Gold’s fundamentals for 2014

It’s been a pretty torrid end to the year for our magazine’s biggest call of 2013. Gold has tanked and the market seems to be in complete agreement that further falls are all but guaranteed. The summer’s rally died a death and we on the cusp of hitting new 52-week lows. Worse still, the precious metal is set to record its first annual price decline in a decade, much to the chagrin of the ardent bulls. If the talking heads are to be believed, the bull market is finished. Even our editor, Zak Mir, has jumped on the band wagon and enjoyed greatly telling us how wrong the rest of us are here!

So what’s gone wrong?

The flippant answer is there is not enough international demand for gold so the price has fallen. Globally, central banks have pulled out all the stops to underpin failing economies, inflation hasn’t erupted, bond yields are falling and stock markets are stratospheric. Measures of fear are in decline and confidence indicators are on the up. All in all, there is just too much damned Christmas cheer out there for us miserly Gold (bah hum) Bugs. (Note to editor – sorry that is the only Christmas reference in this month’s issue, but I couldn’t resist!).

We go into 2014 riding a wave of optimism. All is well, the nastiness of the last five years is behind us and we can happily go back to the way things were. Crisis well and truly averted!

Great!

Apart from one small fact.

This naive view of the world is wholly misguided. Nothing has been fixed, debt burdens have become ever more intense, serious growth is a distant memory and political deadlock means there is a lack of leadership to confront the vast challenges still facing us, in any meaningful sense.

Of course, this view is not at all popular with the powers that be. Just consider Janet Yellen’s testimony to the Senate Banking Committee earlier in November. Her confident statements about the proactive role the Federal Reserve has taken in leading the US economy through the worst of the crisis won resounding praise. The pity was that these comments weren’t based in any sort of reality. The Federal Reserve’s balance sheet is a toxic $3.9trillion morass and the US Government is wholly reliant on the bond purchasing programme to sustain spending. As I showed in last month’s magazine, over the course of 2013 the Fed has bought more US Treasuries than the US Treasury has issued. This deficit monetisation is a disaster waiting to happen and is a candid admission that the system is broken beyond repair.

But investors don’t seem to care about this. The complacency that is driving indices to new heights is as staggering as it is disturbing. The market is behaving as if the accumulated troubles of the last 15 years have been resolved. This is self-delusion on an epic scale. By welcoming more and more QE from America, Japan, probably from Europe and possibly from Britain, the message is clear. Global investors are saying they believe that a debt crisis can be solved by more debt.

Perhaps the flaws in this logic are too obvious and we are missing something in our assessment of the state of the global financial system and the health of the major OECD nations. Maybe it is true that this time is different and the hard learned economic lessons of the past no longer count…

Uck, I can’t even go on writing that nonsense!

Of course this time isn’t different. It never is and as soon as people start believing such rubbish the likelihood is a rude awakening is around the corner. The market is at its most fickle when people start to believe they’ve conquered it. The turn, when it comes, is usually as savage as it is sudden. Very quickly, market forces remind all those who have forgotten exactly who is in charge. But, to be brutally honest this reasoning applies equally to gold bulls. I could have written most of this piece at any point over the last few years. What was true yesterday is true today, will be true tomorrow and will remain true until the inevitable catastrophic correction occurs. Unfortunately, this helps little in deciding on a trading strategy for 2014, as that conclusion could be a decade or more away.

Why gold could be the trade of 2014

So, leaving to one side the “gold to $5,000/oz” calamity trade, there are increasingly compelling fundamental reasons why gold could be the trade of 2014. The first of these is the most obvious. Everyone is saying it won’t be! Think back three years, as we went into 2011. Everybody was convinced that gold was going to break through $2,000/oz. It was a certainty. It is true that the price made a valiant attempt at scaling those lofty heights, only to be toppled in sight of its goal. The price peaked at $1,913/oz on August 23^rd that year and the trend has been solidly down ever since. Fast forward to today and the situation is not too dissimilar. The consensus is that gold has had it. From taxi drivers to tea ladies, all you hear about is gold’s demise. Even my mother lectured me recently about why I should stay away from gold. Sorry mum, but that’s exactly why I want to be long the yellow metal next year!

Then there are the fundamentals.

On this front we’ve had a recent helping hand from those wonderful people in the global PR department at Goldman Sachs. God bless them. They really are fantastic at their jobs. As soon as one of their analysts pumps out a cleverly contrived recommendation (ahem, which we’re sure their traders don’t take positions on the opposite side of…) about why such and such market is going to collapse/fly to the moon (take your pick!) then it suddenly appears in every single major and reputable financial news outlet the world over. There is a wonderful art to their craft, but as far as contrarian indicators go there really aren’t many that are better than those from the Vampire Squid.

It is quite astounding how willing the likes of Bloomberg, Reuters, the FT, CNBC and the like are to parrot the latest proclamations from Goldman, without the slightest hint of irony. The most recent of these has seen Goldman analyst Jeffrey Currie declare that gold is a “slam dunk” sell and is heading to $1,050 by the end of next year. On this basis alone, I would be amazed to see gold trading at anything less than $1,400/oz by December 31^st 2014, as the latest muppet massacre draws to an end.

On a slightly more serious note there is another factor to consider, which could be highly supportive of prices over 2014; the all in mining costs of the industry. To help me here I draw from some excellent running commentary published on www.seekingalpha.com, by an analyst of Hebba Investments. In a series of articles over the last few years, Hebba have built a convincing model of how much it costs gold mining companies to extract gold from the ground, taking into account all expenditure, including items such as exploration and replacement. You can judge for yourself if you think this analysis is worthwhile, but I am fairly certain that this research has been widely picked up, as I have seen an increasing number of references using figures which bear remarkable similarities to Hebba’s numbers. The latest quarter’s review by Hebba can be found here.

For a quick summary, Hebba’s most recent results are based on the 6 million ounces of gold mined by the largest publicly listed miners, which apparently represents 25% of total global production. Hebba calculated that it cost on average $1,221.75 to mine an ounce of gold in Q2 of 2013. This is the highest quarterly figure they have published and costs continue to increase. The table below gives a breakdown of some of the all-in costs of a selection of the largest listed miners;

With today’s gold price languishing just above the critical $1,221/oz level it is a reasonable bet to assume that plans are in place (if not already being acted upon) to cut supply. There have already been a series of high profile rounds of capital raising by some of the major gold mining companies, which point to the strain the collapse in the gold price has placed on balance sheets. Of course, reducing mining operations is no simple matter, but substantially lower gold prices have been with us for some time now. A widespread reduction in gold mining won’t necessarily have a great impact in driving the price higher immediately, but it could well serve to put in place a floor. If the price does drop much lower (which has to be on the cards, in spite of what I said earlier), this could lead to a flurry of announcements that mines are to be closed. With sentiment as battered as it currently is, investors could quickly wake up to the fundamental strength gold could offer.

The point to take away from this is simple. From late 2008 until fairly recently, gold has been viewed purely as a catastrophe trade. However, the decline in price over the last two years, combined with the increasing cost base for miners (including windfall taxes) strongly suggest that a supply squeeze is likely in the next few years. This will transform gold from being purely a hedge against the world ending to a solid play with solid fundamentals.

We might not have reached a bottom yet in the price of gold, but if I am right in my assessment of the market we might not be very far away from one.

Stay tuned to the blog for more technical analysis on gold over the next month.

Article reproduced from the January edition of Spread Betting eMagazine