first majestic silver

Inelastic Gold Supply

February 7, 2006

This article attempts to establish the notion that as the gold price rises, the mine production industry will not bring significantly more gold to market. In addition to other obstacles, they will be stymied by hedge book losses, sure to drain valuable funds. They will face large obstacles from rising costs, such as for energy and construction materials. They must overcome labor shortages. In the year 2005, the gold industry has produced a mere 2% more gold than the previous year. The reasons for the shortfall in what might be expected in mine output are many. Abusive hedge practices are one reason in my opinion for the shortfall. More difficult mine venture projects is another. The conclusion is that a much much higher gold price will be required to encourage sufficient supply in order to meet demand and avert shortages. The prospect might spell greater profit for leveraged physical gold and silver investors than stock holders. However, the unhedged mining firms will see staggering gains in their stock price.

Most people are familiar with the basics of the supply & demand curve. Well, except perhaps economists, who re-invent their craft as they go along, fully sacrificing time-tested principles as they "sell out" and defense their interests. Their self-serving analyses disseminated to the public are routine landscape shrubbery. We are often subjected to questionable economist arguments. One particular story comes to mind, pertaining to the copper market. Supposedly, enormous off-warehouse copper supply (unaccounted for) will drive down the copper price. This has been a Frank Veneroso claim, with details offered on inventory quantities at a few key exchanges. However, where is the factor whereby off-warehouse demand is satisfied off the mainstream copper market? Nowhere. Ever since copper surpassed the $1.00 level, the former advisor to Western central bankers has gone from the argument of inevitable Chinese demand collapse to a new equally shaky argument of excess untracked non-exchange copper inventory. So tons and tons of copper are sequestered quietly, surreptitiously, and managed in such a manner that no customer purchases from these available supplies, even if convenient and nearby, even if official exchange costs can be sidestepped? Nonsense. Whenever a convenient spin is needed on an economic subject, it is alarming how often either supply or demand is ignored, as an oversight (unintended or blatant), or a distortion (accidental or planned) within an argument. Almost a year ago, a colleaugue Greg McCoach in the gold community made a claim as a conference panel member that copper would easily exceed the $2.00 price level. His view was widely dismissed, despite his valid relentless demand side reasoning contrasted against slow arrival of supply due to standard production timelines. Greg was right.

The standard supply & demand theory maintains two notions. As supply increases, the price at which it can be sold declines. As demand rises, the price which it can fetch rises. An equilibrium is reached when demand (D) meets supply (S), so as to clear inventory. Or from the other side, equilibrium is reached when supply meets demand, so as to avoid shortage. The vertical scale is price, the horizontal is quantity in the charts. Where the two curves meet is the equilibrium price dictated by the marketplace.

When shortages exist, as has been the case in both the gold market and the crude oil market, the price mechanism has adjusted to find a higher price to remove that shortage. With crude oil, growing Asian demand led to a gradual ratcheting upward in price. No shortages have been reported or experienced, except for the brief episodes in the wake of the hurricanes in late 2005. The price mechanism works. The phenomenon at work nowadays, a strain to be sure, is that the entire supply (S) curve is moving UPWARD TO THE LEFT, since energy deposits are more depleted with each passing year. With each passing year, less supply is delivered to market at a given fixed price. At the same time, the demand (D) curve is moving DOWNWARD TO THE RIGHT, since developing economies are growing.With each passing year, more demand arrives at the market at a given fixed price.

In the primary mainstream markets, a paradoxical situation seems very evident to mark an extraordinary phenomenon. Gold does not operate under the same rules. My claim is that its demand is inelastic, wherein demand grows as price increases. This is called "gold fever." Also, its supply is inelastic, wherein supply fails to respond properly as price increases. This is the paradox discussed as the article theme.

Barrick Gold hedge book losses have begun now to be quantified. Don't expect setbacks are over for either this firm or other hedge device abusers. Barrick was once accused of being a financial firm masquerading as a gold miner, for the unexpressed purpose of selling forward gold contracts far in excess of actual production. Its entire existence is an anomaly, most likely from its inception being a corporate illicit hedge apparatus, a gold cartel tool. Their senior management hailed from financial firms, not mining firms, and surely not of geologist background. Their central unstated non-chartered modus operandi was founded in neglect of their mine operations, sure to exacerbate their future (like now) gold output. Their reported 13 million gold ounce short position vastly eclipses any future production schedule, an outpouring of acid on their balance sheet of as much as $560 million lost in a single recent quarter. To put that quantity into perspective, 13 million oz short position exceeds all gold exchange traded fund (ETF) holdings. In the past six quarters, try imaging the harsh reality of a $1000 million loss for Barrick.

Anyone who cannot conclude that their acquisition of Placer Dome was motivated by a desire to blend acid with some valid production and cash (alkaloid) is naïve at best or blind at worst. Their combined short position is 21 million oz gold. To date, a $3 billion loss on the Barrick books is staggering, but that amount is likely less than half of the sum necessary to close out their "ingenious" hedge book. Again, perspective is needed. Such a cumulative loss over the years offsets the entire profit generated by Barrick from its ill-designed inception. One can serve up Barrick in an MBA business school program as the quintessential hedge disaster in all of history. My view is that at least one mining firm, and very probably Barrick, will blow up in the next derivative disaster with full publicity and notoriety. My conjecture is that Fanny Mae already blew up, but its publicity has been smothered in secrecy under the aegis of the US Federal Reserve. My other evil conjecture is that the USFed is illicitly transforming Fanny Mae mortgage backed bonds into US Treasury Bonds. Does anyone watch? Does anyone care? Is the law even apply? Are laws relevant to the game anyway?

Finally, the point to be gained from this line of thought is that Barrick, like some other gold miners, has been forced to exhaust its precious cash position. They have therefore denied themselves needed funds for mining operations, to satisfy their charter for gold production (seemingly a nuisance), in order to secure current precious metal output. They aint producing anywhere near as much gold, silver, and other byproduct metals due to their greed, stupidity, arrogance, and fractured fallacious phony business plan. The irony is that first, miners are buyers of gold contracts in a very very big way. Second, as the gold price rises, they might actually produce LESS GOLD. They are being bled dry of cash. A mining stock investor must lick chops, salivate, and find glee in their highly deserved misery. Overly hedged gold miners actually produce less with higher prices.

From my "The Gold Volcano: 15 Roads Merge Golden Lava" in Feb2003, a relevant quote applies as a warning for the effect of hedge book losses on the finance of production operations. Back pre-dating the Hat Trick Letter, when this stat rat was plying his trade in a marketing research firm, a hobby of mine was to write on the gold universe. My self-taught studies of economics (unencumbered by the limitations of professional training toward economics credentials) seemed at the time to clash with both the gold market and with standard USEconomic policy. Thus, the pen hit the paper, or the fingies hit the keyboard. What was said three years ago applies today, in fact with actual numbers attached to the unfolding story.

I find irony worthy of derision in the fact that major buyers of gold on the world market are gold mining firms!!! No indirect forces are at work here, merely survival instincts. Not to be left out are the accomplices to the gold miners, who may not escape with any less harm than their overly hedged miner clients. I mention the private gold bullion bankers, who pushed and sold to excess these dangerous forward contracts. Many are so opaque and exotic that the miner firms themselves are unaware of their actual risk as the price of gold rises. See the story of Ashanti Gold in 1999 for details, where consultants and accountants were hired to analyze the company's risk exposure. Diversion of funds from legitimate operations further limits the ability for mining ventures to bring gold production to market. Most contract buybacks cost more than the original sum taken in. They deprive productive operations, and better yet, they add to gold demand. The gold market shows strong evidence of being an inelastic market. Demand rises with a rising price. And a rising gold price has a detrimental effect on supply, just the opposite of what one would expect!

Future mergers by Barrick and other troubled mining firms are certain for the unexpressed purpose of neutralizing and minimizing the extreme damage to their balance sheets. They crave desperately future gold production. The ultimate impact on the gold price from hedge book buybacks by gold miner mergers will be an ongoing theme. They will support the gold price upon dips, seeing a brief opportunity to cover losses and to remove a portion of their crippled hedge book. They will offer counter-trend support on a seasonal basis. They will inevitably feed a parabolic lift during a panicky hedge book blowup. Barrick only forestalled their highly visible eventual blowup. They bought time, nothing more. Their pants are being pulled down by the cantilever of the rising gold price. Or, to burden the reader with imagery further, as the gold show lifts the curtain, the fat asses, shriveled members, and empty heads of Barrick and other destructive hyper-hedgers are exposed for all to see, a wondrous sight indeed.

The same is, by the way, the motive for JPMorgan's acquisition of Chase Manhattan, and later Bank One. Neutralize the acid from disastrously underwater hedge books with valid capital (alkaloid). Many pondered how JPMorgan evaded the grim reaper with all their derivative losses yet to be declared. They too bought time and extended the financial metastasis. They also merged with cash rich Sumitomo, a giant Japanese bank. The best description of this abusive hedging practice gone amok in disease pathogenesis might be FINANCIAL CANCER.

And then there is more. Additional cost pressures come in various forms, such as higher energy costs (like natural gas, diesel), rising material and construction costs (like steel, cement, lumber), and escalating labor costs. Drill equipment rental costs have tripled in the last few years alone. Let us not overlook the rising property prices all through Alberta, also up three-fold since 2001. Escalating energy and construction costs have been well publicized in recent months, perhaps even motivating strategies for hedge funds to go long the commodity but short the stocks. That strategy worked beautifully this past autumn. My guess is they covered the shorts starting in December.

Don Lindsay, CEO of Teck Cominco, paints a bleak labor picture. He claims "The constraint on people that the industry is facing today is absolutely enormous… You could put $3 billion into exploration right now, but the teams who have the training, who have the relationships, who have the experience required, all of those people right now are fully engaged and fully funded." Lindsay traced the origins of the labor shortage back to 1997. According to him, the feeder systems were disrupted by the Bre-X scandal, the Asian Meltdown, and the commodity bear market. He expects demand to remain robust from China. Keep in mind that over two thirds of geologists in the world hail from Canadian schools. So if professional shortages exist in Canada, we have a very large problem indeed. Mirroring the crude oil roughneck labor shortage is the mining labor shortage. Another parallel exists. Lindsay points out that within a decade, 60% of all Canadian scientists working the geosciences will be at least 65 years of age. The overall impact is surely that new mine deposits will take longer to find, longer to produce, and cost more.

A recent Yale University (by Gordon, Graedel, Bertram) research study points to dwindling potential supply from new mine deposits for basic industrial metals. Their findings highlight the future strains. Even if recycled, supplies from finite resources might not meet the needs of global production demand. The risk is of ongoing depletion, against a backdrop of significant non-recycled waste, estimated at 26% for copper and 19% for zinc. They cite an extreme risk for platinum depletion in the face of limited substitution for critical catalytic converter applications. As shortages and depletion take a bigger bite out of production, cost pressures will mount.

Can anyone remember the last "gold fever" event? It occurred late in 1980, marked by daily news events, stories about a conspiracy to corner the world's silver market by the infamous Hunt Brothers, and pictures of lines around street corners with hundreds of people (mostly young) suckered into buying at the top from coin dealers and jewelry outfits. My memory is vivid. Contrast for a moment to the year 2001, when gold was at its bottom $265 price. Nobody could give a rat's ass, nobody could care less, as financial rags ignored the tremendous bargain, as dealers had to beg customers to purchase the barbarous relic in any form. So at the lowest price, gold went begging with little interest. So at the highest price, gold garnered enormous interest and enthusiasm. That is backwards, grasshopper. The gold market is unique, like other markets subject to frenzy. That screams of inelastic gold demand. Its demand curve is backwards, noted by a rising demand associated with a rising price. For this reason, few can gauge how high gold can go amidst the full force of the mania.

For comprehensive treatment, this topic deserves mention. It is essential that silver must enter the picture. Gold might skyrocket in price, but silver could languish, denied ample press coverage, ignored by the masses, simply overlooked, or suffering from industrial lack of demand. Perhaps it might suffer from the disinformation of harsh impact due to photographic demand in an increasingly digital world. Unlike gold, silver is consumed in large quantities, while most of the gold ever produced still rests in vaults. We know the concept in the form of "sympathy" as in Hewlett Packard rose in sympathy after IBM reported a big lift in revenues and profit margin. Cross demand is hereby addressed.

The same inelasticity claims apply to silver, since a precious metal, although of second class status. Silver might benefit from additional industrial demand, owing to its many unique and irreplaceable applications, as the global economy and especially the developing world matures. Commercial demand would augment investment demand to send silver into orbit for price. However, if a global recession occurs, commercial demand would dampen the investment demand.

In an attempt toward completeness, here are industrial usages of silver, with some surely omitted without intention.

  • Sensitivity to light (photographic)
  • Conduction of electricity (electronic circuitry)
  • Super-conductivity transmission (low temperature)
  • Heat dissipation (engines)
  • Burn treatment (antiseptic)
  • Water filtration (antiseptic)
  • Preservative of lumber (pressure treated wood)
  • Storage of electricity (batteries)
  • Dietary supplement (health)
  • Kill werewolves (full moon only)

The good rock hero Elvis Presley is quoted. Let us show gratitude for a colossal force behind gold demand, the major thrust from a grand strategic misfire not to go away any time soon. Let us all rejoice for the screwed up self-destructive overly hedged gold miners. May they enjoy a slow death from a thousand cuts as they endlessly cover their acidic hedge books, and add to relentless demand from their own folly. It is my theory that they will never fully cover such hedge books. They will endlessly purchase, endlessly move their "line in the sand" to incrementally higher price levels, endlessly avert death by buying a little more time. As they do so, they extend to the lifespan of the gold bull market. With each critical line shift, we can be assured of wave after wave of future buying of futures contracts from these corrupt speculators who posed as miner executives. May they be handed their heads. May their executives be recycled to the jobless ranks. May their corporations shrivel from capital blood loss. May their infrastructural bones wither away and become brittle from neglect.

Each higher gold price level comes with larger losses per rolled contract, which might actually ensure rather consistent quarterly losses for years on end. We will surely see. THE HEDGED MINERS WILL NEVER BE FREED FROM THEIR GREEDY CORRUPTED CONTRACTS. They will require a steady sequence of more mergers, more central bank cooperative bailouts, and more shenanigans from clandestine back room deals. With each desperate round comes more bidding for other mining firms. My conjecture is that only the heavily hedged firms with merge, with each other. The unhedged healthier firms will avoid destructive injurious caustic relationships and offers to merge, as they should.

The gold investment community might ponder a strange thought. We might hope for NO EXPLOSION BLOWUPS from derivative accidents among the gold mining firms. Without the blowups, we benefit from the endless short covering, endless demand support, endless upward lift to the gold price. With blowups, the climax would be upon us. Without a climax we extend the bull's longevity to our glee. My preference is for an endless sequence of years for the gold bull to nod in gratitude to the gold cartel for their backfired hedge book strategy and maintenance management schemes geared now toward survival, and no longer toward unethical profit. Keep shifting your lines in the sands, clowns! Each shift is a lock for yet another profitable quarter for gold investors.

Many of these factors, and other important topics, are discussed and analyzed in the Hat Trick Letter, which appears as a monthly newsletter, published in mid-month.

A final tribute to Sir Alan Greenspan, inflationist par excellence. Good riddance to this accomplished serial bubble blower, this astute obfuscator, our maestro rationalizer of all things inflexible, the abject central bank heretic who long ago forgot all prudent economic concepts, the knighted fool who warned then blessed then embraced irrational exuberance. Three cheers to the man who redefined inflation and legitimized all asset bubbles and rendered them free from danger, even beneficial, so that our entire USEconomy could rest atop the bubblicious foundation driven by destructive retail consumption. He replaced legitimate US manufacturing wealth origination with the printing press basis of mortgage origination. The handoff in the official ceremony offered the real hint on the problem. Alan Greenspan was thanked, and referred to as "the only central banker to enjoy rock star status." This point is of shame not fame. A responsible central banker is part of the woodwork, invisible to the masses, not a rock star enjoying political limelight and public adulation for his support of easy money and unending accommodation. These are traits of a drug dealer, not a central planner masquerading as a central banker. Observe the USEconomy, symbolized as the poor guy resting under the weight of colossal debts in every national corner and crevice.

May Greenspan ride into the sunset, even if mounted backwards on his bull. You are on the right track if memories are conjured up from actor Slim Pickens riding herd on a descending nuclear bomb in the movie "Doctor Strangelove". The accompanying painting was commissioned by Scott Walters of Max Capital Markets Ltd in Toronto, kindly shared with me. See and be sure to notice the rider mount, unaware of what his bubbles hath wrought, the bull in retreat, the bear viewing its next meal, and the warplanes (shaped as pigs) looming overhead. Is that a gold capstone under that there rock? The foundation must have slud downstream a few miles, kilometers, or perhaps light years!!!


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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 24 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at For personal questions about subscriptions, contact him at [email protected]

Jim Willie

Jim Willie

Jim Willie CB, also known as the “Golden Jackass”, is an insightful and forward-thinking writer and analyst of today's events, the economy and markets. In 2004 he launched the popular website that offers his articles of original “out of the box” thinking as well as content from top analysts and authors. He also has a popular and affordable subscription-based newsletter service, The Hat Trick Letter, which you can learn more about here.  

Jim Willie Background

Jim Willie has experience in three fields of statistical practice during 23 industry years after earning a Statistics PhD at Carnegie Mellon University. The career began at Digital Equipment Corp in Metro Boston, where two positions involved quality control procedures used worldwide and marketing research for the computer industry. An engineering spec was authored, and my group worked through a transition with UNIX. The next post was at Staples HQ in Metro Boston, where work focused on forecasting and sales analysis for their retail business amidst tremendous growth.

Jim's career continues to make waves in the financial editorial world, free from the limitations of economic credentials.

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