Wednesday, January 20, 2010

A Metric To Keep An Eye On

Gold skeptics have often pointed out that the correlation between gold and inflation is a poor one. The gold bear market of the '80s and '90s is pointed to as a time when gold went down even though inflation was positive. However, there's a related correlation that works better than raw inflation: real interest rates. When they're negative, gold tends to shoot up.

In an interview published by Seeking Alpha, Craig Stanley elaborates on this relationship:
Real interest rates are the only metric that is correlated with the gold price. If you can hold U.S. dollars via Treasury bills, notes or bonds and they are paying a positive real interest rate that is not being inflated away, then why hold gold that doesn't pay anything?

However, it is not a linear relationship. Instead, gold prices tend to significantly increase only if real rates become negative. The current bull market in gold that started in 2001 corresponds to U.S. three-month Treasury bill real rates falling below 0%....

During times of low to negative real interest rates, gold reclaims its traditional role as money, with investment demand the prime driver of the gold price.
Later, he specifies that real rates are used to identify the overall long-term trend; they're not very useful as a trading tool.

Also in the interview, he explains why some gold-mining companies haven't been able to capitalize very well on the gold price rise: their costs have risen along with the proceeds: "On average, [gold mining companies'] inputs, such as labor, steel, and diesel increased over 15% annually." Gold itself has increased about 20% annually over the course of the bull market, leaving little room to expand profits.

That cost squeeze goes a long way in explaining why the new gold bugs have moved into physical gold. Companies that can't boost free cash flow all that much when the product they're selling has vaulted up don't inspire much confidence among professional investors, particularly big ones. Physical gold has no cost-clip except for storage costs.

Although the pile into physical gold pushes back the issue, it's only a matter of time before shareholders try to chivvy gold-company managements into becoming more cost-conscious. I haven't seen any trend of this sort developing yet, but it is a potentiality.

Gold companies, especially juniors, are discovery-driven. Consequently, there's a kind of Bizarro World effect in the exploration world. Exploration juniors that sell for less than their net assets - in some case, less than their net current assets - don't attract value investors because the typical shareholder expects the cash to be spent. Dilution is usually welcomed - sometimes, cheered - because it brings more money to spend on developing a property.

Granted that gold producers aren't exploration companies, but the heart of gold mining is developing new properties. With such an ethos, there may be opportunities for cost containment. If so, we may see it amongst the mature producers.

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