An acute shortage of readily marketable physical gold is developing that we believe will deepen in years to come. This possibility seems to be unrecognized by those who are short the gold market through paper contracts. The relentless dumping of synthetic or paper gold contracts since 2011 by speculators in Western financial markets has caused the shortage. The steady selling has driven down the price of physical gold, hobbled the gold-mining industry, and drained the stores of gold held in the vaults of Western financial centers. We believe that the shortage will worsen because (1) the precursors of production (exploration, discovery, reserve life) are very negative, (2) the mining industry has little financial credibility and seems unlikely to attract capital even with a big rise in gold prices, and (3) refining capacity limitations tend to create supply bottlenecks when physical demand spikes.
Therefore, absent any significant and sustained rise in the gold price, we expect few new mines to be built for many, many years to replace depleting and aging mine reserves. In addition, refining capacity should remain static for the foreseeable future. At the same time, the pool of vaulted gold in readily marketable form that supports paper/synthetic gold trading has all but vanished as Asian demand has drained inventories in London and other Western storage complexes.
The seemingly endless supply of notional gold coming from the sellers of synthetic is the strongest explanation for the extended, and in our view overdone, decline in the gold price from peak levels of 2011. Quantities of synthetic gold sold are created out of thin air, with almost no connection to physical metal. The negative investment thesis seems to rest upon confidence that central bankers, and the Fed in particular, will steer a course away from radical monetary experimentation that will return to a normal structure of interest rates and robust economic growth. The fact that these expectations have not been fulfilled in the nearly nine years since the initiation of zero interest rates, notwithstanding the recent 25-basis-point Fed rate hike, leads us to believe that investor credulity in central bankers may be stretched about as far as it can go.
The very popular short exposure in gold is, in our opinion, vulnerable to a trend reversal/mega short squeeze. This would occur if gold ETF assets under management (AUMs) were to rebuild or if holders of COMEX futures were to stand for delivery in a big way. Gold ETF AUMs peaked at 2400 metric tons (“t”) in December 2012 vs. 1300 currently. A 200- or 300-t influx to GLD and other ETFs would put a severe strain on London liquidity, which we estimate to be substantially below 1000 t currently. When and why a trend reversal might occur is a matter of guesswork, but a trend change is inevitable (as in all markets), and the dynamics promise to be powerful. In our view, the short interest in paper gold rests on a credit pyramid that is precarious. When a trend reversal occurs, we expect that machine-driven trading, which is agnostic as to investment fundamentals, will serve as a powerful accelerant to the upside, just as it has led to overshooting on the downside.
The Gold Mining Industry Is Severely Incapacitated
Over the past 10 years, aggregate debt of the gold-mining industry increased from $1 billion to $41 billion. (For purposes of this discussion, all figures refer to the ten largest companies included in the XAU index as a proxy for the industry.) The increase in debt was to fund capital expenditures for mine expansion in the expectation of sustained high gold prices. From 2005 to 2011, the gold price per ounce rose from $429.55 to $1420.78; it averaged $803.60 over that six-year period (numbers from Bloomberg). Managements, investors, and lenders were uniformly bullish as the gold price reached $1900.23 in 2011 amid predictions of a government shutdown in August of that year. Following the 2011 peak, the dollar gold price fell steadily to sub-$1100 levels, a decline of more than 40 percent. The decline has severely undermined industry profitability, added further strain to balance sheets, and raised doubts as to future returns on capital committed to new mining projects.
Equity investor enthusiasm enabled the industry to double share issuance over that 10-year period to fund mine expansion and corporate acquisitions. The incremental return on investment from equity and debt issuance has been highly disappointing. Significant increases in capital have spurred little production growth, and share issuance has severely diluted equity investors. Aggregate profits have fallen from a peak of $14 billion in 2011 to negative $5 billion in 2014. Gold production over that same period rose an estimated 13 percent, from 38 million oz. to 43 million oz., while per-share production declined from .38 oz. to .21 oz., or 45 percent.
To us, this cumulative and collective misfortune has translated into a loss of credibility and perhaps an inability to raise significant incremental capital for several years to come. In our opinion, it will require a sustained rise of several years in the gold price to attract capital for new mining projects, assuming that such projects even exist in light of the severe reduction in industry exploration expenditures and discovery rates. In the absence of a sustained rise in the gold price, the most likely outlook over the next two to three years in our opinion is for the industry to continue in a survival mode of balance-sheet repair and running in place to remain positioned for a future rise in the gold price.