Since 2001 gold has been on a bull run. The gold price has had to factor in the results of the credit crunch for the past 2 years. That means for the previous 6 years gold has been rising independent of the worries of investors looking for safe havens. In that time demand has risen from investors, jewellers and industry.
Today we take ourselves away from all the hype, from all the news being fed to us and try and decide whether the price of gold is justified. To weigh the decision we look at the textbook factors - supply and demand.
Has production declined? Well yes according to Barrick Gold's (ABX) president Aaron Regent. He told the the Telegraph recently that the global output had been dropping by 1 percent annually since the start of the decade and that there was "a strong case to be made that we are already at 'peak gold.'"
‘Peak gold’ is the theory that we have reached the highest level, its peak, of production and over the following years production levels will drop lower and lower.
Backing up Aaron Regent’s claim, the World Gold Council's production figures show global mine production increased in 2006, largely as a result of increases in supply from China and Indonesia, but subsequently decreased for the following years In 2006 mining companies produced 2,485 metric tons. Since then it declined in 2007 to 2,478 metric tons and then to 2,415 metric tons in 2008.
But didn’t we say last week production was being ramped up by all of the mining companies? Well yes we did... and we also came to the conclusion, albeit an obvious one, that production is increasing because miners are realizing higher profit margins. The point is there is still a lot of gold in the ground which is yet to be discovered and finds are still being made. The Arabian shield is a good example of huge gold deposits that are yet to be mined and offer excellent potential, both Centamin Egypt (OTC:CELTF) and Kefi Minerals can testify to that.
If the gold price continues to rise we'll see more companies with big finds coming through as countries follow Saudi Arabia's example and relax their laws to foreign investment and expertise.
‘Peak Gold’ is not as bad as it sounds
Gold isn't consumed (except for some industrial uses) so 'peak gold' is not as important a factor as 'peak oil'. Because gold isn't consumed, most of the gold ever produced is still here. The consequence is that the annual production is a fraction of the total amount of gold circulating freely in the world. This means that the annual supply fundamentals shouldn't play as big a part in the overall demand as it does in oil.
Spinning this on its head this means that the supply of gold is steady. There is nothing that is inflating the supply of gold and subsequently this makes it attractive as an alternative to fiat, paper money that you can increase the supply of.
Yesterday, the World Gold Council released their third quarter report and revealed gold jewellery demand is down everywhere but China.
Jewellery demand in Q3 2009 was 30% below year-earlier levels. Most countries recorded a decline, the most severe being India, Russia and Turkey (-42%, -52% and -55% respectively).
This isn't surprising because the precious metal has been priced out of jewellers budgets. This is a big problem. It means that the businesses that depend on gold to make a living will see their profit margins squeezed. It means we're less likely to see gold in jewellery except for the very wealthy.
A few years ago I had a discussion with a commodities trader who was telling me why he thought gold will reverse its trend and drop to 300 dollars. His reason was that the metal is not used for a wide variety of things. It's a metal that has no value to the common man.
Today, only a couple of years later, we are shown the intrinsic value of gold as an alternative to fiat currencies. And it's not the value to the common man that is driving the demand, it's the value to a wealthier tier of people, people who need to safe guard investments.
The effect of the recent supply of money
When we wrote last week's article, a reader responded that it is obvious there is an increase in production, but the true question is whether this will outstrip demand. But demand is a funny thing, especially with gold. Gold is an investment vehicle, somewhere to store your money at a comparative rate to others. As such it needs to be compared to other investments.
John Stepek, the editor for MoneyWeek noted:
Cheap money policies are inflating asset prices around the world. This seems self-evident. For one thing, everything is going up. Stocks, bonds, gold, oil, base metals – it doesn't matter. Assets that shouldn't really be correlated are all heading up together.
And this brings us to the point. There is an excess of money in the financial markets that is floating around. It must park somewhere. And so it finds itself being drawn into many different channels.
The Feds low interest rate is inspiring a new wave of investing
A few years ago the difference in interest rates amongst currencies inspired carry trades. This is the practice of borrowing currency with a low interest rate and using it to buy into a currency with a high interest rate. It has been a very profitable trade of the past decades but in todays world it faces bigger problems. It is very difficult to predict currencies in the current climate. The unpredictable nature of the currencies means large investors are unwlling to invest in them. So today we have low interest rates in the US and the UK but we also have an unpredictable currency market.
The result is that banks can borrow at very low rates and put their money into stocks, bonds, assets, and anything else which will have a higher yield.
This is the new carry trade. The low interest rates are inspiring banks to borrow money and invest it in the markets. This together with the monetary policies injecting cash into the financial system is the reason why everything seems to be heading up. The problem comes when the interest rates rise. But as Ben Bernanke signalled the other week, that's not going to happen for a while yet. Which brings us to our final point.
Many economists and journalists are now expecting a double dip recession. They anticipate a reduction in the stock market before a true recovery can begin. It certainly looks as though there is much that is still not sorted out. You need only look to the fact the UK government is still propping up the economy with a recent cash injection of 25 billion pounds. We've lost count of all the 0s floating around, but then maybe the government has too.
If the UK and the US were to have a further stock market crash, and today is just another bear market rally then what does this mean for gold?
If we look back across recessions gold stocks usually perform well. On October 28, 1929, the Dow Jones Industrial Average dropped 12.8%. The day after it lost 11.7%. Undoubtedly you've heard of The Great Depression for the succeeding years. The result was a lift in the price of gold mining companies.
Homestake Mining Company, one of the largest gold producers in the early 20th century experienced an enormous share price increase of 450% over those four years, from 1929 - 1933. Homestake was one of many mining companies that prospered during The Great Depression. This was a time of deflation. And this was at a time when the price of gold was fixed.
Fast forward to almost a century later and we are in the middle of another recession that verged on becoming a depression, and once again gold mining stocks have been the main drivers in the market to date. Consistently we're seeing mining stocks balancing the markets.
The problems haven't gone away. The markets are not repaired yet. We hold our breath waiting for another crash/drop in the markets before a true recovery can take hold. In our opinion, and this should not be taken as advice, there is still a period of depressed stock markets to come... and this means that the gold mining stocks have further to gain when this takes hold.
We watch for further events that will indicate what is going to happen next. So stay with us as we look at what news will bring us this week, and what will affect the price of gold.