Does Gold Have a Silver Lining?


The gold market has without a doubt cooled down in the past year. The sharp fall in the price of gold has been reflected in the prices of gold exchange-traded funds such as SPDR Gold Trust and iShares Comex Gold Trust . Will the gold market recover from its recent tumble? Is there a silver lining for gold investors? Let's examine recent developments in the gold market in order to determine where it is heading next.

Demand for physical gold
The two major countries that lead the demand for gold (demand for the physical metal) are China and India. Both countries account for nearly 46% of the global demand of gold. Nonetheless, during the third quarter, India's demand for gold plummeted by 32% due to the government's decision to raise import taxes in an attempt to reduce the demand for gold. Moreover, the weak rupee against the U.S. dollar has also curbed the demand for gold in India.

Conversely, China's demand for gold continues to grow, mainly for jewelry. In the third quarter, demand grew by 19%, year over year. This trend is likely to keep gold prices from tumbling further.

Demand for gold as an investment
Despite the potential positive effect thephysicaldemand may have had on gold prices, the main issue remains the demand for gold for investment purposes. This factor is still the main driving force behind the progress of gold prices.

According to SPDR Gold's fourth-quarter earnings report, demand for gold for investment purposes peaked in 2011. In 2012, the global demand for gold for investment purposes fell to 2010 levels. The current estimates are that the demand in this segment won't be much different in 2013 than in 2012.

Gold ETFs have also experienced a drop in demand. In the past year, gold ETFs such as SPDR Gold andiShares Comex Gold Trust have experienced a sharp drop not only in their prices but also in the amount of gold they hold. During 2013 these ETFs' lost nearly 28% of their value. Moreover, SPDR Gold's holdings have plummeted by nearly 40% during the year. iShares Comex Gold Trust lost nearly 25% of its gold holdings. These findings serve as additional indications for softer demand for gold as an investment. Based on the above, is the demand for gold for investment purposes continuing to weaken?

The recent decision by the FOMC to start tapering its asset-purchase program might have reduced the price of gold. But this mini-taper isn't likely to have a strong effect on the prices of precious metals. The chart below shows the developments in the price of gold and the U.S. money base in the past several years.

Source: Federal Reserve and Bloomberg

As you can see, the price of gold rose sharply during the era of QE1 and QE2. But QE3 seems to have had little effect on the price of gold. This finding suggests the price of gold wasn't strongly affected by QE3 so that a slower asset-purchase program won't have such a strong adverse effect on gold. Let's turn to the supply side and see how the recent developments in this segment could affect gold prices.

Will production decline?
From the supply side, the main concern is the potential slowdown in the amount of gold produced. If gold production falls, this could tighten the precious metals market. One reason for a lower volume of gold production is the decline of precious metals companies' profit margins due to higher production costs and lower gold prices.

Leading companies such as Barrick Gold and Newmont Mining have had a sharp drop in their profitability: In the third quarter,Barrick's profitability fell from 34% in 2012 to 29.6% in 2013. Barrick is also looking into ways to lower its production and delay future projects: A few months ago, the company announced it will suspend construction activities at the Pascua-Lama mine except those required for environmental protection and regulatory compliance, which will prolong the completion date by one year to the end of 2016. Such a decision was made partly due to higher operation costs, economic conditions, and a much lower gold price.

Moreover, Barrick's capital expenditures are expected to drop by up to $1 billion in 2014. These steps are likely to reduce the company's costs but could also cut down its future production.

Newmont Mining's profitability also fell during the third quarter from 29% in 2012 to 16% in 2013. The company's gold production remained nearly unchanged in the past year: In 2012 gold production reached nearly 5 million ounces; in 2013, the current estimate is for 4.9 million ounces. Nonetheless, during the third quarter, the company's capital expenditures have declined. If this trend persists, this could also suggest little to no growth in gold production in the coming years.

If gold producers keep cutting their production, it could tighten the gold market.

Bottom line
The gold market isn't likely to recover from its recent tumble anytime soon. Nonetheless, gold investors can still hold on to the strong demand for the physical metal in Asia -- mainly China. This could keep gold prices from plummeting further. Moreover, the recent FOMC decision to taper QE3 isn't likely to have a long-term adverse effect on the price of gold. Finally, gold miners might start to cut their gold production, which could eventually reduce the supply of gold.

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