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Gold: Double Bubble, Toil And Trouble

The War in Iraq has become more costly in terms of lives and money unlike the Persian Gulf War whose $60 billion cost was underwritten by the allies. The United States fiscal deficit is running at a record breaking $400 billion each year and the rising $58 billion-plus Iraqi occupation cost is not even included. The White House deficit is 50 percent higher than administration forecasts made only six months ago. The reversal from surplus to deficit in the past three years is the biggest since after the Korean War in 1953. At $455 billion, this year's deficit would eclipse Bush's father's deficit, then a record $290 billion. Next year the projection is for an astonishing $475 billion of red ink. Indeed, money and debt is growing faster than the economy. Simply put, Bush has turned out to be the largest spender in American history.

Deficit Disorder
In the past, foreign money was attracted by a strong US dollar, stock market, and superior financial returns. But now, America's status as the world's ultimate safe haven for capital is looking shaky. This War on Terrorism, Bush's tax cuts, a new Medicare drug bill and Bush's reelection campaign appear to be a recipe for deficits as far as the eye can see - whatever happened to the balanced budget forecasted only eighteen months ago? Moreover, in the first quarter that other deficit, the US current account deficit soared to a record 5.1% of Gross Domestic Product (GDP) or half a trillion dollar annually. America's trade deficit is the result of years of excessive consumer over-spending. America is buying goods on money borrowed abroad. Because Americans have few savings and because they import much more than they export, they need over $2 billion a day of capital inflows just to finance this shortfall. And the US is not the only profligate borrower. The Europeans' budgetary deficits have breached the 3 percent GDP ceiling threshold. Japan has a budget deficit approaching 8 percent today.

Most worrisome is the serious balance of payment crisis that lies ahead, since the structural problems underlying the American dollar remain. Near zero interest rates have undermined the dollar in favour of higher yielding currencies. The yield premium enjoyed by the Canadian and Aussie dollars have proved popular with traders recently. This "carry" trade transaction is particularly profitable since investors could borrow funds in US dollars investing those proceeds in higher yielding Canadian and Aussie dollars. The Canadian dollar has risen about 15 percent against the US greenback.

Greenspan's Feet of Clay
In 1996 stock prices were soaring and Alan Greenspan cried: "irrational exuberance." Yet last year, determined not to repeat the same mistake Japan made ten years ago, Greenspan lowered interest rates thirteen times. In May, the Spinmeister saw falling prices and cried: " deflation", fueling another bond-market rally that ensured a successful tax stimulus package. That he was "taking his book" was ignored by all. In July however, he saw recovery and burst the bubble he created causing the biggest bond rout in ten years. Alan Greenspan appears to have worn out his welcome. Not only is the economy struggling, but his jawboning no longer works. Greenspan's musings of natural gas shortages coincided with a peak in prices and storage levels have increased every week.

Greenspan has simply lost the confidence of the market and with it America's fiscal credibility. Support for the Bush administration is also wavering. After boldly calling "to bring them on," Bush appears mired in not only a Vietnam-type war but has unified much of the Western World against him. With confidence in its leaders ebbing and the prospects of massive twin deficits, the inevitable capital flight will doom the United States to a lengthy period of higher interest rates and slower growth. History shows the bigger the problem, the more painful the eventual adjustment.

Further worsening the dollar picture is that the relentless loosening of monetary policy has unleashed cheap money into the system, spawning an endless supply of bubbles. US policymakers have opened the fiscal and monetary spigots, bringing down interest rates to the lowest levels since 1958 when Buddy Holly was alive. To date, the Fed's massive reflationary pump priming and the willingness of government and households to take on more debt has fueled consumption offsetting the risks of deflation and recession. Corporate debt remains at record levels, prompting many companies to refinance their older borrowings taking advantage of lower rates but increasing total indebtedness. Government, business and consumers are simply living beyond their means.

Debt Must Eventually Be Rolled Over
There is no question that the United States avoided deflation with a heavy dose of pump-priming, bringing interest rates down over five percentage points. The last round of tax cuts was financed by another round of deficits that generated more consumer borrowing and an inflated housing bubble. New borrowings and mortgage refinancing set records as new and existing home sales rose to record levels. The mortgage refinancing binge may be at an end due in part to the fact that near-zero interest rates have upticked and the financial institutions of Freddie Mac and Fannie Mae, are being scrutinized by the regulators. And, the chaos in the bond market has triggered a rise in rates worsening troubles at Freddie Mac and Fannie Mae. Of concern is that these financial institutions were the conduits that allowed America to remortgage at successively lower interest rates. Good for the consumer? Yes. Good for Freddie and Fannie? No. Freddie and Fannie were huge users of derivatives. Hedging activity in mortgages is worth more than $5 trillion that is substantially bigger than the market for Treasury bonds. Recent studies show that only a 1.5 percentage increase in interest rates could erase half the value of Fannie Mae's assets. It is these derivatives that led to the wholesale departure of Freddie's management and the European Central Bank's decision to eliminate all Freddie and Fannie's debt.

The Bond Crop Never Fails - Until Now
So far, governments have had a lucky combination of growing debt and falling interest rates. However in recent weeks, the bond market suffered its biggest sell off in two decades. The once flat yield curve is now steepening upwards signaling the end of the 22-year bull market. Of more concern is that almost a third of the government's debt matures within a year making the US vulnerable to not only recent interest rate hikes but also funding swings. The US Treasury's giant $60 billion offering as part of the program to raise a record $230 billion in the second half of this year met a mixed reception. Indeed the Treasury will need to raise $450 billion over the course of the next year.

So sooner rather than later, the biggest debtor nation in the world must rollover this debt. With a negative real US fed fund rate for the first time in twenty years, raising money will not be so easy. And Asian countries, who hold a whopping 70 percent of the world's currency reserves due to support purchases and trade surpluses are likely to diversify their holdings out of Treasuries into precious metals and euros. At the very least they may demand higher interest rates for keeping their money in dollar denominated assets. Asian countries currently have over $1.7 trillion in foreign exchange reserves. Japan alone held over $429 billion of Treasuries in May and China held $122 billion of Treasuries. Any falloff in capital inflows or if they sell some of those securities would push the dollar even further down making US investments less attractive. We have been down this road before. Suffering such losses, the exodus may resemble the late seventies when the dollar collapsed, plunging more than 40 percent, the deficit reached a peak of 3.5 percent and 20 percent interest rates ensued.

Gold Is The Real Money
Money is cheap. Too cheap. Today one can buy a car for six years and not pay a single cent of interest. What's the downside then? When borrowings are encouraged with near zero interest rates, there is no incentive to hold cash. When money has no value, then hard assets become dear. After three years of disappointment and an unprecedented build-up of liquidity, there has been a gradual shift to hard assets from paper assets. Our view is that rising commodity prices, imploding bond markets and a pickup in gold are signaling that a sea change has occurred. History shows that gold is an excellent alternative to paper money. Since ancient times gold has consistently been valued as currency. While supply and demand trends are important, gold's role as a store of value has made it a natural hedge in any portfolio. Since July 1999, the US dollar has lost about a third of its value while gold has risen about $100 an ounce or almost 40% from its 21 year low. As a financial asset, gold has outperformed all asset classes in the past five years. Our concern is that while there is "free" money today, there is no free lunch.

s Gold broke above $360 per ounce on continued lack of confidence in the US dollar. Our bullishness is based upon gold's role as classic hedge against the debasement of the US currency and ongoing geo-political worries. We believe the outlook is even more favourable amid structural imbalances in the US economy. In the months ahead, rising trade and budget deficits and the inevitable inflation risks that result from the Fed's deficit financing will underpin higher gold prices. A weaker dollar is a consequence of America's profligacy. We believe that gold will reach $510 per ounce this year aided by increased gold consumption from the Far East, continuing hedge buybacks and a long awaited decline in global mine production. Gold, however, is in the early stage of its bull market. Sure, gold is up $100 from its lows and has outperformed the US dollar. Gold's price advance, however, is not absolute but rather the dollar's depreciation against gold. Gold is simply the benchmark. As such it will continue to outperform stock markets and currencies and is a good thing to have. The second quarter was a tough quarter for the gold producers due to the stronger Canadian dollar and rising costs, which squeezed margins further. The dilemma for the mining industry is that with even the higher gold price at $360 per ounce, the industry is not very profitable. The producers need a gold price in excess of $400 an ounce in order to get a reasonable return from existing assets. As such, most companies have pared back their exploration budgets to the bone, which threatens their future since the majority has not been able to replace production and depleting reserves. Consequently, we expect a new round of mergers and acquisition activity since there have been few discoveries. Indeed, we continue to emphasize our Top Ten juniors, because many possess deposits found in the nineties, and in a growth-oriented environment these companies will become the next takeover targets. Our Top Ten juniors are: Bema Gold, Campbell Resources, Crystallex, Eldorado, High River Gold, Miramar Mining, Northgate Exploration, Philex Gold and St. Andrew's Goldfields.

Top Ten Juniors Symbol Price 52 Week Range Shares Market Prod'n Mkt Cap
  High Low Mil Cap Oz(000) per/oz
Bema Gold BGO 3.00 2.93 1.39 349.0 526.99 270 1,952
Campbell Resources CCH 0.55 0.67 0.29 59.6 20.86 35 596
Crystallex Intl KRY 3.63 3.95 1.00 100.0 234.00 95 2,463
Claude Resources CRJ 1.52 1.80 0.82 53.1 62.66 52 1,205
Eldorado Gold ELD 3.12 3.24 0.99 226.0 519.80 95 5,472
High River Gold HRG 2.15 2.45 1.28 97.4 146.10 150 974
Miramar Mining MAE 2.25 2.40 1.05 125.5 190.76 130 1,467
Northgate Explor NGX 1.88 2.05 1.10 193.0 274.06 275 997
Philex Gold PGI 0.46 1.45 0.41 40.2 18.49 0 0
St Andrews Goldfields SAS 0.195 0.33 0.15 1559.0 319.60 0 0
Average 1513

Agnico-Eagle Ltd.
Agnico reported a small loss due to the loss of production attributable to the rock-fall that occurred earlier in the year. Agnico is on track to produce 300,000 ounces this year and the results were in line with expectations. Of importance is Agnico's $7 million purchase of Barrick's idled Bousquet mine that is to the west of Agnico's LaRonde mine in northwestern Quebec. Agnico also acquired rolling stock and a large array of exploration data. We believe that the acquisition is not only timely but given Agnico's long history in the area, we like the exploration possibilities. The acquisition of Bousquet gives Agnico over 20 kilometres of favourable ground and with their modeling and knowledge of the area, we can expect additional discoveries. Bousquet has two shafts on the property. At newly acquired Lapa, only seven miles east of LaRonde, Agnico has five diamond drills working on the Contact Zone and a pre-feasibility study is expected before yearend. Metallurgical test work is being conducted and Lapa material could easily be sent to the newly expanded LaRonde facilities. Although Agnico shares have recaptured some of the loss due to the rock-fall, Agnico has changed their mining sequence and does not expect to lose any production from the rock-fall. We like Agnico shares due to the exploration prospects, long life reserves and with over eight drill rigs turning, we expect a steady diet of exploration news. With the expansion at LaRonde largely completed Agnico should produce 400,000 ounces next year and the shares are attractively priced here. Buy.

Barrick Gold Corp.
Barrick's results were $0.11 per share versus $0.11 per share a year earlier, but the results were boosted by a $0.04 per share tax recovery. Results were also buoyed by a tax rate at less than 10%. Of significance is cash flow that was down due to a dramatic increase in costs. Key operations at underground Meikle and Bulyanhulu adversely affected results. While mine sequencing and processing issues continue to plague Barrick, ground conditions and some fundamental issues at Bulyanhulu will temper Barrick's results for the next few quarters. Barrick will be hard pressed to produce 5.5 million ounces this year.

Of concern is that while Barrick has pared down the world's largest hedge book to 16.1 million ounces, the hedge book is still a lightening rod for investor dissatisfaction. After years of top performance, Barrick's stock price has been a laggard. Investors want Barrick to move more aggressively to reduce its hedge position either by delivering out or indeed repurchasing those obligations. Using a derivative to flatten a derivative is not correcting the problem. At quarterend the marked-to-market position of the hedge book was a whopping negative $615 million. Barrick still has more than 3 years worth of production sold forward. Looking ahead Barrick is slowly turning around under the guidance of Greg Wilkins who will more likely fine-tune Barrick's financials due to his background. What is needed, however is not another financial engineer but a fundamental change in direction in-line with the new gold market. Aside from reducing their hedges, from a mining standpoint, Barrick is in need of an acquisition because it faces depleting mines and rising costs. Pierina for example will go from 900,000 ounces to 400,000 ounces next year. And, there is nothing on the horizon next year to replace this lost production. New mines such as Alto Chicama, Valedero and Cowal are in the advanced development stage, but production is not expected until 2005 and 2006. From a developmental standpoint we can see expansions at Eskay, Round Mountain and Ruby Hill, but these are smaller projects.

Bema Gold Corporation
Bema Gold is an intermediate gold producer with key assets in Canada, Russia, South Africa and Chile. Bema lost money in the second quarter due to higher operating costs at the Petrex mine. In the second quarter Petrex Mines produced 38,662 ounces at a cash cost of $354 an ounce, which was inflated due to the strength of the South African rand. The Julietta mine (79%-owned) produced 108,000 ounces and should produce 116,000 ounces of gold this year at a cash cost of $159 per ounce. Newly acquired Petrex Mine (100%-owned) in South Africa should produce 200,000 ounces of gold at a cash cost of $230 per ounce. The Refugio mine (50%-owned) in Chile was reopened and should be in full production by mid-2004. Bema also has two mega projects including the Cerro Casale deposit (24%-owned), which is a large world class copper/gold porphery deposit in northern Chile. While a bankable feasibility study was completed, higher commodity prices are required since this project could cost more than a billion dollars to put into production. More promising is the Kupol property, which is a large epithermal gold/silver system in Russia. The Kupol property is in Far East Russia and so far 116 holes have outlined a vast system. Assay results were promising and further drilling is needed. The next forty holes will be important and expected in September. Drilling is ongoing with two Canadian and two Russian drill rigs and a total of 26,000 meters of drilling is planned. Bema can earn 75% interest in the property from the government of Chukotka. We like Bema Gold for its leverage to the gold price and its array of assets in inventory, particulary Kupol.

Eldorado Gold Corporation
Eldorado Gold shares have done well following the orderly sale of the control block from Gold Fields. The $62 million bought deal finances Eldorado's equity stake in Kisladag. Eldorado is developing the 100% owned Kisladag project in Turkey and the company has received the environmental certificate and is now awaiting the construction permit, which will allow the company to begin construction. With reserves of 4.5 million ounces, Kisladag could produce 200,000 ounces of gold per year from the heap-leach operation. Production could begin in late 2004. Eldorado is the owner of one of the few major deposits that is a company builder. Eldorado's management is considered highly professional and capable of developing Kisladag. With long life assets, we believe that Kisladag's ounces are conservative and that higher throughput could boost initial production to 250,000 ounces for at least ten years. Eldorado is producing about 95,000 ounces from the Sao Bento mine in Brazil. We continue to recommend Eldorado shares for Kisladag as well as the prospects of bringing the Efemcukuru project in Turkey on stream as an underground operation.

Goldcorp Inc.
Goldcorp reported an excellent quarter of $0.10 per share versus $0.09 an ounce at an overall cash cost of $100 per ounce. Goldcorp boosted its production estimate for this year to 530,000 ounces from 510,000 ounces. With US$285 million of cash and bullion, the company is on track to hold more gold than the Bank of Canada. Goldcorp plans to boost its production from both an expansion at Red Lake and corporate acquisitions. The company also has a $68 million mining portfolio and wisely uses this as a "skunks works" giving management a listening post to developments in the mining industry. Goldcorp is currently stockpiling sulphide concentrates, to be treated at Camphill Mine next door and at Barrick's Goldstrike autoclaves. The expansion at Red Lake includes a new shaft to be completed within three years at less than $90 million. Surface facilities and infrastructure will be completed by yearend, which would permit a production rate at 1,000 tpd. We continue to 7 recommend Goldcorp based on its rising production profile, low costs, rock-solid balance sheet and aggressive management. The company is fully taxable so we speculate that an acquisition would lessen Goldcorp's tax bite as well as diversify the Red Lake base.

Kinross Gold Corp.
Kinross reported a loss of $0.02 per share versus a $0.05 loss a year earlier. Cash flow improved reflecting efficiencies of the merger. Lupin continued to be a weak link but was shutdown this month. Kinross raised $185 million with a share offering with proceeds going to retire the outstanding 5.5% convertible debentures. Fort Knox produced 101,000 ounces in the quarter and total cash costs were shaved by $10 and ounce. Kinross is looking for extensions of reserves at Round Mountain and is planning to reopen Refugio next year. The Birkachan deposit will likely produce gold next year at the Kubaka facility. Kinross was adversely impacted by the strength of the Canadian dollar, which hurt all Canadian producers. With the limited roster of senior producers we believe that Kinross will be a prime beneficiary. The company has proven capable of digesting acquisitions and is now on the road to improve profitability. We believe the company has a pipeline of projects to sustain 2 million ounce per year status and thus we recommend the shares. Kinross is the seventh largest primary gold producer in the world and the fourth largest in North America. With less than three percent of the gold reserves hedged, the company provides investors with instant leverage to the gold price. Kinross also has a balanced geopolitical risk profile and an entrepreneurial management team.

Meridian Gold Inc.
Meridian reported a strong second quarter profit of $0.10 per share, which included a $0.03 gain for the sale of 30%-owned Jerritt Canyon in northern Nevada to Queenstake Resources. Meridian is expected to produce 420,000 ounces this year, down from 436,000 ounces, reflecting the sale of Jerritt Canyon, which was a high cost and short lived mine. Meridian's major asset, El Penon in Chile had another good quarter but there was little news from the 3 million ounce Esquel project in Argentina where there has been a delay due to local politics. While Meridian is largely a one-asset company, we continue to like the shares, since the street is paying little for Esquel. Esquel could easily be brought into production once the politics are settled. Meanwhile the company offers no hedges, low cost assets and a debtfree balance sheet. Buy.

Northgate Exploration Limited
Kemess South, located in north-central British Columbia, will produce 280,000 ounces of gold and 75 million pounds of copper at a cash cost of $150 per ounce. Northgate has successfully fine-tuned the Kemess South mine but we feel that Kemess North might be an ambitious undertaking. Northgate will release its pre-feasibility study for the Kemess North deposit shortly. While Kemess North is on the other side of the mountain, plans are afoot to develop this deposit at a cash cost of $200 an ounce, yielding 250,000 ounces of gold and 120 million pounds of copper per year. Kemess North would require over US$150 million and would not be in production till later in the decade. As such, we expect that the Brascan group will divest Northgate to a larger company that would have the financial and technical wherewithal to bring Kemess North into production. At current levels then, Northgate shares are undervalued and thus recommend purchase for an eventual takeout.

Newmont Mining Corporation
Newmont announced an excellent quarter of $0.22 per share compared to last year's $0.17 per share. Newmont reported that its Australian Yandel hedging issue would be completed by quarter's end resulting in a gain for Newmont and the elimination of the liabilities. Newmont, unlike many of the senior born-again hedgers who have given lip service to hedge buybacks, is virtually hedge-free. However, Newmont has more debt to total capital than others because of the acquisitions of Normandy and Franco Nevada. Debt however, is manageable since only $200 million is needed next year. Newmont could easily sell assets from Newmont Capital and a sale of the 14% stake in Kinross, could net a quick $350-$400 million.

Newmont's future is dependant on the development of its vast array of assets in Nevada and Yanacocha (Phoenix is a non-starter). We expect Newmont to continue to do well as the premier gold producer with estimated production of 7.2 million ounces and operations on five continents. Having digested Franco-Nevada and Normandy, we do not expect Newmont to be in South Africa and thus will likely sit out much of the expected M&A activity in South Africa. We continue to recommend the senior producer with core holdings in geographically secure United States, Australia and Peru.

Placer Dome Inc.
Placer reported a $0.16 per share profit, which was due largely to non-cash items. Of more significance was the skyrocketing production costs, which increased 27% to $220 an ounce versus $175 an ounce last year. Placer produced more gold this year, due to its acquisition of AurionGold and is on track to produce 3.6 million ounces. However, those ounces come at a cost because Placer has inherited two expensive hedge books. Placer still has a hedge book of 10.8 million ounces, which translates into over 3 years of production sold forward. Placer's acquisition of EAGM in Tanzania will result in an increase of Placer's hedge book at a time when most other producers are doing their best to reduce their hedge book. Placer is going the other way. At Cortez Hill, Placer has six drills turning and a reserve estimate is finally expected at yearend. Placer has recently boosted exploration spending to $75 million, up from $60 million. Placer has over 60 percent of its reserves in South Africa, which is painful due in part to the more expensive rand. And there has been little progress over South Africa's empowerment bill, which could see the confiscation of a portion of its South Deep investment. Placer shares were undervalued but its heavy weighting to Africa and with a maturing gold profile despite recent purchases, the shares are a suitable source of funds. We recommend investors use the current price strength to take profits.

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