Gold and Silver An End-of-Term Report
This paper highlights some of the more important aspects of the gold and silver markets which emerged during the compilation of this year's sold and silver surveys*.
Does gold mine production matter?
You will probably be aware that world gold mine production fell back, albeit marginally, in both of the last two years. You will almost certainly be aware that South African mine production fell by 10 % last year - the latest figures, incidentally, indicate a further decline in the first four months of this year of almost 6 %. But there has not exactly been a rush to buy gold futures as a result. Is this because there have been compensating increases elsewhere or is it that mine production no longer matters? The question also needs to be asked because some commentators feel that supply does not consist of the additional metal mined each year but, rather, the total cumulative amount mined since the dawn of man. They argue that, because of the large above- ground stocks in the hands of private citizens and the central banks which can be lent, sold or otherwise mobilised, price formation is determined much more by the behaviour of these holders, rather than by what the mining industry produces. While, on a short- to medium-term view, there may be some truth in this, in the longer term, mine production does matter. We saw this in the late 1980s, when there was a very widespread negative perception among investors, and even producers, about the prospects for the gold price because of the rapid rise in output. Looking even further back, we saw the opposite in the early to mid 1970s when the decline in world production helped stimulate investment in gold. But you cannot look at production on its own - which is why the concept of the global gold gap is important.
This is the difference between mine production and scrap on the one hand, and physical demand on the other, which shows how, in recent years, it has been possible to bridge or fill the gap with a mixture of official sector sales and lending. But the role that mine production plays in determining the size of the gap that has to be filled is one of the key elements in setting the future price of gold.
Is potential gold liquidity finite?
This question, of course, relates to the massive increase in producer hedging last year. For instance, the estimates in Gold 1996 suggest that more than 461 tonnes of gold were required just to fund last year's increase in forward sales, with the corresponding liquidity required to cover all outstanding forward sales rising to more than 1,700 tonnes.
Simplistically, the answer of course, is yes - liquidity is finite. You cannot borrow more than all the gold that has ever been produced, even though with the panoply of derivatives now available (one only has to think of the synthetic gold loan which was popular a few years ago) it sometimes appears from the statements of some analysts that they regard liquidity as a totally nebulous concept unrelated to physical supply and demand . On the other hand, potential liquidity (the part so far untapped) appears to be huge relative to the amount so far mobilised. But, in practical terms, and especially after what happened to leasing rates last year, the real question is whether it will be as easy for the gold business to borrow, say, the next I,700 tonnes of gold liquidity should it be necessary. Given that the official sector has provided more than 90 % of the total liquidity to date, it is important to look at what it has done so far.
Gold 1996 estimated the total liquidity provided by the official sector as of the end of last year at 2,400 tonnes, representing around 7 % of total official gold reserves and made available mostly as deposits. It is worth noting, incidentally, that the deposits (but not the swaps) shown in Figure 2 are generally still reported as being in central bank reserves, even if the physical gold is currently sitting in a display case in Bombay rather than in the vaults of a central bank. One wonders what would happen if all the central banks suddenly decided that they would all like their gold back at the same time.
In that such an event is very unlikely, the concern is much more about where the next lot of gold borrowings are going to be found. At first sight (the left-hand pie in Figure 2), the position seems very reassuring - there is, after all, plenty of gold available - in both the industrial countries and in the official institutes (the IMF, the BIS and the EM!). However, when we look at the picture for just those central banks which are already active mobilisers, the picture shown in the righthand pie is rather different. Now we can see that just under 12,000 tonnes are included in the total and 21 % of these have already been provided to the market.
These active mobilisers do not just include developing country central banks, though this group has included the most active lenders. In fact, the larger part of the total official reserves of the mobilising central banks consists of industrial country reserves but because these banks have, so far, only activated a small part of their holdings, the bulk of the liquidity provided to date has come f om developing countries.
But a third pie encompassing just the developing country mobilisers - the group with the greatest proclivity to provide liquidity to the gold business - would show that around 40 % of their reserves have already been lent.
If you were to judge that the major part of future liquidity is likely to come from the nonindustrial group of countries, then the left-hand pie shows that only around 10 % of the so-far immobilised official gold reserves (i.e., 3, 500 tonnes) come into this category.
The big questions that need to be addressed are, firstly, how much more and at what leasing rates will the current mobilisers be willing to lend and, secondly, how many central banks in the so-far nonactive group, located mostly within the industries countries, will eventually join the party? Lastly, there is the question of how much liquidity will be provided by the multi-lateral official institutions - it should certainly not be assumed that all the gold which they control is effectively sterilised.
Price, prosperity and population
Bearing in mind the importance of the global gold gap, what is it that determines the level of physical demand? The answer is a whole raft of economic, social, cultural, religious and demographic factors. But, the three most important are prosperity, population and price.
The available evidence suggests prosperity is of overwhelming importance. This can be seen by considering the way the developing world's expenditure on gold jewellery has developed since the start of our Gold survey in 1968.
Many of the countries in the "Less Developed Country" (LDC) group are now more developed than some in the industrial group but, for consistency, the data in Figure 3 include all the non- OE CD countries together, excluding the former communist bloc. This picture shows the estimated expenditure of this group on gold jewellery as a share of GDP. This is graphed not against time, but against wealth (or its proxy GDP per capita). What this picture reveals is that, overall, the developing group of countries has become more prosperous, with per capita GDP almost doubling over the past quarter century and, much more importantly, that the share of this rising wealth expended on jewellery has been rising. As people in this group get richer, they tend to spend more of their wealth on gold jewellery also shows that price does have an impact, as can be seen from the dips in 1973 and 1980, but it should be remembered that, over the whole period shown here, the gold price has just about doubled in real terms.
One of the best comparisons that can be made to illustrate this point is between the development over the past 15 years of per capita consumption of gold jewellery in India and Italy - two countries with very different cultures and levels of development but that have in common a similar cultural affinity for gold.
India consumption has grown steadily from a very low base, primarily due to the benefits of good harvests improving wealth and, to a lesser extent, a falling real price since the early 1990s. Italian consumption has also continued to grow, and, most importantly, without showing any sign of maturity (although the economic and political turmoil of the past several years has taken its toll on demand generally in the economy). Most importantly, the ratio of per capita consumption has moved within a range of between 5 and 10 in this period.
The main conclusion is that contrary to what one often reads, the gold market has nothing to fear from the process of economic development. Of course, Italians do not use gold in the way that Indians do. (namely as their preferred means of saving). But, if India becomes more like Italy over the next few generations or centuries, we can be sure that on average, its people will be buying more, rather than less, gold than they do now.
Finally, on population, the main thing to remember is how young Asia is, especially relative to an increasingly geriatric Europe. There is no doubt about the size of the next generation of gold buyers. The only question is whether they will have the income to make them actual, rather than potential, purchasers.
Inflation and investment
It is often said nowadays that gold's old role as a hedge against inflation is dead – thanks, in the main, to the development of sophisticated financial products, though it could be argued that it is inflation that has been missing, rather than gold's reaction to it, for most if the past 15 years.
It is certainly true that there was moderately sustained investment during the two waves of inflation in the 1970s (which incidentally seemed much more important then than they do now, because of the much smaller overall size of the market before the 1980s' booms in both fabrication and mine production). By contrast, investment since 1980 has bad a much more speculative character, occasionally responding (positively) to higher prices, as in 1983 and 1987, while perhaps the only year to show a positive correlation between gold and inflation in the recent past was 1990. However, that year also saw the build-up to the Gulf War and the collapse of Drexell, so inflation was not the only thing on investors ' minds.
But, looking to the future, if there should be a return of even moderately higher levels of inflation in Europe and North America, it is almost certain that this will be accompanied by renewed investment in gold, although this is likely to prove of a transitory nature. Much more important, and of longer-term significance, is the cumulative impact of even moderate levels of inflation on the purchasing power of the dollar. This is reflected, for instance, in the rise in gold mine production costs in 1995. The problem is that the whole market is obsessed with the $400 level as if there was no inflation at all. This is what economists call money illusion. Thus, if gold were to stay at this level forever, it would simply get cheaper and cheaper for consumers and at the same time more and more difficult for miners to make money (and, last year, according to the analysis in Gold 1996 , around 14 % of production was already unprofitable on a total cost basis).
By-product silver supply
Because the major part of silver mine production derives from by-product sources, GFMS has put a major effort into analysing the sources of silver from mines which were developed to produce, in the first place, copper, lead /zinc and gold. Perhaps the most interesting aspect of the supply chapter in this year's World Silver Survey is the way that the share of silver from the gold mining sector has risen steadily over the last five years, in spite of the flat trend in gold mine production. The reason for this is that those gold mines which have closed clown have tended to be mining silver-lean ores, while those which have started up (especially in Latin America) have been silver rich. ln 1995, however, it was the very large by-product silver content of just two major new gold-silver mines, Eskay Creek in Canada and Mt Muro in Indonesia, which produced a sharp increase in the contribution of gold mines to silver output.
Copper mining also contributed a substantially increased amount of by-product silver last year, whereas, by contrast, silver produced from the lead/zinc mining industry tended to stabilise after four years of falling output. However, this may change if higher lead prices result in more start-ups, like the Cannington lead-zinc-silver mine now under development in Queensland, Australia.
Stewart Murray, Chief Executive, Gold Fields Mineral Services.
After qualifying as a metallurgist from London University, Dr Murray studied for a PhD at Imperial College on the subject hybridising of titanium alloys. In the decade up to 1984, he worked for the International Wrought Copper Council in London, serving as its Secretary General from 1980 to 1984. He then joined Consolidated Gold Fields (CGF), being responsible for the Group's commodities research, until the company was taken over by Hanson PLC in 1989.
In that year, Dr Murray set up Gold Fields Mineral Services (GFMS), with the backing of Gold Fields of South Africa. The publications of GFMS include the authoritative annual survey of the gold market, formerly published by CGF, and now in its 29th year. Since 1993, this has been supplemented by two annual updates. In addition, in 1994, GFMS was appointed by the Silver Institute in Washington to undertake the preparation of its annual World Silver Survey.
Dr Murray is a member of the Council of the World Bureau of Metal Statistics, having been its Chairman from 1989 to 1991.