When the senior gold miners started reporting “all-in” cash costs earlier this year, investors noticed something startling: they aren’t making much margin at all.
If these companies were told a decade ago that gold would be worth more than US$1,600 an ounce, they would have been popping the champagne corks. Instead, they are finding that the price isn’t high enough to justify many new mines due to rising costs. “The gold price is still not high enough to sustain the gold mining industry,” said George Topping, an analyst at Stifel Nicolaus. “If you look at the seniors, they’re marginal or negative free cash flow for this year after capex.”
Demand for gold remains relatively sturdy. It dropped just 0.7% in 2012 from a record high in 2011, according to GFMS. So it raises an obvious question: Why aren’t prices higher?
These would seem to be ideal conditions for gold. In addition to ongoing economic uncertainty and record-low interest rates, a number of recent events appear positive for bullion: QE3 (which extends QE indefinitely, despite the concerns of some Fed officials), and the fiascos around the U.S. debt ceiling and fiscal cliff. But look beyond the headlines and the story isn’t so bullish. Martin Murenbeeld, chief economist at DundeeWealth and a close gold market follower, said while there has been much talk about money printing and QE, the monetary base has stayed fairly flat.
“From our perspective, the surprise was how little the Federal Reserve and the European Central Bank pumped up their balance sheet last year,” he said. “The Federal Reserve’s balance sheet was flat, and the ECB’s actually declined a little bit.”
That is starting to change this year, he noted, as the Fed is pumping US$85-billion a month into the system. He also expects the ECB will get more active later this year due to economic headwinds. But his outlook for gold is not nearly as optimistic as it was a year ago, when he thought Greece was on its way out of the EU and the ECB would be forced into much more serious action.
“Europe didn’t fall apart. The reason is that the ECB stated that they’re going to defend the currency,” said John Stephenson, vice-president at FirstAsset Investment Management. “I think that was a much more seminal event than people give it credit for.”
He noted that while the Fed is buying securities and creating plenty of credit in member banks, the banks are not taking those increased reserves and extending credit into the broader economy “in any dramatic fashion.” To him, this is proof that the “hyperinflation” theory beloved by the gold bugs is just not happening.
Another potential factor behind gold’s mediocre performance is the strong performance of the broader stock market. The S&P 500 has been on a terrific run since late 2011 (roughly when gold peaked), and investors have rekindled their love of dividend-paying stocks. The one thing gold does not offer is yield, and the thirst for yield has moved money out of the sector. High-profile investors George Soros and John Paulson are among those who reduced their gold positions.
There is also a concern that it simply ran up too much and too quickly. While gold has been on a steady uplift since 2000, the rapid run up to US$1,900 an ounce in the summer of 2011 created a surge of selling and a huge increase in scrap supply, which quickly drove prices down. They never really recovered.
That all said, gold has not experienced a true mid-cycle correction since the start of this bull market, which it did during the last one in the 1970s. A pronounced rise in interest rates or severe slowdown in Chinese demand are two potential catalysts for a correction that are often discussed, but neither one seems to be imminent. All the same, there is more talk about the gold cycle being over today than there has been in a number of years.
The fact the bull market has run so long leads to a more cerebral explanation for gold’s recent doldrums: People might just be weary of hearing about it. While they still may be optimistic about gold’s underlying fundamentals, it is no longer the sexy new investing story. That investor fatigue could be weighing on the market. “There’s always sentiment and fashion in the investment market,” Mr. Murenbeeld said.
There are plenty of reasons for gold investors to be optimistic. Interest rates are not going up anytime soon. The U.S. federal debt and deficit continue to be astonishingly high. And while the crisis in Europe has largely stabilized, the situation remains extremely tenuous, particularly after Italy’s inconclusive election last week and Great Britain’s loss of its AAA credit rating.
On the supply side, the mediocre price is taking its toll as mining companies are cutting back spending, scaling down projects and cancelling them entirely. That will have an greater impact over time, but for now, there is not much for investors to get excited about.
“I think gold has gone too far too fast, and there’s no reason to think it will go higher unless you think the world is coming to an end,” Mr. Stephenson said. “And if you do, you’re better off going to a Caribbean island and sitting in the sun for a while, watching it implode from there.”
While global gold production continues to rise by a small amount each year, analysts at National Bank recently predicted that a “production cliff” will kick in around 2017 in which supply will begin to fall sharply. If that happens, it would have a profound impact on the market.