Editor’s note: this is an excerpt from the May, 2010 edition of Diggers and Drillers. At the beginning of that month, the gold price traded below US$1,170. In that report, Alex made a case for what gold’s ‘intrinsic value’ may be. Read on for how he arrived at the figure…
Gold’s value as the world’s one true currency could be more that US$27,000 an ounce.
Take a look at my argument below and decide for yourself. Even if gold achieves just ten per cent of this price, you still stand to make some spectacular gains by investing in gold in the right places.
The supply of gold is falling steadily. As with any other commodity the price of gold ultimately depends on just two things: The supply of gold, and the demand for gold.
Before we get to the exciting part of the story, it is important to look at the supply of gold. It’s paving the way for higher prices just as much as the big picture macro-economic story.
Aaron Regent, president of Barrick Gold, perfectly summed up the supply situation last year when he said, ‘Global output has been falling roughly one million ounces each year since the start of the decade’.
The gold mines of the world produced just 90 million ounces last year. That figure was a brief improvement on previous years. But the overall trend is still steadily downhill.
The reason for falling production is that despite a tripling of the global gold exploration budget in the last ten years, substantial deposits are running out and are becoming harder to find. Another factor is that the average grade of the gold ore mined has also been falling. In 1950, the average ore mined was 12 grams per tonne. Sixty years on and it is a quarter of that: just 3 grams per tonne.
The peak for global annual gold production seems to be behind us. Some analysts are already calling it ‘peak gold’. In fact, production from gold mines only managed to supply 75% of the 120 million ounces of identifiable global gold demand last year.
The 25% shortfall was bridged by ‘scrap gold’, which is largely sourced from recycled jewellery. Remember those Cash Converters adverts? There is only so much gold jewellery that people are prepared to sell though, and this level of supply can’t be maintained for long.
Demand on the rise thanks to currency mismanagement
In 2008, 30% of gold demand was for investment purposes. This demand was pretty much equally split between physical gold, and gold exchange traded funds (ETFs). Last year, gold demand for investment purposes jumped to 38%.
And here is the big point I want to make here: This figure is set to keep rising as governments continue to mismanage the major currencies of the world.
The move in May by the European Central Bank (ECB) to create a fund of 720 billion Euros to prop up the single currency was an historic day for the currency. The ECB’s action put another one of the world’s major currencies on a head on collision course with inflation. The ECB plans to print money to buy government bonds in order to stop member states defaulting.
This sends out a clear signal that the ECB is prepared to debase its currency and reduce the value of the Euro, rather than have the currency fail. This is a brand new look for the ECB as it has always endeavoured to be anti-inflationary.
Europe’s sovereign debt issues had been hanging over like storm clouds, but the ECB’s move to solve the problem by debasing the currency was the tipping point. The ECB has pretty much followed the Fed’s method of dealing with the problem.
With two major currencies being manipulated at the expense of holders of the currency, it only follows that investors are losing faith in paper money and are increasingly turning to gold as a safe haven.
Central banks seem to be thinking the same thing. They have become net buyers of gold in the last year. The total value of gold held by central banks globally is currently about US$1.7 trillion (or sixteen times the value of the total global gold demand). This is a very bullish signal for the future price direction as central bank’s holdings dwarf the size of the market.
Gold’s intrinsic value – US$27,163/Oz?
Goldman Sachs is forecasting up to US$1,300 by year’s end. Most of the other investment banks are currently revising their gold forecasts for the year on the back of the ECB’s latest moves. For the last few years I have noticed that the investment bank gold forecasts have always come in too low.
Blackstone Advisory Partner’s Vice Chairman, Byron Wien, is also expecting US$1,500 by year’s end. Precious metals economist Jeff Nichols says that he is ‘…confident in the forecast of US$1,500 by the end of 2010, with gold reaching US$2,000 or possibly even US$3,000 in the next few years’.
I mentioned in a recent email update that James Turk, the founder of Gold Money, is expecting gold to hit US$2,000 by the end of this year, and US$8,000 by 2015.
I also reported that fund managers QB Partners had a crack at calculating gold’s ‘intrinsic value’ by dividing the total Fed liabilities (US$2.5 trillion) with the official amount of Fed’ gold holdings (8,100 tonnes). This comes to a figure of US$9,500/Oz.
Continuing along the same theme, I then calculated gold’s intrinsic value myself at a global level by dividing the global public debt (US$38.3 trillion) with the total amount of gold in central banks globally (1.4 billion ounces).
The value comes in at a staggering US$27,163/Oz.
My calculation and the QB calculation assume the world reverts to the Gold Standard in the near future. This may seem fanciful, but some form of monetisation of gold is looking less unlikely by the month as fiat currency continues to be mismanaged globally.
The idea I want to convey with this calculation is that these large numbers give some indication of gold’s intrinsic value, whether it is ever realised or not. This is what I like to think of as gold’s ‘centre of gravity’, with the gold price trending in the direction of this value as individual fiat currencies gradually unravel one at a time.
Many look at today’s gold price as being high. The fact of the matter is the gold price is still very low. We have heard a few times in recent years that gold has made another ‘new high’, but in ‘real’ terms, it hasn’t even come close.
Dr. Alex Cowie
Editor, Diggers and Drillers
for Markets and Money