Dear Reader,
Having just wrapped up many long hours on this month’s edition of The Casey Report – which looks like it will again top 50 pages – I must confess to a certain sense of post-exertion lethargy.
Not that I’m complaining, mind you. While I enjoy being crazy busy, more than is probably healthy, a day such as this, with no big pressure hanging overhead, is a rare and welcomed change of pace.
And so, leisurely, I turn to what’s what in the attempt to separate that which is important from that which is mere hype and news filling.
Here’s one item – it has to do with our favorite metal, gold. As many and maybe even most of you now count precious metals among your most important assets, keeping an extra close eye on the metals just now seems worthwhile.
Central Banks Banking on Gold
That’s the title of a just released report by Raymond James, which is far more commodity savvy than many of its competitors. Following are some excerpts you might find of interest…
The major paradigm shift we have seen evolve recently is the transition of central banks from net sellers of gold to net buyers. Given the inelasticity of mine supply, this shift has significant implications for gold’s supply/demand equation over the medium term. Furthermore, the symbolic implications of central banks buying gold (i.e., indicating a lack of confidence in the U.S. dollar) should underpin healthy retail investment demand as well. We believe this lack of confidence may not be restored for several years given the extent money supply has increased in the U.S. and the extravagant levels of U.S. public debt that will be further encumbered by the building burden of an aging population and health care inflation.
We continue to believe the equities are roughly 30% undervalued versus the gold price, and as a result we recommend investors add to their precious metal equities positions. We also suggest, based on historic valuation metrics, that the Junior/Mid‐tier producers offer better upside at current levels.
And…
EXPECT GOLD & SILVER PRICES TO REMAIN STRONG
Since the end of the third quarter gold and silver prices are up 16% and 9%, respectively. In absolute terms gold is up $163/oz, an impressive result; however, we would argue this is just the beginning of a longer‐term period of strong precious metal prices based on:
1. Investment demand continues to be extraordinarily strong (and we see no reason for this to change) given the loss of confidence in both the financial system and policy makers and as investors prioritize capital preservation over capital appreciation, increasing portfolio allocation to more creditworthy or “safe haven” investments, i.e., precious metals. Regaining this loss of confidence in the financial system and policy makers, in our view, will take a considerable amount of time, earning precious metals a permanent place in any prudent portfolio and underpinning prices over the longer term.
2. The specter of future inflation is building. Recall it is the fear of inflation that tends to drive the metal prices higher.
3. Declining supply – central banks have moved from net sellers to net buyers. This is a significant structural change in the gold market as central banks have been net sellers for two decades. Central banks looking to diversify their reserves in light of the rampant currency debasement have very few options available, and we would argue gold is the most attractive. It is also important to note new mine supply has essentially just been replacing aging mines. Given the long lead time between finding a deposit and actually moving it through to production is on average around 10 years, new mine supply remains largely inelastic. Adding further pressure on the supply side of the equation is the dearth of new discoveries and the increasingly challenging mine development environment.
4. All‐in costs remain high – aging mines are experiencing declining grades, and new projects tend to be of lower quality, requiring higher and higher metal prices in economic studies, which are still returning IRRs in the mid to high teens.
5. Very low/negative real rates – lowers the opportunity cost of holding hard assets. Most major countries (including the U.S.) continue to support a low interest rate environment; we suspect this will be the case for some time to come as increasing rates may derail recoveries.
On point #3, Doug Casey points out in his article The Greater Depression Is Here in this month’s edition of The Casey Report (more here), since peaking in 2001 at 83.7 million ounces, annual gold production steadily fell throughout most of the period and has only recently shown an upswing. When you take out the impact of dehedging, gold from new mine supply in the third quarter came in at about 73 million ounces on an annualized basis.
That is not to say that the world is running out of gold, but anyone in the industry will tell you that it’s not an easy business to be in under the best of circumstances.
Now more than ever, finding a new deposit of any potential size, then raising the capital to evaluate its potential as a mine, then raising the additional capital to turn it into a mine – all the while fighting a rear guard battle against NGOs, environmentalists, greedy politicians, and, depending on where you operate, armed rebels – requires a Herculean effort. There’s an old adage in the business that only one in a hundred discoveries becomes a mine, and I suspect that the success rate could be even lower than that.
Simply, building a mine is very much not like building a new box store or fast food outlet on a conveniently accessible corner.
Meanwhile, against new supply, the demand for gold is currently running at an annualized pace of over 100 million ounces.
Of course, as demand increases, so, typically, does the number of people willing to ship their treasured family heirlooms off to the nearest smelter. That makes up a lot of the shortfall between new mine supply and demand: recycled gold is the second largest source of supply after new mine production.
Interestingly, even with gold’s more or less steady rise in price, the supply of recycled gold has been steeply falling throughout 2009 – from 18.2 million ounces in the first quarter, down to just 9.02 million ounces in the third quarter.
Even more eye opening is the shift in supplies to the market from central bank selling, which has gone from 1.9 million ounces being sold into the market in the first quarter of 2009, to a net purchase of almost half a million ounces in the third, reflecting a year-on-year fall of 83%.
So, what’s important in all of this?
I would contend that, no matter what else comes out of the current crisis, the true nature of the fiat currencies has been revealed for all to see. And gold has been once again found to be the only reliable form of money.
The long-term consequences of these revelations (which are not revelations at all to most of you, dear readers) are that anyone who’s been paying attention – individual and institutional investors – will never again dismiss gold as having no role to play in modern finance.
Further, the idea that central banks should divest themselves of their only tangible asset – gold – has been relegated to the trash heap of history. It is thus that we are now hearing influential voices in China calling for an increase in its reserves of another 159 million troy ounces of gold, roughly twice annual global gold production. At $1,200 gold, that means they’d have to spend $190.8 billion, which, while a lot, is really not all that much compared to the size of their reserves of U.S. dollars.
Of course, were they to try and aggressively meet those sorts of targets – competing as they are with other central banks that have now seen the golden light – the price of gold would head much, much higher. That argues for them trying to do off-market transactions – buying whatever gold the IMF wants to sell before it hits the market, for example. And it argues for them rebuilding their gold reserves at a more measured pace.
But most of all, it says that there is a new and very solid floor under the price of gold. Can it correct 5 or 10% in the event of a broader market sell-off? Sure. But more than that? I doubt it.
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