Analyses based on annual supply and demand of gold appear on a daily
basis, whether posted to gold web sites or in the financial media, many of
them by the most respected analysts of gold-mining shares. These articles
typically show an imbalance between supply and demand, suggesting that there
is a gold supply deficit. From there, the conclusion follows that a much
higher gold price is required in order to bring supply and demand into
balance.
There is no gold supply deficit. Even if there were, to cite Dick Cheney,
"deficits don't matter". The dollar price of gold is formed through
the balancing of total gold supply and demand against total dollar supply and
demand. The incremental supply and demand during any one-year period is
irrelevant to the price. The illusion of a deficit comes about from an
incorrect interpretation of supply and demand figures: annual amounts rather
than totals are compared.
On the supply side, the annual production of gold has almost nothing to do
with its price. Neither does decades of under-investment in gold exploration,
the lack of new discoveries of gold deposits, miners' cash cost per ounce,
nor environmental delays in permitting new mines. The output of the
gold-mining industry has very little impact on the gold price.
On the demand side, the "annual demand" for gold � as it is
computed in the models showing a deficit � is a misleading figure. The
comparison of annual amounts is relevant for a commodity that is consumed but
not one that is held as is gold. For an asset that is held, the annual demand
has no business being compared against annual supply, for the comparison
tells us nothing about the price.
Whose Deficit?
While I could cite hundreds of examples if I had been collecting them over
the years, in the interest of space, I will cite only two to make my point.
These two examples were selected not to single out the particular writers, as
there were many others that could have been chosen, but because they happened
to pass in front of me recently.
First, this
article on a mining site:
GOLD supply shortages were possible in the
long-term, according to recent research produced by Canadian research house,
Metals Economics Group (MEG). It said in a press statement that recently
discovered deposits of more than 2.5 million ounces, enough to attract the
interest of major gold producers, were not adequate to replace their
production.
And this
piece from a financial news site:
�JP Morgan believes the gold market outlook
continues to improve. Demand continues to strengthen (even if only for
one-off events such as the establishment of gold Exchange Traded Funds or ETFs),
but this stronger demand is not being met by higher supply thanks to
declining production from South Africa in particular. This means central bank
selling is required to meet the shortfall, but the quantity of this selling
is limited under agreements in place between the banks.
The Case for a Deficit
In order to understand why there is no deficit, I will explain why some
people think that there is one. (To be fair, I believe that the gold analyst
community is divided on this issue.) The problem with the supply deficit
theory is in the interpretation of the numbers, and not the numbers
themselves. Because the exact numbers don't matter so much, I will use the
gold supply and demand figures from a prominent industry source, the World Gold Council, without attempting to
verify them. Values for the last three years are found in their supply
and demand spread sheet (may require free registration). Even if slightly
different numbers were used, the point that I am going to make would not
change.
Table 1, below, is based on the WGC figures for the last two years. Note
that they do not show much of a deficit for 2004 and a slight surplus for
2005. The WGC, as far as I know, has not promoted the supply deficit
argument. However, I am citing their figures because they use the annual
supply and demand methodology, the same methodology that is used by analysts
who think that there is a deficit.
Table 1: WGC Annual Figures
(tonnes)
|
2004
|
2005
|
Supply
|
|
|
Mine production
|
2469.0
|
2520.3
|
Net producer hedging
|
-426.5
|
-131.1
|
Gold scrap
|
847.7
|
860.9
|
Official sector sales
|
469.4
|
660.6
|
Total supply
|
3359.7
|
3910.7
|
Demand
|
|
|
Jewelry
|
2612.8
|
3131.8
|
Industrial & dental
|
409.7
|
420.1
|
Bar and coin retail investment
|
397.1
|
409.2
|
Other retail
|
-56.8
|
-22.5
|
ETFs
|
132.6
|
208.1
|
Total demand
|
3495.5
|
3726.6
|
Balance (total supply � total demand)
|
-135.8
|
184.0
|
A report from the UK
branch of the French bank Cheuvreux caused considerable discussion when
it was released last year. This report, using the same flawed methodology,
showed much larger supply deficits on an annual basis. It is worthwhile to
understand the discrepancy between these two reports. On pages 26 and 27 of
the report, the information used to construct Table 2, below, appears. While
the WGC shows a surplus for both 2004 and 2005 on the bottom line a report
from the Cheuvreux report, while using essentially the same numbers as the
WGC, shows estimated supply shortfalls of hundreds of tons annually. (The
Cheuvreux report cites the World Gold Council as the source of the data but
the annual numbers differ slightly. I am not sure why but the differences are
small so it doesn't affect the argument.)
Table 2: Cheuvreux Annual Supply
and Demand
(tonnes)
|
2004
|
9M2005
|
Supply
|
|
|
Mine production
|
2461
|
1842
|
Net producer hedging
|
-427
|
-123
|
Gold scrap
|
829
|
608
|
Supply before official sales
|
2864
|
2327
|
Demand
|
|
|
Jewelry
|
2613
|
2129
|
Industrial & dental
|
409
|
316
|
Net retail investment
|
342
|
305
|
ETFs
|
133
|
125
|
Total demand
|
3498
|
2874
|
Supply Shortfall
|
-634
|
-547
|
Official Sector sales
|
475
|
489
|
Balance
|
-159
|
-58
|
The difference between the two reports using the same raw data are
substantial and must be explained. The main source of the WGC definition of
supply value includes official sector sales while the Cheuvreux definition of
supply does not. In the Cheuvreux report, the net supply minus demand (which
they call supply shortfall) is greater than the net of supply minus
demand in the WGC report by an amount approximately equal to the size of
official sector sales. Because the official sector sales are a fairly large
number, the Cheuvreux value for net of supply and demand is a negative number
in both 2004 and 2005.
Cheuvreux shows the official sector sales in a separate row appearing in
their table after Supply Shortfall. By removing official sector sales
from the supply, this format implies that official sector sales were
necessary in order to fill a deficit between the other components of supply
and the demand. While official sector sales offered "at market"
probably do affect the gold price, this impact is exaggerated by offsetting
official sales against annual figures rather than totals.
Deficits Don't Matter
Let's look at how the WGC and the Cheuvreux arrive at a deficit.
In the WGC report, a footnote states (with some caveats) that the Balance
term is partly due to residual error (presumably errors in measurement);
and that the remaining Balance is the "implied value of net (dis)
investment" ("includes institutional investment other than ETFs and
similar stock movements"). In the WGC report, a negative Balance
(deficit) would occur in any year where there are net private (non-official)
sales. (I should point out that the WGC does not use the term
"deficit", though many writers using these figures, or figures like
this, do use that term.)
The Cheuvreux report starts from the position of the WGC report, however,
Cheuvreux does not include the additional differential due to the omission of
official sector sales from their definition of supply. Cheuvreux defines a
deficit year as any year during which there were net private plus official
sector sales.
A word can be defined to mean anything, but is the definition useful? I
will argue that to define a deficit year as a year in which there are private
sector or official sales is more than a little bit misleading, because it
leads to thinking about the gold market as if it were a spot market for a
commodity that is consumed rather than held.
For a commodity that is consumed, an annual incremental deficit would
imply a higher price in the future because the deficit could only be filled
by a drawdown of existing stockpiles, which would eventually become exhausted
if the deficits continued. Upon the depletion of stockpiles, the price would
have to rise to the point where demand was in balance against only that
supply that was produced.
But gold is not that sort of commodity. There is no need at all for supply
on an annual basis excluding private sales to come into balance with
demand on an annual basis. It is not even true that these must balance over
any number of years. The reason for this is that a sale out of someone's
stockpile of gold does not reduce the total amount of stockpiled gold.
All it does is to shift the gold from the seller's private stockpile to the
buyer's private stockpile. A market could remain in a "deficit" of
this sort forever without the price ever going up (or going down) as buyers
and seller shifted the contents of their stockpiles among themselves.
Stocks and Flows
We can divide economic goods into those for which the entire annual supply
is destroyed in the process of consumption, and those for which new supply is
hoarded. Economists call the former "flows" and the latter
"stocks".
Analyzing the supply and demand over a short window of time for a
flow-type good would tell you a lot about where the price was likely to go.
But annual supply and demand for the second type � of which gold is the
premier exemplar � tells you almost nothing about its future price movement.
First, consider a good that is consumed, where by "consumed" I
mean that the economic value of a unit is destroyed over the course of its
productive life. One example is DVD players. The economic value of a player
is destroyed as the player wears out. All of the supply that manufacturers
produce must be sold. There would be no real reason for Sony to sit on
warehouses full of aging players. The price of the players can only fall as
they become obsolete, and on top of that, they are costly to store. Sony must
sell everything that they produce at whatever price the market will support
at the time.
Competition from other manufacturers to sell, and competition among
consumers to buy Sony's players, or other goods entirely, ensures that the
price at which the players are sold will be whatever price clears the market
between all buyers and sellers on a very short time scale. In micro-economic
jargon, most final goods have a vertical supply curve once they arrive at the
market. The same would be true of any perishable good, most manufactured
goods, and commodities that can only be stored for a short time, such as beef
or eggs.
But for most known commodities, the aboveground supply is relatively small
compared to the quantity that is permanently used up every year. Most of what
is mined, drilled, grown, or raised on a farmed is consumed soon after it is
produced. In some cases, large stockpiles of a particular metal � e.g. silver
� have been accumulated and in other cases accumulated stockpiles have sold
off (silver again). But absent a large stockpile the market price of these
goods is pretty close to the level that balances the recent supply and
current demand.
When it comes to a stock, total (not annual) supply and demand determine
the price of each unit. Consider the following example concerning equity
shares of a corporation. Suppose that an equity analyst appeared on CNBC
stating that the price of a common share in company XYZ, with 100M shares
issued, would rise (or fall) because they were only issuing 1M new shares
this year, while the demand for those shares would be 2M. This analyst would
be pricing the shares as if they were a stock-type of good. Using this
method, a daily volume of 1M shares would be an annual volume of about 250M,
which would create a "supply deficit" of 249M shares assuming 1M
new shares issued.
It is easy to see the fallacy here. Even if the capital raised from
issuing the new shares added no value at all to the corporation, at worst it
would only dilute the value of the existing shares by 1%. A stock with 100M
shares outstanding could easily trade 1M shares per day without the price
rising or falling as people rearrange their portfolios with some who
wish to hold fewer shares selling, and other investors who wish to hold more
shares buying.
The True Supply of Gold
To understand the price of gold, the relevant supply is the total supply,
not the new supply coming to market during the last year (or week or
month). The supply of gold consists of all of the supply that exists. The
relevant demand is the total demand, not the new demand coming to
market during any year.
For gold, there is always a large stockpile, and it never gets smaller.
The vast majority of all gold mined throughout human history still exists and
is held either in bars, coins, or jewelry. According to the WGC, this
quantity was around 155,500 tonnes at the end of 2005. Almost no gold is used
up (in the sense of being destroyed or becoming permanently unusable) ever.
In most cases when a buyer purchases gold, it moves from the seller's hoard
to the buyer's hold.
The World Gold Council estimates
that 52% of gold is held as jewelry. James Turk subdivides jewelry
holdings into low carat and high carat. The former is purchased mainly for
the gold value, as an alternative to buying bars and coins. The latter is
purchased mostly for fashion. According to Turk's estimate (which was published
in 1996), monetary jewelry at that time accounted for about 60% of jewelry
with fashion jewelry accounting for the remaining 40%. However, even when
made into jewelry, the gold is not destroyed and can come back into the
market as scrap. The WGC figures show significant recovery from scrap.
The reason that total supply and not annual supply matters is that the
gold market is not segregated into two markets. There is not one gold market
for the current year and another gold market for aboveground gold that was
mined in previous years. The gold market is a single market in which all
sources of supply are indistinguishable. Every existing ounce of gold
competes for sale with every newly mined ounce. A buyer of gold doesn't care
whether he is buying recently mined gold or gold that was held in bars for
100 years, or the product of melted jewelry.
Every ounce of gold that is held by someone is potentially for sale at
some price. While not every ounce of gold in private hands is for sale at
the current market price, any ounce of gold could potentially come to
market. A lot of gold is held in small stockpiles among widely dispersed
owners. Some is for sale just above the current spot price, some only at much
higher prices. The varying levels of prices at which different units of goods
held in a stock are offered for sale is what makes the supply curve
upward-sloping rather than vertical as is the case in consumption goods.
Is it true that a lot of gold is not for sale at all, so it should not be
counted as part of the supply? In short, no. Gold is held as a store of value
over time. The point of holding a store of value is not to hold it forever
and then have it cremated along with your corpse. A person will only store
value over time because they anticipate the need for the value some time in
the future. Anyone who anticipated having no needs in the future would not
need to store value over time. And the stored value is only stored for a
finite period of time until the person holding it becomes aware of
something that they need more than what they have stored. That would be the
time to sell.
Note also that every new ounce of gold that is mined does not need to be
sold at the current market price. Unlike most manufactured goods, gold-mining
companies do not necessarily have a vertical supply curve for their product
because it does not spoil or become obsolete. While many mining companies do
sell all of their supply at spot soon after they have mined it, some mining
companies sell their supply at a pre-determined price that in some cases was
fixed years in advance through hedging contracts. And other mining companies
choose to hold mined supply in reserve with the anticipation of selling it
later, at a higher price. Goldcorp
has done this in the past, at one point accumulating more vault gold than the
central banks of a large number of small nations.
The Demand for Gold
It is easy enough to see that the supply of gold is the total supply. But
what is the demand? It turns out that the demand is equal to the supply.
To understand this, we introduce the concept of reservation demand.
Most people are familiar with exchange demand. Exchange demand is expressed
by giving up something in an exchange in order to for the thing demanded.
Reservation demand is a demand that is expressed by holding onto something
that you own.
People who hold gold are demanding it by holding it off the market. As
Austrian economist Murray Rothbard explains,
At any point on the market, suppliers are
engaged in offering some of their stock of the good and withholding their
offer of the remainder. � This withholding is caused by one of the factors
mentioned above as possible costs of the exchange: either the direct use of
the good (say the horse) has greater utility than the receipt of the fish in
direct use; or else the horse could be exchanged for some other good; or,
finally, the seller expects the final price to be higher, so that he can
profitably delay the sale. The amount that sellers will withhold on the
market is termed their reservation demand. This is not, like the
demand studied above, a demand for a good in exchange; this is a
demand to hold stock. Thus, the concept of a "demand to hold a
stock of goods" will always include both demand-factors; it will include
the demand for the good in exchange by nonpossessors, plus the demand to hold
the stock by the possessors. The demand for the good in exchange is also a
demand to hold, since, regardless of what the buyer intends to do with the
good in the future, he must hold the good from the time it comes into his
ownership and possession by means of exchange. We therefore arrive at the
concept of a "total demand to hold" for a good, differing from the
previous concept of exchange-demand, although including the latter in
addition to the reservation demand by the sellers.
The Total Picture
Now that we have covered the total supply and total demand, the proper
rendering of the supply and demand situation would look something like Table
3, though the numbers are not exact. Note that when all sources of supply and
demand are counted, there is no deficit. Total supply and total demand must
always equal because every transaction has a seller and a buyer. Over time,
there is a gradual accumulation of the stock of gold and a possible shifting
between investment holdings (bar, coin, ETF) and jewelry.
Table 3: Total Supply and Demand
(tonnes)
|
2004
|
2005
|
Supply
|
|
|
Mine production
|
2469
|
2520.3
|
Destroyed by industrial/dental use
|
-409.7
|
-420.1
|
Recovered from scrap
|
847.7
|
860.9
|
Existing supply
|
149,131.90
|
152,038.90
|
Total supply
|
152,038.90
|
155,000.00
|
Demand
|
|
|
Industrial & dental
|
409.7
|
420.1
|
New bar and coin retail investment
|
397.1
|
409.2
|
ETFs
|
132.6
|
208.1
|
Reservation demand from prior accumulation
|
151,099.50
|
153,962.60
|
Total demand
|
152,038.90
|
155,000.00
|
Balance (total supply � total demand)
|
0
|
0
|
The price of gold is determined as is the price of any stock: by total
supply and total demand. The price is that price which balances total
supply against total demand, including reservation demand. The
price of gold, in terms of dollars, or other fiat money, balances supply of
all gold offered for sale at a range of prices in dollars with demand for
gold � including both demand to exchange dollars for gold and the reservation
demand for dollars and for gold.
Looking at supply and demand over a single year tells us nothing because
the annual supply and demand are only about 2�3% of the total supply and
demand, while the price of gold depends mostly on the other 98%.
Suppose that during a particular year, there are net sales from
stockpiles. This tells us nothing about what the price of gold will do, because
when gold is sold, it goes from the seller's private stockpile into the
buyer's private stockpile. There is no limit on the number of consecutive
years in which sellers of gold can sell out of their stockpiles as long as
there are buyers who add to their stockpiles that same year. This type of
trade in gold could go on forever without the price changing because
individuals' needs change all the time. During a given year, there will
always be some people who have an increasing need of a store of value and
others having a decreasing need. The former become buyers, the latter,
sellers.
Annual changes to supply and demand do not influence the price much, if at
all, because annual changes are small compared to the total. Around 98% of
supply during any year was previously mined. And around 98% of demand is
reservation demand, while only around 2% of demand is exchange demand for
mined gold.
Newly mined gold does have some effect on the gold price, but only insofar
as it dilutes the total supply of gold by a small amount. As previously
discussed, mine supply dilutes existing supply by about 2% annually. If the
supply of gold were diluted by 2% each year, and existing holders wanted to
hold the same amount of gold in their portfolios measured in purchasing
power terms, then existing holders would rebalance their portfolios
adding about 2% to their positions and the price of gold would have to fall
by about 2%.
If gold-mining were to increase by 50% from the current year to the next
year, would the price of gold collapse? Not at all. After a 50% increase, the
proportion of new mine supply out of total supply would only rise from 2% to
3%. Gold demand would not need to increase by 50% in terms of ounces to
absorb this supply, only by about 0.98% (1.03/1.02 � 1.0).
But even this overstates the influence of newly mined gold. It is probably
more relevant to measure demand in dollar terms rather than in ounces. In
this example, if the price of gold in dollars declined by about 0.97%
(1/0.98) while gold demand in dollars remained constant, the demand in ounces
would increase by just enough to balance the new supply. With a total demand,
properly counting reservation demand, absorbing the newly mined gold
into the market doesn't appear nearly so difficult.
Another way of making the same point is to suppose that gold-mining
stopped entirely. Investment demand by new investors in gold would have to be
met by an equal amount of disinvestment by existing holders. In that case,
then every buyer would have to buy gold from a private or official sector
seller. If an annual deficit year is defined as one in which there are net
private sector sales, the market would be in deficit every single year. No
matter how high the price moved, the market would still be in deficit. There is
no price of gold that would cure the deficit because of the way that the
deficit is defined. But the price would not necessarily go up under these
conditions because any sales out of a seller's stockpile are exactly offset
by additions to a buyer's stockpile. All that happens in a market like this
is that stockpiles change ownership from owners who value them less at that
time to owners who value them more. No general statement about the price can
be made; however, during periods of the classical gold standard, the
purchasing power of gold tended to rise by a few percent per year.
Silver is Not Gold
When it comes to silver, deficits do matter. Here I cite the works of
silver analysts David Morgan,
Ted Butler,
and Charles
Savoie. For most of the past few thousand years, annual mine supply was
in equal or in surplus over annual consumption, and stockpiles were
accumulated year after year, at one point reaching around 6 billion ounces.
Over the last forty years, stockpiles have been drawn down to nearly zero. At
the present time, all of the silver consumed during any given year is silver
that came out of the ground that year, with a decreasing contribution from
stockpiles.
With silver, it does make sense to look at net private sales from
stockpiles as filling a deficit between supply and demand. Why is this true
for silver and not for gold? For the most part, demand for silver is
consumption demand, and most consumption demand is destructive, meaning that
the silver ends up in a form where it cannot easily be reclaimed and brought
back into the market.
Therefore, the deficit of mine supply relative to destructive demand
implies a necessary sale out of stockpiles. These finite stockpiles cannot
continue to supply the world with 100Moz of silver for consumption annually.
At some point, they must be exhausted and higher prices will then be required
in order to bring supply and demand into balance on an annual basis.
To the extent that the silver is held for investment purposes, then everything
I have said about gold applies to silver. The same would be true for
photographic demand for silver because most silver used in photography is
reclaimed. Silver is partly held for investment purposes and partly consumed,
so its price behavior will result from a combination of the two models.
Conclusion
Does the non-existence of a supply shortage theory make the case for gold
weaker? I say no. At the beginning of this article, I stated that there is a
bullish case for gold. If not the mythical shortage of mined supply, then
what is it?
Analysts including Frank Veneroso, Reginald Howe, Robert Landis, John Embry, and
others affiliated with the GATA organization
have shown in a series of research
reports published over the last five years that central banks have
created what amounts to a large naked short position in the gold market using
paper derivatives. The accumulation of shorts without any offsetting longs
has been a negative for the gold price, especially during the late 90s.
But the ultimate bullish case for gold is none other than the
bearish case for fiat money, the dollar, and central banking. Gold is money
and while central banks have the ability to
debase fiat money up to a point, they are in the end limited by the
acceptability of their paper as money. The end game of the paper monetary
system is collapse and its replacement by the natural monetary order of gold.
|