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.
{ 25 comments }
I just finished an econometric analysis for my undergraduate econometrics class. Using the USD price of gold since 1971, I proved pretty soundly that mine yields, in year t, year t-1, etc. have no significant effect on the change in gold price. Of course, we already know this, but the mainstream economists I have for teachers keep demanding that I ‘prove’ perfectly logical theoretical conclusions with empirical evidence which may be unsound, by using econometric methods which are error prone and highly subjective.
In either case, gold is probably more like a capital market. It’s definitely NOT a consumption good market, and merits NO comparison to oil.
Very nice comment Thomas, you should blog.
In this post I’m looking at the usual and less usual metrics for assessing the current valuation of the dollar price of gold
http://raphaelkahan.blogspot.com/2009/12/gold-is-this-bubble-yet.html
Thomas, I am just wondering if one can think of gold’s value as a hedge against default? I am starting to notice that gold is reacting positively upwards when there is a higher risk of default (Dubai for instance) and it drops when percieved default risk abates. That was certainly true for the US dollar. It was always seen as the ultimate safe haven. But when Dubai World announced that it would miss some payments the gold price in US dollars went up much more than the US dollar index did.
Thanks for the article on peak gold. Peak Gold is constructed from the same type of scientism as most other economic fallacies debunked by von Mises. Esp. useful with regards to the current Chicken Little mentality (Peak This, Peak That) are the inimitable works of Julian Simon (The Ultimate Resource II) and the studies by Theodore Modis. I can’t complain though, sales of my Chicken Little Hard Hats with the THC patch are up even in these tough economic times.
http://www.panamericansilver.com/silvermarket/documents/WorldSilverSurvey2008Summary.pdf
the above link (not sure if its is legitimate) says silvers largest demand sector is something called ‘industrial offtake’. whatever. i assume that means industrial usage. – but i am not sure if such usage uses up the silver or not basically creating a consumption good.
demand for coins (capital good/market?) was only 4% while indsutrial use was well over 50%.
gold may operate differently.
the link also mentions a 4% increase from 06 to 07 in mine production and a 16% price increase.
Scott T:
The the silver market is quite different from the gold market. Silver is primarily an industrial metal with some investment demand, while gold is the opposite. The supply/demand model based on mine production is a better model of the silver market than of the gold market, but there is more demand-to-hold silver than most commodities, other than gold.
Robert
“one need only buy a fourth as much of it as a decade ago to keep actual physical purchases constant”
WHAT? I can’t figure this out to save my life!
N. Joseph Potts:
What I think that Lex was trying to say is that over the time period, the price of gold is up by about four-fold, so you can buy one quarter as many ounces to make the same purchase in value terms. Or something like that.
Peak oil is also nonsense. We have still not even used 10% of the KNOWN reserves on earth, counting shale. Yet even if we were on our way to using it up, prices would simply adjust to new market data;
-prices would increase, sparking a search for new reserves in the many places we have not looked; alternative energies would become more profitable for PROFIT SEEKING businesses; demand for fuel efficient cars, housing insulation, etc.. would increase.
-Because of this irrational argument, we waste money in unprofitable investments that no logical entrepreneur would undergo..because they end up like this debacle http://www.nytimes.com/2009/11/27/business/energy-environment/27ethanol.html?_r=2&ref=business
Not meaning to rain on your parade, Sean A, but I’m afraid no PROFIT SEEKING business and no economic process whatsoever is able to reverse the unstoppable exhaustion of easily accessible energy forms. You say prices would adjust? How about crude prices rising 100-fold due to evident speculation on the downward slope of the peak oil? How do you think US economy would function if it would have to pay 300% GDP for fuels? Seems pretty impossible, eh? So then it would have to radically curb oil consumption, right? All-rightey, how about cutting 1/2 population from transportation? How about cutting 99% of the medicines? Prices would fix this? I DON’T think so, go figure aspirin costing you half of your monthly income, would change priorities, eh? How about mass depopulation? How exactly would economy and free market fix it?
No amount of economic adjustment and optimization, as wonderful as it is, is able to overcome fundamental limits to energy availability. As of the coming 50 years (maybe 100, if we are really lucky and do a good use of the remaining coal and both coal and uranium deposits actually are as good as advertised), nothing short of nuclear fusion is going to save us from an energy crunch, a crisis that would make “the panic of 2008″ with its bankruptcies and turmoil, or even the GD with its mass unemployment, hunger, impoverishment and despair seem like a VERY enviable past.
steve saville comes to a similar conclusion about this mindless obsession with mine supply:
http://safehaven.com/article-14980.htm
mind you, he’s well-versed in austrian economics.
I’ve read Saville’s piece and disagree with him. Mine supply should be (and is) a long-run factor in pricing, even if it only represents 1.4 pct of total gold available. In theory (and fact) the cost of producing new ounces for the market should (and does) influence the floor market price. Think of the market without any outlet to obtain new ounces other than those held by central banks or available from a limited number of wealthy individuals. What a fiasco that would be!
Ed Boyle, Jr:
“Think of the market without any outlet to obtain new ounces other than those held by central banks or available from a limited number of wealthy individuals. What a fiasco that would be!”
I’m not clear what problem you are alluding to. Because of the small amount of gold mined in relation to trading volumes, most gold bought and sold on the market is not from miners, and yet gold is one of the most liquid traded assets in the world. It can be purchased on three continents on a 24×5 basis. The world we live in today is a world in which nearly all of the gold in the market is not sold by miners. As I point out in my article, they have little impact on the price because they are basically price takers, selling at a price determined by the other gold owners who choose not to sell.
I’m also not clear what is the problem with central banks being sellers of gold. Are you worried about a lack of liquidity? Over past years, central banks have sold thousands of tons. They have been a provider of liquidity.
Also not clear what is the point about wealthy individuals. Gold ownership is quite broadly distributed through out the world. In the US, anyway, I doubt that wealthy people own much gold since it is culturally considered an oddball tin-foil hat kind of thing here. I’m not sure about other countries but I suspect that in Asia it is more common for wealthy people to own some gold. What does it matter whether buyers or sellers are wealthy or middle-class?
What’s wrong with saying Peak Gold refers to the fact that gold is becoming increasingly harder to mine to the point it’s no longer worth mining? This means the amount of active gold is fixed and can go up in price. This would be good news for the holders of gold.
to gil:
absolute prices are not what motivate businessmen. it’s all about margins.
The key point is that the gold mined is very small. Even with increased production, lead times are large between exploration and production. In some cases new metallurgical processing will be needed. The net result is that nobody is going to able to “pull a FED” and increase the supply of gold by 25% over the course of a year.
Question for Robert
It appears that the prices for various type of gold (Maple Leafs, Krugerrands, Englehart) has converged. This would indicate gold is now trading like a currency. What is your opinion on this?
Thanks – Walt
“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.
So gold is for fools? Like those foolish Zimbabwe citizens panning for what?… foolish gold to keep from starving to death!
The reason gold is categorized as a precious metal has to do with both the supply and the demand. Gold is always in demand to some extent. In good times the supply is ample.
When global currencies crash or a crash is feared the demand for gold will far exceed the supply. Then all the non-fools will be out of luck but the fools should do quite well.
Intelligent and Civil!
Panika,
You offer a lot of words without any counter argument.
“You say prices would adjust? How about crude prices rising 100-fold due to evident speculation on the downward slope of the peak oil? How do you think US economy would function if it would have to pay 300% GDP for fuels?â€
Disregarding your completely arbitrary figures, prices are not only the best, but the only way for intelligent investment. What is your alternative? government investment in arbitrary quantities in what’s currently fashionable amongst scientists wanting subsidies, but not necessarily practical—e.g. ethanol. If prices rise “300%†fuel alternatives become a much better investment and will be in much higher demand.
“How exactly would economy and free market fix it?â€
Again, investments tend to be more responsible, more efficient, and better directed when the investor is using his own money—i.e. is subject to profit and loss. I don’t know if you caught my point about the debacle in ethanol, but it is a pretty serious blunder from an unaccountable investor. I suggest reading the link i posted in my first comment.
“How about cutting 99% of the medicines? Prices would fix this? I DON’T think so, go figure aspirin costing you half of your monthly income, would change priorities, eh? How about mass depopulation? ”
–Umm..What? All markets can do is adjust to the data they’re given. If some despot began exterminating civilians or cut 99% of medicines, yes it would be nearly impossible to maintain a market; but an external institutional destruction of the market for, say, medicine does not present a case for market failure. If hypothetically 99% of medicines were lost in a ship sunken in a storm, the market is the only way of appropriately allocating the remaining supply in any non-arbitrary manner. And it does this through prices.
“nothing short of nuclear fusion is going to save us from an energy crunch, a crisis that would make “the panic of 2008″ with its bankruptcies and turmoil, or even the GD with its mass unemployment, hunger, impoverishment and despair seem like a VERY enviable past.â€
This would fall into that alternative energy category I spoke of. Unless you’d prefer to nationalize the energy industry…then, well just read some LVM please.
Where do you get such optimistic views on Peak Oil Sean A?
“If the price of oil goes up then the alternatives will look more attractive.”
Gee, I’m sure many would consider riding a pushbike to work or walking to the local store to get the daily newspaper and a bottle of milk if they had to pay double or more at the fuel pump. Farmers would probably consider using horses to plough the soil if the fuel prices went way up too. Then again isn’t it the Libertarians who mock the electric car, solar panels and wind farms?
Gold is a commodity. It is also unique commodity, because it is NOT consumed like oil. As Blumen correctly points out: “Analysis of the economics of gold price formation by the financial media is nearly all wrong.”. Nevertheless, I still don’t think the mechanics of the economics of gold price formation has been clearly identified. (Some people get close by recognizing the value of gold as a hedge.)
I suggest that the gold price formation is based on the perceived value of the underlying currency. That is, the price of gold is NOT changing but the perceived value of the underlying currency has gone either up or down. (This applies to all commodities to a degree.)
Gorden Liddy is running TV advertisements promoting the purchase of gold that unintentionally “proves” what I am saying. He holds up a bar of gold and a very small dollar bill. The size of the gold bar is the same, but the dollar has shrunk in size (value).
Gil:
“What’s wrong with saying Peak Gold refers to the fact that gold is becoming increasingly harder to mine to the point it’s no longer worth mining? This means the amount of active gold is fixed and can go up in price. This would be good news for the holders of gold.”
You make a valid point that it could become sufficiently difficult to find and mine gold that the volume mined would decrease year over year. I don’t think that I explained very clearly in my blog post what I meant. I added up update in which I tried to explain this better. What I meant is that the impact of peak gold on the gold price would be minimal, while the impact of peak oil on the oil price would be substantial. So the analogy to peak oil does not work.
Walt D:
“It appears that the prices for various type of gold (Maple Leafs, Krugerrands, Englehart) has converged. This would indicate gold is now trading like a currency. What is your opinion on this?
Thanks – Walt”
I’m not sure that I understand the question. I would expect that the gold bullion coins would trade at approximately their bullion value, plus a small premium to reflect manufacturing costs. In some cases there has been a scarcity of coins in relation to bars, so coins have traded at a premium. This can happen because small investors may have the funds to purchase coins but may not have the funds to purchase bars; or for other reasons may prefer coins over bars sufficiently that they are willing to pay a premium.
But I’m not sure how you get from this to “trading like a currency”. In what respect do you mean that? Gold always to some extent trades like a currency.
http://www.gold.org/deliver.php?file=/value/stats/statistics/pdf/Demand_Tonnes.pdf
the above link (if true) states that jewelry by far outpaces any other use for gold. perhaps the jewelry gold is just a more desireable way of keeping gold (as a hedge??) as opposed to coins sitting somewhere ( i dont think too many are circulated now – apparently krugerrands a best suited for this role) .
of the 3800 tons mined in 2008 2100+ tons went to jewelery – a form of investment i guess?…only 460 tons went to perhaps the somewhat difficult to recover-gold in industry.
so what exactly is golds real market? it doenst operate as a circulating money to a large degree and has a small (but in some cases necessary )industrial role yet people hold it it by the ton??
is it truly then (for the large part) seen as a hedge against currency denominated investments??
Scott T:
The World Gold Council follows the flawed annual supply and demand methodology. The question is not what happened during any given year but how to characterize the holdings of all existing gold.
In my article on The Myth of the Gold Supply Deficit, I cite statistics indicating that about half of total gold holdings are jewelry, with about 60% of the jewelry holdings classified as bullion jewelry and 40% ornamental. If you add the investment holdings and bullion jewelry, you get 80% of total holdings comprising investment demand. Even the 20% ornamental jewelry is not in the strict sense “consumed” because it can come back to the market and some times does. Most people would not sell their wedding ring but many people do inherit their parents’ or grandparents’ jewelry that is out of style or has no sentimental value to them.
Robert: As an old mining analyst, my thoughts always revolve around what is best for the mining industry (not very popular anymore). I was trying to postulate a future scenario where there was no more gold mining industry..zilch. Let’s say it occurs at $3,000/ oz. The only available gold is now (probably) in the hands of either central banks (which is actually the people’s gold..the bankers seem to have forgotten that, but that’s another issue) or the people who could afford it at $3,000, which would be mostly wealthier people. I’m just saying that, in my opinion, having a viable gold mining industry providing new ounces..however small in relation to the overall hoard…is important and shouldn’t be ignored to the point of running it down needlessly or, worse, ignoring it.
Aneutronic nuclear fusion can increase the energy availability.
http://www.crossfirefusor.com/nuclear-fusion-reactor/overview.html
Comments on this entry are closed.