Bottom In Gold Likely To Be Below $770

Includes: GLD, GLL
by: Robert Wagner

Executive summary:

  • Gold will likely bottom below $770/oz.
  • The fix cost heavy balance sheets of gold miners is conducive to over production.
  • China, hedging and basement gold may complicate supply and demand dynamics.


The factors that drove gold to $1,900/oz have mostly reversed themselves. Many of the reasons gold got to $1,900/oz were pillars of sand in the first place, so investors should not be surprised to see gold falling.

The main reasons to hold gold are:

1) An inflation hedge.

2) To protect against "tail risk."

3) As a diversification asset.

There is no inflation to speak of, nor is there likely to be as long as U.S. unemployment is near 13%. Most "tail risk" is in the past and is being unwound out of gold. Diversification assets are best to hold while they are reverting up to the mean, not collapsing towards it.

The main headwinds facing gold are far more real and significant.

1) Rising rates increase the opportunity cost of holding gold.

2) Economic recovery further lowers "tail risk."

3) Production of gold has been surging while the gold price has been falling.

In my opinion, further economic recovery is the death sentence for gold. Supporters of gold will talk of the "physical demand" for gold being driven by the "love trade." The "love trade" is completely self limiting. As lovers drive the price of gold higher, it chokes off further demand. You can buy many dozens of roses and boxes of chocolate for the cost of a single ounce of gold. The higher the price of gold, the greater the opportunity cost as measured in roses and chocolates. The vast amount of that demand comes from 2 countries: India and China.

To make matters worse, India has a current account issue, and China's production has been exploding.

China's gold production barely registered on the map in 1980, and in little over 30 years they have taken the top spot. China has likely just barely scratched the surface of what they may find.

Additionally the trade to China tends to be seasonal and centered around the New Year.

The gold market tends to see a spike in physical gold purchases by China ahead of the annual Lunar New Year, which began on Jan. 31 this year. Gold futures prices managed to hold up well even after the Chinese new year holiday, with prices posting three weekly gains in a row.

The facts are, while gold will certainly have its dead cat bounces like it is having now, the path of least resistance for gold is down. The tail winds that blew it into the stratosphere have become headwinds, and those headwinds are likely to start to blow stronger. Even if India does relax its trade restrictions, gold imports will simply push India back into a current account deficit. Also that chart above represents annual production numbers. Gold isn't consumed, so each year of record gold production simply adds to the world's supply of gold. Gold isn't like oil where the world needs a continual supply to keep it running. New supplies of gold simply add to the existing supply. The supply just keeps growing.

The big problem I see for gold is that it is a capital intensive industry on a grand scale, and much of the production is coming from countries that may not consider free market principles when making production decisions. Gold has an estimate cost of production of around $1,200/oz. Understandably gold has recently bounced off the $1,200/oz support level, but I doubt that support will ultimately prove to be the bottom.

During the boom years, the cost of gold mining soared. But this year the average cost of producing an ounce of gold is already showing signs of retreating, according to metals consultancy Thomson Reuters GFMS.

All-in costs are expected to ease back to around $1,200 an ounce in 2013 from $1,228 last year

That however is a highly misleading statistic. As I pointed out above, gold mining is an extremely capital intensive industry. That means they have a large percentage of their expenses in fixed costs, much like the airlines. Companies, especially capital intensive companies, will continue to produce as long as it can cover its variable costs, at least in the short to intermediate term. The real cost that is relevant to gold production isn't the average cost, but the average cash cost. The costs that require cash flow. The costs that get collectors showing up on your doorstep if they aren't paid costs.

total cash costs fell to $769 an ounce in the second quarter from $796 in the first three months of the year.

That is why I would put the maximum bottom price of gold around $770, but I wouldn't be surprised to see it fall below that. Airlines often continue to run at huge losses hoping to outlast the competition. Gold is a lot like the airlines, only worse. Gold has China as the main producer, and they are using gold as part of their monetary and industrial policy. China's monetary and industrial policy most likely won't consider free market accounting principles when they make their decisions to produce or not. If China wants to dominate the world's gold production, it will do so regardless of the cash or total costs.

The other problem for gold is that a large number of people have been buying physical gold to stash in their basements. Many of my friends own physical gold along with guns and bullets. Sooner or later their wives are going to pressure them to clean out the basements, especially once they find out how much they have lost on those gold holdings. At least you can take the guns and bullets out and have some fun with them, all the gold does is sit there, take up space and really annoy the wife. Sooner of later the wife will win and the gold will be dumped on the market. So even if mining operations do shut down, that doesn't mean the supply of gold on the market will decrease. Basement gold represents a large overhead supply that could drive gold below production costs.

The gold can also come from the basements of exchanges and banks, as the recent supply out of the UK demonstrates. The fact is most gold doesn't get consumed, it just adds to the existing stockpile waiting to be shifted around to different accounts. Developing nations, however, aren't likely going to want to hold their gold reserves forever; they will eventually be used to build roads, bridges, schools and other infrastructure. Right now China exports goods and services to the West, and accepts gold in exchange. The Chinese exports do far more to improve the standard of living and productivity of the Nation importing from China than the people of China benefit from having a stockpile of gold sitting in a bank. That is the irony of this lust for gold; the Nations accumulating it are exporting their true wealth.

By far the largest quantity of gold (119 tons) was imported from Great Britain - part of this total is likely to have come from sold [exchange-traded fund] holdings," they said. "This underpins the gold flow from west to east that has been underway for months now.

Additionally many gold miners may have hedged their production so they don't care what the price of gold is. Regardless of the price of gold, if a gold mining company hedged its production, the spot price is irrelevant. There is evidence gold miners have returned to the practice of hedging after years of avoiding it.

In conclusion; if my thesis is correct that we are on the back side of a gold bubble, and that gold is headed lower, I would place a maximum minimum price on gold at around $770/oz or right around the cash cost price. That however would be a maximum low point, and I would expect gold to eventually trade below even its cash cost. China gold production and basement gold represent supplies of gold that may come to the market regardless of the cash cost. Because of the difference between average total cost and average cost, I expect that the $1,200/oz support level is a just another "pillar of sand," as is the hype about the "love trade." Those arguments may be enough to generate a temporary dead cat bounce, but they are unlikely to reverse a well established long-term down trend and overcome the ever increasing headwinds gold is facing going forward. Also, the most likely sign that the gold bear market is over will be when Peter Schiff and other Perma-Gold Bugs turn bearish. That will be the true signal that a new gold bull market is beginning.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Disclosure: I am long GLL. I own calls on GLL. 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.

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