Commodities | Apr 10 2008
By Greg Peel
The price of gold rallied in the US on Wednesday on a weaker US dollar, a strong oil price, and because industry experts Gold Fields Mineral Services released their annual survey for 2008 with an accompanying bullish view.
GFMS was not at all surprised the gold price saw a correction recently from its high of US$1030/oz to below US$900/oz given the speed of the prior run up. Nevertheless, chairman Philip Klapwijk believes the fundamentals behind that bout of bullishness are “still very much with us”, particularly US dollar weakness and “skeletons in banks’ closets”.
Klapwijk thus suggests gold could potentially make it to US$1100/oz this year, although he believes US$1200/oz would be “going a bit far”.
The reason is that in the cold hard light of day, gold plays a dual role. Its dominant role in the financial markets is one of a currency – an alternative to the US dollar reserve currency in particular and all paper money in general. It is a hedge against dollar weakness specifically, and against economic weakness, inflation, and financial and geopolitical turmoil. It is traditionally the safest of safe havens, but it pays no dividend.
However, 75-80% of the world’s gold production is acquired not by investors or central banks, but by jewellery manufacturers. Unless there is a strong demand for jewellery, there cannot be a sustained demand for gold. As the gold price has run up from its lows to its highs in the past decade, the meaningful pullbacks have often occurred as jewellery demand has fallen – fallen because the price is just too high.
The bulk of demand comes out of Asia, particularly from traditional sources such as the Indian “wedding seasons” and Chinese gift occasions. While oil-rich sheiks in the Middle East and wealthy American industrialists might be typical buyers of gold jewellery, it is the poor sap middle class Indians and Chinese who are forced to buy gold lest they lose face in their communities. When the price gets just too high, the gifts get smaller, and gold demand for jewellery wavers.
In recent years the growth of commodities funds and investment products has seen a much greater demand from investors, helping to drive the price of gold. In the meantime, the economies of China, India and other developing countries have boomed, providing higher incomes to those who need to stump up with the trinkets. Thus the cut-off level for gold jewellery demand has risen higher each year, providing a gradually increasing support level on pullbacks. Gold has thus followed a pattern of running ahead of the jewellery demand threshold, blowing off and falling back, and re-establishing jewellery demand at the new level.
This is why Klapwijk sees $1100 as a possibility in 2008 but not $1200. The latter price is a bridge too far for jewellery demand just yet.
But it is also why 2007 saw gold begin the year at just over $600, and then spend a good six months stuffing around at the $700 mark. There was an awful lot of derivative market selling going on at $700 (we won’t go into why – GFMS is a not a supporter of manipulation conspiracy theories). It took the collapsing US dollar at the onset of the credit crunch for gold to take off, but at below $700 there was a sustained demand for jewellery. It was a classic Mexican stand-off.
Now that we have since hit $1000, it is interesting to note the “physical” drivers behind the gold price rise in 2007, other than the “wealth preservation” effect.
Actual mine production, which has been on a trend decline for decades, fell by 0.4% in 2007 to an eleven-year low. The biggest falls were in South Africa, where mines have been forced into rolling closures due to power supply problems, but both North and Latin America also experienced declines. The winners were Indonesia and China. In 2007 China became the world’s premier producer of gold. There was little assistance from the “scrap” market, where sales fell 15%. Klapwijk puts this down to the sellers holding out for higher prices.
On the flipside, “official” (central bank) sales increased in 2007 over 2006, which was almost entirely due to selling among the European Central Bank Gold Agreement countries. Under the agreement member countries can only sell 500t per year (Sep-Sep) in total, and while 2006 saw central banks mostly preferring to keep their gold, 2007 saw big forced sales from a troubled Spain and an orderly selling program from the Swiss as part of a portfolio adjustment exercise. Outside of the CBGA (where a great proportion of the world’s gold is held) other central banks became net buyers for the first time in over a decade.
Jewellery demand in 2007 grew by 22% in the first half, providing that support at $700. As the gold price took off on credit crunch fears, jewellery demand fell 9% in the second half. That helps to explain why a big hole opened up in the market just recently – there was no physical support at such high prices.
A threat to Klapwijk’s US$1100 forecast may have come from the announcement this week the International Monetary Fund intends to sell 403t (13moz) of its 3217t holdings. When the announcement was made the gold price took a bit of a dive in an already fragile market.
However, all veteran gold traders know it is foolish to fear the IMF.
The IMF has been threatening to sell gold since about the time Columbus returned from the New World. If you earned a dollar every time the IMF gleefully announced it wanted to sell gold, you wouldn’t need to invest in gold. Veteran gold traders always greet such proclamations with a yawn. Usually nothing happens and the IMF shuts up for a while. However, this time it might just be a bit more serious, given the Fund needs to consolidate and restructure itself from an over-bureaucratised leviathan with limited investment power into a sleeker model with the opportunity to bring its investment charter into this century.
In order to sell gold, the IMF must gain approval from 185 member countries and, more importantly, the US Congress. The last time the IMF actually wanted to sell gold was in 1999, and Congress knocked it on the head and told the IMF to go away and start thinking about reducing its own costs. Whenever the issue has been raised since it has taken only a slight rise of the eyebrow from Congress and the IMF has crawled back timidly into its box.
But this time it appears IMF MD Dominique-Strauss Kahn has a rationalisation plan that may just meet with Congressional approval. If that’s the case, then the IMF will be free to start dumping great loads of gold.
But don’t despair. The Fund’s intention is to simply ease out bullion over a number of years in such a way as to not upset the prevailing market. The implication here is it will not sell into a falling market, or trigger a market fall, but rather ease gold quietly into a rising market. Moreover, it will incorporate itself into the CBGA framework, such that any IMF sales will only occur if the CBGA quota (500tpy) is not reached and it won’t allow that quota to be breached. Any sales will also be fully transparent.
In this way any IMF selling would be no different from European central bank selling, and bear in mind that European banks sold 480t in 2007 (30% up from 2006), yet gold rose from under $600 to over $700 in the September-September period. The CBGA banks have sold a further 191t already since September 2007 and gold is now over $900.
Beware irrational exuberance, says Klapwijk. GFMS is long term bullish, but these sudden bursts of energy only create a vacuum of diminished jewellery demand in the short term.
Investors thus should either buy gold and put it in the bottom drawer, and only check the gold price yearly, or sell on parabolic rallies before re-establishing at US$100-150 lower. Sounds easy, doesn’t it?