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Gold is up - so What ?

May 20, 2002

After the latest run up for gold will we see once again accelerated producer forward selling as we have seen it in the last five years? Will the gold price be down once again to new lows ? Many analysts, investment bankers and also producers do think (hope) so as there are still many short positions out in the market.

To evaluate the situation, it is very important to know what actually causes a price response in the gold market. As it can be seen in the below chart, gold production had always a big influence on the gold price among other factors. The huge increase in gold production put pressure on the gold price, although also dishoarding and central bank sales have been a major factor in gold's decline.

On the demand side (see below chart), gold just behaved like it should: demand increased when prices went down and vice versa.

What is then the trigger for a price rise in gold ? If demand wanes through higher prices - just like it did in the latest quarter by 10 % worldwide - how can prices go up even further? The answer lies in supply. Gold - like many other commodities - bottoms out through disruption in supply. Now why should supply fall when prices just start rising, the opposite should be the case. This is what market theory tells us.

Nevertheless, as many analysts and investors know very well the markets, they still do not recognise a fundamental shift in production structure in the mining industry and in this case the gold mining business. Just as production grew further and further despite falling prices, it is now very likely that production will fall further and further despite rising prices.

The fundamental change in the mining business took place already decades ago, yet has accelerated enormously in the latest years. The change is economies of scale. In short, that means the larger the operation, the lower the unit costs of an item. It happens everywhere. In the IT, business where huge factories produce hundred thousands of PC's, in the telecommunication industry where millions of mobile phones are produced at ever lower unit costs. It also affected the service business as computers now manage millions of bank accounts. This is what made up the huge productivity revolution in the last decades.

Yet it started in the mining business first and will also end in the mining (commodity business ) first. In the mining industry, ever larger mines could reduce cash costs substantially, albeit at ever growing capital intensity. As mining companies soon started to become restricted in funding large operations, forward sales came to the rescue. Through forward sales, companies could construct giant mines. At completion of these giant operations they could easily drive out competitors through lower cash cost (unit costs). This is what actually happened in virtually all sectors of the industry, yet at a very large scale in the mining and commodity business.

As the whole economy, including consumers, benefits from this development, why should we worry? There are some layoffs in the mining sectors, yet overall job growth should overcompensate these losses. We are all better off as we can consume products at an ever declining price.

There are basically two reasons why we should worry. First, the leverage of the whole economy and the mining business increased dramatically. Just to mention an example Pasminco, the Australian zinc miner, which filed for bankruptcy last year, produces 1 mill tons of zinc, nearly 15 % of worldwide production. Despite very low cash costs of its Century mine, the company had to file for bankruptcy due to hedging losses. The risk in financing and also hedging became unmanageable for the company. As this company still produces zinc despite bankruptcy, it depresses worldwide zinc operations and threatens to bring down the world zinc mining business completely thus depressing new investments and paving the way for huge price increases in the future.

Secondly, depletion is extraordinary high in these gigantic operations. This is now especially evident in the gold mining sector. The big three mining companies have reported already vast declines in ore grades and production in the first quarter of the current year. At the same time cash and production costs have increased dramatically. Of course, the trend is downplayed by the management and further improvements are promised. Yet I am not so sure if the top managers really understand what is happening on the floor of their industry.

Nevertheless, according to the latest report on US gold and silver production, gold production already declined in the US to 20 tons (for January) an annualized decline of 100 tons to 240 yearly production from 330 tons in 2001. Even worse, silver production declined by 48% in January, leaving the annualized output at around 1200 tons of silver versus over 1700 tons in 2001.

This production decline and cost upsurge occur at still high hedge positions of the companies. The unfilled hedge positions combined with dramatically rising production costs restrict the ability of companies to fund new production thus decreasing the supply in the future. Adding the lack of interesting mining deposits due to already high depletion, we will see soon a dramatic fall in supply of gold in the next years. As the giants have already squeezed out many competitors of the market, the market cannot count on small mines to fill the gap quickly. We have to wait years before small mines can be reactivated.

We have now the interesting situation that higher gold prices will be followed by even higher prices as supply will fall due to changes in the mining structure.

In my personal view, gold is in this case a harbinger for the coming changes in the world economy. The giant operations we have today in the commodity sector as well as in high tech, agriculture… are highly cost effective, yet very inflexible and vulnerable to changes in external factors like currency devaluation, changes in demand and supply, hedging…. As the giants break down, we will have to look at a complete new, flexible and more sustainable structure for our economy.

In 1792 the U.S. Congress adopted a bimetallic standard (gold and silver) for the new nation's currency - with gold valued at $19.30 per troy ounce
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