Gold miners were already wobbling on the backs of their heels, struggling to keep their balance. Now the recent sell-off in gold has knocked them down to the canvas.
Though not quite knocked out, they have certainly taken a beating. In the last 5 trading sessions alone, while the most popular gold ETF, SPDR Gold Trust (NYSEArca:GLD), is down 12%, miners are down even more.
Goldcorp (NYSE:GG) is down 13%, Newmont Mining (NYSE:NEM) is down 17%, Yamana Gold (NYSE:AUY) is down 22%, Iamgold (NYSE:IAG) is down 24%, and Barrick Gold (NYSE:ABX) is down 28%.
Once their heads stop spinning and they stop seeing stars, you can bet there will be a good deal of adjustment throughout the mining industry, which may bode well for commodity prices.
Teetering on Unprofitability
With gold prices still $1,100 higher than their $250-270 lows some 12 years ago—up more than 420% even with the recent tumble—you would think gold miners would still be singing cheerfully all the way to the bank.
Not so. Mining has become a very expensive business over the last dozen years, with labor, exploration, and new mine construction growing in cost year by year.
Remember too that throughout this period, producers took advantage of steadily rising gold prices to venture deeper into their mines in pursuit of ounces that were once unprofitable at lower prices. They also ventured into more difficult terrain to open new mines which were suddenly made viable to tap.
But with gold back at mid-2010 levels, all that new supply which had become viable over the past 3 years has become unviable once again.
It might be quite the noteworthy development that the recent tumble in gold stopped where it did—at least for now. This is pretty much the level where many producers can still operate profitably, though only just. Most miners are close to that very thin borderline where the ink turns from black to red.
The average all-in operating costs for North American gold producers is around $1,200 per ounce, RBC Capital Markets estimates. Gold above these prices keeps the companies in business.
But should gold fall below that all-in cost price, credit lines would be maxed out, necessary stock issuances would slash share prices, and a scaling back of operations would pad-lock mines to all but the easiest ore to dig out.
In a note cited by Bloomberg, RBC analysts describe the adjustments gold producers would have to make:
“We would expect all the gold producers in our coverage universe to cut all discretionary expenses, cut capital spending sharply, defer new capital development programs and in some cases cut dividends.”
Jeffrey Burchell, a fund manager with Toronto-based Aston Hill Financial Inc., adds:
“You need the high-cost producers to move away from high-cost production and take supply out.”
Of course, gold producers with substantial reserves will hardly go out of business, as there will always be buyers of new gold supply each and every year. But that supply will be reduced—by as much as 30%, analysts estimate—as ore that is harder to reach and more costly to extract is left imbedded in rock. The current price is just too low to get it out.
Yet if you take as much as 30% of a commodity’s new supply off the market, you will inevitably stop the price from falling, if not cause it to turn back up. Thus, the end of the commodity bull run may not necessarily be upon us just yet. What is upon us is volatility, and in a very big way.
Behind the Volatility
It all comes down to supply and demand, with the price self-correcting over time. When falling prices cause mines to scale back production, the reduced supply will ultimately drive the price back up. And a rising price will once again bring all those expensive mines back online.
It makes for a very volatile market, especially for gold. Many seem surprised that gold should be as volatile as it is, given its traditional role as a safe-haven. It’s supposed to be safe.
Quite simply, gold is as volatile as it is because it is universally traded by every nation on the planet within a wide and varied spectrum of reasons to trade it.
While central banks trade it to diversify their reserves, institutions trade it to protect their portfolios against currency fluctuation. While producers trade it to lock in future sales, industrial users trade it to lock in future costs.
And while hedge funds and speculators trade it to make a quick buck, average and typical investors trade it because analysts say every portfolio should allocate at least 5% to 15% to it.
Since the reasons for trading gold are so varied, you will frequently have huge buy or sell orders popping up out of the blue, without any real change in the underlying economic condition. Maybe a fund is going bankrupt, and it has to unload everything. Maybe a bank is reallocating more of its investments into stocks.
It is speculated that a large hedge fund placed just such a large order—some 400 tons—on Friday, April 12th, triggering a succession of stop-loss sell orders. The price quickly dropped through large gaps between clusters of stop loss orders, and the plunge was made worse when large institutions removed previously cued up buy orders in expectation of better entry points later on.
Whatever the cause of this recent upheaval, if institutions or individual investors have decided that gold still occupies an important place in their portfolios, perhaps they might be better served embracing the volatility instead of fleeing from it. For indeed, volatility presents a great opportunity for making profit.
Capitalizing on Volatility
The first thing we need to appreciate about volatility—even as pronounced as we have seen it recently—is that it is not Earth-shattering but is in fact very, very normal.
The following graph compares gold’s recent volatility to that of 2008’s correction (using GLD as the reference).
2008’s correction has 3 down waves (red) and 3 up waves (green) before the correction officially ended in the spring of ’09. The current correction of late 2011 to today has had 4 down waves (red) and 3 up waves (green) thus far. Looking at the percentages of each of these waves will likely surprise you.
2008 Correction Current Correction
Wave 1 -15% -16%
Wave 2 +13% +13%
Wave 3 -23% -14%
Wave 4 +22% +16%
Wave 5 -22% -14%
Wave 6 +39% +17%
Wave 7 N/A -25%
Of the first 6 waves, both then and now, the current correction has been less volatile than 2008’s correction in 4 of them, equally volatile in 1, and more volatile in 1 by a mere 1%. And the current wave 7 is only 2% more volatile than 2008’s most volatile, wave 3. So far, that is.
In dollar terms, yes, the current correction’s rises and falls have been larger. But on a percentage basis, they are in line with the norm.
Despite this frequent turmoil in the gold price, if one still has the need—and the stamina—to hold some gold, a relative-value trade can help siphon some profit out of the volatility. And the gold miners are one way to do it.
As mentioned at the outset, gold miners have been hit harder than gold, which is often the case in a falling market. Yet in a rising market, these beaten-down gold companies often outperform the metal, as can be seen in the one-year graph below, comparing the GLD (black) to the Market Vectors Gold Miners ETF (NYSEArca:GDX) (beige), and the Market Vectors Junior Gold Miners ETF (NYSEArca:GDXJ) (blue).
More often than not, the gold miners will move more than gold in either direction, both up and down. The “% Compare” section at the bottom of the graph shows the performance of the two miner ETF’s relative to GLD, which is flat-lined at 0% in black.
In the relative value trade between two instruments, cash is like water that flows downhill. That is, funds are moved out of the higher instrument into the lower instrument.
If an investor had applied this trading technique through the past year, he would have moved funds from gold to the miners in the red circles, and then moved funds from the miners back to gold in the green circles. In so doing, the profit earned from the miners as they outperform gold is subsequently stored in gold.
It takes courage to apply the relative-value trading technique. As the most recent red circles to the right of the graph indicate, now may just be one of those times. There may be a better moment next week or next month, but at scaled intervals the relative value trade will lock in profit and lower the dollar cost averages of the investments.
The real advantage in the relative value trade is that new money is not required. If one has allocated, say, $10,000 to the gold space, one might slide $1,000 or $2,000 at a time back and forth between gold and the miners as the situation warrants. This would still offer exposure to upward price gains, and at the same time it would periodically improve the dollar-cost average.
And let’s not forget silver, which also provides gold with a great relative-value dance partner, as the graph below shows.
Gold Targets Cut
It is not surprising that the major banks have cut their price targets for gold. Morgan Stanley (NYSE:MS) two days ago cut its 2013 gold forecast to $1,487 and its 2014 outlook to $1,563—both higher than today’s price.
Last week, Goldman Sachs (NYSE:GS) cut its targets to $1,530 in 3 months, $1,490 in 6 months, and $1,390 in 12 months, also higher than gold is today. But its 2014 year-end target of $1,270 is lower.
While Barclays Plc (NYSE:BCS), Credit Suisse (NYSE:CS), Societe Generale, Danske Bank, and BNP Paribas all predict lower average prices in 2014, Deutsche Bank (NYSE:DB) sees prices rising to $1,637 later this year and higher still to $1,810 in 2014.
No one has a crystal ball, which is proven by all these changes to forecasts on a regular basis. But one thing is foreseeable: there will be more money printing, low interest rates, and more stimulus for a few more years to come.
Since the underlying economic conditions have not improved enough to change central bank policy, they have likely not changed the argument for gold’s resumed rise. The conditions which lifted gold these past 12 years are not only still present, but are growing ever more prevalent than ever before.
Even so, traders move markets. Not reasons.
If you liked this article, you may also enjoy: