Why Gold Mine Supply Has No Bearing on the Price of Gold

Today we have a guest contributor, Robert Blumen.  Robert is a subscriber to The Dollar Vigilante and is a software developer in San Francisco who writes for the Ludwig von Mises Institute, Lew Rockwell.com, and other financial and economics web sites.

Last week we responded to a Globe & Mail article in two separate blog pieces, titled “The Worst Argument Against Gold We’ve Ever Heard” Part I & II.

We pointed out many errors and misunderstandings of the gold market by the writer but today Robert Blumen wrote in to expand on another area in which the writer was wrong.  Below, Robert Blumen explains more:

Hello Ed and Jeff,

I read with great interest your update last week about the Kanadian fund manager who is bearish on gold — bearish for all of the wrong reasons.  In addition to the points you made in your follow up, it should also be pointed out that like most analysts and writers, he totally misunderstands how the gold price is formed.

While the author is correct that “gold must obey the law of supply and demand”, his explanation of how the law works is fatally flawed.   The supply and demand numbers presented in the article are meaningless and tell us nothing about the future direction of the gold price.  

The key to understanding the gold price is that gold trades as an asset, not a commodity.   A commodity is a good that is purchased in order to be permanently removed from the market (usually destroyed), while an asset is a good that is purchased in order to be held.  

The most important consequence of peoples’ desire to hold an asset is that the accumulated stockpiles of the good exceed the annual production volumes by a large margin.   In the case of gold the ratio of the world’s holdings of gold to annual mine supply is about 65:1 while for most other commodities it is less than 1:1, i.e. there is less than one year’s total production in above-ground stocks for most commodities.

Let’s delve more deeply into how this difference affects the fundamentals of each type of asset.   For a given commodity, everything that is produced is sold; everything that is sold is purchased; and everything that is purchased is consumed.  For the moment, let’s idealize the situation a bit by assuming that there are no above-ground stockpiles of this commodity at all.   Under the circumstances, then, we can say that the amount of the commodity that is traded is both the total supply and total demand.    Another way to say this is that every time a commodity is traded, we can assume that the supply of the commodity decreases by that amount (because the purchaser will take it permanently off the market).

Now consider the situation for gold, or for any asset (such as shares of your favorite mining stock).   Because so much of the asset already exists and so little is produced most of the trading takes place among individual shifting their existing stock piles back and forth.    In an asset market, the simple relationship between the quantities produced,  supplied, demanded, and consumed breaks down.   For gold, the quantity consumed is effectively zero because gold is either held in investable form (bars and coins) or as jewelry.   

The size of existing stockpiles of gold and the large trading volume makes the mine supply more or less a non-factor in determining the gold price.   Far more important is the price at which existing sellers are willing to part with their ounces.    As traders swap their ounces for fiat money and vice versa — unlike a commodity — the total supply of gold remains the same.    All that has happened is that gold moves from one person’s stockpile to someone else’s.

To quantify the impact of mine supply on the market I have (elsewhere) estimated the trading volume on the London Bullion Market Association (LBMA).  The LBMA can absorb an entire year’s mine output in about six trading days.  And consider that the LBMA is only one of several investor bar markets worldwide,  and that the investment market as a whole includes the coin market as well.   While I do not have a precise number, I estimate that an entire year’s worth of mine production turns over in the physical market in several days.

For a commodity, increases or decreases in the quantity produced can have a dramatic effect on the price because the quantity consumed must move either up or down along with the quantity produced.   Because there are no stockpiles to buffer the difference between production and consumption, the only way for them to come into balance is through price.   But for an asset, things work differently.  An asset is not consumed, it is only traded.  While the supply of an asset may increase, so long as the increases are small compared to the existing stockpiles, most trading consists of the change of ownership of existing stocks.   These purchases and sales can take place at any price, and the price is not dependent on the volume traded.

The author of the Globe and Mail article, David Berman, states “the underlying fundamentals are now looking distinctly negative for the metal’s long-term prospects.”

However, his explanation shows a deep misunderstanding of the gold market.  With the above background,  we can begin to address the errors.

The first error is that he looks at the market only on an annual basis:

“According to GFMS, the London-based precious metals consultancy, global jewellery purchases plunged to 1,759 tonnes last year from more than 3,000 tonnes at the start of the decade, as the rising price of gold turned off consumers and jewellery makers cut back on gold content.”

The entire gold market is a single integrated market with one price.  There is not one market with one price for gold produced this year and another market selling at a different price where existing stockpiles of gold are traded.   Looking at gold on an annual basis gives the appearance that the supply – and therefore the demand – are highly variable.  If the supply goes from 1759 to 3000 over a few years, then demand must also nearly double, otherwise the price would plunge, right?  Well, no.   The supply of gold is not 1759 or 3000 tonnes, it is about 150M tonnes – the total world supply of gold.  And what about demand?  The demand is also 150M tonnes, exactly equal to the supply.  And the supply has not doubled over the last few years, it has grown modestly by about 1-2% each year.

For a commodity, the demand consists of off-take from the market for destruction.  An asset, on the other hand, is not destroyed; it is acquired in order to be held.  The demand for an asset consists of what economists call reservation demand, meaning that investors demand an asset by holding it off the market while the price is below their selling price.   Demand for gold has not and does not need to double to keep pace with mine supply.  As the supply grows by about 1% each year, reservation demand must only grow by the same amount in order to keep the market in balance.

Here is where we get into the meat of Berman’s case for the bearish gold supply fundamentals:

“At the same time as demand is falling, gold supply is rising. Most central banks, for instance, are jettisoning their gold holdings. According to the World Gold Council, total gold holdings were about 30,600 tonnes in December, down nearly 2,900 tonnes since the start of the decade – and these overall declines take into account an increase in gold holdings by China’s central bank… Adding to supply is ramped-up production from mines. This rose to a four-year high of 2,572 tonnes in 2009. In addition, consumers are now happily mailing in their “scrap” gold jewellery to the host of gold-dealing companies that have sprouted up in recent years. Add in this recycled gold and total world supply hit 4,034 tonnes last year, the highest level in at least a decade.”

Correction, Mr. Berman: a seller selling gold is not an increase in supply.  It is only a transfer of existing supply from one owner to another.   It does not matter whether this seller is a central bank or someone melting scrap.

Is central bank selling a huge bearish indicator?  3,000 tonnes per year is about annual mine supply.  This is, as noted above, a few trading days’ volume.  If there are no buyers near the market price, then it could be bearish, but not nearly as bearish as it sounds when you consider that the total supply of gold is 150,000 tonnes – 50 to 100 years annual production.

The real influence on the price is not possible to quantify.  Once the gold changes hands, the price depends on the reservation price of the new buyers, which could be higher than that of the recent seller.

Berman also misunderstands the relationship between investment products and jewelry:

“Unlike most commodities, gold isn’t consumed in high quantities. Industrial uses account for only about 10 per cent of total demand, which is why jewellery makers have traditionally provided most of the market for the metal.  However, global demand for gold jewellery has been in steady decline, replaced only by demand from fickle investors – a shift that could have a disastrous impact on the price of gold if those buyers turn squeamish.”

And:

“Of course, gold is still in high demand. But the source of this demand is now investors, who have become gold’s biggest buyers for the first time in about 30 years. These buyers have no uses for gold, other than the hope of selling it to someone else at a higher price somewhere down the road.”

In reality, investment and jewelry are not so different.  They are two different ways of holding gold.  In either form, the gold is not destroyed.  The boundary between them is somewhat fluid based on the relative intensity of investment demand versus jewelry demand. As gold becomes more in demand by investors demanding bars and coins, the opportunity cost of using it for jewelry increases. At the margin, more people will sell back unwanted jewelry as scrap and (also at the margin) more buyers will substitute silver or other metals for gold. If the investment demand fell, then at the margin people would hold onto more of their family jewelry and use more gold in new jewelry fabrication.  What Berman describes as a fall in demand is only a natural shift between different ways of holding gold as investor valuations change.

Can we analyze the price of gold by looking at supply and demand?  While that should work for a commodity, it does not work for an asset.   The reason is that supply and demand for an asset in quantitative terms doesn’t change (much).  The supply is what it is and the reservation demand is equal to the supply.  We cannot use the trading volume as a measure of supply and demand because the price at which the existing supply changes hands does not depend on the trading volume: the price can rise, fall, or go sideways on increasing, or decreasing volume.   The deep confusion exhibited by writers and analysts on this issue contributes to a lack of understanding by investors.?

Thank you very much Robert for providing some excellent information and analysis on how to value gold.

 

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