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Gold: More on the Risk-Free Gold Price
My first contribution to Economic Straight Talk, in January, focused on 'What is the risk-free gold price'. That apparently generated quite a few comments, and I have been asked me to clarify some points on this subject.
Before doing that:
I wrote last month that the risk-free gold price probably was around $800. Actually, it probably is around $950 -$1,000 at present. The $800 price was the price CPM Group calculated in January 2012; and,
costs in the gold mining and refining business have been rising sharply over the past several years, for a variety of reasons. Today, merely one year later, that same calculation would return a price closer to $1,000 per ounce. Yes, inflationary pressures in the gold market would have raised this price 19%- 25% in just one year, in stark contrast to the U.S. general consumer price inflation rate closer to 1.7% at present.
That may seem like a very sharp increase in the risk-free price of gold, but take this into context. Given the enormous secrecy surrounding the amount of gold held by private investors and central banks, which is estimated to be more than two billion ounces at present, the uncertainty in the parameters that would dictate what this risk-free price would be are extremely high. The margin of error in such calculations is extreme.
There are two key points that I want to make this month about this risk-free price:
first, I need to define and describe what we mean when we speak about the risk-free price; and,
second, I need to discuss in greater detail how we derive this price, something which was given short shrift in last month's commentary due to space considerations.
The risk-free price of gold is not the low price to which we reasonably might expect gold prices to decline in the current and foreseeable economic environment. It is a long-term base price to which gold prices theoretically might be expected to decline in an environment that was free of the political, economic, and financial risks that drive investors to buy gold.
Gold prices are determined and influenced by many factors, including:
mine production trends;
the costs of production and refining;
secondary recovery trends (whether people are selling their gold jewelry, for one thing, to raise money either because prices are high or economic conditions demand that they sell their jewelry to eat and live);
fabrication trends in electronics and other industries; and,
central bank gold buying and selling patterns.
The single most important fundamental factor influencing gold price levels, trends,and directions is investor demand for gold: Are investors buying a lot of gold, a little bit of gold, some volume in between, or, sometimes, actually selling gold on a net basis as a group back into the market.
These investment buying trends are flavored primarily by exogenous variables: Things outside the gold market. Some investors determine the levels and extent to which they wish to buy and sell gold based on internal market factors, such as mine production trends, but most investors buy gold because of their perceptions of economic,political, and financial trends. Inflation is a key variable. So are currency exchange rates - not just for the dollar, but for other currencies and the domestic currency of individual investors.
Stock market trends, both nominal and real interest rate levels and trends, banking stability or instability, government deficits and fiscal management (or lack thereof), political security, and many other factors all are considered by investors in their determining whether to buy a little or a lot of gold, refrain from buying, or sell some of what they have.
The gold market often is said to be two markets. It actually is several. There is:
a commodity market for gold, with the price determined by the costs of production, refining trends from mines and scrap, jeweler demand for gold, and other industrial users of gold;
the investment or financial market for gold - what investors want to buy. This is the most important market for determining the price of gold;
the monetary market for gold - the amount of gold central banks and monetary authorities need or want. This market actually is quite distinct from the financial market for gold populated by private sector investors, although many gold market commentaries miss this important fact.
The risk-free gold price is the price to at which the first gold market described above might see a balance between supply and demand, in the absence of the economic, financial, and political risks that would cause the second market to be free. It is the theoretical market clearing price of a hypothetical gold market in which investors and monetary authorities were neither buying nor selling gold. It is not even the price to which one would expect prices to fall in the absence of investor buying, since prices tend to over-shoot market clearing tops and bottoms.
Thus, the risk-free price of gold is the price of gold that might be expected to clear supply and demand in a world in which investors did not feel compelled to buy more gold as protection from the uncertainties that stimulate them to buy gold.
In the late 1990s, when many investors (not including CPM Group's analysts, it must be stressed) felt that the world had entered a "New Economic Paradigm" free of inflation, recessions, and financial distress, investors pulled back mightily from buying gold. The price fell from around $340 to around $270 over a five year period, before politicians and financial market titans found ways to convince the average investor that they should not believe this gibberish. When prices began falling sharply in 1997 our comment was that on a long-term basis gold prices below $320 were unsustainable, but that the short term could last five years. It did.
This risk-free price must not be confused with another theoretical price CPM Group calculates: The long-term sustainable market clearing price that might reasonably be expected over the coming decade, based on reasonable expectations of future economic, financial, political, and governmental trends. That is a much higher price than the $950 - $1,000 risk free price mentioned at the outset, but it also is a subject for another commentary later, as it demands a detailed explanation.
We calculate this price by estimating past and current supply and demand, and calculating the costs of producing gold from mines and scrap as well as the costs and affordability of using gold in jewelry, electronics, dental amalgams, medical devices, and other manufactured products that contain gold. We add to this model projections of future supply and demand, including changes in the costs of producing and using gold. All of these factors, past, present, and future, are meshed together in a complex model that yields the estimated risk-free price of gold.
The 25% increase in the risk-free price over the past year, mentioned earlier in this article, is a reflection primarily of rapidly rising mine production and operating costs. While these rising production costs are rising sharply, in electronics, a relatively small segment of demand for gold, costs are falling because electronics manufacturers are implementing programs to reduce the amount of gold they need per product. For example, a current-generation tablet computer uses approximately one-tenth the amount of gold that a current laptop computer uses.