Signs of 'tipping point' in gold already emerging
The gold price could still rise substantially over the next 18 or so months. “$700/oz, $800/oz, even $900/oz gold prices are, to me, not unrealistic, if certain conditions are met,” affirms precious metals consultancy GFMS CEO Paul Walker. (GFMS recently published its Gold Survey 2006.) “I am definitely bullish about gold,” he states.
“But there are clouds out there for gold, further down,” he warns. “We are starting to reach a tipping point.” The key forces at play today in the gold market are the exchange-traded gold funds (ETFs) and the jewellery market.
“Gold is definitely not a dollar story – I think gold is dancing to a different tune; for the first quarter of this year, the correlation between the gold price and the dollar:euro exchange rate was only 25%,” he highlights.
Nor is it a petroleum story – the correlation between the oil and gold prices is almost equally poor.
The central banks which are members of the Central Bank Gold selling Agreement (CBGA) are likely to sell between 400 t and 450 t of gold this year, which will represent a sizeable drop over last year’s record figure of more than 650 t; other central banks are likely to buy gold.
However, non-CBGA central banks have typically been net sellers of roughly 100 t/y of gold, so their probable switch to buying this year, although “decent” in quantity, will only make them modest net buyers.
“CBGA countries hold an average of 44% of their reserves in gold, which is top heavy – their sales are simply an asset diversification exercise,” explains Walker.
(The US has 71% of its assets in gold, which would be decidedly top heavy if it were not for the current deficit-burdened state of the US economy.) None of the major East Asian dollar holders are expected to significantly buy gold in the short to medium term.
In fact, some central banks have expressed the view that the gold price has probably reached too high a level for them to make substantial purchases.
GFMS has a permanent office in Beijing (as well as in India, and Australia, in addition to its head office in London) – indeed, the research undertaken by the company for its annual gold, silver and platinum reports involves its 18 analysts and consultants visiting some 300 companies in 39 countries over 12 months.
As for retail consumption of gold – that is, sales of gold coins and gold bars – you can, at present, pretty much forget it.
“The retail investment market is very flat – frankly, it’s disappointing: bar hoarding is lacklustre and official gold-coin production is flat, and this in a bull market!” he avers.
Globally, coin fabrication fell by 3% and bar hoarding increased by a mere 2%.
“Retail interest in gold seems to have evapor- ated, but the jury is still out on whether this is a temporary or permanent development,” he adds.
India, of course, remains the exception, but sizeable increases in Indian bar hoarding were almost entirely offset by the significant drop in hoarding by the Japanese.
Concerning industry, the manufacture of gold bonding wire for electronics consumed about 145 t last year.
“This is a high margin market, a growth market – it was up 3,3% year-on-year,” he highlights.
On the supply side, the quantity of gold scrap supplied to the market in 2005 was only 1,5% greater than in 2004.
The first quarter of this year, however, saw a major increase in the scrap price.
The amount of gold locked up in hedging arrangements, which reached its peak in 1999, has been declining ever since, and continues to do so: that producer dehedging involved only about 130 t last year as against more than 400 t in 2004 was a result of exceptional circumstances; gold miners are generally still hostile to hedging, and GFMS forecasts that dehedging levels could reach 200 t to 300 t this year.
“The South African, American, Australian and Canadian share of world gold production has been in decline for quite some time, and this continues,” points out Walker.
The largest production declines year-on-year (2004/5) were in South Africa and Canada, with South African production falling 46 t to its lowest level since 1923.
However, these declines were slightly more than balanced by production increases elsewhere – global mine production rose by 2%.
The world’s two largest gold-mines – Indonesia’s Grasberg and Peru’s Yanacocha – both delivered markedly stronger performances last year.
The biggest contributors to new production were Lagunas Norte, in Peru, El Sauzal, in Mexico, and Telfer, in Australia.
There will be further new mines commissioned this year, while those commissioned last year or (like Telfer) at the end of 2004 will ramp up to full production.
This should result in a 90 t, or 4%, increase in mine production this year.
On the cost side, global gold-mining costs increased by 8% and cash costs by 7%.
While South Africa and Australia remained the highest cost countries, it was North America that saw the greatest annual increase in costs last year, with Canada seeing a jump of 19% and the US up 11%.
Which leaves us with what are now the twin hearts of the gold market: jewellery and ETFs.
“ETFs have changed the market for gold; they have generated a new, broader, marketplace for the metal – a new kind of investment universe – and this is very important,” asserts Walker.
“The outlook for ETFs is potentially huge; gold holdings in ETFs could double or treble: we’re on the cusp of this over the next 18 months,” he expands.
Significantly, investors in ETFs include major companies seeking to diversify their investments and which are and will be long-term investors.
And it is investment which is driving the current and continuing bull run.
This investment wave is sustained by the “high probability” of a sharp decline in the growth of the US economy and a slide in the dollar.
“There will be a major decline in the dollar; internal and external balances will eventually force it to crack and it’ll be ugly, perhaps even reaching $1,50:€1,00 to $1,60:€1,00,” he affirms, “but the question is: when?” At present, there is no answer.
Other gold investment drivers are thought to be greater inflationary pressures and the increasing political tensions in the Middle East.
On the other hand, rising short-term interest rates put gold at a disadvantage and thus create a negative for gold for investment.
But what of jewellery? “Of the total above-ground gold stocks, 52% of the estimated total of 155 500 t is in jewellery – the official sector gold holdings account for only 18%,” he emphasises.
Jewellery is also the biggest demand sector for gold, making it the single most important support for the gold price.
And it is here that the warning lights are flashing red – the gold price is getting too high for the jewellery market.
“I’ve been surprised by how resilient so many jewellery markets have been; one reason is the expectation on the part of jewellery buyers of yet higher gold prices – but that will turn; I am nervous, as the fundamental supply and demand support for gold at these prices is increasingly weak,” he says.
While jewellery demand for gold increased by nearly 100 t last year, this increase was almost entirely in the first half of the year, which was marked by stable prices in the low $400/oz range.
By the fourth quarter of 2005, and early 2006, a marked weakness was obvious in this market.
The total jewellery offtake of gold for this year could drop as much as 500 t over last year, or by 20% to 30%.
And the higher the price goes, the more jewellery demand will go down.
Over the next 18 or so months, demand for investment and es- pecially the rocket-like rise in ETFs will more than counterbalance this fall.
But then supply will again come to exceed demand and the cycle will turn once more.
“The gold price may indeed hit $850/oz or higher, but then there will be a correction, which has the potential for being fairly sharp, and the gold price will go down, unless investors can be persuaded to stay in the market or if the jewellery market fully accepts higher prices – which is unlikely,” warns Walker.
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