Gold Price Pain Point
Friday, 1/10/2014 09:41
At a gold price of $1050 some 50% of gold mining is losing money. Tough for analysts too...
DEFLATION, inflation and re-inflation all play into scenarios for the gold price and precious metals equity markets, according to Paolo Lostritto, director of mining equity research at National Bank Financial when he gave this recent interview to
The Gold Report...
The Gold Report: Paolo, what three words would you choose to give our readers a sense of what to expect in the gold mining and precious metals equity space in 2014?
Paolo Lostritto: Defense, defense and more defense.
TGR: The Vince Lombardi approach.
Paolo Lostritto: Even though deflation risk is priced into most of the equities, it's difficult to predict when inflation expectations will start to gain traction. While quantitative easing tapering efforts are being introduced with some signs of economic improvement in the US, we believe tapering could reignite deflation fears.
The market was reassured after Janet Yellen's nomination as Federal Reserve chair, but the bond yield-to-maturity suggests that deflation risk is still alive and well. There is more work to be done before inflation becomes a bigger concern, and as such, we believe the gold market will remain challenging. The challenge is centered on balance sheet risk in a market where margins are negative, thus resulting in many value traps that are out there right now.
TGR: Earlier this week, I spoke with a US-based analyst who believes that rising wage pressure, higher rent and food prices in the US will lead to a slow climb in inflation in 2014 and beyond. Yet, you are talking about the risk of deflation. Other than bond yield rates, what else tells you that deflation is the bigger risk?
Paolo Lostritto: Across the board, commodity prices have been under pressure, suggesting that the risk of deflation is still real. Another data point is the inflation expectations data set compiled by the Cleveland Federal Reserve. Right now, it shows that inflation expectations are muted at best.
We believe we are in a similar environment to the 1974-1976 midcycle correction in gold before the onset of inflation. During that period, gold fell from $200 per ounce to $100 before higher money velocity generated inflation in the Western world that drove gold prices to more than $700. While gold has nearly decreased by a similar percentage since the highs set in 2011, we have yet to see definitive evidence of higher money velocity. This, combined with positive real rates, results in our cautious stance.
It is worth noting that if higher inflation were to materialize, it is likely to be driven by emerging markets, which would then begin to export said inflation. I believe gold could go much higher in the long term, but in the meantime, we've got to take a position that a lower price is quite possible and that balance sheet risk remains high.
TGR: An October 2013 research report from National Bank Financial (NBF) suggests that there is inflation risk when the money multiplier increases beyond a 1:1 ratio. What will keep that ratio below 1:1?
Paolo Lostritto: The money multiplier is a crude measure of money velocity. While it demonstrates that both the monetary base and M1 are growing, there has been enough to translate into higher inflation expectations. The government is giving mixed signals. The Fed's policies are reinflationary. Government policies, in contrast, have been emphasizing austerity.
We need to see that the liquidity being provided is actually getting traction and is producing real economic growth. While there are early signs that this is starting to happen, I would like to see how the bond market reprices inflation expectations. We still believe the deflation risk remains high – you need to be defensive.
There are signs that the US economy is turning around. But, many economists don't see inflation in the system, and that's bad for gold. That will change only when the velocity of money starts to improve, leading to better capacity utilization, which translates to higher inflation expectations. It will take time for those signals to align.
TGR: In the event of another collapse, what weapons does the Fed have left?
Paolo Lostritto: More money is all we've got left. The Fed can purchase more bonds, which effectively introduces more liquidity, but we would probably see monetary policies that would coincide with fiscal policy to allow for some infrastructure projects. We would want the new liquidity to show up in the real economy, as opposed to the coffers of Tier 1 banks.
TGR: Physical holdings in exchange-traded funds (ETFs) have fallen in lockstep with the gold price. Are Chinese and Indian gold imports enough to sustain the gold price, or push it higher?
Paolo Lostritto: About 800 tonnes have sold out of the ETFs, and there have been a similar amount of purchases through Hong Kong into mainland China. Demand in India remains robust, despite elevated import taxes. There also are signs of more smuggling into India. However, we're still dealing with a potential 1,800 tonnes of ETF supply.
The weak
gold price is less a function of supply-and-demand and more a function of deflation risk. We see gold as another type of currency. If all the gold mines in the world shut down tomorrow, it would only equate to removing 0.1% of aboveground stocks.
TGR: What's your projected trading range for gold in 2014?
Paolo Lostritto: We're using $1300 per ounce to value our stocks. If our worries are confirmed and the bond market starts to signal an increased risk of deflation, we could be dealing with a lower gold price deck.
The average all-in sustaining cost number may be the better number to use. That could drop to $1000-1200 per ounce.
On the flip side, if we see velocity and inflation expectations start to go up and the real rates go negative again, that fair-value number is probably closer to $1600-1800 per ounce. This is a very difficult time to predict the gold price.
TGR: When NBF calculates all-in cash costs for gold miners it uses a different definition than the World Gold Council. You omit non-cash remuneration and stockpiles/product inventory write-downs. On all-in sustaining costs, you also omit reclamation and remediation at operating and non-operating sites. Would investors be better served if these definitions were the same across the board?
Paolo Lostritto: We, and the World Gold Council, are trying to define the true average cost of the industry. We are roughly in the same ballpark. You mentioned what we exclude, but we also include cash taxes. The World Gold Council excludes cash taxes and interest payments.
Remember, we're tabulating this based on public data. Not every company breaks out its true sustaining capital in a given quarter versus growth capital. We approximate the sustaining capital number by using depreciation, depletion and amortization as a proxy. Of course, it won't be accurate because it uses depreciated data dollars as a proxy, but it's a good start.
TGR: Roughly what percentage of the producers you follow make money at today's level of all-in cash costs or all-in sustaining costs?
Paolo Lostritto: From an all-in sustaining cost perspective, the Q3/13 50th percentile is around $1050 per ounce. That means 50% of the industry is losing money, not from a growth perspective, but from a sustaining basis at $1050 per ounce and above. It was $1200 per ounce in Q2/13.
TGR: That's shocking. Does that make you want to look for a different line of work?
Paolo Lostritto: We're in the midst of a once-in-a-century event. I believe there are two ways out of it. Scenario one: We have a deflationary recession, also called a depression. Scenario two: We repeat what happened in the 1970s and we inflate our way out. But this time it's on a global scale.
Based on the behavior of the central banks of Japan, the UK and the US, they seem to be trying to inflate their way out. The question then becomes, when will inflation gain traction?
TGR: A recent NBF research report compared takeover transactions among senior producers, midtier producers, developers and explorers. Where are investors getting the best bang for their buck?
Paolo Lostritto: Historic transactions have to be considered in the context of the market at the time. Today's market resembles 2008. One could argue that this is a great time for free cash flow entities to acquire assets. In a market where cash is king, it's all about doing bite-size, tuck-in type acquisitions that allow companies to take advantage of a challenging market.
Structurally, some large companies are set up to mine gold at a rate that Mother Nature cannot support. Deposit discoveries are not the size or frequency that can support them. There's an opportunity for the smaller companies to acquire good assets that can be developed to create tremendous value when the market turns.
TGR: On net asset value (NAV) and enterprise value per ounce, which of those four spaces provides the best return to investors?
Paolo Lostritto: There's a lot of value out there, but investors want to avoid being caught in a value trap. For example, a company may be cheap on a price-to-NAV and price-to-cash flow basis, but it also could have lots of balance sheet risk. If it goes bankrupt before the market turns, investors are caught on the wrong side of the trade, despite the fact that it's great value.
I would rather buy something that generates free cash flow. "Be defensive" has been our thesis since early 2013. Free cash flow companies will yield, even if this market lasts four more years; the NAV continues to grow. When the market rerates, investors are actually up.
TGR: Do you have a parting thought for investors as we usher in 2014?
Paolo Lostritto: It's been a challenging market on multiple fronts. There are a lot of moving parts and it has been frustrating for everybody in the mining space. A lot of exuberance has been flushed out of the system.
Nonetheless, there are good people doing some good things. There are value propositions out there. Solid management teams will be able to take advantage of this market to drive value in the longer term.
TGR: But you're still preaching defense?
Paolo Lostritto: Correct.
TGR: Paolo, thanks for your time and insights.
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