Gold's Hidden Risk
May 20, 2018
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Gold has been a longtime investment favourate of many investors, despite its lackluster long term rails record,* together with non precisely for perpetual merchants of doom, who stance the shiny metallic every bit an attractive telephone phone pick on fiscal disaster. Joining their ranks are a number of 'value' investors that receive got promoted together with owned gilt inward the post-GFC era, amongst the bull instance unremarkably centering about the metallic beingness a hedge against hyperinflation or other unintended consequences emanating from experimental key banking policies seen inward the post-GFC period. Reference is likewise oft made to the meaning underperformance of gilt over the yesteryear decade vis-a-vis key banking concern monetary base of operations expansion.
Some value investors (notably David Iben of Kopernik - an investor I grip inward high regard) likewise indicate to the fact that gilt is trading at or below the high goal of the global mining production cost curve, together with below the 'incentive price' for novel discoveries. For most commodities, this scenario by together with large (although non invariably) underwrites the toll downside - the exceptions beingness if (1) demand falls significantly together with sustainably (something that seldom happens exterior cyclical fluctuations); together with (2) if the cost bend moves significantly downwards together with 'flattens', if depression cost producers expand output much faster than demand increases (something that has happened to Fe ore over the yesteryear decade).
Further, Iben believes that gilt miners - who receive got underperformed the metallic itself - are specially attractive together with depression risk, given that 'gold nether the ground' is beingness excessively discounted relative to 'gold higher upward ground'. It is non an unreasonable argument. If people are prepared to pay US$1,300/oz for gilt higher upward ground, amongst the intention of holding it over multiple decades every bit a shop of value together with inflation/crisis hedge, why should people pay alone US$200/oz for gilt 'below ground' that tin dismiss travel produced at an AISC (all-in sustaining cash cost) of say US$800/oz, yielding a US$500/oz margin?
There are inward fact potentially proficient reasons that Iben may receive got overlooked - albeit that the risks are tail risks, rather than base-case risks. If 1 sets aside for the 2d the shiny metal's rich history together with romanticised notions harking dorsum to distant bygone eras were 'gold was money', together with instead simply looks at the metal's demand together with furnish fundamentals, it is clear that in that location are inward fact meaning together with irreducible downside risks that are seldom discussed yesteryear the bulls. This does non hateful prices volition inevitably become downward - in that location are likewise tail risks to the upside every bit good (were speculative demand to substantially increase). But the downside risks are much greater than oft stated.
Let's accept a look. Annual 'demand' for gilt is some 4,300 tonnes, piece mine furnish is alone 3,300 tonnes - a seemingly bullish picture. However, alone most 2,300 tonnes of demand are drawn from actual industrial together with commercial uses - predominately for the manufacture of jewellery, but likewise for pick out niche technical industrial applications. Generally speaking, demand for these usages has non been growing, having fallen significantly inward the developed world, which has been partly (but non fully) get-go yesteryear increased jewellery demand inward emerging markets such every bit Cathay together with India.
Furthermore, the 1,000 tonne gap betwixt annual aggregate 'demand' together with mine furnish is plugged yesteryear recycling. People seldom throw away gilt rings or other valuable jewellery, which are either resold, or melted downward together with reused. This is 1 argue why gilt demand from the jewellery manufacture inward developed marketplace has continued to turn down over fourth dimension (it has fallen 67% inward the yesteryear 30yrs inward the US). If recycling of 1,000 tonnes is netted from physical demand of 2,300 tonnes, cyberspace demand for novel gilt production is alone most 1,300 tonnes per year, or precisely 40% of annual mine production (and falling) of 3,300 tonnes.
The residual of furnish is absorbed yesteryear investment/speculative demand - some 2,000 tonnes per year. This derives from a combination of ETF cyberspace purchases; key banking concern cyberspace gilt reserve accumulation; together with physical demand for coins together with bricks. There are unopen to 30,000 troy ounces inward a tonne, together with so at US$1,300/oz, 2,000 tonnes of gilt fetches most US$80bn.
What this agency is that every year, investors receive got to buy some other US$80bn worth of gilt merely for the toll to non become down. This is dissimilar from many investments. For a typical stock, the number of shares on number does non materially alter from twelvemonth to year, if at all. Consequently, if existing investors were to precisely create upward one's heed to grip what they already held, the toll would stay stable. However, inward the instance of gold, if that was the case, the toll would driblet precipitously, every bit new demand is needed precisely to absorb additional supply.
What would hap if investors, inward the aggregate, decided non to add together to their gilt holdings inward a given year? The toll would request to driblet to a grade which reduced annual gilt production to precisely 1,300 tonnes per twelvemonth - i.e. the grade of cyberspace demand (net of recycling) absorbed inward consumer together with industrial applications. This would require 60% of all gilt production to halt. It would travel monumentally catastrophic to the manufacture - specially because a meaning fraction of gilt producers bear debt, together with inward a heavily oversupplied market, the toll would autumn to the marginal cash cost of production at the 40th percentile of the global cost curve. This would probable require the gilt toll to autumn to somewhere inward the vicinity of US$600/oz - perchance to a greater extent than if manufacture stress inevitably caused manufacture costs to deflate inward the mode witnessed inward other post-correction commodity industries.
Furthermore, this is non to lift the opportunity of net withdrawals of gilt holdings. Ask whatever uranium investor most the affect secondary supplies tin dismiss receive got on spot prices, together with they volition enjoin you: a lot together with for a long time, together with it tin dismiss travel really painful. If cyberspace withdrawals of investment holdings were to accomplish 1,300 tonnes (or higher), the spot gilt toll would autumn to a grade that rendered all producers loss making on a cash-cost ground (analogous to the uranium industry, where secondary supplies receive got depressed spot prices to below the cost of production for almost all producers). That would travel a toll of some US$300/oz. It would travel gold-producer armaggeddon. Given that total global gilt stocks are some 170,000 tonnes, the cyberspace sale of 1,300 tonnes is far from an impossibility.
How probable is this to happen? It's difficult to say. If gilt prices were to turn down materially, it is arguable that investment demand would increment (as - probable - would goal jewellery together with industrial demand). However, given the pro-cyclical nature of fiscal markets, it is likewise possible investment/speculative demand would decrease, every bit holders - suffering increasing losses; disillusionment; together with broken bull theses (particularly every bit global involvement rates rising together with key banks motion to scale dorsum QE programmes) - moved to peel exposure. ETF outflows would travel really possible. Central banks - oft bureaucratic herd followers - could likewise trim back gilt holdings later experiencing bruising losses together with a loss of confidence inward gold's 'store-of-value' credentials. The demand for gilt for piece of job inward jewellery inward countries such every bit India, China, together with inward the Middle East, could likewise turn down every bit these countries grow together with modernise, every bit jewellery is used every bit a shop of value inward many of these countries. That appeal may wane if prices autumn together with every bit superior investment/savings products arise together with inflation falls.
On the other hand, the global population continues to increment yesteryear +1% pa (albeit amongst population gains concentrated inward less-affluent areas of the globe), together with global wealth together with gross domestic product is growing yesteryear some 3% existent together with some 5% nominal. 2,000 tonnes of cyberspace novel furnish vs. 170,000 tonnes of 'stock' furnish is thus below the measurement of existent together with nominal gross domestic product growth, together with at a charge per unit of measurement alone modestly higher upward global population growth, which could back upward existent gilt prices at unopen to electrical flow levels.
History would tend to advise that the latter scenario is far to a greater extent than likely, together with I grip that it is. However, in that location are downside tail risks to gilt prices, together with inward particular, gilt miners, that ought to travel borne inward heed yesteryear investors. This is 1 argue I receive got relatively express exposure to the sector (my exposure is contained to a 0.5% seat inward Russian gilt miner Polyus, which trades at 20% of the electrical flow value of its in-ground reserves of 68m ounces, later netting off debt together with the AISC of producing that gold, together with paying revenue enhancement on profits, together with is a 1st decile producer inward terms of production costs).
I likewise ain no physical gilt together with receive got absolutely no wishing to alter that positioning. With gilt yielding no income, together with persistent downside tail risks, I run across the risk/reward every bit unattractive, together with believe in that location are far superior ways to hedge inflation opportunity (e.g. yesteryear owning dry soil or capital-light companies amongst pricing power).
LT3000
*For instance, nominal prices - earlier inflation, tax, together with storage costs - receive got increased at precisely 3% over the yesteryear 30yrs, at a fourth dimension when equity together with belongings markets receive got been a boon to investors.
Some value investors (notably David Iben of Kopernik - an investor I grip inward high regard) likewise indicate to the fact that gilt is trading at or below the high goal of the global mining production cost curve, together with below the 'incentive price' for novel discoveries. For most commodities, this scenario by together with large (although non invariably) underwrites the toll downside - the exceptions beingness if (1) demand falls significantly together with sustainably (something that seldom happens exterior cyclical fluctuations); together with (2) if the cost bend moves significantly downwards together with 'flattens', if depression cost producers expand output much faster than demand increases (something that has happened to Fe ore over the yesteryear decade).
Further, Iben believes that gilt miners - who receive got underperformed the metallic itself - are specially attractive together with depression risk, given that 'gold nether the ground' is beingness excessively discounted relative to 'gold higher upward ground'. It is non an unreasonable argument. If people are prepared to pay US$1,300/oz for gilt higher upward ground, amongst the intention of holding it over multiple decades every bit a shop of value together with inflation/crisis hedge, why should people pay alone US$200/oz for gilt 'below ground' that tin dismiss travel produced at an AISC (all-in sustaining cash cost) of say US$800/oz, yielding a US$500/oz margin?
There are inward fact potentially proficient reasons that Iben may receive got overlooked - albeit that the risks are tail risks, rather than base-case risks. If 1 sets aside for the 2d the shiny metal's rich history together with romanticised notions harking dorsum to distant bygone eras were 'gold was money', together with instead simply looks at the metal's demand together with furnish fundamentals, it is clear that in that location are inward fact meaning together with irreducible downside risks that are seldom discussed yesteryear the bulls. This does non hateful prices volition inevitably become downward - in that location are likewise tail risks to the upside every bit good (were speculative demand to substantially increase). But the downside risks are much greater than oft stated.
Let's accept a look. Annual 'demand' for gilt is some 4,300 tonnes, piece mine furnish is alone 3,300 tonnes - a seemingly bullish picture. However, alone most 2,300 tonnes of demand are drawn from actual industrial together with commercial uses - predominately for the manufacture of jewellery, but likewise for pick out niche technical industrial applications. Generally speaking, demand for these usages has non been growing, having fallen significantly inward the developed world, which has been partly (but non fully) get-go yesteryear increased jewellery demand inward emerging markets such every bit Cathay together with India.
Furthermore, the 1,000 tonne gap betwixt annual aggregate 'demand' together with mine furnish is plugged yesteryear recycling. People seldom throw away gilt rings or other valuable jewellery, which are either resold, or melted downward together with reused. This is 1 argue why gilt demand from the jewellery manufacture inward developed marketplace has continued to turn down over fourth dimension (it has fallen 67% inward the yesteryear 30yrs inward the US). If recycling of 1,000 tonnes is netted from physical demand of 2,300 tonnes, cyberspace demand for novel gilt production is alone most 1,300 tonnes per year, or precisely 40% of annual mine production (and falling) of 3,300 tonnes.
The residual of furnish is absorbed yesteryear investment/speculative demand - some 2,000 tonnes per year. This derives from a combination of ETF cyberspace purchases; key banking concern cyberspace gilt reserve accumulation; together with physical demand for coins together with bricks. There are unopen to 30,000 troy ounces inward a tonne, together with so at US$1,300/oz, 2,000 tonnes of gilt fetches most US$80bn.
What this agency is that every year, investors receive got to buy some other US$80bn worth of gilt merely for the toll to non become down. This is dissimilar from many investments. For a typical stock, the number of shares on number does non materially alter from twelvemonth to year, if at all. Consequently, if existing investors were to precisely create upward one's heed to grip what they already held, the toll would stay stable. However, inward the instance of gold, if that was the case, the toll would driblet precipitously, every bit new demand is needed precisely to absorb additional supply.
What would hap if investors, inward the aggregate, decided non to add together to their gilt holdings inward a given year? The toll would request to driblet to a grade which reduced annual gilt production to precisely 1,300 tonnes per twelvemonth - i.e. the grade of cyberspace demand (net of recycling) absorbed inward consumer together with industrial applications. This would require 60% of all gilt production to halt. It would travel monumentally catastrophic to the manufacture - specially because a meaning fraction of gilt producers bear debt, together with inward a heavily oversupplied market, the toll would autumn to the marginal cash cost of production at the 40th percentile of the global cost curve. This would probable require the gilt toll to autumn to somewhere inward the vicinity of US$600/oz - perchance to a greater extent than if manufacture stress inevitably caused manufacture costs to deflate inward the mode witnessed inward other post-correction commodity industries.
Furthermore, this is non to lift the opportunity of net withdrawals of gilt holdings. Ask whatever uranium investor most the affect secondary supplies tin dismiss receive got on spot prices, together with they volition enjoin you: a lot together with for a long time, together with it tin dismiss travel really painful. If cyberspace withdrawals of investment holdings were to accomplish 1,300 tonnes (or higher), the spot gilt toll would autumn to a grade that rendered all producers loss making on a cash-cost ground (analogous to the uranium industry, where secondary supplies receive got depressed spot prices to below the cost of production for almost all producers). That would travel a toll of some US$300/oz. It would travel gold-producer armaggeddon. Given that total global gilt stocks are some 170,000 tonnes, the cyberspace sale of 1,300 tonnes is far from an impossibility.
How probable is this to happen? It's difficult to say. If gilt prices were to turn down materially, it is arguable that investment demand would increment (as - probable - would goal jewellery together with industrial demand). However, given the pro-cyclical nature of fiscal markets, it is likewise possible investment/speculative demand would decrease, every bit holders - suffering increasing losses; disillusionment; together with broken bull theses (particularly every bit global involvement rates rising together with key banks motion to scale dorsum QE programmes) - moved to peel exposure. ETF outflows would travel really possible. Central banks - oft bureaucratic herd followers - could likewise trim back gilt holdings later experiencing bruising losses together with a loss of confidence inward gold's 'store-of-value' credentials. The demand for gilt for piece of job inward jewellery inward countries such every bit India, China, together with inward the Middle East, could likewise turn down every bit these countries grow together with modernise, every bit jewellery is used every bit a shop of value inward many of these countries. That appeal may wane if prices autumn together with every bit superior investment/savings products arise together with inflation falls.
On the other hand, the global population continues to increment yesteryear +1% pa (albeit amongst population gains concentrated inward less-affluent areas of the globe), together with global wealth together with gross domestic product is growing yesteryear some 3% existent together with some 5% nominal. 2,000 tonnes of cyberspace novel furnish vs. 170,000 tonnes of 'stock' furnish is thus below the measurement of existent together with nominal gross domestic product growth, together with at a charge per unit of measurement alone modestly higher upward global population growth, which could back upward existent gilt prices at unopen to electrical flow levels.
History would tend to advise that the latter scenario is far to a greater extent than likely, together with I grip that it is. However, in that location are downside tail risks to gilt prices, together with inward particular, gilt miners, that ought to travel borne inward heed yesteryear investors. This is 1 argue I receive got relatively express exposure to the sector (my exposure is contained to a 0.5% seat inward Russian gilt miner Polyus, which trades at 20% of the electrical flow value of its in-ground reserves of 68m ounces, later netting off debt together with the AISC of producing that gold, together with paying revenue enhancement on profits, together with is a 1st decile producer inward terms of production costs).
I likewise ain no physical gilt together with receive got absolutely no wishing to alter that positioning. With gilt yielding no income, together with persistent downside tail risks, I run across the risk/reward every bit unattractive, together with believe in that location are far superior ways to hedge inflation opportunity (e.g. yesteryear owning dry soil or capital-light companies amongst pricing power).
LT3000
*For instance, nominal prices - earlier inflation, tax, together with storage costs - receive got increased at precisely 3% over the yesteryear 30yrs, at a fourth dimension when equity together with belongings markets receive got been a boon to investors.