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The fact that investors around the world are turning to gold is
remarkable. Unlike a bond, stored
gold offers no yield and, unlike a stock, gold provides no leverage to the
performance of an enterprise.
Buying gold is not an investment per se, compared, for example, to
buying a gold mining stock, where a company’s financial performance is
linked to its resources and production, at the same time providing leverage
to the gold price. In fact,
industrial applications for gold consume far less than the annual supply,
thus investing in gold is fundamentally different from other
commodities. According to the World Gold Council (WGC), investment demand for gold, e.g., from
Exchange Traded Funds (ETFs), was up 46% in the third quarter of 2009.
Gold is commonly viewed as an inflation hedge and, because it is the
only financial asset with no counterparty risk, as a safe haven, but the
spectacular rise in the gold price indicates more than caution on the part of
investors. Gold hit a low of
$713.50 per troy ounce on November 13, 2008 (London Bullion Market
Association PM Fixing) and closed at a 52-week high of $1,115.25 on November
11, 2009, up an astounding 56.31% from its 52-week low.
Chart courtesy of StockCharts.com
Central bank gold is the proverbial elephant in the room that no one
wants to talk about. With official
gold holdings of 29,633.9
tonnes of gold worldwide, compared to world gold production of roughly 2,400 tonnes per year, central bank gold
sales, leases and purchases, have a huge influence over the gold price. Central banks are changing
their reserve asset compositions and a number of central banks, led by India and China (which has been
the
world’s largest gold producer since 2008), are buying gold.
Evidently, the full faith and credit of the United
States of America isn’t what it used to
be. Faced with a weakening
world reserve currency, the questionable
status of the world’s largest economy, and unsustainable
US government spending, central
banks are rendering a quiet vote of no confidence on the US dollar.
The US economy, the US government, US banks, and US stock markets
exhibit various problems including unemployment, looming commercial
real estate defaults, the US budget deficit, a massive public debt
and huge unfunded liabilities, residual
toxic assets on bank balance sheets, mounting mortgage defaults and credit card
delinquencies, an emerging stock market
bubble, etc. Unless the economic problems of the US
can be addressed, the US dollar will quite probably loose its status as world
reserve currency. Whether a
transition to a new world reserve currency would take place in a cooperative
manner, e.g., a managed retreat of the US dollar, or in a more disruptive way
is unclear.
Gold Supply and
Demand in 2009
Under ordinary economic conditions, a rising gold price might reflect,
for example, increased demand, the effects of currency debasement or
inflation expectations, but a sustained rise in the gold price characterized
by growing global investment demand indicates something more. New York University Professor of
Economics Nouriel Roubini has suggested that commodity prices reflect an
emerging global asset price bubble fueled by the
fast-growing US dollar carry trade. While Professor
Roubini’s ”mother of all carry trades“ thesis accounts for
the effects of low US interest rates driving global speculation and a decline
in the US dollar, it does not specifically consider gold, which has unique
supply and demand characteristics.
Based on data provided by the WGC, Gold Fields Mineral Services Ltd. (GFMS), and the US
Geological Survey, the world gold supply is expected to be approximately 2,400 tonnes in
2009. Gold demand is expected to
exceed supply by roughly 1032 metric tonnes (1 metric tonne is the equivalent
of 32,150.7466 troy ounces), a large shortfall equal to 43% of the gold
supply.
Assuming the average decline in industrial consumption for all of
2009, compared to 2008, will be roughly the same as that of the most recent
quarter:
- The jewelry industry, by far the largest
industrial consumer of gold, is expected to consume roughly 1,705 tonnes
of gold by the end of 2009.
Jewelry demand was down 22% in the third quarter and is expected
to account for only 71.04% of the 2009 gold supply.
- The electronics industry, where consumption was
down 25% in the third quarter, is expected to consume roughly 76.1
tonnes of gold by the end of 2009.
- The field of dentistry, where consumption was
down 11% in the third quarter, is expected to consume roughly 49.75
tonnes of gold by the end of 2009.
- For all other industries, where consumption was
down in the third quarter an average of 9%, total consumption is
expected to reach 79.08 tonnes of gold by the end of 2009.
Total industrial demand is, therefore, expected to reach 1,909.93
tonnes of gold by the end of 2009, or approximately 79.58% of the estimated
2009 gold supply.
Although gold is not actually circulated as money, gold
coins and bullion bars are in high demand and investment demand was up 46% in the third quarter. Investment demand is expected to
account for roughly 1,727 tonnes of gold in 2009, an amount that exceeds the
demand of any single industry.
Outside of the electronics industry, where scrap gold
recovery is high, and the
field of dentistry, gold is not typically consumed destructively. As a result, unlike any other
commodity, the vast majority of gold mined throughout history, estimated at 162,780 tonnes by the end of 2009, remains in existence today.
Central Bank Gold
and the US Dollar
Despite the fact that it is not generally used as money, gold is held
by central banks as a currency reserve and official
central bank gold holdings amount to 29,633.9 tonnes worldwide. Official gold holdings represent
roughly 18.2% of all gold ever mined and the expected 2009 gold supply is
equivalent to roughly 8.1% of official gold holdings.
Since gold no longer served an official monetary purpose after 1971,
which marked the end of the Bretton Woods system, central banks began to sell
and to lease gold based on their individual requirements and continued to do
so until 1999. Prompted by the UK Treasury’s planned sale
of 415 tonnes of gold (58.04%
of UK gold reserves at the time), the Washington
Agreement on Gold was established
in 1999 to maintain the value of remaining central bank gold reserves by
coordinating central bank gold sales.
Under what is now the Central Bank Gold Agreement (CBGA), central banks have sold gold in limited
quantities (400 tonnes annually between 1999 and 2004, 500 tonnes annually between 2004 and 2009, and 400 tonnes
in 2009). However, official sales do not account
for gold leasing.
Central banks lease gold to earn interest thus offsetting storage
costs by leveraging what had been until this year an otherwise marginalized
financial asset to generate cash flow.
Rather than borrowing cash at higher interest rates, gold producers,
for example, may lease gold and sell it to raise cash, paying the lessor in
physical gold from future production.
Gold dealers may wish to lease gold in order to cover derivative
positions, such as options or futures, either paying the lessor in physical
gold or settling contracts in cash.
In cases where leased gold is sold by a lessee into the open market,
the gold supply is affected, which might affect the gold price. Although gold lease
rates, which have been
historically lower than interest rates, and central bank
participation in gold
leasing arrangements are documented by the London Bullion Market Association
(LBMA) and other organizations, gold leasing remains an unregulated
market. Since gold leases can be
settled either in gold or in cash, it is difficult to calculate the effects
of gold leasing on the supply and demand dynamics of gold or on the gold
price. In any case, since 2008, central banks have reduced gold leasing at traditionally low rates, e.g., rates below 1%.
What is more important is that central bank
gold sales had begun falling short of the annual sales allotment of the CBGA in 2006, declining to an
estimated 345.5 tonnes in 2008. Since
1999, the gold supply has averaged approximately 2495 tonnes per year, while
central bank gold sales through 2008 averaged an estimated 394 tonnes,
equivalent to 15.8% of annual supply on average. In 2009, however, central banks became net buyers of
gold and some central banks began
to repatriate gold reserves. China,
for example, began adding gold to its reserves and India recently agreed to purchase
200 tonnes of gold from the
International Monetary Fund (IMF).
Setting aside gold leasing, central bank gold sales, having
effectively added an estimated 15.8% annually to the gold supply for the past
decade, can only have had a dampening effect on the gold price and as well as
on gold investing. Therefore, the
effect of central banks rather suddenly switching from net sellers of gold to
net buyers of gold is equivalent to a reduction in the 2009 gold supply of
approximately 15.8%.
In addition to the projected 43% shortfall in the 2009 gold supply,
the US
dollar’s precipitous decline led to a rise in commodity prices across the board. The US Dollar Index hit a 52-week low
of 74.93 on November 9, 2009, down approximately 16.39% from its 52-week high
of 89.624 on March 4, 2009.
Chart courtesy of StockCharts.com
Demand for gold in 2009 is expected to exceed the supply by 43%,
including a reduction in supply of approximately 15.8% due to the effective
termination of central bank gold sales, while the US dollar is down approximately
16.39%. At the same time, there
has been a fundamental shift in central bank policy. Eastern central banks in particular,
led by India and China,
are buying gold, while Western central banks have cut back gold sales and
have reduced gold leasing at traditionally low rates.
Setting a Gold
Price Target
The 16.39% decline of the US dollar tends to be reflected rather
directly in commodity prices, thus the gold price, considering that the
demand for gold is global, could reasonably be expected to rise approximately
16.39% from its 52-week low in 2009 based solely on the decline in the US
dollar.
The effect on the gold price of the 2009 supply shortfall of 1032
metric tonnes could be extraordinary if obvious shortages were to occur, or
it might be nominal if consumers of gold were to substitute another
commodity, e.g., silver.
Substitution, however, seems very unlikely both in terms of industrial
uses for gold and in terms of investment demand. Thus, a naive estimate of the impact
of the supply shortfall on the gold price might assume that the gold price
would rise no more than the shortfall in supply, i.e., by no more than 43%
(inclusive of the estimated 15.8% reduction in supply due to the effective
termination of central bank gold sales and setting aside entirely the subject
of gold leasing).
Combining the
16.39% decline of the US dollar and the estimated 43% shortfall in supply
might suggest a gold price approximately 62.6% higher than the 52-week low of
$713.50 (London PM Fix), which occurred on November 13, 2008, 1 year ago,
i.e., a naive price target of 1,160.15 as of November 2009. The 52-week high
of $1,115.25 on November 11, 2009 was approximately 56.31% higher than the
52-week low, thus the actual gold price at that point was lower by roughly
6.29% compared to the 52-week low than the naive price target of 1,160.15.
Based on these estimates, the gold price does not seem to indicate an asset
price bubble.
Which Way is the
Elephant Going?
The proverbial elephant in the room is on the move and the room is not
very big in comparison. It seems
likely that Western central banks are holding off further gold sales, at
least while discussions on a new world reserve currency, i.e., IMF Special Drawing Rights (SDRs), are taking place. Led by India
and China,
key IMF members
want gold included as a component
of the a world reserve currency.
As long as using gold as a component of a new world reserve currency
is a possibility, not only are central bank gold sales on hold but central
banks will almost certainly continue to buy gold in the foreseeable future.
There is no fundamental reason for the current gold price trend to
reverse in the foreseeable future, and, despite the steep rise of the gold
price in 2009, gold does not appear overvalued. It seems possible, although unlikely,
that if gold were to again be marginalized in a new world reserve currency
regime, as it was under the US dollar standard after 1971, central banks
might again start selling and more aggressively leasing gold at some point in
the distant future. In that case,
the gold price would eventually fall, perhaps to some stable, lower level,
once again reflecting the conflicting desires of central banks to both
leverage their gold reserves and also maintain their value. However, given the global financial
crisis stemming from of the US dollar’s 64-year reign as world reserve
currency, it seems much more likely that central banks will guard their
hoards jealously in coming decades.
Alternatively, if a new world reserve currency were to emerge having a
significant gold component, what would then be a certainly higher gold price
would likely remain at a higher level indefinitely. It also remains possible that the
decline of the US dollar could accelerate or that the apparent differences
between Eastern and Western central banks could become more acute, in which
case the gold price could rise more rapidly and the process of deploying a
new world reserve currency might be accelerated as well as potentially
disruptive.
The Hindu deity Ganesha, widely revered as the Remover of Obstacles,
is readily recognizable because he has the head of an elephant. Gold languished from 1971 until 2009
as a commodity that central banks had little better to do with than to
systematically dissipate through sales and leases, while the most significant
problem they thought they faced was the risk of dishoarding too much too
quickly. From 1971 until 2009,
central bank gold entering the market was a factor of the gold price and a
risk for investors. After 38
years, the effective termination of central bank gold sales has rather
abruptly removed that obstacle.
Desiring to mitigate risks associated with the US dollar, central
banks, led by India and China,
have, in effect, promoted gold from its 38-year status as a non-financial
commodity once again to its historical role as the premier global financial
asset. This historic change in
central bank policy signifies a profound break with the past and broadcasts a
clear message: gold is a world-class financial asset fairly valued at more
than $1,000.00 per troy ounce.
With this momentous event, the words “as good as gold”
again have meaning.
An analysis of supply and demand fundamentals suggests that the
current gold price does not indicate an asset price bubble, and the historic
change in the status of gold by central banks implies a major revaluation not
yet reflected in the gold price.
As the restructuring of the global economy continues, particularly
with respect to the world reserve currency, there is a clear possibility that
the gold price will move up sharply from current levels.
Ron Hera
Hera Research
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by Ron Hera
Ron Hera is the founder of Hera Research, LLC, and the principal author of the Hera Research
Monthly newsletter. Hera Research provides deeply researched analysis to help
investors profit from changing economic and market conditions
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About Hera Research
Hera Research, LLC, provides deeply researched
analysis to help investors profit from changing economic and market
conditions. Hera Research focuses on relationships between macroeconomics,
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investment opportunities with extraordinary upside potential. Hera Research
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