Editorial: Gold’s fundamentals still look good

The detailed supply and demand figures for gold released in January by London-based consultants GFMS paint a compelling picture of a bull market that still has a ways to go.

Gold prices surprised most gold analysts on the upside last year, peaking at US$725 per oz. in May and averaging US$603.77 per oz. for the year — a gain of 35.8% from 2005 and the fifth consecutive year of appreciation.

Furthermore, GFMS — one of this decade’s canniest gold-price prognosticators — predicts gold will average US$674 per oz. this year, within a range of US$602-US$752 per oz.

While GFMS says it’s a mistake to lump gold in with the larger commodity complex, it also cautions that gold is not just an anti-dollar story.

Contrary to the expectations of many, mined gold production actually declined by 2.2% in 2006 to 2,467 tonnes, or about the same level seen in 2004. In fact, annual mined gold production hit a plateau in the late 1990s, around the 2,400- to 2,600-tonne mark.

Notable declines in mined gold production last year included: Indonesia, down 54 tonnes; South Africa, down 18 tonnes; Australia, down 16 tonnes; and Canada, down 15 tonnes. Production shortfalls just from the world’s two largest gold mines — Grasberg in Indonesia and Yanacocha in Peru — accounted for 75 tonnes of reduced output in 2006.

Overall last year, mine supply was characterized by project development delays and temporary operational failures such as the pit wall instabilities seen at Kumtor in Kyrgyzstan and Batu Hijau in Indonesia.

Globally, the average cash cost of production soared to US$318 per oz. in the third quarter of 2006, compared with US$217 per oz. in the same period in 2005, owing mainly to higher prices for consumables. In particular, there was a huge jump in costs in the United States.

Looking ahead, GFMS predicts that gold mine production will rise to 1,215 tonnes in the first half of 2007, up 3.4% year-over-year.

Some of the slack in mine production was taken up by scrap gold coming into the market at a rate of 1,069 tonnes in 2006, up 20% from 2005.

At the same time, however, official sector gold sales amounted to just 300 tonnes, down 50% from 2005.

While central banks have been net sellers of gold since 1989, GFMS points out that the second year of the second Central Bank Gold Agreement (CBGA), which ended in September 2006, was notable for being the first year that signatories substantially undersold their annual 500-tonne ceiling, selling only 396 tonnes.

On the buy side, there was a major turning point for gold last year, with net official-sector buying outside of the CBGA countries — the first time in many years.

As a result, GFMS says to expect substantially lower selling from the official sector in the coming years.

(Gold as a percentage of total reserves for the U.S. is 74% and for the CBGA countries, 50%. For China and Japan, the numbers are 2% and 1%, respectively. For the other countries, the figure is 3%, and for all countries, 10%.)

While official-sector gold purchases are harder to pin down, Russia has admitted it added 9.2 tonnes to its official reserves last fall.

Apart a few flakes in the odd martini, gold is not “consumed” like most other commodities, and stocks can always be made available at the right price. GFMS estimates that above-ground stocks total around 155,500 tonnes, divided between jewellery (52%), official holdings (18%), private investments (16%), and other fabrication (12%). About 2% is lost or unaccounted for.

Total demand for gold dropped 5% in 2006 to 3,866 tonnes, though total dollars spent actually rose over the same period. In particular, jewellery demand fell 16.2% last year to 2,267 tonnes.

GFMS has noticed an important new trend in jewellery sold in India, with increasing purchases of low-carat gold for adornment instead of the more traditional buying of high-carat jewellery for investment purposes. (Adornment jewellery being less likely to be sold as scrap if the gold price rises modestly.)

While GFMS considers the biggest downside risk for gold to be the potential for selling from private investors, it also recognizes there’s still not a lot of investment money coming into the gold sector, with world investment totalling 687 tonnes last year, compared with 814 tonnes in 2005 and 312 tonnes in 2004.

GFMS describes the gold exchange-traded funds (ETFs) that have been created in recent years as having “shifted the demand curve for gold permanently,” and having opened up gold to a whole new group of investors, including big pension funds.

The seven gold ETFs trading on 10 exchanges worldwide are worth US$13 billion, or, as the World Gold Council puts it, now hold more gold than the People’s Bank of China, which has the ninth-largest gold reserves of all central banks.

GFMS also comments that the “floor of the gold price is a solid one,” and that the real action will come in the second half of 2007, with the potential for “spikes to US$680 per oz. and beyond” in the next 18 months.

Gold bugs should check out the London Bullion Market Association’s website at www.lbma.org.uk for a collection of new gold price predictions for 2007 from 29 gold analysts from around the world.

Encouragingly, all the gold analysts are more bullish in their predictions for 2007 than 2006, with an estimated average gold price of US$652.38 per oz., within a US$566-US$742 per oz. range.

Remarkably, this same group grossly underestimated the 2006 average gold price by some US$70, so this year’s predictions are probably most useful as a gauge of market sentiment.

Meanwhile, Merrill Lynch has calculated that the total value of mergers and acquisitions in the gold sector in 2006 was a record US$19.3 billion, with some 31 significant transactions.

Merrill found that the average acquisition price in 2006 was at a 0.6% premium to the prevailing gold price, compared with 17.8% and 33% discounts for mine and development project transactions, respectively, in previous years.

With natural gas, oil, coal and copper prices all retreating in the past year, gold is one of several key commodities still flexing its strength and showing considerable potential for higher prices in the years ahead.