Gold equities are in competition with gold ETFs for shareholder dollars. In this Gold Report interview, Goldman Sachs Managing Director Ian Preston discusses the steps gold companies must take to pull investors back from the ETF space and shares Goldman Sachs' outlook for the gold price over the next year or so.
The Gold Report: Your recent commodity price research shows a gold price of around $1,811/ounce (oz) for 2013. Could you talk with us about how some of the macroeconomic issues influence that forecast?
Ian Preston: When we look at gold, we don't have in mind a specific supply/demand balance going forward. It's easy enough to see the supply side. In trying to forecast a price for gold, we tend to run out a 4% per annum contango from the current gold price until we think US interest rate policy will reverse and rates will start to climb. That stage just keeps on moving out – as it has with Quantitative Easing (QE) 3.
We look at the gold price to forecast earnings, and over the next 6 to 12 months, we'd expect $1,650/oz at the lower end and, if it breaks through, $1,850–1,900/oz at the upper end. If accommodative fiscal policies continue globally, it could go significantly higher. But bear in mind that as equity analysts we're trying to forecast earnings, and to do so we want to be as close as possible to where the gold price will be for the next three to six months, even if the range is quite broad.
TGR: And in your world, it's better to be conservative than hyperbolic.
IP: It doesn't do our investors any good if we use a $2,000/oz gold price for the next six months and it ends up averaging $1,780/oz. It's more meaningful to say we have a positive view around gold. And we do. Considering such accommodative fiscal regimes, very low interest rates globally and central banks buying gold where previously they have been sellers, it's pretty difficult to take a negative view on the gold price over the next 12 to 18 months.
TGR: Many analysts at the Denver Gold Forum last month echoed that sentiment. They don't see any catalyst that would push the gold price down appreciably. Let's talk about gold equities and exchange-traded funds (ETFs) in the context of the backdrop you described.
IP: From a risk diversification point of view, the ETF clearly gives investors exposure to gold. So the gold majors aren't competing with each other for investors; their competition is the gold ETF. Over a 10-year timeframe, the correlation between gold equities and the gold price is very strong, but more recently – say the last 12 months – gold equities, certainly for the majors, have underperformed the gold price. That's partly due to the fact that, certainly among the majors, earnings per share (EPS) hasn't reflected the leverage to an improving gold price.
TGR: Underperformance relative to the gold price actually goes across the board, not just the gold majors. In fact, it's magnified in the juniors and the smaller companies. Just to clarify your point, though, what are some of the majors you're talking about?
TGR: In the environment you described earlier – QE, European sovereign debt issues, central bank buying and so on – what can these companies do to make a more compelling case for themselves with investors?
IP: First, they must deliver on whatever guidance they've given the market. That's an imperative to have investor confidence. They also must maintain long-life reserves and be able to replace them on an annual basis to keep a perpetual gold production chain going. That's what the gold ETFs give investors.
TGR: But gold ETFs have grown dramatically over the past five to seven years. What's given them such an edge?
IP: An ETF costs investors a small amount to hold but carries no risk as compared to a gold equity that comes with operational risk, acquisition risk and potentially political risk. On the other hand, ETFs cannot pay dividends, so meaningful shareholder returns that offset a lot of the operational risks inherent in the gold equities could bring back some of the investors who have gone to ETFs.
I think the gold seniors are aware that the return to shareholders is among the key criteria. All of them were talking about it in Denver. Whether the return takes the form of a payout ratio or a percentage of the payout ratio or free cash flow or is tied to the gold price, the majors got the message loud and clear that they have to do more than rely on the gold price to see share price appreciation and shareholder returns.
To be more attractive to investors than the ETF, the gold seniors also must grow EPS. Increasing volume when gold prices increase accelerates EPS growth, but volume growth must drive EPS growth – not simply higher gold prices. With volume-driven EPS growth, improving gold prices also give investors more leverage to gold than they would have in an ETF. And I think perhaps we're starting to see recovery in the gold equities. But it all starts out with meeting the guidance they give the market.