An Interview With Philip Klapwijk

Includes: DGL, GLD, IAU
by: Hard Assets Investor

Philip Klapwijk is the chairman of GMFS and editor of The Outlook For Gold Investment. At GMFS, he helps oversee production of the annual Gold Market report, which helps set the tone for the gold market for the year to come. He is widely regarded as one of the foremost authorities on precious metals in the world.

He spoke recently with the editors of about where the gold, silver and platinum markets are heading next. [HAI]: Gold recently touched $1,000/ounce. What is forcing the price higher?

Philip Klapwijk (Klapwijk): Investor demand, which is coming both directly through investors buying physical gold and through "paper gold" instruments, ETFs and futures. In addition, there is indirect buying through the inflow of funds into the broader commodities market. Very often, when investors get broad commodities exposure, gold is being purchased as well.

HAI: Do you expect that trend to continue or have we reached the top?

Klapwijk: I do expect the trend to continue for at least the balance of this year and probably into 2009. We believe the drivers behind the continued interest in gold and commodities continue to apply.

HAI: What are those drivers?

Klapwijk: Interest is driven by the uncertain financial environment that has stemmed from the subprime crisis and now includes the broader credit markets crisis. With interest rates being lowered aggressively, you're seeing an impact on the dollar and on inflation expectations. This concerns investors and is promoting a fairly sustained move into gold.

HAI: And you expect this to continue?

Klapwijk: If we look at the next year or so, we would expect to see continued instability in the financial markets. We don't believe the problems we are seeing on a daily basis will go away in a hurry. These are deep-seated problems that stem from overborrowing in the U.S. in recent years. This will probably not be resolved by the measures being discussed by the authorities today.

We expect ongoing problems in the financial markets to spook investors. With U.S. interest rates continuing to be cut and maintained at low or negative real levels, and with the European monetary policy taking a different tack, we expect to see further declines in the U.S. dollar against the euro, against the currencies of commodity-producing countries and also against the Chinese yuan.

If you look at that backdrop, the case for gold investment will remain pretty positive into 2009.

HAI: The price of gold is already up strongly. How does that factor into the equation?

Klapwijk: [Actually], that creates a vicious circle for gold. The fact that the price is going up is attracting more investor interest, which is driving the price higher, which brings in more investor interest...

HAI: But isn't the rally getting a little long in the tooth?

Klapwijk: We do recognize that some of these factors will start to operate more weakly or go into reverse as time marches on. If you look for instance into commodities flows, there could be some fairly significant short-term setbacks if we see a major correction to base metals and the energy complex as the global economy slows down. That could provide a headwind for gold.

Also, at some point, the probable weakness in U.S. dollar and in U.S. equity prices will be reversed. At some point, U.S. stocks and the U.S. dollar will start to look like good value, and gold will look very expensive.

HAI: But we're not there yet?

Klapwijk: I think we're some ways from that, actually. But I do think ... we're in the final stages of this bull market. If you look at the bull market for gold as starting in 2001, when gold came up from around $300/ounce, we think we're getting into the final stages of that bull market. The difficult thing to judge is how much new money will come into gold over the next nine months or the next year while things are still positive. That makes it difficult to forecast what price level we could reach [before any pullback].

We are inclined to believe that gold will puncture $1,000/ounce and might get to $1,200/ounce. We think that if it gets above $1,000 solidly, it will probably move quite a bit higher, and there will be investor power to take it there. But those levels are not sustainable. Once gold gets to those levels, it will be being driven by investor demand and not by fundamentals. So once gold falters, we will see it come back significantly.

HAI: We've seen a lot of "fast money" move into the gold market. How has the gold market changed in recent years?

Klapwijk: Gold volatility has gone up from around 14-17% to 25-26%. Gold is almost trading with the type of volatility more typically associated with a metal like silver. I don't know if that's worrying; for some investors it makes it more attractive. There is scope for some fairly large moves in the price of gold, with some significant down moves with subsequent recoveries, and very large intraday trading ranges.

HAI: Have we seen any producer hedging come back into the market to take advantage of high prices?

Klapwijk: No. We've seen none. In fact, we're continuing to see dehedging. But the producer hedge book has fallen below 1,000 metric tons, so the scope of further dehedging is limited.

We do expect dehedging to continue to support prices in 2008, but it will be of declining importance. We expect that to continue in 2009. At some point, however, I do expect hedging to come back ... not voluntarily, but as a condition forced upon producers that have marginal operations.

HAI: But we're not seeing producers looking to lock in the current high prices?

Klapwijk: No, and we do not expect to see opportunistic hedging like that. I just don't believe that will happen. That would require such a massive change in psychology, and the shareholders would not buy it.

HAI: What about platinum prices? Those have been soaring recently. Is the new platinum ETF playing a role in that?

Klapwijk: When the idea of a platinum ETF was first proposed, it was interesting to see the very vociferous response from the producers, who really didn't want to see the ETF launched. You can see where they're coming from. There is very little above-ground stocks of platinum. By definition, a successful ETF will lead to significant market disruptions. To some extent, this has already happened at the margins, in that the ETF has exacerbated an already tight market situation.

But having said that, the main reason platinum is where it is today is the production situation in South Africa. Instead of production growing, it's declining. And there is the distinct possibility of further declines in 2008. That's what's been behind the march up in prices. On top of that, you have funds and investors jumping in and getting on the bandwagon and pushing prices higher. Expected surpluses have been replaced by unexpected deficits.

There are fundamental reasons behind the strength in platinum. Even ignoring investors, the market is tight. For gold, the $700/ounce rise in price has been investor-driven. In platinum, it's driven by the fact that there really is very little of the stuff around, and the demand for platinum is incredibly sticky, particularly now that jewelry demand has been reduced by higher prices. Auto catalysts and industrial demand for the metal remain solid, and that demand is not very price-sensitive at all.

HAI: What about silver?

Klapwijk: Silver traditionally is more volatile than gold, and it has traditionally had a very strong correlation with gold. If you look at the most recent leg in the precious metals rally, silver was lagging gold for a while, but it then sprang to life with a vengeance. We've seen quite amazing volatility in silver.

Like gold, silver is very much an investor story. Silver is a narrower market than gold, and if sufficient money comes into that market, prices can be driven up substantially over a short period of time.

The other thing that has helped silver is the strength in copper metal prices. We've noticed recently a much stronger relationship between silver and copper than used to be the case. With copper at record levels, that's provided some lift for silver.

HAI: Why would those two metals be linked?

Klapwijk: I think the relationship exists because silver has become an industrial metal. Over 50% of silver is now used for industrial purposes. The good thing for bulls is that that demand is relatively price-insensitive in the short run. But it does mean that silver could be vulnerable to any significant turndown in industrial demand.

HAI: With that in mind, where should investors be placing their money? If there's a major recession coming in the U.S., which of the three metals is best positioned?

Klapwijk: If there's a major recession, I would probably say platinum is best-positioned, but it really depends to the degree that global car demand is affected by a global economic slowdown. Much of the growth in car registration has come from emerging markets. If we get the decoupling scenarios that commodity market optimists would like or expect [with emerging market economics continuing to do well even as the U.S. economy suffers], you could argue that platinum would fare the best, particularly given the supply situation with South Africa. But we have had some froth in the price of platinum, so it's no sure thing.

Gold should do better than silver, because gold is a more pure financial play than silver. Silver already has a purely speculative component. And silver is more vulnerable to a setback in the industrial metals complex than gold. It also has fundamentals that could deteriorate more rapidly, as we're expecting significant growth in silver mine production in the next year or so.

HAI: Thank you, Philip.

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