Investing In Gold: Let the Hoarding Begin…
A Daily Reckoning White Paper Report
By Eric J. Fry – Editor, The Rude Awakening
If you buy an ounce of gold today, you might regret it tomorrow. But if you don’t buy an ounce of gold today, you might regret it two years from now…if not sooner.
According to a freshly minted research report by Chevereux analyst, Paul Mylchreest, the gold price is in the process of moving higher…much higher. The confluence of several potent trends, says Mylchreest, will lift the gold price to at least $1,000 an ounce by 2008. If the Chevereux analyst is on target, today’s gold investors need not be overly concerned whether they pay $550 or $600 for an ounce of gold.
Investing In Gold: A Gold Rising
All major sources of supply are declining, says Mylchreest, at the very same moment that many major sources of demand are rising…and will continue to rise. To make things even more interesting, the global gold market already faces an annual supply shortage of about 600 tonnes. Even though the gold price has doubled over the last few years, Mylchreest believes it will double yet again over the next few years, if not quadruple to a “super spike” price of $2000 an ounce. We are persuaded by his bullish arguments.
World mine production has failed to increase since the end of the 1990s, and actually fell by 5% in 2004, according to the World Gold Counsel. The drop in production is no great mystery. Gold prices were so low throughout the 1990s, that the mining companies sharply curtailed their exploration efforts. “[Once] exploration has been sharply cut,” Newmont Mining’s CEO, Pierre Lassonde, explains, “it takes at least seven to eight years for a rise in price to generate not just exploration, but the subsequent exploitation of the results…” In other words, the global gold mining industry will not be ramping up supplies any time soon.
Meanwhile, Western central banks appear to be curtailing both “official” and “unofficial” sales of gold. In the name of “reserve diversification,” these banks have been unloading tonnes of gold from their vaults every year. (Ironically, Eastern central banks have enlisted the identical phrase to INCREASE their gold holdings). European central banks, in particular, have been conspicuous sellers of gold for several years. At the same time, they have been lending their gold to bullion banks, who in turn, have been selling it – in some way, shape or form – into the open market.
But now it appears that Western central banks are reducing their direct official sales, while also restraining their gold-lending activities. Chevreux estimates that central banks have trimmed their gold loans outstanding by more than 2,000 tonnes over the last two years.
Investing In Gold: Hedging Transactions
The global gold mining industry is also reducing its gold-selling activities. Throughout the 1990s, many gold producers “sold forward” their production to lock in a profit. These hedging transactions have been artificially suppressing the gold price for several years. But now that the gold price is rallying, many mining companies fear that selling their future production at today’s prices will merely hedge away their future profits. So they are cutting back. Chevreux estimates that global gold producers have trimmed their forward sales by about 42% – a drop from 2,271 tonnes to 1,323 tonnes.
All the while that the above-cited sources of supply are drying up, demand is soaring.
Investing In Gold: Gold and Foreign Exchange Reserves
The central banks of China and Russsia, for example, have been boosting their gold holdings, while promising to buy even more. Last November, the Russian central bank announced plans to double its gold reserves. A few days later, President Putin remarked, “I support the proposal that the central bank pay greater attention to precious metals in forming our gold and foreign exchange reserves.” Chinese officials have voiced similar intentions…all of which conjures up some fascinating ‘what if’ scenarios.
For example, even though Japan and China have the eighth and tenth largest gold holdings in the world, these gold holdings are equivalent to only 1.1% and 1.3% of their respective reserves. “If we were to assume,” Salman Partners reasons, “that these two countries were to increase their holdings by 50%, to [only] 1.6% and 2.0% of reserves, respectively, these two central banks alone would have to purchase more than 680 tonnes of gold in the open market (equivalent to 27% of last year’s mine supply). We do not anticipate a change of this magnitude in 2006; however,…even a slight shift towards higher gold reserve levels outside of Europe and the USA could have an enormous impact on the price of gold.”
The notion is not so far-fetched, as the tables above implies. Several Eastern central banks hold grotesquely large positions in U.S. Treasury securities, alongside their curiously petite holdings of gold. But recently, a few key banks have halted or slowed their purchases of Treasuries. “There has certainly been a slowdown in the rate at which China has been buying US Treasuries in the second half of 2005,” Chevreaux notes, “and Japanese holdings have been flat throughout 2005. These trends for the two largest holders of Treasury securities are a potential worry for the US Treasury and the Fed.”
Perhaps that’s part of the reason that individual investors are also piling into the gold market. Individual investors are snapping up everything from numismatic coins to gold stock mutual funds. The StreetTRACKS Gold Trust (NYSE: GLD), which launched late in 2004 with a market capitalization of less than $200,000, already boasts a market cap greater than $6 billion – making it the seventh largest publicly traded gold stock.
Investing In Gold: The Value of Gold
But still, gold and gold stocks represent a surprisingly small portion of most investment portfolios. The market capitalization of the world’s ten largest gold stocks totals less than $100 billion, which is less than one third of the market cap of General Electric. The market for physical gold is also relatively small. “The value of all the gold on the planet is $2.7 trillion, based on a $550 price per ounce,” Chevreux calculates. By comparison, the total value of the US stock and bond markets exceeds $35 trillion.
“If, therefore, investors attempted to divert even 1% of the value of the U.S. stock and bond markets into gold,” Chevreux fantasizes, “this would be equivalent to $350 billion, or roughly 19,800 tonnes of gold. This amounts to 13% of all the gold in existence and is nearly eight times the annual production of mined gold.”
Commodity funds are also sniffing around in the gold market. And while these fickle, short-term investors might not establish long-term positions in the gold market, their short-term activity could create the sort of drama that triggers follow-on buying and leads to much higher prices.
“At some point, both central banks and private institutions will have their fill of dollars,” former Fed chairman, Paul Volcker, remarked one year ago. “I don’t know whether change will come with a bank or with a whimper, whether sooner or later…It is more likely that it will be financial crisis rather than policy foresight that will force the change.”
At some point, in other words, gold will flirt with a four-digit price tag…that point may be fast-approaching.
Eric J. Fry
for The Rude Awakening
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