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Gold: Cost of Production, Portfolio Diversification and Buying on Dips

Friday April 26, 2013 15:45

Editor's Note: Seasoned Metals Analyst, Kira McCaffrey Brecht shares her extensive commodities knowledge on Kitco.com. Kira has been writing about the financial markets for over a decade -- posts during her career include Managing Editor at TraderPlanet, Chicago Bureau Chief at Futures World News, Market Analyst at Bridge News and Technical Analyst for MMS International and Managing Editor at SFO Magazine.

Gold investors are bruised but not broken. But, the yellow metal is still vulnerable to another down wave of selling pressure. Last week's action and modest rebound was a "pause" to the bear collapse. Friday's bearish shooting star candle on the daily June Comex gold futures chart shows the bulls are unable to defend gains right now.

Given gold's recent fall from grace as gold ETF holders dump positions and rush for the exits, the yellow metal for now has lost its "safe-haven" cache—its appeal as a store of wealth as developed nations’ global central banks continue to embark on massive money-printing and quantitative easing ventures. None of those factors have disappeared: global central banks continue to debase fiat currencies with their current monetary accommodation, but for now the overwhelming sluggish global growth continues to hold inflation at bay, which has decreased the perceived need to hold gold for now.

Despite the recent collapse in prices, there remain strong and solid factors that argue for portfolio diversification into gold. Lower prices points ahead may offer savvy long-term investors and players a better entry zone.

"Gold can be an effective diversifier that helps reduce portfolio volatility. And, the correlation between gold and traditional assets generally decreases in bear markets. Our expectation that gold would underperform in the face of strong equity performance highlights this point," wrote Mary Ann Bartels, CIO of portfolio strategies at Merrill Lynch in a research note to clients last week.

Additionally, Bartels added, "Gold may be best described as the portfolio protection investors hope they don’t need. It can be a 'cost' to performance when equities are doing well, but when things go wrong, gold can potentially provide a safe haven."

Given the current liquidation phase in the gold market, it is important to understand its position as an actual physical commodity with costs of production. The "cost of production" figure is an important number for gold investors and traders to understand.

When the spot price of gold is above the cost of production it spurs producers to mine more—as there is more profit incentive for them. When the spot price of gold falls below the cost of production, producers have less incentive to ramp up overall production levels. But, then, supply begins to diminish, which in turn eventually creates a bullish supply/demand outlook. It is a cycle all physical commodities go through.

What is the cost of production for gold? Barclays analysts answered that in a research note last week: "Last year, the average cost of production was $673/oz, and the marginal cost of production (90th percentile) was $1,104/oz," wrote Barclays analysts.

However, one must add in capital expenditures as well: "Assuming sustaining capex at around $200/oz, this indicates cost support at around $1,300/oz, based on last year’s data; our global database encompasses 35% of global production. Should prices dip below marginal cost, around 10% of production under our cost curve becomes cash-negative, representing an estimated 262 tonnes of cash-negative gold production globally," Barclays added.

Bottom line according to Barclays’ analysis? "From a fundamental perspective, support comes into play initially at around $1,300/oz before a substantial quantity of mine production is put at risk," they wrote.

Looking ahead, the technical charts reveal gold prices are still vulnerable near and medium term. A so-called "measured move" target or objective on the downside comes in around $1,250 per ounce, which is based on the gold market's large sideways trading range between $1,800 and $1,525 from November 2011 until the early May breakdown.

Institutional players agree that more downside still could be ahead.

“How much more selling is left? BofAML Commodity Strategists Michael Widmer and Sabine Schels believe cyclical headwinds will continue to weigh on gold in the short term. They say that the price breakdown, combined with improving global economic growth, modestly higher rates and benign inflation means gold could fall another $150/oz from here to $1200/oz," wrote Bartels, in a Merrill Lynch note.

Analysts at Credit Suisse are even more bearish.  "Our technical analysts identify as the next key area of support: $1,310/00, if this level is breached the next key level is $1,156, and then $1,122. Beyond that they target $1,000," wrote Credit Suisse in a research note last week.  

Bottom line? Gold investors should prepare for another wave down. But, now is the time to plan your reactions and objectives. Are you a longer-term investor looking to add five to 10% of portfolio diversification into gold? Additional selling in the days or weeks ahead could offer an excellent buying spot for the longer-term.

At some point soon, cost of production will come into play—and offer support to the gold market.

Major physical demand trends, including emerging market central bank and consumer demand from India and China have been rising, with little likelihood of those trends ending.

Gold may simply be in the process of switching hands of the key bull drivers—changing over from Western exchange-traded fund speculators into the hands of longer-term, more patient and culturally driven investment outlooks of Indian and Chinese gold holders.

Don't get swept up in the emotion of falling prices. Lower gold prices can mean an opportunity and a commodity "on sale." Consider your long-term goals and plan appropriately for the potential for additional gold losses ahead.


By Kira Brecht, Kitco.com, follow her on Twitter @KiraBrecht

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.

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