Why Gold is Likely to Keep Moving Higher

"Gentlemen, this is a football." -Coach Vince Lombardi at the start of Green Bay Packer football camp

Occasionally I like to take a close look at gold's fundamentals -- a gut check of sorts. It helps me get a deeper sense of what is driving the market. It also helps me reorganize my thinking around sound principles. Vince Lombardi, the legendary coach of the Green Bay Packers, always stressed knowing and understanding the fundamentals as the key to success on the football field. Likewise, learning the fundamentals is key to knowing and understanding gold. By doing so, you will become a more confident, better informed and successful gold owner.

From scarcity to shortages, the past is prologue

I cannot remember a time when the fundamentals have lined up more favorably for gold. The factors which have driven the price up over 75% over the past few years remain in place and in fact seem to be intensifying. The past, in this respect, could very well serve as prologue. Great forces, mostly benevolent, are at work in the gold market. Demand, as reported copiously by the mainstream financial press, continues to grow steadily on a global basis. It is on the supply side of the equation, however, where we now find the strongest arguments for resumption of the bull market. To come to the point, fundamental trends suggest that the gold market may be moving from a period of general scarcity to outright shortages. Unless some formidable source for gold is suddenly found, the period of shortages could come to full flower as early as 2008.

Though benevolent forces seem to be guiding the gold market at the moment, there is, at the same time, a darker side to the emerging gold story. A shortage raises the possibility that investors who have yet to purchase gold (or plan to purchase more) might be crowded out of the market by major financial institutions and mining firms intent on squaring their physical short positions.

The threat of a gold shortage should not be taken lightly. Recent reports of a rice shortage in Asia are a case in point. Nation states immediately began hoarding rice and governments put incentives in place to encourage production. The possibility for shortages applies to a range of key commodities, not just gold. Along these lines Goldman Sachs recently predicted explosive rallies in commodities led by crude oil rising to $175 per barrel. Shortages, hoarding, rapid price increases, breakdowns in international trade, a collapsing social order and the increased purchasing power of gold -- all typically accompany periods of currency debasement.

The mining companies face reduced production. . .

In 2005, the world's mines produced 2,550 tonnes of gold. In 2007, production had declined to 2,447 tonnes. Production, in fact, has been in steady decline for a number of years. Newmont Mining's Pierre Lassonde, who is generally considered one of the more savvy mining executives, explains why the mines have failed to increase production even with prices at record levels: "When is the last time we had a 30 million ounce discovery in the world? It's not in this decade, I can tell you that (and) it's not over the last 10 years. It's a long time ago. Look at exploration expenditures ­ they are going up, but we are not getting the discoveries. And not only are we not finding them, but the ones we do find, they take forever to put into production." Lassonde goes on to say that in his view "it's not going to get any better ­ at least for the next five years, and possibly for as long as the next 10 years."

. . .And forced covering of their forward sales

The steadily rising gold price has encouraged some mining companies (and forced others) to buy back their previous forward sales -- a process called dehedging. Though some analysts in the industry perennially predict the dehedging will slow, it has instead accelerated and become a major factor on the demand side of the gold balance sheet. In 2005, the mines dehedged 86 tonnes of metal. By 2007 that figure had grown to 400 tonnes -- a 465% increase.

When a mining company dehedges, it reverses its previous role as a seller in the fundamentals' equation and instead enters the market as a buyer. The effect on the supply-demand chart has been dramatic. What was once supply which acted to hold down the price has now become demand and an impetus to the price. This role reversal has contributed significantly to gold's steady rise over the past several years.

The plight of African mining giant AngloGold Ashanti is a case in point. Miningmx.com reports that Anglo is currently receiving 20% less than the spot price of gold (assuming a $900 price) due to its contracted forward sales. What's worse is that Anglo is contracted to deliver 60% of its hedge book over the next three years.

To buy its way out of the hedge, one top analyst believes a massive share issue amounting to one-third of the company's equity would be required. "It's a bombshell," he says, "and they are in more trouble with this hedge than anyone realizes." Thus not only will Anglo's shareholders experience hedging losses on the bottom line, they may be forced to suffer serious dilution of their interest as well.

For those who own the metal itself, such problems are grist for the mill. Anglo's forced purchases, no matter how they are financed, go straight into an already buoyant gold market. Keep in mind that the AngloGold Ashanti story is just one among many in the world of gold mining. "Being underwater" is an industry-wide problem. Analysts estimate the complete industry hedge book at roughly 1000 tonnes with additions still being posted annually.

Some key producing countries are keeping production at home

Have you ever asked yourself how much of the gold mined actually makes it to the open market? One would think that all the gold mined makes it to market. However, like much in the gold market, the answer to that question is more complicated than it appears on the surface.

Few people know, for example that China, which became the top gold producer in the world this past year, is a net importer of gold. (Annually, it produces about 275 tonnes and consumes about 325 tonnes.) In short, the biggest market for Chinese gold is the Chinese people themselves, and the demand is large enough to consume everything China produces.

Beyond direct retail demand which is likely to increase as China prospers (the Chinese people have a particularly strong attachment to gold), there is the question what China is likely to do with all the dollar reserves it has piled up over the past few years. There are constant rumors that its huge sovereign wealth fund is buying gold. The central bank has also been cited in press reports as a potential buyer. Should any significant tranche of gold be made available, there is a strong chance that China might be a buyer.

Similarly, Russia, the fifth largest producer, is a net accumulator of gold. Only in its case, acquisitions are being made in the open as part of its central bank operations. In 2005 First Deputy Chairman of the Central Bank Alexei Ulyukayev, undoubtedly with President Vladimir Putin's blessing, said the bank would be purchasing gold "on all markets on which it is available," meaning both domestic and foreign markets. This gold will become part of Russia's national reserves and serve as a bulwark for the ruble.

So, in the case of the world's first- and fifth-largest gold producers, the gold in essence never leaves its borders. What appears to be production that should grease the wheels of international supply is actually gold hoarded by the nations which produce it.

Others face serious limitations on their production

The South African mines have seen their production decline steadily over the years. Labor unrest, political instability and high-cost, deep ore structures have all taken their toll. Now the South African government has informed the mines that they will have their electrical power rationed for the next several years. Experts warn that the power shortages could cut gold production by as much as 15% to 20%. This translates to almost 55 tonnes of gold suddenly disappearing from the supply table -- a not insignificant number. The power supply problem could add to the demand side of the ledger as well. Writing for Financial Times, John Dizard made the following observation: "A lot of South African gold production has been hedged through short sales. It may be the case that the banks who lent the gold for the short sales have suggested that the cutback-plagued mines cover their short sales with open market purchases. That could have fueled part of the gold pop in recent weeks."

The official sector is not as committed to selling as some might think

Central bank, or official sector, sales are governed to a large degree by the Central Bank Agreement on Gold [CBGA]. The signatories, which include most of the major European central banks (the primary sellers over the last decade) are restricted as a group to selling no more than 500 tonnes per year. There is also strict regulation of leasing gold -- another method of supplying the market.

When the International Monetary Fund recently announced that it was seeking permission from its members to sell its gold, it stipulated that the sales would be conducted under the guidelines of the CBGA. That said, there is still the possibility that the IMF sales will be blocked by Congress. At a time when other central banks have become reluctant to sell, that could come as a major blow to the supply side of the market.

Some top analysts, like Gold Fields Mineral Services, think CBGA sales could come in at less than the 500 tonnes allowed for the 2007-2008 fiscal year which ends in September. And as for the 2008-2009 CBGA fiscal year, some analysts are predicting a sharp drop off in sales. Virtual Metals stated in a recent report that sales could be as low as 247 tonnes unless some official sector entity, like the IMF, stepped into the breach. As of this writing, the World Gold Council reports only 191 tonnes sold of a possible 500 tonnes in the 2007-2008 CBGA fiscal year -- another indication of the growing reluctance on the part of central banks to sell.

click to enlarge image

Table courtesy of World Gold Council

Note: On March 31, the World Gold Council reported that Switzerland, one of the primary sellers in recent years, is now approaching the end of its latest 250 tonne selling program. Germany, meanwhile, has announced that it will not sell gold in the new CBGA year beginning September, 2008.

By and large, central bank sales do not carry the same weight they did years ago when simply the announcement of a major sale would send the gold price reeling. For the most part, the market has already factored central bank sales into the supply-demand equation. As a case in point, when the IMF announced its interest in selling gold a few weeks ago, the market slipped back for a day or two and then resumed its sharp upward advance. The real story here is not the market effect of CBGA sales, but what will happen if the 500 tonne quota falls way short. As the Virtual Metals report concludes, "[I]f sales [IMF] do not happen or the decision is not made in time - the final CBGA year will turn out to be very interesting."

Demand from investors strong as inflation, systemic risk hit most economies

As a primary indicator of the strong overall demand, gold has risen sharply over the last five years in every major currency -- the U.S. dollar, the euro, pound sterling, the Swiss franc, Japanese yen and Canadian and Australian dollars. The surge in demand has been accompanied in each of these nation states by rapid commodity inflation (particularly oil), general price inflation/stagflation, currency depreciation and an international credit crisis. In particular, the exodus from the dollar which has gathered pace over the last few years has led both private and institutional investors globally to ratchet up their gold acquisitions.

Investment demand, since the inception of the bull market, has climbed relentlessly higher as a result. In 2001, according to World Gold Council statistics, 400 tonnes were purchased for investment. By 2007, that figure had climbed to just over 1000 tonnes, and the 2007 gold turnover in dollar terms set a new record. Above ground stocks of gold held for investment in the aggregate now rival that of central banks -- 25,800 tonnes held by private investors and 28,500 tonnes held by the official sector.

At 69% of the total demand, gold jewelry still accounts for the largest share of overall gold consumption. Though the largest portion of fabricated gold is purchased for adornment, there is still a significant amount of jewelry purchased in India, the Far East and Pacific Rim as a form of wealth and for cultural purposes. With strong economic growth likely in these countries for years to come, gold demand should grow with it. "Jewelry consumption in the developing markets," says the World Gold Council, "has been expanding rapidly in recent years following a period of sustained decline, but several countries, including China, still offer considerable potential for future growth in demand."

Conclusion

I would like to leave you with a comment on the gold supply and demand numbers in the aggregate. Gold Fields Mineral Services [GFMS], the industry's most reliable source for gold supply-demand statistics, reports a total mine supply of 2447 tonnes for 2007, but that number is problematic. When you account for the dedicated Chinese and Russian production, the projected central bank quota shortfall, the curtailment of sales from South Africa, and the potential for accelerated producer buy backs, a different picture emerges -- one not of copious supply but of shortages. The fundamentals lead us to the conclusion that there has been real substance to the gold rally of the past two years -- a rally which has taken the price 75% higher. Those who have called gold's up trend the latest in a string of speculative bubbles do so from a lack of perspective and understanding. Likewise, the fundamentals hold out promise for the future in that none of the trends in place are likely to reverse anytime soon. We are left with the impression that the gold bull market is likely to stay on course in 2008, even if we experience a short-term correction or two.

Comments

[leh]

Brilliant piece, nice work! Great overview of this commodity and its underlying story. Nice to see some substantive reporting and analysis.

Cheers,

Larry Hayes

[Kingbruce]

I was laughed out of Barclays Bank in 1965 for asking the Manager to buy gold with the sale price of my house and savings. The tears rolled down his cheeks and I walked out ashamed !!!
Most of my assests these days are in gold and silver and foreign currencies. I would love to hear from you on the future of Silver as l believe this is also a future play overlooked by many.

Kingbruce.

[L-bow]

Enough with the charts and all the fancy analysis where gold is concerned: How about a common sense approach!
Gold has no fundamentals and practical no industrial use. So, gold is either one of two things; a hedge against inflation or a hedge against uncertainty: On inflation, Gold is up about 42% per year since 2001 with US inflation somewhere between 5 and 9%, so gold is light years ahead itself in this respect. Historically though, gold has not been a sound inflation hedge.
As a hedge against uncertainty, if things get really bad, gold is virtually useless. One certainly cannot eat gold and jewelry is probably not going to be foremost in most folks minds, except to sell!
Gold mania like tulip mania is all perception and hype and fueled by articles like yours. Gold mania, plain and simply, feeds upon itself. Folks jump on the gold train as it begins to move and more more folks pile in until runs out of steam. The problem is that nobody really knows where the gold train is going. It's all imaginary. The train starts up the hill until it runs out of steam and then rolls back down. The steam is purely imagination based, making gold's movements even more transparent than with most other investments. However, the known entity at the moment is that the gold train never made it much past the 1000 foot mark in the face of massive incertainty (Bear Stearns potentially taking down the entire global financial system), and is now around the 900 foot mark, metaphorically speaking. It looks to me at least that something around $1000 an ounce is the max folks were willing to pay as a risk premium for virtually unlimited uncertainty. Knowing that, folks are now jumping off the train, with a few of you trying to persuade them to stay aboard.
In this sense, you are trying to convince folks to remain on board a train heading down the mountain in hopes of eventually getting them to the top, when the very real threat of an implosion of the entire world financial system could not get it above the $1000 mark. The question then becomes, what will?

[Henry L]

I am so glad there are a few analysts who can take a comprehensive view of their subject and report their findings in an apparently unbiased manner (altho he's definitely a gold bull)!. Thanx, and keep up the good work.

[bhakta]

Very well written and researched. Thank you. I agree with you whole heartedly.

[James Cullen]

While this is a well done piece, you should read his bio to understand that he isn't totally unbiased.

[User 30121]

To Dan Perkins: Okay, so let's say U are correct in your assessment on gold. Where do I put my $$$?

[silverbullet]

The real place to put your money is in silver. Silver is money and has industrial use. Gold will continue to surge because the dollar will continue to crumble. Inflation is much greater than the government reports. They understate it dramatically in order to controll the costs of their budget entitlements like social security. The actual deficit for this year is 4 trillion dollars by corporate standards. Silver will be $300 an ounce due to the dollar and new technology that uses silver. Gold is gold, silver is super

[pockyclips2020]

Energy prices have more than quadrupled since '01. Everything we consume requires energy. Energy is paid for (at this time) in dollars.
Dollars are printed on paper. Gold is real. You will see $1200/oz gold
before $700/oz gold.

[eric hart]

To Mr. Perkins,
A few rejoinders:
"Enough with the charts and all the fancy analysis where gold is concerned: How about a common sense approach!"

The analysis presented is not emotional nor fancy, but is instead rational and empirical, vs. your ideological and deductive remarks.

"Gold has no fundamentals and practical no industrial use." Incorrect on both counts, The fundamentals are supply and demand, as presented buy the author, and are entirely relevant.

Just as we are likely near peak oil, so are we likely near peak gold, with gold demand outstripping gold supply. How much more fundamental do you want?

As for the "no industrial uses comment", this is both irrelevant and incorrect. Many great investments have no industrial uses. And according to reliable sources, gold is made into literally tons of jewelery. This may not meet your definition of 'industrial', but it is real consumption of a limited resource.

"So, gold is either one of two things; a hedge against inflation or a hedge against uncertainty: On inflation, Gold is up about 42% per year since 2001 with US inflation somewhere between 5 and 9%, so gold is light years ahead itself in this respect. Historically though, gold has not been a sound inflation hedge."

Inflation over sufficiently long periods of time tracks the creation of money. The creation of money in the US and many other countries has been growing greater than 15% annually. The official inflation numbers are bogus and completely fabricated. Inflation globally is increasing.

Gold has historically been a poor inflation hedge during periods of falling or stable prices. We are not in one of those periods.

Moreover, gold does not trade in a free market, and this accounts for much of the last 25 year underperfomance. Gold trades in a manipulated quasi free market, very much controlled by governments. This control is ending.

"As a hedge against uncertainty, if things get really bad, gold is virtually useless. One certainly cannot eat gold and jewelry is probably not going to be foremost in most folks minds, except to sell!"

Gold is a store of value. You cant eat stocks or bonds either, but I will invest in them as well. If you have gold jewelry that you sell then you are supporting the point the author is making--that gold can be a rational, even superior investment. As a store of value and an investment holding some of your capital in gold makes sense.

[LJ]

Gold has industrial uses. Integrated circuits and MMIC's are metalized with gold before final assembly of the package. Superconducting materials are made with gold alloys. In many industrial applications, silver cannot replace gold because of the following reasons: 1) gold has a much higher melting point; and 2) gold never forms any oxide when subjected to heat.

[drposhmoney]

Over the long term, if gold performed better than global inflation then fiat currencies would cease to function. Therefore, governments will collectively ensure that gold always underperforms global inflation (in the long run). Enough said!

[low]

All said, then I guess the wherewithal of producers is not quite relevant to these equations. XYZ Mining
could just happen upon the unimaginable but are also
confined to the same terms as central banks, despite the possibility that a global populace should still find
it desirable? I fully understand the need to control the
price, where reasonable. But, what happens if the public decides that power should belong to them?

[joenobody02]

Gold is simply a form of currency. You cannot eat a gold coin nor a copper penny but they both have value. The value of the USD is backed by the promise of the US government. The value of gold is backed by its scarcity.

[No Moss]

I'm sorry, but you know it's a market top for gold by the number of articles touting gold to go to $1500-2000-higher. Gold can come down based on supply when institutions start selling, like the IMF recently has. There is a lot of gold gathering dust, and higher prices bring out sellers. The last spike in gold prices faded quickly and didn't recover for decades. I'd be surprised if the current spike didn't end in a similar fashion.

We have a perfect storm of financial panic, a falling dollar, falling home prices, falling stock prices, and quickly rising commodity prices, especially energy-related commodities, which have the most pervasive inflationary effect on economies.

Will gold still be king when it's safe to come out and play? Probably not.

[User 176368]

Sorry, its not even close to a top. We're only half way to gold's inflation adjusted high of 1980.

Gold will not be king when its safe to come out and play but it will be in the mean time; allowing you to preserve your capital to buy up the world on the cheap. Just remember to sell when things go from "really bad" to "less bad".

[TWS User]

For Michael Kosares:

Great article. Two questions.

First, why do you regard the producers as "forced" to buy out their forward hedges? If they deliver their production to satisfy their short positions over time, they are not losing money; they are not even making less money than they expected when they planned out their hedges. At most they have a case of seller's remorse, no? So why are they "forced" to buy out the hedges?

But perhaps the producers aren't "forced" to buy at all. Perhaps, after years of selling forward into a market they regarded as overpiced, they are simply capitulating at last to the general bullishness. In other words, they are buying in their hedges simply to participate fuly in the generally-expected further price appreciation from here. If so, then what we are seeing is the commercials, traditionally the most skeptical players, capitulating to the general buying frenzy. You may call it new demand, but once they're in too, who's left to buy?

Which brings us to my second point and question. One simply cannot translate fundamental analysis to a justification of a price level without considering the amount of speculative money in the game. With enough hot money, the price departs from any rational relationship to fundamentals. You can argue that fundamentals will reassert themselves eventually, and that is true, but as Keynes said, the market can remain irrational longer than you can remain solvent.

So what I miss in your article is any analysis of how much of all this "demand" is speculative. If the Chinese central bank switched some reserves from dollars into gold, I would guess that they are likely to lock the gold up and forget about it. That is real demand. But producers buying in their hedges is a trading activity, which reverses the moment they perceive that the upward trend is broken. And what about that mountain of money (including a lot of mine!) in ETF's like GLD? I'd bet that most of that money is in pretty weak hands (like mine!).

So if you post for us again, I'd like to see some more effort to understand how much gold is being bought for speculation, compared to normal trading volumes, real consumption, changes in bank reserves, etc.

Thanks

GC

[RobertSczech]

Regarding gold and inflation: In 1913, one ounce of gold sold for less than $20. A few weeks ago, one ounce of gold sold for $1,000 - a price increase by a factor of 50. According to the federal inflation calculator (google it) at the Federal Reserve Bank in Minneapolis, goods and services worth $20 in 1913 would cost $418.79 in 2007. There is no better proof that gold is an excellent inflation hedge. Even if gold fell down to $400 per ounce (very unlikely), it would still cost as much (in inflation adjusted Dollars) as it did cost in 1913.

One further reason to hold gold: It is the only widely recognized asset which can not be taxed away by either collapse of the currency, inflation or direct taxation. Possession of gold was historically synonymous with the ability to escape government terror.

Finally, to say that gold is worthless because it is useless is nonsense. In truth, gold is valuable because it can not be used. Everything which can be used, will be used, and, as the result of that usage, it will wear out and deplete, that is, it becomes worthless because of that usage. Gold is precisely valuable because it can not be used up. It is this almost religious property of gold which explains its popularity in jewelry making.

Finally, it requires a supernova in order to create gold. In other words, all gold on earth comes from outside the solar system as our sun is too young and too small in order to be a supernova.

[Aborrower]

thauthor wrote: "Above ground stocks of gold held for investment in the aggregate now rival that of central banks -- 25,800 tonnes held by private investors and 28,500 tonnes held by the official sector."

With miners producing ~2,500 tonnes per year that means there is a 20-year supply of Gold overhanging the market. At what price point will private investors begin to make their 10-year supply of Gold available? Ditto, the official sector?

[Novajack]

Why do so many come up these complex analyses of the spiraling price of gold?--All that we need to know goes back to a simple economic principal "THE RULE OF SUPPLY AND DEMAND".

[RobertSczech]

"THE RULE OF SUPPLY AND DEMAND" does not explain anything since another basic principle of economics says SUPPLY = DEMAND. Things which are not produced will not be demanded and things which are not demanded will not be produced (for long).