Before I continue let me bypass all the conspiracy theories about gold (to which I do not subscribe) and let me also put aside the controversial issue of if gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) are money or not. In today's article I will concentrate on just one thing and that is, what might the price of gold be, based on the cost of production. Also, how low can gold possibly go, assuming maximum downside bearish market pressure.
Generally, the price of any mineral or precious metal is a function of the cost to get it out of the ground plus a markup for the nice people doing all the hard work (the mining company). If gold corrects below the cost of production, then miners will not make any money. And when miners don't make money -- because they cannot cover their cost -- they stop mining and production falls. And when production falls to such an extent that demand outstrips supply, then prices will go up again and the miners will once again start production.
So in a sense, the absolute bottom for gold is the level required for miners to bring it out of the ground. If gold were to trade below that level, production would stop. So one question is, what does it cost to get gold out of the ground?
Taking a cue from a recent article written by fellow SA contributor Hebba Investments -- and if his numbers are accurate -- the true cost to produce an ounce of gold (excluding write-downs) was $1287 for 2012. However, he also states that the true cost to mine gold is actually less than $1287. In most cases the true cash cost is under $1000 an ounce for most miners.
On the other hand, the CEO of Barrick in a note to shareholders, said that:
In 2011, the company performed well against this strategy. Barrick met its operating guidance for the ninth consecutive year, producing 7.7 million ounces of gold at total cash costs of $460 per ounce, positioning Barrick as one of the lowest-cost senior gold producers. (emphasis added)
So we are getting some very conflicting numbers here. And while I have no reason to doubt the CEO of Barrick, if Barrick's cash cost of gold production is that low, why has Barrick's stock returned to 1990 levels and the other big miners such as Newmont (NYSE:NEM), AngloGold (NYSE:AU), Gold Fields (NYSE:GFI) and Harmony Gold (NYSE:HMY) have retreated to 2003 levels?
In any case, for the purpose of this article I will use the data from Hebba Investments. Having said that, I will use the $1000 mark as the absolute minimum gold must trade for, in order for most miners to be in business and for the world to have a steady supply of gold.
The next question is, can gold fall below the cost of production? Absolutely. Gold as well as silver can under certain conditions trade below the cost of production. It happened more than a decade ago. In fact silver was trading below the cost of production for many years and was only produced as a byproduct of other mining activities.
But prices cannot fall below the cost of production for long. It can happen for a few months, but it's not something that can last for a very long time.
So assuming maximum bearish pressure by market forces, I would have to say that the worst case scenario for the price of gold is in the $1000 mark.
But there is another question that needs to be answered. Can the cost of production fall, whereby we will then need to establish an even lower absolute rock bottom baseline for gold -- even below the $1000 mark -- assuming production costs fall?
The answer is also yes. In fact, I think the cost of production will probably fall over the next several years, for the same reason that production costs skyrocketed over the past decade.
When gold prices started rising in 2003 -- after a two decade siesta -- there were no mining engineers to be found. All of a sudden companies were in desperate need for mining engineers, because the old timers were retiring and colleges and universities didn't have mining curriculums, because there was no demand.
The same thing applies to many companies that provided products and services to mining companies. Many companies did not invest in their business because they could barely make any money due to low demand.
Then all of a sudden it caught everyone off guard. There was tremendous need for everything in the mining space and the pent-up demand increased prices for these products and services much more than anyone imagined.
As long as the price of gold was going up, more and more mining companies were forming and getting in on the act to produce gold and more and more products and services were needed.
Now if and when gold prices will retreat (and we have indications of such as of late), then the need for these products and services will be lower and I think the cost of mining will start falling.
Of course for this to happen, we need to see the price of gold falling over the long term. Currently we only have indications that this might happen and we do not yet have an established trend.
Assuming the data from fellow SA contributor Hebba Investments is correct, then the worst-case scenario for the price of spot gold -- assuming maximum bearish market sentiment -- is probably in the $1000 range, for a maximum period of several months.
However, lower gold prices over the long term might also lower the cost of production. If this is confirmed, then the absolute rock bottom price for gold might even be less than the $1000 mark.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.