Gold Without Crisis

Top Gold Mining analyst questions the long-term support for gold, absent today's "crisis mentality"...

A PhD METALLURGIST who began his career working with Xstrata (then MIM Holdings Limited) at Mt. Isa, Queensland, Tony Parry is now a senior analyst with Sydney, Australia-based Resource Capital Research.

Previously working as a mining equities analyst with James Capel Limited (now part of HSBC), as well as in equity sales and mining corporate finance – marketing to institutional clients in the UK and Europe – Tony Parry established his own consultancy in 1993, advising many small-medium enterprises on strategic planning.

Today, when building his long-term models for Australian junior Gold Mining companies, he uses a long term Gold Price of US$900 per ounce. But Tony thinks gold's fundamentals are weak and that fear is artificially propping up the price, as he explains here to The Gold Report...

The Gold Report: Tony, you joined Resource Capital Research as a senior analyst in 2008. Tell us about your coverage sector.

Tony Parry: At Resource Capital Research, we cover exploration and development companies, typically those with emerging production profiles that have not been picked up by the market or major brokerage firms and need further research coverage.

We cover three sectors – gold, uranium and iron ore. We publish major reports each quarter covering a number of significant companies in those sectors, and these reports contain a commodity price outlook for the commodity we're looking at.

TGR: On the gold side, Australia has quite a history of Gold Mining, especially in the Kalgoorlie area. But in other countries, gold has taken on something of a stigma in recent years. What's the general sentiment toward Gold Mining right now in Australia?

Tony Parry: Australian mining is a very positive and somewhat booming sector. It's growing strongly, and there's no major resistance to further development, apart from the normal environmental and social concerns about developing mining operations.

TGR: What sort of play is gold receiving in Australia's mainstream media? Is there a buzz about gold at $1300 an ounce?

Tony Parry: It's exciting times for the gold market; $1300 an ounce is a pretty significant breakthrough and, of course, that's getting a lot of play in the financial reporting sector. We're seeing lots of articles on the Gold Price. Every article seems to be placing a bet on gold. So, yes, there's quite a buzz in the press and there are a lot of people talking about gold.

TGR: Do you think the average Australian is aware that $1300 per ounce is really good for the Australian economy in terms of exports?

Tony Parry: Yes, I think they're pretty in tune with what's happening in the resources sector; as I say, it's such a significant part of the Australian economy. Even in the largest cities there's no doubt the Gold Price is widely visible.

If you got in a taxi in the capital city of Australia and talked to a taxi driver about what's going on, he would probably talk to you about the Gold Price.

TGR: What are we looking at in terms of mining's contribution to GDP there?

Tony Parry: I don't have the exact numbers, but something like 30% of Australia's total exports are made up of mining-related commodities. The three big exports in Australia are coal, iron ore and gold, in that order.

TGR: Your firm predicted an average Gold Price of just below $1200 an ounce for 2010; obviously that was a little low. What sort of fundamentals did you see in the gold market and in the global economy that led you to say in a recent report "take away the 'crisis mentality' and gold looks precarious"?

Tony Parry: What we were seeing and what we're still seeing is that the "doomsday mentality" is driving investment demand in the gold market. The simple fact is the "crisis mentality" has not been removed from the equation since we made those forecasts. In fact, the "crisis mentality" is bubbling along very well, perhaps even increasing as European sovereign debt concerns continue to make headlines.

And we're still seeing major concerns about the US economy and the issues surrounding quantitative easing, which are starting to have an impact on the US Dollar. There's quite a bit of pressure on the US Dollar.

Perhaps we felt that there was going to be some easing of that crisis mentality in the coming quarter or two, but at the moment there's no sign of that and it may very well be increasing.

TGR: But in looking through RCR's September report on gold, your price estimates are quite conservative across the board. In your financial models, you're now using a long-term Gold Price of $900 an ounce. That seems particularly bearish.

Tony Parry: It does in the current environment. We say in Australia that predicting the Gold Price is a bit of a mug's game. The fundamentals are pretty tricky to go on, so you've really got to go on the psychology of the market. Gold doesn't have enough underpinning it to make a projection on the fundamentals.

TGR: I agree, but you must see something in those supply and demand fundamentals to project such conservative prices.

Tony Parry: That's right. At the end of the day we have to come up with some sort of basis for our forecasts. We asked ourselves: is $1300-an-ounce gold sustainable or is that a spike? We believe that in a few years' time and once everything gets back to normal – and please don't ask me when that is – we will see gold come off the top quite significantly.

Our argument is that the Gold Price is being sustained by strong "safe haven" investment demand. But if you take that demand away, we see weak fundamentals; jewelry demand is quite weak, which has been the main source of gold demand, before investment demand started challenging jewelry demand in recent times.

Gold Mining production is increasing because of the increased prices, so there's more supply coming on the market. We're also seeing increased scrap supply from recycled gold.

On the demand side, we're seeing negligible purchases from central banks, perhaps because they just don't want to buy more gold at these prices. And as I mentioned, we've seen the end producer de-hedging, which has been a demand-side factor in recent times. We may even see more hedging from producers.

If you put all that together, and significantly reduce investment demand, we see gold coming significantly off the top. We wouldn't be expecting that in the short-to-medium term. But if you ask what's the fundamental value of gold? At the moment, we say that's about $900 to $1,000 an ounce. That is probably the ultimate baseline that gold will come back to when it's safe to go back into the water with the other asset classes that people don't really trust at the moment.

It could be a number of years, but investment banks will be doing the same; they won't be factoring the current Gold Prices into their long-term valuation models. And I think that's fine because if we're wrong, and a company still looks good on that basis, that's pretty good news for the company.

But we do see the speculative element washing out in time.

TGR: In your report you said that in the future you could see a sustained inflationary uptrend that could ignite gold's "store of value" demand. You added that it's too far off to be a factor in the short-to-medium term. Could inflation prop up gold once this "crisis mentality" subsides?

Tony Parry: That's a good question. There's no doubt that inflation is in the melting pot as an argument for holding gold. Quantitative easing is the pump priming the US economy and other economies. The classic theory is that the more money you pump into the system, the higher inflation is going to be in the end. At the moment, we're seeing more concern with deflation in the US and European economies. You'd have to say inflation is not a strong factor right now.

Longer term, yes, inflation could rear its head. But inflation would require some economic growth to become a real factor, and by then you may see equity markets back into the next bull phase. I have a hunch that by the time that is happening, some of the speculation in gold will have washed out. I see that as a bigger factor than the "big inflation" argument.

For the record, we just published our September quarterly gold report, and we're feeling less bearish. Given the continued concerns in the market, we expect gold to keep pushing up into the first half of 2011. We're looking at around $1335 to $1350 during that period.

TGR: In your June report you said that in the last five to seven years, one of the major trends in Gold Mining has been for gold producers to buy out their hedging contracts to gain more exposure to the spot price. But you also said in a recent report that the gold sector could see a "return to net producer hedging at Gold Prices above a $1000 an ounce driven by producer concern that the highs for gold may have been seen for now and the requirement by project financiers to lock in for future margins." That's remarkable. Have you seen any evidence of hedging above $1000 per ounce?

Tony Parry: Well, I'll be honest – not a lot at the moment. There's no doubt that the producer hedge book has run down to virtually zero.

TGR: I've talked with a number of analysts who like Gold Mining juniors that are producing, but that also have some strong exploration upside. Do you follow companies that fit that description?

Tony Parry: Yes, but first I want to comment on that thesis. There's no doubt that exploration is a tremendous driver of shareholder value for emerging companies. What we're seeing is that a lot of the Australian companies in West Africa are having excellent exploration success. In fact, they're getting huge gains on their share prices – 200 to 300% – due to exploration success. That's happening because they are discovering gold at a discovery cost of around $10-$15 an ounce.

Equity markets, doing simplistic valuation multiples on gold resources and reserves, value them typically at $50-$100 an ounce once you've got a significant gold resource established, maybe 500,000 ounces or more. If your discovery cost is $10-$15 an ounce and you're being valued by the market at $50-$100 an ounce, there are tremendous gains to be made through exploration success. You're getting very high leverage on those exploration multiples. That's the game at the moment.

TGR: Do you have some parting thoughts on the precious metals sector in Australia?

Tony Parry: Yes, obviously, the Gold Price is up 31%, in US Dollar terms, in the last 12 months. But the Gold Prices in producing countries haven't been nearly as strong because of the appreciation of currencies. The Canadian Gold Price is up 23% in that 12-month period, as opposed to 31% for Gold Prices in US Dollars. And in Australia, the Gold Price is only up 19%.

But if you look at the performance of the indices over the same 12-month period, the US-based gold stocks, with the S&P gold index, are up 49% in that 12-month period. That's performing better than the Gold Price, and that's to be expected as there are no currency issues there.

In Canada, the gold index is up 18%; so, it's actually underperformed the Gold Price. You'd have been better off holding gold rather than Canadian gold stocks in that period. That's partly due to the fact that the Canadian Dollar Gold Price was up just over 20%.

But the Australian gold index in that 12-month period is up 43%, even though Australian Gold Price was up only 19%; so, Australian gold shares have been fantastic performers. And I am sort of bragging.

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