Gold above $ 700 per ounce driven by speculation

By Marino G. Pieterse         May 29, 2006 www.goldletterint.com

It should be evident that this price explosion had nothing to do with an unexpected change in fundamentals, but has been part of the overall speculative hype on metal markets, including record prices for copper, zinc and nickel. Gold certainly didn't run its own course, as has been demonstrated by a relative strong price correction to a current level of $ 650 per ounce.

The World Gold Council (www.gold.org) reported in its recently published update on supply and demand statistics with data for the first quarter of 2006 that sustained interest from different groups of institutional investors drove the gold price to new highs  However, according to figures completed by GFMS (www.gfms.co.uk), the world's premier research institute on gold, total demand for gold at 835 tonnes was 16% lower than in the first quarter of 2005, primarily as a result a significant fall in jewellery demand particularly in Asia and the Middle East, This is according to my prediction in Goldletter's April-issue, when I pointed at the price sensitivity on demand as a result of increasing gold prices.

Gold jewellery demand, accounting  for 52% of total demand, fell 22% (175 tonnes) to 531.4 tonnes from 706.8 tonnes in the first quarter of 2005, compared to 109 tonnes flowed into Exchange Traded Funds (ETF's). Although this was the largest quarterly increase in investment since the World Gold Council backed street TRACKS Gold Shares listed on the New York Stock Exchange at the end of 2004, also according to my expectations this demand was not strong enough to compensate fully for the decline in jewellery demand.

With the gold price having increased strongly, apart from an increase of 28 tonnes of mine production, supply from old scrap increased 104 tonnes in the first quarter compared to the same period in 2005, but official sector sales decreased by 152 tonnes.

On the demand side against the strong decrease of 171 tonnes in jewellery demand, and a decrease of 44 tonnes in bar & coin retail investment, offset partly by ETF's & similar, while net producer dehedging increased 138 tonnes to keep total supply and demand in balance.

While already having pointed at the growing pressure of price sensibility on demand since the gold price has passed the $ 500 since early December 2005, it should be clear that at today's prices of $ 650 per ounce the price sensitivity will prevent the gold price to pass the $ 700 barrier once again in the near future.

That means that opportunistic gold market views have to bring other arguments on the table to justify predicting gold prices of $ 1,000 plus. Having been a speaker at the recently held "Gold Investing" Conference in Geneva, I got the answer when invited gold experts from North America stated that gold is money and, in connection with a further decline of the dollar, the only safe haven.

However, like with the fundamentals on supply and demand, this argument is in conflict with reality. First, since the end of 2003 the dollar has not declined further at all against major currencies, the euro and yen. Actually, the dollar rallied strongly in 2005 from $ 1.35 at the end of 2004 to $ 1.18 at the end of 2005, before it showed a correction this year and is traded at the same level of the end of 2003 now.

Second, gold's monetary role declines since the reserves held in gold by the major 11 central bank holdings, declined from 84% in 1950 to 15% in 2005. While the value of gold reserves increased from $ 29 billion to $ 197.7 billion over this period, the value of non-gold reserves skyrocketed from $ 5.6 billion to $ 1,139 billion as a result of which the percentage of monetary reserves held in gold decreased from 84% in 1950 to 15% in 2005.

In the meantime, US dollar exchange reserves by major Asian countries increased to $ 2,204 billion, with gold only presenting 1.49% of total exchange reserves. Because particularly China showing the strongest growing exchange reserve in dollars, and exceeding $ 900 billion this year, did not buy gold at $ 400, $ 500 and $ 600, it is hard to believe that China's Central Bank will buy gold at today's prices.

In this respect, it is widely neglected that the Chinese yuan in fact is part of the dollar block as long as the appreciation of the yuan against the dollar is limited despite the yuan being strongly overvalued against the dollar, as is demonstrated by China's trade balance surplus with the US of $ 200 billion on an annual basis. China will not allow the dollar to fall however, in order to protect its economic growth, in return of which it will keep financing the dollar deficits. There might be a change in policy however, whereby China will shift from buying treasury bonds to buying hard assets, in which case the trade imbalance will decrease.

The good news is that the strong gold price increase of more than 50% from $ 400 to above $ 600 has a positive impact on the valuation of gold reserves, as gold majors have valued their reserves at an average of $ 400. At the same time, the financial position of majors has dramatically improved with strongly growing cash flows in 2006, provided that the gold price will not drop under $ 600.

In mining, many projects which were not economically viable at gold prices below $ 400 are now being reactivated and will have a positive impact on gold production in the next few years, enhanced by a growing number of mid-tier producers.

Within this scenario it is intriguing to watch that the overall price performance of gold shares has stayed well behind the boom in the bullion price, thereby offering many attractive investment opportunities

Marino G. Pieterse
editor-in-chief

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