Considering gold’s outstanding fundamentals, it’s no surprise that demand has stayed strong a decade into its bull. And with demand only expected to strengthen in the years to come, a lot of weight rests on the shoulders of gold’s suppliers.
In order for this yellow metal to find an economic balance, consumers rely on a supply chain that had been quite consistent over the years. The major supply sources of mine production, recycling, and central-bank sales had worked in symphony to meet demand. Unfortunately over the course of gold’s bull this supply chain has grown increasingly inconsistent and unreliable, with these sources exhibiting extreme volatility.
Supply from central-bank selling has been the most volatile of the major sources of recent. According to respected research house/consultancy GFMS, CB sales averaged between 400 to 500 metric tons (mt) per year from 1989 to 2007. Over this long span the world’s monetary authorities geared their reserve biases towards fiat currencies, and consistently dumped gold onto the market. These gold sales had thus become a reliable source, accounting for about 10% to 20% of global supply.
But with the recent travails in the global financial markets, CBs quickly realized the folly of their ways. Countries suddenly started to worry about their own currencies, and others they held as foreign reserves. All the meanwhile gold was gaining more and more recognition as the global reserve currency it had always been, and it suddenly became a legitimate hedge to the gamut of fiats.
As a result, the consistent and reliable gold supply from CB selling faced serious peril. Many CBs decelerated or outright halted their selling. And provocatively some went against the grain, and actually started buying. Per GFMS tracking data of net CB buying/selling activity, 2008 sales were slashed in half to just over 200mt. 2009 followed with another huge haircut, coming in with marginal net sales of less than 50mt. And then in 2010 CBs were actually net buyers of gold for the first time in over 20 years.
With this astonishing change of events not only did gold’s supply chain completely lose a big source, CBs had joined the consumer ranks and were now competing for gold. And this trend is expected to continue. Already in Q1 2011, CBs had purchased more gold (estimated 129mt) than in all of 2010!
So with supply from central-bank sales completely gone, gold’s other major supply components have had no choice but to pick up the slack. And thankfully some upside volatility on the recycling front has helped fill the gap in recent years. In the beginning of gold’s bull, recycling accounted for about one-quarter of supply. But thanks to the allure of higher gold prices, recycling has skyrocketed to where it now accounts for about 40% of supply.
Indeed higher gold prices have prompted folks to work harder to extract scrap gold from spent equipment/electronics. And there has been a huge surge in people recycling their old jewelry. But interestingly this increased selling on the jewelry front is somewhat of an unsustainable phenomenon, and will likely reach a point of exhaustion in the very near future.
Anybody who watches television and listens to the radio has experienced the bludgeoning of ads by companies that wish to take unwanted gold off your hands. You can also open your local newspaper and find out about the nearest gold party. Show up to one of these with your friends, and you can dish your gold to an opportunist host while enjoying cocktails and hors d’oeuvres.
The problem is this surge in recycling has coincided with a brutal recession. Many of the folks cashing in their gold are desperate for money to pay their bills and feed their families. And it won’t take long for this desperation selling to be exhausted. Most people interested in selling their gold have done so, and it is likely that the gold coming in from this channel will see a decline in the coming years.
So with no more CB supply and what is likely to be a softening in recycling, this leaves the supply chain resting firmly on the shoulders of mine production. Yet even this reliable gold supplier has experienced volatility of its own as you can see.
Mine production has always been the primary source of gold, responsible for about 60% of supply in recent years. And leading into gold’s bull, which officially commenced in 2001, mine production had been pretty consistent. Through 2003 the miners had delivered at least 2500mt of gold per year for five years running.
But you’ll notice that in 2004 mine production took a dive, down by over 6% in a single year. And this was the beginning of a tailspin that saw production fall by a staggering 12.7% over five years. By 2008 the miners were producing at levels not seen since the mid-1990s. Yet over this same period the price of gold had more than doubled.
This trend was of course quite alarming, and gave additional fundamental support to gold’s already-powerful bull market. It was also perplexing that this type of trend was even possible considering gold’s upward momentum. With the price of gold surging past record highs, you’d think the miners would do everything in their power to boost volume. And that perhaps even the droves of new miners would start making material contributions. Yet seven years into gold’s bull, the miners were unable to answer the call.
There are many explanations for this huge production decline, but ultimately it came down to a systemic issue in the gold-mining industry. Simply put, this decline was a direct product of the bear that preceded the current bull.
During those cold dark years of the late 1980s and 1990s, the low gold prices forced the miners into survival mode. And those that did survive focused their efforts on the operations side of the business, working to optimize and expand their existing mines. With low margins and a lack of investor interest, they just didn’t have the financial bandwidth to explore for new deposits and stgelop new mines.
This prolonged exploration lull resulted in a lack of discoveries, and thus reserve renewal. And the lull in stgelopment put the gold-mining industry way behind the curve in grooming the next generation of mines. As clearly demonstrated in the chart above, this lack of activity resulted in serious consequences.
As mature mines deplete their reserves, they are either shut down or shift to the mining of lower-grade ore, which naturally drops output. This normally isn’t a problem if new mines are built at a fast-enough pace to cover the shortfall from mature mines. But without a strong pipeline of next-generation mines to cover the shortfall, it doesn’t take long for aggregate production to see a material decline.
Fortunately in the midst of this production decline, the gold miners were working hard to stop the bleeding and right the ship. This bull’s higher gold prices and higher stock prices allowed them to finally put capital to work exploring and stgeloping. And the result has been an increase in discoveries and a ramp-up of mine builds.
But just as the damage from the previous exploration cycle had a lagging effect that permeated well into this bull, it’s taken many years for the current exploration cycle to get ahead of the depletion curve. It takes a lot of time, and money, to get from discovery to production. Finally in 2009 we started to see the fruits of the current exploration cycle, and over the last two years we’ve seen production grow by an impressive 10.6% to an annual volume of 2500mt (per the U.S. Geological Survey).
This recent growth is of course the good news, but the bad news is mine production is still down nearly 3% bull to date. And in the face of growing demand and weakness from the other supply sources, this is a huge problem. These miners have now had a decade to ramp up production, and the fact that they are not yet at par indicates there is still a structural problem. The natural lag in getting new mines from this exploration cycle online is one thing, but there is more than meets the eye in this struggling industry.
There’s no question that gold mining is a tough business. And as time goes on, it only gets tougher. Gold is a rare precious metal for a reason, with its occurrence in economic lodes fleeting. Miners have accepted that the low-hanging fruit is gone, which has forced them to get creative in tapping the lower-grade and higher-complexity ores. But this geological conundrum is only one of many challenges the miners are faced with.
Miners are also subject to operational risk on a variety of different levels. And let’s not forget about geopolitical risk. Greedy governments want a bigger piece of the pie, unionized labor is more costly than ever, regulatory requirements are increasingly stringent, and misinformed environmentalists have too much pull with the bureaucrats.
So what does this mean for the future of mine production? Well according to most experts, it’ll continue to be a tough and volatile road. Gold miners will continue to operate in a growingly-hostile environment. And in all likelihood they will be hard-pressed to collectively meet growing demand in the years to come.
Thankfully the big increase in supply over the last couple years has taken off some pressure in the interim. But folks shouldn’t get too comfortable with this outsized rate of growth. This impressive run is in large part a result of the long-awaited commissionings of a handful of mega mines, which are not annual events.
Overall the gold industry’s infrastructure is still on the mature side, which will require a lot of new mines to come online in order to cover the shortfalls from depleting mines in the coming years. But even at these higher prices, this is easier said than done. In fact, even with this recent sharp production growth there are still rumblings that the world has seen or will soon see a peak in gold production.
I personally don’t buy into this theory for a variety of reasons, notwithstanding the fact that 2011 might deliver record mine production. The reality is if the price is right, over time the miners ought to be able to deliver at any demand level. There’s a lot of gold in the ground that may not be economically feasible to extract at $1000, but sure would be at $2000 and higher.
Regardless of the challenges, the fact is if the demand for gold continues to climb, the miners simply must rise to the occasion. And with gold’s long-term fundamentals still wildly bullish, we should expect demand growth to put continual supply pressure on the mining industry for years to come.
From an investor’s point of view, of course gold should continue to be a top performer. And as any seasoned trader knows, adversity presents big opportunities. The real gains should still reside in the stocks of the elite miners that are capable of successfully exploiting the supply side of the gold market.
The world’s biggest and best gold miners have enjoyed quite a run over the last decade. And their stocks have greatly leveraged gold’s performance, rewarding investors with legendary gains. Measured by the venerable HUI gold-stock index, bull-to-date leverage of about 3 to 1 has delivered 1500%+ gains for these stocks!
But provocatively even though these secular numbers are great, gold-stock investors haven’t been feeling the love in recent years. In fact, many will argue that these miners’ stocks have been dogs over this stretch. And indeed there’s something to this gold-stock disdain.
Interestingly prior to 2009 the HUI had positively leveraged gold at a clip of about 5 to 1. But seven long years of positive leverage in this ballpark has been quickly throttled when you consider the performance of the miners relative to gold since. And the last 18 months in particular have been simply dreadful. In 2010 with gold up 30% and the HUI up 33%, there was only 1.1 to 1 leverage. And so far in 2011 with gold up 6% and the HUI down 9%, the only leverage is to the downside.
This lack of positive leverage is indeed an alarming trend, one that has long-time gold-stock investors and speculators scratching their heads. 2008 was of course the year of the Great Stock Panic, and also coincidentally the year mine production hit its low. Did the stock panic thwart this leverage? Has mine production growth the last couple years numbed investors’ sensitivities to the importance of gold miners? Who knows! What we do know is that gold stocks used to be the hottest sector in all the markets, and now it seems as though they’ve lost their glitz and glamour.
So are the olden days of big positive leverage gone? On a corporate level as measured by the HUI, perhaps. Even prior to the stock panic leverage was declining in individual gold uplegs. And one major reason for this is many of the miners that constitute this index have gotten so big that their size alone makes it difficult to push big gains.
That being said, the larger stocks still ought to deliver positive leverage based on their inherent risk. 5 to 1 was heavenly, 3 to 1 is fantastic, and even 2 to 1 would likely be enough to entice traders into gaming the gold stocks. But 1 to 1 and/or underperformance is unacceptable. No wonder investors have been shying away!
The recent gold-stock performance is an anomalous enigma. Gold stocks even measured by the HUI will regain positive leverage to gold. But considering the circumstances, we’re likely entering into more of a stock-picking environment rather than all-gold-stocks-to-the-moon like before. The miners still have to mine gold, it’s just a matter of picking those that will thrive in the process.
There are many more gold stocks today than at the beginning of the bull, and investors just can’t expect any handful of stocks to outperform gold anymore. But those stocks that hold the right deposits and operate with the right margins should greatly outperform, and ought to deliver excellent leverage.
The bottom line is global gold supply has undergone a radical shift in recent years. Central-bank selling has ceased amid a global financial crisis, recycling has surged as opportunists take advantage of the higher gold prices, and mine supply has bounced all over the place as the bear/bull exploration cycles have their effects on the market.
And for reasons mentioned above it is mine production that will be the key component of gold’s economic balance going forward. This source has and will be the primary supplier of gold, and investors should be able to continue to ride the miners to profit in this bull. Prudently hand pick a custom portfolio of great gold stocks, and legendary gains can still be won.
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