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by Professor von Braun
November 2nd, 2000
Certainly since early in 1997 owning shares in gold mining companies has been an unprofitable exercise. Even at today's price levels I still read comments that suggest these shares are a "good" buy, that the gold price is going to explode, that mining companies are a good hedge against inflation and so on. But are they? Or is the worst yet to come? Will a good buy become a goodbye?
Not so long ago it was relatively easy to understand a gold mining company. One could look at its cost of production, reserves, additional prospects, cash flow, profitability and location. Reading annual and quarterly reports gave one a realistic picture of the company. Mining analysts employed by brokerage houses on average kept up with additional potential and advised their clients accordingly.
Now things have changed. Really changed. The complexities of the paper gold market have spread to mining companies and even before one invests in a gold producer the criteria required to make an accurate assessment of a companies prospects has grown.
The first question that needs to be asked is "does the gold price have further to fall?" Given the complexities of this market, the widespread use of derivatives, the amount of paper gold, the inability of demand to affect price and further central bank sales, it is perhaps prudent to assume that the worst is not over yet.
Also worth keeping in mind is that bear markets don't end with a whimper. The final move down usually bankrupts the remaining players, the last of those still playing the long side. We have not seen this yet, although we are getting close.
The second question that needs to be asked is "are you buying a mining company or a hedge fund?" What happened to Ashanti and Cambior last October was an early warning signal about the perils of hedging and the negative effect it can have on shareholders, by virtue of a collapsing share price. Since that time we have had the usual ridiculous press releases coming from some mining companies that are supposed to inform the shareholders, but are really not other than a response to the times. Of course a CEO is going to say--after being asked 5000 times--that the company is reducing its hedge book, or will stop selling forward from now on, or has covered its shorts.
The bottom line is that they can't. Any company that has a hedge position is involved in the derivatives business. They can no longer deliver into these positions with additional gold other than what they produce than they can continue to high grade their respective deposits without incurring increased costs.
The idea of a mining company buying gold on market to eliminate a forward sales position is, with a few notable minor exceptions, a myth. The physical gold required is simply not available. A concerted effort to cover hedges by purchasing gold would cause the price to rise and margin calls would result. Whoops! Most mining analysts know this, although little has appeared in print to date. That's apart from the fact that most mining companies don't have enough cash to facilitate this type of transaction anyway.
Unless a company's hedge book is clearly understood and the company is clearly telling the truth in terms of the extent of its position, they are best left alone.
The next question that should be asked is what is the extent of the company's debt? Some mining companies have debt levels that would have been manageable at $325 gold but are problematic at $275. In some cases they have also hedged, so if the price rises they too may face margin calls. Even the comment that they have only hedged 12 months production and are not at risk is a fallacy. All hedge books are at risk, which translates to the underlying assets being at risk. Which suggests a falling share price!
No longer is it possible to place mining companies under one umbrella either. They need to be looked at from several different factors these days. It is best to look at this industry as extremely fragmented and begin to consider a) location and b) the currency of the location.
Mining companies located in the US are most at risk from a rising US $ and a falling gold price. Companies located in South Africa are being helped by the weakness of the SA Rand, while companies in Australia should be benefiting from the weakness of the Aus $ and aren't.
The Australian gold stock index is telling us something given its failure to respond to the gold price in rising Aus $'s. Rumors about several Aus gold producers having problems with their hedge books continue to appear. They also appear to be currency-related; not only did they sell forward but they locked in the exchange rate as well, in some cases when the Aus $ was at 65 cents US. Now it is struggling to stay above 52 cents US, a 20% decline.
Mining companies that have little or no forward sales stand to benefit the most when the derivatives game ends, but they too are at risk at present. Can they survive falling gold prices? Do they have enough cash to continue subsidizing current production? Is their cash cost below $200 and what is there total cost? Don't be fooled by announcements that highlight the cash cost and don't mention the total cost. Debt costs, as do senior management and head offices. The high grading of some mines also has some analysts (the better ones) looking at the hidden costs of that activity as well. Every time rock is moved a cost has been incurred, not forgetting of course rising fuel costs either.
Companies with projects in exotic locations are also at risk. Regardless of where, should the gold price finally move up, then countries that need gold will not hesitate to nationalize existing projects if they have to. The former Soviet Union, South America and parts of Asia are not what I would call stable. Nor can a company with low cost production in one country expect to use that to offset high production costs in another. It may work for a while but at some stage, as the derivative debacle unravels concerns will be raised by political opportunists.
Generally speaking, when a bear market in any market ends the first leg up of the new bull market is missed by most investors. The remaining longs were blown away in the final leg down, the move up tends to be fairly quick, and by the time investors realize what's happening it's time for a pause. How many people were buying oil stocks when oil was at $10 per barrel?
The final leg down will not worry those with substantial hedge books, depending of course on what currency they are using, but the first leg up will...especially if gold exceeds $400. The margin call saga will take time to unfold and the damage will not be known for a while.
Yes, there is money to be made in gold stocks, but, given the uncertainty surrounding hedge books and the fact that it is not easy to extricate ones production from a forward sales position, it is perhaps better to be cautious at this late stage of a bear market.
Some Wall Street brokerage houses are, currently, even recommending gold stocks to their clients...while their bullion desks are selling the metal down. Whether they have spoken to their respective analysts or not I don't know, but I do know that the back room boys are working overtime to come up with new computer models that suggest arbitrage opportunities, mostly for their firms account. Don't be surprised if the front room is unaware of the back rooms strategy.
The Prof can be contacted by email at email@example.com
Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.
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