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There is a misguided belief among some that the price of gold (NYSEARCA:GLD) cannot fall below its cost of production. The theory suggests that gold producers will shutter operations if costs exceed the price received for the commodity. This would effectively reduce supply and maintain an impenetrable support price. This idea is entirely specious.

The most obvious reason mine owners would be reluctant to mothball an operation is a belief that the price of their commodity will eventually increase. In that case, the losses incurred by shuttering would outweigh those from producing at a loss. Once mines are shut down, they rapidly lose value. Equipment such as excavators, pumps, compressors and motors would deteriorate from lack of use. Separating equipment and mills run the risk of obsolescence between the time of shuttering and re-commissioning. The loss of institutional memory from departed employees would seriously affect efficiencies upon startup and beyond. Costs of shuttering, care and maintenance, and restarting are expensive and weighed before any decision is made to close a mine.

The shuttering of a marginal producer would have less effect on gold supply than would that of a large operator with more to lose. But it is the larger miners which are less likely to shut down. The more capitalized the miner, the more it desires to maintain its assets in operating condition. Those heavily capitalized operations produce more gold, and continued production at larger mines, even at a loss, would regulate drops in supply. The larger operators have a greater margin to reduce costs through scaling down exploration and development, concentrating on higher-grade ores and reducing staff. These measures can keep cash flow positive even through lean times.

Those who say, "Buy gold because it costs less than it does to dig it out of the ground," are completely off base. There is no single cost to produce gold. No two mines are alike; each employs different practices and is subject to different costs. Costs at a single mine are not static and fluctuate on a daily basis. Besides constantly changing variables, chronically misleading accounting practices make it difficult for an investor to determine all-in costs of a mine. To determine a global cost per ounce produced and make an investment decision based on that is pure folly.

The price of gold will continue to be determined by market auction. Whether the auction is for paper or physical gold is irrelevant. The costs of labor, material and capital goods to produce gold have nothing to do with its price. Gold's value is derived from how much people desire or need the object, not on how many resources were expended on its extraction.

Source: The Gold Floor Fallacy