Ever since the
beginning of gold’s bull market, this metal’s economic balance
has come under intense scrutiny. Demand has been on the rise as more and more
investors have embraced gold as a store of wealth. And the supply chain has
done its best to meet this growing demand.
considering gold’s sharply rising price over the last decade, it is
clear that this market has been experiencing a major structural imbalance.
And the supply side of the equation has proven to be a fascinatingly volatile
realm, making it quite difficult to set the scale.
this supply volatility is somewhat of a new phenomenon, as the major supply
sources of mine production, recycling, and central-bank sales had been
relatively consistent and reliable in feeding demand for many years. But for
a variety of reasons, this just isn’t the case anymore.
One big factor
that has radically altered supply’s cadence is an actual loss of one of its major sources. Just
in the last couple years gold supply from central-bank sales has completely
dried up. In fact, the CBs have since become substantial net buyers of the metal. According to metals-research consultancy
GFMS, in 2011 CBs loaded their coffers with 440 metric tons of gold (~10% of total annual supply).
It is no doubt entertaining watching the CBs implement radical
changes in their fiscal strategies. And while it is wise of them to buy gold
rather than foolishly sell it like they had been doing for so many years, this shift
has resulted in a big impact on the global supply chain. For nearly 20 years
leading to 2007 CB sales averaged between 400mt to 500mt per year, a consist and reliable supply source that was the
equivalent of up to 20% of global
gold supply. This source is now gone!
second-largest source of supply, recycling, has also seen its fair share of
volatility over the course of this bull. For many years recycling was
consistently good for about a quarter of global supply. But thanks to higher
gold prices coinciding with a brutal global recession, this supply source has
seen a huge boost over the last
recycling exceeded 1500mt (nearly 40%
of global supply) for the first time ever, and it has been above this level
for three years running. But though this surge has partly counteracted the
loss of CB supply, recycling volume has been trending down over the last couple
years. Interestingly this downward trend has many folks scratching their
heads considering gold’s record highs, but it does make sense
considering the timing of the big 2008 and 2009 recycling surges that brought
us to these levels.
Sadly much of
the recycling during these surges was desperation retail selling, the hawking
of gold jewelry in order to keep food on the table during hard economic
times. And since it doesn’t take very long for this type of recycling
to reach a point of exhaustion, as most people who needed to sell in this
fashion have done so by now, these 1500mt+ levels are likely short lived. In
2011 recycling was down by 2%, and I would expect it to keep trending down
towards normal levels in the years to come.
central-bank sales now extinct, recycling in a downtrend, and gold demand
still at record levels, gold’s final source of supply has a lot of
weight on its shoulders. And with mine production typically accounting for
about two-thirds of total global supply, thankfully it is used to bearing
such a burden. But as you can see in the chart below, even this primary
supply source comes with its fair share of volatility.
In the several
years preceding and in the early years of gold’s bull, mine production
was consistently generating annual output of at least 2500mt. But by the time
2004 rolled around, this supply source started taking a dive. And over a span
of five years global mine production had fallen by a staggering 12.7%. At
2008’s low point of 2260mt, the world’s mines were producing
10.6m ounces less than they were in
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
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.
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 this chart 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.
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.
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.
But while this
2011 tally is quite an accomplishment, the miners can hardly afford to sit on
their laurels as they look ahead to the future. Their challenge now is to not
only sustain production, but ideally to continue down this path of growth.
The miners still have some making up to do for their shortcomings in the
beginning part of this bull, and they’ll likely need to answer the call
of continually rising demand.
even with 2011’s all-time high, bull-to-date average annual gold
production comes in at only 2493mt. This happens to be the exact same average
of the final four years of gold’s bear, meaning that in aggregate
there’s been no production growth over a period of 15 years! This is
pretty sobering considering the rising gold demand over this time.
And speaking of
rising demand, the supply chain needs to be ready for what is expected to be
massive investment-demand growth in the coming years. Investment demand is
typically what drives the second and most important stage of a secular
gold bull. Even though measurable investment demand has already increased
over four-fold from 2001 to 2011 according to GFMS data, we haven’t
likely seen anything yet.
Not only will
central banks continue to diversify away from fiat currencies that are
inflating into oblivion, more and more investors will find their way to gold.
We’ve already seen demand for both in-possession
physical and asset-backed ETFs
greatly increase. But measured by dollars, this increase is miniscule in the
grand scheme of global investment capital.
Still today the
majority of institutional and retail investors don’t own gold in their
portfolios. And for those that do it is usually only a very small fraction of
their capital. Thankfully gold’s appeal as part of a diversified
portfolio is starting to gain traction. And it won’t take much
widespread interest in gold, even if it remains a small portion of a
portfolio, to trigger demand many multiples higher than where it is today.
scenario mined supply will continue to be heavily relied upon to meet demand.
Not only will the miners need to continue to pump out volume, they’ll
need to continue to put significant capex into
securing production and reserve renewal. Many more deposits will need to be
discovered, and many more mines will need to be built.
In order for
this to happen gold prices will need to remain high,
and investors will need to stay interested in the mining companies. Higher
gold prices will allow for higher margins for the producers, which ought to
give them higher cash flow and thus more capital for
exploration and development. And investor interest will supplement
producers’ cash-flow shortfalls as well as fund the work of
non-revenue-generating explorers that are in the trenches scouring the planet
for more gold.
While the gold
price will take care of itself, unfortunately things aren’t as simple
as they seem on the investor front. In theory it is natural to assume that
higher gold prices would lead to investor interest in gold stocks. But this
hasn’t been the case lately as anybody currently invested in this sector will tell you. And
this could end up being a major problem if it carries on for a prolonged
period of time. Without investors, capex will
naturally fade. And this would restart a nasty chain reaction that would eventually
lead to a decline in production volume.
Though it is no
doubt a contrarian view these days, at Zeal we don’t believe the gold
stocks will remain out of favor for much longer. It is just too early in
gold’s bull for a sustained loss of investor interest to effect a sector failure. And if we are indeed at the tail
end of the sentiment storm that has hammered these stocks, then legendary
gains can be won for investors who are properly positioned in the elite
companies laying the groundwork for the mining industry to continue its
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we’ve been positioning in gold stocks in anticipation of what should be
a healthy upleg. And we believe the smaller
beaten-down juniors ought to greatly outperform when the gold stocks finally
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The bottom line
is growing gold demand has really tested the mettle of the global supply
chain. And accordingly this chain has experienced wild volatility and radical
transformations over the last 10+ years. But of all the ebbing and flowing in
the major sources of supply, one constant is that mine production will
continue to shoulder the majority of the burden of meeting this demand.
production had lagged early on as the miners fought to rebuild an
infrastructure that had been woefully neglected, we are finally starting to
see the fruits of 10+ years of labor via a banner 2011. And so long as higher
gold prices and investors support the miners, they should be able to
successfully supply what is expected to be continued demand growth.
Our expert research team looked at the universe of 100 or so junior producers
trading in the US and Canada, and after thorough analysis whittled this group
down to our dozen fundamental favorites that we believe have the highest
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The bottom line is even though gold continues to forge higher, gold
stocks have disconnected from the historically positive leverage that
investors are used to seeing. Not only have the gold stocks not kept pace
with gold, they’ve sold off hard, with the juniors just getting
But so long as gold’s bull remains intact and its fundamentals
compelling, this gold-stock fear will prove totally unjustified. The most ardent
of contrarians realize that gold stocks can’t be held down for long,
and that the carnage we’ve seen, especially in the juniors, offers huge
buying opportunities. Selling has likely reached the point of exhaustion, so
carpe diem before the herd returns.
So how can you profit from this information? We publish an
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