About a month ago the price of gold dropped sharply through several chart support levels, and the bounce that followed is already looking anemic as Peter Hug of kitco.com put it so well today. This mid-April drop follows a multi-month downtrend that has taken the spot price for one ounce of gold from $1795 in October 2012 to $1360 as this text is composed. It is the opinion of your humble scribe that we haven't seen the end of this trend yet and more pain is in store for investors snagged long in a gold-related trade.
Gold miners are caught between a rock and a hard place; with the rock being the described spot price scenario and the hard place being production costs, which have been rising substantially along with the spot price in recent years, but have so far refused to replicate the drop. Fellow writer Hebba Investments has been putting out a series of articles allegedly computing the "true cost" of mining gold and has been coming up with some seemingly outrageous numbers. Hebba uses a method that grossly simplifies cost accounting and therefore his results can only be considered very rough ballpark figures at best. However, his numbers and cost calculations from other sources all demonstrate that margins for gold miners are diminishing and some mines are already running at a loss. First victims of this margin squeeze have been recorded with some high-cost mines already being placed on care & maintenance. If the gold spot price drops further then more mines will be in danger of becoming unprofitable and a number of these mines and projects will be suspended or discontinued. If this trend eventuates it will undoubtedly lead to a reduction in supply of new gold for the moment; and also into the future since exploration is often one of the first expenses to be cut.
In his latest piece Hebba argues that reduction in supply of new gold will lead to higher gold prices again and continues to state that commentators who do not follow this logic "lack understanding about marginal supply in the gold industry." Well, your humble scribe belongs to this group of people (and we won't deny that lack of understanding is a possibility we do not discount in our view of ourselves). As stated before we believe that the amount of new gold production has marginal influence on the gold price; reduced mine output will in our opinion not drive the spot price, neither up nor down. Other factors will, but mine output simply does not feature very prominently at all in the price finding equation.
Here is our argument in short (the longer version is here). Gold does not get consumed and because gold is a store of value gold is usually kept in safe places and preserved. Therefore, a very high percentage of all gold ever pulled from the ground is still available, totaling an estimated 165,000 tonnes of above ground gold. About 2500 tonnes of gold are mined per year. Just over 400 tonnes of this total are mined in China and never reach our markets. Let's assume that the rest (it is actually less) is sold at spot price into the market. On average, that equates to around 186,500 ounces per day entering the market as new gold from mines, mostly at around spot price.
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 traded per day. And that number includes only traders in London who bothered to participate in this survey. When looking at these numbers it becomes obvious that new mine supply is simply too little to feature prominently among factors moving the price of gold.
It has been argued that a large percentage of above ground gold is not available for trading since it is locked away in vaults and owned by Reserve Banks or other institutions who will not trade the metal readily. We disagree and believe that all of this gold is de facto on the market if the price is right.
It has been argued that most of these trades are "paper trades" and do not concern physical gold. Well, that might be true but as long as "paper gold" is treated the same as physical gold this does not matter. As far as traders are concerned the spot price is what it is and gold is traded at that price; be it gold futures, physical gold old or new, or an ETF such as SPDR Gold Trust (GLD) or the Sprott Physical Gold Trust (PHYS) -- it's all traded just the same.
Some experts view gold as money and a host of studies have pushed the argument that gold does not suffer from inflation. Apparently an ounce of gold has bought a nice toga in ancient Rome and it still buys a nice suit nowadays. A summary of this argument is given in this article. If we accept this line of thought then newly mined gold simply represents new money entering the market balancing out growth that eventuates over time. By chance it seems that gold mining has always produced just enough to keep that balance. Take away the supply of new money, err new gold, and the effects will be felt over time, but very slowly and very gradually.
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.
Well, actually all the other sellers who sell at spot price at any given time are equally weak handed. Otherwise they would not be selling, right? And as explained above on average gold miners represent only a fraction of all these selling weak hands. If the selling hands become stronger the price rises and gold miners can sell at a higher price. If the selling hands become weaker the price falls and gold miners have to accept this price or close their mines. The weak hands that are doing the selling will not bother if another mine closes...
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.
250 tonnes! Wow. London dealers turn over 15 times that. Per day!
And so what if 25% of GLD is removed? Why should the price of gold rise because of that? Oh wait a minute, reductions in gold held at this fund are getting close to 20% this year; has anyone noticed gold appreciating lately? And over at the COMEX: has anyone noticed the outflow there? This supply has just vanished from the market and the price of gold is dropping when according to Hebba the price of gold should be soaring towards new heights.
Hebba argues that as mine supply dwindles this gold must be sourced from existing owners and supposedly these owners are stronger hands and will demand a higher price. Sorry, does not wash. Why is the price declining rapidly (about $10 since we started writing this piece)? Because existing owners (the supposed strong hands) are selling, oh yes and a few miners at the same time but far too few of them to make a difference, I am afraid.
Let us look at history and test our differing opinions against hard data. Above is a diagram showing gold price and gold production since 1900 keeping in mind that the gold standard fixed the price of gold until the early 1970s. We sourced this data from here (production) and here (price) and normalized the data to 1970 levels. There are a few interesting observations to make.
- When the price of gold was fixed production increased by 300% and fluctuated quite significantly. Price must be discounted as the driver during this time.
- After 1970 correlation between price and production is weak, a mere 0.41 in fact. If Hebba's theory was correct correlation would need to be close to -1 to signal inverse correlation.
Here is what we believe is happening: price is driven by a complex set of economic and political parameters, and production is mainly driven by technology. These two drivers are not related. However, there is some small degree of interaction between price and production. A gold price rally provides an incentive to increase exploration, which will eventually lead to more production. And falling prices will reduce spending on exploration and production will suffer from this reduction some time down the track. This model implies that there is a time lag built into this interaction and due to increasing licensing times and increasing difficulties in finding economical deposits this time lag is getting bigger over time. In our model price leads production. In Hebba's reasoning production leads the price. We fail to see the evidence for Hebba's reasoning and will stick to our guns.
What does this mean for investors in the gold mining space? Well, look at the gold price development and follow its cues. Don't fight the gold price trend, all miners will tank when gold tanks and most miners will rise when gold rises.
Therefore, if the gold price enters a downtrend then short the miners. The Direxion Daily Gold Miners Bear 3x Shares ETF (DUST) is a possible vehicle for this purpose.
If the gold price goes up, then go long on the miners also - either via a gold mining ETF such as the Market Vectors Gold Miners ETF (GDX) or directly with mining companies. Companies with strong fundamentals and healthy balance sheets will benefit the most from a gold price rally, so doing research while the gold price is unfavorable pays off when the next rally is neigh. Try Agnico Eagle (AEM) or Goldcorp (GG) if larger companies are preferred. Or look for more junior companies such as SilverCrest (SVLC) or Luna Gold (OTCQX:LGCUF) (just to name a couple) which offer higher rewards but also higher risks. Streaming companies are an option somewhere in between the miners and the metal in terms of risk with Silver Wheaton (SLW) of Sandstorm Gold (SAND) our declared personal preferences.
And before we part, here is our personal outlook for the coming weeks and months: We believe that the price of gold is heavy and will be heading south a bit further, and probably for a bit longer than most of us would like to think right now. However, we expect a rally to eventuate later in the year and we suggest that the upcoming summer doldrums will present us with some very attractive buying opportunities.