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Investing In Gold: Demand For Gold Declines, Will Prices Follow?

Demand for gold has been declining worldwide, but prices haven't. What does this mean for someone investing in gold?

Gold demand declined 11 percent in the third quarter of 2012 compared to the third quarter of 2011, according to the World Gold Council ( Demand fell in every sector except for purchases by central banks.

But, surprisingly, the price of gold increased 9.6 percent from the end of September 2011 to the end of September 2012.

Quarter to quarter statistics confirm the trends.

Gold is unlike other commodities in many respects. For investors, one of the significant differences is that the supply of gold (called "above-ground gold") never decreases; it only increases. So declining demand should cause a decline in the price of gold, not an increase.

The gold supply never decreases for several reasons. First, gold is not used in the usual sense; it is not consumed. When gold bars are turned into jewelry or jewelry into gold bars, the supply of gold does not change. Nor does the gold supply change when one investor or central bank buys from another.

Compare that to oil. When a car burns a gallon of gas, the gas goes up in smoke. New oil must be pumped to be refined into more gas. If oil production declines, world supply declines.

Second, gold does not deteriorate over time. It doesn't go stale, soften, rust or lose potency as it ages. Special storage - freezers, airtight containers - is not needed. Thousand-year-old gold is just as valuable as new gold of the same purity.

The result? Mining is not needed to maintain the worldwide supply of above-ground gold. Mining only serves to increase that supply.

The individual sources of demand are another concern. Jewelry demand has been declining since at least 1997. Jewelry demand in 2011 was 40 percent lower than 1997 and demand in the first three quarters of 2012 was 9 percent lower than the same period in 2011.

Industrial and dental demand declined in 2011 and is on track to decline another 6 percent this year.

Investment demand (bars, coins, Exchange Traded Funds, etc.) declined 3% in the first three quarters of 2012 compared to 2011.

The bright spot for gold demand was official sector (central bank) purchases. Central bank activity went from net sales to net purchase in 2010, and net purchases continued to be positive in 2011 and the first three quarters of 2012.

Is this a bubble? It's possible. Investors purchase gold on the assumption that some future investor will buy at an even higher price. That's sometimes called the "greater fool theory," and it is a shaky assumption when demand is declining and supply and prices are increasing.

Gold investors need to be concerned.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.