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Gold Market Strategies: Hedging the Unthinkable
David Crichten-Watt, Phoenix Gold Fund

December 2003

Whenever the Bundesbank was asked its position with regard to possible sales of bullion from its foreign reserves, the traditional answer was that the bank would never sell its gold reserves because those were the only assets it held that were not another party's liability. It is certainly this factor that has caused gold to be the principal store of value throughout documented history by almost every civilisation on our planet. Of course it has been decried as a "barbarian relic" and it is true that, in normal times, it is an asset that is worse than useless, for not only does it offer no annual return but, on the contrary, an investor will have to pay to have it stored safe from the hands of thieves or confiscatory governments. However, one can make a very strong case that the present is not a normal time. The world's largest economy is now sporting ratios we are more accustomed to see in relation to third world countries in default; the second largest economy appears mired in a deflationary sinkhole and its struggles to escape have led to fiscal deficits that cannot be serviced in a normal interest-rate environment.

Indeed, globally, the levels of indebtedness, at approximately 300% of global GDP, have reached a level that virtually precludes further growth. The policy of the present US Administration of cutting taxation at a time of soaring fiscal deficits appears, on top of a current account deficit that now surpasses 5% of GDP, to invite a catastrophic decline in the value of the US currency. With foreign investors holding claims on US financial assets exceeding 8 trillion dollars one can be excused for bringing out the old maxim "better years too early than minutes too late". The sole remaining buyers of US dollars now are the Asian central banks, which must continue to keep their own currencies competitive as long as China maintains the renminbi/dollar peg. This will go within a year or so and it is anyone's guess what will happen to the dollar after that.

Although low interest rates are of much greater benefit to a debtor nation than to a creditor, they are no more likely to stimulate savings and investment in the US economy than they have in Japan. It is surely only a matter of time before the central banks accept that the only way in which they can reflate the global economy is to devalue all currencies against gold. It was this strategy that worked in the 1930s but it is important to note that the US economy was the slowest to emerge from the depression and the reason for this was that the US government confiscated all gold from US citizens immediately prior to raising the price of gold from US$20 an ounce to US$35 in 1934. Thus those living in the land of the free had the same number of dollars in 1935 as they had held in 1934 whereas everywhere else, those who held their savings in gold, and there were many, found they had 70% more dollars than before. Such a reflation strategy will work only when gold is widely held by the public. The central banks therefore have been doing the right thing, albeit perhaps unwittingly, by selling their gold reserves (although this action is, in itself, adds to deflation). When they come to face the impact of the present deflationary environment on a global economy carrying debts three times its annual output, they will accept the need to buy back their reserves at much higher prices. In order to return the ratio of gold to international monetary reserves that was established by the Bretton Woods conference in 1944, the gold price would have to rise to SDR 4,500 from the present price of SDR 244. Is it impossible that gold prices can rise 2000%? It happened during the 1970s when gold rose from $40 an ounce to $850 an ounce. In the present economic environment, every portfolio should have the ultimate hedge - it should be insured against everything else going wrong - it should have some exposure to gold.

What is the most effective way in which one can participate in the gold market? Essentially, there are two choices: either one buys bullion which has to be held somewhere in custody, or one buys shares of gold-mining companies where the gold is still in the ground and has to be mined and extracted. Purchasing bullion and having it stored in locations such as Switzerland, London, or Singapore is probably the best way in which one can hedge against one's government behaving like the US government in 1934. However this belt and braces approach comes at the cost of annual custodial fees and is probably not appropriate for an institutional investor. The institutional investor will probably feel comfortable buying gold on the commodity or financial futures exchange, although one must recognise that there is the risk of the exchange defaulting or changing the rules (it has happened!).

At present the most liquid bullion market is over-the-counter amongst the established bullion banks where dealings take place 24 hours a day. Most of the bullion banks will provide margin facilities to a creditworthy client. There will, of course, be a counter-party risk, but most of the bullion banks are supervised, and ultimately supported by, a central bank. Recently, it has become possible to buy gold bullion on the Australian Stock Exchange via a listing sponsored by the World Gold Council and in this case the custody charges are included in the price. It is expected that this example will be followed by various other exchanges and may become popular but there is the restriction that one can only deal during the exchanges' opening hours and in the local currency. Of course bullion is also the subject of options trading, both quoted and over-the-counter, but here again one would have to assume the counter-party risk.

Most bullion trades over the counter - and therefore the entire market - are opaque, but the market is large and liquid and can accommodate investments of billions of dollars without too much difficulty. The market in the shares of gold mining companies, however, certainly cannot, for the entire market capitalisation of the global industry is approximately US$70 billion, or slightly less than Toyota Motors. Intrinsically the gold-mining companies have enormous operational leverage to the price of gold. Last year the industry's cash cost of production per ounce was approximately US$245 but the true cost, after depreciation, amortisation, and the exploration necessary to replace the reserves would have been close to the present price of $335. Thus at present gold prices the mining companies make very little and, as a result, annual production is likely to fall. However at $435 per ounce for gold, the industry will make US$7 billion more than at present. Thus any rise in the price of gold is likely to be magnified several times by rises in the share prices of the mining companies. Mining, of course, is an intrinsically hazardous business: walls can collapse, ore-bodies can be otherwise anticipated, miners can strike, etc. So it is important to have as diversified a portfolio of shares as possible.

One other important factor to bear in mind when considering investment in the industry is that some mining companies have already hedged their exposure to the gold market by selling forward their future production at fixed gold prices. Anyone seeking exposure to gold as a hedge against unknown changes in the global monetary system must avoid such companies, for, if gold prices rise dramatically, other essential commodities will rise too. Thus, in the situation where gold were to rise, as it did in the 1970s, by 2000%, then the price of oil, electricity, carbon, salaries, and most other costs of a gold mine would also rise. While today, a mining company might be producing gold at a cash cost of $250 per ounce, which it sells at $350 an ounce, it is not inconceivable that, in five years' time, that same company will be selling gold at $2,000 an ounce that it will be producing at a cash cost of $900. If, however, it has committed to sell that gold at a fixed price of say $400 for the next seven years (and some companies have worse hedge books than that) then it will be out of business.

Clearly both the gold price and the price of gold-mining companies' shares are determined by sentiment towards the paper (or fiat) currencies, credit markets, etc and sentiment is always subject to wild swings. Consequently, the volatility in a portfolio of gold-mining stocks is extremely high. One can attempt to smooth the volatility by trading the relevant options and trading bullion against the shares etc. This is what we try to do but, as can be seen from the performance record at, volatility cannot be avoided totally. However, we created this fund for our clients together with the advice that they should put 10% of their assets in gold and pray that it does not work out. For, if it does, it will probably mean the remaining assets will have taken a beating. Since inception in February 2001, the fund has been up as much as 370%; most other assets, at best, have languished. In addition, we believe this is only the beginning of the rise in gold prices! The chart below, which shows the ratio of an ounce of gold to the Dow Jones Industrial Index, tells it all.

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