This is the 7th in a series of 11 Posts that will be published on this Blog each Monday and Wednesday from November 3 to December 8. All 11 Posts will be filed under the Blog Category ‘Gold as an Investment’. For previously issued Posts in this Series click here. We hope you find this series of Posts useful.

While preparing this Post Series, I found two recently published books I think particularly helpful: The Goldwatcher: Demystifying Gold Investing, John Katz & Frank Holmes, 2008, John Wiley & Sons, Ltd. and Guide to Investing in Gold and Silver, Michael Maloney, 2008, Hachette Book Group USA. I highly recommend both. Where I have adopted ideas from those books, I have put them in italics. Page references to The Goldwatcher and Guide to Investing in Gold and Silver are denoted by (Goldwatcher – page xx) and (Guide – page xx) respectively. I also recommend www.theGoldwatcher.com Blog and www.GoldSilver.com, websites related to those respective books, to those of you interested in gold.

General Conclusions

My reasoning behind my conclusions with respect to Gold as an Investment are set out in this Post Series. Succinctly, they can be summarized as follows:

1. Gold is ‘real money’, fiat currencies are not. This is because at any point in time gold satisfies all components of the definition of ‘money’ where as a ‘store of value’ that definition in part means that ‘money’ must be able to be reliably retrieved and ‘predictably useful’ when retrieved. Fiat currencies do not meet this test as ‘money’.

2. At any point in time the U.S. $ is a measure of the price of gold, not a measure of its value.

3. At any point in time Gold’s value needs to be thought about in the context of its then current and prospective purchasing power, having regard to prevailing and prospective macro-economic conditions.

4. Whether the future economic circumstance is inflationary or deflationary some gold is a good thing to own as a ‘safe haven holding’.

Gold Supply and Demand

In the introduction to this Post 2 reference books are mentioned. I would like to draw your attention to a 3rd recently published book, Buy Gold Now, Shayne McGuire, 2008, John Wiley & Sons, Ltd. Like the other 2, Buy Gold Now is available at Amazon.com. Shayne McGuire is the Director of Global Research at Teacher Retirement System of Texas, one of the U.S.’s largest pension funds. Again, I recommend this book to you. In this Post, where I have adopted ideas from that book I have put them in italics. Page references to Buy Gold Now are denoted by (Buy Gold Now – page xx). In particular I recommend readers carefully review:

1. Part Two: Supply and Demand Fundamentals and Swing Factors (Goldwatcher – pages 40–48); and,

2. Gold’s Scarcity: New Sources of Demand and Falling Supply, (Buy Gold Now – pages 137–145).

Gold Supply and Demand – Overview

The following table summarizes World Gold Supply and Demand Statistics in Tonnes for the years 2003 – 2008 (2007 estimate adjusted to actual, 2008 updated forecast – source, www.virtualmetals.co.uk) found in The Goldwatcher (Goldwatcher – page 41) – statistics that are delineated somewhat differently can be found on the World Gold Council website at www.gold.org:

Principally following my review of the sources mentioned in this Post I have reached the following conclusions with respect to prospective gold supply:

1. With respect to mine supply it is unlikely that this supply source will increase significantly going forward. In fact, mine supply has declined slightly from 2003 – 2007 (from 2,512 tonnes to 2,426 tonnes). This is because:

• few new major deposits are being discovered in circumstances where any given mine is a finite and non-renewable resource; and,

• mine development and operating costs are escalating. According to McGuire ‘the cost of extracting and refining an ounce of gold has soared due to rising costs as well as increasing difficulty of finding it. The average global cost of producing an ounce of gold has surged to nearly $500 an ounce, almost double the level of 2000’ (Buy Gold Now – page 143). The cost of producing an ounce of gold of course varies on the type of deposit (mineable by open pit or underground), deposit grade and metallergy, geographic location, availability of external and internal infrastructure, and so on, but on balance there is little doubt that ‘cost of mining’ as a generalization is increasing – meaning that only ever higher gold prices will justify exploration and development of increasingly scarcer and more difficult extraction of gold from deposits.

2. With respect to ‘scrap recycling’ it strikes me that at any given point in time there ought to be a correlation between the amount of ‘scrap recycling’ and the gold price measured in U.S.$. Gold scrap can be described as gold that is not in coin, bullion or retained jewelry form. Much of what is considered gold scrap comes from damaged jewelry or jewelry sold to raise cash. Other sources of scrap gold include dental scrap, or gold scrap recovered from scrapped electronic products. Interestingly, gold recovered from scrap has not fluctuated greatly through the 2003 – 2008 (est.) period, ranging during that period from 900 – 1,100 tonnes per year – indicating that in a period of generally rising gold prices there has not been the co-relation I would have expected. At the same time, the 2003 – 2007 period was one of perceived economic vibrancy and may have contributed to the fact the larger amounts of jewelry were not sold for scrap. Having said that, I would have thought that at some higher gold price point ‘good and usable’ jewelry might well be turned in for cash in quantities that might influence the aggregate gold supply.

3. With respect to ‘hedging’ as a supply source, while I have not found a study supporting this, it strikes me that most companies who previously had serious gold hedge positions will by now largely have unwound them, and in the current environment likely won’t renew them having regard to current accounting rules and gold price volatility. It strikes me that this is supported by the negligible ‘hedging supply’ estimate for 2008 set out in the above table.

4. With respect to Government sales as a supply source, in September, 1999 pursuant to what is referred to as The Washington Agreement (correct name ‘The Central Bank Gold Agreement’) a central bank gold quota sales agreement was established – initially for a five year period (Goldwatcher – page 46). Pursuant to a later version of this agreement 16 countries (mostly European) are permitted to sell no more than 500 metric tons of gold each year – but to the surprise of many observers have not been meeting their quota in the past two years (Buy Gold Now – pages 141-142). In the current economic and fiat currency environment it will not surprise me if that trend continues, which view is confirmed – at least for 2008 – by the 2008 estimates reflected in the above table.

Gold Demand

1. With respect to ‘jewelry fabrication’ I believe two extremes are worth considering:

• first, where the price of gold rises significantly in a period when consumers cut back on spending, the amount of gold used in jewelry fabrication may drop – particularly in circumstances where consumers come to realize that the mark-up on ‘gold’ jewelry makes it unlikely a purchaser would ever recover his or her initial investment. Jewelry fabricated from less than 22 carat gold (24 carat gold being .999% pure) is much less valuable by ‘pure gold weight equivalent’ than physical (pure) gold at any point in time. This is because gold jewelry less than 22 carat needs to be re-refined – at no small cost per ounce. It is for this reason that gold jewelry sold in India often is fabricated from 22 carat gold, notwithstanding the ‘softness’ of the product; and,

• second, at the other extreme it may be possible that more high carat gold jewelry will be fabricated and sold as an ‘investment product’, although fabrication costs will militate against this.

In any event Katz believes: In circumstances where ‘for over twenty years the jewelry industry alone has accounted for some 70% of gold sales and absorbed more than all newly mined gold’ … ‘with no real prospect of an increase in mined gold the pattern will continue unless investment demand either falls or drives the gold price to a level that undermined the economics of the Jewelry Industry. In markets where demand for gold is surging and growth potential is almost unlimited many of the factors that drive investor demand also drive jewelry demand. This applies in India and China where a third of the world’s population live and where incomes have been and continue to rise dramatically’ (Goldwatcher – page 42).

2. With respect to ‘legal tender coins’ the amount of gold used in them has varied little from year to year from 2003 – 2008 (est.) – i.e. from 85 – 123 tonnes per year, and seems unlikely to have a material (i.e. significant) effect on overall gold demand going forward.

3. With respect to ‘electronics’ and ‘other end uses’, again the amount of gold demand has varied little from year to year from 2003 – 2008 (est.) – i.e. from 615 – 750 tonnes per year. In positive economic times this demand may reasonably be expected to grow, and in economic downturns to fall. One factor that could spur demand would be the development of further industrial uses for gold – something the Gold Mining Council and the Gold Mining Industry both are sponsoring (Goldwatcher – page 42).

4. With respect to ‘ETF’s’ it strikes me their recent history and current economic uncertainty suggests continuing and growing demand.

5. With respect to ‘Central Bank Purchases’ I know of know way to predict government philosophies or intents. In recent years Central Bank Purchases have had little influence on gold demand, but whether that continues remains to be seen.

6. With respect to ‘Dehedging’, this has been a continuously decreasing ‘gold demand’ category dropping continously (with the exception of 2006) from 529 tonnes in 2003 to 339 tonnes in 2008 (est.).

7. Interestingly, on the demand side it has been estimated that there are approximately 158,000 tonnes of gold owned in various forms throughout the world (Buy Gold Now – page 137). Accordingly, if a comparative small amount of U.S.$ currently invested in the world’s stock markets sought physical gold as a ‘safe haven’, gold’s price ought to escalate significantly. To put this in at least some perspective, McGuire claims that: ‘If … investors pulled just one percent out of their investments in U.S. stocks and bonds and put the cash into gold, the precious metal’s price would likely double and perhaps triple’ (Buy Gold Now – page 137). Buy Gold Now was published in 2008 but before the recent serious erosion in U.S. equity market prices (this Post is being written in late November, 2008). Accordingly, McGuire’s statistics would no doubt be wrong today, but nevertheless likely still would be directionally correct.

Concluding Comments

1. The important sources of gold supply obviously are ‘mine supply’ and ‘scrap recycling’ which in the 6 year period ended 2008 (2008 being estimated) have accounted for just under 86% of all world gold supply, with ‘mine supply accounting for just over 60% of all supply. Given that:

• few new large deposits are being found, and extraction costs, production costs, and related environmental remediation costs are increasing, it seems likely that only higher gold prices will result in a constant or increasing annual gold supply from mines;

• ‘scrap recycling’ may increase supply if gold prices escalate – although persons selling ‘gold scrap’, be it jewelry or other ‘gold scrap’ may be disappointed with the price it fetches if it is less than 22 carat purity; and,

• Central Bank sales and purchases are unpredictable given they are based on government policies which are subject to change. If anything, I suspect Central Bank sales will contribute less net supply to the world gold markets going forward than they have in recent years, but have no empirical evidence to support this supposition.

2. On the demand side, the three important ‘demand groups’ are ‘jewelry fabrication’, ‘electronics and other end uses’, and ETF accumulations, collectively accounting for at or over 75% of total world gold demand. Given that:

• ‘legal tender coins’ are not material (i.e. significant) to overall world gold demand;

• gold jewelry, while purchased perhaps in part for cultural reasons in India (the largest consumer group) in particular, is in the end a discretionary expenditure. That being the case, in times of economic downturn and consumer spending retraction, one would think world gold demand related to jewelry purchases would decline – with demand perhaps being buoyed up by demand created from developing countries where consumers ‘save’ and may perceive gold jewelry as a store of wealth – which as noted above, unless in 22 carat form likely is a poor ‘store of wealth’ at best;

• gold demand for ‘electronic and other end uses’ likewise might decline in times of economic downturn, although there is always the possibility that given gold’s physical properties it may find application in medical or other areas that might provide substitute demand;

• given what is currently (in late November, 2008) transpiring in the equity markets, including volatility, uncertainty, and what appears to me to be increasing reduction in investor confidence, it will come as no surprise to me if some of the cash that is being taken out of the markets finds its way into gold ETF’s or physical gold. Should this occur, such demand may offset all or part of declines in other types of demand for gold; and,

• assuming hedging is something gold producers likely will be more wary of in the future than they have been in the past, hedging and dehedging are together something that may effectively result in a future net reduction to annual gold demand.

3. So where does all this leave me. Frankly, in a position where it does not strike me as a certainty that gold demand will outstrip supply in the near future in a way that would by itself drive gold prices denominated in U.S.$ higher. Having said that, it also strikes me that world gold demand could quickly outstrip world gold supply in a time of economic uncertainty (which we are certainly in as this is written), or an escalation in terrorism or world conflict.

4. I don’t know the exact route to the ‘end game’ nor am I able to predict the ups, downs, and disruptions along the way. Having said that, I intuitively think the standard of living enjoyed by upper and middle economic class Americans and Canadians is likely to decline over time – perhaps more abruptly than one would like to imagine. In such an environment, if one accepts that Gold’s ‘value’ as ‘real money’ it seems to me that it is a wise thing to hold some physical gold as a ‘safe haven holding’. That is not to say that based on my thinking to date I am recommending a physical gold holding to the exclusion of owning one or more fiat currencies, equities and other investments. I have simply concluded that I think ‘some physical gold is a good thing to own as a safe haven holding’.

For previously issued Posts in this Series click here.

The views expressed in this Post are those of the author. They are offered to readers for information and general guidance only. They are neither intended to, nor should be taken to, constitute economic or investment advice. See Legal Disclaimer.

© 2008, Stock Research DD Inc., all rights reserved.

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• Gold as an Investment – How I Assess It and Why – Post #9 of 11
• Gold as an Investment – How I Assess It and Why – Post #8 of 11

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