Greetings from Rome and Denver: Gold in 2014

Nick Moore, BlackRock Natural Resources Team
Richard Davis, BlackRock Natural Resources Team

Greetings from Rome and Denver
It is now a little over two years since the gold price hit its all-time intra-day high in nominal terms of around US$1,920/oz. Since then the direction of travel has been lower, with the metal trading at a near three-year low in late June this year of US$1,180/oz – a decline of nearly 40% or US$740/oz. This year will, in all likelihood, see the first decline in the annual average price of gold since 2000. With this in mind, we dispatched our newest team member – Nick Moore – to Rome to attend the London Bullion Market Association (LBMA) annual precious metals conference. Nick, known in the industry as Nick ‘Metals’ Moore, has joined us as a Commodity Strategist, bringing to the team 30 years of experience in base and precious metals analysis.

Headwinds well-rehearsed
As mentioned in the conference, for gold as a non-yielding asset, the opportunity cost of holding the metal will increase as higher interest rates make cash a more attractive alternative. A reduction  in geo-political  risk  in the Middle  East (notably defusing  the threat  of military  strikes  around  the issues of Syria’s chemical  weapons and Iran’s nuclear ambitions)  could also limit  the metal’s appeal as a ‘safe haven’. But uppermost in the minds of gold investors has been the record sales of gold from physically held Exchange Traded Funds (ETFs). We estimate that 715 tonnes (23mozs) have been sold since the end of 2012. The good news is that much of this gold has been bought by retail investors and central banks.

Tailwinds in the wings
Also discussed were other positive factors for gold, such as the importance of China and India to the market of gold jewellery and the strong culture of gold ownership in those countries. Jewellery demand is price elastic, which means that price- conscious buyers rushed to take advantage of gold’s steep price tumble in April. The World Gold Council (WGC) noted in its Q2 2013 Gold Demand Trends review that these two countries accounted for a combined 60% of world jewellery demand. Indeed, for the first time, 2013 will likely see China eclipse India as the world’s biggest gold consumer. A leading independent precious metals consultancy GFMS note that Indian jewellery fabrication rose by 25% to 350 tonnes in the first half of 2013 despite the record rupee price, with Chinese jewellery up by an even more impressive 41% to 345 tonnes. India has historically had a strong affinity for physical gold ownership driven by traditional gold gifting at marriages and auspicious festivals.  Seasonality for gold jewellery demand is strong and is now under way, which is also likely to be helped by gold’s fall to below US$1,300/oz, its lowest price in over three years. The Indian Grand Wedding season runs from October through to March  (the cooler months),  followed  by Diwali (this year in November), followed by Christmas, which is important  for adornment  jewellery,  and ends with  the Chinese Lunar New Year, when high carat  chuk kam investment  grade jewellery  is typically gifted.

Central banks are on the bid
Another strong theme from the conference was that of the enduring demand for gold from the official sector or net central bank buying. At the conference, a spokesman from the Deutsche Bundesbank noted that “gold constitutes an essential component of its reserve assets and meets its needs for security and portfolio diversification”. Germany has the world’s second largest gold reserves at 3,390 tonnes (109mozs) and represents 10% of world central bank reserves. The Bundesbank put forward four key functions of gold in their reserves, which included universal acceptance, diversification, robustness against shocks and providing a level of confidence.

Since 2001 the main sellers of gold have been advanced economy holders such as Switzerland (1,328 tonnes), France (589 tonnes) and the IMF which disposed of 403 tonnes. Excitingly, in 2010 gold disposals reversed and for the first time in over 20 years central banks became net buyers. This buying was driven by central banks in emerging markets such as Russia, Kazakhstan, South Korea, Bangladesh, Philippines, Mexico and India, many of which are still underweight gold as a percentage of their foreign exchange reserves. They view owning gold as a key way to diversify these huge reserves. At the LBMA conference various central bankers suggested that emerging market central banks were targeting to have between 4%-7% of their total foreign exchange reserves in gold and that most were still underweight that target. For example, China and South Korea both hold only about 1.3% of their foreign currency reserves in gold, Saudi Arabia 2.0% and Mexico 3.0%. The WGC estimates that European central banks at the end of September held 10,782 tonnes of gold, an average 58.3% of their reserves in gold. While they have been sellers for many years, we are comforted by the European Central Bank Gold Agreement which limits annual sales of gold by its signatories to a maximum of 400 tonnes. Gold sales under the past year of the agreement were less than five tonnes – the lowest level of sales since the agreements began in 1999 (see chart below).

It is important because central banks – even net sellers – remain wedded to the ideology of gold ownership. We would not be surprised to see fresh buying in 2014 by the emerging market central banks taking the opportunity to accumulate further holdings at much lower price levels – a typical price averaging down portfolio strategy.

Important, if true
While the LBMA delegates discuss gold bullion market dynamics and trends, the Denver Gold Forum focuses on the equity market and is regarded as the industry’s leading annual gathering of CEOs of gold mining companies. Not surprisingly, the mood was somewhat subdued compared with previous years, given the weakness in the gold price. In light of the more difficult environment, one of the key themes to emerge at the conference was a renewed emphasis on shareholder returns through cost-cutting initiatives and better capital management of gold mining companies. On the subject of costs, some companies are starting to quote all-in- sustaining-costs (AISCs). Compared with cash operating costs, AISCs (which include costs such as operating costs, taxes, royalties and sustaining capital) are a much better reflection of the true cost of producing gold and the fact that companies are now more focused on this metric is encouraging.

Production growth was another theme discussed in Denver. On the face of it, it may appear to be a disappointing throwback to the days when the industry was targeting growth for the sake of growth at any cost. However, today management seems to be more conservative in their expectations and have a better focus on generating an economic return on new production.  As a consequence, marginal projects have been placed on the back burner and we are seeing the closure of unprofitable mines. Very few companies spoke about greenfield exploration and the phrase ‘aggressive exploration programme’, which was liberally bandied about a decade ago, appears to be off the agenda, at least for now. If the industry delivers on its promises, we believe that share prices can be re-rated.  In the coming months we will closely monitor corporate quarterly results for any evidence of that.