Speech to the Sixth Annual India International Gold Convention
Goa, India â€“ September 5th, 2009
Jeffrey Nichols, Managing Director, American Precious Metals Advisors
Thank you, Mr. Chairman for your kind introduction . . . and many thanks also to the conference organizers for inviting me to participate in this prestigious gathering.
It is a great honor to be here today, not only to share my views â€“ but to learn from you, and make many new friends in the Indian Gold Community.
A few weeks ago, in preparation for todayâ€™s presentation, I asked the conference organizer what I should talk about. He said, I should talk about 15 minutes in the morning . . . and about 10 minutes in the afternoon.
Only then did he say: â€śIn the morning talk about global supply and demand. In the afternoon talk about the price outlook.â€ť
To many gold-market analysts, it may appear to be an artificial distinction to separate a discussion about supply/demand fundamentals and the price outlook with a luncheon break.
Traditional economic theory says the price of a commodity is a function of supply and demand. But Iâ€™d like to suggest an alternative point of view:
In the world of gold, price come first . . . and changes in the supply/demand fundamentals follow.
In other words, the supply and demand for gold â€“ as measurable quantities â€“ are more a function of the yellow metalâ€™s price, rather than the other way around.
Meanwhile, the price itself is a reflection of the collective psyche of the marketplace and its millions of participants worldwide. Simply put, an ounce of gold is worth exactly what people think it should be worth â€“ and the supply/demand fundamentals adjust themselves to this price level.
Iâ€™m married to a psychiatrist. If I want to know the future price of gold, I ask her!
Iâ€™m an economist. If she wants to know what the price means for supply and demand, she asks me!
Gold is a rare and unusual commodity because it is first and foremost a financial and monetary asset whether it is held in bars and coins by Western investors and central banks, or jewelry by Indian housewives and individual investors and savers across Asia and the Middle East.
Consider the share price of any company that trades on the New York Stock Exchange or here in Mumbai or anywhere else for that matter. The number of shares outstanding for most public companies may be fixed for years . . . but the share price goes up or down based solely on what the collective wisdom of the market deems fair and appropriate.
Although for gold, the number of ounces may not be quite so fixed, changes in supply, that is to say new supply from mine production, are very small relative to the entire stock of gold outstanding.
The entire above-ground stock of gold is estimated to be roughly 165,000 tons . . . and this stock grows predictably from new mine production by some 2,300 to 2,400 tons a year.
Prospective changes in annual mine output, at least for the next few years, are also fairly predictable . . . and are already reflected in todayâ€™s gold price.
If not the growth of new supply, what is it that sets the price of gold?
It is changes in the willingness and desire of existing and prospective gold holders â€“ individual and institutional investors, owners of gold jewelry and other items, and central banks and other official-sector institutions â€“ that set the price.
And, though itâ€™s not quite this simple, it is changes in the price that cause changes in the various sectors of supply and demand â€“ not the other way around!
The main categories of supply and demand are mine production, old scrap arising from the recycling of jewelry and other gold-bearing items, jewelry fabrication, net official-sector transactions, and net investment by individuals and institutions in bars and coins.
Mine Production in Decline
Mine production peaked in 2001 at 2,645 tons, an all-time high, and has been falling gradually ever since â€“ a downtrend that is expected to continue at least for the next few years. This year we expect new mine supply of some 2,370 tons and two years hence, in 2011, it will likely have dwindled to the neighborhood of 2,275 tons.
Over the long term â€“ looking out five to 10 years or longer â€“ mine output is a reflection of price versus the rapidly rising cost of production and the increasing difficulty and expense in finding new deposits large enough to offset the loss of production from the ongoing depletion and exhaustion of existing mines.
In addition, increasingly stringent environmental regulations are adding to costs and unfriendly government attitudes toward mining or foreign ownership in some countries are discouraging exploration and development.
It should also be mentioned that the stock-market crash and continuing global credit crisis has slowed funding and retarded gold-mine development in many countries.
However, one explanation to the on-going decline in worldwide mine production is that prices in the past couple of decades simply have not been high enough to encourage exploration and mine development sufficient to replace the dwindling economic reserves in the historic â€śbig fourâ€ť gold producing countries â€“ South Africa, the United States, Canada, and Australia.
Interestingly, the locus of world gold-mine production is shifting from the â€śbig fourâ€ť to the emerging market nations. China, Peru, Russia, and Indonesia together accounted for 20 percent of total world mine supply ten years ago. Today, their share is now 35 percent â€“ and their share of worldwide mine production will continue to increase for years to come.
China became the worldâ€™s number one gold-producing country in 2007 â€“ due not only to the rapid pace of mine development and the continuing rationalization of the industry . . . but also due to the collapse of South African gold production as that countryâ€™s mines have been rapidly depleted and the difficulties of operating at deeper depths have restricted mining.
Although there is much exploration and mine development activity in all of these countries â€“ and more can be expected as prices rise and access to financing improves â€“ it will not be sufficient to reverse the downtrend in global gold-mine production for at least the next five years â€“ and likely longer.
Even if big price increases occur in the next year or two sufficient to provoke a rush of exploration and mine development, for projects large enough to make a big difference, it usually takes five to ten years or longer to move from exploration and development to large-scale production.
The Rise of Secondary Supply
Unlike â€śprimaryâ€ť output from mines, â€śsecondaryâ€ť supply â€“ the recycling of old scrap â€“ mostly from jewelry â€“ reacts quickly to changes in the price of gold beyond certain levels that are seen by holders as attractive â€śsellingâ€ť points.
Last year, as prices rose through the $800, $900, and $1,000 levels, holders of old gold jewelry and other items â€“ here in India and elsewhere in Asia, as well as in the Middle East, in the United States, Europe, and virtually everywhere â€“ made a collective judgment that the price was too high. As a result, scrap supplies exploded, so much so that there was a flood of metal into the market, making the higher price levels unsustainable.
Scrap recycling, which on average runs about 1000 tons a year climbed to double that rate in the fourth quarter of 2008 and the first quarter of 2009.
In the past couple of years, the rise in jewelry scrap has also been a reflection of economic hardship, high unemployment, a desperate need for cash by some holders of gold jewelry, and the collapse of equity and real estate values.
Here in India, as you know, high-karat â€śinvestment-gradeâ€ť jewelry is bought and held as much as an investment and savings medium as it is as an adornment. Indeed, as a result of your countryâ€™s strong cultural affinity to gold, in many years, India has been the worldâ€™s largest and most important gold-consuming market.
But late last year and early this year, India instead became a major source of supply, as many holders of gold jewelry sold their old bangles, chains, and the like back to the market â€“ responding to the historic high rupee-denominated gold prices.
Around the world, even in the United States and Europe where jewelry is typically low karatage (and hardly worth its weight in gold), people have scavenged their dresser drawers for old bracelets and the like to sell for immediate cash.
This desire to recycle and cash in has been facilitated by the rapid expansion of a scrap-collecting infrastructure with traditional jewelry retailers, shopping center kiosks, and itinerant scrap buyers vying for the business and making it easy for people to sell their old gold items.
The Fall of Jewelry
Letâ€™s turn from old scrap â€“ where jewelry is a source of supply â€“ to jewelry fabrication, which until recent years has been a steady and reliable source of gold demand.
Gold jewelry fabrication demand reached an all-time in 1997 at 3,342 tons â€“ and, since then, has been trending downward. This year, I expect worldwide jewelry fabrication demand will total little more than 2,100 tons.
Much of the decline in jewelry offtake has occurred since 2001 and reflects the substantial rise in gold prices â€“ both in U.S. dollar terms and in local currencies for many important geographic jewelry markets.
With the continuing credit crisis and global recession, demand has also been hit hard by the collapse in retail sales, especially in the United States and Europe. In addition, and of importance to the near-term outlook, the steep decline in fabrication has been exaggerated by the running down of inventories on hand at manufacturers, distributors, and retailers.
Again, it is important to distinguish between the West, where jewelry is bought as consumer or luxury items and the East where, as in India, jewelry has important investment, savings, and cultural characteristics.
I look forward to learning more from my Indian colleagues at this conference about the prospects for jewelry consumption in your local market.
In general, I expect a modest recovery in worldwide jewelry demand, reflecting the improving economic environment in some of the developing markets â€“ especially India and China â€“ and supported also by some rebuilding of inventories . . . but this recovery will be muted by the expected rise in the metalâ€™s price over the next few years.
Official Sector Gold Policy
Letâ€™s turn our attention to the official sector. As many of you know, central banks and the IMF have been a hot topic in the world of gold this past year.
I believe we are now at a key turning point in the modern history of gold as an official reserve asset. Central banks attitudes with respect to gold are becoming increasingly positive. After years of persistent net sales by central banks in the aggregate, the official sector may soon become a net purchaser of gold from the market.
In fact, if we include sovereign wealth funds â€“ which are non-central bank government-owned investment institutions â€“ the official sector may already be a net buyer of gold.
On average, the central banks of the world hold about 10 percent of their international reserves in gold . . . but there is great disparity from country to country and region to region.
The major Euro-zone nations together hold about 55 percent of their assets in gold. In contrast, the Asian nations as a group (including India) hold only about two percent of their reserves in gold. China has about one and a half percent of its reserve assets in gold and Russia holds about four percent in gold.
For the past three decades beginning in the mid-1970s, gold has been under the threat of massive sales by the worldâ€™s gold-rich central banks and by the International Monetary Fund as well. In fact, the official sector has been a net seller of gold each and every year since 1989.
At times, official sales â€“ and the threat of more to come â€“ have contributed to negative sentiment in the marketplace with the price typically falling whenever one or another central bank announced a sales program.
This was seen most dramatically in 1999 when, much to its recent embarrassment, the Bank of England sold over half its official gold reserves at an average price of about $275 an ounce!
Other European central banks â€“ among them Switzerland, France, Italy, Spain, Portugal, and the Netherlands â€“ followed Britain, together selling about 3900 tons in total over the next 10 years.
Realizing that their gold sales were having a considerable disruptive affect on the market and the metalâ€™s price, the European central banks announced in September 1999 their agreement to limit future gold sales to no more than 400 tons per year over the next five-year period.
This first Central Bank Gold Agreement (also known as the Washington Agreement) was followed by the second Central Bank Gold Agreement, which limited sales by the European signatory nations to 500 tons per year for another five years.
Just a few weeks ago, the European Central Bank and 18 other central banks announced a third Central Bank Gold Agreement that caps the groupâ€™s aggregate sales now again at 400 tons per year for another five years.
All of this may prove to be irrelevant because the European central banks have not been inclined to sell much gold this past year â€“ and my guess is that they will not sell much at all during the next few years.
For one thing, the pattern of sales in recent years suggests that those central banks most eager to sell have already done so. For another, many central bankers are bullish on the metal and donâ€™t want to sell an appreciating asset.
Moreover, central banks that have sold large quantities of gold in the past decade look foolish indeed as the metalâ€™s price has moved higher and the value of their U.S. dollar reserves has declined.
European central bank sales in this final year of the second Central Bank Gold Agreement, ending in just about three weeks, will probably total no more than 150 or 160 tons versus the 500 tons allowed.
I believe the decline in gold sales by the European central banks reflects a renewed respect for the yellow metal as a reserve asset and reliable store of value.
The European Central Bank, in announcing the latest Agreement said, â€śGold remains an important element of the global monetary system.â€ť
The Swiss National Bank, a signatory to the Agreement, added that it â€śhas no plans for any further gold sales in the foreseeable future.â€ť
Germany and Italy, the two biggest holders of official gold after the United States and the IMF, have both implied they have no intention to reduce their gold reserves.
And, perhaps a harbinger of things to come, the European Central Bank also reported recently that one of its members (and a signatory of the Central Bank Gold Agreement) recently purchased gold, going against the trend of the past decade.
The International Monetary Fund has also made news with its plans to sell 403.3 tons of gold to support lending to the poorest countries. IMF membership is expected to approve these prospective sales before its annual meeting this October.
IMF strategists have suggested sales might occur gradually over two or three years. Others believe all 403 tons may be sold â€śoff the marketâ€ť directly to one or a few central banks â€“ with China, Russia, India, Brazil, or the Gulf states mentioned as possible buyers.
Importantly, the new Central Bank Gold Agreement incorporates these sales by the IMF, even though the Fund is not a signatory.
More specifically, the Agreement â€śrecognize(s) the intention of the IMF . . . and noted that such sales can be accommodated within the (Agreement) ceiling.â€ť In other words, total sales by the European central banks and the IMF cannot exceed 400 tons per year or 2000 tons over the five-year term of the Agreement.
To a large extent, gold sales by the IMF are already anticipated and factored into the current price. However, direct sales â€“ off the market â€“ to one or more central banks would be confirmation that central bank attitudes are shifting in favor of gold and would likely have a positive affect on the metalâ€™s price.
The big news of the past year has been announcements from both China and Russia that they have been buying gold from their domestic mine production â€“ importantly demonstrating that large central banks can gradually buy gold without disrupting the market.
The past April, China told the world it had purchased 454 tons since 2003, bringing its total official holdings to 1,054 tons â€“ still less than two percent of its total official reserves.
I believe China continues to buy gold from domestic production at a rate of at least 75 tons a year â€“ but gold purchases this year have not yet been transferred to the central bank and have not yet been reported as official reserves.
Looking ahead, as Chinaâ€™s domestic mine production rises from year to year, its official purchases may very well increase at a similar percentage rate.
Russia, like China, has also been buying gold for official reserves from its own domestic mine production, which this year should total close to 190 tons. Prime Minister Putin has said that Russia should hold 10 percent of its official reserves in gold bullion versus the four percent that it held at midyear. Some reports suggest the country has added some 40 to 50 tons to its official reserves so far this year while other reports put purchases this year at 90 to 100 tons.
Last year, speaking at a gold conference in Shanghai, I told the Chinese they should be adding to their official reserve gold holdings. Today, I say the same to the Reserve Bank of India, with only four percent of its official assets now in gold. To the extent that you can buy gold without disrupting the world market, do so.
I look forward to returning to the speakerâ€™s rostrum this afternoon to discuss investment and the future price of gold.
AFTERNOON PRESENTATION â€“ PRICE OUTLOOK:
The Expansion of Investment
While changes in goldâ€™s commodity fundamentals are important â€“ particularly to those of us in the trade â€“ it is developments in the investment arena that will have the greatest impact on the evolution of the market and on the metalâ€™s price.
Before discussing the macroeconomic environment and its implications for the future price of gold, letâ€™s focus briefly on one very important institutional development:
The introduction and growing popularity of exchange-traded funds (ETFs) have changed the gold market in a very important structural and fundamental way that is not yet well appreciated or understood by many observers of the gold scene.
Gold ETFs are gold-backed stock-market securities representing ownership in a trust designed to track the ups and downs of the metalâ€™s price. Despite some rumors to the contrary, gold ETFs are backed 100 percent by physical bullion held in depositories on behalf of ETF investors.
Importantly, gold ETFs are bought, sold, and trade just like equities on a stock exchange â€“ yet they avoid the tax, storage, and other difficulties associated with owning physical gold.
By facilitating gold investment and ownership they have, without a doubt, brought significant numbers of new participants to the market â€“ not just individuals but hedge funds, pension funds, and other institutional investors.
So much so that bullion held in depositories on behalf of ETF investors totaled more than 1,667 tons in late August, more than the central banks of either Switzerland or China.
However, the rapid growth of gold exchange-traded funds is a two-edged sword for gold, increasing volatility both up and down. Remember, ETF investors can just as easily exit the market, selling their gold as quickly as they might sell any equity â€“ and some day many ETF investors probably will!
Itâ€™s the Economy
As I discussed earlier today, the future price of gold â€“ at least over the long term â€“ has little to do with mine production, or secondary supply, or any of the other â€ścommodityâ€ť fundamentals of gold supply and demand.
Remember, gold is first and foremost a financial or monetary asset held as a savings medium, store of value, and investment.
As such, over the long term, its price is determined by the real (or inflation-adjusted) rate of return on other competing financial assets versus the expected rate of return on gold itself â€“ where the expected return is simply the marketâ€™s own collective forecast of its future price.
Real interest rates are also a precursor of the U.S. dollarâ€™s performance on world currency markets and future inflation at home â€“ since low or negative real rates indicate a reflationary monetary policy and high real interest rates indicate a restrictive monetary policy . . . and it is monetary policy and money-supply growth that ultimately affects gold, inflation, and the dollar.
The historical data show that the U.S. dollar gold price is inversely related to the real (or inflation adjusted) rate of return on U.S. Treasury securities.
Not surprisingly, the current bull market for gold that began in 2001 (with gold near $255 an ounce) has, for the most part, been a period of negative or low real interest rates.
In fact, in the years of market-determined gold prices (since August 1971 when President Nixon closed the gold window) each and every time the real inflation-adjusted three-month U.S. Treasury bill rate fell below zero into negative territory, the U.S. dollar gold price rose over the subsequent 12-month period.
The great bull market for gold in the late 1970s culminating in the 1980 high near $875 an ounce was a period of negative real interest rates in the United States. And, goldâ€™s run up in late 2007 and early 2008 â€“ an advance that saw the price rise briefly over $1,030 an ounce â€“ was again a period of negative real interest rates.
Today, real â€śinflation-adjustedâ€ť interest rates across a range of maturities are again negative . . . so, if history is a guide, we can expect the price of gold to trend higher over the next year.
Although many economists, politicians, investors, and news reporters are beginning to talk about economic recovery in the United States, those that are seeing â€śgreen shootsâ€ť in my view are looking through â€śrose-coloredâ€ť eyeglasses . . . and there is significant risk of a â€śdouble-dipâ€ť recession with further contraction and a second down-leg yet to come.
Sure, Wall Street has enjoyed a good run as corporate America cut expenses by laying off millions of workers . . . but small businesses, which are the backbone of the American economy are dying . . . and recover is agonizingly slow in terms household income, unemployment, and other measures of wellbeing.
With banks afraid to lend, businesses canâ€™t borrow, and it is impossible for the U.S. economy to resume a healthy, durable expansion. Meanwhile, regional banks are still failing under the weight of bad commercial loans and household mortgages. And another wave of real-estate insolvencies and worthless loan portfolios is coming from the commercial real-estate sector.
Indeed, much of the recent uptick in economic activity reflects the government stimulus programs, such as the just-expired â€ścash-for-clunkersâ€ť program that gave the U.S. auto industry a temporary boost. While some of these programs help businesses and households in the short run, they are all adding to the Federal budget deficit and will complicate the Federal Reserveâ€™s monetary policy dilemma.
As a result, the Fed will remain under pressure to maintain a stimulative monetary policy with low real interest rates for some time to come â€“ perhaps years. Bad news for the dollar and inflation but music to the ears of gold bulls.
The Future Price of Gold
As my clients know, I am â€śextremely optimisticâ€ť on the gold-price outlook â€” but, unlike many other bullish analysts, I believe the metalâ€™s ascent will take several years to reach its next long-term cyclical peak.
In the meantime, and partly because of the activity of ETF investors, we can expect high volatility and a difficult climb, fraught with sharp reversals along the way that will, at times, cause some observers to wonder if the market has already topped out.
Ultimately, gold will most likely climb into the US$2000 to $3000 range â€“ but it could go even higher given the right confluence of economic and political developments . . . or if a late-cycle mania produces a final hyperbolic bubble before the gold-price cycle moves into its next bear-market phase.
Ladies and Gentleman, thank you again for your attention this afternoon. Now, I am looking forward to meeting many of you personally . . . and hearing your thoughts about the future of gold.