Last week was a great week for gold. Its price increased from US$1,310 per ounce to US$1,340 per ounce, which is a rise of 2.3%. This caused gold miner Newcrest Mining Limited's (ASX: NCM) share price to increase by 6%.
The main reason for gold's price rise was the decision by the Federal Reserve to keep US interest rates on hold. The subsequent relief rally may keep gold moving higher in the short run, but I believe it will be a different story over the medium term.
A Changing Outlook
Since gold offers no interest payments, it is highly sensitive to US interest rates. The higher the US interest rate, the greater the opportunity cost to investors of holding gold versus an interest-producing asset. Further, a rise in interest rates will (other things being equal) boost the value of the US dollar. Since gold is traded in US dollars, this will make it more expensive for non-US investors to buy it. This will reduce demand for gold and could cause its price to fall.
Although a lack of an interest rate rise is good news for gold, I believe that it is only a matter of time until the Federal Reserve raises US interest rates. The consensus forecast is for a December rise, since the effects of Brexit on the global economic outlook have thus far been less than feared. Further, the global economic outlook is more positive than it was earlier in the year.
When US interest rates rise, the likelihood is that the gold price will fall. Since Newcrest relies on gold for nearly 90% of its sales and is therefore a price taker, this will negatively impact its financial performance.
Financial Standing
Newcrest has made progress in reducing its cost base. For example, it reduced its all-in sustaining costs per ounce by 2% to US$762 in financial year 2016. This combined with an increase in gold production of 1% to 2.4 million ounces and a higher gold price means Newcrest has been able to reduce net debt by 27% to US$2.1 billion as at 30 June 2016.
This equates to a net debt to equity ratio of 30% and a net debt/EBITDA ratio of 3.5. Interest payments were covered 4 times by operating profit in the 2016 financial year. This is comfortable in terms of covenant headroom during a period when gold prices are relatively high. However, should gold prices fall, Newcrest's financial standing could quickly deteriorate. This is thanks to its status as a cyclical miner exposed almost exclusively to gold. In this sense it has a higher risk profile than better diversified mining peers such as BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO).
Outlook
In my view, the outlook for gold in the short term is positive. Delayed interest rate rises plus high uncertainty among investors could cause a further rally. However, over the medium term interest rate rises are highly likely. They could cause the price of gold to deteriorate alongside Newcrest's financial performance and share price.
Therefore, I believe that investors should avoid Newcrest and instead focus on these 3 blue-chips which could boost your long term portfolio returns.
