The Superlative Impact of SupermajorsJoe Foster, Portfolio Manager and Strategist08 February 2019
Gold breaches $1,300 level amid Fed moves
On 25 January, gold moved above the psychologically important US$1,300 per ounce level on anticipation of an earlier-than-expected end to the Federal Reserve’s (Fed’s) bond portfolio sales. The Fed’s comments suggested that the US central bank is, indeed, in “pause” mode, and that future market and economic conditions will determine whether it would revert back to easier crisis-era policies. As a result, gold advanced to a nine-month high to end January with a US$38.76 (3.0%) gain at US$1,321.21 per ounce. Gold stocks also gained, with the NYSE Arca Gold Miners Index advancing 7.5% and the MVIS Global Junior Gold Miners Index up 9.5%. Mining news was dominated by the Newmont Mining and Goldcorp merger.
Signs of softening growth emerge globally
While the Fed is clearly concerned about the health of the US economy, reports released elsewhere in January also showed mounting concerns over a global economic slowdown. China’s Caixin manufacturing survey experienced its second consecutive month of contraction and the lowest reading since 2016, German industrial production fell 4.7% year-on-year, while France’s annual GDP growth slowed to 1.5%. The OECD’s Composite Leading Indicator suggests that 2019 global growth is losing momentum. On 28 January, the ECB indicated that it is ready to use all its policy tools to support Europe’s softening economy.
Central bank purchasing of gold picked up in 2018
While the US dollar index fell slightly in January, it has not relinquished its 2018 gains due to the growing economic weakness outside the US. Accordingly, the gold price advanced across most local currencies and the US dollar. This is historically safe haven behaviour when investors sense increasing financial risks globally.
The World Gold Council reported that central banks purchased 651 tonnes of gold in 2018, the second highest total on record. Central banks have been net purchasers of gold since 2010 as more countries are finding a need to diversify their paper currency reserves. While China was a consistent buyer earlier in the decade, it has not reported any purchases for nearly two years. But in December, Beijing reported an increase in gold reserves of approximately 10 tonnes. It remains to be seen if this signifies a resumption of regular Chinese buying.
Gold eyes $1,365 price ceiling in 2019
Central banks are running out of time to normalise policies amid preparations to stimulate economies through the next recession. The Fed funds rate appears to have peaked at just over 2% while the balance sheet seems to be bottoming at US$4 trillion. Meanwhile, the ECB can’t get its policy rate above negative 0.4% after purchasing US$3 trillion worth of bonds. What will the financial system look like when the Fed funds rate falls to zero (or less), fiscal deficits exceed US$2 trillion annually, and the Fed bond hoard tops US$10 trillion? We may find out in 2020.
The recent shift in Fed policy was the catalyst that moved gold through its first significant price hurdle of US$1,300 per ounce. It seems likely that gold could now test the more formidable US$1,365 level, which has acted as a price ceiling for the past five years. If further fundamental risks develop around Brexit, the economy, or the stock market, then gold and gold stocks may finally move into a higher price range.
Newmont-Goldcorp joins supermajor class amid focus on profitability
The structure of the gold industry has changed with the announcement of a second blockbuster merger in January. The first was the Barrick-Randgold combination announced last September. Not to be outdone by Barrick, Newmont announced plans to acquire its peer Goldcorp in an all-stock deal valued at US$10 billion to create the world’s largest gold company. Like Barrick, Newmont intends to sell non-core mines to focus on a smaller portfolio of larger, higher quality properties. However, the enlarged Newmont will have 21 mines (Barrick has 13), so integrating both companies will be a challenge.
Goldcorp’s current management was a disappointment. Since taking charge of the company three years ago, they have missed earnings expectations half of the time. As a result, Newmont is acquiring an excellent suite of assets at a discount and Goldcorp shareholders will get the quality management they have long been waiting for.
There are several implications this transaction will have on the industry that we find interesting:
- These mergers create an exclusive class of majors that no other company or combination of companies will be able to replicate. Supermajors Barrick and Newmont will produce between five million and eight million ounces per year. Majors Anglogold, Kinross, Goldfields, Newcrest, and Agnico Eagle have production targets ranging between two million and four million ounces per year. The supermajors will have unmatched economies of scale and the liquidity to attract the largest institutional investors.
- Today’s companies have a streamlined management structure, proper incentives, and the experience of past mistakes to drive value creation. Nonetheless, execution will be challenging for these two behemoths.
- In the gold industry, bigger isn’t necessarily better. History has shown that acquisitions often don’t pay off, and having too many mines becomes difficult for a single company to manage. A number of mid-tier CEOs have commented that six to eight mines are optimal.
- Past cycles saw majors merge to get bigger. This cycle they are merging to become more profitable. The managements of Newmont and Randgold believe they can instill proven management structure, efficiencies, and technology in their new companies. They are also looking to divest unprofitable mines. If successful, they will be smaller (though still supermajors), more profitable companies in a couple of years.
- There are roughly ten mines between the two supermajors with values ranging between US$100 million and US$1 billion that are now up for sale. The potential buyers are the majors and mid-tiers. We know many examples of aging mines that were neglected or undercapitalised, but later became successful core properties after being sold to a smaller company. We hope to see more win-win transactions that bring a source of growth and value creation to the majors and mid-tiers.
Through the low gold prices of the past six years, we have seen financial, operating, and capital discipline that we believe is here to stay. Corporate structures are flatter and more responsive. We expect the supermajors to create value and set new standards for the industry.
All returns are in US dollars
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