Investing in the Gold Sector
Content supplied by Breakaway Research
Since the gold rush days of the 1850’s, Australia has been a significant world gold producer. However, the recent spate of global consolidation in resources has resulted in many operations now residing in foreign companies. Nevertheless, there are a number of gold companies listed on the ASX which range from the largest, Newcrest Mining, through to mid tier producers and numerous junior explorers.
Historically, the gold sector has attracted a premium rating over other parts of the resources sector. This has been attributed to gold’s special properties in terms of an inflation hedge or ‘safe haven’ currency, as well as the generally lower complexity and capital costs associated with gold development projects.
Investment in the gold sector can therefore be either or both of:
- Leverage to an increasing gold price
- Company specific factors such as growth through new development projects and/or an exciting exploration portfolio
S&P/ASX Gold Index (XGD)
Two new real-time indices, the S&P/ASX300 Metals & Mining index and the S&P/ASX Gold Index were launched on Monday 7 August 2006 by Standard and Poor's. The indices have been developed after consultation with the market and are a joint initiative between ASX and Standard and Poor's. S&P/ASX Gold Index will include companies in the Gold sub-industry of the All Ordinaries Index. This Index will be of significant benefit to the gold industry, helping to raise the profile of this vital market sector.
S&P/ASX Metals & Mining and Gold Factsheet
Gold Price Leverage
Gold is an unusual commodity in that most of the gold historically mined still exists, predominantly in the form of jewellery, coins or bar hoarding, particularly by Central Banks. Therefore the supply characteristics of the market can vary in response to the supply of scrap and Central Bank sales or purchases. By contrast, the demand for gold, and hence the price of gold, reflects changes in investment levels on top of physical jewellery and manufacturing demand. Investor interest itself is driven by perceptions of inflation and currency stability.
Accordingly, before discussing some of these issues, it is worth briefly recapping the influence of gold on the world monetary systems.
Historically, gold’s aesthetic and indestructible qualities quickly led to it being adopted as the standard measure of value or a monetary asset. Traders operating with imperfect market knowledge would hold their reserves in gold rather than in paper money or trading credits. However, prior to the 19th century, most countries were on a silver or bimetallic standard (gold and silver) and it was not until the discoveries in Russia, South Africa, Australia and California that gold became the standard.
Under the Pure Gold Standard, all countries fixed an exchange rate between national currencies and gold and hence currency cross rates could also be established. The Gold Standard operated until the World War I followed by a variation called the Gold Bullion Standard until the 1920’s before Governments then moved to add foreign exchange to gold holdings to form the base for the fiduciary issue. The US dollar has predominated in this function which was known as the Gold Exchange standard.
In the late 1960’s widespread concern at the adequacy of the US gold stock to meet outstanding US dollar liabilities sparked large speculative demand on the assumption that the gold price would increase above the official US$35/oz level. In response, a two-tiered system was introduced to create two separate markets; an official market in which gold could be transferred between monetary authorities at the existing price of US$35/oz, and a private market in which the price would be determined by supply and demand. In 1973 the US Federal Reserve terminated the two-tier system, which has led to the gold price now being determined by open market forces
Central Bank Holdings
Traditionally, Central Banks hold gold primarily as a hedge against the devaluation of reserves held in key currencies. In many cases public allegiance to the concept of a gold based fiduciary issue, especially in countries which at one time or another have suffered extensive paper monetary debasement, makes large gold reserves an essential monetary tactic for reasons of public confidence.
However, there are certain costs attached to holding gold, not the least of which is the opportunity cost of interest foregone on substitute reserve assets. At times the gold price has depreciated in real terms while there are costs involved in storing and transport.
During the latter part of the 1990’s Central Bank gold sales were common and provided some dampening to the gold price. While the sales were common by European countries, along with Canada and South Africa, the Australian Reserve Bank sold 167 tonnes of gold in 1997 which reduced its holdings from 247 tonnes to 80 tonnes. It believed that this level is consistent with Australia's longer-term requirements and the proceeds of the gold sales were immediately invested in foreign currency assets (government securities denominated in US dollars, Japanese yen and German marks).
Central Bank gold sales are now generally more transparent with agreements for future sales levels and ‘ceilings’ on the amount of gold sold annually.
Safe Haven Investment
Increased investment in the ‘safe haven’ of gold often occurs when there are risks of currency depreciation, particularly due to perceptions of increased inflation or as in the recent rally, a depreciating US dollar in response to high US current and capital account deficits. In this situation the gold price appreciates to offset the declining US dollar, but may remain at a relatively constant price, when quoted in say Euros.
In times of significant world instability such as the Middle Eastern wars, investors may be attracted to gold in response to the uncertain outlook of overall world economic growth, and particularly its affect on US growth and therefore the US dollar.
The fact that Central Banks and other investors hold significant positions in gold has allowed the development of gold hedging. Gold hedging is used in managing gold price risk but can also allow companies to earn a contango on future gold sales and therefore receive higher revenues.
The contango represents the difference between prevailing interest rates and the cost of borrowing the gold from a Central Bank (gold lease rates are generally in the order of 1 to 2%, but are occasionally are squeezed to high levels). In a simplified process, the mining company borrows the gold from a Central Bank and then sells that gold into the spot gold market. The money it raises from selling the gold is then invested in the money market, hence the company gains on the difference between the prevailing interest rate and the gold lease rate it is paying for ‘borrowing;’ the gold. As it mines new gold, this gold is then theoretically returned to the Bank to repay the loan.
The views on hedging are mixed. One perspective is that it weakens the gold market due to the immediate effect of the spot sales and there is associated reduced earnings leverage for gold companies because they have locked in a future sales price. The other perspective is that hedging provides the opportunity to enhance a company’s future revenue from the addition of the contango. Many Australian gold producers have been significant hedgers during the 1990’s with mixed success.
Company Specific Factors
Like other mining companies, gold companies can offer growth prospects with exploration success and the development of new mines. As mentioned earlier, the generally lower complexity and capital costs associated with gold development projects often creates a market premium in gold companies. However, investors need to review the growth opportunities and strategies for specific companies to establish the merits of an investment.