The shine on gold is fading

FABRICE TAYLOR

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April 17, 2009

Fabrice Taylor is a chartered financial analyst.

ftaylor@globeandmail.com

Fans of Dennis Gartman who didn't read his latest missive should know that as of two days ago he is bearish on gold. That's subject to change on a daily - if not hourly basis - but as of the latest report, that's the trade.

Mr. Gartman, in the unlikely event that you haven't tripped over him, is the well-known trader and ubiquitous author of The Gartman Letter. Assuming his gold trade is right, we might be at the top of the gold market. If that's true, though, gold mining is a sunset industry. If $900 (U.S.) is the top, gold mines are an endangered species.

Take Barrick Gold Corp. ABX as an example - as a proxy for the industry in fact. It's the biggest and most prestigious of the world's gold miners, with a market capitalization of $26-billion. Seventeen analysts rate Barrick a buy, two a sell. (Mr. Gartman says this is a great reason to be short because the buyers have already bought. When everyone is long gold, in other words, short gold - or producers.) Barrick has been around for about 25 years. Over that quarter century it's amassed a mere $2.3-billion in retained earnings. That's more than just about any other company, but to call Barrick rich is a stretch. That's true even at $900 gold.

A few short years ago it cost the firm less than $200 to dig an ounce of gold out of the ground. BMO Nesbitt Burns pegs the cost at $450 to $475 this year. It's still making more money but the margins aren't much better, if they're better all.

And mining gold isn't getting easier. No less an authority than Barrick chairman Peter Munk says it's possible that all the easy gold deposits have been found. Now they look for gold on top of Andean mountains. They find it there too, but the grades are meagre. And as Mr. Munk puts it, if you think it's hard to ski at that altitude, try swinging a pick axe. Or words to that effect. (And try moving parts of a glacier while you're at it.) The capital cost of these projects runs into the billions. Production that Barrick paid a lot less for years ago - the easy deposits in politically and geographically safe places like Nevada - are depleting and supposed to be replaced by these exorbitant mountain-top properties.

Mr. Gartman would not approve of that trade, but what's the company to do? And despite adding to reserves this way, production isn't going up much, if at all, again according to BMO's research. It gets worse for Barrick, and other miners.

The company hedged a lot of its gold at prices well below today's market and, in some cases, below production costs. It's very hard to make money when you promise to sell for less than your costs. The hedge book has burned a multibillion-dollar hole in the balance sheet (even though it's off-balance sheet). It must make the company's bankers giddy with anticipation. On top of that there's $5-billion of debt on the books.

So where will the company - the industry - find the cash to build these remote mines? Not from cash flow: There's not enough of that after shelling out to keep the lights on. Not from debt, judging from the recent financings. No, it will come from selling more shares.

Ten years ago, Barrick had 377 million shares outstanding. It's hosed out half a billion more since then, a lot of that for acquisitions. Again, this is typical of the industry. Over the past decade, the return on the stock is low single digits - which is better than a lot of gold names. Gold may be insurance, and insurance only pays off when there is an accident, but you might be better off self-insuring instead of buying these policies.

At the top of the market for other commodities, companies don't issue shares. Their equity is expensive and they're on top of the world. They issue debt instead (which is why the plunge in prices has killed or is killing so many companies.)

If this is really the top of the market, you can see why the industry is finished. Taking into account the all-in cost of finding and producing gold, miners and their investors can't afford prices that are much lower than where they are now.

If this is the beginning of an irreversible decline in mining, it stands to reason that the price of gold is inevitably headed higher over time. Demand won't go away even if supply does.

There will be higher prices for gold, but we'll just have to wait until the next cycle comes round.