Growing gold supply a serius concern for investors

Where is gold going? How do you weigh the factors in your forecast? Before trying to forecast future events, it is often beneficial to look at the past. In the 1980s, gold demonstrated its volatile nature. It began the decade trading at US$560 per oz. and ended at US$399. In between, it traded as high as US$715 and as low as US$285. There were several reasons for this. In the midst of all this volatility, one fact remains unmistakably clear: throughout most of the 1980s, gold was in a bear market.

First of all, and most important, the overall macroeconomic environment was not conducive for gold investment. After a debilitating struggle with high inflation rates in the late ’70s and early ’80s, the G-5, and later the G-7 countries, decided to wage war on inflation, a war that continues today. Persistent high rates in most countries and a tightening of the money supply, especially in the early ’80s, resulted in relatively high real yields for most of the decade.

Secondly, the decade saw a 90% increase in gold supply originating from both the Western and Eastern blocs. It is also important to remember that during the latter half of the 1980s, stock markets worldwide experienced the longest bull market ever recorded, with returns that bullion could not match.

This brings us to more recent history. After a strong runup beginning in the fall of 1989, which carried through the early part of 1990, the writing appeared to have been written on the wall; we were seeing the beginning of a new bull market in bullion. However, on March 26, gold was hit by a freight train at full speed. It appears that Middle East interests sold large amounts of gold to raise cash for either military or financial purposes. The size and the manner by which the sales were conducted caught most observers by surprise. The net result has been a severe erosion of investor confidence which has kept gold in a malaise of volatile prices, with a downward bias and lethargic short-lived rallies.

I think that for most mere mortals it is impossible to consistently forecast short-term gold prices. What is important to most observers, especially those of us whose primary purpose is to analyze gold equities, is to try and identify long- term trends in the gold price. I will begin with the factors that have a longer-term effect on gold prices and proceed along the spectrum toward short-term influences.

The basic supply and demand trends appear to look positive for bullion prices in the longer term. The boom in worldwide production and reserves, which was the hallmark of the 1980s, will be contrasted by the decline of overall production in the 1990s.

I estimate that 1990’s production exceeded 1989’s level by less than 5%, and that 1991 production will increase by only 1-2%. My best telescope tells me that by 1994-95, production will begin to roll over and continue downward for the rest of the decade. The reason for this decline is simple. The cost of finding or acquiring, developing and producing an ounce of gold is much higher today than it was even just a few years ago.

Consider these figures. Costs are escalating rapidly as inflation, lower-quality orebodies, and the new added costs required to meet more stringent environmental standards, begin to add up. I estimate that on average, the Canadian company cost for development, depreciation, overhead and financing charges is about US$100 per oz. If one adds this cost to known cash costs, one would come to the conclusion that at $350 per oz. the industry is not making money even on a pretax basis. It’s clear why managers make extensive use of forward sales. The cost situation is particularly bad in South Africa where plummeting grades, high inflation and deeper ore sources have made about one-half of the nation’s industry unprofitable.

Another part of the lower production equation is governments’ new found unwillingness to subsidize gold mining. Canada and Australia have done away with tax- related subsidies and it doesn’t appear that the South African government will be very generous when their high cost producers come knocking with “hat-in-hand.”

At the same time, fabrication demand, led by the surge in jewelry demand for bullion, has been growing by leaps and bounds. Did you know that in 1989, jewelry demand accounted for 110% of all the gold mined in the Western world?

The large increase in jewelry demand, which occurred at the end of the decade, was fuelled mainly by the large growth in worldwide disposable income and by the much more aggressive marketing efforts of the World Gold Council.

Unlike many observers, I believe that after a temporary slowdown in demand, which will stem from a global recession, jewelry demand will continue to grow at a very brisk pace. Why? Well, for many years gold had not been marketed as aggressively as other precious metals, gems or diamonds. As a result, many markets remain largely untapped.

This will change in the 1990s. I believe that large strides will be taken in the development, packaging, distribution and marketing of gold jewelry worldwide. The net effect will be that more and more bullion will be directed toward the jewelry manufacturing sector at a time when Western mine production will be declining.

Over the next few years, fabrication demand will very likely remain ahead of mine and scrap supply combined. This is definitely bullish for gold. However, I must caution that this trend will create a strong long-term foundation for prices, but will not have a dramatic effect on prices in the short run.

Large shifts in global prosperity have a significant effect on private and central bank investment demand for bullion, which in turn has a direct effect on both long-term and short-term prices. The large oil price runups in the 1970s and early 1980s were not only beneficial for bullion because they created a positive economic environment for higher gold prices, but they also generated a large amount of wealth in the Middle Eastern countries, which eventually found a home in gold.

When the world was on the gold standard, gold was indeed the currency of last resort. Back then it was either gold or the U.S. dollar. Later the dollar took prominence, but we knew that gold was there as the ultimate backstop. If a sophisticated investor was not in the U.S. dollar, he was in gold.

I know that this is an oversimplification, but the relationship has worked for many years. In the past, a decline in the U.S. dollar almost immediately was accompanied by a rise in the U.S. dollar denominated gold price. Currency swings were fairly good predictors of both short-term and long-term changes in the gold price. However, with the emergence of the yen and the deutsche mark as secure investments, gold now has some additional competition.

If today’s sophisticated investor wishes to switch out of the U.S. dollar, and find a safe haven for his funds, he has a choice of two or three instruments that have outperformed bullion.

Certainly had German or Japanese investors invested in their own currencies in 1985 when the U.S. dollar was at its peak and gold prices were at a decade low, their returns would have outperformed those of bullion. This fact is one of the main reasons for the gold’s lacklustre performance during the recent past. Europeans, who were once the main hoarders of gold, have become net sellers. Despite this trend, I believe that at some point the dramatic decline in the U.S. dollar, which by no means has hit bottom, will begin to put upward pressure on bullion prices.

All over the world, governments, financial institutions, corporations and individual investors are experiencing a massive “credit crunch.” Very tight monetary policies in the G-7 countries, high real yields and falling commodity prices are all squeezing the vice. It appears that the large asset inflation which occurred worldwide during most of the 1980s is beginning to spiral downward, a situation exasperated by the dramatic increase in oil prices.

Nowhere is the situation more acute than in Japan where the 1980s saw an astronomical rise in real estate va
lues, which were in turn used to increase collateral used for bank loans. As well, corporate loans were made on the back of large equity positions held in an outrageously overvalued stock market.

Tight money and high oil prices have brought the vultures home to roost. The market has plummeted and a real estate crisis is coming down the track with ferocious velocity. One of the side effects of this financial mess has been the disinvestment of gold.

It should not come as a surprise to anyone that the beginning of gold’s lethargic performance began at about the same time as the Japanese market decline. By no means is this liquidity squeeze limited to Japan. For further confirmation one only need to look at the situations in Brazil and the USSR In these countries, commodities represent very liquid current assets which can be readily sold for hard currency required to buy anything from food to capital goods. It makes sense that gold would be one of the first commodities sold. After all, you can’t eat it and you can’t heat your home with it.

So here lies the root of the problem. There is more gold making its way to market than ever before.

For 1989, Gold Fields Mineral Services estimated that the supply of gold from all sources, including net disinvestment, central bank sales and Russian sales, totalled 3,000 tons. It is likely the 1990 total supply figure surpassed 3,400 tons.

This large increase in supply is minimizing the effect of many of the positive stimulants that otherwise would be propelling gold prices to higher levels. In addition, if the current supply glut continues, it will eliminate the expected positive impact of gold loan repayments, which would have begun to have a meaningful impact beginning in 1991.

The question now becomes: will the rate of supply continue at current levels or will it taper off to a more “normalized” flow? The answer to the question is dependent on the many factors that motivate the four key players. First of all, we should look at the price itself as a prime source of motivation. Clearly at US$400 per oz. or greater, there seems to be no limit to available supply. Conversely, during the last price drop, it was interesting to see how quickly the supply dried up, and demand picked up, as soon as the price went below US$360. This suggests that bullion prices could be stuck in a trading range for some time.

Of the four players, the central bankers, save the Russians and Brazilians, are the most difficult to read. Outright reserve sales and purchases of bullion from this source are difficult to predict. However, there is no doubt in my mind that they will remain active in the swap, gold loan and forward sales markets, although at reduced levels given the real risks that they are taking in lending their gold.

For the first time in history, the producers as a group are large enough to effect short-term gold prices. The rapid development of the futures and forward markets in gold and related synthetic instruments, has made it possible for producers to mobilize their in- ground reserves as much as five years in advance of their production.

This telescoping of bullion sales has a dampening effect on price. In my view, producers will continue to sell forward as quickly as their credit worthiness and their orebodies will allow. Forward sales are here to stay.

Turning our focus to the USSR, I feel the situation there is likely the leading factor behind the supply increase. Simply put, the country is in economic chaos. They are selling both gold and platinum among other commodities to raise hard currency. The Soviets would stop selling gold only if the West was to loan them massive amounts of money. In my mind, this is an unlikely scenario given the problems that the G-7 countries are having at home. The one positive factor about Russian sales is that, in the past they have tended to dry up very quickly at lower prices.

The last major source of the additional supply is the large institution and individual investor. The “credit crunch” will force continued sales from this source. Although, as in the Russian situation, sales are price sensitive and can quickly change to purchases.

My overall assessment of the supply situation is that the market will have to adjust to accommodate to an increased level of supply coming from any number of sources, although I don’t believe that on a constant basis supply will remain as high as 3,400 tons per year. Perhaps a fallback to 1989 levels will be more appropriate.

In the medium-to-long term, I believe that the gold price will move significantly higher. Typically, toward the end of an economic cycle, bullion prices begin to pick up under the pressure of rising commodity prices and general inflationary trends. At this time gold begins to outperform bonds as indicated by rising bond yields.

In the third quarter of 1989, gold entered into this phase. Unfortunately, prices have been dampened by a large wave of selling. Unlike the end of the previous cycle, the world is not experiencing double digit inflation. On the contrary, today’s environment is permeated by disinflationary sentiment. However, this time around, we have created a situation with a very high probability for a financial slip that will send severe shock waves through the global financial community.

Let’s survey the situation. In the U.S. you have the massive hangover resulting from a long spending party. The symptoms are runaway fiscal policy, a Savings and Loans crisis that threatens to tear out the country’s economic foundations, and the lack of political conviction to set things right. Some have estimated that the S&L bailout will require more than half a billion dollars. At the same time the U.S. budget deficit is hovering around the $300-billion mark.

The situation in Japan is not much better. Their real estate and banking crisis could be potentially more disastrous than the situation in the U.S. Even the Germans who once believed that the bailout of their Eastern brothers would amount to tens of billions, are now finding that it will take hundreds of billions.

When was the last time anyone talked openly and seriously about the potential failure of an American and Japanese bank? I don’t believe the governments will allow a financial disaster to occur; the consequences could be devastating. However, I do believe that the only way out of this global financial quagmire is for the continued and consistent easing of G-7 monetary policy. Any attempts to severely restrict money growth will probably result in a deeply felt financial shock. Either way, it’s too risky not to own gold.

If that was not enough, we also have the situation in the Gulf. A breakout of hostilities will likely result in higher gold prices.

Therefore, I think that gold could be stimulated back to the US$425 level. From that point onward it’s difficult to make a projection. Prices will then be dictated by the discipline of supply, or lack of it. If the producers resist the urge to lock in production at US$450, and if enough speculative demand materializes, the price could reach the US$450 level.

The last time gold prices reached that level, on the way up, they eventually peaked at US$500. I don’t know if the Central Bankers will want that to happen again. I am sure that they will do their best to prevent it. However, in my mind their ability to successfully cap a gold surge similar to the one in 1987 is questionable. If discipline is lacking and the price cannot break through the US$420 level, then the gold price could remain confined within the US$350-42O trading range for some time.004 Egizio Bianchini is a senior mining analyst with securities firm Nesbitt Thomson Deacon of Toronto. This article formed the basis of a presentation to a Toronto conference during the latter part of 1990.