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Michael Coulson: Gold -- safe haven or bull trap?

Section: Daily Dispatches

By Michael Coulson
Tuesday, October 7, 2008

I am genuinely proud that when I was chairman of the Association of Mining Analysts we held two gold seminars at which the much-reviled Gold Anti-Trust Action Committee spoke. What they said about the gold market and the shadowy world of derivatives has come home to roost, and with an accuracy that I cannot recall the like of in over 35 years as a stockbroker and mining analyst.

Contrast their early-decade comments with those of London gold guru Andy Smith, who forecast at the first AMA seminar that, after a short-term run, gold would fall to $65 per ounce. For that forecast to come true now would require the world to suffer the worst deflation since the cavemen ran out of sharp stones eons ago!

In Wednesday's edition of the Financial Times, where the wish is always father to the thought, the mighty columnist Lex once more laid into gold. Of course his desire to see gold crash (or perhaps just fall back) will someday possibly be realised. However, it is clear that statements that jewellery demand is plummeting show Lex has no understanding of the gold market.

Unfortunately I can't send him any of my past annual Gold Books, as I am down to my last copy. If Lex had read them he would note that when the gold price goes up because of investment demand, jewellery in volume terms falls. That has been going on for decades. And when the price falls, guess what -- volume jewellery demand rises.

However, if Lex looks at the money-into-jewellery figure he will see over the longer term that it rises whatever the price of the yellow metal; all that happens is that when the gold price rises sharply, consumers buy fewer items or often simply drop their purchases down a category to lower-gold-carat items. Averaged over a period, they do not spend less money.

So now that we've got that out of the way, what are we actually facing in the gold market today?

The gold price spent most of the summer trading between US$960 and US$740, and primarily in a downward trend from mid-July to early September as the financial crisis slowly but publicly fermented. GATA cried foul and manipulation, and the "great and the good" scoffed at GATA, as they had done for the past 10 years, for daring to think that the authorities intervened in markets, let alone gave the gold market a moment's thought.

Well, several weeks ago as the current financial crisis deepened, a steady recovery for gold set in. Then suddenly a couple of weeks ago the dam burst as Lehman went belly up-and AIG went into meltdown, and in a matter of hours gold had risen $70 and burst back through the $900 level. It was like the good old days of the late 1970s, when Iranian sabre rattling used to unnerve financial markets. Of course in those days the only place the then-tiny band of market cowboys, the derivative spivs, could get some gold action was on the plain-vanilla Winnipeg Commodities Exchange. Back in those days there was, of course, no borrowed central bank gold to play with.

As for the all too often ignored gold mining industry, the long-term gold bears surely know that all is not well. Despite several years of rising prices, production is still trending lower, the great gold fields of South Africa are now in their twilight years unless there is a sensational increase in the gold price (think $2,000 plus), and with aging mines in countries like Australia and stagnation in other major producing countries like the United States and Canada, any hope of an increase in mine output, despite China's progress, is a forlorn one.

Certainly nothing can happen in the short or medium term, since even attractive sizeable projects like Fruta del Norte in Ecuador and Tropicana in Australia are several years away.

The current financial crisis has made it fiendishly difficult to raise "speculative" finance anywhere as the ashen faces of overseas exploration company promoters, seen going around the City of London now that summer is over, so eloquently bespeak. Gold's actual and relative strength against other metals seems to make little difference. If you haven't already raised your money, it's a struggle to do it now.

The other big problem facing gold mines and developers is costs. By the end of this year average costs per ounce across the global gold mining industry are likely to be not far from $500. Add non-mining costs and there is little profit even at current prices for a significant number of gold mines. Once again mighty South Africa is in more pain than most, and in that country there is also the issue of political uncertainty and the fear that the next president (not counting the present caretaker), probably Jacob Zuma of machine-gun fame, will favour unions, which will mean further cost pressures on the labour front. At least any recession in South Africa at this time will probably relieve some of the operating pressure on the mines caused by the power reductions that plagued them for months earlier this year.

One intriguing point in the supply/demand equation that is attracting a lot of attention is the odd situation in the gold coin market. A number of major coin issuers, including the US Mint, are having difficulties getting gold coin blanks, as physical gold seems to be in very short supply. Of course at times like these a purist would find little surprise in this supply problem; after all, when other assets are being trashed, gold comes into its own, and there is quite a trashing going on currently, leading to very high demand for gold coins, a demand being fed by the fact that despite everything the gold price is experiencing high volatility both up and down.

Cynics might see a great irony in this, for though there might be a big squeeze on physical gold, there is clearly a very large supply of so-called paper gold (if that's not an oxymoron) in the market. The supply/demand problem in the US particularly makes one wonder if the US authorities are deliberately slowing Gold Eagle coin sales and pushing the gold price down at the same time to discourage mass switching from bank deposits -- real money (sic) to gold -- that is, real, real money. And if they fail, what might be the chances that they repeat the strategy of the 1930s and ban gold purchases by US citizens?

Of course gold is no longer a central part of the monetary system as it was then, but the "land of the free" is no longer quite what it was either. Can the paper gold tail continue to wag the physically pressured gold dog? It seems unlikely, and when regulators eventually start to examine the entrails of the horrific derivatives smash that we are seeing worldwide, they may well decide that the whole gold derivatives structure needs unpicking.

Who can forget the farce of the late 1999 surge in the gold price, following the central bank agreement to restrict gold sales, which almost caused both Ashanti Gold and Cambior to go under because of their toxic derivative positions? Do we think, almost 10 years since then, that those holding gold derivatives now fully understand what they have committed themselves to? We doubt that the corporate managers and boards have a clue, even if the investment bankers behind the strategies claim that they understand. In these days of increased legal board responsibility, this lack of knowledge is probably as good a reason and incentive for boards to sanction the closing of hedge books as the rising gold price itself.

So where do we go from here?

Many commentators think that as recession forces commodity prices lower and lower, gold will fall in tandem. There is also some confidence that the financial crisis will soon be dealt with and things will return to normal, if slowly, as Western nations, particularly the US, avoid recession and the BRIC countries, particularly China, continue to grow rapidly.

Wishful thinking or calm wisdom? My bet is that gold has further to travel, as does the economic crisis, and that $2,000 per ounce is still achievable.

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