The Future For Gold Supply Looks Grim: An Opportunity For Gold Investors

| About: SPDR Gold (GLD)

Recently, we published a true all-in costs article that gave investors insight into the true all-in costs that miners are spending to produce each ounce of gold. After removing write-downs and exceptional costs, gold companies spent almost $1300 per ounce to extract gold in 2012. Even with these high expenditures, the industry is actually producing less gold in 2012 than in 2011 - rising costs and lower production is not a recipe for a healthy industry.

If these cost figures sound high to you, they are affirmed by Jamie Sokalsky, President and CEO of Barrick Gold (NYSE:ABX), in a November 2012 speech [pdf] in Hong Kong. Mr. Sokalsky says:

These projects are costing much more to build. We know this at first hand and it is not solely for one type of commodity. It is in all resource areas: iron ore, gold, copper, etc. This is a big challenge that we have to manage and it is also going to have an impact on supply. When you add in exploration and G&A expenses, the all-in costs for the industry are approaching $1,500 per ounce. This was highlighted in a recent UBS report and compares with a figure of approximately $850 per ounce four years ago.

This means at current gold prices, many miners are barely profitable and producing gold at a loss. Costs have been rising faster than the gold price, and this has been cutting miner's margins and is one of the key reasons gold equities have considerably lagged the gold price. Investors should remember that the key driver of gold miner valuation is not a high gold price or increased production, but the size of their margins. It is better for a miner to have an all-in production cost of $500 at an $800 gold price than to have an all-in cost of $1250 at a $1500 gold price.

Some investors may argue that costs are rising because lower grade ores are being processed, with high gold prices making these ores economic. While this is true, the result of more processed ore should be significantly more gold production - but that is not what has been happening. Over the past 11 years gold prices have increased 500%, but production has only been up around 6% over the same period.

This means that even though miners are processing lower grade ores they are only barely increasing supply. With the recent sizable drop in gold prices, much of the previously economic ore may not be economic any longer, which will cut back further on gold supply.

Additionally, miners that have barely been getting by with prices over $1500 per ounce are now forced to cut back on spending even further to deal with lower prices. Unfortunately for them, most of these expenditures are very difficult to meaningfully cut and that will make many of them cut significantly on exploration expenses.

Greenfield projects have been and will be cut further, and many junior miners will find a lack of majors to partner with in their project development, which may lead to many of them going out of business. This will dramatically reduce future gold supply since mine development takes years to complete and cuts in spending and discovery now mean lower supply in the future.

Why Annual Mined Supply of Gold is Relevant

Some investors argue that mined gold supply is irrelevant to the gold price because above-ground gold stocks are much greater than annual mined supply. While it is true that above-ground stocks dwarf mined production, this argument stems from a lack of understanding about marginal supply in the gold industry.

Investors must understand that mined gold supply from gold miners can be regarded as gold in the "weakest of hands" - they are the most marginal sellers. Gold miners produce gold and sell that gold on the market at the spot price because they have to use the money to meet their production costs.

If gold miners reduce production, then day-to-day demand must be met from other sources that are much more sensitive to prices. The buyers who ordinarily find the 2700 tonnes a year of mined supply to meet their demand will have to make due with 2500, 2200, or 2000, and so forth. This differential will have to be made from existing holders of gold, who care much more about prices than miners, and as gold drops they will be less willing to sell at a loss or small profit. Thus this supply will not be available to the market at any spot price (unlike newly-mined gold) and these sellers would prefer to wait for higher prices - which ultimately will result in a further constriction of supply.

To put this into perspective, if mined gold supply drops 10% because miners are cutting back production and struggling to survive, that would be around 250 tonnes (8 million ounces) of gold supply that would be removed from the market. This is equivalent to 25% of the GLD gold trust or all of the gold held by COMEX - this is a significant amount of supply that would have to be found from existing holders of gold. If it is not then gold prices will jump significantly higher.

Thus mined supply makes a huge difference to the supply and demand equation because it supplies physical gold to buyers regardless of spot price. When mined supply is forced down because mines are unprofitable then this difference in the physical market has to be made up from current physical holders of gold - which will be very tough to do in a tight physical market.

Conclusions for Investors

The supply picture for gold is only getting worse and many companies are close to their all-in gold costs at current prices. This offers an opportunity for savvy investors to accumulate an asset that has a constrained future supply picture and is already close or below its all-in costs of production. Investors can buy the ETFs (GLD, PHYS, and IAU) to invest in gold, but we also highly recommend that investors also purchase physical bars and coins because they offer investors much more protection than the ETFs if the global financial system starts to experience more trouble.

For gold equity investors, this environment is very tough and many companies are going to struggle to survive if prices do not rise. Investors should carefully select gold equities that have strong balance sheets and low costs of production for this current gold environment. But they must realize that many of these companies pose a great risk if gold prices fall further.

We will close with a quote from Barrick CEO Jamie Sokalsky from the earlier speech:

However, the outlook for growth in supply in a few years looks more and more under threat. Thus, the supply of gold is likely to be lower going forward. We are not going to see huge growth, even if the gold price goes up considerably. That should then be supportive for the gold price and ultimately result in a healthier industry.

This was said with gold around $1700 per ounce in November 2012 - how much more constrained is the supply picture going to look with gold at $1400? Based on the current and future supply picture, gold is a tremendous buying opportunity for courageous investors who can patiently accumulate - we believe they will be richly rewarded.

Disclosure: I am long SGOL. 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.