Six reasons why you should still buy gold

A couple of days ago on the pages of this newspaper doubts were raised on why gold prices have been going up. It was pointed out that George Soros once said that, “Gold is the ultimate bubble.”

But Soros also said that “Nothing is quite as profitable as investing in an early stage bubble.”

So let me set aside any doubts about investing in gold to rest and point out several reasons why gold price is likely to continue to go up in the days to come.

And if at all it’s a bubble, it is still an early stage bubble.

Most people who advocate investing in gold follow the Austrian school of economics, which believes that ultimately all paper currency goes back to its inherent value i.e. the cost of the paper which it is printed on, basically zero.

This is primarily because with the freedom to print currency, more and more currency is printed and that ensures that the currency ultimately does not hold any value. This printing of currency has been   a worldwide phenomenon over the last few years.

The US dollar is being printed big time to revive the moribund US economy. Given this threat to the stability of the US dollar people have been buying gold and hence the rise in price of gold, is the commonly given reason to explain the rise in price of the yellow metal.

But there are more reasons why the gold price will continue to go up. (This write up borrows heavily from In Gold We Trust, a report released by Standard Chartered on June 14, 2011 authored by Yan Chen, Jeremy Gray, Wei Ouyang, Subu Varada and Yongxin Zhang)

Slow production growth of gold over last 20 years:  Even with the price of gold going up over the last ten years, there has hardly been any significant growth in gold production. In fact, gold production over the last 20 years i.e. between 1990 and 2010, has been going up at the rate of only 0.7% per year.

In comparison, the gold production between 1900 and 1990 grew at the rate of 1.9% per year. The major reason for this slow growth rate has been the decline of South Africa as a producer of gold.

As the Standard Chartered report points out “A very important driver of the slow production growth was the dramatic decline of South Africa, which produced about 1,000 tonnes in 1970, but below 200 tonnes last year...The US, the second largest gold producing country in the 1990s, saw its production declining for the 11th consecutive year in 2010, falling to 230 tonnes from its peak production of 461 tonnes in 1999.”

China is now the largest producer of gold. But the gold mined in China largely comes as a by product of mining done for other base metals and this production can be volatile. Also gold deposits at the end of 2010 were estimated to be at 51,000 tonnes or around 19.2 years of production at the current rate.

As the report points out “There are few large deposits, and most of the mines have difficult geological and metallurgical conditions.”

Gold production to remain slow in the years to come: The report analyses 345 gold mines, which produce 1,764 tonnes of gold every year accounting for nearly 67% of world gold production.

It concludes that over the next five years, the gold production will grow at the rate of 3.6% per year over the next five years in the base case scenario assumed. The bullish growth rate of gold production comes to 5.6%, whereas the bear case comes at 1.2%. These growth rates again are pretty bullish given that the growth in gold production has only been at 0.7% per year over the last two decades.

The primary reason for the slow growth rate over the next years is that very few large gold mines are expected to commence operation over the next five years. Only 7 gold mines (green or brownfield) and 1 copper/gold mine are capable of adding a total of more than 500koz of gold production each over the entire 2011-2015 period.

What also does not help is the fact that most gold mines take some time to be set up. “According to a study conducted by MinEx, the average lead time for the 214 greenfield projects in 1970-2003 was about 5.4 years in Australia, Canada, and the US, and 8.3 years for other countries.” Also the cost of building a new mine has shot up dramatically.

“There are many projects under pre-feasibility studies, among which Xstrata’s Tampakan coppergold mine in Philippines is a large example. This is to be a large-scale,low-cash-cost, open pit mining operation with an average annual production of 375,000 tonnes of copper and 360,000 ounces of gold over an initial 17-year mine life. However, this mine, which could cost more than $5 billion to build, will not start production until 2016,” the report points out.

Central banks buying again: Between 1996 and 2009, central banks all over the world were net sellers of gold. This trend has changed recently. In 2010, central banks were net buyers to the extent of 76 tonnes of gold. In the first quarter of 2011, central banks bought gold to the extent of 129 tonnes.

As the report points out “From peak net sale of 674 tonnes of gold in 2005 to an annualised net purchase of 516 tonnes (129 tonnes x 4) for 2011, the shrinkage of gold available to satisfy demand amounts to 1,190 tonnes, which is 44% of last year’s gold production from mines.” 

Central banks were major suppliers of gold and this change in trend augurs well for the price of gold. Further, most Asian countries have very low amount of gold as a percentage of their reserves. For China, gold was only 1.6% of its total reserves. For India and Japan this figure stood at 8.2% and 3.2% respectively.

In comparison, the world average stands at 11.1%. Imagine what would happen if all these Asian countries got their gold holding as a percentage of their reserves in line with the global average. As the report points out “Currently 1.8% of China’s forex reserves are in gold; if China were to bring this percentage in line with the global average of 11%, it would have to buy another 6,000 tonnes of gold, or more than 2 years global mine production.”

Supply deficit: Due to the slow growth in mine production and central banks turning buyers once again, the supply of gold over the next five years will be lower than the demand. Even with the assumption that the demand for gold stays flat over the next five years, there will be deficit of 665 metric tonnes of gold, expects the report.

Increasing incomes in India and China: The price of gold has shown an almost one to one correlation with the increasing disposable incomes in India and China. In 2010, India and China’s gold consumption was 962 and 580 tonnes respectively. As the report points out “. These two countries together accounted for nearly 60% of global gold production from mines.”

Dollar is not the only currency in trouble:  It is worth highlighting that dollar is not the only currency that has lost value against gold over the last ten years. As the accompanying table points out, gold has gained value against almost all major currencies. This states very clearly there is a issue of credibility about paper currencies, and it just does not stop at the US dollar.

And these factors could lead to the price of gold shooting up to $5000 per ounce (one troy ounce equals 31.1 grams), the report concludes. So there are enough reasons to still buy gold.

The writer is a finance professional