Buy Gold And Silver: Look To Supply And Demand

Includes: AGQ, GDX, GLD, IAU, SLV
by: Christopher F. Davis

I keep hearing that the precious metals sector is dead. In fact, that's what I heard Friday morning (7/5/13) at my trading desk after the release of the June jobs number, showing 195,000 jobs added and unemployment holding firm at 7.6%. The number is slightly better than expected, but is still anemic for a real recovery. As soon as the numbers were released, the Federal Reserve tapering talk resumed sending gold and silver plummeting once more and the "gold and silver are dead" crowd was sure to let me know.

If the precious metals could ever be 'killed' as it were, then I imagine gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) would not have been around for millennia while fiat currencies have come and gone. I'm often asked "why bother with the metals, why are they worth anything?" True, as a society we do indeed come together in a social contract to apply value to currencies, which are established and maintained by governments, central banks etc. If you think about it, anything could be a currency or a store of value. Bartering was a successful economic approach for many years, and was the basis for communities developing. People of varying trades came together to form a cohesive mutually beneficial existence. The farmer bartered with the blacksmith, who bartered with the trapper, who bartered with the tailor etc. Currencies just became a standard form of said barter or a universal bartering tool.

But in theory, we could come together as a society and put an intrinsic value on anything. As an example, we could value dead skin cells. Yes, he who holds the most collected dead skin cells is the richest man alive. Is it really any different than gold and silver? Barring the fact that humans produce skin cells and there is only a finite supply of gold and silver (which are also inorganic versus organic for skin cells) there really isn't a difference. It is just that we as a society assign value to it. We have come together as the human race and chosen gold and silver as precious objects. That will not change in our lifetime despite any argument the bears may make. In fact, in this article I will present supply and demand data, historical bull market information, as well as insight into a key component of the metals market, the miners, which could indicate that gold and silver are only taking a breather.

Historical Gold Bull Market In A Bad Economy

For millennia, the place of gold and silver has been to serve as stores of value. They protect wealth better than any other investment. Look what happened in the 1970s when we came off of the gold standard and allowed private ownership of gold. Investors, the rich, middle class, and working class alike, piled into the metals. At the beginning of the 1970s, gold was at $35 per oz. Ten years later the price stood at $870 per oz (figure 1). This is a percentage gain of 2,485%. In contrast, during the same time the Dow Jones Industrial Average (NYSEARCA:DIA) increased from 809 to 839 points. This represents a total gain of 3.7%; not per year, but for the whole decade.

In the 1970s, the U.S. and European economies were characterized by low growth, high inflation and a high unemployment rate. Further, increasing national debt and an expansion of money supply made the currencies less valuable. All of these factors led investors to diversify their portfolios towards material assets, and gold in particular. Following this bull market, gold entered a 20-year decline/holding pattern with bouts of bearishness. For those calling the metals dead, they see history repeating itself. They believe we are entering a bear market once again. I contend this is incorrect despite the decline in prices over the last six months. Gold and silver got a little ahead of themselves indeed, but are in no way dead and I believe the bull market is simply taking a break.

The difference between the 1970s and now is that we have little to no inflation. There are fears of deflation. Further, big money has been dumping the metals to get into stocks. This is unlike what happened at the end of the 1970s, when inflation was high. Inflation will eventually pick up once more which will be good for gold and silver. The jury is out on whether all of the quantitative easing that has occurred will lead to hyperinflation. For now, it is at bay, but is one reason gold and silver are worth purchasing. What I find fascinating is that today there is much higher demand for the metals compared to the 1970s, and only a finite supply of each, particularly silver.

Figure 1. Historical Price of Gold in the 1970s

Silver Supply Eventually Won't Meet Demand

Before talking about gold, let me point out that megatons of silver are consumed in industrial processes, and further, while sometimes recyclable, silver is often discarded into landfills, never to be recovered. This is the result of silver having been intentionally underpriced for many decades, because it is not worth the labor prices to recover used silver. Industrial processes have been intentionally designed not to consume gold (and silver is a better conductor), and at the high prices gold has commanded for decades, it is nearly all recycled. It is said that 99% of all gold ever mined is still in existence above ground. For these reasons, silver stockpiles as a percentage of all silver ever mined is so much smaller than gold stockpiles as a percentage of all gold ever mined. Ted Butler is quoted as saying this, 15 years ago:

"at the end of World War II, total known stocks of silver amounted to ten billion ounces (with the US government holding 4 billion ounces of that total amount). At that time, we were just entering an era of unprecedented global economic expansion that has lasted to the present. In this era, silver was consumed in a variety of vital modern applications at a phenomenal rate. Today, known stocks of silver have shrunk over 95%, to maybe a half a billion ounces. The nine and a half billion ounce draw down in total silver inventory, was the result of the persistent shortfall between supply and demand, which continues to this day. Not coincidentally, the current 200 million-ounce annual deficit in silver mirrors the long-term trend line average. This continuing deficit is remarkable in that there has been decent growth in world production of silver over the past 50 years, but obviously not enough to satisfy the surge in industrial demand."

This argument is sound. Demand for silver is unprecedented, not just for precious metal investment, but in industry, particularly in technology. In smartphones alone, over $1 billion worth of silver is utilized annually. Add a few extra billion dollars for all of the computers, tablets and televisions sold each year. Now think about all of the other industries using silver (jewelry, dentistry, nanotechnology etc). It is in finite supply with ever increasing demand. Eventually, this needs to normalize, and when it does, silver prices stand to benefit.

Gold Demand Really Never Ceases

Demand for investment gold is very strong. Earlier this year, the U.S. Mint ceased production of the 1/10th oz American Gold Eagle due to record demand. This was a sign of record buying, but what is more interesting was the recent World Gold Council Report, which highlights the demand worldwide. Highlights from the report include continued strong demand in jewelry, particularly in India. The report also suggests a decreased demand for investment gold, but further investigation reveals that the decline in investment demand relative to Q1 2012 was solely attributable to the net outflows from ETFs, which obscured the strong rise in investment demand for gold bars and coins at the retail level. In technology, demand has been stable, holding around 100 tons over the last year and a half. And the central banks? Well isn't it peculiar that they added 109.2 tons of gold to their reserves in Q1 2013, the ninth consecutive quarter of net purchases?

And what about global supply? For the first quarter of 2013, there was supply of 1,050 tons. This was little changed from first quarter of 2012. Wait a minute, central banks purchased 10% of the world's gold supply for the first quarter? Well they certainly got a bargain as prices dropped dramatically in the first quarter. I can only imagine what the purchasing has been like thus far in Q2. It is painful to be a holder of gold and silver, particularly if you have purchased in the last year or so, to watch the value decrease while demand is so high. However, for the long-term it is worth holding onto your metals, or buying at these levels, despite the fear that is prevalent in the market. If central banks are huge buyers at these prices, it would not be illogical to purchase some as well. Besides severe inflation or a collapsing dollar, what could drive prices higher given that we already have high demand?

Mining Could be What Saves Metal Prices

A year ago I wrote a piece called "time to pick up the gold miners," in which I highlighted that the announcement of all of the easing set to be announced by the Fed and central banks globally would push gold and silver higher. This was a prescient call, as returns of 40%-50%, or even 100%, were made in some names in just a few short months in the space. In September 2012, you couldn't be in a better spot given the increase in gold and silver prices from July-October 2012. The mining stocks performed beautifully.

With the devastating sell-off that began in October 2012, the sector is now being avoided like the plague. However, these same miners could be what supports gold and silver prices. Looking to production cost for gold as an indicator, which relies on several factors and varies globally, a ball park average to produce one ounce of gold is about $1,000. For silver, this is about $22. The all in costs of production vary by miner, but clearly with silver at $18.85 and gold around $1215, cost is a major issue. Some gold miners, particularly those in Africa and Latin America are underwater, paying more to produce gold then they can sell it for. The majority of silver miners will now operate at a loss as well. This has major implications, and is a reason you should consider buying gold and silver at these levels.

If the gold and silver price remains close to or below production costs for a long period of time, it will cause great change for the industry. In some places of the world, gold's production cost doubled and silver production tripled in the last decade. Costs are only seen going higher as these companies have been cutting costs to the bone as metal prices have declined. In order to stay in business, higher gold and silver prices are required to make gold mining profitable compared to previous prices.

What we will likely see is smaller miners slowing production or even going out of business. There may also be a lot of acquisition in this period while stock prices are depressed. Mergers cannot be ruled out either. If gold and silver prices continues to fall the situation will be unsustainable. If production goes offline, demand would have to drop off for prices to remain depressed. The information I present above suggests that demand will only increase over the years, especially in technology. Thus, either gold and silver are likely to find their floor soon (which could be gold $1200, silver $18) or prices will decline further, which could result in a major supply and demand imbalance in the next few years. Both of these scenarios are likely, and both are dependent on what happens with the miners. However, in either case, gold and silver are very attractive at these levels.

Where Do We Go From Here

In the short-run when you consider metals as a 'safe haven,' the U.S. recovery seems to be on track, the Chinese credit crunch is easing, the European recession is stabilizing and Japanese growth seems to be ramping up, which is an issue for the metals no doubt. These positives could push more money out of the metals into equities. However, we are in shaky territory. If any of these go awry, people will be looking for safe havens. On the other hand, growth isn't necessarily bad for the metals, as it could lead to some much desired inflation, which always helps metals. I cite a lot of data on demand above. The appetite for gold appears undiminished in China. China's largest gold producer, the state-owned China National Gold, anticipates that gold demand in China is likely to exceed 1,000 tons this year. China gold also informed us that the first half of the year had already seen gold demand of around 800 tons. That's almost all of 2012's demand (832 tons)!

While demand isn't going anywhere, and that bodes well for the bulls long term, the U.S. dollar index continues to push to recent highs. At the time of this writing, the dollar has hit a fresh four-week high, which in turn has added selling pressure to the gold market. The jobs number for June, which led to more belief tapering would occur, has punished the metals once more. It seems that every time there is talk of tapering, gold and silver get hit again. I believe much of this is priced in and the downside from here is limited. For the next few quarters, it would be prudent to watch the miners, as they are an integral component to what happens with gold and silver prices in the near to mid-term future. At these levels, gold and silver present lucrative entry points for those on the sidelines.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Additional disclosure: I own physical gold and silver as well as some individual companies in the sector. I allocate 7% of my sector to this space.