Why all things aren't equal for gold
Amanda Lang
Financial Post
NEW YORK - If only gold behaved like other commodities, one could
reasonably expect the price of bullion to rise.
Two separate industry groups this week painted a portrait of wonderful
conditions for producers: rising demand coinciding with falling
production.
According to the World Gold Council, demand for gold climbed 16% in
second quarter, a record for any three-month period.
Meanwhile, the Gold Institute, a Washington industry group, said
production of gold worldwide will decline this year for the first time in
20 years and be flat for the next four years.
That should produce a price increase. For gold bugs, who have
watched the yellow metal slide in price from $420 an ounce in 1996 to
around $260 now (all in U.S. dollars), such an increase appears as
manna.
But experts warn investors shouldn't count their golden eggs just yet.
The gold market has always been split, with the physical market --
real-world demand for jewellery and industrial use -- bearing little
relation to the paper market --the vast quantity of gold bought and sold
through derivative products but never actually delivered.
The paper market can obscure the supply-demand picture to the extent
that real scarcity of the metal, which should flow through to prices and
which some experts say is the market condition right now, doesn't
produce higher prices.
Even getting a clear picture of the market can be difficult. Some
analysts believe the quantity of gold on paper doesn't exist at all. That is,
if everyone who "owned" gold tried to cash it in, the market would
suffer a major crisis.
One signal of that dissonance is clear from the concern around central
bank gold sales, said John Lutley, president of the Gold Institute.
Central bank sales have captured headlines worldwide in recent years,
but sales by banks were actually lower last year than, for instance, in
1996. And without those sales, the world would have faced a gold
shortage last year.
"Demand for gold far exceeds mine production," said Mr. Lutley, with
the difference made up by recycling or scrap and central bank sales.
The problem, said John Ing, president of Maison Placements Canada
Inc. in Toronto, is that while the paper market obscures the true picture
of supply and demand, it could also represent a pending threat.
Producers, led by Toronto-based Barrick Gold Corp., have learned to
hedge their production output. In Barrick's case, it has sold forward
about four years' worth of production, meaning it has sold at current
prices gold it won't mine for years.
Hedging allows mining companies to offset production costs while
locking in current prices, in the event bullion prices fall.
It didn't take long for savvy investment bankers to realize they could
borrow the gold for these hedging programs from central banks, which
offered low lending rates. By borrowing at, say, 1.5%, bullion banks
such as Goldman Sachs could then invest the capital in treasuries
yielding 4%, and pocket the difference.
That "gold carry" is, like the yen carry used by hedge fund Long Term
Capital Management, a bet on "spreads."
This is fine in a static environment. But as the world learned when Long
Term's yen bet turned sour, the world can be volatile.
A similar change in spreads on the gold carry would wreak havoc that
could make Long Term -- which threatened the financial system down
last year -- seem a minor incident, Mr. Ing said.
Goldman recently bought 4,700 futures contracts for bullion, Mr. Ing
noted, which could be a sign the bank wants to get its hands on some
actual gold.
"The paper market has flooded the physical market for gold," Mr. Ing
said, "which is why we are close to a 20-year low."
Ultimately, the fundamentals for gold are bullish, experts said. While
lowered production -- largely a result of cost-cutting driven by the low
price of their product -- isn't the best scenario for mining companies'
long-term results, higher prices might help gold companies jump back
into exploration in a hurry.
Meanwhile, the huge short position on gold could get squeezed out of
the market as fundamentals force the price upward, analysts said.
"These guys are sheep, when one moves, they all do," said Mr. Lutley.
Any weakening in the U.S. dollar would be good news for gold.
And, he added, investors may have new-found interest in gold if stock
markets fall sharply.
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