When will gold prices recover? This question has to be on the minds of even those investors solely investing in gold for the long term. There have been a lot of explanations given for the weakness in gold, ranging from blaming the decline on short-term weakness in the Japanese yen vs. the U.S. dollar, to Nouriel Roubini's contention that the price of gold is headed below $1,000 based on a lack of inflation and strength in the global economy.
With all of this noise in the background regarding why gold prices are behaving the way they are, I believe it is useful to look at the fundamentals driving gold: supply and demand. These fundamentals apply to both gold as a physical investment, and gold traded through ETFs. However, it is important to note when dealing with ETFs that physical demand is only loosely correlated with ETF demand, as I will discuss further in a moment.
Let's start by looking at the supply of gold and how it has changed over time.
Click to enlarge images.
The graph shows that both the total amount of gold that has been mined and the annual production of gold has increased rapidly over time. Furthermore, while there have been dips in the amount of gold mined each year (the red line), the total amount of gold available has always continued to increase. That, of course, logically makes sense since gold is the ultimate durable good. As a result, in order to absorb this ever-increasing supply of gold while keeping a stable or increasing price, gold needs persistent continuous increases in demand.
Gold demand is based on gold investors who can basically be divided into three categories: Those who think the metal has little or no value ("non-believers"), those who think that the metal has value in times of inflation and uncertainty, and "true believers" who see gold as a great best long-term investment or who use it extensively as a form of decoration. The non-believers virtually never invest in gold so they aren't particularly relevant to its price. The true believers generally hold physical gold and rarely sell, so there is unlikely to be any change in price resulting from shifts in their demand. Instead, the price of gold seems to be driven right now by decreasing demand from this middle category of investors -- the opportunistic ones who include most institutions and foreign governments. Countries like China, for example, have slowly been cutting back on their gold holdings (see chart below) for several quarters now with the result that prices have started to fall significantly.
Since 2000, many countries have apparently become more confident in fiat currency, leading them to cut gold holdings broadly, with many developed nations leading the way.
These charts suggest that gold demand is increasing over time, but it is not increasingly uniformly. That is, some investors have decided that gold is a less useful investment than it once was -- most likely because the risk of catastrophic economic meltdown has declined. In these charts, of course, we were examining central banks, but the same point applies to individual investors as well.
Yet to properly look at gold demand and what might be influencing it, we need to get an idea of how much gold is being bought by different groups. In general, gold demand can be broken down into three different areas -- jewelry, investment demand (mainly through ETFs but also through physical bullion), and demand by industry (most notably the technology sector). The table below shows this detail along with the associated price elasticities for gold over this period. (Note the table ends with 2011 data because newer data is not yet available.)
The table illustrates the demand for gold is significantly dependent on the investment community, and that it has become more dependent over time. In 2001, total gold demand was roughly 3,700 tonnes (a tonne is one metric ton, or 2,205 pounds). In 2011, it was roughly 4,000 tonnes. So demand increased about 10% total. Yet, the bigger shift was in investment demand, which went from 357 tonnes in 2001 to 1,641 tonnes in 2011. As of 2011, roughly 40% of all gold that was produced was consumed by the investment community. This consumption was mainly through ETFs.
To the extent that investors lose faith in gold as an attractive investment, the metal may experience significant production surpluses leading to lower prices --unless that excess production is picked up by jewelry use. Unfortunately for gold investors, since ETFs make up the bulk of investment in gold, even the recent surge in physical investment demand is not enough to offset the liquidation by ETFs. Instead, those hoping for a rebound in gold prices need to watch the jewelry market and fashion trends carefully.
Jewelry use of gold has fallen dramatically over the last decade. There are a couple of possible explanations for this. It could be that other metals have started to become more common in jewelry with gold falling out of favor, or it could be that increased gold prices have led jewelers to begin selling products with less gold content so as to prevent their customers from getting sticker shock. Or it could be a combination of these two effects; I tend to believe it is a combination. I certainly have seen anecdotal evidence of more silver, platinum, and mixed metal jewelry in the last few years, but it's also very likely that the rapid spike in gold prices (detailed here) has led jewelers to cut back on gold use. Now that gold prices have fallen so much, if prices stay low, perhaps higher gold content jewelry will come back into fashion.
Assuming for a minute that increased jewelry demand does not pick up the slack in consumption from diminished investment, prices of gold will surely fall over time. To determine how much of an effect a gold surplus could have on prices, we need to look at gold's past price elasticity of demand. This is shown in the chart below.
Using the chart above, and some assumptions on the amount of the gold investment decline seen in the last year, we can get a basic idea of gold's equilibrium price. Specifically, we can guess based on the history shown above that production is likely to hover between 2,500 and 2,800 tonnes, with the exact amount being dependent on a variety of factors including the future outlook for gold prices (consensus decreasing) and mining costs around the world (consensus is for increasing costs based on commentary from (NEM), (ABX), (FCX), (KGC), and (GG)). Given this, it is probably safe to assume that gold production next year might be perhaps 2,600 tonnes. Scrap or recycling rates have been fairly stable for the last few years, but will likely fall a little bit on account of the lower price. So let's assume the scrap rate will be 1,100 tonnes. This gives us a total supply of 3,700 tonnes.
So we need to find a point on this graph where ex-technology (demand of ~400 tonnes), total demand is for 3,300 tonnes. There are a number of points that fit this range, so the projected price depends on the mix of demand between jewelry and investments. Given that investment demand was 1,600 tonnes in 2011 when gold was viewed extremely positively as an investment, it is likely that gold will have no more than 1,500 tonnes of investment demand this year. This implies that in order for the market to clear, gold will need to have a market price of just above $1,400 per tonne. I have done this graphically below for the purposes of illustration in this article, but mathematical calculations bear this out as well.
So what does this imply for investors? Well for one thing, the price of gold is probably not going anywhere this year. This applies to both physical gold and the ETFs tracking gold. The negative investment sentiment expressed by the massive levels of ETF liquidation simply weighs too heavily on demand, and jewelry fashion is unlikely to come back to favor gold instantly. What's more, most of the big gold miners that I mentioned above have existing projects and cannot easily get out of their contractual obligations surrounding those projects. Furthermore, Rio Tinto's (RIO) new mine in Mongolia is scheduled to reach commercial production in the next 12 months (and start producing today), and will add at least marginally to world gold supply.
Given these factors, and the supply/demand relationship above, investors in gold need to settle in for the long run. For investors in ETFs there are other options for generating returns off of their investment, such as the one I discussed here. Investors in physical gold will simply need to be patient. As so many other investors have found in the last five years, investors in gold are simply going to need to be patient, make sure they have a balanced portfolio that meets their individual needs, and keep the faith in their long-term investment thesis on gold.