Tokyo Terror Hits Gold

Why hasn't the huge US money expansion created inflation and a soaring Gold Price...?

PREVIOUSLY MANAGER of Casey Research's Energy Research Division, professional geologist Dave Forest now serves as managing director in Vancouver for Notela Resource Advisors, and his analysis has been featured on Kitco.com, Financial Sense and The Daily Reckoning amongst other leading Gold Investment sites.

Working in the Gold Mining and oil/gas sectors for over a decade, Dave Forest writes the free weekly e-letter Pierce Points, which covers global commodities markets. Here he speaks to The Gold Report about why the massive expansion of the money supply has yet to create inflation or send Gold Prices sharply higher.

The Gold Report: A lot of other newsletter writers and analysts say that with the money supply expanding we should expect aggressive inflation, if not hyperinflation. Can you give us your perspective on whether that's necessarily true?

Dave Forest: The assumption is that because we've increased the US monetary base by close to a trillion Dollars over the last nine months that inflation is guaranteed. We're locked in, that's a certainty – we're heading toward higher prices for most of the things we buy. But just because you increase the money supply does not necessarily guarantee inflation.

Certainly when you create a trillion new Dollars, you raise the possibility of inflation, but the real key lies in where most of that money goes. The most telling statistic is that even though we've increased the monetary base by a trillion Dollars, 90% of that money – about $900 billion – sits in the vaults of commercial banks around the US as excess reserves. So we're in a situation where most of the new money has gone straight into bank vaults.

It's not out roaming the streets, buying things like food and fuel and bidding up prices. We've seen this movie before. It was called "Terror in Tokyo". Back in the '90s, the Japanese government created the Yen equivalent of about $400 billion in an attempt to reinflate its economy, and the exact same thing happened. Most of that money sat in bank vaults and failed to inflate anything, with the result being that prices for almost everything in Japan fell for the next decade.

TGR: But won't the money in the bank vaults eventually come out and bring on inflation? Or is there some timing scenario that totally avoids inflation?

Dave Forest: The real key is when and how that money gets released from banks and goes out onto the street. It's almost like we have a dam and we're pouring all of this money, all of this liquidity, into the reservoir behind the dam. Then we're waiting to see whether it will be released and flow downhill. For the most part, the release valve is bank lending and consumer and business borrowing.

The theory of stimulus would be that you give money to the banks and the banks lend it to individuals and to businesses, which then go out and spend it and put it into the real economy and start helping to reinflate prices. We're not seeing that.

All of the data shows bank lending in the US for businesses and individuals is down by about $100 billion over the last nine months. That's the largest drop in borrowing we've seen in the last 10 years. So the message is that consumers are not borrowing and banks are not lending. Banks are having trouble finding people creditworthy enough to borrow. You don't want to lend money to somebody if you're not sure that they can pay you back.

TGR: If we added $1.2 trillion to the money supply and lending is down only $100 billion, where is the rest of it?

Dave Forest: Most of that has ended up in the banks in the form of excess reserves. A large amount also went abroad in the form of currency swaps to help foreign governments provide US Dollars to people in those countries who need them. Those currency swaps will notionally be swapped back at some point, which means that money will be returned and retired. All of these factors mitigate or moderate the impact of the trillion-dollar increase in the monetary base.

TGR: This whole discussion started with the fact that increases in the money supply don't necessarily mean inflation because a lot of this money is trapped within the banking system. Is there a scenario in which we would just continue in a deflationary environment because the money never comes out of the banks? Or at some point in time will it come out and drive inflation?

Dave Forest: That's the key question. Will it come out and when? That's why we say inflation is not guaranteed just because of the increase in the monetary base. It's certainly a possibility. And, again, the mood of the business community and the consumer are key. If US consumers and businesses – borrowers – suddenly become happier about prospects for the economic future in the US, they could indeed start to borrow and banks will start to lend and we'll see that money starting to move out into the wider economy. At that point, we certainly could get a dramatic increase in inflation. But if they don't and if borrowing continues to decline, that money will sit in the banks and we certainly could have deflation despite the increase in the monetary base.

The other consideration there, of course, is that the government is now trying to bypass the banks and put money directly into the economy through stimulus spending. If they are successful in injecting large amounts of money into the real economy by paying for bridges and roads, that's another situation where the money does start to get out onto the street and we could see inflation.

TGR: Many people who follow gold are predicting an enormous increase in the Gold Price because of this pending inflation. If the new money is trapped in the banks, though, do you suppose gold will remain in its current range?

Dave Forest: That's been the experience so far. A lot of people say, "Wow, the monetary base is increasing, so this has to be bullish for gold." But here we are a trillion Dollars later and gold is still trading between $900 and $1,000. The event that everybody expected to drive gold to the moon has happened, and gold hasn't gone to the moon. If that money does start to get out into the economy, it certainly will be good for gold, but we're not seeing that at the moment.

TGR: Canada's Metal Economics Group Report – the MEG Report – findings indicate that replacement reserves are increasingly difficult to find for producers and in essence this will decrease gold production as we look forward. Can you speak a little bit to that and the implications on the price of gold?

Dave Forest: The idea is basically that producers are having a more expensive time replacing their gold reserves. Major gold producers are very sensitive to their reserves replacement ratio, so if they produce a million ounces a year, they want to see a million ounces a year or more added in reserves so the tank isn't running dry.

In places like South Africa, for example, you can add reserves by looking for gold at deeper levels, but the problem is that that gold becomes more expensive to mine, so you pay more to discover and produce those reserves. There's a movement afoot amongst producers to try to find lower-cost sources of new reserves, which is taking the form of looking into new technologies and new countries.

TGR: Given that we're still looking for new technology and looking at new countries, the fact that buying the reserves is increasing and mining reserves are increasing, why shouldn't we see gold increase just due to supply and demand factors?

Dave Forest: That's an interesting question. The shorter answer is we should, because in several countries the strategy has been for producers to move toward lower-grade deposits where they can add tens of millions of ounces to their book. Those deposits are available in many parts of the world; they'd been passed over because they weren't profitable to mine in the past. So as producers move towards those lower-grade reserves, yes, we should see an increase in the cost of gold because it costs more to produce those deposits.

The mitigating factor there would be that, generally, when the price of a commodity rises, there's the opportunity to make a lot of money. When you can make a lot of money, you usually attract a lot of smart people and those smart people tend to ruin it for everybody by finding better and cheaper ways to do things. In the mining industry we've seen that in the past with the development of technologies like heap leaching. So in the '70s when we had a rapid rise in the price of gold, we did a lot of work on developing heap-leaching technology. That basically enabled low-grade gold deposits to be produced relatively cheaply and brought the production price push on the Gold Price back under control. So we expect that to happen and be a mitigating factor if Gold Prices do rise.

TGR: To what would they have to rise to really influence these smart people and new technologies to come in?

Dave Forest: Even now we're seeing gold as one of the few sectors that's shown much life in the investment community over the past nine months. I think in the first four months of this year there was something like $4 billion raised globally for gold projects. So, even at a $900 Gold Price, we're seeing a lot of interest. I suspect that even if gold rises by a few hundred Dollars to $1,000 or $1,100 or $1,200, we would still see a lot of interest around the world in gold projects.

TGR: A lot of things seem to be influencing the price of gold, though. We're in a deflationary environment. We may not see inflation for a year or more until that money comes out of the banking system. We have increased mining costs. With all these factors at play, what's going to cause the price of gold to go up?

Dave Forest: Conceivably, it may not go up. We could have a situation where gold stays range-bound between $750 and $1,000, the way it's been over the last couple of years, especially in a deflationary environment where you'll have some selling of gold as people try to raise money and some buying of gold. That's been our investment thesis; you can't bank on a rise in the Gold Price as your underlying argument for stock selections. If you're counting on a rising Gold Price to lift all boats in the gold stock sector, you may be disappointed.

TGR: Another thing that you've written about in your newsletter is that deflation, while it's bad for a lot of companies' performance and probably for the general stock market, it could actually be good for gold companies. Can you explain that?

Dave Forest: Gold stocks are sort of in a win-win situation. If we get inflation and the Gold Price goes up, obviously gold stocks do well and that's the scenario that everybody expects when they buy gold stocks. The other scenario that's interesting is that historically, during periods of deflation, gold stocks are one of the few assets that do well. That's because during deflation things are getting cheaper and you can sort of win by not losing or not losing as fast as everything else. The historical evidence is that gold tends not to lose as fast as everything else. Because there's some demand for gold, it's a store of value.

So the Gold Price tends to go down more slowly than the price of things like oil, labor, chemicals – all of which are used in producing gold. The end result being that for a gold producer, the sale price of your gold stays relatively high while all of your costs come down considerably – the costs of your mine workers, your process chemicals and the fuel to run your machinery (particularly in an open pit gold mine). So margins tend to improve. The experience in past deflationary periods is that gold miners' margins improved, and improving margins mean improving cash flow and generally improving stock performance.

TGR: But if the replacement reserves are lower grade and more expensive to mine, are we looking at a wash, where the margins are about the same? Or are you expecting, even at $900 an ounce gold, new technologies will come in to make those lower-grade replacement reserves more economically viable?

Dave Forest: Usually what happens when we have a period of profitability in the gold sector, there tends to be a lot of exploration for new gold deposits. That usually results in the discovery of some major world-class gold deposits, which are the highest grade, the most profitable gold deposits around the world. Those tend to be the cost setters for the entire industry. They're usually the cheapest to mine and the highest quality. So if we get a period of intense interest in gold stocks, we can probably expect one or two major discoveries that will help to offset the rising costs at other gold deposits because they'll be high grade and large and low cost to produce.

TGR: Given we've got all these factors, what do you see as a good investment strategy through the next 12 months?

Dave Forest: Gold Mining stocks are sort of hedged both ways. If we get a deflationary scenario, we'll probably see margins improve for the producers and that eventually will translate into interest in the more junior gold stocks. If we get inflation, then obviously the Gold Price rises and all of these gold stocks do well. So we like gold stocks, particularly those that have cash.

One of the problems at this point is many of these companies are struggling for survival. They've run out of money, and raising new money in the equity markets has been tough. So good gold companies, companies that have a strategy for discovery and the cash to do it, are good protectors of investment in that they'll do well regardless of what happens on Wall Street.

TGR: Do you have a preference for those that are in production or near production?

Dave Forest: No, We like both sides. We like juniors that have a good strategy for identifying new projects, doing some early-stage work and then bringing in a larger partner – a major or an intermediate – to do some of the work in proving that up. We like that model. We also like development-stage companies that have a deposit where there's potential to add significant value by doing a relatively moderate amount of work. And we like the seniors, too. The seniors will benefit from a rising Gold Price in inflation or from rising margins in deflation. So, across the spectrum, I think gold stocks are going to be a good investment.

When you look at the stages of the exploration cycle, the lifecycle that a project goes through as it grows up from being a piece of land in the middle of nowhere in Alaska or Papua, New Guinea or wherever, to being a mine, it goes from early exploration to advanced exploration to drilling to development and then to mining.

The interesting thing is that the potential to add the most value for the least money is at the earliest of those stages. When you go out and stake a piece of land somewhere, it may only cost $25,000 or $50,000 to hold that land. Then by applying some fairly inexpensive work, by going out and doing some field mapping, taking a helicopter out for a day, having a look around, perhaps doing a bit of geophysics, maybe spending $50,000 or $100,000, if you can show that there's a decent chance that that piece of ground may have a large deposit beneath it, you've now added a considerable amount of value.

If a company does that kind of work, we may see a major company come in and commit to spending maybe $5 million or $10 million to earn an interest in the property. Any time you can attract an investment of that magnitude for a payment of $50,000 or $100,000 on your own, that's a very good return on capital.