Burned By Gold Gold's painful decline over the past 18 years has singed investors, halved the market value of mining companies, and thrown thousands out of work. Now the central banks are selling. How much longer will this go on?
By Andrew Serwer

(FORTUNE Magazine) – As soon as the news flashed over the wire, UBS gold analyst Andy Smith got a sick feeling in his stomach. It was last Oct. 24, and though the wire report was sketchy, it appeared that a group of experts appointed by Swiss banking officials had recommended that their country sell some 54% of its gold reserves. Frantically, Smith worked the phones from his paper-strewn London office trying to get hard information. Finally, hours later, the Swiss issued a press release--in German. "I was using my high school language skills to translate," recalls Smith. "It hurt my brain." But after struggling through the first few sentences, he understood enough: The Swiss were indeed considering selling their gold.

Smith knew the news would absolutely sandbag the gold market. While Switzerland doesn't hold as much gold as the U.S. or Germany, it is the only country that still partly backs its currency with gold, and any hint of selling could have a cataclysmic effect on market psychology. Smith nervously counted the minutes until the COMEX opened in New York, 1:20 P.M. London time. Sure enough: gold immediately plunged from $323 an ounce to $306 and never recovered. It was among the biggest one-day declines in the decade.

Sadly enough for Smith and the thousands of others whose livelihood depends on gold, the Oct. 24 plunge was exceptional only by degree, not by direction. In case you haven't noticed, gold has been in a horrendous bear market since 1980. Back then inflation was running in double digits, the dollar was considered a wasting asset, and an ounce of gold fetched as much as $850. But as successive Federal Reserve chairmen wrung inflation out of the U.S. economy, gold began an uneven but inexorable slide to around $300 an ounce--making this most precious of metals a lot less precious. Last year was particularly brutal, as central bank gold sales, short-selling, and the disinflationary effects of the Asian crisis combined to knock gold down 20%. Maddeningly, the metal's long-term tailspin has occurred against a backdrop of soaring prices for other investments: Stocks are up 1,537% since 1980, bonds 698%.

Gold's generation-long death march has left no shortage of disappointment and disruption in its wake. Gold-mining companies have to contend with shriveled market caps and shrinking operating margins. Their employees watch their job security ratchet down with each drop in gold's London fixing, while the towns where they live nervously tighten the civic belt. And a few contrarian money managers continue to bet their flagging reputations (not to mention their shareholders' dwindling money and patience) on a gold rally that should appear but never does.

Still, the metal Keynes called a "barbarous relic" continues to exert a unique hold on people's imaginations--part industrial commodity, part heirloom, part currency of last resort. Yes, gold has lost 67% of its value over the past 18 years, but men still lower themselves into the earth and dig up some 2,400 tons of the stuff each year. Central bankers still hoard 35,000 tons of it in their national vaults (although with less conviction than ever before). And plenty of investors continue to leap at bullish arguments for gold. In recent years, for example, it was the alleged rise in jewelry demand from newly prosperous Asians (see box "The Force That Wasn't"); more recently, it was Warren Buffett's sudden taste for silver (see box "Why Gold Isn't Silver"). Even so, everyone involved with gold must have wondered at one time or another in the past few years, "Is gold ever going to come back in value?"


It's a late January morning in a New York City hotel conference room, and Newmont Mining CEO Ron Cambre readies himself to deliver his company's year-end financials to Wall Street analysts. Shuffling through his papers, Cambre takes a deep breath. "We had an outstanding year," he begins confidently. "We maintained our leadership position in the industry. We mined just under four million ounces of gold last year--the most by any North American company ever. Operating earnings climbed 70%...." Cambre soon enough concludes his presentation and then takes questions from the analysts. Most begin their queries by congratulating him on "a great quarter," and then go on to ask detailed questions about mining operations in Indonesia and Peru.

But wait a minute. Isn't everyone forgetting something here? While Newmont, North America's largest gold producer, is in reasonable shape, the analysts and Cambre are glossing over some ugly basic realities. Bluntly put, the company is in a shrinking industry, and its product lost a fifth of its value in the past year. Two of Newmont's competitors, Pegasus Gold and REA Gold, recently filed for bankruptcy, and others, like Echo Bay and Royal Oak, haven't earned a profit in at least five quarters. Last year the total market cap of all the world's gold companies fell from $71 billion to $46 billion, a remarkable 35% drop. That would give the entire industry roughly the same market cap as Home Depot.

Newmont is one of the industry's most efficient companies, but it too has been squeezed by gold's decline. Its total cost to produce an ounce of gold--including overhead--is upwards of $250, uncomfortably close to gold's current price. The company's net margin has fallen from as high as 15% in the early 1990s to around 11% recently. Its return on equity has drifted down to the single digits. And worst of all, its stock has fallen from a high of $60 in 1996 to below $30.

Cambre, a no-nonsense mining executive who was brought in from Freeport-McMoran in 1993 by Sir James Goldsmith--who at the time had an interest in the company--must feel other frustrations as well. His most recent grant of 25,000 stock options is deeply out of the money at $55. And Cambre's base pay has climbed only 5% over the past few years, while increases in other compensation have been modest too. "It's damned frustrating," says Cambre in a conversation after he's through with the analysts. "We're working twice as hard as we used to, but when you have a wind in your face like this, what can you do?"

One thing he might have done was to hedge his future sales against price declines. When Newmont bought Santa Fe Pacific Gold last May, it inherited a 1.1 million-ounce hedged position, which Cambre promptly began to unwind. Why would he do that in a falling market? Back then Cambre said, "This is a time to reassert our confidence in the metal and provide our shareholders the opportunity to fully participate in any rally in the gold market." Andy Smith of UBS attributes Newmont's reluctance to hedge to a certain gold-strike mentality among gold-mining executives. "Cambre is of the school that believes ultimately the sky is blue," he says. "And if you believe that, you don't sell forward." Selling forward, after all, is an admission that you expect your product to be worth less in the future than it is today.

In contrast, Toronto-based Barrick Gold, the second-largest North American mining company, the one Morgan Stanley analyst Doug Cohen calls "the marquee name of the gold group," has maintained a mammoth hedging program covering some $4 billion of gold. Last year the hedges allowed Barrick to sell its gold at $420 per ounce, an average of $88 over the spot price. Multiply that by three million or so ounces Barrick produced last year, and you can see that the company reaped an extra $269 million in revenues. In fact Barrick has hedged its production until the year 2000 at $400, and effectively its entire reserves at $350. That may be one reason Barrick carries a market cap 60% higher than Newmont's, even though its revenues are 20% smaller.

But even Barrick hasn't totally escaped the pain wrought by gold's decline. The company has shut down low-grade mines, for which it took a $385 million write-off in the third quarter. Newmont, too, is taking steps to cut costs. On that day in January, Cambre tells analysts that his company is reducing capital spending, cutting back on exploration, and laying off 500 administrators and miners.


The night before Cambre made his Wall Street presentation, Newmont miner Trevor Smith had been out drinking Budweisers at Shenanigans Game Lounge not far from his home in Elko, Nev. Smith had the next day off, so he stayed out a little later than usual, but managed to meet his dad for breakfast the next morning at 7. Still a little bleary from the night before, Smith made his way home after breakfast to bed. At 9:30 A.M. the phone rang. It was Wren Doxey, a Newmont mine foreman. "Trevor, I'm sorry to tell you this, but we're going to have to lay you off," said Doxey. "With the price of gold what it is, we just have to let people go."

Elko is located in northern Nevada along interstate 80, some 300 miles east of Reno. The town of 35,000 happens to be close to the 50- by five-mile Carlin Trend, one of the largest goldfields in the world (along with Witwatersrand in South Africa and Kalgoorlie in western Australia), with more than 70 million ounces of proven reserves. The discovery of the rich deposit in the 1960s produced a modern-day gold rush. Barrick and Newmont, the town's two dominant employers, pumped tens of millions of dollars into the local economy and created over 4,000 relatively well-paying jobs. Miners piled into town from around the country.

Smith came rather late to the gold rush, arriving from his native Montana seven years ago when he was 18. "I applied for a job at Newmont and got it," he says. "It was pretty straightforward." Indeed. When he was laid off, he was making about $39,000 a year. Not bad for a 24-year-old with no college education.

Like thousands of other miners, Smith used to make the 30-mile trip from Elko to the mine sites, which are massive moonscapes of dirt, mud, and at this time of year, snow. Barrick's operations spread out over 7,000 acres and include a giant one- by 1.5-mile open-pit mine. Perched on the pit's northeast rim is a control tower where engineers at a desktop computer use a GPS system to track the location of each of the company's 74 giant Caterpillar dump trucks. These mighty Cats, each two stories tall and worth $1.6 million, ride on the left side of the dirt tracks that spiral down into the pit; that way the drivers can better see the edge of the road. A $26 million electric trolley system brings the trucks up the 1,000 feet from the pit's bottom, saving diesel fuel and speeding them up the steep grade.

Barrick and Newmont both have underground mines at Carlin too. The entrance to Newmont's mine is a portal in the side of a pit wall. Miners tear 1,800 feet down this hole in low-slung, powerful half-tracks at alarming speeds. The scene underground is a cross between Star Wars and Mad Max; muddy, hot, and loud, with whole rooms carved along the sides of major passages for garages and power plants.

You can't see the gold ore at Carlin. It is microscopic and embedded in the rock. Still, the underground mines yield as much as one ounce of gold per ton, a rich take in this business. To extract the ore, the companies refine the rock through cyanide leaching, roasting, and pressure-cooking (no sauteing or simmering though), all of which is done on giant outdoor mounds or in megarefineries at the mine site. At the end of the day, with all those miners and all that equipment and all that effort, a single refineryman pours the molten ore into molds, making from five to ten 50-pound gold bricks. Each is worth some $250,000. Armored cars arrive at deliberately irregular intervals to haul away the booty, which is shipped to Salt Lake City and London for further refining.

With the amount of gold still left in the Carlin Trend, most locals were counting on the boom to continue indefinitely, even as gold prices weakened through the mid-1990s. But now, with the dramatic price declines of last fall, there has been a palpable shift in sentiment. Locals whisper at the checkout at Albertson's supermarket about further layoffs. There's even talk of cutting the school budget.

What will happen to Elko if the metal sticks at $300 for a few years? It's hard to say. Because the cash cost to extract the ore from Carlin is generally low--around $200 per ounce--the town ought to at least weather the downturn. But the layoffs at Newmont have taken their toll

on the town's morale, and Trevor Smith, for one, has seen enough. Now he has turned his thoughts to Oregon or California, where the union may help him find a construction job. "Right away when I got the call about the layoff, I knew I had to leave Elko," he says. "There won't be any more work here."


Gold joke, circa 1998: Q: What's the best way to get $25,000? A: Put $50,000 in a gold fund.

Money manager Jean-Marie Eveillard sighs and reaches for another cigarette. "The idea when I started my fund in 1993 was that gold was a long-depressed asset. I thought the downside risk was modest. Everything was right with the world, so maybe that would change," he says in a strong French accent. "But it hasn't worked out that way."

Eveillard is a man not used to failure. Widely regarded in the fund business as a smart, contrarian investor, he has made his shareholders good money in his other funds. As the head of the U.S. investing business of the giant French bank Societe Generale, he has built assets under management from $18 million in 1978 to more than $5 billion today. But his foray into gold stocks has been a disaster. Last year, Eveillard's SoGen Gold fund was down 30%. The year before that it was flat. And the year before that. And the year before that. All told, Eveillard's fund is down 17.6% since its inception in the summer of 1993, vs. a gain of 134.5% for the S&P 500. "It is humbling," he admits. "And very public."

Not that any of Eveillard's peers have done better. The average gold mutual fund has produced an average annual loss of 12% over the past three years, while the group's total net assets have dropped from some $5.7 billion in 1993 to around $3.3 billion today. If your mandate was to invest in gold stocks in the past few years, there has simply been no place to hide.

But on one significant point Eveillard does stand out from his peers. He has decided, and publicly announced, that if the price of gold does not improve this year, he will seek to shut his fund down. Under the circumstances this would not be an irrational act, yet none of his peers have suggested they will follow suit. The reason? The roughly 40 precious-metals funds now on the market continue to bring in some $50 million a year in management fees to fund companies. What about Eveillard? "I would rather maintain some integrity," he says. In fact, his main reservation about shuttering his fund has nothing to do with forgone revenues. "I'm just afraid that the day after I liquidate the fund, gold will start to rise."

Another investor who has been publicly wrong on gold for a long time is the famously bearish market commentator Jim Grant. " 'Tis the age of financial assets," Grant says with dismay. "I anticipated a succession of currency crises [in Asia], but what we didn't see was that it would be so bearish for gold, because people flew into dollars instead."

Ever hopeful, however, Grant recently bought the ADRs of South African mining companies such as Vaal Reefs, Durban Deep, and Western Deep, along with shares of Barrick. The South African stocks represent a particularly bullish bet because their production costs tend to be higher than at top-line North American companies like Newmont and Barrick. As a result, a small increase in the price of gold can translate into a giant boost in operating margins. "At some point," Grant says hopefully, "central bankers won't be able to solve all the world's problems."


Could Jim Grant finally be right? Maybe. With gold, anything is possible. But here are several scenarios, short term, intermediate, and long term.

In the short run, as in this year, it's certainly possible for gold to bounce back $10, $20, or even $30 an ounce. It all depends on how much gold the European central banks decide is necessary to back the new euro currency. The announcement will probably be made before midyear. Right now the market is leaning toward the assumption that the bankers will shun gold. If instead they mandate that gold be used to back the euro to a greater degree than anticipated, the market could rebound nicely. Barrick CEO Peter Munk, who recently spent several days with those bankers in Davos, Switzerland, is bullish. "I think the Germans and French will reaffirm they aren't sellers."

Over the intermediate term, however, it's difficult to be bullish. Gold-mining executives constantly point to the roughly 1,000-ton imbalance between the amount mined and the demand, mostly from jewelry manufacturers.

What this optimistic case ignores, however, is the 35,000 tons of gold held by the world's central banks. That's enough to supply the world's jewelry fabricators for ten years, even if no one pulls another ounce of gold from the earth. According to gold trader Merrit Levenberg, the central bank overhang accounted for much of gold's recent dismal performance (along with the short sales by hedge funds). Significantly, only a minimal amount of gold--493 tons--actually came on the market, and the sales were all by countries with modest reserves, such as the Netherlands, Argentina, and Australia. The amount sold was less than the 588-ton increase in gold used for jewelry fabrication in 1997. Plus, it represents only 1.4% of the amount sitting in central-bank vaults. "But that's just the point, isn't it?" says Andy Smith of UBS. "There's a lot more to sell."

Don't look for much relief from this worry in the foreseeable future. As gold's bear market drags on, central bankers are finding it increasingly difficult to justify storing a large share of their countries' wealth in a depreciating asset that has never earned a penny of interest. Some bankers have turned to lending some of their gold to so-called bullion banks for annual interest between 1% and 2%. But that's not much comfort to gold bulls, since borrowed gold is used to short the market. Besides, from a central banker's point of view, leasing gold is not nearly as rewarding as keeping the money in dollars--that is, U.S. Treasury bonds--paying 6% or so.

Looking further ahead, though, it's hard to imagine that at some point gold won't rise again. Perhaps a new round of global inflation could lead to a restoration of gold's traditional role as a safe haven. Ask Eveillard if he sees any reason to be bullish about gold, and the Frenchman pauses for what seems like 20 seconds. Finally he says, "Maybe it's just that gold has been down so long, and no asset stays down forever."