Falling Gold Prices Will Hurt Freeport-McMoRan

Apr. 9.12 | About: Freeport-McMoRan Inc. (FCX)

A strong dollar and even a partial recovery in the United States could be bad news for gold producers like Freeport-McMoRan (FCX). Gold prices for June delivery were down by at least $44.30 an ounce on New York's Comex on Tuesday.

The reason gold prices sunk to an 11-week low was the latest report from the Federal Open Market Committee, or FMOC, part of the Federal Reserve. This committee reported that the U.S. dollar is indexing higher against other currencies and oil prices are lower. This could indicate economic recovery, or at least a recovery in the stock and other investment markets.

Part of the reason for the lower prices is that the committee recommended that the Fed not increase interest rates. That means that the geniuses at the Fed don't think a new round of inflation is around the corner. It has been fears of inflation and a coming collapse of the U.S. dollar that have been driving the demand for gold in recent years.

It seems that the markets aren't paying attention to all of the scare advertising for gold firms on cable TV lately. Instead, they seem to think that the U.S. dollar will remain strong and there will be no inflation. If that's the case, then the price of gold could fall further, and with it, demand.

This change in attitude on markets like the Comex seems to have sent money flowing out of precious metals and back into stocks and bonds. Whether or not this is the beginning of the end, the great gold bull market we've seen in recent years is anybody's guess.

A fall in gold prices could definitely affect gold mining companies like Freeport-McMoRan. The nine month low in bullion prices caused the South African gold mining index to fall by 4.5%. Companies that were affected include Africa's biggest gold producer AngloGold Ashanti Limited (AU) and Gold Fields Limited (GFI), which is the world's fourth largest gold producer. AngloGold Ashanti fell by 4.2%, while Gold Fields Limited fell by 5%.

A loss of market confidence in gold could be bad news for Freeport-McMoRan, which is facing a potential fall in copper demand in its biggest market, China. A fall in both gold and copper prices could hit the company hard.

Particularly worrisome is that there seems to be more to gold's slide than comments from the Fed. The increased production and the glut of gold on the market in recent years may finally be catching to up to the exchanges. The gold market appears to be really vulnerable right now, especially to any fall in demand.

Businessweek blamed part of the reason for the gold price's fall on a strike by jewelers in India. India is the world's largest market for jewelry gold. Indian jewelers walked out in mid March to protest a new tax on non-branded jewelry.

It's obvious that the gold market is on very shaky ground, so expect further price decreases. The effect of lower bullion prices on the major gold producers such as Freeport-McMoRan could be less than we think. Gold, after all, is only a small part of the company's business.

Gold mining could still be very profitable, even with significant falls in the commodity prices. Even with a $44 price drop, the yellow metal was still fetching $1,623.4 per troy ounce on the Comex on Wednesday. That means there's still a lot of money to be made from it.

Freeport-McMoRan seems to think so. It declared a cash dividend of 31 cents per share on March 28. The dividend is payable on May 1. We have to wonder if the company will be able to do the same thing next year. Demand for copper in the biggest customer, China, seems to be falling off.

Freeport-McMoRan is not the only gold company doing well these days. Bloomberg reports that profits at AngloGold Ashanti, the world's third largest producer of the shiny metal, increased by one third. Business at AngloGold Ashanti was so good that the company gave its CEO, Mark Cutifani, a 24% pay increase. AngloGold Ashanti's net income rose to $1.55 billion in 2011, but it didn't meet its production target of 4.69 million ounces of gold per year.

AngloGold Ashanti is spending a lot of its profits on increased exploration. In 2011, the company spent $98 million on Greenfield exploration in 17 countries. It was actually prospecting in such exotic locations as Egypt, Ethiopia, and the Solomon Islands. It is even looking for gold underwater in a partnership with diamond giants DeBeers. In 2012, AngloGold Ashanti plans up to up its Greenfield exploration budget to $108.

AngloGold Ashanti intends to spend $150 million on pre-feasibility studies at its two projects in Colombia, La Colosa and Gramalote. It also intends to conduct feasibility studies at the Central Mongbwalu deposit in the Congo. Since there's lots of copper in that region, it could mean that AngloGold Ashanti intends to enter the copper business and compete with Freeport-McMoRan, which is also developing a project in the Congo.

Another company that seems to think gold has a bright future is Gold Fields Ltd. The company is looking beyond its traditional South African sources with an aggressive program of expansion and development. It has active mines in Australia, the African country of Ghana, and Peru, and it's actively looking for more in Canada, Kyrgyzstan in the former Soviet Union, Peru, and even Finland.

The Gold Fields website indicates that it could give the go-ahead for four additional mining projects within the next 18-24 months. The company has also budgeted $150 million for active exploration. Its's ultimate plan is to increase its reserves to five million ounces of gold.

So, what effect will all of this additional production have on the world's gold market? It will probably drive down the prices. Only a growing marketing could absorb all of this demand, and the market doesn't seem to be growing.

One big question mark looming over the entire gold business is China, where demand has been high. If the Chinese economy slows or contracts, a lot of the additional demand could disappear. This already seems to be happening with copper. The current copper stockpiles in Shanghai currently exceed the Chinese demand.

It should be pointed out here that, unlike copper, the demand for gold is largely driven by emotional or behavioral factors. People buy gold because they don't trust the economy or money. They're afraid of inflation, political turmoil, or a currency collapse, so they put their money into something tangible. If things get bad, people buy gold.

If you adjust it for inflation, the gold price hit its all time high during the uncertain year of 1980. Gold prices were actually higher in 1980 than they were in 2010. It hit another high on June 8, 2010, right after the end of the great economic meltdown of 2007-2008. The reason the metal fetched so much in those times was the fear of inflation and political uncertainty.

Gold demand is largely based on fear, and as uncertainties about the economy decrease, the demand should fall. An interesting point here is that the demand for precious metals often slackens if an economic downturn lasts for a while. People get used to the situation and lose some of their fears. They also begin seeing opportunities in other areas, such as the stock market.

Even the demand for gold jewelry in India, which is driving a lot of the demand for the metal, is based partially on fear. India has a long history of failed government intervention in the economy and confiscation of wealth. People there buy gold jewelry figuring that it is one thing that socialist politicians cannot steal from them.

An interesting point here is that demand for gold could increase if the Chinese economy starts to slow. If the Chinese get nervous about their economic future, they may start buying a lot of gold, particularly if it looks like the Communist Party rule there is about to collapse. Any economic downturn in China could lead to political unrest, which could bring down the regime in Beijing.

Another factor that could again get the gold bull running is the U.S. economy. There's still a lot of uncertainty in the U.S., fueled by the presidential election, high oil prices, and questions about ObamaCare. This could lead to higher demands for gold.

Unrest in China would be good for Freeport-McMoRan's gold business, but bad for its copper and Molybdenum sales, because it would probably mean lower demand. The question is whether the higher gold profits can make up for what the company loses on its other production.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.