Why is the Gold price going up - vigorously - and what makes it do so?

We were asked the question, " What makes the gold price rise?", and the answers are not difficult to detail, but we realised that we were being asked the wrong question. The wrong question because a list of factors would be like a pile of bricks. One can't see what the house will look like, unless you see the Architect's plan of the house, as well. Likewise, it is the interaction and impact of different factors, as well as the timing and the proportion, relative to the rest of the factors, that will decide the shape of the bull market, the price levels achievable as well as the extent of the bull market, and gold's future.

Most readers have been taught that gold is a commodity, a relic of simple brutish days when, man was too backward to develop a sophisticated monetary system, such as the one we have today. Simply put gold id thought of as a "Barbarous Relic"!

We can only warn those who think that way, to walk carefully, because they don't understand the road they're on.

First we will describe the bricks of the gold world, which have contributed to this recent price rise. Later, we will describe these, we hope, in a way that will bring perspective to you and an inkling of where the price is headed.

The Bricks of the gold world

Here are the facts of the matter. On this table are described, what makes the gold price go up and down, succinctly. But this doesn't tell the story at all, except to tell us, what has made the gold price go up or down over the last three years. The host of other features that have influenced the pattern of demand and supply in other years are still capable of reappearing, so should be highlighted, primarily because we expect them to pop up soon. Wouldn't it have been wonderful to have given you the figures for the next two years, as we have no doubt, that you will see the full spectrum of influences that you could possibly see on the gold price.

Turning back to the above table, apart from one key feature, it describes a gently changing picture, from the days when gold was 'successfully' treated as a 'barbarous relic', to when the restoration of gold's Monetary role began to be re-established, after the announcement of the "Washington Agreement". Then, both the Demand and Supply picture began to change: -

If we are right in our extrapolation for this year [2003], the market cannot bear the extra demand without a substantially increasing average price of gold for the year. This extrapolation is based on our assessment of the external factors, such as the destabilising of the world economy and politics, as well as the change in factors directly affecting gold [below]. When such an overall decay occurs, such as the one we are witnessing right now, the symptoms of that decay manifest themselves in dramatic ways: -

• For example: - In 1933 to 1935, the world was trying to exit from a depression and the clouds of war were looming. President Roosevelt made a decision on gold to ensure U.S. reserves were filled with as much gold as could possibly be acquired, to the end that the gold market was dominated by the U.S. governments rapacious buying of gold, initially from the captive market of U.S. citizens, [which was followed by, the banning of the private ownership of gold by U.S. citizens], followed by outbidding the market price of gold, for the gold of other nations and their citizens. All other factors were pushed into a minor role as the U.S. government bought thousands of tonnes to fill a war chest and re-establish to growth post- war.

You may be saying that this is just a piece of obsolescent history, but in reply we would ask, 'is it?'. Could the future hold similar prospects? When you hear both Russia and China make public statements that their reserves hold too many decaying Dollars, would it not be fair to think that "He who ignores history is doomed to repeat it?

• Russia's Central Bank - "Our U.S. $ reserves are now in excess of 50% of holdings". They then confirmed a desire to diversify away from this position. Previously they have confirmed they would be increasing their gold reserves and have slowly done so adding in excess of 100 tonnes in the last years or so. We expect this process to continue, if not accelerate. Subsequently, the first Deputy Chairman of Russia's Central Bank announced that Russia, "would hold a minimum of 10% of its reserves in gold". Not only did that imply they were in the process of acquiring another 80-100 tonnes of gold right now [clearly from volumes headed for or from the open market], but said this level could increase. It is not a leap of faith to think that they will keep gold in volume terms growing.
• China - The Chinese Central Bank announced their current policy was to 'diversify away from excessive dollar holdings' It has increased its reserve holdings of gold by 200 tonnes, or 50% in just over the last year. They have liberalised the ownership of gold for individuals and continue to open up the gold market to itself and its citizens. It currently hold 2.4% of its reserves in Gold, a figure 12.6% below that of the generally, conservative views of the European Central Bank. It is clear that the process of increasing gold's content in both the hands of its Central Bank and its citizens will be an on-going, if not accelerating process. Please note that simply to catch up with other developed countries levels of gold in their reserves, China has to buy 3,150 tonnes more of gold [to raise the gold content of their reserves to 15%]. Prior to the "Year of the Ram" having started recently, the Chinese public, who for the first time were allowed to buy retail gold, bought so much that the People's Bank of China had to release some of its own gold into the Shanghai Gold Exchange to cool down prices which had risen above international prices [I don't think many Chinese people have heard of Iraq]
• In North Korea lately, the private gold holdings of Korean citizens were handed over to the government in a show of Patriotism, to restock the nation's reserves. Again gold found a critical role in times of distress [this was in this millennium].

We are absolutely certain that the present world situation is ripe for a positive move to gold, in the eyes of both individuals and governments. This has to be positive for the gold price.

Supply

Mine Production - Because the gold price has been so low for so long, the profitability of gold mining has diminished considerably. We are talking of prices that produce a profit for the Shareholders, being too low to warrant expenditure on exploration. As a consequence the likelihood of the discovery of a low cost deposit [making a profit below $300] has diminished considerably. This in turn has discouraged expenditure on exploration. From exploration to gold production takes 5 years, usually. It has been so long since the prices established these low levels that we are beginning to see mine production beginning to drop, this year. The pace of this drop will pick up from now on, for the next few years. This is the natural demand / supply formula, we all know so well.

But shouldn't this work on exploration blossom quickly? A responsible miner needs to be convinced that the high gold price will still be there, when the gold starts coming out of the ground. It takes a steady average gold price to convince him of that, not what could be a short term spike in the price.

So, dropping volumes of newly mined gold will contribute to the rise in the gold price, more significantly from this year onwards and fore some time to come, until new production is established, as it pulls supply further away from demand.

Old Gold Scrap - Unlike other commodities, gold is not consumed, it can be returned to the market. This source of supply is price sensitive, but not always, obviously so. As owners of the cheaper types of jewellery see prices rise, so they sometimes realise profits by turning in their gold for re-smelting. We say cheaper gold, for the jewellery costs can be in excess of 50% of the costs of good jewellery. Few wives are impressed by husbands selling their jewellery, it could prove a once in a marriage event - the last one?

Whilst gold is hoarded in a pre-war climate, escape is oft provided by sales of scrap. However, as you can see from the above figures, prices do not have to rise for scrap gold to be sold. Perhaps the increase in sales from 2000 to 2001, was due to a fear that the gold price was still on a downward slope. The gold price during 2001 saw the solid base in the gold price being built, which may have deterred sales as expectations of higher prices were factored in. The increase in scrap sales came mainly in the last quarter of the year [primarily from the Middle East], as the increase in price was absorbed and as prices rose.

We do expect the supply from this source to rise in line with movements in the gold price, as this is a form of gold price speculation too. So long as this sector perceive a gold price rise is on the way, they will buy or hold gold. If they perceive a fall is due, they will sell.

Producer Hedging - It seems the days of selling gold forward to finance the development of a mine have gone, certainly until interest rates rise to provide the large contangos which add the cream on the forward sales of gold. We cannot see interest rates rising for some time to come and find it difficult to see such a scene in the near to medium term.

Producer hedging is ideal for a market where one expects a neutral, to dropping, gold price, Those who followed the 'hedged' road secured prices [in 1998 you could sell forward at just below $300 and achieve a net income of $355] below the current market levels, thereby denying the shareholders the opportunity of a rising income, from a rising gold price. We do not expect to see this type of operation resurrected, until the general perception in the market place, as reflected in lease rates, the contango and the gold price, is for a fall over time, with no prospect of a medium term rise, in the price. As you can see not only has supply from this source has dried up [see Net Producer Hedging as a source of Demand - below] but the producers have been turned into buyers of gold, in a rush to unwind these hedges.

Producer hedging produced accelerated production and subsequent sales of gold, at a time when the price was falling, over the long term. It was a useful tool to produce a growing supply of new gold at a time when the U.S. $ was in the ascendancy, and the U.S. in particular, supported by the developed countries, wanted no challenge from gold. The $ had to grow in use until it was by far the most used and plausible of the world's reserve currencies. This objective has now been achieved, so the Monetary Authorities have no more need to suppress this judgemental challenge form Gold. Consequently, they have no interest in encouraging an accelerated supply of gold. This is now being reflected in gold being withdrawn from the gold lending scene, by Central Banks, as well as the limitation of gold sales by 15 of the key developed countries, as reflected in the Central Bank Gold Agreement.

Dis-Investment - In the year 2000 the market mind set was still for falling gold prices as reflected by the figures for that year. As the change in direction of the gold price became apparent so dis-investment fell. In 2002 it ceased, as the destabilisation of the investment scene set in. With this set to continue, as gold forms a solid asset class in the minds of Investors, outperforming other asset classes, so we expect to see Investment from "Safe Haven" or Long term Investors rise considerably, keeping Dis-Investment at zero. This could prove the most dramatically growing gold demand factor, as this demand factor buys solely to get away from other decaying assets. When the dis-investor becomes the Investor, gold is performing its most valued function of providing safe havens and wealth preservation, for the large investors.

Demand

Jewellery - Jewellery is price sensitive, but also reflects the general level of wealth. The healthier the purses of the affluent, the more is spent on gold jewellery. In India the demand pattern is linked to religion as well as culture, so the level of demand is dominated by the amount of funds to be spent on jewellery, which varies only with the success of the agricultural season. One would therefore expect the demand from India [855 tonnes in 2001] to vary with the cost of that gold. i.e. if the gold price rises 10% so the volume of purchases will drop 10% as the funds available remain the same. But the religious connotations and sentimental values reduce the amount of gold treated as a speculation. This being said, we do expect Jewellery demand to reduce by around 400 tonnes worldwide, this year at the most in line with the price increases.

Electronics - Generally a relative constant, driven by technological demand, not price, we would expect this source of demand to maintain its level in the foreseeable future. The demand for items consuming gold will dominate this side to gold. This is strictly a commodity use of gold. The figures again demonstrated a dropping demand in 2001, when the average price dropped somewhat [$279 down to $271], then a further drop of 10%, in the 2002 year when the average price rose 20%. In this sector gold reacts as a commodity would, but because of its unique qualities, is not easily replaced by a poorer quality metal. We do not see a large change in the amount of gold bought for industrial reasons.

Official Coin - Difficult to gauge, as this reflects a certain patriotic demand, and other factors not related to the usual picture of demand and supply. Germany, Malaysia and other countries are issuing gold coins for commemorative reasons.

China on the other hand wants it citizens to own gold. The Banking system in China is fragile and not near the levels of sophistication of the West. Gold is seen in China as a traditional place to place savings. Coins will be a place where the small investor can place his savings.

This market, particularly in the Far East, is not so price sensitive. We have no doubt that the Chinese government appreciates the strategic wisdom of the nation's individuals buying gold through the markets. That one's citizens have gold "under the mattress" proved useful in the U.S. when Roosevelt forced Americans to hand over their gold to the government, in 1934. Should China continue this route, with Coins supplied from Switzerland as well, the net Chinese holdings of Gold Coins, will continue to rise strongly.

Official coin has risen ahead of the gold price in 2001 then fallen 10% in 2002. We do not believe this is due to the rise in price. Indeed we believe 2003 will see demand from this source rise significantly.

Dentistry - Another relatively non price sensitive, commodity use of Gold and one that will not vary so much with a rising price until it rises too much. The fashion of Dentistry will have a far greater impact than the price of gold. Difficult to get one's teeth around the price at which demand will change, one can only tell the story of an unfortunate fellow, with very golden teeth in his smile, sitting on top of a load of timber travelling to the mill in Malaysia, who was decapitated when passing under a bridge. The driver realised something had happened further down the road, came back found the head, but the gold had gone.

What can one say?

Other Ind. Uses - This again will vary more with the state of the economy, than with the price of gold, so should remain the same for the foreseeable future. The price pattern is the same as in other areas of Fabrication with demand dropping in 2001 from the year 2000. the 10% drop in 2002 we do not believe reflects price sensitivity and expect the same level of demand in 2003.

Medals Imitation Coin - This is one area where we could see a rise in demand in a rising gold price environment. Perhaps the figures showing the same drop in 2001 from 2000, reflected price expectations too. With the potential for good price rises, 2003 could see a change in this market reflecting the small "safe-haven" buyer entering the market.

Bar Hoarding - Usually the vehicle for high worth individuals, when investing in gold. We note the change in pattern in the price compared to Fabrication demand. Perhaps these buyers were more perceptive, understanding the "Washington Agreement" better than most of the market. We can see this in the pattern of buying as the price changed. Between 200 and 2001 as the price dropped $8 on average demand for bars grew 7% on the year. Between 2001 and 2002 this increased by 10%. We expect it to have risen strongly in 2003, as the structural decay of the world economy and investment instruments is properly assessed by fund Managers.

Central Bank Buying - We have treated this as a new feature and not shown a net figure, because of its importance. It is a departure from the policies shown by Central Banks in the past. Central Banks have for so many years encouraged gold sales, given the impression they were about to sell gold and generally been anti gold, that when we see Central Banks talk of buying gold or actually doing so in quantity, it is of vital significance to the gold price and its future levels. The actions of China and Russia, according to them, will continue to be to acquire Official Gold for their reserves. We have no doubt that many Central Banks are reflecting on the future for gold reserves in the light of the falling $, and will either not sell gold or not sell gold and buy gold. This and the large scale buying of gold by Investment buyers will create new and sustainable price levels for gold, we have no doubt.

Net Producer Hedging [De-Hedging] - Perhaps the main drive behind the gold price last year, with the normal suppliers of gold becoming buyers the unwinding of hedge positions became a dramatic feature of demand. 352 tonnes of gold were bought in the market by Producers clearing their books to some extent and putting them in a position to profit from a rising gold price. With gold currently in the middle $360's, these hedges are not as profitable as unhedged positions selling into the market. It is clear that the risk of disappointing shareholders and losing out on the higher gold prices is inspiring gold producers to maintain the policy of unwinding these hedges, as a matter of haste. Gold above $400 would paint a poor picture of management getting $350 or so for their gold.

We expect the demand from the market for gold to cover these hedged positions to be the same, if not more this year.

In the main, the above factors for demand / supply have the picture of a commodity metal, with interesting facets reflecting gold's ability to out perform other asset classes. Over the last two decades, barring last year, the price has been in a bear market, which emphasised the commodity aspect, keeping prices where they were. Jewellery demand kept gently rising as the world's wealth grew, so eventually the market balance reflected a price in the higher $200's.

However, factors such as Central Bank ownership and controlled selling, tells us that there are other features to this metal that change it from solely a "commodity", to something of far greater depth and breadth, so obscuring our ability to forecast its behaviour. The fact that in times of uncertainty or economic decay, gold has performed better than any investment, highlights its value, above other commodities. The forces that come to play on gold, sit on top of the commodity aspect of gold and creates a blend that separates it not only from other commodities, but other investments.

Like a weathervane, the gold market rises to its greatest potential when other markets are decaying. We are now looking at a potential level of decay far worse than most investors appreciate. The response of the gold price is the same as in similar times in the past. Words such as "Trust" in values, "Confidence" in the future are features of a growth market. The reverse is true and is beginning to be reflected in our current world investment scene. So: -

"Why is the gold price going up - vigorously - and what makes it do so".

• Look back at our table above and take out the Central Bank sales at 549 tonnes in 2002. If that were removed from the market what would have to happen to the price to make it rise to the point so as to encourage sufficient dis-investment, Old gold scrap to compensate for that loss of supply? Remember, it can't come from mining! Will this happen - keep your eyes on the next Central Bank Gold Agreement to be signed in Sept 2004!
• Look at a price sufficient to reduce the demand for jewellery in the developed world by 400 tonnes [it would have to be a lot higher than you think] and add the expected 300+tonnes bought by the Chinese [its happening already] this gives only a reduction of 100 tonnes to the expected Jewellery demand in 2003 as we have extrapolated above. Now - Add to the above demand figures, a Central Bank purchases increase to 500 tonnes - then we have the same problem, a very heavy shortage.
• We know that Bar hoarding and Investment buying is growing strongly. This could add a further 200 tonnes or more to the demand, without any leap of the imagination.

We have expressed this in terms of the present picture of demand and supply, because it gives one facet of the explanation, in terms of how actual volume of demand out weighs the supply. Again this seems inadequate, insofar as we cannot measure adequately the weight of the impact of external factors, on the impetus to the gold price. So we move on to external market factors that drive the price, which usually, the layman has difficulty in identifying as directly related to a gold price rise. Some of these are: -

• For the professional the measure of total return on capital employed has to dictate his decisions. Translated, it reads, where can I make the most total income. Note this is not a simple addition, for it must include where can one minimises losses and preserve what one has already. So the professional makes a review of the available opportunities and selects the best . This process can follow these lines: -
   
  • A deposit in $, for instance, has been losing money in terms of inflation, as well as value, compared to other currencies. Gold has outperformed all key currencies and equity markets for some time now. HenceGold is at the top of the performance league over the last year, in terms of total return on capital return. Will it continue? If the review shows it will, that is where the investment is made.
  • Interest rates on the dollar are below inflation in the States and expected to fall still [income returns dropping]. What is the future for interest rates and there impact on the different markets. Currently, they are headed lower in a deflationary climate. This is not only a danger to future income but to present income, hence the bear equity markets, and the rising prices in the U.S. T-bond markets.
  • The external value of the $ is dropping because of a trade deficit to other nations, often, inadequately compensated for by capital inflows, leaving a falling $. This deficit is likely to continue for the foreseeable future. Hence the professional non-U.S. citizen has to deduct the assumed future value of the $, from the expected positive return from his U.S. investment, currently the result is not a pretty sight.
  • Our professional will logically, turn back to gold and go to the next stage assessing prospects as accurately as he can. This means asking the most often asked question in the markets is, will the gold price go higher still? Our man, if he really wants that professional approach turns to the Technical picture, which highlights the most likely shape of future markets. The measuring of price patterns to highlight future price performances has been refined to extraordinary levels, and has transformed profitability achievements wonderfully. At Gold-Authentic Money, Tony Henfrey is the expert, who has tracked the gold price almost 30 years. His abilities were aptly demonstrated recently when he gave the big buy signal at $319 for the short term and $324 for the long term buyers - right on the button! Our professional would consult him before acting, during the action and look to him to tell him when the action should stop! [Subscribe through www.authenticmoney.com ]

• Going further out on the big picture, the gold price is affected on the individual front most heavily by the overall climate in financial markets. Like the weather, whilst all the individual features of the weather are important, it is the final mix of them that permits an accurate forecast. In times of growth the financial climate is fair to good, as we have seen in the last 20 years and more, but these weather patterns have now changed and a season of storms is not only forecast but hitting home hard. Sadly, this is the weather that gold finds best. It is the port in the storm, the safe- haven. It acts contrary to markets usually, if allowed to do so. Left alone, it would be an investment :"for all seasons", as it was previously. What makes up the best weather patterns for gold: -
   
• Confidence waning in the economy, once it has exhausted its growth potential. Reflected in falling equity markets [which used to be brought about by raising interest rates] and as being seen now, falling interest rates in an attempt to stimulate growth, but being ineffective.
• Abuse of the management of paper currency. This can be reflected in inflation getting out of hand or over expansion of the money supply [this is happening now to counter the deflation, now impacting in Japan and now the U.S. & Europe], or simply spending more than comes in [deficit management] to the nation or government.
• General confidence in the Investment instruments and their management has to diminish alongside of falling confidence in government financial management. Like the arrow on a Barometer, confidence is swinging round to bad weather, right now, with news of one of the most respected Auditing firms in the world, being indicted of Fraud, following another one months ago [KPMG & A. Andersen], leading to a question mark being raised over accountants in genera, as well as losses in their multi billions being made in some sectors of the economy.
• The final safe place for paper money is the bond market or cash. Deposit rates having hit negative levels in the States and expected to fall further still, the Long Bond market yields are dropping quickly to levels where the risk reward ratio becomes minimally attractive. With storm clouds gathering on other fronts the small patch left under the sun loses most of its attractiveness.
• The Financial climate has been so good for so long [the bulk of the life of most financial managers] that the need for a port in a storm is almost forgotten. As a result the port is in poor condition, the price in 1979 was felt to have a floor of $300. Even after a spectacular run, the gold price is only 25% up from there, so one can say it is still at low levels. This bodes well for the extent to which gold could rise.
• The prospect of war raises risks on so many levels, which hastens the pace of moves into gold.. In the immediate situation, the almost certain war on Iraq spotlights troubling possibilities for the outcome. If the war is efficient and effective, supplies of oil will increase to the extent that prices could more than halve, so boosting growth in the U.S. and other developed economies and assuring Bush of re-election. However, if the war protracts, and possibilities of oilfields being set alight, or other Arab states reacting with diminished supplies the oil price could soar to $100 a barrel [as stated by Sheik Yamani, past Saudi Oil Minister]. Gold becomes the favoured asset class of the individuals and institutions.
• Central Banks realise that Gold's place in a nations reserves give confidence to all, both inside and outside a nation, when that confidence is on the wane. The Washington Agreement was primarily a re-affirmation of key central banks view that gold is a valued part of any nations reserves. Add to this the acquisition of gold for reserves, by China and Russia, no doubt to be followed by many other Central Banks, demand for gold in a monetary role has begun and will continue. At current price levels, there is insufficient gold to permit a large scale expansion of gold reserves. At significantly higher prices, it can be done. By allowing the market price to rise significantly a nations reserves of gold, in value terms, will rise, with minimal open market purchases. Whilst most of the western nations will not be inclined to sell any of their gold from now on, a rise in the gold price of these reserves will go a long way to convince outsiders that sufficient gold is held to back their currency. Those without gold would be horribly exposed. So the weather conditions ideal to gold would be a cessation of sales of gold by Central Banks and the gentle acquisition of gold by Central Banks presently short of it.
• The realisation of the impending price rises of large proportions, has been seen by some key players in the market, who have been reacting over the last year. The Gold Producers have seen it and although they secured profits as their stated motive, were aware that if they do not clear this away, they could miss out on a price rise in gold that would all but destroy their credibility and future. The demand from gold miners for gold, to remove this possibility prompted a new demand factor to hit the ,market last year to the extent of 352 tonnes. 2003 should see a similar demand or higher. There is a belief amongst many that this type of demand extends to open short positions of huge proportions. We are not qualified to comment on that, except to say that any massive short covering would accelerate the price rise to destabilising proportions, if it is the case.
• The final condition that would accelerate the price of gold to the stratosphere would be a degeneration of the financial, economic and political world scene to such an extent, that a repeat of President Roosevelt gold acquisition acts were repeated, by the U.S. or Europe or both, with other power blocks competing for the same gold. At the moment unlikely, buy technically possible.

So again, "Why is the gold price going up - vigorously - and what makes it do so? The above ingredients are what make the gold price rise so vigorously. But more has to be said about this vigour have only just begun to impact on the gold price. We have seen the Producers precipitate the current price rise, with only a small impact from the above other factors. As these factors reach maturity, so there will be an acceleration in the gold price rise. The pace of these upward moves will be like the gear changes. Currently we are accelerating in first gear, soon we could change to second gear. There are several gears to follow.

In "Gold-Authentic Money" and its sister publications, "Changing Tack" we give effective, early-warning guidance to subscribers in the gold market on the Technicals, as well as root understanding and perspective on the Gold markets today.

Julian D. W. Phillips
www.authenticmoney.com