Friday, January 11, 2013

What happens if Gold Price goes too low?

Many people fear if the gold price will become too low and they will lose their investment. I, on the other hand, am waiting for the Gold price to get too low :-).

People who fear gold prices getting too low are thinking in terms of currency. This is the wrong way to look at gold. Gold is the currency that measures other currencies. Measuring it in terms of other currencies is a mistake.

If you look at the amount of gold held by Central Banks you will notice that they have increased their holdings since 2008. If the value of gold could drop, why would Central Banks increase their holding?
Bron Suchecki of Perth Mint has written a nice summary of the CBs activity over the past decade. You can also look at the data per country, almost every country has increased.

Now lets look at how the price can drop without crisis and why it will be a good thing for physical gold holders.

The first thing to understand is that gold price at the present time does not depend on physical gold demand, it depends on paper gold demand. There is a huge amount of paper gold trading that goes on in the world and it dwarfs the physical gold trading 1,500,000:4,500. My number in previous articles was way too low. Wikipedia also corroborates those numbers.

Currently the price of gold is down, and has been down since Sept 2011. This does not mean that there is no demand for physical gold, it just means that there is little demand for paper gold. If the demand for paper gold keeps on reducing the price of gold will drop. Lets see what will be the consequences of such a drop.

There is 4500mt of gold traded in the world. Of this 2500mt comes from mining and 2000mt is from scrap. Scrap means the gold sold by people. Of the 4500mt, over 2000mt is used in Jewelry. The jewelry use is typically by Asian people. This demand is very inflexible, as in it cannot be replaced by paper gold. Another 1000mt is used by bullion investors. This demand is somewhat flexible, as it can be replaced by paper gold. But note that people who buy physical gold are paying extra costs for it. If they really wanted it for short term trading they would not be buying physical gold and instead would buy paper gold. So the majority of this demand is also inflexible. About 300mt is industrial demand which is very rigid.

It is very likely that if the price of gold goes down demand of physical will go further up. The Indian govt is trying to convince people to buy paper gold, but unfortunately you can't make jewelry from paper gold :-).

Now lets see what other effects happen when the price of gold goes down.

Mines are affected with a low price of gold. There are two kinds of costs that we read about in the mining industry. Cash Costs, that are actual running costs. These costs are minimum, and are required for running the mines. Below these costs the mines will not be able to run. But this is not the actual costs at which the mines will close down. There are other costs involved, exploration, and profits. No business will operate at no profit. Even share holders want profits. The total of these is the Running Cost of a mining company.
Running costs are probably crossing 1500$/oz at the present times. Cash costs were nearly 700$ in 2011, and are now upto 900$-950$/oz. Barrick Gold had a cash cost of only 460$/oz in 2011. The present price of gold is around 1650$/oz. It is expected that the mines will be in deep trouble at 1350$/oz.

What happens if the price of gold is 1350$/oz? Or if the costs of mines increase further owing to inflation, reduction in yield, and reduced exploration.

The mines will start closing down, reducing the mining output. If the Output goes much below the current level, the demand for physical gold will outstrip the production. This can only be managed with a higher price, but the problem is due to a lower price. The demand for physical cannot be reduced by unavailability of physical from mines, because there is a huge above ground stock in common people's hands.

What will happen is that some people will be willing to sell gold at a higher price than what the paper gold market suggests, and Asians (particularly Indians) will be willing to pay the higher price. If this is done commonly and openly, the price of paper gold and the price of physical gold will diverge. It is highly likely that this problem happens in India, because the Indian Physical market is much more active than the rest of the world. At that time true value of paper gold will be revealed which is zero.

Once the paper gold's value is revealed, immediately the value of physical gold will rise. There will be a discontinuity as the physical gold will more or less disappear from the market as lots of money will be after gold, and slowly the real price will be arrived at in the actual market.

Remember the above treatment is done in the case of no crisis situation.

The above case is highly improbable. It is highly likely that if this situation happens, the 1.5million tonnes of paper gold which is equivalent to 70T$, more than the global GDP, will be gone. This will cause a major disturbance in the Economic health of the world. It is highly likely that we will plunge into a crisis situation.

Because of this consequence to the world economy, the price of gold will never be allowed to drop so low that mines start closing down, or people wanting physical are not able to get their physical easily. The price will drop when the crisis happens, in that case lots of paper investments will become worthless, including paper gold. Note: Stocks are not paper investments, but you do need to have the papers in your possession. The crisis will happen overnight as it is a consequence of loss of confidence, which happens overnight.

Another issue is China. China is at present the largest producer and consumer of gold. It is actually turning into a black hole for gold. It has been buying a whole lot of gold via Hong Kong. It is also buying up large mines in South Africa and elsewhere. Rest assured it is not buying these mines to sell the gold in open market. China seems to be intent to have 10,000tons of gold as reserve. Once the effective production of gold (not including gold in Chinese control), gets too low, the economy is in trouble. The Chinese have already shown that they are now, not too much concerned about the economy going south. China was the country that bought US Treasuries in the last decade to allow the system to survive for so long. Since Sept 2011, it has stopped providing that support. Since then China's UST hoard has been reducing.

The countries worst affected by the economic downturn are US, UK and Japan, so these countries can help keep the price of gold up. Of these really US is the only one which can actually do something about it. It seems Europe has also given up. There was no surge in the price of gold before the 4th Jan ECB's quarterly update.

My estimate for the crisis is between 2 to 5 years. Possibly earlier than later. It seems to me that UK will be the first to plunge into crisis, and then trigger the rest.

No comments:

Post a Comment