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The Mighty Metal

John Myers
May 10, 2004

The Daily Reckoning PRESENTS: The demand-side fundamentals for gold are excellent. But won't supply increase as the price increases? Not necessarily.

"There are a zillion people looking for gold these days, because with the gold price up and money flowing in that direction, people can get financed to go and look for it," says John Embry, chief investment strategist at Sprott Asset Management. "But the fact is gold is a precious metal, and the reason it's a precious metal is that it's not that easy to find. So I think that, much as in the exploration boom of the mid-'90s where incredible amounts of money were put into the ground, remarkably little was found." Like us, Embry believes that despite intense efforts, very little gold will be discovered over the next few years. And also like us, he believes that we are entering an era of new wealth creation that will fuel demand for precious metals.

"We've got a worldwide boom going, particularly in the Third World, much of it driven off sort of the consumer strength in the United States," adds Embry. "The United States is desperate to avoid deflation and they've been printing money... creating credit at a rapid pace. And the bad news for the U.S. is that an awful lot of that demand that they're creating is leaving the United States shores and it's going over to China and India and other places in that part of the world, and what is underwritten is a very significant boom. I would submit that China is almost out of control at this point, on the upside in the sense that credit creation is growing at extremely rapid levels."

So close is Embry's reasoning to ours that you may think that your editor "word-jacked" his story. But the truth is we both see the same sorts of trends that will power gold to much higher levels.

Who Will Seek Gold?

Why am I so confident the Midas metal is set to soar to higher levels? Two reasons - or really two certainties... first of all, Washington refuses to accept a crushing deflation. Second, vast numbers of people are generating new wealth - wealth that they will no doubt spend but also save... some of it in the form of gold bullion.

With so little confidence in the dollar these days, it seems certain that some of the world's new bourgeoisie will look for other instruments in which to stash their savings. If even just a fraction of the world's new wealth is invested in gold, it will have an explosive impact on bullion's price.

Demand Squeezes the Earth

As more of the new wealth invests in gold, we encounter the same old problem: lack of supply.

Gold is extremely scarce. Each year, all the gold mines in the world produce only about 80 million ounces. A world-class gold discovery yields a million ounces... but they are rare. When you consider that the world's three largest gold mining companies produce less than 15 million ounces a year, you get the picture.

South African production peaked in the 1970s, while Canadian gold production has been in decline since 1991. The truth is that it is getting harder each year for blue-chip gold companies just to replace their reserves. In fact, over the past decade, many gold conglomerates have shut down exhausted gold mines.

Of course, there have been plenty of mergers and acquisitions, but they don't add a single ounce to the world's inventory of gold. They merely change the ownership of the same gold.

Today the mining industry is on a treadmill, desperately trying to replace 80 million ounces of annual production, just to stop from shrinking. With larger discoveries harder and harder to find, it is almost certain that world gold production will decline this decade.

"Consider that to mine the 80 million ounces of gold that is produced each year, assuming that the average worldwide grade is 10 grams per tonne (it is probably less), would require moving, crushing and processing 250 million tonnes of rock," writes analyst Paul van Eeden. "That would make a 3.4 billion cubic-foot hole, and the gold produced would be only 4,500 cubic feet. No wonder it is tough making money mining gold."

Profits Rise With Tight Gold Supply

Of course, higher prices over the past year have made gold mining more profitable for most companies, and we are, in fact, within striking distance where even the most expensive deep-shaft miners will become profitable (more on this in a moment).

But what I think is so fascinating about the gold market is that the entire amount of gold discovered this year will be worth approximately $30 billion. That is less than one-quarter of Coca-Cola's market cap and a minuscule fraction of the $11 trillion-plus U.S. bond markets.

The gold market is so very thin that if just one in 1,000 of the world's nouveau riche were to buy even a paltry few ounces of the Midas metal, its price would soar. And while the U.S. bond market is growing by a trillion dollars every year, and M1 money supply has grown on average by more than 7% per year over the past five years, the aboveground gold supply is growing by about 1%.

Eying Our Golden Future

Meanwhile, the gold price is now hovering around the $400 level. It has also broken below what some feel is an important psychological level several times, perhaps signaling trouble.

Don't believe it. The great gold bull market of the 1970s had several corrections, one of which was of a far greater magnitude than this hiccup.

Newmont Gold President Pierre Lassonde agrees with us. He also points to the 1970s to demonstrate why gold could soar in an era of what he calls a "manic-depressive dollar." "We haven't even started to correct the U.S. financial imbalance of the last three years, said Lassonde. "Don't tell me that the gold bull market is over. It has hardly even started."

Newmont's president predicts gold will outperform other assets for some time to come. "As long as they don't cure the financial imbalances, the dollar will continue to go down and be very volatile. I don't know how long it will take, but it will take quite a few years [to work through], and that is the gold story in a nutshell."

Gold Soars Over Falling Dollar

The truth of the matter is that Asian holdings of American government debt have soared, while the U.S. government is spending at a record rate. But I think what is most interesting is another fact Lassonde points out - that technical innovations in mining have dried up.

Even if he's wrong on this point, though, and cheaper exploration extraction methods are developed, gold production is certainly going to lag future demand. There have been incredible advances in finding and mining gold over the past hundred years, but on average the aboveground gold supply has grown by scarcely 1% per year. If the advances in geology, particularly in the 1940s and '50s, could not break this barrier, I am doubtful anything that science has to offer tomorrow will, either.

"The last real gold bull market was in the 1970s," Lassonde recalls. "It went on for 9 years, from 1971 to 1980. What we've had in the past 20 years are bear market rallies. So when you read... that the average gold bull market is 40 months and we're 36 months into it - and that's bad. Well, you know what, they haven't seen anything until you go back to the 1970s."

Citing a strong dollar-euro correlation, Lassonde said, "Over the past two-and-half years gold has been a currency, not a commodity. That's because the dollar, as currency of last reserve, is not acting that way, thanks to the U.S. financial imbalances that are enormous, unresolved and growing."

On the last point I couldn't agree more. But Wall Street is having a hard time coming around to this point of view. You must remember that most stockbrokers don't know a darn thing about commodities, other than the fact that a bull market in gold is typically bad for business. Not one in 50 stockbrokers has even a rudimentary education in geology, and is far more likely to have an MBA on his wall, a testament to the fancy business ratios he learned in grad school.

Just one problem: Resource companies don't fit many of these ratios. What does fit is good management, and, most of all, opportunity... opportunity to find and produce gold, and opportunity to profit and grow through sound practices and a good (we prefer great) exploration team.

Don't pass up on sound resource stocks just because they're not Wall Street's darlings. And if you miss the coming bull market in gold, well...

...you can't say we didn't warn you.

John Myers
May 10, 2004

Editor's note: John Myers - son of the great goldbug C.V. Myers - has been helping readers earn suprisingly lucrative returns in stocks largely unknown to Wall Street's wunderkinder since his early 20s. Our man on the scene in Calgary, John has his fingers on the pulse of natural resource profits - including oil, gas, energy and gold.

Osama Bin Laden has recently offered 1,000 grams of gold for the head of any U.K. or U.S. citizen, and 10,000 grams for the head of Paul Bremer and other senior U.S. staff in Iraq. This is exactly what John was concerned with when he put together the shocking exposé on the advent of a new "secret currency" in the Middle East... which could have disastrous effects on the U.S. economy. Don't miss it - the effect on your portfolio could be significant:

The New Secret Currency - A Deadly Threat to the U.S. Economy.

This article appeared on the The Daily Reckoning website.
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