The Truth About Gold

BUSINESS INSIDER

The truth about goldImage: AP Photo/Mark Lennihan

table of contents

• a brief intro (3)• what drives gold prices (7)• but wait, that’s not all (20)

• what about real interest rates (24)• so where are prices going (29)• everyone has an opinion (37)

• the actual production of gold (45)• the Fed responds (52)

• appendix (58)

For thousands of years, gold has been used as a currency, investment, and commodity — cementing its importance as an asset

4600 B.C. Earliest evidence of gold used as jewelry

1091 B.C. China legalizes the use of gold as money

560 B.C. to 400 A.D.

Gold coins are minted by King Croesus (present day Turkey); Julius Caesar introduces a gold coin as common currency

1284 to 1300 Venice and Great Britain issue the gold ducat and florin, respectively

1511 to 1700

Spain launches its hunt for gold and finds massive reserves in Brazil in 1700. By 1720 the country is producing more than 60% of the world’s supply

1799 Gold production begins in the U.S.

1848 Gold rush gets underway in the U.S., with more than 300,000 people moving to California

1900 The U.S. passes the Gold Standard Act

1933 to 1937

The Gold Reserve Act of 1934 ends the minting of gold coins and raises the price of gold to $35 per ounce to trade in to the treasury (formerly set at $20.67)

1971 President Nixon ends the ability to trade U.S. dollars in for gold

1980 Gold sets a then-record high of $870 per ounce

2001 to 2007 China becomes the world’s largest producer of gold after deregulating its market

2004 The first gold ETF begins trading

2008 to 2010

The “Great Recession” in the U.S., and a larger global slowdown, push gold prices over $1,000 for the first time ever

Source: U.S. Global Investors

The price of gold remained unchanged following the Gold Reserve Act of 1934 (which set a fixed rate). But in the 70s the price of gold began fluctuating as markets set pricing PRICE OF GOLD (TROY OUNCE PER USD)

Chart: Eric Platt/Business Insider, Data: Bloomberg

Over the past five years, the price of gold has rallied to record highs, making it the center of the investment conversation

PRICE OF GOLD (TROY OUNCE PER USD)


Then, after hitting highs in ‘11, gold retreated. Where it’s going next is anyone’s guess…

PRICE OF GOLD (TROY OUNCE PER USD)


So … What Drives Gold Price Movements?

For some time, gold had been seen as an inflation hedge For most of the 70s and 80s, gold seemed to be driven by inflation Since 2000, that correlation hasn’t persisted


In the last decade, booming demand from emerging markets has been a major driver

In 1999 Asia accounted for 39 percent of global gold demand

By 2010 the Asian market reached 57 percent of total market demand Those increases are being driven by India, China, and Vietnam

Map by Eric Platt/Business Insider, Data from Google Maps

Over the past decade, gold prices have followed the uptick in Asian demand

Source: GMO, GFMS Ltd., World Gold Council, Bloomberg

GMO’s Amit Bhartia and Matt Seto charted the two figures through 2010 — the results highlight Asia’s importance in gold pricing

And gold has generally been bid up in overnight trading in Asia even as it sells off in London AM trade

PRICE OF GOLD INDEXED (2007 = 100)

Prices in India — currently the world’s largest market — are driven by consumers

Gold prices appreciate in November at the time of Dhanteras, the start of a five-day gold buying period

However recently both countries have logged slower gold demand growth — concurrent with gold’s sell off

Jewelry sales remain the largest input of gold demand, although it declined marginally year-on-year

Source: World Gold Council

“Jewellery has been the prime source of demand for gold over many decades, and it remains in poll position. In 2010, it accounted for just over half of global demand and the trend has persisted this year. Consumer appetite is in evidence across the world, particularly in gold’s cultural heartlands, China and India.” – World Gold Council

Demand by central banks has also been a major driver – now topping $82 billion


Growth has been driven by the rapid ascent in average prices year-on-year

Investment, as a portion of overall demand, jumped 160 basis points to 40.3 percent of total demand in 2011

Geographically, the Pacific region accounts for a substantive 58.1 percent of global gold demand (jewelry and investment)

Source: Thomson Reuters GFMS, World Gold Council

Central banks hold 30.9 thousand tons of gold in reserve Top Countries Holding Gold (as of February 2012):

United States: 8,133.5 tonnes (74.5% of reserves)

German: 3,396.3 tonnes (71.4% of reserves)

Italy: 2,451.8 tonnes (71.0% of reserves)

France: 2,435.4 tonnes (71.1% of reserves)

China: 1,054.1 tonnes (1.6% of reserves)

LARGEST AUTHORITIES HOLDING GOLD IN RESERVE

Chart: Eric Platt/Business Insider, Data: World Gold Council

On the ETF investment side, more than half of all gold is held by the SPDR Gold Trust (GLD) at 41.1M troy ounces Top ETF Holders of Gold (as of April, 30, 2012):

GLD: 41,099,101 troy ounces (53.8%)

ZKB: 7,072,607 troy ounces (9.3%)

IAU: 5,792,446 troy ounces (7.6%)


LARGEST GOLD ETFS BASED ON GOLD HOLDINGS

And those ETFS have been increasing their investments in tandem with gold’s appreciation

Since 2003, there are now 21 major gold ETFs and ETNs


Those ETFs are focused in the U.S. and Europe Largest North American ETF: GLD (NYSE) with 53.8% of total

Largest European ETF: ZKB Gold ETF (SWX) with 8.9% of total

Largest African ETF: NewGold (JSE) with 1.6% of total

Largest Asian ETF: Gold Benchmark ETS (IN) with 0.4% of total

Largest Australia/Pacific ETF: GBS (ASX) with 0.6% of total

Largest Middle Eastern ETF: GOLDIST (ISE) 0.07% of total

GEOGRAPHIC PLACEMENT OF ALL GOLD ETFS AND ETNS


But that’s not all that drives gold prices …

Gold is also an expression of fear The price of gold moves in tandem with the CBOE’s VIX

index (a measure of expected volatility in the S&P 500) BI divided the spot price of gold by the spot price of

gasoline to isolate gold movements from broad commodity rallies


And investors generally shift assets into gold ETFs when volatility peaks

Citi charted ETF flows to the VIX index and found some graphic corollary between the two

Investors moved to gold after a number of major events, including Lehman Brothers’ bankruptcy and the Sept. 11 attacks

And what about real interest rates?

Many economists have offered the premise that gold rallies when real interest rates fall below 2%

• The real interest rate is simply the nominal interest rate minus inflation

They point to the 80s and 90s when the real interest rate ran mostly above 3%

When inflation began to cycle higher at the start of the 80s, gold’s ascent was cut short

That said, the recent run-up (2001-2011) in gold has yet to eclipse the highs hit at the beginning of the 80s when prices are adjusted for inflation

PRICE OF GOLD (TROY OUNCE PER USD) INDEXED TO CPI


Where Are Prices Going?

At the start of 2012, BI surveyed commodity experts and found an overwhelmingly high price targets — even after the precious metal had sold off

The banks weigh in:

DEUTSCHE BANK: “Consequently, our strongest conviction trade remains long precious metals and specifically gold. In an environment where real interest rates are negative and the US equity risk premium is high we expect this will sustain strong private and public sector demand for gold.”

GOLDMAN SACHS: “We expect gold prices to continue to climb given the current low level of US real interest rates. Further, with our US economics team forecasting slower US economic growth throughout 2012, we expect US real interest rates to remain lower for longer, supporting higher gold prices.”

MORGAN STANLEY: “Beyond the safe haven status associated with uncertainty surrounding the European sovereign debt crisis, we also believe that: 1) the gold to oil ratio highlights that, on a long-term real purchasing power basis, gold is close to fair long-term value; and 2) the prospect of sustained negative real interest rates reduces the opportunity cost of holding non-yielding assets.”

LOW MEDIAN HIGH

$1,850/oz. $1940 $2,200

Estimates on this page as of 1/15/12

But since then, targets have been cut nearly across the board as gold faltered. Citi now predicts 2012 prices of $1,720 per troy ounce

“Gold prices should remain supported given low real interest rates and continued financial interest from central banks and private investors. However, price action could be volatile as markets are caught between changing inflation and monetary policy expectations, political turnover and sudden demand for liquidity.”

- Citi’s Edward Morse

Photo by Christopher Furlong/Getty Images

Morgan Stanley’s Hussein Allidina remains bullish on gold despite the likely end of QE. Morgan now projects a 2012 PT of $1,825 per troy ounce.

“We do not believe the removal of trades predicated on additional liquidity and further unconventional monetary policy signal the end of the bull market in gold. This 'liquidity trade' is only part of the investment case and has also been overwhelmingly focused in the paper gold market, rather than in the physical investment market. Indeed, the recent price weakness appears to have encouraged further physical demand for gold, reflected in heightened inflows into physical ETFs.”

Image: Mario Tama/Getty Images

UBS, which used to have an above-consensus gold estimate, slashed its price target 18% at the end of the first quarter to $1679

“UBS believes that capital flows are accelerating out of emerging markets and that tighter liquidity is hurting commodity demand. Furthermore, China has not been stimulating private construction, lowering commodity intensity. Coupled with the risk of a cyclical slowdown in the US that may trigger renewed credit stress, UBS has reduced its near-term commodity outlook.”

— UBS’s Brian MacArthurImage: TwicePix/Wikimedia Commons

So how has it actually performed against other assets?

First, a look at gold prices fluctuated next to crude oil

PRICE OF GOLD (TROY OUNCE PER USD) DIVIDED BY PRICE OF CRUDE (BARREL)


In nominal value, markets have kept up with increases in gold prices

PRICE OF GOLD (TROY OUNCE PER USD) DIVIDED BY S&P 500 INDEX


But over the past decade, the price of gold has far outpaced U.S. house prices

After hitting highs in 2006, the S&P Case-Shiller Index has lagged gold price increases

PRICE OF GOLD (TROY OUNCE PER USD) DIVIDED BY S&P C/S Index (SEASONALLY ADJUSTED)


And everyone has an opinion …

Warren Buffett“Gold, however, has two significant shortcomings,

being neither of much use nor procreative. True, gold has some industrial and decorative utility,

but the demand for these purposes is both limited and incapable of soaking up new production.

Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.”

Image: Michael Loccisano/Getty Images

Ben Bernanke"Gold standards are far from perfect monetary

systems … have to go to South Africa and dig up tons of gold, and move it to New York and put it in the basement of the Federal Reserve bank of

New York."

Image: Mark Wilson/Getty Images

Ron Paul“What did the Romans do to their currency? The

Byzantine Empire had a gold standard for a thousand years and they did quite well and they

didn’t fight wars. But the Roman empire eventually destroyed their currency. They put in wage and price controls before they diluted the

metals. They inflated. They thought wealth could come by fooling the people.”

Image: T.J. Kirkpatrick/Getty Images

Peter Schiff“What’s so appealing about gold is that it does have intrinsic value. It’s paper money, it’s the dollar and

the euro that ultimately have no intrinsic value. They are just pieces of paper with numbers written

on them. The government can put any number they want on that paper, but gold is real. The

government can’t create gold out of thin air, it has to be mined. The big picture is all bullish for gold.”

Image: Jessica Hill/AP Images

Jim Grant“To me the gold price takes the form of a very

uncomplicated formula, and all you have to do is divide one by ‘n.’ And ‘n’, I’m glad you ask, ‘n’ is the world’s trust in the institution of paper money and in the capacity of people like Ben Bernanke to

manage it. So the smaller ‘n’, the bigger the price. One divided by a receding number is the definition

of a bull market.”Image: Bebeto Matthews/AP Images

Nouriel Roubini“But, since gold has no intrinsic value, there are

significant risks of a downward correction. Eventually, central banks will need to exit quantitative easing

and zero-interest rates, putting downward pressure on risky assets, including commodities. Or the global

recovery may turn out to be fragile and anemic, leading to a rise in bearish sentiment on commodities

– and in bullishness about the US dollar.”Image: Chiang Ying-ying/AP Images

John Maynard Keynes

“The choice of gold as a standard of value is chiefly based on tradition. In the days before the

evolution of Representative Money, it was natural, for reasons which have been many times

told, to choose one or more of the metals as the most suitable commodity for holding a store of

value or a command of purchasing power.”

Image: AP

So how do you actually mine gold?(and who does it?)

Gold mining is intense (here’s a very quick explainer)

1. Mine is excavated, elevator shaft installed, cooling systems set up,

etc.

2. Explosives are used to unearth ground in tandem with workers

checking the walls

3. Materials are sent up to ground level

where a sieve filters gold from excess earth

4. Particles are then smelted together to about 90% purity

5. The mining company then ships the rough bars to a

refiner where the bars will be melted down

6. The refiner reworks the gold into a bar over 99% purity,

stamps with a unique identifier and ships to

its final owner

Image: CNBC

The physical production of gold is not central to the U.S. or Europe — in fact, countries like China, Russia, and Australia are huge producers

And production does not simply mean mining — scrap supply/recycled gold accounts for more than a third of the world’s supply

Increased production of gold will be driven by two new large projects in Latin America

(+): Pascua Lama on the Chilean-Argentinean border and Pueblo Viejo in the Dominican Republic; as well as increases in Mexico and Brazil

(-): Declines at Yanacocha and Lagunas Norte in Peru

Map by Eric Platt/Business Insider, Data from Google Maps

These three miners are some of the largest in the industry

UBS recently cut guidance on many gold mining companies because of the weakness in commodity prices

EPS price targets are now on average 37 percent lower than earlier this year

Goldcorp Kinross Newmo

nt

And there’s not that much gold in the world…

According to Warren Buffett, if you were to pack all the gold in the world into a cube, it would measure 68 feet on any given size

That’s slightly shorter than a tennis court’s length

Image: Julian Finney/Getty Images

The Fed responds…

After repeated attacks in 2012 to end the Fed and return to a gold standard, Ben Bernanke hosted a lecture series at GWU — here’s what he said:

Image: Federal Reserve Bank

One of the big problems: the U.S. would be exposed to bad policies of other countries using the gold standard


Also, investors can attack the commodity, causing huge fluctuations


And lastly, a gold standard can cause huge medium term issues The Fed pointed to a global shortage of gold in the 19th century that hurt

farmers who faced declining crop prices, but non-fluctuating mortgage and debt payments


That’s it.

Questions:

e-mail: [email protected]

APPENDIX: Historical Gold Demand

Source: LBMA, Thomson Reuters GFMS, World Gold Council

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