just to clear the air
I was interviewing a prominent tycoon in Hong Kong in the mid-1980s when the topic turned to gold. He told me that he had long since sold all the gold bars he had once used to store his wealth. He was now holding currency and currency derivatives instead. I soon found that this was the norm among the rich and powerful in what had once been the center of gold bug-dom.
This was akin to travelling to southern California and seeing budding cultural trends in the US. That’s when I began to realize that gold that had lost its function universal function as a store of wealth. Yes, gold retains this function in third world countries like India, where people don’t trust or can’t afford banks, but–in my view–nowhere else.
As fun as it might be to elaborate on this theme, I want to write more about the mechanics/quirks of the gold market–mostly about production–than about popular delusions.
–Inventories, held either as gold bars or in jewelry, dwarf production. As decision of holders in the three biggest markets–India, China and central banks– to liquidate can have a significant effect on price.
–Gold mines typically have pockets of ore that are very rich in gold and others that are relatively thin. Industry practice is to aim for maximum sustainable mine life. This means mining larger amounts of relatively poor ore are when prices are high and shifting the mix toward richer ore when prices are low. One practical consequence of this practice is that actual production cost figures from the past few years of high prices are going to overstate the cost of production in today’s lower price world. Another is that production amounts tend at least initially to expand when prices fall.
–When mines get in financial trouble they begin to “high grade,” meaning they produce exclusively from their richest ore deposits and they cut the amount they usually spend on maintenance and on developing newer areas to mine. This is ultimately destructive of a mine’s long-term prospects, but it ups near-term cash flow–and it can go on for an extended period.
–When I began studying gold mining companies in the late 1970s – early 1980s, gold miners were very financially conservative because they understood clearly that their industry was subject to violent ups and downs in price. Their number one rule was to have no debt and a large cash reserve. That’s no longer the case. Heavy borrowing urged by CFOs with academic finance training but little industry experience has meant that mines need to generate enough cash to service debt as well as pay operating costs. This intensifies the need to generate maximum cash flow, even at the expense of diminishing long-term mine viability.
–Bankruptcies may help the orebodies. But because they remove the burden of debt service, they make the near-term supply situation worse, not better.
The gold price can go lower, and stay depressed for a longer period, than I think most people expect.
Thanks Dan. I think you are 100% correct – this is really interesting and corroborates my more general observation regarding commodities and energy / oil related businesses. These commodity cycles tend to be much longer than what I read about in the financial press today. Perhaps it is having lived through the 1970s, watching my family’s business boom (which had commodity / oil exposure) followed by the 1980s and 1990s, watching my family’s business struggle from their exposure to these same commodities. Then we had a huge surge in the naughts. The point is, these cycles appear to be measured in decades, not quarters – probably for reasons like your explanation of gold miner behavior. To the extent this is about right (resurgent growth in China / India may make it different this time) one would think many commodities would be in for a soft decade or two (not a soft quarter or two). The other point that I think gets lost in much of the speculation around commodities and mining is that many of these extractive businesses aren’t particularly good businesses – in fact, many are poor businesses that consume cash over time (regardless of how the underlying commodity is doing). Gold may or may not be worth holding, but from my perspective, gold mining is a terrible business.