FUNDAMENTAL REASONS TO OWN GOLD

By: John Embry, Chief Investment Strategist Of Sprott Asset Management Inc. & Sprott Gold And Precious Minerals Fund.

1. Alarming Financial Deterioration in the U.S.

   In the space of a mere three years, the financial situation in the U.S. has experienced a remarkable transformation. The Federal government budget surplus has turned into a massive deficit (which if correctly accounted for on an accrual basis would be in the trillions of dollars), the trade and current account deficits have reached levels which have portended currency collapse in virtually every other instance in history, and the debt position of individuals has become so extended that higher interest rates and/or economic recession would be catastrophic.

2. Global Currency Debasement

   Because of the aforementioned difficulties, the U.S. dollar is both fundamentally and technically weak and is fated to fall dramatically. However, most other countries are very reluctant to see their currencies appreciate and will resist the inevitable fall of the dollar. Thus, we are in the early stages of a massive global currency debasement which will see tangibles, and most particularly gold, rise significantly in price 

3. Investment Demand for Gold is Accelerating

   When the crowd finally recognizes what is unfolding, they will seek an alternative to paper currencies and financial assets and this will create an enormous investment demand for gold. This phenomenon is already well underway in gold friendly areas like India and the Middle East but is only in nascent stages in the Western world. To facilitate this demand, a number of new vehicles like Central Gold Trust and Gold Exchange Traded Funds (ETF's) have been created.

4. Negative Real Interest Rates in Reserve Currency (U.S. Dollar)

   To combat the economic and financial fragility in the U.S., interest rates are being held at inappropriately low levels and with inflation rearing its ugly head, real interest rates, at the short end of the curve, are negative. Despite Fed Chairman Greenspan's promise of "measured" interest rate hikes, real rates are expected to remain in negative territory. There has been a strong historical relationship between negative real interest rates and stronger gold prices.

5. US Federal Reserve Policies in the Event of Increased Deflationary Pressures

   Fed governor Ben Bernanke has been very explicit in respect to this issue, suggesting that the U.S. government has a printing press and would be prepared to use it, if need be. In fact, he went so far as to suggest that the authorities would drop money from helicopters to avert the spectre of deflation. The validity of fiat paper money rests upon confidence and these sorts of policies, if ever implemented, would surely destroy that confidence.

6. Ongoing Proliferation of Financial Derivatives

   The dramatic increase in the usage of financial derivatives in recent years, many of them over the counter and thus unregulated, is creating an unquantifiable risk element in the financial system. With notional values well in excess of U.S. $100 trillion, this is not an insignificant issue. It is worth noting that Warren Buffett, one of this generation's most successful investors, refers to them as "weapons of mass financial destruction". An adverse development on this front would dramatically impact confidence in paper money 

7. Existence of a Huge and Growing Gap Between Mine Supply and Traditional Demand

   Gold mine supply is roughly 2500 tonnes per annum. Traditional demand (jewellery, industrial uses, etc.) has exceeded this by a comfortable margin for a number of years, even in the virtual absence of any investment demand. Some of the gap has been filled by recycled scrap but Central Bank gold has been the primary source of above-ground supply.

8. Mine Supply will Likely Decline in the Next Three Years

   Even if traditional demand were to erode in the event of worldwide economic weakness, and investment demand disappointed, the supply-demand imbalance would probably persist due to constraints on mine supply. Mine supply could well contract in the next several years, irrespective of the level of gold prices, due to a dearth of exploration in the post Bre-X era, a shift away from high grading which was necessary for survival in the lengthy period of subeconomic gold prices, mining practices which permanently impaired a number of mines during the same era, and the natural exhaustion of mines.

9. Large Short Positions

   To fill the gap between mine supply and traditional demand, Central Bank gold has been extensively mobilized, primarily through the leasing mechanism which facilitated both producer hedging and financial speculation. Strong evidence suggests that at least 50% of reported Central Bank gold reserves have entered the market in this process. This is owed to Central Banks by their counterparties in these transactions, the bullion banks. Whether the Central Banks ever get their gold back is immaterial to the case for gold because the gold is gone and can't be sold again. However, if the Central Banks were to demand that their gold be returned, it could trigger an epic short squeeze.

10. The Central Banks are Nearing an Inflection Point When They Will be Reluctant to Provide More Gold to the Market

    The Central Banks have already supplied too much already via the leasing mechanism, a development somewhat reminiscent of the late 60's and early 70's when Central Banks sold well over 100 million ounces in an ultimately failed attempt to hold gold in the neighborhood of U.S. $35.00 per oz. A new generation of central bankers appear to have learned nothing from the past. The renewal of the Washington Agreement, permitting European Central Banks to sell 500 tonnes per year for five years, may have been misinterpreted by many observers. There is increasing speculation that there will not be a sufficient number of candidates prepared to sell to come anywhere near the maximum amount allowed.

11. Increasing Likelihood of Central Bank Gold Purchases

    The Russian and Far Eastern Central Banks have been accumulating enormous quantities of U.S. dollars in their reserves and have stated their intentions to lessen that exposure by diversifying into other currencies. Gold, which is regaining its status as a currency, comprises a very low percentage of their reserves currently and is an obvious candidate for inclusion. As a sign of the changing times, Argentina, which was nearly bankrupted by a failed dollarization scheme several years ago, recently announced that their Central Bank has purchased more than 50 tonnes of gold for its reserves, much to the chagrin of the IMF.

12. Large Increases in Outstanding Gold Derivatives Despite a Major Reduction in Producer Hedging

    Producer hedging has been sharply curtailed in response to several corporate blow-ups caused by excessive hedging, the latest involving the Australian producer Sons of Gwalia. In addition, underperformance by the stocks of heavily hedged producers, rising gold prices and materially lower contangos have reduced the incentive to hedge. So instead of producers supplying additional gold to the market through the hedging mechanism, the reverse is now happening. Despite this, gold derivatives, as reported by the Bank of International Settlements (B.I.S.), have continued to rise, suggesting either a major bet against the secular trend of the gold price or the possibility of nefarious activity (i.e. price suppression) in the gold market.

13. Gold is Remarkably Cheap in the Context of Oil Prices

    Since gold began to trade freely in 1971, the ratio between the price of an ounce of gold and a barrel of oil was established, and thus created a metric by which to compare their relative values. If the average ratio, measured over the past 33 years, were in effect today, gold would be trading several hundred dollars higher than it is currently. With a strong probability that high oil prices may be here to stay, gold looks very undervalued.

14. The China Factor

    Chinese citizens have very recently been given permission to buy gold for investment. When a similar event occurred several years ago in India, demand rose sharply. In view of the size of the Chinese population, its rising standard of living, and its proclivity for gold, this could be a seminal event for gold demand.

15. Gold as Money Continues to Gain Credence

    Islamic nations are investigating a currency backed by gold (the Gold Dinar), countries such as Russia, which were previously plagued by weak currencies, are talking about fully convertible currencies backed by gold, and the Argentine Central Bank's purchase of gold suggests that President Nestor Kirschner may be in the early stages of making good on a campaign promise to introduce a gold backed peso as an antidote to the financial disaster that his country experienced.

16. Rising Geopolitical Tensions

    The increasing probability of a long conflict in Iraq, deteriorating conditions in general in the Middle East, the nuclear ambitions of Iran and North Korea, and the ongoing terrorist threat posed by Al Quaeda are among many geopolitical issues which could make investors very uncomfortable. A fearful public has a tendency to gravitate towards gold.

17. Limited Size of Total Gold Market Provides Tremendous Leverage

    All the physical gold in existence is worth approximately U.S. $1.5 trillion and the capitalization of all publicly traded gold companies is in the neighborhood of U.S. $100 billion. When the foregoing fundamentals encourage a strong flow of capital towards gold and gold equities, the trillions upon trillions worth of paper money will propel both to unfathomably high levels.

Gold is undervalued, under-owned and under-appreciated. It is most assuredly not well understood by most investors. At the beginning of the 1970's, when gold was about to undertake its historic move from U.S. $35 per oz to over U.S. $800 per oz in the succeeding 10 years, the same observations would have been valid. The only difference this time is that the fundamentals for gold are actually better.

April 28/11

June 30/10

June 30/09

June 30/08

Annual Financial Report 2007