In an earlier article we laid out the case for the importance of annual gold mining production and how it heavily influences the supply picture of physical gold. Gold mining companies have been having a tough time controlling gold costs, and the true all-in costs of an average ounce of gold is now being produced at close the $1300 per ounce. Even with the price of gold averaging more than $1600 per ounce in 2012, total gold production was down for the miners we researched, which encompassed more than 25% of total annual gold production.
Higher premiums are still present from Dubai to Shanghai, U.S. Mint sales have been breaking records, and other mints and refiners are producing gold coins and bars round the clock to meet demand for physical metal. Counterintuitively, the market price of gold has been dropping even as we see the highest amount of physical demand in years.
Gold seems to have formed a bottom, and with such a large short position, we believe gold is just waiting for a catalyst to propel it higher and force a number of shorts to cover in the face of strong physical demand and a tight supply picture. These catalysts are tough to predict, but with such an overwhelmingly negative outlook by hedge funds and paper gold investors (hence the large short positions), news that may normally have little effect on the market may end up being the spark that sets the short-covering blaze. We may see it in the form of the shutdown of the largest gold mine in the world for an extended period.
Grasberg and the Mine Shutdown
Unknown to many gold investors, the largest gold mine in the world is the Grasberg mine that is operated by Freeport-McMoRan Copper & Gold (NYSE:FCX) and located in Indonesia. This monster of a mine has averaged over 1 million ounces of annual gold production over the last three years and, according to FCX, holds the world's largest gold reserves.
Over the last few months, Grasberg has hit a number of setbacks. Three weeks ago a tunnel collapsed while thirty-nine workers were undergoing safety training. This led to worker protests and a government closure of the whole facility that was only resumed at the Grasberg open-pit mine last week (other portions still remain shutdown).
On Friday, a wall collapsed hospitalizing a worker and exacerbating an already accident weary workforce. The mining ministry ordered all mining shutdown at Grasberg for at least three months while the accidents are investigated and safety precautions are taken. Additionally, workers already on edge about contract negotiations are now increasingly unhappy with safety at the mines. Three months may already exhaust supplies of FCX ore, but if the strike leads to a longer closure and more worker demands, then production may be halted for much longer.
Opportunity for Investors
Both copper and gold may get a boost from the shutdown of the largest goldmine and second largest copper mine in the world. Physical supplies of gold are already tight in the Far-Eastern markets, and the closure of Grasberg for at least a few months may force consumers of gold and copper to look elsewhere to fulfill contracts if FCX has to declare force majeure. This mine closure follows a mine collapse at Bingham Canyon that recently cut gold, silver, and copper output at the huge Rio Tinto (NYSE:RIO) mine located in the United States.
This may lend support to a copper price that Goldman Sachs believes will drop in the next twelve months. But the real opportunity may be in gold because it seems that gold is just awaiting a catalyst that may propel it higher as shorts cover. This is a significant impact to supply, located in the part of the world with highest physical gold demand - supplies will have to come from elsewhere to meet these physical needs.
Investors may have an excellent opportunity buying the beaten up gold ETFs of GLD, PHYS, and CEF. Cuts in physical supply may provide additional short-term support, but it could also provide a catalyst that will push the heavily short hedge funds to cover their huge positions. Investors should take the bullish side of this crowded short trade, because one day a positive news event for gold will push gold much higher to the upside and rewards investors patient enough to wait for a change in sentiment to an asset with very bullish fundamentals.
Disclosure: I am long SGOL, PHYS, PSLV, SIVR. 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.