(The following is from The Commodity Refiner, a monthly publication of Barclays Capital Research, and is concerned with gold and silver metals markets. Subsequent instalments will cover platinum group metals and base metals markets.)
While financial markets fret about the threat of deflation, commodities markets appear to be positioning for a strong second half to the year. A large element of speculative activity has been behind the performance of commodities as an alternative asset class so far this year. However, if this is bolstered by an improvement in demand-side fundamentals over the remainder of 2003, then commodities markets are likely to continue building on the strong performance seen in the first half.
Recent economic data have contained some mixed messages for commodities demand, but overall we discern an improving trend. The U.S. economy is showing signs of better growth ahead, and although European prospects still look shaky, Asia appears to be recovering relatively quickly from the impact of SARS early in the second quarter.
Better global growth will present risk managers with a challenging environment. Those outside the U.S. have benefited from the weakness of the U.S. dollar, enabling them to make physical purchases and lock in forward prices at extremely attractive levels over the past few months. However, the corollary of a faster-growing global economy will almost certainly be a stronger dollar, potentially magnifying the impact of rising commodities prices over the second half of the year.
If gold continues to act as a barometer for the health of the U.S. economy and dollar, it should continue to trend downward, its descent hastened by the demand destruction that recent high price levels have engendered. The outlook for platinum will largely depend on Chinese appetite for white metal jewelry and European diesel vehicle sales, while the outlook for palladium is bright only for the longer term.
Gold and silver
The environment at the recent London Bullion Market Association (LBMA) conference in Lisbon would have shocked most observers. Had you attended an equities conference in 1999-2000 or a bond conference today you would have been met by virtually unbridled optimism. Remember Dow 100,000: Fact or Fiction, the book published in September 1999 that argued that the Dow would reach 100,000 by 2020? When that book was published, the Dow was just shy of 11,000 and had risen nearly 40% over the previous two years. It followed on from Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market and was symptomatic of a market that promised to “liberate investors from conventional wisdom and change the way everyone thinks about stocks and investing.”
Surely, with the gold price having risen 37% in the two years prior to the LBMA conference, one would have expected a similar degree of optimism, if not necessarily such radical predictions. Instead the mood was overwhelmingly negative. Tawhid Abdullah, chairman of the Dubai Gold & Jewelry Group, noted that “today’s customers have forgotten about gold jewelry and will find enough happiness from non-precious jewelry.” In a direct challenge to other market participants, he asked them to “consider the posh offices and comfortable lifestyles . . . provided by the [jewelry] trade.” Mr. Abdullah clearly “gets it” — ultimately gold is about jewelry, and jewelry demand continues to stagnate.
According to Steve Son of the Korea Jewelry Manufacturers Association, “our gold jewelry sales in total are only one-fourth of those made a year earlier.” South Korea was the twelfth-largest jewelry market in the world, according to data released by the World Gold Council, consuming 60.7 tonnes in 2002. Mr. Son went on to say that “if current conditions continue, it is unlikely business will recover for the rest of this year.” Even a 50% fall in Korean demand, let alone a 75% fall, would take demand below the dismal levels seen in 1998, when Southeast Asia became a net exporter of gold. And Korea has been untouched by SARS. Jewelry demand has collapsed SARS-stricken Hong Kong and Singapore. Interestingly, however, jewelry demand has fallen by more than total retail sales, suggesting that the higher price is hitting already-weak demand. April 2003 retail sales in Hong Kong were down by 15.2% by value versus April 2002, and jewelry sales were down by 42.3%. A similar situation occurred in Singapore, where April 2003 retail sales were up 1.6% versus a 24.5% decline in watch and jewelry sales.
A creative gold bull, however, could easily explain away jewelry’s greater decline — possibly by arguing that non-jewelry retail sales were boosted by SARS-related panic (surgical masks?). Perhaps, but SARS is certainly not responsible for the 27% fall in Italian jewelry exports in the first quarter of this year — or indeed the 8% fall in German retail jewelry sales over the same period. But then again, perhaps this can be explained by the weak European economy. Of course, the same could be said for the U.S., where jewelry sales growth in the first quarter, though slower than total retail sales, was at least positive (2.3% and 3.8%, respectively). Ditto Japan, where jewelry demand fell by almost 10% in the recent first quarter, compared with the corresponding period of 2002, according to Gold Fields Mineral Services (GFMS). Surely, of course, the demand picture must be positive somewhere. Perhaps, the oil rich Middle East? Not only did Mr. Abdullah’s mood suggest otherwise, but World Gold Council/GFMS statistics show that Saudi gold demand fell to less than 143 tonnes in 2002, down 16% from its peak of more than 170 tonnes in 2000. Indeed, despite an average oil price of US$26 per barrel, demand was 10% lower than in 1998, when oil averaged only $14.38. This appears to have continued into 2003: in the first quarter, demand was 4% below year-earlier levels, despite a 56% rise in the oil price.
Saudi Arabia is not alone. According to Tushar Patni, chairman of Abu Dhabi Gold and Jewelry Group, “business at Abu Dhabi’s gold souk is down by at least 50%.”
So perhaps one can forgive the jewellers for their somewhat morose mood in Lisbon. But what of the producers? Surely they must find current price levels sufficient to lift their mood? Actually, there was little crowing about the rally from that sector. Perhaps because the weak dollar has, in many cases, hurt (via the impact on costs) more than it has helped (via a higher gold price). In its recent first-quarter report, Anglogold stated that “the stronger local currencies in seven of the eight countries in which we operate, in relation to the U.S. dollar, the currency in which we sell our product, has had a significant negative impact on costs, margins and earnings.” The rise in the gold price only “partially” offset these negative effects. Similarly, at Placer Dome, “cash costs increased to $205 per oz. while total costs increased to $260 per oz. due to the appreciation of the South African rand and Canadian and Australian dollars against the U.S. dollar.” And so miners — at least those with production largely outside of the U.S. — have reason for mixed emotions.
But what about bankers, as always the largest group at these events? If any group was more depressed than Mr. Abdullah, perhaps it was this one. Banks have seen their traditional businesses grind to a halt while “investment” has yet to fill the void. The more derivative-focused banks have seen demand for their products continue to fall, with the notional amount of gold derivatives now down 30% from its peak in the fourth quarter of 1999, according to data released by the Office of the Comptroller of the Currency (OCC).
The “physical” bullion banks have also suffered. Collapsing physical demand means, obviously, lower physical volumes, a situation best exemplified by recent LBMA clearing data. Indeed, the only intermediaries who should be happy are Comex brokers, specifically the ones who own seats on the exchange.
It is no coincidence that those most strongly promoting gold as an investment are the banks themselves — perhaps
seeking to replace revenues lost as hedging and physical demand collapse. Indeed, one analyst at the conference went so far as to ask, “Can you afford not to have gold in your portfolio?” Unfortunately, the answer to this question seems generally to be “yes.” U.S. Mint gold eagle sales in May 2003 were 2,000 oz., their second worst on record (since 1992).
If the banks, exchanges, and purveyors of new gold-linked product were the biggest promoters of gold investment, other participants took a somewhat more skeptical view. Bernard Swanepoel, CEO of Harmony Gold, said “the investment case for gold is dicey at best, and I’m not convinced it will drive the gold price indefinitely . . . We should not saddle one horse and one horse only.” Indeed. Although the holders of the near record Comex long position may not want to hear it, gold producers and consumers alike confirmed that the gold market is far from healthy and, indeed, may be facing challenges more serious than those of 1999.
In previous reports [reprinted in The Northern Miner], we noted that silver prices were torn between positive short-term price encouragement arising from a short speculative position and longer-term negatives arising from a continuing slide in photographic demand. Shortly thereafter, the growing realization of the likely impact of SARS on photographic demand prompted us to caution further that risks were skewed towards the downside.
Since our last silver report published in these pages, silver prices have traded between US$4.43 and US$4.88 per oz., and are now trading just below US$4.60. We thought it worth revisiting some of the issues outlined in our previous discussion. Non-commercial positions have swung from short 3,680 lots (18.4 million oz.) to long 13,682 (68.4 million oz,) as of June 17. Although the long position is slightly below its historical average, it is hardly likely to provide the upside pressure of a significant short. It is worth noting, however, that, at 13,676 lots (68.4 million oz.), the gross short is approximately 25% above its long-term average. Although there is little statistical support for a rally, this does suggest that there is some room for positive pressure from short covering.
However, the SARS issues highlighted subsequently appear to be taking a significant toll on silver demand. After having reduced second-quarter operational earnings estimates to US60-80 per share in April, Kodak, the world’s largest maker of photographic film, reduced the expected range to US25-35 per share. In announcing the reduction, Chairman and CEO Daniel Carp noted that “in April, our guidance assumed that the effect of SARS on picture-taking would be much less than it has turned out to be. The SARS outbreak, as well as concern about geopolitical tensions, is preventing people from participating in activities that foster picture-taking. Travel and leisure spending is weak, for example, and that means fewer pictures are being taken worldwide.” According to estimates from Kodak, “industrywide sales of consumer film in China during April and May were nearly half of the amount sold during the same two months a year ago.” The Chinese film market had previously been growing at 10% per year and was one of the few bright spots for silver halide demand. Indeed, Kodak went on to say that it “expects that economic weakness, reduced tourism and geopolitical turmoil will continue to affect sales and earnings for the balance of the year.” Given the strong relationship between Kodak revenues and photographic silver demand, it is clear that SARS, terrorism, war, and economic weakness are likely to hamper silver consumption in 2003.
Also highlighted previously was the strong relationship between silver prices and the Metal Component of U.S. Durable Goods Orders. Overall, the average correlation is 65%, though the correlation of the annual changes is lower, at 22%.
This comparison is complicated by the 1997-1998 “Buffet rally” in silver, which certainly represented an asymmetric shock to the silver market. Looking only at the period since January 1999 (by which point the silver market had absorbed the impact of the buying), the correlation of the annual changes is a more respectable 62%.
Although there is obviously volatility in the relationship, the chart suggests that at US$4.87 in mid-May, silver prices were clearly overvalued — up 5.8% over May 2002, while the Metals Component of the Durable Goods Index was down 8%. Indeed, notwithstanding the subsequent fall in silver prices, even at current spot (US$4.60), the discrepancy is significant (-8% versus -0.4%).
The final reason we cited for potentially being bullish over silver was its historical correlation with signs of economic growth; specifically, the historical positive correlation between the gold-silver ratio and the ratio of the S&P 500 index to the 10-year bond. Silver has tended to gain historically, as stocks have gained relative to bonds. Indeed, since we last reported on silver in The Miner, stocks have gained relative to bonds. However, gold has strengthened dramatically against silver, pushing the gold-silver ratio 5% higher. Perhaps, then, this is an indicator best left as a research and not a trading tool.
In summary, then, the current state of the silver market is characterized by several factors:
— Speculative shorts have been switched into longs. There is therefore less likelihood of a short-covering-induced rally, though it’s worth noting that gross shorts are larger than their historical average.
— Photographic demand looks likely to be even lower than had been forecast. SARS, terrorism, war, and other factors appear to be having a significant impact on tourism, with a direct influence on photographic demand.
— The Metals Component of the Durable Goods index remains significantly weaker, year-over-year, than the silver price.
— Although equities prices have gained relative to bonds, which in the past would suggest that silver should gain relative to gold, prices have failed to respond.
— Economic data (silver prices have shown a 55% correlation with U.S. gross domestic product growth) have been mixed.
Overall, therefore, the balance of risks in silver remains to the downside. While it is true that economic data may support silver later in the year, in the short term, durable goods data suggest there is more risk of a downside move. Finally, though silver may, in the short term, be supported by strength in gold, the gold-silver relationship has been breaking down over the past decade. We believe, therefore, that silver prices will continue to find resistance at their recent highs (US$4.85 and US$4.90) and that there is a serious risk of a move through recent support at US$4.40.
Gold and silver market summary
The fundamentals of the gold market do not look supportive of the price in the medium-to-longer term. Demand has fallen sharply in the current gold rally (in place since early 2001), and statistics released by GFMS show that total fabrication demand fell by 11% in 2002 and is now down 15% since 2000. The bulk of this fall occurred in the crucial jewelry sector, which represented more than 75% of demand on average during the 1990s. The world is now spending less money on gold jewelry. After peaking at US$36 billion in 1996-1997, global jewelry spending has fallen to US$26.8 billion. Notably, gold appears to be losing market share to platinum.
Investment demand looks unlikely to fill the void left by reduced consumer demand, since the investment that has been supporting the price over the past 18 months has been in gold futures (paper gold) traded on TOCOM or Comex, and not the physical spot gold traded on the London Bullion Market. Further false support is offered to the price by the phenomenon of producer de-hedging. When a producer hedges, it agrees a price for unmined production with its counterparties and sells its production forward at these prices on the rationale that the company is then protected from possible price falls. But in periods of price increases, the company is also insulated from price rises. This was most evident in the late 1990s
, and equity markets began to reward unhedged companies that were able to take advantage of price rises. As a result, gold miners began to de-hedge, whereby they bought back forward contracts to allow them to sell their production spot in the future. The de-hedging process has been artificially inflating the gold price since this process began and has picked up pace in recent periods.
Silver demand is divided into three main components:
— industrial (41% of the total);
— jewelry and silverware (31% of the total); and
— photography (24% of the total).
The photography industry is proving to be most problematic for silver demand, and this is highlighted by Kodak, whose revenues have been falling steadily since 2000. The company recently cut its 2003 earnings forecast by more than half, citing the impact of SARS on its sales in Asia and economic weakness in Europe and the U.S. However, the increasing popularity of digital cameras, from which only a fraction of photographs are actually printed, and disposable traditional cameras, which tend to encourage recycling of the silver they use, pose a longer-term threat to silver demand.
From a fundamental supply perspective, by far the largest source of silver is as a byproduct in lead-zinc production (35% of the total), and the zinc industry has perhaps the worst economics in the base metals complex. Were zinc production to be cut back, silver supply would be reduced regardless of the level of the silver price.
— Kevin Norrish is head of commodities research/energy and Ingrid Sternby is the base metals analyst for Barclays Capital Research. The opinions presented are the authors’ and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the authors at kevin.norrish@barcap.com and ingrid.sternby@barcap.com
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