The historical case for silver to overshoot gold in this bull market...
CONSISTENTLY RANKED as one of Canada's top 10 gold and precious metals mining analysts, geologist Barry Allan's Research Capital utilizes his 15 years' experience in the Gold Mining sector that brings together geological fieldwork, equity research and finance.
Before joining Research Capital in 1997, he was a gold and precious metals mining Analyst with Gordon Capital, BZW and Prudential Bache. Prior to equity research, Barry was a member of the specialist finance group at CIBC, one of Canada's largest financiers of mining projects.
Here he speaks to the Gold Report about the historical gold-silver ratio, and why silver tends to overshoot on the upside. He foresees a short-term breather for gold and a strong surge by silver – meaning that we're approaching silver's season to sparkle.
The Gold Report: When we interviewed you last March, you were very bullish on gold and silver, partly because demand for gold is being driven by investors rather than jewelry and also by worldwide currency crises, particularly problems with the US Dollar. Gold is now approaching $1,200 an ounce, and central banks have shifted from selling to Buying Gold. What's your impression of where we are in this precious metals bull market now?
Barry Allan: It's fair to say that all the ingredients we talked about in March have really come to fruition and quite dramatically so. I recently saw statistics in our financial Globe & Mail about fundamental purchasing of gold by the average person. We are seeing unprecedented hoarding rates, as far as people putting gold in safety deposit boxes is concerned, but also a continuing evolution in the amount of gold going into exchange traded funds, Gold ETFs. And as you pointed out, we have seen this material shift by central bankers. It's now fashionable to actually to own gold as part of their foreign holdings.
I am a bit concerned that gold is becoming too fashionable, that it is now not only mainstream thinking that you need some gold, but it's actually approaching a point where gold is occupying the forefront of a lot of people's attention. Short term, that worries me a little. Nevertheless, while we might have some short-term weakness, prospects for the US Dollar and interest rates still suggest that in certainly US Dollar terms, my expectations for gold a year from now are higher than where we are now.
TGR: What do you mean by the short-term weakness?
Barry Allan: In the near term we are always cautious about the seasonality element, which basically says that gold gets into a tough environment toward the end of January or February. It certainly has been the case for the last number of years; and I have no reason to suspect that will change. We typically go into the doldrums before the beginning of spring. But with that caveat, we continue to be optimistic on both gold and silver. We don't really see the dynamic of the market changing all that much over the long-term.
TGR: A lot of people who see this current market rally as a bear market rally are calling for a correction; in fact some are even calling for a crash. If the market does crash, will gold and silver decouple or pull back with the general market?
Barry Allan: My expectation is to see a certain amount of correction in gold. I do not expect a decoupling. Gold has become fairly tied to investment opportunities and prospects in the sense that if we get into a tough equity market, you're going to see some profits taken in gold as well. The more you say gold is an investment vehicle, the more it will behave like other investment vehicles. If we're having a general contraction in equity markets, I find it hard to believe that we wouldn't have some correction in gold – certainly gold equities, but also in the price of gold itself.
TGR: But aren't the metals often viewed as a hedge against downturns?
Barry Allan: Yes, but on a practical basis people will take profits. Gold is certainly a hedge against currencies, but if the market is correcting, why would I sell my equities and go straight to currencies? Wouldn't I go to gold? It's that kind of logic. The practical part of it, though which I have seen over the years, is that any time we've had an equity market correction, we've always had a correction in the commodity price as well. I do not expect that to decouple. It may be less of a phenomenon, but I don't expect a surge in bullion price if equity markets roll over.
TGR: Silver prices have done very well this year, along with gold, but they're still a lot of "silver bugs" who expect it to start to increase relative to gold due to the gold-silver ratio. What do you think will happen with silver?
Barry Allan: That's a fair comment. Certainly what we've been tracking and saying is that silver has lagged gold. History has shown us that silver often does catch up and tends to overreact, so we fully anticipate that gold and silver will come back into line. We haven't changed our thesis; we've always argued that the best predictor for silver price is the price of gold. We look at gold as our benchmark. The R-squared value of the correlation between gold and silver is the best predictor for silver prices, with the caveat that it tends to lag and then it tends to overshoot. For that reason, particularly now, we'd be more apt to be in silver than gold.
TGR: Because you're expecting silver to catch up.
Barry Allan: That's correct. Yes. And that's based on a little more concern about gold and a little more correction in the ratio.
TGR: Are you looking for silver to have that increase before the seasonality downturn? Or is that more likely to occur throughout 2010?
Barry Allan: Probably more in the seasonality period. I would expect the ratio to correct itself with silver holding up a bit better than gold. We'll certainly see silver trying to catch up while we're in this bullish environment for gold, but I really think it's going to be a matter of gold coming more into line with silver, at least for that period. After that, they'll march together again. But again, in a rising Gold Price environment, silver almost always lags.
TGR: So, even though you're expecting a really nice run up in silver, both silver and gold had a very nice run 2009. With this tremendous increase in metals prices, why aren't most of the mining companies generating a corresponding increase in profits?
Barry Allan: That is a really good question, and there is no really good answer. Gold companies have not distinguished themselves in capitalizing on this Gold Price environment to get earnings to the bottom line. Quite often, we've had disappointments, start-up issues, grade problems, and on and on we go – to the extent that the rise in bullion prices is not translating into bottom-line performance. We have had an immoderate amount of disappointments by our senior gold companies, whereby mines haven't started up as planned or on schedule. There's a long list of woes we could go through – but in short, they just haven't delivered the goods. That's one reason why gold equities have lagged gold commodity prices.
TGR: That's not a bad answer. But are there other reasons?
Barry Allan: Another factor is the evolution of ETFs. If you want Gold Price exposure, you now have a much more liquid way of getting that exposure. An ETF gives you that exposure without exploration exposure or operating cost exposure and other things that go along with owning part of a mining company – and, by the way, these companies have not gotten earnings to the bottom line anyway. The two phenomena together have been the primary reasons that gold equities have underperformed the commodity.
TGR: Why aren't the mining companies successful at getting earnings to the bottom line?
Barry Allan: This gets back to the fundamental logic of gold mining. When Gold Prices rise, gold miners will go to a more marginal ore grade. By virtue of extracting lower cut-off grades, they cannot achieve the same percentage increase in bottom-line performance that they would if they were taking higher-quality stuff. It's a little bit a self-defeating kind of process, but they're looking to get the maximum level of cash flow. Their margin with a poorer-quality ore grades is not quite as large as it would have been, but total cash flow generated is better because they're producing more ounces.
Some of this is going on as we speak. You've seen the evolution of large low-grade deposits, which are classic examples of what I've described. In Canada – it's been more common in other parts of the world – we are now rather uniformly getting one-gram–ore-grade deposits in hard rock, or even less, and that's a direct result of these high Gold Prices. So high metal prices do have consequences on the bottom-line performance of Gold Mining companies.
TGR: Let's continue down that line of thought about the effect of increasing Gold Prices on ore quality for a moment. Suppose we have a settling out of the Gold Price or a correction that takes it back to $1,000. In that case, these lower-grade deposits might no longer be attractive from a cash flow standpoint. And if that happens, won't we run into a supply issue?
Barry Allan: No, because a good portion of the mines will have been built already.
TGR: At what point would supply become an issue?
Barry Allan: You'd see a contraction in gold supply only if you start getting into the marginal cost of production, which probably sits in the high $400s now.
TGR: So as some of these new mines come on board, we actually might begin to see a rapidly increasing margin in the next year or so.
Barry Allan: Absolutely.
TGR: As the higher grade ore starts to come up top?
Barry Allan: In one case, a higher-grade ore is a bit difficult. The company's economics work by economies-of-scale. It's low margin, high volume. That's where they make money. With the Gold Prices we're looking at now, they'll be rolling in cash. They'll be producing 600,000 ounces of gold annually. They're going to be a very significant gold producer, and considering their original return on capital was based on $850 gold, they're going to have a wonderful margin if these Gold Prices hold up and will become a very significant cash flow generator.
TGR: When we spoke in March, you talked about the balance between low and high-beta stocks, with the relative weight in your portfolio depending on whether you were bullish or bearish on the sector. To what extent is your portfolio weighted toward more high-beta stocks now?
Barry Allan: In the summer months we'd gone to a high-beta strategy in the sense that we wanted exposure to gold. We continue to be there at this point and – unless something catastrophic happens here in the short term, which I am not anticipating – we'll probably stay there right on into early 2010. We have a technical analyst and I watch charts fairly closely. If we see some rapid outbreak in Gold Price, even more than we've already had, I might go to a defensive mode a little bit more quickly. By that I mean go to a low-beta strategy in gold stocks – go to low-cost operators; low-debt kinds of companies; away from the smaller market cap companies and into the bigger cap companies – and maybe straight to ETFs as well. If there's an outbreak in Gold Price, I am going to say, "You know what, I'm going to take profits here, thank you very much."
TGR: More of a profit-taking thing...
Barry Allan: Absolutely. Going to a defensive strategy comes back to an overall phenomenon I've observed in analyzing some 29 years' worth of quarterly data. The end of the first quarter is an extremely high-risk period for gold. Better than 45% of the time, we get into a problem at the end of the first quarter. About 30% of the time it will be in the second quarter. It's rarely a fourth-quarter problem; only 5% of the time have we been in an ugly Gold Price environment in the fourth quarter.
Because of this pattern, I'd need something – something like a very dramatic move up by gold – to really shake my fundamental seasonality strategy and go to a more defensive posture now. Some people are saying we've had it already, but I'm not there...yet.
TGR: You've indicated that you're looking for the "next generation" of Canadian gold mines. Why not stick with the ones that are already up and have cash flow and profit margins?
Barry Allan: When Gold Mining stocks move, you have tiering of companies. The big tier moves first, then the intermediates, then the juniors. Then you see the last tier, the very high-risk stocks – the people who are in exploration mode or in development mode. That's where we've gone to try and engineer our performance. It really has nothing to do with Gold Price, per se, but as I said, it has everything to do with successfully adding to the ounce count. We're looking for value, creation of value, and that's where we see our next generation of emerging gold producers.