Why gold miners are set for further gains

The gold price seems likely to hit $1,000 an ounce. That's good news for gold miners - higher prices mean higher profits. But there's another reason investors stand to profit from the sector...

It is our view that gold bullion is probably headed to $1,000oz and on that basis we would want the portfolios to remain exposed to what we believe to be a very considerable investment opportunity.

In the long-term, on average, one ounce of gold bullion purchased sixteen barrels of oil, currently that ratio is only 8.6 times. Assuming oil remains at $60 a barrel should we return to the long-term average ratio, it would mean gold bullion priced at $960oz. Since the end of the Bretton Woods agreement in 1971, the Dow/gold ratio has averaged 12.5 times. Applying the current Dow price of 11,000 therefore, implies a gold price of $880oz.

Against the background of those historic ratios our expectations for $1,000oz seems eminently reasonable.

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Investec Asset Management recently published a research document entitled The Gold Price". Summarised as follows:

Gold is no longer just a currency story. Its negative correlation with the US dollar broke down in 2005 and the price began to rise in all currencies.

Gold supply is likely to be constrained for some time. Supply of mined gold has been flat for the past few years and is forecast to remain so as no major discoveries have been made in recent years. In addition, central banks are no longer de-stocking.

Demand from emerging markets, notably China, which has recently removed restrictions on its citizens to owning gold, is rising.

Gold has been made highly investable by the introduction of Exchange Traded Funds. Gold is an attractively priced commodity at a time of ample global liquidity and its lack of correlation with other financial assets has driven up investment flows.

Gold appeals to investors concerned by the risk of inflation, instability caused by high oil prices, global economic imbalances and geopolitical uncertainty.

The bull market in gold and gold shares is young as the gold price only started rising in non-US dollar terms in the first half of 2005. Gold miners' margins have just begun to recover and the sector is due for further consolidation, which bodes well for equity prices.

They also commented on gold mining shares, saying that the relationship between gold shares and the gold prices is a direct one: higher gold prices tend to be realised almost immediately in higher earnings and net asset values, which tend to follow through to share prices. The breakdown between the US dollar and gold in 2005 has been positive for miners, when the price strengthened in the face of a strengthening US dollar and, consequently, also in non-US dollar terms. The imbalance between demand and supply means that gold is rising in all currencies, allowing gold miners to realise higher selling prices for gold in their producer currencies and raise margins.

Until September 2005, most gold shares had under performed the metal due to disappointing earnings reports, caused by lower grades and higher energy and labour costs. Subsequently, normal market patterns have resumed and gold shares have performed in line with the gold price.

They end by pointing out that consolidation is the order of the day, as it is cheaper to buy gold reserves from the market than to discover them from the ground. The top ten gold producers control only 37% of the gold market compared with aluminum and copper at 53% and 54% respectively, platinum at 98%.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

See our section on investing in gold for more articles on the price of gold. If you would like to learn more about investing in other metals, see our articles on commodities.

For more from RHAM, visit https://www.rhasset.co.uk/

And you can find out more about investing in gold by reading the report below...