Sober warning on gold's bull run

Apr 17, 2010 11:45 PM | By Jim Jones

Amid the hysteria whipped up by the gold bugs, it is refreshing to hear a measured view on the gold market. It came this week with the publication by metals consultancy GFMS of its 2010 annual survey of the gold market.

GFMS's Paul Walker foresees a volatile gold price trading between $1050 an ounce and $1300 this year, with a forecast average of $1170.

For the past two years, the world's gold market has been driven by investment demand. Last year, GFMS reckons, the world's gold supply totalled 4287 tons from newly-mined metal, scrap sales and a minuscule release from official reserves.

Of that, one in every three ounces was absorbed by implied net investment demand. People were panicked early in the year by fears of economic collapse, inflation or a belief that investment in gold offered good returns.

But investment demand was the only sector to show increased off-take last year. Jewellery and other fabrication demand declined with rising gold prices.

In round figures, last year's demand for gold jewellery could have been matched by scrap deliveries.

Take a look in England, Europe and North America - a whole new business sector has developed to get people to sell their unwanted gold. It has developed in a very short time and represents a major structural change to the supply side of the market just as exchange-traded funds (ETFs), that hold physical gold, have altered the demand side.

Last year about a quarter of new mine supply was absorbed by other fabrication demand and there was some bar hoarding and net producer de-hedging.

But 45% of the world's newly-mined gold was absorbed by investors. Gold miners cannot hold back their gold for long - they need the cash flow, particularly as costs continue to rise inexorably.

On average the world's cash cost of producing each ounce of gold is reckoned to have reached $478 in 2009. Going further, GFMS reckons that if non-cash costs and capital expenditure are added in, the cost rises to $717. And even that does not include items such as depreciation and inventory costs that help lift the total to a sustainable long-term cost of $925.

And it is these latest market trends that Walker believes could exacerbate any price downturn. The bulls bellow that inflation is inevitable given the extent of deficit spending in countries affected by the economic crisis and that this will be accompanied by soaring gold prices as investors seek a safe haven. Maybe.

But Walker puts another point of view. If inflation takes off, central banks such as the US Federal Reserve or the Bank of England are likely to raise interest rates as they have done in the past to combat the inflationary peril. The upshot of this would be higher costs of holding gold leading to disinvestment pressures.

Near-zero interest rates, which meant holding costs were low, helped fuel gold's recent run, as did fears over inflation and possible sovereign debt defaults. These factors could well persist through 2010, Walker argues. But they will not remain in place forever.

A tipping point might be reached suddenly. Those with longer memories will recall what happened when gold was heading to record highs of $850 an ounce back in 1980 - companies, traders and individuals unloaded "scrap" bullion by the ton and helped push the price into a steady decline that lasted almost 20 years.

As it is, lower prices are needed to attract people back to the jewellery sector, and there are also trends towards substitution - coating electronics wiring with cheaper palladium rather than expensive gold is one example.

If anything, GFMS became "bullish" on gold back in 2002, and its expectations were based on fundamental research - wearing out shoe leather on visits to mines and markets. So its current caution should not, perhaps, be dismissed lightly.

Certainly fears for inflation or for a fully fledged dollar crisis might lift gold prices, but GFMS believes that a rally that breaches the $1300 mark could herald the final stage of the current multi-year gold bull market. At this stage, discretion might