadequate pricing.

Should the willingness of foreigners to hold US dollar assets turn to distaste, capital flows will reverse and the dollar will depreciate. When this happens, the idea of outsourcing production to Latin America and Asia for re-export to the U.S. will make the California energy crisis seem innocuous. The dollar price of all commodities will rise. Previously cheap exports will become expensive, disrupting production flows and profit margins. According to Bridgewater Daily Observations, net foreign ownership of the US economy is $1.7 trillion, or 18% of GDP. Foreigners hold 44% of the liquid treasury market, and 20% of the US corporate bond market. Bridgewater states: "Capital flows have been driving the dollar and the dollar is driving the trade deficit." This virtuous circle only needs a change of perceptions to turn vicious. According to Bridgewater, "Over the past two years, more than 40% of foreign corporate acquisitions have been tech companies. Most of these were telecom companies, and these have been the big losers."

Goldman Sachs, and its commodity subsidiary, J Aaron, has been at the epicenter of California's energy crisis. According to the 1/26/01 NY Times, the same advisor who profited from brokering the sale of electrical plant generating capacity to the upstart independent power producers they also financed, is also supplying 10% of Pacific Gas & Electric's natural gas. According to the Times, "Goldman Sachs has perhaps the greatest interest in how the power crisis is resolved." However, the firm was "still assessing whether its various banking relationships would cause so many conflicts that it could not accept a role in advising the state." Coincidentally, Robert Rubin of Citigroup, former Treasury secretary and former Goldman Sachs partner, "is advising Gov. Gray Davis on strategies for dealing with the state's energy crisis." Citigroup stated that Rubin was "acting as a private citizen, not in his corporate capacity", notwithstanding the fact that "the Salomon Smith Barney unit of Citigroup has been a frequent adviser in deals between utilities and power companies."

A follow up article (2/11/01) "How California Fell Prey To Power Sellers" concludes with an interview with a Mr. McIntosh, a scheduling director at a California power agency and a 29-year veteran of the regulated electricity world. He recalled being "interviewed by a group of out-of-state energy companies at a Colorado resort five years ago for a 'pick-your-brain' conference on how deregulation would work." He goes on to say "they had a group of M.B.A. types out there that were already figuring out how they were going to make money in the California market." In a subsequent memo to his bosses at Pacific Gas and Electric, he said "these guys are going to eat our lunch and the rest of California's."

California's electric dilemma is not dissimilar to Ashanti Goldfield's difficulties of late 1999. Ashanti Goldfields, a gold producer based in Ghana, was placed in a precarious position by its investment bankers and commodity traders as the result of over reaching on its balance sheet and its gold hedging portfolio. The company survived, only barely, after yearlong sessions of workout meetings with its creditors, who included the Goldman Sachs and J. Aaron. The investment firm appears to have displayed a disregard for the best interests of its clients. Surely these highly intelligent bankers were capable of sensing the potential jeopardy to their clients arising from their elaborate schemes. However, sound judgment and common sense have slim survival chances in a competitive, transactions oriented environment that rewards sales skills used to manipulate intellectually undermatched clients.

What is revealing is not the fact that a particular firm figured prominently in these two incidents. More striking is the unstated assumption that the bankers are smarter than the market. Through the use of derivatives, bankers have been able to impose their erroneous judgments, bad advice, and unworkable schemes on financial and physical markets to a greater extent and for more sustained periods than at any time in history. Derivatives enable financial institutions to intervene in any market by blurring historical distinctions of geography and specificity that had made, for example, the price of gold, the price of wool, and the price of bond futures independent and non correlated. With derivatives, the distinctions between various markets have ceased to exist. Separate markets are "all points on a continuum of risk, stitched together by derivatives." (from "When Genius Failed", the story of Long Term Capital Management) Investment and commercial banks have come to resemble closed end hedge funds. "Proprietary trading" is another name for leveraged bets on market outcomes. Aberrations of valuation, such as the NASDAQ mania, are the financial market expression of the viewpoints and emotions of those able to employ and activate the vast leverage of derivative instruments.

There was a time when banks would get into trouble almost exclusively by making bad loans. Once discovered, provisions were taken for the appropriate impairment. In the world of derivatives, there is little accountability. The potential for pouring fresh money into a bad bet is almost unlimited. "Proprietary positions" are not disclosed, and worse, they are probably not even understood by high level management. It is not surprising that the derivatives community is strenuously resisting new FASB accounting standards calling for more disclosure. In their present obscure and inaccessible status, derivatives are the perfect tool for the solidification and institutionalization of bad thinking.

The collapse of Long Term Capital thoroughly discredited the financial theories underpinning derivatives. Notwithstanding that debacle, derivatives continue to grow in popularity because trading in them is still regarded as a highly profitable activity. At the end of 1996, according to the Financial Times (FT.com), no derivatives were held in the US banking system based on figures reported by the Office of the Comptroller of the Currency. At year end 1997, the figure stood at $55 billion. By last September, the figure was $379 billion, a seven-fold increase.

The lesson in natural gas is that outcomes in physical markets cannot be manipulated according to the views of traders and bankers whose principal realities are mathematical models and trading screens. The similarities between natural gas and gold are powerful. Derivatives traders and bankers have subjected both markets to heavy doses of intervention. The scheme to deregulate the utility sector was cooked up by investment bankers. It was premised, in part, on the view that natural gas would remain cheap indefinitely. Derivative trading in natural gas was an important aspect of deregulation. It is hard to believe that natural gas derivative bets would have taken a bullish view of future prices. Forward sales by producers coaxed out by bearish derivatives traders provided the raw material to short the gas market. While the pattern is similar to gold, natural gas inventories and supplies from forward sales commitments were comparatively small in relation to physical market demand. For this reason, market realities have affected natural gas prices far sooner than gold.

As for gold, every market participant knows that there is a very large imbalance of supply and demand for the metal, filled only by the selling and lending of central bank reserves. It is no secret that if official sector behavior were to change, the gold price would skyrocket. Still, producers, bullion dealers, and speculators cannot short gold fast enough and behave as if nothing will ever change. Gold represents another screw up waiting in the wings for the derivatives business. Negative market sentiment for gold could not be stronger. Recent articles in Barron's Commodity Corner (2/12/01) and The Financial Times "Lex" column (2/11/01) are typical of the sort associated with turning points. According to Lex, "Gold has become a marginalized currency that is still in search of a new -- and probably much lower -- fair value." The certainty exuded in these two articles approximates the maximum complacency comparable to the Nasdaq top and should alert all contrarians.

A declining gold price is pivotal for the goldilocks myth because it signifies no inflation worries. But what if the masters of the universe, so confident of their outlook, have been jumping the gun by manipulating the gold price lower? In this case, gold could have been sending out false signals as a discounting mechanism. The year to date (2/22/01) decline in gold prices has been generated by increased short selling, which now stands at the highest level on record relative to the open interest, based on CFTC numbers.

Most curious that the first PPI and CPI reports of during the new Bush administration were shocking to the low inflation camp. Is it possible that the financial markets orientation of the Clinton administration and Rubin treasury in some way influenced the Bureau of Labor Statistics to tweak previous inflation reports through seasonal interventions or hedonic adjustments to paint a pretty picture for the financial markets? It is not hard to believe based on the ethical standards of that administration.

The recent acceleration of hedging by Barrick, Anglogold, and Harmony must be welcome news to bullion banks starved by low volatility and the previous moratorium on expanded hedging by major producers. Barrick has expanded its hedging despite the fact that Pascua, one of its growth projects has been shelved by low gold prices. Still, Barrick carries the Pascua ounces as reserves and has hedged them according to its customary practices even though they have said that these ounces cannot be economically produced in this low price environment. Both Anglo's and Barricks hedge books of 15mm ounces have a "mark to market" that is barely positive, despite depressed gold prices. Anglo has locked in prices for half of its production over the next five years that equate to poor or even negative rates of return on reserves they have acquired in recent years outside of South Africa. It is difficult to reconcile the acquisition of new mining reserves by both companies at total costs (including an allowance for cost of capital) that are well above forward prices they are receiving through hedging at depressed prices. As we noted in The Folly of Hedging, it makes no sense to sell ounces at less than their acquisition cost.

Harmony was required to hedge by bankers financing its recent acquisition of marginal assets from Anglogold, and no doubt believes it can do better with the properties than its previous owner. The Harmony hedge is in the form of a put, and will not prevent the company from benefiting from higher gold prices. In fact, all three companies will benefit from higher gold prices, because the bullion dealers are willing to take the chance that this will not materialize. Anglogold's mark to market goes negative very likely in the $290 area. Bullion dealers have a major vested interest in low gold prices and would be the biggest losers if gold prices break out and stay at high levels, following the natural gas pattern.

As with natural gas, the resource is being squandered. Instead of focusing on monetary issues, the industry and the World Gold Council is promoting gold as jewelry. Monetary reserve assets are being dissipated as trinkets for mass consumption.

Central bankers will not sell and/or lend gold indefinitely. Real interest rates, the principal hurdle for gold, are declining. A weak stock market and economy promise to push real interest rates into negative territory at the same time commodity prices break out to unprecedented levels. Political pressure will influence central bankers to validate high prices with ever-faster money creation. As stagflation returns, central bankers will shift in herd like fashion from gold sellers into gold hoarders. They will realize, too late in the game, that their extensive gold lending operations were ill advised. Low prices have eviscerated the gold mining industry. Few producers are generating profits and exploration budgets continue to shrink. Production will begin to decline within the next two years, and precipitously within four. Even substantially higher prices will not increase supply for several years. As with gas, substantial new supply is years away. Chalk up a big loss for the derivatives players. If the natural gas price can spike from $1.50/mcf to nearly $11 in two years, and then settle out at more than $5.00, surely a four digit gold price in US dollars seems plausible.

by John Hathaway / Tocqueville Asset Management L.P.
February 27, 2001

Copyright © 2001 by John Hathaway and Tocqueville Asset Management L.P. All Rights Reserved.


This commentary is not an advertisement or solicitation to subscribe to the Tocqueville Gold Fund, which may only be made by prospectus. To receive a free prospectus, which contains more information on management fees and other expenses, call (800) 697-FUND (3863). Read it carefully before you invest or send money. The Gold Fund is subject to the special risks associated with investing in gold and other precious metals, including: the price of gold/precious metals may be subject to wide fluctuation; the market for gold /precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. In addition, there are special risks associated with investing in foreign securities, including: the value of foreign currencies may decline relative to the US dollar; a foreign government may expropriate the Fund's assets; and political, social or economic instability in a foreign county in which the Fund invests may cause the value of the Fund's investments to decline.

Reprinted by USAGOLD with permission of John Hathaway. No further reproduction without permission.

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