Large Caps' Equity Holds Value As Gold Prices And Production Costs Rise
TWST: We spoke about a year ago, and your commodity team was looking for gold to go to $1,450 or better, and it has done that. Where do we go from here?
Mr. Beristain: The latest forecast has come off a little bit. The bank's commodity team out of London a few months ago was calling for gold to be as high as $2,000 an ounce on average for 2012. We since pared back our estimates about three months ago to $1,900, but still roughly $150 higher than where we are today and still supportive for gold equities.
I think from this point forward, given that gold tested already the $1,800 mark a few months back, it's not so much the absolute number that gold gets to from this point forward, but if investors start to form a belief that gold will at least sustain in the $1,700 to $1,900 range in the next few years - that really does change materially the outlook for these equities. I think the thought process for a lot of investors prior to the summer spike was that gold was somehow going to reach a "peak" level and then collapse. But since the collapse happened, gold has clawed its way back to the high $1,700s, and I think that's giving people some faith that perhaps we're not going to the capitulation that has been feared.
TWST: Given this background and the global economic uncertainties, why shouldn't gold come down?
Mr. Beristain: Because gold is probably the one true currency in the sense that it cannot be manipulated. What we have seen are actions on behalf of central banks that continue to view the printing of money as the solution to a lot of economies' problems out there. In fact, we recently have seen statements from the Bank of Japan that they are again going to try to manage down the relative value of the yen to the U.S. dollar as their currency's value is too strong for them to maintain export competitiveness. We've seen over the last year the drama play out in Europe over the Greek debt crisis. Again, the solution there seems to be print more euros. Obviously, in the U.S., we've already had two rounds of quantitative easing, and at this point the door remains open to more of the same. Even the Swiss franc, during the summer, there were statements by their central banker chief that he was basically going to manage or peg the relative value of the franc to the euro, which until then had actually been appreciating vis-a-vis the euro. So by basically threatening to buy as many euros as necessary to keep the Swiss franc exchange rate down, and then in turn the euro itself weakening through the summer, he accomplished his goal.
So I would say, generally speaking, that there has been an inflationary uptrend in the printing of money from major world economies. The trend is clear, most of the world's central banks are either trying to manage down the relative value of their currencies and in the case of both the U.S. and Europe, print more money to fund gaps in the country budgets and/or plug the capitalization in their banking sectors.
TWST: Is there no end in sight for this kind of response going on?
Mr. Beristain: Not for the time being. Conversely, we have not seen the response from the lenders of money to demand higher interest rates. So despite the fact that some currencies are being managed downward, investors seem to be willing to take low or even negative real interest rates. So that's a fairly supportive environment for gold - the continued financial problems that many economies have faced combined with governments printing more money or outright seeking to devalue their currencies to maintain relative competitiveness. So on that basis, gold really becomes the one true barometer of worth in the world because you can't go out and print new supplies.
TWST: Given these uncertainties, what are central banks doing at this point with their gold holdings or purchases?
Mr. Beristain: On that front, things have gone a little bit quiet through the fall, perhaps a function of recent market volatility not just in gold, but across all asset classes. Through the summer, we had seen some high-profile purchases. The central bank of Mexico had purchased 100 tons of gold in 1H11. Korea purchased 25 tons in June, and Thailand had noted it purchased 53 tons between 2010 and 2011.
Recently, some of the concern has shifted to, what if some of the central banks become sellers of gold? We have seen some hesitancy or resistance perhaps from China to ride to the rescue of Europe, so perhaps some countries that have a lot of gold, such as Italy, could be in a position to sell some of that gold to foreign creditors as a way to reduce their debt loads. I don't know if we're entering a new period here where, ironically, the harder the financial problems of some of these countries to square the government spending become, it could lead to some selling of some crown jewels, i.e., the accumulated gold that they've saved up over centuries.
TWST: But no sign of that happening yet.
Mr. Beristain: No sign. It is something, in fact, I have been reading snippets about - Germany has basically said this would not be an option. We're also not hearing any firm suggestions of that from governments in Europe, but it is a question I have received from some investors.
In the interim, we have not heard any real strong one-way remarks from further central bank purchases in the second half of the year. In the absence of that, I'd say that the central bank purchasing or selling has gone fairly quiet. I believe it would be a worrisome signal if central banks started to liquidate their gold, especially developed markets as central banks are still very large holders of the metal. However, I do think it would probably, ultimately, take the form of a transfer from central banks of overindebted nations to lending banks perhaps in less developed markets or that hold less relative gold but are long paper currencies, so indirectly a further way for them to diversify into gold. I'm not saying levered nations would necessarily sell gold through open market transactions and depress the gold price, but it would be concerning if we did start to see Greek or Italian central banks offload their gold without clear signals that this was being done in an off-market and organized way.
TWST: Do they have enough to make a difference in this big gold market?
Mr. Beristain: For example, mined world gold production annually is about 2,600 tons and demand is around 4,300 tons, the difference in demand being met by secondary supply, which is mainly the remelting of above-ground gold stocks, which could be jewelry or recycled industrial metal from electronics. A country like Italy, for example, is sitting on roughly 2,500 tons of gold reserves. So in that context, Italy's gold reserves are basically equivalent to the world's entire gold mining output for one year.
TWST: But it's not likely they're going to dump it all at one time.
Mr. Beristain: No, it's not likely, and I think that would pretty much be a sale of last resort, but it's something that has gathered too much traction. And there are many types of proposals being put forward to solve some of the leverage problems in certain countries of which this could be one.
TWST: If gold holds in this $1,700 to $1,900 range, what's that going to do to the mining industry? Is it going to provide additional stimulus?
Mr. Beristain: I think it should. Just to finish the point on the earlier question, you were asking about what have been the trends on central gold buying. The last updated data point I have is first-half data for 2011. On a first-half basis, central banks were actually net buyers of about 200 tons of gold globally and those would be some of the banks I mentioned earlier. If that trend were to hold, gold purchases by central banks could annualize toward a net 400 tons of gold in 2011. That would be pretty much the mirror image of what central banks had been doing until 2007 where they were basically net sellers of an average of around approximately 400 tons per year of gold into world markets. Our view, and what we talked about last year, was that we believe central banks would turn into a net buyer category for gold, and that has happened thus far.
TWST: Is this because of the general economic problems that they've made this shift?
Mr. Beristain: I think it's more a drive toward diversification, and it's been mainly emerging market banks that have been the buyers of this gold. Whereas if you look at the balances of their assets that they have tended to hold in the past, especially for Latin American and Asian central banks, it's generally been U.S. dollars because that was the main lender to these economies. So after the debt crisis in the 1980s and 1990s, a central bank's number one goal in those countries was to accumulate as many U.S. dollars as possible to leave foreigners comfortable with the idea that in the event of a run on a domestic currency, they would still be able to have sufficient dollars to pay off their foreign debt, which tended to be denominated in U.S. dollars. What's happened as some of these countries have diversified their international trade - Brazil is a good example - they have started to trade a lot more with China and other Asian economies than in the past. That has led them to want to own alternative currencies in their asset mix and some of them in the last few years diversified into the euro.
But now, we've seen effectively two rounds of quantitative easing in the U.S. and the second Greek debt crisis threatening currency unity. I think that is calling into question the diversification strategy of some of these emerging market central banks where they're perhaps questioning: Do they only want to own counterpart currencies as part of their asset mix or do they want to own more hard assets such as gold and other precious metals as part of their diversified assets? I think it's simply a drive toward diversification away from holding just paper currencies and holding more gold at some of these central banks.
For example, China still has a very low official ratio of gold as a percentage of its reserves, in the 2% range today, and far less than that of the U.S. or Germany that have over 70%. So it's a rebalancing away from the current stark underweighing that emerging market central banks have in relation to gold, and trying to reweigh toward higher relative gold holdings because perhaps now they are in a position to accumulate reserves and be more selective as to what instruments they choose to hold savings in. Now that they've gone through some weakness in their trading counterparty currency relative values such as the U.S. dollar and the euro, they are questioning from a pure diversification strategy: Do they want to have all their eggs in a paper currency basket?
TWST: Going to the other side of the equation, the supply side, what's this going to do to production?
Mr. Beristain: For better or for worse, production in the gold sector has been and continues to be a very long time in coming. I think that the gold industry has lagged the recovery in output growth that started in the industrial metals in the mid-2000s. You'll recall the recovery in copper really started in 2002, when it hit a bottom of about $0.70 a pound, but by 2005 was back in health, and that kind of price recovery was starting to drive the thought process of some of the copper producers to invest in new mines. Gold did not really start having a healthy recovery until the world financial crisis, following which gold prices truly started to exceed gold production costs for the entire industry. So the high gold prices have only been high enough to encourage aggressive expansion since the fourth quarter of 2009. At that point, gold crossed the $1,000-per-ounce threshold.
Through much of 2010, the gold miners went back to the drawing board to figure out what would be the new long-term gold environment for them. It wasn't until 2011, this year, and really spring of this year, that we started to see some major growth announcements from the larger companies such as Newmont, (NEM) which in May of this year came out with a new six-year growth plan to start to grow their output. And unfortunately, the lead time to build the next generation of gold mines is ultimately going to be measured in decades, not years. So much of the growth that the super majors are talking about, such as Newmont and Barrick (ABX), the main effect of that would be seen in the 2015 to 2020 period. A company like Newmont is actually treading water in terms of production for the next few years. In aggregate for the industry, we are seeing very modest potential increases in output for the next few years, measured in the very low single digits. By 2016, Newmont expects to ramp up production by about 2 million net ounces per year versus today's 5 million ounces. But that's going to be very second half loaded and post-2015 time frame.
TWST: So it's kind of a big increase for them, but not much in terms of the industry.
Mr. Beristain: What we continue to see, for example, from the industry overall, is declining production rates out of some countries like South Africa that continues to have issues with energy-supply consistency, higher wage rates, more environmental expense and an appreciating currency vis-a-vis the U.S. dollar. Australia also has been struggling to increase output.
What you have in the gold industry, unlike other mining products, is a fair amount of attrition from existing mine fleets because the average mine life for a typical large-cap miner is only 13 or 14 years. So as those mines are depleting, the existing mine fleet is running itself down. The new growth has to be sufficient to make up for a large attrition tax in order to provide net growth overall for a company or for the industry. As companies are not in the business of advertising their declining mine production, they play up their growth targets, but the truth is somewhere in between the two extremes.
At the same time, we have seen the cost of doing business in the gold sector continues to rise, unabated. We have seen continued pressure from all sides. A lot of countries have been stating they want an increasing share of royalties or taxes or currency controls. Unions have continued to ask for double-digit annual wage hikes. Suppliers see the high industry margins and negotiate generous margins on their products and services. We continue to see pressure in the form of strong currencies in countries in which gold mines operate, and additionally, energy costs tied to fuel oil and global oil prices continue to be high. So we're seeing a lot of cost inflation in the industry, which perhaps if a project looked good two or three years ago on paper, from both a unit operating cost and a capex point of view, there has been a huge escalation in the expected costs of world-scale gold mines.
Based on what I've seen, I would argue the capex for a 1 million ounce gold mine has roughly doubled in the last four years from $3 billion to $6 billion. So what's happening, even though the gold price has also roughly doubled, it's taking many of these projects back to the drawing board as they are requiring very serious sober second looks for the gold majors to take the leap. It's not necessarily a no-brainer to greenlight all of the projects that have been put out there in the last few years, given the changing cost landscape.
TWST: Even with prices where they are?
Mr. Beristain: Even with prices where they are, because as I mentioned, there have been a lot of changing variables such as rising resource nationalism, increasing taxation burdens either current or proposed, and a big change in the relative currencies where they stood a few years ago. So all of these issues are conspiring to require more review time, and additionally, to have more balance sheet strength than before given the increasing scope for execution errors in the hundreds, if not billions, of dollars. In the meantime, a high gold price has allowed the industry to accumulate cash in excess of their capex needs and dividends. So right now, they are in the process of fortifying their balance sheets before embarking on these large multiyear growth plans.
TWST: Is that going to result in more M&A activity in the space? We've seen a good deal already.
Mr. Beristain: It always depends on the relative values in the market - does it make more sense to buy or build at any given point? If you had have asked me that question a year ago, I would have said it made more sense to build than buy because you had the next generation of gold producers - juniors and explorers - trading at fairly high valuations. The markets, until recently, have taken some time to come to grips with the diminishing financing options for smaller, riskier companies. Hence, the relative value for a large company in the past would most likely have been to pursue internal growth. However, what we have seen though in the past six months or so has been a change in relative valuations. Now the gold majors, unfortunately, are trading more cheaply now than they were a year ago, but the midcap space has done proportionately worse in terms of performance. So in an environment where debt issuance and equity issuance are becoming harder, the advantage swings to the court of the established producers with fortified balance sheets. If you're a project startup company, it's a pretty tough environment right now, and the only thing that's certain is your cash burn. You will continue to have to spend money to keep developing the project, but you're not seeing any money coming in the door as you are at a preproduction stage. In an up market, that shortfall can be papered over by effectively issuing small amounts of equity because your equity is trading expensively, already pricing in some kind of an ultimate M&A takeout. Now that M&A premium to net present value has come down quite a bit, so that's making midsize companies more affordable from an M&A point of view for the large guys.
TWST: Is this price range for gold for what's called relative stability, $1,700 to $1,900? What's that going to do to the resale market for gold? Is that going to bring more metal into the marketplace?
Mr. Beristain: I think the resale value for gold is probably driven by two things. One is the absolute price of gold. And if tomorrow the price of gold is $5,000, that would probably encourage more people to seriously consider keeping grandma's heirloom jewelry. But the other factor is also the person's personal economic circumstances. So if they believe they're close to getting a job or if they're able to liquidate other assets, perhaps they're not going to be as motivated sellers. So while in absolute terms the gold price is attractive enough to encourage the liquidation of jewelry, I also think that the period of panic selling two to three years ago into gold's rally has also abated and the flows of recycled flows into gold have also stabilized.
TWST: Even at a modestly higher price probably, is it going to change that much?
Mr. Beristain: I don't think so. If anything, we're starting to have some economic recovery in North America. That might actually reduce people's willingness to sell their gold just for the sake of liquidity.
TWST: It sounds like a fairly favorable outlook for gold prices and the gold industry in general. Is that a good assumption?
Mr. Beristain: Yes. I think gold prices seem to be stabilizing at a higher plateau than people would have thought possible just a year ago. The factors which support gold's relative value vis-a-vis world currencies continue to be in place - as I mentioned, low interest rates and the printing of money from developed economies and/or the active managing down of currency values. The mining sector is just in the early stages of rising to meet incremental gold demand. So I'm not that concerned that the industry will be flooding the world with new gold supplies any time soon. From a retail point of view, I think that panic selling has subsided too.
A key issue remains that ETF demand has waned for gold and ETFs in aggregate hold roughly half as much gold as world central banks. So if you saw a loss of faith in gold investors at a retail ETF level, for example, if there were better perceived relative investments to be had such as stocks, bonds or real estate, that could pressure world gold prices. Under such a scenario, less people would seek to hold gold ETFs, and in turn the ETFs would become net sellers of gold instead of the net buyers of gold that they've been in the last decade. It is definitely a risk, but one that is hard to forecast.
In the current environment, investors seem more concerned with preservation of capital since the world financial crisis and the perceived opportunity cost of the next best investment is low. If, however, you get an environment where equities perform steadily, volatility drops and equities start yielding a more normalized equity return of 6% or 7% per year and you have a normalization of interest rates, then the relative opportunity cost of holding gold, especially in a flattening gold environment, goes up. That's why, at present, gold equities become a more relative attractive investment than just straight gold because you have the combination of earnings that are leveraged to a further bump in the gold price and the potential to share in expected production growth, and you're getting paid a rising dividend.
There is a rising change of culture of gold producers to returning cash to shareholders. Dividend policies, not only in the gold sector, but generally in the mining sector, have become quite prevalent, a sort of sea change in the attitude of a lot of the miners. Some of them have come up with creative ways to tack the dividend payment to some change in their underlying metal price as Newmont has done. They've gotten a fair amount of press for linking their dividend policy to the price of gold. Hence, you should be able to obtain a gold-plus return by holding a gold equity, first, from the financial leverage to the price of the metal. Secondly, the expected earnings trend of the company should help these equities now that they've come out with well-defined medium-term growth plans, which should engage investors in the belief that these companies are effectively morphing into growth stocks again. Thirdly, you've got the enhancement from a dividend yield, which is ranging between 1% and 3% in the space right now.
TWST: Are investors getting on board?
Mr. Beristain: I think we've seen a good uptick in interest from investors in the space. I don't think we are at full bullish levels because there's still a fair amount of doubt in the investment community as to number one, do they want to own gold, which by some portfolio managers is simply viewed as a currency bet and not viewed as a legitimate asset class. But if you overcome that, then there is the question of, do they own gold or do they own gold equities? And still to this date, unfortunately, owning gold equities has not outperformed gold. Thirdly, they have a belief that gold is going to stabilize.
Then stock selection matters a lot. There have been several cases where management actions or even unforeseen geological problems at mines lead to a very rapid correction in the equity value. So the risk is you do your homework, you're right on your gold view, you're right in wanting to own a gold equity, but you may pick the wrong gold equity. That's why I think that there's some advantage at least to being in the larger, more diversified players where you can mitigate a little bit the country and mine selection risk. As I mentioned, in an era of rising resource nationalism, you can partially mitigate that risk if something goes wrong in one region of the world or one mine.
TWST: What should investors be doing at this point?
Mr. Beristain: We are still advising that the equities of certain producers that we cover, such as Newmont, Barrick and Goldcorp (GG), look attractive on a valuation basis, whether it's price earnings or free cash flow yield. We would still be recommending owning of large-cap gold equities. On a year-to-date basis, investors would have done well by owning any of the aforementioned names. Relative to August's market decline, Newmont held up very well performing as a hedge against an overall negative portfolio. So I would say that the way people should look at investing in gold equities is they're not going to be, at least in the gold majors, swing-for-the-fences-type investments. These are not tech stocks. They're not junior exploration stocks, which have the potential to double or triple. They are slow and steady, should provide stable returns with an increasing level of dividend yield that act as a good counterweight to the overall performance of the portfolio. So in times of crisis, the gold equity tends to hold up better. Unfortunately, during times of market rallies, they will underperform. But it's still not bad to have something that's in your portfolio with a negative correlation to the rest of your holdings, and ultimately, if you can pick the right stocks, you should be able to outperform as well.
TWST: Thank you. (TJM)
Note: Opinions and recommendations are as of 10/31/11.
Jorge Beristain, CFA
Deutsche Bank Securities Inc.
60 Wall St.
New York, NY 10005
(212) 797-4664 - FAX