The Case Of The Missing Gold Demand

Includes: DUST, GLD
by: Macro Investor

I have written a lot about how drop in Indian demand has been the main culprit behind lower gold demand and prices in 2012. Indian demand fell from ~1,000 tonnes in 2011 to ~850 tonnes in 2012. Chinese demand went up, but still was not enough to overcome the drop in Indian demand. All in all, prices for the yellow metal suffered. It seems like I was barking up the wrong tree, so to say, all this time.

First, the bad news. The World Gold Council believes that in terms of demand, 2013 will be similar to that of 2012. I do not need to reiterate what this means for price of gold (NYSEARCA:GLD). It will flatline, just as I had anticipated several months back and wrote about it multiple times on Seeking Alpha.

Anyway, back to demand. Reports Reuters:

Demand for gold fell last year for the first time since 2009 as Asians bought less jewellery and Western investment dipped, the World Gold Council said in a report bears saw as new evidence the 12-year rally may be topping out. The WGC, which is funded by the gold industry, said on Thursday that gold consumption was expected to be steady this year.

The WGC is an industry public relations body. I can assure you that they do not say things like "steady consumption" without thinking a lot about it. This is akin to Tim Cook coming out and saying that the unit sales for iEverything is going to be flat year over year. If gold was a company, this would spell doom for its share price.

Where is all this drop in demand coming from? It cannot be all Indian demand loss, as the Chinese are increasing their buying. Matter of fact, over the Chinese New Year, jewelry sales just went up 38%. Reports Bloomberg:

Commerce ministry data show jewelry sales jumped 38.1 percent over the festival compared with a 16.4 percent increase in 2012.

Are there other players beyond the Indian and the Chinese? We can rule out the Central Banks, as they have been buying as historic levels. (Of course, this flies in the face of the constant allegations that Central Banks are shorting gold to suppress prices, but such is logic when it comes to the gold bull circle.) Anyway, just to make sure that we are not missing anything, I decided to double check. Reports International Business Times:

Central banks last year added the most gold to reserves in almost a half century and will likely remain an important force in the gold market in 2013, the World Gold Council said Thursday.

Who is it then? Who is the culprit behind crushing the demand for gold? I was stumped. Then I remember what Sherlock Holmes said in The Sign of Four:

When you have eliminated the impossible, whatever remains, however improbable, must be the truth.

It must be the gold bulls.

It is odd to say such a thing. How can gold bulls themselves be the driving force behind lowering the demand for something that they cherish? The answer, though, is simple. Gold bulls bought in abandon when gold prices were going up. They mostly held on to the gold, hoping to sell at a higher price when the end of the world comes (or US inflation spikes, whichever comes first). They have not been adding more to their gold stack, at least not in enough volume to push demand up. Some, in fact, may even be selling as prices have flatlined. Reports Reuters again:

Bar and coin investment fell sharply in the United States and Europe last year, with U.S. offtake dropping by more than a third and European buying down 29 percent. Overall investment demand last year fell 10 percent to 1,534.6 tonnes.

This is a big problem. Gold investors in the US and EU are not buying enough. If gold was an equity with an earnings stream, this wouldn't matter. As earnings would grow (hopefully) the value of each share (oz) of gold would increase with it. But gold being an inert metal with very little industrial use has no earnings associated with it. The price of it can only go up if people buy more and more of it. If they don't, then prices will flatline. If they sell instead, prices will drop. Hence, buying gold is akin to buying a stock with no earnings whatsoever. The investor is depending on the Greater Fool theory - waiting for more investors to join the fray and buy the gold away.

It is a Ponzi Scheme, in other words. One that has worked for centuries, I must admit, as the Governments linked gold prices to currency. Once those merry days are gone, gold bulls have to depend on themselves by buying up even more volumes of the metal every year to support price increases, and never think of selling any of the yellow metal to realize gains. As, that, unfortunately, will drop the price of the metal. There are no earnings or cash flows behind the metal to support it. There is only confidence in the metal. This is different from confidence in a fiat currency, backed by the full faith and power of a national Government that has the right to raise taxes if need be to pay back the bonds. This is a true and old confidence game when it comes to gold.

If the confidence goes, or if people want to realize gains, the price will crash.

So, is the confidence in gold gone now? Reports the World Gold Council spokesman via Reuters again:

The announcement of (bond-buying) in Europe and quantitative easing in the United States also mitigated fears of a near-term crisis, and I think that's why bar and coin demand fell.

So, there you have it. confidence is being restored to the ability of the national governments in the largest monetary entities in the globe. Hence, confidence is eroding in the yellow metal. It doesn't take a Sherlock Holmes to figure out why the demand for gold is down in US and EU.

So, what does that mean for your investment thesis, dear reader? I continue to believe that while shorting gold is a fine play indeed, the real play is in the miners. The miners are really a leveraged bet on gold prices. As gold prices drop, the profit margins of the miners get squeezed. Their cost structure is already going up at around ~15% each year, as the easy gold has been extracted already. Labor and fuel costs keep going up as well. At a sub-1200 price of gold, many miners would have no option but to shut down operations, given that the marginal cost of production is now at around $1200/oz. That's where the real money is.

In my mind, the obvious choice to benefit from this squeeze would be to hold the Direxion Daily Gold Miners Bear 3x Shares ETF (NYSEARCA:DUST). This ETF is up some 47% in 2013. I believe there is another 10-15% left in this ETF this year, as I expect gold prices to collapse as Paulson inevitably folds, while gold extraction costs keep going up. Of course, nothing is a guarantee, but the immutable laws of demand and geology give me comfort that DUST is on the way up.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.

Disclosure: I am long DUST. 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.