I'm often asked "why bother with the metals, why are they worth anything?" Similarly, I'm often inundated with those who claim the metals are "dead." 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. 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. However, for all of recorded history, the human race has come together and chosen gold and silver as precious objects, in addition to currencies. They have long been regarded as a store of value. They protect wealth better than any other investment. That will not change in our lifetime despite any argument the bears may make, and demand has not ceased.
Demand for the metals hasn't slowed. 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. 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.
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? If central banks are huge buyers at these prices, it would not be illogical to purchase some as well.
While demand is on the rise and supply is finite, the key question for the bulls is what will spark a rebound? In fact, in this article I will present insight into a key component of the metals market, the miners, which could indicate that gold and silver are only taking a breather.
The Miners May Be The Spark That 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. I opined that this would especially help the Gold Miners Index (NYSEARCA:GDX), Junior Gold Miners Index (NYSEARCA:GDXJ) and the silver miners index (NYSEARCA:SIL). This was a prescient call, as returns of 40%-50% were made in these indices, and in some cases even 100% returns were made in some individual names in just a few short months. 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 until mid fall of last year.
As we know, a terrible sell-off began in October 2012 and the sector is still being avoided like the plague, although there has been a small bounce off the bottom. It is these same hated miners that 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 $950-$1100. For silver, this is about $21-$23. The all in costs of production vary by miner, but clearly with silver at $21.75 and gold around $1366, cost is a major issue compared to when silver was at $35 and Gold was at $1750. Some gold miners, particularly those in Africa and Latin America are underwater, paying more to produce gold than they can sell it for. The majority of silver miners are now operating at a loss as well. This has major implications, and is a reason you should consider buying gold and silver at these levels. But why do I think this is the case?
The answer is quite logical. If both gold and silver prices remain close to or below production costs for a long period of time, it will cause great change for the industry. There will have to be businesses that go bust, others that merge and some will sell off their assets. Barrick Gold (NYSE:ABX) recently just sold off some properties and it was enough to get an upgrade to buy. 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.
Thus, besides more asset sales, we will likely see many smaller miners slowing production or even going out of business. Costs are being cut to the core. There will also be a lot of acquisition in this period while stock prices are depressed. We are already seeing some interesting takeover speculation from lower cost Chinese miners who may be interested in picking up properties on the cheap.
What is clear is that if gold and silver prices continue to fall the situation will be unsustainable. If the metal prices stay at or below the cost of production, all bets are off. Things could get really ugly. If production goes offline, demand would have to drop off for prices to remain depressed. However, as I stated in the introduction, demand will only increase over the years, especially in technology. Thus, either gold and silver are likely to finally hold a steady floor soon (which could be gold $1350, silver $22). Because the mining industry is responsible for production, either metal prices will need to hold around current levels or go up to keep pace with demand. If prices drop and stay depressed for some time, mines will close. This 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, because either of these cases will result in gold and silver rising in the future.
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, at least as a safe haven. These positives could push more money out of the metals into equities in the next few months. However, 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. Demand for gold appears undiminished, especially 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, which was 832 tons. The demand outlook for silver is even stronger.
While demand isn't going anywhere, and that bodes well for the bulls long term, for the next few quarters, it would be prudent to watch the miners. This is because 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 as either supply and demand will keep prices at current levels or higher, or prices decline, miners go out of business, and supply is crunched. Either scenario, in my opinion, will result in rising prices in the future.
Additional disclosure: I own other select miners in the precious metals sector. I also own physical gold and silver bullion. I allocate ~7% of my portfolio to the metals/miners.