Alarm bells ring for gold

Johannesburg - Investment in gold will be the driver to push the price to $1 100 or more this year, further damaging an already battered jewellery sector and increasing scrap supplies into the market. Prices will come off over the next five years as that investment dries up and retreats, says GFMS CEO Paul Walker.

It's difficult to be too definitive about what will happen in the gold market, with a number of variables feeding into forecasts for the price. What benefits one side of the equation has a negative consequence for the other.

Investment in gold in a period of tremendous economic upheaval pushes the price up to record highs but the consequence is that a "bedrock" sector of the market, the jewellery making and retail business, takes a pounding as buyers look for cheaper alternatives or stay out of the market until prices come back down.

"Over the last two or three years, the only thing that sustained the gold prices we've seen has been investment demand," Walker said. "Investment demand has been strong and consistent enough to take metal off the market to sustain those prices."

Indian scrap sales have been modest on expectations of higher rupee gold prices, but there have been relatively heavy flows in the Middle East, North America and Europe, made up of distress selling or people needing to raise cash, and from trade stocks, Walker said.

"This is where we start to sound the alarm bells for the long-term sustainability of high gold prices because the supply chain for gold jewellery, which is still the bedrock of this market, is slowly but surely being eroded by these high prices," he said.

GFMS, the London-based metals consultancy, forecasts that scrap, which has increased substantially in the year-to-date, will most likely be higher for the full year compared to 2008.

According to GFMS data, scrap supply in the first quarter of 2009 has surpassed the sharply lower amount of gold used in making jewellery, the first time in nearly 30 years.

"That tells you that jewellery fabrication has contributed negative demand for the first quarter. It's a remarkable and frightening prospect. Does this continue or doesn't it? If you're forecasting where the market is going you have to make a judgment call on this particular dynamic," Walker said.

Wall of scrap

"What's happened in the first quarter of 2009 is an absolute phenomenal wall of scrap coming back onto the market. It's come from everywhere," Walker said. "It does start to sound the alarm. Is this a once off?"

"I think the second quarter will be very revealing if we see the gold price move back over $1 000 and above. It's absolutely critical as to what happens to scrap as to what the sustainability of this is."

Stripping out scrap flows into the gold market, Walker argued that there was not enough demand - be it jewellery fabrication or industrial offtake, which has taken an "absolute kicking" - for the gold currently being mined and that the excess was being mopped up by investors seeking out a safe haven for value.

"I believe investment will be a key feature in this market for the balance of this year and possibly 2010," Walker said. "But when that turns there is only one thing that brings that brings this market into equilibrium."

He said prices would have to drop - something that is likely if investment demand stops growing and becomes neutral if sentiment towards equities and bonds changes - to bring in physical demand for the metal to return to the market to equilibrium. "There lies the challenge for gold. It's not the story for the next year or two but the next four to six years."

He argued that gold prices will be "a lot lower" than they are now in the next four to five years, which raises the possibility of the Chinese government diversifying its massive reserves to incorporate gold. It is thought to have largely held off doing so because of the high gold price and for fear of disrupting the gold market.

The large flow of scrap gold is generally ending up in vaults, predominantly in London, Walker said, estimated the private holdings over the past eight years have grown to be twice that of the 1 600 tonnes held in gold-backed exchange-traded funds.

He told an anecdotal story of JP Morgan advising a client in Japan that it was restricting silver storage to one container per day. "There's a wall of silver coming back into London," he said.

GFMS forecasts mine production will rise this year by between 20 and 30 tonnes, mainly on increased output from Australia, Asia and West Africa.

Central bank gold sales are expected to remain weak this year, with the International Monetary Fund sales of 403 tonnes of gold through the Central Bank Gold Agreement, which caps official sector sales at 500 tonnes, not expected before 2010.

"The IMF sales are already priced in and they don't really concern me. I don't think it will have that much of a price effect and won't be massively influential," Walker said.

He said he expects the Central Bank Gold Agreement, which expires in September this year, to be renewed and for the cap of 500 tonnes a year to remain in place. "I'd be extremely surprised if it's not renewed."

- Miningmx.com