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In the discussion following various articles here (and here and here) on Seeking Alpha, comments have been made with regards to an allegedly looming supply shortage of gold and its assumed effects on the price of gold and the shares of gold miners. Warnings of a looming supply crunch or predictions of mine production being "the key component of gold's economic balance" can be found frequently in gold-related discussions and publications. Mention should also be made of Wallstreet for Mainstreet which has a lot of information also advocating this line of thought (for example here).

We have stated our opinion that the traditional concept of supply and demand does not work for gold, at least not in the sense of the definition this concept works for commodities. And as a consequence we have concluded that gold mining has a negligible influence on the cash price of gold as expressed by the price of physical gold, the SPDR Gold Trust ETF (GLD) or the Sprott Physical Gold Trust (PHYS).

In the present article we would like to elaborate on our view. In order to avoid confusion let us attempt a definition first. Traditionally it is assumed that in a competitive market the price of a particular product is determined by interaction between supply and demand of this product. The price of the product will settle at a point of equilibrium where the quantity of the product demanded at current price equals the quantity supplied by producers at current price.

Consider corn crops, for example, and let us keep things simple. Corn is harvested and sold at prevailing market prices, turned into a variety of products which are finally consumed. If corn or corn-based products are not consumed, they turn bad after a finite amount of time and need to be discarded. The farmers growing the corn provide supply, and people consuming corn-based products determine the demand. In a good year, the crop will be rich and supply will be plentiful. Competition between suppliers will ensure that corn price decreases. Because of the decreasing corn price, corn products can (and in a free market will) be offered at cheaper prices leading to increased demand. The equilibrium between corn supply and corn demand will quickly lead to the prevailing market price for corn at the given time.

This scenario seems simple enough because we have baked a couple of assumptions into it.

  • Firstly, corn is used in products that get consumed. The economic value of corn is destroyed over the course of its productive life.
  • Secondly, corn cannot be stored over extended periods of time. And even during the small time frames that corn can be stored, this storage is costly. Therefore, all produced corn must be sold and consumed within a reasonably short time for it to realize its value.
  • Thirdly, trading corn takes place in a market economy without too much distortion.

The described scenario is typical for most known commodities. And the assumptions we listed are the main reasons why textbook supply and demand models work so well when predicting the price of commodities, including base metals. Base metals are consumed as they become part of some product such as a mobile phone, a car or electrical wiring to name a few (first assumption above). The above-ground supply of most base metals is small when compared to the amounts that are consumed because storage is expensive and metals corrode and deteriorate over time (second assumption). Base metals can be traded reasonably freely without too much interference from non-market entities (third assumption). For these reasons supply and demand models work well for base metals as they do for other commodities.

Gold is different.

  • Firstly, gold is not consumed. (Consumption of gold in the sense described above for corn only takes place in small amounts compared to the total amount of above ground gold for some electronic devices, dentistry and medical or aerospace application. For the purpose of this article we can safely assume this factor.)
  • Secondly, gold can be stored indefinitely and relatively cheaply.
  • Thirdly, gold is a highly symbolic material with associated political connotations. Free trade of gold historically is the exception, not the rule.

Over literally thousands of years gold has been accumulated above ground with hardly any of this gold being consumed. During this time gold has been accepted by people and by ruling powers alike as a store of value. Production of new gold is miniscule when compared to the gold already stored in above-ground vaults.

Supply almost exclusively comes from people or entities wishing to sell above-ground gold at the prevailing price. No gold is consumed and the same ounce can be sold time and again over thousands of years, always at the prevailing price. Gold is used almost exclusively as a store of value. There is no reason for storing value without the intention of realizing this value at some point. For this reason we consider every above-ground ounce of gold as being for sale at some price.

Demand comes from people or entities wishing to buy this gold at the prevailing price. Demand is equal to supply; it is as simple as that. If the price of gold is higher than a buyer is willing to accept, the buyer walks away. No trade done, no harm done. The buyer might still remain in demand, but for the time being no trade occurs. Text books call this reservation demand. At the right price demand would be close to infinity, except there is not enough above ground gold to satisfy this infinite demand. The distinct limitation of potential supply is the reason why the gold trade is driven by the supply or sell-side.

Gold miners do not feature in this equation. Their output is much too small compared to the above-ground gold and therefore holds no leverage. They can elect to sell at the prevailing price determined by the described system, or sell at a pre-arranged price to a pre-arranged buyer, or not sell at all. The gold trade will continue regardless.

Now, what moves the price of gold?

In our view it is solely the wish of gold holders to realize the value of their holding so the value can be swapped into something else. This holds true for an individual being just as well as for national banks. And this is the point where governments, politics and macro-economics enter the equation. Boundary conditions provided by governments, by economic cycles and political propaganda can shift the perceptions and intentions of gold holders and potential gold buyers who might decide to sell or buy at a different price than what seemed appropriate previously. And thus the price expressed in cash changes, and with it supply changes, and with it demand changes.

The combination of gold being the ultimate store of value on the one hand, and the price of gold being driven by actions of the powers that be on the other hand, provides for a fascinating playing field. History is riddled with examples of attempts by various powers to control (or manipulate) the price of gold in their favor, such as fixing the gold price, gold confiscation or price manipulation to name a few. (The invention of "paper gold" may well be the latest scheme along these lines. Feigning availability of gold that is actually not physically there is in fact a pretty old trick that has been tried in vain since the Roman Empire.) However, we know of no record of long-term success of such a scheme.

Depending on the analysis of economical and political developments there may be numerous reasons to invest in gold or gold-related products.

  • Physical gold provides insurance against loss of value.
  • Various investment vehicles enable bets on a falling gold price such as Direxion Daily Gold Miners Bear 3x Shares ETF (DUST) or ProShares UltraShort Gold ETF (GLL).
  • Various investment vehicles enable bets on a rising gold price, however we continue to favor streaming companies such as Silver Wheaton (SLW) and Sandstorm Gold (SAND) along with selected gold mining companies.

In the end, such analyses come down to choosing indicators and making a personal call. For the record, as outlined very recently here and here, we have stated our conviction that the gold price will drop a little further before forming a bottom and then rally during the second half of this year.

Source: Gold Is Not A Commodity: What Moves The Price?