Metal Sparks
Gold: Crumbling Pillars
In our view, the dramatic sell-off in the gold market
since 12 April has all the hallmarks of panic-driven,
stale long liquidation, stop-loss and capitulation
selling in the face of a concerted short sale that
began in New York on Friday April 12. We trace the
origins of the short sale assault to the 10% reduction in
CME margins for gold futures contracts that took place
in November 2012. The subsequent the erosion of some
of the major pillars supporting the gold bull market that
occurred in the interim provided fertile ground for such a
successful and attractively priced assault on the long
skew to investor positioning in the market. As a result of
the magnitude of the mark-to-market effect of this move
on YTD average prices, and the subsequent reset to the
pricing basis of the forward curve, we have
downgraded our gold price forecasts to
US$1,487/oz in CY2013 (-16% from our previous
forecast) and to US$1,563/oz in CY2014 (-15%).
The erosion of the long-running bull trend we attribute to
a number of factors, of which we would highlight the
following three as the most important:
1. ETF liquidation: Fund selling is probably the most
important single influence, with persistent liquidation
from these funds evident since early February.
2. Speculation over European central bank selling:
The spectre of a return of central bank net selling is
clearly of great concern to the market, particularly if it
would neutralise the current trend of buying from the
emerging market central banks.
3. Nervousness over the possibility of the Fed
pulling QE early: The latest Fed minutes suggested a
growing consensus from Federal Reserve Board
members to slow down federal purchases of MBS and
other assets.
The Four Pillars of the Gold Bull Market Appear to be Crumbling
We have previously identified four pillars that have
underpinned the gold bull market evident since 1999:
1. The persistent rise of gold investment demand
expressed through the physically backed exchange
traded funds, a phenomenon that emerged in 2003;
2. a controlled environment of central bank selling as a
result of the three Central Bank Gold Agreements
since 1999 and the emergence of significant buying
from emerging market central banks;
3. the unwinding of the global gold hedge book (i.e., gold
buy-backs); and
4. anemic mine supply growth.
While the influence of latter two factors have largely played out,
the influence of the former two since the end of the global
financial crisis have been substantial. In our view, the
perception of waning investment demand and European
central bank selling could represent the crumbling of the final
two pillars supporting the gold bull market.
Declining risk aversion, declining safe have demand.
Worryingly for the outlook for the gold price, it is increasingly
evident that investor conviction about the desirably of this form
of investment, along with other safe-haven assets, is declining.
Arguably, the single most important of these pillars for the gold
bull market has been the rise in investment demand for
physical gold. We have long argued that this form of demand
for physical gold primarily reflected investor demand for
instruments to hedge systemic financial risk during the 2008-09
financial crisis and its aftermath, while providing a long-term
hedge against fiat currency debasement risk at a time of
sustained financial risk aversion.
In our view, the notable failure of gold to perform in the face of a
new chapter in the long-running Eurozone sovereign debt and
banking crisis and heightened political tensions on the Korean
peninsula have been leading indicators of declining investor
appetite for such hedges. Further evidence of the declining
demand for safe havens was provided by the negative gold
price reaction to market speculation that the recent minutes
from the FOMC suggested that the US Federal Reserve might
be preparing for an earlier-than-anticipated exit from
Quantitative Easing 3 (QE3) or lower bond purchases under
the current program. While we do not believe that the Fed is
likely to materially change its stance towards QE3, despite the
very significant expansion in global liquidity represented by
recent changes to Japanese monetary policy, in a market
where bearish sentiment is rampant, market perceptions to the
contrary have a disproportionate force.
This decline in risk aversion has been physically manifested in
the physical gold ETFs. As of the time or writing, the aggregate
holdings of gold-backed ETFs has declined by 249t, or just
over 8 million ounces of gold since January 1, 2013 – the
longest period of continuous long liquidation since 2003.
The spectre of European central bank gold sales returns
Furthermore, this decline in investor demand for gold as a safe
haven asset is occurring at a time when another pillar of the
gold bull market is potentially eroding away. This became
evident during a press conference on April 12, 2013 following
the EU Finance Ministers’ backing of a €10Bn loan for Cyprus
in which Cyprus will have to provide €13Bn of its required
funds. In that press conference, the president of the ECB
indicated that while Cyprus does not have to sell its gold to
provide part of this funding obligation, any money raised from
the sale must go towards covering any losses incurred from
emergency loans to the country’s banks.
In our view, this statement underscored a new risk to the gold
price from the current phase of the long-running Eurozone
financial crisis, namely that the absence of Eurozone central
bank selling as a financing option might be about to change.
While the size of the potential gold sale from Cyprus is small
(possibly10t, or 321,510oz), it is the precedent that any such
sale might set which is of far greater concern to the gold
market. The combined gold holdings of distressed Eurozone
economies, Portugal, Spain, Italy and Greece, is currently
3,228t, or 103,783, 428oz, a level that is only currently
surpassed by Germany and the USA.
As a result, if the notable absence of Eurozone central bank
selling, which also been a key component of the gold bull
market, were to progressively reverse at a time of lowered risk
aversion, further falls in the gold price from current distressed
levels are possible. While we do not subscribe to the likelihood
of this development materializing, the fact that the market is
beginning to price this outcome is clearly negative for near- to
medium-term investor sentiment towards the gold price.
Where is the bottom?
Given the magnitude of the volumes traded in futures markets
over the past three days, the dramatic rise in open interest and
the heightened volatility of recent days, we are reluctant to try
and identify a hard floor in the retracement that we have seen in
the spot market. Overshooting is also a well-established
feature of these types of sentiment-driven markets, and some
very material technical damage to the long-established uptrend
in the gold price has been done. We note in this context the
psychological impact of the breach of technical support at
US$1,525/t, long thought to be demarcation line between a
rising or falling long-term price trends.
Interestingly, in this context, and with a longer-term look at the
gold price in the context of the changing industry cost structure,
the data suggests that over the medium to long term, spot gold
prices tend to trade closely with marginal C3 mining costs or
the 90th percentile of current industry costs. This definition
represents the combined level of cash mining costs, fully
allocated corporate costs and mine asset depreciation. Exhibit
5 shows that until April 2011, the spot price for gold traded in a
relatively tight range around this changing level of industry
costs. Much of the fundamental support for a rising gold price
during this period was provided by this phenomenon. However,
it is also clear that since 2011, when prices began a strong
upward move to a new all-time spot nominal high of
US$1,923/oz in late 2011 and subsequently traded at a new
annual average nominal high in 2012, this relationship broke
down. The recent dramatic events in the gold market suggest
that at a C3 marginal cost of US1,200/oz estimated by
consultants Wood Mackenzie Brook Hunt for 2013, and a cash
spot price at the time of writing of US$1,376.40/oz, we are we
are much closer to this relationship being reestablished than at
any time in the past two years.
However, there is a further interesting element to this cost price
relationship that has become pronounced in the past few days.
Morgan Stanley uses an incentive price methodology to try and
identify the price at a given level of total costs that would
generate a sufficiently high return to cover industry and
company costs of capital on an after-tax basis. Our current
estimate is at a US$1,200/oz C3 marginal cost, the incentive
gold price is US$1,356/oz, strikingly close to the current spot
price. Consequently, as a sharp move below this level would
materially endanger returns to new and some existing mining
projects and choke off new mine supply, we would conclude
that after the exhaustion of the current selling pressure and risk
of overshooting subsides, we will find a fundamental floor
reasonably close to this pricing level.
Changes to our gold price forecasts
Following this review, and the events of recent days, we have
reviewed our gold price forecasts. As a result of the magnitude
of the mark-to-market effect of this move on the YTD basis
average spot gold price, and the subsequent reset to the
pricing basis of the forward curve, we have downgraded our
gold price forecasts to US$1,487/oz in CY2013 (-16.1% from
our previous forecast of US$1,773/oz) and to US$1,563/oz in
CY2014 (-15.4% from our previous forecast of US$1,845). If
realized, our price deck would now underline the fact that in
annual average terms the peak of the gold bull market in US
dollars was achieved in 2012, although on a spot price basis
this occurred in 2011.
No comments:
Post a Comment