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Gold: The Only Game In Town?

By David Duval
December, 2002

The old axiom that "figures lie and liars figure" seems particularly appropriate in today’s economic climate given the massive accounting scandals that have plagued the market, parts of which remain a virtual wasteland.

Making matters worse, last year’s terrorist attack profoundly altered the psyche of ordinary investors, the ones who typically underpin a market in good times and bad.

With the dust finally settling on the biggest market bubble in history, and Federal Reserve Chairman Alan Greenspan denying any role in it, investors might be forgiven for viewing the future of their investment portfolios with considerable trepidation if not downright alarm.

Given all this uncertainty in the economy, those of us with a few grey hairs can understand why sentiment toward gold has improved significantly in the past year. Nonetheless, most of the investing public remains totally ignorant about gold, its role in the world monetary system, and what investment opportunities are available in the gold sector.

Since the start of the bear equities market in March 2000, mutual fund tracker, Lipper Inc., notes that gold funds are up a whopping 68.3%, well ahead of the high profile real estate sector which was 45.4% higher. Compare that to the abysmal performance of US equity mutual funds in the past year and their July redemptions of $49 billion, the largest outflow in history.

The big question today of course for investors is whether or not gold’s upward trend is sustainable. In my view the answer is an unqualified yes! The main reasons include: the inflationary growth in the US money supply; the United States’ $450 million current account deficit and its negative consequences for the US dollar; a loss of faith in paper assets because of accounting and other scandals; the closing of hedge positions by major gold producers; and good old fashioned supply/demand considerations.

An exhaustive study by Beacon & Associates concludes that if gold prices were to remain under $300 per ounce, world output could fall by at least 25% over the next 5 to 7 years, exacerbating the current supply deficit even more. Today, annual gold demand far exceeds global mine production with most of the present deficit being met by direct central bank sales and central bank leasing for mining hedges and financial speculation.

Anyone tracking the volatile swings on the New York and NASDAQ markets in recent months has probably developed an understanding of the classic "short squeeze" where panicked investors have driven stocks higher to cover their short positions. Well, central banks have been doing something similar in the gold market for decades.

They’ve been lending increasing amounts of gold to bullion banks and other speculators who have used complex derivatives to limit their risks and generate additional income. The size of this derivative-related short position is officially acknowledged to be approximately 5,000 tonnes but in reality is probably two or three times that.

In effect, that gold has been sold into the physical market and any sudden price increase would force borrowers to replace that gold through spot market purchases at much higher prices. Between one third and one half of all central bank gold would no longer be accessible if this happened. That’s a volatile scenario that would make the $850 per ounce gold high in 1980 seem like a minor blip on price charts. And the spark to set it off would likely involve some international conflict (Iraq?) or significant terrorist incident.

Determining where to invest in the gold sector is a question everyone should be asking. My weighting is generally 70% in senior non-hedged gold companies and the remainder in well-financed juniors. For the juniors, management is the biggest single risk, even greater than project risk in my view. I seek out management with good track records and preferably more than one success which eliminates the so-called luck factor. (And yes, there’s more than a bit of luck involved in the minerals business). Success doesn’t necessarily imply a major discovery because a lot of good market plays have evolved from projects that didn’t quite make it. Mark Twain once said that "history never repeats itself but sometimes it rhymes" and this probably applies to junior explorers more than anyone.

For senior gold producers, cost of production is probably the most important factor and that’s a function of the quality (grade) of their mines. You only have to look at Goldcorp to understand what I mean. Goldcorp’s flagship operation in Ontario’s Red Lake mining camp is the richest in the world and its mill is processing ore that averages more than 2.0 ounces per ton. The mine’s cash costs are only $65 per ounce. For a mining company, Goldcorp also has a history of thinking "outside the box" making them a real anomaly in the gold mining sector.

David Duval is a Vancouver-based mining journalist, author and former Technical Advisor to the United Nations. Article is courtesy of www.resourceworldmag.com