Gold industry needs to develop markets

For four weeks now, we have been seeing the Friday Effect: the gold price goes up in anticipation of military action on the weekend, and gold shares rise along with it. The old “safe haven” theory appears to be operating once again.

Then the Monday Effect comes along and wipes out the safe-haven premium.

Thus it has been with everything that has moved the gold market in the past five years: there is a jump, and a slow settling-down to the main trend line. Perhaps there is an explanation that does not resort to conspiracy theory, and perhaps a plausible explanation could shed some light on what the industry could do to get out of its hole.

At the Denver Gold Show at the beginning of the month, Christopher Thompson, chairman and chief executive officer of Gold Fields, presented a thoughtful examination of the gold market. Although it does not make comforting reading for instinctive gold bulls, Thompson at least sees some hope for the industry beyond its adopted mantra of “consolidation.”

From an examination of the operating and financial condition of the nine major gold producers, Thompson concludes that the gold industry took on a defensive posture through the years the gold price declined. Higher production rates, along with a slight shrinking of the reserve base, have sharply diminished reserve life. Another trap was the industry’s use of high price assumptions to calculate reserves; when those high prices never appeared, the writedowns started.

And it has been acquisition, not exploration, that has propped up the industry’s reserves. Between 1993 and 1998, the gold industry spent 70% more on acquisitions than it did on exploration; in the last two calendar years, the industry has spent three and a half times as much on acquisitions as on exploration.

Acquired ounces are expensive ounces, and the expense shows in gold producers’ financial condition. The nine companies Thompson examined saw their total debt rise to US$5.2 billion from US$3.5 billion in 1997; their book value — hit by writedowns of projects and reserves — fell to US$10.4 billion from US$11.7 billion in the same period. Results of that kind can hardly give much comfort to the backers of consolidation-at-any-price.

And yet Thompson, one of the leaders of the non-hedging camp, concedes (as does another non-hedger, Pierre Lassonde of Franco-Nevada Mining) that without hedging this picture would be far worse. And Thompson says that for hedgers in a world of decreasing interest rates, rising lease rates, and a stabilizing gold price, “the advantage is slipping away.”

Thompson estimates that replacing an ounce of gold costs between US$295 and US$408. At present prices, the metal is not worth finding, even on Fridays. And if reserves are not worth finding, they are even less worth buying, a truism borne out by the deteriorating balance sheets.

Costs have fallen, but in South Africa and Australia, falling local currencies have played a major role in cutting costs. To a lesser extent, the same has happened in Canada. “Real operating cost reductions,” says Thompson, “have been achieved only by a few.”

In staying on the defensive, the industry survived but left itself open to the fundamental threat to its existence: that it no longer has a buyer of first resort for its gold. That is the ground that had always been conceded to the central banks, who hoarded gold as a guarantee of their currencies. If a country’s economy, and consequently its money supply, grew, then so did the gold holding of its central bank.

Thompson recognizes that those days are gone. Many central banks have abandoned gold as a major monetary asset; few, if any, are accumulating it. And an industry that has had no reason to ensure the marketability of its gold is now faced with exactly that task.

Thompson contrasts this with base metal producers, who have always had to develop their markets (the nickel market, virtually invented by the big nickel producers, is the classic example). His challenge to the gold industry is “to manage existing [markets] and create new markets for gold.”

It is unlikely to be easy. The jewelry business, which takes off about three-quarters of newly produced gold, is cyclical but does respond to active marketing. Industrial applications — the mainstay of the white metals — are always developing, but often these are not big-volume consumers.

That leaves bar hoarding, which Thompson calls “the new market opportunity.” He suggests that investment demand can be stimulated by offering new products beside the familiar bars and coins, and ownership can be made easier by developing a distribution network and providing more (and more timely) market information.

That may be hard to do. In the end, the investor will be determinedly cold-blooded about his choice of investment, and bars, coins, other physical gold, or gold-backed derivatives will be bought only when they produce adequate returns. A perfectly transparent market might be brought into being, yet if it simply gives investors a window to see the price dropping, it will have done the industry no good.

But whether investors can be led to gold or not, the industry must do something if it is to survive. When gold became, in essence, a bad buy for central bankers, it lost its principal market; and Thompson’s point is that it needs a market again.

Some participants in the gold industry, particularly gold investors, have talked as though the world owes the gold industry a revenue stream. Thompson plainly realizes this is not so: and the industry would do well to listen.