An Analysis Of Supply And Demand For Gold

Includes: ABX, GLD, NEM
by: UltraLong

Gold Supply

I have used data from second quarter 2011 issue of Gold Demand Trends from World Gold Council (WGC) released in August to plot supply and demand for gold. Total mine supply takes into account producer hedging. Apart from Q2 2010 and Q1 2011 producers have been de-hedging in the observed time period which reduces the total mine supply. The de-hedging was particularly significant in the year 2009 when total mine supply was reduced by 236.4 tonnes by the activity. In 2010 it was reduced by 108.4 tonnes and in the first half of 2011 de-hedging activity was reported to be just 3.9 tonnes.
gold supply
(Click to enlarge)

The amount of recycled gold seem to be fluctuating around 400 tonnes per quarter. One interesting observation in the Q2 2011 issue of Gold Demand Trends was that the correlation between change in local recycled gold supply and local price has diminished in recent years in some countries. In Indonesia and South Korea the correlation between the two was high between 1998 and 2006, but has since dropped significantly. According to the WGC report “this suggests, at the very least, that consumers are acclimatising to an environment of and an outlook for rising prices. It could also be a signal that near market supplies of recyclable gold are dwindling and ever greater price moves are required to flush out additional supply.”

Apart from first half of 2009 (not seen on the graph) and fourth quarter of 2010 the official sector sales hasn’t contributed anything to the supply. On the contrary, central banks have been buying. The figures reported by WGC exclude any delta hedging of central bank options (whatever that means). At any rate, this leads to the obvious question: why to report official sector “sales” on the supply side when it seems that they have flipped from sellers to buyers.

Gold Demand

gold demand
(Click to enlarge)

The first thing that pops up in the chart plotting demand for gold is the total demand for gold bars and coins. It has been rising significantly in the observed time period. Demand for technology is pretty much flat. Jewelry demand is the most significant one and it is also the one fluctuating greatly from one quarter to another. It is clear that wedding seasons and holidays in which gold purchasing is customary have a big influence on the jewelry demand.

Gold ETFs [such as (NYSEARCA:GLD)] and similar products make trading gold very easy. And that shows in the demand. The movements both up and down can be big. The category “OTC investment and stock flows” include institutional investment other than what is reported in category “Gold ETFs and similar products.” It also includes “stock movements and other elements as well as any residual error.”

Putting it all together

Producer hedging and de-hedging activities have a big impact to the supply of gold. To my knowledge most big players are done with de-hedging so the question is that when hedging will start again. Hedging means that total mine supply would grow creating downward pressure for the price of gold. The mine output is also growing all the time as rising price of gold makes more and more projects economically viable. On the other hand, each ounce of gold mined is away from the reserves which are finite.

Central banks know that gold is the ultimate currency so I would be surprised if they would be net sellers any time soon given all that is wrong in the world of finance. It is likely that those that have it sit tightly on top of it. Those that have too much paper reserves will look ways to convert paper to gold. All in all, it is hard to see any shocks coming from the supply side any time soon.

The demand side is not that stable. It is hard to estimate how big portion of buyers are pure speculators and how big portion of them are going to sit on top of their bullion no matter what happens. I would tend to believe that many who buy physical gold in form of either bars or coins are not going to easily sell. Gold coins and bars may be sitting in bank vault to start with so it is going to require much more effort to sell them than shares in some gold ETF. The cost of buying and selling bars and coins is also big enough to prevent short term speculation. However, the volume of gold sold in this way starts to be so significant that mere drop in sales will do a lot of damage. You do not need people to offload their bullion to send price downwards.

The most volatile demand for physical gold comes from ETFs. And there lies the most probable source for demand shocks along with futures markets. There is a clear gold fever going on and so far the fluctuations in demand in various categories have partly cancelled each other creating a rather smooth ride upwards.

10 year gold KITCO

I would say that there is about equal change of perfect storm sending prices sky high or sending them into abyss. A perfect storm will occur when big fluctuations in demand categories go the same way: either up or down. At any rate, I do not expect the gold fever to last forever. It is clear that a bubble is forming and at some point of time the music will stop and gold price goes to free fall mode. However, before this we might see a truly spectacular run.

My strategy is to gradually sell gold and buy value stocks as the price of gold gets higher or there is further decline in the stock market. I have also gold miners in my portfolio. So far gold has outperformed the miners, but I believe that might change in the future. My favorites in this sector are Barrick Gold (NYSE:ABX) and Newmont Mining (NYSE:NEM). They are among the biggest gold miners, have huge reserves and most of their mines are located in relatively stable regions.

Disclosure: I am long NEM, ABX. Long Physical Gold via various ways.