TWST: Gold is still trading at a high price. Should it be at this point?

Ms. Collins: I think, in the current economic environment, it makes a lot of sense for gold to be at such a high price. In the third quarter of 2011, we saw a very high level of demand for gold. Jewelry demand for gold was actually down and demand from the technology sector was flat, but we saw demand from the investment community be very strong because of the strong performance of gold to date, as well as because of worries about macroeconomic uncertainty.

TWST: You mentioned jewelry demand was down. Does that reflect the general economic weakness around the world?

Ms. Collins: I think it can reflect economic weakness and it can also just be a result of some response to the high price of gold. So somebody who is going to purchase jewelry, say in India, is going into a shop and they go in with the intent to spend a certain amount of money on gold jewelry. When the price of gold goes up, it means that they'll be buying fewer ounces, but they'll be spending the same amount.

TWST: Is it because of that equation they are getting less for their investment dollar, or is it because in a weak economy people buy less jewelry?

Ms. Collins: The year-over-year decrease in gold jewelry demand, say from India, was 26% in volume terms. But in terms of the amount of money they put into jewelry, it was actually up about 2%. So they are spending more. They are spending a little bit more in money, but getting that much less in gold ounces because of the higher price.

TWST: Is India the biggest swing factor in the jewelry market?

Ms. Collins: India and then other emerging economies like China. India is a major player, yes.

TWST: You also mentioned technology demand. Is that reflecting fewer computers being sold and henceforth less gold usage?

Ms. Collins: It's been flat year over year. The recent run-up in gold prices probably hasn't been driven one way or another by demand from the technology sector, but there is a possibility that demand from the technology sector is going to decrease in the near term.

Some of the other companies we cover on the basic materials team, such as chemicals companies or other suppliers into the semiconductor industry, have been commenting that semiconductor inventories are getting high now, so we could see another round of destocking in semiconductors, which would affect the demand for gold from that area in the near term.

TWST: How important is technology segment demand?

Ms. Collins: It's small. Number one is jewelry, number two is investment - those are relatively close to each other. And technology is a much smaller part of overall demand for gold on a global basis.

TWST: What's going on on the investment side? Is it being driven by this whole ETF development?

Ms. Collins: Sure. Gold ETFs have been introduced in the past several years, so that's an increasing opportunity for people and companies to invest in gold in a very convenient way. Obviously, by definition, it's exchange traded, so it's very convenient, very easy, and that's really driven a lot of new investment in the gold space. So you are right to point out that ETFs are one important and growing source of demand for gold.

TWST: What's happening on the central bank side? It looks like they've become buyers rather than sellers in the past couple years.

Ms. Collins: Yes. Recently, the central banks have been net buyers of gold. It's unusual. Previously, they had been net sellers of gold. So that's another important driver for the increasing gold prices, not only this year, but in the last several years.

TWST: What's changed? Why have they become buyers all of a sudden?

Ms. Collins: The answer to that question is partly a mystery because central banks tend to be circumspect. But gold is a vehicle for parking foreign exchange reserves. Diversification is another reason for central banks to buy gold.

TWST: How general is this shift of central banks buying more gold, or is it a couple of countries that are driving it?

Ms. Collins: No, it's general. The central banks as a group have become net buyers of gold. Every quarter, you might see some swings in either direction by individual countries, but in aggregate they've been purchasing more gold than they are selling, which is unusual relative to what we saw in the previous two decades.

TWST: I know it's hard to predict, but is that likely to continue for a while?

Ms. Collins: In the current environment, I think that we are seeing a lot of factors that lend support to gold prices and continued investment demand in gold. You have uncertainty, you have - except for in recent weeks - a weak U.S. dollar, and you've got concerns about inflation, especially in emerging countries. And a lot of the factors that drive increasing demand for gold from an investment perspective will probably be around for at least the near term.

TWST: How about on the other side of the equation? What's going on the supply side?

Ms. Collins: Mine supply has increased, and it's increased in response to high prices.

And you've also seen recycled supply increase, but not to the extent that you might otherwise expect, which indicates that recyclers are expecting prices to rise even more. Prices are up a lot year over year, but recycled supply has not increased as much as one would expect, which seems to indicate that people who might be interested in liquidating their jewelry or something of that nature are looking for even higher prices, or it could be the case that a lot of the easy to recycle gold has already been purged from the market.

But getting back to the miners, mine supply is up in response to higher prices, but it hasn't been easy for the miners, and they are facing their own challenges as well.

TWST: Why hasn't it been easy for the miners to ramp up production here?

Ms. Collins: Part of it is geology. It's just becoming harder for them to get that much more gold out of the ground. Part of it is that they are able to get gold out of the ground in increasing amounts, but costs have gone up a lot, both operating costs and capital costs for new mines, and there are some political concerns where governments are taking more of a share of royalties and income from the gold miners, or in some cases, there might be local opposition to mining developments. We've seen that in a couple of countries this year. And then the gold miners themselves as investment opportunities are struggling because gold-mining equities have been underperforming relative to the price of gold.

TWST: Why have they underperformed?

Ms. Collins: Theoretically, the prevailing thought in the investment community several years ago was that gold miners should have leverage to the price of gold in both directions, so in a rising gold price environment, gold-mining equities should outperform the gold price, because as gold prices increase, more of a company's resources become economic to mine. So it's not just that their current production becomes more valuable, but they're actually going to produce more in the future because it makes sense to do so.

Several years ago, there was the thought that gold-mining equity would outperform the rising price of gold, but that hasn't been the case. You and I already talked about higher costs. Part of that's directly linked to the price of gold because when gold prices rise, royalties will rise. And the prices of other important commodities, such as diesel, electricity, and explosives, have also increased. In South Africa, where some of the world's highest-cost mines are located, the mining unions were able to successfully negotiate wage increases of 8% to 10% during the summer of this year. Also, it's not just that each miner is making more money, but it's also the case that it is taking more labor to produce the same amount of gold, so mining there is becoming more labor intensive.

Right now, I'm just talking about production that's currently on line. The capital cost of projects that are being developed right now for future mine supply has been increasing, and now we're seeing $3 billion, $4 billion, $5 billion price tags on some of these largest mines that are coming to fruition just because of how much capital cost inflation we've seen in this industry. That's the cost side. So that's a direct income statement impact. That means there is going to be less of a benefit to a producer's income statement from high gold prices than you might otherwise expect.

Then there is political uncertainty, and that can the affect investors' sentiment toward a company or can actually impact a company's income statement or future earnings stream if their mines are punished - so to speak - by local governments.

Finally, there is also the fact that people who are interested in investing in gold, either equities or gold the commodity, can do away with company-specific risks by just going straight to the ETF or physical gold. They don't have to worry about a miner's projects getting expropriated.

It's also very possible that in aggregate, the equity market is not discounting current gold prices. So with gold at $1,700, $1,800 an ounce, it's very likely that equity markets for gold miners are not discounting those same prices in perpetuity. It looks like equity investors don't believe that these high gold prices are here to stay.

It's also possible that gold miners have lost some of the premiums that they've been awarded by the market in times past. You can look at this in one of two ways. One is, you could argue that in the past gold miners had been awarded a very low cost of equity by the market. And another way to slice that is to say that in the past gold miners were given a premium valuation by the market. Compared to other miners of nonprecious metals, gold miners would trade at much higher p/e or EV to EBITDA multiples. We've really seen those multiples compress this year for gold miners, and part of that could be due to all the factors that I'm talking about, especially the fact that there is a possibility that equity markets are not factoring in high gold prices into perpetuity. But it could also be the case that gold miners have lost their premium in a sustained fashion because investors can go to the ETF, and there are other opportunities now for investing in gold that are convenient that weren't available in the past. So it's possible that the low cost of equity afforded to gold miners has gone away to some extent for a long time.

TWST: The marketplace has changed.

Ms. Collins: Yes, that is true.

TWST: As we look at these changes, are they going to stay in place or are we going to see additional changes?

Ms. Collins: We talked about how there are lot of good reasons for gold prices to be high and where they are today, but I think in the long term we could see some of the pressures relieved. Some of the catalysts that people talk about for seeing gold prices fall eventually would be an increase in real interest rates, because the interest rate environment is very low right now, and that's been driving people into gold. Also, it's unusual that central banks are net buyers instead of net sellers. Jewelry is still the number one contributor to demand for gold, but its role has been lessened as the investment community has taken up more of the demand for gold, and that's an unusual phenomenon too. If these drivers flip back to the way things were in the past, it's possible that we could see gold prices come down.
For gold miners, kind of a different way to approach that question is that either one of two things could happen to see the gap between gold prices and gold equities close. One is that people could start factoring in higher-price gold price expectations or you could see the gold companies start to take more concrete actions to address the disconnect, and we've seen that this year. Many gold companies have always issued dividends in the past, but very recently they initiated dividend policies where they're specifically linked to gold price levels. Newmont  (NEM)and Eldorado (EGO) have done that. It's very transparent, so each quarter their dividend from Newmont or Eldorado will be at a certain level depending on what the price of gold has been. Obviously, gold as the commodity itself doesn't offer any income. We're seeing companies trying to address the disconnect in a concrete way, and so far the equity markets have responded very positively to the extent that you can measure sentiment surrounding these announcements.

At Morningstar, we like it from a fundamental perspective because mining companies tend to behave very procyclically. When times are good and they are flush with cash, they tend to buy other companies, and those other companies tend to be trading at high valuations because times are good. And when times turn, and the industry starts faltering because commodity prices are falling, the companies are left with a lot of debt. It's very hard for mining companies to invest in a contrarian fashion, but having a gold-price-linked dividend kind of forces managers to be less procyclical and more contrarian because when times are good, they have more cash going to their shareholders, which leaves less cash on hand for them to do those acquisitions and vice versa. When gold prices fall, their dividend will decrease and they'll have that source of cash freed up to help them invest in their business.

TWST: Is this going to undercut ETFs a little bit?

Ms. Collins: I don't think that it can completely solve the problem because it's not going to take away some of the concerns that people have about investing in individual miners relative to the ETFs or even baskets of miners. It doesn't take away from the high costs, the political uncertainty and things of that nature.

TWST: Is this kind of approach going to slow M&A activity in the space?

Ms. Collins: It's possible. It depends on how many companies end up going with the gold-price-linked dividend. Eldorado's always had a very contrarian management team. They haven't really been about chasing crowded bets. They've been more focused on finding interesting places to invest in where other miners have not really been interested in going, so they've been able to buy or invest in mines on the cheap. Therefore, I don't think that gold-price-linked dividends will mean a lot less M&A activity in the space. In fact, M&A activity is one of the things that people talk about as solving the disconnect, especially if you start to see more junior miners being purchased by the larger companies.

TWST: Has that been the pattern in the industry?

Ms. Collins: It wouldn't necessarily be different than in the past. But I guess this round we haven't seen as much M&A activity yet. We've seen a few big purchases. But Barrick (ABX), for example, their most recent purchase wasn't even a gold company - it was a copper company. I guess when people are talking about M&A activity being one candidate for closing the disconnect between gold miners and gold prices, it's probably smaller companies that are hopeful, and they are hoping to see more M&A activity.

TWST: When you look at the next year or two, what's your general thinking on gold prices?

Ms. Collins: I think that in the near term, gold prices will continue to be high and volatile because the world will continue to be giving us factors that lead to strong demand for gold from investors. I mean, in emerging economies, they will continue to be worried about inflation and that will lead to stronger investment demand for gold, while investors in developed economies will be concerned with the value of the dollar and other fiat currencies, which can drive demand for gold as a hedge against currency debasement risk.

But I think in the long term, we populate our models with a lower long-term gold price assumption, which is closer to $1,200 an ounce. We do that for couple of reasons. Eventually, we will see gold prices come down if we see an increase in real interest rates - that could be one catalyst. Also as I mentioned, it's very unlikely that equity markets in general are factoring in today's gold prices well into the future, so using a long-term gold price forecast of $1,200 an ounce really helps us to pick companies as opposed to making a sector call based on gold prices. For example, we can focus on low-cost miners and investment opportunities, where expectations for a company's production by the market are less than what we think will actually be the case.

And then finally and most importantly, if you look at the cost of mine supply, the highest-cost miners are still pulling gold out of the ground at a cost that leaves them very profitable today even after factoring in for the recent cost inflation. In a commodity industry, that shouldn't necessarily be the case over the long term. I mean, South African miners, which exhibit the highest-cost structure in the industry, they can pull gold out of the ground at total costs of say $1,100 to $1,200 an ounce, and in most commodities, you should think that long-term price of the commodity will converge with the marginal cost of production. And I think that those are forces that we'll see that play out in gold as well.

Shifting over to the demand side of the picture, in order for mine supply to be demanded at all, we have to see net positive investment each and every year, which means that globally we have to buy more gold than we already have, which is a big statement. Central bank holdings alone equal 12 years of mine supply. So there is a lot of gold above the ground, and if any of these macroeconomic factors that have been causing people to invest more in gold turn around and head the other way, you could see disinvestment in gold. A lot of the forces that have been driving gold prices higher have been part of a positive feedback move. I mean, people have seen that gold has outperformed other asset classes and that has drawn them to investing in gold. If you see the flip side, things might run in the other direction.

TWST: Given your kind of cautious outlook, what are you telling investors to do?

Ms. Collins: As a group, a lot of our gold miners are fairly valued. We have one company that we think is slightly undervalued, and we think it's worth taking a closer look at, and that's Yamana Gold (AUY) ticker AUY in the U.S. and YRI in Canada. And that's a company with a portfolio of low-cost South American mines, and they have some very attractive growth projects in the pipeline. And we think that the market is not fully factoring in their future production growth when there are signs that they should be able to bring those mines on line. And we think Yamana is attractively valued. It's not a deep discount at these levels, but we do think it's attractively valued. Yamana is one of the few gold miners whose share prices have kept pace with bullion so far in 2011.

TWST: Is that the only name you are recommending at this point?

Ms. Collins: Yes, it is the only name that we are talking about at this point. Most of our other companies are fairly valued.

TWST: Anything else we should touch on?

Ms. Collins: I think that wraps it up.

TWST: Thank you. (TJM)

Note: Opinions and recommendations are as of 11/22/11.

Elizabeth Collins, CFA

Associate Director
Morningstar, Inc.

22 W. Washington St.

Chicago, IL 60602

(312) 696-6000