Gold And Underperforming Gold Stocks

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This story features NEWCREST MINING LIMITED.
For more info SHARE ANALYSIS: NCM

-Several reasons to be bullish on gold
-Paper and debt being debased
-Mine output to rise but challenging
-Gold stock preferences

By Eva Brocklehurst

There's a strong reason to continue holding gold. Actually there's a few. ScotiaMoccata has little confidence in governments' ability to deal with the massive debt problems sweeping the globe. The bullion bank expects investors will not want all their wealth backed by paper assets and will spread risk by holding gold and other hard assets. Greater monetisation of gold is therefore likely to be bullish for prices.

After the quantitative easing (QE) in September and, as yet, no solution to either the EU debt problem or the US budget deficit, there is likely to be more QE ahead as policymakers buy time. With QE creating money at will, ScotiaMoccata sees the value of paper money being debased and debt problems now so big that the only entity capable of paying it off is a global pool of wealth. It follows then that the value of the debt will be reduced by devaluing the currencies the debt is priced in. As such, investors and creditors are likely to diversify away from non-convertible currencies and that will deliver more monetisation of gold as they seek to preserve wealth.

The US dollar could weaken in the medium term as the US struggles to tackle the budget deficit. Given the inverse relationship between the dollar and gold, ScotiaMoccata believes the dollar may well be a positive factor for gold. In addition, the other safe havens such as US treasuries and German bunds are looking overbought. In theory, you would expect government bonds to do much better in a deflationary environment as even a small yield is better than none, but ScotiaMoccata argues gold can also do well. Faced with deflation, the bank expects governments to do more QE and, in turn, that would debase currencies further. Although gold would not pay a yield, it would stand a good chance of holding its value against currencies that are being debased.

Mine output is expected to edge higher in 2012 as new production comes on stream, but, according to ScotiaMoccata, this will be countered by falling production at existing mines as producers encounter lower ore grades, adverse weather and production disruptions. Despite ten years of rising gold prices it has become more difficult to bring new mines on and harder to find new large deposits. The time taken to bring a new project into production has increased considerably due to government and environmental legislation – all of which increases the capital and production costs significantly. In 2012, the bank expects mine output to increase around 1% to 2,855 tonnes, while output is expected to climb around 3% in 2013, to 2,940 tonnes. The 3,000 tonnes level may not be seen until 2014.

Citi agrees that the potential for mine success against a backdrop of continued cost escalation, geopolitical uncertainty and fewer high yielding ore bodies looks challenging. However, the broker sees ASX gold miners moving through a crucial period of production growth with several projects commissioned in 2012. Significant additional production is coming on stream near-term, including sector leader Newcrest's ((NCM)) Lihir expansion and Cadia East. Given this outlook, in conjunction with only a modest level of indebtedness across Australian gold stocks, management will soon have the convenient problem of deciding how to allocate surplus capital.

What of the stocks that are favoured in this bullish scenario? OceanaGold ((OCG)) is one. Citi considers the Didipio mine (Philippines) will be a game changer for cash costs and a step change in production. Commissioning risks are there but Citi is confident in the ability of operational management to deliver. Beadell Resources ((BDR)) is the other top pick. Its operations are ramping up at Tucano (Brazil) and this project provides for very strong cash generation in early years, with significant additional exploration upside. Citi estimates that the mid-cap gold stocks under its coverage alone will be sitting on cash of $2.5bn by 2015. The implications for this includes increased merger and acquisition activity, dividend payments and aggressive exploration.

It's not before time. Gold equities have delivered a sustained period of underperformance relative to gold, Citi notes, a source of much frustration for those positioned in miners but left unrewarded. Returns from gold mining equities are particularly disappointing considering the amount of de-hedging that took place in the last decade.Citi forecasts relatively flat gold prices around US$1,700/oz for the next two years, peaking at US$1,800/oz in the first quarter of 2013, with prices moderating from 2015 as global economic conditions improve.

Deutsche sees gold supported at US$1,700/oz level and with resistance around US$1,750/oz. The broker notes it is hard to predict day-to-day movements in the price. The metal may trade heavily over the course of a day and then suddenly shift lower for no apparent reason. Deutsche puts this down to the increase in use of black-box algorithmic trading models which make understanding the behaviour of gold on a short-term basis challenging. The gold market continues to respond reasonably predictably to the usual drivers over a longer time frame but, on an intraday basis, predictability diminishes considerably. Deutche also suspects that, as active investors move to the sidelines given the uncertainties in many markets, these models may become a larger force than usual.

ScotiaMoccata expects gold prices, which have flatlined in 2011-12, will post new highs during 2013. How high prices go is difficult to gauge, but the bullion banker would not be surprised to see prices reach US$2,200/oz. Should prices undergo another correction in the short term then it would look for good support around US$1,600/oz. Eventually, once the bull market has run its course and there is less need for safe-havens, prices could retrace back towards US$1,100-1,200oz as investment gold is liquidated and supply surges, but that's not what's expected in the year ahead.
 

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