Why you should hang on to your gold

published 23 May 2007

Don't say it too loudly, but gold investmentin 2007 is starting to look like a crowded trade. In the last fortnight, both The Times and The Daily Telegraph have run bullish reports on the metal. The FT notes that institutions have a "growing love affair with gold". Deutsche Bank, the world's largest securities firm, expects gold to rise as the US dollar falls further this year. But "now that everyone expects [gold] funds to continue powering ahead, expect a downturn", warns one fund manager. There's too much "hot money" in the metal, says another. Could they be right? Take a look at the year ahead and you'll find it isn't likely: there are very good reasons to buy and hold gold investments in 2007.

Gold investment: Demand from India is likely to grow

India leads the world in its love of physical gold and by March it's due to get its first exchange traded fund (ETF) in the metal. Despite charging 0.4% annual storage fees, these ETF products have proved popular in the West. But India's could put them all in the shade. Gold already has "the highest penetration of any other financial product", says KVS Manian, head of Kotak Mahindra Bank, which is behind the new ETF. Private individuals in India own more than 14,000 tonnes of plain necklaces, rings and bracelets nearly 10% of the world's above-ground gold stocks, and more than the US, German and French governments put together. But until now, "India [has been] a one-way street when it comes to investment", says David Gornall, director of Natexis Commodity Markets Ltd. Exporting scrap gold is illegal, so the only way of taking profits is to sell to a jeweller, who might charge 10%-15% in fees. Kotak Gold, on the other hand, will charge 4% in and 1% out, on a minimum outlay of around $1,200.

The festival of Akshaya Thrithiya in late April should then give a more traditional boost to India's physical gold demand. It's the third most auspicious day in the Hindu calendar. Across southern India last year 70,000kg of gold jewellery was sold in one day, while shopper numbers were up 50% on 2005. But don't call your broker to buy a fistful of gold call options just yet. "A feature of Indian demand is its extreme sensitivity to price volatility," notes Kotak Bank; these seasoned gold investors hate buying necklaces and bracelets on a spike, only to see the price fall back. This month's violent action in gold prices (falling from a high of more than $640 an ounce to a low beneath $605, before rebounding) may dent Indian demand this spring.

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What's more, says Neil Meader at London's GFMS consultancy, "the modernisation of an economy can be a double-edged sword" for gold investments. In poor rural areas with no formal banking system, gold often acts as a savings account. So as India and China modernise, people may put their money into bank accounts rather than plain gold jewellery. But gold remains "an integral part of Indian culture", notes Gornall at Natexis. And with the number of households earning above $80,000 per year set to treble in the next decade, it seems more likely that gold ownership will keep growing especially considering that, on a per-capita basis, India still lags more developed markets. Per head, Turkey's jewellery sales in 2006 were six times greater than India's in volume terms, according to data from Virtual Metals and Fortis Bank.

If jewellery demand puts a floor under gold prices in 2007, what might set the ceiling? Increased gold mining output would cap any rise and basic economics says mining output should now be rising in response to six years of higher prices. Yet gold mining supply fell 2% last year, says Helen Holten at Standard Chartered Bank. Virtual Metals in London reckons output slipped 1.5% from 2005. Gold mining firms are trying to keep abreast, but problems of cost, politics and finance are capping how fast they can dig gold ore out of the ground. The "easy gold" in safe regions has already been mined. North American output this year is forecast at just 78% of 2002 levels.

Then there's cost. Newmont Mining, the world's second-largest gold miner, was recently downgraded to "underweight" by mining-stock analysts due to rising costs. In the five years to November, its average production costs rose by two-thirds per ounce. Prudential Equity now forecasts that Newmont's combined output with Barrick Gold, the world's largest gold miner, will be 40 or 50 tonnes less than expected in 2007.

Another problem is that, as gold miners extract their ore, the value of their balance-sheet assets falls. But replacing gold-in-the-ground with new discoveries is harder than ever. Westhouse Securities reckons that, between 1985 and 2003, new gold ounce discoveries slipped by 30% from the previous 15 years. Each new ounce discovered also cost 2.6 times as much to locate. Large deposits judged at 2.5 million ounces or more aren't enough to replace the major gold miners' current rate of production, says Canada's Metals Economics Group. Between 1992 and 2005, world output totalled 1.1 billion ounces. New large reserves were barely half that size.

Gold miners also face the classic problem thrown up by a commodities boom populist governments stealing their assets. The military government in Fiji last week seized the Vatukoula mine belonging to Australia's DRDGold. In December, the Russian environmental agency revoked two mining licenses owned by Peter Hambro, the London-listed gold producer. Environmentalism is another issue. Take Gabriel Resources' project at Rosia Montana in Romania. It may hold the largest undeveloped gold reserves in Europe, but upturning five mountains to get at 450 tonnes of gold doesn't fit with today's green politics.

So how can gold majors defend their share prices? Mining bosses have gone crazy for mergers and acquisitions (M&As). Merrill Lynch said last week that global gold mining M&A hit a record $19.3bn in 2006 and more bids are likely in 2007 (see the box overleaf for potential targets). But this does nothing to increase total global supplies. Nor does M&A simply shift gold reserves from one balance sheet to another.

Will today's M&A frenzy prove short-sighted? Consider how the industry responded to gold's slump during the 1980s and 1990s. By June 2001, says the Mitsui Hedge Book, the global gold-mining industry had sold forward a massive 3,421 tonnes of production well over 135% of an entire year's output onto the futures market. That "hedging" made short-term sense during gold's 20-year bear market. It funded production and locked-in fixed prices for future output. But it also helped drive prices lower. Now that gold has trebled against the US dollar, miners are desperate to buy back their forward sales.

Falling sales by Western governments should also support the gold price. European central banks sold only 396 tonnes of gold last year, against an agreed limit of 500 tonnes. But emerging economy governments are buying gold for their currency reserves. The details are secret, but analysts guess Russia bought 8.7 tonnes of gold between August and October, while Middle Eastern banks may have bought 100 tonnes in 2006.

But trying to forecast 2007 demand and supply misses the crucial point why would anyone buy gold in the first place? The metal has few industrial applications. New compounds are replacing it in dentistry, and it will never pay a dividend. Gold costs to own, in storage and insurance fees. Add a minimum 2% surcharge from the gold dealers, or a dealing spread plus stockbroking charges should you trade gold ETFs, such as the LyxOr GBS, and gold soon looks like a losing trade unless the price rises in terms of your local currency. And that's where its potential lies today.

Gold can't be made at will, no matter how pricey it gets. This is why it's been used as a store of value for 5,000 years or more. Gold's attraction is that it is rare: an attribute of money that no longer holds true for dollars, pounds, euros or yen. Gold is a "global currency", says Anthony Fell, chairman of RBC Capital Markets in Toronto, "the only one that is freely tradeable and unencumbered by vast quantities of sovereign debt and prior obligations". Royal Bank of Canada now trades gold off its currency desks, rather than viewing it as a commodity. If you look at the flood of paper assets in global financial markets, you can see why.

India's money supply has surged more than 200 times since 1975, helping to knock the value of the rupee down from eight per US dollar to 48 per dollar. In Britain, the broad money supply is rising at 14% per year, faster than at any time since 1991 and well ahead of every other major world currency. But the supply of stockmarket securities, bonds and complex derivative products is rising faster still. "Financial innovation in the last few years has been extremely strong," says Gilles Gilcenstein, head of asset management at BNP Paribas. "We've seen that in credit derivatives and equity derivatives, trackers, certificates..." Financial innovation is now so rampant, in fact, that derivatives weigh in at $340trn altogether, more than eight times the value of all goods and services traded in the real global economy last year.

Today's bubble in novelty and complexity is sure to blow up if not in 2007, then all in good time. Holding gold acts as insurance. The "barbarous relic", as it was dubbed by John Maynard Keynes so beloved of apparently naive investors in the booming economies of India, China and the Middle East is the ultimate antidote to "financial innovation". Nobody's promise, gold is also no one's to create. And while you're waiting for the mountain of debt and derivatives to explode, you will own a secure physical asset that's likely to keep rising in value, thanks to the rules of supply and demand.

Last year, the US Mint issued its first pure gold coin in American history, and its first gold coin since 1933. The 2006 Buffalo featuring the profile of a Native American was available to buy from the US Mint's website and cost $800 per coin (the gold spot price was around $700 an ounce at the time). Collectors scrambled for the coins but one side effect was that, as the new supply of Buffalos flooded the market, the price of other vintage coins fell. So much so, in fact, that pre-1933 graded US gold coins are now selling at 20-year lows in relation to their "premium over melt value". In other words, the amount of money investors have to pay for these coins' rarity value over and above the value of their gold content is at its lowest in two decades (see the chart on the right).

So why buy these instead of plain old gold bars, or the less glamorous bullion coins? Well, even if the price of gold stays flat, says Sjuggerud, "your downside is limited, as they've fallen closer to their melt value than they've ever been". And if the gold price keeps rising, the upside could be huge. According to Sjuggerud, the Professional Coin Grading Service's rare-coin index (the PCGS 3000) rose 665% between 1987 and 1989 and 1,195% from 1976 to 1980.

Rare gold coins are, of course, valued at a premium to the gold price and there is added risk in that their value is affected not only by the price of gold, but also by the level of demand from collectors. If you would rather get purer exposure to the gold price, you can buy bullion coins. These allow investors to buy almost pure gold (between 91.6% and 99.99%) legal tender coins at a small premium to the spot price, depending partly on the type of coin you buy. Popular options include Krugerrands and British Sovereigns. Coins are generally a better option than bars bars tend to be cheaper, but they are harder to sell, and you can't divide them up and just sell part of the bar if you want to realise some gains.

Owning physical gold in the form of coins (or bars, for that matter) can be costly in terms of insuring and storing it. If you're not concerned about actually being able to hold your gold in your hand, then you might want to consider exchange traded funds (ETFs), such as the London-listed LyxOR Gold Bullion Securities. These funds can be bought like a share, and track the price of gold. Management fees are around 0.4% to 0.5% a year, and there will be share dealing costs, depending on which broker you use.

Alternatively, BullionVault.com (whose head researcher, Adrian Ash, wrote this piece) is another way to buy into gold. The company allows investors to buy and sell fine gold in any quantity from one gram upwards. The gold is vaulted by ViaMat in New York, London or Zurich and the key difference is that investors gain outright ownership of the gold they buy. Paper securities such as ETFs are backed by gold, but this is usually held in trust. BullionVault's annual charges run to 0.12%, with dealing spreads below $3 per ounce. For more details, see www.bullionvault.com.

Gabriel Resources (Toronto: GBU) offers a very high-risk play on the Rosia Montana gold mine in Romania, one of the world's largest undeveloped gold deposits. Environmental campaigners have blocked Gabriel Resources' plan so far. But the final decision due from Bucharest early this year could make the company a prime takeover target for Newmont Mining (NYSE: NEM), a major shareholder. "Buy if you dare!" says Casey. This could either double in short order, or give you "a 50% haircut".

Adrian has written all things gold related from if it’s worth buying, what the real price of gold should be and what’s the point of gold for MoneyWeek. He has also written for other leading money titles on his gold expertise including Business Insider, Forbes, City A.M, Yahoo Finance and What Investment Magazine. Now Adrian is head of the research desk at BullionVault, a physical market for gold and silver for private investors online.