Daily Global Market Outlook
The Hedgers' Incentive
31 March 2003

a currency & gold market analysis
by Ed Bugos

Friday was a fabulous day for the gold sector even if gold prices didn't participate much themselves, yet.

Gold stocks had their best one day gain since December. They closed up on the day about as much as they did on the week - to illustrate how sluggish trade has been. The AMEX Gold bugs index surged almost 8% Friday. But it still was runner up to the S&P gold sector index, which was up 8.3% on the day.

Shares of Durban, Glamis, Goldcorp, IAMGold, Goldenstar, and Hecla Mining were up more than 10%. Anglogold and Newmont were both up better than 8%. Anglo and Newmont are the world's two largest gold miners if you weren't already aware of it.

To be sure, gold and the main gold sector averages still have resistance to contend with - 125 to 135 in the HUI, and $335 to $360 for gold - even if the longer term trends are intact. However, the rally in gold shares looked bullish, and may underscore our outlook, that the worst is behind for this sector. I get particularly excited, from a technical point of view, when gold shares trade as strongly as they did on Friday, just when the Dow is turning down. Gold shares tend to be a leading argument you see, at least at the healthier stages of a gold bull.

Newmont released its quarter and year end numbers Friday morning. They were held up due to a difference of opinion between the company and the SEC over the accounting for its recent acquisitions. Nevertheless, buried in the quarterly report was news with bullish implications. I think it was the catalyst for Friday's move.

The results came on Friday. Earnings were $0.42 cents per share, compared to a loss of 28 cents in 2001. The news was better than expected. There were criticisms that the fourth quarter numbers looked better than normal because of the restatement of earnings in the first nine months, and the 6 cent per share tax benefit in Q4. But the full year figures largely excluded the impact of the adjustment. And there was no tax benefit for the full year.

However, that's not the exciting news we're talking about.

The gold sector took off after Newmont's release, which came before the bell. Only later did the press begin to notice that Newmont updated the status of its hedgebook as of March 26, 2003.

Newmont announced it had bought back 804,000 committed ounces and delivered 449,000 ounces of hedges in the first quarter up to last Tuesday, over and above the 500,000 ounces covered in the fourth quarter 2002 - see the text in the box to the right. What does it mean?

In a recent issue we showed clearly that the hedged gold producers weren't achieving full share valuations. In particular, we showed how Newmont's share values have sunk to a discount vis-à-vis their fair market values since the third quarter of last year, while the other (unhedged) producers continued to command a premium. In other words, the market began pricing a risk premium similar to what we uncovered to be the case in all the other hedged producers' shares.

Note in Chart 1 that Newmont's shares traded persistently near par - to our valuation estimates - until about the third quarter of last year when they traded at an increasing discount. This wasn't the case with the unhedged producers, which continue to trade at or above par (par is our theoretical fair market value), on average.

But it certainly is the case that the hedged producers, almost regardless of the size of their relative hedges are being endowed a higher risk premium because of them.

In our small sample of producers, the average hedged producer trades at an (unweighted) average 67% "discount" to the value of its reserves (proven & probable) per share, and a 34% discount to our estimates of a theoretical fair market value - see chart 2 below for an illustration, and for some of our fair market value assumptions at the bottom.

By contrast, the average unhedged producer has generally continued to trade at or above par, and is currently trading at a 7 percent "premium" to the value of its reserves per share, as well as a 24% premium to our estimate of fair market value (our sample included Barrick, Agnico Eagle, Anglogold, Goldcorp, Glamis, Kinross, Meridian, and Newmont).

Effectively, the market began pricing Newmont like a hedger, which makes sense since it only became one late in 2001. At any rate, we estimate (from reviewing the quarterly reports) that last year the company delivered 1.16 million ounces of gold into its hedge book, allowed options to expire on about 270,000 ounces, and bought back 520,000 ounces worth of hedges. The result was that its committed net gold hedge fell from 7.1 million ounces to 5.15 million ounces by the end of 2002. Are you still following...

After unwinding another 1.25 million ounces worth of hedges in the first quarter, the net committed gold hedge stands at 3.9 million ounces. 800,000 ounces of that position was bought back outright for $25 million. That's almost twice what they bought back in all of 2002 - over and above what was delivered or had expired. In a question period during its conference call on Friday, Newmont said the hedges it was unwinding were non-Yandal related.

The Yandal operations are part of the Normandy acquisition. The company says that the hedge book liability is non-recourse to Newmont, and is still generating a positive cash flow at any rate. There was talk about some of the counterparties exercising a "right to break" option on the Yandal-related hedges, but to us it only indicates the creditors must be uncomfortable about the future price of gold.

You can see that Newmont has stepped up its hedge liquidation plan, which might boost the market's confidence in its "no-hedging" philosophy posted throughout each public report.

Provided you're bullish on gold, the upshot of it is Newmont's stock probably has upside over and above its leverage to gold prices - stemming from the market effect of the unwinding of the derivative-risk premium - so long as the market's confidence continues to increase in its no hedge philosophy.

But the news is even more bullish for the gold sector if it's a bull market; as you can see in chart 2 above, the hedgers paying attention to their share values must notice as you do that they can achieve fuller market valuations by ridding themselves of their hedges simply by looking at their competition.

In Newmont's case (this is not a prediction), if we're right about the above hypothesis, the stock could trade back up to $30 per share - even assuming gold prices, or the outlook for gold prices, don't change. But then, if the implications for gold weren't obvious before, they are now: Newmont is a believer in the bull market.

Cautionary note: this is neither a forecast nor analysis of Newmont. It is an analysis of the implications for the gold sector. There are other factors to consider for an investment in Newmont shares. Operating Engineer's Local Union No 3 in Elko County Nevada went on a two day strike over pay and safety issues with the company for instance. They've since gone back to work last we heard, but the situation bears watching. Moreover, Mineweb reports that Newmont still has to write down some goodwill, which will lead to a higher debt to equity ratio, and might result in an equity issue towards yearend. Though, the verdict on that is out, because Newmont explains that the goodwill is actually a new category of asset - not quite reserves and not quite an intangible - as a response to changing SEC regulations.

Also obvious by chart 2 above is that both Anglo and Kinross (despite Kinross' relatively small hedge) have at least as much to gain from a hedge liquidation as Newmont does.

Barrick wasn't included in chart 2, but it's trading at around the average. Were Barrick able to liquidate a large quantity of its hedges this year, it would have enormously bullish implications for its own share values, since they also may have a hate premium attached. That's the message here folks.

Newmont's announcement may mark the beginning of another phase of this bull market, where the attitudes of all the (hedged) producers shift from delaying, to acting decisively. After all, for two years now the market has made increasingly clear the incentives for making that decision. And that could slap the Cabal right in the face. In a gold bull market, I believe we will soon see, the cabal is irrelevant!

The comeback in gold stocks Friday is in no small way related to these developments.

But so too has the war premium stopped deflating - or at least traders have realized it's hard to make money trading it. And the US dollar can't find traction, despite about a 20% correction in gold prices. Now, at the opening bell Monday morning, S&P futures are off 14 points.

Another bullish factor could be that the speculative froth - from the January run up to $390 - has largely been weeded out now. Andy Smith (precious metals analyst), for instance, called on a big gold bear last week, so maybe we've shaken out the weak hands...

Smith makes the typically boring bearish argument that the central banks simply want to sell all their gold, but have decided to mercifully subsidize the producers who apparently had lobbied the central banking community for the Washington Agreement in 1999 (good through 2004) - restricting the central bank selling of gold to tranches instead of all at once.

Uh, huh. Subsidizing producers? Which ones? Do the central banks have favorites? Because some of the ones Smith's thinking would apply to are getting strangled by their hedges. And what of the bankers that have all their interest rate derivatives fixed to benefit from a low interest rate environment? How are the central banks subsidizing them? The main group benefiting from rising gold prices are the unhedged gold producers, and their shareholders.

Should the central banks continue "subsidizing" this group, then, they risk problems at some of the larger producers, as well as the bullion bankers vulnerable to the impact from higher gold prices and therefore interest rates. Sorry, we have to reject Smith's theory on grounds, well, that it sounds stupid. It involves an institution subsidizing a relatively small sector at the expense of the main sector it is trying to protect?

Let's stop wasting our time and consider the other side of the coin.

Putting aside the obvious issue of deliberate gold price manipulation, and disinformation, or not, here's another possibility.

The Washington Agreement was put in place to keep central banks - and other players taking their lead - from liquidating their gold too quickly, or from getting the wrong signal from the Bank of England's announcement in the spring of 1999 to liquidate the remainder of its own gold reserves.

That doesn't mean producers weren't lobbying for it to happen. It just means that's why the central banks agreed to it.

It's not a matter of whether gold is a good asset. We already know it's not an asset. It's money - in the economic sense, rather than the physical or legal sense.

In fact, it's because gold has no intrinsic value as an asset, or capital good, that it is ideally suited to the task. It's simply the commodity most treasured by the consumer, and in a free market environment where government's intervene and devalue their currencies for political gain, due to its unique monetary characteristics, it is a terrific barometer of the dollar's value also.

But I suppose it doesn't matter how many times we superimpose an upside down gold chart over the dollar (index) chart, in order to highlight this relationship. Smith and other bears argue that a technology revolution combined with the perfection in central banking policy over the years has made the dollar invincible. What can we say to that, except hogwash.

Gold moves forecast movements in the dollar. They have for as long as the charts go back, but for a few exceptions. They also tend to lead commodities, and ever since the mid seventies gold has maintained its lead on commodities even if the premium has come down somewhat through the past 20 years. Note the long term trend below.

The United States has had two major dollar devaluations in the 20th century. The first was after the 1929 stock market crash, and the second came after the Nifty Fifty (tech stock bubble) crashed in the late sixties / early seventies. The dollar's value was rigged in both instances, so the subsequent results were rather extreme (imbalances pent up). Guess how they were rigged in both cases? The US government had a mandate to fix gold prices. Actually, it was to fix the dollar, but the inference is clear. It was done by manipulating gold.

Consequently, the imbalances accumulated until in 1934 FDR had no choice but to confiscate the right to own gold, and in the 1969 period, the London Gold pool was disbanded.

Andy Smith would like us to believe we live in a world where central bank professionalism and technology have made gold irrelevant. But the reality is we live in a world where profuse inflation policies (or bubble economics) lead - time and again - first to an overvalued dollar, then to dollar devaluation.

Smith says Greenspan and co. have created the ideal money for the capitalist system to thrive. We argue corrupt monetary policies have undermined that process, and strain it every day.

Smith works for the establishment. But he couldn't tell money from cow poop.

The technology revolution is bullish for gold, because it will uncover the lies, the nonsense, and the deceit. All of them, one by one.

However, one mustn't forget that it's a two way street. Technology has empowered the market, but it has also empowered the market's enemies. The gold bull market is destined to drag out until the truth in matters of money has amassed critical momentum, and the economy has healed itself of the malinvestments that plague it.

But let this truth stand no opposition. Twentieth century monetary policies have "driven" gold demand (and values) like no other century ever has. Let the central banks sell their remaining piddly gold reserves into that ongoing fact.

Edmond J. Bugos