EDITORIAL & OPINION — COMMENTARY — Who killed the golden goose?

Whenever logic falls short of explaining actions or facts in the popular mind, conspiracy theories tend to surface. We saw this in the aftermath of president Kennedy’s assassination, and we’re seeing it today, with gold at 20-year lows. We think we know who killed Kennedy, but we’ll never know for certain why. As for the Golden Goose, there’s even less mystery as to who, and yet the why is just as enigmatic.

The single greatest damage caused to the gold price has been indiscriminate leasing, by central banks, of their gold reserves at give-away interest rates. The current one-month lease rate for gold bullion is less than 1%, while the 12-month rate is around 1.5%. Compare this with U.S. T-Bills for the same duration going for 4% to 4.8%, and you find a spread of more than 3% in favour of U.S. T-Bills.

U.S government T-Bills are the most risk-free form of dollar-denominated debt. Gold, which is not a debt of any government, is denominated in U.S. dollars. Does it make sense that it be priced at a 75% discount to U.S. T-Bills? I think not. Perhaps a 25%, or at most a 50%, discount (as with the silver leasing rates) might be more appropriate. The gold lenders — that is, the central banks of Switzerland, Germany, etc. — are conferring on borrowers billions of dollars of benefits while their gold reserves have been depreciated by more than $50 billion in the past year alone. These suicidal rates are a gift to the speculators, hedge fund managers and producers who hedge.

In the meantime, producers who have hedged their short mine lives or high cash costs of production (such as the Australians) have enjoyed a huge windfall. Some have made the most of it by hedging up to 10 years of production or, in some cases, not only their entire reserves but all their resources. For long-life producers that are heavily hedged, this could prove to be a pyrrhic victory, as they are helping to reduce the value of their remaining ounces in the ground, which can be four to five times larger than their hedge books. Clearly, the biggest winners are the speculators, the people least interested in gold.

The sale of gold reserves by central banks is another issue. In the past, it could be done without affecting the market. Canada, for example, disposed of close to 1,000 tonnes over 10 years without causing so much as a ripple. Why, then, has the Bank of England’s proposed 415-tonne sale, to take place over several years, been so devastating? Gold has lost 10% of its value in just over a month. The answer is simple: different times. In a non-inflationary environment, such as we experience today, the great bulk of gold’s demand is in jewelery. Jewelery demand, in turn, is directly a function of world economic activity. Right up until 1996, the world economy was solidly growing, mostly because of the tremendous expansion of the Asian tiger countries, which also happened to be large gold buyers. Gold demand grew accordingly, more than doubling in that timeframe and absorbing large central bank sales yet keeping prices in the range of US$360 per oz.

Not so today. With the Asian economies in disarray, and Europe barely escaping recession, incremental gold sales can be absorbed only at lower prices. If the central banks continue to ignore these market conditions, their sales could overwhelm whatever demand there is and drive gold prices right down to US$200 per oz., if not lower. The gold market is not as infinite as the central bankers’ incomprehension of its workings!

Producers have reacted in typical miner-like fashion by boosting output to cut cash costs. At a time when gold is hitting 20-year lows, production is setting new records. Does that make sense? Obviously not. The miners have driven down their cash costs of production to about US$200 per oz. at the end of 1998 from US$250 in 1995. This didn’t do much to help the bottom line as gold plunged more than US$100 per oz. in the same period. Even worse, a great deal of the cost gains were achieved by mining at grades well above reserve grades: for example, in the U.S. some millhead grades are 36% higher than the mine’s reserve grade. In plain language, it’s called “high grading,” and it can’t go on forever, as orebodies are being depleted at a much faster rate than is prudent.

In the past two years, about US$3 billion in gold mine investments has been written off, and more will follow. At US$260 an oz., 40% of worldwide gold production is losing money on a total-cost basis. It is not surprising that, in light of the dismal returns generated by this industry, the equity markets have all but disappeared for the more junior companies and shrunk considerably for even the seniors. Unfortunately, the mines and mills that were built with easy money are now hard to shut down and contribute to the downward spiral in the price.

What can be done? Plenty, as it turns out. First, gold lenders should recognize that gold is denominated in U.S. dollars and not Japanese yen. Much like the physical market, the gold-lending market is finite. By charging below market rates (compared with, say, silver, where the stockpile is already in private hands), central bankers are encouraging massive speculation in one of their reserve assets. If they were to help develop new financial instruments using gold, they might be able to put more of their reserves to good use without giving them away. How difficult is it to understand that they have everything to gain: from higher interest revenue to larger capital gains on their gold reserves to a more stable financial market.

Second, central banks should co-ordinate and monitor the effect of their sales on the gold price. It would be entirely to their advantage to refrain from driving down the price by holding back sales in a weak demand environment or, better still, picking a price of say US$300 per oz. as a floor to any sales.

Whether they like it or not, as long as six central banks own about 30% of all the gold ever mined, their actions will have a profound influence on the market.

As for producers, the longer they wait to take action — that is, to cut production — the worse things will become. Maybe the world economy will briskly turn around and save the day, and maybe the CIA killed president Kennedy.

— The author is the president of Franco-Nevada Mining and Euro-Nevada Mining, both of which are based in Toronto.