Does Gold Have a Silver Lining?

The gold market has cooled down in the past year. The sharp fall in the price of gold has reflected in the prices of gold ETFs such as SPDR Gold (NYSEMKT: GLD) and iShares Gold Trust (NYSEMKT: IAU). Will the gold market recover from its recent tumble? Do gold investors have a silver lining? Let’s examine the recent developments in the gold market in order to determine where the gold market is heading next.

Demand for gold – physical demand

The two major countries that lead the demand for gold (demand for the physical metal) are China and India. Both countries account for nearly 46% of the global demand of gold. Nonetheless, during the third-quarter, India’s demand for gold plummeted by 32% due to the government’s decision to raise import taxes in an attempt to reduce the demand for gold. Moreover, the weak Rupee against the US dollar has also curbed down the demand for gold in India.

Conversely, China’s demand for gold continues to grow mainly for jewellery. In the third-quarter, the demand grew by 19%, year over year.  This trend is likely to keep gold price from tumbling further.

Besides the demand for the physical metal, gold also serves an investment.

Demand for gold – investment  

Despite the potential positive effect the physical demand may have had on gold price, the main issue remains the demand for gold for investment purposes. This factor is still the main driving force behind the progress of gold price.

According to SPDR Gold, the world largest gold ETF, fourth-quarter earnings report, the demand for gold for investment purposes have peaked in 2011. In 2012, the global demand for gold for investment purposes fell to 2010 levels. The current estimates are that the demand in this segment won’t be much different in 2013 than in 2012.

Gold ETFs have also had a drop in demand.  In the past year, gold ETFs such as SPDR Gold and iShares Gold Trust have experienced a sharp drop not only in their prices but also in the amount of gold they have held. During 2013, up to date, these ETFs’ prices lost nearly 28% of their value. Moreover, SPDR Gold’s holdings have plummeted by nearly 40% during the year. iShares Gold Trust lost nearly 25% of its gold holdings.  These findings serve as additional indications for softer demand for gold as investment.  Based on the above, is the demand for gold for investment purposes continue to weaken?

The recent decision of the FOMC to start tapering its asset purchase program might have reduced the price of gold. But this mini-taper isn’t likely to have a strong effect on the prices of precious metals. The chart below shows the developments in the price of gold and the U.S money base in the past several years.

gold money base 2013Source: Federal Reserve and Bloomberg 

As you can see, the price of gold sharply rose during the era of quantitative easing 1 and 2. But quantitative easing 3 seems to have had little effect on the price of gold. This finding suggests the price of gold wasn’t strongly affected by QE3 so that a slower asset purchase program won’t have such a strong adverse effect on gold. Let’s turn to supply side and see how the recent developments in this segment could affect gold prices.

Will production decline?

From the supply side, the main concern is the potential slowdown in the amount of gold produced. If gold production falls, this could tighten the precious metals market. One reason for a lower volume of gold production is the decline of precious metals companies’ profit margins due to higher production costs and lower gold prices. Leading companies such as Barrick Gold (NYSE: ABX) and Newmont Mining (NYSE:NEM) have had a sharp drop in their profitability: In the third-quarter, Barrick’s profitability fell from 34% in 2012 to 29.6% in 2013. Barrick is also looking into ways to cut down its production and delay future projects: A few months ago the company announced it will suspend construction activities at the Pascua-Lama mine except those required for environmental protection and regulatory compliance, which will prolong the completion date by one year to the end of 2016. Such a decision was made partly due to higher operation costs, economic conditions and much lower gold price. Moreover, Barrick’s capital expenditure is expected to drop by up to $1 billion in 2014. These steps are likely to reduce the company’s costs but could also cut down its future production.

Newmont Mining’s profitability also fell during the third-quarter from 29% in 2012 to 16% in 2013. The company’s gold production remained nearly unchanged in the past year: In 2012 the gold production reached 4.978 million ounces; in 2013, the current estimate is at 4.95 million  ounces. Nonetheless, during the third-quarter, the company’s capital expenditures have declined. If this trend persists, this could also suggest little to no growth in gold production in the coming years.

If gold producers keep cutting down their production, it could tighten the gold market.

Bottom line

The gold market isn’t likely to recover from its recent tumble anytime soon. Nonetheless, gold investors can still hold on to the strong demand for the physical metal in Asia – mainly China. This could keep gold price from plummeting further. Moreover, the recent FOMC decision to taper QE3 isn’t likely to have a long term adverse effect on the price of gold. Finally, gold miners might start to cut down their gold production, which could eventually reduce the supply of gold.

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Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.