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Gold: Gaming the System

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Despite the $340 million settlement by Standard Chartered or MF Global's disappearance of $1 billion of customer funds that were somehow co-mingled with MF's proprietary position, economic interests have blurred the lines between the regulators and the regulated. Regulators are focusing on the big banks again as they attempt to investigate the manipulation of LIBOR, the leading benchmark that underpins at least $350 trillion of securities. Already Barclays PLC has paid a hefty fine and removed its top management, in a scandal that might involve the Bank of England. That the central bank and its surrogate bankers are so intertwined is a reflection of the crony capitalism that has become all too common in the West. Needed are structural reforms but as we have seen in America, the Dodd-Frank creation aimed at overhauling the finance system, morphed into 1,319 pages and its proposals have yet to be enacted four years later. And tellingly, no investment bank or banker was arrested or charged after the crash.

Markets have been struggling with high frequency trading (HFT) as computers have taken over. Computer or algorithmic related trading makes up more than 50 percent of the market volume and trading is aimed at more gaming than adding liquidity. We believe that high frequency trading puts the client last as institutions try to game the system taking advantage of clients' Maison orders. At one time, markets were held to the test that clients came first! Exchanges are reluctant to shut down these systems because of the business from the trading volume. However the $400 million loss by Knight Capital shows that even in the United States there is no control over these algo traders. Tellingly, it took one week for Knight Capital to discover the software problem. There is no question automated trading has brought gains in price efficiencies and liquidity, but the exchanges have become too fragile and too big to fail. Regulators do not have the financial arsenal to keep up with today's software. So what to do? First there should be a delaying mechanism and software must undergo testing and at a minimum the same regulatory scrutiny that personnel and sales personnel must undergo at least once a year. Add in rules requiring them to hold more capital.

The unfolding LIBOR saga while not a surprise to us certainly was a surprise to the Street. The big banks rigged for their own benefit the LIBOR rate that determines the pricing of trillions of dollars of financial securities which the banks charge each other and their clients for the various financial products. Unfortunately, this is just the tip of iceberg and exposes the glaring flaws of not only the banking system but the "me first" culture applied to their products as well. Largely unregulated, like derivatives, LIBOR has functioned for over forty years but the disclosure that the banks were gaming the rate is just another reflection of how banks game the system for their own benefit.

Who Can You Trust?

In the past we have found a symbiotic relationship between central banks and government. Indeed, with its bond buying, the Fed and soon the ECB has supplanted the private sector as a price setter. Lately this relationship has benefited government at the expense of the private sector. President Reagan established a working group known as the "plunge protection team" (PPT) which consisted of members of the Treasury, Federal Reserve, SEC, and others whose purpose was to intervene in the markets at the appropriate moments to prevent significant volatility. This "plunge protection team" is believed to have used the banks to purchase stock index futures in the crash of 2008. The idea was to give the public, confidence but in fact reflected the government's cynical view that markets can be manipulated for their own benefit. And, we go further back to 1985 when the Plaza Accord between the governments of the United States, Germany, France, and Japan agreed to devalue the US dollar in relation to the Japanese yen and German mark in order to give a boost to US exports. The US dollar fell by more 50 percent in two years. Japan never recovered from that serious recession. Gold took off during that period. The devaluation was so successful, that two years later the same group convened another meeting in order to stabilize the dollar from sinking further.

This Accord was also the beginning of the great debt bubble. America has grown wealthier, however financed by debt. In mid-1985, US households owed about $2.2 trillion in credit. Today consumer credit debt tops $12 trillion or a 445 percent increase. What had happened at the Plaza Hotel and other times shows that governments including central banks and their surrogate banks regularly act in their own best interests. Central banks were supposed to be the lenders of last resort and independent, but today they have become creators of money rather than stewards and rather than lenders of last resort, they have become lenders of first resort. Rather than independent, central banks have become another arm of the government. By ratcheting rates to near zero, the central banks lend money to prop up their failing banks so they in turn could buy government obligations. Bailouts have gone to the banks, so those banks can use leverage to buy more of the sovereign debts of their respective governments, secured of course by equally dubious collateral. Central banks have run out of road and their efforts to stimulate the economy have set the stage for rapidly rising consumer prices. The burden of fixing our economies has fallen to the politicians, and this time the legislators are also running out of time.

Prepare for the EU Breakdown

And so in Keynesian fashion, governments are looking for opportunities to increase total demand to get the private sector to spend. In doing so, debt increased. America's total government spending is now at 40 percent of GDP, the highest level since World War II. But it's an illusion. More government spending financed with too much debt has not helped. The resulting debt load has become bigger and more difficult to finance. The eurozone problems of the "too big to fail" institutions and the gargantuan creation of contingent liabilities have been exacerbated by the huge debt problems of Greece, Spain and other eurozone members who assumed the private sector obligations on an ever expanding scale. Moral discipline or moral hazard went out the window as governments and their central banks took on the obligations and printed enough money to pay for those obligations bailing out their banks from the consequences of their own mistakes which of course led to ever more speculative behaviour with diminishing returns. Liquidity problems quickly became solvency problems.

Financial markets have zigzagged with every eurozone bailout proposal bringing hopes for a solution. But now the European Central Bank itself has become irrelevant with a proposal to give the European Stability Mechanism, the permanent bailout fund, equivalent banking powers to obtain unlimited new and improved credit securities, backed of course by the debt-ridden sovereign securities. The proposal is similar to what was tried in America in the early eighties during the savings and loans crisis when a good bank and a bad bank was set up. This time who is to be the bad bank? The ECB? And atypical of the eurozone crises, not only are there divisions among countries, there are divisions amongst the banks with the Bundesbank saying nein, nein, nein, to any proposal. Debt still must be dealt with and no one including the Bundesbank has enough capital to handle the breakdown of the EU.

Reality Sets In

The Chinese have put on hold projects and spending until the new round of leaders are elected in the Fall. And, in the United States, President Obama has also put everything on hold until after the US elections. The vacuum has been filled by investors' misplaced optimism that since nothing has happened, all must be well. Both elections will be over in the Fall and then worries such as the "fiscal cliff" or Greece's debt woes or China's growth path will resurface. Investors too appear to be impatient, losing confidence in the ability of debtor nations or central banks to work their way out of debt. Increasingly higher borrowing costs are the new norm. In Europe, currency union was to be the solution but debt must eventually be dealt with, either by defaulting (see Russia) or more likely inflation (see seventies). America remains a time bomb.

Its public debt at almost $16 trillion is the world's largest, making it too big to bailout. Debt won't navigate the United States out of the crisis any more than it has helped Europe or Argentina.

America faces a debt crisis caused by deficit spending as it pushed to give the consumer everything and the reliance on consumer spending and housing of course, peaked in 2008 when household debt represented some 130 percent of income. The inevitable bust almost sank America's financial system, necessitating almost $4 trillion of taxpayer money to bailout into its banks, car companies and of course the mortgage companies. Government spending still grew. Today, America is still recovering from this housing bust that has left housing prices half of what they were from their highs. Yet, consumer debt is still 140 percent of income, and despite the upcoming election, neither candidate has addressed the approaching "fiscal cliff", a combination of tax increases and spending cuts. There is no question of the urgent need to reform, particularly monetary reform.

Supercycle Still Alive

Meanwhile the threat of a new global food crisis and higher inflation is the new worry in the wake of the worst US drought in half a century which has caused higher prices for agriculture commodities like corn and soyabean prices, surpassing the 2007 food crisis levels when food riots erupted in thirty countries. The impact of a food shortfall cannot be solved by bailouts. High prices will create geopolitical tension. Russia is hinting at limiting exports. Price increases are causing changes as farmers slaughter livestock and switch crops - moves that will shape industry and inflation for years. The US is the world's largest exporter, supplying half of the world's exports of corn and much is consumed by livestock. This time, however 40 percent of the corn crop is used to produce heavily subsidized biofuel and the devastation of the crop raises the value of corn as both food or fuel. The US has 47 million people on food stamps so the choice is important. Inflation? Economists say no, but cost-push inflation and the excess global liquidity created by our central banks has laid the foundation for higher inflation ahead. The slowdown in the price of so many commodities from oil to metals, to agriculture is temporary as China will resume its uptrend with the appointment of a new set of leaders for the next decade. However China's strategic moves to acquire international resources using the capital markets is a sign of sophistication and mastery. CNOCCs bid for Canada's Nexen or China National Gold's interest in African Barrick is not only a usage of their huge cash reserves but underscores their growing appetite for global commodities producers, especially gold.

Gold As A Default Currency

The link to gold was ended when the Bretton Woods' system of fixed exchange rates was scrapped by the big governments of the United States, Germany and Britain. Rather than linking to gold, currencies were allowed to float backed by the "faith and confidence" in their respective governments. A debt explosion ensued as more and more credit was created. Fiat currencies allowed the central banks to finance wars, deficits, housing booms, various bailouts and today there is hope that it will fix Europe's problems. In 1964 total credit was $2 trillion and by 2007 it surpassed $50 trillion. Today there are some $600 trillion of credit derivatives swamping the world's entire GDP by 10 times. Credit morphed into derivatives like asset backed securities, credit derivatives, swaps, synthetic collateral debt obligations etc., becoming the fuel of the shadow banking system which is nothing more than Wall Street IOUs. Where did this credit go? Asset prices for oil, commodities and real estate have increased. Dollars have gone into emerging markets that produced both real estate and inflation spikes. Importantly, it allowed governments to get bigger.

The age of fiat money was the creation of modern central banks, and forty years later Investor confidence has been lost in the credibility of the central banks to become stewards of our money. It is this continued lack of trust and investor confidence that policymakers need to tackle. Time and again, banks have failed with the result that everyone is trying to game the system while blaming the market. But the system is flawed, fiat currencies are not money.

Trust in the current monetary system and its institutions, assets and markets are at an all-time low, so that gold's store of value qualities have become highly prized. Central banks are buying gold as a hedge against the falling dollar and favour it as a safer investment than sovereign debt of their peers. Central banks own one sixth of all gold ever mined and are the largest holders of gold. After a twenty year period of selling, central banks bought the most gold since the collapse of 1971 of the Bretton Woods which created fiat currencies and the problems today. It has become the default currency. South Korea has recently added 60 tonnes of gold to its reserves. Gold ETFs have also become popular offering investors liquidity and zero counterparty risk. Moreover, gold cannot be manipulated nor devalued by governments. We believe a big part of the solution is the creation of a new monetary standard. In our last research report, we wrote about the remonetisation of gold as a solution to the debt problem. After all, for thousands of years, gold has been money.

Or how about devaluation whose history shows that it can be a short term palliative by governments? In 2002, Argentina devalued the peso by floating against the dollar, and while there was surge in consumer spending, there was also a surge in Argentina's foreign debt ratio which went from 60 percent to 183 percent. Debt remained unchanged but the main cost was debt as a percentage of GDP obviously increased, as Argentina soon found its debt load was unsustainable and a prelude to IMF loans. Prepare for the breakdown of the EU.


Gold Exchange Traded Funds (ETFs) have greatly influenced supply and demand with 2,400 tonnes held by global ETFs. Hedge fund manager Paulson took advantage of the price weakness, doubling his holding. ETFs provide liquidity, tax advantages and correlate closely to bullion moves and like bullion, have outperformed gold stocks. The second largest source of new supply is the gold industry with some 22,000 tonnes in the ground.

Amid all this, gold stocks have fallen out of bed. The underperformance continued in the latest quarter and despite the gold price over $1600 an ounce, gold companies remain in a funk. Even the intermediate group of producers were hurt. Eldorado reported a down quarter. Centerra reported continuing problems in Kyrgystan and of course Kinross' second shoe dropped. Yet the intermediates are the ones able to show growth, not through acquisitions, but actual organic growth due to bringing mines on-stream. New players, Osisko and Detour have not yet captured the Street's imagination but not only are they takeover targets there is still room on the upside.

So what is the problem? Part of the problem, is that in the quest for growth, mining companies have brought on marginal projects with the expectation that the higher gold price would keep the projects onside. The key however was execution. The mining industry is run by investment bankers, lawyers and accountants who depend upon their CCO's for execution. While some are talented, the problem is that there is a dearth of experienced senior mining talent. There is no question that there are a lot geologists, skilled engineers and bright accountants, but the fact that the cost overruns, poorly designed mine plans and insufficient drilling resulted in disappointing multi-billion dollar losses, underlines the skill shortage. In addition in the past ten years, new discoveries have been the mostly easier, near surface deposits and the open pits are now reaching their maximum depth. Trucking and rock competency issues has called for the need for mining engineers. The majority of the mining companies have just been lousy investments because they have lousy investments. Costs have increased and rather than the $600 an ounce cost average, it appears that many miners' actual cost is in excess of a $1,000 an ounce. Further, the lack of discoveries has dented market enthusiasm.

Peak Gold

As a result, the spending spree in Canada's gold mining industry is slowing. Many of the gold miners' mega-projects are over budget and to date two CEO's have been replaced. Early this quarter, the gold miners' costs have significantly increased which was responsible for the dismal performance of their shares. The reality is that we have reached peak gold. The major players are on a treadmill and growing their production has proved to be prohibitively expensive while takeovers have not been accretive. To be sure the industry has not discovered sufficient deposits to replace its production. Gold then must go higher and we continue to look for $3,000 gold.

Increasingly, governments have sought to pluck the golden goose of mining from nationalization to outright confiscation from countries such as Zimbabwe, Indonesia and Bolivia. Taxes have increased in Australian and Mongolia. Once mining friendly Peru has Newmont's $5 billion Conga project stuck in a political stalemate. High grade silver producer Excellon has been caught between a fight among the Mexican unions and a blockade by the unions has resulted in a stoppage in production.

Peak gold like peak oil has become a reality. However, the gold industry has not become like its commodity, rare, Gold companies continue to issue paper for acquisitions, believing their shares are highly valued currency. How wrong. Goldcorp has made 10 acquisitions of which all were for shares. While Goldcorp's portfolio grew so did the price tags. Kinross made four takeovers, including Red Back and what have they to show for this? Still, we expect CEOs to continue to chase the holy grail and cheap prices will ensure another round of M&A activity, particularly among the mid-tier sector.

Consequently gold stocks are cheap. How cheap? We have calculated the market cap per ounce of in-situ reserves at less than $400 per ounce. Gold companies provide leverage to the gold and their in-situ reserves are the second largest source of gold other than the central banks who are buyers today.

We expect investors will seek out those gold players and will look for no surprises. Dividend growth will thus be important as well as free cash flow. Execution is key. Finances and balance sheets will become important. Yet the industry has a pretty good record; in fact they were able to mine Bay Street much more successfully than they have been able to mine their backyards. Still, they produce a product that is scarce and because of their own ineptness will become scarcer. Gold shares thus are great buys here, particularly since we have seen the lows.


Barrick Gold Corp

The world's largest producer of gold dropped the second shoe and said that Pascua-Lama, some 5,000 metres in the sky might cost $8 billion in a budget blowout, up from the original $3 billion price tag and $5 billion in a recent revision. Pascua-Lama has become a sinkhole and is symptomatic of the gold industry's penchant for bigger and better. We have said for some time that mega projects bring mega problems, from Kinross' Red Back to Goldcorp's Penasquito and now Pascau-Lama. Barrick also wisely shelved the multi-billion Donlin project in Alaska and the Cerro Casales project in Chile.

The revision of costs comes less than a month after Aaron Regent was fired. Barrick reported a disappointing $0.75 per share due to a drop in production to 1.74 million ounces from 1.9 million ounces. Cash cost increased to $685 an ounce. Newly appointed CEO, Jamie Sokalsky, a chartered accountant by background, also lowered long term production guidance to 8 million ounce. He reaffirmed that Barricks' investment decisions will be based on free cash flow but Barrick will still spend almost half a billion this year, less if African Barrick is somehow sold. Barrick poured its first gold bar at Pueblo Viejo in the Dominican Republic. The mine, which is a joint venture with Goldcorp Inc. is expected to produce 1 million ounces a year. However, given the capital cost at $3.8 billion, in hindsight would Barrick have been better off acquiring a Detour Gold or even Osisko which would have produced comparable ounces, but at less cost? We believe that Barrick should return to basics and has room to significantly increase their dividend payout beyond the miniscule 20 percent payout and even buyback their shares. Barrick should simply show investors the money to recapture investor attention. The shares are a buy for the expected turnaround.

Eldorado Gold Corporation

Eldorado has seven operating mines, three under construction and three in development. Eldorado also reported a drop in earnings to $0.07 per share or half of the $0.14 earned last year. Eldorado lowered its production guidance to 660,000 ounces down from 775,000 a year and lowered its semi-annual dividend to $0.06 a share. Their problems were attributable to delays at Efemcukuru in Turkey and Eastern Dragon in China. Permitting is a problem in China and Efemcukuru appears to have developed teething problems over its concentrate which is shipped to Kisladag for leaching. Eldorado has been problem free so far but it appears that its Greek acquisition is also not so problem-free. Eldorado's cash cost have increased to $480 per ounce. Nonetheless, we like Eldorado's rising production profile.

Kinross Gold Corp.

Problem plagued Kinross has lost a third of its value this year finally replaced Tye Burt with J. Paul Rollinson. Kinross is a tale of two stories. One, Kinross took a $2.5 billion write off at the Tasiast mine in Mauritania after only 17 months earlier buying Red Back mining for a whopping $8 billion. Similarly Kinross' Fruta de Norte project in Ecuador which was acquired for $600 million still has not reached agreement with the government and that project faces a write-down too. Newly minted Rollinson must deal with Tasiast, whose capacity has already been cut in half despite a lack of mine plan and feasibility study. The second story is that Kinross' other major asset in Russia faces declining output. Kinross reported a halving in earnings and Rollinson's task is complicated by high costs, high G&A and high expectations. Sell.

Newmont Mining

Newmont reported a 28 percent decline in the second quarter earnings as gold mining costs rose 17 percent. Newmont warned that the $5 billion Conga gold mine in Peru will be delayed. Small mercies since Newmont lowered its 2012 capital expenditures by $300 million as a result, but still plans to spend a whopping $2.7 billion this year. Newmont has been in a harvest mode which has allowed it to pay a healthy dividend tied to the gold price. The world's #2 producer, is looking to boost output in Indonesia, but that part of the world is risky. Newmont lowered its guidance due to lower output form crown jewel, Yanacocha. We prefer Barrick.

Osisko Mining Corporation

Osisko continues the improvement at its Canadian Malartic open pit mine in Quebec, producing 92,000 ounces despite a fire that shut down its mill for 10 days. Lower grade and teething problems resulted in a per ounce cost of $1,000 an ounce. Osisko plans the ramp up of a secondary crusher and installation of a pebble crusher that will lower per ounce costs. Daily throughput rates at the mill will also help. We continue to like the share here.

Yamana Gold Inc.

South American player, Yamana reported a drop in earnings despite improved production. Yamana will spend $125 million on exploration this year. The acquisition of Extorre Gold makes sense and is a useful tuck-in acquisition giving access to the major Cerro Moro gold and silver project in Argentina. Yamana has $600 million of cash and should produce 1.2 million ounces this year and 1.5 million ounces in 2013. The company boosted its dividend but still has room to share with shareholders.

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Analyst Disclosure
Company Name Trading Symbol *Exchange Disclosure code
Aurizon Mines ARZ T 1
Barrick Gold Corp ABX T 1
Centerra Gold CG T 1
Centamin PLC CEE T 1
Detour Gold DGO T 1
Eldorado Gold Corp ELD T 1
Disclosure Key: 1=The Analyst, Associate or member of their household owns the securities of the subject issuer. 2=Maison Placements Canada Inc. and/or affiliated companies beneficially own more than 1% of any class of common equity of the issuers. 3=<Employee name> who is an officer or director of Maison Placements Canada Inc. or it's affiliated companies serves as a director or advisory Board Member of the issuer. 4=In the previous 12 months a Maison Analyst received compensation from the subject company. 5=Maison Placements Canada Inc. has managed co-managed or participated in an offering of securities by the issuer in the past 12 months. 6=Maison Placements Canada Inc. has received compensation for investment banking and related services from the issuer in the past 12 months. 7=Maison is making a market in an equity or equity related security of the subject issuer. 8=The analyst has recently paid a visit to review the material operations of the issuer. 9=The analyst has received payment or reimbursement from the issuer regarding a recent visit. T-Toronto; V-TSX Venture; NQ-NASDAQ; NY-New York Stock Exchange


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