Friday, April 22, 2011

Why gold could hit $5,000

Fears of inflation and global turmoil have sent precious metals surging, with gold trading at all-time highs above $1,500 an ounce. How much further can it climb?

With turmoil overseas and energy prices on the rise, investors are worried. They're worried about geopolitical risk. They're worried about a falling dollar. And they're worried about inflation becoming entrenched as the Federal Reserve continues to administer its cheap-money medicine despite signs of inflation.

As a result, gold is on the move again. For much of last year, gold moved higher over worries about Europe's debt crisis and a "double dip" recession in the United States. Prices fell into a funk in the fall, though.

Now, a new set of concerns has gripped the hearts and minds of investors. Fear has returned.

And the yellow metal again set new highs this week, closing on April 21 at $1,503.80 an ounce.

So how high can it go?

Believe it or not, some analysts are calling for prices to move close to $5,000 -- not immediately, but sooner than you may think.
The road to $5,000 gold

This is because, according to the folks at Standard Chartered Bank, gold is moving into a new "super-cycle" as a number of structural factors -- including consumer demand from Asia and tepid growth in supply -- combine to push prices higher. The team, led by Dan Smith, is looking for prices of $2,107 an ounce in 2014 as its base forecast.

The team's members see the potential for much more. In their words, "statistical modeling suggests a possible 'super-bull' scenario of gold prices rallying up to $4,869 in nominal terms by 2020."

It's all about supply and demand.

The driver is increased wealth in Asia. The evidence shows a strong relationship between rising incomes in places like China and India and increased gold demand. Much of this is cultural, with gold holding a place of special religious reverence.

Data from the Shanghai Gold Exchange show that China's gold imports reached 230 tons in the first 10 months of 2010. But in only the first two months of 2011, industry experts cited by Standard Chartered estimate that imports hit 220 tons. No doubt, Beijing's somewhat weak-handed efforts to fight inflation are contributing to the rise, as people look to protect their burgeoning wealth from the ravages of rising prices.

David Davis, an old-hand mining engineer in South Africa who tracks precious metals for SBG Securities, notes that even poor peasant farmers in India, if the monsoons are good and the crops are bountiful, will splurge on a grab of gold. These people may not understand the value of interest-rate compounding or portfolio diversification, but they know that gold is an ancient and universally accepted store of value.

Indeed, the "super-bull" scenario depends on China and India: This outlook assumes that the average income per head in China and India reaches 30% of the U.S. level by 2030 -- up from 2% of the U.S. level in the 1980s and around 6% now. This seems very likely. Standard Chartered is looking for India alone to create nearly 500 million new manufacturing and service jobs over the next 20 years -- jobs that will expand India's middle class from 10% of the population today to 90% over the period.
The inflation fight

It won't be a straight shot to $5,000 an ounce, however. That's because history shows that while gold tends to rally in the period leading up to an interest-rate hike, it stalls a couple of months before the actual move higher.

We're in such a period now. The European Central Bank became the first rich-world monetary authority to tighten policy last week. In the U.S., the Federal Reserve's $600 billion "QE2" program to push money into the economy is set to end in just two months, and near-zero interest rates appear unlikely to last.

That could result in some volatility for gold over the next few months as the market waits to see how aggressively ECB President Jean-Claude Trichet and Fed Chairman Ben Bernanke attack inflation. Gold, of course, is the traditional hedge against inflation for investors. And right now, the inflation threat continues to grow.

"Real" inflation-adjusted interest rates are negative since inflation is currently running higher than interest rates. The two-year Treasury yield stands at 0.85% while consumer price inflation is running at 2.2%. The negative 1.45% real yield is a sign of extremely cheap cash and bubbling pressure on prices. And it's forcing investors out of cash and into assets that will hold their purchasing power in a negative rate environment -- assets such as gold.

Merrill Lynch analysts note that this condition of negative real rates, as long as it lasts, will be supportive of gold prices. Bernanke will probably be a softie while Trichet, due to step down in October, will be more hawkish. So, at least here at home, negative rates are likely to continue.
Where to find a gold mine?

Also, the short-term picture is clouded by the increased supply poised to come online. Gold mine output tends to lag about 10 years behind price peaks, because of the difficult logistics involved in locating, extracting, processing and transporting virgin gold. So far, production growth has been subdued: Mine output expanded 7% in 2009 but only 3% in 2010.

This tepid growth is actually a big improvement: Davis notes that between 2001 and 2008, global gold production declined around 1.3% per year on average. That's changing now as prices move higher. From his office on the northern fringes of Johannesburg, Davis told me that there's been a "moderate uptick" in supply as a number of new mines -- in increasingly unstable and difficult-to-reach corners of the world -- have started up over the last 18 months.

A recent survey by consultancy PWC found that 71% of gold-mining companies planned to spend extra cash on developing new projects. With cash margins up 40% year-over-year toward the end of last year, at $655 an ounce according to GFMS data, Smith believes there is "plenty of money available to spend, which will help to power the next upswing in mine investments and projects."

Over the long term, the supply situation tightens again. Davis is looking for mine production to start dropping at a 2.5% annual rate starting around 2013 or 2014 "as global exploration discovery is unlikely to be sufficient to replace production." He notes that we are already seeing signs of a "contraction in exploration targets and exploration efficiency, which, despite an increase in exploration expenditure, has not kept up with the replacement of sufficient reserves to maintain mine production."

Just getting the math of global production growth to work is difficult. It requires not only the continuous replacement of existing reserves but a steady stream of new discoveries to boost overall mining output.

The problems are geography and geology.

After peaking in the early 1970s, South African gold production is dropping off. In 1966, the country produced 78% of the world's gold. Now, the figure is around 10%. The high-quality ores that came out of the Witwatersrand and Free State fields are gone. All that's left is of lower quality and deeper down, forcing costs higher. New production has moved to Russia and other former Soviet republics, South America, China, and the rest of Africa. Not exactly the friendliest or cheapest places for Western mining companies to work.

Also, engineers just are not finding as many rich new seams of ore in the Earth's crust. Gold Fields (GFI, news)exploration manager Tommy McKeith finds that total discoveries have been in a steady downtrend since 1980, despite a massive increase in exploration budgets during the same period.

More worrisome has been the huge drop in so-called "green field" discoveries -- new ore deposits unrelated and unconnected to existing assets. McKeith comments that, in his opinion, the industry is not sustaining itself over the long haul. Reserves are being depleted. New assets are increasingly being found only in risky parts of the world. And the ore being discovered is of lower quality than what came before.

All of this is pushing up the cost of production -- which will act as a hard floor to gold prices going forward and crimp the availability of supply just as Asian consumers get heavy pockets. Over the next few years, Davis is looking for the industry's global all-in costs associated with mining -- including equipment and exploration expenditures -- to move toward $1,600 an ounce. And as production drops off past 2014, costs will only accelerate.
Where is the ceiling?

That brings us back to the big question: How high will gold go?

For an extreme upside forecast, Société Générale strategist Dylan Grice notes that if America, out of frustration with the Fed's failures, were to return to the gold standard and restore the dollar's convertibility into gold, prices would surge to nearly $8,000 an ounce. This is the price at which the U.S. monetary base, which has jumped from around $800 billion before the financial crisis to more than $2.4 trillion now, would be fully backed by available gold.

We've come a long way. When the Fed was founded in 1913 and policymakers were limited by the dollar's convertibility into gold, prices were stable at $20.67 an ounce.

For investors looking to profit from gold's rise toward $2,000 and beyond, the initial focus should be on precious metal ETFs like the SPDR Gold Shares (GLD, news)and the iShares Silver Trust (SLV). (Silver rises as the poor man's alternative to gold.)

But over the long haul, as supply slowly and painfully increases in response to price peaks, it's the stocks of gold and silver miners that should outperform. Easy exposure can be had from the Global X Silver Miners (SIL, news)-- which holds the likes of Silver Wheaton (SLW, news)-- as well as the Market Vectors Gold Miners (GDX), which holds Barrick Gold (ABX, news).