Gold, a commodity?
November 21 2003
Even though I can’t individually
respond to the feedback I get on this column, I do read all of it
and I appreciate it too. Even the one telling me that I’m
a moron who doesn’t know a thing about gold and gold stocks.
Several people asked what I thought about Australian
gold stocks and the Aussie Dollar. In a general sense I think the
Australian Dollar will do well against the US Dollar, perhaps even
better than the South African Rand since the country is in much
better shape, but I don’t know nearly enough about Australia
to talk about it in any kind of detail.
One of the projects that I have assigned myself is
to figure out what the gold price is likely to do in currencies
other than the US dollar. The Australian Dollar is on that list,
but not first. I’ll probably start with the Canadian Dollar,
then the Euro and then the Australian Dollar, but don’t hold
me to that order because it all depends on what I have time for
and which data I can get first.
This week I want to discuss why one of the common
reasons used to justify a higher gold price is flawed. It illustrates
why analyzing gold as a commodity doesn’t work – a topic
we’ll cover for the next few weeks. Don’t get me wrong,
I believe the price of gold is likely to exceed $1,000 an ounce
in the not-too-distant future, but not for the reasons most people
Gold, a commodity?
Most analysts today view gold as a commodity. As such, they try
to make sense of the gold price the way one would approach, say
copper, or nickel, by looking at changes in the physical supply
and demand for the metal. This failed during the 90s, when analysts
called for a higher gold price, and the gold price declined. Then,
since the turn of the century, they have been calling for lower
gold prices, yet the price of gold is rising.
Have you heard that the gold price just has to go
up, because total worldwide mine-production is only 2,400 tonnes
per annum (average from 1990 to 2002) while fabrication demand is
more than 3,300 tonnes? Surely this, almost 1,000 tonnes per annum
deficit, has to drive the gold price higher.
Of course, what is left out of the equation are things
like official sector sales, scrap sales, gold loans, forward sales,
hedging, etc. Gold Fields Mineral Services (GFMS) adds up the total
supply of physical gold and compares that to the total demand for
physical gold, including all the items listed above, and some others.
The difference between total supply and total demand is deemed to
be net investment demand, which can be either negative (disinvestment)
or positive (investment).
Whether GFMS’ derived net investment demand
is absolutely accurate is not all that important; we can assume
that the overall trend of investment flows is correct because it
is influenced by changes in the supply and demand for gold from
categories that we can measure.
So if the assumption that gold can be analyzed as
a commodity is correct, there should be a correlation between net
investment demand and the gold price. Does net investment demand
have any effect on the gold price? Could the decline in the gold
price between 1990 and 2000 have been a result of a decline in net
A quick glance at the volatile nature of net
investment demand (Figure 1) could lead to the conclusion that there
is no correlation between it and the gold price. I also plotted
the net investment demand trend line from 1990 to 2000, just in
case the correlation was hidden in the volatility. While it’s
too early to know for sure, it seems as if there has been an uptrend
in net investment demand since 2000, which is why the trend line
truncates in that year.
Looking at the trend line, it appears that while net
investment demand was trending down, the gold price was declining.
This corroborates the view that gold could, indeed, be analyzed
as a commodity.
Or, could we say that as long as the gold price was
declining, net investment demand was trending down? These are not
the same. Is investment demand driven by the gold price, or is the
gold price a function of investment demand?
Looking at the chart above may lead the casual observer
to conclude that net investment demand is in fact the cause of changes
in the gold price. After all, the gold price bottomed, and started
its bull market rally only after the downtrend in net investment
demand was reversed in 2000. Clearly net investment demand picked
up prior to the inception of the gold price rally. But it didn’t.
Net investment demand is in the order of a few hundred
tonnes of gold per annum whereas annual physical gold trading is
in the order of thousands of tonnes. Last year, for example, gold
trading on the London Bullion Market Association (LBMA) alone was
in excess of 6,600 tonnes, while the net investment demand for gold
was only 137 tonnes, or 2% of the trading volume. From 1997 to 2002,
worldwide net investment demand represented on average only 1.96%
of the gold traded on the LBMA. Considering that the LBMA is not
the only place in the world where physical gold changes hands, we
can conclude that net investment demand represents less than 2%,
and probably less than 1%, of physical gold trading.
Even though price is set at the margin, I don’t
believe the magnitude of net investment demand is sufficient to
influence the actual gold price in any significant manner.
Furthermore, the gold market is not confined to the
United States, even though the gold price is ubiquitously quoted
in US dollars. The price of gold is determined by many factors not
indigenous to the United States, such as economic prosperity around
the world, concern for currency devaluations including, but not
limited to, the US dollar, international political instability,
social insecurity, war etc.
Given that net investment demand represents the aggregate
of global economic trends, it makes no sense to try and correlate
it to the gold price in US dollars alone, without considering the
price of gold in the rest of the world, which by definition must
incorporate all currency exchange rates.
An analyst in Lusaka, for example, may find value
in analyzing the gold price strictly in terms of Zambian Kwacha,
but in reality his analysis will reflect mainly the Kwacha exchange
rate, with a minor contribution from the actual gold market. The
same applies to an analyst in New York, working strictly from a
US dollar perspective.
To solve this problem I created a global gold price
using a GDP-weighted index of 35 currencies, representing in excess
of 75% of the world’s economy. Since 1998 I have been looking
at the gold price from a whole-world perspective, and it’s
been very interesting. For one, it allowed me to be very, very bullish
on gold as early as 1998.
Looking at the bigger picture, it was immediately
evident that the gold price in US dollars was predominantly a function
of the US dollar exchange rate, at least since 1992. (We are working
on getting this index published on Kitco and updated automatically
Let’s look at net investment demand again, but
this time comparing it to the GDP-weighted average worldwide gold
price. Net investment demand is, after all, worldwide net investment
It’s obvious (Figure 2) that there is
absolutely no correlation between net investment demand and the
gold price. It is also quite obvious that the increase in the gold
price preceded the upturn in net investment demand by several years.
Net investment demand is therefore not a good leading indicator
for the gold price. If anything, it’s a reaction to the gold
Paul van Eeden
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
investment publication. For more information please visit his website (www.paulvaneeden.com)
or contact his publisher at (800) 528-0559 or (602) 252-4477.
This letter/article is not intended to meet your specific individual investment
needs and it is not tailored to your personal financial situation. Nothing contained
herein constitutes, is intended, or deemed to be -- either implied or otherwise
-- investment advice. This letter/article reflects the personal views and opinions
of Paul van Eeden and that is all it purports to be. While the information herein
is believed to be accurate and reliable it is not guaranteed or implied to be
so. The information herein may not be complete or correct; it is provided in
good faith but without any legal responsibility or obligation to provide future
updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility,
or assumes any liability, whatsoever, for any direct, indirect or consequential
loss arising from the use of the information in this letter/article. The information
contained herein is subject to change without notice, may become outdated and
will not be updated. Paul van Eeden, entities that he controls, family, friends,
employees, associates, and others may have positions in securities mentioned,
or discussed, in this letter/article. While every attempt is made to avoid conflicts
of interest, such conflicts do arise from time to time. Whenever a conflict
of interest arises, every attempt is made to resolve such conflict in the best
possible interest of all parties, but you should not assume that your interest
would be placed ahead of anyone else’s interest in the event of a conflict
of interest. No part of this letter/article may be reproduced, copied, emailed,
faxed, or distributed (in any form) without the express written permission of
Paul van Eeden. Everything contained herein is subject to international copyright