Silver And Gold Post April De-Rating

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– Gold investors bail out
– Fabrication inventories high
– Silver vulnerable
– Goldminer share price impact assessed

By Greg Peel

It all happened in April, in the space of a few days. In the first quarter of 2013, the gold price was relatively strong, notes Macquarie, having fallen by only 3%. In late March gold broke down through US$1600/oz and quickly hit 1550 before staging an attempted rebound. That rebound failed, and by April 15 gold hit 1360.

The sharpness of the fall took the world by surprise. Conspiracy theories abound, as they always do in the gold market, regarding shenanigans between the bullion banks and the Fed and a problem of a lack of physical metal. Leaving these theories aside, one might argue that gold fell because it was no longer rising. The metal traded over 1900 in 2011 before consolidating back towards the 1600 mark in the ensuing period. In that time, the Fed has stepped up QE, the ECB has threatened (although has yet to use) OMT and Bank of Japan has deluged the world with yen. It is such central bank activity upon which previously bullish (and almost universally so) forecasts were built.

Yet there was no response from the gold price. Global monetary inflation failed to materialise. Indeed, CPI inflation readings kept falling. Tenuous holders of gold exchange traded funds, the instrument that opened the door to easy retail gold investment in the mid-noughties, began to lose faith. The initial trickle soon became a flood. For whatever reason, it all came to a head last month.

GFMS data suggest net outflows from ETFs totalled 177t in the March quarter compared to net inflows of 53t seen in the March quarter 2012. Outflows have accelerated since. For Morgan Stanley, the failure of the gold price to return to its highs and its recent price plunge suggest the bullish monetary easing story had already been priced in.

Back in March, the Macquarie analysts believed an investor sell-off would likely be countered by physical market purchases, especially in jewellery, which would “rebalance” the price. A breakdown of the GFMS March quarter data, now available, provides an insight in to what was going on before the April price crash.

As noted, ETF positions fell by 230t year on year. Mine supply rose 23t and scrap supply fell 16t suggesting total supply rose by 7t. Subtract this amount from ETF outflows and 237t was offered for sale. To whom?

End-consumers (dental, electronics) bought only 4t more than last year. Jewellery fabrication accounted for 17t more than last year. Central banks bought 109t, but this was 6t less than a year ago. Bar and coin investors were more excited, buying 35t more than last year, with a 52% increase in Indian purchases the stand-out. But it appears the most significant buying came from “inventory changes”, at 120t, or net 195t more than last year.

Macquarie assumes that such a change implies inventory building by jewellery fabricators. This does not bode well, given de-stocking will always follow re-stocking at some point, however it appears jewellers de-stocked their own inventories of jewellery pieces given a 60t increase in jewellery sales from last year.

Then came the big price fall. Bear in mind that price volatility is driven not by physical market activity, but by Comex futures market activity. On any given day, turnover in Comex gold futures exceeds the total amount of physical gold ever mined in the history of mankind. Comex positions close out at zero sum at the end of each contract, but virtually all are closed out before expiry to avoid physical delivery and ensure transactions are in cash only. Over that one week in April, the winners and losers would have felt the gains and losses in their bank balances, not in who had been stuck with the gold.

Macquarie’s conclusion, having sorted through the actual physical market data, is that a rebalance was “only somewhat apparent” in the March quarter. Early data between end-March and now have shown a big jump in jewellery “consumption” (buy and wear, or stick in safe), particularly out of China. Macquarie estimates China “consumed” 83t in the month of April, having consumed 185t in all of the March quarter.

Those who remember the day after (in Australia) the night gold fell over US$100 might remember scenes on the nightly news of punters rushing into bullion vendors to snap up small bars and coins. “Gold fever” has been felt around the world ever since the gold price bottomed out early in the twenty-first century following the great central bank gold sell-down which followed the Long Term Capital Management hedge fund disaster, and much talk has since been heard of gold “having” to reach US$2000/oz and beyond.

Those voices have now fallen silent, but for the zealous few. Alas, while those who rushed into to buy gold after April’s big drop-off would have spent time boasting how they picked up the equally sharp bounce, gold has since returned to retest the April lows.

The sudden fall in the gold price has also come as a shock to Australia’s many listed goldminers, particularly higher cost producers somewhat later to the game, although all listed goldminers have been punished in the subsequent sell-off. The assumption now, in many quarters, is that the gold price will likely to continue to fall. The hedge against inflation has proven redundant, and the safe haven of gold as a wealth store has lost its appeal as the global economy begins to show signs of improvement, with risk assets and yield now in greater favour (gold provides no yield).

If the gold price does fall further, higher cost goldminers will find themselves in negative free cash flow positions. Credit Suisse has run some analysis on just what impact a lower gold price might have on Australia’s larger goldmining names.

In this example, Credit Suisse has held the exchange rate steady and left by-product prices (eg copper, silver) unchanged from current forecasts while dropping the gold price to US$1100/oz and doubling its discount rate for valuation from 5% to 10% to accommodate a higher risk premium. Under such a scenario, CS calculates net present values would reduce by varying amounts for various miners to levels below current prices (21 May) – 11% for Perseus Mining ((PRU)), 21% for Alacer Gold ((AQG)), 49% for Evolution Mining ((EVN)), 50% for Regis Resources ((RRL)) and 66% for Newcrest Mining ((NCM)). The analysts note that Evolution and Newcrest are heavily impacted by their debt positions, which explains why, in the latter case, the country’s biggest goldminer with a percentage of lower cost legacy production still suffers the biggest fall in NPV.

Silver is often referred to as gold’s poor cousin but whereas gold is predominantly a currency proxy rather than a “commodity”, silver is split between a currency proxy and an industrial consumable. The fall in the silver price from April has been no less spectacular than that of gold.

Standard Bank notes that the silver price broke through significant technical support at US$22/oz and is likely to trade into the 15-20 range of September 2009 to September 2010. Standard Bank was already holding a bearish view on the metal but was still surprised by the severity of the price fall.

Since 2009, China has proven the growing source of demand for silver but above-ground inventories are now estimated to be equivalent to 18 months of fabrication demand, up from 16 months at the start of 2012 and only four months in 2009. Comex positions suggest speculators have become increasingly short silver, which sets the metal up for the odd short, sharp price rebound, but unlike the case in gold, silver ETF investors are yet to head for the exits. Standard Bank notes gold ETF positions have been reduced by 17% but silver positions have increased 1%.

Every silver lining has a cloud.

Citi’s commodity analysts believe the sharpness of the fall in the silver price suggests a strong rebound may yet be expected, but that any return to the US$27-28/oz level will attract renewed selling. Beyond that, silver prices have, like gold, been rising for a decade and the demand-supply balance outlook does not bode well.

On the demand side, silver has suffered from the same consumption overcapacity as many base metals at a time when the use of silver in photography – once the metal’s primary source of consumption – has all but faded away with the increasing ubiquity of digital imaging. On the supply side, production of silver has not fallen off to meet weaker demand for the explicit reason that silver is a common by-product of gold production. As touched on in the Credit Suisse analysis above, gold producers sell their silver by-product to reduce the net cost of the production of the primary target, gold. As long as goldminers keep producing gold, so too will they produce silver, irrespective of silver demand.

The resultant excess demand must then be picked up by investors – those who choose silver as a safe haven/inflation hedge preference over gold – to prevent further price falls. Yet at this stage there is a greater risk the ETF floodgates could open on silver, as they have on gold, rather than investors piling in further.
 

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