Gold is everywhere to be found in the GCC. People in the region have historically seen it as an intrinsic store of value, as ornamentation, as a symbol of prestige.

The fabulous, crowded gold souks display the appeal of the precious metal (with millions of dirhams worth on display in Dubai, there is never a police presence to be seen!) in the form of breath taking jewelry, in traditional designs and in modern Italian interpretations. It has its place in architecture (as a colour) or within products (either physical gold plating or solid gold).

With the resurgence of metal prices, the Dubai Metals and Commodities Center (DMCC) has announced the construction of a 56-story tower dedicated to the Dubai Diamond Exchange, in a 300 hectare project along Sheikh Zayed Road. Separate towers will be built to house the Dubai Gold Exchange and the Dubai Commodities Exchange. The objective is to dominate the East-West trade in the metals.

Artist’s depiction of the Almas (Arabic for Diamond) Tower

In 1971, the US government took the bold step of de-linking its currency from its gold reserves, which had been established in 1785 when the US$ was created. This changed the US$ from something freely convertible to gold to an IOU that depended purely on the credit worthiness of the US government. With its historic levels of debt that increase annually by record-breaking deficits, the status of the US $ as the world’s reserve currency has been undermined.

Gold, which has been a monetary asset throughout history, benefits by providing an alternate store of intrinsic value.

In 1974, the US government allowed its citizens to own gold again as an investment, something that had been banned in 1933. The price of gold jumped from a relatively stable $ 35 per ounce (oz.) in 1971 to $ 174 per oz at the end of 1974. In 1976, it fell sharply to bottom out at $ 103, and then began a sustained surge that culminated with a peak price of $ 875 in 1980. This was during a period of rising interest rates.

In the short run, as we are currently witnessing, gold and other commodity prices tend to be volatile. They are smaller markets in terms of capitalisation and therefore prone to swings as hot money jumps in and out. But in the long run, prices react to fundamentals. In previous newsletters, I have shown how macro-economic factors are affecting the US economy and therefore forcing the downward trend in the US $, which directly benefits gold.

Gold demand is driven by two fundamental factors: demand for jewelry and investment demand. The supply of gold through mining, about 2,600 tonnes annually, is about equal to jewelry demand.

However, investment demand has grown from 156 tonnes in 2001 to 888 tonnes in 2003(!), according to a GFMS Survey (used by the World Gold Council in its statistics).

What are some of the other current stimuli for gold prices?

• In 2003, China allowed its citizens the right to buy gold for the first time since the Communist take-over. This has created a large base of investment demand for gold, which will only grow as the Chinese economy creates wealth within the middle class. The per capita consumption of gold in China is 0.2 grams, while it is 1 gm in India. The UAE has the highest rate, at 30 grams.
  
• Potential Chinese retail demand for gold shares: In December, 2003, Fujian Zijin, a Chinese mining company raised $ 1.5 billion Hong Kong Dollars in an IPO. For every 1 share being offered, there were 683 retail buyers (oversubscribed).
  
• India has allowed futures trading in gold to recommence, after a 40-year ban.
  
• Japan has announced that it will re-examine the possibility of increasing its gold reserves and that it will not intervene as aggressively as before in buying US Government debt. Japan and China hold over US$ 1 trillion of US debt and appear to be increasing gold in their official reserves while the European and North American central banks are busily divesting their gold reserves.
  
• Malaysia has introduced the Islamic Gold Dinar. It hopes that this currency will eventually replace the US $ as the medium of exchange for trade between Muslim countries.

If you missed the introductory issues of this newsletter, please click on the links below:

I want to mention two caveats before we go any further:

• It is critical, for your financial well being, to hold a diversified portfolio of assets. Numerous studies show how well diversified portfolios comprised of unrelated asset classes outperform investments concentrated in fewer assets in the long run.
• Investing in commodities should be part of your investment portfolio but it should be no more than 10% of your total portfolio, unless you are knowledgeable about the sector.

There are essentially three types of mining companies:

• Companies that focus on production (Senior Producers): These are large companies that primarily focused on mining for precious and base metals. They have revenues, strong balance sheets and can be invested in on a fundamental basis, by examining their gross and net margins, debt:equity ratios, cashflows and other traditional criteria.

  In addition, a valuable measure is the market capitalisation of the company relative to its reserves in the ground (which is the estimated amount of gold and other metals that lies within the areas on which they have mining claims). These reserves represent potential future production.

  These companies generally don’t explore for gold, so they use up part of their reserves every year. To replenish them, they then buy smaller companies, paying a premium to do so.

  If the reserves are healthy and management is sound, these companies will do well with rising gold prices. But because things are relatively transparent and predictable, it also limits the returns compared to smaller companies (see below).

  For example, Newmont is the largest gold producer in the world. It’s share price moved from US$ 18 in July 2001 to $49 in December 2003 (up 172%).

• Companies that focus on production and exploration (Junior Producers): These are intermediate sized companies that primarily focused on mining for precious and base metals. They have revenues and generally strong balance sheets.

  In addition, they are actively seeking to expand their reserves through exploration and development programs. As they incur costs related to these activities, for which the benefits will occur if they are able to discover greater reserves, they undertake exploration to improve their appeal to investors and enhance their market value. This also makes them attractive takeover targets as the industry seeks consolidations during boom periods.

  Junior Producers offer potentially better returns than Senior Producers, due to their existing production which provides the basis for a tangible investment while their exploration provides significantly higher upside potential.

  Wheaton River, which I talked about in the last issue, went from $ 0.60 to $ 4.17 in the same period (up 595%). While Wheaton grew through acquisitions, it was a typical example of the type of returns generated by intermediate sized producers.

• Companies that focus on exploration (Junior Explorers): These are companies scouring the world in search of the fabled treasure. This is the most speculative end of the spectrum, with high risk and extra-ordinarily high return if the company finds indications of metal mineralisation of sufficient potential.

  These companies are true ‘blue sky’ ventures (named after the US securities regulation protecting companies from liability when making projections or estimates). Because they have no revenue and typically expense a lot of their overhead while searching for resources in the ground, the balance sheets generally look sick (even to non-accountants!) and the income statement is simply and inevitably a sea of red ink.

  Because of the potential return, investors in this sector typically allocate a percentage of their investments in the commodities sector to this class of companies, in the search of the ‘Big One’, the one that might provide retirement level returns. Like all lotteries, it happens to some companies (and their shareholders) on a periodic basis.

  Gammon Lake, a well capitalized exploration company, went from $ 0.45 in July 2001 to $ 10 in March 2004, a return of 2122%. It had no revenues during this period and a cumulative loss of $ 10 million to Jan 2004, but it was able to show multi-million oz. gold resources, which led to the huge increase in market valuation.

There are many ways to invest in commodities:

• Buy the physical asset: you can buy bullion bars or gold coins and hold these as insurance against bad times. For coins, you pay less premium when you buy and sell national one-ounce gold bullion coins, like the Canadian Maple Leaf, Australian Nugget and South African Krugerrand.
• Buy metal based Mutual Funds: These are available on all major exchanges. You need to decide on which fund will perform better than others, reasonableness of fees, etc.
• Buy Exchange Traded Funds (ETF): World Gold Council has launched an ETF, with a low management fee that has real gold acting as security for the shares.
• Buy Future and Options: Available on all major exchanges. Allows benefit of leverage which none of the above do, but very risky. You have to know what you are doing.
• Buy Shares of Mining Companies: This is the part of the commodities investment spectrum that I can provide readers with detailed information on, for Canadian companies. The potential returns are higher here than the other categories, but with more risk. Because the companies are publicly traded, you benefit from the inherent leverage, and seek to enhance returns to your overall portfolio.

What this newsletter is attempting to do is to provide readers with a perspective that I have, regarding global economic forces at play and how to benefit from and/or hedge against them.

I want to raise the awareness of readers to consider investing in commodities as part of their portfolio. To this end, my suggestion is for investors to consider investing a part of their portfolio the commodities sector, including Canadian resource equities.

This acts to take advantage of what I believe is a bull market is the commodities sector and to hedge against what I believe is a falling US dollar, by investing part of your assets in Canadian funds and as insurance against global financial storms.

Your assets in GCC currencies, by virtue of being linked to the US$, are at risk as the US$ falls.