Is it too late to join the gold rush?

Published by Ceri Jones on 01 December 2009.
Last updated on 01 December 2009

Man panning for gold

Gold scaled a record high of $1,117 (£670)/oz in mid-October - another spike in an astonishing run that has seen it rise for eight straight years.

The gains seen in 2009 have largely been driven by investors who have flocked to the metal in the absence of other investment opportunities, recognising that there is no loss in holding gold while interest-bearing accounts are paying so little.

But the hype has been intensified by high profile speculators such as hedge fund manager John Paulson, taking large positions. Paulson announced he has built up a $3.2 billion holding in State Street Gold Spider, an exchange traded fund (ETF).

"Once the price closed above the previous high of $1,045, a lot of investors became interested," says Dan Draper, global head of Lyxor ETFs. "In technical terms, the trend was confirmed."

Draper adds: "Speculation could keep the gold price high for months or even years, but the sheer volume of ETFs and derivatives tracking gold could be changing the dynamics of the market and creating a new paradigm."

One concern, for example, is the boom in gold ETFs, which now account for more than 700 tonnes of the metal and could easily flood back onto the market if conditions change.

Despite this speculative frenzy, demand for the metal is not strong. Jewellery accounts for two thirds of demand and, at current prices, that demand has fallen.

India is the largest consumer, devouring about one fifth of the world's supply - twice as much as China and the US - but although Asian markets are recovering more quickly than the West, Indian imports of gold dropped nearly 60% in the year to September compared with the same period last year, according to the Bombay Bullion Association, which represents the gold trade in Mumbai.

Unlike other commodities, almost all the gold ever mined is available as potential supply and could flood back onto the market. Many Asian families, for example, use gold as a repository of wealth that they sell in hard times.

This year, India experienced its worst monsoon in three decades, impoverishing rural populations that depend on farming output for their economic wellbeing.

The other aspect to gold's meteoric rise is its perception as a safe haven asset against a backdrop of soaring government debt and quantitative easing, which is debasing global currencies.

Even Alan Greenspan, the former US Federal Reserve chairman, has warned that the dollar's collapse is encouraging investors to buy metals to hedge against declines in paper currencies.

Talk about the dollar's fall from grace as the world's reserve currency helps push up the gold price because it is viewed as a hedge against dollar weakness and as an alternative currency.

The price was lifted, for example, by India's central bank purchasing 200 tonnes of the metal, which it swapped for dollars, as the country's finance minister issued a pessimistic statement about the state of western economies.

"Our view on the gold price comes down to one basic factor," says Jamie Horvat, portfolio manager at specialist commodity managers Sprott Asset Management, which last year predicted a gold price of $2,000 and hyperinflation on a global scale.

"Governments [and central banks] are destroying the wealth of savers by expanding money supply around the world and devaluing their currencies. The US has doubled its monetary base in the past 12 months, as it tries to force money into the system and force spending.

When that happens currency is debased against hard assets and gold, as the ultimate store of value, eventually reacts to that environment."

Horvat says the short-term fight between deflation and inflation is similar to 1973-76. "Gold moved from $33/oz to $180 or so in that volatile market. Unfortunately, the end result of the quantitative easing then was stagflation. And that set up the euphoric run of gold into the $800 range in the early 1980s."

"The future price of gold depends on what central banks do," agrees James Turk, founder & chairman of "The key to understanding gold is its consistency in purchasing power over long periods of time. For example, one ounce of gold purchases essentially the same amount of crude oil it has purchased at anytime since the end of World War II.

"In other words, the rising price of gold means national currencies are losing purchasing power. So, if central banks continue to pursue policies that debase the national currency they are managing and cause the currency to lose purchasing power, the price of gold will rise in terms of that currency, but an ounce of gold will still purchase the same amount of crude oil."

Even after its eight-year rally, the nominal peak price in 1980 at $850/oz adjusted to account for inflation equates to an equivalent price today of $1,884/oz, which does not suggest that current prices are out of sync in real terms.
Mining companies are optimistic on the gold price. "Investing in gold mines involves environmental, corporate and political risk," says Mark O'Byrne, managing director of Ireland-based Gold Investments.

"But, while in the 1980s and 1990s most gold miners hedged their production because they feared prices would fall, they are now 'going long' on pricing, which shows faith in the sustainability of the price."
Conversely while a resurgence in concern about hyperinflation or a collapse in the dollar may make prices rise, the likelihood is low. Gold investors seem to have factored in the idea that governments will leave the exceptional monetary and fiscal stimuli in place too long, but this may not be the case.

Assuming a partial recovery in the dollar, research consultancy Capital Economics expects gold prices to fall back below $1,000/oz by the end of this year and to $800 in mid-2010.

Among other precious metals, silver is tagging along with gold, but the hot money is on palladium, which has risen 75% so far this year but could make another 50% gain. Around half of platinum and palladium is bought by the motor industry for catalytic converters.

A surge in car sales and supply concerns are boosting platinum group metals. More specifically, most growth in the US is expected in petrol cars that require palladium-heavy autocatalysts.

Gold mining shares
Gold mining shares have been lagging the physical metal's stellar performance, and could rise by as much as 20% to 30% in the next year if stock markets stay on course because the sector was severely sold off last year, losing about 40% as it was dragged down by the rest of the market.

The key to making a good investment in gold shares is to ignore the price of the metal and concentrate on the fundamentals of the mining business. The average price of gold production is currently $650/oz, which, at prices around $1,100, means a fat margin of $450/oz.

Against this must be added capital costs and weakness in the dollar pushing up costs in the local currencies. For example, the strength of the South African rand has eroded gains for local gold producers, which sell their product in dollars and pay costs in rand.

Currently, big names such as Barrack Gold and Newmont Mining may be paying too much for production and could be impacted quickly if the metal's price falls. Relatively few very large projects are ready to be brought on and some of those are in regions of political risk such as Russia, Democratic Republic of Congo and other parts of Africa.

The Holy Grail is a gold miner offering organic growth that is not "greenfield' in a relatively stable country.
An example is Lihir Gold (LGL), an Australia-listed miner with vast resources on Lihir island in Papua New Guinea. Its expansion is low risk as this is a large open pit mine rather than a project relying on technological developments in mining methods.

The miner is also expanding its production in Africa following its acquisition of Equigold. The management has learned from their mistakes - LGL bought the Ballarat mine in Victoria, Australia and disappointed investors with a large write-down, but the new mine is a different story.

However, the biggest gains will come from smaller shares that are lagging their larger peers. Small miners are often the last to rise because they are less researched, spend less on public relations or may be listed on an obscure exchange. Tiddlers might also become bid targets as major players struggle to maintain production.

"We like the sector independent of the gold price as growth companies in the sector are not well researched," says David Whitten, head of global resources at Colonial First State. "For small companies, it is all about the quality of the ore.

It is hard to predict improvements in technology for moving tons of dirt, but in gold mining factors such as truck size do not feature as largely as they do in other commodity sectors. That is what is good about this sector; there is quality emerging in small and medium sized companies."
Examples of small stocks with potential are Andean Gold (ASX:AND) (TSX:AND), which is bringing on an Argentinian project of high grade, and Canadian miner Detour Gold (TSX: DGC), which is likely to require more capital, but stacks up well on a discounted cash flow analysis.

Wesdome Gold Mines (TSX:WDO) has announced higher resources from its Wesdome gold deposit north-west of Val d'Or - three times higher than a report prepared in 2005. Also in Canada is Rainy River Resources (TSX:RR), which has ongoing studies into multimillion-ounce deposits and recently announced pleasing results from 10 new drill holes.

Eldorado Gold (NYSE:EGO) has a successful track record at generating growth from acquisitions and its operations in difficult countries such as Turkey and China.

How to invest

How best to invest in gold depends largely on how long you plan to hold it. Gold coins or bars are fine if you plan to invest for the long term, but this would not suit an investor who wishes to enter and exit the market quickly with low commission and trading expenses.
Some financial advisers say gold should represent 10% of a blanaced portfolio. The traditional thinking is that you have to hope it doesn't perform well because if it does, the rest of your portfolio is unlikely to be thriving.

Physical gold

Holding physical gold entails the hassle of safe-keeping and insurance, plus a premium for manufacture. Coins such as Krugerrands start at 5% mark-ups, while bars carry a smaller premium than coins; typically about 4%.

The World Gold Council keeps a list of bullion dealers who will deal with private investors. Investment in gold is free of VAT, but purchases may be reported to HM Revenue & Customs.

Harrods has teamed up with Swiss refiner Produits Artistiques Metaux to sell gold bullion and coins at its Knightbridge store, making it the only location in London where investors can purchase a 12.5kg gold bar 'to go'.

Some organisations will store the gold on your behalf. At Bullion Vault you can buy gold held as part of a 400 ounce bar in the vaults of a bank in London, New York or Zurich, at a cost of 0.12% per year with insurance included.

The Perth Mint enables investors to own bullion held at the company, and is backed by a guarantee from the government of Western Australia, which is rated AAA by Standard & Poor's. Charges are 3.9% to buy for the minimum investment of £6,000, falling to 2% for £100,000 or more.


Spreadbetting allows leveraged exposure to precious metals. Firms such as Interactive Investor, IG Index and City Index offer the ability to take a bet on the price of gold. You can also take a view on movements in either direction.

It is best for speculators with short- term horizons, as you will pay financing costs for positions held overnight. No commissions or taxes are levied on spreadbetting and gains are free from capital gains tax.

This article was originally published in Money Observer - Moneywise's sister publication - in December 2009

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