By Fabrice Taylor
The Globe and Mail, Toronto
Wednesday, April 16, 2008
Ask an economist what happens to the supply of a commodity as its price rises and he’ll tell you it eventually goes up as producers try to take advantage of good times.

History shows that it isn’t necessarily so with gold, though, and that history makes a pretty good case for the metal.

In the 1970s, bullion prices rose from $35 (U.S.) an ounce to $700, yet gold production fell sharply. Why? In 1970, the gold mining industry was in terrible shape. The majority of production – 80 per cent – came from underground mines, and most of that from South Africa. Underground mining is very expensive.

Until 1968, the price of gold was fixed by central banks at $35/ounce. (It was called the Gold Pool). The cost of mining wasn’t fixed at all, of course, so the profitability of gold mines was crushed. So producers started high-grading their ore bodies, stripping out the richest ore rather than taking a little good rock and mixing it with a little lower-grade rock.

Production rose because the mills kept running at capacity, by and large, but were processing higher-grade ore, and were thus putting more ounces of gold into the market.

At the same time, producers cut back on exploration and development to conserve cash.

This explains why by the time the Gold Pool, and the broader Bretton Woods accord, were fully unwound as the decade turned over, production was peaking, and why, in the seventies, as the price soared, production fell. Mine operators — the ones that survived that is — had to start putting lower-grade ore through their mills because the good stuff was gone.

They hadn’t spent enough on exploration, so they hadn’t replaced their reserves either. They didn’t have the money to expand after so many lean years. Plus, although the price rose for much of the seventies, costs also rose rapidly because of inflation.

Sound familiar? The situation today isn’t much different. Gold prices are way up, but producers aren’t making much money. And despite a rise in bullion prices — a big and drastic rise — there’s not a lot of new capacity coming on stream.

According to the U.S. Geological Survey, world gold production peaked in 2000 at 2,600 tonnes. Gold prices pretty much bottomed, with respect to the current cycle, around that time. In six years, production fell to 2,460 tonnes. There will likely be a small decline when the 2007 numbers are published. Production in 1970 hit 1,480 tonnes before falling to 1,200 in 1975, where it stayed for several years before climbing sharply in the eighties.

But there’s a difference between today and the 1970s, says gold maven and stockbroker (and my former business partner) Murray Pollitt, who provided me with the above information.

In the eighties, when gold prices stabilized around $350-$400/ounce, production moved in earnest from underground mining, which is expensive and generally smaller scale but higher grade, to big open-pit mines, which are relatively cheaper but low grade. A lot of tired underground mines, stripped of their juiciest ore, became open pits, thanks to advances in technology and cheap fuel (open pits use a lot of diesel). That allowed ore that was previously uneconomical to see the light of day, literally and financially. But the industry’s fortunes didn’t improve much, and they really started to turn south in the following decade.

The upshot is that today, while we have rising prices (especially in U.S. dollar terms), we also have soaring costs, dropping production and a dearth of inventory in terms of untapped reserves. Imagine what oil at $112 (U.S.) a barrel will do to open-pit mines.

Look at some of the big projects that are touted as a big deal: Barrick’s Pascua Lama, which is way up in the mountains of Chile and has a huge royalty on it, not to mention the billions in investment required to get it going. Galore Creek, in British Columbia, which was mothballed when the cost of getting it producing skyrocketed. Hope Bay? Dubious also.

In a nutshell, supply today is falling, perhaps irrevocably so. Demand? Rising, in fits and starts. There’s inflation in the air, there are ETFs that make it easy for retail investors to buy gold directly and there are sovereign funds with tens of billions of dollars looking for a home and probably not looking for more U.S. Treasuries.

The demand side would be even more bullish if gold was still viewed as money. How likely is that ever to happen again?

Well, maybe more likely than you think.

For the past few decades, governments, led by the United States, have done their best to strip gold of its role as currency in favour of paper money. But history is long, and in its fullness, gold has spent far more time playing the role of money than not.

As Mr. Pollitt points out, not that long ago the United States preferred gold to fiat money. As owner of both a creaky financial system and the single biggest depository of bullion, it might be tempted to return to that preference one day.


Fabrice Taylor is a chartered financial analyst.

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