The ecstasy of gold

THE most exciting commodity is thrilling investors again, but the question marks that cloud future scenarios throughout the resources sector seem especially precarious in this space.
The ecstasy of gold The ecstasy of gold The ecstasy of gold The ecstasy of gold The ecstasy of gold


The forces that drive gold are so complex and nuanced that it's difficult to speak in terms of fundamentals, constants, ground rules or any historically accepted wisdom.

One thing is clear however: unlike any other major commodity, gold's historical insurance value is intimately tied to its ability to incite emotion. And it's because of this fact that it often zigs while the other metals zag with pitiless logic.

The recent momentum in the Australian gold industry is only the latest example of this often unpredictable nature. Even as energy and bulk commodities continue to drag, base metal prices flatline and investor appetite for resource risk is betrayed by an erosion of mining plays from the ASX, the gold business regains its footing.

For Australia, the bounce is rooted in that delicate cocktail of the local dollar versus the US dollar, what the US gold market is doing and the cyclic attention from major foreign investors sniffing for a bottom in the market. Merger and acquisition activity has picked up among the usual suspects, with North American private equity firms shopping for Australian bargains and China continuing to optimise its gold accumulation strategy via its expanding state-owned miners.

The deals have been flying fast and furiously (though not necessarily recklessly) in the past few months, with OceanaGold buying Newmont Mining's 100,000-ounce-per-annum Wailhi mine in New Zealand for $US10 million, Independence Group taking a key stake in potential takeover target Gold Road Resources and Chinese major Zijin Mining Group topping up its offer for Norton Gold Fields.

In project acquisitions and divestments, explorers Kidman Resources and Genesis Minerals have picked up company-defining gold properties, while Barrick Gold has shed most of its Western Australian assets. The Canadian giant also sold half its interest in Papua New Guinea's Porgera mine to Zijin for $298 million after notably offloading its operation at Lake Cowal, New South Wales to Evolution Mining.

Share price movements for many companies in the sector have been healthy this year, with Evolution, Northern Star Resources, Saracen Mineral Holdings and St Barbara making strides into - or at least toward - midcap status.

"It's a reflection of the creation of these mid-tier gold producers, mainly the two front runners Northern Star and Evolution, because the depreciation of the Australian dollar has made them more competitive on a global scale," Patersons research analyst Matthew Trivett told RESOURCESTOCKS*.

"It's a positive sign when you see people like Sumitomo earning into the Gold Road Resources tenements, where people aren't seeing the opportunities at the production level and are looking to downscale - but investors still need to be cautious about the quality of the asset."

Japanese conglomerate Sumitomo Metal Mining's investment in WA's South Yamarna project, however, doesn't fully represent the broader trend among major investors in the latest gold deal frenzy. Most activity by massive overseas companies with marginal exposure in Australia has been a matter of cautiously hiving off whatever they have.

The local welterweights take a window of opportunity into the big time while the minnows continue to hunker down.

"The small end of the market is still hampered by the frets that investors have over the dilution impact of finding something and the cost of bringing that deposit to commercial production, generally through issuing equity all the time," Fat Prophets analyst David Lennox said.

"That's really where the junior end has fretted since 2012 or 2011. Investors have just that mindset now that if you find something, it's got to be the crown jewels or we'll punish you by valuing you at a dilutionary commercial price.

"We're not seeing that filtering down approach that we would have seen in other boom-bust cycles, where the big companies suddenly thought, ‘we're not very good at exploring, let's pick up a few juniors.' The gold stocks at this point in time haven't been fishing around in the micro end of the market, they've been happy to look in their own backyards."

The risks of success

Even for the successful graduates into midcap status, the golden ladder can be slippery.

Eagle Research Advisory managing director Keith Goode notes that when gold plays chase index fund attention via quantum leaps in market cap valuation, the slide back to where they came from can be equally dramatic.

"When companies acquire something that has a similar market cap as themselves, they've often crashed and burned. I just hope Evolution haven't bitten off more than it can chew," Goode said.

"Lake Cowal is sub-level caving, which from a mining viewpoint is a completely different, big-boy game to anything else out there. There's a huge amount of expense upfront before you can start the cave and blast it. When you blast the cave, you have to do it in a sequential set fashion in order for it to cave properly. If you stuff it up - which is what Big Bell did years ago - then you lose the cave and you have to start again deeper down.

"Yes, they have Newcrest as a partner sitting behind them. Newcrest has the experience to do a sub-level cave. Maybe they'll be involved. Maybe it will even be passed on to Newcrest in return for further shareholding."

Back on the small-cap end, the risks are just as daunting.

With the gold price wavering in a relatively tight range after its post-GFC stabilisation, the sentiment necessary to fire up exploration and junior investment activity has been lacking, even with the latest round of headlines stoking enthusiasm for all things yellow.

"These stocks basically rise on hope, and then once a mine is actually opened, the price will actually come down once reality hits," Cochrane Investment Services boss George Cochrane said.

"A lot of the volatility in these stocks is based on pure speculation, and speculation mounts when the gold price is rising, which it hasn't done in the past four years. I have a policy of trying to avoid stocks that are priced under 20c simply because the volatility is such that it can wipe you out very quickly. Most penny dreadfuls these days are under 20c, that's how bad the conditions are. They're some of the worst conditions I've seen in 20 years."

The human element

In gold, investment pitfalls are perhaps more insidiously camouflaged than in any other resource sector. The emotional factor of gold subjects players at all levels to a higher risk of cognitive dissonance, unrealistic expectations and obsession.

The highly polarising nature of the commodity encourages flamboyant and extremist perspectives, from alarmist gold-bug manifestos to the rabid gold-bashing rhetoric parlayed by the likes of Warren Buffet. More dangers lie in that fact that even one's trusted advisers are subject to irrationality brought on by gold's heightened emotional effect.

This mania can be exacerbated by a lack of transparency in global gold traffic, relatively increased market unpredictability and a failure among many investors to distinguish between price and value - what it's going for generally and what it's worth in a context more relevant to any particular buyer.

"That's when you take a step back and try and be rational about it," Trivett said.

"Put some sort of reasonable filters over the companies that you want to invest in - companies that are in the bottom half of the cost curve, companies that have demonstrated good management, companies that have a good safety record or companies that have a good environmental track record. So you're going to have less of the external risks that can affect the margins that these companies can generate.

"Those are the things these companies have control over. They have control over their operations and that cost base. They don't have control over the price."

Lennox highlighted reliance on price predictions as his number-one red flag.

"The most common mistake is trying to pick the direction of the gold price, saying we're going to buy into the gold sector because we're going to get good leverage from the gold price rising," he said.

"You might as well buy a gold bar, because you're going to get exactly the same leverage without the risk of the equity market on top of that."

Price predicting in gold is complicated by the changing nature of the commodity's unique safe haven character and its responsiveness to multiple political factors.

Decidedly volatile inputs such as money supply policies from major financial institutions and geopolitical quakes in key economic states are among the most commonly cited drivers on this point. But some analysts, including financial services group UBS Global, have suggested that after a decade-long bull run for gold, its reaction function to "risk-off' investment scenarios has weakened over the past several years. Indeed, nerve-racking Greek debt talks have done little to improve gold prices in recent weeks.

Chinese whispers

Accurate pricing is also challenged by the difficulty in boiling the global gold market down to an intuitive supply-demand equation. China imported around $7 billion in gold from WA last year, representing more than half of the state's output. Yet the metal's biggest consumers, India and China, have not actually exerted that much of an influence on where the price has gone.

That may change, however.

Anticipation is building for the possibility of a Chinese gold standard, by which the de-facto pricing measure would be yuan-per-gram rather than US dollars-per-ounce. The International Monetary Fund is expected to decide this September whether the Chinese currency will be included in its elite basket of emergency lending reserves.

Analyst expectations are high for approval of the yuan this year considering its strides in internationalisation and increasingly ubiquitous transactions. If the currency is ushered in the IMF's group of monetary anchors, China's mysteriously massive gold reserves - sometimes presumed to exceed 8000 tonnes - could precipitate a new gold pricing standard.

Goode says this will probably send the gold price higher. He's called for a run on gold around September-October after the Shanghai Gold Exchange celebrates the two-year anniversary of the launch of its international board.

On the Shanghai International Gold Exchange's first anniversary in September last year, the board propped up gold prices by moving into 24-hour trading. This September, Goode believes the timing could be right for another announcement that would strengthen the yuan's case with the IMF.

"If you look at the past three cycles of the US dollar, it's been five years up and 10 years down. This is the fifth year up of the dollar, so the planets are aligning a bit in some way. Maybe the yuan replaces the US dollar as the reserve currency," he said.

"China's pushing very hard to take control of gold fixing in yuan per gram. It already does it in China as it is. If that occurs, it means Comex have lost complete control of the gold price, and London and the whole lot."

Any price increase that may arise from these macro-level machinations will be heartily welcomed, not just from the producers that will immediately cash in, but from the explorers still desperate for a sentiment booster among their would-be investors.

Historically, Australian gold exploration accounts for at least one fifth of national mineral exploration spending despite the dwarfing presence of the more lucrative iron ore and coal industries. Gold exploration expenditure fell about a third over 2013-14 and has continued to wallow this year, but the cyclic pressure this trend can put on prices may deliver some foreseeable relief to drillers.

"The thing is, how will it impact future supplies if the gold companies aren't investing in their exploration," IBIS World senior industry analyst Alen Allday said.

"Where are their future outputs going to come from? They cut budgets on their exploration, and that might be okay in the short term, but in the long term, that could have a bit of a negative impact. A bit of potential lack of supply down the track could support gold prices as well, and that ranges from short term to medium term to long term."

This ray of light for the explorers helps emphasise what small-cap investors have always known about the fundamental importance of the exploration business. Besides providing a bedrock to Australia's gold industry, exploration plays give an opportunity to create value independent of the unpredictable macro themes that sputter throughout the sector with intermittent coherence.

Sometimes investor cues in the gold space crossover dissonantly like multiple radio signals trying to inhabit the same channel frequency. Amid the static, however, the explorers offer one wealth-building micro influence that overrides all the hype: finding gold.

*A version of this article was first published in the July-August 2015 edition of RESOURCESTOCKS magazine.