What Is The Fundamental Value Of Gold?

21st Oct '11 by Andrew Butter

3 comments 7447 reads

If the fundamental value of gold measured in US-Dollars wasn’t a mystery before; then the past few weeks have added another dimension to the confusion. Supposedly gold is a “safe haven”, so when the rumors of Armageddon started circulating about the Euro, the price “ought” to have gone up? It didn’t, it went down…by 20%...so much for that theory. Is the latest story that the Euro-refugees figured the 10-Year Treasury was a better bet than gold…even after the downgrade? So much also for the idea that gold is an inflation hedge, that pretty much went out the window after all of the QE didn’t cause hyper-inflation, but even-so the price of gold, as measured in dollars doubled. Marc Faber says he will keep buying gold until Ben Bernanke stops printing; well Ben appears to be saying that he doesn’t think any more QE will help and it’s time US Congress grew up and started doing their job instead of just milking the cow for their own account, so is Marc still buying?

OK, the idea that gold is somehow driven by the same thing that drives the price of oil (whatever that is) still sort-of holds. Sort-of…at least on that score the spikes in gold prices do appear to follow spikes in oil prices although by that metric the price should be a lot less than now, as in about $1,000 based on historical trend-line correlations between gold prices and oil. There again, the dramatic decoupling of WTI from Brent starting in 2009 is confusing, as in which one should we be tracking now, if either?

Putting aside what’s driving the fundamental it looks like there might have been a bit of a bubble and bust in gold 2008/9 (or a bust and a bubble in the dollar if you are an Austrian), and the recent events look suspiciously like that too? If those were indeed bubbles-and-busts, then if the bust was fully expressed, one would expect the “fundamental” at the moment of time between the bubble and the bust, to have been somewhere in-between, as in the square-root of the top multiplied by the bottom? If that’s right we can draw two “fundamentals”, put a line through them, and Voila!!

If you buy that logic then the line A-B is the trend, and if indeed “the trend is your friend”, then gold…

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marben100

21st Oct '11

Thanks for an interesting article, Andrew, though I am always wary of putting too much faith in anything that makes assumptions about trends.

There is, however, one real piece of fundamental data worth adding in to the mix, when trying to gauge likely future gold prices. That is, cost of production. There is a very useful report here, from ABN-AMRO. It shows that costs of gold production, in dollar terms, have been rising very steeply, increasing by 13% y-o-y in 1Q11 (perhaps that gives a better metric of real inflation than govt. stats? ;0)). Median cash costs stood at US$583/oz at that time. One can easily add another $200/oz to those cash costs IMO, to allow for finding costs, CAPEX and G&A.

So, that implies to me that there must be a (medium term) "floor" under the gold price at around $1,000/oz. Any lower than that and many higher cost mines will start closing (top quartile mines will start to lose money at those levels) and new supplies will get taken out of the system. Of course, I do appreciate that much of gold demand is filled from "above ground" sources but nevertheless, I find it hard to believe the market could withstand a crash in gold production for long.

The takeaway for me is that investment in high cost producers (or gold itself) is pretty risky - but I continue to feel that Medusa Mining (LON:MML) , with costs around $200/oz and strong anticipated medium term production growth looks like a sound investment - especially as I can hedge a fall to $1,300 by June 2012 pretty cheaply using put covered warrants.

Cheers,

Mark

Andrew Butter

The "beauty" of gold is that there isn't much new stuff to be found which is why it's used as money.

I don't think that changes in the supply/demand will affect price much, I could see a situation where no new gold is mined and still the price would be determined by a "fundamental" linked to the state of the various fiat currencies, and the amount of debt associated with them.

That said, $1,000 to bring the stuff to the market looks like a great deal at the moment, I understand that a big part of that cost is energy, which can explain to some extent the link between gold prices and oil.

I didn't say there would be a crash, although I suspect that may be on the cards and I find it hard to see an upside.

Will I short? Mm...thinking about it, whatever, I don't think we will be seeing $2,000 for some time.

Daytona

13th Nov '11

There's no mystery. Gold returns are linked to real interest rates -

Annual return from gold = ((T Bill rate - Inflation) - 2%) x 8

http://www.crossingwallstreet.com/archives/2010/10/a-model-to-explain-the-price-of-gold.html

Gold vs. Real interest rate model

What is the Fundamental Value of Gold?

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Andrew Butter

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