Commodities | Jun 05 2007
By Greg Peel
Gold is an enigmatic beast, for it tends to trade in nature more akin to a currency than a commodity, despite simply being a metal. Traditionally gold is a hedge against global inflation, and trades in an inverse relationship to the US dollar. It also traditionally trades on a positive correlation with oil, but a negative correlation with equities. And when all said and done, it is considered a hedge against global tensions and disasters. Despite these relationships however, gold is still a commodity and thus subject to the demand/supply dynamic. In the last few years it has also be opened up as a direct investment instrument.
In the last couple of years, gold hasn’t necessarily been reading the script. For example, the extraordinary rally to US$725/oz in late 2005/early 2006 occurred despite a rally in the US dollar during the period. And recently gold has found strength despite a bull market in global equities, but fell when China fell in February. Gold’s traditional relationships have started to break down, at least in a wider picture.
One inherent problem is the US dollar/inflation conundrum. If inflation rises in the US, then gold should rise, but if rising inflation leads to a rise in interest rates then the US dollar is revalued and the gold price should fall. It stands to reason that gold must have its own, grander-scale direction. One overriding consideration is where does one turn to in a “flight to safety”? Traditional gold, or the more recently preferred global reserve currency – the US dollar? As central banks and governments around the world look to diversify away from an imbalance of US dollar investment, gold is regaining favour as a safe house. But as the Chinese stock market correction in February showed, it’s not necessarily that safe, and the US dollar still looks comforting at the end of the day.
While considering such riddles, it’s easy to forget that gold must be dug out of the ground and that some 70% of it ends up as jewellery. One can argue until one’s blue in the face that the gold price should rally on a weak US dollar, but someone still has to buy it. Financial investors have so far shown that alone they do not to have sufficient clout to overcome the price elasticity of jewellery demand. A lot of that demand comes from middle class Indians and Chinese, and they are not immune to price. If it’s just too much then it’s just too much. When gold formed a bubble in ’05-06 it was new-investor driven – jewellery buyers hit the sidelines. This meant there was a vacuum underneath the blow-off top and that vacuum very quickly had its effect.
Evaluating the direction of the gold price is thus an exercise in weighing up all such factors. It is beholden upon analysts to give this a go, and with that in mind both Macquarie and National Australia Bank have released reports this week culminating in gold price forecasts. Both are bullish in the shorter term.
Macquarie recently updated its gold price forecasts. Most interesting are the analysts assumptions for the average price over each of the next three fourth quarters. That is, Macquarie is factoring in a gold price of US$700/oz in 4Q07, US$745/oz in 4Q08 and US$635/oz in 4Q09. The analysts’ long term gold price is US$500/oz.
The first point to take into consideration is that a long term forecast is a means of valuing a gold stock and not a prediction of the gold price in the future. In other words, Macquarie doesn’t necessarily see a return to US$500/oz in the longer term, it is simply a “reversion to the mean” construct for time so far away that no one could ever predict just what might happen in the meantime. Gold miners estimate the “life” of a particular mine, referring to just how long they can keep pulling out gold until the mine dries up. If this estimation is ten years, then a gold stock analyst must ascribe a value to each of those those ten years of production. If a flat line gold price assumption was used (ie spot as it is now) then the resultant discounted valuation of 2017 gold would result in a stock price valuation today that is a multiple higher than it is currently and not realistic on a time uncertainty basis. Thus the standard procedure is to set a long tem price at the ten-year price average, or perhaps at an extrapolation of the ten year mean price trend, or something similar.
It also follows that at some point, if consecutive yearly forecasts rise initially, they must then turn down in order to tend to the long term price. Hence Macquarie, for example, has no specific demand/supply basis behind its US$635/oz forecast in 4Q09 – the price just has to start heading towards US$500/oz, which incidentally it hits by 4Q12 on the analysts’ price curve. They also make the comment that “we see the balance of risks is to the upside of our long term forecast”.
Macquarie’s bullish short term forecasts are, however, based on what the analysts suggest are “incrementally more positive data points”. The story for gold is not equivalent to that of base metals (another bullish story for Macquarie) because China is not consuming gold in the same consumable fashion. However, the macroeconomic environment and gold’s supply/demand fundamentals are nevertheless supportive of the gold price in the near term.
The world’s gold supply is not growing. This is not necessarily a function, at present, of there being no more gold left to find, but a function of the increasing cost of gold production. Every mining operation in the world is suffering from the same cost pressures. The China story caught the world by surprise and now there’s not enough mining experts, not enough labour, not enough energy, not enough water, and not enough equipment to go around. Gold miners are struggling to build new projects on time and on budget. And while everyone is in the same boat, gold has suffered more so as runaway base metal and bulk commodity prices have sparked an exploration/development rush in those commodities leaving it hard to find anyone to form a gold production team.
At present, notes Macquarie, new gold mines are only replacing depleting overall production. There is no growth.
Another positive factor is the reduction of central bank selling. While the gold market has been spooked recently by a rush of such selling in ominous amounts, the fact remains that last year the Washington Agreement banks sold less than 400t of their 500t quota and it still appears 2007 will again see a shortfall. Central banks can’t keep on selling gold forever, and Spain, for example, has this year sold some 25% of its reserves. The UK sold 50% of its reserves in 1999. There is still a vast amount of gold held at Fort Knox, but something has to give currencies their value.
Macquarie also surmises that there is a limit to how much gold will be sold in a “post 9/11 world”. Gold was aggressively short sold in the 1990s and this led to historically low prices, but a combination of geopolitical risks, turmoil in the Middle East, oil shock fears and general inflationary worries have conspired to render gold something one doesn’t want to be short in. Net investor positions on the Comex futures exchange remain long, the analysts note, if not at historical highs.
Gold producers have also undertaken a process of “dehedging”, the extent of which has surprised Macquarie and other analysts. Gold hedging, usually in the form of forward sales, has long been used to (a) finance project development and (b) provide a floor price for gold receipts. While a sensible practice from a risk management point of view, gold hedging in the 90s had descended into farce as gold producers became speculators rather than hedgers, forward selling more than they might be able to deliver on, and subsequently coming undone. Sons of Gwalia is one such example, Croesus another.
Dehedging involves delivering into contract arrangements rather than rolling them over, which was often the case previously, and even buying back contracts to clear the slate. This effectively makes gold producers either buyers or not-sellers, both of which are positive for the gold price. Gold Fields calculates gold hedging peaked at the end of 1999 at nearly 3000t. This year Barrick and Lihir Gold (LHG) alone have bought back 125t of obligations.
Aside from the negative ramifications of hedge blow-ups such as Sons of, gold producers have been heartened that over the past few years the gold price has begun to rise after a long time in the doldrums. With bullish sentiment behind them, producers are electing not to hedge as it simply places a cap on their potential sale prices. As most hedging contracts were made several years into the distance, it is taking a while for these contracts to roll off. That is why some companies are electing to clear the slate – it frees up their share prices to be more closely leveraged to the spot gold price.
Finally Macquarie has focused on continuing US dollar depreciation, particularly against Asian currencies, given relatively slower US economic growth and interest rate differentials. The analysts also forecast a mid-2008 price of US$1.40 to the euro, which implies, they calculate, a gold price of US$715-765 based on gold’s inverse relationship.
National Australia Bank forecasts gold to average US$675/oz in 2007 and US$725/oz in 2008.
NAB notes that the mining strike in Peru was the fillip for gold’s assault on US$700/oz in April but May saw a pullback as the strike was resolved. It must also be noted that each time gold has approached that figure lately it has encountered a virtual wall of selling, mostly from the so-called “bullion banks”. The last time it happened the market was so sure it would break through this time that it got itself very long. We have since tested US$650/oz but appear to have recovered.
NAB notes that it has been gold’s recent relative lack of volatility that has encouraged demand in “price sensitive markets” – being the jewellery markets. While gold traders may find the constant bouncing around in the US$650-700/oz range volatile enough, the truth is we’ve seen nothing like the extraordinary bubble rally and bust of 2006, when jewellers were forced onto the sidelines.
Absolute price is not as important to the jewellery maker as is price stability. For jewellery makers (and coin producers) have to buy their gold ahead, spend time fashioning the metal, and ship it out for sales to Indian or Chinese buyers during wedding or other cultural seasons, or to Middle East magnates waving petrodollars. The jeweller will always sell a piece, but he can’t afford to take a hit on the gold price fluctuation between raw material purchase and product sale. Therefore volatility is the enemy of the jeweller. For the buyer, a higher price usually means a lesser trinket is purchased rather than no trinket. Hence while jewellery sales during price hikes have always been lower by tonne, they’ve always been higher by dollar value. But it has been noticed that the threshold of pain price for traditional jewellery buyers has been ratcheting up over the last few years, forming a floor price underneath spot. Each time gold settles at a higher average, the jewellery buyer returns.
NAB notes that end-user gold consumption fell in 2006 by 9.3%, but that jewellery demand (about two-thirds of end use) fell by 16%. By contrast, global consumption increased by 4.3% in the March quarter 2007, year on year. The bulk of this represents a pick up in jewellery demand from the last quarter ’06 and into the first quarter ’07. Strong economic growth in China and India and strong petroleum revenues in the Middle East have supported consumption growth. The Chinese government has assisted by liberalising the local gold investment market which has led to a strong leap in gold bar hoarding.
The close inverse correlation gold has usually exhibited with the US dollar/euro price has broken over the last two years. However, as the rate of growth of the gold price has slowed, traditional jewellery, bar and coin investment has grown but direct investment in products such as exchange traded funds has slowed. ETF investment inflows were down 68% year on year in March. This is not so surprising, as the introduction of such instruments itself fuelled gold’s popularity as an investment vehicle. The rush was on, and that culminated in the bubble of May 2006. A lot of those investors were greenhorn, first-time buyers. A lot did not come back. However, if gold heads above US$700/oz once more, ETF investment may well prove popular again.
NAB agrees with Macquarie with regards to the increasing cost of gold production. Global gold production fell last year, due mostly to the ongoing contraction of one of the world’s most significant gold suppliers – South Africa. South African production is expected to maintain its downward trend in 2007, but increased production in Australia, the US and Latin America is forecast to offset, resulting in a modest 1.1% gain to around 2500t. In Australia’s case, the 2007 increase should come from some new projects, but also in comparison to production lost last year due to cyclones. Unless, of course, we get more cyclones.
NAB also makes note of accelerated gold dehedging and of reduced central bank sales. The analysts also suggest gold demand will be more a factor of investment in 2007, rather than a correlation with exchange and interest rate movements. They are also standing firm on their belief that the Fed will cut rates, even twice, before the end of the year. Market consensus has tended to the contrary recently but NAB still believes the US housing and labour markets will remain weak.
UBS analysts, in contrast to Macquarie and NAB, put out a report in the US last week entitled “Has gold lost its lustre?”. The argument put forward is based on the fact that gold has rallied along with equity markets, bucking tradition, and appears to have not only decoupled from the US dollar but from the oil price as well (gold has not followed oil up in its recent run above US$60/bbl, however, it has tried to, and met staunch resistance above US$690/oz). In the meantime, gold stocks have underperformed the bullion price.
Gold is meant to be a portfolio hedge, but it is not performing as one. But then to make matters worse, gold stocks are not following bullion as it rises. UBS thus asks, is it worth holding gold stocks?
UBS analysts in Australia are quick to point out that Australian bullion stocks have not suffered such underperformance. The question of underperforming stocks also has to be considered in the context of other resource investments – such as base metal stocks and bulk commodity stocks. These stocks are hot, and until gold can break US$700/oz, gold stocks are not. If gold does break US$700/oz, then it may become a different story. Macquarie and NAB forecasts are fairly conservative, given that there are others who see US$850/oz (the previous high set in 1980) being breached any time soon as well.
But to do so in a short space of time would rely on a lot of ETF-style investment interest, as jewellery demand would once again recede on price volatility. Those predicting such dizzy heights do so on a presumption of a continuing decline in the US dollar. While gold has supposedly decoupled from its relationship with the dollar, such a decline is a necessary element in gold’s next significant move forward.
