Gold paying the price of past hoarding

It was a nice two weeks, but gold faded back to US$265 per oz. as though it had never seen US$280. Gold lease rates, which went up — gasp! — half a point, are back near 2%. Nothing seems to move the gold market anywhere but back to its main trend line.

One issue is demand for physical gold. According to the most recent statistics from the World Gold Council (WGC), jewelry demand is rising and now outstrips mine production by about 1,000 tonnes. But the underlying price trend has not responded. That is not new: the production deficit has been with us for the past thirteen years. Gold has fallen from US$500 to US$265 per oz.

The WGC, as well as some more far-sighted producers, has called for a concerted marketing campaign to spark demand for gold. Naturally, this would focus on the jewelry market, but such a campaign, on its own, probably could not shoulder the burden of increasing the gold price.

That leaves bar-hoarding, which, two decades ago, drove a wild price rise, but which now, at least in the developed world, is probably a dead issue. Twenty years ago, “currency collapse” was on the lips of every soothsayer. Today anyone fretting about currency stability is seen as a compulsive worrier.

Perhaps the worst thing central bankers did to the gold price was not to sell so much gold, but to tend their monetary flocks so carefully that those with purchasing power in the developed West are now thoroughly confident in fiat money.

What is still clear is that even if demand for physical gold rises, it can be satisfied out of above-ground stocks. There is some question about how much gold the central banks really do hold and how much of what they report is actually an account payable under existing gold leases. But when central banks and international institutions have about ten years’ demand either sitting in vaults or on paper, a sudden buying spree by jewelry manufacturers or investors won’t require any new mines to be opened.

Anyone anxious for central banks to hold significant gold reserves would do well to reflect on how those reserves affect the gold price. Not even the most rabid gold bug can deny the effect above-ground stocks have when they are sold; but even when they are not sold, the large supply overhang can have the effect of depressing the price. (It would be pretty hard to contend that there is no price depression when large stocks of copper or nickel — or pork bellies, for that matter — build up in warehouses, so why would gold be any different?)

The fact is that gold may have the worst of all possible worlds under the present set of circumstances. There is mine production, plus a certain amount of gold floating around under lease, which satisfies immediate physical demand. There are large, above-ground stocks on the books — numbers that may or may not actually apply to 400-ounce good delivery bars stacked in vaults — whose principal market role is to weigh on the price. And there are secure, interest-bearing investments that appeal to all but the most fearful.

In a perfect market, chronic oversupply would simply mean that the price would fall far enough that the commodity would not be produced. Once the oversupply was worked off, producers would come back in again. Anyone with experience of reopening a gold mine knows life isn’t that simple. But the gold market’s deviation from pure supply-and-demand economics does raise questions about whether the market has somehow failed.

There is certainly a perversity in the way many gold producers make their money. As was pointed out recently by Pierre Lassonde, one of a few people in the gold business given to indulging in hard thought for more than a minute or two at a stretch, large hedged gold producers make as much money from their hedge books as they do from mining gold. Some make even more.

It’s economically rational: hedged producers have been the only solid moneymakers in the gold business. But if hedging gold is the way to make money, why mine it at all?

At least on the face of it, there must be something distorting the market. In the view of the unhedged gold producers, the chief scapegoat has always been gold leases, and with good reason. Lease rates have exceeded the carrying rate on gold futures contracts only rarely, such as in a brief lease-rate spike in early 1995. They have exceeded basic money-market rates, such as the U.S. Federal Funds rate and the London interbank rate, even more rarely, the last time being in 1999, when the central banks agreed to limit gold sales.

It becomes easy to make money when you can carry or lease gold for less than a generally accepted risk-free discount rate. So the hedged gold producers do just that, and can’t really be blamed for it.

But what hedging has also done is make it economic for thoroughly hedged producers to carry money-losing operations. Perhaps they do it expecting that prices will turn up one day (another triumph of hope over experience), but the effect is to put more gold, uneconomically produced, on the market. And so supply goes up, prices go down, and low-cost operators go unrewarded for their competence.

Add to that a tendency, among some companies, of accepting large writedowns, and consequently balance-sheet losses, on poorly performing mines or on low-grade reserves, and the race to the poorhouse is on.

Perhaps it’s simply that gold is paying the price for having been a monetary asset. Gresham’s law operated: when gold was the best currency around, it was hoarded, by individuals, rich and poor, by mercantile interests, and finally by central banks to back their paper. Now, gold’s monetary role has been largely superseded, but as a commodity, centuries of hoarding have put it in fundamental, long-term oversupply.

The irony is that pushing central bank gold on to the market may prove the best thing for gold prices in the long run. But J.M. Keynes had its number: in the long run, we are all dead — and so, of course, are a great many gold producers.