What's Holding Gold Back?
Introduction by James Turk

In the following commentary Doug Casey considers the question, what's holding gold back? My answer to this question is central bank intervention in the gold market, which is driven principally by one factor. By trying to cap the price of gold, central banks can create the illusion that the dollar is worthy of being the world's reserve currency when in fact it is not.

Gold and the dollar are competitors. A lacklustre gold price may lead people into thinking that all is well with the dollar, when in fact it is not.

But regardless of the reasons why gold is not keeping pace with the price rise of other tangible assets, two points are clear. Gold is undervalued, and it has a lot of catching up to do. When this reality eventually hits home and the flight from the dollar accelerates, the result will be as Doug says: "The shift back towards gold will be akin to trying to squeeze the contents of the Hoover dam through a garden hose." As a consequence, Doug expects: "Gold isn't just going through the roof; it's going to the moon."

What's Holding Gold Back?
by Doug Casey
International Speculator

The billion-dollar questions -- the ones that could make any of us billionaires if we knew the answers for certain -- are: When will the gold price finally get going? And how high will it go?

I'm discounting, for the moment, the fact that gold has already moved up substantially in recent years: from $256 in early 2001, to $436, as of this writing, for a gain of about 70%. That's peanuts. I'm on record saying that I expect gold to hit $500 by the end of this year. It may be soon thereafter, but I'm sticking with my prediction, and with my assertion that that's only the beginning -- gold isn't just going through the roof, it's going to the moon. And sooner than most people expect.

But to try to answer the question, I think we need to answer another one first: What's holding gold back? And even another before that: Is gold being held back?

It's a complicated issue, with different answers from just about everyone trying to untangle it. My sense is that gold is being held back, if not deliberately, then at least by market conditions -- which include mass investor psychology.

To begin with, a quick look at the market fundamentals. (For a detailed look at the economics of the gold price, I suggest going back to the April 2003 issue of this newsletter -- conveniently archived on our web site -- in which Paul Van Eeden did an excellent job of laying it all out.)

According to Gold Fields Mineral Service, about 2,464 tonnes of gold were mined in 2004. Add to this central bank sales, scrap gold sales, and a few other variables, and supply runs around 3,500 tonnes per year -- though Q1 2005 was good for producers and the number may come in closer to 4,000 tonnes this year. This is pretty closely balanced by jewelry fabrication (46 tonnes more than total mine output in 2004), dental and industrial uses, retail investment purchases, ETFs (exchange-traded funds), etc.

That balance is a very important point. According to the World Gold Council, total supply was only 190 tonnes greater than demand in 2002. The net surplus was 676 in 2003, and ­169 (that's MINUS 169) tonnes last year. Supply was LESS than demand in 2004. So a significant move in any of the supply or demand factors can have a huge impact on the price of gold, and, as I'll explain below, some of these factors are changing in ways that are bullish for gold.

Based on a detailed look at the fundamentals, Jon Nadler, one of the world's leading consulting experts on the gold market, formerly with the World Gold Council and now a senior manager at Kitco Precious Metals (the world's premier online precious metals dealer), says that gold "should" be trading in the $480-$520 range and is poised to move into that trading range soon.

This meshes with my own gut feeling. Most commodities are trading higher -- with many metals and energy commodities boasting triple-digit gains, or more. Molybdenum is currently up 1171.6%, uranium 325.4%, natural gas 496.9% -- even base metals like copper (175%) and nickel (238.3%) are up more than gold and silver. So gold, despite being up 68.7%, is significantly lagging many other commodities. The figure for silver, as I write, is 67.4%. That's interesting, in that although silver moves independently from gold on a day-to-day basis, it has a high overall correlation with gold.

So ... What's Holding Gold Back?

When asking this question, the first thing that comes to many people's minds is that some group of interests is manipulating the price of gold to keep it artificially low. That may or may not be the case, but there certainly are a number of economic reasons for gold to be priced as it is -- or at least as it was until recently.

1. Supply

After the price of gold spiked over $850 in January of 1980, gold production increased substantially -- and it stayed up, even with the steep falloff in gold prices. Production has gone from about 1,200 tonnes per year in 1980 to its current level, over 2,500 tpy. The total amount of gold above ground is estimated by Nadler at 145,000 tonnes (about 4.66 billion ounces, worth some $2 trillion dollars).

Where did all that new gold production come from? Aside from the dramatic increase in price incentive in 1980, new technologies have matured, such as heap leaching and satellite prospect identification. In addition, since the collapse of communism, many prospective areas of the world have opened to modern exploration.

2. Hedging

Another economic factor keeping the price of gold down recently has been producer hedging. This is a particularly complex part of the puzzle, but in a nutshell, when gold was falling, as it was from 1980 to 2000, many big producers, starting with Barrick, "hedged" against decreasing prices by selling large portions of their future production at substantially over the then-current prices. Since gold is a "carrying charge" market, it's usually possible to sell several years forward at a price reflecting current interest rates and storage costs. In the mid `80s, when gold was, say, $400, that meant they could sell three years out for, say, $520. When time came to deliver, the metal might actually have traded for only $350. That was a very smart thing to do -- at the time. What wasn't so smart was failing to recognize when gold bottomed out and prices started rising again.

The producers have started de-hedging in the last couple of years but they still have massive short positions. By some estimates, on the order of 1,700 tonnes of gold -- almost half last year's entire gold supply from all sources -- is still sold forward.

Obviously, gold sold forward in the last five to seven years at prices considerably below today's is costing these companies a fortune, but the big impact on price may come from the bullion banks. Why? Because they could borrow gold from central banks for nominal interest rates (0.5 to 1.0%), sell it on the open market (believing they will be able to return it when they take delivery on futures contracts bought from hedging mines) and invest the proceeds, conservatively, to clear a 4 to 5% profit margin. This had the effect of increasing the global supply of gold, basically adding already produced (borrowed) reserves onto the production/supply side of the scales.

3. Trader selling

Another purely economic factor holding the price of gold back may simply be traders selling every time gold approaches $440. Why do I say that? In part because you can see gold retreat time and time again, as it approaches $440-$450. Nadler explains: traders, not being long-term-oriented folks, are not waiting for gold to go to the moon. They are perfectly happy to buy in the $417-$430 range and sell the moment they can make $20-$30 per ounce. This doesn't really affect the balance of supply and demand, but since prices are fixed at the margins in general, and are particularly volatile in a relatively small but psychologically important market like gold (if supply hits 4,000 tonnes this year, that would only be $57 billion at $440 gold), even a modest amount of selling by traders can have a strongly negative short-term effect on prices.

4. The Real Estate Bubble, the U.S. Economy, and Interest Rates

Investor fascination with real estate is drawing capital from other investments, even undervalued ones like gold. Why did investors focus on real estate, rather than gold, after the tech bubble burst, the dollar started falling, and broader equities markets started trading sideways?

I attribute it mainly to the fact that gold was in a secular bear market from 1980 to 2001. As a consequence, a whole generation of investors grew up thinking of it as an investment "dog" as well as a monetary anachronism. In addition, the strong growth of the U.S. economy and the years of low interest rates have spawned a complacent mentality among most Americans; they expect continuous prosperity. Given the record levels of debt among individuals and the federal government, this feeling of prosperity must be a form of mass delusion. Rising interest rates are already putting the squeeze on credit card and mortgage holders with variable interest rates. That could get very ugly, very quickly. Though we are seeing the beginnings of a change in attitude, most institutional and retail investors still think putting capital in gold and other precious metals is a little loony.

When the housing bubble bursts, though, I suspect, things will begin to change. Stocks, bonds, and the depreciating dollar won't provide a refuge. The herd is going to head into commodities in general, and gold in particular. Gold is, after all, the crisis commodity -- and, as explained in last month's edition of this newsletter, I am more convinced than ever that we're heading for a financial crisis that's going to dwarf what we saw in the 1930s.

5. Price manipulation?

As long-time readers know, I don't generally subscribe to conspiracy theories. Occam's Razor dictates that the simplest solution to a problem is likely the most correct one. And anybody who has tried to get a few friends to agree on something as simple as what movie to watch can imagine how hard it might be getting dozens of the most powerful malefactors in the world to agree on how to suppress the gold price. But I have to say that the folks at the Gold Anti-Trust Action Committee (www.GATA.org) present a pretty compelling case.

Central banks may not be able to control the price of gold, as was the case before 1971, but they have the motive, means and appearance of influencing it.

The U.S. in particular, since its dollar has in good measure replaced gold as a reserve asset around the world, has an interest in seeing low gold prices, and a quiet gold market. Why? Because the value of the world's fiat currencies, particularly the dollar, rests mainly upon the confidence of the public. Unfortunately, confidence is not a stable foundation upon which to build the world economy. Like any attitude, confidence can change over night. Governments want to maintain confidence at all costs, and the one thing most likely to destroy it and set off a full-scale monetary panic, is a runaway gold price. Therefore, it's quite logical that they will make every effort to suppress the price of gold.

How? Remember what I said about producer hedging above? The key component of GATA's claims is that the central banks are lending gold to bullion banks and still keeping the gold on their books as reserves. In these "swaps," each bar of gold essentially gets counted twice, exerting a negative pressure on the gold price when the borrowed gold gets sold on the open market. There's no question that bullion banks are selling borrowed gold -- what makes this the stuff of a "conspiracy" is that GATA says the central banks are not being truthful about whether or not they are counting gold not actually in their vaults as reserves.

Specifically, GATA Chairman Bill Murphy says the central banks are reporting an aggregate of about 31,000 tonnes of gold held in reserve, but only have about half as much in their vaults. The amount of gold they actually have on hand may be as little as 14,000, or even 12,000 tonnes.

Murphy says the International Monetary Fund claims that it recommends that swapped gold be excluded from reserve assets. However, some central banks report otherwise. For example, a footnote on the central bank of the Philippines' Web site contradicts the IMF's claim: "Beginning January 2000, in compliance with the requirements of the IMF's reserves and foreign currency liquidity template...Gold swaps undertaken by the BSP with non-central banks shall be treated as collateralized loans. Thus, gold under the swap arrangement remains to be part of reserves..."

The European Central Bank, the Bank of Finland, the German Bundesbank, and the Bank of Portugal also confirmed in writing to GATA that swapped gold remains a reserve asset as per IMF regulations. So clearly there is a disconnect here.

Summarizing the GATA argument, in their own words: "GATA believes that the implications of IMF accounting procedures for reversible gold transactions are very significant. Clearly deceptive accounting, countenanced by the IMF, has allowed official sector gold to hit the market without a corresponding drawdown on the balance sheets of central banks. This has made it impossible for analysts to ascertain the exact size of official sector gold loans, swaps and deposits. The unwillingness of central banks to provide even a minimum level of transparency suggests that total gold receivables are substantially larger than the accepted industry figure of approximately 5,000 tonnes. Macroeconomist and former World Bank consultant Frank Veneroso contends that 10,000-15,000 tonnes of gold have left central bank vaults via loans, deposits, and swaps."

Could central bankers really be stupid enough to lend out gold to people who are selling it, in return for a measly 0.5% interest?

Yes. My impression of central bankers is that most are not smart enough to buy low and sell high; they're a bunch of stumblebums from wealthy families who know how to dress well. They likely feel quite clever getting 0.5%, when before they were getting nothing. I also don't doubt the favor to the bullion banks often gets repaid with cushy jobs or consulting contracts after the bureaucrats go out into the private sector.

What happens if production from Barrick and the other hedged producers (many of whom are taking a severe beating from rising costs and commitments to sell gold at below-market prices) falls off and J.P. Morgan and the other bullion banks can't replace the gold they've sold at prices they can afford to pay? It will be a scandal of a scale that, by itself, could move gold much higher.

But even if that doesn't happen, it's easy to see that the bullion banks must feel a well-deserved and thoroughly unpleasant jolt of panic every time the price of gold heads north -- especially with mine strikes in South Africa, unrest in Peru and environmental activism threatening gold production in other places.

If they can't replace the gold they've sold from new mine production, they'll have to get it on the open market, and that could wipe them out. And if the bullion banks go bust, the central banks will be caught with their suspenders down; they'll be forced to go public, admitting that they have less than half the gold they've been reporting in reserve. Fear of that outcome could certainly drive them to lend even more gold to the bullion banks, adding selling pressure whenever the price of gold goes up, making the hole they are digging deeper each time.

Whether or not there's any deliberate price manipulation may be hard for GATA to prove. However, GATA's questions of the central bankers regarding their policies on reserves, swaps, sales, etc. are valid and deserve answers. I've made light of GATA's efforts to force disclosure in the past only because I've felt they were doomed to failure, not because I disapproved of the intent.

I asked Bill Murphy how long before the bullion banks and central banks hit the wall and the whole house of cards collapses. Bill answered: "I think we're there now. I'm not sure the central banks can lend any more gold out -- the scandal could break at any moment."

What Will Make Gold Move?

Obviously, a significant change in any of the factors above will send gold up sharply. Specifically:

1. Central banks

Whatever the case may be in central bank reserve reporting, the fact that they are lending their supposed reserves out to entities that subsequently sell the gold for a profit is not in question. The question is, how much? They may be running low on physical inventory. Remember: by their charters, they have to keep a certain minimum amount on hand. Furthermore, most of the big central banks are signatories to the Central Bank Gold Agreement (CBGA), which limits their bullion sales to 500 tonnes per year -- a limit they've already broken, with one month left to go in this fiscal year.

Because of the lack of transparency, we can't say when they'll hit their limits, but at some point -- and it can't be too far off -- the central banks will have to stop selling.

2. Production

There are numerous problems facing the gold industry on the production side. According to the World Gold Council, production was already down last year, by about 4.9% compared to 2003. Demand was up 9.5% at the same time. One reason for this is increased environmental and political opposition to mining operations, such as the trouble Newmont has been having at their giant Yanacocha mine in Peru. In South Africa, where social unrest and the rising rand (vs. the dollar) has put gold producers under serious pressure, output continues to drop. The figures for Q2 2005 show another 2.4% drop in output (down 18% versus a year ago). South Africa now supplies about 14% of the world's mine output, down from 80% in 1970.

Another reason is the decreasing success of exploration. Heap leaching is a couple decades old now (the advent of cheap bulk tonnage gold mining around the world is partly responsible for the decrease in South Africa's share of mine output and largely responsible for the great increase in production over the last few decades) and many of the world's most easily identifiable heap-leaching targets have been put into production. The major producers -- the ten largest companies account for about 46% of the world's new mine production -- need a steady stream of new multi-million ounce deposits simply to stay in business. Newmont, for example, needs to find 6 to 8 million new ounces of gold every year in order to maintain the value of its shares, and deposits of that scale are getting fewer and farther in between.

It remains to be seen if this year's production will keep up with demand. It did in Q1 2005, but only by 47 tonnes, which is very similar to the 45-tonne surplus in Q1 2004 -- a year that ended up in shortfall. If supply falls significantly short of demand and central banks are limited in how much they can sell, we could see major increases in the price of gold in short order.

3. General demand

Increasing world population alone would increase demand, but that growing population is also increasingly wealthy. Jewelry fabrication currently accounts for about 71% of world gold demand, and the biggest sources of that demand are India and China, where GDP is growing much faster than in the U.S. and Europe. Unless those economies go into serious corrections, the largest portion of world demand should remain very strong for years to come ... especially as we see continued pressure on fiat currencies, pretty much across the board.

Furthermore, some central banks may be buying, even as others are selling. Public data summarized by the World Gold Council shows Russia buying repeatedly over the last few years, as well as the Philippines, Mongolia, Venezuela and a number of other third-world countries from time to time. Don't let the 500 tpy of official central bank bullion sales fool you, aside from whatever is being swapped behind closed doors, the overall central bank reserve level is not being sold off as quickly as some people say. There are even signs that some central banks may step up buying -- the Russians and the Chinese in particular.

Also, new industrial and other uses for gold are being found all the time. It's important to remember that, as one of the 92 naturally occurring elements, gold has unique properties that are critical in an increasingly hi-tech world: It's the most corrosion resistant, ductile, and malleable of all metals.

4. Geopolitics

The Arabs will be increasingly interested in turning their oil money into gold, just as they did in the late 1970s. This is inevitable, with so many Americans adopting attitudes of "the only good towel head is a dead towel head." Interestingly enough, one of the last things Saddam Hussein did before Baby Bush took him out was to announce that Iraq would be selling oil for euros instead of dollars. And one of the first things the U.S. did on taking control of Iraq was to cancel that arrangement. (Notably, the first-ever euro-denominated international oil bourse is scheduled to open in Tehran in March 2006 -- unless, of course, we manage to turn Iran into a parking lot first.) Military efforts to prop up the dollar will only shake confidence in the greenback all the more, of course, which is good for the gold price.

Meanwhile, I've heard that Russia and China are thinking about dumping the dollar as a vehicle for facilitating trade between those two countries. It makes little sense for two major powers to use the unreliable currency of a potential enemy for trade with each other.

The U.S. government has a great deal of knowledge of what's happening with, and control over, its currency everywhere in the world -- this is inconvenient for foreign governments. But neither the ruble nor the renminbi circulate outside of their issuing countries (these are "blocked" currencies), so, if those countries stop using dollars, what are they going to use? The euro? I doubt it. It suffers from the same problems as the dollar, and is worse in some ways. If the dollar is an "I owe you nothing," the euro is a "Who owes you nothing," backed largely by dollars. Gold is the only sensible way to go. Perhaps this is why Russia has been buying gold, and China is rumored to be planning to do the same.

5. De-hedging by gold producers

Hedged gold producers still have some 1,700 tonnes of gold to deliver that has already been paid for. The yearly amounts subtracted from this total essentially decrease output, which is bullish for gold.

6. Real estate bubble popping

The psychological impact of the real estate bubble popping is worth reflecting upon. After the tech bubble burst, and people's confidence in equities in general was shaken, a land rush was almost inevitable. After all, what would make the average person feel more secure than real property, land you could stand on? If your speculation didn't work out, at least you still had the real property -- not just a piece of paper. Gold would be the only other asset (with the possible exception of government bonds, but that's still just paper and not as reassuring if you think the country is in serious trouble) that most people can "instinctively" feel secure holding. With the economy still strong and the pre-9/11 American empire looking unshakable, people's shift to real estate rather than gold was unsurprising. So, fast-forward to 2005. Where will people put their money if they don't trust equities, don't trust Uncle Sam to remain solvent, and are worried about falling real estate? What else could offer anywhere near the security and investment upside as gold (and a side position in silver)? Answer: nothing.

7. Technical "reasons"

I'm not a chartist, but I do pay attention to them. At a minimum, they give perspective on where something is relative to where it's been. And they make it easier to see where the current trend may be leading. Specialists look for many finer points. I've seen some very compelling charts that paint bullish pictures for gold, on the basis of many different factors. Bud Conrad, who pulled together a companion article that appears elsewhere in this edition, is one of the more thoughtful and competent chartists I know, specializing in fundamental economics rather than "technical" trends. His article in this issue has a few eye-opening charts. Bud is working on a comprehensive analysis of gold markets that we hope to be publishing soon. Until then, Bud's article in this issue will give you a feel for his approach -- and why so many chartists are bullish on gold.

8. Psychological barriers

As I was working on this article, gold again flirted with $440 and then pulled back (GATA says the central banks sold foreign currency holdings for dollars on August 30, 2005, pushing the dollar up in order to keep gold from spiking after Hurricane Katrina -- which it obviously "should" have done). From $440, only $10 (a 2.3% gain) would take us over the important $450 barrier. The last time that happened, it made headlines -- as it will the next time. This alone, with or without any of the factors above, could bring more investor interest. Which, in turn, could push gold still higher. Note that the $480 to $520 range Jon Nadler is calling for averages to $500 -- another barrier number that investors and the media will likely pay attention to.

What Will Make Gold Go to the Moon?

I have been saying for years now that gold will go to the moon when people realize what paper money is actually worth. Next to nothing. That's the real key to really large movements in the price of gold.

Again, unless it triggers something bigger, $500 gold is still cheap in inflation-adjusted dollars.

This meshes with a comment Nadler made when we last spoke: "I think the key factor in today's lackluster investment demand market is the relative absence of the 'common man.' When the man in the street starts buying gold, no traders, no central banks -- nothing and no one will stop that flood of demand. That individual will come to the market and start buying once they understand that real wealth means how much money you get to keep -- not how much more you can eke out of the next home purchase or hot IPO stock."

I agree. The $50-$60 billion per year gold industry is a relatively small one, utterly dwarfed by, say, the oil business. It's nothing compared to a world economy estimated at over $50 trillion. Involvement of Nadler's "common man" will blow the doors off. What will make that happen?

While there are any number of reasons, from additional terrorist attacks, to rising energy prices (or prices of everything impacted by energy, which is to say, most things), my candidate for what will get things moving would have to be a resumption of the fall in the dollar -- in time, accelerating to the level of a collapse.

Of course, a falling dollar is really just the expression of widespread awakening to the financial swindle the government is running to fund its wasteful ways.

As foreign governments and the teeming masses begin to catch on to the idea that the government's version of currency is a rapidly dissipating deception, no more sustainable than, say, Pokemon cards that can be endlessly printed, the smarter members of the herd will break toward gold, and in increasing numbers. As already discussed, the gold market is not a big one -- which is why I often use the analogy that the shift back towards gold will be akin to trying to squeeze the contents of the Hoover dam through a garden hose.

Conclusions: What to do?

Of course, I could be wrong about the direction of the economy, and my strong belief that, over time, people will gravitate towards a tangible, universally accepted commodity such as gold over pieces of paper, or electronic bytes representing that paper.

While we wait to find out -- because only time will tell -- we can make a lot of money by buying great resource stocks cheap. Even if it turns out that much higher gold prices aren't in the cards, for reasons I can't foresee at this time, there are still any number of solidly managed junior exploration companies and developers with the potential to provide us with doubles -- and more -- on our money in the years just ahead.

The truth of that contention is that virtually all of the projects currently in the feasibility phase use in their assumptions a gold price in the area of $350 to $400.

If I'm wrong on the big picture, you'll find some consolation in the profits we're making. On the other hand, if I'm right, it will be champagne all around. Except for the average American.

In the meantime, building a personal hoard of gold and some silver, maybe up to 10% to 15% of your overall portfolio, getting out of traditional equities and speculative real estate ... generally hunkering down, would seem to me to be the prudent thing to do.

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DOUG CASEY is the author of Crisis Investing, which spent 26 weeks as #1 on the New York Times Best-Seller list. He is also editor and publisher of the International Speculator, one of the nation's most established and highly respected publications on gold, silver and other natural resource investments.

Published by GoldMoney
Copyright © 2005. All rights reserved.
Edited by James Turk, alert@goldmoney.com

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