Gold Price Defies Law of Supply & Demand

by RJ Wilcox on July 19, 2013


Before diving into the Weekly Recap, we present an abbreviated version of our Comparative Analysis Table for your reference and ours.  It compares the operations of 12 of the top gold producers as measured by market cap.

It is a sampling of our in-house analysis, customized to capture key metrics of the gold mining business.  The complete table, available to subscribers, encompasses a list of mid to large-cap producers and a mountain of painstaking data gathering that we keep updated on a monthly, quarterly, and annual basis as the information is released.

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Gold Miners Comparative Analysis Table

Weekly Recap

Usually our Weekly Recap focuses on the important developments that occurred in the gold market during the week, hence the clever name.

This week, however, I would like to link many of the important trends and events we have highlighted over the last several weeks and organize them by the respective roles they play in shaping the supply and demand landscape of the gold market.

The reason for our detour is because there appears to be something very strange happening in the gold market.  On the one hand we see surging worldwide demand led by Asia and, interestingly, emerging market central banks.

On the other hand, the gold price has fallen dramatically in the face of this staunch demand.  This suggests that historic demand is being overwhelmed by an even larger wave of selling. Is this actually the case or has the law of supply and demand broken down.

If you are unfamiliar with production levels in the gold mining industry, you might be inclined to think that the gold miners must be oversupplying the market given the current price weakness.  If you do, it’s a good thing you read our weekly recap!

In 2012, the World Gold Council (WGC), an authority on the topic, reported that gold production totaled 2,857 metric tonnes.  Although this represents an historic amount of production, the mined supply has actually not grown very much over the course of the 12 year bull market.

In fact, gold production has experienced significant declines during this time period, for reasons that are best presented at length another day.  However, here’s the supply chart for your consideration.

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World Gold Production

In contrast to mined supply, it might surprise you to know that gold demand for 2012 was an astonishing 4,408 metric tonnes.  That’s a massive difference of 1,551 tonnes.  Most investors are completely unaware that gold demand dwarfs mined supply by such a large number.

What makes up the difference?  According to the WGC, it’s “Recycled gold”.  If you believe this, we’ve got a big orange bridge for sale. This vague term can really mean anything and we think the WGC is simply being very cautious with the way they present how the supply deficit is being filled.

The sheer size of the supply deficit number is enough to invite suspicion, but we’re relying on more than just suspicion to dispute the idea that the sale of “Recycled gold” into the market has overwhelmed surging global demand.  Something’s amiss!

Let’s take a brief diversion and come back to this topic.

Econ 101

Arguably, the most basic economic concept known to man is the law of supply and demand. It’s a concept that’s easy for most of us to get our minds around. The basic idea is that, the relative amounts of supply on the one hand, and demand on the other, are brought into balance by the price.

Quite simply, if the level of demand is more than, or rising faster than, the level of supply, prices have a tendency to rise.  The reverse is also true.  If the level of supply is more than, or rising faster than, the level of demand, prices tend to fall.  Man has been conscious of this relationship since the dawn of civilization.

With the entire scope of Econ 101 now under our belt, let’s explore this fundamental economic law in terms of gold and see if it helps us make sense of the recent Acapulco cliff dive in price.

Historic Gold Demand & Central Bank Intervention – Vietnamese Style

There was a very interesting news story we highlighted in our News Corner called “Granny’s Gold Bars Are Key to Vietnam Push to Boost Dong”.

The story details the recent policy changes made by the Vietnamese Central Bank regarding gold and its place in the banking system

The stated reason for the intervention has to do with the fact that the inflow of gold is causing an outflow (i.e. selloff) of the local currency and thus is undermining the currency’s value.  The important thing to note is that the scale of the problem is such that it warrants unusual intervention by the central bank.

The policy initiatives to stem the tide of gold buying include the central bank naming themselves the sole gold importer, the Saigon Jewelry Co. the only legal gold refiner and wholesaler, and banning commercial banks from paying interest on gold deposits held by bank customers.

It might come as a surprise to many in the West, but Vietnamese people, along with the citizens of many other countries, can purchase gold from, and deposit it in, the bank.  In return, the bank pays them interest on their gold deposit.

However, on June 30th, the central bank banned the practice of paying interest and, adding insult to injury, ordered the commercial banks to charge a storage fee for the deposited gold in an effort to curb gold hoarding by its citizenry.

The article then goes on to mention a rather curious component of their initiative.  Apparently, the central bank has also conducted a gold auction in which the commercial banks are the bidders.

Now why would commercial banks be interested in buying gold at a central bank sponsored auction?  The devil is in the details.

One is left to infer from the information presented in the article that as the banks have gone from paying interest on gold deposits to charging a storage fee, it has encouraged depositors to withdraw their gold.  Which is what has happened since a person’s incentive to leave it deposited in the bank is gone.

Asking for your gold deposit back shouldn’t be a problem unless the banks no longer have their depositor’s gold, which is exactly the problem!

What did they do with it?  We don’t know for sure, but we can speculate that they likely leased, loaned, hypothecated, sold, or ‘whatevered’ it with the intent of making a profit on various carry-trades.

This is what banks tend to do with deposits.  However, as many banks are starting to find out, you don’t lend out gold you don’t own because you won’t get it back!

The main point is, the banks don’t have the gold and therefore the central bank is making theirs available to cover the commercial banks short position and to avert a serious crisis in confidence.

So far, to settle deposit obligations, commercial banks have reported buying 44 tons of gold, which is equivalent to 1.4 million ounces or US$1.8 billion.

In the grand scheme of things, this doesn’t represent a huge amount of gold. However, what this story accentuates is the extraordinary gold demand coming from just one country in Asia and the economic upheaval it is creating.

On the other side of the coin, this discussion also wedges a foot in the door and sneaks a peak into the banking systems involvement in, and fear of, the gold markets.  It is a hint at how the massive 1,551 tonne gap between mined supply and global demand is actually being met.  “Recycled gold” indeed!

Restoring Faith in the Economic Law

The World Gold Council likely has their reasons for being ambiguous on the matter, but we have no such reservations.  In their reporting, they provide no evidence to support their assertion that the global supply and demand imbalance is made up by “Recycled gold”.

It’s an assertion on their part, and we believe they are simply labeling the difference between supply and demand with a title that sounds reasonable.

However, Eric Sprott of Sprott Asset Management and of Kitco commentator fame, began publishing a 3 part series, on behalf of clients, beginning last September, entitled “Do Western Central Banks Have Any Gold Left”.

His analysis, in our view, conclusively demonstrates that the U.S. government is in fact, not in theory, a significant source of the mystery gold supply.  His analysis is based on detailed data published by the U.S. government itself, along with other well-known mainstream sources like GFMS, Bloomberg and the CPM Group.

Although involved, one conclusion of the analysis, which we strongly encourage serious investors to get their hands on, is that “Over the span of 22 years, the total amount of gold that the US has exported – above and beyond its supply capability – is almost 4,500 tonnes!”

This 4,500 tonnes could only come from the U.S.’s official gold holdings, which the government officially maintains is currently close to 8,100 tonnes.

When this information is combined with the dramatic dishoarding of gold by ETF’s over the past year, and the sudden and equally historic drawdown of COMEX gold inventories, it’s not hard to see where the overwhelming supply is coming from.

Due to gold ETF liquidations, inventories are down from levels near 82Moz to 64Moz, a drop of 22% since 2012.  The COMEX inventory is also down from 11Moz to 7Moz, a drop of 36%.

We don’t necessarily need to explain why this avalanche of selling is happening, we should just appreciate the impact it is having on price.  Although, our earlier review of events in Vietnam provides some clues to the physical liquidation.

The price of gold is falling for the simple reason that, for now, there is an ample supply of physical gold, with willing sellers, to meet and overwhelm historic demand.  Rest assured, the law of supply and demand has not broken down.  We simply needed to identify the major source of supply to make sense of the precipitous gold price action.

From an investor’s standpoint, an important question is whether this enormous selling is sustainable?  It’s not hard to answer.  At some point, limited inventories will run out and it is virtually impossible for the mining industry to make up the supply gap.

Equally important to the gold price discussion is, it is unlikely that global demand will abate anytime in the near future.

In part 3 of our 4 part series on Investing Wisely in Gold Producers we address these supply and demand fundamentals in greater detail.  If you’re interested, you can sign-up on our site.

The above discussion is one of the reasons why we remain mid to long-term bullish on the gold price and selected gold miners; and tolerate short-term shenanigans.

That’s it for now.  We look forward to seeing you here next week.

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