Market Gup Shup: Metals

Gold: Is it a Consolidation phase ($900-$950 level) or things are really going wrong?

What is going on behind the scene?

Gold still remains the best bet in precious metals. Gold has given an annualized return of 46.28% YTD and around 40% annualized since we wrote our first thesis and recommendation on gold (see article date January 21, 2008). Gold roared to a lifetime high of $1,030.80/ troy oz. on March 17, 2008 but then tumbled to a two-month low of $872.90 in early April in a broad commodities sell-off. It has bounced since then and stood around $935 an ounce on April 15, 2008. There has been increasing media reports and speculation about future of gold. In our opinion, the concerns like, “is the bull run over”, “has gold seen its golden season”, are baseless and we have reasons for our strong view. Many on the street are also arguing that the shining in gold was due to the increased money flow in the commodities complex (Commodity ETF’s/funds), however we think this remains one of the factor but certainly not the underlying one, gold has its own reasons supporting the price movements.

The answer to the first question in the headline is affirmative and second question is negative.

Recent concerns/factors working for gold:

1. Strong fundamentals: Increasing supply concerns from South Africa:

Gold still enjoys the case of strong fundamentals where demand is still more than supply (see our previous analysis "Gold: its ain't the fever what it used to be Jan 2008")

South Africa (SA) is one of the top producers of gold. In terms of 2007 mine production it accounted for around 11.1%, Just behind China which enjoyed 11.3% (see production chart). Lately SA is having

growing imbalance between the power consumption and generation. As a measure of regulation and in order to control things, SA govt. is controlling all the power allocation to all the business’s which primarily includes gold mining. As per last update, SA govt. is now allocating around 90% of the power which the mines used to consume earlier. This is regardless of which mine is producing how much in terms of efficiency and cost, hence even if the producer may want to allocate 100% or more of the power to some low cost and more efficient mines and keep certain high cost mines closed , it has no option but to suffer on rising costs for non-efficient mines.

As per experts and power industry

consultants the power problem is a structural problem on account of lack of build up of new generation facilities coupled with increased usage and bad weather, hence the situation might take around 2-3 years to get fully normalized. Major gold producers like Gold Fields, Anglo American (400,000 ounces shortfall) have already announced reduced production guidance on account of power shortages.

Source: http://www.goldsheetlinks.com/production.htm
Source/further readings supporting the thesis: 2007 world gold production fell marginally and 2008 output to stabilize – GFMShttp://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=50465&sn=Detail

2. Renewed demand from Asia particularly India: Seasonality

Though there is no denial of the fact that demand was subdued in India and China due to high gold prices, the fact remain that gold is the party essence for every celebration in India. This time the pullback is attributed to or rather spurred because of the wedding season (ending May 2008) and The Akshaya Tritiya festival (May 7, 2008). Jewellery demand may see a major spur due to these two reasons.

We have studied the data from 1970 for gold demand and came to the conclusion that gold does have seasonality factor. The first and fourth quarters are the periods when there was rise in gold price on account of higher demand, while the second and the third quarters were seen as quiet or flat demand during the particular year. Having said that, the analysis is based on normalized data and we have removed specific outliers to improve data quality.

Source/further readings supporting the thesis:
Indian demand keeping gold markets alive
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=50690&sn=Detail
Return to gold by Eastern jewellery markets means price may have bottomed
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=49719&sn=Detail
Citigroup warns of waning gold investment, seasonal slack - but positive long term
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=50688&sn=Detail

3. IMF sales – a perspective. The gold for sale is different from the rest!

The recent announcement from the US Treasury on 25th February, approving in principle the proposal for the IMF to sell some of its gold reserves, marked a reversal of policy and generated a knee-jerk reaction in the gold market, with prices dropping by $10 to close at $938 that day.
It looks as though any sales by the IMF will be restricted to 400 tonnes used in a previous sale and repurchase agreement – and in any case would be made within the existing CBGA sales Agreement. The market is right to remain unfazed!

This looks very much like the gold that was used in sale-and-repurchase transactions with the IMF in 1999 and 2000. In these transactions the IMF sold gold to Brazil and Mexico at prevailing market prices and then immediately accepted it back at the same price in settlement of financial obligations of those countries to the IMF. While the net effect on gold holdings was zero, the gold thus accepted was entered onto the IMF's books at the prevailing market price rather than the official price of SDR35/ounce. In accordance with the IMF Articles the equivalent of SDR35/ounce from the proceeds of the sales was retained in the General Resources Account. The increase in the value of the gold held on the balance sheet was deemed to offset the liabilities of Mexico and Brazil to the IMF.

There are three things which needed to be noted in this regard as observed by Crockett Committee:

Firstly the undertaking-sale of gold-should be qualified in important ways that limit its impact on the gold market. In the first instance, the amount should be limited to the 400 tons I mentioned, without envisaging any additional sales.

"Secondly, the sale should take place within the existing Central Bank Gold Agreement, that is to say it would not be additional to sales already programmed by central banks, but would be accommodated by reductions in the amounts of gold that the central banks might sell under the Central Bank Gold Agreement.

"And thirdly, we have emphasized that the sale should be undertaken in a very careful way in terms of their periodicity amounts and manner of sale such as not to disturb the market.

Source/further readings supporting the thesis:
IMF sales – a perspective. The gold for sale is different from the rest!
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=48222&sn=Detail
Swiss Central Bank gold sales – further analysis
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=49939&sn=Detail

Producers Removing Hedges

In 2007, most gold producers (E.g. Newmont, Barrick etc) removed their gold hedges in anticipation of a rise in gold prices, which came true in the last quarter of 2007, witnessing a substantial increase in gold prices, although top-line gains of these companies were affected and offset by higher operating costs, still the highest operating cost was around $400-500 per ounce which still leaves a decent margin on a price of $800 gold.

Production more difficult, limited supply and consolidation underway

Since the depletion of gold mines is more rapid then the other conventional mining assets like base metals, Gold producers are constantly pushed to acquire new assets. Although prices remained elevated, key producers remain under huge pressure to increase reserves and lower production costs. It should be noted that in most cases there has been no new discovery of precious or base metals, the reserves were lying there for years, just uneconomical to produce because of the low prices.(refer table/charts below.)

Gold fever. It isn’t what it used to be!

We look back on the last time gold hit $850 (1980) with even gold teeth going into the melting pot. Not this time though, as many feel the metal has much further to go yet on its upward path. The hype and hoopla that accompanied gold's record-breaking rise the last time around is probably missing this time partly because although there is plenty of risk around, including high oil prices, there is little 1970s-style doom saying.

Though the price of gold seems very high today, the record $850 an ounce it hit at the London fixing on January 21, 1980, translates in today's money to more than $2,150 and therefore we can say that we are comfortable at these levels (inflation adjusted).
(Refer to http://www.mineweb.com/ for more details)

If that’s the case, why is gold falling now?

The only reason gold peaked recently ($918/ounce), coming back to $880 levels, is a result of current scenario in which the market for gold-specific factors that have been acting unfavorably. There have been two price drivers have become less supportive.

First, central bank selling has picked up for some parts of the world, and second, speculation is underway.

Having said that; a strong recovery in physical demand (particularly from India & China) and positive external drivers outweigh the two gold specific factors for now. Hence in our view the gold prices are likely to maintain their upward momentum in the months ahead.

More room for upside

We anticipate that gold prices will continue to increase on account of a weak U.S. dollar and concerns about inflation. Gold is up approximately 30% for the year, with a year-to-date average price of $760 per ounce. Notably the 5-yr return on gold was a total of 140%. We expect a weak global economic growth, increase in inflation fears, a flight to quality for safe haven and other market concerns with the broader economy which will in turn support for higher gold prices. Historically it has been seen, that a US FED easing cycle results in money flowing into commodities especially oil (a.k.a.black gold) and precious metals.

Some of the charts to support the thesis:

World Consumption Pattern