Bullish Gold Supply
It's hard to believe that gold's bull market is nearly a dozen years old. And boy has it been a delight watching it mature from its 2001 infancy. It's also been fun observing the ever-changing dynamics of gold's structural fundamentals, particularly how the supply side of this metal's delicate economic balance has responded to fast-growing demand.
Until recently gold had three sources of supply, mining, recycling, and central-bank sales. However as a result of the world's governments collectively realizing the folly of their ways, CB sales have recently dried up. And provocatively not only have the CBs stopped selling their gold, they've flip-flopped to become major net buyers of the metal.
In the World Gold Council's latest Gold Demand Trends publication, which is compiled by Thomson Reuters GFMS, it was reported that central banks purchased a whopping 535 metric tons of gold in 2012. Incredibly this level of CB accumulation hadn't been seen in nearly 50 years. Supporting this was the fact that Central Bank Gold Agreement (CBGA) selling was virtually nil last year (with the exception of 5.5mt sold by Germany, specifically for coin minting).
For nearly two decades up to 2007, CB selling steadily and consistently accounted for up to 20% of gold's supply. Now rather than being a major supply source, central banks are large consumers that gobble up a significant amount of gold. In 2012 CBs accounted for around 12% of total global gold demand.
Given this CB shift over the last few years, even more pressure is placed on the other supply sources to meet demand. And recycling has certainly been carrying its weight. For quite some time recycling consistently accounted for about a quarter of global gold supply. But since 2008 it is way up, now accounting for close to 40% of total supply.
Higher prices are of course impetus for an increase in recycling, but it's no coincidence that recycling's surge came on the heels of 2008's brutal global economic crisis. The epic housing/bond/stock panics that drove the world into a deep dark recession unfortunately forced many folks to sell their gold in order to pay their bills and feed their families.
And even though most of the world has since come out of the recession, ongoing economic weakness and political uncertainty has kept the scrappers and hawkers active. Per the WGC recycling in 2012 remained above 1600mt, still within spitting distance of 2009's record high.
But while this timely recycling surge has essentially filled the CB void, its sustainability remains a growing concern considering the diminishing effects of its two main drivers. The first driver, higher gold prices, will naturally lose its luster. Not because prices will fall, but rather folks will grow more comfortable with them at a higher level. If prices stay high enough for long enough, people will gain confidence in gold's appreciation potential and thus hold on to it.
The next driver, desperation selling, is quite temporary. Selling jewelry and ornamentals due to hardship will reach a point of exhaustion. Folks' inventories of what they're willing and/or able to peddle will deplete sooner rather than later. And when this happens, recycling levels will plunge.
When recycling does tail off, gold's top source of supply will shoulder an even larger portion of the demand burden. Thankfully mine production is accustomed to carrying the load. And as you can see in the chart below, the gold miners have stepped up their game in recent years.
The data I used for this chart is the latest and greatest from the venerable U.S. Geological Survey (USGS). The USGS recently posted a 2011 revision and 2012 estimate for global gold production. And as you can see, the miners have delivered another all-time production high.
Mine production historically accounts for about two-thirds of the global gold supply. And its trends are quite fascinating as illustrated by these annual production figures since 2001.
What sticks out the most in looking at this chart is how long it took the miners to respond to this gold bull. Even though gold's bull market is 12 years old as illustrated by the upward-trending red line (gold's annual average daily price), 2012 only represented the fourth year of upward-trending production.
Incredibly mine production was actually down over the first 7 years of gold's bull market. Even though gold's price had more than tripled, production fell by a staggering 11% to 2008. 280mt (9m ounces) less gold came to market that year than in 2001, just crazy during a period where demand was skyrocketing. It's no wonder the price of this scarce metal has risen so dramatically!
In order to make sense of this prolonged production decline, we must view it in exploration-cycle terms. And it is important to remember that gold's bull market was born on the heels of a brutal 20-year secular bear market.
In the front half of this bear, the mining industry was rocking and rolling. Even though the gold price was declining, the days of $500+ gold were still fresh on the miners' minds. And in anticipation of a price resurgence, a lot of capital was put into exploration.
This early work resulted in a solid pipeline of discoveries and next-generation mines, which really put the gold-mining infrastructure in great shape. But alas, the higher gold prices never came. And by the time the 1990s rolled around, gold's relentless grind started to wear on the miners.
This wear was primarily seen on the exploration front. As the bear progressed, it became consensus that gold mining was a losing cause. And investors and miners alike deemed exploration a waste of money given gold's continual decline. Interestingly though you couldn't see this wear as measured by production, with volume actually up 18% in the 1990s!
This dynamic of lower exploration and higher production is an example of the lagging effect of exploration cycles. As is the nature of the mining industry, present-day success is the product of many years of hard work. For a decent-sized deposit it can take in excess of 10 years to get from discovery to a fully-developed mining operation.
Production growth in the 1990s was actually the product of the strong preceding exploration cycle. It was the increase and success of exploration in the late 1970s and 1980s that led to this growth. Even though much fewer drills were spinning in the 1990s, the industry had a pipeline to feed off of.
But this lack of exploration would eventually come back to bite the gold-mining industry. And this is exactly what happened in the early part of our current bull market. After many years of capex neglect, the infrastructure degraded. And due to a huge lack of meaningful discoveries in the 1990s, the pipeline grew thin and miners were unable to replace their depleting mines. The mining woes from 2001 to 2008 were a direct result of the poor 1990s exploration cycle.
Thankfully the 2000s bull ushered in a powerful new exploration cycle. With renewed excitement for gold, literally hundreds of new mining companies hit the hills in search of it. Both the miners of yore and these new companies were able to commit major capex towards exploration thanks to a huge inflow of investor capital. And their work resulted in big discoveries that served to bolster the pipeline of next-generation mines.
These discoveries, both brownfield and greenfield, led to new development that was finally able to outpace depletion by 2009. And after a couple years of growth, in 2011 production output had finally exceeded 2001's. It effectively took 10 years for this exploration cycle to produce a true growth crop!
And not only has mine production returned to pre-bull levels, its 18% rise over the last four years has delivered new all-time highs. But while this 2700mt level in 2012 is impressive, it needs to be taken in context.
When you include the USGS's 2012 estimate, average annual production over the course of this bull comes in at 2494mt. Provocatively this is essentially the same average of the 5 years preceding this bull. In this context, our current bull has yet to produce material production growth!
Looked at in a more generous light, global gold production is up 5.5% since 2001. But considering a huge increase in demand and a 500%+ rise in gold's price over this same time, again this is pretty weak. So this of course begs the question, will the gold miners be able to deliver continued annual production growth in order to deliver decisive secular growth? Sadly I submit that the answer is no at current gold prices. And I'm afraid they'd even have trouble sustaining the current level of production for much longer without gold's price rising from here.
It's simple really. Gold is non-fungible, and much of the low-hanging fruit is gone. The miners are thus forced to go after the harder to find, harder to extract, and lower-grade gold in a geopolitical environment that is increasingly hostile and a market environment that is increasingly stingy. The tangible and intangible costs of mining gold are skyrocketing, and lately the miners have had a heck of a time raising capital.
We already saw a slowdown in 2012's year-over-year growth rate (USGS +1.5%, WGC +0.4%), and some experts believe we could see a slight decline in mine production in 2013. I believe that in order for the miners to materially grow production, or sustain current levels for that matter, that they need to have a financial incentive that is much more compelling than what they have today. And this is quite bullish for gold's future.
But considering the hyper-bearish sentiment towards gold of recent, most would argue that a material rise in its price is out of the question, that this bull market is done for. And indeed it's been a tough slog over the last 1.5 years. Gold's price has ground sideways, the mining stocks have seemingly lost their luster, and according to the WGC, investment demand was slightly down year-over-year in 2012. If you didn't know any better, you'd think the writing was on the wall for gold's bull to be over.
At Zeal we know better though, and we hold the contrarian opinion that this gold bull still has legs. Gold's structural fundamentals are still in great shape. And we haven't likely seen anything yet on the demand front. With fiat currencies inflating away into oblivion, investors will have no choice but to hedge their hard-earned capital with gold.
Investment demand is up about four-fold over the course of this bull, but mainstream investors have come nowhere close to integrating the ultimate currency into their portfolios. When mainstream interest does finally find its way to gold, demand will skyrocket.
This will force higher prices, especially if mine supply tails off a bit and stokes a renewed sense of scarcity. And this will compel the miners to grow production, to continue to bring the fruit of this exploration cycle to market. Before this bull is out we need to see meaningful secular production growth, and we haven't seen this yet.
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The bottom line is gold's supply chain has been subject to wildly changing dynamics over the course of this bull market. We've seen the complete loss of a major supply source (central banks), along with massive growth from another (recycling). And gold's biggest supplier (mining) has had a tale of two trends over the last dozen years.
Mine production's latest trend is a growth one. And in 2012 this source delivered all-time record-high output as the latest exploration cycle continues to bear its fruit. But with the year-over-year growth rate quite low in a currently hostile market environment, it'll be interesting to see if this trend can continue. Thankfully even if there is an interim stall, the higher prices I suspect we'll see in the future will no doubt keep the miners interested.
Mar 01, 2013
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