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In a recent article, The Case Against Gold David Berman
interviews a Canadian fund manager who is bearish for all of the wrong
reasons. As do the vast majority of analysts and writers, he totally
misunderstands how the gold price is formed.
While Berman is correct that
“gold must obey the law of supply and demand”, his explanation of
how the law works is fatally flawed. The supply and demand
numbers presented in the article are meaningless and tell us nothing about
the future direction of the gold price.
The key to understanding the gold price
is that gold is in demand as an asset, not as a commodity. A commodity
is a good that is purchased in order to be permanently removed from the
market (usually destroyed), while an asset is a good that is purchased
because the buyer values it more as a holding than for its direct use.
The most important consequence being held rather than destroyed is that
the accumulated stockpiles of exceed annual production by a large margin.
In the case of gold the ratio is between 50:1 and 100:1 while for most
(consumed) commodities it is less than 1:1, (i.e. less than one year’s
total production is held in above-ground stockpiles).
For a commodity, everything
that is produced is sold; everything that is sold is purchased; and
everything that is purchased is consumed. The act of consumption removes the
supply from the market permanently. For the moment, let’s
idealize the situation a bit by assuming that there are no above-ground
stockpiles of a commodity at all. Subject to this simplifying
assumption the following is true: the amount traded is the same as the amount
produced which is the same as the amount consumed.
This mathematical identity is not true
for an asset. Because so much of the asset already exists and so
little is produced, most of the trading takes place among buyers and sellers
who are only shifting the existing stock piles among themselves. The
equality of the quantities produced, supplied, demanded, and consumed does
not hold. Small amounts of gold are consumed for industrial uses but the
quantity permanently consumed can be considered effectively zero because most
gold is either held in investable form (bars and coins) or as jewelry. The
quantities bought and sold are by definition equal, but the quantities
produced and consumed are not equal, nor does the quantity produced
necessarily equal the quantity bought and sold. The quantity bought and sold
can exceed quantity produced by an enormous ratio because there is no limit
on how much existing stockpiles of the asset may be traded during a one-year
period.
The different relationship between the
quantities produced, consumed, and traded between a commodity and an asset is
the source of much of the confusion about gold.
For a commodity, increases or decreases
in the quantity produced can have a dramatic effect on the price because the
quantity consumed must move either up or down along with the quantity
produced. Because there are no stockpiles to buffer the difference
between production and consumption, the only way for them to come into
balance is through price. But for an asset, things work differently.
For an asset, most trading consists of the change of ownership of existing
stocks. The gold that gets produced will certainly be sold, but
trading volumes during a year will far exceed new mine production because of
the large volume of trade of existing holdings.
To quantify the impact of mine supply
on the market I have (elsewhere) estimated the trading volume on the London
Bullion Market Association (LBMA). The LBMA can absorb an entire
year’s mine output in about twelve trading days. And consider
that the LBMA is only one of several investor bar markets worldwide, and that
the investment market as a whole includes the coin market as well.
While I do not have a precise number, I estimate that an entire year’s
worth of mine production turns over in the physical market in several
days.
Because mine supply is small compared
to existing holdings and because the volume traded exceeds mine supply by a
large ratio, mine supply is quickly absorbed into the market and has little
impact on the gold price. Far more important is the price at which
existing sellers are willing to part with their ounces.
With this in mind, let’s return
to the article.
Berman
states ”the underlying fundamentals are now looking distinctly
negative for the metal’s long-term prospects.” As we will see
reaches this conclusion by looking at the market only on an annual
production basis:
“According to GFMS, the
London-based precious metals consultancy, global jewellery purchases plunged
to 1,759 tonnes last year from more than 3,000 tonnes at the start of the
decade, as the rising price of gold turned off consumers and jewellery makers
cut back on gold content.”
As explained above, looking only at
annual production ignores most of the gold market. The entire gold market is
a single integrated market with one price. There is not one market with one
price for gold produced this year and another market selling at a different
price where existing stockpiles of gold are traded. Looking at gold on an
annual basis gives the appearance that the supply – and therefore the
demand – are highly variable. If the supply goes from 1759 to 3000 over
a few years – almost a 100% increase — then demand must also
nearly double, otherwise the price would plunge, right? Well, no. The supply
of gold is not 1759 or 3000 tonnes, it is about 165,000 tonnes – the
total all mined gold in history that has not been lost or destroyed. And what
about demand? The demand is also 165,000 tonnes, exactly equal to the supply.
And the supply has not doubled over the last few years, it has grown modestly
by about 1-2% each year for a cumulative increase of less than 20%.
What does it mean to say that the
demand for an asset is equal to the supply? For a commodity, the demand
consists of off-take from the market for destruction. An asset, on the other
hand, is not destroyed; it is acquired in order to be held. The demand for an
asset consists of what economists call reservation demand, meaning that investors
demand an asset by holding it off the market while the price is below their
selling price. Demand for gold has not and does not need to double to keep
pace with mine supply. As the supply grows by about 1% each year, reservation
demand must only grow by the same amount in order to keep the market in
balance.
Here is where we get into the meat of
Berman’s case for the bearish gold supply fundamentals:
“At the same time as demand is
falling, gold supply is rising. Most central banks, for instance, are jettisoning
their gold holdings. According to the World Gold Council, total gold holdings
were about 30,600 tonnes in December, down nearly 2,900 tonnes since the
start of the decade – and these overall declines take into account an
increase in gold holdings by China’s central bank
Adding to supply is ramped-up
production from mines. This rose to a four-year high of 2,572 tonnes in 2009.
In addition, consumers are now happily mailing in their “scrap”
gold jewellery to the host of gold-dealing companies that have sprouted up in
recent years. Add in this recycled gold and total world supply hit 4,034
tonnes last year, the highest level in at least a decade.”
Correction, Mr. Berman: a seller
selling gold is not an increase in supply. It is only a transfer of existing
supply from one owner to another. It does not matter whether this seller is a
central bank or someone melting scrap. And moreover, is central bank selling
a huge bearish indicator? 3,000 tonnes per year is about annual mine supply.
This is, as noted above, a few trading days’ volume. If there are no
buyers near the market price, then it could be bearish, but not nearly as
bearish as it sounds when you consider that the total supply of gold is
165,000 tonnes – 50 to 100 years annual production. The real influence
on the price is not possible to quantify. Once the gold changes hands, the
price depends on the reservation price of the new buyers, which could be
higher than that of the recent seller.
Berman also misunderstands the
relationship between investment products and jewelry:
“Unlike most commodities, gold
isn’t consumed in high quantities. Industrial uses account for only
about 10 per cent of total demand, which is why jewellery makers have
traditionally provided most of the market for the metal.
However, global demand for gold jewellery has been in steady decline,
replaced only by demand from fickle investors – a shift that could have
a disastrous impact on the price of gold if those buyers turn
squeamish.”
And:
“Of course, gold is still
in high demand. But the source of this demand is now investors, who have
become gold’s biggest buyers for the first time in about 30 years.
These buyers have no uses for gold, other than the hope of selling it to
someone else at a higher price somewhere down the road.”
In reality, investment and jewelry are not so different. They are two
different ways of holding gold. In either form, the gold is not destroyed.
The boundary between them is somewhat fluid based on the relative intensity
of investment demand versus jewelry demand. As gold becomes more in demand by
investors demanding bars and coins, the opportunity cost of using it for
jewelry increases. At the margin, more people will sell back unwanted jewelry
as scrap and (also at the margin) more buyers will substitute silver or other
metals for gold. If the investment demand fell, then at the margin people
would hold onto more of their family jewelry and use more gold in new jewelry
fabrication. What Berman describes as a fall in demand is only a
natural shift between different ways of holding gold as an investor and
consumer valuations change.
The intentions of the jewelry buyer and
the investment buyer may be different. Investment buyers hold gold as a store
of value, while jewelry buyers may use it for ornamental purposes. But the
gold is still held and most jewelry can and does eventually return to the
market as melt. And furthermore, in some parts of the world a lot of jewelry
is purchased as a store of value – a wearable investment. In the West
investors prefer to hold gold as bars or coins while in Asia and the Near
East, some jewelry purchases are investments rather than ornamental. Bullion
jewelry has a low workmanship value-added compared to ornamental jewelry
which sells for substantially more than its gold melt value.
Berman also makes the common error of
quantifying gold demand by counting trading volume. As explained above, for a
commodity the quantity traded is equal to both production and consumption,
but not for an asset. For an asset, the supply and the demand are both equal
to the total quantity stockpiled. There is no obvious relationship between
production and trading. High market volume in the gold market means a high
level of demand and an equally high level of supply. This does not provide a
clear indicator of the price direction in the market, though this does not
stop many analysts from pointing to high trading volume as evidence of either
a lot of demand (if they are bullish) or a lot of supply reaching the market
(if they are bearish). We cannot use the trading volume as a measure of
supply and demand because the price at which the existing supply changes
hands does not depend on the trading volume: the price can rise, fall, or go
sideways on increasing, or decreasing volume.
An example that I like to use to
illustrate this point is if an analyst studying a particular stock (corporate
equity) wrote “demand for the shares of corporation XYZ were 30M
shares…but we expect demand for the shares to increase next year to 40M
shares, which is very bullish”, then anyone reading this would have to
scratch their head a bit in trying to understand what the analyst meant. In
fact, the statement is meaningless — the analyst would be spouting
gibberish. The deep confusion exhibited by writers and analysts on this issue
contributes to the lack of understanding by investors and the continuing
stream of articles such as Mr. Berman’s piece.
One of the best indicators that the an
analyst is in a state of deeply misguided thinking is that he provides two
different numbers for supply and demand. The numbers result from adding up
some fraction of the total gold trades on each side of the market and calling
those numbers “supply” and “demand”. As noted above,
trading volumes do not measure supply differently than demand. If the supply
and demand number are not equal, then the analyst has counted some trades as
supply only and others as demand only. These numbers do not mean what these
analysts say they do and they tell you nothing about the direction of the
gold price.
When reading interviews and articles by
prominent gold analysts – such as Jon Nadler and Jeffrey Christian – providing price
forecasts based on quantitative figures for supply and demand, keep in mind
that these numbers are meaningless and so then are their interpretations of
the numbers. Whenever I listen to or read a Jeffrey Christian interview I
feel the urge to grab him by the shoulders, shake him, and shout “Stop
talking nonsense, man!”.
In the end, the gold price is not
analyzable by quantitative measure of supply and comparing it to a
quantitative measure of demand. Supply and demand are identical and both are
equal to the total stock of gold. The price depends on the reservation price
of the owners of existing stockpiles as compared to the buy price of existing
holders of fiat money. This cannot be measured other than by the gold price
itself.
How then do we forecast the price of
gold? Personally I am sympathetic to methodologies that compare the
purchasing power of an ounce of gold over time to other assets such as a
man’s suit or the DOW index. Another approach that makes some sense to
me is looking at historical trends in gold’s total
“capitalization” compared to that of other financial assets. But
it’s hard to point to an arbitrage that would bring the price of gold
in line with historical values of these metrics.
Robert Blumen
Robert Blumen is
an independent software developer based in San Francisco, California
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