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 do.
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
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
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 investment demand?
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
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
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 in real-time.)
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 demand.
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 price.
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