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Gold ETFs vs equities, Goldman Sachs surveys the battleground
Goldman Sachs Managing Director Ian Preston discusses the steps gold companies must take to pull investors back from the ETF space and shares. An interview with The Gold Report.
Posted: Monday , 22 Oct 2012
The Gold Report -
The Gold Report: Your recent commodity price research shows a gold price of around $1,811/ounce (oz) for 2013. Could you talk with us about how some of the macroeconomic issues influence that forecast?
Ian Preston: When we look at gold, we don't have in mind a specific supply/demand balance going forward. It's easy enough to see the supply side. In trying to forecast a price for gold, we tend to run out a 4% per annum contango from the current gold price until we think U.S. interest rate policy will reverse and rates will start to climb. That stage just keeps on moving out-as it has with Quantitative Easing (QE) 3.
"If accommodative fiscal policies continue globally, gold could go significantly higher."
We look at the gold price to forecast earnings, and over the next 6 to 12 months, we'd expect $1,650/oz at the lower end and, if it breaks through, $1,850-1,900/oz at the upper end. If accommodative fiscal policies continue globally, it could go significantly higher. But bear in mind that as equity analysts we're trying to forecast earnings, and to do so we want to be as close as possible to where the gold price will be for the next three to six months, even if the range is quite broad.
TGR: And in your world, it's better to be conservative than hyperbolic.
IP: It doesn't do our investors any good if we use a $2,000/oz gold price for the next six months and it ends up averaging $1,780/oz. It's more meaningful to say we have a positive view around gold. And we do. Considering such accommodative fiscal regimes, very low interest rates globally and central banks buying gold where previously they have been sellers, it's pretty difficult to take a negative view on the gold price over the next 12 to 18 months.
TGR: Many analysts at the Denver Gold Forum last month echoed that sentiment. They don't see any catalyst that would push the gold price down appreciably. Let's talk about gold equities and exchange-traded funds (ETFs) in the context of the backdrop you described.
IP: From a risk diversification point of view, the ETF clearly gives investors exposure to gold. So the gold majors aren't competing with each other for investors; their competition is the gold ETF. Over a 10-year timeframe, the correlation between gold equities and the gold price is very strong, but more recently-say the last 12 months-gold equities, certainly for the majors, have underperformed the gold price. That's partly due to the fact that, certainly among the majors, earnings per share (EPS) hasn't reflected the leverage to an improving gold price.
TGR: In the environment you described earlier-QE, European sovereign debt issues, central bank buying and so on-what can these companies do to make a more compelling case for themselves with investors?
IP: First, they must deliver on whatever guidance they've given the market. That's an imperative to have investor confidence. They also must maintain long-life reserves and be able to replace them on an annual basis to keep a perpetual gold production chain going. That's what the gold ETFs give investors.
TGR: But gold ETFs have grown dramatically over the past five to seven years. What's given them such an edge?
IP: An ETF costs investors a small amount to hold but carries no risk as compared to a gold equity that comes with operational risk, acquisition risk and potentially political risk. On the other hand, ETFs cannot pay dividends, so meaningful shareholder returns that offset a lot of the operational risks inherent in the gold equities could bring back some of the investors who have gone to ETFs.
"Gold seniors are aware that the return to shareholders is among the key criteria."
I think the gold seniors are aware that the return to shareholders is among the key criteria. All of them were talking about it in Denver. Whether the return takes the form of a payout ratio or a percentage of the payout ratio or free cash flow or is tied to the gold price, the majors got the message loud and clear that they have to do more than rely on the gold price to see share price appreciation and shareholder returns.
To be more attractive to investors than the ETF, the gold seniors also must grow EPS. Increasing volume when gold prices increase accelerates EPS growth, but volume growth must drive EPS growth-not simply higher gold prices. With volume-driven EPS growth, improving gold prices also give investors more leverage to gold than they would have in an ETF. And I think perhaps we're starting to see recovery in the gold equities. But it all starts out with meeting the guidance they give the market.
TGR: Do you see the Philippines more as an emerging gold district than in the past?
IP: There's no question that the Philippines has the resource base that might have hosted a lot more development over the last five or six years. Given the resource endowment and a quite skilled labor force, you would have expected the Philippines to have participated more in the resource boom.
It's really starting to come to the fore now, though, because mining companies have to go where the deposits are. I think activity will increase in the Philippines as some of the global majors get involved there. Xstrata Plc (XTA:LSE) has a controlling stake in the Tampakan project. In March, Gold Fields Ltd. (GFI:NYSE) from South Africa exercised an option to take a 40% stake in Far Southeast in the Philippines, and soon afterward announced an option to acquire 100% of the Guinaoang deposit. There are some major nickel operations in the Philippines too.
TGR: In another fairly major acquisition, B2Gold Corp. (BTO:TSX; BGLPF:OTCQX) bought CGA Mining Ltd. (CGA:TSX; CGX:ASX), which has an asset in the Philippines, the Masbate gold project. So it looks as if quite a bit is bubbling in the Philippines.
IP: And the government has done a lot of work in clarifying the legal issues surrounding ownership rights. Once miners are comfortable with that, you're on the road to more significant development. The smaller companies usually start moving in first because they're a bit more nimble. Then the midtiers and the seniors follow. Once the whole spectrum is involved, you really start to see quite significant development.
TGR: Do you have any suggestions for our readers on the investment environment going forward?
IP: We certainly sit in the camp that believes the commodity boom is not over in the sense that volume growth will continue. Still, we've probably seen the best of most metal prices already and each of the metals will react differently over the next few years. For example, in iron ore, we expect the seaborne-trade market to be in oversupply probably in two or three years' time. Copper, in contrast, could well have upside remaining because China's demand will grow. Even though its growth rate has declined, it's off that much larger base, so, volume growth for copper is still very much intact-and the same goes for seaborne-traded iron ore.
From an equity investor's perspective, with a few exceptions the easy part of earnings going up because prices were going up is pretty well behind us now. But we'll still see earnings growth driven by those companies that can grow volumes.
TGR: That suggests that investors have to be pickier.
IP: Absolutely. You have to be much more focused on, first, the commodity. Clearly, we think gold still has a very favorable outlook. Then you have to focus on the companies that can grow volumes without actually issuing fresh equity.
TGR: And volume growth without blowing out your per-ounce cost structure.
IP: Absolutely. But cynical clients would say, "Yes, everybody is talking the talk. We need to see them walk the walk now."
TGR: Well put, Ian. Thank you so much for your time and your thoughts.
Ian Preston is a resources analyst for Goldman Sachs' Global Investment Research in Australia and New Zealand. In 2000, he joined JBWere, a private wealth management firm that in 2003 partnered with the Goldman Sachs Group Inc., as a research analyst covering the gold sector. Mid-cap base metal companies came under his coverage umbrella later in 2000, and Preston assumed responsibility for emerging small- and mid-cap mining companies in 2004. He was named managing director in 2010.
Prior to 2000, Preston was a resource specialist, working on both buy and sell sides of the financial services industry in Johannesburg and Brisbane. Following graduate school, he spent four years analyzing and implementing new mining projects in diverse metals, and earlier in his career, he spent six years working for copper and gold mining companies in operational and management capacities.
Preston earned a degree in mining engineering from the University of the Witwatersrand in Johannesburg in 1974 and a Master of Business Administration from the University of Cape Town in 1980. He is a registered professional engineer in South Africa and an accredited member of the Securities and Derivatives Industry Association.
1) Sally Lowder of The Gold Report conducted this interview. She personally and/or her family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Goldcorp Inc. and B2Gold Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Ian Preston: I personally and/or my family own shares of the following companies mentioned in this interview: Newcrest Mining Ltd. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.