David Davis, Credit Suisse
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Gold market 'inextricably changed'

Posted: Thu, 22 Feb 2007

[miningmx.com] -- TWO years ago, David Davis, a gold analyst for Credit Suisse Standard Securities (then Andisa Securities), wrote a 55-page report called ‘The Future of Gold’. At the time, the gold price had staged a promising recovery from a low of $255/oz to around $430/oz. The gains represented a recovery but there was scepticism the gold price could travel much further. Optimists were smoking their socks.

According to Davis’s report, however, the gold price would be $700/oz by December 31, 2008 increasing to $1,200/oz in 2015. History shows us now that even Davis was too conservative for 2008 (gold breached $700/oz last year, and is tipped to do so again in 2007). Can we therefore suppose $1,200/z is too timid a suggestion as well?

“Putting all the factors together we’ve got an inextricable change that only a collapse in the jewellery market can stop,” said Davis. Jewellery demand accounts for just over 2,000 tonnes/year of the 2,600 tonnes annual production.

But the astounding fact is that the world’s primary production of gold has been in supply deficit, with minor exceptions, for the last 15 to 20 years. That means not enough new gold is being mined to feed demand. Take 1997 which recorded a primary gold supply deficit of 1,000 tonnes, said Davis. Why then the 20-year long gold bear slide?

According to Davis, secondary supply of gold from central banks filled the supply deficit. Today, this is changing as the difficulty of finding new primary supply increases. Geopolitical disorders and US dollar distress are other factors changing the playing field. For years, hopelessly convicted gold bulls have been talking (raving) about a runaway gold price. They could be right.

Said Ian Cockerill, CEO of South African gold producer, Gold Fields: “Existing mines are mature. The rate of newly discovered gold is inadequate, and gold producers have been steadily dehedging.” He also believes US inflation is “beginning to rear its head”.

Perfectly respectable professionals, becoming emotional about the infamously fickle gold price, may appear unseemly, but the change in sentiment towards gold is broader than that. It is also being reflected in the sudden popularisation of the gold-backed exchange traded funds (ETF), one of which trades on the JSE as Newgold.

These are shares backed by actual gold but without the cost and hassle of holding the metal. Instead, it is held on behalf of the scrip owner in a bank vault. There’s also less of a bid/ask spread as in gold coins which is somewhere around 15%. The spread between buyers and sellers in ETFs is only 1%.

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In addition, the share can be redeemed. Interestingly, however, it seldom is, said Cockerill. “When gold fell from $725 to $600/oz last year, the redemptions on the ETFs were minimal. This is sticky money, and new money.” Moms and pops can own the ETF because it trades like a share and tends to react with less volatility than the actual dollar price of gold.

Meanwhile, Cockerill said he recognised the hand of professional investors in the recent improvement in the gold price. “You can see it happening. The gold price goes up and then corrects, but never to the level from which it came.

“Personally, I can see the gold price going significantly higher.”

So what are the major factors affecting the current gold market. They summarise as follows:

The production/reserves deficit:

Like it or not, the volumes of newly mined gold are falling off a cliff, and so are the reserves to replace it. Of the 81 million oz in primary gold consumption, only nine million oz is being replaced by newly discovered gold.

The ETF phenomena:

Consumption of gold-backed exchange traded funds (ETFs) accounts for 660 tonnes of gold. This makes the four existing ETFs the ninth largest store of gold after the European Central Bank. And more ETFs are being prepared, one for India.

Official sector turnaround:

Suddenly gold is sexy again after the Bank of England played the gold price like the country does its cricket. Official sector gold sales are slowing, and fast. Of the 500 tonne/year quota on central bank sales to end-September, 2006, it’s thought only 370 tonnes hit the market. The dehoarding process, when it does happen, is more transparent.

The Economic Factor:

General funds are joining their emerging market counterparts in buying gold shares to mitigate against geopolitical, currency and other financial risks. The US dollar is tipped to weaken further. Equities are doomed. And there’s no impact yet from China whose highly regulated gold market is being slowly liberalised.