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July 06, 2007

Gold: The Fundamental Rules
by Adrian Ash

"...Asia's booming economies are colliding with its traditional love of gold. If you like unstoppable investment trends, it might pay to take note..."

SO THE FUNDAMENTAL rules still apply in the credit markets then - and complex mortgage derivatives leveraged to the Nth degree still need the original home-buyer to meet his monthly repayments if they're to avoid blowing up.

You might have expected someone at Bear Stearns...then Queens Walk in London...and now Italease in Milan, Italy...to have spotted this simple fact.

You might also have expected gold to shoot higher as the panic leaches out of synthetic CDOs and into investment portfolios across the developed world.

After all, gold is everything that a collateralized debt obligation is not.

Simple, tangible and highly liquid, gold is instantly marked-to-market by bullion traders working 24 hours a day. Nor is gold anyone's promise or anyone's to create at will - again, the very opposite of today's high-leverage credit derivatives.

Gold also has a long history of storing wealth. Once more, that makes it as different from "toxic waste" as you can get. So shouldn't Western investment cash now be fleeing the debt markets for the security of this rare, indestructible, historically valuable asset?

Well, far from the hedge-fund dealing desks of London's Mayfair district, "physical gold demand is light," reports Lokesh Agarwal, a director at Brijwasi Bullion & Jewelers in Lucknow, India. "It is going to be like this for the next few days."

In fact, "the whole of July will be dull," says a New Delhi gold dealer. But Indian gold demand - which accounted for one ounce in every five sold anywhere in the world last year - always flags mid-year. And looking ahead, investors who spurned gold below $650 per ounce this week might just come to wonder why they didn't buy the dips.

"Good rains forebode a good harvest that will boost agricultural income, helping farmers to buy more gold this year," reckons James Steel, metals analyst at HSBC. The monsoon season is forecast to be "normal" according to the Mumbai Met' Office. That looks set to boost gold demand amongst Indian farmers, the world's hungriest buyers of the shiny yellow metal, as August leads to a slew of festivals and post-harvest weddings.

"Gold prices still appear to be at attractive enough levels to merit accelerated purchases from the emerging world," Steel goes on for HSBC, "and we suspect buying will soon materialize." With good rains, a good harvest of rice, corn, lentils, cotton, soybeans and sugar cane is expected. Paying extra cash to local farmers, that bonanza is likely to find its way into physical gold, he believes, bought in lieu of retail bank accounts - still lacking all across rural India.

Physical gold might not only enjoy a hike in demand from India, either. Last week, Vietnam opened its first gold bonded warehouses, one in Hanoi and one in Ho Chi Minh City. These new gold depositories will cut gold-dealing costs to institutional investors. Insurance costs will also be reduced, according to Nguyen Huu Thuan at the Sai Gon Jewelry Company. The World Gold Council now estimates that demand for gold in Vietnam could reach 70-80 tonnes this year.

Further north, in China - where economic growth for 2007 was this week pitched at 10.9% by a government report - the Shanghai Gold Exchange (SGE) will allow individual investors to begin trading physical gold later this month. The China Daily says the move will "provide a welcome alternative at a time of high stock market volatility".

"Trading in physical gold has so far been limited to professional traders," the paper reports. "The minimum lot for trading has [now] been set at 100 grams - widely seen as quite a low threshold for individual investors to participate in the physical gold market."

"It should attract many investors," reckons Tang Mingrong, an analyst with Ling Rui Gold Investment Co. "The increasing need of hedging risks by individual investors will spur the launch of physical gold trading."

Indeed, "we look at gold as a barometer of wealth in the world," said Jason Mraz, head trader at Ospraie Management - the New York hedge fund running $7 billion in commodities and basic industries - at the Commodity Investment Summit in London last week. "The underpinning of demand is very strong."

"Most commodities in China still look extremely bullish, and China's influence looks fairly positive," adds Adam Rowley, a commodities analyst with Macquarie Bank in London. "On trend, we would see China as an unstoppable force in these markets."

"We are extremely bullish on the prices of gold, silver and diamonds over the next couple of years," chips in Scotia Capital as it begins coverage of precious metals. "We believe that falling gold and silver production, along with rising investment and jewelry demand, will drive prices higher."

A lack of new gold-mining discoveries has so far "kept the speculative money out of the gold sector," says Scotia Capital. "Although exploration Dollars have skyrocketed, few discoveries of any size have been made."

"Cost curves are not allowing prices to go back to historical norms," continues Mraz of Ospraie Management. "We don't think the mining industry has the ability to respond to demand. The compelling story we see in gold is indicative of other metals, which is a shortage of mining labor."

In short, Asia's booming income is colliding with its love of physical gold...even as soaring mining costs and a lack of big finds continue to cap production. You might agree that makes a compelling case for buying and holding gold today. Yet formal investment by Western funds has been slipping ever since this year's top above $692 per ounce, hit back in early spring.

Last week alone, net longs on Comex gold contracts fell by one-fifth to a near six-month low. Open interest has dropped by 11% since the end of February. On the world's stock markets, exchange-traded gold funds - led by StreetTracks GLD - suffered net redemptions of 11.6 tonnes between April and June. Despite floating on both the German and Italian bourses, the LyxOr GBS gold fund added just 4.5 tonnes, less than 5% growth despite adding the two largest European investment markets outside the United Kingdom.

Of course, the commodity markets have seen outstanding growth over the last few years. The amount of pension fund money invested in gold, oil, base metals and soft commodities is now put at $80 billion. But that's still just a fraction of total global pension fund assets. London's Financial Services Authority estimates them to be around $18.6 trillion.

Derivatives trading in the commodity markets has also risen sharply, growing five times over since 2004 on the Bank for International Settlement data. But the total market in all futures and options - including equity, currency and interest-rate derivatives - is put at more than $415 trillion. Commodities derivatives account for less than 1% of that sum. Gold futures & options represent less than one-tenth of that volume, too.

Very few people, in short, own either physical gold bullion or a call on gold outside the booming economies of Asia and India right now. Demand looks set to continue growing in those fast-emerging markets. But here in London, in contrast, almost everyone seems to have a stock broking or spread betting account instead.

If you favor rarity - and you like unstoppable investment trends - it might pay to note that debt now litters Western asset markets. The global hankering for gold, on the other hand, has barely even begun.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events and should be verified elsewhere if you choose to include it in your own analysis.

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