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Peak, or...NO Peak?

By Jon Nadler      Printer Friendly Version
Jan 9 2008 8:55AM

Good Morning,

Gold prices aimed for new heights overnight and achieved at least one - a tick above $892 per ounce. Continuing stimulus for the move came from crude oil which reconquered the $97 level amid apprehensions of militant attacks in Nigeria (a country that has already lost a fifth of its peak output capacity due to the turmoil). Stern words of warning directed at Iran by the US administration ratcheted tensions one more notch on the geopolitical front and added to gold's safe-haven appeal. Relative strength indicators point to an overbought market, but as our colleagues at Standard Bank point out, "Gold seems determined to break through the psychological $900 barrier. But the market is nervous, with nobody really wanting to pay the highest ever price for gold, but nobody is prepared to sell either."

New York spot bullion opened more than $16 below the stratospheric numbers it reached overnight, and was quoted at $878.00 per ounce - down $1.30 at the moment. Traders are indeed exhibiting nervousness at this juncture, despite the fact that they find it hard to cash in on handsome profits. Consumer sentiment and spending data reveal a concern and a purse-strings contraction underway in the US and even in Euroland. On the other hand, the volume of US mortgage application surged by 32.2% during the week that ended Jan. 4, reversing the three previous consecutive weeks declines, this according to the Mortgage Bankers Association's weekly application survey.

Silver gained 9 cents to $15.77 while platinum added $4.00 to reach $1551.00 per ounce. This session could see a pause in the near-vertical ascent pattern that has been with us of late. At the very least, the action looks like it will be plenty choppy. Supports come into the picture in the (mid) $860's and could be tested. 

The US dollar is showing some muscle this morning, rising to 76.31 on the index. Hyper-bulls will define it as the bounce of a deceased feline, no doubt.

And now, for something...completely different: Peak or... NO Peak?  Dissertation time.

For those of you who care to look beneath the surface, a much talked-about recent article in Business Week, titled "Headlines aside, gold has lost luster" and a recent flood of commentaries arguing that gold somehow must reach its inflation-adjusted high has prompted the following expose. Our good friends at CPM Group in New York have seen the debate for some time now and I have distilled their views and ours into the following segment:

Nominal gold prices now are at their highest levels since 1980. They in fact traded much higher than the Jan 21 high of that year. That is the only other period in history in which gold prices have been as high as they are now. Adjusted for inflation, however, gold prices remain below their levels from 1977 into 1997. Many investors and others cite these low inflation-adjusted prices as justification for expectations that gold prices will rise much higher, and remain high. While there are some reasons to view gold prices in real terms, this overlooks the relationship between gold prices and fundamental factors such as mine production, scrap recovery, fabrication demand, and investment demand patterns.

Despite real gold prices that could be argued as being "low" compared to prices over much of the past three decades, future price trends will depend heavily on nominal gold prices relative to the costs of production at many gold deposits, the cost of refining metal from scrap, the cost of using and buying gold in jewelry, and the potential that some investors will decide to take profits based on high nominal prices.

Ever since gold trading officially and legally began on the Comex on 31 December 1974 history shows that gold prices have spent more than half of the time since then trading between $250 and $450. Gold has spent fully 28.6% of the past 30 years trading between $350 and $400. This should not be surprising, since at this range of prices is what econometric studies suggest has been the long-term market clearing price range for gold: At levels above $400, a tremendous amount of additional gold ore becomes economically feasible to mine, and can have the long-term effect of increasing supply sharply. Also, above $400 gold becomes expensive for use in jewelry, which leads to a sharp reduction in jewelry demand and an equally sharp increase in the amount of newly refined gold being recovered from jewelry sold for its scrap content. In other words, above $400, a lot of gold comes into the market, and fabrication demand falls off sharply. It takes scary economic and political conditions driving investors to hoard increased amounts of gold to keep prices above $400 -- the sort of market that has been seen consistently since 2001.

Similarly, below $400 the incentive for bringing new mines on stream falls sharply. Supply falls. Jewelry holders hang on to their old jewelry, seeing it as not being worthwhile to sell their jewelry for its gold content. Jewelry demand meanwhile tends to rise sharply as prices fall below $350. These trends have tended to make the range of $350 - $400 the market clearing range for gold prices, levels at which supply and demand broadly are in balance. Prices can spend a great deal of time below this market clearing range, as was the case fro 1997 through 2001. Prices also can spend long stretches of time above this range, as has been the case since the fourth quarter of 2004. In the long run, however, gold's supply and demand fundamentals strongly suggest that, barring extreme levels of investment demand or central bank selling, the gold market tends to be in balance between $350 and $400.

Now, even if we were to be very generous and allow for this clearing price of the metal to increase to, say, $600-$650 and remain there, well you can still see that there is no logical reason to expect that we 'must' trade and remain at the inflation-adjusted $2200 per ounce anytime soon - if ever. The operative word here is "barring extreme levels of investment demand" - such as let's say after a pre-emptive attack on Iran, another terrorist strike in the USA, etc. Such events could indeed result in a brief - but unsustainable- spike to levels unknown. Conversely, the other key word is 'central bank selling' -as in massive liquidations by the official sector (for whatever reason). Since we do not believe that either extreme is likely to materialize, the expectation that the market will eventually revert to the mean - even if a higher mean than the 400 area- is justified.

This is important as one considers the real and inflation-adjusted prices for gold. The gold market clearing range is computed in nominal dollar terms. Many observers focus on the fact that while nominal gold prices  have risen to levels beyond even their 1980 record levels, adjusted for inflation since then, real gold prices remain relatively low. They have suggested that this implies scope for further sharp appreciation in gold prices lie ahead for this metal, even though there are no economic theories to justify such conclusions. While it is true that gold prices are not as high in real, inflation-adjusted terms as they are in nominal terms, that means very little to most producers and consumers.

The key to understanding the economic factors that will weigh on gold prices over the long run are more centrally focused on nominal prices. The average cash cost of producing gold at mines now is roughly $350 per ounce on a nominal basis. It had ranged between $200 and $280 per ounce over the past two decades. That compares to a nominal price above $600, meaning that gold mining presents enormous profit opportunities to any company able to find new gold to mine. This differential in nominal prices matters to the price of gold. The nominal price of gold jewelry, on the other side of the gold market's ledger, meanwhile is measured not so much against its historical price by would-be consumers, but rather against the costs of competing luxury goods and other forms of jewelry on a nominal basis.

More important on the demand calculations made by jewelry manufacturers, who need to keep the wholesale price of their jewelry at a certain low level in order to allow retailers to purchase the jewelry for sale to the end consumers. Jewelry manufacturers do this by reducing the amount of gold per piece of jewelry, so that rising gold prices can lead to lower gold use in jewelry even as the dollar value of the jewelry increases. For these reasons and more, the nominal price of gold is more important than the inflation-adjusted price of gold in determining whether gold is "cheap" or "expensive" in the eyes of producers, consumers, and others at any given price and time.

Best Regards,

Jon Nadler

Senior Analyst
Kitco Bullion Dealers Montreal



Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco 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 Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.