Earlier this week, gold crossed USD 2000 per troy ounce for the first time thus recording its highest level to date. Price of gold is inversely related to the dollar. This is because gold price is denominated in dollar. So, weaknesses in dollar get reflected as increase in price of gold. As we are going through uncertain times, due to the Covid-19 pandemic, and the stock market in the US has also been down, dollar has weakened. But, will gold prices remain high for long?
Gold prices, like other metals and other commodities, are affected by both demand and supply factors. But, there are certain basic characteristics as far as metal prices are concerned. Its purity is testable to a high level of accuracy. They also have high value per unit weight. Moreover, unlike other commodities, they are not perishable, and can be stored for considerable lengths of time without damage. This is particularly so in the case of gold.
Secondly, production is highly sensitive to the price movements, as we will see in detail later. What are the factors that go into costs of production is publicly available and is transparent. There is considerable data made available on these by various agencies including by leading gold manufacturers. The production of gold is also not affected by uncertain and uncontrollable factors such as weather and natural disasters. Finally, there is also large volume of historical data available on how and where the metals are consumed. This applies to gold also.
These factors affecting metal prices can be further divided into short term, medium term, and long term factors. In the short term, of up to, say, three years, prices can result in changes to both demand and supply. Apart from changes in end user consumption patterns, this will also get reflected in adjustments to the inventory. Production usually does not change in the long term.
In the medium term of from, say three to eight years, production levels could change, new investment decisions could be taken, and price changes could trigger speculation on long term commodity prices. Mines which were considered uneconomical, might come into operation if prices go high over the medium term. Conversely, when prices go down, as happened in the case of shale oil in the petroleum sector, certain mines might get closed down.
In the long term, technological changes might be effected. This was how sustained how prices of petroleum spurred further research in exploiting shale oil reserves. High prices might make exploration for new sources of supply more worthwhile. It might also incentivise those who are looking for substituting with cheaper alternatives, or at least do further research in that direction. In the long run, there could also be significant changes to how the industry operates, and what its structure would be. Similarly, there could be environmental issues which might prevent further expansion or exploitation. What is precisely short, medium, and long term might also vary across commodities.
Gold is very similar to financial assets as far as its price behaviour is considered. There are also other characteristics that make it an ideal asset for traditionally conservative institutions such as central banks to invest at least a part of their reserves in. The price behaviour of gold reflects its monetary status. This status is derived from the availability of large gold inventories which can be used for lending or borrowing thereby resulting in a very well defined gold lease market and rate structures. These rates along with the spot price and interest rates in the US, apart from the behaviour of some major players such as central banks and gold manufacturers get reflected in the forward prices.
So, what makes gold so special? First is its indestructability. Second, because of its malleability and ductility, the ease with which it can be standardised and purity verified. Thirdly, as already observed, the high value per unit weight. This brings us to the fourth point, the low costs in storage and transportation because of the high value per unit weight. The fifth point is the availability of large stocks and the readiness of those who own gold, including central banks, to lend. This makes the market quite liquid, and difficult to manipulate.
What drives the sentiment in gold investment is first the fact that it is a traditional investment asset especially in countries like India which was for long the biggest buyer of gold in the world before being overtaken first by China and then Russia. Secondly, linked to the first point, it has been an asset of choice when investors opt for flight to quality, when they lose faith in major currencies such as the dollar, and in financial institutions and instruments. Thirdly, the fact that it is being trading for long and is a widely accepted traded asset also drives investment in gold. All these makes the gold market a very interesting field of study.
Where does that leave gold prices in the short to medium term. First, as long as the markets remain turbulent, the price of gold will remain high. Its prices in the forward markets have been higher than the spot rates. Right now, the market is in contango, or in other words, the future prices are at a premium over spot rates. In markets where physical delivery is the norm, this could be attributed to storage, financing (cost of carry) and insurance costs.
When the medium and long term factors kick in, the situation could change and the market go into normal backwardation, where the spot price is higher than future prices. This happens when there is a benefit to keeping the commodity, say, anticipating supply disturbance which gives rise to what is called a convenience yield.
© G Sreekumar 2022
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