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What Determines the Price of Gold?
Mine supply has
very little influence on the price of gold.
Anyone who
agrees that the gold trade is a market would accept the premise that the
price depends on supply and demand. Where most analysts go wrong is to analyze gold using what I will call the consumption model. This
model counts the current year's mine production plus scrap (and, in some
versions, central-bank sales) as supply, and the current year's purchases of jewelry, coins, bars, and industrial gold as demand.
Gold and the Consumption Model
The consumption model is good
way to forecast the price of a commodity that meets two conditions:
- it is destructively consumed
(or spoils), and
- the annual production of the
commodity is large in relation to existing, above-ground stockpiles.
Oil is a good
example of a commodity that meets these conditions. It is refined and then
irreversibly combusted. The oil price must
enable the market to clear more-or-less current production with current
consumption, buffered only by the oil sitting on tankers and in underground
reserves. Reserves cannot do not hold more than a few months' supply, due to
the high rate of oil consumption in relation to the storage capacity.
The consumption
model does not explain price formation of a commodity where the two
conditions are not met, because owners of the existing stocks own much more
of the commodity than the producers bring to market. Consequently, they have
far more influence over the price than do producers. Gold is the best example
of such a commodity: gold is not consumed; people buy it in order to hold it;
gold has the largest ratio of stock to annual production of any commodity.
In fact, it is
estimated that nearly all of the gold ever mined in human history still
exists. This supply grows by only 1 to 2 percent on
an annual basis; or, if we look at the ratio from the other side,
approximately 50–100 times the annual mine production is held in
stockpiles.[2]
The consumption
model would hold true if each year's gold were segregated into its own
market, with no arbitrage from previous years' markets. But this is not the
case: everyone who is buying, selling, and holding forms a single, integrated
market. A buyer doesn't care whether he receives gold mined within the past
year.[3]
Gold miners are competing with all of the holders of gold stockpiles when
they sell. Contrary to the consumption model, the price of gold does clear
the supply of recently mined gold against coin buyers; it clears all buyers
against all sellers and holders. The amount of gold available at any price
depends largely on the preferences of existing gold owners, because they own
most of the gold.
Looking at the
supply side of the market, each ounce in someone's stockpile is for sale at
some price. The offered price of each ounce is distinct from that of each other
ounce, because each gold owner has a minimum selling price, or
"reservation price," for each one of their ounces. The demand for
gold comes from holders of fiat money who demand gold by offering some
quantity of money for it. In the same way that every ounce of gold is for
sale at some price, every dollar would be sold if a sufficient volume of
goods were offered in exchange. While some dollar owners are not interested
in owning gold at any price, those who are interested have a maximum buying
price for each ounce that they might purchase. You can think of their buying
prices for gold ounces as their reservation price for holding dollars.
How the Price of Gold Is Formed
Rothbard provides a detailed,
bottom-up analysis of price formation in a market like this. I will
demonstrate his model with a sequence of diagrams that show how the dollar
price of gold is formed. As a first step, suppose that while gold trading had
been suspended for some time, the preferences of some of the gold owners and nonowners changed. Thus, when the market opens, some of
them wish to buy while others wish to sell.
Rothbard
constructs supply and demand curves using the reservation prices of the
individual buyers and sellers. The supply curve at each price is the total
amount of gold ounces for sale by all gold owners at or above that price. The
demand curve at each price is the total amount gold ounces that could be
purchased with the dollars offered at that price (or below that price). The
market-clearing price is that point where supply and demand are balanced.
Figure 1:
Before Trading
When trading
opened, the market participants would converge on market-clearing price. Once
a price had been established, all of the buyers offering at or above that price
would buy, and the all of the sellers asking at or below that price would
sell. Trading would continue until no one wanted to exchange gold for dollars
or dollars for gold. At that point in time, the market will have cleared.
Supply and demand curves would be as they are in Figure 2.
After trading,
everyone has adjusted gold and dollar balances to their preferred levels. The
market would show two quoted prices for gold: the best bid and the best
offer. The best bid
is the price offered by the marginal nonbuyer of
gold, and the best offer
is the price asked by the marginal nonseller of
gold. More trading could occur only if a buyer increased their bid price, or
a seller decreased their ask price, for at least one ounce.
Figure 2: After
Trading
Suppose that,
from this new starting point, one gold owner lowered his asking price for one
of his ounces below the best offer of the most marginal seller. A trade would
then take place between the gold owner and the marginal seller. What would
the situation be after the trade? The same as before, except that the best
bid and best offer prices might
be different. The new prices would depend on the reservation price of the
buyer of the single ounce. If his reservation price were above the best bid
but below that of the next most marginal seller, then the new buyer would become the marginal seller
and would set the best offer price. But his reservation price might be much
higher — enough to make another one of the existing gold owners the new
marginal seller.
The miner is
different from other gold owners in that he produces gold, while the other owners
bought their gold. But from a price-formation standpoint, it doesn't matter
how or where it came from; the miner can choose a reservation price, or not.
Most miners do not have a reservation price; they sell at market.[4]
The gold
analysts and I agree that, in a market, the marginal buyer and seller set the
prices. It is also true that the miner is always a marginal seller because
they sell at market. However, the entire
population of suppliers and demanders must be considered in order
to identify who the marginal buyers are and the price where the trades take
place. All of the demanders influence the price through their decision not to
offer a higher price. All of the (nonmine)
suppliers influence the price through their decision not to ask for a lower
price. To sell at market
means to sell at the price
set largely by those buyers and sellers who do have reservation prices.
The problem with the consumption model is that it ignores the influence of
the majority of sellers on the price.
How does the
presence of sellers selling at
market affect the price? The miner's presence affects the supply
curve as shown in Figure 3.
Figure 3: Mine and Nonmine Supply
Some trades will
take place below what was the best bid before the miner entered the market,
as shown in Figure 4.
Figure 4:
Mining and Supply
Once the miner
has sold his stocks, we are back to the situation shown in Figure 2. What was
the freshly mined gold is part of the new buyer's stockpile. There will be a
new bid and ask price, which will take into account the reservation price of
the person who bought the miner's gold. We cannot say what the new bid and ask
will be: either could be above or below the price before the miner sold.
Some Objections
Now that I've
explained how the price of gold is determined in the market, I will look at
two of the objections I have received when I have presented the ideas above:
Mine supply is the only supply available to the
market, because gold investors are primarily of the buy-and-hold mindset.
If gold buyers
typically have long holding periods, then is gold like oil that was burned or
corn that was eaten? Is it gone forever and not part of the market?
Every asset is
for sale at some price. While many small gold coin and bar buyers have a
reservation price that is more than $10 above today's price, they do have a
reservation price. There is a point at which other assets (stocks or bonds)
or consumption goods (cars or houses) would start to look more attractive
than holding the marginal ounce of gold. There can be no doubt that a good
many gold owners would become sellers at $5,000, $10,000, or $100,000 per
ounce.
Existing stocks of gold don't affect the price
because they are not for sale at the current price.
On closer
examination, this is not really an argument: it is only a restatement of the
definition of price.
A price in a
cleared market is that quantity of money below which nothing is offered for
sale. While this is true, it does not provide any information about what the price will be. As
discussed above, the price at which the first mined ounce is sold is set by
the marginal nonseller and nonbuyers
of gold.
Suppose, for
example, that all of the gold owners had a reservation price of $5,000 or
higher per ounce, with the buy prices of people holding dollars remaining
where they are now. If that were the case, then once miners had sold their
gold, gold would be offered at around $5,000 per ounce.
Conclusion
While
mining doesn't have much impact on the gold price, the reverse is not true:
the gold price has significant influence on the mining industry. The
economics of mining explains this. The cost of getting the gold out of the
ground is sensitive to several factors, including the grade of the deposit,
its depth below the surface, proximity to refining infrastructure, the cost
of energy, the cost of labor, and other variables.
The marginal cost of mining more gold above current production rises rather
sharply. It would not be profitable for the gold-mining industry to increase
production enough to have much impact on the total gold supply during any
given year.
The consumption
model of gold pricing ignores the influence of the majority of sellers on the
price of gold. It counts only a minority of the sellers. The consumption
model does include "scrap sales" (sales by those sellers whose
reservation price was low enough to result in a sale). But the suppliers who did not sell outnumber
those who did — by a large margin — and the selling price of
those who did sell was primarily determined by those who did not.
Robert Blumen
Also
by Robert Blumen
Robert Blumen is an
independent software developer based in San Francisco, California
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