Simple Supply and Demand - Gold

In college, I wasn’t sure what I wanted to do when I grew up. I started out double majoring in political science and history. I thought I might want to be a lawyer. Then, in my sophomore year, I decided I wanted to teach. So I added secondary education as a third major.

My parents were supportive of anything I wanted to do. They only gave me two stipulations. I had to graduate in four years. And I had to be 100% self-sufficient as soon as I walked off Indiana University’s beautiful Bloomington campus.

Needless to say, I had a few sleepless nights. I wondered what I would end up doing...and could I make it in this dog-eat-dog world? Then I discovered my first economics class. Something clicked. All the charts, formulas and theories made sense. It was as if the proverbial light bulb went off over my head. This was my calling.

Economics is logical. When supply exceeds demand, prices fall...and vice versa. When demand is greater than supply, prices rise. It’s such a basic idea. Yet how many times do we apply that logic to the investments we make?

Probably not as much as we should. But if you have read The Daily Reckoning for the past three years, you know that demand for gold has far exceeded supply. As a result, gold prices rose steadily in 2002, and gold stocks dominated the market. It made perfect economic sense. But 2003 has been a different story...or so it looks on the surface. The yellow metal has fallen from a high of $382 on Feb. 5 to its current price of about $320. Both the XAU and HUI indexes are off 19% and 20% respectively.

From far away, it looks like the ultimate store of value is on the ropes. But if you move in to take a closer look, you might be surprised by what you see.

The world consumes about 120 million ounces of gold each year - most of it for jewelry. But gold mines only produce 80 million ounces a year - leaving a real deficit of 40 million ounces - or 50% of its production. Demand still far exceeds supply. So why are spot prices and stocks falling?

Nothing ever rises straight up for an extended period of time. In any major bull run, there are bound to be some correction periods. Take, for example, the most explosive gold rally in the past 100 years - the 1970s bull run. After coming off a double bottom in 1970, gold rose from $35 an ounce to $65 in the summer of 1972. Then the yellow metal consolidated for about six months, trading between $50 and $60 an ounce.

Investors who sold during the initial downswing (thinking the run-up was over) missed the next explosive rise. By January 1975, gold sold for about $180 an ounce. And as we all know, it didn’t stop there. Gold prices soon soared all the way above the $800 mark.

All during the 1970s, demand for gold remained high – as evident by the 9.9 million ounces of gold coins sold in 1979. (This was a record at the time.) Still, gold prices and gold stocks didn’t rise straight up; people took profits from time to time. And that’s what is happening today.

Demand for gold exceeds supply by 50%. And as long as that remains true, this bull run is not over. If I am right, you can be assured of two things. One, this current correction in spot gold prices and in gold stocks is just that - a correction and not a downturn. And two, the best way to profit is to buy when everyone else is selling - that would be now.

So...what stocks should you look to own? You may scuffle, but your best bet for high returns will be to invest in the smaller gold producers - the juniors. Consider why...

Just to break even in terms of production, gold miners worldwide must find 80 million new ounces each year. Most of that gold is mined by the major companies. Or so most people think. But even the largest mines eventually get old and become depleted. So how do the world’s largest companies keep meeting that 80 million mark?

Not by finding new gold on their property. Nope, they acquire smaller, hungrier gold companies with fresher mines. Take Newmont Mining for example. Newmont is the world’s largest gold producer. Last year, it was able to replace 9 million ounces of depleted gold. President Pierre Lassonde said no other company has ever accomplished such a feat. How did it do it? It acquired two smaller gold companies - Franco-Nevada and Normandy Mining. This is key.

Major gold miners are running out of ways to replace lost gold. So, they are forced to look to smaller companies to pick up the slack. And that is one reason to own juniors now - in anticipation of more acquisitions and greater consolidation. When a smaller company is bought out by a larger one, shareholders usually benefit with a premium stock price. In the months leading up to the Franco-Nevada acquisition, its share price rose nearly 40%.

I expect to see more consolidation in the gold mining industry - especially as demand for gold continues to exceed supply. Large companies will keep looking to buy smaller companies to match last year’s production levels and take advantage of high spot gold prices above $300 an ounce.

And if all of my theories are correct, there couldn’t be a better time to capitalize on the junior gold miners than now. Many stocks are down 50% or more from their highs in the past year. Overall demand for the yellow metal remains high. And the herd has been on a selling spree for two months now.

If you are a contrarian with a tolerance for risk, this is your cue to buy.

James Boric,
for The Daily Reckoning
www.dailyreckoning.com

Editor's note: James Boric is the editor of the small-cap advisory letter Penny Stock Fortunes, where he looks for great companies at penny stock prices. James also writes a weekly e-mail called the CXS Alert.