Thursday, November 19, 2009

The Real Story About Gold Supply and Demand

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

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Just once I would like to see a media article that had a accurate supply and demand analysis for a commodity. Usually reporting is completely one-sided with only supply or demand discussed out of context. No matter how much detail is provided for one, it is meaningless unless you have information on the other. Media coverage of oil is notorious for providing this incomplete picture. The gold market is apparently not immune to it either.

Media reports today include "Gold Demand Falls 34% in 3rd Quarter: World Gold Council". A dire picture of falling demand for gold is painted. Supply issues are at least lightly, albeit very incompletely broached. While you are left with the impression that this news should be devastating for gold prices, if you check you will see that gold had a nice rally between July and September. Anyone who took the first week of economics 101, would immediately conclude the supply versus demand picture must have improved. Reporters are most likely to have been journalism or English majors and may not have even the rudimentary knowledge needed to be aware of this. They frequently miss the real story for the same reason.

Much is made in the gold supply figures about a drop in Indian demand, down 42% to 111.6 metric tons year over year in the third quarter. Not mentioned was that there are times that are considered inauspicious for buying gold in India and that period was twice as long in Q3 2009 as it was in Q3 2008. India consumer demand for gold is followed closely because it has been the number one source of demand for gold from seemingly time immemorial. However, World Gold Council figures indicate that the Chinese bought 128.6 metric tons of gold in the third quarter of this year outpacing the Indians. A little research also reveals that the Chinese bought more gold in the first half of the 2009 than the Indians as well. Retail price controls were only abolished in China in 2001 and since then consumer gold purchases have consistently outpaced GDP growth. China is clearly becoming the top market for gold knocking India off its perch. This is a big story. While that's the the headline you should be seeing, that's not what is being reported.

The World Gold Council also claims that investment in gold coins and bars were down 31% year over year and gold ETF inflows were down 72% year over year in the third quarter. If this is true, something has to be taking up the slack, either more demand elsewhere or decreasing supply. This is some vague reference in their press release about financial instruments and dehedging somehow creating more demand for gold. The specifics are not stated though. Hedging by mining companies is indeed dropping rapidly falling from 530 metric tons in Q3 2008 to 359 metric tons in the third quarter of this year. Barrick Gold (ABX) has been closing out its large hedge book and this has been helping to push gold prices up lately. Closing out hedges has the same effect for commodities as short covering does for stocks.

Miner hedges are only the tip of the iceberg however when it comes to short covering in the gold market. Mining hedges represent only around 20% of central bank leasing for gold. Central banks have been lending out their gold for years to miners, big banks and hedge funds (this is how they make money on their holdings). This usually results in an immediate sale of gold on the market and this was a major factor in keeping gold prices down in the 1980s and 1990s. Leasing has been in rapid decline during the 2000s however and you may have noticed the price of gold has gone up as leasing has diminished. It is estimated that there were 4300 metric tons of gold leased by central banks in 2004 and this was down to 2345 tons by the end of 2008.

The World Gold Council admits gold supply fell 5% in the 3rd quarter. There have been 3 main sources of market supply for gold in the last two decades - mining, scrap and central bank selling. So far gold mine production peaked in 2001 and then dropped year after year. It looks like it will be up this year. Supply from scrap is highly variable. Sales were 569 metric tons in the first quarter of this year, but were down to 283 tons in the third quarter. Central bank selling seems to have turned into net buying. Central banks accounted for 14% of gold market supply just a few years ago. This fell to 8% in 2008. Central banks bought a net 15 metric tons of gold in the third quarter of 2009 (this doesn't have anything to do with the Indian central bank purchase of 200 tons of gold recently, that took place in the 4th quarter). Central banks shifting from being a source of supply to a source of demand represents a major sea change for the economics of the gold market - something else that is worthy of headline coverage.

Spot gold has reached as high as $1153.90 recently and has been hitting one all time high after another in the 4th quarter so far. The market tells you what the actual supply demand picture is quite clearly. If it contradicts the information you are receiving, it is because that information is incomplete or wrong. Believing otherwise is a sure way to lose money.

Disclosure: Long gold, no positions in ABX.

NEXT: U.S. Interest Rates Go Negative Again

Daryl Montgomery
Organizer,New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.



Oh yes supply and demand.

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