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Many gold and GLD investors have a misconception about gold market economics and erroneously believe that newly mined gold supply is irrelevant to the gold price. Unfortunately, this causes investors to completely ignore the fundamentals of global gold mine supply and leaves a large hole in their understanding of the gold market.

It is very strange because the concepts of supply and demand are learned in every introduction to economics course, and yet in the gold market, the only new supply to existing stocks (mine supply) is completely brushed off. New supply is important in analyzing other financial assets like stocks, bonds, and even real estate -- everyone knows that if a company issues more stock or a government issues more bonds, all else equal, the price will drop.

So why in the gold market do investors argue differently?

The two main arguments against the relevance of gold mine supply are as follows:

  1. Newly mined gold supply makes up only a small portion of existing gold stocks (about 1.5%) and thus it is so small that it does not influence price.
  2. Exchanges such as the London Bullion Market Association (LBMA) can trade the equivalent of total annual mined supply in less than a week, thus it is such a small portion of total gold trading that it is irrelevant to the price.

These arguments are essentially two sides to the same coin -- that newly mined gold supply is a small portion of either total gold stocks or total gold trading and thus it is irrelevant. Let us now go into the flaws in these arguments.

Newly Mined Gold Supply is Only a Small Portion of Existing Gold Stocks

This argument is based on the premise that the total amount of existing gold is around 171,000 tonnes (we and others have questions about the accuracy of this number, but we will use it since it is probably the most cited amount), while according to the USGS, new mine supply is around 2700 tonnes per year. That means that total newly mined gold only adds 1.5% to total gold inventories, and thus can have little impact on the price.

The problem with this argument is that the great majority of the above-ground gold stock is not up for sale. Sentimental jewelry, heirloom artifacts, central bank gold reserves, industrial goods with gold content, forgotten/buried gold, and even everyday jewelry is not gold that is up for sale except in exceptional circumstances. For example, the gold reserves of the top 40 central banks make up around 30,000 tonnes (a little less than 20% of all existing gold), this is gold that exists but cannot be counted as gold supply because it is not available to the market.

It may be better for investors to think of total existing gold supply similar to the way we think of shares of stock in a company. Total existing gold is like outstanding shares, gold actually available for sale is like the stock's float, and newly mined gold supply is like new share issuance. Holders of gold who have no intention to sell (whether for political, economic, or investment reasons), are shareholders but their shares are not part of the current "gold float" and are thus not able to satisfy demand.

Nobody knows for certain what "gold float" is available to satisfy demand, but we can take supply data from the World Gold Council (WGC) to give us an idea. According to the WGC, gold supply for 2012 was 4408 tonnes as shown in the following table:

(click to enlarge)

As you can see, newly mined gold supply makes up a great majority (about two-thirds) of annual gold supply.

This is the big flaw with the above-mentioned argument, it assumes that all existing gold stocks are on the market at current prices -- which is completely not true. As we have mentioned, some gold is not available to the market at any price (try offering the US Treasury a nice premium for its gold bars and see how many get sold to you), while other gold is only available at much higher prices. If prices rise to much higher levels then of course "gold float" will increase, but in the absence of significant price shocks then gold supply from existing gold stocks is a relatively small percentage of existing gold. As we can also see, mined gold supply makes up a large percentage of the gold available to market and thus it is very relevant to determining price.

Let us now deal with the second argument against the relevance of newly mined gold supply.

Exchanges Trade Many Multiples of Newly Mined Gold Supply in Short Periods of Time

Fellow Seeking Alpha author Itinerant makes this argument succinctly in a recent article, and here is an excerpt that sums up the argument:

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.

10.9 billion ounces of gold is approximately 330,000 tonnes of gold, or double all above-ground existing gold. This is what London traders supposedly trade in one QUARTER. Or if calculated to a daily figure, the 3600 tonnes traded per day is more than all of annual world gold supply. This would mean that newly mined gold supply is irrelevant to price because it is such a small proportion of traded gold -- and this is only one gold exchange.

The problem with this argument is that by comparing paper gold markets to physical gold markets, it ends up comparing apples to oranges. The London gold market and COMEX are exchanges that do trade physical gold, but the amount of physical gold exchanged is very little compared to the amount that is traded. For example, the COMEX may trade 200,000 gold contracts per day (20 million ounces) yet COMEX warehouses only keep a little under 8 million ounces of gold total -- there is no way that 20 million physical ounces actually change hands.

What is this telling us? This is telling us that we have securitized gold and most traders trade it as a derivative and not a physical metal. Traders take huge positions and buy and sell, book profits and losses, but have no real desire for the physical metal -- their positions are simply derivatives based on the gold price. This should be clear to the rationally minded, since it would be impossible for even half of daily COMEX trading to take delivery -- it would completely wipe out gold inventory. And this is all in less than a day. So how can we really take these statistics as physically traded gold? More importantly, can we really assume that this trading can meet physical demand for gold?

Thus the volume numbers at these exchanges are irrelevant to physical gold demand simply because it is a fractionalized physical market, with the great majority of volume representing trading between participants that have no desire for the physical metal. Gold bars and contracts traded back and forth between participants hundreds of times in a day are not representative of physical gold demand or supply.

For example, if I trade an ounce of gold with my friend one hundred times a day for a whole year, I have officially traded more than one tonne of gold -- but our trading can obviously not be used to meet one tonne of physical demand.

This is all pretty obvious when one considers that if even a moderate portion of annual physical gold demand turned to these markets for gold supply, it would have a significant impact on the market and gold stocks. For example, an exchange like the COMEX would only be able to supply the physical market with less than 250 tonnes of gold supply before being wiped out -- or less than 10% of annual gold mine supply.

Thus the main flaw in the argument is that the volume on these exchanges is not representative of the actual gold backed by the exchanges. The volume on these exchanges cannot meet physical gold demand any more than the one tonne traded between my friend and I can meet the physical gold needs of Dell Computer.

Why Newly Mined Gold Supply is Very Important to the Gold Price

As we can see, both arguments against the relevance of newly mined gold supply have major flaws in them, and by this point most investors should start to see the importance of newly mined gold supply.

The two main reasons why newly mined gold supply is very important to the gold price are as follows:

  1. Newly mined gold supply makes up a large portion of annual gold supply (it provides two-thirds of annual physical demand, according to the WGC numbers above).
  2. It is held in the weakest hands (the gold miners) who sell that gold at the prevailing market price.

Since newly mined gold makes up a large percentage of the 4400 tonnes of annual world gold supply, any significant reduction in this supply would need to be met with supply from other sources. The buyers who ordinarily find the 2700 tonnes a year of mine 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 the miners, and as gold drops they will be less willing to sell at a loss or marginal profit. So this supply would be unavailable to the market at low spot prices (unlike newly-mined gold, which is sold regardless of spot) as these sellers wait for higher prices -- which ultimately would significantly constrict supply.

To put this into perspective, if mined gold supply drops 10% because struggling miners cut back production, 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 -- a large amount of supply that would have to be found from existing holders of gold. If current gold owners hold back their gold from the market and do not make up for this shortage of supply, then what we will have is deficit in the gold market and the pressure will build for higher prices.

Opportunity for Investors

Investors make the most money when they find paradigms that are incorrect and they invest directly against them. It is not easy, it takes a lot of patience, and it requires people to be able to stand up against conventional understanding and hold tight as their positions are questioned and ridiculed by the mainstream. But if investors are correct, then the rewards can be tremendous.

This misunderstanding of the importance of mined gold supply allows investors a huge opportunity to get ahead of an upcoming supply crunch in gold. The gold supply situation is getting worse and our calculations of the true all-in costs for gold in 2012 show very thin margins for the miners at current prices, even as costs continue to rise. This is also affirmed by a speech given by the CEO of Barrick Gold (NYSE:ABX), who talked about future supply crunches in gold at a time when gold was trading over $1700 per ounce -- the current price will only exacerbate that.

Investors with the courage and patience to go against the paradigm can take advantage of this situation by buying GLD, PHYS, CEF, and most importantly physical gold, while they wait and watch the gold miners struggle to control costs. Cutting costs will lead to drops in production (which we are already seeing), and if the gold price stays low long enough, a future structural deficit in gold that will force much higher prices in gold.

When the markets start to understand that future gold supply will be significantly curtailed, sentiment will change -- and it may change very fast. This is all assumes that all goes well with the extraordinary measures taken by policy makers, if it does not then gold demand may increase significantly even as production drops -- which may cause a rise in the gold price that may surprise everyone.

The opportunity is here, and now it is time for investors to grab the gold bull by the horns and hold on tight, because we believe it will be a terrific ride.

Disclosure: I am long SGOL, PHYS, SIVR, PSLV. 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.

Source: The Importance Of Gold Mine Supply: A Terrific Opportunity For Gold Investors