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POG

By

Chicken Noodle?

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Gold $419 Silver $6.90 - Tuesday 17th May, 7pm Sydney


G'day. Gold and silver stocks continue in their role as the punching bag of the financial markets. The Amex Gold Bugs Index (HUI) has taken another flock of uppercuts recently, from $194 a couple of weeks ago, and currently sits unsteadily above the $165 level, for the time being. A near 20% drop in the equities index on a $15 drop in the underlying metal does not seem rational, IMO. But again, I sound like an old broken record.

I did notice that Prof. Fleckenstein in his latest Rap had a wee peep over his shoulder, way back to mid-2003, before he could compare a few of the bigger guys like Nemont Mining (NEM) and Pan American Silver (PAAS) to current valuations. The metals, gold and silver, sure have a ways to fall to reflect the corresponding price levels of $350ish and $5.75ish. I concur, and these bigger miners haven't been smashed anywhere near quite as badly as some of the "lesser lights", companies who only produce 200-500,000 or so ounces per annum. That doesn't necessarily mean it's all green lights for the metal equities though... just 95% green, in my view (not advice).

Something is way out of kilter and from what I see and hear from the physical markets, the prices of the metals are well supported around current levels. The metals are too high or the equities are quite inexpensive comparatively. My great mate Hong Kong Long said to me today - "Geez Lozza, aren't some of these precious metal shares a bit skinny down here? You'd think the gold price was about $350 or something. I might even have to shift some of my meager dollar-denominated savings into some of those puppies. Which ones?" he enquired. He is the master of understatement and without doubt, one of the most cerebral men I know. When something flashes up on his radar screens, it is time to take some notice. He also suggested that the oil price is still a bargain down below the $50 level. Apparently China, amongst others, is a good buyer down here, and in the forward dates. The oil forward curve is pretty flat (actually it's in contango for some periods, he reminded me) compared to recent memory, say, back to 2001. But then again, my memory isn't so flash these days. It must be the changing weather.

China has a heap of dollars lying around the place in bonds and other U.S. denominated paper assets. Combine this with their massive and increasing oil appetite, well, this is just a tidy little bargain for them. Oh, and don't forget India. There's a lot of cars over there and lots more to come onto their roads, and they're increasingly industrializing, requiring some serious energy resources. All of this, plus way more, happening in the home of the largest buyer of physical gold in the world? Hmmm.

Time will tell whether this is the metal equity "bargain of the year" or a metal price "short of the decade". Sentiment is the key to these miniscule metals markets. Metal equities are seriously "on the nose" at present, and we should remind ourselves that this is not a recent phenomenon. They've stunk for a year or so while metals are less than 10% off their post-Volcker highs. Since 2000, the metal equity sector had a somewhat positive sentiment blowing at its back all the way through to early 2004. The gold price followed suit. In Q1 2004, something changed. Have a look at, say, a chart of the gold price over the last 5 years and overlay it with the HUI or Philly Gold & Silver Index (XAU). Look closely at your monthly gold charts and decide whether the uptrend is still intact. Something's gotta give, either way.

I don't want to get stuck talking about individual equities, as some have enquired, as that is not what this forum is about and I'm not about "public" stock picking. What I will comment on is what characteristics to note in any company that they are taking a look at. I have been asked about some apparently high PE's of some mining companies, especially forward looking PE's. My initial response is - what are next years earnings based off? Assumptions. Whose? What gold prices are assumed. If gold were at say $500 an ounce, what would be the PE then? Unhedged gold companies have some serious optionality inbuilt in them. How people price that optionality is their issue. I say that a gold producer with gold reserves in the ground is a non-maturing call option on gold. What is that worth? Better still, find one who isn't producing but has economic reserves at higher prices. They should be the "ultimate flyer" in my books. Dig away, people.

An increase in assumed realized gold price makes a massive difference to the PE. Mining costs have risen sharply recently(especially non-U.S. based miners like South Africa, Canada and Australia), eroding margin and earnings thus lifting PE's. Will these cost increases continue? I dunno. Can they be hedged? Some of them. But let's say that costs remain stable, yet the gold price rises $50 from the "assumed" price that generates that 25x PE. The PE would be dramatically affected, especially a high cost producer. Earnings from gold sales rise, the number of shares on issue remain constant (one would expect), as does gold production. All of a sudden the PE is lower, sometimes by a lot. Increases in POG (price of gold) flow directly to the bottom line and improve PE's very quickly. One negative issue for the large guys is reserve replenishment. We've spoken about this before, and, with the lack of exploration activity over the past 10 years or so by the big boys, mostly due to an extended period of depressed metal prices, I expect that the big guys will just start buying high-end exploration companies and soon to be producing miners. Opinion only.

We can readily see the leverage that gold producers have to the gold price. It works both ways and at present the equities are being hammered faster than the POG should dictate, IMO, and as discussed above, it appears that many analysts/traders expect a significantly lower POG. I don't. Higher cost producers are significantly more advantageously affected than low cost producers, with a higher POG. The incremental increase in EPS is massive if you are a $400 an ounce producer and gold rises from $425 to $500, than if you're a $100 producer with the same gold price dynamic. If people expect sustained higher gold prices then the higher cost, not the lower cost producers, should give you the bigger bang for your buck. For the gazillionth time - Hedging, reserves, resource convertibility to reserves, management, debt, sovereign risk (political, infrastructure and social), project risk (geological and mechanical), cost of production, exploration potential. .... Not that much to look at really.

Gold has hung in well at the $418 level after just buckling at the $422 mark, late last week. A proxy long dollar position has seen a reasonable amount of short selling, IMO. This will be reversed when the paper players realize the extent of the physical market strength on these dips, no matter what the dollar does. Next level I would worry about would be sub $411 but that will take a lot of physical gold to keep it down for very long. I note the Aussie gold price is higher today with gold at 419 than when it was when gold was $432.

Silver is very solid and again the physical market appears tight. I expect silver to hold above the $6.80 level, it should be $7++ at present, and concern would be below $6.65 (which in today's markets could be a matter of hours away, but very unlikely in my eyes, but we've gotta be aware of the risk.)

Deflation is the buzz word for this month it appears. And so it comes to pass that every real asset cops a pounding, but not the equity markets in general. Let's see what my old favorite - inflation - has to say about everything in the coming few sessions with PPI and CPI hitting the screens. Hedonics and obfuscation cannot continue to hide the inflationary facts for much longer, IMO. And what's the deal with the Caribbean bond purchases? I thought the Caribbean was all just about sun baking, drinking rum, reggae music, bone fishing and cricket? (yeah, yeah, all the tax haven, hedge fund stuff .... whatever). Where were they a while ago when yields were higher? Isn't it magic how timely their appearance, in size, has been?!! Prof. Succo notes that the Chinese and Japanese didn't turn up this month. Very telling, IMO. Guess who's got a gut-full of dollar debt? Norway also pulled the pin.

Winter has arrived here in Sydney. Wet, windy and cold (the temperature only got up to 22C yesterday). It was one of those days where the sofa beckons and chicken soup starts bubbling on the stove. We even played "meals on wheels" for my little brother who was ill yesterday and Lisa's chicken noodle soup was too good to keep to ourselves. A great day for a movie. Today has been positively "Melbournesque". (Melbourne is famous for its "four seasons in a day" weather). One minute you're sitting on the veranda in your sluggo's (Speedo's) catching some rays, and the next you're in your winter robe and Uggies trying to warm up and keep out of the bucketing rain. But I digress.

Gold is looking a little better bid here in Asia, nudging through $420 at the time of sending, but that means nothing these days as all the action appears to happen in the first 20 minutes of Comex, and the last 10- and it's generally been down. It possibly will do so again tonight, so am wary of further weakness but comfy in my knowledge of the physical markets ability to soak up a heap of metal down here and below. My sources also tell me that Copper is being smacked again early in London. China is selling some stockpiles to alleviate some supply tightness in the local market and there appears more to come. Hmm.

Lisa and I watched Pulp Fiction. It's the Princess's favourite movie of all time. She has owned 4 copies of it over the years and can quote just about every bloody line in the movie. She couldn't believe it when I told her I had never seen it in its entirety. I'd either been disturbed by flight attendants, disrupted by kids, fallen asleep at some stage due to these bloody hours we keep down here, or something else. I knew the movie well enough but had always missed something important, usually the same periods of the movie. I'd even forgotten that Bruce Willis was in it! Anyway, I reckon Samuel L Jackson is without peer as an actor, especially those sorts of roles. (Remembering that we don't hear any "ebonics" and all that "gangsta stuff" down here). Anyway, I marveled watching him do his Ezekiel 25-17 spiel before he popped the kids who owed "the man", and again in the diner with the young robber couple. So, for those like me who wouldn't know Ezekiel from Adam, or haven't seen Pulp Fiction..... Here's the text from the movie, not the bible. (Yeah, I know it's not the real Ezekiel 25:17!)

Samuel L Jackson (Jules) - "The path of the righteous man is beset on all sides by the inequities of the selfish and the tyranny of evil men. Blessed is he who, in the name of charity and good will, shepherds the weak through the valley of darkness. For he is truly his brother's keeper and the finder of lost children. And I will strike down upon thee with great vengeance and furious anger those who attempt to poison and destroy my brothers. And you will know my name is the Lord when I lay my vengeance upon thee."

Pretty serious stuff to say to someone before shooting them dead, in cold blood, eh! Being an Irish Catholic, Christian Brother and Jesuit educated son of a trainee Brigidine nun, all that "early" bible stuff wasn't our main gig. We spent most of our time on Chapter 2. Sure we read about those plagues and stuff, and Sister Geraldine back in grade 4 made sure we read a few of the "boys" stories like David and his slingshot, Wotsisname with the funny coloured coat (you know the guy they made that Broadway show about), Samson and his awful hairdresser and that Daniel guy who liked the lions, but this Ezekiel fella was all news to me. He seems a fairly highly-strung chap judging by what he had to say, but it all sounded pretty cool coming from SLJ. Anyhow, I reckon that it is one of the great movie pieces. Then I got to thinking about the gold market and what vengeance it will lay down and on whom.

As I've said before, there are two types of people in the "gold world". The owners of physical metal and associated commodity equities (the true believers in real money and individual wealth preservation / protection) versus the paper money printers, wealth confiscators and re-distributors, fast money short term speculators and perennial short sellers.

Enjoy the day,

Laurie


position in gold, silver, nem, paas, oil

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