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Wednesday, September 22, 2010 - 15:32
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Wednesday, September 22, 2010 - 15:32

7 Key Questions About Gold

Wednesday, September 22, 2010 - 3:32pm

Gold is on the march. The yellow metal is spiking to a new all time (non inflation-adjusted) highs of nearly $1,300 per ounce on renewed speculation that the Federal Reserve's next moves will only strengthen the case for higher gold prices down the road.

Let's take a closer look at some key questions to see if gold is set to shine even brighter or eventually lose its luster.

Q: What is the Fed concerned about?
A: In its most recent statement after Federal Reserve Open Market Committee (FOMC) meetings, the Fed noted that potential deflation is of increasing concern. (Core annual inflation has been running at 0.9% for five months in a row, its lowest pace since 1966.) Any drop in prices could spell real trouble for the economy and would imperil borrowers that are seeing lower income but constant debt levels.

Q: What might the Fed do?
A: To help support prices, the Fed can inject money into the economy by buying back bonds. (The bondholders that sell their debt back to the government would presumably put that cash to use elsewhere in the economy.)

Q: Why should that impact gold?
A: Many fear that the Fed is simply inviting the prospect of troubles down the road. Early in the last decade, the Fed also sought to boost the economy's prospects by keeping interest rates low. That set the stage for rampant low-cost borrowing and an eventual housing boom, which turned out to be disastrous for the economy when the music stopped.

This time around, the concern instead focuses on what might happen if the economy hums back to life but the Fed has a hard time keeping growth (and inflation) from surging. In the recent economic bubble, inflation never emerged. Yet gold bulls insist that we won't be so lucky next time. That's because budget deficits are now far higher, and if the United States can't meet its obligations, then inflation will rise as the Fed raises interest rates to keep attracting buyers for its debt. That would cause the dollar to weaken and gold would provide shelter in the storm. (But if rising inflation fails to materialize, then many that had bought gold on inflation fears may look to sell their positions.)

In addition, gold isn't as closely tied to economic cycles as are many commodities and equities, and it is frequently bought to diversify portfolios and guard against losses elsewhere. Conversely, as economies improve and stock markets rise, the argument for owning gold weakens. The fact that gold is hitting new highs even as the S&P 500 has had a strong two-week run is fairly unusual.

Q: What's the upside for gold?
A: Ah, the crystal ball question. Bulls think it can move toward the $2,000 per ounce. mark, which is actually the all-time high when adjusted for inflation. [Read: The Truth About Gold]

Why that price? There seems to be no real way to peg an actual projected value on gold. The price is driven by sentiment and not any sort of underlying asset value. We can figure out global demand for gold, and also how much is being produced each year. But we don't have a clear read of how much actual gold is sitting in central banks and especially in safe deposit boxes. Contrary to popular belief, central banks tend to offer contradictory statements on their gold holdings to keep currency speculators from knowing the state of their finances.

Gold producers generally spend around $450 per ounce to produce gold ($900 on a fully-expensed basis), so with gold above $1,000, there is ample incentive to hike output. And rising output of anything tends to have a dampening effect on prices. It hasn't happened yet, but some suspect we may be reaching the point of a gold glut -- at least in terms of industrial and jewelry demand. Financial hedging demand is fairly immune to supply, and could continue to power gold higher. Gold contracts that expire in 2016 place a $1,447 price on an ounce of gold.

Rising prices have a way of feeding on themselves. JP Morgan's asset management arm continues to load up on gold on expectations that it will attract even more interest in coming years. (This is also known as the Greater Fool theory or the Keynesian beauty contest.)

Q: What's the downside?
A: The short answer is that gold could fall below $500 if all of these concerns fail to materialize. That's where gold traded back in 2005. And that's likely the area where supply and demand are truly affected, financial hedging considerations notwithstanding. As long as massive budget deficits remain as a concern, however, gold is very unlikely to fall back to that level.

Q: If I think gold has more to climb, should I buy gold or gold stocks?
A: The benefit of buying gold (or a gold ETF like the SPDR Gold Shares (NYSE: GLD)) is that you aren't paying for the operating expenses of gold companies and you are eliminating company-specific risk. And since gold producers may seek to lock in (or hedge) the price at which they can sell gold, they may not be able to fully profit from the sharp upward move in gold prices. (Currently, most gold producers are unhedged and willing to accept market risk, but that may change if prices rise higher.)

Then again, profits at gold-mining firms can grow even faster than the underlying commodity's price if they didn't lock in prices. That's due to the fixed-cost nature of gold mining. As noted earlier, it costs roughly $450 per ounce to mine, store and transport gold. So with gold selling at $1,000 an ounce, that's a $550 gross profit. But if gold prices rose +50% to $1,500, then per ounce gross profits would nearly double to $1,050. (Actual profits are well lower when non-mining costs are included.)

During the past 25 years, gold stocks have historically traded for between 12 and 24 times projected profits. Now they trade for just 11 times next year's profits. But that's because profits have risen so sharply and could well re-trench. If gold stayed above $1,200 per ounce for a number of years to come, then these stocks would look appealing. But if gold fell below $1,000 per ounce, then these companies' P/E ratios would appear astronomically high.

Investors can also look at where the gold miners trade in relation to their net asset value (NAV). They have historically traded between 1.4 times and 2.4 times NAV (except in early 2009 when they traded below NAV) and currently trade at 1.8. That NAV would rise and fall in step with any move in gold prices.

Q: What about "peak gold?"
A: While the question of peak oil dominates energy markets, it's really not important in gold mining. Most publicly-traded gold producers estimate that they have proven reserves that are equivalent to 10 to 20 years of annual production (and a similar amount that they have yet to verify as recoverable). And unlike oil that disappears when it is used, actual industrial demand for gold is so small relative to the amount held in bank vaults and jewelry chests, that any shortage could be met fairly easily.

Yet it is getting more expensive to mine gold as the easiest plays have been mined out and new mines are in increasingly remote or hard-to-mine locations. In 2000, it cost roughly $175 to mine and transport an ounce of gold. That figure moved above $250 in 2006, above $400 in 2008, and appears headed toward the $500 mark in the next year or so. Despite that rise, gross profit margins have surged. Gold miners made roughly $50 for every mined ounce from 1990 through 2005. Per ounce profits are up nine-fold since then.

But as noted above, miners have plenty of overhead costs, and it actually costs more than $900 to produce an ounce of gold when they are accounted for. That's why gold miners would hate to see a sharp pullback below $1,000 an ounce.

Action to Take --> All of this highlights a real conundrum for investors. Gold prices are being supported by economic concerns that have yet to (and may never) materialize. Gold can easily power higher (and technicians note that it just passed an important resistance level). But on a fundamental basis, gold appears quite overvalued. If gold prices fell to a point that truly reflects the fundamentals, then gold miners would see profits evaporate. Gold makes sense as a defensive hedge and as a means of diversification. But it's not a clear value as a pure investment.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.