by Joung Park
After exhibiting few signs of life during much of the 1980s and 1990s, gold prices have revived during the last 10 years, climbing more than five-fold from the 2001 average price of less than $300 per ounce to more than $1,400 today.
So what drove this massive increase in gold prices during the last decade? We believe four major factors have been largely responsible for the recent surge in gold prices:
- The inception and proliferation of gold-backed, exchange-traded funds (ETFs).
- Growing retail demand from emerging markets, particularly from China and India.
- Central banks switching from being net sellers to net buyers of gold.
- Miners scrambling to eliminate their gold hedge books.
While we think that some of these factors could continue to provide a tailwind for gold prices, we believe many of the factors cited above are unsustainable over the long run, thereby lending support to our lower long-run gold price forecast (compared to high current prices).
Recent Tailwinds Ultimately Could Turn Into Headwinds
Since they first started trading domestically in 2004, bullion-backed ETFs have enjoyed immense popularity among gold investors. By giving investors a cheaper and more convenient method of investing in gold, as compared to purchasing and storing gold jewelry or bullion, these gold ETFs helped stoke gold investment demand. While we recognize the manifold appeal of gold ETFs and regard these investment vehicles as more than just a temporary fad, we doubt that gold ETFs can continue to attract the tremendous amount of inflows over the long run, like they have done so far in their brief history. In fact, we've already seen net inflows into gold ETFs in 2010 (and so far in 2011) decline from their 2009 highs.
In addition to ETFs, rising retail gold demand from emerging economies--particularly India and China--has helped boost gold prices. While the deregulation of the Chinese investment gold market in 2001 certainly helped stoke emerging-market demand for the yellow metal, we think the primary driver behind this trend is the growing middle class in both India and China, which is spending some of its newfound wealth on gold jewelry and investment products. Retail investment demand growth in particular has been robust, as we suspect some of that "jewelry" demand in China and India was actually for investment purposes. In fact, more than 80% of Chinese gold jewelry purchased in 2010 was 24-carat pieces, which are especially desirable from an investment point of view due to their pure gold content. As with most commodities, we believe the demand for gold should continue to benefit from the thriving spending power of the Chinese and Indian middle classes.
Central banks are major swing players in the gold market, and we've recently seen the official sector switch from being net sellers of bullion to net buyers, thereby benefiting gold prices. Given that central banks often execute gold transactions on the order of hundreds of tons at a time, official sector sales (or purchases) can exert a huge influence on gold prices. And after being consistent sellers of bullion, the official sector became net purchasers of gold in 2010 for the first time in decades. This development mainly has been driven by central banks in emerging markets (especially China, India, and Russia) expanding their existing gold reserves through open-market purchases, which has more than offset the continued sale of gold reserves by central banks in developed economies.
While recent trends in official sector gold sales have been a major tailwind for gold demand during the last few years, we don't think it would be wise to extrapolate this trend over the long term. After all, official sector sales (or purchases) are heavily influenced by policy and social considerations that can easily shift with political sentiment. And if central banks decide to resume selling their gold reserves, such a move could be extremely detrimental for gold prices, given that current total central bank holdings (at about 30,000 tons) amount to roughly 12 years of current mine supply. Clearly, the central banks' decisions to either continue purchasing gold, or revert to their historical role as major suppliers of the yellow metal, merit close watching given the massive influence that central banks wield on the gold market.
In contrast to official sector transactions, miner hedging activity going forward is fairly easy to predict. Given that gold miners' hedge books have been whittled to less than 5 million ounces by the end of 2010 (from more than 100 million ounces at the end of 2000), miners will no longer have to purchase gold on the open market (or earmark their current production) to cancel existing forward sales agreements. This would mean that a previously significant tailwind for gold demand will subside going forward, and could even reverse to a headwind if gold miners decide to rebuild their hedge books to lock in historically high bullion prices. In fact, we've recently seen a return to hedging by several silver miners. Granted, many gold miners were burned during the last decade by having to eliminate hedges as gold prices skyrocketed, and might not be so eager to jump back into a hedged position. But in any case, the winding down of de-hedging activity will eliminate one recent source of gold demand and thereby help pressure gold prices downward.
We Are Adopting a Lower Gold Price Forecast
Our analysis of the four main drivers of rising gold prices during the last decade shows that many of these positive catalysts cannot be sustained indefinitely--especially inflows into gold-backed ETFs and miner de-hedging activity. Furthermore, some of these tailwinds for gold prices could easily reverse to headwinds, which would exert significant downward pressure on bullion prices. While low real interest rates, a weak U.S. dollar, as well as macroeconomic and geopolitical uncertainty certainly could help bolster gold prices in the near term, we believe the more fundamental factors discussed in this article will wield a larger influence on bullion prices over the long term. We believe these considerations all help support our new gold price forecast, which is based on a marginal cost analysis and projects long-term bullion prices to settle significantly below current spot prices. For more details on our new gold price forecast, please refer to our stock analyst note, Long-term Gold Price Projections Reduced.
Elizabeth Collins and Min Tang-Varner also contributed to this article.