Don Coxe on Gold – Basic Points Feb 2010

The following extract on Gold is taken from Don Coxe’s Basic Points, 19th February 2010:

Among the biggest metal stories since the last Resources Conference have been the dramatic run-up in gold prices, and the announcement of Barrick’s unwinding of its hedges.

Barrick’s hedging program was the right big thing during the years of gold’s Triple Waterfall collapse – and the wrong big thing once gold had entered a new long-term bull market.  The Barrick volte-face helped drive gold prices to new heights.

For decades, many gold companies’ executives and promoters spoke longingly of the coming Golden Age when gold would trade at $1,000 an ounce.  Gold finally broke that magic barrier last September, and has remained in The Promised Land since then, but gold mining stocks (as measured by the XAU) peaked out week ago.

As we wrote in December (Financial Heroin), when gold broke into Four Digitland, it suddenly began to look less like a store of value and more like a speculator’s plaything.  Why was gold running wild?  We cheekily suggested, as historians, that this moment in metal history could be driven by dates of the past.  According to dubious hypothesis, gold’s first target should be 1066 (Battle of Hastings), the next 1215 (Magna Carta), with a near-term peak of 1258 (The Provisions of Oxford) and a one-year target of 1345 (Onset of Black Death, which began to fade away by 1350).  Bullion bounced all the way to Magna Carta before the mini-bubble burst and gold plunged briefly back, bottoming out – at 1066.

What converted so many skeptics into chrysophiles was (1) Barrick’s capitulation to market forces, and (2) word that the Government of India was buying 2,000 tonnes of gold from the IMF for its foreign exchange reserves.  Analysts also noted that the list of European central banks who were not taking advantage of their gold selling rights under the Washington Agreement seemed to be gaining new members.

The new elixir for gold investors and gold bugs alike: what happens if (1) all the central banks in the Washington Agreement stop selling and start buying and (2) China and other heavyweights decide to put a meaningful percentage of gold into their forex reserves?  As gold broke through $1,000, that kind of buzz began to spread, and, after thirty years in which gold bugs talked of ‘Gold at a thousand’, suddenly the new target was $2,000.  The wise Pope (Alexander, that is), would understand:

Hope springs eternal in the human breast.

Man never was, but always to be blest.

Aaron Regent, Barrick’s market-savvy new CEO, comes from a base metals background at Falconbridge.  He helped fuel the flames of desire (after he had shrewdly convinced Barrick to pull in its huge hedges) by touching and stroking a hitherto-undiscovered erogenous zone in gold bugs: peak gold – which could be the latest Big Thing since peak oil.

He noted that the new-mined production of gold has been declining for a decade, and suggested this could prove to be the equivalent of what has been happening to major oil fields (such as the North Sea, Cantarell and Alberta’s sedimentary basin).

During that decade, gold’s price trebled, yet the feared and revered ‘Iron Law of Commodities’ did not re-appear to spoil the fun.  (’The cure for high commodity prices is high commodity prices.  When prices climb, new production appears and prices fall back: always has happened; always will.’)

Another ‘law’ was cited in some quarters during the later stages of gold’s long run-up: the Stupid Central Banker Rule: ‘As for gold, do the opposite to what central bankers are doing: they’re nearly always wrong.’

These self-styled sophisticates noted that central bank buying helped drive gold to $800 an ounce thirty years ago, and their selling helped drive it to $250 at the end of the past decade.  Since then, they’ve continued to sell into a rising market.

This is one of those ‘rules’ that makes its proponents look smart, but has a hidden problem: since central bankers have apparently stopped selling and are now buying, shouldn’t we be rushing to the exits and buying something more secure – like Treasurys or Citigroup debt?

The longest-established ‘Golden Rule’ is that ‘He who has the gold makes the rules.’  It was cited with relish month-in, month-out, from 1974 through 1982.  It stopped working  in January 1980, but its hordes of true believers kept relying on it for years thereafter.

Much of recent commentary on gold (and, to a lesser extent, the other precious metals) is that Obama’s deficits, coupled with Bernanke’s money-printing, could produce either a Depression or runaway inflation.  To us, this is an argument investors really should take seriously.

We have advised those who, terrified by soaring global fiscal deficits and global liquidity, talk of a rush to cash by selling most or all their equities that gold could be the optimal investment under both extreme outcomes.

Since we regard cash as an unattractive asset for investors who fear Depression most (they should own long-duration high-quality bonds instead), we argue that a holding of gold and gold stocks offers excellent protection under both extremes, and attractive potential under a regime of moderate inflation and modest recovery.

Gold was the best investment during the Rooseveltian 1930s and the Carteresque 1970s.  Mr Obama seems at times to be a blend of those two Democratic Presidents.  The first was a confident, charismatic interventionist, whose economy was actually rescued by World War II; the second was a well-meaning, yet inept, President who seriously weakened America at home and abroad.  Nothing became him in his Presidency as the leaving of it – first, by giving the world the gift of Paul Volcker, and then by losing to the reformist Ronald Reagan.  While on vacation, we spent some time watching Obama on TV.  We found him even more impressive than we had thought previously.  What he’s peddling may well be the wrong answers to our problems, but his charm and energy are infectious.

Such bad news as there has been about gold recently has been confined to disappointing news from some of the major gold mining stocks that unleashed big selloffs.

We have held some of these recently-wounded companies in our Fund (The Coxe Commodity Strategy Fun) because of our belief that long-duration unhedged reserves in politically-secure ground meant they were better than bullion in a bull market for gold.

Why?  Because all mining (and oil) companies report reserves on the basic of economically-recoverable minerals.  If gold were back at $250, total mineable gold reserves might be barely adequate to meet the collective bling demands of all Grammy winners.  Conversely, were it $2,000, new-mined gold production would surge past current levels – but it wouldn’t double: There ain’t enough gold in them thar hills.

Miners report three kinds of mineral reserves: proven and probable reserves, and resources.  The latter category is generally lower-grade, has not been drilled out in detail, and may have been estimated primarily by geophysical and geochemical techniques.

One reason a big boost in bullion prices has not meant a big jump in gold production – but was actually accompanied by declining output – is that the kinds of mining companies in which you should invest are those who recognize that each ton of ore taken out of the ground brings the mine closer to closure.  A mine’s closing is painful for stockholders and management, but is usually a disaster for a community.  Therefore, responsible mining means mining some lower-grade ore during periods of high metal prices to expand mine lives.  This not only serves the community, it protects the value of the company’s biggest asset – the mine.  This was illustrated a while back when Freeport McMoRan announced a slight reduction in its copper and gold output, which meant earnings came in modestly below the estimates of some Street analysts.  Some of these responded with criticisms of management’s ‘failure to execute’, and argued that shareholders should reconsider their approach to stock.

These criticisms bespoke not sophistication, but ignorance.

When copper and gold prices soared, that gave Freeport the chance to mine some lower-grade secitons of its Grasberg mine, thereby extending its life and smoothing its earnings growth.

The idea of steady, uninterrupted, and predicted growth in per-share earnings is a construct of modern portfolio theories about what makes good investments.  It doesn’t work with commodity companies, because the prices of their products are subject to wide swings over time.  As applied to mines, that valuation technique makes as much sense as giving the Academy Award to the actress whose facial expressions are the most predictable.

That’s one reason why we do not recommend giving the highest recognition to mining analysts who make the most accurate short-term earnings forecasts.  We rely most on those analysts who have real understanding of the nature and challenges of each of the mines a company is operating or is planning to open (or re-open), and the management’s longer-term strategies.

Nevertheless, rising metal prices will almost always mean increased ore reserves – and in some cases, the results can be dramatic.  There are huge ore-bodies in politically-secure areas of the world that are virtually worthless at $1.25 copper and $600 gold but can be bonanzas at $3.00 copper and $1,100 gold.

We have argued that investors should overweight the gold mines and underweight the bullion if they are bullish on the metal, and reverse the strategy if they turn bearish on the metal.  Quite simply, higher gold prices not only mean more profits from existing reserves, but likely mean major additions to published reserves.  You win – or lose – two ways on a significant move in metal prices.

There is one other alternative form of precious metal investing that we have employed in the Coxe Commodity Strategy Fund: the royalty and streaming companies.  The pioneer in this field was the original Franco-Nevada, which was merged away, but has since been reincarnated.  It has acquired some imitators and competitors, but the field doesn’t yet look so overcrowded that investors’ returns will shrink.  These companies don’t operate mines: they buy percentage shares of the output, either on an overall basis, or one component part of the production – usually a precious metal.  A relatively recent entrant to this entrepreneurial sector – Silver Wheaton – illustrates the most impressive feature of the concept: According to The Northern Miner, the company has the highest maket capitalization per employee on the New York Stock Exchange – 23 employees for a $6 billion company. 

Conclusion

The latest published estimates for global fiscal deficits this year and last are $14 trillion. Dennis Gartman quotes a friend who explains a trillion by saying that a pile of US $100 bills totaling a trillion dollars would be 800 miles high.  Conversely, all the gold on earth could be held within a few bank vaults.

It is less than a century since all major currencies became non-exchangeable into gold (or, in the case of US, silver).  That is, in human experience terms, a brief interval.  During that time there have been two World Wars, many lesser wars, one Great Depression, many recessions, and many localized depressions.  The purchasing power of the greenback – the global store of value – declines year in, year out.

Since the invention of paper money and the development of foreign exchange markets, there has never been a time when the central bank of almost every industrial nation in the world that matters is pumping out money at near-zero nominal rates – and government deficits continue to explode, while demographics in the G-7 countries continue to erode.  Long before the fifty-year bonds of some European countries mature, the workforces of their issuing countries relative to retirees will have plummeted to levels that are insupportable under almost any economic theory.

When the sum of existing debts, present deficits, and future predicted deficits is so far beyond human experience, investors should go back to the Old Reliable: ‘There may never have been a time where Gold had a better claim to inclusion in all portfolios dedicated to wealth conservation.

What has long been the popular metaphor for a sure-fire money-making idea of almost any kind?

‘It’s a gold mine.’

Exactly.