Thursday, November 19, 2009

Gold Observations

Last Thursday we talked about Gold and when I made a return to work this week after a multi-week absence, several colleagues were keen for my thoughts on the yellow metal.

With Gold leaping to yet another all-time high in early London trade on Wednesday (coming within 50¢ of $1150 an ounce), the 64 thousand dollar question becomes: is it a bubble that is about to burst or will Gold go higher?

So let's consider what's happening.

As was stressed last week, the real motivation for the movement to Gold is not as a hedge for inflation. The reality is that it performs that role very poorly.

The current move to gold around the world is a hedge against the mismanagement of the state - which at this time and place is the United States with it's world's reserve currency status.

We are currently witnessing perhaps the most profound paradigm shift in gold from the patterns seen over the last 20 years. During that time European monetary authorities sold the precious metal and Asian central banks accumulated official reserves in the form of US Treasuries.

But now that pattern is being turned on its head.

Currently, sales in Europe have slowed to a crawl and Asian banks have started swapping their dollars for gold.

GFMS, the London-based consultancy, estimates that over the past 20 years net sales from the official sector have run at an annual rate of about 400 tonnes - about 11% of the total supply. But the combination of slower sales in Europe and fresh gold purchases in Asia are set to cut the official sector's bullion net sales to about 50 tonnes this year, the lowest level since 1988.

The shift is important for the gold market on two fronts: the interest provides psychological support and, more important, caps a source of supply.

Things began to really pick up steam when the IMF approved the sale of 403.3 tonnes of gold back in September 2009. In a completely unexpected move, India was the official purchaser of 200 on those tonnes in October.

It is largely understood that India sold holdings of US Treasuries to make the purchase.

Next up came the central bank of Sri Lanka who purchased gold in the open market at market prices, another surprise move.

Now the IMF has announced that Mauritius' central bank bought gold at market prevailing prices on November 11 for about $71.1 million (US Dollars) in total. According to data from the London Bullion Market Association, gold was quoted on the afternoon "fixing" that day at USD 1,115.25 a troy ounce, a record high at that time.

Before the transaction, Mauritius - a tiny nation made up of islands in the Indian Ocean more than 1,000 kilometres off the East coast of Africa - held 1.9 tonnes of bullion - 3.2% of its total official foreign reserves - according to data from the mining industry-backed World Gold Council. The purchase more than doubles the reserves to 3.9 tonnes.

It's another brutal kick in the teeth to the concept of nation states storing their wealth in the in the security of US Treasuries.

Even Zimbabwe, which a year ago had hyperinflation running at 231 million percent annually, is now considering reintroducing its Zimbabwe dollar, but this time fully backed by assets, including gold.

With India, Sri Lanka and now Mauritius adding to their gold reserves – and with Zimbabwe looking to purchase gold, it is putting extreme pressure on the gold supply. "It is the sentiment that matters" and not the size, says VM analyst Gary Mead in the latest BNP Paribas Fortis Metals Monthly. "The bottom line is that the Gold Price rally has got everything going for it right now: Few official sector sellers, some official sector buyers, a low-interest rate environment, and a weak US currency. It's a perfect storm."

Included in that perfect storm are the following elements:
  • Decreasing Gold Mine Production - Annual worldwide mine production of gold has decreased by 9.3% since 2001. Gold prices have nearly quadrupled since then, but more gold is not being produced because resources are being depleted and the quality of those resources is diminishing. When a discovery is made, it takes about 7-10 years to get a mine permitted and into production, making it difficult to quickly ramp up gold production.

  • Investment Demand for Gold - Large institutional investors, such as hedge and pension funds, are making large allocations to gold and gold shares. Individual investors are also getting in on the action, with gold exchange-traded funds (ETFs) gaining influence. SPDR Gold Trust (NYSE: GLD), the largest physically backed ETF on the planet, is now the 6th biggest holder of gold bullion with more than 1000 tons. That is helping to facilitate and spread the ownership of gold by individuals. In fact, in the first half of 2009 investment demand for gold is up 150% over the first half of 2008, according to the World Gold Council.
  • Asian Demand for Gold is Exploding - Asia, with its more than two and a half billion people, has a major impact on investment demand. Asians have a long-standing cultural affinity for gold as a store of wealth. India is the world’s largest gold consumer. For the last 50 years, until 2009, the Chinese government has forbidden its citizens from owning gold. But now China is encouraging its citizens to buy both gold and silver. Today, Chinese investors even have access to gold-linked checking accounts. As a result, demand for gold in mainland China is expected to triple in the next few years.

Gold’s price has increased every single year since 2001. In 2001 gold sat at $300 an ounce. It has risen now for eight consecutive years. Are we currently in the middle of a secular bull market for gold?

Bull markets typically last about 17 years and end with a mania stage where investors throw the concept of supply and demand out the window and frantically invest in gold. Analysts note that this pattern has repeated itself over the last hundred years of investment history.

More importantly, when adjusted for inflation, gold is nowhere near that highs it attained in the 1980s. Adjusted for inflation, gold should be at $2,000 an ounce.

And if these factors are going to place even more upward pressure on the metal than the 1980s did, it would suggest that we are about to see a major run up in gold prices.

The gold market is very small in relation to the currency, bond or stock markets, so when investors start to pile in, it could just send prices through the roof.

As a side note Jim Rogers, the renowned global commodities investor and author, said he doesn’t ever like to buy something making all time highs but he is not selling his gold. He believes Gold is going to go much higher in the course of the bull market. He also warned that it doesn’t mean it can’t go down 20% next year but during the course of the bull market it is going to go much higher and whatever you are seeing is not a bubble yet.

Jim also said that being a contrarian, he should be selling gold when others are buying. But he hastens to add that he also sells at the top and that he doesn’t think this is the top.

“In my view, in this bull market in commodities gold will make all new highs adjust for inflation,” he said.

A possible coming drop of 20% in the price of Gold?

So my response to my colleagues was to read today's blog.

Like so much of everything we discuss here, the issue is all about confidence in the economy of the United States. You need to investigate that issue thoroughly and make decisions accordingly.


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