The price of gold has declined more than 20 percent so far in 2013. At below $1,300 per ounce, a fair amount of discussion has been happening around the value of gold.
Since gold does not generate any income and it is relatively expensive to store, its valuation has historically been difficult to assess. Recently, with the U.S. dollar rising and interest rates edging up, hot money began to move out of gold exchange-traded funds (ETFs) and into other channels—notably, U.S. equities. Now let’s attempt to assess the value of gold.
Gold has always had its own unique value. Because central banks can print money in large quantities to stimulate the economy, gold, which has a finite supply, will always have followers who view it as a way to preserve monetary value. This is especially true in many less-developed countries where the majority of the population does not have freedom or access to move money and invest in the U.S. stock market.
Historically, families in many parts of the world pass part of their fortunes to the next generation in some form of jewelry and gold. In most developing countries, corruption is a major issue and an especially large portion of the wealth is concentrated in the hands of a small number of people. They dare not put everything in bank accounts (today it is more difficult to keep offshore accounts secret), so much of the wealth will be used to buy gold and other precious jewelry, and thus demand outlook in the long term is solid.
Over the past decade, environmental awareness has increased, and public awareness of labor conditions at gold mines in developing countries also has been elevated. As a result, labor and environmental restoration costs for gold mining companies have skyrocketed. As the easy-to-mine gold has already been extracted, mines are digging deeper and deeper underground, thus increasing the cost of production. That is why in the last decade, while the price of gold has more than doubled, stock prices of gold mining companies have been less satisfactory. Such costs will only increase going forward.
At current prices, some gold mining companies may lose money, and if these price levels hold long term, an industry wide consolidation is inevitable. At present, the price of gold is near the production cost of the majority of gold producers, and some less-efficient projects are experiencing delays. As such, physical supply from the mining industry will decrease.
Supply from the secondary market may also be constrained. Central banks are unlikely to rush to sell their gold holdings for several reasons. First, the act of selling gold reserves would be viewed as a lack of self-confidence. It doesn’t solve major problems anyway, and if central banks have liquidity problems, the gold will simply change hands between central banks as opposed to hitting the open market.
Second, the price of gold has fallen so far from its recent highs that sellers would be limiting their returns. Third, currently with gold prices at or below production costs and demand for physical gold holding firm, even prospective sellers are waiting for better timing.
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