Shareswatch Australia Blog

Few precious metals stir the emotions of investors quite as much as gold. But just as it stirs emotions, it also causes many people to forget about the basics of investing and plunge into gold seeking their fortune, only to suffer losses and heartache. Currently there is a lot of focus on gold as it is seen as a good asset to hold in times of trouble, so now seems like a good time to have a look at what drives gold prices and other gold market fundamentals.

Firstly let me clear when I say that I am not an active buyer or seller of gold, gold related investments or gold mining stocks. I am not promoting gold in any way and the purpose of this article is just to present some information readers might find interesting. I make this point because as I did research for this article, I found a lot of bullish material on gold that was written by people who have a vested interest in talking up gold.

Also beware of “pump and dump” tactics. This is where people “talk up” small gold exploration/mining companies in which they already own shares. Often these people will then post comments in blogs, forums etc. and talk about spectacular gains to be made by buying stock xyz. They then wait to hopefully sell their shares at a profit to anyone who takes the bait.

Personally I have had a mixed run when investing in gold and on balance I would have to say I am a gold investing loser. (that is not an easy thing to do during a gold bull market!) I did learn a very important lesson though, and that is that many analysts do not have the necessary skills when it comes to determining the benefits and risks of investing either directly in gold or in gold stocks.

An economics degree might be great for crunching numbers, but it is not going to help an analyst understand the engineering and science behind getting gold out of the ground in manner that is profitable.

So my suggestion to anyone that is going to invest in gold mining company stocks, is to try and get some good research on the company you are looking at done by someone that really knows mining. (like a person who has a degree in mining engineering or geology for example) If you are thinking of investing in physical gold or via an Exchange Traded Funds (ETF’s such as ASX:GOLD) then it is still a good idea to have some basic understanding of gold mining and production. (as these are important factors in determining gold prices)

A good starting point when looking into gold as an investment is to appreciate what drives demand. According to the World Gold Council the major demand for gold in 2007 was driven by:

2007 Identifiable Gold Demand (tonnes)

Jewellery and consumption – 2400.9

Industrial and dental – 461.1

Identifiable Investment – 656.6

ETF’s and similar products – 253.3

Total identifiable demand – 3518.7

What surprised me about the above figures was the large demand for gold for use in jewellery. Of course I knew that a lot of gold is used in rings etc. especially in India for example, but based on the figures from 2007 the demand for jewellery was around 2.5 times that of the total demand for investment and ETF’s and that did surprise me.

The demand for industrial gold is also quite significant so if I was thinking of investing in gold today, I would be wondering how demand is holding up during the current economic crisis. From what I have been able to find out the picture is mixed as the demand for jewellery gold is falling whereas the gold for investments purpose is rising. (nothing is ever simple!)

This then leads us into the sometimes emotional area of gold bulls and gold bears, where fact and fiction are mixed and much of what is touted as “independent analysis” is actually someone trying to push gold as investment.  Rather than try and work out who is right, the bulls or the bears, let me just lay out the cases for both sides as I see it.  Please feel free to post a comment or drop me a line if I missed something or you wish to make a case for either side.

The case for being bullish on gold.

• It is a defensive asset.

• It retains/stores value.

• The worlds banking system is in trouble, gold is safe.

• Investment demand will continue to drive up prices.

• There is a shortage of gold. Annual global mine production is around 2500 tonnes, annual global demand is 3500 tonnes.

• As people in India, China etc. become more affluent they will want more gold thus prices will continue to rise. (i.e increased demand)

• The gold miners are bullish.

A good case for the bulls is set out in these articles: Gold Production and Reserves 2 and Don’t Miss the Coming Gold Bull

The case for being bearish on gold.

• Jewellery  and industrial (?) demand is falling as a result of the economic crisis.

• There is no shortage of gold. There is vast amounts sitting in vaults, on people’s fingers and in display cases etc.

• A significant amount of gold is recycled each year and this helps meet demand.

• Gold is just another commodity that is trading at bubble like prices.

• The world’s banking system will recover and people will then make a rush to exit their gold positions.

• The gold miners are bullish. (just like the oil companies were just before oil prices went through the floor)

A good case for the bears is set out in these articles: The Myth of the Gold Supply Deficit and Gold: Recycling Threatens Demand-Supply Equation

I appreciate some of the statements above seem contradictory but this is often the case when you look at both sides of an argument. For example the gold bulls may point to the gap in supply (around 1000 tonnes a year) as a reason why gold prices will keep rising whereas the bears (and there is not many of them) would point out that there are vast amounts held in storage and that gold is also recycled to help meet demand. (up to 25% of global demand apparently is met in this way)

The supply and demand situation for gold is more complicated than for most other commodities because vast amounts are stored and because it is recycled. We also need to think about how much gold is actually “consumed” each year…i.e. becomes unrecoverable. I have not been able to find any good data regarding this but I have been told it’s only a very small percentage of the gold in circulation.

My overall impression is that the demand side for gold is softening at the moment. Yes demand for investment gold is rising (and has been for some years) but I am sure when we see the figures come out for the Q4 2008 and Q1 2009 that jewellery demand (and probably industrial demand) has dropped significantly.

On the supply side I would expect more gold is recycled at current prices and that production efforts have been ramped up. Personally I feel gold is now trading at a “fear” premium” and not according to just supply and demand fundamentals. If the world economic situation deteriorates then gold prices may rise, however if the global economy starts to show signs of recovery then gold prices may fall quite quickly.

By the end of this year we will know who was right, the gold bulls or the gold bears. Meanwhile I will be happy to sit on the sidelines for now and watch how events unfold.

Related posts:

1. Are we in a gold bubble? Could gold prices fall?
2. Is the gold bubble about to burst?
3. Shares, gold, real estate, cash: strengths and weaknesses.
4. A stock market correction, some panic and nervous investors.
5. Economic mixed signals, the ASX All Ords & gold prices.