By Jim Puplava   & Eric King
March, 2004

www.financialsense.com

Fundamental Review
by Jim Puplava

The bull market in gold and silver has barely begun. It is still in its infancy as gold and silver move into their rightful role as real money. Unlike the last bull market of the 1970s where gold and silver were plentiful, this bull market is being driven by scarcity and the debasement of currencies around the globe.

Gold and silver have been running supply deficits for well over a decade. According to the work done by GATA the gold vaults at central banks are now half empty. Over the last decade, through gold sales, gold loans and gold swaps, gold has flowed steadily out of the vaults of central banks reducing large stockpiles of gold.

In the case of silver, supply is now at critical levels. Just as central banks have dishoarded over half of their gold inventory, aboveground stockpiles of silver have been eroded to critical levels as a result of 14 years of supply deficits. Those 14 years of supply deficits are now starting to impact the markets as the price of silver goes parabolic.

While the memory of the last gold and silver bull market is rather faint, today’s professional investor and gold mining company would do well to revisit that market. During the last bull market, the price of silver rose from $1.32 an ounce to as high as $50 an ounce with the Hunts trying to corner the silver market.

Factor 1: Trade Deficit

The price of gold rose from its Bretton Wood price of $35 an ounce to $850. Gold and silver, which had been regulated and suppressed, rose like a Phoenix from the ashes assuming its historical role as money. The 1970s was a period of an expanding money supply, escalating government budget deficits and dollar debasement. Over three decades later we now find ourselves in the same predicament. However, the fundamentals of the gold and silver markets are far more favorable today for three specific reasons. In addition to an expanding money supply, we now must add America’s monstrous trade deficits which are putting vast amounts of dollars into foreign hands.

Factor 2: Dwindling Stockpiles

A second factor that will influence this new bull market in the precious metals is that supply is far more limited at a time that markets are far more integrated and larger in scope and size. This means that demand factors could send prices to levels never seen or dreamed before. Silver prices above $150 an ounce and gold prices of $3,000-$5,000 are not out of line. This may seem unrealistic to many, but I strongly believe that this is where we are headed. Silver stockpiles are dwindling each year. The U.S. government’s stockpile of 2 billion ounces is gone. Dealer inventories are minimal and it is getting harder and harder to acquire or take delivery on large orders of silver.

Silver has been depressed by large short positions. Today commercial hedgers, speculators, and small traders are short 106,877 contracts, representing 534 million ounces of silver short. Long positions are of equal size. The problem is there is nowhere near this amount of silver held on the COMEX for delivery nor are aboveground stockpiles this large. There may be additional ounces of silver available in the form of jewelry, silverware, and coin in existence, but it can’t be mobilized by exchange officials to meet delivery if it is demanded. In essence the short sellers are trapped if the longs demand delivery, which may be one reason why exchange officials have raised margins on silver. In summary a major factor going forward in this new bull market will be the supply of available gold and silver to meet growing worldwide demand. In simple economic terms growing demand and dwindling supply means higher prices.

Factor 3: The Danger in Derivatives

Another factor that could influence the gold and silver markets is the precarious condition of our financial markets. During the 1970s gold and silver bull market, the derivative market was just in its formative stage. Derivatives began to grow in size after 1973 as a result of the work of three economists- Fisher Black, Myron Scholes, and Robert Merton. The Black–Scholes model enabled investors to determine how much a call-option is worth at any given time. The combination of this model along with probability theory caused the derivatives market to explode. Today it is estimated that the worldwide market of derivatives is between $125-$150 trillion. The U.S. banking system has increased its derivative position from $10 trillion to $67 trillion over the last decade. Derivatives, as Warren Buffett has described them, are financial weapons of mass destruction capable of taking down and destroying the global financial system. If the derivative market implodes as I think it will eventually, the financial markets will cease to exist in their present form. Investors and speculators will be looking for a safe haven. Gold and silver represent the only available safe haven that isn’t a liability. As much as fiat paper money advocates have tried to discredit gold and silver as money, they can’t fight the tide of history. Gold and silver have outlived every single fiat money system ever erected by kings, emperors, prime ministers, presidents, or any central bank. Gold and silver are the only real form of money that has ever existed, a point that is irrefutable in history.

These three factors, an out-of-control U.S. trade deficit, dwindling stockpiles of gold and silver, and an expanding derivative market on the verge of imploding are what will make this new bull market in gold and silver go to levels never imagined before. I don’t believe there is an analyst, economist or investor who can quantify today how high this market in gold and silver will take us. All that an investor needs to grasp is the fact that demand is growing and getting larger by the day, while supplies and stockpiles shrink globally.

The Race to Replace

This brings me back to the issue of supply. Supply comes from mines and the production of gold and silver is falling and will fall even further in the years ahead. The last phase of the bear market in gold and silver in the mid-nineties led to mass consolidation within the gold industry. Today’s behemoth’s such as AngloGold, Barrick, Newmont, Goldfields, Placer Dome, and Harmony Gold are a bi-product of that consolidation. According to the chief executive of one of the largest consolidators AngloGold's Bobby Godsell, “It is the end of big picture gold consolidation; there is no compelling logic to combining anymore. The real challenge now is how to replace your ounces for the future.”  The race to replace ounces is about to begin. It will take the form of takeovers of small producers with long reserve lives and high quality junior mining companies with large in ground reserves that can be mined economically.

The majors have problems. They not only have to replace their reserves, but also their existing reserve base is becoming more costly to mine. In South Africa, up to recently the largest producer of gold in the world, the South African producers have missed out on all of the gains of this new bull market. SA producers have seen their cost go up each year in Rand, while their revenues have receded thanks to the fall in the dollar. Their costs keep going up in Rand, while their product sales decline in dollars. The gold price has risen by close to 33% in dollars over the last two years. The problem for South African producers is that the price of gold has fallen by 15% in Rand terms. The result is that earnings have plummeted, buffeted by higher costs and falling prices. In addition to impacting SA production costs, an appreciating Rand is also impacting reserve calculations as shown in the two tables below:

The problem on the supply side is that the cost structure for many of the world’s largest gold mining region and miners have gone up, while the price of product sales have gone down. The emerging trend over the next few years is one of declining production for the world’s largest producers of gold and silver. This is backed by the fact that gold production per share for the Majors such as Newmont, Barrick and AngloGold have fallen from 6.4 ounces per share in 2000 to 4.2 ounces per share in 2003. Current production trends indicate that production will fall back to 2000 levels, while the number of shares outstanding has increased substantially.

Major Problems

While gold sales have improved for very few large producers (VLGP’s), the exception being Newmont which has reduced its hedge book substantially, most producers have seen lower sales prices when viewed in terms of domiciled currencies. In addition to lower dollar prices for gold SG&A (selling, general & administrative) costs have been rising sharply. Exploration costs are also going up as a result of two factors: inflating material and labor costs and lower ore grades. For many of the majors the cream in ore ounces has already been mined. Evidence indicates that ore bodies for the majors are in decline.

What this means is that the majors are going to have to go out and replace their reserves. They can do this in one of two ways: either go out and find new ore deposits (which can take considerable time) or go out and buy ore deposits in the ground. The problem with going out and exploring for gold and silver is that the lead time from discovery to production can take as long as 5-7 years, depending where the gold is discovered. In North America the lead time keeps increasing in length due to environmental restrictions and regulations. This does not help in the short run, so buying ounces that already exist in the ground is one of the few viable alternatives.

The problem for the majors is that they have missed the first leg of the gold bull market. They have stood aside and let share prices get away from them. What the majors have done is to focus on capital reconstruction and the repair of damaged balance sheets as a result of the acquisitions made during the 90’s and depressed prices from the last phase of the bear market. The rush of capital has been more to the benefit of companies than it has been shareholders.

Junior Discoveries Shine

During the bear market of the last decade majors could purchase juniors at a price of $25-$30 per ounce in the ground. The price of gold was depressed and after the Bre-X scandal, juniors were merely trying to survive. The days of $25-$30 per ounce in the ground are gone forever. Gold isn’t going back to $255 again, so $25-$30 gold is a pipedream. What we are more likely to see in the future is $100 an ounce for gold in the ground. Even higher prices will be realized for high quality reserves that can be mined at an economical cost. There are simply no other alternatives outside making new elephant size discoveries similar to the Hemlo, Grasberg, Yanacocha mines. The odds of discovering a Hemlo each and every year are not impossible, but more likely improbable.  The majors are going to have few choices outside the junior mining arena because that is where all the new gold and silver deposits reside. It has been the junior mining sector which has been both nimble and successful with the drill bit. The juniors have been doing most of the discovery work, while the majors have sat back and acted more like finance companies, a situation that is very similar to what is going on in the oil and gas industry.

Unless the majors are willing to act soon (and I think they will) they are going to face angry shareholders who will want to know why production keeps declining, while the price of gold and silver soars. If you were a major mining executive, would you want to be facing shareholders each year at the annual stockholder meeting and talk about why production keeps declining? The share price of majors, which have lagged far behind the junior mining or second tiered producing sector, may fall further behind as investors begin to take notice. It will become similar to what has happened to the price of gold hedgers such as Barrick and Placer who have seen their shares lag the markets considerably. Their hedge book has capped gold prices and profits. What worked during the bear market in gold doesn’t work anymore when you are in the beginning stages of what could be the biggest gold and silver bull market in the last 100 years. It is all about supply and it is supply that matters. The companies that can find and produce the gold and silver wins in this new major bull market in metals. In the majority of the cases these are the juniors.

Investor Influence

The problem for the majors is that they are going to see stiff competition in the search of ounces. Their competition this time around is not just from their peers, it will also come from investors. Believers in this bull market have been accumulating bullion and junior mining shares for the last 2-3 years. When we invest in a junior, those shares are permanently taken off the market. As an investor and a believer in this new bull market, we don’t trade our shares. We hold them as long-term investors. Simply put, there is a shortage of high quality product out there. We own only 7 juniors, but our positions are sizable in the companies we own. When we buy, we hold. This means that shares are taken permanently off the market. This leaves fewer shares to buy, which can only lead to higher prices down the road as ounces are added on the balance sheet.

The gold and silver mining market is small by comparison to other financial markets. Just three companies, Newmont, Barrick and AngloGold make up 35% of the market capitalization of all listed gold and silver stocks. The market cap of the Amex Gold Bugs Index is only $50 billion. The market cap of the Philadelphia Gold and Silver Index is only $71 billion. The market cap of many juniors is only $25-$50 million -- chump change in today’s global financial markets. Quite simply, there isn’t enough gold and silver bullion or mining shares to satisfy investment demand. The entire gold and silver bullion market along with the capitalization of all gold and silver mining equities is not much over $130 billion. This market is minuscule in comparison to the global market capitalization of stocks and bonds which runs in tens of trillions of dollars.

For the majors it is a tough call. Do you go out and try to find the ounces--a process that can take 5-7 years, or do you step up to the plate and pay up for gold that has already been discovered lying dormant in the ground in the portfolio of a junior exploration company. My analysis tells me they embark on an acquisition spree once they realize their precarious predicament. For many of the majors, their mine life has been declining.

It is no longer a question of finding ounces anymore. It has become a question of survival. According to geologist H.R. Bullis, today’s VLGP’s are unlikely to survive at current production rates over the next decade. It is time to open the checkbooks and go get the ounces.

Today’s Markets

Markets were up overseas and lower here in the U.S. on Monday. The Dow closed at its lowest price in a month led lower by a fall in the prices of Intel, Kodak, and GE. The NASDAQ got hammered losing almost 2% on the session. There just aren’t a lot of catalysts right now and share prices are steeply overvalued. The economy is starting to soften again as it looks like the U.S. dollar remains vulnerable. The only thing holding up the dollar is the central banks of Japan and China. Outside these large buyers of dollars there is nothing fundamentally holding up the greenback but fiat air. While the share price of almost everything was in the red today, there were a few exceptions in silver shares and oil.

In other markets bond prices went even higher as yields fell to 3.77% on the 10-year Treasury note. Oil and gold prices pulled back slightly, while the price of silver remained unchanged at near record highs. The dollar retreated and looks vulnerable at this point.

Volume on the NYSE was only 1.2 billion shares, while on the NASDAQ volume climbed to over 2 billion shares, a heavy distribution day for the NASDAQ. Market breath was negative by 18-14 on the Big Board and 21-10 on the NASDAQ.

Jim Puplava

Technical Review
by Eric King

I have stated that I liken the coming consolidation phase in the gold and silver market to that of the networking sector in the 1990s and I coined the term for the future consolidation as the "PAC-MAN" phase. Higher share prices for major mining companies such as Newmont Mining coupled with declining production is signaling that the consolidation phase which I have previously written about is at hand. As the share prices of networking companies vaulted higher they began to use their stock as "currency" in order to make acquisitions and offset the fact that their acquisition targets had also gained significantly in market value. The culmination of this paper "currency" acquisition frenzy, or as I like to call it "PAC-MAN" phase, ended with Cisco purchasing Cerent Corp. for 6.9 BILLION dollars in an all stock transaction late August of 1999. At the time, Cerent incredibly only had $9.9 million of sales and had lost $29.3 million in the first half of its fiscal year!!! Nortel had already purchased Bay Networks for $9 billion and Lucent had purchased Ascend Communications for $20 billion in all stock transactions. The main thing to consider here is that the companies which were making significant acquisitions during that time period watched their share prices climb to extraordinary levels while competitors were left in the dust. It was during this time that the "PAC-MEN" ruled.

Cisco Daily from 1990 to 2000

Cisco, led by John Chambers was the master of acquisitions making 12 to 18 each year at its peak and consequently their shareholders and management made fortunes during this remarkable time period. $1,000 invested in CSCO in 1990 was worth $1,640,000 at the top, an amazing 1,640 fold increase! As the chart shows, acquisitions increased as the paper value of Cisco's share price appreciated.

Cisco Weekly Chart from 1990 - 2000

Note the MACD on both the daily and weekly charts of CSCO as it shows the periods of consolidation and how long-term investors held on despite "sell" signals.  Of course the "wise" investors sold into the mania.  During this "PAC-MAN" consolidation phase companies such as Cisco were looking to make sure the acquisitions kept them in a "strong product cycle" which in turn kept their share prices climbing.

Lucent Technologies was also a large "Pac-Man" during this time eventually purchasing Ascend Communications for 20 billion dollars in an all stock deal using it's paper as "currency" two days after buying Keenan for 1.5 billion dollars.  During a four year period, Lucent gobbled up 38 companies while it's share price was on it's way into the stratosphere.

LU Daily Chart from 1996 to 1999

Now let's take a look at the Networking Index:

Even though companies in the NWX (Networking Index) already had extraordinary gains by the time the NWX was created in 1996, networking companies which understood the "PAC-MAN" concept began to aggressively make acquisitions using their stock as "currency."  These companies which ruled as "PAC-MEN" watched their share prices skyrocket!!!

Networking Index Daily Chart from 1996 to 2000

Just as the networking executives saw the need to keep the "strong product cycles" alive by continually purchasing junior networking companies, the big winners in the mining sector will be those companies whose CEO's understand the "PAC-MAN" concept and use it to acquire high quality juniors that add significant ounces to the balance sheet as the price of gold and silver skyrocket!

Now let's take a look at gold during the last secular bull market and how it ended in a mania:

GOLD Daily Chart from 1977 to 1980

The daily chart of gold from 1977 to 1980 shows the culmination of the last great secular bull market in gold.  You can see the daily MACD stretching to the sky near the 100 level.

Gold Weekly Chart from 1977 to 1980

A look at the weekly chart from 1977 to 1980 shows the weekly MACD exploding to the upside. We should look for the fireworks in this secular bull market in gold to be no less exciting.

Gold Weekly Chart from 1971 to 2004

As you can see from the above weekly chart of gold which covers 1971 through today, the weekly MACD went parabolic in the latter stages of the last secular bull market. Note that the MACD today is still hovering near the "zero" line. There is still unimaginable room to the upside in this secular gold bull market after gold finishes its consolidation around the $400 level

Now let's turn to the HUI (Gold Index) and its implications in the coming "PAC-MAN" phase:

HUI Weekly Chart from 1996 to 2004

As you can see, the HUI created in 1996 has moved from around the 35 level close to 260 at the recent peak and is currently trading above 230. This process of the secular bull market pricing up the major mining shares will allow them to use their stock as "currency" during the coming "PAC-MAN" phase. Although the price of junior mining shares have also appreciated, the major mining companies which use their shares as "currency" and "get the ounces" will position themselves for the greatest appreciation to the upside as the price of gold and silver soar, just as the major networkers who gobbled up junior networkers saw the price of their stocks soar.

In this secular bull market in gold and silver there will be major mining companies whose share prices will leave their competitors in the dust because they grasp the "PAC-MAN" concept first and begin to aggressively purchase high quality juniors adding ounces to the balance sheet in what will in all likelihood be a very, very long secular bull market in gold and silver.

Eric King

© 2004 Jim Puplava & Eric King
March 8, 2004