What a difference 10 years can make

The Gold Price in 2001

In May 2001, the gold price was barely over $250. The Dow was sitting at just over 10,735 and it had just crossed over 10,000 a few months earlier. The US three-month T-Bill was about 3.8% and today, as you know, it is about zero. The Fed fund rate was set at 6% and that is also now about zero. The US dollar was the currency of choice. It bought v1.12 in those days. Europe for Americans is cheap – it was a bargain. Today, of course, it buys you about 40% less.

In 2000, the US population was about 280 million. It consumed 7.2 billion barrels of oil per year, or 25 barrels per person, while China with 1.2 billion people consumed 1.6 to 1.8 billion barrels or 1.5 per person. In the last 10 years, the US has actually gone down to 22.6. Higher prices do work miracles, do they not? In China, consumption has not quite doubled – but almost – to 2.7 barrels per person. That is just to give you an idea of what is happening in China and the impact of China on the whole world of commodities, not just gold.

Finally, China’s foreign exchange reserves stood at a paltry $166 billion 10 years ago, and are over $3.1 trillion today. Now, I will give you just a little rapid overview of 2001 and what was happening then. The central banks were selling 479 tonnes of gold. The average cost of production for gold was $319. The gold producer hedge book totalled over 3,000 tonnes, and mine production was peaking at 2,600 tonnes per year.

Changes in the Gold Market Overview

The reason why I am looking at that is to look at the lessons of the last 10 years and see what may happen over the next 10 years. What are the lessons to be learnt and the changes in the gold market that we see over the last 10 years? Well there are five big things. Firstly, central banks have gone from sellers to buyers. Secondly, producer hedging is dead. It is deader than a doorknob. Thirdly, investment demand has grown from 4% to 37% of overall demand. That is a huge, tectonic change.

The counterparty to that is jewellery demand, which has collapsed from 84% to less than 50% of total demand this year. Finally, the role of recycled gold in the supply side has gone from 17% to 39% of total supply. That is huge, specifically for the refiners. What has not changed? Technology demands have stayed constant at about 12%. Mine production is essentially flat. It was 70% and is now 61% only because recycled gold has taken so much more. I will now go a little bit deeper into each of the components and give you a bit more of the flavour.

European Central Banks

Looking at central banks, from 1990, the European central banks started to exhibit what I would call the jailbreak syndrome: who can sell that useless yellow metal the fastest before the price dropped to zero and the tens of thousands of tonnes that were held in the vaults of their banks would turn to dust. The lure of the US dollar was so great. It paid interest and it was the reserve currency of choice, so they wanted to get rid of that yellow stuff gathering dust, and so they did. If you total it up, they sold over 5,000 tonnes and have lived to regret it.

I should have entitled my next slide ‘the biggest losers’, but the point is made. If only they had kept their gold. The biggest surprise is who leads the parade of the biggest losers. People always think it is the UK, but the UK actually came in third. The Swiss and the French led the parade. The total notional loss of $1,800 gold is over $200 billion. It makes the Greek crisis look like chump change. However, it is just as instructive to look at who is not there: Germany and Italy, the second-largest holders of gold after the USA. Interestingly, Italy had been in trouble in 1970s and it had to do a loan collateralised with gold. Guess which loan they repaid first? It was their gold loan. Today, Italy has 2,500 tonnes of gold in its vault worth over $150 billion. That is enough to plug a hole or two. It is my absolute view that in the next two years, you will see Italy use its gold to once again plug some of their holes in their budget because they are going to have to. It also comforts me that the European central bankers responsible for the sale of the gold of their countries have since been promoted to handle the financial crisis. The gold market is in good hands!

Asian Central Banks

As the 1990s and the first decade of the 21st century were defined by European bank selling, I believe that the next 10 to 20 years will be defined by Asian central banks buying. Most of the Asian countries have emulated Japan in its mercantilist policies of the 1970s and 1980s, and have accumulated very large foreign exchange reserves. The global financial crisis of 2007 and 2008 has highlighted the vulnerability of the reserve currency, the US dollar. It has also highlighted the fragility of the euro, leaving only gold as the currency of last resort. It is our view that the Asian central banks will move over time to a 15% weighting in gold as a minimum. If you look today at the European central banks and each of the countries, their gold weighting is probably closer to 50% in their reserve exchange. I would say that the Asian central banks will move first to 15%, but I would not be surprised if they go higher than that. Just with 15% weighting, if you look at their current reserves, that would represent 17,000 tonnes of gold to be purchased over the next 10 years. Any significant retrenchment in the gold price, in my view, will be seen as an opportunity to boost their gold reserves.

Gold hedging

Central banks, as I noted earlier, were not the only sellers in the 1990s. A number of producers thought that they had found the equivalent of the financial elixir of perpetual profits in the form of gold hedging. The peak was reached in 2000 at just over 3,000 tonnes of gold. It was mostly borrowed from the central banks at miniscule interest rates because they could not care less, it was so worthless, in order to capture a contango in the 3% range. Just to remind you, hedging was first introduced in finance as a risk-mitigating instrument. If you do not take a view on price and you constantly hedge, it is a zero-sum game. However, the producers took a view – the wrong view. They ended up accumulating colossal losses that they had to make up by diluting shareholders’ equity, and we all know too well which company ended up having to do a $5 billion equity to pay off their hedge book losses. It is a good thing they did it at the time they did it, because today it would be $10 billion.

So there are two reasons why hedging today is essentially dead. Firstly, the gold company shareholders do not want their company to hedge their production. They want to have full leverage to the gold price, and they are punishing companies that would even think of that by decreasing the price- earning ratio of the company, which makes them less likely to be competing for assets with other companies. Yet, the real reason is that there is no contango left. The price today and tomorrow is actually a flat price, while the actual price keeps going up. So you are much better off not hedging. With a zero-interest-rate policy announced by Bernanke for the next three years and possibly even longer, I do not see a return of hedging for quite a number of years.

The Gold ETF

To me, the most remarkable development of the last 10 years, and I will admit that I am a tad biased here because I had a bit of a hand in its creation, has been the advent of the gold ETF. The first of its kind was the World Gold Council-backed GLD, which is now listed on a multitude of exchanges. For the first time in history, one can buy gold 24 hours a day, seven days a week, with a minuscule friction cost. The idea when we created this ETF at the World Gold Council was, and I still remember telling the members of the Council, that if we want gold to be an alternative currency to the US dollar and to the euro, gold has to be completely and totally liquid. You have to be able to buy it 24 hours a day, seven days a week – only then will we have a currency that can compete with the dollar, and that we did. It took two and a half years and $15 million to get it through the SEC. You can imagine that when the SEC found out that the gold price was fixed twice a day, they went bananas. That did not compute in their regulations. That is why it took so long to get it through, but we did, and for a while a month ago, the gold ETF was the largest ETF on the planet.

In little more than seven and a half years, the gold ETFs have accumulated in total some 2,300 tonnes of gold that have been purchased for a value of well over $145 billion. The global financial crisis of 2007 and 2008 brought down the financial systems and a lot of currencies. The central banks flooded the market with liquidity and cash in a bid to divert a 1930s-style depression. Gold, once again, is performing its role as the ultimate reserve currency, just like it did in the 1970s and in the 1930s.Let us face it: these days, currencies are like families. All of them are more or less dysfunctional and each has its own therapy. Gold, when you look at it, looks pretty good. That is why people are buying it. Investment demands have also exploded.

Demand for Gold

Investment demand has gone from 4% to 37% of total demand, but I think it has got an even brighter future. When you look at global asset allocation and wealth, gold today accounts for a miniscule 1% of total wealth. A simple doubling, going from 1% to 2%, of this position would represent purchase of 31,000 tonnes of gold at today’s price. Inconceivable? I think not. I think it is going to happen. It is happening. That is another source of gold demand that we are going to see coming year after year for the next five to 10 years. Every year there are around 3,500 tonnes of refined gold produced, and if 50% of that is going into investment demand, then the amount consumed in other uses is bound to decline.

That rest is jewellery. The funny thing about jewellery is that it responds to economics 101: the lower the price, the more the demand; the higher the price, the lower the demand. When gold was $250 in 2000, 84% of total demand was jewellery. For a few years, the gold price went up and jewellery demand went up. That is because it validated earlier purchases. People said that they had bought a necklace at $250 and now it is worth £300 so they thought they should buy another one, so then it went to $350.That worked for a number of years until the gold price got too high. At that point, jewellery demand started to go down, except in two countries – China and India. You can clearly see it is all happening today in those two countries, where demand for jewellery continues to increase even as the gold price increases. Between them, in 2010, they bought in 1,100 tonnes of jewellery compared with 200 tonnes in the US and Europe combined. It is happening there.

In 2004, when I was Chairman of the World Gold Council, I visited a store in Beijing run by Mrs Wong. In that year, that three- storey store of gold and jewellery only sold 1 billion yuan of jewellery. The yuan in those days was 8.2 to $1. This year, that same store will sell over 10 billion yuan of jewellery. The yuan is a little stronger than it was then; it is down at about 6.0 to $1 today. Think about it – 10 times the amount of jewellery in a space of seven years in one store. When you look at it from a combined 20% of total consumer demand, today between China and India, you are looking at 60%. It is going higher. I think that, within the next five to 10 years, between China and India, you will be looking at well over two-thirds to 70% of total consumer demand for gold. In the US and Europe, gold is going to be a very high-class item, much like diamonds are today and some of the nicer stones. That is what is likely to happen.

Technology

We have talked about the five things that have changed the most. Now let me just refer to the couple of things that have not done much in the last five years. I am talking about technology. If you look at the technology sector, essentially about 11% or 12% of gold has been used in technology over the last 10 to 30 years. It does not seem to change. However, starting in early 2000, the World Gold Council decided to try to help the people that write papers about gold. We decided that we would publish those papers and help them connect so that people knew what was happening in the world of gold. That has made a big difference. The number of papers and patents that have been issued and awarded for the utilisation of gold in medical and commercial use is the equivalent of mining exploration.

I believe that at some point in the future a significant new application will be found that will have an impact on gold demand, so that not only are you going to have jewellery and investment demand, but you are going to have another significant commercial use of gold. As an example, the first gold-based auto catalytic converter went into commercial production for the 2012 model year.

A medical application would be a game-changer. For example, if there was something like a gold-tipped Viagra pill, that would be game- changing. That would have a huge impact. Maybe it will happen, but when I look at the number of papers that are written and the number of patents, I think it will happen, but I do not know when.

Gold Production

On the supply side, we have said that essentially we have had flat production. That is not quite the reality because we have had seven or eight years of decline in world production, but then in the last two years, there has been very strong growth again. In effect, it is the same as it was 10 years ago. That is all nice, but the reality is that the reason the producers have been able to increase production is because they have dropped their grades and they have let their costs go up. They have kept the margins, but the margins have not expanded as much, so as a consequence, the stock has not done very much if you look at the gold equities. That is a big surprise.

If you look at Newmont, today it is at $62 and that is the same as in 2004. In 2004, gold was $450. Today it is $1,800. How can that be? If you look at the head grade, it went from 1.5 grams to 0.8 grams and everything costs more. The most surprising thing in terms of the mining company over the last 10 years is the lack of major new discoveries. That is a big problem for the industry. Looking at the 1980s and 1990s, in each of those decades, they found at least one super deposit of 50 million ounces plus. That is a gold strike. At Yanacocha, they were producing 3 million ounces of gold. We have not had one since 1993, which is 20 years ago. Where are they? We used to find three to five 15 to 30 million ounce deposits a year. It has been more like one, two or three at the most in the last 10 years. When you look at that, you really wonder what is going to happen. We can keep increasing production by about 2% for the next five to 10 years. That is a very subdued rate of production unless the industry puts more money into R&D and starts to find more deposits. It is not going to happen otherwise.

The Market and Gold

I just want to finish with a chart of the Dow Jones industrial average divided by the gold price. It is a very simple way to look at the relationship between financial assets and hard assets in the form of gold, and what they look like over time. Looking at the chart across the page, there are a number of very interesting points. Firstly, you can see that there are times to own financial assets, like from 1980 to 2000, when the ratio went straight up for 20 years – so just buy financial assets. From 1946 to 1966, it was another great time. By the same token, there are times where you should really be in hard assets and forget the financials and banks. From 2001 to today, that has certainly been the case.

The other interesting point is looking at the last bull market in hard assets, which lasted 14 years from 1966, when the Dow hit 1,000 for the first time, to 1980, when the ratio peaked in terms of gold ratio to the Dow at one- to-one. The same thing happened in 1934. If you look at the 1930s bull market, you have to look at silver to get the length because gold was fixed in those days. The length of the bull market would have been about 16 years.

Therefore, we have two previous bull markets of 14 years and 16 years respectively. Let us say that there is maybe another four to six years left in this bull market on average. Furthermore, the reason we wrote the letter in 1999 was to say to our shareholders that it took 42 ounces gold to buy one unit of the Dow. In 1980, it was one to one. The Dow was 800 and gold was $800. In 1934, the Dow had gone from 370 in 1929 to 37 and gold was up at $35; it was 1.1-to-one.

So, where do I think the gold price is going? I think it is going back to parity with the Dow at one-to-one. The Dow today is 10,700. From a ratio of 42 in 2001 to 6 in August 2011, the corresponding change in the gold price was a rise from $250 to $1,850. It has gone up by $1,600. If the ratio goes down from 6 to 1 (with the Dow unchanged), the gold price is going to go up by about $8,000. So it has got as much to go in ratio terms as it has already gone up.

My parting word is that this bull market is far from over. There is one more thing that you should note, however, as a note of caution. In the 1970s bull market, there was one very strong correction. The gold price went down 50% from 1974 to 1976, and a lot of people went bankrupt in those two years. We could have a correction of that magnitude in this bull market. We do have a correction and I believe there is going to be a strong correction at some point. It will then set up this last, explosive phase of this bull market that will take the gold price to numbers that few people imagine.