What’s happening with gold? Who’s benefiting and why? These are some of the important questions we explore below with the Executive Vice President and Head of ETFs at Sprott Asset Management, John Ciampaglia. Gold prices have seen a sharp rally in recent months. Find out what this means for your portfolio and the markets.
CommodityHQ.com (CommodityHQ): What is the driving force behind the rally in gold prices we’ve seen since the beginning of the year?
John Ciampaglia (J.C.): Right now, gold is reestablishing its role as a monetary metal and alternative currency. As central banks around the world allow their currencies to devalue in Russia, Brazil, or certain countries in Europe, gold all of a sudden looks a lot more attractive because it’s priced in U.S. dollars.
The second thing that’s happening is the negative interest rate policy that’s being implemented in a number of countries. First it started with Japan, and then it spread to other nations in Europe. And now we have $7 trillion dollars of sovereign bonds with a negative yield. This has really got the markets concerned. Global growth is not where policymakers want it to be, and it seems they are running out of things to try to stimulate growth. If you don’t have any yield on a fixed-income investment, gold looks more attractive even though it has no yield. We joke internally that gold becomes a high-yield investment when compared to a negative interest rate.
The third factor driving things is the U.S. dollar, which appears to be running out of gas here after a long rally. It performed well in the first few months of 2015 and has been range-bound since. It seems as though the trade is kind of crowded, and the expectations for more interest rate increases in the U.S. have really dissipated in the last few months.
CommodityHQ: It seems that the West has depleted much of its gold reserves. Where did all the gold go in the last three to four years?
J.C.: For the last three or four years, precious metals have been basically left for dead. In North America there has been a very interesting phenomena where investors have generally not been exposed to precious metals for three years. As a result, gold was all shipped east to countries like India, Russia, China and Vietnam. Individuals, countries, and central banks view gold as a monetary metal and want to have it as part of their foreign reserves. They just don’t want to have all their assets in U.S. dollars.
CommodityHQ: What is the difference between precious metals and mining stocks that investors need to consider?
J.C.: When people are looking at precious metals, we always tell them that gold bullion is your fear trade. You have a percentage in it, and it acts as an anchor in your portfolio. The mining stocks are more of a greed trade. You’re buying them on the basis that you think gold is going to go up and you want to play that on a leveraged basis because of the inherent operating leverage inside of the companies.
Historically, bullion is the least risky because it represents a store of value. Senior gold mining stocks have equity risk and have moderate correlation to the broader stock market. For someone who wants to be more speculative, junior gold stocks are your risk capital because of their higher exploration and development risk. The allocation to bullion and/or stocks really depends on an investor’s risk profile.
CommodityHQ: Speaking about mining stocks, we’ve seen in some regions, such as South Africa, many mining companies cutting production. Now, they’re doing more acquisitions. Do you think going forward that’s going to be the trend in terms of the global mining companies?
J.C.: The best way to describe what you’re saying is there’s a real bifurcation in the market. The companies that had less debt going into the downturn have done a better job weathering the storm. They have more efficient and profitable operations. Those companies are in a much better position to opportunistically take advantage of the companies that didn’t fare as well.
The companies that suffered the most in the downturn are selling assets. That’s their future revenue as they’re trying to pay off their debt because it’s too high. They’re mothballing mines that may not be economical at this gold price.
We’re seeing this bifurcation in the marketplace where the companies that are stronger are definitely taking advantage of the weaker companies. We see that happening in the royalty and streaming space. If a company needed to raise capital in the downturn, it could issue debt. But if it had too much debt already, that avenue was closed to them because they’re trying to reduce their debt load. Another option to raise capital is to sell stock. But they can’t sell stock because their valuation is so low, and they’ve got to dilute everyone. Therefore, many companies opted to go into royalty and streaming deals, which is kind of a hybrid financing option. These companies essentially sold future production to other companies at discounted prices.
The balance sheets for those financing and royalty companies have been very strong, and they’ve been able to tap the markets for equity when a lot of other companies could not. Those deals are great for the royalty and streaming companies, and they should end up with pretty good returns over the long term. They were able to buy future production at very low prices when the other party was desperate for capital.
The junior space is kind of the same in terms of where the market is going: it’s really a barbell. There are a number of high-quality companies, and investors are interested in financing their stories. There are also hundreds of very small speculative companies that are really, in our opinion, lottery tickets. Analysts would need to do a lot of technical due diligence with geologists and engineers to really understand whether there’s any investment merit there. A rules-based indexing approach, such as ours, cannot do that analysis. Therefore, our junior mining index does not consider companies with a market cap below $250 million because you need to be a highly trained manager with a lot of technical skills to properly evaluate those companies.
CommodityHQ: We currently have a strong U.S. dollar. The value of gold is in U.S. dollars, but the cost of production for companies is in local currencies, which are weaker. What effect does that have on gold mining companies?
J.C.: That’s a really good point. The Canadian and the South African mining companies have really gotten a boost from lower local currencies. So if you’re a Canadian company with a mine in Ontario, all of your costs are in Canadian dollars for the most part and your revenue is in U.S. dollars. Sure, the Canadian dollar has rallied a little bit, but the fact is it’s still at a very attractive rate. That has really benefited a number of the Canadian companies as well as the South African companies with the rand devaluing.
The other thing that has helped to some degree is oil prices. Many mining companies are huge consumers of diesel. And as the price of diesel has come down, it is an input cost that’s fallen for them.
When you look at lower local currencies and lower diesel prices, both of those have helped to improve profitability, particularly when gold was kind of going sideways last year. Now, they have those benefits on top of a gold price that’s 20% higher. You can see how that’s going to flow through to the bottom line, and how all of a sudden you get operating margin expansion, because there’s so much operating leverage in the business. If I’m selling an ounce of gold two months ago at $1,080, and now I’m selling it at $1,240, most of that is profit. Has anything really changed in my cost structure at that time? Not really. So it really flows to the bottom line, which makes these companies much more profitable when prices are higher.
And for the weaker companies, what it also does is reduce their insolvency risk. A company can quickly go from losing money to getting to break even. What we’ve seen in the recent rally is that some of the marginal producers have gone up the most because their insolvency risk falls. In the early stages of the rebound we’ve seen the lower-quality companies go up the most.
The Bottom Line
Gold is a great diversification tool for your portfolio. It is now becoming important to gain exposure to this asset as it is returning to its role as a monetary metal. There are many ways to get yourself this exposure, including ETFs, mutual funds, bullion funds, and mining stocks. As Ciampaglia mentioned, a great way to gain exposure is through bullion funds, which are a safer bet than mining stocks and provide tax advantages to certain investors in the U.S. However, if you are more risk-tolerant, the Sprott Gold Miners ETF (SGDM) and the Sprott Junior Gold Miners ETF (SGDJ) are great ways to play the mining stocks rally. These two ETFs have outperformed gold significantly since the beginning of the year.