A fork in gold's road

The independent expert's report on the mega gold merger of Newcrest Mining and Lihir Gold has produced an intriguing and novel insight. The traditional relationship between gold equities and physical gold has broken down.

Grant Samuel has a very long history of valuing gold companies. In its report (which endorsed the Newcrest offer in the absence of a superior proposal) it says its experience has indicated a consistent relationship between sharemarket and transaction values for gold companies and the value of physical gold.

Market values, it said, have consistently reflected the value of mining inventories at spot gold prices, less the present value of all extraction costs.

That was the case until the onset of the financial crisis in 2008. From that point there had been a 'dislocation' between physical gold and gold equities.

The history showed a clear correlation between gold shares and physical gold, with equities generally out-performing physical gold during periods of rising gold prices because they effectively provide a geared exposure to gold.

From January 2008 to mid-July this year, however, Grant Samuel said the gold price had increase 45 per cent (from $US834 an ounce to $US1212 an ounce) while the S&P TSX Global Gold Index rose only 12 per cent. That occurred even though cash margins for the big producers had actually been increasing, which suggests a major de-rating of gold equities relative to physical gold.

In fact there appear to be two quite distinct breaks in the relationship – the big one after Lehman Brothers collapsed and another widening earlier this year as the European sovereign debt crisis erupted.

The obvious explanation for the breaks in the correlation since the crisis developed is gold's peculiar status as a secure and portable financial asset. In times of crisis physical gold provides greater reassurance than shares in corporate entities.

Equities might also be affected by the overall momentum of markets and move differently to the market for physical gold. As recent experience here would suggest, there's also the possibility that the tax regime for corporate entities might change.

Grant Samuel also proffered an alternate, or perhaps complementary, theory. It says the underperformance of gold stocks relative to physical gold might reflect an equity market assessment that the rise in the gold price might not be sustained and therefore valuations of gold equities were based on lower longer term price assumptions than the spot price.

Yet another possible influence in undermining the relationship might have been the difficulty the major gold producers have had in offsetting the depletion of their reserves with new resources.

Most of the bigger recent discoveries and new mines have been in porphyry-hosted deposits containing other metals, notably copper.

The copper price fell during the crisis, so the divergence between physical gold and gold equities might also reflect a somewhat less golden flavour to the equities than was the case in the past.