EDITORIAL & OPINION — COMMENTARY — Banks need simple gold plan

As the gold mining industry holds its collective breath and peers over the US$250-per-ounce precipice, it is time to ask if the death of a responsible gold mining industry is in your best interest. Usually, central bankers need not concern themselves with micromanaging the economy through evaluations of specific industries. However, gold mining is different. In your rush to exchange gold for working assets, you are debasing the value of your gold assets to a far greater extent than the relatively minor gains in interest received from those sales. This will sow the seeds for a strong reversal in supply and demand dynamics and, therefore, pricing.

In the absence of primary supply, prices will rocket upwards after the central banks have disposed of their excess gold. This could destabilize the entire financial system. At the very least, without a reliable supply from mining, unprecedented volatility in the gold price would be expected. Is this your objective?

The central bankers of countries wishing to dispose of their gold holdings must prevent this potential catastrophe by instituting an orderly sale process. It is not gold sales that have shaken the market so badly, but uncertainty about future dispositions. Look what the disorderly process of the past few years has done to the value of your remaining holdings.

The past three years of selling and threats of sales by central banks have knocked about US$120 per ounce off the price of gold. Multiply that by the 36,000 tonnes held by central banks and you have a paper loss of US$130 billion. It is unlikely that this loss will be recovered by interest gained on those sales anytime in the foreseeable future.

Central bankers selling their gold could not have done a better job of getting less money for their product. Since the central banks own enough gold to satisfy 10 years of global demand, a little planning now could go a long way in ensuring that the orebodies of today are not completely wasted.

What is taking place in the murky world of gold trading is analogous to a once-prominent company that has run into financial difficulties. If everybody has shares on margin and the share price is falling, brokers will issue margin calls. If these are not paid, the liquidation process begins. In this type of situation, the first one to sell gets the best price. The only difference is that the price of gold will go back up when the selling pressure is relieved.

In any event, an orderly disposition of excess gold over the span of a few years could result in a large increase in realized revenue for central banks, compared with continued liquidation in a falling market.

Aside from profit, a healthy gold industry has other benefits for you to consider. Gold mining employs over a million people worldwide, many of them in poor countries. Furthermore, only well-financed mining companies can protect the environment. These companies have the skills and resources, as well as the inclination, to mitigate the impact of their activities. Local hand miners the world over are not able to direct any of their attention to remediation or reclamation. They generally operate outside regulatory boundaries. No matter how low the gold price goes, the small hand miners will still exist because it is all they know how to do. Thus, a shutdown of the industry will remove all responsible operators and leave the small fringe players.

Part of the blame for the current situation lies squarely at the feet of the gold industry and, to a lesser degree, its co-conspirators, the investment bankers. No other basic, capital-intensive business can command the high valuations of gold mining companies. Because of this mystique, mines were built that should not have been. Too much emphasis was placed on pure production for production’s sake. This obsession with size will surely give way to a greater emphasis on profitability. However, it costs the average, well-run gold company close to US$300 to produce an ounce of gold when all expenses — including depreciation, financing, acquisition, reclamation and general and administrative costs — are added to the ledger. The latest jargon about “total cash costs” is smoke and mirrors.

At today’s gold price, most small mining companies will disappear in a couple of years. Certainly the weak and leveraged will be gone before that. Bigger companies with large hedge books could probably last five years or more, but even giants of the industry could disappear in ten years or so. Take away the forward-selling premium or contango and the industry is simply not profitable at today’s low prices.

Perhaps this is what central bankers desire. You are willing to part with your bullion for less than the long-term costs of production. For the most part, you still own the gold you owned 25 years ago. Some of the smaller central banks, notably those of Canada, Belgium, Holland, Argentina and Australia, all highly indebted countries, have made meaningful dispositions over the last 10 years. What has changed is the existence of the gold that they control. Approximately 40% of the estimated world inventory of 130,000 tonnes has been mined in the last 20 years. Individuals and industry have absorbed this new supply, not central banks. As a result, the percentage of physical gold in the world controlled by central banks has dropped to 27% from 45%. Has this factor made the bankers feel irrelevant?

I believe it is important to know the position of the U.S. Federal Reserve in relation to a viable gold mining industry. While gold pays no interest, it is no one’s liability, either. Therefore, it is a static asset. Perhaps there is no place for gold in the reserves of the large, modern central bank. Perhaps the Federal Reserve sees certain benefits in purchasing the estimated 12,000 tonnes of excess gold currently slopping around the system. Is it just coincidence that the country with the most gold (the U.S., with 8,000 tonnes) also has the strongest currency?

Unless central bankers desire the complete demise of the industry, they could help all concerned, including themselves, with a clear plan for the disposal of excess gold. Central banks should declare how much gold they are selling and keeping.

A 20-year proposal to sell, say, 10,000 tonnes at prices scaled up by US$10 annually at fixed prices would be well-received by everyone except speculators. A 1,000-tonne-per-year disposal could easily be absorbed if the market is not distorted with more “official cheating.” A central repository and administrator could ensure good delivery, and could even put down a sizable deposit for the current owners of the gold by creating transferable warrants for one to 10 years, with strike prices at US$10 increments.

This is just one idea, but a semblance of order and a plan are required to save the industry while at the same time increasing the value of the remaining gold held by the central banks. Such a system would be immensely profitable to those selling the gold and, in paper terms at least, to those holding it.

In fairness to gold mining companies, investors, other bankers and the environment, perhaps you could share your thoughts on the future of our industry, which I observe to be in a state of rational despair.

— The preceding was sent to the heads of several central banks by the author, chief executive officer of Toronto-based Wheaton River Minerals.