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Peak Gold?

December 15, 2009

Analysis of the economics of gold price formation by the financial media is nearly all wrong. The majority of articles and research reports obsess about mine supply, as if it mattered (which it doesn’t see 1 and 2). There are additional pointless discussions about whether the gold industry is in a phony deficit or surplus (neither).

A variant of this fallacy is forecasting the gold gold price by looking at its cost of production. We know as Austrians that costs do not determine price. While it is true that a positive differential between the price of gold and the cost of operating current mines results in profits for gold miners, the market adjustment to eliminate this differential takes place mostly through a rising cost, rather than a falling price. The mining industry would surely respond to profit opportunities by producing lower-grade deposits with a higher cost per ounce, but this will not increase the total supply of gold by much because marginal costs rise so dramatically with increasing supply. Even if twice as much gold could be mined at a cost of $1000/ounce than at a cost of $500/ounce, this would only increase the growth rate of current supply from 1.5% annually to 3%.

Another bogus concept is “peak gold”. This is meant to be an analogy with peak oil. I am not taking a position here on peak oil, but the concept of peak oil is not obviously flawed the way that peak gold is. There is a structural difference between the gold market and the oil market: all of the gold ever mined still exists, while most oil is burned shortly after it is extracted. This means that the price of oil must balance the quantity extracted with the quantity consumed over a relatively short time frame. In the gold market, the vast majority of gold supply is already above-ground; the market is dominated by supply and the demand-to-hold existing stock. Mine supply is a minor factor because it is small in relation to the existing stock. If mine output were to decline each year, the total supply of gold would still continue to increase, at a slower rate, maybe 1%/year instead of 1.5%/year.

I have been pleased to see in recent weeks two articles expressing a correct understanding of this issue:In the Lex Column of the Financial Times titled Peak Gold?, the unsigned author makes the great point that increasing demand-to-hold the metal is met through a rising price, rather than increasing supply.

[peak gold] is absurd. Rising prices or faltering mines do not equal scarcity. Indeed, even investment “demand” is mitigated by price as one need only buy a fourth as much of it as a decade ago to keep actual physical purchases constant. It is not really demand in the same sense as other finite commodities because gold is almost always just being held in order that it might later be sold, to a greater fool, at a profit.

Contrast this with oil. Every year, over four times as much gold is mined and over twice as much recycled as is actually needed by industry, while annual crude supply more or less equals demand for oil. Global oil stockpiles would satisfy just 48 days of crude demand, while the 163,000 tonnes of gold that the World Gold Council estimates are above ground would last 375 years, or nearly 3,000 times longer.

Even this figure is hypothetical since if gold really were to become scarce it would cease to be used in some applications, with industrial demand shifting instead to other materials, just as the 1970s price surge led to porcelain’s ascendance in dentistry.

Secondly, the always insightful John Hathaway, in A Contrarian’s Dilemma

The supply of gold increases at a far slower rate than that of paper money. Each year, the gold
mining industry produces around 2500 metric tonnes of the metal. This quantity adds a puny 1%
or 2% to the above ground supply of 163,000 or so metric tonnes. There is little to suggest that
this grudging pace is likely to change in the foreseeable future. Unlike economically sensitive
commodities, to which it is frequently and incorrectly linked, gold does not get used up.
Therefore, traditional supply and demand analysis does little to explain price movement. It is
better to think of gold as a multi trillion dollar capital market asset. In theory, all of it (at least
that which is held as investment or quasi investment) is potentially for sale at any given time.
Price behavior is best explained by macroeconomic considerations and the greater investment
climate rather than micro economic considerations such as mine expansions or jewelry
consumption.

Update 1 (12/15/09 3:15 PM PST): What I meant by the concept of “peak gold” being obviously flawed is not to deny that gold production could have peaked. While I don’t have a point of view on that issue, what I was trying to get across is that the relationship between peak gold and the gold price is nothing like the relationship between peak oil and the oil price. Because oil is burned, if less of it is extracted, then the price must rise to allocate the remaining amount. The existence of peak oil would imply a higher oil price. Not so with peak gold. As long as gold is being mined, the total supply of gold will continue to grow at a faster, or slower rate. All things being equal, an increasing supply of gold would imply a lower gold price.

Update 2 (12/15/09 4:00 PM PST): Thank you Robert Newson for providing a link in the comments section to Steve Saville’s excellent article on this topic. I had read this article and planned to include it in my blog post but forgot. Make that three articles now in the past month that are starting to break down the massive tidal wave of bad information on this topic. Or even four if you count the article that Saville quotes in his piece. Disclosure: I know Steve Saville. He and I discussed this topic prior to writing our respective articles. Steve’s comments helped me clarify my own thoughts and presentation.

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