Guarded optimism for 2014 from PI Financial’s Jim Mustard

VANCOUVER — In the final talk of the Association for Mineral Exploration British Columbia’s (AME BC) Roundup conference, PI Financial’s vice-president of mining investment banking Jim Mustard gave the audience reason to believe gold prices will stabilize and investors will return to the mining sector in 2014 — if miners work to rebuild lost trust.

“We have been through a crisis, I certainly believe that,” Mustard said. “Now the mining sector needs to rebuild its trust with investors. There have been huge problems with the sector, whether it’s technical, whether it’s financial, whether it’s over-optimism. We need to rebuild trust — we need to make investors money in this industry again, and I think this is a fantastic place to start.”

Looking around the sector, Mustard sees opportunity: Valuations are down; commodity prices are down; the downturn has lasted about as long as such cycles usually last; there is little reason for the U.S. dollar to continue climbing; and the rally in other equity markets is expected to slow.

“Gold is off almost 50% from its high in 2011, and now we’re into the third or maybe fourth year of expenditure cutbacks, from majors to juniors,” Mustard said. “But the average gold price so far this year has held around US$1,240 per oz., and I find that encouraging.”

After losing almost 35% in 2013, a stable gold price certainly is encouraging. Like many of his peers, Mustard blames exchange-traded funds, or exchange-traded products (ETPs), for part of gold’s 2013 decline.

“Starting in about 2009 there was a fairly dramatic increase in ETP gold holdings,” Mustard said. “Then the gold price started to decline, but the S&P continued to rise dramatically over the last two years — we saw a dramatic shift out of gold by those funds. That was really one of the key issues we were confronted with last year.”

In late 2012 ETPs held over 2,600 tonnes of physical gold. By the end of last year that inventory had been sold down to 1,740 tonnes, a 33% decline. Mustard does not expect the scenario to repeat itself, and indeed in January ETPs only sold 2 tonnes of gold.

Mustard is also interested in physical gold’s movement around the world. The official line from China’s central bank is that its gold reserves have been unchanged for years, but observers disagree. In fact, many believe China holds 2.5 times more gold in reserve than the 1,040 tonnes claimed.

“Why is this important?” Mustard said. “Because the question is: where is all the physical gold going? Who now owns it? There’s a tremendous amount of discussion about the paper trade in gold — the hypothecation of gold sitting in vaults in London or Fort Knox. And Asian demand has traditionally been 45% of global output, but between China and India that demand is estimated to be 80%. So there are some pretty dramatic shifts taking place in terms of where the demand lines up.”

The other elephant in the gold room is money supply.

Quantitative easing (QE) was expected to support the gold price. The U.S. Federal Reserve’s massive bond-buying program has been injecting billions of dollars into the market each month since 2009, a huge boost to liquidity that should have devalued the U.S. dollar and boosted gold because of its “safe-haven” status.

At first the stimulus corresponded with a rising gold price, but in 2012 those factors decoupled, and in 2013 gold fell while stimulus continued. Mustard thinks this is because banks are not paying the liquidity forward.

“Deposits at commercial banks are going up nicely — thank you very much, Fed — and their balance sheets look tremendously improved, but they’re not lending it out,” he said. “When they do, that’s when we’re going to see a lot of inflationary pressure.

“I think that’s part of the answer to the question of: when will the phoenix rise from the ashes?” he continued. “It’s when we start to see inflationary pressure return to the marketplace. It hasn’t been there for the last couple of quarters, and that’s one reason that gold prices have not been reacting to all the QE money.”

Currency concerns will also play a role in 2014. Several countries have seen their currencies devalued of late, including Argentina and Turkey, and some are reacting by raising interest rates. Rising interest rates suggest an inflationary market, which is typically good for gold.

To look forward sometimes requires looking back. Using a chart of the S&P/TSX TSX Venture Composite Index and its predecessors going back to the mid-1980s, Mustard pointed out that market cycle downturns can be as short as a year, but generally max out at three years. Even the downturn that followed the Bre-X Minerals scandal of 1997 only lasted three years. And the current cycle is three years old.

“We’re guardedly optimistic,” he said. “One year to stabilize — that’s this year — and maybe two or three more to be back. I think 2014 will be a year of volatility, but investors rejoice! There is a fire sale of opportunities out there.”

Retail investors are not the only ones looking for opportunities. Mustard acknowledged the sector’s increasing interest in private equity.

“It’s there, believe me,” he said. “I’ve met these groups and they have capital like you wouldn’t believe that is ready to deploy. They’re being selective — it’s sticky money. But it’s an indication that the equity market isn’t far behind, because they wouldn’t be deploying their money if they didn’t think they would get a solid return on that investment.”

Mustard asked almost 40 analysts and market observers for their gold-price predictions. While a group are calling for US$1,000 per oz. or less, he said the consensus was rallying at US$1,200 per oz. for 2014. At PI Financial, Mustard says analysts are using US$1,400 per oz. in their 2014 models.