Gold Prices Remain Strong



Gold miner Newcrest Mining Ltd. (ASX:NCM) is optimistic on the gold price in 2013. And like a pilot fish benefitting from following sharks around, mining services provider Ausdrill (ASX:ASL) will likely get its share of the spoils too.

Let’s start with the first question everyone asks a gold mining company executive whenever they meet one: Where is the price of gold heading?

At the Mines and Money Conference in Hong Kong yesterday, Greg Robinson, CEO of Newcrest Mining, gave the answer every gold investor loves to hear: between $1,500 to $2,000 per ounce in 2013, reports Bloomberg.

“If I look at the preconditions for the gold price in the medium term,” Robinson made his case at the conference, “I think about monetary supply, currency devaluation, interest rate, inflation, political economic drivers.” “I’m confident about the gold price. I expect [it] to stay strong for the medium term,” Bloomberg quotes.

Notice that the reasons he and many other gold mining executives repeatedly give to back their expectations for higher gold prices have recently become long-term in duration. They don’t so much cite short seasonal demands that can lift gold prices for a few weeks or months. Today, they cite mostly macro-economic conditions that, once set-in, will exert upward force on the gold price for years—such as inflation and weakening currencies.

This means there is a whole new multi-year phase to the gold price that has only just begun. “There [are] more reasons to own gold today than there have ever been,” Eric Sprott, Chief Executive Officer and Senior Portfolio Manager at Sprott Asset Management, claimed at the conference. “I hardly think the crisis is over. The crisis is in full bloom,” quotes Bloomberg.

Now, if such demand by itself isn’t ample enough cause for a rising gold price, then just factor a shrinking gold supply into the equation, and you will really have a case then.

One major cause for a shrinking gold supply is the recent 18-month stagnating gold price. In fact, gold is currently trading at a discount to its future value. At the conference, Robinson described the effect, as quoted by The Australian newspaper. “Investors and market analysts are forecasting steeper ‘backwardation’ of commodity prices.”

Pause right there. What is ‘backwardation’? “A market is ‘in backwardation’ when the futures price is below the expected future spot price for a particular commodity,” defines Investopedia.

This means that a gold futures contract is currently trading below the price where gold is expected to be at when the futures contract expires. It is cheaper today than it will be at its expiration.

Hence, gold producers are reluctant to sell too much gold just now. Why lock-in a futures delivery obligation at today’s futures contract prices when spot gold at the time of that future delivery will be much higher then?

The consequence of this is lower than optimal revenue for the producers, as Robinson explained, “Recently the combination of lower commodity prices and inflating costs has resulted in lower profits and cashflow for all major companies. The project capital commitments and cost overruns have been aborting the cashflow the industry has been producing,” quoted The Australian.

At today’s low spot and futures prices, gold miners will sell only the bare minimum they need to keep them in business. They are saving the bulk of their inventory and un-mined reserves for the bigger payoff down the road.

In turn, the consequence of lower sales revenue means shareholders are not getting very much return on their investment at the present time, as The Australian confirms, “The drop in prices and revenue had meant the resources sector had not been able to reward shareholders with high dividends or capital returns.”

Extend the consequences chain a few links further and you can see that investors will not be readily forthcoming with new investment capital for such dismal returns as the miners are currently delivering. And less investment capital means fewer new mines opening for business, as Robinson summed up:

“The lower revenue drivers coupled to the current high cost of operations leaves new projects in a long taxi queue for approval and funding and that queue will continue to grow in the short term,” quotes The Australian.

Hence, lower commodity prices mean lower sales revenue, means lower returns, mean less available investment capital, means fewer new mines, mean a falling supply that cannot keep up with a rising demand. And this is great for the gold price.

We can expect, then, that since gold producers are expecting higher commodity prices in the near future, they will want to prepare themselves now by increasing their output capacity and profitability. This is precisely what Robinson reported the industry is doing.

“The rapid shift in the sector has seen the industry focus move significantly to maximise returns from existing assets, reduce costs, cut capital and drive productivity,” quotes The Australian.

One sub-sector of the mining industry that stands to profit from this repositioning by mining sharks is the mining services industry. Like pilot fish swimming alongside sharks, mining support companies provide valuable services to the mining sharks and glean a nice profit for themselves in the process.

Australian-based Ausdrill Ltd (ASX:ASL), in business since 1987, has already gained substantial ground in the field. Yahoo! Finance outlines the long list of services Ausdrill provides:

“Ausdrill Limited, a diversified mining and services company, provides various services in mining, drill and blast, exploration, procurement and logistics, manufacturing, and telecommunications in Australia, the United Kingdom, and Africa. Its services include earthmoving; drilling and blasting; exploration drilling; in-pit grade control; energy drilling; water well drilling; and mineral analysis.

“Additionally, it provides mining supplies and logistics services; contract mining services to the telecommunications and utility sectors; and blasting services for open pit mining.”

In an article appearing in The Sydney Morning Herald, Ausdrill reported that “sales increased 14 per cent to $579 million during [the first half of fiscal 2013], while normalised net profit and earnings per share (EPS) were flat year-on-year at $57 million and 18.8¢, respectively. The interim dividend was maintained at 6.5¢ a share, fully franked.”

Although “the company ended the period with $481 million in net debt, an increase of just more than $240 million during the six months, on the back of a negative cash-flow outcome as well as the payment for acquisition of the BTP equipment hire business,” the report explained, “gearing (net debt-to-net debt and equity) remains reasonably sound at 38 per cent, with interest cover at more than nine times.”

With a market capitalization of $881.93 million (Yahoo! Finance), the company’s stock price does carry the increased volatility that all small-caps do, as the company itself reported, “The stock has had a roller-coaster ride. It is down 24 per cent in the past year due to the volatility of commodity prices and uncertainty over mining activity levels. However, the stock price has rebounded 25 per cent in the past three months, driven by a reset of the market’s expectation of Ausdrill and a return of investor confidence.”

In a rising market—once gold finally gets there again—it is the small caps that generally lead the way in stock price percentage gains; hence the recent 25% upward gain when gold itself moved only 3 to 4% over the past 2 weeks.

“Despite the recent rally,” the company’s report in the SMH concludes, “the stock is trading at an attractive 7.6 times fiscal 2013 consensus EPS estimates and 2.9 times earnings before interest, tax, depreciation and amortisation (EBITDA). While the low multiples may be justified partly on the basis of the company’s capital intensity, we regard the discount to the market to be excessive. The stock is also yielding more than 5 per cent, fully franked. Consequently, we believe the stock is worth buying at present levels.”

Whether you as an investor like the solid prospects of a large mining shark like Newcrest, or you have an appetite for a faster moving, more volatile pilot fish like Ausdrill, the opportunity to generate capital gains and even some dividends from gold companies may fast be at the door step.

Demand for the safe-haven metal is high, supply is low, and global financial crises abound. Put these all together and you have a perfect storm.

By Joseph Cafariello
Thursday, March 21st, 2013 – Wealth Daily 

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