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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.
However 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.
Interestingly 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.
Gold’s 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 four years.
In 2009 recycling exceeded 1,500mt
(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.
So with 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 2,500mt. 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 2003.
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 five 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.
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 2,400mt 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.
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.
Interestingly even with
2011’s all-time high, bull-to-date average annual gold production comes
in at only 2,493mt. 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.
In this 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 success.
In our acclaimed weekly
and monthly
newsletters 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 catch a bid. Subscribe today
to draw on our expert market analysis and also to find out which stocks we
are specifically recommending. Investors can also directly tap the pool of
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research reports.
Our last two reports profile our favorite junior gold producers and
explorers. Buy them
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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.
Though 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.
Scott Wright
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 probability for success. Each of these stocks is profiled in detail
in our hot-off-the-presses 34-page research report that is now available for purchase on our website. Buy your copy today!
At Zeal we use reports like this to feed trades in our acclaimed weekly and monthly newsletters. And we recently issued new buy
recommendations on several of our favorite junior gold producers. We
anticipate that these stocks will see gains akin to the 51%+ average
annualized realized gains that we’ve had in nearly 600 stock trades
recommended in our newsletters since 2001, and hopefully better. Subscribe today to see our current trades and get truly contrarian
stock-market analysis.
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
brutalized.
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
acclaimed monthly newsletter, Zeal Intelligence, that details exactly what we are doing in terms
of actual stock and options trading based on all the lessons we have learned
in our market research as well as provides in-depth market analysis and
commentary. Please consider joining us each month at … www.zealllc.com/subscribe.htm
Thoughts, comments, or flames? Fire away at scottq@zealllc.com . Depending on the volume of feedback I may
not have time to respond personally, but I will read all messages.
Thanks! Copyright 2000 - 2005
Zeal Research (www.ZealLLC.com)
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