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Analyst report
Gold price spike a boon for gold producers
January 30, 2008
Brendon Lau, ShareAnalysis
Many gold stocks have outperformed the broader market by 20%, if not more, over the last month, thanks to a record surge in the spot gold price. Although gold has come into some profit taking, the trend is still strongly up. However, on the downside, the sharp rally in the sector means only select buying opportunities remain.
There are several factors supporting the sharp rally in the gold price since the beginning of the year when spot prices broke above the trading band and touched a record high of US$915/oz. These factors include a waning US dollar, high global inflation, geopolitical tensions and rising risk aversion due to the current economic jitters, in particular the US (see Insight for details).
These issues remain in play and it would not surprise us to see gold break fresh records over the coming months, if not weeks. This positive sentiment has even spilt over into other precious metals, such as silver and platinum.
While higher gold prices are a big positive for gold producers, the gains enjoyed by the sector have taken some shine off our listed gold stocks. Valuations for some of the gold miners we cover are starting to look stretched, ahead of their results next month, and the outlook for these stocks is less glowing then the outlook for the commodity itself.
There are a number of reasons for this. Firstly, mining costs have risen significantly over the past three years and we expect that a large portion of these cost increases cannot be reversed in the future. Furthermore, our gold miners have failed to fully benefit from the strong rise in the spot gold price due to the appreciating Australian dollar against the US dollar, which reduces income in Australian dollar terms.
Thirdly, there are very few large high-grade gold deposits currently being developed. The projects in the pipeline are of a lower quality and, thus, will have a higher cash cost per ounce of production. Miners will only undertake more extensive exploration and development projects if long-term gold prices rise above historical averages, so that a more suitable return can be achieved to justify the investment.
What all this means is that the upside for most of our gold producers are limited and we only have one gold-exposed miner (outside the large diversified miners) with a BUY recommendation. However, as we have mentioned in previous articles, there is another way to gain exposure to rising commodities, and that is to invest in undervalued companies that provide services to these miners.
Having said that, we also note that in the current environment where the outlook for gold is positive, some gold stocks may surge well above their fundamental value on takeover rumours, as gold producers seek out growth options via acquisitions.
Historically, the average price of gold in real terms is around US$550/oz, which was our previous long-term forecast. We have recently increased our long-term gold price forecast to US$600/oz to reflect the more bullish outlook for gold. We believe that we are conservative in our forecasts and the risks to the gold price are to the upside.
Two stocks out of the six on our site that are exposed to gold's resurgence and with a positive outlook are Oxiana (OXR) and Sino Gold (SGX).
OXR is a copper and gold producer with our BUY recommendation. OXR has approved the development of the Martabe mine (subject to approval from the Government of Indonesia), which has a mine life of nine years, with annual production of 200Koz of gold and 2Moz of silver. There is upside potential at Martabe from two adjacent deposits that were not included in the initial feasibility study. Our 12-month price target on OXR is $4.12 (Technical recommendation: HOLD for now; more range trading expected).
SGX said that Jinfeng is now in production, although there are still problems with the flotation recovery. White Mountain is on schedule and on budget, with commissioning expected in late CY08. The takeover of Golden China Resources was successful, and the Eastern Dragon gold deposit was purchased for US$90M. Jinfeng's cash cost of US$412/oz was higher than we expected but we believe SGX will find a solution to its flotation problems and, as a result, will achieve a lower cash cost in CY08. We like SGX's growth profile, with a number of new mines on the horizon. We are upgrading our short-term recommendation on SGX from Hold to BUY, with a 12-month price target of $8.40 (Technical recommendation: HOLD - wait for break at about $8.50).
Why gold is expected to climb
Gold has certainly sprung back into fashion quite dramatically and we would not be surprised to see it conquer new highs in the short term as the fundamentals that had put gold on its pedestal are still very much in play.
One of these fundamental factors has been rising global inflation. With relatively few industrial uses, gold has long been regarded as a stored value, and thus, a hedge against inflation as its price generally fluctuates with inflation (if all things are equal). For this reason, gold (unlike industrial metals) does not have a convenience yield.
For financial market aficionados, the convenience yield is the benefit of having the physical commodity now rather than a contract or derivative for that commodity. Convenience yields are used to calculate future pricing for some commodities, and it explains why some commodity prices can slip into backwardation when the convenience yield rises above the risk-free rate (see Insight article on 26/11/06 for more details). Since global inflation is expected to remain stubbornly high for 1H08 if not beyond, this bodes well for the gold price.
Usually, higher inflation would lead to higher interest rates, and that boosts currencies like the important US dollar. However, recession fears and speculation of deep interest rate cuts in the US are keeping the greenback on a back foot. As all commodities are priced in US dollars, a drop in the value of the greenback usually triggers a compensating upward adjustment in the price of the commodity.
Furthermore, gold is also regarded as an alternative investment to the US dollar, which explains why the spot gold price is the most inversely correlated commodity to the US dollar. The poor outlook for the greenback is benefiting gold, and this trend is not likely to change in 2008.
The third factor supporting the gold price is fear. Gold demand normally rises during times of uncertainty, whether it is driven by economic, political or social factors. The potential US recession triggered by the credit crisis is arguably the biggest threat to global equities over the last five years. Fortunately for gold investors, this gloom is expected to persist over 1H08.
As a final note of interest, we have written before that there is a significant inversed correlation between the price of gold and equities during past US recessions, while no correlation exists during market corrections. This is probably because it is only during a recession that investment capital moves across asset classes in significant amounts. The fact that gold has hit new highs as US stocks tanked may be a telling sign that the US economy is already experiencing an economic contraction.
Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.
More articles from this edition of CompareShares:
Trader profile: Trading for a living – Shean Gannon
Takeovers: Should you buy the bidder or the takeover target?
Resident Trader: The Trader’s SMSF
Stocks: Stock of the week – Incitec
Commodities: Gold price spike a boon for gold producers
Smart Investing: Market shocks highlight the importance of planning
Expert Panel: Why would I buy an option over a stock I like rather than a share?
Rates: Why the RBA will not hike
Rogue Trader: France says SocGen is "in crisis"
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions. |
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