BASIC FACTS ABOUT GOLDThursday, 8th September 2011
There are about 5 billion ounces of above ground gold supply worth about USD 9 trillion at current prices. Less than half of this is in deliverable, investment-grade form. The above ground gold supply is growing at about 1.5% annually, the 300 year average.
New gold supply is price inelastic. If you double the gold price, production will fall as miners extend precious mine life by processing lower grades through fixed rate capacity. Finding and building new capacity is the work of decades. Re-opening old mines is difficult and expensive and there are few worthwhile opportunities which have not been exploited. Meanwhile, discovery rates are declining, discovery costs are rising, mines are depleting and production is falling. All the evidence suggests that we are at or very near peak gold production. The world's best gold deposits have been found and mined.
Gold's highest and best use is in a vault as a store of value. Jewelry 'consumption' of gold is simply a traditional store of value. Gold is not a commodity because commodities are consumed and their inventories are measured in months of production. The readily available on-surface supply of gold equals more than 60 years of production at the current rate which means that using traditional commodity-oriented supply/demand analysis to project the gold price is completely irrelevant. The industrial/medical uses of gold are minimal. If gold had important other uses, there would be less of it and the price would be lower because it would be valued as a commodity subject to substitution effects. No other substance has the unique properties and an above-ground supply large enough to act as an ultimate store of value which is why gold has had this role for at least 6000 years.
Gold is therefore a financial asset in physical form and sometimes a currency. It goes up in price when confidence in other financial assets [stocks, bonds and currencies] is falling and falls when confidence in these alternatives is rising.
Other financial assets have the advantages of convenience and income. Gold's advantage is that it is final settlement anywhere in the world. Gold backs itself whereas other currencies and financial assets merely represent, and depend upon, the countries and companies which issue them and stand behind them. Gold is a currency without a country or central bank...there is no issuer to inflate supply or default on its obligations.
The current value of above-ground gold is about 1% of the aggregate value of the world's financial assets. In 1980, when inflation weakened confidence in stocks and bonds, this ratio was greater than 25%. It currently requires almost 7 ounces of gold to buy the Dow, down from 44 in 1999. In 1980, the ratio reached 1 to 1.
The world's major paper currencies are being printed at a reckless rate to support inflated asset prices and unsustainable debt levels and to prevent one currency from appreciating against another. These paper currencies pay little or no interest and can be borrowed at real interest rates that are well less than zero. Meanwhile, the central bank sponsors of this paper are buying gold. What, then, will dissuade the world's wealthy institutions and individuals from converting these currencies into gold?
Gold has no P/E or other standard valuation metric. Its price can go where the market decides. How much will the owners of trillions of dollars in financial assets pay to protect themselves from deflation, inflation or default?