Gold: review and outlook

METALS COMMENTARY/CPM GROUP

The gold market underwent tremendous changes in 2003.

Prices rose sharply, from a low of US$322.20 per oz. in early April 2003 to US$417.20 per oz. on Dec. 30. The annual average price was US$364.07 per oz., measured on the settlement prices for the nearby active Comex futures contract. That was 17.1% higher than the US$310.94-per-oz. average in 2002, which in turn had been 14.5% higher than the US$271.67 average in 2001. Last year’s average price was the highest since 1996, the year before gold prices broke below US$320 per oz. and spiraled down to levels below US$300. The high of US$417.20 per oz. was the highest daily settlement price since Feb. 2, 1996.

The price rise reflected a surge in investment demand for physical gold to its highest levels, by a wide margin, since 1967, the year an investor run on gold broke the post-war Bretton Woods dollar-gold international monetary system. Investors also poured enormous amounts of money into gold futures and options last year. The investor buying came from all quarters, including many institutional fund managers around the world that previously had never invested in gold. Individual investors from Bombay and Dubai to New York and Geneva also were heavy buyers. Investors spent about US$12.3 billion on gold purchases in 2003, and another US$2.7 billion on purchases of gold in jewelry form for investment purposes; this compares with only US$2.7 billion invested in gold in 2001 and US$8.2 billion in 2002. That 456% increase in the flow of money into gold explains the entire upward movement in gold prices.

Why have investors been putting so much more money into gold than they did one or two years ago? The answer to that lies more in the realm of macroeconomics and international political developments than in gold supply and demand fundamentals.

The fundamentals do apply, of course. It is just that trends in mine production, secondary recovery from scrap, central bank sales, and fabrication demand have not been as critical to the price rise as have been trends in currency markets, stocks, bonds, and overall economic conditions, all of which have been stimulating investment demand for gold.

Preliminary estimates are that investors may have purchased 33.9 million oz. gold in 2003. That was the most investors had purchased on an annual net basis since they bought 46.8 million oz. in 1967. At that time, investors bought so much gold that they forced the central banks of the world to close the private-sector gold window facility, which allowed private investors to exchange their currencies for gold. It was the beginning of the modern free gold market.

The high volumes of gold bought by private investors in 2003 pushed prices even higher. Prices had risen to just below US$350 per oz. by the end of 2002. They continued to rise throughout 2003, reaching US$431.50 per oz. on an intraday basis on Jan. 6, 2004. Prices settled at US$426.80 per oz. on Jan. 9. Gold slid back to a low of US$392.70 per oz. on a settlement basis on March 3, before recovering to around US$420 by the end of March. There was a large amount of open interest in the April Comex gold futures contract at that time, leading to some congestion in the delivery process for the April contract. That was one factor that pushed gold prices higher.

Broader economic, political, and financial market concerns continued to stimulate investor interest, even as some investors and others in the market were questioning whether gold prices might have risen too far, too fast, or already had reached their peak in January. As a result of these conditions, it appeared that gold prices would strengthen in early April.

Investment demand

In dollar terms, at the annual average prices of the past three years, investor demand for gold bullion, coins, and medallions rose from US$2.7 billion in 2001 to US$8.2 billion in 2002, and then to US$12.3 billion in 2003. The 2003 figure excludes about 7.5 million oz., worth another US$2.7 billion, that was purchased as gold jewelry.

Also of importance has been the breadth of investment buying. There have been institutional investors, hedge funds, general investment funds, wealthy individuals, and poor individuals around the world buying gold in large quantities.

They also have been buying gold for a wide range of reasons. The decline in the dollar has garnered a tremendous amount of attention, and that is well-deserved. People are rushing to sterilize their dollar exposure.

Most of the gold purchased in the Australian gold equity issue last year, for example, was purchased by Middle Eastern investors seeking to get money out of their countries without violating currency transfer restrictions. They found they could buy gold equities in Australia legally, so they did. Indeed, investors have been buying gold for various reasons; the dollar is only one of them. The Middle Eastern investors were seeking a hedge not only against the dollar but against economic and political conditions in their region and countries. Political unrest and uncertainty certainly have played a key part in investors’ decision-making toward buying gold.

Investment demand is expected to remain high in 2004 on an annual net total basis. Investors may acquire another 30.1 million oz. gold on a net basis this year. One thing to watch is the degree to which this demand is being loaded into the front half of this year. There is a possibility that economic and financial market conditions will be less stimulative of investor demand for gold during the second half of this year. If this proves to be the case, full-year demand may remain high, but the second half of the year could see both lower investment demand and lower gold prices as a consequence.

Total supply

Total supply rose 2.8% between 2002 and 2003, from 107.5 million oz. to 110.6 million oz. The increase reflected a sharp increase in the amount of gold being refined from scrap, especially in India and the Middle East. This increase more than offset a small decline in mine production.

In 2004, total supply may decline 2.2%. This projection is predicated on the view that mine production will continue to fall, while the flow of gold scrap into refineries also may decline, perhaps sharply.

Mine production of gold is estimated to have declined 0.6% between 2002 and 2003, from 64.5 million oz. to 64.1 million oz. Declines were registered in South Africa, the U.S., and Canada, whereas Australian output inched up slightly.

Production in several other countries, such as Tanzania, Ghana, Peru, and Indonesia, rose last year. A further contraction, perhaps on the order of 0.5% to 63.8 million oz., is projected for 2004. Once again, U.S. production is expected to decline. Australian output also may dip this year, whereas South African and Canadian production is projected to stabilize. The declines in some countries will be offset by newer, lower-cost mines coming on-stream elsewhere.

The estimate for 2003 and projection for 2004 are a bit controversial, as some in the gold market have repeatedly stated that gold production has to fall in response to the long period of low gold prices. Production already has fallen because of the effects of low prices. Mine production, on a worldwide basis, has declined steadily since 1999. Production last year, projected at 64.1 million oz., was off 4.6 million oz., or 6.7%, from 68.7 million oz. in 1999. Further reductions are projected for this year, but the rate of decline and the extent of the drop going forward are likely to be abbreviated as a result of higher gold pries.

The rise in gold prices over the past two years has taken gold prices to levels at which an enormous amount of additional mining capacity has become profitable once again. It will take a few years for this to have its full effect on mine production, but if prices remain high, mine production worldwide should start increasing in 2005, and continue increasing for the next several years.

Mine production of gold is the only transparent sector in this market. While jewelers, investors, refiners, and even central banks tend to mask their gold market activities, most gold mining companies trumpet their output and their expansion plans. The decline in gold mine production since 1999 has been the result of the long period, beginning in 1997, when gold prices were below US$320 per oz. During this time, some of the higher-cost, older gold mines closed. Some relatively new, high-cost mines also closed. Exploration and development budgets were slashed. New mines and expansions were deferred. The cumulative result of these cutbacks in mine expenditures was that, by 2000, the amount of newly mined gold being refined and sold in the world began to contract.

It appears the contraction continued in 2003, and will continue this year. However, the higher prices have begun to stimulate a revival in gold mining. Most gold mining companies now are dusting off their new mine programs and expansions. Some mining companies expect production rates to continue to decline in 2004, as there is a significant lead time between moving toward production expansions and achieving them. The trend is clear, however.

There are roughly 12 million oz. of gold mining capacity that most likely will come on-stream over the next five years at major mines, with several hundred thousand ounces of additional capacity likely to come from smaller mines. These are new mines that will now be developed, expansions at or near existing mines, and old mines that will be reopened. All of this represents an increase of roughly 25% from current gold mining capacity outside of Russia, China, and central Asia. In 2002, an estimated 5.8 million oz. gold were refined from scrapped jewelry and other objects and products in India. In 2003, the volume may have been as high as 16.1 million oz.

It seems that gold secondary supply rose at least 13% between 2002 and 2003, to 29.4 million oz. from around 26 million oz. This is using a figure of 11.3 million oz. for India, compared with the high end of the range of estimates, at 16.1 million oz.

Secondary supply is a relatively small portion of total supply. Even with the surge in scrap recovery last year, secondary supply accounted for only 26.6% of total supply. This year, gold secondary recovery may decline by 3.2 million oz., or 10.8%. There are already signs that the trend began emerging in the first quarter, reflecting the fact that last year there was a surge of gold jewelry sold as scrap when prices rose. The surge may have passed, so that even if prices remain high, there may not be as much jewelry sold this year for its gold content as there was last year. Scrap still would remain high by historical standards: around 26.2 million oz.

Fabrication demand

While investors were buying more gold, the high price was having a negative effect on fabrication demand. Around 90% of annual gold demand goes into jewelry and decorative objects, and these are extremely price-sensitive applications.

As gold prices rose over the course of 2003, it had a devastating effect on gold use in jewelry in most (but not all) regions. That’s because much of the gold jewelry bought in the Middle East and South Asia is, in fact, bought as investment demand. The statistics in this report show that gold demand worldwide declined a mere 0.2% between 2002 and 2003, from 92 million oz. to 91.7 million oz. Jewelry demand on a worldwide total basis declined 0.5% to 82.4 million oz.

These figures contrast starkly with the experiences of many companies in the gold jewelry trade. While demand was falling sharply in many jewelry markets, it was rising sharply in other markets, such as India, other South Asian nations, Turkey, and the Middle East.

Excluding India and the Middle East, gold fabrication demand dropped 11.6% between 2002 and 2003, from 65.6 million oz. to 58 million oz. Demand for gold fell 22% in the Italian jewelry market in 2003. Gold imports dropped 33%. Some of this represented a shift to Turkey and China for manufacturing. Part of it represented a decline in jewelry use of gold, owing to to high prices.

Demand also fell in the U.S., Thailand, Japan, Germany, France, and other major consuming countries. Meanwhile, demand for gold rose 33.7% in India and 20.8% in the Middle East. While most of this is classified as jewelry use of gold, much of it was actually for investment purposes.

On a worldwide basis, fabrication demand is projected to decline another 0.8% in 2004. To some extent, the divergent trends of 2003 are expected to continue.

Price predictions

CPM Group’s analysis of the gold market has focused for some time on the long-term market-clearing ranges for gold. From 1980 through most of 1997 gold prices traded mostly between US$340 and US$420 per oz. Within this range, supply and demand were broadly in balance. Prices spiked above and below this range briefly at various times during the 17-year period but tended to gravitate back into this range.

In the second half of 1997, prices broke below this range and dropped into a range of US$251-300 per oz. for most of the next four and a half years. Reports repeatedly suggested that these price levels were too low to be maintained in the long run. (The short run, it was noted, can last many years, due to the lags and slow movements in some sectors of gold supply and demand.) Prices moved out of this range in the second quarter of 2002.

There have been suggestions that a market-clearing range for gold in the long run might be US$320-380 per oz., or maybe US$320-400 per oz. The lower range from that which was maintained for most of the past two decades reflected secular changes in gold mine production costs, jewelry fabrication technology, and consumption patterns, among other factors.

CPM Group believes prices probably cannot be maintained above US$400 per oz. in the long run. Again, the short run can last for years, before these long-term factors catch up with the market. The analysis behind this conclusion remains intact.

Some gold market observers have suggested that the fundamentals of the gold market have changed in ways that render this analysis outdated. More importantly, they have focused on changes in the overall world economy, especially regarding the value of the U.S. dollar, as reasons for expecting gold prices not only to stay above US$400 per oz. but to move much higher.

Analysis of the gold market and the underlying world economy suggests caution should be exercised in relation to such conclusions. The macroeconomic trends that have helped stimulate investor demand for gold over the past two years, pushing prices higher, may not persist going forward.

It is not at all certain that these were secular, permanent changes in the world and not cyclical trends that already are changing. The dollar has fallen mightily since its peak in early 2002 but is now is back to levels that were common for a decade, from 1987 to 1997.

Although some observers believe that the dollar’s decline over the past two years is the beginning of a permanent, long-term decline in its value, an alternative, more supportable view of the dollar is that the decline over the past two years was a cyclical correction from a grossly over-bought state in January 2002, and that the extent of its decline may already have occurred. The dollar has fallen several times in the past three decades. Past periods of decline have lasted 2-3 years. And so, the current decline may prove to be another one of these cyclical corrections from an over-bought state, and not the beginning of the end for the dollar.

This view is supported by the fact that any currency’s exchange rate is a reciprocal. For the dollar to continue to remain weak or fall further against the other major trading currencies (the euro, yen, Swiss franc, and British pound sterling), economic conditions in the countries and regions that issue these currencies would need to be supportive of a view that these regions will outperform the U.S. economy in the future. This is not the case. That’s not to say that the dollar would not decline sharply against the Chinese yuan, if the latter were allowed to float. The dollar would. Against the major traded currencies, however, the dollar may have economic fundamentals on its side. Gold’s supply-and-demand fundamentals also suggest caution is in order: there is a tremendous amount of gold mine capacity that is profitable at prices above US$350 per oz. One should expect an increase of at least 25% in world mining capacity over the next four or five years if gold prices remain above US$350-380. Already, gold jewelry demand, excluding the quasi-investment demand, is falling sharply — partly as a result of price-induced cutbacks. Higher supply and lower demand often tend to push prices lower.

Central banks, meanwhile, are likely to sell less gold annually in the future than they have over the past two decades. This should provide support for gold prices at higher levels.

Finally, investment demand, which clearly has been the single most important driver in gold prices since the 1960s, has a history of dissipating after one or two years. The gold market now is into the third year of high levels of investment demand. It is too early to conclude that there has been a permanent change that mandates gold prices will remain above US$400. It is possible that some of the factors that have stimulated the sharp rise in investor demand for gold will stick around for years to come, while others already may be dissipating. The dollar’s decline, the weak stock market, and the recent recession in the industrialized world all may be passing, replaced, in the second half of this year, by stronger conditions. So, too, the period of low and declining interest rates over the past two years is expected to give way to modest increases in the near future.

These factors may suggest weaker investment demand for gold, and consequently lower prices. However, some risks still remain in the stock market, currencies, and other markets. Any increases in interest rates are expected to be mild for a couple of years, at least. Thus, the negative consequences for gold of these trends may be less than otherwise.

On the other side of the balance sheet for gold, the higher level of international political and economic tension does not seem likely to dissipate in the next several years. It may grow worse, with even more political instability evident in the Middle East.

Also, inflation has been tame for two decades now. It may continue to be so, but it could pick up a bit, especially if the energy markets remain riled. Regardless of actual inflation, there may be a renewal of higher inflation expectations on the part of investors around the world, which could help keep investment demand for gold as an inflation hedge higher than it would be otherwise.

On balance, some of the factors that have caused investors to buy near-record amounts of gold last year, and this year, may be dissipating. Others may continue, and the net effect on gold may be to keep gold prices above those long-term market clearing prices for several years, as investors continue to place some hedge bets on gold.

— The preceding is from Gold Report 2004, published by New York, N.Y.-based CPM Group. The full report is available at www.cpmgroup.com