HSBC Analyst Victor Flores on Gold
Source: The Gold Report (5/23/07)
The Gold Report recently caught up with analyst Victor Flores of HSBC Global Research in New York. In January, Victor and his research team produced the 17th edition of The Senior Gold Book: Bridging the Gap.Victor shares his thoughts on how the sector is faring as we approach mid-year, and what factors are affecting gold companies' performance.
TGR: Last May the gold market went wild. The price shot up, then dropped back down. We've seen volatility this May as well. Why do you think that's happening?
FLORES: The markets tend to slow down as we head into summer, so that was part of what happened last May. The other thing that happened is that we had a big run on gold commodities just before we hit the summer slowdown. We reached the point, as the gold price moved above $700, where jewelry demand was affected, and where scrappers were starting to recover pretty quickly. I wouldn’t be surprised to see some resistance this year as we get closer to $700, and I wouldn’t be surprised to see jewelry demand soften somewhat. I also wouldn’t be surprised to see scrap coming back into the market. The big difference between this year and last year is that last year, we were still in the middle of what I would call a rather a broad-based commodity boom.
TGR: Can you expand on that?
FLORES: Go back and look at the charts last year. Copper, zinc, platinum, gold – they were all moving pretty much in tandem. However, since then, we’ve seen that each of the metals has more or less broken rank. They’ve started to follow their own supply and demand fundamentals much more closely. That would explain why gold is making a move in response to a weaker dollar, rather than just following copper on its way up, as it did last year.
TGR: You talk about gold as a quasi-currency. Why is that?
FLORES: Gold has historically been seen as an alternate type of currency. And although it doesn’t necessarily back the dollar or back the Euro or back any other major currency, I still think it has somewhat of a monetary value. There are central bank holdings in the metal. You know, people have said over the years that gold is the one form of value that you can transport and use to buy goods and services anywhere in the world. I don’t think gold plays that sort of “doomsday role” anymore. I think we’ve moved beyond that, to a point where institutions and individuals realize they can invest in the GLD exchange-traded fund (NYSE:GLD) as an alternative to the dollar. If I think the dollar’s going to go down, I can buy gold in the physical form, or buy shares of GLD.
TGR: Can you discuss the discrepancy between how the equities are performing relative to the commodity? In January you said, “We expect this general disenchantment with the equities relative to the commodity to continue in 07.” What kinds of pressures are affecting the equities’ performance?
FLORES: The performance of the gold price relative to the equities, for the first quarter of the year, and for the year-to-date period, validates that statement. So far we’ve been correct in saying that investors are disenchanted with the equities relative to the commodity. In the first quarter, the gold price was up about 4 percent, and the stocks were down about 4 percent. There’s still this big discrepancy between the way the shares are performing and the way the gold price is performing. And moreover, remember, historically people have talked about the leverage in the equities relative to the commodity. They’ve talked about two- and three-times outperformance of the equities relative to the commodity. This implies that if the gold price is up 7% or 8%, the equities already this year should have been up somewhere between 20% and 30%, when in fact, they’re barely up at all. So, what is driving that? In a nutshell, the companies are not generating the types of earnings, cash flows, and returns that the market would have anticipated, given the rise in the gold price. And that lack of financial performance is reflected in the share price.
TGR: These companies are under real cost pressures, aren’t they?
FLORES: Absolutely. The reality is that when the gold price started to move, we all thought, o.k., here come the returns associated with that move. We didn’t anticipate the costs would rise to the extent that they have. In a sense gold has become the victim of the very successful commodity cycle that we’ve had. On the one hand, revenues are up because gold prices are up, but costs are under pressure. Therefore, margins have not expanded. Oil had a big move, and that’s a big factor in gold production. In fact, anything energy related, whether it’s diesel fuel or electricity that runs processing plants, is up. Steel is up, which means that anything that you build or any new piece of equipment is going to cost more. Copper is up, so tubing and piping cost more. Nickel, which has made its way into the price of the stainless steel that is quite commonly used in processing facilities, is up. So the success of the commodity rally unfortunately has come at a price for the gold companies and it has impacted their performance.
TGR: Is the lack of expected financial performance truly driven just by increase in costs? Or have gold companies entered into long-term contracts that have negatively affected their revenues?
FLORES: That’s a good question, and the answer is no, not really. There haven’t been any major contractual agreements. Companies pay the spot price for fuel, they pay the spot price for electricity, and for things like mining contracts if a company doesn’t have its own fleets. Yes, there have been some long-term contracts, but in fact, what we’ve seen is that those contracts were under-priced. Now that they’re coming due, they’re being negotiated at higher rates. Hopefully at some point, the gold price will continue to perform well, but energy prices will come down, or maybe copper softens, or steel prices start to soften, and we’ll have the reverse of what we have had recently. But so far, we haven’t seen that.
TGR: Let’s talk a little about industry consolidation – the “urge to merge” as you call it in the book. Can you comment on this trend toward growth through acquisition?
FLORES: This industry has grown through consolidation for the past almost 20 years, so this is really not a new phenomenon. However, we’ve now reached the stage where the biggest companies are quite large relative to what they would have been 15 or 20 years ago. And therefore, when one of the big players tries to take out another, the deal tends to be bigger. More importantly, though, in my view, the nature of the consolidation has changed. I think the larger companies, for the most part, are not going to buy out their peers or mid-tier companies. I think they’re seeking asset-specific transactions that allow them to get their hands on an asset that they think will make a difference to their business. They’re no longer going to take on a whole package of assets, some of which don’t really fit their business, just to get the one they want.
That’s one way in which the consolidation has changed. The other is that the mid-tier companies, which were once able to grow organically, now find themselves in the position that the seniors were in 10 years ago. For instance, 10 to 15 years ago the largest companies in the industry produced maybe a million ounces. They found it was hard to grow from a million ounces to two million, so they started buying each other out. Today’s mid-tier companies are producing a million ounces apiece, or are trying to get to a million ounces, and they’re now facing the same pressures the senior companies faced 10 years ago. So they need to consolidate, and they’re starting to look at each other, or look down the food chain a bit.
TGR: Do the larger companies go specifically to the mid-tiers to find that asset selection?
FLORES: No, I think they will go lower, because the mid-tier companies today aren’t really single-asset companies. They own a number of assets. And as I said, I don’t think the large companies want portfolios that have a lot of assets, and they’re not willing to buy a packet of assets just to get one company or to get one specific project. They are more likely to target a junior that has one project that looks appealing for one reason or another. I think it’s more likely that the mid-tiers will sort of gobble each other up.
TGR: Is the mid-tier growth inhibited by capital, meaning they don’t generate enough cash to have enough capital to invest? Or is the mid-tier inhibited by the sheer number of projects?
FLORES: I don’t think capital is a limiting factor at all. There’s plenty of capital available. Just look around at the industry and its ability to raise money, whether through equity, debt, or both. The limiting factor, I think, is assets. Companies ask themselves, how can they generate the most returns? Through exploration? Or by buying the projects on the open market? Historically, the returns from exploration are much greater than they are from acquisition. So, why aren’t these companies exploring more instead of buying each other out? The reason is, that exploration generates greater returns, but only if your exploration efforts are successful. Exploration takes time and money, and it’s not easy to find these projects. Finding these quality assets – that’s the limiting factor.
TGR: Thanks very much – we appreciate your insights.