Why gold may have a long way further to fall

On Monday, 15 April 2013, the gold price fell US$145/oz., its worst trading day in history. Technically, this ended an 11-year bull run in the metal. The market searched for reasons: Cyprus selling its gold reserves to pay back the Russian oligarchs inv

Every year, the world produces some 2 800 tonnes of new gold. This pours viscerally, almost unnoticed, onto the top of an estimated 171 000 tonne glittering mountain of already-mined metal. Here on the surface, far from its deep dark origins, it sits untarnished and immortal in vaults and safes, on necks and fingers, enticing people from all walks of life into its unfathomable, compulsive grip. It has only two meaningful, often interchangeable, purposes in life: as a store of value and an adornment.

At the most basic level, the battle for control of the metal occurs between two heavyweight protagonists. In the one corner we have the ‘fabricator’ who buys the metal to create jewellery, trinkets and expressions of lifelong togetherness. In the other corner we have the ‘investor who believes somewhat piously in a mystical ability of this particular metal to protect him against the four horses of financial apocalypse: inflation, weak economic growth, currency devaluation and geopolitical risk. When the investor gets scared, he buys gold as a talisman to magically protect his portfolio. Notably, he did so in the late seventies and has, more recently, done so through the last decade.

In order to price-elastically stretch the metal away from jewellery demand, the investor must offer more for gold than the fabricator is willing to pay. This is the ‘investment premium’. Conversely, when the investor is happy with life, he no longer needs his lucky charm and it is left to the fabricator to decide what price he thinks it is worth and what price his customers are willing to pay to clear the market of available gold (excluding this investment premium).

How does one settle on a price, however, and how much is the investment premium? There is no other commodity like it. Gold is not permanently consumed and creates no income. The surface stockpile of gold completely overwhelms newly-mined supply and thereby defies the normal logic of commodity producer cost curves. There are therefore no earnings or income yields, no reference price or base cost that an investor can safely rely on, either technically or fundamentally. There is no intellectual capital and no products, services, patents, brands, management, land or buildings. There is simply no intrinsic value to gold.

Holding gold is nothing more than an act of faith. It is a true example of ‘castle in the sky’ investing: you buy it simply because you think that you will be able to ride it for a while and then sell it to someone else for more. Were you to own it in physical form, you may gain a degree of ‘Midasian comfort’ in taking it out, polishing and admiring it. But this is a rather unquantifiable benefit and very unlike the tangibility of a bi-annual company dividend cheque that will pay the grocery bill (not to mention the risks associated with keeping it hidden under the mattress).

It is self-evident that the true believers have had an enviable golden ride recently. In a little over a decade, the gold price has risen some 600% from US$250/oz. in 2001 to US$1,800/oz. in 2011. Since then, it has bounced around a bit at these rarefied levels before, more recently, falling back to below US$1 500, where it currently trades.

The following table illustrates the changing patterns of supply and demand during this period. From this, one can perhaps gauge the sustainability (or otherwise) of the price surge. It has certainly not come from a growing desire to wear more jewellery or reduced mine supply. It has rather come from a sustained increase in investment demand and, by implication; the price currently carries a significant investment premium.

Note how fabrication demand has fallen 25% over the last 11 years, from representing 89% of new supply to 58% as the price has risen. Note too how investment demand has increased 333%, from representing 11% of new supply to 42% as investors crowd the market. Fabrication demand now needs to increase by 72% just to net-off current investment demand should this pattern reverse. Such a scenario, rather optimistically, assumes that investors merely stop buying and hold their existing positions rather than selling the rather worryingly liquid exchange traded funds that currently amount to just over 2 600 tonnes, almost an entire year’s supply of newly-mined gold.

Every year, some 3 000 tonnes of newly-mined and scrap gold comes to the market. This metal needs to be bought, either by the investor or the fabricator or both. The investor probably has enough right now. The financial storm clouds don’t appear to be increasing in categorical severity. In fact, things may just get a little better in the next few years, in which case, he may want to pre-emptively unload a little of his special protection into the market whilst it still carries its investment premium.

So, how far could the gold price fall if investors pull out? Just how big is the investment premium? If the bear market in gold in the early 80s is a guide, gold could still fall a further 50% to US$750 before the fabricators take up all the slack left by departing investors (source: CitiGroup).

Right now, you should probably think of the gold price as some rare and beguiling knife suspended in front of you by barely-visible tendrils of investor sentiment. Your job is to catch the knife when it falls without hurting your savings. You can, however, decide to do nothing. To instead watch it slice through the air before hitting the table, there to quiver in disbelief at the unfairness of its fate. Then, when the investor has departed in search of the next opportunity and the fabricator is the only buyer left, only then can you safely pick up the knife.