Mining’s old guard needs strong medicine
A new report details subpar investor returns in the mining industry over the last decade, particularly big cap diversified companies which have not adapted to new realities.
“Here we go again”, with the “Same Ol’ Situation”, so “Follow the Yellow Brick Road” to a “Future so Bright, You Gotta Wear Shades.”
I’m obviously inspired by music this week.
In case you didn’t recognize all of the song references. “Here we go again” is actually reference to “Here I go again” a classic 80’s rock ballad by Whitesnake. Please excuse the creative license. It helps frame our thoughts on the debt ceiling this week.
“Same Ol’ Situation” is another 80’s rock classic by Motley Crue. It’s intended to frame our view that QE will continue indefinitely, regardless of recent Fed jawboning otherwise.
These first two songs symbolize the above two gold price catalysts, which we think should prompt investors to “Follow the Yellow Brick Road”. Of course this song came from that timeless classic, The Wizard of Oz (1939).
Should you follow this advice, we feel that you will have a “Future so Bright, You Gotta Wear Shades.” Unfortunately for the band Timbuk3, this song was their only hit. It’s kind of ironic if you think about it.
Anyways, we hope you enjoy the theme and today’s topic, so let’s get to it.
“Cause you know what time it is”, it’s debt ceiling time, “raise the roof!”
Before briefing you on where the debt ceiling debate stands, let’s start by making a bold prediction. Remember, you heard it here first. The debt ceilingWILL be raised.
All kidding aside, how can anyone take such a debate as anything more than a circus act?
To quote the U.S. Department of the Treasury,
“Congress has always acted when called upon to raise the debt limit. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit…”
In this context, does anyone really believe that once the political theatrics and posturing are said and done that the debt ceiling won’t be raised? Perhaps they’ll push past the deadline to add some credibility to their circus antics. But as far as we’re concerned, U.S. debt ceiling debates are a stellar example of an anticlimax!
The real issue of course is perpetual trillion dollar budget deficits fueling mushrooming federal government debt. From this perspective, the debt ceiling is like that silly paper sign that cheerleaders hold up in front of the stadium tunnel for American football teams to crash through as they run onto the field. They don’t even slow down before impact.
Nevertheless, the debt ceiling has become an integral and recurring part of the U.S. budget and borrowing process. Therefore, the manner and timeliness in which Congress handles the matter can and does have a significant impact on the credibility of the U.S. government, public opinion, and the markets.
This is especially true since the Global Financial Crisis (GFC) in 2008 and the extraordinary budgetary and monetary expansion that has taken place in its aftermath.
For example, during the 2011 budget crisis, Congress failed to raise the debt ceiling in a timely manner. As a result, the Treasury was forced to resort to“Extraordinary Measures” to fund the government while Congress and the President debated the matter.
A couple examples of these extraordinary measures are things like suspending required funding of government employee retirement accounts, such as the Postal Service and the Exchange Stabilization Fund.
The four-month delay, which ran between April and early August, resulted in the first downgrade ever of U.S. government debt by well-known rating agency Standard & Poor’s. These events significantly undermined public confidence as Congress’s reputation plummeted in public opinion polls and has not recovered since.
In the aftermath, stock markets around the world had their worst week since the GFC. In addition, the Government Accountability Office estimated that as a result of the loss in credibility, future U.S. government borrowing costs would be significantly higher than they would be otherwise.
Unfortunately, by its very nature, the debt ceiling is an issue that refuses to go away. Budgets remain at unprecedented levels and therefore the nation’s debt continues to climb precipitously. As a result, U.S. government spending once again reached the debt ceiling at the beginning of this year.
The government’s response this time was a variation on the 2011 theme. The President signed into law the “No Budget, No Pay Act” which suspended the debt ceiling until mid-May. For its part, the Treasury once again resorted to Extraordinary Measures to keep the government’s lights on.
In May the farce continued when the debt ceiling was reestablished at $US16.7 trillion, which was the exact level government debt had already reached. Therefore, this new debt ceiling was breached almost immediately and forced the Treasury to continue its use of Extraordinary Measures. However, the Treasury then indicated that it would exhaust its means to fund the government by sometime in the fall.
This oversimplified explanation brings us to where we are today, with the exhaustion of the Treasuries ability to fund the government.
Despite how poorly the U.S. political establishment (i.e. Congress and the President) has handled these matters since the GFC, we can’t predict whether they will handle it any better this time or script a sequel to their prior chaotic performances.
Still, regardless of whether they bungle the operation, handle it smoothly, or manage something in between, we remain certain that deficit spending will continue at its historic pace. Therefore, the debt will grow, and the debt ceiling will continue its inexorable rise.
And what happens when you continually raise the debt ceiling? Well, gold tends to go up. Take note of the correlation between the rising debt ceiling over the last 23 years and the gold price depicted in the chart below.
(Click to enlarge image)
“Look at them yo-yo’s, that’s the way you do it
You print them dollars like Ben Bernanke.
When the debt ceiling is raised, the U.S. Treasury will be allowed to borrow more money. With that problem solved, all they will need to do is find someone that will buy the mountains of Treasury debt issued by the government.
In the pre-GFC past, this was not a big problem. But, as we commented in last week’s missive, “Ben Bernanke Is Just Stringing You Along”, the traditional buyers of Treasury debt, namely China and Japan, don’t have the appetite they once had. And the only guy left with the incentive and the printing press to pick up the massive debt tab is the Federal Reserve.
We were not surprised that the Fed decided to extend QE3. It is intriguing that this decision came just ahead of debt ceiling negotiations. In this context, we don’t think it’s a stretch to infer that the Fed may be keeping their options open should the federal government need to borrow money when the debt ceiling debate dust settles.
Of course an additional reason why the Fed engages in QE is to suppress interest rates. With another debt ceiling increase imminent, controlling interest rates becomes ever more paramount.
As is repeated constantly, printing oceans of new money in the form of QE undermines the value of the dollar. Thus dollars become increasingly worth less when compared to assets that can’t be printed in the same manner. For an illustration of this, look at the chart below which shows the gold price since QE was started back in 2008.
(Click on image to enlarge)
Because you are an intuitive observer, you have no doubt noticed the shaded QE3 box and recognized that during this period the gold price has declined significantly.
There are obviously many factors that affect the gold price. Therefore, we are not suggesting that there is a direct linkage between QE and the gold price. The relationship is indirect and there are many contributing factors.
We have written at length in prior articles about the reasons for gold’s price drop over the last year. Our point here is that we think the current price action is transitory. In our view, with the debt ceiling raised as expected and QE-Infinity in place, their positive contributory effect on the gold price remains intact.
India is arguably the world’s largest gold consumer. Therefore we pay a great deal of attention to goings-on in the country’s gold market as part of our effort to understand supply and demand fundamentals.
Since January, the Indian government has continuously tried to suppress gold imports in order to rescue their plummeting exchange rate and balance of trade deficit. Their tactics have been to increase the import duty by 500% and institute a requirement that 20% of all imported gold be exported.
They had failed miserably until August when India imported a paltry 2.5 tonnes of gold.
However, several recent news reports suggest that India may be back in the gold game.
The reason for the halt in imports was due to the confusion created around the so-called 80/20 import and export rule. And now, because the government and the banks have clarified and agreed on how the rule should work, imports are set to resume. Intriguingly, this will be just in time for festival season.
This is obviously good news for gold investors. Typically, India’s festival season is responsible for 40% of their yearly gold demand. If this turns out to be the case again this year, India will easily surpass a record 1,000 tonnes of gold.
However, the government has indicated that they intend to limit gold imports to 845 tonnes for the year. This amount is still in record territory but casts significant doubt on the 1,000 tonne mark.
According to the World Gold Council, India has imported 616.5 tonnes of gold so far this year. Therefore, in light of the stated cap of 845 tonnes, we see a rational upside of over 200 tonnes between now and the end of the year.
Of course the best case scenario would be to see India import another 400 to breach the 1,000 tonne mark. Either way, 200 to 400 tonnes represents a reasonable assumption and a sizeable chunk of gold demand this fall.
We haven’t commented on the gold miners lately. However, we felt it appropriate to summarize the headwinds currently faced by the gold miners. Their negative impact on supply in combination with QE-Infinity and the return of India to the gold markets is good news for the medium to long-term gold price.
There has been a lot going on in the industry and not much of it good, at least in the short-term. Despite the fact that we believe the price is going higher and that the industry will emerge from the current upheaval much stronger and more profitable, we don’t foresee an increase in mined supply.
In fact, for a host of reasons, the mined supply of gold will likely decline in the years to come.
Very generally, they are dealing with rising costs, a declining gold price, declining profits, declining cash flow, record billion dollar write-off’s, dramatically increased regulation and taxes, labor issues, nationalization threats, declining discoveries, and declining ore grades.
With just a quick survey of the sector you will see many projects in dire straits(couldn’t resist). As an example, earlier this year Kinross abandoned what is considered one of the largest undeveloped high-grade gold projects in the world, Fruta del Norte, due to intentionally prohibitive tax requirements by the Ecuadorian government.
Another mammoth project that has recently incurred a setback is the Pebble deposit in Alaska. Already facing significant environmental hurdles, the Pebble deposit just lost its major JV partner Anglo American. This leaves the future of the large deposit uncertain.
There are many other examples including the large Rosia Montana project in Romania, which is facing strong social pushback for environmental reasons also. In Papua New Guinea, a prolific gold producing country, the Oki Tedi Mine was just nationalized.
As additional examples, the huge Pascua Lama (Chile/Argentina border) and Minas Conga (Peru) projects have been shut down with their futures in limbo.
With the industry facing unprecedented challenges, the gold supply is not likely to increase going forward. We believe this will to be true even though the industry is likely to emerge from its current troubles leaner and meaner over the next 2 years.
Even though the gold price has risen significantly over the last 12 years, mine supply has remained flat and, during the middle part of that span, actually declined.
Usually when the price of something increases over an extended period of time, so will its supply. This has not been the case with gold, as you can see in the chart below. The reasons are due to resource scarcity and challenges unique to mining. Viable mineral deposits are hard to find and developing a mine is capital, expertise, and time intensive.
As a result, no matter what the price of gold, supply will never dramatically increase and this is very bullish for the price. The chart below makes our point.
(Click on the image to enlarge)
For all the reasons discussed above “We know who we want to take home”.Gold.
The debt ceiling will be raised, U.S. debt will continue to climb and it will be funded by QE. As a result, gold demand will remain strong as people, institutions, and governments look to protect themselves from the aggressive devaluation of the world’s reserve currency (aka the US dollar).
And as we never tire of pointing out, a great way to take advantage of a rising gold price is by buying the shares of promising gold miners that offer strong leverage to the gold price. For this reason, you should check out our Comparative Analysis Table below.
It provides many critical metrics to use in evaluating and comparing gold mining companies. Its purpose is to help discerning investors pick the most promising gold producers, which have already begun to profit strongly from the price increase since late June.
Despite the recent pullback, gold is up roughly 12% from its interim low near $1,190 on June 27th. As a result, the majors in our Model Portfolio are up between 6% and 38% since that time. Shouldn’t your portfolio have some exposure to these returns?
(Click the image to enlarge)
That’s it for this week. Thanks for reading and we hope you enjoyed the Gold Miners music playlist!
Regards,
RJ Wilcox
