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Stunningly True: Gold ETF Has Badly Damaged Gold Equities

By Timothy Wood       Printer Friendly Version Bookmark and Share
Jul 23 2010 9:36AM

ST. LOUIS ( -- Early last decade, the idea of a gold exchange traded fund took root. The concept seemed sound at the time, but gold mining companies may be experiencing a serious case of buyer's remorse as evidence mounts that equities have surrendered considerable leverage to gold compared with the ETF. Indeed, the ETF is a competitor rather than an ally.

Investment demand for physical gold collapsed after the incredible success of the Krugerrand program of the 1980s. Efforts were made to revive coin demand, and to stimulate jewellery offtake, but none of the measures showed much success despite gold prices declining to historic lows.

Breakfast at Tiffany's

In 2000, then Barrick CEO, Randall Oliphant, used the results of a Credit Suisse First Boston study about the likely benefits of industry-wide gold marketing to establish a "Steering Committee" to develop the proposal. Consulting firm McKinsey was hired to conduct research and provide recommendations. That report hit the market in mid 2001 and supported a large new global marketing campaign.

Interestingly, McKinsey made no reference to increasing demand outside jewellery - the consultants and industry had become extremely insular in seeing jewellery as its only growth path.

McKinsey estimated that a new $200 million per year marketing campaign could add 340-500 tonnes of gold jewellery demand by 2006, adding $30-40 per ounce per year. At the time, the World Gold Council (WGC) was spending around $50 million per year to market gold, almost all of that directed at consumers.

It was reckoned that the jewellery campaign would add $8.5-$12 billion in net present value.

Oddly, McKinsey concluded that a $50/oz increase in the gold price would possibly trigger a 400 tonne increase in annual global mine production. But that as a minor glitch compared with the failure to identify and quantify the potential for a pure gold investment vehicle. Indeed, McKinsey's projections were several hundred times wrong compared with what eventually transpired.

The McKinsey proposal never got off the ground as WGC allies, mostly South Africans, put up some resistance, and non-WGC members saw no reason to stop free riding. As a consequence though, the WGC was overhauled and its under-performing initiatives were cancelled as then Gold Fields [GFI] and World Gold Council chairman, Chris Thompson, decided he'd had enough.

Besides, the WGC had another idea that was germinating - the world's first exchange traded gold security that would be linked with the spot market.

Go for Launch

By May 2003 the WGC had filed an S-1 Registration Statement with the Securities & Exchange Commission with hopes for a quick launch. It wasn't to be as legal wrangling and ownership disputes took their toll. Those were eventually settled, and GLD launched in late 2004.

It had to contend with considerable sniping from purists and competitors, but it found traction in institutional circles, especially hedge funds.

The major turning point came when gold prices started to accelerate higher in early 2006, averaging more than $600/oz a month for the first time in decades. That "doubling" from the prior lows seems to have dissolved some trading barriers just as the ETF's marketing was spreading. But the ETF's success has come at a tremendous price for gold equities.

As you can see from the chart below, GLD has continued to improve its leverage to gold, whilst gold equity leverage to the metal has gone into reverse.

Companies represented in our market capitalization index are Barrick Gold, Goldcorp, AngoGold Ashanti, Gold Fields, Randgold, Harmony, Kinross, Newmont, Eldorado, Yamana and IAMGold.

We're not suggesting you get more out of GLD each time the gold price rises - as you should with a gold stock - but it is clear where the precious metal money flow has gone, and that the owners who are spliced into the fees generated by the ETF are doing incredibly well.

The net result is that gold company stock has been become much less useful than it used to be. Little surprise then that debentures and other debt instruments found customers in the gold sector.

Gold miners have certainly benefited from from the higher gold price stimulated by ETF driven investment demand. However, the decline of their paper's purchasing power is not trivial in a sector that is dependent on deal-making for growth. It is also disturbing that a reciprocal correlation has developed between gold equities and the the gold ETF - that was definitely not in the thinking when the industry backed the ETF.

The persistent and widening divergence raises questions about how gold company mineral resources should be valued going forward. We would argue that mineral resource optionality is no longer as valuable as it once to be. Investors need to consider placing a greater emphasis on free cash flow and the ability to bring resources to market in the shortest time frame possible.

The insulting irony is that lower gold prices may actually make gold mining scrip more valuable.

Timothy Wood