What Value Gold
Written by Tony Gray   
Tuesday, 15 December 2009 14:43

What Value Gold?

Attending a self managed superannuation fund conference in Adelaide in March 2009, a gold dealing group sponsoring one of the sessions claimed that every portfolio should have at least 10% gold. The disbelief in the auditorium was audible – and I include myself in the immediate reaction. No financial planners or accountants I knew were advocating gold. And yet gold has been the longest serving store of wealth for mankind. It was only after 1971 that the US dropped the gold standard and since then the price has been set by supply and demand. Gold has a number of industrial uses and there is of course jewellery making. The largest reserves are held as a store of wealth – especially by central banks.

Mine supply has been inadequate to meet demand for decades and production has been in decline since peaking in 2000 – despite a rising gold price. All of the politically stable major producers are producing less gold as time passes – South Africa, the United Stated and Australia. South African production has been steadily declining for 40 years and yet output still equals the rest of Africa combined.

The World Gold Council estimate global mine supply at 2,500 tonnes per annum and demand at more than 3,500 tonnes per annum – the gap being met through the sale of existing gold from reserves. It is estimated that all of the gold ever mined totals 165,000 tonnes – which fits within a cube with a length between 20 and 21 metres per side!

Central banks in the developed world and especially Europe had been selling down gold reserves on a net basis since 1988 – and this supply depressed the price through the 1990’s. The depressed price resulted in an extended period of underinvestment in new exploration.

This situation has now reversed, with central banks adding to reserves on a net basis. China, India and Russia have all expanded gold reserves significantly. There is now also a new but now familiar player in the market – the exchange traded fund. Gold exchange traded funds now hold the 5th largest reserves of gold.

Demand for jewellery making has declined as the gold price has spiked, but investment demand has the potential to dramatically lift the price when combined with a declining global production profile. There is also the fact that income returns for investors in the US, Europe and Japan are very low and hence the opportunity cost of holding gold is lower.

Currency Note

Gold trades in $US, as do many of the world’s commodities. Weakness in the US economy, concerns about the structural budget deficit and rapidly escalating debt levels have been cited as a reason for the US price of gold to rise – and this is correct to an extent. In reality, it is what the international investor is prepared to pay for gold in their local currency that is important – and a weaker US economy has highlighted the attractiveness of gold as a store of wealth.

This is important for investors who might otherwise buy US treasuries as a store of wealth. A weakening US dollar reduces the value for international investors and it is not as if the income yield is terribly attractive with record low interest rates.

The Australian dollar has rallied strongly against the $US since February 2009 and at ~92 US cents is well above the circa 78 cent average since the Australian dollar became free floating in 1983. To illustrate, when the gold price recently peaked at $US 1,226 per ounce in early December 2009, in Australian dollar terms it was still 14% below the February 2009 peak (when the price of gold was $US 1,005).

Why Have Gold Exposure?

There are two key reasons why a gold exposure might be considered for portfolios:

1. Hedge

The Australian dollar price of gold rose dramatically as other growth assets fell sharply in the latter half of 2008 and early 2009. This was due to a flight to gold as a store of wealth and a weakening Australian dollar. It now seems that most traditional growth assets are more correlated – so the diversification benefits of holding property, shares and international investment has decreased.

While cash and fixed interest investments (at least in Australia) are relatively safe and should not decline in value, they will not generate growth. Having some gold exposure in a portfolio provides a hedge (protection) against poor performance by inflation hedging (growth) assets, especially if produced by an international crisis that sees a sell-off in the Australian dollar.

2. Rising Gold Price Trend

Let’s hope that we do not see a repeat of the global financial crisis, or severe after-shocks that depress asset prices and that gold does not need to serve a hedge role.

Regardless, serious doubts about the sustainability of the developed world approach of running structural budget deficits; ever increasing levels of debt (not just in absolute terms, but relative to the size of the economies); the rising risk of default and ultimately the value of paper money all contribute to a potential explosion in demand for gold. After all, for how long can investors accept ‘quantitative easing’ by the US – which is just a fancy way of saying they are printing money.

The instrument for investors to easily buy gold is also now available – through the presence of global exchange traded funds. We saw the impact of exchange traded funds, hedge funds and derivative markets on the oil price in 2008, when investor demand (not end user demand) pushed prices to a ridiculously high $US147 per barrel (compared to ~$70 presently).

We are likely to see more expenditure on gold exploration and production in response to the higher gold price, although there is going to be a sizeable time lag. Whether this can turn around the declining production profile is unknown, but the term ‘peak gold’ is now circulating.

Increased investor demand, coupled with inadequate and sluggish new mine supply is a recipe for a rising gold price.

What Type of Exposure?

Gold can be physically purchased and personally stored; although more commonly (and especially for self managed superannuation funds) it would be purchased and stored with (say) the Perth Mint. I do not really see the need to physically own gold in Australia.

A more convenient proxy for physical gold is to buy an exchange traded fund that physically stores the gold. I have attached a profile on an ASX listed ETF, trading under the code ‘GOLD’. Each unit represents 1/10th of a troy ounce of gold and is stored by HSBC in London.

The value of GOLD units rose from ~$91 in September 2008 to ~$152 per unit by February 2009 as the gold price rose and the Australian dollar (and other growth assets) fell. This is an example of the hedging role gold can play. The units are presently trading at ~$120 per unit.

There are also exchange traded funds that provide exposure to palladium, platinum or silver and one that is a composite of these precious metals (with a higher weighting to gold). The code for this latter Precious Metals basket is ETPMPM. Again, these are backed by physical holdings of the underlying metals.

A leveraged exposure to gold is available through purchasing shares in gold miners. This is since a rise in the price of gold expands profits and profit margins and should lead to a share price that rises at a faster rate than the gold price. This works in reverse also, where a falling gold price can rapidly erode profit margins. I have noted below some blue chip and speculative gold stocks.

Newcrest Mining (NCM)

Newcrest is Australia’s largest gold miner, producing some 1.6 million ounces of gold a year and targeting 2.3 million ounces by 2014. They are a low cost producer with a range of new mines or expansion of existing mines occurring every year for the next 5 years. All gold sales are unhedged, which means full upside and downside leverage to the gold price.

The company has low debt levels ($84 million at 30 June 2009 compared to expected earnings of $804 million this financial year), generates strong cash-flow and whilst it does not appear cheap on 2009 historic earnings or even 2010 forecast earnings, does look cheap on 2011 estimates.

The yield is pitiful at 0.4% unfranked – although this is forecast to be 0.8% (50% franked) by 2011. There is a price, in terms of income yield, in holding gold exposure as a hedge or for growth.

Newmont Mining (NEM)

Newmont is the second largest gold miner in the world, behind Barrick Gold. It has a secondary listing in Australia following the purchase of Normandy Mining. The company also collects sizeable royalties from precious metals production.

Newmont is a global producer, with reserves of around 85 million ounces (proven and probable reserves). We do not have research forecasts but debt levels are low and a profile report is attached.

Lihir Gold (LGL)

Lihir Gold has a patchy track record, with the main Lihir mine in PNG only becoming profitable on the recent stronger gold price. Apart from increased political (country) risk, the higher cost of production should make the share price more responsive to the gold price – that is, higher risk and return (production is unhedged). As such, I would allocate a lesser amount to Lihir Gold in comparison to Newcrest Mining or Newmont Mining.

The company is moderately priced on 2010 forecast earnings (calendar year reporting) with a nominal unfranked dividend of 1.1% expected.

Saracen Minerals (SAR)

We have viewed research from other brokers that is quite positive on Saracen’s Carosue Dam gold mine (North East of Kalgoorlie) and the associated production facility. This research is available on the www.saracen.com.au website. Gold production is expected to commence in February 2010 with as much as 100,000 to 120,000 ounces p.a. produced as a mid-cost producer (one estimate is $640 per ounce cash cost). The company’s market capitalisation is $150 million and earnings of $30 to $38 million by 2011 are possible. Mine life has already been extended to 8 years, with other exploration or development expected to add a further 3 to 5 years. Gold sales are unhedged.

Hillgrove Gold (HGO)

Hillgrove Gold sold their substantial stake in Eastern Star Gas (ESG) and cash reserves at 8 December were $106.5 million against a current market capitalisation of $158 million. The company has the major Kanmantoo Copper Project near Adelaide that could be in production in early 2011, with some gold production as a by-product.

The company also has a range of prospective gold and precious metal tenements, with the Masu project on the Indonesian island of Sumba returning high assay results from preliminary trenching. We have attached a recent company presentation.

Range River Gold (RNG)

This company is highly speculative. Gold production has commenced this month at the Mt Morgans deposit. The extent of production and costs are not yet known – although the company refers to a near-term target of producing 40,000 ounces of gold per annum for 5 years. Gold sales are unhedged.

A key asset is Owen Hegarty, a director with an impressive track record of getting things done when he was in charge of Oxiana (he left when the firm merged with Zinifex to form Oz Minerals).

Warning: The above commentary on gold and reference to specific stocks should be considered general advice that may not suit your personal goals or position.


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