The Goldwatcher

The gold price had been caught in a 20-year bear market when Gordon Brown decided to sell off 400 tons of Britain's gold reserves at rock-bottom prices. That more or less marked the bottom of the ferocious bear market. But that's just the way markets behave. Bear and bull markets do not usually end without a 'grand finale'. In 1979 and the beginning of 1980, the gold price was in bubble territory as almost any news at the time was interpreted as a reason to buy gold. There was a similar bubble in the oil market during the first half of 2008 when exaxctly the same thing happened and any news was viewed as a reason to buy oil. Energy specialists were trying to outsmart each other by predicting a $200, $300 or even higher oil price in a not so distant future. After all, when the oil price is hovering around $140 and you want to make the headlines, you'd better not come up with a boring price target of say $150.

But back to gold. Since the 'Gordon Brown moment' the gold price has been in a lively bull market and a terrific investment over the past 12 years. This makes it even more amazing that gold is still being viewed by many as 'something that does't pay a dividend, so why on earth should I buy it'. We have all heard a countless number of 'experts' during the past decade predicting the imminent collapse of gold and as long as we keep hearing this on a regular basis, I guess we shouldn't worry too much. Bull markets like to climb a wall of worry, shaking off as many participants as possible along the way. The gold price topped out in August/September of last year and since then gold has basically been consolidating in a $1500-$1900 range. This makes it probably a good time to share some thoughts from the book "The Goldwatcher" by John Katz and Frank Holmes, which I read some time ago.

The book covers most if not all aspects of the gold market, including many gold statistics and a complete chart book at the end. One of the chapters discusses 'the rise and fall of the Gold Standard' and it's definitely worthwile to get some historical perspective on what happened when the gold price spiked in January 1980 to above $850. Here it goes. In 1980 US President Jimmy Carter was in his last year of office, unpopular and unlikely to be re-elected. Inflation was out of control. There were serious geopolitical tensions as well. The Soviet Union was invading Afghanistan. In January 1979 the pro-American Shah had been forced to flee Iran. In Februar Ayatollah Khomeini returned from exile. On 1 April Iran declared itself an Islamic Republic. Within a year of the Iranian revolution fuel shortages were experienced and crude oil prices surged from $15 to almost $60 a barrel. On 4 November militant Islamic students demanded the extradition of the Shah from the US where he was being treated for cancer to stand trial in Iran, stormed the US embassy in Teheran and held more than 90 people hostage. Iran's revolutionary guards and the police did nothing to stop the embassy siege. Iranian television indicated support by broadcasting live pictures. Ayatollah Khomeini also voiced his support. In April 1980, a US mission to rescue the hostages failed. The embassy hostage siege lasted 444 days and only ended in Januari 1981. As mentioned earlier, the gold price had peaked exactly a year before in January 1980 and the average gold price for that entire year was $612,56. The gold price was clearly a reflection of the political, economic and geopolitical anxieties at the time, and the speculative blow off phase nailed the top of the bull market.

Another interesting aspect described at length in the book are some of the swing factors on the supply side of gold. I mean, isn't it strange more people haven't noticed the fact that gold production is not rising? One would suppose that, after 12 years of rising gold prices, every gold producer in the world would be incentivized to produce as much gold as they can to profit from these higher prices. But that's not really what we've seen in terms of gold production. So maybe it's just not as easy as one might think to increase gold production? South Africa is one classic example as its gold output has fallen dramatically over the last decade. Until South Africa was overtaken by China at the end of 2007, it was entrenched as the world's largest gold producer. However, South Africa still has vast unmined gold reserves but they are very deep (5km) underground and the grades are in many cases so low that mining can only be undertaken profitably when the gold price is high or when an established mine is already working around the same deposit and covering all overhead costs.

Another reason gold production hasn't increased more recently is the lack of exploration in the late 1990s when the gold price was low and declining. It takes years to build a new gold mine after an economic deposit is discovered - given the feasibility studies that must be conducted, the rounds of financing and the many permits that must be secured. All of these obstacles contribute to the delays and disappointments that are often encountered when trying to bring a new mine into production. But back in the late 1990s, there was another factor that played as well: the Bre-X gold mine scandal. Bre-X Minerals Ltd, a junior Canadian mining company, claimed that it discovered a massive gold deposit in the jungles of Borneo (Indonesia) and its stock price rocketed up to more than $200/share. It soon came out during the geological assessment that Bre-X's super rich discovery was in fact the greatest fraud in mining history. When it became clear that Bre-X salted its core samples with gold dust to make the deposit appear larger than it was, the company's stock collapsed and investors (among them several large pension funds) lost $4 billion in equity. This in turn led to a litany of lawsuits and an overhaul of Canada's stock markets that pretty much dried up capital for junior gold companies during this low gold price period. The result was obviously that gold exploration was cut back even further as venture capital turned its attention to the booming high-tech sector and gold producers focused on their existing projects, ofen using high grading to keep their cash costs under control. Between 1997 and 2001 there was no significant exploration to speak of and very few new gold deposits were found. That began to change some years ago. But given that most exploration efforts are not very successful -and even if they are, it takes many years from the feasibility study until final production- you need a whole lot of exploration to end up with some decent real gold production many years later.

Finally, one of the biggest swing factors on the supply side in recent history has been the behaviour of central banks around the world. Under pressure of sales by European central banks the gold price fell to a trough of around $250 in 1999. In September of that same year the 'Washington Agreement' was reached between 15 European central banks, setting a maximum sales quota of 400 tons/year. In 2004, the agreement was extended to September 2009 with the quota increased to 500 tons/year. Then in 2009, the third 'Central Bank Gold Agreement' was reached, again for a period of five years, but the collective ceiling was again reduced to 400 tons/year. As the signatories had significantly undersold the permitted annual ceiling in the final two years of the second Agreement, the new lower ceiling did not really come as a big surprise. For some reason, our European central banks have nearly stopped selling their gold. By contrast, many other central banks around the world have started buying more gold. Recently, the central banks of Russia, Mexico, Turkey, Argentina and Kazakhstan to name just a few, have been adding more gold to their reserves. If we add up all the selling of the central banks of the developed markets with the buying of the central banks of the emerging markets, central banks have now become a net buyer of gold.

Another chapter in the book discusses the many possible investing choices if you want to buy some gold. Should you buy physical gold bars, try your luck with a gold ETF maybe, buy gold coins, jewellery, gold funds or gold mining companies? The answer obviously depends on your risk appetite. I would say that anyone interested in buying gold should start off with some physical gold which you can buy at several specialised agencies. It's up to you if you want to buy some gold bars or if you prefer certain gold coins, but this is where you should start. You might want to be very careful with some of the gold ETFs as one is not always sure if they are really fully backed by physical gold or if you're just buying some paper gold instead. I personally don't know that much about gold jewellery but I've noticed my wife has a very outspoken opinon on this matter so I leave that part up to her. But the point I'm trying to make is that one should not start buying gold mining companies unless they already hold some physical gold. Always start with the physical stuff and if you have an appetite for more, only then might you consider to start climbing the risk ladder. Given that many gold stocks seem to have had their own 'Gordon Brown moment' lately, this might actually not be such a bad idea. But always remember the Bre-X story and Mark Twain’s famous description of a gold mine as a “hole in the ground with a liar at the top”, so tread carefully.

Source: The Goldwatcher - Demystifying Gold Investing by John Katz & Frank Holmes