Kitco Commentaries - Marino G. Pieterse

Recovery in jewellery and retail investment demand paves the way for gold price to rise above $ 700

In earlier issues of Goldletter International, I noted that gold didn’t run its own course in 2006 by showing a price increase of 24% from $ 513 at the end of 2005 to $ 635,70 at the end of 2006, thereby touching an interim high of $ 725,75 at May 12, 2006. In fact, the gold price followed the boom at base metal markets, specifically driven by Chinese demand. This is clearly indicated in the overview of the accelerated increase of the gold price in the first half of 2006, which was in concert with the strongly increasing Brent oil price from $ 58,87 barrel at year-end 2005 to an interim high of $ 78.44 per barrel on August 7, 2006.

Since then, a steep correction occurred to an intermediate low of $ 51.31 per barrel at January 16, 2007, followed by a recovery to a current price around $ 60 again, which shows the same pattern in performance as the gold price did.

This correlation between gold and oil prices is in contrast with an assumed, but since 2004 no longer valid, correlation with the course of the dollar against the euro.

Particularly because of a strong upward correction in 2005, today’s value of the dollar against the euro is lower than at year-end 2004, and the dollar has even touched a four-year high against the Japanese yen.

I am one of the only few financial strategists who have not expected a further fall of the dollar for three years now, based on the fact that, although the yuan was officially depegged from the dollar in mid-2005, it has only appreciated 6.5% to date. I expect China to continue to support the value of the dollar, thereby having sustainable economic benefits of an annual trade surplus or more than $ 200 billion and ongoing growing monetary reserves to more than $ 1,000 billion.

Although China’s central bank has said that it is looking for new riskier ways than only US and European government bonds to invest in, like corporate bonds, stocks or even real estate and commodities which have better long-term return, there are no signs that the central bank in China hasn’t shown any action to increase its gold holdings as a hedge against its dollar holdings.

Obviously, gold is considered to be a dead investment from an Asian monetary point of view, like it was for the Japanese in the 1980s when their economy was booming. Gold holdings in both Japan and China are less than 2% of total monetary reserves. Therefore, in my view, only wishful thinking on increasing these percentages can be accounted for opportunistic gold price estimates above $ 1,000 within the next few years.

According to the World Gold Council, based on statistics prepared by GFMS of London, the world’s premier gold research institute, identified demand for gold fell by 10% in tonnage terms in 2006, broadly in line with the reduction in total supply. In dollar terms, demand rose by 22% to reach a third successive annual record of US$ 64.3 billion.

While demand for jewellery also established a new record in dollar terms of US$ 44 billion, 15% up on 2005, in tonnage terms it fell by 16% from 2,702 tonnes to 2,611 tonnes, with price volatility deterring purchases in the first half year.

Identifiable investments rose 7% in tonnage terms from 596 tonnes to 637 tonnes, 27% up on 2005 (208 tonnes).

The 533 tonne (13%) reduction in total supply was primarily due to a sharp increase in de-hedging (reducing net mine supply) from 403 tonnes to 86 tonnes and a 52% fall in net central bank selling from 659 tonnes to 319 tonnes. These were only partly offset by a 20% increase in old gold scrap supply from 889 tonnes to 1,069 tonnes.

Particularly because the upward trend in Identifiable investment, GFMS is positive on the outlook of gold, which in my opinion is in conflict with the fact that Inferred investment, which includes institutional investment other than ETF’s & similar, stock movements and other elements as well as any residual errors decreased from 255 tonnes to 90 tonnes. As a result, total investment demand decreased 14.5% from 851 tonnes to 727 tonnes in 2006.

Although I don’t expect a booming gold market based on demand and supply in 2007, I have noted a positive change in sentiment since both jewellery and retail investment demand picked up in the second half of 2006. The driving force for higher gold prices on the demand side remains the jewellery industry, but on the other hand de-hedging could decline substantially, with major producers, led by Barrick Gold, cleaning their books. Having adjusted to a price level above $ 600 again, breaking the $ 700 barrier again is within reach in the short term.

I expect the consolidation process within the gold industry to continue, as it proves to make more sense to buy reserves and resources, particularly of mid-tier companies, rather than to spend millions in risky grass roots projects. This process is enhanced by a strong increase in cash flows of major producers, as has already been demonstrated by an increasing number of take-over bids in 2006.

Despite increasing production costs in the last two years, operatingmargins have increased substantially from a level of $ 70, related to a gold price around $ 400 and average production costs of $ 330, compared with today’s gold price of $ 680 and production costs which are increasing by 10% to 20% per year.

While major producers valued their reserves at $ 400 per ounce in 2005, these have been upgraded to an average of $ 500 per ounce in 2006, thereby increasing the life time of reserves to an average above 15 years. This means that in contrast with most base metals, there will not be a shortage in gold in the foreseeable future.

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