Last week the World Gold Council (WGC) released its highly-anticipated Gold Demand Trends (GDT) report for Q4 and full-year 2009. GDT reports contain analysis of independent data compiled by GFMS Limited detailing supply and demand trends in the global gold market. They are jam-packed with key fundamental reads that undergird gold’s secular bull.
Generally only select groups of industry stakeholders and traders are the ones who anticipate these reports. Most people couldn’t care less what they say, and if you mention WGC they’ll think you’re talking about golf. But with gold gaining mainstream popularity in recent years, GDT reports are now a lot more relevant.
CNBC even gave face time to one of the WGC’s executives to discuss this report on the day of its release. And being the consummate gold skeptic, CNBC centered in on the fact that identifiable gold demand was down 11% in 2009. The talking heads just couldn’t understand how gold prices could remain strong in this environment, especially with supply up 11% over this same time period. The WGC exec of course held his composure, expecting the tough questions, and methodically explained why the gold market was still healthy.
Quickly on the demand front, this 11% slide was frontloaded in an anomalous Q1. With virtually all spending grinding to a halt, jewelry consumption (gold’s largest demand component) from Q4 2008 to Q1 2009 tanked by a whopping 38%! Jewelry demand eventually returned over the next 3 quarters when folks realized we weren’t spiraling into the next Great Depression, but the damage had been done.
Year-over-year jewelry and industrial demand were down 20% and 16% respectively. These figures alone are indeed chilling, but the resiliency of the gold market shined amidst adversity. One of the main reasons 2009’s average gold price was 12% higher than 2008’s is growing investment demand.
In the face of economic uncertainty gold’s intrinsic appeal has really blossomed, with investment demand skyrocketing in recent years. Identifiable gold investment demand was up 7% in 2009 and is up 85% in the last 2 years. But though gold investment did pick up some of the slack from jewelry and industrial shortfalls, overall demand was still off.
As for supply, 2009 was an anomalous year on this front as well. And one of the biggest peculiarities was also driven by the wild economic volatility. With folks convinced that financial Armageddon was imminent, many pawned off their jewelry and ornamentals in order to raise cash. And this was seen via a huge increase in scrap supply. From Q4 2008 to Q1 2009 recycled gold increased by a staggering 62%!
Though scrap supply subsided after Q1, when the panic sellers exhausted their resources, 2009 still saw a giant 27% increase over 2008. In 2009 scrap supply accounted for about 40% of the total gold supply. But while a large component of supply, scrap has and will be overshadowed by the activity of two other major supply components.
And most provocatively, one of these components may be going away. For a long time central-bank sales had a major influence on the overall balance of the gold markets. And though by volume what the CBs delivered to the markets had been smaller than what was generated by recycled gold, CB sales were material. But a unique attribute to CB activity is it is not fixed to one side of the economic spectrum. CBs have the ability to supply or demand gold, to be net sellers or net buyers.
And in 2009 we saw what could be a strategic shift in CB activity, a change that would have a resounding effect on the gold trade. In the last 3 quarters of 2009 CBs actually shifted to becoming net buyers of gold. For the year CBs were marginal net sellers as a result of Q1 selling, but if the trend from the last 3 quarters persists it will break a 20+ year net-selling streak.
This CB buying activity is very refreshing to see. Gold has been and will always be the ultimate form of money. Its timeless value transcends the life of any fiat currency, and it’s steady in its role as an inflation combatant. Perhaps it is a stretch to think that the financial leaders of the world’s nations understand this concept. But a step in the right direction tells us they are at least willing work towards better diversifying their large fiat reserves.
Central banks couldn’t be ignored on the supply side of the gold trade, and shouldn’t be on the demand side either. CBs have a lot of buying power, and if they decide to start stockpiling gold again it could have a material impact on the balance of these markets.
Last but certainly not least on the supply front is mine production. Mining is responsible for the majority of gold supply, about 60% over the last several years. And the prevailing trend of this component is one of the major fundamental reasons for gold’s secular bull. As you can see in the chart below, the gold mining industry is in the midst of some serious structural problems.
For global mine production data I used the numbers from the US Geological Survey (USGS), which closely matches GFMS estimates. And with the USGS’s recent release of final 2008 data and 2009 estimates, this bar chart shows an updated bull-to-date production trend. The first thing that needs to be made note of is 2008’s final number, a downward revision from the USGS’s original estimate of 2330 metric tons.
At a final 2260 metric tons (72.7m ounces), this 3% reduction from original estimates and 5% decline from 2007 makes 2008 the weakest production year in this entire bull. The miners actually tallied their lowest gold output since 1995! This significant decline really demonstrates the ongoing struggles of the mining industry.
Since the beginning of its secular bull, gold has powered higher by an amazing 373%. With its price moving from the $200s to over $1000, you’d think the miners would have incentive to ramp up production in order to take advantage of these higher prices. Not only should the existing miners be encouraged, but the barriers to entry should be way down. Like the 49ers of yore, savvy entrepreneurs have had ample reason to flock to the gold scene.
But instead of ramping up production to meet growing demand, a startling trend has taken shape. Since 2001 mined gold production has fallen by 8.6%. And though the USGS’s 2009 production estimate is 4% higher than 2008, it is still expected to be the second-lowest annual output in this bull. This clear downward trend is foundational fundamental support for gold prices to remain high.
There is a lot of conjecture as to why and how this trend has unfolded. And it is peculiar being that all throughout history the miners hadn’t had trouble finding and mining gold. In fact, with the help of modern mining methods such as heap leaching, annual global gold production doubled from 1980 to 1997. But with production capping out in 2003 at about 2600 metric tons, has the world seen a peak in gold mining output?
The concept of “peak gold” is an idea that has been tossed around ever since this 2003 apex. And there is certainly a compelling argument for it. Gold is after all a finite resource and there is only so much of it in the earth’s crust. Prospectors have been scouring the planet for thousands of years in search of this metal for kings, and the majority of the easy gold could well be extinct.
A big proponent of this “peak gold” theory is the CEO of the world’s largest gold miner, Barrick Gold. Now it might seem a bit self-serving for a gold mining executive to support a theory that would keep the price of his primary product high. But Aaron Regent brings up some good points.
Regent’s main platform is eroding ore quality. He points out that in addition to it being increasingly difficult to find ore, that grades have dramatically fallen over the years. In the major gold-producing countries of Australia, Canada, and the US, ore grades have fallen from an average of about 12 grams of gold per metric ton in 1950 to 3 g/t today. South Africa also knows this problem all too well. Lower grades have been a major factor in its colossal production declines.
Ultimately whether we’ve seen “peak gold” production or not, there is no denying the fact that the mining industry is in a state of disarray. In a period where gold demand is rising yet mine supply falls by an average of over 1m ounces per year, where does the future balance of this market lie?
On the demand side of this greater economic question, I just don’t see higher prices deterring people’s wants and needs for gold. In our current age of consumption and out-of-control government spending, people are watching the value of their fiat-currency-backed holdings erode with every passing day.
Gold has many fundamental merits, but it is essential for investors to hedge their portfolios against the vagaries of the global economic scene. And we are seeing more and more investors come to this realization with the growing popularity of such vehicles as gold-backed ETFs. But since gold investment has yet to decisively penetrate mainstream ideology, we likely haven’t seen anything yet on the demand front.
With investment demand expected to be the driving force of the ongoing bull, the heavy lifting of the gold market balance will lie on the shoulders of the suppliers. Today’s higher gold prices, and what will likely be much higher future prices, will provide incentive for the miners to find and produce enough gold to meet demand. According to the USGS there is at least 19 years of identifiable economic reserves at the current production rate, along with another 20+ years that have the potential to be economic at today’s prices. There are plenty of known resources today and miners have long been able to renew reserves via ongoing exploration.
Unfortunately current known resource levels don’t explain the alarming production downtrend or how it can be reversed. But before we look for a solution we must consider the means that justified this end. We must look well before this current bull in order to understand the stgelopment of today’s environment. And you don’t have to look too far to discover that price was the impetus for this means.
It should be no surprise that prior to this gold bull was a gold bear. And with prices trending downwards in the 1990s and early 2000s, mining companies had very little incentive to invest in infrastructure. Mineral exploration and stgelopment is very expensive, so with low margins and no end in sight in gold’s decline, generative exploration and new mine stgelopments were the first things to be cut from budgets. And naturally after years on end of infrastructure neglect, production pipelines became thin and output eventually fell.
Fortunately now that we are seeing higher gold prices, capital is finally finding its way back into the mining industry so the years of neglect can be corrected. But it will take at least as much time on the flip side to right the ship and demonstrate growth. While barriers to entry are lower today (as seen by the hundreds of new juniors on the scene), it still takes a great deal of time and capital to find and stgelop gold deposits.
In reality many of the gold mines being brought into production today are tapping mineralization that was discovered decades ago. Most of the new deposits that have been and will be discovered via grassroots exploration during this gold bull have yet to make a material impact on production.
As for the lower ore grades, this is indeed the future. In the good-old days alluvial fields with giant nuggets and surface outcrops with visible gold were like simple pirate maps that made gold discovery a lot easier. These anomalies marked X on the spot leading to rich underground booties of gold veins. But these finds are a lot less common today. Even with the help of modern exploration technology, gold discovery is complex and cumbersome.
But grades need to be considered in context. Interestingly, technology has allowed certain lower-grade ores to become very economical to mine. In fact, some of the world’s biggest and most profitable operations today are mining gold with an average grade of less than 1 g/t!
Of course not all deposit types can be mined like the ones mentioned above. And deposits with complex ores are certainly a lot more expensive to mine at 3 g/t than 12 g/t. But “expensive” is relative. In actuality there is a right price for any grade or ore complexity. Gold can be profitably mined from sea water and sandy beaches if prices were high enough! And this is one of the biggest arguments against “peak gold”.
Regardless of whether the miners can ever claw back to the 2003 peak, this production decline simply can’t persist indefinitely and will likely turn higher in the years to come. But it will take time for the mining industry to build-out a network capable of extracting the more challenging gold deposits along with the newer discoveries.
Mining will always be a challenge. This is a tough business to be successful in for a variety of reasons. Miners must contend with government and environmentalist hostility, price volatility, geological uncertainty, climate, and operational challenges among the many. But their role in the global supply chain is unchanging. Scrap supply will continue to play an important role and the central banks will have an intermittent impact, but it is the miners that are tasked with meeting what will be growing investment-driven gold demand.
Yes, big high-grade deposits are harder to find and average gold grades are down. But if the price is right the miners will find and deliver the gold. And the right price is probably a lot higher than where it is today. As investors we can capitalize on gold’s right price by buying the mining stocks that are best-positioned to leverage this metal’s gains. Though the industry is struggling, the remnant is very appealing in a higher-gold-price environment.
The elite miners that have serviced this gold bull so far have seen amazing profits with the price of their product rising nearly 5-fold since 2001. And their shareholders have seen legendary gains, as gold stocks typically exhibit positive leverage to the fortunes of their underlying product.
The bottom line is the 2009 GDT report summed up a rough year for the gold markets. But while both demand and supply were affected by an extraordinary economic event, growing gold investment averted what could have been a much worse situation. And this is likely a sign of what’s to come, as this demand component will continue to be a big driver of gold’s secular bull.
Another big fundamental driver is the supply struggles of the mining industry. Though output was up from the previous year, 2009 mine production was the second worst tally in this entire bull. Mine production is still in a downtrend, and a strategic shift from this direction will be slow-moving as the industry continues to recover from a long period of underinvestment. And the quality miners delivering the gold should greatly profit and reward shareholders along the way.
© Copyright 2000-2009, Zeal Research (www.zealllc.com). Zeal Research is a US-based investment research company – you can visit their website at http://www.zealllc.com/. Zeal’s principals are lifelong contrarian students of the markets who live for studying and trading them. They employ innovative cutting-edge technical analysis as well as deep fundamental analysis to inform and educate people on how to grow and protect their capital through all market conditions. All views expressed in this article are those of the author, not those of TheBull.com.au. Please seek advice relating to your personal circumstances before making any investment decisions.
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