Gold Overview – US$1,500 just the start

As expected, gold didn’t require much effort in smashing through the US$1,500/oz psychological barrier on the back of a host of economic factors in Europe and the US and other politico-economic uncertainties in Africa and the Middle East.

And don’t expect gold to stop: there’s only one direction for the price (amidst profit-taking) and that’s up.

The trigger for gold’s cracking of the US$1500/oz mark was the Standard & Poors’ downgrading of the US triple-A rating credit rating. Coupled with ongoing serious debt worries in Europe, and violence and revolution in the Middle East and North Africa, it’s a perfect storm for precious metals, particularly gold and silver.

Don’t be fooled by the sudden influxes and withdrawals of speculative money from the resource sector. Speculators have seen the opportunity to profit from one of the greatest economic expansions in history, which has provided fertile ground for sizeable swings in commodity prices.

Silver was one of the best (or worst) examples, with the price surging by almost 80% from its low in late January to its recent peak in late April, a period of just three months! Clearly this was unsustainable and something had to give. But silver’s fundamentals are still favourable and the price will recover.

With interest rates remaining low in most countries, there is virtually no reason not to own gold, as the metal currently offers the best returns around, without any significant risks. And irrespective of the potential for handsome returns, gold is also a fabulous insurance policy in the current financial climate.

The move by S&P to downgrade the credit rating of the US is somewhat ironic, because it comes at the same time as it has revised upwards the credit rating of former problem child, Rio Tinto. The Rio upgrade is appropriate and acknowledges the restored financial strength of the company’s balance sheet, which has been achieved through prudent financial management, namely cutting expenditure and eliminating debt.

This is the same sort of fiscal medicine that markets have been calling for the US to swallow, but so far politicians and bureaucrats in the world’s biggest economy have remained complacent, instead seemingly happy to try and spend their way out of trouble. It’s little wonder that S&P have applied the blowtorch to US economy.

All of this, coupled with further serious financial worries in Europe and ongoing violence and revolution in the Middle East and North Africa (which may be spreading to Ivory Coast and Burkina Faso in West Africa), paints a hugely compelling scenario for gold. Inflationary fears will keep interest rates low, which means that the most touted reason not to own gold – the fact that it doesn’t generate any interest – is virtually irrelevant.

Countries with big deficits are happy to see their currencies devalued, which means that the only constant in the world today in terms of value remains gold, the supply of which is fortunately outside the control of governments.

China remains a key player in all of this, which is why comments this week by central bank Governor, Zhou Xiaochuan, are extremely important. In his view China needs to reduce its foreign- exchange reserves as they currently exceed the level the nation requires. The management and diversification of the holdings, which topped US$3 trillion at the end of March, should be improved.
He believes one option would be to consider some new types of investment agencies which focus on new investment areas.

Considering that the US dollar and US Treasuries are the bulk of China’s reserves, what this all boils down to is a warning to the US that China will no longer be buying as many dollar-denominated assets. In fact it might even become a seller. This is a major warning indicator as to the future value and importance of the US$.

Whether industrial commodities perform to the same degree depends on whether the perceived recovery in the economies of the U.S. and Europe continue to gather steam, and Chinese tightening does not cut too significantly into that country’s growth. Irrespective, I am extremely bullish on the outlook for both ‘hard’ commodities (minerals, metals, energy) and ‘soft’ commodities (food, crops), due to growing demand pressures coinciding with supply-side restrictions.

All this has been taking place just as GFMS has released its 2011 gold price outlook. The GFMS price outlook is for gold to average US$1,450/oz in 2011, although this forecast contains significant seasonal volatility, with prices forecast to head down to the US$1,350-$1,370/oz range within the next three months, then rebounding toward US$1,600/oz by year end 2011.

Average gold mine cash costs in 2010 were US$557/oz, +17% (or +$79/oz) compared to 2009. After only 3% cash cost growth during 2009, gold mining cost inflation in 2010 returned to the 15%-25% annual levels seen between 2003 and 2008. The biggest driver of 2010 cost inflation was FX rates, as the currencies of gold-producing countries strengthened relative to the US$, contributing to a US$39/oz increase in cash costs.

A 5% decline in average head-grades to 1.51g/t was the next largest contributor to cash costs, adding US$24/oz. Declining head grades is a major concern for the industry. The industry is being insulated however, with the average total cash margin increasing from US$495/oz to US$668/oz due to a 26% increase in the gold price. I believe that declining grades will necessitate a higher gold price, not only now but in the future.

Don’t forget that the same key factors that have been driving the gold price recently – weakness in the US$ that shows no sign of easing, combined with investor nervousness related to the ongoing ‘quantitative easing’ taking place in the US – have actually been present for the past decade. Now, we have geopolitical concerns in MENA and financial worries in Western Europe added to the mix, with little prospect of resolution.

US fiscal irresponsibility has further raised the spectre of a scenario in which the international role of the dollar has come into question. The US cannot continue to run a current account deficit without jeopardizing the stability of the world economy. Little wonder that the gold price is set to continue its inexorable climb.

Gavin Wendt is the founder of MineLife, publisher of the MineLife Weekly Resource Report