The Screaming Fundamentals for Owning Gold and Silver
Gold and silver are not (yet) in bubble territory and large gains remain, especially if monetary, fiscal, and fundamental supply-and-demand trends remain in play.
Not surprisingly, the high prices for gold and silver have stimulated quite a bit of exploration and new mine production. With over a decade of steadily rising prices, there has been ample time to bring on new production. Which leads to a real surprise: In the case of gold, relatively little incremental mine production has occurred.
The analytical firm Standard Chartered has calculated a rather subdued 3.6% gold production growth over the next five years:
Most market commentary on gold centres on the direction of US dollar movements or inflation/deflation issues – we go beyond this to examine future mine supply, which we regard as an equally important driver. In our study of 375 global gold mines and projects, we note that after 10 years of a bull market, the gold mining industry has done little to bring on new supply. Our base-case scenario puts gold production growth at only 3.6% CAGR over the next five years.
(Source - Standard Chartered)
Of course, none of this is actually surprising to anyone who understands where we are in the depletion cycle, but it's probably quite a shock to many economists. The quoted report goes on to calculate that existing projects just coming on-line need an average gold price of $1,400 to justify the capital costs. Meanwhile greenfield, or brand new projects require a gold price of $2,000 an ounce.
This enormous increase in required gold prices to justify the investment is precisely the same dynamic that we are seeing with every other depleting resource: Energy costs run smack-dab into declining ore yields to produce an exponential increase in operating costs. And it's not as simple as the fuel that goes into the Caterpillar (CAT) D-9s; it's the embodied energy in the steel and all the other energy-intensive mining components along the entire supply chain.
Just as is the case with oil shales that always seem to need an oil price $10 higher than the current price to break even, the law of receding horizons (where rising input costs constantly place a resource just out of economic reach) will prevent many an interesting, but dilute, ore body from being developed. Given declining net energy, that's forever as far as I am concerned.
The punch line of the Standard Chartered gold report is that they think $5,000 gold is a realistic target and go on to note the most important shift in gold accumulation of the past 30 years:
The limited new supply comes at a time when central banks have turned from being net sellers to significant net buyers of gold. The result, in our view, will be a gold market in deficit, even assuming flat growth in demand.
With the supply-demand balance so out of kilter, we see the gold price potentially going to US$5,000/oz.
The emergence of central banks being net acquirers of gold is actually a pretty big deal. Over the past few decades, central banks have been actively reducing their gold holdings, preferring paper assets over the 'barbarous relic.' Famously, Canada and Switzerland vastly reduced their official gold holdings during this period, a decision that many citizens of those countries have openly and actively questioned.
The World Gold Council out of the UK is the primary firm that aggregates and reports on gold supply-and-demand statistics. Here's the most recent data on official (i.e., central bank) gold holdings:
Note that the 2009 data is lowered by slightly more than 450 tonnes in this chart to remove the one-time announcement by China that it had secretly acquired 454 tonnes over the prior six years, so this data may differ from other representations you might see. I thought it best to remove that blip from the data. Also, the data for 2011 is for the first four months only, so we might expect 2011 to be a record-setter if the current pace continues.
Overall, world supply and demand are a bit out of alignment right now, with supply increasing by 2% last year and non-official demand increasing by 10%:
The summary of the fundamental analysis is that with mine production seriously lagging, the price increases for gold, and increased central bank and investment demand, we have set the stage for some hefty price increases irrespective of any fiscal or monetary shenanigans.
However, once we put those back into the mix, I forecast a quite volatile but upwardly sloping price for gold over the coming years. Possibly a very steep upward slope at points.
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