While Gold Supply Peaks, Gold Is Headed Higher

Includes: GDX, GLD
by: Katchum

In a previous article, I pointed out that the marginal cost of gold production including exploration, feasibility studies, construction, maintenance, production and taxes has doubled since 2009 up until now. That has placed a large burden on gold mining companies over this period. The result was a decline in the gold mining index (NYSEARCA:GDX) of around 10% since 2010. Even when the gold price steadily went up from $800 to $1600/ounce, there wasn't a lot of profit to be made by the gold mining companies themselves. This means that gold mining companies are very dependent on the gold price for their margins and profits. At the same time, I want to make a case that the gold price is also very dependent on the mining companies.

If anyone ever says that gold mining production isn't going to affect the gold price, you can use these charts to prove them wrong.

In 2012, we had 4000 tonnes of total gold supply per annum, while gold mine production was around 2812 tonnes per annum in 2012. That's a 70% interest of gold mine production as compared to the total gold supply.

If the gold miners continue to have lower prospects for production due to the marginal cost of production rising above the gold price (total marginal cost is currently $1500/ounce), then the supply of gold will drop. As a result we will see a rising effect on the gold price when this supply breaks down.

Mine supply had been going up since 1974 (Chart 1), but has peaked since year 2000. I believe mine supply is going to stay flat or even drop going forward due to decreasing ore grades and higher marginal costs of production.

Mine production was very important in the 70's as gold mine production was almost 100% of total gold supply. As we progressed, secondary supply came into existence (Chart 2). Gold was being recycled more and more as the price of gold gradually went up. Even though gold supply from mining became less important over the years, it still comprises 70% of total supply.

The meaning of this high percentage is that when mines produce less, due to inflation of cost to mine the gold, it will still have a significant impact on the gold price.

The next question arises then. Can gold recycling keep gold supply up in the coming years?

It can if the price is right. But the price of gold hasn't gone anywhere these last several years, so we see the supply due to gold recycling flattening out in 2011 (Chart 3). Most of the increase in gold recycling supply was due to retailers selling off their gold (aka "Cash for Gold"), but there is a point of exhaustion. This is an unsustainable source for gold supply and I expect this supply of recycled gold to drop back to the trendline of 750 tonnes per annum, unless of course the gold price starts to increase much higher.

So on one part of the supply equation we have a flattening mine supply, due to the rising marginal cost of production. And on the other part we have a dropping supply due to less recycling of gold. Knowing that gold demand will continue to go up due to the Asian economies increasing their gold buying (in particular China as we noted that gold imports from Hong Kong to China are exploding), while gold supply is dropping, I believe the gold price (NYSEARCA:GLD) will be very supportive going forward. This is especially the case when the Western economies have started to buy gold again since 2008 as I pointed out here.

Disclosure: I am long AGQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.