The Trends Favor Gold

03/16/2009 12:00 am EST

Focus: GLOBAL

Lawrence Roulston

Editor and Publisher, Resource Opportunities

Lawrence Roulston, editor of Resource Opportunities, expects gold prices to continue to move higher, which should help mining companies that have a lot of the yellow metal.

Investors have taken refuge from the financial crisis in the safe haven of gold. The strong demand for gold coins and bars has created a shortage of physical product. Exchange traded funds (ETFs) and similar investment vehicles have become extremely popular. Gold ETFs now hold 45 million ounces of gold, an all-time record.

For the first time in nearly three decades, the public is looking favorably on gold as an investment. And yet, gold stubbornly refuses to break through $1,000 and overtake the record price set a year ago.

The reason is that investor demand is only part of the picture. The European central banks are among the largest holders, and their sales over the past decade have been a major factor in the market.

The European banks have agreed not to sell more than 500 tonnes (or, about 16 million ounces) of gold a year. For the past three years, they have sold less than the quota. However, that might change with the banking crisis.

Another large holder, the International Monetary Fund (IMF), has been talking about selling some or all of its gold for years, and again, the financial crisis may result in more of its gold on the market. Other central banks are buying, offsetting part of the European selling.

The Asian nations hold a very small portion of their reserves in gold. China, with $2 trillion, the largest foreign currency reserves of any nation, holds less than 1% in gold. There is speculation that China and other nations might increase their holdings.

Physical demand for gold is dominated by the jewelry market. Demand in the developed world has fallen sharply with the recession, offsetting growth in jewelry demand in the emerging economies.

A very important factor in gold is the see-saw between investor demand and jewelry demand. Investors tend to buy as the price rises and sell as the price falls.

Jewelry makers do the opposite. The big swing variable, and therefore the most important determinant in the short-term price, is investment demand.

When investor buying overwhelms the slowdown in other sectors, the price rises. Economists will tell you that when the price of a commodity increases, demand falls and production increases. Economic theory doesn't necessarily apply in the mining world.

The gold price has more than tripled in the past eight years, yet demand continues to rise. On the other hand, the supply of gold, also contrary to economic theory, is falling as the price rises. Gold mine production has been falling for several years, peaked in 2002, and is projected to continue to fall.

Equally important, the overall reserves in the gold industry are declining. Most of the gold production is now coming from mines that are more than 15 years old. The pace of mine closures will accelerate, putting further downward pressure on the level of gold production.

For years, the large gold companies have grown through acquisitions. While Barrick (NYSE: ABX) and Newmont (NYSE: NEM), for example, are each bigger than they were a few years ago, the industry is shrinking. The larger gold companies have grown through mergers, but those mergers have been dilutive: the amount of gold reserves per share has declined substantially over the past few years.

What does all this mean to an investor?

There are many reasons to believe the gold price will go higher, perhaps a lot higher. But, not necessarily right away. In fact, gold has a nasty habit of dropping back after it makes a big move.

But regardless of what happens to the price in the near term, the mining industry desperately needs new deposits. Shareholders of companies that find new deposits will be richly rewarded. And since it is getting harder to find new deposits, companies that have gold deposits hold extremely valuable assets.

Subscribe to Resource Opportunities here.

Related Articles on GLOBAL