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There is no denying gold’s store-of-value relevance
throughout the history of the world. It has been and will always be the
ultimate form of currency. Even today gold’s alluring and timeless
qualities transcend every political, social, and monetary boundary that man
puts into place. Gold’s core fundamentals will forever be rock solid.
Another key element to gold’s fundamentals is simple
economics. And it is economics, supply and demand, that will always dictate
gold’s price over time. On the demand side we have seen a big increase
over the years due in large part to population growth and ease of access.
Gold is not just a metal for kings anymore. Over time a large
global distribution network has been built that sells gold, in small or large
quantities, to anyone who wants to buy it. And with such a rapidly growing
world population, especially in the last 100 years, a greater number of
people want to own this precious metal.
On the supply side, the onus is on the miners to bring enough
gold to market to meet demand. But the miners can’t just turn a spigot
and spew gold at will. One of the many reasons why gold is precious is its
rarity. Simply put, this metal is hard to find. And when it is found,
economically extracting it from the earth presents its own challenges.
So far the miners have been able to supply gold to the people.
But they’ve really had to ramp up their efforts in the last century to
meet skyrocketing demand. Interestingly over 80% of the gold mined in the
history of the world has happened since 1900, with over two-thirds of this
volume in just the last 50 years. We’ve also seen a double in world
production just since 1980. This massive production increase is driven by the
demand of a growing populace hungry for gold!
But will the mining industry constantly be able to keep up with
growing demand? I’ll give my opinion on the answer to this question in
a bit, but in the mean time I’ll say it will continue to be a growing
challenge. Mining gold is not as simple as harvesting a crop. This yellow
metal is finite, once it is mined there is that much less remaining hidden in
the earth.
And these miners have the same geological landscape to work with
today as those miners thousands of years ago. The only difference is the low-hanging
fruit has already been picked. Gold producers must now search for and mine
their gold in locations that may not be very amenable to mining. Many of
today’s gold mines are located in parts of the world that would not
have even been considered in the past based on geography, geology, and/or
geopolitics.
And these factors among many are attributable to an alarming
trend we are seeing in global mined production volume. According to data
provided by the US Geological Survey, global gold production is at a 12-year
low. And provocatively this downward trend has accelerated during a period
where the price of gold is skyrocketing.
You would think that with the price of gold rising at such a
torrid pace gold miners would ramp up production in order to profit from this
trend. But as you can see in this chart this has not been the case, at all.
Not only has gold production not responded, but it has dropped at an
unsightly pace that has sent shockwaves throughout the gold trade.
As the red line illustrates gold’s secular bull began in
2001, finally changing direction after a long and brutal bear market drove
down prices to ridiculous lows in the $200s. To match this bull the
blue-shaded area provides a picture of the corresponding global production
trend. And you’ll notice that in the first 3 years of gold’s bull
production was steady. This is not a surprise as you figure it would take the
producers a few years to ramp up supply.
But instead of supply increasing in response to growing demand
and rising prices, it took a turn to the downside. And what’s even more
amazing is the persistence of this downtrend. Since 2001 gold production is
down a staggering 9.3%! In 2008 there were 7.7m fewer ounces of gold produced
than in 2001.
Now from an economic perspective this chart clearly displays the
supply side of the imbalance that has shaped this bull. And with gold demand
on the rise it is natural for prices to trend higher. But with particular
focus on this supply side, let’s try to gain an understanding of what
this trend may mean for the future of gold.
In my eyes there are two strategic reasons why production is
down. First are the growing challenges that gold miners are faced with today.
And second is that prices are not high enough for gold companies to make the
structural changes necessary to ramp up production.
As for the challenges, these come in all shapes and sizes. And
these challenges are quite important to understand. I’ve dedicated
entire essays to gold mining challenges in recent years, so I won’t
exhaust the subject here. But I will provide a couple of interesting
examples.
One of the largest-scale examples is South Africa. SA had long been
the world’s premier gold producer. As recent as 1970 this country was
responsible for over two-thirds of global gold production, producing a
whopping 32m ounces that year. Its massive gold deposits that knife through
the earth’s crust have been the source of a large volume of rich
high-grade gold.
But as mentioned above the low-hanging fruit has now been
picked. South Africa’s easy-to-access near-surface gold zones have been
depleted for the most part and the economics are not as robust pulling gold
from deeper in the earth. There are other external factors that have
contributed to SA’s gold mining woes such as currency and power issues.
But the fact is less near-surface gold and higher operating costs to mine the
deeper gold have led to the fall of South Africa’s gold mining
dominance.
Interestingly South Africa’s rapid production decline was
a big impetus for the previous secular gold bull of the 1970s. By 1975 SA
only produced about 23m ozs, a nearly 30% decline from 5 years earlier. With
such a big drop from the world’s largest gold producer there was ample
reason for the price of gold to rise.
This trend of declining gold production from South Africa has
continued through current. And after such dominance it is amazing that it is
no longer the world’s largest gold producer. In 2007 China took over
the top spot and then in 2008 the United States even passed it by. SA is now
number three with Australia right on its heels. In 2008 it produced just over
7m ounces of gold, a staggering 77% drop from 1970 levels and its lowest
volume in 86 years.
Well with global gold production obviously growing since 1970,
the rest of the world has picked up South Africa’s slack. And
interestingly it is technology that has enabled this to happen. The mere
mention of this technology drives environmentalists crazy, but heap leaching
has revolutionized the gold mining industry.
Leaching gold out of ore is not a new or complicated chemical
process, but its utilization on a large scale has radically changed the face
of mining for gold. Newmont Mining was the first company to roll out this
technology on a large-scale basis in the early 1970s, utilizing it at its
operations in Nevada’s prolific Carlin Trend. And heap leaching is now
used at the majority of large-scale gold mines throughout the world.
Having had the chance to tour a massive heap-leach gold mining
operation first hand, I must admit this technology is quite impressive.
Essentially mined ore is crushed to a certain size and then place on a giant
leach pad. The ore is then irrigated with a leach solution (for gold this
solution is diluted cyanide) that dissolves the gold out of the ore. After
eventually percolating to the bottom of the leach pad this solution is
collected for processing.
This leach pad can be thought of like a super-large bath tub. It
is lined with a thick layer of plastic, and when the ore is
“cleaned” of its gold the bathwater is drained and sent off for
processing. The gold is eventually converted back to its physical form via a
variety of processes and becomes the shiny yellow metal you see today.
Heap leaching has allowed miners to tap lower-grade gold
deposits that would not have been economical prior to this technology. I
can’t imagine how high the gold price would be today if heap leaching
wasn’t available. But even with this technology and others, it is still
getting harder and harder to find the big gold deposits that will eventually
become the next generation of mines.
Finding these deposits requires large-scale exploration efforts.
And exploring for and eventually developing gold mines demands massive
amounts of capital. This is a major reason why gold bulls are secular in
nature. Gold prices need to be high enough, for long enough, to give mining
companies the incentive to perform gold exploration and development.
Coming out of a bear the miners were settled into a prolonged
period of low prices where there was no incentive to spend money on
exploration. And after years of neglect in this area the pipeline of major
gold discoveries and mine development projects runs thin. It can take up to
10 years and billions of dollars to build a large-scale gold mine. So perhaps
it is no wonder production lags in the first part of a gold bull, such as we
are seeing today. It can be looked at as a bear-market-recovery period.
But even though it takes a while to react to higher gold prices,
it is still a concern that gold production is continuing to fall 8 years into
this bull. And you don’t have to look too far at the individual mining
companies to see that this problem is industry-wide. We have seen a lot of
consolidation in this bull market, with a flurry of M&A activity. But
even the miners at the top of the heap, those seemingly at the vanguard of
the M&A food chain, have experienced material declines in their
production volume.
The world’s four largest gold miners combine to produce
over one-quarter of the annual mined supply of gold. But amazingly Barrick
Gold, Newmont Mining, AngloGold Ashanti, and Gold Fields have 2009 production
forecasts that are 20% lower than total volume from just 3 years ago. These
four majors will collectively produce 5m ounces less gold than they did in
2006!
There are a myriad of reasons why this is happening across the
entire gold mining industry. Whether operational, geological (lower-than-expected
grades), geopolitical, environmental, or countless other reasons, presently
operating gold mines are producing less and new mines aren’t being
brought into production fast enough to replace the depleted ones. This is a
simple formula for lower overall production.
In terms of the overall economic balance there has long been a
large gap between mined supply and total demand. And while this gap has been
filled by other major supply sources such as scrap sales and central bank
sales, this falling production volume does not bode well for the future
balance of the gold trade.
If you are interested in perusing formal supply and demand data
on the gold trade, I encourage you to look at that which GFMS puts together
for the World Gold Council. Not surprisingly there have been structural
supply deficits over the course of gold’s secular bull. And while this
recent global economic crisis has lowered gold demand on the fabrication
front (jewelry and industrial) and increased scrap supply from folks trying
to cash in on gold’s price strength, it is investment demand that is
really going to drive the remaining years of this bull.
And even though investment demand is on the rise, we have only
seen the tip of the iceberg considering the rampant inflation fears that will
take hold of the markets sooner rather than later. The central banks and
scrap sellers will only be able to supplement mined supply so much.
Scrap sales in particular are the second largest supplier of
gold, far more than central bank sales. And a good portion of the recent
surge is a result of distress selling. This type of selling will quickly be
exhausted. The poor souls willing to pawn their jewelry and ornamentals to
raise cash will eventually run out of such items to sell. And many of these
folks will be buyers again when they realize it is not the end of the world
and remember why they owned gold in the first place.
Ultimately it is gold mining, which is responsible for about 60%
of total supply, that will carry the burden of meeting what will continue to
be growing investment demand. And to answer the question above, yes, the
mining industry will be able to keep up with demand over the long run. But
the key is, only at the right price.
Even though there has been a lengthy production decline, the
world is not running out of gold to mine. And it is not likely that we have
seen a peak in mined production. Now the low-hanging-fruit idiom is very
important to understand in regards to the future of this industry. It will be
more expensive to extract the lower-grade gold that the miners of the past
have left us with, but there is still plenty left. Heck, if the price was
high enough gold could even be extracted from ocean water. It is all a matter
of perspective.
And from what I can see the perspective of today’s miner
is that the gold price is not high enough and/or has not stayed high enough
for long enough yet to warrant any semblance of a growth spurt in this
industry. Now this gold bull has ramped capex for exploration up over the 1990s.
In the previous decade there was practically no such thing as exploration
budgets as those miners that survived had to do just that, survive.
But there have been some impressive gold discoveries in recent
years. And there has also been renewed activity at the sites of earlier
discoveries that have become economical at this higher gold price. But there
has not been a rush to develop operations and bring mines into commercial
production. Some of this has to do with the lagging effect that I mentioned
above, it just takes time to bring mines online. But miners also want to see
consistently higher gold prices before they invest the massive capex that it
requires to construct mines.
As an investor there are many ways to take advantage of what
will likely be a resurgence of gold production in the latter half of this
bull market. First is actually investing in gold. If demand continues to
rise, driven by investment, simple economics tell us the price of gold has to
rise if supply from the mining side continues to be strained.
Another way to invest is in the stocks of these mining
companies. Investing and speculating in gold stocks is riskier than doing so
in the physical metal. But because of their profits leverage they offer excellent
reward potential. The gold miners that are able to control their operating
costs and leverage gold’s gains should see their stocks greatly
outperform the gains of the underlying metal.
At Zeal we have been trading gold stocks since gold’s bull
began in 2001. And over this time this sector has been one of the
best-performing in the entire markets. We also loaded up on gold stocks in
their extreme weakness around the lows of the stock panic. And so far these
trades in our weekly and monthly newsletters have excellent unrealized gains.
And there is ample opportunity to buy gold stocks even today as
they are still undervalued relative to gold. Gold is pushing forward on its
quest to pierce the $1000 barrier and beyond, which should happen this year.
And if this happens gold stocks should post awesome gains. If you are looking
for a contrarian perspective on these wild and crazy markets and would like a
peek at our trades, please subscribe to one of our acclaimed newsletters
today.
The bottom line is global mined gold production has fallen at an
alarming rate since the beginning of this gold bull. Even though ramping up
volume in an infrastructurally-challenged industry is going to lag
gold’s price rise, this trend must reverse soon if supply is to meet growing
demand.
The gold mining industry is indeed faced with a growing number
of challenges in producing its product. But these challenges can be overcome
if the price is right. And the only way gold miners are going to invest the
huge capital it takes to build enough new mines to grow this industry is if
the gold price stays high and continues to rise. Ultimately the stocks of the
companies tasked with boosting gold production will thrive throughout the
course of this secular bull.
Scott Wright
July 31, 2009
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articles by Scott Wright
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