- Gold finds support at $1,200 in 2014.
- Supply analysis shows that gold price cannot go much below the current production cost of gold at $1,100.
- Central Banks and China are net gold buyers.
- The outflow of gold ETFs has stopped, and the COMEX inventory is at an all time low.
- Supply and demand analysis indicates that the gold bear market is ending.
Since the second half of 2013, gold price has hit low three times. It seems that there is strong support at $1250/oz level. Whether the price of gold will go up or go down from here, there is a great debate. See chart below for the recent gold price:
Gold, like any merchandise, changes price according to supply and demand. In this article, we will look at the supply and demand to understand where gold price is possibly heading.
Gold demand is best summarized by the data from World Gold Council. The demand can be categorized into jewelries, industrial use, bar and coin investment, ETFs, and central bank net purchase. The breakdown demand in each category is listed in the Table 1. The total worldwide demand per quarter is around 1,000 tonnes for the last eight quarters. However, we notice that the ETF demand has been negative in 2013. ETFs were a net seller of gold in 2013. In Q1 2014, the outflow of gold from ETFs has stopped. Whether ETF gold will revert to inflow in the next few quarters remains to be seen.
According to the World Gold Council, the supply of gold is coming from mining and recovery from the consumed gold by the industry. We will talk about the gold recovery later. Let us look at the supply from mining in Table 2:
The supply of gold from mining is around average about 730 tonnes per quarter and is trending up slightly. What is not shown in this table is the cost of producing gold today. The average cost per ounce of gold produced by four major gold miners - Goldcorp (NYSE:GG), Newmont (NYSE:NEM), Kinross (NYSE:KGC) and Barrick Gold Corp (NYSE:ABX), are shown in Table 3 (Visual Capitalist):
Many smaller miners without the economy scale have much higher costs than the big ones. That is the reason all miner shares were hit much harder than the gold price itself in the gold bear market. The reason for the high cost of gold production is because an average grade gold mine produces only 5.3 grams of gold for each ton of earth mined. The cost will continue to rise when the higher grade ores are getting scarcer.
The gold bear market in the last two years has been devastating to the gold miners. The gold miner stocks as well as the Market Vectors Gold Miners ETF (NYSEARCA:GDX) and Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) all suffered much more than the gold price itself. While gold price dropped by 30% from its high, the gold miner shares dropped more than 50%. GDXJ, ETF of smaller gold miners, dropped by a whopping 73% from its high. If the gold price drops below $1,100, many unprofitable mines will be forced to shut down or reduce production. The gold supply from mining will reduce dramatically. This provides a very strong support for the gold price at $1,100.
The gold production is decreasing in the four major gold producing countries - South Africa, Canada, the US and Australia - despite the fact that the world top 20 gold producers increased their gold exploration budget from $300 million in 2002 to $1.4 billion in 2013. The decline is particularly significant in South Africa, where the gold production fell 50% in the last decade. The higher investment and the employment of better technology in gold exploration do not help to produce more gold. The outlook of gold supply is not bright. The worldwide gold production is saturating (World Gold Council Report).
The declining of gold production in the above mentioned four major gold producing countries is offset somewhat by the gold production in China. China's gold production has been rising - now at the level of 428 tonnes per year in 2013 (Xinhuanet), overtaking South Africa as the world leading gold producer since 2007. China produced about 15% of the gold in the world in 2013.
However, the China's gold production may not help to suppress the gold price for two reasons: First, China locked the domestically produced gold in China for strategic reason. Growth in the gold reserves is one of China's strategic targets, outlined in its Eleventh Five-Year Plan period (2006-2010). The plan sets out to increase China's gold reserve to between 3,000 and 3,500 tonnes by 2017. It is trying to diversify its foreign currency reserve by shifting toward gold away from US dollars. The last officially released gold reserve in China in July 2010 was 1,054 tonnes. It represents only 1.4% of China's foreign currency reserve vs. 74.5% of US, 71.4% of Germany, and 71.1% of France (Bullion Street). China has a long way to go to match its gold reserve to anywhere near the level of major Western countries.
In addition, all Chinese gold miners are small scale, and most of the ores are low and medium grade, thus high production cost. It is quite possible that the gold production cost in China exceeds well above $1,200 per ounce. At current gold price, China finds that imported gold is cheaper. Therefore, despite that China is the world leading gold producer; China is also the world leading gold importer.
Secondly, China's known gold mine reserve is estimated at 8,000 tonnes, less than three years of worldwide production. At the current mining rate, it will be depleted in two decades. The reason that China today still has enough gold mines is because China is a late comer in the gold production and most of its mines are relatively new. As late as 1980, China's gold production was only 10 tonnes.
The supply / demand gap
The supply and demand data show that there is a gap, as shown in Table 4. Demand is exceeding supply by a wide margin. Apparently, the gold has to come from someone's inventories or vaults. The gold price and the gap between supply and demand are plotted in the Chart below. We can see a rough correlation between these two.
The World Gold Council attributes the gap filler as being the recovered gold from industry. However, this is not a satisfactory explanation. If we look at the gap of supply and demand and the industrial use of gold, we will find it is hard to reconcile.
The supply demand gap is in average 3.28 time as large as the industrial usage during the time frame of analysis. It is physically impossible for the recovered gold from industrial usage to fill up this gap because the industry cannot spit out more gold than it consumes. Even if the industry can recover 100% of the gold it consumes, it is still far from enough to close the gap. That leaves us to identify other possible sources of the supply.
One possible source is the reduction in the COMEX inventory. The quarterly COMEX gold inventory is listed in Table 6. (Source: Habba Investment)
In 2013, COMEX had a net outflow of gold 103.7 tonnes. The COMEX gold inventory level today is already as low as the level in 2008 right before the gold price doubled in the next four years. In fact, the COMEX inventory level is much worse today because the open interest of paper gold trading is much higher today than in 2008. The potential owner for each ounce of gold is at a scary level of all time high of 55. (see here)
There are other outflows of gold into the market. For example, it is published that the gold holding of SPDR Gold Shares has been down dramatically from 1,286 tonnes in 2012/Q1 to 785 tonnes in 2014/Q2, as part of the ETF outflow, which is already counted in the demand (Table 7). But the gold SPDR Gold Trust sales to pay Trust's expenses is not part of the ETF outflow. It contributes to the supply.
Net gold buying by Central banks
Central banks are the largest owners of the gold in the world. The historical gold holding of the Central Banks is shown in the Figure below:
Since 2007, Central banks have reverted their positions collectively to net gold buyers from net sellers since 1965. This is a significant change because of their huge positions in gold. The gold reserves of the three largest economic entities in the world: the European Union, the United States and China, have over 8,972.6, 8,133.5 and 1,054 tonnes of gold reserves, respectively. China is trailing far behind, and doing everything to catch up.
On 19/5/2014, the European Central Bank and 20 other European central banks signed the fourth Central Bank Gold Agreement. In this agreement, the signatories agreed that gold remained an important element of the global monetary reserves and self-imposed a sell limit. Even before the signing of the agreement, in the last five years, major gold holders from European central banks have virtually stopped all gold sales - selling less than 25 tonnes of gold against an agreed limit of 2,000 tonnes.
Gold flows from West to East
China's catch-up game to increase its gold reserve on par with the US and EU is apparent from its gold import. Chart below (Chart of the Day) shows China's accumulated import since September 2011. Luckily, due to the negative sentiment of gold in the West, China is able to buy gold at a cheap price. SPDR Gold Shares ETF alone dumped 501 tonnes of gold between Q1 2012 and Q1 2014. China is like a black hole for gold - whatever goes in, does not come out again. Now that the ETF gold outflow has stopped (Table 1), there is likely to be a squeeze in the gold market in the near future.
Some investors use US inflation against the gold price and find gold is still too expensive today at around $1,300/oz. It is important to remember that gold trade is worldwide, and its price cannot be measured against the inflation index in one country alone; despite that the US is the largest economy in the world. Certainly, the US inflation rate is not a motivation for China to accumulate gold. It maybe more appropriate to measure gold price against the US debt since the dollar is the world's reserve currency (see below). The US debt level is certainly a strong motivation for China to accumulate gold. By using this benchmark, the gold looks incredibly cheap. Whatever index used to compare gold price must have an underlying motivation that affects the demand and supply of gold.
It is the supply and demand that decides the real action in the market. The supply is determined by what is available for trading, not what is locked up in the vault. The analysis shows that the upside for gold is more likely than its downside.