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Jon Nadler

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Rising Fall?

By Jon Nadler       Printer Friendly Version
Aug 1 2008 3:44PM

Good Afternoon,

Bullion values turned lower once again following yesterday's GDP-related and mostly technical bounce. Friday's trading session brought prices down to a low of near $902 per ounce, as the US dollar picked up a few notches on the index (@ 73.41) as well against the euro which fell after BMW abandoned sales and profit forecasts due to slumping US sales. The metal turned higher in late trading, following gains in crude oil precipitated by Israeli statements regarding the "unacceptable" stage that Iranian nuclear development is reaching. Platinum-group metals fell sharply, following yesterday's US GDP figures for Q4 2007, this morning's $15.5 billion Q2 2008 loss reported by GM, and by a further 13.3 percent fall in Ford auto sales.

Gasoline and platinum demand destruction continues, from the assembly line to the gas pump. Americans are evidently refusing to pay more than about $4 per gallon and have began opting for alternatives - including cutting back on their traditional summer vacation-related leisure driving, and simply not buying cars. Falling fuel demand is seen as continuing through year-end, according to a heavily-read Marketwatch article by tireless reporter Myra P. Saefong. Such news continued to adversely impact the noble metals as the week drew to a close and vacation month began.

New York spot gold opened $3.30 lower at $910.00 and was last seen at the same exact level, 45 minutes prior to closing, as the metal headed for its third weekly loss. Silver fell 23 cents to 17.48 while the rout in pgm-group metals continued to unfold - platinum lost $97 falling to $1639 and palladium dropped $14 to $365 per ounce. Rhodium fell $100 to $8135 and is now nearing a $2000 loss from its fairly recent peak. Automotive sector news and a brighter supply outlook out of S. Africa continue to present a hurdle to price advances. Gold itself is showing signs of fatigue after a third week of declines that - albeit one punctuated by decent-sized isolated rallies- have brought it to the edges of the $900 area once again. Closing above $915 remains desirable at this juncture but the metal will need fresh geopolitical or dollar developments in order to change course significantly, as players are likely unwilling to take on large bets ahead of next week's Fed gathering. Commodity Online offers this technical take on the yellow metal: "Gold staged a 30 dollar bounce off of yesterday’s lows to 925 earlier in the session, but drifted back to 914 in the afternoon. Despite the bounce, the overall price action is bearish while we remain below 935. Downside support is seen at 888 - the 200 day moving average and 76.4% retrenchment."

As the Olympic Games get underway net week, we are all likely to see a shiny, confident, and prospering China on our television sets. Indeed, the country has made miraculous progress on many fronts. But, after a string of white-hot growth years, it appears that the gears in this giant's economic engine are slipping just a tad. Even such relatively minor declines in the Chinese economic rpm present potential difficulties for perpetually starry-eyed commodity super cycle advocates. The myths of an insatiable China and an ever-voracious India are coming under closer scrutiny than your average piece of evidence on CSI. So is the concept of a mania phase that is putatively set to begin in metals.

As China experiences a worsening energy crisis and faces the threat of persistent power shortages over the next 12 months, Purchasing Manager Index data released today confirms that the country's manufacturing sector contracted in July for the first time since 2005. Weaker exports are taking a toll on the economy. As such, sustaining rapid growth is China's primary economic priority now. In a sign of official concern that the economy is slowing too sharply, the central bank has authorised banks to increase their lending by 5 percent.

Whilst some economists have said that factory closures and transport restrictions introduced to improve Beijing's air quality for the Olympics could have affected business sentiment, a parallel survey of purchasing managers conducted for brokerage CLSA pointed to a much more modest slowdown. All of which has caused some observers to question - could the shedding of a few basis points of economic growth justify investors taking some $305bn of commodities bets off the table, does the arithmetic stack up?

Today's Financial Times asks the question and says:

"China’s economy has grown in excess of 10 per cent annually for five years in a row and may yet scrape through for a sixth year – although probably not if slowing official numbers reflect reality. That in itself need not zap commodity demand. Fixed asset investment, around half of economic output, remains strong; government spending – including post-earthquake reconstruction – should take up any slack from the corporate sector. Yet China can still spoil the day for commodity bulls.

The country responded to soaring prices by ramping up domestic commodity production and foraging for alternatives. Take nickel as an example. Stainless steel producers turned to lower grade nickel pig iron, shipped in from south-east Asia and blasted in local furnaces. By the end of last year, Merrill Lynch estimates, this substitute accounted for 7-8 per cent of global nickel supply (the consequent collapse in nickel prices has since shuttered many of these manufacturers). In 2005, China’s copper production rose 42 per cent versus 7 per cent for consumption.

Hopes that power shortages in China will eliminate some of this local production and galvanise imports are wide of the mark. The energy-intensive aluminium industry is particularly hard hit: big producers are cutting production by up to 10 per cent from this month. But inventories are robust and the Chinese industry is not geared towards imports. Slower economic growth will play a part in denting global demand. But more important is China’s unwillingness to pay the very prices it has helped inflate."

We will now devote the final section of the week to the recently issued RBC Capital Markets report and outlook on gold, as brought to us by Mineweb's Barry Sergeant. While RBBCM does see somewhat higher ($1,000) prices ahead, the report is balanced and does not ring the TEOTWAWKI fire alarm bells so frequently being rung by many sales agenda-driven so-called research economists at gold-selling firms and newsletter-vending publishing enterprises. And, at least, the RBBCM report does cover the potentially gold-negative aspects of the equation as well. Which, is something you normally do not encounter among promo...sorry mega-bullish 'experts.' Here goes:

"The numbers in the markets indicate that gold exchange traded funds (ETFs), along with gold royalty companies such as Franco-Nevada, have outperformed practically all listed gold - and other resources - stocks over the past two months, a time when global resources stocks have been mercilessly hammered. Gold ETFs, representing a proxy investment in gold bullion itself, have been outperformed over the period by silver ETFs, which traditionally display a higher "beta" than gold bullion prices during times of crisis or stress, currently seen in global investment markets.

Specialist analysts at RBC Capital Markets have sought to look forward, and in a report out to clients this week, recommend that it's time to buy listed gold stocks, not least on seasonal factors. RBCCM analysts argue that the macro outlook remains constructive, on a combination of a US dollar "that shows no clear leadership as a global reserve currency", and, second, that "central banks continuing to aggressively reflate the economy will likely maintain pressure on currencies relative to gold and other hard assets. This backdrop is complemented by emerging market countries that are facing energy and agriculture inflation which is expected to be positive for gold". RBCCM's analysts see a positive outlook for the back half of 2008: "the seasonal slowdown for physical gold demand is nearly behind us, and we expect increased demand looking ahead to August, September, and October. With the US Federal Reserve rate cycle on hold for the time being, the US dollar drifting and inflation pressures growing around the world, particularly in the emerging market economies, we believe the timing is right for investors to be buying gold and gold equities".

As observed over the past 12 months, the RBCCM analysts anticipate that larger capitalisation listed gold stocks "with established production bases and higher share liquidity" will continue to outperform smaller capitalisation names. From a fundamental perspective, the analysts continue to favour gold companies with improving production and cost profiles, gold reserve upside, active exploration programs and strong management teams.

RBCCM analysts identify several positive factors for gold bullion prices:

  • Non-European Central Bank announcements regarding gold purchases (Russia, UAE, Qatar)
  • Chinese foreign exchange reserves topping $1.4 trillion, dominated by holdings of US treasury securities. The Chinese central bank continues to comment on the need to diversify foreign exchange reserves

  • Firm demand for gold ETFs, near an all-time high of 29.8m ounces
  • Gold equities pricing in gold bullion at $850-$875/oz long-term
  • Expectations of a US Federal Reserve rate pause, and no rate hike expected, and
  • Mine supply flat in 2008, with a decline expected in 2010.
  • Potentially negative factors affecting gold bullion prices are identified as:
  • Jewellery demand showing strong elasticity in India and the Far East
  • Switzerland deciding to sell 200 tonnes over two years, replacing Germany in the ECB gold sales agreement, and
  • The potential for IMF gold sales as part of the ECB gold sales agreement.

RBCCM analysts point also to the ratio of the spot dollar gold price to the Philadelphia Gold & Silver Index (XAU), given that the analysts believe that the ratio is an important indicator for identifying periods when gold stocks are relatively cheap or expensive, compared to gold bullion. The current ratio is around 5.4 times, and has averaged five times over the past few months. According to the RBCCM analysts, when the ratio is above five times, the average one-year holding period return for the XAU has historically been 40%; when the ratio is between 4.5 and 4.75 times, the average return has been 27%.

The RBCCM analysts also note that the net speculative long gold futures position on COMEX has coincided with the run in the price of gold. On 19 February 2008, the net long position in futures reached an all-time high of 25.3m ounces; with the recent selloff in gold, the RBCCM analysts expect a further decline from the 25 July level of 23.7m ounces. The analysts look for the "positive correlation between gold and the speculative futures position to continue, and look for the long position to remain strong as gold consolidates and makes another run at $1,000 an ounce in September-October 2008".

The RBCCM analysts also argue that seasonality provides a compelling argument for investment: "Over the past 28 years, gold has typically outperformed on a monthly basis in the months of April and May. This is usually followed by a seasonal slowdown in the [Northern Hemisphere] summer months, and an upsurge in the early fall. With this in mind, investors may be able to exploit near-term weakness in gold and gold equities before a positive run in the late summer, early fall period".

Finally, the analysts note that over the past couple of years, ETF gold products "have emerged as a meaningful component of gold demand, accounting for 7% of total demand in 2007. Following a slowdown in mid-2007, the five primary ETFs have added almost nine million ounces, coincident with the gold price rally". During the recent rally in the gold price from its low of around $850 an ounce in early May to around the $970 an ounce level in early July, ETF ounces under management bounced back from 25.9m to a record 29.8m ounces (and are currently 28.8m as of July 25). This overhauls the previous all time high set in March when gold bullion hit its record of $1,033 an ounce. "We believe", conclude the analyst, "that investors continue to use this product not only for short-term trading opportunities but also for long-term or strategic investment purposes".

We are most interested in seeing how the Fed rate pause/hike and Indian demand issues play out on the positive and negative factor fronts, and also believe that they will be the impact factors of highest significance as the gold price scenarios play out during Q3 and early Q4. You, of course, are free to pick and choose those factors that you believe will prevail over others and drive the metal to different levels from those we have today.

Happy Trading. Pleasant Weekend.

Jon Nadler
Senior Analyst
Kitco Bullion Dealers Montreal



Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.