Gold Supply Misconceptions

August 11, 2010 – At current Gold prices many of the mining companies are taking a drubbing. Clearly, the worst hit are those with the highest operating costs.

Many of the more marginal mines (i.e., those mines now at or below break-even) have a cash operating cost above $300 per ounce. In other words, it costs these mines over $300 to extract one ounce of Gold from the ground. After adding in non-cash charges such as depreciation, these mines are struggling, with nearly all of them operating at a loss when all costs are included.

I have seen many studies in recent weeks that have identified those mines operating at no better than break-even, or worse still, at a loss. And believe me, they are numerous. About 50% of the South African mining industry is not making money. The number for Australia is about 35%. Somewhat less than 20% of the North American mines are operating without any profit. These totals are indeed staggering.

In many industries, aggregate production begins to slow when profits disappear. Those companies that cannot operate profitably will close in order to protect shareholder capital, a prudent measure. However, this obvious conclusion does not necessarily apply to the Gold industry. Do not expect any massive cutbacks in production, regardless how low the Gold price falls or how long it stays down at these low levels.

This conclusion is counter-intuitive. How can all these marginal mines stay in business if they are not making a profit? There are several reasons, including the following:

(1) Price expectations. Few people expect the Gold price to remain this low. Consequently, each mine will do whatever is possible to keep operating in an attempt to stay open for business until the Gold price reaches the other side of this ‘valley’. Many miners have seen low Gold prices before, and they respond accordingly. Lean and trim operations become even more lean and trim. As the old saying goes, necessity truly is the mother of invention.

Moreover, there are prudent reasons to keep operating. Suspending operation and then putting a mine on a ‘care and maintenance’ basis until the Gold price once again rises can be costly, and as a consequence detrimental to shareholder capital.

It can also be costly to resume operation once mining has been suspended, and it may be difficult to locate and re-hire experienced crew, who may have sought out jobs with other mines during the suspension. Therefore, in the expectation that the current low Gold price is a passing phenomenon, a leading objective of the management of many mining companies is to avoid putting mines on care and maintenance.

At the very least, rather than take the chance of acting precipitously, most companies are prepared to risk some capital to fund operating losses for an initial wait-and-see period, in other words, waiting for several months to see whether the Gold price bounces back up.

(2) Devaluation of exchange rates. Mines outside the United States have one potentially very big advantage over mines operating within the United States. The local exchange rate may be devalued against the US Dollar so that the price of Gold in local currency terms does not decline.

South African production in particular will benefit from this ‘miracle’ of financial engineering. The South African Rand has already been weak as the Dollar price of Gold has fallen, and is currently at Rnd 4.67 per Dollar (compared to Rnd 4.42 only a couple of months ago, a 6% decline).

To examine this point further, if the Gold price were to drop 5% from here while at the same time, the Rand falls to Rnd 4.90 (also a 5% move), the Gold price in Rand terms remains unchanged. If the Rand, however, were to drop to Rnd 5.14 (a 10% decline) while the Dollar price of Gold falls by only 5%, the mathematical result is that the Rand price of Gold will actually rise by 5%, and this improvement for the most part goes right into the bottom line of the mining company.

The only negative impact to earnings from the devaluation is the higher cost of imported materials required in mining, but these are insignificant. The highest cost is labor, which in some South African mines can be over 50% of operating costs.

If you doubt that exchange rates can be managed to favor a local industry, I suggest that you study the Chilean copper industry during the early 1980’s. As the Dollar rose during the first Reagan administration and the copper price fell over 50% from its 1980 peak, Chilean production continued almost unabated. At the same time, US-based copper mining shriveled as mines within the United States were not able to operate profitably with US Dollar costs at the new, low US Dollar price.

(3) Forward selling. Many mines have sold forward their production and have as a result locked in a revenue stream to ensure some operating profit. Therefore, these mines will continue operating. However, there is an interesting feature that needs to be considered in these circumstances.

Many of the mines that have sold forward are now operating at a loss when measured on an all-in cost basis (some of the more marginal operations are even underwater on just a cash cost basis). In other words, though they may report a profit to shareholders because their revenue was locked in at higher prices, many mines – particularly in Australia – would now be reporting operating losses if they hadn’t sold forward their future production to secure that revenue.

This observation of course leaves open the question whether or not these mines should buy back their forwards at current prices. In this way, the mines earn the profit from their forward sales. Because they are operating at a loss, they can in effect buy Gold in the market at a price below their operating cost. Once the forward was covered and the profit realized, they can then put their marginal mines on care and maintenance until the Gold price again rises.

Most mines will not, however, take this action of suspending operation. Sure, a few operations already unprofitable at higher prices may close, but the weight of Gold coming on to the market each year will continue to be above 2000 tonnes per annum. Again, there is in the management of most companies the natural reaction – which is often the prudent course – to avoid the care and maintenance option.

What conclusions can be drawn about the Gold price from the above observations?

Given the immediate and obvious conclusion that nearly all current mining production will continue, do not expect any drop in mine output to be a factor that will help the Gold price. This conclusion may be seen as bad news by some people desperately seeking any bullish news that may help the Gold price, given their thinking that cut-backs in production will be beneficial to the Gold price. However, do not be dismayed. This on-going production of Gold really is not a big deal, nor has the annual production of Gold ever been a big factor in determining the Gold price. In this regard, Gold is truly unique.

Gold is the only product, indeed the only good and service, produced for accumulation. Everything else is produced for consumption. Therefore, annual production is an important component of the supply/demand equation foreverything but Gold. Because this reality about Gold is not well recognized, there exists today a widespread misconception – and this includes many people within the Gold industry – about the factors that determine the Gold price.

Nearly all the Gold ever mined throughout history still exists (some 116,000 tonnes), and of this amount, more than 80,000 tonnes is being utilized for monetary purposes (bars, coins and high-karat monetary jewelry popular in Asia and the Middle East). This Gold can be mobilized and made available to the market at a moment’s notice, if there is a change in demand preferences by the owner of any ounce of Gold.

Therefore, while it is true that the Gold price, just like the price of any other good or service, is a function of supply and demand, the factors of supply for Gold are different. Its supply is the 116,000 tonnes of Gold existing in the aboveground stock. Annual production, which is presently about 2100 tonnes, is consequently not a big factor in the Gold price (it’s only 1.8% of the total supply of Gold).

Therefore, it is not only very misleading, it is also incorrect to speak of a deficit in the Gold market. Though you hear this term all the time, it is nonsensical. The reality is that Gold is always in equilibrium at every instant in time and at every price.

These so-called deficits are purportedly a measurement of the annual sales of physical Gold, which in turn is compared to annual production. I say purported because these figures are offered with seemingly scientific precision but in reality are vague and loose estimates of the annual physical flow of Gold.

Currently, the deficit is thought to be some 1800 tonnes, equaling total annual ‘sales’ of 3900 tonnes less the 2100 tonnes expected to be mined this year. Given the nature and size of the Gold market, these flows must unavoidably be ‘measured’ (really, guesstimated is the best description) with a very high degree of imprecision, sotheiraccuracy is unreliable.

The reality is that once Gold is purchased, it does not vanish from the market never to reappear again. There is no vacuum between supply and demand that can only be filled by new mine production.

The bare truth is that Gold mined last year or a 100 years ago is perfectly substitutable for Gold mined today. Some of the Gold sitting in your bank vault may have been mined by the Romans!

While Gold is subject to the same economic laws as other products, it is the demand for Gold that is all important in determining the price of Gold. Because some 85,000 tonnes of Gold can be mobilized at a moment’s notice, it is the demand for this Gold that has a profound impact on the Gold price.

For example, if the Australian central bank no longer has the same demand for Gold that it once did and it chooses to dishoard 167 tonnes, does it really matter whether there is a so-called deficit between annual production and sales? No, of course not. But let me quickly add, the above explanation of the reality of the Gold market is not implying that I am bearish about Gold’s prospects. Quite the contrary.

Because Gold is demand driven, changes in demand are needed to drive the Gold price higher. I expect the demand for Gold to change markedly. Any number of events could spark this increase in demand. Inflation, a reversal in the stock market, a financial collapse at a Japanese bank, etc. Almost any financial event could be the factor that causes a change in demand preferences between any national currency and their competitor – Gold.

In summary, because new annual Gold production really isn’t a big factor in the Gold price, it is not bad news that annual production will not decline much. Nor is it good news that Gold is in a deficit. Personally, I would rather see Gold in a so-called surplus if it meant that the Gold price would be higher.

So don’t expect the Gold price to go soaring anytime soon because of the items impacting the supply side of the equation. The factors affecting supply are all just so much noise, inconsequential to the big picture. For the Gold price to rise, it is essential that the demand for Gold – the demand for those 116,000 tones, and particularly the 80,000+ tonnes held as money – change. The demand for Gold as money must be heightened. And I expect that it will.