Buy Gold Miners Instead Of Gold

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 |  Includes: ABX, GG, GLD
by: Alpha World

Summary

Gold prices fell almost 30% last year as the Fed hinted at easing its bond purchases.

As gold prices plunged, physical demand for the precious metal picked up in China.

Going forward, physical demand in China and India will be the key drivers for the gold market.

Gold now has a strong floor at around $1,200 an ounce, however, it has limited upside potential as the Fed ends its bond purchases.

Investors looking to gain exposure to gold should opt for gold miners instead of physical gold or ETF as the present price environment will help miners generate steady cash flow.

Gold's decade-long rally ended last year as the precious metal fell almost 30%. Gold slipped as the Federal Reserve hinted in May 2013 that it will start easing its bond purchases as the U.S. economy showed signs of recovery. Since the financial crisis of 2008, the Fed has introduced bond purchases, also known as quantitative easing, on three separate occasions. The last of these bond purchases called QE3 began in September 2012 and was the biggest of all three.

Gold has been one of the biggest beneficiaries of the Fed's expansionary monetary policy. Indeed, the precious metal surged past the $1,900 an ounce mark at one stage and some analysts suggested that $3,000 an ounce level was possible. Not surprisingly, over these years, investors poured money into gold-backed exchange traded funds, including the world's largest SPDR Gold Trust ETF (NYSEARCA:GLD). Between April 2009 and April 2013, the SPDR Gold Trust ETF gained more than 55%.

The surge in gold prices also benefited gold miners, who in the wake of higher prices undertook costlier projects. In addition, the gold mining industry also did away with hedging as they looked to fully capitalize on gold's rally. With the Fed printing money, it seemed that gold was the best asset.

Why Gold Benefits from Fed?

Between 2009 and 2013, gold prices appreciated significantly, thanks primarily to the Fed's bond buying program. The precious metal also benefited from an uncertain economic environment following the financial crisis.

Gold is seen as a safe-haven asset, as well as a hedge against inflation. The developments since the financial crisis made gold an ideal asset for investors. The financial crisis led to the global economic recession and boosted gold's appeal as a safe haven. In times of turmoil, investors generally prefer physical assets such as gold, and this was the case after 2008.

The financial crisis also forced governments and central bankers across the developed world to introduce measures to prevent the global recession from turning into a depression. With limited options on the fiscal side and interest rates near zero, the Fed in 2009 announced an unprecedented measure, quantitative easing. The Fed has launched three separate rounds of bond purchases, with the last one being in 2012. There is no denying that the Fed's efforts boosted the equity market, with the S&P 500 posting substantial gains. Indeed, that was the Fed's intention. The Fed's rationale for quantitative easing was that the surge in equity markets would create a wealth effect, which would eventually boost consumer spending and bring the U.S. economy, which relies heavily on consumption, back on track.

While the easy money was expected to boost spending, it also sparked concerns over long-term inflation. And this is one reason why investors poured money into gold and gold-backed ETFs. Other factors that helped gold included geopolitical tensions in the Middle East, the fiscal cliff issue and the sequester.

Economic Recovery and Gold's Decline

The U.S. economy began showing signs of recovery in late 2012, with especially the housing market getting back on track. The Fed's goal with QE3, though, was a significant recovery in the labor market. In May 2013, the Fed felt that the labor market was recovering, and hinted that it would start easing its bond purchases later in the year.

The Fed's outlook sparked a sell-off in gold and the precious metal posted an annual loss for the first time in thirteen years. Gold fell almost 30% last year.

The sharp pullback in gold prices also hurt the gold mining industry, with several companies writing down asset values. It also created significant pressure on the industry to bring down their all-in sustaining costs. Not surprisingly, gold miners were among the worst performers in the S&P 500 last year. Shares of Goldcorp Inc. (NYSE:GG) fell more than 39%, while Barrick Gold Corporation (NYSE:ABX) dropped more than 48%.

Indeed, at the end of last year, gold miners would not have made it into an investment portfolio for 2014. However, that has changed due to some of the developments this year. In fact, if you are looking to gain exposure to gold then the best bet would be to go long on miners instead of buying gold or gold-backed ETFs.

Buy Gold Miners Instead of Gold

During the easy money days, going long on gold certainly made sense. But, the Fed is winding down its bond purchases and QE3 will end before the end of this year. The end of QE3 does not mean that the Fed is tightening its monetary policy given that interest rates are still near zero and are expected to remain low at least until the start of 2015. However, with the end of quantitative easing, an important driver for gold prices is being taken away.

Surprisingly, gold has not done badly this year. Gold prices have been hovering around $1,300 an ounce level and have gained around 8% so far this year. The key driver has been geopolitical tensions in Ukraine and the Middle East. More importantly, gold seems to have found long-term support at around $1,200 an ounce level.

Indeed, as gold prices plunged last year, physical demand in China picked up. In fact, China went past India as the world's largest consumer of physical gold last year. What this has done is changed the dynamics of the gold market. If the gold market was driven by the Fed's bond purchases until last year, it will now be driven more by demand trends in China and India.

Physical demand for gold has been weak in both countries this year. A report from the World Gold Council released last week showed gold demand in China shrank in the second quarter of 2014. Gold purchases in China fell 52% to 192.5 metric tons in the quarter ended June 30, 2014. In India, gold demand dropped 39% on a year-over-year.

The drop in gold demand in these countries is understandable. Gold prices have appreciated this year amid the unrest in Ukraine and the Middle East, which triggered safe-haven bets. This means that if prices were to see a pullback, demand will pick up again like last year.

As a result, gold prices now have a strong floor. The floor seems to be at around $1,200 an ounce. Therefore, if investors were to unwind their safe-haven bets and prices do see a pullback, there is likely to be a strong support at around $1,200 an ounce as physical demand will pick up. At the same time, gold has limited upside potential. The precious metal will see occasional upswing, however, with the Fed now not in the equation, there will not be any significant price appreciation. In fact, this is what we have seen so far this year.

Gold's appeal as an investment in recent years was due to the potential of significant price appreciation. But with limited upside potential, gold is not an attractive investment; especially given that it is not an income-generating asset. A better bet would be to go long on gold miners instead. Indeed, gold miners are far more attractive in the present environment than gold or gold-backed ETFs.

My bullish stance on gold miners is based on two things; a strong floor for gold prices and cost cutting measures from miners.

As gold has found long-term support at around $1,200 an ounce level, it has created a lot of certainty for miners. And with miners looking to bring down their all-in sustaining costs, the existing price environment means that they can generate steady cash flow. It also means that there will be no more asset write downs.

In the second quarter of 2014, Goldcorp had reported all-in sustaining costs of $852.25 an ounce. The company expects its all-in sustaining costs for the year to be at the lower end of its guidance range of $950 an ounce to $1,000 an ounce. Barrick Gold's all-in sustaining costs for the second quarter were $865 an ounce. The cost-cutting efforts and a strong support for gold prices mean that major miners will be able to generate positive cash flows, reduce debt, and possibly increase distributions to shareholders. This makes holding gold mining stocks a lot more attractive than just holding gold or gold-backed ETFs in the current environment. Not surprisingly, shares of Barrick Gold and Goldcorp have outperformed the S&P 500 and the SPDR Gold Trust ETF so far this year.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.