Investing in Gold

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 ittomorrow. But if you don’t buy an ounce of gold today, youmight regret it two years from now…if not sooner.

According to a freshly minted research report by Chevereuxanalyst, Paul Mylchreest, the gold price is in the processof moving higher…much higher. The confluence of severalpotent trends, says Mylchreest, will lift the gold price toat least $1,000 an ounce by 2008. If the Chevereux analystis on target, today’s gold investors need not be overlyconcerned whether they pay $550 or $600 for an ounce ofgold.

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 demandare rising…and will continue to rise. To make things evenmore interesting, the global gold market already faces anannual supply shortage of about 600 tonnes. Even though thegold price has doubled over the last few years, Mylchreestbelieves it will double yet again over the next few years,if not quadruple to a “super spike” price of $2000 anounce. We are persuaded by his bullish arguments.

World mine production has failed to increase since the endof the 1990s, and actually fell by 5% in 2004, according tothe World Gold Counsel. The drop in production is no greatmystery. Gold prices were so low throughout the 1990s, thatthe mining companies sharply curtailed their explorationefforts. “[Once] exploration has been sharply cut,” NewmontMining’s CEO, Pierre Lassonde, explains, “it takes at leastseven to eight years for a rise in price to generate notjust exploration, but the subsequent exploitation of theresults…” In other words, the global gold mining industrywill not be ramping up supplies any time soon.

Meanwhile, Western central banks appear to be curtailingboth “official” and “unofficial” sales of gold. In the nameof “reserve diversification,” these banks have beenunloading tonnes of gold from their vaults every year.(Ironically, Eastern central banks have enlisted theidentical phrase to INCREASE their gold holdings). Europeancentral banks, in particular, have been conspicuous sellersof gold for several years. At the same time, they have beenlending their gold to bullion banks, who in turn, have beenselling it – in some way, shape or form – into the openmarket.

But now it appears that Western central banks are reducingtheir direct official sales, while also restraining theirgold-lending activities. Chevreux estimates that centralbanks have trimmed their gold loans outstanding by morethan 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 goldproducers “sold forward” their production to lock in aprofit. These hedging transactions have been artificiallysuppressing the gold price for several years. But now thatthe gold price is rallying, many mining companies fear thatselling their future production at today’s prices willmerely hedge away their future profits. So they are cuttingback. Chevreux estimates that global gold producers havetrimmed their forward sales by about 42% – a drop from2,271 tonnes to 1,323 tonnes.

All the while that the above-cited sources of supply aredrying 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 wouldhave to purchase more than 680 tonnes of gold in the openmarket (equivalent to 27% of last year’s mine supply). Wedo not anticipate a change of this magnitude in 2006;however,…even a slight shift towards higher gold reservelevels outside of Europe and the USA could have an enormousimpact on the price of gold.”

The notion is not so far-fetched, as the tables aboveimplies. Several Eastern central banks hold grotesquelylarge positions in U.S. Treasury securities, alongsidetheir curiously petite holdings of gold. But recently, afew key banks have halted or slowed their purchases ofTreasuries. “There has certainly been a slowdown in therate at which China has been buying US Treasuries in thesecond half of 2005,” Chevreaux notes, “and Japaneseholdings have been flat throughout 2005. These trends forthe two largest holders of Treasury securities are apotential worry for the US Treasury and the Fed.”

Perhaps that’s part of the reason that individual investorsare also piling into the gold market. Individual investorsare snapping up everything from numismatic coins to goldstock mutual funds. The StreetTRACKS Gold Trust (NYSE:GLD), which launched late in 2004 with a marketcapitalization of less than $200,000, already boasts amarket cap greater than $6 billion – making it the seventhlargest publicly traded gold stock.

Investing In Gold: The Value of Gold

But still, gold and gold stocks represent a surprisinglysmall portion of most investment portfolios. The marketcapitalization of the world’s ten largest gold stockstotals less than $100 billion, which is less than one thirdof the market cap of General Electric. The market forphysical gold is also relatively small. “The value of allthe gold on the planet is $2.7 trillion, based on a $550price per ounce,” Chevreux calculates. By comparison, thetotal value of the US stock and bond markets exceeds $35trillion.

“If, therefore, investors attempted to divert even 1% ofthe value of the U.S. stock and bond markets into gold,”Chevreux fantasizes, “this would be equivalent to $350billion, or roughly 19,800 tonnes of gold. This amounts to13% of all the gold in existence and is nearly eight timesthe annual production of mined gold.”

Commodity funds are also sniffing around in the goldmarket. And while these fickle, short-term investors mightnot establish long-term positions in the gold market, theirshort-term activity could create the sort of drama thattriggers follow-on buying and leads to much higher prices.

“At some point, both central banks and private institutionswill have their fill of dollars,” former Fed chairman, PaulVolcker, remarked one year ago. “I don’t know whetherchange will come with a bank or with a whimper, whethersooner or later…It is more likely that it will befinancial crisis rather than policy foresight that willforce 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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Here are some resources about Investing in Gold:

CNN Money Business news and financial market coverage

Gold World #1 Resource Site for Gold, Silver, Copper & Beyond

Investopedia Your Source For Investing Education. Includes the most comprehensive investing dictionary on the web as well as articles and tutorials

Monex America’s billion dollar buy and sell market for bullion and precious metal trading

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