Gold - It's Going Up!

Overview

Gold has been valuable to mankind for over 5,000 years of recorded history. It has attracted investors throughout the centuries, protecting their wealth and providing a “safe haven” in troubled or uncertain times. Gold has a “proven” ability to provide a shelter from such negative market effects as inflation, catastrophic events and political unrest.

Gold historically has been, and is still, used as a commodity, a currency, a store of value, a precious financial investment and a cherished form of adornment. More recently, because of its unique properties, it has also being used in medical, dental, electronic, and scientific applications (i.e. gold-coated visors protect astronauts’ eyes from searing sunlight on NASA Space Programs.)

Gold is not only a commodity, it is money – it is a currency. Central banks hold gold (not oil or potash.) Gold has a monetary value. In today’s world of massive deficit spending, political unrest, inflating currencies (i.e. “fiat money” or excessive printing of paper currency) and financial/credit crises, gold’s monetary role is reasserting itself.

After six years of dollar destruction, with more to come after the US government’s rescue of Fannie Mae and Freddie Mac, the IndyMac takeover and the Bear Sterns bailout, the price of gold is getting ready to head through the roof.

Investment demand for gold is increasing and the remonetization of gold has begun.

What caused the recent drop in the price of gold?

The recent decline in the price of gold was caused by a massive liquidation of gold (and related products) by hedge, pension, investment and other funds. Funds were forced to raise capital and look for profit due to the infamous “sub prime” credit/financial crises. Portfolio managers had problems and were selling in a quest for profits and a quest for liquidity. Interesting to note:

1. This liquidation and subsequent decline occurred around the same time (or slightly before) the announcement of UBS taking a US$5B hit and J.P. Morgan taking a US$1.5B hit (both sub prime related); and

2. The old saying “gold as a safe haven” proved its merit once again (funds were fortunate to hold gold; it maintained its value and allowed funds to raise capital in uncertain markets.) Where would these funds be if they didn’t hold gold?
This liquidation started the snowball rolling and, as with any stock or security, selling brings selling thus the decline in price, a classic example of what’s often referred to as the “herd instinct”, one cow starts running and the rest inevitably follow.

Why is gold going to go up?

• Fundamentals: supply is decreasing; demand is increasing.
• Historical “proven” reasons: gold is a safe haven; gold is money; gold is a currency hedge; gold is a commodity; gold is an inflation hedge; gold is reliable in uncertain (and unprecedented) times.
• Major gold companies are no longer hedging and are currently unwinding existing hedge positions.

Supply is Decreasing

The supply of gold comes from four sources:

1. from existing mining operations (mines with the principal purpose of extracting gold from the earth);

2. as a byproduct of mining (generated as a byproduct of mining other minerals such as copper or silver);

3. from waste reclamation (processing waste from older mines using modern technologies); and

4. from recycling (industrial scrap or old jewelry.)

While there is currently a great deal of gold exploration underway, new discoveries typically take years to go into production. In spite of all the money being spent on exploration, it has not resulted in a great deal of new gold coming into the market. At the same time, existing deposits are being depleted.

The bear market (in mining) from 1997 – 2002 curtailed exploration by mining companies – expenditures fell by over 60% and therefore exploration and discovery for new deposits effectively came to a halt. As it takes 5-10 years to go from discovery to production, the world’s gold supply will not fully recover from this lack of exploration until 2011-2012.

Gold can often be recovered and recycled after its use. Gold from industrial scrap and old jewelry can be melted, refined and used again. Recently, new jewelry buyers are keeping old necklaces, bracelets, rings and so on thus this supply of gold has been declining.

Demand is Increasing

There are two primary demands for gold: fabrication demand and investment demand.
Fabrication demand includes anything made from gold including electronic, dental, medical, jewelry and other industrial products. Gold has unique properties which allow it to be used in certain applications where no other mineral or metal would suffice. Gold use in fabricated products increased 8.3% last year and is forecasted to increase another 8.2% this year with the bulk of the increase expected to be from jewelry in developing nations.

Investment demand in gold has increased considerably in recent years. Since 2003, investment has represented the strongest source of growth in demand, with a year-on-year increase in value terms of 45% by the end of 2006, and growth over the past five years of around 300%. Investors are buying gold as an inflation hedge, as protection against a falling dollar, as an alternative to stocks and bonds, and as a store of value in the world they perceive to have greater risks to their wealth and well being. China has been buying gold as well as India and other emerging nations.

Gold is a Safe Haven

In volatile and uncertain times, there is typically a “flight to quality” as investors seek to protect their capital by moving it into assets considered to be safer stores of value. Gold is immune to most troubles that can befall a market, such as the current credit crisis that is crippling the US markets and economy.

Gold is Money – Gold is a Currency Hedge

Gold has long been regarded by investors as a protection against currency devaluation. There are always a few currencies in the world that are threatened by mismanagement by their own governments. Gold allows investors to protect themselves. History suggests that gold always wins against an inflating paper currency (i.e. onethat is subject to excessive supply growth.)
J.P. Morgan was quoted as saying about gold: “Gold is money. That’s it.”
Alan Greenspan, in justifying the US’s decision to continue to hold gold reserves, said in 1999: “Gold still represents the ultimate form of payment in the world. Germany in 1944 could buy materials during the war only with gold. Fiat money in extremis is accepted by nobody. Gold is always accepted.”

Gold is a Commodity

As a physical asset, gold can rise in price as its underlying fundamentals change (which are changing for the better.) Investors who follow the physical gold market closely can make robust profits.

Gold is an Inflation Hedge

The value of gold, in terms of the real goods and services that it can buy, has remained largely stable for many years. In 1900, the gold price was $20.67/oz, which equates to approximately $503/oz in today’s prices. In the two years to end December 2006, the actual price of gold averaged $524. So the real price of gold changed very little over a century. In contrast, the purchasing power of many currencies has declined.

Hedging

The gold industry was the first to use hedging and, interesting to note, the gold industry is the first to exit hedging. Major companies (such as Barrick, Newmont and AnlgoGold Ashanti) have unwound hedged positions with more unwinding to come, inevitably creating a positive impact on the gold market.
Uncertain (and Unprecedented) Times
There is a tremendous amount of financial risk in the system (credit crisis, level of household debt, the housing bubble, the amount of U.S. Treasuries held by foreign central banks, etc…) and more shakeout in the financial industry to come. History has proven, when all else looks risky, gold flourishes.

Summary

With so many factors overwhelmingly in favour of gold, the gold mining industry is poised for a stellar (and unprecedented) rise in profitability and profile. In today’s world of massive deficit spending, credit crises, inflating currencies (i.e. excessive growth in money supply) and financial imbalances, gold’s monetary role is reasserting itself. Investment demand for gold is increasing and the remonetization of gold has begun.