Get Ready - Here Come the Gold Stocks!

You’d have to be a monk living in isolated penury to miss the fact that gold is on a tear. Specifically, it has risen from $277.75 on January 4, 2002 to $950 last week, a gain of 242% in just over 6 years. Over the same period, the trembling S&P 500 is up an anemic 22%. Casey Research’s David Galland explains what he sees as the best way to profit from this trend.

In a gold bull market, an investor would expect the profits on gold stocks to be a multiple of those to be had from bullion. That leverage comes from simple arithmetic: once a gold producer covers its production costs, then each 1% rise in the price of gold can translate into a 5%, 10% or even richer improvement in the bottom line. For a company such as Barrick, with 125 million ounces in proven and probable reserves, even a $1 per ounce increase in the price of gold can mean big money.

And so we see that between January 2002 and last week, the gold stocks were in fact up 612%. So far, so good.

Yet, the gold stocks have stalled in recent months; between August 1, 2007 and February 21, 2008 gold bullion rose 42%, but gold stocks were up just 37%.

What’s going on? Is it that, in their concern over the broader equity markets, people have forgotten that gold stocks are associated with gold? Or is something else at work here?

The answer is "something else."

While there are a number of plausible reasons for gold stocks lagging of late, we have come to the conclusion that the true explanation reaches much farther into the past. It’s that the managements of the gold producers have only recently escaped the state of fear they operated under during gold’s 20-year bear market.

Consider: as recently as the year 2002, gold was still trading near $280. Against that number was a cash cost of around $250 per ounce for a typical company. That cost figure is about as low as the number could go, and it was the response of an industry beaten down and huddling in a trench.

Caution lingers after the reason for it has gone. As gold began its upward move in 2002, it did so against the backdrop of an industry still in mothballs and still run by managers whose primary skills were cost cutting and frugality. This is important on a number of fronts.

1) Having been trained in the acid bath of razor-thin margins, management was intensely skeptical about gold’s rally. They suspected it might be just another bear market trap, ready to punish unwary optimists who parted with cash to ramp up production.

2) In the hunkered-down years, miners focused on the higher-grade, easy-to-mine material that gave them the best shot at turning a profit, however small that might be. And being in survival mode, they were extremely cautious about buying new equipment or maintaining a large workforce. Employee rosters were reduced to the bare minimum.

3) Because staying in business was such an urgent goal, they were willing, even eager, to sell future production at a set price — a perfectly rational strategy in a bear market, because it at least assured they would receive a price that covered the known costs.

With all these factors taken together, it’s easy to understand why the industry was slow to respond when gold started rising. In fact, it was only in February 2003, with gold trending over $350, that Barrick Gold Corp., the world’s largest gold miner, began the expensive process of unwinding its hedges. And it wasn’t until November of that year that the company announced it would stop forward selling altogether and would eliminate its entire hedge book.

Once the turning point came – when management finally realized the bull market was for real — the industry began to scramble to catch up. Which, in a choo-choo industry like mining, means hiring and training lots of people, buying or refurbishing the equipment needed to reestablish production on second-tier deposits, upgrading facilities, building expensive new mills, etc., etc. And, of course, dealing with the challenge and expense of unwinding hundreds of millions of dollars worth of forward hedge contracts.

The rebuilding of the gold mining industry, in short, really only began in earnest over the past few years.

As would be expected, the costs associated with rebuilding the industry sent big hits to the bottom line, resulting in the kind of ugly financial metrics that repel institutional investors.

The metrics were not at all helped by the shift away from high-grade ore, because the lower the grade, the more the material you have to dig, hoist, haul and process, meaning increased production costs. In addition, the industry rebuild occurred against a backdrop of generally rising inflation and a falling dollar, which helped push the cash cost of production up by more than double from the mothball years, keeping the miners unattractive as investments.

By contrast, the base metals companies, which had hit bottom earlier, near the end of 1998, had already emerged from the mothball stage, thanks to increasing demand from China and elsewhere. They were, as a result, well on the road to recovery when the big price increases for base metals kicked off in 2004. So, while the gold miners have been widely shunned as ugly ducklings in recent times, the base metals sector has been enjoying salad days, reflected in multi-billion mergers and acquisitions and, of course, sharply higher share prices.

Here at Casey Research, we are of the firm opinion that, now that the biggest costs related to restarting their industry are behind them, the big gold companies are poised to take off. The proof should come in rapidly improving margins which, lo and behold, we have begun to see in the quarterly reports now being released.

Just last week, Goldcorp announced that fourth-quarter profit had nearly quadrupled over the same quarter the year before. And then Kinross announced that it, too, had posted a record quarter, with profits up almost three-fold over Q406. Meanwhile, Barrick reported that net profit for 2007 was 28% ahead of 2006. In addition, Barrick is feeling sufficiently flush (and optimistic) that it’s buying out Rio Tinto’s 40% interest in the Cortez Hills joint venture for $1.695 billion… cash.

And the exception to this picture of profit eggs finally hatching is only superficially an exception. Newmont announced a loss of $1.8 billion in 2007. But most of it came from a one-time house cleaning — $531 million to unwind 18.5 million ounces of forward gold sales and a $1.6 billion non-cash charge to terminate operations related to merchant banking. Look past those elements, which are an overdue recognition of money that went down the drain years ago, and you find that Newmont’s mining business is actually in a healthy position. Looked at from another angle, Newmont took these charges now because they could afford to do so and because they felt that the damage to their share price would be softened by the strong performance of their current operations. Now that they’ve cleaned up the books, they too are dressed up to join the profit party.

It won’t be long before others also note the pending improvements to the bottom lines of the big gold companies. The investment herd, we are convinced, is coming and, we expect, coming soon.

How to profit?

First and foremost, you want to be moving into the established producing companies post haste. The gangway on this ship is getting ready to be pulled up.

Secondly, you should seriously consider moving some funds into the higher-quality junior exploration stocks. History has proven that, absent an exciting discovery story, the big gold stocks must get in gear before investor sentiment can reach the critical mass needed to ignite the juniors.

History also shows that as profitable as the big gold companies are in a bull market, returns on the juniors can blow those away. Exponentially. This upside, of course, comes with a greater degree of risk.

But paradoxically, this risk has been largely mitigated by the majors’ slow take-off. That’s because, anticipating that the gold stocks would follow the metal higher – and history shows no example of them not doing so – investors have already poured record amounts of money into exploration programs. As a result, we now know which companies have the goods — significant discoveries that juniors have spent tens of millions to define and prove up with the clear intent of selling to the majors.

The missing element, of course, has been that, until recently, the majors didn’t have enough free cash to make those acquisitions. That is about to change.

While you don’t know me and so will have to take my word for it, I am not the type of person to fall in love with any investment. And any time I feel such an urge coming on, I check all my assumptions twice and then check them again. That said, I will also say that I have never been more bullish than I am now on the gold mining sector as a whole, with an added nod to the well-run exploration companies.

Regards,

David Galland
for The Daily Reckoning
March 04, 2008

David Galland is the managing director of Casey Research, publishers of Doug Casey’s monthly International Speculator advisory. For over 27 years Doug Casey and the Casey Research team have provided self-directed investors with unbiased research on investments with the potential to provide double- and triple-digit returns by tapping into evolving economic and investment trends ahead of the crowd.

It is snowing this morning…winter is not over; in fact the worst weather of the year may still be ahead.

Yesterday, the Dow held steady, after falling 315 points on Friday. Gold rose again – another $11…to $986. It looks like $1,000 gold is only days away, which means that $2,000 gold can’t be far behind. And when it gets here, we know our Dear Readers will be ready. Find out how you can prepare yourself to fully profit from this epic rise in prices here.

This is the big month, when mortgage resets peak out – with nearly $120 billion worth of mortgages being adjusted upwards. Naturally, you’d expect Americans to be feeling pinched…especially with prices of energy and food at record levels.

"Americans start to curb their thirst for gasoline," says a Wall Street Journal headline.

Car sales fell in February – as you’d expect. Retailers report slower sales. And the economy itself, when last measured, was neither moving ahead…nor retreating, but stock still.

This has prompted a rush to judgment on the part of some critics:

"The Federal Reserve’s Rescue Has Failed," announces a headline in the English paper, the Telegraph. Ambrose Evans-Pritchard, the paper’s business editor, says, "The verdict is in. The Fed’s emergency rate cuts in January have failed to halt the downward spiral towards a full-blown debt deflation. Much more drastic action will be needed.

"Yields on two-year U.S. Treasuries plummeted to 1.63pc on Friday in a flight to safety, foretelling financial winter. The debt markets are freezing ever deeper, a full eight months into the crunch. Contagion is spreading into the safest pockets of the US credit universe."

Mr. Evans-Pritchard then brings up New York’s Port Authority, which operates bridges, bus terminals and airports in the New York, New Jersey area. The Port Authority is backed by both state and federal governments. Yet, when it went to borrow money, it was treated like the junkiest of junk credits…forced to pay 20% rates.

"I never thought I would see anything like this in my life," said James Steele, an HSBC economist in New York.

"No sane mortal needs to know what term-auction means, except that it too became a tool of the U.S. credit alchemists," continues Evans-Pritchard. "Banks briefly used the market as laboratory for conjuring long-term loans at Alan Greenspan’s giveaway short-term rates. It has come unstuck. Next in line is the $45 trillion derivatives market for credit default swaps (CDS).

"Sub-prime debt is plumbing new depths. A-rated securities issued in early 2007 fell to a record 12.72pc of face value on Friday. The BBB tier fetched 10.42pc. The ‘toxic’ tranches are worthless.

"Why won’t it end? Because US house prices are in free fall."

The article goes on to mention that we are only half way through the mortgage-reset storm. Expect more bad weather, says Evans-Pritchard.

But here at The Daily Reckoning, we are in no hurry to pronounce judgment on Ben Bernanke’s plan to save the U.S. economy. We don’t have to. We knew it was a mistake from the very beginning. Exactly how the markets would react, we couldn’t say. But the idea of rescuing people from too much debt by lending them more money struck us a bit like serving martinis at an AA meeting; it was bound to lead to trouble.

The trouble we seem to be getting is popularly known as ‘stagflation.’ Prices rise, but so does unemployment. It wasn’t supposed to work that way. Inflation was supposed to spur consumers to spend money and businesses to hire people. But people eventually catch on to the trick. They eagerly get rid of money…and prices do rise. But they also come to realize that it’s not a real boom…but a phony boom… So, businesses do not expand…do not hire…and do not earn more money. They raise prices, but their costs go up too.

Still, the ‘stagflation’ label is reassuring to people. Those over the age of 40 can recall the stagflation of the Nixon years. In retrospect, it didn’t seem so bad. But there, too, we part company with most observers. It wasn’t so bad then because America’s economy was much, much stronger – strong enough to take Paul Volcker’s bitter medicine…and survive.

This time, the financial authorities aren’t even opening the medicine cabinet. They’re afraid the patient couldn’t stand the treatment. Instead, they’re administering the old elixir that got the economy into serious problems in the first place – more cash and credit.

Different circumstances…different treatment…we will surely get a different result. Stay tuned…

*** The costs of the credit crunch are mounting up. Each estimate is bigger than the one than before it. The latest estimate from the Union Bank of Switzerland is $600 billion. Economist Nouriel Roubini goes even higher – at $1 trillion. Of course, those are just the direct losses…the disappearing cash. There are also losses in implied wealth (and subsequent changes in spending and retirement plans) from falling house prices themselves. The residential housing market is worth some $20 trillion. If it goes down 30% from top to bottom, as expected, that’s a loss of more than $6 trillion.

*** Remember the Golden Rule: He who has the gold makes the rules.

As nations get rich, typically, they buy gold – or steal it. What else can they do? How else can they protect their wealth?

When Britain was the world’s dominant empire, it loaded up so much gold in the Bank of England that the floor collapsed. Then, power shifted to America. The United States collected its war debts and the gold went back to the U.S.A with the doughboys. In a few years, the United States had the world’s largest stockpile, in Fort Knox, Kentucky.

In 1971, Nixon announced that the United States would no longer honor foreign claims on its gold – after Charles de Gaulle insisted on turning in dollars for the metal in the 1960s. Since then, the world has operated on a dollar standard. Foreign governments stockpiled dollars, rather than gold, and trusted the U.S. Treasury to make sure their dollars didn’t lose too much value.

Alas, lose value is just what the dollar did. It went from about $1 down to 5 cents during the 20th century. But the drop was fairly gradual…and other currencies fell along with it – more or less. And the U.S. economy was so strong and so far ahead of the rest of the world, people felt safe holding the greenback, even though it was losing value steadily.

But now, two things have changed.

First, wealth is shifting away from the United States. America is no longer a growing power, but a fading one. The real money is being made in other places. The energy exporters, for example, are piling up money – especially dollars – at breakneck speed. And the Asian exporters too are making trillions.

Second, the world is losing confidence in the dollar as never before. Everyone knows the Bernanke Fed can’t defend the buck. There are too many of them. Instead, Bernanke has to try to fight the economic slump – with more cash and credit…further inflating the world’s supply of dollars.

That’s why the dollar index is at its lowest level in 35 years.

"Dollar: it will only get worse," says CNNMoney.

This leaves the foreigners in a tight spot. They’ve got trillions worth of dollars…and the buck is falling. What are they going to do?

The answer is: what rising powers always do – buy gold. The price of the yellow metal has been in a bull market for nearly 10 years – a bull market that began almost precisely on the day, in 1999, when Gordon Brown sold English gold at a 20-year low in the gold price. Since 2001 gold has risen 240%. Since Sept. 18th, when Ben Bernanke his 5 rate cuts, it has dropped 36%. Like individuals, nations want to preserve their wealth; for the past decade gold has been the best way to do so; even central bankers are catching on.

Russia and Qatar are buying heavily. Qatar is using its oil revenues to buy a tonne of gold per month. Russia is buying three or four times as much, and now has more gold in stock than the Bank of England.

China is said to be buying too – but very cautiously. China has so many dollars, if it wanted, it could buy almost half of all the gold ever mined.

Looking ahead, it is hard to see what would stop gold now – except a worldwide financial meltdown. Some commentators insist that Western governments will sell their gold to take advantage of the high price. The IMF has already been cleared to sell nearly $100 million worth – to cover its budget shortfalls. But with the price rising…and the inflation pumps working round the clock…what central banker or treasury secretary is going to want to be the one who sells the family’s silver now?

And you haven’t missed the boat on the gold bull market. No matter how high prices go, we know of a way that you can buy gold – for a penny per ounce. No joke. You can pad your portfolio with the change you find in between the couch cushions.

*** Talk about bad weather!

"Many trees have fallen…and the electric lines are down. It is as if we had suffered an aerial attack or lost a battle. This is a terrible disaster. We’re hungry and cold."

This message comes from China, via our Buenos Aires correspondent, Horacio Pozzo.

He goes on to tell us: "China has suffered in the last few weeks, a severe crisis, with temperatures at their lowest levels in 50 years and record snowfalls. Energy shut-offs, water shortages, supplies of food running out, millions of people trapped, unable to produce or buy…creating an unimaginable paralysis…exposing to the world China’s extreme fragility…

"Unshakable and powerful China has succumbed not to recession, nor to economic slowdown…but to Nature. Something much more powerful…and against which there is no Bernanke, no lower rates, no more liquidity, no Buffett, no credit insurance…nothing to save us."

China runs on coal. And coal runs on rail lines. And rail lines in China have been covered with snow and ice. When the coal stopped getting where it was supposed to go, practically the whole country came to a halt. Economic losses were on the order of $15 billion, with 350,000 houses destroyed and (according to the public reports) 100 people dead.

Until tomorrow,

Bill Bonner
The Daily Reckoning