February 25, 2013
Gold isn’t glittering as vividly as it was six months ago. Odds are, that won’t change any time soon, even with investors like David Einhorn rooting for bullion prices to pull stocks like Barrick Gold (NYSE: ABX) back out of the doldrums.
Investors once again seem comfortable taking risk in their investment portfolios, in spite of the lackluster pace of economic growth and the growing probability of some kind of stock market correction. When investors embrace risk, they shun the kind of safe haven investments to which they flock when they panic, such as Treasury bonds and – yes – gold.
That’s why gold currently languishes at its lowest levels since last fall, below $1,600 an ounce and down about 12 percent from where it changed hands in October, when the market was still fretting about the infamous fiscal cliff. Even though the threat of sequestration still looms large at the end of the week, the last-minute deal carved out in Washington as 2013 dawned seems to be encouraging investors that the risk of catastrophe isn’t as great this time around.
The bull case for gold, which has its roots all the way back in the 2008 financial crisis, seems finally to have run out of steam, for very good reasons. For starters, safe havens rarely generate all that much in the way of returns, especially after their rallies get long in the tooth. That’s the case for both Treasury securities and for gold at this point: Each incremental bit of return gets harder to justify, absent an apocalyptic scenario on the horizon.
Meanwhile, the worst risks never really materialized. The financial system didn’t collapse. China has avoided a hard landing. Greece, Spain and Italy (and the rest of the nations on the periphery of the Eurozone) may have put a big dent in the region’s economic prospects, but the EU hasn’t collapsed. Japan may be reviving. Economic growth may be hard to come by, but it’s not the end of the world.
After years of anxiety, investors are finally willing to relax enough to venture into riskier investments, and that’s bad news for gold. But the current state of affairs also is bad news for most other major commodities, such as copper, other base metals, crude oil and natural gas. Without a stronger rebound in global economic activity and demand, the outlook seems as gloomy for them as it now looks for gold. And that means it’s time to shun stocks of commodity producers, however much risk you may think you are willing to embrace these days.
With rare exceptions, commodity producers – oil and gas exploration and development companies or mining companies – are caught between the proverbial frying pan and the fire. Grappling with a flat to declining commodity price – whether it’s triggered by a slump in demand or rising supplies – is bad enough. Add that to the fact that many mining and energy production companies invested heavily in developing new mines or oil wells when prices were much higher, only to see them come onstream when the demand/supply balance had altered dramatically, and you’ve got a recipe for trouble.
As a result, a large number of these companies have higher operating costs and – to the extent that they used debt to finance their capital spending programs – higher interest payments as well. Meanwhile, the outlook for their cash flow has slumped. So even if you think that gold itself might recover, or that the economy will revive and send the prices of copper and aluminum higher, with few exceptions you probably don’t want to own stocks in companies that will struggle to get back on their feet.
Just look at Rio Tinto (NYSE: RIO), which recently reported its first-ever loss for a full year since its U.K. and Australian operations merged and the Anglo-Australian became a dual-listed, publicly traded mining giant. Writedowns on its assets left the company with a $3 billion loss for 2012, while a 16 percent decline in revenue highlighted the magnitude of the impact of the slump in metals prices. Barrick Gold took a $4.2 billion writedown on the value of a Zambian copper mine, leaving the company with a loss of $3.8 billion for the fourth quarter, and questions swirling about whether its cash flow will be adequate given that its production costs will rise from $945 per ounce of gold in 2012 to $1,000 this year.
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Another excellent reason for shunning these stocks, even as value investments, is that their managers by now should have learned the lesson that commodity markets are cyclical. Making big expansion plans or giant acquisitions (like that of Alcan by Rio Tinto back in 2007) may seem logical when commodity prices are high, but all too often this kind of over-expansion is what brings big commodity producers to grief when the tide turns. Yet, over and over again, we see mining and energy companies that have made the same error, whether it is out of a conviction that “this time it’s different” or simply a willingness to overlook the risk.
Either way, it’s hard to argue in favor of owning stock in a company whose CEO emerges in a time of crisis promising new discipline (Rio Tinto) or to sell high-cost assets (Barrick Gold) far too late in the game.
Gold may well recover some of its shine; all it would take is for another panic to grip global financial markets, however briefly. Just don’t try to play any rally indirectly through the mining sector, however appealing the valuations may seem.