Ignore The Doom And Gloom And Buy Gold

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 |  Includes: GLD
by: The Outsider

In terms of value, gold had a terrible performance in the last three months, leading some people to believe that the secular bull market of gold is over. Recently, gold price dropped to below $1,200 an ounce, scoring the lowest price ever since last three years. This was the worst quarterly performance in more than 40 years for gold. One of the major causes of such downgrading of gold price is the Federal Reserve's decision to cut quantitative easing by 2014. However, for long-term investors this may represents a buying opportunity for following reasons. Firstly, the gold price approaches its mining cost; secondly, central banks continue to increase their balance sheets; and finally, financial investors may be looking for bargain-hunting as the gold continues to be oversold.

Mining Cost

Although gold production cost depends on several factors and varies over the world, on average, the cost is about $1,000 for an ounce. In the U.S., however, the average cost to mine gold is the lowest in the world and it is about $900 per ounce. In Africa, the breakeven point of gold mining can reach up to $1,300 per ounce. This is above the current market value of gold, and can have serious effects on the industry over the mid- to long-term.

If the gold price remains close to its production cost for a long period of time, it will be a great concern for those working in this industry. In some places of the world, gold's production cost doubled over the past five years. Therefore, higher gold prices are required to make gold mining profitable compared to previous prices. This is explained by the fact that fixed costs in the industry soared in recent years. Particularly wages have risen considerably. If gold prices stay near or even below its production cost over an extended period of time, smaller mines will face difficulty to adapt and their margins should decrease rapidly. If this situation extends, they may even have to be closed. If the gold price continues to fall it would mean that the majority of the mines would then be turned into unprofitable and unsustainable. Therefore, the gold price should not fall much further from its current level and if it does, the closure of some mines will certainly occur leading to lower gold supply. This will be supportive for the gold price over the long-term and a major reason why the secular gold bull market is not over.

Central Banks

Another reason why gold will continue to be attractive for the foreseeable future is its role as a 'currency'. Gold does not work as a regular commodity because it does not get consumed like one. The lion portion of gold mined throughout history still remained in existence today. On top of that, total global gold stockpiles continue to increase only slightly every year through additional mining. This is the main reason why some people see gold as a 'currency'. Total gold supply can only grow marginally while paper money supply can grow exponentially through central banks' printing programs, as seen since the end of the global financial crisis of 2008-09. As the world's central banks increase the size of their balance sheets, through bond buying programs which is usually referred as quantitative easing, they inject new money into their banking systems. Given that gold has a relatively stable supply, in fact, there are more dollars available in the system will lead the investors to seek safer assets and therefore the gold price should rise. This long-term relationship is continuing since the beginning of the gold bull market in 2000 and should continue over the next few years, as central banks worldwide continue to increase their balance sheets to counterbalance the deleveraging process we are going through.

Even though the Federal Reserve wants to taper or completely withdraw its purchases over the next few months, the size of its balance sheets should remain extremely high for several years. For instance, due to the 'operation twist' and other measures, the average maturity of the Fed's assets is long which most likely will be held until maturity as long as the U.S. economy maintains its below-average economic growth path. Furthermore, Japan's recent quantitative easing announcement will also add a few more billions yens into its balance sheets over the next couple of years. Thereby, it will largely replace the Fed's negative action for gold. The Bank of Japan's $75 billion equivalent per month of yen printing represents a massive injection of money relative to the size of the Japanese economy and is certainly a boost for gold. Given the previously mentioned relationship between the world's central banks' balance sheets and the gold price, this will certainly be a strong bullish factor for the next couple of years.

Conclusion

Although there are many individuals who believe the gold is in a bubble and its secular bull market is broken, in my opinion, the long-term picture bodes well for gold. There are structural factors that will support gold prices to remain stable close to its current levels over the next few years, such as supply adjustments and the continuing global central banks' balance sheet expansion. Consequently, the downside seems limited for those with a long-term view. Furthermore, as seen in gold's' first sell-off in April, physical gold demand is remaining strong and further dips should lead consumers, especially, in emerging markets to buy aggressively. To conclude, for long-term investors, gold seems attractive at its current price and although more periods of weakness may occur, still it should be seen as a buying opportunity.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GLD over the next 72 hours. 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.