Finally, A Reason To Buy Gold Miners

A strange thing occurred at 2:00 PM Eastern Time on Thursday. While the price of the SPDR Gold Shares ETF (GLD) continued its free-fall, curiously the price of the Gold Miners ETF (GDX) jumped on high volume, adding 2.5% for the day.

My first reaction was that the abnormal divergence between the spot cost of the metal from the price of miners’ shares must be due to some kind of quarter-end portfolio rebalancing. Upon further review of the day’s news, I think the miners’ revival may be the result of another impetus, which may continue to contribute support to miner stocks.

As the market opened, it appeared that gold was due for a “dead cat bounce” from drastic losses earlier in the week, and the Miners rebounded with the metal. However, by 1:00 PM, GLD had given back the gains and the miners were pulling back as would be expected. Near 2:00 PM a story was circulating on the newswire that the World Gold Council had issued new guidelines for analyzing gold mining companies. The WGC distributed “a Guidance Note on ‘all-in sustaining costs’ and ‘all-in costs’ metrics, which gold mining companies can use to report their costs as part of their overall reporting disclosure. The World Gold Council has worked closely with its member companies to develop these non-GAAP measures which are intended to provide further transparency into the costs associated with producing gold.”

In order to understand the significance of this news, we should revisit the Mark Twain assessment of the industry: a gold mine is a hole in the ground with a liar standing next to it. Too many investors have been burned by gold miners’ claims, and distrust keeps many others away from legitimate mine operators.

In order to prevent deceptive representation of a miner’s potential for profitability, the US Geological Survey, SEC and Canadian authorities have created strict reporting requirements. Categorization of a mine’s resources must meet certain requirements, and a more complete explanation of this may be reviewed in our SA article, Beware The Trap Door Under Miner’s Silver Reserves. Despite all the attempts at clarification, most investors have little faculty for understanding exactly what miners mean when they tout, “our production costs are below $400.” It is frustrating and difficult to understand why a miner cannot earn more profits with the spot price three or four times the production cost.

The problem is that the “operating cost” or “production cost” only factors in a small portion of the miners’ expenses, excluding things like corporate G&A, amortization, reclamation, some exploration and capital expenses, etc. A better measure is the WGC’s “sustaining cost,” which is the actual cost to sustain the operation, including all the above and other costs. The sustaining cost for most miners exceeds $1000 per ounce, including all the costs incurred by the company.

We think this news proved positive for miners’ stocks for the following reasons:

  • The guidelines define an acceptable alternate to GAAP accounting that is consistent in the industry.
  • They more realistically allow the comparison between the spot price and the company costs, and its relationship to profits.
  • They bring to the investing public the realization that the spot price of gold cannot fall to triple digits without drastically affecting supply.
  • They enable legitimately efficient companies to differentiate themselves from miners that promote their prospects with partial information.

The definition of “all-in costs” and “sustaining costs” can be found in the WGC guidance memo.

Although the “sustaining costs” have not been published for most miners, we added a calculation from the Alamos Gold investor presentation in the following table we sent to clients recently:

AGI $ 812 1.7% 1.9 No Debt/Buybck
EGO $ 928 2.2% 2.1 China/Political
AUY $ 945 2.7% 2.1 Debt/Political
ABX $ 1,120 4.3% 2.2 High Debt
CAGDF $ 1,126 4.5% 4.0 Asia/Political
NEM $ 1,129 4.7% 2.6 Debt/Divvy Inc.
GG $ 1,168 2.4% 2.2 Moderate Debt
AEM $ 1,245 3.3% 2.6 High Debt
IAG $ 1,257 5.7% 2.7 Debt/Low Rating
FCX UNKNOWN 4.4% 2.2 Diversified

It is clear why Alamos Gold chose to highlight this metric in its presentation. In addition to low sustaining costs, we prefer mining companies to have some dividend yield, a moderate debt level and low political risk. As a comparison, the table also includes the current YAHOO analyst consensus number (lower is better).

Alamos Gold is the clear winner in the cost category, and the debt free balance sheet offers strong support for growing dividends even if the spot price drops. The dividend is lowest among these ten, but the company recently announced a share buyback program. In the recent earnings report, the company explained its intent to continue exploration and development of its properties, and these are initiatives that can readily be cut back if the gold drop becomes worse.

Yamana Gold is also attractive in this comparison with very low costs. Debt is also moderate, but some important properties are in politically-unpredictable Argentina. AUY has sold off more severely than most, so it may benefit from a bounce.

We also think that Newmont Mining and Goldcorp, Inc. should be on the watch list for bottom fishers.


We had considered $1246 per ounce as the support level for gold, although that appears too optimistic. That is the level in September 2010 when the price of gold exploded up, creating a gap-like phenomenon that had to be backfilled. It also is a point where some miners must evaluate how to sustain their operations, possibly to shut-in mines or slow production. This eventually will support the price of gold, although the immediate bearishness requires caution. However, if investors understand that the price of gold cannot continue indefinitely below its production price, miners like Alamos, Yamana and Goldcorp may justify a long-term investment. With the new reporting options from the World Gold Council, these stocks will be able to differentiate themselves from the crowd going forward.


The Gold Correction Is Not Over

Legendary commodity investor Jim Rogers has never been shy about vocalizing his opinions about the investing world. In particular, Rogers has an affinity for commodities like ags and precious metals. Gold has been one of the most talked about hard assets of the last two years, as the metal soared to all-time highs, only to watch its price take a tumble in the months that followed. All along the way, Rogers had been calling for a correction for gold, and it is a sentiment that he still holds today.

Gold In a Free Fall

Since making highs in September 2011, the price of gold has dropped nearly 30%, as equities have rallied and investor interest in precious metals has waned. This has all happened despite the current $85 billion monthly printing from Ben Bernanke and the Fed, which many thought would spark inflation thereby sending gold higher. Thus far, inflation has stayed low and the appeal of gold has simply faded, as investors have increased their risk appetites and sought higher yielding securities.

With the threat of QE ending and markets maintaining a bullish momentum, the outlook for gold looks more bleak as the days go on, fueling Rogers’ comments that gold has yet to finish its current correction.

Rogers on Gold

One of Rogers’ major sticking points was the fact that gold had 12 straight winning years, something that is unheard of for a commodity. In fact, the SPDR Gold Trust ETF (NYSEARCA:GLD) and iShares Gold Trust ETF (NYSEARCA:IAU) have never had a down year for as long as they have been around. 2013 is shaping up to be a poor yield for gold, and Rogers does not see it ending anytime soon.

“Until it scares a lot of people, the correction is not over. I would certainly like the correction to be over this afternoon and see gold go to $2,000 or to $3,000, but that’s not reality,” said Rogers. He did maintain that while he was not currently buying the asset, he also was not selling, as he firmly believes that gold will resume its bull market at some point over the current decade.

Thus far, Rogers has been right on the money with his predictions for gold over the last two years, granting more weight to his recent comments. If gold continues to fall over the coming months, it could be an enticing entry point for investors looking to time the bottom of this precious asset.


Redemptions In The GLD Are Bullish For Gold

Recent outflows from physical gold exchange traded products (we use the SPDR Gold Shares, GLD) have been interpreted by the financial press as a sign of weakness in the demand for gold as an investment vehicle.

However, a closer look at the evidence suggests otherwise: the largest outflows in the history of the GLD (see Figure 1) started well before the large drop in the price of gold we observed on April 15th, 2013 (-9%, which represents a 1 in 11 years event). In fact, the net redemption of shares of GLD started as early as the second week of January 2013 (on a 3-month cumulative rolling basis). In this note, we will explore the theory that it was the shortage of physical gold and the ensuing arbitrage opportunity that drove market participants to redeem shares of GLD.

So why are the bullion banks that act as Authorized Participants for GLD, a group that includes JP Morgan and HSBC and others (who by-the-way were mostly bearish on gold leading to the April Crash), redeeming so many shares of GLD?

One explanation could be that they are trying to match supply and demand so that the net asset value (NAV) of the ETF is in line with its price. Historically, we have observed that large movements in and out of the GLD are associated with large discounts/premiums to NAV (Figure 2). This is due to the constant creation/redemption of the shares to minimize the discrepancies between the ETF share price and the NAV. However, the recent wave of redemptions has occurred even while the premium to NAV has been very stable, hovering around 0% for most of the year.

Source: and Sprott Calculations.
Last Observation: May 28, 2013 (Week 22).

Source: SPDR Gold Trust, Sprott Calculations.
Note: Large flows are defined as weeks where the average % change in tonnes lies in the top or bottom 10% of its distribution (i.e. tail events).

We believe that the answer lies in the discrepancy between the paper and physical markets for gold. Over the past few months, there have been rumours of bullion bank customers unable to redeem their gold. While, at the same time, physical demand in Asia has been extremely strong this year. According to the World Gold Council (WGC), Indian imports should reach 230-400 tonnes in Q2 2013 (an increase of more than 200% year-over-year) and imports from China keep breaking records (the WGC now forecasts total Chinese imports of 880 tonnes for 2013).

This is reflected in the large premium customers in these markets pay over the “London Fix”, the price one should be able to get for physical gold. One way to measure the extent of the demand imbalance for physical gold in Asia is to look at what has been termed the “Shanghai Premium”, which is the difference between the quoted physical gold price on the Shanghai Gold Exchange and the London Fix gold price. Figure 3 above shows a weekly time series of the Shanghai premium in USD/oz. of gold. Since the beginning of the year, the Shanghai premium has been consistently above zero and historically large, reaching more than $50 per oz.

Source: Bloomberg. Last Observation: May 28, 2013 (Week 22).
Definition: Shanghai Gold Exchange Au9999 Gold (USD) minus London Gold Market Fixing Ltd – LBMA AM Fixing Price/USD.
“The Shanghai Premium is calculated on a weekly basis. Formula: (SHGF9999 Index * CNYUSD Curncy * 31.1g/oz) – GOLDLNAM Index”.

Putting the pieces together

It is clear that demand for physical gold in Asia is strong and that the price of gold in these markets is well above the “Western” price. This creates arbitrage opportunities for market participants that have access to large and cheap quantities of physical gold in the West. The bullion banks happen to be the only ones able to redeem GLD shares for gold, and the GLD, with its 1,000 tonnes of inventory, acts like a large physical gold bank.

Source: Bloomberg, SPDR Gold Trust, Sprott Calculations.
Note: Shanghai Premium shown as a 3-month Moving Average GLD flows are rolling cummulative flows over 3 months

According to the GLD prospectus, the bullion banks can create or redeem units for as little as 10bps (0.10%). Even with transport and insurance costs (which are arguably lower for large transactions and large international banks), there is a clear arbitrage opportunity for the bullion banks when the Shanghai premium (or any other physical gold price premium in emerging markets) is as large as it has been recently.

Moreover, because of the intense demand for physical gold we have seen so far this year, it is very probable that the bullion banks themselves are in a shortage of physical gold, hence the need to use the GLD reserves.

Indeed, since 2005, there has been a strong negative correlation between GLD flows and the Shanghai Premium (-53%) (Figure 4 above). This means that large outflows (redemptions) from the GLD are typically associated with high premiums in the Shanghai gold market. This association has been particularly marked since the beginning of the year, with historically large outflows corresponding to an all-time high in the Shanghai premium.

To conclude, the evidence presented here suggests that, contrary to what has been stated in the financial press, the flows out of the SPDR Gold Trust may have been generated by the bullion banks to take advantage of an arbitrage opportunity in the physical market. This arbitrage opportunity occurred because of the intense demand for gold stemming from Asia and the inability of traditional suppliers to provide this GOLD (hence the large Shanghai premium). We believe that this activity further supports our hypothesis that there is a lack of availability of physical gold and an obvious dislocation between the physical and paper gold markets.

In these conditions, it is not hard to imagine that prior to April 15, the bullion dealers, with their large resources, were tempted to sell large amounts of gold futures in order to lower the spot price and make the arbitrage even more profitable by increasing the spread and sparking a tsunami of buying in Asia.

To us, this is clearly a bullish signal for gold.