This is the first in a series of posts in which I’ll discuss the supply and demand forces that will drive the next bull market in gold. I’ll start by addressing the supply side of the equation.
The market receives gold from four sources: mining, recycling of jewelry, sales by central banks, and sales by gold ETFs. I’ll address mine production in this post.
Falling mine production
Mine production is the largest source of gold to world markets, providing about 60 percent of total supplies over the past five years. However, it’s a virtual certainty that mine output will decline over the next decade. Recent history suggests why.
As prices rose six-fold between 2001 and 2011, mining companies, chasing higher profits, invested $11 billion to increase production. Nevertheless, they managed to increase output by an average of only .4 percent per year. Why? Because gold is getting harder to find and more expensive to mine. The easy gold is already out of the ground.
The average all-in cost of producing an ounce of gold has risen to $1400/ounce over the past decade. As I write, gold is at $1367, which means that miners are underwater on much of the gold they’re mining today. As a result, miners are slashing exploration and capital budgets and closing mines.
Despite a decade of skyrocketing prices, the financial condition of mining companies was weak even before this year’s price plunge; since 2010, mining stocks have fallen 29 percent. Even as prices climb in the next bull market, miners will be in no better condition to increase output than they've been over the past decade.
Gold production moves east
Not only is output falling, a rising share of the world’s gold supply is being mined in countries that are politically unstable or are adversaries of the West. For example, in 2000, 48 percent of the world’s gold production came from the U.S., Canada, Australia, and South Africa, highly reliable sources of supply for the West. By 2012, the U.S., Canadian, and Australian share of world production had fallen to 22 percent. South African production had fallen by 60 percent, and political instability had risen to the point the country could no longer be considered a highly reliable source of gold.
In contrast, between 2000 and 2012, the combined production of China and Russia rose from 11 percent to 18 percent of the world’s gold mine output. Likewise, politically unstable countries in Africa and Asia accounted for a larger share of gold supplies in 2012 than in 2000.
These trends are likely to accelerate over the next decade. As a result, gold prices will rise as labor conflicts, government expropriations, confiscatory taxes, and terrorism interrupt supplies and raise the cost of production. We are already seeing evidence of these developments with the increase in labor strife in South Africa and elsewhere, and talk of mine expropriations by governments. These risks will intensify as gold mines shut down, workers are laid off, government revenues fall, and economic conditions worsen in these countries.
Finally, gold mine production is likely to fall for another reason: Based on estimates by the U.S. Geological Survey, at current rates of production, world gold reserves will be exhausted in 20 to 35 years. The effect on prices will be felt long before mine production begins to wane. Following the example of OPEC, an organization of Gold Producing and Exporting Countries (GoPEC) could form to set prices by controlling production and exports. But unlike oil, which can be displaced by other fossil fuels, renewable energy and nuclear power, there are no substitutes for gold.
In my next post on gold supply and demand forces I'll discuss jewelry recycling, central bank sales, and sales by ETFs.