Gold has recently dipped to $1268.40 per ounce, according to the latest spot bid from Kitco. This is an excellent bargain for long term investors to buy back gold holdings they sold last year, as it is very close to the cost to mine it (average AISC is estimated to be $1200 per ounce). At this price, miners in the past (Q4'13) have hedged rather than sell all they could produce.
Sensible investors should put a portion of their portfolios in gold, and possibly other precious metals such as silver, platinum and palladium. Gold in particular, has proven to be a good hedge against other asset classes. It has low correlation with most other assets, and at times proves to be very profitable, such as during the decade 2001-2011 when it handily outperformed both stocks and bonds despite not producing income.
Investors who desire income should consider mining royalty companies such as (NYSE:FNV), (NASDAQ:RGLD) and (SLW). But gold royalty companies and gold miners are not a suitable substitute for owning gold bullion. They are much more volatile and their value fluctuates greatly depending on their profitability. Only bullion is intrinsically valuable without reference to any profit and loss statement. Only bullion is not subject to counterparty risk.
The most immediate reason to own gold is that the seasonal demand for physical gold should be showing up between now and the end of the year. And this year will be compared to last year when the usual seasonal demand did not materialize due to lower prices in the first half pulling the demand forward by half a year. Thus, while the first half of 2014 has looked anemic, the second half should be quite robust. When we compare 2014 demand to 2012 or to an average of several years, we see that demand is still in line with historical levels.
Longer term, investors can be sure that gold still has monetary value because central banks are buying. They are buying at the rate of over 100 tonnes per quarter. Russian buying is particularly conspicuous. The People's Bank of China, on the other hand, prefers to do its buying in secret. No one really knows how much they are buying each quarter, nor do we know how much they've accumulated.
The World Gold Council points out that the rise of a middle class with surplus wealth in China and India is bullish for future gold demand. These nations have an affinity for gold extending back thousands of years. These retail gold consumers will be wanting increasing amounts of gold jewelry and also gold coins and bars in the future. It should also be noted that demand is becoming harder to trace in these two largest gold markets, China and India. Official figures are understating demand because of smuggling in the case of India, and unreported imports in the case of China. WGC figures are therefore known to be understating demand in these most important nations.
On the supply side, there are three sources of gold: miners, recyclers, and occasionally bullion holders. Currently recyclers are finding it hard to persuade people to part with their scrap gold at these prices, so their output is down considerably.
Miners sold a record tonnage of gold in the last quarter, but production was down, and they made up for it with 50 tonnes from their hedging stock. They are mining their best ores because lesser ores are unprofitable at these prices. They will run out of both hedging stock and rich ores in the not-too-distant future.
Gold miners have had to cut back on expenses due to the lower gold prices. A lot of their cost cutting efforts are only succeeding in stealing profits from the future. They have closed down less profitable mines and shifted production to richer ores. They have cut back on exploration and capex. But they have tried to maintain their revenue, so production has been cut as little as possible. This means they are mining their richest ores at a fast rate and will soon run out. Then they will be forced to cut back on production and wait for the price to rise until they can open up those less profitable mines. This in and of itself means that a shortage is coming and a spike in the price of gold will come.
But there's more. Each time the miners have to open up mines with poorer ores, that increases their costs. It takes them more manpower and more capex to move more rock to get at fewer ounces of gold. This again means that the price of gold is on a long-term exponential curve. Some will argue that miner's costs don't make a difference, that retail gold prices depend only on demand. Hogwash! Gold miners produce about 3/4 of all gold that is traded. Most above-ground gold is fabricated as jewelry or other uses, or hoarded as bars and coins. Both fabrication and hoarding take metal out of circulation for long periods of time (years, decades, or centuries).
Bullion holders already sold off a large portion of their holdings. The ETFs sold off in 2013, and the central banks were selling off in the 1990s. Central banks have recognized that their selling was not wise, and have been buying gold back starting about 10 years ago. Contrary to popular belief, bullion holders normally do not contribute to gold supply, but rather demand. ETF holders sold against their best interests. Had they held on, demand would have exceeded supply by several hundred tonnes in 2013, and the price would have been forced to rise. Most investors have not recognized that their selling was unwise and have not bought back their holdings.
The dollar has been strong lately, but that's mostly due to structural European weaknesses that are pulling the euro lower. Europe will eventually get its act together, because if it doesn't the euro will fall apart. In my estimation, it is much closer to dissolution than last year when people were talking about the possibility of Greece leaving the euro. The latest elections across Europe showed that the populace is at the end of their patience and nobody is feeling like the current system is benefiting them, even the Germans.
The invasion of Ukraine only serves to further reveal the impotence of the European Union. The eastern European nations are not reassured by the deterrent value of a few economic sanctions that hurt Europe at least as much as Russia.
When Europe finally does pull itself together, it will become more clear that the dollar is in a death spiral as well. We have borrowed from the world, created a record debt far beyond any other nation and cannot pay it back. The official number is $20T, but that doesn't begin to cover all the obligations of the US taxpayer. The only ways out are inflation or outright default.
Technically, the US already defaulted when it refused to let Germany repatriate its gold held by the Fed in New York. The Germans subsequently downplayed the event, but the Fed's actions spoke louder than words to those with the ears to hear.
Of course, the federal debt of over $20T effectively prevents the Fed from raising interest rates. They say they will, and perhaps they will manage a token .25% hike next year, but they have to keep rates below normal for the foreseeable future or precipitate a federal budget crisis. This in and of itself implies a weak dollar and stronger gold prices.
Long term, there can be only one conclusion, gold must go higher. A lot higher. The $1900 an ounce we saw in 2011 was only the start. So what should investors buy?
SPDR Gold Trust ETF (NYSEARCA:GLD) is the most popular gold investment vehicle, and usually has the smallest spread. But it has high fees and an overly complex structure. Some people don't trust GLD. Its gold is held in a bullion bank that is part of the banking system. Against such distrust I would point out that the large GLD holders include Paulson & Co, Bank of America, and Morgan Stanley along with a host of other illustrious names in the financial world. These are companies that should be the first to know if GLD was unreliable.
iShares Gold Trust ETF (NYSEARCA:IAU) has the lowest fees of any gold bullion ETF that I'm aware of. It should do marginally better than GLD for long term holders, but be careful of the spread. It also suffers from the same trust issues as GLD since it, too, holds its gold in a bullion bank.
Merk Gold Trust ETF (NYSEARCA:OUNZ) has the special feature that it allows individual investors to redeem their shares for gold, for a fee. Some investors may feel that this gives them added assurance that the gold is really there, and if they really need coins or bars for trading purposes, they are readily available.
Some people prefer to be assured that their gold is held in facilities outside the US, such as Switzerland [ETFS Physical Swiss Gold Trust ETF (NYSE:SGOL)] or Singapore [ETFS Physical Asian Gold Shares Trust ETF (NYSEARCA:AGOL)]. The United States under Franklin Roosevelt confiscated gold from US citizens, and they want to circumvent any repetition of that event.
I do not recommend closed end funds [CEFs] for owning gold. CEFs typically sell at a discount to NAV, sometimes very significant discounts. This means that unlike ETFs, you may be unable to get full value for your CEF shares for long periods of time. Only when gold is in a raging bull market will you be able to command a premium for your CEF shares. I would purchase a CEF only for income producing assets like bonds that never have to be sold.
I myself own gold in a Kitco gold pool. This is similar to an ETF in that you own shares of a store of gold, but it is not a part of the banking system, and therefore it may survive better in a financial emergency. Kitco also sells coins and bars of gold and other precious metals. This is an excellent source for those investors who do not have a local coin dealer they can trust.
Speculators may wish to own an ETF of major gold miners [Market Vectors Gold Miners ETF (NYSEARCA:GDX)] or junior miners [Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ)]. Even more aggressive are the 3x leveraged versions, Direxion Daily Gold Miners Bull 3x Shares ETF (NYSEARCA:NUGT) and Direxion Daily Junior Gold Miners Index Bull 3X Shares ETF (NYSEARCA:JNUG). I do not recommend these for long term investments, but they can at times be quite profitable. The major miners have been bid up since their lows of last year, so Yahoo finance lists the PE of GDX as 31, while GDXJ is still only 13. But both still have more upside potential than downside.
Disclosure: The author is long JNUG.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.