Gold supply: A volatile situation

What to watch for in gold fundamentals

For the casual observer this downtrend just didn’t make any sense, especially considering that during this time the average price of gold had more than doubled. Why wouldn’t the miners want to ramp up production in order to take advantage of these higher gold prices? Well the simple answer is, they couldn’t.

Since gold is a finite natural resource, it cannot be manufactured. And with the process of producing it involving painstaking extraction from rocks, naturally it doesn’t grow back. Gold miners can’t just turn a spigot or dial to increase the production flow whenever they want. They are bound by the physical constraints of the geology and engineering of their operations.

When economical reserves are depleted, the miners must then move on to a new deposit in order to replace production. And since there is only so much gold on the planet, the next generation of deposits are usually harder to find and tend to be more geologically complex. And to complicate matters even further, the process of replacing reserves and production is not linear and sequential.

In order to maintain production levels and secure future pipeline, the miners must be exploring and developing in parallel with existing operations. For a decent-sized mine it typically takes about 10 years to get from discovery to commercial production. So if a miner only has 5 years of mining life remaining and has yet to discover its next deposit, it is already well behind the curve.

What we are seeing in the first part of the chart on the previous page is the lagging effect of an industry that fell way behind the curve in production and reserve replacement. And the culprit responsible for this production decline was the brutal secular bear that preceded our current bull.

With the price of gold spiraling downward in the late 1980s and 1990s, most gold miners struggled just to survive. During this time many miners saw their margins vanish. This of course severely depressed cash flow, and thus didn’t allow for much non-operational spending. And to make matters worse, investors didn’t want anything to do with the gold companies, which made raising capital nearly impossible.

So with the existing miners not spending nearly what they needed to on exploration and development, along with hardly any new entries into the space, the global gold-mining infrastructure greatly suffered. The big production decline to 2008 was an aftereffect of many years of neglect. Mines were depleting at a faster pace than their replacements were coming online. Needless to say, this sharp production decline was quite alarming during a time in which gold demand was skyrocketing.

Thankfully beginning in 2009 we finally started to see the effects of this bull’s exploration and development cycle. Global gold production had jumped to exceed 2400mt for the first time in three years. And it has been on the rise ever since.

It is important to realize that 2009’s growth is the product of efforts that were kicked off eight years prior. Newfound capital from rising gold prices and investor interest kicked off a major increase in exploration spending beginning in 2001. This spending led to new discoveries. And it took many years of developing these discoveries to finally generate enough production to outpace depletion.

Several years and tens of billions of dollars in capex later, the once dilapidated gold-mining industry finally started to get its color back. And the miners have been doing their best to make up for lost time. 2009’s production increase was followed by a 2500mt+ year, the first since 2003. And in 2011 the miners achieved record-high gold production of 2700mt (87m ounces) according to the latest figures compiled by the US Geological Survey. In just three years global mine production is up an incredible 19.5%, which translates to 14.1m more ounces extracted from the earth in 2011 than in 2008.

Next page: Mining's future

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