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Carting away Mt. Price
Stock analyst Clive Maund, in an article entitled Vista Gold Corp Takes No
Prisoners (www.321gold.com July 10, 2003) confessed as follows: "My
fundamental knowledge of the company is restricted to the memory of a photo
in a vast open pit of a huge mining truck of the type that carted away Mt.
Price in Australia." I may add that the truck, along with three others,
plus a hydraulic shovel Vista used to own, were sold back in 1998 and have
not since been replaced, even though the company could produce gold at a cash
cost of $183 an ounce. As CEO Ronald J. (Jock) McGregor explained, mining and
selling gold at present prices would mean dissipating company assets
irresponsibly.
Yes indeed. If all gold
mining companies adopted the policy of Vista, the price of gold wouldn't be
where it is. But even the so-called unhedged
companies are falling over themselves to produce and sell all the gold the
traffic can bear, cheered on by a crowd of dividend-hungry shareholders. They
don't realize that they eat the seed corn, nay, they
cook the goose that would lay the golden egg. So why conjure up the boogie-man
of official gold-price manipulation? It is the gold mining industry as a
whole, hedgers and non-hedgers alike, that must
accept blame for the low gold price. But for the greed of managers the
industry would have far more clout than the price-manipulators, real or
imagined. It is the gold miners who have the ultimate weapon: strike action.
Threatening to shut down the flow of new gold to the market would bring this
point home like nothing else. Gold miners could, single-handed, cart away the
mountain of depreciating paper money with Mt. (Low Gold) Price to boot, if
they only treated their product with a respect appropriate to the monetary
metal. Unfortunately, most have fallen victim to the official
gold-demonetization hoax and they treat gold as if it was just another
commodity such as frozen pork bellies (this being the example favored by
economists in the pay of central banks).
Greed overtaking
husbandry
Greed is as old as human race.
The last time it overtook husbandry in the realm of gold was over 35 years
ago. In 1968 you could still buy gold at $35 per oz. The price had not
changed for 35 years, since 1933, in spite of six years of depression; six
years of World War II; six years of Marshall give-away; six years of Korean
War; six years of escalation of the Vietnam War; the Berlin blockade, the
Cuban missile crisis and other Cold War battles. All these historic events
have contributed to monetary depreciation in the order of 75 percent. The
gold mining industry was badly hurting. Yet it kept producing and selling
gold at break-neck speed as if there was no tomorrow. The gold producers of
the 1960s, just as those of today, were doped by the paper-money magic. They
were coaxed out of their possession of a real asset to exchange it for a
phony one. In giving it up at a ridiculous price they were unwitting stooges
helping postpone the day when gold could break its shackles. Nobody then or
since has bothered pointing out the folly of the inmate who would ingratiate
himself to the jail-keepers by assisting them to make his yoke heavier.
Once more gold miners are
ingratiating themselves to Dollar Almighty just at the time when the halo is
fading and the crown is about to fall. The volume of gold production is
increasing as gold miners zealously feed the beast. It looks as if history
repeats itself.
After 1968 the price of
gold ran up more than three-fold in less than three years, leaving gold
miners with egg on their face for their zeal to produce and sell all that
gold at the uneconomic monopsony price dictated by the government. They had
frittered away the best assets of their shareholders. One might have hoped
that, after the fiasco, gold-mining executives would learn their lesson. It
wasn't meant to be.
The economics of gold
mining
The lesson gold-mining
executives have failed to learn in 1968, so that they are now condemned to
repeating the same old mistakes, is that of the economics of gold mining
which is very different from that of base metal mining. The reason for the
difference is that gold is the monetary metal. It is this fact that makes the
marginal utility of gold constant, while that of a base metal is declining
(as is the marginal utility of anything else, for that matter).
It is declining marginal
utility that compels the miner of base metals to go after the top grade of
ore available. Only in this way can he protect his market share. In base
metal mining "the fastest gun prevails". In gold mining, by
contrast, the fastest gun invariably shoots himself
in the foot. The gold miner has no market share to worry about. Husbandry takes precedence over speed
and volume. The successful gold miner reaches not for the top but for the
marginal grade. This is the lowest payable grade that can, at the current
price of gold, still be mined profitably while the mining of lower grades
would result in losses. As can be seen, in this way the gold miner
maximizes not his profits but the useful life of his mine. The best
grades are saved to the end. When an exhausted gold mine is abandoned no
payable grade of ore is left behind, unlike in the case of an abandoned
copper mine.
It also follows from this
cardinal rule of gold mining that if the gold price falls, the defensive step
the miner ought to consider will be the lowering of mill-capacity
utilization, all the way down to zero if need be. Normally he would keep
mill-capacity utilization constant at 100 percent as only in this way could
he guarantee the profitability of his enterprise. But a falling gold price
calls for extraordinary measures such as cutbacks in production to prolong
the fast-shrinking life of the mine, even if it meant accepting losses as the
price of protecting mining assets. It is clear that this choice is not
available to the copper miner facing falling prices. He must produce in order
to survive. Copper has declining marginal utility, and the miner's strategy
is to bring it to market with all deliberate speed. The gold miner has no
such constraints. His product has constant marginal utility. Gold locked up
in underground ore bodies is valuable no less than gold locked up in bank
vaults. It must be produced most sparingly in order to preserve wealth
represented by mining assets. Falling gold price is a double whammy: it pushes
payable grades of ore into the submarginal
category, thereby causing further losses in addition to the direct loss due
to the lower price of the product.
In and out of
the ground, gold teaches husbandry to mankind.
Perpetual option
I fully anticipate
violent objection to my thesis. My detractors will argue that no enterprise,
not even a gold mining operation, can long survive while making losses. The
price of shares will plunge to zero and, shorn of its source of capital, the
enterprise is forced to fold. My argument is that a well-managed gold
mine is an exception to the rule. Share prices will not fall to zero even if
the gold mine is losing money, because the well-husbanded inventory of
gold-bearing ores, free from attrition, retains its value indefinitely.
This leads me to the
subject of a gold-mining share as a perpetual call option on gold bullion.
All analysts recognize the fact that the price of a gold-mining share (but no
other type) has a built-in option premium. Gold-mining shares normally trade
at a premium over book value. The book value of a (debt-free) gold mine is
defined as the value of gold represented by its payable grades of ore plus
plant and equipment minus extraction costs. Unlike in base metal mining,
depreciation of payable ore reserves is conspicuous by its absence. No one
has attempted to provide a scientific explanation for the fascinating
phenomenon how gold-mining shares manage to defy the law of gravity. The sole
reason for the option premium is the fact that gold is the monetary
commodity, a
distinction shared by no other. Stockholders bid up the stock
price to the point where it will reflect the full option premium, provided
that managers operate the mine most conservatively, that is, they maximize
the life-span of the mine rather than profits.
The balance-sheet concept
of gold
In a well-managed gold
mine only marginal grades of ore are exploited. It is remarkable and
important that economy can be further enhanced by processing a blend of
marginal and submarginal grades of ore. Thus the
value of submarginal grades, normally considered to
be zero, becomes positive even without assuming higher gold prices in the
future. Another source of the option premium is the balance-sheet concept
of gold. The fact is that gold is kept in the asset column of the balance
sheet of individuals and institutions without any promise of return to
capital. No other asset is treated in this fashion. Why? Because gold
is the only financial asset that can balance a liability without itself showing
up as a liability in the balance sheet of someone else. That someone else
may happen to default, leaving one holding the bag. This makes gold the
ultimate agent of portfolio insurance. It makes little sense to talk about
the day-to-day "performance" of an insurance policy. Performance
comes after disaster has struck. Likewise, it makes little sense to talk
about performance in relation to a gold stock, except as a measure of the
extent to which the full option premium is realized. And this depends solely
on how conservatively the gold mine is managed.
Gold mines that husband
their resources less conservatively (typically by producing and selling all
the gold that the traffic can bear) are punished for their profligacy by a
fast-shrinking or even zero option-premium. It is true that the share price
of a producing gold mine also incorporates another, the income-premium
representing the present value of the flow of expected dividends. Be warned,
however, that nowadays income-premium eclipses option-premium as most gold
mines pursue quick profits to the detriment of mine life-expectancy. But
dividends come at the expense of attrition of ore reserves and, therefore,
the income-premium is programmed to self-destruct, regardless whether the
mine is put in or taken out of production. The income-premium is ephemeral
and has no part to play in protecting the value of pensions. By contrast, the
option-premium is durable and it is crucial for the pensioner.
Not only have gold miners
failed to manage their mines more conservatively for the past fifteen years
than the miners of the 1960s, they have in fact greatly accelerated attrition
through mindless short-selling, misleadingly called "hedging". We
must distinguish between "hedging false" as practiced by some of
the most glamorous gold mining companies today, and "hedging true"
as it should be practiced by conservatively managed companies. "Hedging
false" is in fact unilateral short selling. It is nothing but
self-fulfilling speculation in the expectation of a lower price. There is no
way to get around this basic truth. We should clear up the confusion about
what constitutes proper hedging or "hedging true", and what
distinguishes it from short speculation in the expectation of a lower price,
or "hedging false".
"Hedging true"
Proper hedging would have
to be bilateral, that is, it should involve forward buying in addition to
forward selling. The two taken together is justified by the same principles as
those justifying the harvesting of energy represented by the tides and ebbs
of the seas. When the tide comes in, (i.e., the gold price swings to the plus
side) it is proper for the mine to sell gold for future delivery, assuming
that this policy is complemented by another: when the ebb goes out (i.e., the
gold price swings to the minus side) the mine will buy gold forward. In this way the futures trading
activity of the gold mine remains well-balanced and will not give impetus to
speculation to weigh the market down on the short side, creating a falling
trend in the gold price as is the case with the present so-called "hedge
plans" of some large producers, which only induce speculators to keep
selling gold at the first sign of strength in the gold price but refrain from
buying at the first sign of weakness.
Let us look at the
economic justification of forward buying and selling in detail.
Paradoxically, forward selling is an economy measure designed to lengthen the
useful life of the gold mine. It permits the miner to extract his submarginal grades and spare the payable grades of ore.
Every time the gold price goes up, certain submarginal
grades of ore in the mine temporarily become payable. Theoretically they
could be mined profitably. However, technically it is not feasible to shift
ore extraction back and forth between various sites on short notice following
the whims of the gold market. Such shifts are time-consuming and expensive.
By the time they are completed, the gold price may have fallen back and the
opportunity to mine submarginal grades profitably
gets lost. This is where forward selling comes in. Every time the fluctuating
gold price swings into plus territory, the company sells gold forward in the
futures market as a proxy for selling cash gold obtained from submarginal grades. Notice the quantitative limit imposed
on forward selling by the inventory of submarginal
grades. Each forward sale must be accompanied by the earmarking of a definite
part of that inventory. The short position created by the forward sale must
be covered when the earmarked inventory is extracted, milled, refined, and
sold (or earlier, if it can be done profitably).
The miner works the
miracle of turning stone into bread. He takes a worthless piece of rock, the submarginal grade of ore, and out of it creates a most
valuable asset, gold. This seemingly impossible feat can be performed for two
reasons: (1) gold is the monetary metal, (2) mindless government policy has
made the price of gold fluctuate. It is this fluctuation that allows the gold
miner to sell forward whenever the price-swing is in plus-territory,
temporarily making submarginal grades profitable to
mine.
Forward buying, no less
than forward selling, is also an economy measure. It allows the gold miner to
replenish his diminishing ore reserves at the best possible price. A
forward-looking gold mining company is always prospecting for new
gold-bearing properties to replace spent ore reserves. However, the checking
of the quality and quantity of gold-bearing ore at the new site, the
searching of title, and the negotiating of a price
is a long, time-consuming process. By the time it is completed the gold price
may have moved up, rendering the new acquisition uneconomic. This is where
forward buying comes in. Every time the fluctuating gold price swings into
minus-territory, the company buys gold forward as a proxy for the purchase of
new gold fields. Notice the quantitative limit imposed on forward buying by
the scope of prospecting. Each forward purchase must be matched by a
prospective new gold field under negotiation. The long position created by
the forward purchase must be covered as the new gold field is acquired (or
earlier, if it can be done profitably).
There is no speculation
involved in "hedging true." It is neutral as to the future price of
gold. It does not provide speculators with a clue about falling trends in the
gold price. It does not involve fraudulent reporting of questionable profits.
It does not constitute manipulating assets and liabilities off balance sheet
to the detriment of the shareholders. But it does make a positive
contribution to extending the life of the operation.
"Hedging false"
What passes for hedging
today is a scam based on another scam: that of fiat money. Why is fiat money
a scam? Because it is grounded in the notion that it is proper to allow
the U.S. Treasury and the Federal Reserve to issue liabilities which they
have neither the means nor the intention to meet. Nobody has ever offered
a valid argument showing that there are defensible grounds for these
privileges without counter-wailing responsibilities. There are none. Here we
come up against a double standard: if an individual or a private firm tried
to issue liabilities which they have neither the means nor the intention to
meet, then they would be facing criminal prosecution. Fiat money is a
gigantic legalized Ponzi-scheme.
The Constitution of the
United States properly recognized the inequity and dangers inherent in such
an arrangement, and forbade the government to monetize its debt. It says
volumes about the shaky grounds for the dollar, and portends ill about its
future, that its managers are willing to go to the length of contemptuously
trampling on the Constitution in order to protect their turf.
"Hedging false"
works as follows. The gold mine borrows gold from a bullion bank at the low
gold-rate of interest. It sells the gold bullion in the cash market and uses
the proceeds to buy U.S. Treasury securities yielding at the high paper-rate
of interest. The difference between the two rates is then added to revenues,
and the mine is reporting higher mining profits year in and year out. The
pretence is maintained that the mine has increased revenues by selling its
product forward "to take advantage of a high gold price." But what
are the criteria by which it can be established that the price is high? Any
price is a high price that can be pushed down by the threat of an artificial
oversupply. The gold miner puts a marketing policy into effect that
deliberately makes the price of gold fall and then poses as a hero who has
invented hedging.
The whole procedure that
passes under the name of "hedging" today is fraudulent. A forward
sale is a transaction that will not be closed out for several years, when the
borrowed gold is returned to the lender. But until closed out it will not be
possible to determine the profitability of the deal. Not only does the gold
mine indulging in "hedging false" declare profitability
fraudulently, it is actually paying out phantom profits in the form of stock
options to executives, thus robbing the shareholders. Ignored is the
possibility that the borrowing arrangement may not be extended for a further
period by lenders and the mine must buy gold in the open market at a loss to
cover the liability. Also ignored is the scenario that the gold price may
advance so fast, never to return to its level where forward selling occurred,
that the gold mine is unable to cover its short positions profitably and must
incur horrendous trading losses. Be that as it may, the premature reporting
of questionable profits is a clear fraud to mislead shareholders. It should
be stopped by the government's watchdog agencies. It isn't, and this makes
"hedging false" a conspiracy involving the gold mine, the bullion bank,
and the government. It is a scheme to manipulate assets and liabilities off
balance sheet to the detriment of shareholders.
Why would the government
risk the odium of being an accomplice to fraud stinking to high heaven? My
guess is that it is led by the desire to perpetuate the regime of
irredeemable fiat currency. The low gold-rate is the benchmark to which the
paper-rate of interest is invariably compared. The spread between the two
measures the decay in paper currencies. "Hedging false" is designed
to manipulate this spread by closing it. That makes fiat currencies appear
healthy when in fact they all suffer from the effects of advanced and
possibly terminal decay.
Tormenting the elderly
My grandfather and, a generation
later my father, accumulated pension rights in the service of the Hungarian
government that should have made their retirement years care-free. Instead,
they were both reduced to abject penury. In their productive years they were
paying good money into the government-managed pension fund, and the
government managed to pay them bad money that was hardly sufficient to buy
food when they were old, helpless, and no longer able to fend for themselves.
I had served at the same
Canadian university for 35 pensionable years before I retired. My university
is on record that it reduced professors' salaries and pensions in the 1930's,
ostensibly to compensate for the appreciation in the value of the monetary
unit. There is no guarantee that the same trick will not be pulled again. In
addition to my university pension I also have a smaller pension from the
Canadian government. This unfunded pension plan is compulsory to all Canadian
wage-earners, but it will clearly be bankrupted by the fact that the ratio of
contributors to pensioners is falling dramatically because of fewer births
and longer life-expectancies. To compensate for this the government considers
raising the contributions as well as the age of eligibility of wage-earners,
but is facing considerable resistance on both counts. My pension may go the
way of my father's and grandfather's. Church doctrine holds that tormenting
widows and orphans is a sin "crying to high heaven." By the same
token so is tormenting the elderly.
In planning my own
retirement I had to find a way to protect the value of my pensions against
the ravages of both inflation and deflation. I decided that the best
protection was the purchase of out-of-the-money call options on gold bullion.
(An out-of-the-money option is one having no intrinsic
value, only time value, and are less expensive for that reason. By
contrast, an in-the-money option has both intrinsic value and time value.)
However, publicly traded options on gold bullion don�t exist. (In the 1970's
there was a Geneva-based investment firm Valeur-White-Weld,
later acquired by Credit Suisse-First Boston, that used to trade call options
on gold bullion, but apparently it no longer does.) But even if you could
have them, call options on gold bullion would be too expensive and would not go
out far enough into the future. I then hit upon the idea of leaps (long-dated
call options) on Barrick stock. When on closer
scrutiny I realized that Barrick's so-called hedge
plan was utterly fraudulent, I tried to meet the (then) CEO, Peter Munk whom I didn't know in person, but knew that he was a
fellow immigrant from Hungary. Not surprisingly he declined to see me.
Instead, he directed me to the company treasurer Jamie Sokolsky
in charge of hedging operations. During a session with Sokolsky
lasting an hour and a half I presented to him my Memorandum entitled
"Gold Mining and Hedging", explaining the difference between
unilateral and bilateral hedging (as above). He promised to study it and would call me
in a month's time. I have never heard from him again. This convinced me that Barrick was not serving the interest of its shareholders,
but was probably acting as an agent for a third party (such as a government
or a central bank). This assumption seemed to have been confirmed recently at
the trial Blanchard vs. Barrick et al. where
Barrick refused to answer questions on its dealings
with central banks on the strength of confidentiality (indicating that Barrick has been acting as a front to cover up central
bank activities in the gold derivatives markets).
Pensioners’s gold
But let's go back to my
original story. I exercised my leaps, sold my Barrick
stock, and looked for an alternative. I asked a number of stock-broker
friends of mine if they could recommend gold-mining companies that have deliberately
reduced or, better still, stopped production in the face of falling gold
prices. To my amazement, in each case my friends said that they were unaware
of the existence of any such company. They are still looking.
I find it obnoxious that
practically all the advice available to gold investors today is of the get
rich quick variety. What about people who just want to live and let live?
What about the retired people who want to protect the modest pension they
have earned during their working lives? What about those on wages and
salaries who in planning their retirement realize that the government-sponsored old
age security just won’t be there for them when they will need it, so
that they ought to provide their own? These people are not motivated by the
thought of getting rich quick. They just want real protection, because they
don’t trust the phony protection loudly propagated by plans sponsored
by governments and employers. These plans are all suspect, because the
benefits are denominated in an irredeemable currency, such as the dollar that
managed to lose a record of 90 percent of its purchasing power during the
very first decade after it was cut free from gold in 1971. There is no reason
to believe that the dollar may not repeat or even beat that record in the new
century! The point of my article is that these people are not being
well-served by investment advisors who advocate the ownership of gold mining
stocks with a management hell-bent to push up share prices by producing and
selling all the gold the traffic can bear at the expense of mine-life (and
there are lots of non-hedged
companies in this category). The trouble with these companies is that they
are exhausting their gold reserves prematurely, and their policy to replenish
them is likely to fail as they do not reinforce prospecting with forward
purchases of gold (as explained above under the caption hedging true).
Pensioners should be very
selective, and they should only look at the most conservatively managed gold
mines with a declared policy of cutting back production (or withholding
produced gold from the market) in response to falling gold prices. Once
invested in the stock of such a gold mine, there are several strategies that
(prospective) pensioners may choose from. The simplest is to sit back and
collect the ever-increasing dividends the company is expected to pay once the
gold price makes sufficient advances, to supplement their shrinking pension.
Another strategy is to
keep "exercising the perpetual option" as the price of gold waxes
and the value of pensions wanes. After each major surge in the price of the
conservatively managed gold mine the pensioner would sell part of his
holdings and convert the proceeds into gold bullion. This play is based on
the expectation that the price of the stock of a conservatively managed gold
mine will go up much faster than the gold price. This expectation is
well-grounded. There is a double bonanza at work. In addition to the value
of payable ore reserves, the volume of those reserves has to increase,
as submarginal reserves enter the payable range
thanks to the higher gold price. In this way the pensioner acquires gold ever
more advantageously. In spite of paying an ever higher dollar-price for each
ounce, every subsequent share sold is buying him more ounces. The
conservatively managed gold mine produces gold for him. If he owned
the stock of a less conservatively managed gold mine, the company would be
producing gold for others. Pensioners have no use for a gold mining
operation that prefers to make a quick profit at the expense of the life
expectancy of the mine. They are not suitable as protection for one's pension
against inflation or deflation. Pensioners don't need additional income while
their pension still has value. They will need additional income when their
pension is cut because of deflation, or loses its purchasing power because of
inflation.
A third strategy involves
borrowing against the stock, rather than selling it, to get compensation for
the decreased value of one's pension. This strategy is designed to address
the problem of taxes. Since there is no selling, there are no capital gains
to be taxed.
Conservatively managed
gold mines are hard to find. They are not glamorous, they never hit the
headlines. It is likely that they do not presently pay dividends or, worse
still, they report losses as holding gold properties involves costs (such as
providing security, keep renewing mining licenses, paying a skeleton crew,
prospecting for new properties, etc.) On the other hand, the price of the
stock of such conservatively managed gold mines tends to be low and,
initially, it may not increase spectacularly as that of a glamorous gold
stock would. However, the policy of postponing exploitation will pay rich
dividends at the time when the glamorous companies approach the point of
exhausting their mines and must get ready to shut them down, as a result of
premature depletion of reserves.
I am not getting paid for
writing this article by anybody. In doing it I am trying to be helpful to my
fellow pensioners facing the same problem that the value of their pension may
evaporate due to deflation or inflation just at the time when they need it
most. This should be considered as a thought provoking exercise to challenge
conventional wisdom. Pensioners and prospective pensioners should do their
own due diligence to find conservatively managed gold mines that would suit
their needs best in protecting the value of their pension against the ravages
of deflation or inflation.
Antal E. Fekete
DISCLAIMER
AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING
THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL
ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND
SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT
IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS
TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
Copyright
© 2002-2008 by Antal E. Fekete
- All rights reserved
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