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Go for the Gold

By Elliott H. Gue, on Oct. 28, 2016

Investors shouldn’t dismiss gold and silver as plays on a weak US dollar. Although gold tends to fare well when the greenback loses some of its value, the precious metal is a currency in its own right and acts as a hedge against weakness in all paper currencies.

Consider that the US Dollar Index, an average of the exchange rates between the greenback and major world currencies, has increased slightly since the end of November 2015. The spot price of gold, however, has surged by 23.7 percent over the same period.

More important, gold prices tend to benefit when investors lose confidence in the major central banks and the currencies they manage.

The total supply of above-ground gold has increased by 17.5 percent over the past decade and stands at 5.89 billion ounces. Meanwhile, total US money supply (M2) has grown by almost 87 percent to $12.85 trillion.

(Click graph to enlarge.)
M2 and Gold Supply

Whereas central banks can create money on a whim, the supply of above-ground gold climbs slowly over time—one reason why the yellow metal has retained its purchasing power for centuries.

With major central banks pursuing quantitative easing and experimenting with negative interest rates, investors have started to lose confidence in currencies and central banks’ ability to promote sustainable economic growth through monetary policy alone. This skepticism has increased gold’s appeal as a hedge.

Although gold prices have pulled back somewhat of late, the amount of physical gold held by exchange-traded funds has continued to hover around 64 million ounces. Robust demand for gold among investors could propel the precious metal’s spot price to more than $2,000 an ounce at some point in 2017.

(Click graph to enlarge.)Gold Held by ETfs

The yellow metal remains the best way to profit from growing concerns about the efficacy and long-term effects of central banks’ extraordinarily accommodative monetary policies.

Rising interest rates tend to weigh on gold prices because investors prefer to store their cash in dollar-, yen- or euro-denominated assets that offer at least a modest yield. Accordingly, the current era of ultra-low interest rates should provide a tailwind for gold prices.

If the Federal Reserve opts to increase interest rates at a gradual pace (or fails to hike rates in 2017), gold prices could enjoy a banner year. Inflationary pressures would also be a boon for gold prices.

Investor demand for gold continues to increase, with many opting for the convenience of SPDR Gold Shares (NYSE: GLD) and other popular exchange-traded funds (ETF).

The total weight of gold held by ETFs offering exposure to the yellow metal tumbled from a peak of 84.64 million troy ounces in December 2012 to a low of 46.9 million troy ounces in early 2016. And over the past few months, these funds’ gold holdings have soared by more than 20 percent to about 56 million troy ounces.

(Click graph to enlarge.)Gold Held by ETFs

Gold demand also appears to be on the rise in China and India, two of the world’s largest consumers of the yellow metal.

China’s government mandates that all gold imported and mined domestically must trade on the Shanghai Gold Exchange. Physical deliveries of gold to the exchange have been on a steady uptrend in recent years; the plunge in February likely stems from the Lunar New Year holiday, a seasonal anomaly.

(Click graph to enlarge.)Shanghai Gold Exchange Deliveries

We’re bullish on gold and silver miners that meet seven simple criteria:

  1. Relatively low debt or a realistic plan to reduce leverage over time;
  2. All-in sustaining costs needed to maintain output from existing mines that meet or exceed the industry average;
  3. The potential to grow gold and/or silver production significantly over the next few years to take advantage of rising prices for precious metals;
  4. The capacity to finance growth projects without taking on excessive debt or diluting existing shareholders by issuing a flood of new equity;
  5. An experienced management team, especially for small and midsize producers;
  6. A plan for returning capital to shareholders via dividends or stock buybacks; and
  7. Acceptable geographic and political risks.

Tahoe Resources (TSX: THO, NYSE: TAHO)

Tahoe Resources is on course to produce 370,000 to 430,000 ounces of gold in 2016 and 18 million to 21 million ounces of silver from its mines in Canada, Peru and Guatemala.

The company’s Escobal mine in Guatemala, the world’s third-largest silver mine, produced 20.4 million ounces in 2015 at an all-in sustaining cost (AISC) of $9.11 per ounce. AISC includes all cash costs associated with precious-metal production plus the amount of capital needed to maintain a mine’s output. The metric also factors in credits for by-products—zinc and lead at Escobal.

The company’s guidance calls for Escobal to produce about 20 million ounces of silver each year through at least the early 2020s. The same basic forces driving gold demand apply to silver, even though the latter also has industrial applications.

Gold fetches about 72 times an equivalent amount of silver, well above the 20-year average of 62 times. This diversion from the norm implies significant upside potential in silver prices.

(Click graph to enlarge.)Gold Silver Price Ratio

Tahoe Resources’ La Arena and Shahuindo mines in Peru are expected to produce about 200,000 to 250,000 ounces of gold this year, though the company has identified additional reserves in sulfide deposits that could be exploited in coming years. These mines’ AISCs ranges between $700 and $750 per ounce of gold.

In the near term, expansions at the Shahuindo mine should drive production growth. The first phase of this project will come onstream in the second quarter and is expected to produce up to 75,000 ounces of gold per annum; a second expansion is slated for completion in 2018 and will add 170,000 ounces to the mine’s annual output.

Finally, Tahoe Resources’ Timmins and Bell Creek mines in Canada should produce 170,000 to 180,000 ounces of gold in 2016 and boast an AISC of less than US$650 per ounce.

Management expects a series of expansion projects to drive significant output growth from these mines. These endeavors include deepening a shaft at Bell Creek and opening up at least two commercial deposits on the site. All told, the company aims to increase these mines’ annual gold production to more than 250,000 ounces by 2020.

Tahoe Resources plans to grow its gold output to more than 550,000 ounces by 2020 without increasing its AISC appreciably; the company’s free cash flow could ramp up significantly over the next few years.

Equally important, the midsize gold producer boasts a clean balance sheet with a net cash position and last year generated $244 million in cash flow from operations.

Tahoe Resources rates a buy up to US$15.50 per share as an aggressive bet on gold prices.

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Elliott H. Gue is founder and chief editor of Capitalist Times and Energy & Income Advisor.

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