Precious metals markets in 2006

METALS COMMENTARY

New York, NY — The precious metals markets began 2006 with a bang. Prices for gold, silver, platinum, palladium, and rhodium all rose sharply in January. There was a wave of bullishness from investors, with a prominent role being played by institutional investors who have been moving into the precious metals and commodities markets in recent months.

Prices sold off sharply after the initial run-up in January, but even after their sharp decline, precious metals prices remained at high levels, even by recent standards.

More importantly, market metrics suggested that the bullishness on the part of investors that had pushed precious metals prices was largely intact — despite the sharp drop in prices — suggesting that there would be at least one more wave of higher prices between early February and April 2006.

Investors were interested in precious metals for three broad reasons. First, investors have been attracted to precious metals and commodities because the performance of stocks and bonds has not been particularly stellar for several years, and prospects appear to be for more of the same. Second, there is a realization that adding commodities exposure to diversified investment portfolios helps reduce the performance risks of the overall portfolios over time. Finally, prices have been rising, and investors tend to be attracted to assets with rising prices.

As part of the first overall rationale for investing in precious metals, there were many economic and financial market concerns, from inflation and currency market volatility to worries about the economic outlook in the United States and other countries, and the stock market.

One of the trends seen in the gold market since the first quarter of 2003 has been the purchasing of physical gold stored in diverse parts of the world, such as Australia and Thailand, by Middle Eastern investors. This has continued in early 2006.

Another factor that was prominent in 2005 was a sharp increase in the amount of physical gold held through the newly created gold exchange traded funds (ETFs). Most of this gold was held through the gold ETF on the New York Stock Exchange. The total amount of gold held through these funds rose 5.2 million oz. in 2005, representing 11.1% of the net 46.7 million oz. gold that investors purchased in 2005.

This is gold that most likely would not have been purchased by these investors if the gold ETFs had not existed, since much of the buying appears to be from institutional investment management companies that formerly have eschewed investing in gold and other commodities.

Prices did back off in early February, as profit-taking set in. Banks and funds also traded metals from the short side, seeking to make profits on short-term positions.

It must be noted that there are fund managers and other investors who have taken bearish positions toward gold, platinum, and, to a lesser extent, other metals. They have been in a minority in recent quarters.

However, it is clear that some investors are looking at gold at levels above US$500 per oz., silver above US$9 per oz., platinum above US$1,000 per oz., and palladium around US$300 per oz. as being over-bought and more likely to decline in price in the longer term than to rise further.

As mentioned above, prices appear to have at least one more upward run in them. Prices are expected to recover and move higher during the period from mid-February into April.

At that point, things may become much more treacherous. How the markets unfold for the rest of 2006 and beyond will depend to a great deal on how the economic and political landscapes look to investors. It seems most likely to CPM Group that currency markets will move sideways in a volatile fashion during 2006, while stocks may move sideways to slightly downward in a less volatile fashion, short-term interest rates move higher for a while longer, and longer-dated interest rates move sideways to higher. Inflation is not expected to be problematic, although inflation concerns on the part of some investor groups will keep interest active in gold and commodities as inflation hedges.

Political issues, meanwhile, may remain supportive of continued interest in precious metals: Investors simply may not feel comfortable about long-term prospects on the international front, while the scope for political scandals and uncertainty in the United States and some other countries could lend a bit of flavour to the wave of anxiety that has kept prices moving higher in recent years.

The other aspect of the precious metals complex beyond April will be that the metals may start to go their own ways at that point. Gold prices may move slightly lower, as some investors seek to take profits, mine production rises, and fabrication demand declines in the face of high prices. Silver prices, meanwhile, may remain strong and make new highs, as fabrication demand remains somewhat strong, mine production is slower to grow, and investors become even more interested in silver than they have been. The potential launch of a silver ETF could greatly add to investor interest in silver beyond March, while tight physical supplies also could stimulate investor interest.

Platinum prices may move lower, partly the victim of their own high levels. Palladium prices had been expected to move back toward US$300 to US$340 per oz. from their early 2005 lows around US$180 per oz. They already have risen to these levels, and have backed off as of early February. Palladium may remain strong, reflecting a combination of both strong fabrication demand and strong investment demand.

— The author is managing director of CPM Group, a New York, N.Y.-based precious metals and commodities research and consulting company. For more information, visit www.cpmgroup.com.