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By Scott Wright | 29 August 2008
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From a strategic perspective gold is in fine technical shape. It was just about a year ago that it launched from $650 into one of its most powerful uplegs bull to date that saw it briefly eclipse $1000 in March. And while gold seems to be exhibiting gut-wrenching volatility, it has been consolidating on the high side of this most recent upleg and is likely positioning itself to launch into a glorious new upleg that I suspect will surpass the early-2008 highs. While technicals are useful and give traders the opportunity to game the interim movements of this yellow metal, it is the core fundamentals that support the secular nature of gold’s bull. Gold is a commodity without equal and its myriad of fundamental drivers should continue to support a secular uptrend that is probably only near the halfway mark in duration. This is why after the carnage of summer it is vital to review the fundamentals that will continue to drive gold’s bull.
Of course the allure of gold is timeless. All throughout history the beauty, preciousness, and rarity of this metal has made it highly sought after. Gold continues to transcend time and to this day is still considered the ultimate store of wealth for people in every part of the world. And these traits lead to one of gold’s strongest fundamentals, its value as a hedge against wildly inflating fiat currencies. Paper money not backed by gold has and will always fail, as proven throughout history. In fact the first stage of gold’s bull was primarily driven by the weakness of the world’s reserve currency, the US dollar.
Provocatively gold’s all-time nominal high achieved early this year is nowhere near where it needs to be to reach its high measured in constant 2008 dollars. Using the highly-flawed and ultra-conservative US Consumer Price Index we can inflate gold’s nominal price history and see that it is actually cheap at today’s prices. Gold would have to reach $2400 in order to achieve a real all-time high. Ultimately currency inflation hedging and storing value are just a couple of gold’s many fundamental attributes. At Zeal we have been touting gold’s bullish fundamentals since the very beginning of its bull over seven years ago. And I encourage you to peruse our most recent fundamental essay that details the case for a secular gold bull.
But though there are many fundamentals that do support gold going higher, the one that reigns superior is economics. Economics is the most fundamental of fundamentals and its principles are the cornerstone of all market trends. Supply and demand are of course the key components of economic fundamentals. If demand outpaces supply then prices will naturally rise as relatively more money chases after fewer goods. And conversely if supply outpaces demand prices will fall as relatively less money bids on more abundant goods.
When supply and demand are off kilter, the resulting economic imbalance has a near-term effect on prices that should appropriately adjust demand. Prices will either fall to grow demand or rise to decrease demand. And depending on how wide the gap is between supply and demand, prices can swing wildly in either direction in order to achieve an interim balance. In gold we have seen these near-term economic trends play out very well. Since 2001 the price of gold has risen fast enough and high enough to quell the demand for jewelry, gold’s largest consumption category. According to data provided by the World Gold Council, compiled by GFMS Ltd., the demand for gold jewelry has fallen by 800 metric tons since 2000. While consumption has grown in other categories, this decrease in jewelry demand has for the most part bridged the supply/demand gap, but only temporarily.
In contrast to near-term price trends the long-term result of an imbalance is simply a matter of suppliers adjusting their output to meet demand. And in commodities a material change in output is indeed a long-term endeavor. So with the price of gold on the rise, resulting from supply not meeting demand through the course of this bull, suppliers have been tasked to grow their production of gold. And in the gold trade the majority of supply comes from good-old-fashioned mining. About 70% of the world’s annual gold supply is extracted from the bowels of the earth. So with prices high and demand high, over seven years into this bull the gold miners should be quickly ramping up supply, right? Well looking at the chart below this doesn’t appear to be the case.
According to data compiled by the US Geological Survey, the mined supply of gold has been trending down since the beginning of this gold bull. This trend is astonishing, and really is counterintuitive to what you think would be happening this far into a secular bull. Since 2001 the annual average daily price of gold has been trending higher each year, and has averaged an incredible $911 in the first half of 2008. Yet mine production is down! You would think these skyrocketing prices would be all the incentive miners need to ramp up supply and capture legendary profits for their shareholders.
And you don’t have to look very far to see that there is a disconnect at the production level. Take the world’s top-four primary gold miners for example. Barrick Gold (ABX-NYSE), Newmont Mining (NEM-NYSE), AngloGold Ashanti (AU-NYSE), and Gold Fields (GFI-NYSE) are collectively responsible for over a quarter of the annual mined supply of gold. And astonishingly these senior miners are projecting combined 2008 production to be 4.5m ounces less than what they produced in 2006, an 18% decrease. To further buttress this disparity, according to GFMS the total supply of gold in 2007 from all sources was down by over 500 metric tons (16m ounces) from just two years prior. Now high gold prices have kept demand in check, thus leading to only a slight supply deficit in 2007, but this lack of production growth from the mining sector poses a potentially serious structural problem.
Decreasing jewelry consumption has indeed allowed the economics of gold to stay relatively balanced in the interim, but this is not a perpetual trend. Gold jewelry consumption is back on the rise from its 2006 low, and will continue to rise as the world accepts higher gold prices. And interestingly this decrease in jewelry consumption has barely balanced growth on the investment front. According to GFMS, the investment demand for gold has grown by nearly 500 metric tons since 2000. And as this gold bull continues to mature in Stage Two and eventually enters Stage Three, it is investment demand that will lead the charge on the growth front. And the investment demand for gold will be a lot less sensitive to price than any of the other consumption categories.
In the previous essay of this series I presented the case for why global per-capita gold consumption is likely to rise as a result of sharp demand growth from the world’s developing nations, particularly the Asian countries that have a cultural affinity for gold investment. If this trend plays out as I believe it will, the mined supply of gold will need to increase by at least 15% over the next 15 or so years. So for the gold market to have any hope of balancing trade going forward, supply simply must rise. And this increase in supply has to come from the gold miners. The supply dilemma you see in the chart above needs to be confronted and corrected in order for this to happen.
Next week I plan on detailing the challenges that the gold mining industry is facing. There are of course many challenges that result from the economic and socioeconomic issues of today, but we are finding that years of underinvestment in infrastructure and exploration leading into this bull has taken its toll. Mining in general is a tough business. The time and capital required to bring a mine to life from discovery to commercial production is extensive. And when you throw in scarcity, geopolitics, operating cost inflation, geological problems, labor shortages, and many more factors gold miners are faced with, it is apparent this industry is not for the faint of heart. This ongoing lack of production growth will continue to put a strain on the gold trade.
Shifting gears, a major fundamental factor to consider that feeds into the supply side of economics is longevity via the almighty reserves. Gold reserves are simply defined as a base of gold ore which can be economically extracted at the time of determination. Reserves are the lifeblood of gold miners, as their operational and financial-market health is defined by these ounces in the ground. And since reserves feed production, miners must continually explore for and discover new reserves to replace those that are depleted.
When analysts and investors look at a mine or a mining company, fundamentals from operations (or projected operations) such as volume, operating costs, and profitability are important, but mining life draws the most attention. Mining life is simply reserves divided by annual production. If a mine has 1m ounces of gold reserves and is producing 100k ounces of gold each year, it has a mining life of approximately 10 years. Companies can be looked at in the same fashion. Newmont for example has total gold reserves at all of its combined properties of 87m ounces. At a production rate of 5.1m ounces per annum, Newmont has a mining life of 17 years.
Global mining life can also be calculated thanks to reserves and production data provided by the USGS. As you can see in the chart below the USGS estimates that total global gold reserves in 2007 fall in the neighborhood of 42k metric tons (1.35b ounces). With annual mined production around 2500 metric tons (80m ounces), global mining life is about 17 years. You will find that when you research the gold miners most of the quality companies have mining lives of at least 10 years, with many even over 20 years. And this USGS mining-life estimate is very representative of the average mining lives of those elite gold miners that trade in the HUI and XAU gold-stock indexes.
But there are a couple of things about this chart that I find disturbing. First you can see that a big drop in global reserves occurred in 2002. According to the USGS this resulted from a significant decrease in reserves reported from South Africa, the country that had long been the largest gold producer in the world until recently. Not only has gold production been declining in South Africa for over 20 years running, a combination of lack of reserve renewal, high operating costs, labor problems, and declining ore grades has this long-standing gold powerhouse struggling to maintain its stature. Apparently in revaluing its assets South Africa came to the conclusion that its gold reserves were not as robust as originally thought.
But it is not this South African drop in reserves that is alarming to me. As you can see mining life has been consistent. But consistent is not good enough for how high gold prices have climbed. Since a reserve is a reserve based on economics, reserves should be growing with the price of gold. In the simplest of terms, gold is only economical if production costs are less than what it can be sold for on the open markets. For example, back in 2001 when the average gold price was $270, in-ground gold was only a reserve if total operating costs were well under this price. But as prices climb higher, gold that is harder to extract and process, thus more expensive to produce, should become economical.
Before a reserve becomes economical, it resides in the ‘resources’ categories. And mining companies sit on a lot of resources in hopes that they become economical one day. At any given time resources are either waiting for the appropriate geological studies to deem them economical or they have failed studies that at the time determined the gold to not be economical. Interestingly there is in fact a lot of gold in the earth, but much of it does not enjoy favorable-enough geological conditions to mine profitably. It takes a lot of expertise and even some luck to find gold deposits that are economical to mine. But the beautiful thing about mining is every resource has a price tag on it.
So if gold prices go high enough, those resources that are hard to get to or too low-grade, whether at existing mining operations or undeveloped discoveries, will eventually become economical. In going from $250 to $800, there should be a lot more resources that become reserves simply based on economics. Those gold miners in 2001 sitting on resources that had projected operating costs of say $500, twice the market price, would never have dreamed of bringing a mine into production at the time. But in today’s environment, gold extracted at operating costs of $500 would be very profitable. Now granted there does need to be some inflationary adjustments for studies performed back when oil was $20, but operating costs are still not rising proportionately with gold.
So while the mining industry is performing sufficient-enough reserve renewal so that global reserves remain steady, the fact that reserves aren’t growing considering the massive increase in gold’s price is disconcerting. And no matter how you look at it, this does not bode well for the future of gold mining. If you are at all attuned to the gold mining sector in the last couple years, you’re familiar with these companies’ CEOs’ constant grumblings about the existing gold mining environment and how difficult it is to find gold and develop mines these days. But in looking at the lack of global reserve and production growth, this isn’t just lip service to explain why they are struggling, this is reality.
It would be interesting to find out what percentage of today’s reserve renewal is upgrading already-discovered resources based on rising prices versus fresh new discoveries. I would lean more towards the former as gold discovery, especially large deposits, is just not prevalent these days. The easy gold has been picked over or is unattainable based on factors I’ll discuss next week. Ultimately the trend of declining gold production and the lack of reserve growth is a huge boon for gold’s long-term fundamentals. And with the demand for gold expected to rise led by investment demand, the economics alone tell us this gold bull is nowhere near extinct.
After weathering the PM summer doldrums, the smart investors aware of gold’s fundamentals know to look past the hype and avoid the capitulation that is inflicting their comrades. Though the word bubble has been loosely tossed around in the same sentence as gold, this commodity is nowhere near bubble status. And when gold does eventually inflate into a bubble, it will be accompanied by uncontrollable greed and a popular mania. Gold has not been popular yet. It is still a contrarian play and should greatly reward those faithful that stick with it.
At Zeal we have been gold bulls since the very beginning of this bull. In our acclaimed monthly newsletter, Zeal Intelligence, we first started recommending gold to our subscribers in May 2001 when it was in the $260s and gold stocks when they were the pariahs of the markets, trading vastly lower than where they are today. With gold’s fundamentals still wildly bullish, we believe this bull has a lot of room left to run. And with gold entering into what is likely a season of strength, we’ve begun layering in trades to position ourselves for the next upleg.
The bottom line is global mined gold production and reserves are not growing as they should be in the face of fast-rising prices. If gold demand continues to rise as expected, the economic fundamentals alone support this gold bull for many more years as suppliers struggle to keep up. And with these alarming production and reserve trends, it is apparent there is a structural problem in the gold mining industry. The miners are in a constant battle to renew reserves and grow production. And they are failing at this. Next week I’ll discuss some of the challenges that the gold mining industry is faced with.
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World Gold Production (2008)
By Dr Thomas Chaize | 26 August 2008
Each year I take stock of gold and silver production in the world. This is the second edition of "World production of gold." Normally when prices rise, production increases in proportion; however, since at least 2001, gold production seems less and less able to react to rising prices, as if the remedy had less and less effect on the patient.
I. The Peak Of World Gold Production.
In 2001, global production of gold reached its record with 2600 tons— production has never again matched that record. For four years, I have brought you the good news of the fall in the world production of gold; in 2008, the major gold mines in the world seem to have even greater difficulties in maintaining/attaining their former production levels.
Even if the year 2007, with ~2500 tons of gold, experienced a slight growth of 1.1% compared to 2006 (2470 tons of gold), we are still 100 tonnes short of the record of 2001 (2600 tonnes). Since 2005, there has been a small upturn in the growth of world production of gold from 2440 to 2500 tonnes, while during the same period the price rose from $400 to over $900 per ounce. (Gold production increased by 2% from 2004, while the price of an ounce of gold increased by over 100% ...)
Rising prices should cause the same strong growth in gold production in the world as for zinc, molybdenum, and copper. However, the increase in the price of an ounce of gold seems not enough to produce a like increase in the world production of gold for structural reasons. Moreover, I am convinced that the decline in gold production will only renew the assessments of the difficulties of the leading producers of gold, and the gold summit of 2001 will never [again?] be reached. The production of silver will shortly suffer the same fate; but that is another matter!
II. The Major Gold Producers.
Gold production from Australia, from China and the USA is now each at the same level as that of South Africa. It should be noted that the South African gold production has declined to the same level as the gold production of Australia, China and the USA, individually. Thus, gold production from South Africa has dropped by ¾ from its peak in 1969-1970, at 1000 tons of gold produced per annum. It now takes the sum of the four largest world producers just to equal the production of South Africa in 1969. [[In fact, South Africa's production is now below that of Australia.: normxxx]]
It is also interesting to note that among the eight largest producers of gold, gold production for September is substantially below peak: Australia (-10%), South Africa (-73%), USA (-34%), Canada (-43%), Indonesia (-11%), Peru (-26%), Russia (-5.8%)— only China has managed to raise its gold production above its former peak. Some interpret this as scope for increased output, I personally see it as a sign of declining production capacity.
III. Smaller Countries Gold Producers.
The five largest gold producing countries in 2007 were: 1. Australia with 280 tonnes of gold, 2. South Africa with 270 tonnes, 3. China with 250 tonnes of gold, 4. USA with 240 tonnes of gold, 5. Peru with 170 tonnes of gold, 6. Russia with 160 tons of gold, 7. Indonesia with 120 tons of gold and 8. Canada with 100 tons of gold. Gold production of the eight major producing countries fell by 12.3% from the maximum year of 2001 while overall production of gold in the world declined by 3.8% over the same period.
Gold production in the world seems the inverse of money production. It is the many small gold producing countries (old and new) that maintain the world production of gold with a 25% increase of gold production since 2001 (Argentina, Bolivia, Brazil, Chile, Colombia, Ghana, Kazakhstan, Mali, Mexico, Morocco, Uzbekistan, Papua, Philippines, Tanzania,…). But the first eight world producers still accounted for 61% of world production in 2007.
Click Here, or on the image, to see a larger, undistorted image.
I maintain, the year 2001 is the summit of world production of gold, the trend is now bearish for gold production despite the slight increase since 2005. I think that we shall even see, in coming years, a sharper decrease in production than the decline in 2002-2004. In recent years, the smaller gold producing countries have succeeded in shielding the overall world production from experiencing a sudden drop due to the declining gold production in the major producing countries, but it cannot last...
Gold production will continue to decline, the global money supply will continue to increase and so, the price of an ounce of gold must continue up… This my 20th analysis of gold price and production since 2003, with a success rate close to 100%, and yet I have more confidence in this analysis than in the 19 previous ones, rightly or wrongly.
M O R E. . .
Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
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