ETF threat hangs over gold

Allan Seccombe | Mon, 08 Mar 2010 18:01

[miningmx.com] -- THE much-vaunted gold-backed exchange-traded funds (ETFs) could play a critical role in determining the gold price this year if holders of the instrument start selling out and cause a large amount of physical metal to come onto a market where demand is relatively weak.

Warnings about a waning gold price have long been in the market where the metal has risen above $1,000/oz and remained resolutely above that level.

One of the most prominent and blunt warnings came from GFMS CEO Paul Walker back in April 2009 when he warned investment in gold may dry up over the next five years after a spell of strong interest from investors, who were concerned about the dollar, interest rates and economic upheaval, pushed prices to record highs.

A fresh warning this time comes from David Davis, a precious metals analyst at Credit Suisse Standard Securities, and it points directly to the potential for increased divestment from ETFs and what this means for the price of gold and the supply/demand fundamentals.

“We believe that a major problem is looming on the horizon should investment demand remain muted and/or should investment demand start falling away over the next three to five months,” he said in a research note.

“We believe that the possible muted and/or decline in year-on-year investment demand for ETFs will play a pre-eminent role as a swing factor in our supply-and-demand balance for 2010.”

If investors start turning away from gold ETFs because of improving economic data from the United States, a strengthening of the trade-weighted dollar and increases in real interest rates this could lead to an oversupply of gold in the market.

ETFs are backed by physical gold, meaning if an investor buys the product physical metal is taken off the market and stored in a vault. If the investor exits the ETF that physical metal goes back onto the market.

It’s unlikely that jewellery demand, which had dropped off dramatically because of high prices, central bank buying or industrial demand will be able to absorb gold coming onto the market from ETF products, Davis said.

The World Gold Council (WGC), using data compiled by GFMS, said in February demand for gold fell 11% in 2009 to 3,386 tonnes compared to abnormally high levels in 2008 when global financial markets tottered on the edge of collapse.

ETF demand slows

The WGC argued that demand showed signs of recovery towards the end of 2009, as jewellery and industrial demand picked up, offsetting to some extent the pullback in investment demand.

ETF demand was 85% higher for 2009 compared to the previous year at nearly 600 tonnes, driven largely by a strong performance in the first quarter. This demand dropped off sharply by the fourth quarter of the year, coming in two thirds lower compared to the same time a year earlier.

Jewellery demand in 2009 was 20% lower year-on-year, but the trend was steadily upwards, with three quarters of consecutive growth. Jewellery demand reached 500 tonnes by the fourth quarter compared to 336 tonnes in the first as the Indian market showed signs of recovery.

Central banks who are members of the gold agreement had sold just 1.6 tonnes so far out of a possible 400 tonnes, according to figures released in February. The gold agreement runs from September 2009 to end-August 2010.

There have been purchases of gold by central banks outside the agreement, with India, Sri Lanka and Mauritius buying gold from 212 tonne first phase of the International Monetary Fund gold sale programme. There is another 191 tonnes of IMF gold up for sale.

In January, there was a net disinvestment of 22 tonnes of gold from ETFs and some expect the February figure to be fairly similar to that.

By way of example, the South African gold ETF, NewGold, has been reporting divestments and the fund now stands at 1.598 million ounces of gold from 1.7 million oz in November last year.

Davis believes if the gold price remains above $1,000/oz investment demand will remain muted but if the price drops below that level annual demand for the product could fall to between 300 and 350 tonnes. In the three years before 2009, an annual average 280 tonnes of gold was absorbed by ETFs.

“We are of the view that there is increasing downward risk to the gold price should the pace of sales increase. We estimate that institutional divestment alone has the potential to release between 200 tonnes and 300 tonnes in 2010,” Davis said.

The over-supplied position should begin easing as mine supply drops off, with global exploration unable to yield enough replacement ounces for those being mined. The deficit in gold supply should start widening from 2014.

Some market watchers believe the gold price is being held above $1,100 by concerns about sovereign risk in places like Greece and Portugal and the weakness of the dollar. Gold is also at a point in the year where it is seasonally high.