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Particularly since the gold price has recovered from a level of $ 400
at the end of 2003 to an intermediate high of $ 725.75 at May 12, 2006, I am
experiencing an overall lack of knowledge and recognition based on hard facts
how to value developments in demand and supply in conjunction with
gold’s monetary function having changed since a demonetization process
started with the free float of gold in March 1968.
I also would like to get even with the myth that in modern times since
the gold price topped $ 850
in January 1980, gold is a safe haven for investors in
today’s world of turmoil, particularly since the Twin Towers
attack in September 2001 having caused an ultimate clash between western
civilization and modern Muslim extremism
At that time gold did not react at all and showed a very stable price
pattern within a very narrow range around $ 280, after having touched a low
of $ 255.95 in
New York and $ 260.48 in London in April 2001 and ending the year at $ 276.50 in London.
What actually happened to the gold market and stopped the fall of the
gold price since 2001 was the change in sentiment from producer hedging to dehedging.
According to statistics provided by GFMS of London, the world’s premier
gold research institute, gold producers hedged 1,249 tonnes of gold in the
period 1996-1999, followed by hardly any activity in the year 2000. During
this period the gold price dropped from an average of $ 331 in 1997 to $ 279 in 2000, and was
followed by 1,699 tonnes of dehedging in the period 2001-2006, during which
the gold price increased to an average of $ 444 in 2005, before
accelerating to an average $ 604
in 2006.
The determining impact of hedging and dehedging on gold price
movements in the last 10 years is demonstrated by the fact that the basic
element in supply (mine production) accounting for 63% in total supply)
hardly changed during this period and at 2,470 tonnes in 2006, being only 57
tonnes less than in 1997, and the basic element in demand, (jewellery
consumption) at 2,280 tonnes was significantly less at 1,214 tonnes. The fall
of 427 tonnes in 2006, demonstrated the price sensitivity of gold demand last
year when the price of gold increased from $ 513 at year end 2005 to
the intermediate high of $ 725.75 at May 12, 2006, followed by a
decline to an intermediate low of $ 560.75 at October 6, 2006, before
reaching price levels of above $ 600 again.
The volatile price movements clearly show that the gold price did not
run its own course but behaved in conjunction with the bull market for energy
and base metal prices driven by Asian and specifically Chinese demand. in
contrast with energy (oil, gas, uranium) and base-metal related
stocks/reserves, gold doesn’t show a shortage in supply with the top 10
gold producers representing 44% of total world production in 2006 having an
average of 17 years of reserves compared with annual production.
Story of modern gold market begins with free float
of gold in March 1968
The world of gold has changed more in the last 40 years than in the
preceding three of four thousand. Actually, the story of the modern gold
market began on 15 March 1968, when central banks gave up trying to defend a
fixed price at $ 35 per ounce. The London gold
market was closed at the request of the United States and remained shut
for two weeks. The gold price was no longer set; it was free to float. When
the London
market reopened it fixed the price in dollars not sterling.
The sign that fundamental change was due came a year or two earlier
when, for the first time in history, the private buying of gold had exceeded
money supply, forcing central banks to sell into the market to hold the
price.
Although gold is still considered the only universally accepted medium
of exchange, the ultimate currency by which one nation settles debt with
another, it lost its monetary role in the last 40 years when gold
holdings in % of total monetary reserves declined from 73% in 1965 to
15% in 2005. Simply, there just is not enough gold in the world to cover
money supply.
Central banks were largely banished from the market for a while. For
them, the curtain came down in April 1971, when the US Federal Reserve closed
its “gold window” at which so many central banks, especially in
Europe, had traded in dollars for gold for nearly two decades, once again
changing the balance of gold power back across the Atlantic to the restored
economies of Europe.
Demonetization drive since 1971
After having closed its “gold window” in 1971, the US
Treasury, in concert with the IMF, launched an attempt to demonetize gold
entirely. The IMF even altered its articles in 1978 to suspend gold as an
ultimate means of settlement and as the international
“numéraire”.
These actions essentially froze, as if in a time capsule, the gold
holdings of European central banks as they were in 1971.
The world economy moved on, but the ebb and flow of gold holdings that
previously marked changes in the wealth of nations, stopped. With gold
remaining in the vault of central banks, gold holdings in the early 1990s
were targeting a snapshot of where they went 20 years earlier.
Central Bank Gold Agreement
On 26 September 1999, the Washington Agreement on Gold (WAG –
now officially known as the Central Bank Gold Agreement) was announced. The
15 signatory banks participating, holding 15,998 tonnes, 47.7% of the
world’s official gold holdings, stated that they would jointly sell
approximately 400 tonnes a year of gold over the next 5 years, with an
absolute limit of 2,000 tonnes over the whole period.
On March 8, 2004, the European Central Bank and 14 other central banks
announced the renewal of the Central Bank Gold Agreement (CBGA-2).
This new Agreement covers the period 27 September 2004 to 26 September
2009, with the maximum level of sales having been increased from 400 to 500
tonnes per year; with an overall total of no more than 2,500 tonnes during
the 5-year life of the new agreement.
The increase in the sales quota can be contributed to the far stronger
gold market in 2004 than was the case in the third quarter of 1999, gold
having risen 50% in US dollar terms and 25% higher in euro’s.
After having increased to 674 tonnes in 2005 compared to 469 tonnes in
2004, in
2006, at 328 tonnes, net sales registered a 51% decline year-on-year. It is
expected that GBGA gold sales in the current year will end more than 150
tonnes shy of the 500-tonne quota.
The decline in net official sales suggests that the strong
“anti-gold” sentiment, that characterised much central bank
thinking over the 1990s and the early rears of the new millennium, has now
subsided. This shift in attitude has been and will continue to be instrumental
in the structural change to official sector gold actively that is underway.
Fall of the dollar has become a myth
Although the dollar has come under pressure lately on the back of poor
US
economic growth, thereby fuelling fears on further lowering of the federal
funds rate to under 5.25%, it is just levelling with the earlier all-time $
1.36 low of the dollar against the Euro at year-end 2004.
Consequently, the course of the gold price has not been correlated to
the dollar for more than 2 ½ years. During the same time, the dollar
recently touched a 4-year high against the yen.
From this perspective, also geopolitical problems connected with Iran, Iraq
and North Korea,
have been of influence on the course of the gold price.
With the dollar being the world’s key currency in worldwide
trading, including commodities, there is no currency alternative, while
further pressure on the dollar could lead to worldwide economic and financial
turmoil.
This would hurt overall stability in both the Western industrial world
and emerging countries, led by China. Controlling by far most of
the world’s dollar reserves, it is in particular in the interest of China and Japan to protect the value of
their reserves and halt further pressure on the dollar.
In this respect, it is worthwhile mentioning that although the Chinese
Yuan has been officially depegged from the dollar mid-2005, it has only
depreciated 7% in value since then.
No gold purchases by Asian central banks as swap
against the dollar
While gold sales by western central banks are declining, there is no
evidence that large-scale strategic purchases from emerging countries -
notably China, India and Russia – as a swap against
strongly increasing monetary reserves in dollars, will take place in the
foreseeable future.
This diversification argument did not work earlier for Japan in the 1980s, when the country of the
“rising sun” emerged to the world’s second economic powerhouse,
next to the US.
The obvious lack of interest to diversify their monetary reserves in
favour of gold can be attributed to the economic benefit from a stable dollar
on the economy of emerging countries, resulting in a growing trade surplus
and higher monetary reserves.
Although there is a tendency to diversify from US trading bonds into
other assets, higher risk bonds, foreign currency and hard assets, including
strongly growing investments in the energy and mining sectors to sustain
future economic growth, has not been considered as a serious investment
alternative by central banks of emerging countries to date.
Strong correlation with oil price until lately
While the correlation with the course of the dollar has stopped since
the end of 2004, in
the wake of booming energy and base metal prices there has been a strong
correlation between the gold and oil price at a gold ratio fluctuating
between 10 and 12 since the oil prices tripled from $ 20 per barrel by the
end of 2001 to $ 60 at the end of 2006.
However, since the oil price having touched an intermediate low of $
51.31 at mid-January, 2007, and showed a strong recovery to a recent
intermediate high of $ 71.39 the gold price did not follow this time, with
the gold/oil ratio having dropped to 9 lately.
This can be justified by the fact that, as earlier mentioned, the
demand/supply outlook for oil is further tightening, which is not the case
for gold.
Is gold a hedge against inflation?
Another myth in the modern history of the gold market is that
investing in gold is a hedge against inflation.
It is when using the historic gold price of $ 35 as a starting-point
before gold was officially demonetized in March 1968. It certainly is not if
considering the period since the historic high of $ 850 in January 1980, in which case
investing in bullion gold has been an outspoken bad investment alternative
for more than 25 years, and its favour only derived from shorter periods of
cyclical upward corrections.
Actually, gold realized its big price increase in modern history in
the 5-year period of 2001-2006, when inflation in the western world was fully
under control.
Fundamental picture of gold based on Supply and
Demand
Since the demonetization of gold in 1971, the development of the gold
price has been dictated by developments in supply and demand. The major
element in supply is mine production which, according to GFMS, in 2006, at
2,471 tonnes, accounted for 63% of total supply of 3,906 tonnes. On the other
hand, the major element in demand is jewellery fabrication which in 2006, at
2,280 tonnes, accounted for 58% of total demand. Ten years earlier, in 1997,
mine production accounted for 60% of total supply (4.127 tonnes) and
jewellery demand for 78% of total demand.
These figures show that at the supply side, mine production and its
impact on total supply remained stable, while at the demand side, despite a
decline, the impact of jewellery demand represents by far its major element.
As a result, it was not a change in jewellery demand on the one hand
and mine production supply on the other hand that determined the strong
fluctuations in the gold price in the last 10 years. Averaging $ 331 in 1997, and touching
an average low of $ 271 in
2001, the gold price subsequently showed an annual increase to an average of
$ 604 in
2006, representing an increase of 36% compared to the average of $ 444 in
2005.
Implied net investment had a positive but relatively modest impact on
the gold sentiment, which was particularly enhanced since 2004 when the
Exchange Traded Funds (ETF’s) were newly introduced. The demand for
ETF’s doubled from 133 tonnes in 2004 to 260 tonnes in 2006. One should
bear in mind however, that ETF’s represent less than 10% of total
demand, compared to 58% for jewellery demand.
With other elements in supply (including official sector sales and old
gold scrap) and demand (other fabrication and bar hoarding relatively
in balance , it has been net producer hedging (forward sales) in the period
of 1997-1999, followed by net producer dehedging in the following years, that
predominantly determined the course of the gold price.
Course of gold price determined by producer hedging
and dehedging in last 10 years
In the 4-year period of 1996-1999, according to GFMS, net producer
hedging contributed an aggregate of more than 1,200 tonnes to supply, thereby
putting the gold price under pressure, followed by an aggregate of 1,700
tonnes in the 5-year period of 2001-2006.
Dehedging was enhanced by a growing gap between forward selling at low
prices and increasing actual gold prices which in conjunction with increasing
costs of production put profit margins under pressure. As a result, companies
started to lower their gold hedge books.
In 2006, dehedging hit 13.4 million ounces, 9 million ounces greater
than in 2005 and the largest annual production in the global hedge book at
25% since records begin in 2002.
According to Mitsui Global Precious, dehedging is likely to be an
estimated 8 to 11 million ounces in 2007, after having fallen by an estimated
3.9 million ounces to 36.7 million ounces in the first quarter. This cut of
almost 10% was the 20th successful quarterly reduction and means that gold
hedging worldwide is now 64% lower than it was at its peak of 118 million
ounces in the third quarter of 2001.
According to Mitsui Gold Precious Metals, thirty-six other companies
also cut their positions in the first quarter of 2007, collectively reducing
the global hedge book by 1 million ounces.
Five companies added new hedges, but only two of those saw increases
larger than 100,000
ounces each.
Despite, with a few exceptions, opposition to hedging in the gold
industry is such, that it is expected that the global hedge book will fall further,
now Barrick’s major dehedging program has finished and also other major
gold producers have decreased their gold hedge book significantly, a slowdown
in the rate of dehedging is inevitable.
At the same time, new gold hedging is undertaken on a project specific
basis for new projects, like Barrick Gold and Gold Fields have said.
From this perspective it is striking to see that many producers
increased forward sales when gold touched a 20-year low of $ 252,80 in 1999 to hedge
against further declines in prices and have been rapidly unwinding forward
sales contracts as gold’s rally has entered its seventh year. This
contradictional market behaviour demonstrates a lack of market vision within
the gold industry.
This point of view is emphasized by the fact that, while major
producers have upgraded the value of their reserves from $ 400 to $ 500 per
ounce, hedging of a part of future production at currently 30-35% higher gold
prices could add significantly to their cash flows, contributing to a more
active exploration/development and acquisition strategy and substantially
adding to shareholder value.
Booming gold price interrupted by price sensitivity
in demand
More or less running its own course in 2004 and 2005, showing an
increase from $ 400 to $ 500 or 25% over a period of 2 years, the gold price
exploded in 2006 driven by the boom on the oil and base metal markets,
specifically driven by Chinese demand.
Within four months the price moved up from $ 100 to $ 600 by mid-April
2006, followed by a further price boost to an intermediate high of $ 725 just
one month later, equal to a price increase of 41% over a period of just 4
½ months since year-end 2005 ($ 513).
The consequence was that, according to statistics of GFMS, jewellery
demand fell 27% from 1,481 tonnes in the first half of 2005 to 1,073 tonnes
in the first half of 2006, thereby demonstrating the growing sensitivity of
demand at higher gold prices.
This resulted in a 23% correction of the gold price to an intermediate
low of $ 560.75 in
early October 2006. Getting accustomed to higher gold prices, jewellery
demand commenced to recover showing an increase to 1,207 tonnes in the second
half of 2006, and also implied net investment increased from 142 tonnes in
the first half of 2006 to 246 tonnes in the second half of last year.
Considering that since a 2007 intermediate high of $ 691.40 at April
20, the gold price fell back again to a recent low of $ 642.10 at June 27,
this draws to the conclusion that the gold price has not succeeded to find a
balance above $ 650 in
2007 yet.
First quarter 2007 shows turnaround in jewellery
demand, but decline in identifiable investment
According to GFMS, as presented by the World Gold Council,
identifiable demand for gold in the first quarter of 2007 was 4% higher than
in the same period last year (797.8 tonnes). Coupled with the 17% in the rise
of the gold price, this was equivalent to a 22% rise in dollar terms to $
17.4 billion, easily a first quarter record.
Jewellery demand rose 17% in tonnage terms to 572.8 tonnes, albeit
from a depressed first quarter in 2006 (488 tonnes) and compared to 522.8
tonnes, 557.9 tonnes and 710.7 tonnes in the second, third and fourth
quarter, respectively.
Net retail investment rose 28% from 86.2 tonnes to 110.7 tonnes, but
total Identifiable investment declined by 26% from 199.1 tonnes in the first
quarter of 2005 to 147.1 tonnes, as a result of a dramatic 68% fall in
ETF’s similar products from 112.9 tonnes to 36.4 tonnes.
The overall decline of Identifiable investment shows that the gold
market is still looking for a balance around $ 650.
However, it should be notified that Identifiable Investment in 2006
fell back sharply in the second quarter (138.7 tonnes) and third quarter
(124.1 tonnes) before recovering slowly to 187.7 tonnes in the fourth
quarter.
This would paint a positive picture for the gold market in the second
half of 2007, particularly if the turnaround in jewellery consumption gets
more steady.
World gold industry booming
However, with today’s gold price 50% higher than year-end 2004,
the positive news is that the worldwide gold industry is booming with overall
exploration budgets in the mining industry having reached a record level of
more than $ 7 billion in 2006, compared to US$ 5 billion in 2005.
Accelerating exploration and development budgets will results in new
mine ramp-ups and stop the decline in gold production, with a further shift
from traditional to emerging counties.
Particularly junior companies have raised substantial amounts over the
past three years, and high metal prices will help the juniors continue to
attract investors for the short term.
At the same time, a consolidation process is taking place amongst
major and intermediate companies, offering attractive investment
opportunities, enhanced by the value of reserves having been upgraded at a
conversion price of $ 500 compared to $ 400 used over 2005, with a further
potential upgrade to $ 600.
Higher leverage in profits despite accelerating
production costs
Against the gold price having increased significantly in 2006, up 24%
or $ 123 per ounce, cost pressures continue to rise sharply in the world
reflecting the rising costs of labour, energy, mining consumables and
equipment.
Average cash costs per ounce in 2006 were $ 317 per ounce, up 17% or $
45 per ounce, more than double the price hike measured in the previous year.
Depreciation costs increased 24% from $ 68 to $ 84 per ounce, adding to a
rise of total costs of 18% from $ 339 to $ 401 per ounce.
Although the accelerated rise in production costs is worrying the gold
industry, profit margins widened significantly in 2006, resulting in a strong
increase of cash flows.
At an average gold price of $ 444 in 2005, the average profit margin was $
105 or 24%, having increased to $ 203 or 33% at an average gold price of $ 604 in 2006.
However, following my expectation that the gold price, based on the
current outlook of demand and supply, will trade within a less volatile range
of $ 640-660 in
the second half 0f
2007, further increasing mining costs could depress margins this year,
despite a higher, but in percentage terms a lower increase of the average
gold price in 2006 by 36%.
Shift in production from traditional to emerging
countries
An important structural change in the worldwide gold industry is the
shift in production from traditional countries to emerging countries. In the
last 10 years, the share of production from traditional countries (South
Africa, Australia, United States, or Canada) decreased from 54% in 1997 to
36% in 2006 while on the contrary the share of gold output of emerging
countries, lead by China and Peru, increased from 18% in 1997 to 30% in 2006.
However, against better chances of new gold discoveries at lower
production costs than in the traditional countries, investors should consider
higher geopolitical risks in these countries.
These include emerging countries looking for a higher share of wealth,
thereby requiring higher windfall taxes since gold prices increased by more
than 50% since the end of 2003.
 
South-Africa, further decline of gold production in
2007
According to the SA Chamber of Mines South African gold production
fell by 76% to 62.8 tonnes (2.02 million ounces in the first quarter of 2007,
compared to first quarter of 2006, as grades mined in the quarter declined by
an average of 12.9%. About 8% of production came from marginal mines.
The year-on-year decline in the average grade mined to 4.32 g/t gold
was facilitated by the 17.4% increase in the US gold price of US$ 650 per
ounce and the 17.6% depreciation in the South African Rand to R 7.23/US$. This
resulted in a 34% increase in the rand gold price received by the mines and
allowed mining companies to mine lower grade ore that had previously been
uneconomic to mine.
But year-on-year increases of 19.6% in cash production costs and 17.5%
in total operating costs before capital expenditures hampered some of the
flexibility given by stronger prices.
Mining companies invested the bulk of profits derived from stronger
prices in capital expenditure, which increased by 39% to R 1.6 billion in the
first quarter of 2007, representing a recovery in capital expenditure after a
decline in spending both in 2004 and 2005.
Total mining investments fell 20% to Rand
14 billion (US$ 2 billion) in 2004 and by a further 13% in 2005. This
coincided with the introduction of the government’s Black Economic
Empowerment measures that force mining companies to sell 26% of their assets
to black South Africans.
South Africa produced
minerals worth R 142.8 billion (US$ 22.4 billion) in 2005. This included R
38.4 billion of platinum group metals (PGM), R 35.6 billion of coal and R
24.1 billion of gold. Although the gold sector is in steady decline,
production of PGM’s, chrome, iron ore, and coal is increasing.
According to AngloGold Ashanti’s
chief operating officer for Africa. Neville
Nicolai, despite a current gold price of R 150.000 kg (US$
21,716) haven’t been seen in the last 20 years, growth projects in
South Africa would extend the life of existing operations into the future,
rather than increase levels of production.
China will
emerge to the world’s largest gold producer by 2010
Driven by domestic demand the government invested heavily in the
mining industry in the 1990’s and as a result China gold production has
risen significantly to a level where it has overtaken Australia in 2006 as
the world’s third largest gold producer and will overtake the United
States as the second largest gold producer this year.
According to the statistics of the China Gold Association, in 2006,
gold production in China
grew from 224 tonnes to approximately 240 tonnes and is forecast to produce
around 260 tonnes in 2007.
In the first quarter of 2007, China produced 56.2 tonnes of
gold up 16% from the same period last year, of which gold mining enterprises
produced 36.9 tonnes up 9%.
Following the reform of the gold system, China’s gold industry has
entered a new era in gold development. With the gold market gradually
changing, bullion investment and paper gold have become more common.
In the meantime, China’s
gold and jewellery market is developing rapidly. The quantity of sales has
increased at an annual rate of approximately 20%. Having increased from an
estimated 255 tonnes in 2005 to approximately 275 tonnes in 2006, China
now is the world’s third biggest consumer of gold.
Total sales of gold and jewellery were valued at more than 1,400
billion Yuan ($ 181 billion) and exports were valued at $ 5.5 billion.
By :
Marino G.
Pieterse
Editor, Gold Letter
International
Marino G. Pieterse has been an
independent financial analyst and gold specialist for more than 25 years. He
is the chief-editor of Goldletter International, the only gold investment
market letter in English in Europe focusing
on emerging gold regions in the world, as well as reports on individually
featured companies and special reports on other metals, including uranium.
You can receive Gold Letter International’s reports for free by
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