The Gold Standard - TheStreet

The Gold Standard

Freeport McMoRan's increasing focus on copper threatens to throw the leading gold indices out of whack.
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How much gold does a mining company need to produce to keep its stock in a

gold index

?

Not much, apparently, if

Freeport McMoRan Copper & Gold

(FCX) - Get Report

is anything to go by. And that has some gold market insiders calling for change at the exchanges that manage the leading indices.

Freeport, which took over

Phelps Dodge

last month, now claims a mere 10% of its revenue from gold, with industrial metals copper and molybdenum capturing 78% and 12% of total sales dollars, respectively, according to pro forma information provided by the company.

Yet Freeport stock makes up more than 17% of the market value of the Philadelphia Gold and Silver Sector Index, 10% of the value of the Amex Gold Bugs Index and nearly 8% of the Chicago Board Options Exchange Gold Index.

"This has the potential to undermine the value of these indices for many technical analysts who use them in their daily work," says Frank Barbera, the Los Angeles-based editor of the

Gold Stock Technician

newsletter.

Market technicians, or chart watchers, follow the price movements in such indices as indicators about the wider gold patch and use the price patterns to divine trading signals. All of which makes Freeport's continued inclusion on the Philly index a problem, Barbera adds.

"With a 17% weighting for a copper stock, they are out to lunch," he says.

Other industry veterans echo Barbera's thoughts.

"Why would you want a copper company in a gold index?" asks Joe Foster, gold strategist at money manager Van Eck in New York. He acknowledges that hugging the index would keep most investors exposed to gold, but with Freeport in the mix, there is "still likely to be some tracking error."

Although copper and gold have both been in a bull market of late, a U.S. economic slowdown could see prices for the two metals diverge. The value of copper would tend to decrease as economic activity slows. But a recession would also likely auger a weaker dollar, which in turn is generally seen as a positive for bullion prices.

Such a blemish in the purity of an index may not even be noticed by some end-users, explains Peter Rodriguez, an economics professor at the University of Virginia's Darden School of Business. That's because some index-watchers tend to be interested in the liquidity of the associated options rather than in the details. But on balance, he says, it's not an ideal situation.

"I think they should drop Freeport," Rodriguez says. "Certainly copper and gold are far enough apart to sully the index, which is what will happen if it stays in."

At least part of the problem seems related to relative price changes in the two major products that Freeport produced prior to bagging Phelps -- gold and copper. While gold's value has more than doubled since 2001, copper has rocketed up five-fold during the same time. In part, that's why Freeport's revenues last year were split so heavily in favor of copper: 77% came from copper sales, as opposed to 23% from gold.

Such price fluctuations likely help explain how Freeport, prior to absorbing Phelps, was able to stay in the gold indices so long, despite the heavy influence copper has held on earnings.

But Freeport's acquisition of Phelps led at least one index manager to cry uncle. The 38-stock-strong Amex Gold Miner Index ditched Freeport on March 16, after the merger. Thereafter, Van Eck, which last year launched the

Market Vectors Gold Miners

(GDX) - Get Report

exchange-traded fund to track the index, quickly followed suit and purged itself of Freeport holdings.

Eliminating a component from the other three indices might be a little more tricky. The Philly Gold & Silver Index has a mere 16 components, Amex Gold Bugs has 15, and the CBOE's has 13. Even cutting one stock could leave a hefty hole, and replacing it presents other problems.

"If they do replace Freeport with another gold company, the question becomes which one should be used?" asks Van Eck's Foster. "There are no other really big gold companies to include, and the silver companies tend to be small."

Foster agrees. "It's probably a problem for them," he says.

Characteristically, the exchanges are remaining tight-lipped, although they all say regular reviews take place to evaluate the composition of each index.