Inventories play a significant role in the pricing of commodities: when they are low prices tend to rise, while excessive inventories depress prices. However, for most commodities other factors, such as the cost of production, are equally important. Precious metals, which can act as a store of value, are a notable exception. In an in-depth look at the history of gold supply, Sandy McGregor notes that above-ground stocks of gold are now so large relative to annual consumption they are the principal determinant of prices. The same is true for silver and platinum. The impact of industry profitability on price is tenuous.
Renewed interest in gold as a financial asset
Currently central banks own 1 039 million ounces of gold and private stocks in the form of jewellery and bars amount to about 4 200 million ounces. This estimate implies that private stocks are currently worth about US$5.4 trillion. This huge inventory has been accumulated partly because gold is the metal of choice for jewellery, and partly because it is regarded as a store of value in times of social and political disorder.
Since 1980 gold demand has been mainly for the fabrication of jewellery and its role as a financial asset has retreated into the background. This may be changing. As governments seek to interfere in all aspects of economic activity and central banks have embarked on radical monetary experiments which distort asset prices, gold as a store of value, which is not someone else’s liability, is attracting renewed interest among a diverse group of investors. The amount of gold in private hands is large enough for it to play a significant role in the portfolios of investors who fear the consequences of the current fashion among central banks to promote inflation. We are heading back to the 1970s. Then it was the inadequate response of central banks to inflation which gave gold its attraction. Today it is their response to deflation.
Since 1980 gold demand has been mainly for the fabrication of jewellery and its role as a financial asset has retreated... This may be changing
Gold inventories are uniquely large
Gold has by far the largest above-ground stock of any commodity. It has been mined since antiquity, with about 5 120 million ounces produced since 1800. Although some gold has been lost or consumed for industrial purposes and not recycled, most still exists today, either in the form of bullion bars and coins, or as jewellery. These inventories are equivalent to over 40 years’ current annual consumption. While central bank holdings are precisely known, there are no reliable statistics on the exact quantity of the stocks privately owned. However, the simple proposition that together they amount to all gold produced since 1800 provides as good an estimate as any of their order of magnitude and this is the basis of my estimates that follow. To understand the gold price one must understand the history of this inventory.
Pre-1970: When gold was money
Historically gold was money. Prior to 1933 the value of the US dollar was determined by a gold price of US$20.67 per ounce. After some haphazard experimentation, President Franklin Roosevelt devalued the dollar in 1934, fixing gold at US$35 per ounce, a price which prevailed until the collapse in 1971 of the international monetary system established following the Second World War. Until 1965 this price was too high to clear the market and central banks were persistent buyers of surplus production to prevent the price from dropping below US$35. Indeed, in 1937 these purchases were large enough to prompt serious discussion as to whether the official gold price should be reduced. After gold was made a centre piece of the monetary system established at the Bretton Woods conference in 1944, central banks pooled their efforts to hold the price at US$35.
In the years preceding the Second World War the US$35 price made gold mining extremely profitable. Between 1931 and 1940 annual mine production increased from 22 to 42 million ounces. After 1945 production outside South Africa started to decline as margins were eroded by inflation. The exception to this trend was South Africa, where the discovery of high-grade ore bodies resulted in the opening of new mines, which were profitable at US$35. By 1970 world production, including that of the Soviet Union, had increased to 47 million ounces, of which South Africa accounted for 32 million. Between 1932 and 1970 cumulative mine production was 1 312 million ounces, of which 45% was purchased by central banks.
The 70s: The collapse of the post-war financial system
The central bank gold pool ended in 1968 when private investors fearing monetary instability and inflation became large-scale buyers. The movement of the gold price since then is shown in Graph 1. Demand from these buyers ultimately pushed the price to US$800 in 1980. Higher prices had less of an impact on overall supply than one would think. Production outside South Africa stabilised because it was now profitable. Higher prices had a temporarily perverse impact on production because South African mines could afford to reduce the grades of ore they mined. The higher the price, the less gold South Africa produced. As the official sector became a net seller, all newly mined gold ended up in private hands. By 1980 private inventories reached about 1 600 million ounces.
The great bear market from 1980 to 1999
As one would expect, the longer-term response to higher prices was ultimately an increase in supply, in part from renewed interest in exploration for mineable gold. The development of high-altitude helicopters gave geologists greater access to much of the Andes and Rockies. During the 1970s heap leaching technology was developed, which significantly cut the cost of developing low-grade open-cast mines. Large-scale earth moving equipment reduced mining costs. While SA production declined, production elsewhere, driven by new technology, grew strongly.
In the 20 years to 2000 annual world production almost doubled to 82 million ounces. All this gold went to the private sector, whose inventory rose from 1 600 to 2 900 million ounces, but the price gradually declined reaching a low of US$254 in August 1999. The funding of new mines had an adverse impact on the price because they were financed by selling production forward. To make long-term forward prices, bullion banks borrowed gold from the central banks and sold this in the spot market. Mines locked in prices, which made them profitable.
This 20-year price decline was not solely the consequence of increased production. The combination of central bank selling and the liquidation of European investment inventories also had a significant impact. Historically Europeans had long been holders of gold as a reliable store of wealth in a world prone to economic and political upheavals. In response to the monetary crisis of 1968 and to stagflation in the 1970s, investors in Europe further increased their large hoard of the metal.
However, when prudent monetary policy eliminated inflation after 1980 there was no longer a strong rationale for continuing to hold gold. Attitudes changed as wealth shifted to a younger generation, which had been educated in business schools rather than by the Second World War. Gold became an asset you sold rather than kept. Europe became a seller of gold previously held as an investment.
Fortunately these sales coincided with growing jewellery demand in Asia. Gold flowed from Europe to Asia. For Asian buyers European dishoarding constituted an important source of supply, as significant as rising production. Declining prices played a role in enabling Asia to absorb all this metal. On average, gold has a unit price elasticity of demand. In other words, buyers of gold in the form of jewellery and as store of value tend to determine the quantity they acquire by the amount of money they wish to spend. If the price halves, as it did between 1980 and 2000, the amount purchased can double. As the price fell the surplus inventory in Europe was depleted at an accelerating rate.
The decline in the gold price since 2012 is best explained by the proposition that, when Asia is in trouble, gold is in trouble
Consequences of the Asian boom
By 2000 low prices were starting to have an adverse impact on mine production. However, this was not what reversed the direction of prices; rather it was two decisive inventory events which set gold on the path to US$1 900 in September 2011. The first was the elimination of surplus stocks in Europe. These had been sold. The second was a decision by central banks to stop lending gold and to limit outright gold sales. This decision immediately reduced supply. After 2002, as Asian economies recovered from the emerging market crises of 1997, their demand for gold grew rapidly but over the same period mine production stagnated. Increased production outside South Africa was more than offset by a decline in South Africa due to resource depletion. With demand growing much faster than supply consumers were rationed by higher prices and had to pay up to persuade those who held the inventory to part with some of their gold.
The decline in the gold price since 2012 is best explained by the proposition that when Asia is in trouble gold is in trouble. Asia accounts for the large majority of gold consumption. High prices had brought some US and European investors back as significant participants in the market. Three years ago inventories in London were probably about 300 million ounces or roughly three years’ mine supply. A significant decline in Asian purchases left the market with excess inventories and prices collapsed. Surplus London inventories have now largely dissipated, which is reason to believe that as Asian growth recovers the gold price could appreciate significantly.
Gold’s unit price elasticity is a powerful mechanism for clearing the market during periods of weak prices.
Note: Statistics on gold production and offi cial transactions are from the CPM Gold Yearbook 2016.