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Fellow Seeking Alpha author Hebba Investments has been writing a series of articles on the 'true cost' of mining gold and silver over the past weeks. His method is best described in his most recent offering and in most basic terms compares all costs incurred by a company in the course of a year with the ounces mined by this company during the same period of time. Hebba Investments does not distinguish between costs directly related to the actual process of mining and selling production, and other cost positions such as exploration, mine rehabilitation or expansion etc. His argument goes, that all these costs are ultimately necessary for a mining company to produce gold or silver in a sustainable manner. This line of thought has been discussed in much detail following most of his articles on various mining companies, and in conclusion we believe that his (or her) approach has its merits and gives valuable data points when researching precious metal companies. Before we continue we would like to recommend Hebba Investment's line of articles and the lively discussion they have attracted.

In his latest article Hebba Investments provided more food for thought when he presented the accumulated bottom line of his data on various silver producers. Averaged over all silver mining companies that Hebba Investments has analysed so far the 'true cost' of producing one ounce of silver is $23.68 for 2012 excluding write downs, up from $22.21 for 2011. Hebba Investments goes on to argue that this 'true cost' figure provides a floor under the price of silver (SLV), (SIVR), (CEF), (PSLV) since silver companies would stop producing if the price fell below this level.

In taking a look at Hebba Invetsments articles on gold companies and the 'true cost' of producing one ounce of gold that was computed in these articles we could expect the 'true cost' for the production of one ounce of gold to be around $1100 (hopefully Hebba Investments will provide the precise number in due time). Going by the same logic as outlined above this would lead to an assumption that the floor for the price of gold (GLD), (IAU), (UBG), (PHYS) would be around that number.

We believe that Hebba Investment's argument works in principle for silver. Silver is partly an investment vehicle, and partly an industrial metal. In its industrial incarnation silver is consumed in cell phones, solar panels, medical applications and a host of other products. The Silver Institute calculated industrial demand of 487.4Moz of silver in 2010 and estimates this number to increase by one third by 2015. Compared to an average annual silver production of around 680Moz the industrial demand is substantial and it can be safely assumed that this industrial demand would drive the silver price higher again in case of a production shortage due to silver prices falling through the described floor.

If we turn our attention to gold, however, a radically different picture emerges. Annual gold production is around 2,500 tons, adding to an estimated total of 165,000 tons of above ground gold every year. The LBMA in London published results of a survey among London based traders showing transactions of 10.9B ounces of gold during one quarter in 2011. This number converts to almost 1.5 times annual world production per day. And that number includes only traders in London who bothered to participate in this survey.

Gold is used in negligible amounts in industrial applications and for the sake of the present argument we can safely assume that the overwhelming majority of above-ground gold is used for investment purposes.

Let us imagine for one moment the price of gold dropping below the estimated 'true cost' of production and total world-wide mining output withering to a trickle due to closure of uneconomical assets. For the sake of the argument, let us assume that no new gold was produced at all. Would trading in London, New York or Hong Kong be affected by this event? We believe not. If prices fall to such low levels there would be ample supply flowing into the market from investors cutting their losses.

And more to the point: imagine the events that could trigger the price of gold to fall to such low levels. We believe that gold is predominantly a symbolic store of wealth backed by political and financial forces around the world. Events powerful enough to shave more than a quarter off the price of gold would probably create distressed sellers aplenty. The strives of gold miners going out of business would barely register among the turmoil that we envisage would be necessary to push gold down to this level. However, in the very same scenario, silver producers would suffer a similar fate since industrial demand would be drastically reduced in times of severe crises and silver investments would be sold off along with gold investments.

In conclusion

As long as the world continues to turn as we know it the 'true cost' of silver as computed by our colleague Hebba Investments can be rightly viewed as a floor under the silver price. Industrial demand will take care of any lasting violation of this floor.

Gold has no industrial drivers and investors are largely independent of gold production. 'True cost' cannot provide a floor for the price of gold because production of new gold is practically irrelevant for gold investment activities.

However, we view gold as a financial and political tool. Any event pushing the price of gold to levels below current 'true cost' would have to be reasonably catastrophic in nature. All bets would be off in such a scenario and the price of gold or silver could go anywhere in such a situation. We would probably count ourselves lucky if we lived to tell the tale.

Source: Musings About The Floor Under Gold And Silver Prices