• The recent correction of the gold price to below $1,200/oz. has been driven by a sharp rise in US real interest rates on back of fears the Fed will reduce its bond buying program sooner than anticipated.
  • We believe the reaction of bond markets to Fed comments has been overdone, and ultimately real rates will fall from current levels, driving a rally in the gold price.
  • On our estimates, gold, silver and platinum (with implications for palladium) are now trading around 20%, 10% and 25% below their respective average marginal costs of production.  Prices will have to move above these levels to support long-term supply growth.
  • Short gold futures positioning on COMEX is at an all-time high and silver shorts are now at over 10-year highs, indicating scope for powerful short covering rallies once fundamentals improve.
  • Physical gold buyers, notably in China, have increased purchases as the price has dropped.
  • While precious metals prices will be driven primarily by macro and technical factors in the near-term, we believe that at current levels they provide attractive value for long-term investors.

All good bull markets need a correction.  After a twelve year run, the gold price was well overdue a major correction and this is now taking place, albeit at a much higher velocity than its increase – as is usually the case.  The silver price has been dragged down with gold, and platinum and palladium prices have been affected by China growth concerns as domestic liquidity has been squeezed. We believe the price corrections have been excessive and have returned precious metals prices to attractive long-term accumulation levels.

Price correction is overdone

The main trigger for the recent sharp fall in the gold price was more hawkish than expected commentary from Fed Chairman Ben Bernanke at his post-FOMC press conference on June 19th.  Fears of a more rapid than expected scaling back of quantitative easing led to a knee-jerk sell-off of gold and other perceived beneficiaries of the easy money policies that the Fed has been pursuing since the 2008 financial crisis.  A number of key technical barriers have been breached, which has led to further selling. Silver, which has been trading like a high beta version of gold, has fallen even more sharply

In the near-term it is difficult to see any immediate catalysts for a sustained rebound in the gold price. Gold will likely face headwinds as long as US interest rates continue to rise, inflation expectations continue to fall and the US dollar continues to strengthen.  However, we believe these are cyclical factors that are temporary. We believe the reaction of bond markets to Fed comments has been overdone, and ultimately real interest rates will fall back from current levels. Interest rates need to remain structurally low to keep government debt interest costs in check, support the recovery of the real estate market and consumer balance sheets, and offset fiscal drag. The Concluding Statement of the IMF Article IV Mission to the US released on 14 June supports this view.

The correlation of silver and gold price movements has been strong over the long term and this correlation has risen sharply over the past nine months.  We don’t see any immediate reason for this relationship to change and expect that silver’s directional outlook will remain tightly tied to that of gold. Platinum and palladium, however, are far more sensitive to industrial demand – particularly China demand. Therefore the recent sharp spike in short-term interest rates in China has been the main factor behind their price declines.  We expect China liquidity conditions will ease and growth fears will dissipate over the course of the year, removing this hindrance to platinum and palladium price performance.

Prices now below marginal production costs

On our estimates, all of the precious metals are now trading below their all-in marginal costs of production (cash costs plus capital and exploration costs) – and in some cases quite significantly below them.  The costs of finding and extracting precious metals have surged in recent years.  Gold cash costs have increased nearly five-fold over the past ten years and platinum costs have soared even more.  The average marginal cost of production of gold for the largest gold miners is somewhere around $1,500/oz. on our calculations, with a number of mines with all-in costs well above $2,000/oz.  In recent comments by Gold Fields CEO Nick Holland, he highlights that in his view the industry needs a gold price of at least $1,500/oz. to sustain the industry in “any reasonable form”.  The average all-in marginal cost of platinum production in South Africa on our estimates is around $1,800/oz. This is directly relevant for palladium as it is a by-product of platinum production. The average marginal cost of silver is estimated to be around $20/oz.

Therefore, on our estimates, gold, silver and platinum (relevant for palladium too) are now trading around 20%, 10% and 25% below their respective average marginal costs of production.  While prices can remain below marginal production costs for a while, ultimately, as mines are closed and supply begins to dry up, prices are forced back up again.  This is already occurring, with Anglo American Platinum shutting a number of South African platinum shafts earlier this year, and gold miners now slashing costs across-the-board.  If prices do not rebound quickly, closures are likely to accelerate, reducing anticipated supply, leading to a self-fulfilling increase in prices.

Next page: Where to from here?

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