Gold Stocks 2006

Scott Wright     December 30, 2005     2827 Words


As 2005 comes to a close, the bull market in gold is galloping forward into the new year with unrelenting strength.  Within the last month gold broke $500 for the first time in 18 years and has peaked a 24-year nominal high.  There is no denying we are in the midst of a major secular bull market in the Ancient Metal of Kings.  Even with this impressive gold bull, word is just starting to spread to the everyday investor.


With gold shattering multi-decade highs, the financial media has been forced by virtue to cover this gold extravaganza exposing it to the investing public.  Unfortunately many mainstream analysts attribute gold’s recent run as a hedge on building inflation fears and tend to exude a bearish outlook on its future sustainability.


But under the surface of this bull market lays a rock-solid foundation and stock investors and speculators should still have ample opportunity to capture legendary gains going forward.  Inflation fears tend to be a popular attribute but gold’s run lies on core economic fundamentals that mold the base of its foundation.


In addition to its timeless fundamentals, at Zeal we have long discussed gold’s three bull-market stages.  Each stage has historically produced increasingly better gains and it appears as though we are only just in the beginning part of the second stage!  In the first stage gold has risen on good part due to the weakness of the US dollar, masking it as a US-only gold rally.  Nevertheless a huge rally it has been with awesome results for stock investors and speculators who were positioned in companies that mine and explore for this precious metal.


At Zeal we’ve been recommending these stocks to our newsletter subscribers since the very beginning of this gold bull and have been blessed with tremendous gains.  Many of the stocks we have recommended in the past and will recommend in the future happen to comprise the venerable HUI gold-stock index.  The HUI consists of 15 of some of the best publicly traded gold miners in the world and is up 653% since the beginning of this bull market!


This is just an incredible gain and has obviously been one of the best performing stock market indexes in recent years.  But one may wonder with such astonishing gains if it is too late for investors to get a piece of the action.  We think not, in fact, we believe there is still a long way to go before this gold bull has run its course and that the best is yet to come.


Much to the delight of gold bulls everywhere, earlier this year gold appeared to decouple from its Stage One trend of having an inverse relationship with the dollar.  In these last few years the devaluation of the dollar, long considered the world’s reserve currency, was a useful and fairly accurate trading tool for the flowing and ebbing of gold in its upward trend.  It appears now as though gold has divorced from its dollar relationship and is on its own two feet courting the world financial markets.


In the last six months gold has risen in all major global currencies simultaneously and has appeared to move into Stage Two of its bull market.  In Stage Two gold prices are expected to rise based on a sharp increase in global investment demand and break away from the dominant global currency.  Stage Two gains should also vastly exceed Stage One’s as investors around the world pour more capital into not only physical gold, but the investment vehicles that are involved in the physical storage and extraction of it.


So as capital pours into gold upon this renewed global lust for the yellow metal, there will be many opportunities for investors and speculators.  Gold stocks have been and will continue to be the market darlings of this bull run.  Gold itself is up 108% bull to date but gold stocks measured by the HUI, which is considered the premier gold-stock index and serves as our best proxy for the timing of trades, are up over 600% on average.


Even though the HUI has risen so fast in just four short years it has still not garnered much attention from the greater investment community.  Interestingly, the total market capitalization of all 15 companies in the HUI, combined, is less than 25% of Microsoft alone.  Needless to say, gold stocks have thus far been trading among a small group of investors and have not yet begun to get global and institutional attention.


When this does happen the capital flooding in to buy these shares should drive up gold stocks to levels never seen before and score legendary gains for those that are well positioned before the releasing of the flood gates.  Once again the HUI is our flagship barometer for trading gold stocks.  Not only is it important as an elite gold stock index, but its usefulness in timing and formulating many of our gold stock technical trading signals is priceless.  Because of this it is worth a closer look at the fundamentals of the HUI’s components so we may see how they truly reflect on the global gold industry.


One reason we like the HUI as opposed to other gold-stock indexes is demonstrated above by the way its gains outpace those of its underlying commodity, known as leverage.  The gold miners that comprise this index are able to achieve a positive leverage to rising gold by keeping their hedge books at a minimum.  The mining companies in the HUI are bullish on the price of gold and want maximum exposure to what they can sell it for on the open market, thus directly increasing their profits.


There are many other fundamental reasons why the HUI represents a valid leading indicator for gold-stock investing.  As mentioned, the HUI is comprised of some of the biggest and best global gold miners.  And in order to truly examine the HUI and pin its individual components up against the global gold market, I find it best to dig from within.  I pulled the financial statements from the last ten years for each of the 15 HUI components in order to gather key aggregate data that will help us with our examination.


First we find that in 2004 combined HUI gold production totaled nearly 21 million ounces.  According to the United States Geological Survey (USGS), global gold mine production in 2004 totaled 79 million ounces.  This places the HUI, with a combined market capitalization of only $67 billion, as providing the world with over one-quarter of its mined gold supply.  This alone showcases the global strength of the HUI and should be case enough for its continued surge.


And just like any precious metal or energy commodity, gold as a resource is finite.  This finite resource is slowly being depleted in order to maintain its growing demand.  For various reasons it is becoming increasingly difficult to discover and develop gold deposits which has led to today’s economic imbalance.  In order for miners to produce gold and help supply keep up with demand, there is constant pressure to continually renew their reserve base.


Gold reserves are defined as economically mineable minerals that exist in operational, developed or advanced exploration projects and are frequently calculated by each miner.  Reserves are revealed through the results of extensive feasibility studies conducted by geologists and engineers based on samples from the area in question.  A mining company’s reserves are the lifeblood of its organization.


If a miner is pumping out 250 thousand ounces of gold per year but only has 1 million ounces in reserve, investors are going to steer away from them.  Unless they acquire or discover new reserves, this miner would be out of gold in three to four years.  This shows the importance of sustainability as analysts and investors consider two key pieces of information when looking at a mining company.  First is how much does it cost to extract each ounce of gold from the ground?  And second, based on their reserves, is how long is their mining life?


Reserves indeed indicate the sustainability of a miner’s business.  One of the most important business objectives of any mining and even energy drilling company is reserve renewal.  Investors need to have some comfort outside of volatile commodities prices as to the life expectancy and sustainability of the miner in which they are going to invest.


Our first chart presents combined mine production and reserves over the last five years for the HUI components.  As you can see both gold production and reserves have been on the rise in unison with the gold bull market.  HUI components have amazingly increased their reserves by 46% since 2000.  At the same time production has increased by 36%.  These are very sizeable and healthy increases which would seem indicative to a bull market in their product.



A rule of thumb for healthy gold producing companies is to maintain at least ten years of reserves in the pipeline.  As you can see above, HUI gold miners have averaged and sustained about 15 years of reserves in the last five years at their given production rates.  Global sustainability according to reserve and production data provided by the USGS is projected at just about 17 years.  So the HUI components appear to be healthy compared to the global conglomerate.


With HUI production rising each year and mine life maintaining and even increasing, it shows successful reserve renewal.  Now there are several different methods for gold miners to renew their reserves.  One common way is organically through internally upgrading measured and indicated resources.  This happens on those projects the miner is already involved in via reclassifying existing resources to an economically recoverable status or discovering a new deposit on existing properties.


Rising gold prices play a large factor in this organic renewal of reserves.  As previously mentioned, reserves only count as reserves if they are economically recoverable.  Three years ago it was not economical to recover gold if the expenses were greater than about $350 per ounce.  Therefore any gold deposits that had estimated production costs in excess of this amount were not deemed economically recoverable and hence were not classified as reserves.  Today gold that costs $400 or even $450 an ounce to recover is now economically recoverable, thus increasing reserves.


Another way for a company to increase its reserves is through acquisitions.  Just like in any industry, gold companies have an affinity for M&As.  One thing that seems to set the gold industry apart from others though is its perceived necessity for such.  Investors that buy gold stocks usually consider mining life.  If a gold miner is depleting its reserves faster than it is renewing them, it would throw up a red flag and likely turn away investor interest.


If a miner cannot grow organically and just does not have the physical land and resources to increase its reserves, it feels pressure to either purchase someone else’s reserves or to acquire, merge or be acquired by someone else.  Many HUI components have taken these various routes in order to stay attractive to investors and to sustain the longevity of their businesses.


Reserves for HUI components have been growing rapidly as they aggressively position themselves in this gold bull market.  Our next chart displays how global reserves have fared in the last five years.  As you can see, global reserves have been on a noticeable downtrend over the years while the HUI components have consistently taken on an increasing load.



According to the USGS there were about 42,000 tons of gold reserves in the world at the end of 2004, which equates to just over 1.3 billion ounces.  Of those reserves HUI components stake claim to over 26% of them.  Because of the aggressive reserve renewal practices of the gold miners that comprise the HUI, they have increased their portion of global reserves by 63% since the beginning of 2000.


Gold miners, especially those of the publicly traded type, are no fools.  There is no love lost in the volatility of the commodities markets.  When commodities prices are down, specifically gold, miners are forced to cut expenses, slash exploration budgets and cease production at non-profitable mines.  When the commodities markets are hot, it behooves them to ramp up production and accumulate as many reserves and resources as they can in order to take advantage of the bull.  HUI miners have certainly embraced this ideology.


Ramping up production and increasing reserves is not that easy though.  One reason why long-term market cycles, especially commodity market cycles, tend to flow and ebb in greater than ten-year increments is to allow for the time it takes for economic imbalances to correct themselves.  It takes a great deal of time and money to construct a mine, and when demand is rising without supply being able to keep up, only rising prices through an extended period of time are going to bring those forces together.


Even though gold demand has sustained and should increase in the years to come, mined production is having trouble keeping pace.  In 2004 global gold production was at its lowest level since 1997.  And industry experts expect gold production to drastically decrease in the next several years.  Mark Wellesley-Wood, the CEO of major gold miner DRDGOLD recently wrote a commentary with several intriguing insights.


Mr. Wellesley-Wood said, “Despite average annual increases in the price of gold … gold production is set to decline dramatically over the next four years, and the effect could be irreversible.  There are 29 new gold mines in the pipeline right now and even if all these are developed, it would require a further seven projects every year to make up the deficit.”  Mr. Wellesley-Wood believes not all these gold mines will come into fruition due to cost problems and his concern is apparent when he exclaims, “… where are the ounces going to come from?”


Well as the chart below shows, an increasing amount of these ounces are going to be coming from the HUI component gold miners.  In 2004 HUI components produced 26% of the global mined gold supply and they should continue to lessen the spread as time goes on.



As Mr. Wellesley-Wood points out, global gold production is indeed on the decline.  In 2004 there was 5% less gold produced than in 2000.  This shows that gold production volume simply cannot increase with the flip of a switch because prices are on the rise.


Many industry experts believe production will fall due to the lack of exploration in the last decade.  Existing mines are running out of easy gold and watching volumes decrease and expenses rise while new mines are absorbing massive amounts of capital and time to get to production.  Because of the lack of exploration in the 1990s, new discoveries were few and far between and now miners are scrambling to either make these new discoveries or consolidate with those companies that possess them.


This is just one of many fundamental reasons why the price of gold should continue to rise in the coming years.  And with global gold production expected to continue its decline, cascading further from its 5% decrease since 2000, and with HUI production increasing by 36% in this same period of time, its components represent an excellent start for stock investors and speculators looking to take part in this gold bull market.  As the charts above have shown, the HUI is poised to capture the interest and investment capital of an international audience.


Gold is one cog in the wheel of a massive commodities bull market and should have many years left in its run.  2006 ought to be a great year for gold stock investing as the price of gold continues to rise.  The HUI indeed represents 15 of the biggest and best gold miners, but there are hundreds of other gold and precious-metals companies of all sizes that are jockeying for investor funds.


At Zeal we have been recommending gold stocks to our newsletter clients since gold was trading under $300 and the HUI was below 50.  Our research team monitors hundreds of gold and precious-metals stocks of all sizes ranging from junior level explorers to major producers.  We recently added over 20 of these stocks to our Watch List for subscribers and are monitoring technical trends to help us determine optimal times to deploy our capital.


Please subscribe today and join us as we continue to provide cutting-edge analysis and research on the commodities bull market.  Our acclaimed monthly newsletter Zeal Intelligence and our active speculator service Zeal Speculator provide our subscribers with an in-depth look into today’s and tomorrow’s markets.


The bottom line is gold stocks are poised for an excellent year in 2006 led by the venerable HUI gold-stock index.  Current market trends mixed with the long-term economic imbalance in gold have provided miners and explorers with the opportunity to shine as the market darlings of the years to come.


Scott Wright     December 30, 2005     Subscribe