Why Changes in Gold Production Don't Matter
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 8th November 2009.
Most analyses of the gold market consider the annual change in the amount of gold produced by the mining industry to be an important determinant of the gold price, with bulls regularly supporting their case by citing the mining industry's inability to ramp up production and bears sometimes claiming that increasing mine production will eventually weigh the gold price down. Our contention, however, is that the annual supply of newly-mined gold is so small relative to the existing aboveground supply that changes in mine production should be ignored when assessing gold's prospects.
We warn you that the following discussion is quite lengthy (by our standards), but we wanted to cover most aspects of this important topic -- important, that is, for anyone who genuinely wants to understand the gold market -- in one hit.
The aboveground gold supply (and why it makes sense to analyse gold as if it were a currency)
The gold that gets produced each year doesn't get consumed; rather, it gets added to the existing aboveground stock. This means that the entire aboveground stock represents potential gold supply. In this respect, gold is more like a currency than a commodity.
Now, we realise that not all the gold that was ever mined is currently in a readily saleable form, but a substantial chunk of it is. To be more specific, it has been roughly estimated that around 150,000 tonnes of gold have been mined throughout history, about two-thirds of which has been mined since 1945. Of this 150,000 tonnes, we estimate that around 108,000 tonnes* are held for monetary/investment purposes. Monetary/investment (MI) gold includes official gold holdings (the gold kept by central banks and the IMF), privately-held bars and coins, the gold held by ETFs and closed-end funds, and monetary jewellery (24-carat jewellery that is held solely as an investment or a store of value). This 108,000-tonne figure is, in our opinion, a rough but reasonable estimate of the MINIMUM amount of gold in readily saleable form, and clearly dwarfs the 2,400 tonnes of gold produced by the mining industry over the past year.
Analysing the gold market as if new mine supply dominated the supply side of the equation would be like analysing the dollar market as if the only dollars that really mattered were the new dollars that came into existence over the past year. The fact is that a new dollar created today will become an indistinguishable part of a total supply that includes every dollar created, but not yet extinguished/destroyed, up until today, and it is this total supply, combined with the associated demand for this total supply, that determines the dollar's price. Moreover, it could be argued that the gold mined each year is less important to gold's supply-demand balance than are the dollars created each year, because new dollar supply typically constitutes a much greater percentage of the existing stock than does newly-mined gold supply. Specifically, whereas the total aboveground supply of saleable gold increases by about 2% every year, the total supply of dollars sometimes increases at a double-digit rate and rarely increases by less than 5%.
Putting things into perspective
As discussed above, the total supply of gold in readily saleable form is probably at least 108,000 tonnes, which stands in stark contrast to the current annual mine supply of around 2,400 tonnes. This suggests that changes in investment demand (changes in the demand for the total aboveground stock) are more than 40-times more important to gold's price trend than changes in mine supply. To put it another way, a 0.25% (one quarter of one percent) change in investment demand is more important than a 10% change in mine supply.
Data provided by the London Bullion Market Association (LBMA) lend additional support to the argument that changes in annual mine supply are tiny in relation to the overall market. The LBMA reports that an average of around 20M ounces (650 tonnes) of physical gold changes hands on the London gold market every day. This means that the equivalent of more than one year's mine supply changes hands in the space of only four average trading days on the London market. And London is not the world's only market for gold bullion.
If changes in mine supply are irrelevant, then what is relevant?
Over periods of 2 years or less, gold's price trend is usually determined by the combination of the US dollar's exchange value, credit spreads, nominal interest rates, inflation expectations, and the yield curve. However, the long-term is the focal point as far as this discussion is concerned.
Our view is that long-term trends in the gold price are driven by changes in the overall level of confidence in the monetary system and the economy, as best indicated by the long-term trend of the broad stock market (note: there is no reason why the stock market should be an indicator of monetary confidence, except that since the 1930s governments have generally implemented policies that debase the currency and create uncertainty whenever the economy weakens). We point out, for example, that the equity bear market of 1966-1982 coincided with a bull market in gold and gold-related investments (gold stocks); that the equity bull market of 1982-2000 coincided with a bear market in gold and gold-related investments; and that the equity bear market that began in 2000 has, to date, coincided with a bull market in gold and gold-related investments. Correlation doesn't imply causation, but it makes sense that the world's favourite repository of savings over the ultra-long-term would tend to trend inversely to the more speculative investments.
An implication of the above is that almost regardless of anything else, gold's current bull market will continue until the current equity bear market reaches its conclusion, which, based on historical evidence, won't happen until after the average P/E ratio has dropped to single digits and the average dividend yield has moved above 5%.
Wait a minute: most other commodities also rallied during the 1970s, trended lower during 1980-2001, and trended upward during much of the 2000s. How, then, does gold's strong tendency to move counter to long-term trends in the broad stock market differentiate it from any other commodity? The answer is contained in the following monthly chart of the gold/CRB ratio.
To see the true picture it is often helpful to remove the US$ (or any other fiat currency) from the equation by monitoring the performance of things in terms of gold (the Dow/gold ratio being a popular example) or by monitoring gold's performance in terms of other things. Specifically, to find out what gold REALLY did during any period we can review how it performed in terms of commodities in general (as represented by the CRB Index). The following chart makes the point that the gold/CRB ratio has moved counter to long-term trends in the broad stock market, meaning that gold has out-performed most other commodities during long-term equity bear markets and under-performed them during long-term equity bull markets.
Gold's performance relative to other commodities during the 1930s is also worth mentioning. Whereas most commodities and commodity-related equities did poorly during the massive equity bear market of 1929-1938, gold and gold stocks fared extremely well.
Other factors that affect, or are widely believed to affect, gold's price trend
Although our main purpose today is to deal with the ramifications (or lack thereof) for the gold market of changes in gold production, we will take this opportunity to also quickly deal with the effects of central bank gold sales and changes in jewellery demand. In particular, we want to quickly explain why the latter are irrelevant and why the former have some significance, but nowhere near as much as commonly believed.
The effects of central bank (CB) gold sales
In point form, here is a summary of the central-banking community's influence on the gold market. Note that we place the gold held by the IMF and the gold held by government treasury departments (in the US it is the Treasury, not the Fed, that owns the gold reserve) under the 'central-banking umbrella'.
1. CBs hold about 30% of the MI gold stock, so they have the ability to exert influence over gold's short- and intermediate-term price trends. However, their actual sales over the past 20 years have been too small to matter. Specifically, the World Gold Council (WGC) reports that CBs reduced their collective gold reserve at the rate of around 250-tonnes/year during the 1990s and 400-tonnes/year during the first 8 years of the current decade. (By the way, this means that CBs reduced their gold holdings at a faster rate during the current bull market than during the final decade of the preceding bear market, which is consistent with our view that their sales have not been a significant influence on the price trend.)
2. News relating to CB gold sales often has a short-term effect, but does not appear to have altered intermediate-term trends and cannot, in our opinion, alter long-term trends.
3. CB gold sales represent reduced demand by some holders of the MI stock, but these sales could actually cause an increase in overall MI demand. This is because confidence in a fiat currency could fall if the gold reserves 'backing' that currency were reduced, especially during a period when confidence was already in a fragile state for other reasons. Something along these lines occurred during the second half of the 1970s, when gold sales by the Fed (on behalf of the US Treasury) and the IMF were quickly followed by increases in the gold price.
4. CB monetary machinations (manipulations of interest rates, money supply, and pretty much everything else to do with money and credit) are probably of far greater importance to gold's long-term price trend than the gold sales/purchases they happen to make from time to time.
The effects of changes in jewellery demand
Many gold market analysts attribute great importance to changes in jewellery demand. For example, we occasionally read analyses where it is stated that jewellery demand is something like 60% of total gold demand, but what they really mean is that jewellery demand is 60% of the flow of new gold (primarily mine supply, but also including scrap supply). In other words, such analyses completely ignore the huge aboveground supply of gold and the associated demand for the aboveground supply.
The fact is that changes in annual jewellery demand are even less significant than changes in mine supply, and should therefore be ignored when assessing gold's prospects.
Anticipating some objections
1. An argument we've come across is that at any given time there may be few, or perhaps even no, sellers of the existing aboveground gold supply, resulting in the market being dominated by the regular selling of gold miners (gold miners continually sell at whatever the market price happens to be at the time the gold is removed from the ground).
Well, we know from the LBMA statistics that the selling of gold miners is small compared to the amount of physical gold that routinely trades via only the London market. However, even if all current owners of gold decided to 'sit' on their investment in anticipation of higher prices the selling by the gold mining industry wouldn't have an outsized, or even a meaningful, effect on gold's price trend. The reason can best be explained by considering the hypothetical example of Bill and Fred, two shareholders of XYZ Corporation. Bill owns 70% of the outstanding XYZ shares and Fred owns 1% of the outstanding shares. In our example, Fred decides to sell his 1% stake immediately while Bill plans to wait for a much higher price before parting with any of his shares. Even though Fred is the one selling in the present, Bill's decision to hold his shares off the market is vastly more important, as far as the market's price discovery is concerned, than Fred's decision to immediately sell. The reason, of course, is that Bill controls 70-times more shares than Fred. Robert Blumen's article at http://mises.org/story/3593 goes more deeply into this concept.
2. It could be argued that industrial metals such as copper also have huge aboveground supplies if we account for the metal 'stored' in buildings and other structures. The difference is that this metal is not in saleable form. For example, almost regardless of the copper price it will never be economically feasible to tear down functional office and apartment buildings for the sole purpose of extracting the contained copper, meaning that the copper wiring and plumbing built into these structures should not be counted as part of the aboveground supply.
Gold is the only commodity where the "stocks-to-flow" or "stocks-to-use" ratio is so large that the "flow" component can be ignored. This point was touched on in an article posted by Steve Matthews, a hedge fund commodity strategist, at http://www.lbma.org.uk/docs/alchemist/alch32_commodity.pdf. Mr. Matthews concludes: "It's fair to say that nothing else even comes close to gold's 7,019 days [of remaining supply]. This leads us to a proposition that I'm sure some of you have thought about before: the right way to trade gold is as a foreign currency, not as a commodity. You would need someone else to give you a trading recommendation; I abdicate my duty to declare myself bullish or bearish flat price in the face of what I consider overwhelming evidence that gold resides outside my supply/demand analytical framework."
By the way, we think the 7,019 days of remaining supply (the number of days of supply in aboveground storage, assuming that there is no further production and that non-investment demand proceeds at the current rate) mentioned by Mr. Matthews greatly understates the true situation. Our assessment is that the days of remaining supply in the gold market is at least 13,000 (about 35 years). In comparison, the days of remaining supply in the copper market is typically in the 30-90 range.
3. There has been a loose inverse relationship between gold production and gold's price trend over the past 40 years. To be more specific, the following chart of world annual gold production shows a downturn during the first half of the 1970s (a bullish period for gold), a steady upward trend from the early-1980s through to around 2000 (a generally bearish period for gold), and then a tapering off during the current bull market. This has been interpreted as evidence that changes in mine supply do, contrary to our analysis, have a material effect on the gold market. However, such interpretations reveal the danger of blindly assuming that correlation implies causation.
Given the size of the overall gold market it is not reasonable to conclude that the production trends illustrated by the following chart were important influences on gold's price trend over the period in question. So how, then, do we explain the apparent negative correlation between price and production that has arisen over the past 4 decades?
The most logical explanation is that there is, in fact, a cause-effect relationship between mine supply and price, but that price is the cause and mine supply is the effect (a higher price leads to higher production, etc.). Due to the extremely long delay between cause and effect, what we get is the appearance that falling production pushes the price up and that rising production pushes it down; but what is actually happening is that today's production levels are a response to price changes that occurred at least a decade earlier.
The time delay is so long because it will generally take at least a few years of higher gold-mining profit margins to stimulate an increase in exploration activity, that will, after several more years, lead to an increase in production; and it will generally take many years of low gold-mining profit margins to prompt the gold mining industry to reduce its production and exploration activity.
With regard to the past few decades, our assessment is that rising costs combined with a fixed gold price during the 1960s probably brought about the decline in gold production during the first half of the 1970s, while the large increase in gold-mining profit margins during the 1970s prompted increased exploration activity that eventually led to more mines being constructed and higher production during the 1980s.
With gold-mining profit margins generally remaining robust and with many people remaining convinced that gold's next bull market was just around the corner, the industry continued its expansion throughout the 1980s. It wasn't until the second half of the 1990s that the downward drift in gold-mining profitability really began to take its toll, causing exploration activity to all but cease. The result has been an essentially flat production profile from the late 1990s through to the present day, but note that the past 15 months' surge in the gold/CRB ratio (a proxy for gold-mining profit margins) should lead to more aggressive exploration, and, eventually, to higher gold production.
(Chart data from USGS for all years prior to 2006 and from the World Gold Council for 2006 onward)
Gold market analyses -- such as those put together by Gold Fields Mineral Services (GFMS) -- that treat new mine production as if it represented a substantial chunk of the total gold supply, and/or that place great importance on factors such as jewellery demand and scrap supply, are of no use to anyone whose goal is to understand what drives the gold price. In fact, such analyses are worse than useless because they create a false impression. The reality is that the contribution to total gold supply made by newly-mined gold is so small that changes in mine production should be considered irrelevant when assessing gold's upside potential relative to its downside risk.
*The 108,000-tonne figure is derived from the analysis presented by James Turk in his 1993 booklet "Do Central Banks Control the Gold Market". In this booklet Mr. Turk estimated that the amount of monetary/investment (MI) gold was 72.7% of the total aboveground gold supply at the time (1993). To arrive at the 108,000-tonne estimate for the current stock of MI gold, we have assumed that the ratio of MI gold to total aboveground gold is the same now as it was in 1993.
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