Gold still on a feverish pitch

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Evy Hambro, Managing Director and Portfolio Manager with the Natural Resources Team,  Blackrock Mutual Fund, says, "The production of gold keeps falling each year, as all the easy gold has been found. The industry needs higher price for longer to invest in finding new supply."

Gold has been in a bull market since 2001. However, having made a new life-time high in recent weeks, where do gold prices go from here? Market fundamentals suggest that gold prices could continue to trend higher from here. The financial crisis has accelerated an already existing upward trend which is supported by favourable supply-demand fundamentals.

First, the gold mining industry is struggling with production - annual production has fallen by 8.7 percent since its peak in 2001. Despite a historically high gold price and a sharp rise in exploration expenditure, I can see no net increase in gold mine supply over the next five years and expect the declining trend in production to continue.

This is likely to prove supportive for gold prices; as is the strategic shift in the attitude of the world's central banks towards gold. Bullion sales by European central banks have slowed significantly after 20 years of large disposals and we are seeing developing countries (most notably China, India and Russia) significantly increasing their gold reserves as they seek to diversify away from US assets amid concerns over the weakness of the US dollar.

China has almost doubled its gold reserves over the last six years and had been expected to prove to be the chief buyer when the International Monetary Fund (IMF) put more than 400 tonnes of its stockpile up for sale in September. However, India took markets by surprise when it announced in early November that the Reserve Bank of India was buying 200 tonnes of the IMF gold, marking the biggest single central bank purchase of bullion for around 30 years.

 

 

Illustration: Abhijeet Kini

Even with this purchase, India's gold represents less than 10 percent of its total reserves. This move fuelled speculation that other central banks with large US dollar exposure might also diversify into hard assets such as gold. Indeed, Sri Lanka also subsequently admitted to making gold purchases in the past six months. Although the immediate impact on the gold price of this shift in central bank sentiment may be limited, I believe that its longer-term implications are likely to prove extremely supportive for the gold price.

I continue to see a strong investment demand for gold, as witnessed by record levels of purchases through Exchange Traded Funds (ETF). ETF holdings, as a whole, have now reached the very high level of more than 50 million ounces of gold. Investor demand for ETFs seems to be driven by a variety of factors, with investors viewing gold as a hedge against US dollar weakness and against medium-term inflationary pressures, while also providing important diversification benefits.

With regard to gold equities (mining companies), they now appear to be generating leverage to movements in the bullion price, a characteristic that had been conspicuously absent in recent years. We believe that earnings will expand as gold prices rise and investors will be attracted back into the sector.