The nearly decade-long ascent in the price of gold has been accompanied by an unprecedented display of passions regarding this unique yellow metal. All conceivable aspects of gold’s trading patterns, as well as its current and future functions in the economic and monetary system of the world, have been scrutinized and hotly contested. The global financial crises in recent years have furthered the extremism manifested in such discussions.
Sadly, much of what has been debated has only served to confuse the investing public and divert its attention from the metal’s underlying fundamentals. The mantra of the recent period has been uniquely a price and performance-oriented one. As a result, we find ourselves in an arena where bold assertions of $5,000 and $10,000 gold being “just around the corner” are routinely made. There is perhaps one number that might actually be worth pondering, and that is that all of the world’s above-ground gold stockpile amounts to only 0.6% of global wealth, which is not exactly a cure-all for what ails the planet’s economies today — not by a long shot.
Many neophyte gold buyers embrace the view that the liquidity injections the financial system has witnessed since late 2007 will inevitably engender ultra-high inflation levels down the road. However, the answer to how much or how little inflation we actually will experience will be revealed in the approach that global central bankers employ as various economies recover. Their exit strategies will be the key to effectively countervailing potential inflationary pressures by the drainage of this excess of liquidity from the world’s economies.
In fact, many of the abstract questions being posed at the moment are focused on whether the world might fall into further deflation or a possible depression, or whether it veers off in the opposite direction and has to contend with a hyper-inflationary spiral. Few imagine that central bankers might be able to steer a middle course and successfully avoid either extreme outcome. Similar theoretical questions revolve around gold at this point, as well. Is this just the beginning of a sustained mega-rally in this market or the last gasp of a very old and tired gold bull market?
A closer look at the current state of the gold market’s fundamentals might be helpful in getting one back on the proverbial track and cutting through all the noise being made by alarmist hard money newsletters and book-talking, newly minted market gurus. This market, at this time, exhibits some serious flaws and imbalances that ought not to be ignored by would-be buyers all too eager to over allocate in the asset at the urging of their favorite newsletter writers.
According to the latest statistics published by the World Gold Council, mine supplies of gold experienced a 7% year-on-year gain in 2009, rising to 2,572 tons (see “Demanding cash for gold”). In 2008, we thought that the more than $40 billion in exploration expenditures that the mining community undertook since 2002 in the wake of rising gold prices would result in such an outcome. Last year’s mine supply additions came at a time when analysts within and outside the industry were seeing “peak gold” conditions. As it turned out, these could be some distant peaks they were seeing.
Cash for gold
Gold scrap supplies showed a hefty 27% rise last year, one that was clearly engendered by record-high gold prices. Consider that 1,674 tons of recycled gold flowed into the market during 2009, an all-time high and a 68% jump above 2007’s inflows. Turkey and India led the parade of secondary supplies of gold, but new records for scrap intake also were noted in Europe and North America as high gold prices and the need for cash drew old bullion hoards out of people’s hands.
Also noteworthy is that producer de-hedging, a major contributor to the rise in gold prices over recent years, has slowed immensely, falling by 90% in the first half of 2009, to the point where it only represented 31 tonnes over the course of the first half of the year. Currently only 236 tonnes of gold are left in the global hedge book.
World gold jewelry fabrication fell by a remarkable 19.8% in 2009, to a 21-year low of 1,759 tons. Jewelry fabrication normally comprises nearly 70% of the market. The culprits for the sharp decline were once again the very high price of gold and the economic crisis spilling over into the luxury buyer segment (see “Too valuable to wear”). Industrial fabrication demand for gold fell by 26% in the first half of 2009 as weak global economic conditions drove electronics demand down accordingly. U.S. and Japanese electronics-oriented gold demand fell by 39% and 32%, respectively.
The first half of 2009 also marked a significant episode in the history of Indian gold bar hoarding, as it fell by 75% and turned to dishoarding for the first time since 1980. The main driver of this phenomenon has been the perception of limited upside potential in the price of gold bullion. The gold industry could traditionally count on India to absorb anywhere from 600 to 900 tons of the yellow metal annually. Bar and coin retail investment also experienced a hefty global decline of 32% in 2009 relative to 2008.
To sum up, total gold supply for 2009 was up by 11% at 3,890 tonnes, while total demand was down by 11% at 3,386 tonnes. This leaves us with a 504 ton surplus, which can be inferred as having been absorbed by the category of “investment.” Most of the off take from investment can be attributed to ETF demand — a niche that, for example, consumed 465 tonnes in the first quarter of 2009 during what appeared to be the most intense phase of the global financial crisis.
The bright spot in the 2009 total supply/demand equation was that global net central bank sales amounted to only 44 tonnes in 2009 (compared with 236 tonnes in 2008) and were the lowest sales level in 12 years. In fact, a handful of central banks actually bought gold last year. The most heavily publicized such purchase was the one made by the Reserve Bank of India (RBI).
However, the buying of the IMF’s gold by the RBI simply reflects the fact that India’s gold reserves, at 4% of total reserves, had fallen in comparison to the past (gold had made up 8.2% of total reserves at the beginning of 2000 and nearly 20% of them back in 1985) due to the rapid accumulation of dollar reserves and compared with other countries in the top-20 global economic powers list.
The picture we describe above leaves us with a gold market that has become highly addicted to and dependent almost entirely upon continued inflows into gold-oriented ETFs and various speculative hedge funds. Yet, the very same and much-vaunted gold-backed ETFs could come to play a critical role in determining the gold price in coming years, especially if holders of these vehicles sell, unleashing a large amount of physical metal onto a market in which demand is relatively weak.
One of the most prominent and blunt warnings came from Paul Walker, CEO of precious metal consultancy GFMS, back in April 2009 when he noted that investment in gold “may dry up over the next five years following a long period of strong interest from global investors.”
Recently, a new warning came from David Davis, a precious metals analyst at Credit Suisse Standard Securities, pointing directly at the potential for increased divestment from gold ETFs. “We believe that a major problem is looming on the horizon should investment demand remain muted and/or should investment demand start falling away over the next three to five months,” Davis noted.
The gold market we currently are witnessing is one that does not satisfy a single one of the traditional criteria that would define a classic bull market. Yet, the metal is labeled as being in a historic one. Specifically, the current gold market is not enjoying the foundation of a demand position that far outstrips supply, it is not offering shelter from a fast-declining stock market, it is not reacting to significant and manifest inflation, and the price of gold is increasing relative to only specific currencies, not every one of them. Yet, there are hundreds of articles being written about why the gold rally will continue without pause.
According to last fall’s CFTC data, released just prior to gold achieving its $1,220 peak, there were roughly nine long gold positions for each short one. A mountain-sized pile of futures and options contracts, some 800 tons large, was present in the market by late November.
Still, subtle yet telling signs are emerging that the end-game in gold’s epic rise from $252 to $1,226 may be in sight, and that average annual prices might return to more balanced levels, ones that do take the fundamentals into account. For example, the world’s largest marketer of pure gold coins, the Austrian Mint, in October announced plans to slash its coin output by 32% this year.
The Mint took that decision while forecasting that “the end of the global financial crisis will diminish investor demand for gold.” The Mint’s decision appears prescient, in retrospect. It recently confirmed that coin sales have fallen 80% this year as gold buyers began to regain confidence in the global economy.
Vienna-based Marketing Director Kerry Tattersall recently said, “We’re getting back to business as usual rather than the hectic, panic demand we’ve seen over the last couple of years. There’s no more upward surge in gold price to titillate buyers, and a lot of people feel more relaxed about the economic crisis.”
With all that in mind, while the year-to-date average price of gold has been just north of the $1,100 level, we do not see that as sustainable in the long term. We expect gold to average around $990 in 2010. Then, we see that average declining to $900 for 2011, and to $850 in 2012, which we see as the price current fundamentals would support as there is about a 30% risk premium in the price of gold. None of these projections imply that gold will not continue, or should not continue, to have an important role in investment portfolios.
To the contrary, maintaining a core 6% to 10% insurance position in the precious metal would be wise. This holding should be considered as “life-insurance,” not a trading position. Gold may or may not be an effective hedge against inflation, deflation, currencies, or equities, but the one thing that certainly can be said with confidence is that it serves as an excellent hedge against uncertainty. Supplies of that in our world are certainly not lacking.
Silver lining
The silver market offers a similar picture to gold as it too is a market in surplus, heavily dependent on investment off take, while also experiencing a primary fabrication demand decline. At this time, non-traditional forms of silver demand are set to surpass its historic dependence on photography. Fortis Bank Nederland estimates last year’s total silver supply to show a final tally of 35.5 thousand tonnes versus an aggregate demand of 29 thousand tonnes.
This leaves the silver market with a residual 6.5 thousand tonnes to be presumably siphoned off by inferred investment. Silver-oriented ETF demand amounted to 3.1 thousand tons in 2009, while coin demand totaled 1.9 thousand tons. Meanwhile, mine supply of silver is estimated to have risen to nearly 22 thousand tons last year. The problem areas, as with gold, are found in silver’s off take from primary demand sectors such as photography, electrical and electronics, as well as catalysts and brazing alloys.
That said, we expect silver to once again outperform gold in 2010 as it will show a wider trading range, more volatility and therefore more speculative opportunities. While the $15.50 to $17.50 range is the more likely one through the middle of 2010, we cannot rule out a range as wide as $13.50 to $19.50 for silver. Kitco computed last year’s average silver price at $14.67 per ounce, with lows near $10.51 in January and a high at $19.18 in December.
Precious demand
Heavy demand from newly created platinum and palladium ETF vehicles helped push the noble metals’ prices to new heights recently, reaching pinnacles not seen since the 2008 bull run. While total supply and total demand appear fairly balanced for both metals, showing a surplus of 300,00 ounces for platinum and about 150,000 ounces for palladium, strong ETF-related inflows are expected to do what automakers (at least those in the West) have been unable to do as the global economies slowly recover.
Car sales in China and India continue to surge at rates that make other regions look all the more anemic. Production problems in South Africa are also expected to underpin precious metal prices as power supplied to the region’s mines continues to be unreliable. Sporadic black-outs are expected through 2013 as only a few producers attempt to build their own, on-site power generating plants.
We expect platinum prices to trade broadly within the $1,300 to $1,700 range, while palladium might oscillate within the broad $375 to $525 price channel. Volatility will not be absent from this niche either, as the ebb and flow of ETF balances and automaker activity will provide plenty of speculative fuel to the market. We expect positive price performance from rhodium as well, as it makes its way back towards the mid $4,000s.
Jon Nadler is a senior analyst for Kitco Metals Inc. You can see his analysis at
www.kitco.com and www.kitco.cn . E-mail him at jnadler@kitco.com
