Gold Prices: Reality and Illusion

Higher gold prices "inevitable"...

MONETARY POLICY moves stock prices more than economic data releases these days, says Mike Niehuser, founder of Beacon Rock Research. While the potential for higher gold prices is compelling, the decline in the number of discoveries and grades of resources makes mining stock selection intriguing. In this interview with The Gold Report, Niehuser has scoped out jurisdictions and finds the stars are aligning to put Nevada on top. 

The Gold Report: Now that the election is in the rearview mirror and we are well into the new year, what are your thoughts about gold prices and mining stocks for 2013?

Mike Niehuser: In my interviews with The Gold Report over the last couple of years, I have attempted to steer toward moderation but with optimism for higher gold prices, similar to Pierre Lassonde's forecast leading up to the end of the last decade. Early on, Lassonde saw the potential for annual increases of about $100/ounce (oz) in the price of gold through 2010, reaching $1,000/oz. He was surprisingly accurate. 

I have taken this a step further, believing that gradual increases seem inevitable given government and central bank policies in the US and globally. Because inflation, as well as the gold price, is a monetary phenomenon, price levels of products and services are managed by central bankers to trick investors and consumers, allowing them to function on a day-to-day basis. This is money illusion. Bankers and policymakers think people are incapable of separating reality from illusion. This is difficult in real time but becomes more obvious looking in the rearview mirror.

TGR: What was your prediction for gold prices in 2012?

Mike Niehuser: For 2012 I expected gold to trade between $1,400 and $1,700/oz with the potential with some catalyst to trade on the upside to $1,800–1,900/oz. While this is what roughly happened, it didn't happen in a way I expected. I thought gold prices would be more volatile and would follow seasonal demand with highs coming at year-end. Interestingly, prices were pretty flat within my range and came close to $1,800/oz. 

The range and high for 2012 was about $100 more per ounce than my previous estimate for 2011, which was also close. While my forecasts are a little broad, they are moderate compared to the extremes expected by some experts. I am not a gold trader. My focus is on my level of confidence for gold prices to be generally above costs of exploration and operations for the mining sector to be viable for investment. I then try to assess development risk of projects of which stable gold prices are an important part.

TGR: Do you expect the same $100/oz increase for 2013?

Mike Niehuser: I don't see much changing; higher gold prices appear inevitable. I think that the lower end of the range is fixed, but the potential for higher price levels above my range are more than possible if there is a black swan event. For 2013, let's put down $1,500 to $1,800/oz for the gold price and look for a high of $1,900/oz for the year. It may seem a little wimpy to keep $1,900/oz at the high end of the range, but a lot of things could tamp down gold prices, especially in the near term.

TGR: What are the risks that gold prices may fall or even drop below your lower range?

Mike Niehuser: In the big picture, a novice technical analyst may look at a 10-year gold price chart and say that gold has had its run, is losing momentum and should be ready for a long slide to historic levels. There may be some credibility in this assessment; certainly the government requires taking into account trailing averages for calculating resource models. This may be an argument but it's not realistic. We are not in the world of three years ago much less than 10 years ago. Besides, these nominal price charts are not real prices because they don't take into account inflation. 

TGR: What makes gold risky in 2013?

Mike Niehuser: Monetary policy has more impact on moving stock prices than economic data releases—labor data, for example. The recent increase in the price of gold follows quantitative easing (QE) by the Federal Reserve Bank. Gold sputters when the Fed starts talking about stopping its Treasury buying programs. Gold prices have increased among nations that show the linkage of global currencies. 

The Fed believes in the Phillips curve and has a full employment mandate, so if the Fed sees inflation increase over 2% or unemployment drop below 6.5%, we can expect it to increase interest rates. Friedrich Hayek said the micromanaging of the economy is the "Fatal Conceit." If the Fed can convince itself that the economy is strengthening, then quantitative easing may end and investor sentiment fade for precious metals. If the Fed starts increasing interest rates, it could crush gold prices in the near term.

TGR: Do you see the US economy growing in 2013 or the Fed increasing interest rates?

Mike Niehuser: It probably depends on how you measure growth. In my opinion, the media and politicians will talk it up. Large politically connected corporations whose lobbyists have helped them secure monopolistic positions will be optimistic. They are set. If you are a riskier biotech company or resource exploration company, you might have a tough time locating financing. If you look at the velocity charts of the Federal Reserve Bank of St. Louis, you can see by any measure that velocity is at the lowest level in decades. This reflects anemic credit, equity markets and business activity. 

Fed Chairman Ben Bernanke is afraid to death of deflation. Clearly declining velocity has been offset by Treasury purchases, increasing bank reserves that balance with an anemic economy and low inflation. If the economy grows and velocity increases, inflation is going to be a real problem, but great for gold prices. If the economy sputters, the only solution for the central bank is to buy Treasuries. I saw the term "QE Infinity" the other day, great for gold, but a horrifying concept, especially for producers and savers like seniors.

TGR: The Fed doesn't have an easy choice, does it?

Mike Niehuser: In my opinion it doesn't have a choice, but it thinks it does. The Federal Reserve Bank thinkers are largely academics from MIT. These are demand-side Keynesians who believe in the validity of econometric models and their ability to manage the economy as opposed to trusting free markets of individual buyers and sellers or investors. I saw Bill Moyers interview Paul Krugman the other night. To them the problem is so clear: Savers are too greedy or afraid to buy stuff or invest, so demand for goods suffers, which can only be solved by executive action or by the government taxing the rich and engaging in deficit spending. This is the epitome of the Fatal Conceit. The Fed thinkers believe they can manage the economy, and as one of them said, if reality doesn't match their model, reality is wrong. If it were their money, it wouldn't be so scary but Bernanke admits they are experimenting with the economy.

TGR: How does this relate to the Federal Reserve?

Mike Niehuser: In my opinion, the Federal Reserve's job is to maintain price stability but the Fed is now in the economic-health business. The government is in the program-spending business. The Federal Reserve and the federal government are cooperative centers of gravity. It has become apparent since the financial crisis that all the economies are linked. This systematic risk is even greater. All the developed nations are facing the same issue of central banks and spending. Think about Germany's tough role in the Euro with the PIGS (Portugal, Italy, Greece, Spain) nations. Even Switzerland has devalued its currency, caving to its exporters at the expense of savers. Japan is devaluing its currency. In a way the world economy is circling the drain, currency is no longer a store of value and wealth is being transferred to consumers at the expense of savers and producers. 

TGR: Is gold then the answer as a store of value?

Mike Niehuser: Well, it may be one answer. The truly rich have always gotten richer from inflation. Tangible assets like real estate are tax-deferred hedges against inflation. There seems to be more advertisements for tangibles like art and collectables, but it could be my imagination. Inflation hurts holders of currency and currency-denominated debt. This makes it real hard to get credit; nobody wants to provide it only to be repaid in devalued currency at interest rates that do not compensate for that risk. This is one way the government squeezes out private debt and equity. 

The government is big in mortgage lending and student loans while selectively targeting its priorities with guaranteed debt or tax credits. While this increases demand, it doesn't encourage responsible behavior and leads to bubbles. If the government owns the debt and can forgive or modify the debt, it now is both investor and manager of bubbles. The greatest intervention in the US has been cramming down secured senior creditors at General Motors in favor of union pensions. So, yes, gold is a store of value for central banks, retail investors and everyone in between, as a hedge against the government progressively printing itself out of a problem.

TGR: In a risk-adverse market for equities, does gold provide a hedge against inflation?

Mike Niehuser: That has been the conventional wisdom. While the potential for higher gold prices is compelling, the decline in the number of discoveries and grades of resources makes stock selection intriguing. While discoveries may not be related to gold prices, which are a function of production supply not meeting demand, with fewer discoveries where is future production going to come from? 

This is also true of copper. Producing mines are mining at lower grades while demand from China is driving prices up. The big surprise in metals in 2013 might be zinc and platinum with mine depletion and closings due to political unrest. In any event, careful company selection for both producers and exploration companies may produce better-than-expected returns.

TGR: You certainly paint a negative picture for raising capital. Are you bullish on mining stocks?

Mike Niehuser: Buying exploration resource companies at a discount to their in-situ value or gold producers makes sense but this is a very risky business. Most discoveries never become a mine and once a mine is built costs may erode profitability; if a windfall is in the air, governments are all too quick to move the goal posts by increasing taxes or royalties or outright nationalization. This is likely to increase as nationalism appears to be on the rise at the expense of international free trade. I am a true believer of free trade benefiting the masses through comparative advantage being superior to national theft. While "let the buyer beware," I am going to be giving a premium for political stability.

TGR: Are you going to be sticking close to home?

Mike Niehuser: About a month ago I presented at the Yukon Mining Summit on the competitiveness of the Yukon. It is amazing that the Yukon is one of the world's most attractive areas for both political stability and geologic potential. If a company can get into production, it may be set. 

TGR: Is Nevada the best place to invest in gold mining companies?

Mike Niehuser: I think so. I am pretty disappointed in federal regulators in the US, but everyone has heard of Nevada, and consequently the infrastructure is generally good, and this leads to lower costs overall. 

TGR: Do you spend a lot of time in Nevada?

Mike Niehuser: Not as much time as some banking analysts, but I think exploration projects in Nevada will lead us out. 

TGR: What areas in Nevada should investors keep an eye on?

Mike Niehuser: I really like the area around Lovelock, Nevada. This is a fascinating area, as it once contained Nevada's only gold dredge in the placers around Spring Valley. These placers may sometimes suggest nearby hard rock deposits. 

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