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A glimmer of hope for gold

Photo of Gavin Wendt By Gavin Wendt

min read

Strong demand from Asia, constrained new global gold supply, and expectations that US interest rates will be on hold for longer bode well for the precious metal.

Gold continues to defy the sceptics, demonstrating robust price support around US$1,200 an ounce, as we have previously predicted. A host of positive factors are driving gold’s resilience – and most are not new.

The chart below demonstrates that despite perceptions of gold being an arcane relic, it has performed strongly over the last 15 years, particularly against the high-flying Dow Jones and NASDAQ Indices in the United States.

Source: Kitco

(Editor’s note: There are a range of ways to gain exposure to gold via ASX. These include investing in ASX-listed gold companies or through exchange traded products over gold, either hedged or unhedged for currency moves. The ANZ Physical Gold ETF (ASX Code: ZGOL) ETFS Physical Gold ETP (ASX Code: GOLD) and Perth Mint Gold (ASX Code: PMGOLD) are examples).

Perhaps the best illustration of gold’s investment appeal is the strong demand from China and India, to the point where virtually all that’s been mined and produced over the past two years has been consumed by them. This is an amazing statistic that reinforces the unabated flow of gold from West to East.

It isn’t, however, Asia that’s the primary driving force behind the gold price. Right now, it is dominated by sentiment regarding the US economy, particularly the actions of its central bank, the US Federal Reserve. The “will they, won’t they” conjecture surrounding the Fed’s deliberations (to raise interest rates) has cast a pall over the US and the world economy.

Over the past few years, the Fed has tried to talk tough on interest rates, admitting it recognises the dangers of keeping them too low for too long. It points, however, to economic growth in the US as clear evidence that its “easy money” policies are working. But the enduring problem is that while the Fed talks the talk, it isn’t following through, with interest-rate rises perpetually deferred.

This reinforces the underlying fragility of the US economic recovery – something the Fed won’t directly concede for fear of spooking markets. Its easy-money policies have distorted market prices and encouraged destabilising financial speculation, as well as unfairly punishing savers (though low interest rates).

More importantly, the US economy and financial markets have become so heavily dependent on artificially suppressed interest rates that it is extremely difficult for the Fed to wean markets off them without major repercussions. The danger is that the situation won't be reversed in time, as the Fed tends to not recognise the consequences of loose monetary policy until it's too late.

What happens to gold when interest rates rise?
So how will gold perform in a rising US interest-rate environment, given many believe it would be bad for gold? The opposite is true. The important factor is that the ultimate and real driver of the gold price is a negative real interest-rate environment -- which is defined by nominal interest rates minus inflation.

In the real world, central-bank policies of inducing negative real rates to “incentivise” borrowing have expanded the money supply and simultaneously devalued currencies. Debt is inherently inflationary if you can print your own currency, which has been commonplace since the GFC, with virtually all major currencies declining substantially in value.

The key is that the latest US economic data doesn’t support an interest-rate rise, with the Fed admitting as much. This has led to markets lengthening the time frame of any interest-rate move – something we have been sceptical about for some time. Ultimately, the Fed will likely have to raise interest rates, but we expect no negative effect on the gold price.

Demand for gold
Turning to the demand side, latest data by research group GFMS shows China maintaining its top position in terms of gold purchases for 2014. Significantly, GFMS notes that Chinese imports of gold and deliveries from the Shanghai Gold Exchange considerably exceeded the quoted consumption figure.

Altogether, the global Top 20 gold nations account for almost 85 per cent of consumption, with 13 classified as being in Asia and the Middle East – with China and India between them accounting for 47.3 per cent of GFMS-calculated global consumption.

Also interesting is GFMS data regarding the Top 20 gold-consuming nations on a per-capita consumption basis. India is only in 19th place, while mainland China isn’t even in the Top 20. The conclusion is there is strong potential for a huge percentage increase in gold consumption in these nations as per-capita wealth grows.

Official sector gold purchases across the world in 2014 amounted to 466 metric tons, up 14 per cent from 2013 – and the second-highest level since the end of the gold standard. The Russian central bank was the biggest purchaser during 2014 with 173 tons, while several CIS countries increased their holdings.

Bloomberg Intelligence suggests The People’s Bank of China could have tripled its gold bullion holdings to 3,510 metric tons since it last updated them in April 2009 – second only to the US on 8,133.5 tons.

Ashish Bhatia, the World Gold Council director, central banks and public policy, in New York, recently said it was ideal for central banks to hold between 4 per cent and 10 per cent of their assets in gold – which compares with China at 1 per cent, based on published figures. If China continues to increase its gold purchases, this will be hugely supportive for the gold price.

Outlook for supply
In my view, a most concerning aspect (or encouraging, depending on your point of view) of the world gold scene is supply. A quick look at the reserves position of the world’s Top 5 gold producers (Barrick, AngloGold, Newmont, Goldcorp and Kinross) shows a glaring problem – gold reserves are on the slide for all the top miners.

Latest data underlines a deteriorating trend - on average, proven and probable gold reserves slipped by 12 per cent from 2013 to 2014 among the top five gold miners. The reserve declines ranged between 9 per cent and 20 per cent, representing between 5 million and 11 million ounces of gold.

As gold producers have reduced corporate risk (through reduced asset purchases, corporate deals, takeovers etc) and eliminated exploration risk (through massive cuts to exploration programs), new discoveries of gold have fallen ¬– and so has the capacity for gold producers to boost (or even maintain) gold reserves.

This has been exacerbated by an industry focused on cost control, after criticism for years of maintaining operations with marginal or sub-par returns.

How these demand and supply trends affect the Australian gold sector
For domestic producers, US$ gold-price stability around US$1,200 has been a godsend – as the corresponding easing in the value of the Australian dollar has coincided with a drastic fall in the price of crude oil since late 2014, along with dramatic falls in general operating and capital costs – helping to boost operating margins for local producers.
The chart below show the strong rise in the Australian-dollar gold price (courtesy of a lower Australian dollar) since last year.

At the same time, many international gold heavyweights are looking to exit large, non-core domestic gold projects as they retreat to their North American or Southern African bases to lick their wounds. This has presented once-in-a-lifetime corporate acquisition opportunity for cashed-up Australian gold companies keen to expand their production profiles.

Companies such as Northern Star, Evolution Mining and Metals X are among the key gold-sector players involved in strategic takeover activity over recent months, along with successful advanced exploration play Gold Road Resources. These companies have been top sharemarket performers, returning 40 per cent to 75 per cent over the past 12 months.

I maintain my US$1,200 gold support level for 2015/16, with the potential for prices to edge towards US$1,300 over the next couple of years. With the Australian dollar expected to remain subdued compared with the US dollar, Australian-dollar gold prices will remain robust and operating costs will remain in check, providing solid operating margins for domestic gold producers. That reinforces the potential for above-average returns for investors from the gold sector.

About the author

Gavin Wendt is the Founding Director and Senior Resources Analyst with MineLife. Utilising more than 20 years’ experience, he publishes a share-market report focused exclusively on emerging ASX resource companies, targeting superior investment returns.

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