Physical Gold and the Financial Market
Last week we illustrated how gold should be treated as a special alternative to dollar denominated paper assets. Yet, It is not only the "system-hedge" aspects that determine the value of gold, since supply factors also come into play. There has been a lot of talk about the divergence between the gold physical markets and the financial markets. There are those who spout conspiracy theories how financial institutions (including central banks) are manipulating the gold market (and as someone observed that should not come as a surprise since central banks manipulate bond markets and interest rates every day). How much these statements are true is a separate issue, yet there is in fact some level of discrepancy between the financial market and the real market (which overall in the longer run should disappear). This discrepancy can help us separate short run speculations from long run movements.
After the last huge fall in the gold price one could observe that the physical market was not that shaken. Actually, it was spurred. As Bloomberg reported, the Shanghai Gold Exchange supplied 1098 tons of gold in the first part of 2013 (1139 being the total for the whole 2012 year), which is around 40% of annual gold production (yes, you are reading correctly: during half of the year the Shanghai stock exchange saw trading of 40% of annual production). We see therefore some big volume of gold being traded in the market. Although we have to admit there was a visible slowdown. In April 236 tons were delivered, in May 224 and 180 in June.
What does it tell us? The "fundamentals" do not look very frightening. A recent huge decline in gold was a result of investors backing out of the financial investments (ETF funds etc.). Either they had expected very high levels of inflation, or else were interested in the short run "financial" side of the market. Naturally they are big players, they do influence what is going on in the spot market, as we saw last months. Nevertheless there is still a real part of the gold market associated with physical trades. This is what separates gold from paper currencies. Even if gold loses its value in the end there is a real cushion. Gold can go down, but in the end it does not go to zero, because it is a real commodity that has a certain value. As long as it is a scarce useful resource which cannot be printed there is demand for it. For paper currencies there is no such bottom. Once they start losing their value the limit is the cost of producing paper.
In the case of gold the cost of production is a big part of its value. The main reason for gold being valuable is that it cannot be easily produced. It takes time and resources to mine it. What are he current costs of mining gold? It depends on the producer, but overall the costs of producing one ounce of gold are over 1000 dollars. Andrew Su, CEO at brokerage Compass Global Markets, said last month that costs vary between 1000 and 1200 dollars, but in reality they can even be higher.
Could gold go higher, and at least not stay at even lower prices for months? There are strong supply arguments for it. The supply argument tells us that there are cost cushions against further falls after which gold stays low for a prolonged period of time. Especially in the light of the fact that lots of physical gold is being traded in the market.