Gold and silver companies, be they producers or ounce-in-the-ground developers, have lagged the recent rise in gold and silver bullion prices to record levels, confounding expectations of a long-awaited precious metals equity market boom. Cash-flow multiples are low for producers as though current cash-flow levels are not sustainable, and development juniors are trading at discounted cash-flow-based valuations that reflect significantly lower three-year trailing average bullion prices currently at US$1,246 per oz. for gold and US$24 per oz. for silver. What underlies the market’s reluctance to accept current gold and silver prices as a basis for valuing gold and silver equities?
The most obvious explanation lies with the optics presented by the bullion price increase of the past years, which has the exponential pattern of a bubble soon to pop. In the case of gold, its price is viewed as unsustainable because the estimated above ground stock of 5.4 billion oz. has increased over 500% in value since its 2001 bottom, despite having little utility, yielding no return in the form of rent, interest or dividends, and not serving as a direct medium of exchange. As such, the gold stock is feared as a massive overhang whose owners may one day seek to liquidate their positions at a time when circumstances deter buyers.
In the case of silver, the concern is that silver’s more recent sharp rise will unleash the large portion of the estimated 47 billion oz. above ground silver stock that is currently fabricated into functional materials and embedded in industrial processes through a surge of scrapping and substitution by cheaper materials.
Furthermore, because gold and silver are now trading at higher real prices than the average of the past decade upon which development decisions were based, it is reasonable to expect a glut of new mine supply in the next few years as miners rush to take advantage of current prices. The concern is that a 30-40% retreat into the US$1,000-1,200 range awaits gold, with silver settling back into the US$10-15 range, a level where positive cash flow for primary silver producers hinges mainly on base metal or gold byproduct credits at their current prices. Silver is a notorious byproduct credit from zinc, copper and gold mines, and prices in the US$30-50 range will certainly focus attention on enhancing silver recoveries.
Gold and silver equities are also lagging because current prices are seen as a bubble-like response to economic and financial stresses such as the eurozone’s sovereign debt crisis, persistent global trade imbalances, and concern that the rate of U.S. growth will be inadequate to service its existing debt and future entitlement-related obligations. Should these stresses stabilize or resolve themselves, interest in gold and silver is expected to sag and deflate this worry spawned “bubble.”
A further problem is the widely held belief that the gain in real prices for gold and silver merely portends inflation that is just around the corner as governments eventually deal with their debt by monetizing it, or “printing” money. Although inflation remains muted in the United States with deflation a much broader concern, this perception undermines the economic rationale for investing in gold and silver equities.
Determining the extent that current gold and silver prices reflect real price gains requires certain assumptions. If one assumes US$400 as the base at which gold eventually settled in 1980 after its spike to US$850 per oz., and adjust that price by the average annual U.S. Consumer Price Index, we end up with US$1,038 per oz. in 2011 (see Figure 1). The difference between that number and the US$1,702 spot price as of Nov. 21, 2011 works out to 64%, which pales against the 419% real price gain gold underwent from US$36 in 1970 to US$400 in 1980. Nevertheless, this 64% real price gain is quite recent, and significantly boosts profit margins for gold mines whose production decisions were based on considerably lower gold prices. It also has a big impact on the net present value of undeveloped gold deposits as a result of expanded potential profit margins, and because of the potential for lower cut-off grades to boost resources and throughput levels.
The importance of real price gains for both precious and base metal equities cannot be understated because cash flow, the measure by which mining equities are generally valued, depends on the difference between the cost of production and the price received for the production.
The rapid 419% real increase in the price of gold between 1970 and 1980 had a huge impact on the above ground gold stock. During the next 30 years, the mining industry added 2.2 billion new oz. to the 3.2 billion oz. that existed at the end of 1979.
Annual gold production grew until 1999, when weak gold prices made developing new gold supply unprofitable. The resulting decline in gold production did not reverse until 2009, when new supply mobilized in response to the breakout of gold prices in 2005 started to come on stream. According to projections by the CPM Group, annual gold mine supply is expected to hit a record 104 million oz. by 2016, adding 500 million oz. to the above ground gold stock over the next five years.
The profitability of this new gold supply, however, will depend on capital and operating costs. Should governments indeed resort to debt monetization, the current cost structure of operating and developing mines, which has lagged the recent increases in gold and silver, would soon vanish as costs rise in response to inflation gold and silver prices supposedly already anticipate.
Unlike during the early eighties when gold and silver equities were treated as proxies for gold and silver whose value was based on measures such as market capitalization per ounce of gold in the ground, today, the market is treating gold and silver producers and developers no differently than other raw material equities, which are valued on the basis of projected cash flow. It is thus possible that gold and silver equity prices have lagged the gold and silver price trends because a much more sophisticated market senses that it will be mining costs which skyrocket during the next few years rather than equity prices.
Gold and silver equities have also been hurt by the negative visceral reaction most investors have towards the dominant narrative of gold and silver proponents, which is apocalyptic and moralistic. Almost every discussion favourable toward gold and silver is coloured by fear mongering about “fiat currency collapse,” ideological diatribes about the need to eliminate government institutions in favour of a free market reign of terror and the reintroduction of a “gold standard,” and convoluted conspiracy theories about price suppression strategies.
Most people have enough common sense to realize that a world which mutates into the gold bug’s vision of an apocalyptic, libertarian “paradise” is not likely to be kind to them and their kin, regardless how much gold or silver they own. Given that gold and silver equities derive their value from actual or projected cash flow denominated in currencies which the gold and silver bug narrative predicts will effectively vanish, it does not make sense for conventional gold and silver bugs to own equities. The harder the gold and silver bugs push their gloomy narrative, the greater the aversion toward gold and silver equities.
Finally, the conflation of the gold bug narrative with enthusiasm for gold equities common among influential people such as fund managers, analysts, and newsletter writers, despite the inherent contradiction, gives rise to the suspicion that most of these gold or silver bugs are really cynics who do not believe their narrative at all and are merely using it as a tool to foster a gold and silver equity market bubble into which they will liquidate their physical and equity positions for old-fashioned fiat currency well before the bubble pops and normalcy in the real world is restored.
An alternative narrative for silver and gold
There is, however, an alternative way to look at gold and silver which does not require embracing an apocalyptic outlook or conforming with libertarian ideology, which explains why current higher real prices are a new reality rather than a mirage soon to be swallowed by inflation, which offers a case why gold and silver equities are undervalued, and which demonstrates why good news on the debt resolution and economic growth fronts support rather than destroy strong gold and silver prices.
The real driver behind rising gold and silver prices is the inflection that occurred a decade ago in the global economic and military power balance. At the start of the 21st century, the United States was the unrivalled economic and military superpower, but a mere year later at the end of 2001, the U.S. was in the grip of a recession arising from the collapse of the dot-com bubble and had encountered a difficult new enemy in the form of jihadi terrorism. The recession pushed Federal Reserve Chairman Alan Greenspan to embark on a credit expansion which fuelled a real estate bubble that in turn provided the consumer buying power needed to absorb cheap Chinese goods, even as 6 million manufacturing jobs left the United States. Trade globalization helped mobilize 3 billion people loosely defined as the BRIC emerging markets, which adopted in modified form the capitalist methods of the mature OECD economies.
The result of the Greenspan credit bubble has been a rapidly growing global economy in which the United States is undergoing relative decline in terms of its share of global GDP while China is expanding its own share. This inverse trend relationship between U.S. and Chinese GDP is illustrated in Figure 2 (Page 22).
Trends in relative GDP, at least as far as the country in whose currency total GDP is expressed is concerned, tell much about the ebb and flow of economic power. U.S. GDP underwent relative decline from 1970 through 1979, a period marked by stagflation, OPEC-dictated oil prices, the Tehran hostage crisis, and the Soviet invasion of Afghanistan. It was a time when the world was concerned that the United States was a spent power, and the gold price soared.
After experiencing a turnaround in the 1980s and peaking at 35% in 1985, the U.S. share of global GDP declined to 25% in 1995. While relative growth returned, peaking at 32% in 2001, U.S. GDP share subsequently declined to an estimated 22% for 2011. Meanwhile, China’s share of global GDP grew modestly from 1.5% in 1981 to 4% in 2001, but since then has more than doubled to 9.5%.
If IMF GDP growth projections prove accurate, by 2016, the U.S. GDP share will have shrunk to 20.8% while China’s will have grown to 12.4%. This inverse trend is the key to an alternative narrative for gold and silver.
Figure 2 also shows each country’s share of global military spending from 1988 through 2010. The U.S. share of global military spending peaked at 48% in 1988, and then dipped below 40% before stabilizing in the 43-44% range after 2001. China’s share has grown from a paltry 1.8% in 1989 to 7.4% in 2010, making it the second largest military spender in the world at $119 billion.
Although the U.S. share of global military spending has stabilized, its actual military spending has increased from US$273 billion in 1998 to US$698 billion in 2010, while China’s spending has increased from US$17 billion to US$119 billion. Since 2001, the U.S. military budget has soaked up over US$5 trillion in taxpayer funds, and is now carrying an additional annual burden of US$100 billion in spending on veterans of the wars in Iraq and Afghanistan. Military spending is the single biggest item in the U.S. federal budget, and a key driver behind rising American debt, concern over which came to a head during the 2011 debt ceiling crisis. The predictable failure of the deficit reduction super-committee now puts military spending on the chopping block, with the 2012 presidential election boiling down to the question: who should get the axe, the military or retirees receiving Medicare and Social Security benefits?
The rise of Asia
Anybody contemplating the big picture cannot help wonder how the United States will in the medium to long run be able to maintain its dominant economic and military role in a globalized economy whose growth is largely fuelled by nations with a tenfold bigger population base and a substantially lower per capita standard of living that will facilitate a lower production cost structure for at least another decade. What happens to the U.S. dollar as a reserve currency as the U.S. share of global GDP becomes smaller and smaller? What happens to geopolitics when hybrid central command-capitalist economies such as China eclipse the U.S. economy? What happens to the balance of military power as Chinese naval and air capability expands, or, if deficit reduction austerity measures in the United States lead to destabilizing social upheavals that suddenly force the U.S. to abandon its commitment to being the sole military superpower?
Whether this transition due to the “Rise of Asia” is sudden or gradual, it presents good reason for people to be concerned about the future, a future where status quo assumptions may be shattered, where title to fixed assets such as real estate and production capacity may vanish, or where the value of financial assets such as equities and bonds may evaporate. And this concern, in turn, represents a good reason to park some of one’s wealth in gold or silver bullion as a long-term insurance policy that hedges a scenario nobody wants to become reality. This concern – which is based on a generally optimistic outlook regarding a growing global economy, one in which emerging nations become a greater part of the overall economy while the U.S. economy undergoes a long relative decline while still growing absolutely – is the real engine driving international demand for gold and silver bullion.
If indeed the demand for gold and silver during the past five years has been driven by this concern, it will have been of a buy-and-hold nature, where liquidation on a broad scale will not be contemplated for decades, and then only if a new world order no longer reliant on a single nation for stability has emerged. This type of demand for gold and silver, which will be a function of the wealth of the world best depicted as global GDP, has the capacity to generate and sustain higher real gold and silver prices which boost the profitability of existing mines, justify the development of new production, and stimulate exploration for new deposits. If the rise in gold and silver prices began to be understood in these terms, the reluctance to invest in gold and silver equities would disappear, and we would experience a decade-long bull market in the gold and silver resource sector that would twin with a similar bull market for raw materials needed to fuel global growth.
A measure of anxiety
Of course, one might ask, what evidence is there that demand for gold and silver is being driven by anxiety generated by global economic growth rather than fear that the global economy is on the threshold of collapse? What reason do we have to believe that gold and silver are not in a bubble that will pop once the fear of financial collapse dissipates and the outlook for global economic growth turns positive?
Rather than focus on the prices of gold or silver, which, without question resemble bubbles, what if we were to look at the value of the above ground gold and silver stock as being related to global GDP?
Figure 3 depicts the value of the above ground gold and silver stock as a percentage of annual global GDP, shown in red for gold and blue for silver. Neither the gold and silver stock values nor global GDP are adjusted for inflation, which is necessary to allow the percentages to reflect anxiety levels. Under this metric, the gold stock value achieved a peak of 25.7% of GDP in 1980 when it hit $850, while silver achieved a peak of 14.1% when it hit $50. What follows is a long decline that bottoms at 3.9% in 2001 for gold and 0.5% for silver in 2003.
Gold began to emerge from its bear market in 2002, with silver following in 2004,. Both accelerated into exponential uptrends in 2009 after the 2008 financial crisis. At the current average 2011 price of US$1,553 for gold and including projected 2011 new mine supply of 83.2 million oz., the gold stock value represents 12.2% of the US$68.6 trillion in global GDP projected by the IMF for 2011. At the average silver price of US$36 and assuming 746 million oz. of new mine supply in 2011, the silver stock value is 2.5% of global GDP. At the London PM Fix highs of US$1,878 for gold and US$49 for silver, the percentages are 14.7% for gold and 3.3% for silver. These percentages are well below the 18.6% average and 25.7% peak for gold in 1980, and the 6% average and 14.1% peak for silver in 1980, levels that, ,at least in retrospect, indicated a price bubble.
If we view the GDP percentage of the gold and silver stock values as reflecting the degree of international anxiety about the future, with gold seen as the rich man’s anxiety hedge of choice while silver is that of the poor man, these days heavily represented by the large population base of the emerging nations whose citizens have even less reason to trust their governments and a considerably lower income that inclines them to buy silver, then current gold and silver price levels represent less than half the levels of peak anxiety that prevailed in 1980. (The silver spike in 1980 admittedly had little to do with anxiety and everything to do with the efforts by the Hunt brothers to corner the silver market.)
If we accept the argument that the recent trend of global economic growth dominated by emerging nations while the U.S. economy undergoes relative decline is likely to continue for the next couple decades, then perhaps it is reasonable to assume that the gold and silver stock values may hold steady at 10% and 3% for the next five years.
When we apply this assumption to the gold and silver stock that will exist at the end of each of the next five years, and accept the IMF global GDP growth projections as published in April 2011, we would see gold trading at US$1,544 in 2016, with a range of US$1,390 -1,699 assuming an annual swing of 10% (see Figure 4). While this gold price is unlikely to enthuse any conventional gold bug, these growth projections are premised on the continuation of the fairly muted CPI inflation levels the U.S. economy is currently experiencing. This has important implications for gold equities because it means the recent real price gains will hold even though worries about another global recession or depression have subsided.
If we apply the same logic to silver using 3% of GDP for the silver stock value, we would see silver trade at US$53 in 2016 with a range of US$47-58 (see Figure 5). Such an outlook is likely to please all but the more extreme silver bugs, and be very beneficial for silver producers, which are trading at multiples of only five times cash flow projected at the current US$31 silver price. Again, it is important to keep in mind that inflation in this scenario remains low, which means that rising costs will not gobble up the profits offered by current bullion prices.
The flaw in this approach is the reliance on a percentage linked to an outlook sentiment to project gold and silver price levels for the next five years. Choosing 10% for gold and 3% for silver is arbitrary. Less arbitrary is the reliance on projections for new mine supply and GDP for the next five years. A gold or silver price collapse could shut down mines, as could a variety of local disruptions, which would result in lower mine supply that allows for a higher gold or silver price to be calculated using the “metal stock value as GDP percentage” model. But, thanks to the 3-5 year lag in mobilizing new mine supply in response to growing confidence about the resiliency of current gold and silver prices without profit-eroding cost inflation, it is unlikely we will see significantly higher production than projected during the next five years. So how does the outlook for gold and silver look if we vary the GDP percentage of the gold and silver stock value, which will be determined by the market?
Figure 6 expands the annual trading range for gold to reflect the GDP percentage peak and valley of the past 30 years. The 1980 bubble peak of 25.7% would be equivalent to US$3,287 per oz. in 2011, rising to US$3,975 in 2016. In the absence of currency collapse or excessive inflation, such price spikes for gold during the next five years are conceivable but not sustainable. The downside equivalent to the 3.9% nadir in 2001 would be US$476 in 2011, rising to US$554 in 2016. Such low gold price levels are conceivable only in a very deflationary scenario of the sort associated with a global depression or in the improbable scenario that the growth rate of the U.S. economy in the not-too-distant future will outstrip that of China and the rest of the world.
Applying the bubble and bear extremes of the past 30 years to silver yields an even broader trading range, with silver hitting US$206 per oz. in 2011 based on a 14.7% peak, rising to US$249 in 2016, and bottoming at US$7 in 2011 and US$9 in 2016 based on silver’s 0.5% nadir in 2003. However, while gold was truly tested as an anxiety hedge in 1980, silver’s spike was an artificial one which exploited the fact that unlike gold, most of the above ground silver stock was not available for sale in 1980 because it was deployed in some useful purpose.
The conventional gold and silver bug narrative and this alternative narrative both treat gold and silver as an asset class whose primary purpose is to act as a store of value that is fungible, portable, and can withstand legal and political dislocations. But the alternative narrative allows higher real gold and silver prices to flourish as the problems besieging the world get resolved and the world resumes an upwards track of economic growth.
We are in a special historical moment where a dominant “host” nation economy is losing the ability to sustain “parasite” economies. The danger exists that the parasite economies will kill the host economy and thus secure their own demise. The disconnect between gold-silver prices and equities reflects the market’s bias towards this gloomy outcome.
An alternative view is that we are in a transition phase where host and parasite economies are gradually trading places, a process that may take decades. The engine behind this transformation is the fact that the 3 billion members of the parasite economy are adapting the means and methods of the substantially less populated host economy. This may sound like a gloomy outlook, but from the perspective of the “parasite” economies, it is very optimistic. Europeans may be buying lots of gold and silver, but it is the BRIC world which is buying gold and silver while hoping that the host economy survives long enough to nourish the parasite economies into self-sufficient host economies. Although the parasite-host reversal metaphor may be repulsive, it is implicit in the American push to get China to allow its currency to appreciate against the U.S. dollar, and to adopt policies that cultivate the development of a Chinese consumer middle class. Few will reject this explicit goal, but even fewer are willing to admit that a civilization-scale transition is underway.
Embracing this alternative narrative for gold and silver does not require one to dismiss gold and silver bug anxieties that major governments may seek to monetize their debt and pursue currency devaluation. U.S. currency exchange rate declines or widespread global inflation would boost U.S. dollar denominated GDP even without real gains in output. Since the above ground gold and silver stock cannot be inflated without expending energy, resources, labour and time – the reason they are viewed as “hard assets” that store “value” – the effect of currency devaluation or rampant inflation would be to boost nominal U.S. dollar GDP. If we assume that anxiety will be the driver of gold and silver prices, but that this anxiety will be manifested by the percentage of GDP represented by the value of the gold and silver stock, then the underlying equation will translate currency devaluation or rampant inflation into much higher gold and silver price targets along the lines proposed by the more vociferous gold and silver bugs.
Unfortunately, this sort of price increase will not boost the profitability of gold producers and development projects, and do little for gold and silver equities. However, the inevitable overshoot of such a development may serve as the trigger to take current gold and silver prices seriously as the new reality. And that would be very bullish for gold and silver equities, though not for reasons as good as evidence that global economic growth is once again on track.
– The author is the editor of Kaiser Research Online (www.kaiserbottomfish.com).