ETF Sales Sending Gold From West To East, Mine Production Will Limit Downside

By Sumit Roy

Marcus Grubb is the managing director of investment for the World Gold Council, where he leads both investment research and product innovation as well as marketing efforts surrounding gold's role as an asset class. Grubb has more than 20 years' experience in global banking, including expertise in stocks, swaps, and derivatives. After the release of the World Gold Council's quarterly Gold Demand Trends survey, Hard Assets Investor's Managing Editor Sumit Roy spoke with Grubb to get more details on the particulars of some of the report's more surprising conclusions.

Hard Assets Investor: How would you characterize gold demand in the first quarter?

Marcus Grubb: The first quarter saw a fall in demand by 13% to 963 metric tons. That's compared to Q1 2012, which is the ideal comparison because of the seasonality in the market. The real weakness was in ETFs, but if you look outside investment in the ETFs, pretty much everything else was either relatively flat or very strong. The first area of strength was jewelry; we had a rise of 12% in global jewelry demand. India was up 15% and China was up 19%. The other standout was the turn in U.S. jewelry demand. We had the first positive quarter for U.S. jewelry since September 2005. That's a reflection of the improvement in the U.S. economy that we have seen of late. Though it's a relatively below-par recovery, it's clearly visible in the jewelry stats.

On the other side, we did see weakness in investment demand. Investment demand was down 49%, and that was all due to the ETFs. We had outflows from global gold ETFs of 177 metric tons, which is the biggest on record for Q1. Three-quarters of the outflow in ETFs came from U.S.-listed ETF products. Elsewhere, bar and coin demand was actually up 10%, with strong bar and coin demand in India and China.

And the other thing that's interesting is OTC (over the counter) investment -- the last category in investment demand -- was strong in contrast to ETFs; we saw 119 tons of OTC investment. That's sort of the balancing item in the GFMS statistics, but it's largely representative of bullion accounts. I suspect in the quarter it was investors outside the U.S. who were buying gold, because clearly U.S. investors were selling gold in the form of ETFs. If you look at technology, it was relatively flat on the trend we've seen in recent years. It was down about 4%, but still coming in at more than 100 tons a quarter from dental to electronics, fending off the challenges from palladium, copper, and other substitutes.

Finally, central bank demand wasn't too bad either. It was down on Q1 2012, but central banks tend to buy in quite a chunky fashion. I'm sure we've had more buying in Q2 because of the price dip in April. In Q1, we had demand of 109 metric tons, which is a small fall of 5% from the first quarter of last year. But we saw some new names coming in as buyers: Russia and South Korea, Ukraine, Kazakhstan and Azerbaijan were buying gold in Q1.

Overall, we would say central banks are still pretty strong buyers when you consider that of the past 20 years, in 15 of those, they were selling 400 to 500 tons a year. At this rate -- 109 tons in a quarter -- we're on for another 400 to 500 ton-plus year for the central banks in terms of net buying, which will again put this year up near the record year since 1962. On the supply side, mine production came in plus 3.8% in Q1. However, recycling fell 4% due to lower prices, so total supply was flat.

HAI: Great overview. Narrowing it down, how did India's demand perform? Did we see a rebound following the massive plunge last year?

Grubb: If you look at India, demand was up 27% in this quarter, and you had a total figure of 256.5 tons, which is a pretty good number. It's from a low base because of the effect of increased duties on the market in the first part of last year. But if India carries on at that rate, you're going to have a 1,000-ton market by the end of the year, which is where India was in the record year we had a few years ago.

But the striking thing is that although the percentage increase is smaller, China had a very good quarter too. Chinese demand was up about 19%, to 306 tons. For Q1, China was the largest market in the world. Now, India still is the largest market in the annual statistics; China has never eclipsed India yet on that measure. But this is another quarter where China did come in bigger than India.

HAI: So it looks like China is on pace for a record as well, if it keeps it up?

Grubb: If it kept up at that pace, yes, definitely -- you'd have a record in China. We have to be a little careful with that because there's seasonality in these quarters. Especially in China -- that was the quarter of the Chinese New Year, which is always a strong period. But the interesting thing to me is if you look at what's happening now following the price fall in April, we already know that Q2 is going to be a stronger quarter than usual for gold because of the huge increase in physical demand that's happened around the world. It's much stronger than it normally would be in the second quarter.

We've seen huge premiums in India and China in April and May that are still up at something like $20 an ounce in China and probably $15 or $16 an ounce in India. And you're seeing reports by all the jewelers and some of the mints of record demand for products. We're going to see that Q2 is also going to be a pretty strong quarter.

HAI: What's going on with the gold ETFs? It seems like selling by those funds is endless. What's causing this, and how much more does it have to go?

Grubb: We saw 177 tons sold in Q1. Three-quarters of that were U.S.-listed ETFs. I think that it's related to the more bearish positioning in the futures market, which is keeping a lid on the gold price in the face of this strong physical demand. You've had a large increase in shorts on Comex; the net long is the lowest it's been since the start of the bull market. That's a speculative expression of views on the price by speculators and hedge funds.

But also, some investors in the United States have become more positive about the economy since January and that's led to the rally in equities, and also some funds reducing the weighting to safe-haven assets in their portfolio. They've reduced cash, they’ve reduced fixed income on the longer-term view that the bond rally is nearly over, even if there's a bit more deflation to come. And they've lightened up on gold. There are some asset managers who have reduced their gold weightings in the United States. They've taken it out of their models, for example. The ETF reductions are due mainly to U.S. investors becoming more bullish about the equity market.

It's worth remembering that still leaves you with something like 2,200 tons of physical gold in ETFs even after these redemptions, which is a lot of gold. The other thing to remember is the ETFs are quite small in terms of demand. They're about 1.5% of the stock of gold above ground totaling 174 thousand tons. And they're only about 6% to 7% of annual demand when they're not redeeming, typically. There is a possibility that ETFs have become a source of physical gold, and therefore the gold is going eastward. Because if investors are selling at a small premium in the West and getting out of their ETF positions, the gold can then be redeployed to meet this massive amount of consumer demand at a big premium in Asia. That's something that, while hard to prove, is potentially the case. ETFs are now a source of physical gold.

HAI: Switching gears a little bit, you mentioned mine production was up over 4% in the quarter. Could you put that into a larger perspective? Is that a big move, and has production grown a lot over the last several years?

Grubb: No, I wouldn't say it's a big move. We've seen small increases in mine production, but overall, if you look over a decade or more, mine production is only up between 6% [and] 8% in gold, which is about the bottom of the table in terms of metals production. So, while 4% in a quarter is quite a good number historically, there needs to be more persistent increase for it to affect the long-term trend, which has been for mine production to remain pretty flat. I don't really see a trend there. I see this just as a single quarter up 4%, but with recycling down 4%, total supply was flat.

HAI: The miners have often talked about how their costs are pretty close to the current prices, so that will limit downside. Do you have any insight on that?

Grubb: I would just agree with that. Especially looking at an all-in cost calculation, that's absolutely true. That will have an effect of limiting downside. You'll see mining companies respond to a more subdued price environment, and they'll tend to reduce capex. They'll tend to lengthen the mine life, they'll tend to reduce exploration spending, and try and reduce costs of mining. And that will have an effect on supply. The 4% growth in the first quarter is unusual when you think of the background to mine production from here.