Friday, 18 May 2018

Gold's hidden risk

Gold has been a longtime investment favourate of many investors, despite its lackluster long term track record,* and not just for perpetual merchants of doom, who view the shiny metal as an attractive call option on financial disaster. Joining their ranks are a number of 'value' investors that have promoted and owned gold in the post-GFC era, with the bull case usually centering around the metal being a hedge against hyperinflation or other unintended consequences emanating from experimental central banking policies seen in the post-GFC period. Reference is also often made to the significant underperformance of gold over the past decade vis-a-vis central bank monetary base expansion.

Some value investors (notably David Iben of Kopernik - an investor I hold in high regard) also point to the fact that gold is trading at or below the high end of the global mining production cost curve, and below the 'incentive price' for new discoveries. For most commodities, this scenario generally (although not invariably) underwrites the price downside - the exceptions being if (1) demand falls significantly and sustainably (something that seldom happens outside cyclical fluctuations); and (2) if the cost curve moves significantly downwards and 'flattens', if low cost producers expand output much faster than demand increases (something that has happened to iron ore over the past decade).

Further, Iben believes that gold miners - who have underperformed the metal itself - are particularly attractive and low risk, given that 'gold under the ground' is being excessively discounted relative to 'gold above ground'. It is not an unreasonable argument. If people are prepared to pay US$1,300/oz for gold above ground, with the intention of holding it over multiple decades as a store of value and inflation/crisis hedge, why should people pay only US$200/oz for gold 'below ground' that can be produced at an AISC (all-in sustaining cash cost) of say US$800/oz, yielding a US$500/oz margin?

There are in fact potentially good reasons that Iben may have overlooked - albeit that the risks are tail risks, rather than base-case risks. If one sets aside for the moment the shiny metal's rich history and romanticised notions harking back to distant bygone eras were 'gold was money', and instead simply looks at the metal's demand and supply fundamentals, it is clear that there are in fact significant and irreducible downside risks that are seldom discussed by the bulls. This does not mean prices will inevitably go down - there are also tail risks to the upside as well (were speculative demand to substantially increase). But the downside risks are much greater than often stated.

Let's take a look. Annual 'demand' for gold is some 4,300 tonnes, while mine supply is only 3,300 tonnes - a seemingly bullish picture. However, only about 2,300 tonnes of demand are drawn from actual industrial and commercial uses - predominately for the manufacture of jewellery, but also for select niche technical industrial applications. Generally speaking, demand for these usages has not been growing, having fallen significantly in the developed world, which has been partly (but not fully) offset by increased jewellery demand in emerging markets such as China and India.

Furthermore, the 1,000 tonne gap between annual aggregate 'demand' and mine supply is plugged by recycling. People seldom throw away gold rings or other valuable jewellery, which are either resold, or melted down and reused. This is one reason why gold demand from the jewellery industry in developed market has continued to decline over time (it has fallen 67% in the past 30yrs in the US). If recycling of 1,000 tonnes is netted from physical demand of 2,300 tonnes, net demand for new gold production is only about 1,300 tonnes per year, or just 40% of annual mine production (and falling) of 3,300 tonnes.

The balance of supply is absorbed by investment/speculative demand - some 2,000 tonnes per year. This derives from a combination of ETF net purchases; central bank net gold reserve accumulation; and physical demand for coins and bricks. There are approximately 30,000 troy ounces in a tonne, so at US$1,300/oz, 2,000 tonnes of gold fetches about US$80bn.

What this means is that every year, investors have to purchase another US$80bn worth of gold merely for the price to not go down. This is different from many investments. For a typical stock, the number of shares on issue does not materially change from year to year, if at all. Consequently, if existing investors were to merely decide to hold what they already held, the price would remain stable. However, in the case of gold, if that was the case, the price would drop precipitously, as new demand is needed merely to absorb additional supply.

What would happen if investors, in the aggregate, decided not to add to their gold holdings in a given year? The price would need to drop to a level which reduced annual gold production to just 1,300 tonnes per year - i.e. the level of net demand (net of recycling) absorbed in consumer and industrial applications. This would require 60% of all gold production to halt. It would be monumentally catastrophic to the industry - particularly because a significant fraction of gold producers carry debt, and in a heavily oversupplied market, the price would fall to the marginal cash cost of production at the 40th percentile of the global cost curve. This would likely require the gold price to fall to somewhere in the vicinity of US$600/oz - perhaps more if industry stress inevitably caused industry costs to deflate in the manner witnessed in other post-correction commodity industries.

Furthermore, this is not to mention the risk of net withdrawals of gold holdings. Ask any uranium investor about the impact secondary supplies can have on spot prices, and they will tell you: a lot and for a long time, and it can be very painful. If net withdrawals of investment holdings were to reach 1,300 tonnes (or higher), the spot gold price would fall to a level that rendered all producers loss making on a cash-cost basis (analogous to the uranium industry, where secondary supplies have depressed spot prices to below the cost of production for almost all producers). That would be a price of some US$300/oz. It would be gold-producer armaggeddon. Given that total global gold stocks are some 170,000 tonnes, the net sale of 1,300 tonnes is far from an impossibility.

How likely is this to happen? It's hard to say. If gold prices were to decline materially, it is arguable that investment demand would increase (as - likely - would end jewellery and industrial demand). However, given the pro-cyclical nature of financial markets, it is also possible investment/speculative demand would decrease, as holders - suffering increasing losses; disillusionment; and broken bull theses (particularly as global interest rates rise and central banks move to scale back QE programmes) - moved to pare exposure. ETF outflows would be very possible. Central banks - often bureaucratic herd followers - could also reduce gold holdings after experiencing bruising losses and a loss of confidence in gold's 'store-of-value' credentials. The demand for gold for use in jewellery in countries such as India, China, and in the Middle East, could also decline as these countries grow and modernise, as jewellery is used as a store of value in many of these countries. That appeal may wane if prices fall and as superior investment/savings products arise and inflation falls.

On the other hand, the global population continues to increase by +1% pa (albeit with population gains concentrated in less-affluent areas of the globe), and global wealth and GDP is growing by some 3% real and some 5% nominal. 2,000 tonnes of net new supply vs. 170,000 tonnes of 'stock' supply is therefore below the pace of real and nominal GDP growth, and at a rate only modestly above global population growth, which could support real gold prices at close to current levels.

History would tend to suggest that the latter scenario is far more likely, and I agree that it is. However, there are downside tail risks to gold prices, and in particular, gold miners, that ought to be borne in mind by investors. This is one reason I have relatively limited exposure to the sector (my exposure is contained to a 0.5% position in Russian gold miner Polyus, which trades at 20% of the current value of its in-ground reserves of 68m ounces, after netting off debt and the AISC of producing that gold, and paying tax on profits, and is a 1st decile producer in terms of production costs).

I also own no physical gold and have absolutely no desire to change that positioning. With gold yielding no income, and persistent downside tail risks, I see the risk/reward as unattractive, and believe there are far superior ways to hedge inflation risk (e.g. by owning land or capital-light companies with pricing power).


*For instance, nominal prices - before inflation, tax, and storage costs - have increased at just 3% over the past 30yrs, at a time when equity and property markets have been a boon to investors.