It has been a while since I took a good look at gold’s “fundamentals”, i.e. real world supply and demand. The Economist ran a good article on gold on July 8 which triggered more research. I am even more prudent with gold than before.

Demand for gold essentially comes from two different sources: jewellery and investment. Jewellery demand has declined spectacularly in the last decade, most likely in reaction to the rising price of gold. Pretty typical and rational behavior given gold’s five-fold price jump. Indians and Chinese consumers have, so far, kept buying gold while consumers elsewhere have cut their appetite by more than half.  In a May 10, 2010 write-up on the India gold market, the World Gold Council saw more of the same:

So far, India has had a good start to the year, as witnessed in both the Q1 2010 jewellery and net retail investment figures compared to the corresponding period in 2009. (…) with an estimated 10 million marriages a year taking place in India, wedding-related demand accounts for a substantial proportion of overall jewellery demand. Since the fourth quarter of 2009, jewellery demand has been comparatively stronger as domestic consumers became reconciled to making their necessary purchases, notwithstanding prices rising to new record levels in excess of Rs56,000/oz. As consumers have adjusted their price expectations upwards, a further rise in the price could be anticipated.

However, it seems that Indian demand is now weakening under the major price increase that even Indian gold lovers can hardly afford anymore as India’s The Economic Times reported on June 22, 2010:

Gold imports declined by over 50 per cent to 17 tonnes in May as compared to April due to surge in gold prices.
Bombay Bullion Association data shows India imported 34.2 tonnes gold in April. However, Gold prices in May rose to Rs 18,629 per 10 grams in domestic market, and USD 1,248.55 an ounce (28.35 grams) in overseas market.

The Economist on July 8:

“Business has never been this slow in the 14 years that I’ve run this place,” complains Mrs Anand, owner of Hans Jewellers. Lajpat Nagar’s jewellers estimate that sales are down by 40% or more on a year ago.

In a typical year India soaks up perhaps a quarter of all the gold mined in the world. Now, however, not only are people not buying; more and more of them want to swap their gold jewellery for cash. Jyoti Pal, a shop assistant, reckons that these days about as many people come in to sell as to buy. Suresh Hundia, president of the Bombay Bullion Association, goes further: “There are only sellers in the market at these prices and most jewellers are buying back only old jewellery.”

But even with Indian and Chinese support, demand for jewellery has dropped 25% from 3,205 tonnes in 2000 to 2,417 tonnes in 2007. During the 2008-2009 financial crisis, demand declined another 27% to 1,758.9 tonnes. At the end of Q1 2010, trailing 12 months jewellery demand totalled 1,900.9 tonnes. Jewellery was nearly 80% of the total demand for gold in 2000. In 2007 it was 68%. Trailing 12 months, it is only 59%.

What that means is that the “non-speculative”, largely measurable and “fundamental” gold demand component has declined significantly in importance during the last decade and now represents less than 60% of the demand equation. Gold investors have a lot less “solid” demand ground than before on which to base their analysis. And keep in mind that Indian demand for jewellery (25% of the total in 2009) is now giving signs of succumbing to high prices.

That leaves investment demand.

As jewellery demand went down, investment demand went up: for gold in the form of coins or bars, for gold exchange-traded funds (ETFs) and for the services of online companies that allow investors to buy small amounts of pure bullion, stored in underground vaults. Buyers of jewellery might be put off by a rising price; investors are more likely to see it as a sign that the price will increase further still.

Indeed! After a five fold increase in price, total investment demand for gold reached 1,940.3 tonnes in 2009, more than double the 2007 level. The Economist:

Investment in gold ETFs and similar products reached a record high in 2008, of 321 tonnes—and then almost doubled, to 617 tonnes, last year. The stock of gold held by such funds more than doubled to 1,839 tonnes in the two years to the end of 2009. John Paulson, a New York hedge-fund manager best known for making handsome sums betting on the collapse of the American subprime-mortgage market, holds $3 billion-worth of gold ETFs, the largest part of his $35 billion portfolio.

The 229 tonnes of gold sold in the form of official coins last year was the most since 1986, thanks to demand from retail investors in America and Europe. In November demand for one-ounce American Eagle coins was so strong that the American mint ran out of supplies. Rand Refinery, producer of the blank coins which the South African mint turns into Krugerrands, raised its output to 30,000 ounces in the first week of June, the highest rate of production since 1985. In Abu Dhabi those seized by an urge to buy bullion can now head to the lobby of the Emirates Palace hotel, where the Gold-to-Go machine dispenses bars.

Adrian Ash, head of research at BullionVault, one of a number of web-based bullion dealers which allow customers to buy titles to gold bars stored in vaults deep beneath the ground in London, New York and Zurich, reports that business is booming. The sources of Mr Ash’s business are a guide to the sentiment driving many investors into gold, some of them for the first time. In the first half of May the crisis in the euro area was uppermost. Worries that the burden of some countries’ sovereign debt might precipitate a collapse in the euro were stemmed only by the extraordinary measures taken by the European Union, the IMF and the European Central Bank (ECB). At that time, 41% of BullionVault’s new customer deposits came from euro-zone banks, about twice the average since January 2009.

Gold was already the toughest asset to understand and forecast. Now that jewellery accounts for less than 60% of demand, leaving 40% to fickle investment demand, the price of gold will become totally impossible to predict other than through technical analysis (!!!?). Volatility will no doubt increase materially.

True, there is much to fear in today’s world but when fear(s) subside, who will be left holding the bag until prices retreat to levels which could revive jewellery demand?

And we have not even discussed supply yet, which also rests on moving parts. The Economist sums it up that part of the equation quite well:

On the supply side (chart 2, bottom panel), the main source of new gold—what is dug out of the world’s goldmines—has been flat or declining. Mine production peaked in 2001 at 2,646 tonnes and has been a little less than that ever since. A combination of rising production and exploration costs, dwindling output from long-established mines in North America and South Africa, and political and economic instability in other parts of Africa means that mine supplies cannot be ramped up at will.

Another potential source of supply is sitting in the vaults of central banks. In June national central banks, the ECB and the IMF held more than 30,000 tonnes in all. On average, they sold 520 tonnes a year between 2000 and 2007. Last year the flow of central-bank gold almost dried up, even as the price soared. Only 41 tonnes made it to market. Some bulls argue that central banks will at some point become net buyers. However, this week China’s foreign-exchange agency said gold would not become an important element of the country’s official reserves.

The third main source of supply is scrap: jewellery sold to dealers for the value of the metal. While the price was rising steadily in the first few years of the century, scrap sales did not respond: in 2003, when the price averaged $300, 986 tonnes were sold; in 2007, when the price was $700, the amount was four tonnes smaller. But as the price has climbed steeply since, record quantities have been sold for scrap—1,674 tonnes last year.

The sellers include middle-class Indian housewives, who habitually put their savings into gold jewellery. Last year Indians sold 115 tonnes from their private collections, a third more than in 2008. In Turkey, where 217 tonnes were sold back to jewellers, the deputy head of the Istanbul Gold Exchange says that “a widespread belief that gold is overpriced” is leading some to sell “anything they have”. Some sellers may also be feeling the pinch. Last year scrap sales leapt by nearly a third in America, where companies that allow people to mail jewellery in have helped drive up supply. “Cash For Gold paid me $829 for gold jewellery I never even wear!” screams one firm’s website.

Gold investors, attach your seat belt. You have nothing to fear but the lack of fear…


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