Is Gold Making a Comeback?

Gold and leading gold ETF SPDR Gold (NYSEMKT: GLD) have recently rallied, but they haven’t performed well during most of the year: During 2013, the price of gold declined by 23%; the price of GLD fell by 22.9%. Moreover, GLD’s gold hoards plummeted by more than 30%.

Is gold making a comeback? Is time to reconsider investing in this precious metal or gold companies?

One of the main concerns for investors who purchase an ETF that follows a certain commodity is the Contango/Backwardation in the future contracts that could lead to decay and thus slash the profits of investors who purchased these ETFs in case the commodity rose during the period. The chart below shows the normalized prices of gold and t GLD during the past year.

GOLD AND GOLD 2013As seen, the two data sets are closely linked and in sync during the period. This means, GLD didn’t experience roll decay. For a good explanation of ETF decay you can check out on Fool’s site.   

One factor that could determine the future course of gold is the Fed’s next move.

Will the FOMC ease its asset purchase program?

During the year (up to date) the Federal Reserve has been purchasing $85 billion of mortgage backed securities and long term securities treasury bills. This program kept long term interest rate from rising at the beginning of the year but in recent months long term interest rates have sharply increased. One reason for the sharp rise in rates is the strong hints the FOMC and Ben Bernanke provided: Bernanke hinted the Fed may taper its asset purchase program in the coming months and end it by the first half of 2014. How does this relate to gold prices?

  • The asset purchase program augments the U.S money base, which raises the concerns for inflation. Gold is still considered by many as a safe haven investment against inflation.
  • Long term treasury yields and gold tend to be correlated. The drop in long term treasury yields led to a rise in demand for gold as stipulated from Hotelling model. Paul Krugman explains this relation on his blog. If the Fed will slow down its asset purchase program the long term interest rates will continue to pull up, which may pressure down gold price. The chart below shows the developments of the long term treasuries yields and price of gold in the past couple of years. As seen, the price of gold tumbled down in the past month while long term treasuries yields sharply rose.

GOld jULY  2013 

  • The asset purchase program may have pressured down the US dollar against leading currencies, which could have also kept the price of gold from falling.

But the Fed continues to provide different perspectives regarding its next move. Therefore the high uncertainty with respect to the FOMC’s monetary policy is likely to keep the volatility of gold price high in the coming months.

Looking further into the future, however, the ongoing progress of the U.S economy and forthcoming changes in the Fed’s monetary policy, the price of gold is likely to resume its downward trend in the near future.  But the U.S isn’t the only one that affects the price of gold. Let’s turn east.

China and India

Despite the recent developments in the U.S, the demand for gold (the physical metal) continues to rise: China’s imports of gold are rising; the tax hike on gold imports in India has curbed the demand for gold in this country, but overall during the year so far India’s demand for gold is much higher than last year. Moreover, the recent pull back in the price of gold is likely to grow the demand for gold in these countries. The strong demand for gold is likely to keep the price of gold from tumbling further down.

Gold producers

The recent drop in the price of gold is likely to substantially slash the profit margins of gold companies. Gold producers such as Newmont Mining (NYSE:NEM) and Yamana Gold (NYSE: AUY) haven’t done well in the stock market during 2013– despite their recent rally in the stock market. During the year, shares of Newmont Mining plummeted by 38%. The stock price of Yamana Gold plunged by 39%. One factor that will determine these companies’ profit margin is the cost of producing gold.

Cost of production

The direct cost of production for these companies is expected to rise in 2013 compared to 2012. Specifically, Newmont estimates it all-in sustaining cost of production per ounce of gold will range between $1,100 and $1,200 during 2013. The company projects its total gold production will range between 4.8 and 5.1 million ounces, which isn’t far from the total production recorded in 2012 – 4.98 million ounces. Moreover, at the current pace the company’s gold production in 2013 might even be below 4.8 million ounces. Since the current price of gold is roughly $1,300 per ounce, the company is likely to further slash its production.

Newmont has already taken measures to cut down on operational expenses: The Company has recently announced it will cut by one third its workforce in Colorado.

For Yamana Gold the production cost is lower: The Company estimates its all-in sustaining cost of production per ounce of gold will reach $800 in 2013. Such a low cost of production should be reflected in the company’s profit margin: In the first quarter of 2013, Yamana’s operating profit was 30%, which was higher than Newmont’s profit margin of 26.5%. Yamana also estimates its gold production will rise by 20% in 2013 compared to 2012. This means, Yamana may not suffer as much as Newmont will in 2013.

Nonetheless, if the price of gold will dwindle below $1,000 these companies might start losing money and thus might be better off not extracting gold.

Take away

The recent rally of gold might continue in the near future, but I still think that neither gold nor gold producers are about the make a comeback. Moreover, if the price of gold will resume its downward trend and fall below $1,000, gold companies could start losing money and might be better off leaving the precious metal underground.

 

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