On the Price of Gold
by Michael S. Rozeff
by Michael S. Rozeff
Notes of caution are appearing in market letters written by gold enthusiasts. They remain long-term bullish, but some fear that a temporary sharp setback is at hand. Others advise against buying until prices fall back somewhat. Others mention gold's volatility. Some note that commercial hedgers have increased their selling. There is rather widespread fear that gold will have a difficult time making much more headway soon. However, the more that I have studied the gold market, the more I have become long-term bullish. Gold at current prices that now seem high will eventually look cheap at these prices, I believe at this time. I caution the reader that I have no known history of forecasting gold prices accurately and that conditions can change. On December 15, 2008, I mentioned that gold would rise to $1,500 an ounce. There are many back-of-the-envelope ways to obtain price targets for gold. I can generate targets like $1,370 to $1,465, $2,040 to $2,550, and $3,000 to $5,865. In the event of a dollar meltdown, the price would go to infinity in terms of dollars.
A number of bullish fundamentals are involved. A partial list: (1) Much higher prices are in the cards because of the large government deficits and the FED's potential buying of government debt that will add to its already extended balance sheet. (2) Inflationists are at the helm everywhere one looks: in the government, in the FED, among economists, and in the press. Seldom is opinion so one-sided, and one-sided opinion is often wrong. We can expect that the inflationists will inflate to an extraordinary degree. They are trying to reflate the debt bubble, insane as that is. They know nothing else to do. When these measures fail, as they must, and markets do not recover, they may redouble their efforts, which will make gold even more attractive. (3) The chances of a general loss in confidence in government are rising as the authorities flounder around trying to solve the economic problems while making them worse. (4) The economies of the world are sinking rapidly. This means that other assets are not providing the kinds of returns that ordinarily compete with gold and dull its attractiveness. (5) The problems are too large for government to resolve by throwing money at them. They are only building up high debt burdens and underwriting further mal-investments. (6) The banking system is insolvent. It is broken. The Wall Street investment-banking model is shattered. Throughout the world, the largest banks are basket cases. This system is finished. (7) The credit and monetary systems are broken. The large states will now attempt to build a new monetary system to deal with the huge deficits and trade imbalances. The issues are thorny. This will take a long time and be a political football. (8) America, which has the leading economy of the world, is not strong financially. Americans owe the world, not the other way around. The economy, despite some strengths, has weakened over the years. (9) Inflation is going on apace at all the major central banks in the world.
The main specific risk in gold, as I see it, is that the government will suddenly steel itself and resolve the banking problems by nationalizing them and taking their bad assets away. There is almost no other way out for the powers-that-be to preserve their power and the current system. But that method alters the system drastically and reinforces stagnation if it is not handled properly. The government would probably do a nationalization badly. The method and extended time frame for doing it might create even more uncertainty and might even raise the price of gold, but I think in the end it would be a negative for gold. The main general risk is that the economic situation will stabilize and improve, but governments seem intent on not allowing that to occur. If the states moved to link their currencies to gold in a more definite fashion, I suspect the price impact on gold would be negative. While the demand for gold might rise from central banks, it would decline among the public because of a return of confidence in the paper currencies.
By way of general background, estimates of the total amount of above-ground gold range from about 108,000 to 140,000 tonnes. About 30,000 tonnes are held by central banks; about 70,000 to 80,000 tonnes are in the form of jewelry; and about 20,000 tons are held as coin and bullion. These amounts are not at all large. The amount of gold per person in the world is a tiny number, less than 1 ounce per person. The amount of gold in dollars is also a small number compared to the total world wealth. World annual production is about 2,500 tons or somewhat less.
The flight from paper assets into gold is at an early stage. The vast majority of investors, large and small, do not own gold. If any great number of investors want to buy gold at the same time, the price will shoot up. This is only beginning to occur now. The accumulation of gold in the exchange-traded trusts are one sign of this. In 4 years, the trust known as GLD gained about 800 tons of gold or about 200 tons a year, or about a ton a trading day. That's about 32,000 ounces a day, not using metric tons. That's worth about $32 million a day at today's prices. In about 800 days, it would take 800 × 32 millionaires to do this, or 25,600 millionaires in total to commit to gold. The total market capitalization of GLD has recently been about 800 × $32 million or $26 billion. Now, there are over 9 million millionaires in the U.S. In recent days, the daily tons added by GLD have been much greater, around 9 tons a day. Using millionaires is only one way of looking at this. There are millions more people with far less wealth who can seek out gold.
If any great number of people attempt to hedge their future income by using gold, the price will soar. For example, if each retiree with 240 months to live tries to insure future income by buying 240 ounces of gold, the demand would be immense as compared with the available supply of gold. This reflects the fact that most wealth is now denominated in terms of dollars and the dollar has been inflated.
Gold is not the only real asset that people can buy. They can buy a host of other real assets that have various pros and cons that I won't go into, such as silver, copper, timber, land, liquor, rifles, etc. Gold competes with other assets, including financial assets that promise returns. The price of gold cannot get too far out of line with the prices of these other items for extended periods without substitutions occurring. We cannot look at the potential demand (as by looking at millionaires) without recognizing the potential supply of other assets. However, gold has low storage costs, low transaction costs, high recognition, and high liquidity. Gold is volatile in terms of a paper currency, but so are many other assets. If the financial and economic situation should suddenly stabilize for whatever reason, gold liquidation might occur rapidly and the price of gold fall sharply in terms of assets promising real returns. Over long periods of time, many studies tell us that gold has had no real return.
The costs of gold production vary among producers. I examined the production in ounces and the accounting costs of production for six large producers for the years 2005—2007. I obtained the total costs as reported on income statements and divided them by the production in ounces. I found that those costs were $570—$600 an ounce. Another source confirms my estimate with a number of $591 an ounce. That is not the total cost. The cost of the capital should be figured in. That raises costs to $700 to $750 an ounce, using a 10 percent cost of equity capital. The CFO of the largest gold producer (Barrick) estimates the cost of production at $700—$800 an ounce "easily." "To us that's the long-term break-even cost to the industry...below $700/oz to $800/oz long term, the industry doesn't make money." I conclude that an estimate of $750 an ounce for the total production cost of gold is not unreasonable.
This price provides something of a floor for gold. If gold were to fall below this price for any extended length of time, gold producers would slow production down or even halt it. That would reduce the supply coming to market and tend to stabilize the price. They would also find it profitable to buy gold in the market and store it for future sale, since storage costs are low. Why dig it out of the ground at a greater expense? Of course, if demand also fell off sharply for an extended period, the price of gold could stay down for a long time because there is a large above-ground inventory of gold compared to the annual use.
If gold demand rises sharply, producers will attempt to raise production. We do not know how steeply their costs will rise if they attempt to raise production by a large amount in a short period of time. I suspect they will rise sharply. World gold production has actually been falling since the year 2001, according to several sources. Even under current conditions of production, the marginal costs are likely to rise over time. Gold is getting harder to find and more difficult to extract when mines must go deeper. States demand royalties, and gold is often located in places where there is political risk. If gold prices rise and producer profits expand handsomely, states may demand higher taxes.
I always use technical analysis when investing. This is the analysis of price and volume data mainly. Many people regard this as akin to mumbo-jumbo. I find it useful. I do not rely solely on fundamental considerations. My work sees gold as essentially in a strong long-term technical position.
Conditions can change rapidly with any investment as new events and information occur. One has to be ready to change one's mind if the situation changes. Speculation requires being vigilant and on one's toes. The stock of thoughts such as are presented above can depreciate rapidly. Hence, none of the above can be taken as investment advice. They are just various thoughts that have been accumulating in my files.
February 18, 2009
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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