Gold Mining is a lousy, capital-intensive, highly-regulated business. And it's getting harder...
WE HAD PROMISED to tell Daily Reckoning readers about asset allocation for 2010, followed quickly by a un-anaesthetized tonsillectomy, writes Dan Denning for the Reckoning's Aussie edition in St.Kilda, Melbourne.
Both are about as exciting. But instead, we're going to review your 2010 asset allocation strategy in a roundabout way by exposing some of the snarky disinformation being put out by the mainstream media about gold, courtesy of Michael Pascoe at The Age.
The question of element number 79 on the periodic table is making plenty of headlines right now. The latest snarky article is entitled "There's more gold where that came from."
In the article Pascoe takes on the issue of "Peak Gold". But before we get to that, how well does he do in accurately stating the argument for gold? And more importantly, is he right about the relationship between market prices and Gold Investment? Well, obviously we think he's pretty wrong. But let's see what he's said...
"Part of the dogma of the less rational gold bugs is that the world is running out of the stuff. As an article of faith, it makes a pleasant change from the idea that fiat money is about to be exposed as huge confidence trick and we're heading back to the caves."
Webster's defines "dogma" as "a religious doctrine that is proclaimed as true without proof." Already you can see what Pascoe is up to. Gold bugs are nutters and zealots. Apparently 5,000 years of monetary history where gold has proven utility as a medium of exchange and store of value does not qualify as empirical evidence of gold's value. There's no pleasing some people, especially those who come to an argument with their mind already made up.
But fair enough. Opinion journalists get paid to give opinions. They cloak themselves in supposed objectivity because that makes their views more respectable to the mainstream. But we've never been concerned about respectability here at the Daily Reckoning. Why base your judgments on what other people will think of them?
We're entirely subjective in our views. At least it's transparent. And at least we base our conclusions on facts and arguments. And we've not once argued here – although perhaps some gold bugs have – that the world is running out of gold. That is not what "peak gold" means at all.
The first step in any debate is to define your terms. So we will do so here and say that "peak gold" mean's declining annual gold production. We'll prove that in a minute. But just so it's clear, no one in this space is saying the world is running out of gold. But gold IS getting harder to find and more expensive to mine. And the supply of paper money continues to grow faster than annual Gold Mining production.
We won't dwell on the subject of paper money too much longer, except to say Pascoe's dismissal of the current status quo is nearly as laughable as it is naive. He says peak gold "makes a pleasant change from the idea that fiat money is about to be exposed as huge confidence trick and we're heading back to the caves." Seriously. How can any objective observer take a look at fiscal and monetary of the last three years and assume that central banking and fiat money are not a giant con job on the general public? Fiat money allows the government to create money backed by nothing. Not only does decrease purchasing power - especially hurting savers and those on fixed income – it accelerates the misuse of real resources.
When it comes down to it, it's a kind of theft.
The government prints money and gets the benefit of using it first before purchasing power is diminished. It trades paper money for real goods and services – things which take labor and raw materials to produce. The systematic inflation inherent in fiat currencies IS theft of real labor and resources.
As long as that inflation makes house prices and stock prices go up, it appears to please everyone. But it's the argument of this publication that the monetary regime in place since August of 1971 – when Richard Nixon took the US off the gold standard – is first a fraud, and second in the process of disintegrating. It's disintegrating because, at its heart, it's based on the idea that money doesn't have any real tangible value.
Gold does, of course, have tangible value. To the extent that it's intrinsically valuable, it's valuable because its physical properties – relatively scarcity, durability, transportability, divisibility, homogeneity – make it particularly useful as a monetary unit of exchange. To suggest it has no inherent value is to misunderstand the qualities that make money useful, and more importantly, sound.
But back to the issue of production. It's not just the nut jobs in the newsletter industry warning that gold production is falling. It's the gold miners. Of course you have to discount what they're saying to the extent that they're talking their own book. But they do know their own business and they are saying that 2009 could be the last year for some time that gold production rises.
Omar Jabara, the spokesman for Newmont Mining in the US, says that in terms of production, "2009 is the outlier as far as the trend. The trend is that production has been in a general decline since 2000."
Why does that matter?
Pascoe says, quite correctly in theory, that price discovery and market mechanisms help ensure that supply grows when prices rise. Or, in his own words, "The 'peak gold' story isn't quite as dodgy as some of the 'peak oil' scare mongering the more sensationalist media have trotted out over the years – we'll never run out of oil as the market mechanism very successfully rations it and because, at a price, we simply make the stuff. Shell, for example, is spending $20 billion building a gas-to-diesel plant in Qatar."
Running out of oil or gold? Don't worry! We'll just make more of it.
It's hard to reconcile this with the fact that the Gold Price has been rising since 2000, but gold production has not. In late 1998 the Gold Price was in the mid-$200s and annual global production was just under 2,500 tonnes per year. Since then, the Gold Price is up 340%. Yet production this year is set to be just over 2,400 tonnes. That's an increase over last year, yes. But it's still down from Gold Mining production of ten years ago. So why aren't higher prices attracting new producers?
Well there are a couple of factors here. First, a lot of the big mines that were producing in the 1970s – especially in South Africa – are seeing production declines. That's not say all the mines are played out. But they're having to dig deeper and pay more for labor and energy, all of which leads to rising production costs.
That is, despite the rising price, production costs are rising faster for some companies. Those companies are making less money from the price rise, leaving less to invest in new exploration and production. Besides which, surely Pascoe would know that there's no such thing as just-in-time gold production.
You have to find the stuff. And it has to exist in an ore body that's economic to mine at current Gold Prices. And you have to get permits to mine it. All of that takes time and money – usually many millions and many years – during which central bank printing presses are busy churning out new paper notes at a much faster rate. The supply of paper money is growing a lot faster than the annual mine supply of gold, which does not look like growing much at all in the coming years.
Barrick Gold's Vincent Borg says that, "It's a fact that gold production from mines has been in decline since 2001 and has gone from 85 million ounces to about 75 million ounces a year...It sort of goes down about one million ounces every year and or forecast is that it will continue to decline despite the higher price."
In most markets, higher prices to attract new producers. But as we've said before, quoting our friend Doug Casey, Gold Mining is a lousy, capital-intensive, highly-regulated business. It is not like opening a lemonade stand. Therefore gold production does not automatically increase because prices are higher. That's a fact, not a dogma.
Yet Pascoe persists. He quotes Standard Bank analyst Waler de Wet, who, presumably because he has a South African sounding name, must be right about gold. De Wet told clients that, "Given that the US gold mine production is 10% of global mine production, if you assume gold resources are proportionate to current mine production, global resources could be 330,000 tonnes. That is another 137 years of production."
The argument here is that higher Gold Prices turn more resources into proven reserves. That is, marginal gold projects become economically viable with higher Gold Prices. But the reason that these projects were marginal to begin with is that they were more expensive to bring into production (away from infrastructure, lower ore grades, smaller ore bodies). If the margins don't improve on the projects, there's no guarantee anyone is going to bother producing them, especially if the cost of production is rising as much or more than the Gold Price.
Further, why would anyone assume that "gold resources are proportionate to current mind production?" It seems like a rather large assumption to make. As anyone who's spent any time analyzing resource stocks knows, a resource is not the same thing as a proven reserve.
The energy market is fortunate that higher oil prices make other sources of unconventional more economically viable. That's why Australia's LNG and coal-seam-gas industries have done so well this year. But you can't just "make more" gold the way you can make more energy. The world doesn't need oil. The world needs fuel and the work that fuel can do when you burn it. Thus, high oil prices lead to investment opportunities in oil and other energy sources, which eventually brings down the price of energy.
The funny thing is that the last time we checked, the oil prices is above $70. This confirms the peak oil thesis. The age of cheap energy is over. Oil is still out there. But it's getting harder to find and more expensive to produce. The cheap stuff is going fast.
With gold, of course there is more Gold in the ground waiting to be mined. But who's going to mine it? And at what cost? It's an expensive business. And even if exploration spending boomed and turned up even more gold, it will take years to bring into annual mine supply.
You could argue that the rising Gold Price is only a function of scaremongering by newsletters like the Daily Reckoning – or that it's being ramped up by speculators and fund managers. This would explain why gold producers didn't increase production to meet rising prices. They saw the price rise as fictional or fundamentally unsound.
We wouldn't agree with that argument, mind you. But it's one way to explain why gold production isn't more price sensitive. The other is the simpler one: gold production is hard to increase, no matter what economic theory or Michael Pascoe says.
But by the end of the article you can see that Pascoe doesn't really have his head in the argument, just his heart. "The Gold Price's recent stall thanks to the Greece and Dubai-inspired up-tick in the US Dollar demonstrates just how much of the gold rally has really been a currency story rather than anything intrinsically valuable about the yellow metal.
"It's just another alternative to greenbacks, one that doesn't do much productive or pay dividends but relies purely on speculation for any non-currency price improvement. The unkind might think that's why the gold bugs keep the scare campaigns coming – that and the need to sell more internet newsletters."
He's partially right and mostly wrong here. Yes, the rising Gold Price is a function of the bear market in paper money. Gold is better money than paper, if you're a gold bull. That makes gold stocks a leveraged speculation on higher Gold Prices. But we don't have to say any of that to sell newsletters. After all, this one...The Daily Reckoning...is free. Instead, we keep saying it because it continues to be important. Only a numbskull would ignore all the warnings about paper money coming from the markets in the last two years. Rising fiscal deficits...insolvent banking systems...the re-monetization of gold by central banks as a reserve asset. These aren't articles of faith. They're facts.
Of course gold isn't an investment panacea. But it's something you should take a lot more seriously than Michael Pascoe does. Unless you're worried about being respectable amongst those of your friends who thought that a currency crisis was something that only happened in history books, and not something you ought to prepare for.