Dec '14/Jan '15


Where did all the gold money go?

By Doug Pollitt

Gold investors are a pretty unhappy bunch these days. The pullback in both the price of bullion and gold shares has seen many people lose a lot of money. But what might be more disheartening yet is that – over the course of the great bull market between 2000 and 2013, when gold went from US$250 per ounce (oz) to US$1,900/oz at its height – many of these same people did not make money then either.

There has been no shortage of explanations as to why gold shares performed so poorly. Some say exchange-traded funds (ETFs) drew money away while others point to cost-push inflation. But none of these withstand scrutiny. Instead, what we find is that there is something inherently structural to today’s gold sector that mitigates profits for investors in this space.

We can get some perspective if we look at what happened in oil and base metals, two sectors that also enjoyed a strong bull market in their respective underlying commodity prices during this time. Here, industry also had to contend with rising input costs and tight labour conditions, but unlike gold, shares in oil and base metals did provide investors with solid returns.

The secret behind the better performance of oil and base metal shares is not difficult to discern – the financial performance of these companies, as expressed in retained earnings and dividends, also did well. The same cannot be said of gold companies, whose underlying performance fared about as well as the shares did: not well at all.

So gold shares underperformed; and it was not because ETFs “sucked money away” but simply because the gold mining industry was a poor place to do business, even with the tailwind of a rising gold price. And simple input cost inflation cannot be cited as the reason, with the counter-examples of oil and base metal companies in plain sight.

The gold space, as an asset class, has macroeconomic characteristics distinct from other asset classes like stocks and bonds, and these characteristics become more attractive when the competing asset classes fall out of favour. But at the same time, gold is a tiny asset class compared to stocks and bonds. To put this into perspective, the market value of U.S. stocks is about 100 times that of gold stocks and that of U.S. bonds is about 200 times that of gold stocks. In this way, it only takes a small trickle out of such asset classes and into the gold space to be very disruptive. But what if there is no good place for this deluge of incoming capital to go?

The oil business again provides insight. A lot of money also flowed into this patch: in particular into the Albertan oil sands. But here, there were opportunities to deploy capital in oil sands development projects that were sufficiently robust so as to provide investors with decent return.

Recent gold investment flows, on the other hand, can be compared to trying to fill a shot glass with a pitcher full of water. (The shot glass represents the relative size of the viable gold sector and the pitcher represents financial investment.) The shot glass gets filled, but everyone else at the table gets wet.

Unlike the oil sands, there were not, at the outset of the bull market, field upon field of sub-marginal gold opportunities to exploit should the price rise. The gold just was not there. Testament to this assertion is that the billions and billions of dollars’ worth of investment in the sector triggered no supply response at all.

But the money flowed in anyway – lots and lots of it. And money never rests. It has to go somewhere, even if there is nowhere good for it to go. Too much money chasing too few opportunities drove down the cost of capital and this easy money led to poor investment decisions, as it always does. There will be a new cycle and when it comes, there will be much more money chasing far fewer opportunities.

Deposits at producing mines are in secular decline while the drills have stopped turning. Meanwhile, six years of quantitative easing has resulted in more credit than ever. This portends very well for the gold price in the longer term. But unless the gold industry can find the discipline to resist the temptation of cheap, bountiful capital, investors should remain mindful of the lessons of the last cycle and stay cautious and discerning, as difficult as that will be.

Doug Pollitt
Doug Pollitt graduated from the department of mining and metallurgical engineering at McGill University in the early ’90s and spent the next decade writing software code for machine vision applications. Just as the market for technology was taking off, Pollitt opted to move downtown and become an analyst at brokerage Pollitt & Co. Inc. in the gold space, the market for which was moving in the opposite direction. He has never been a good trader. He lives with his wife and three kids in Toronto.

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