GOLD: Production, Supply and the Demand

March, 2009

In response to the many readers who have asked me: When will the gold bubble burst?

I guess the quick and dirty answer is - the gold bubble will burst only when gold soars straight up from $2,500 an ounce to $4,000 an ounce and everyone you know ‘is in’. Coffee bar chatter, cocktail party natterings, cab drivers, everyone bending your ear – all asking the same question, ‘when will gold break $5,000!

In other words, as of now there is no gold bubble and there will not be a gold bubble for some time to come. The underlying reason is basic supply and demand. In the housing business, when the market heats up, developers build more houses – usually to the point of overbuilding. In the process, everyone is talking about housing. We read about housing in our newspapers, and watch housing segments on our television sets. Inevitably housing turns into a bubble, and like every bubble, it bursts.

With gold, most people do not have a clue as to what it is trading at, or where to buy it or how to own it – or how important gold is to the entire economy. Most people are still unaware that at the end of the day, gold will become recognized as the underpinning of our entire financial system.

I suppose I could make a case for the other incredibly dangerous and massive bubble forming (the US dollar), but let's save that for another day, as right now the gold (and silver) story is far too compelling.

The best place to start might be the basics: production, supply and demand.

Doesn’t it make perfect sense? Now that investing in gold has become unquestionably recognized as an essential strategy against financial surprises – the world’s mining production cannot keep up!

We should have seen this coming because as early as spring 2008 there was a growing global urgency to own gold. One only had to look at the sudden scarcity of gold and silver coins. Be it at gold shows where the bullion booths were lined up until they were sold out (usually in less than two hours), or at bullion exchanges, aggressively looking to restock their shelves. So when WGC (World Gold Council) put out their year end report the evidence was there for all to see.

It may come as a surprise to some that since 2000, global gold production has steadily declined – even though the price of gold has risen dramatically. In 2000, annual gold production hit 2,573 tonnes. In 2005, tonnage dropped to 2,518, on its way to 2,469 tonnes in 2006. In 2007 the slippage continued – to less than 2,400 tonnes.

Okay, so with global gold production down to less than 2,400 tonnes and ‘identifiable’ gold demand at 3,659 tonnes, logic would dictate that the mines had better start thinking of increasing their production to meet demand. The only problem with that is that production has fallen over recent years – and will continue to fall.

Only a few short years ago, South Africa was the reigning champ when it came to global gold production. At their peak (1970) South African production came in at 1,000 tonnes. Last year South Africa produced a miserable 296 tons of gold (levels not seen since 1922).

For anyone studying gold production in South Africa, 1922 was almost a complete write-off, thanks to the bloodiest strike in that nation’s history. For the 2008 figures to even slightly compare to the 1922 numbers clearly indicates how South African gold production has gone into the tank. South Africa has slipped to third place and I doubt if they will be able to hold that position in the years to come.

As to China, the world’s current top gold producer – don’t hold out too much hope that they will be able to take up any of the slack. According to the Zijin Mining Group (currently owning the largest gold mine in China), they expect existing mines in China to run out of gold entirely by 2014.

Another top producing country, Australia - announced their annual gold production hit a 19-year low in 2008, despite a surge in the market value of the precious metal. Figures released by mining consultant Surbiton Associates show production for the 2008 calendar year was 299 tonnes – a fall of 29 tonnes, or 12% on 2007 figures.

Without getting into the multitude of country-specific reasons why global production has fallen off so dramatically, there is another huge elephant in the room that has not really been mentioned much. Supply!

Even if someone were to wave a magic wand over the gold producing countries; delivering unto mining companies instant labour harmony while at the same time brokering a love-in with environmental luddites – and in the case of South Africa, providing a sudden over-abundance of electricity, there is one glaring fact that cannot be denied – we are running out of gold. As the chart above clearly indicates - known reserves have plunged to historic lows.

I do have faith in the mining community to find more gold. But it will not happen overnight. (While we wait, expect the price of the yellow metal to soar to unheard of levels.) According to Dr. Martin Murenbeeld, chief economist of the Dundee Group of Companies:

“The gold mines are still suffering from the period of time in the late 1990’s when the Gold Price was depressed. It takes upwards of 10 years for companies to find gold and then get it out of the ground and get it into the market. We are seven years past the bottom of the gold price, so certainly the next three or four years we’re going to see mine supply be relatively weak.”

Some people theorize that things happen in three’s. This can be both positive and negative in connotation. So it should come as no surprise that with gold mining production in steady decline and gold reserves at their lowest – almost every aware investor realizes we are in the early months of the mother of all gold rushes. In other words, record Demand!

The demand for physical gold (and silver) has not only set new records, it has turned into a stampede. During the last half of 2008, the demand for bullion skyrocketed in many countries. To name only a few: Germany, USA, England, Canada, Brazil, India, China and Russia – record demand against a dwindling supply of bullion. During the summer of 2008, the US Mint abruptly stopped selling gold coins. For the first time in living memory, the Perth Mint ran out of product. A quote from my January report: Gold: The Asset of Last Resort - the only strategy

Increasing the output of gold is certainly a priority in some countries; recently the Rand Refinery Ltd, the world’s largest gold refinery increased production to its highest level in over twenty years. Why has the Johannesburg refinery doubled production to 20,000 ounces of ‘blanks’? Overwhelming demand! To date, the Rand Refinery has manufactured, marketed and (promptly) delivered more than 46,000,000 ounces of Krugerrands since the coin was first introduced in 1967. Since then, the only thing that has changed is the delivery date. What used to take a few days can now take a few weeks.

Locally, it used to be that you walked into a bullion dealer, bought a gold or silver coin, paid for it and exited with your purchase. The dealers had inventory, worked to a 4% over spot margin and had a modest flow of regular customers. Fast forward to mid-2008 and the situation changes – overflow customers paying nearly double the margin and rationed to how many coins you could buy. Moving to the end of 2008, growing line-ups and margins moving to 10% (or higher) over spot. And you can wait up to two months for delivery of your bullion. Rationing and Shortages.

Is the move to gold justified?

One look at the condition of the economy and there can be only one answer to that question. A resounding YES!

There are some who continue to cling to the notion that holding gold is strictly a defensive measure, a hedge against a major devastation like a global nuclear war or a total economic collapse. In the past, we have witnessed individual countries hit hard by war or financial disaster – 1930’s France and Germany come to mind. During those troubled times, thousands of people in those countries moved aggressively to gold. And now? With just about every country on the planet in the grips of a serious recession, the move to gold has turned into a global gold stampede.

The one country that I (along with the world’s bullion banks) have on watch is the United States. Historically, the allure for physical gold ownership by Americans has never been wide-spread. Except for a brief period during the Civil War, holding gold in the US was rare. Americans, living as free men were more interested in creating new wealth than safeguarding what they had already earned and set aside. Miners who came away with bags of nuggets and gold dust from the Klondike or the goldfields of California exchanged their gold for greenbacks without a moment’s hesitation. When the US came off the gold standard in 1933 and owning gold bars was forbidden, Americans on the whole, were not overly concerned.

Traditionally, whatever demand there was for gold came from middle-class conservatives in the western states – where persistent distrust of big government and its power to manipulate paper money remained the strongest. Of course the economic shocks of 2008 have jarred the confidence of ALL Americans to such a degree that old traditions appear to be changing.

Thanks in part to my ever-vigilant readers I am in receipt of (albeit anecdotal) evidence the American public en masse is turning their focus to gold. Reports of unruly line-ups in front of bullion shops in New York City to a flurry of TV ads in Kentucky, hard- selling ‘instant cash for old gold’, to the growing bullion business carried out on E-Bay – all indicating that Americans are waking up to gold. More importantly, they are focusing on physical gold. This will not make the bullion bankers comfortable, nor happy – as the western markets are 90% paper based. The COMEX futures market almost never see an ounce of physical gold change hands. Rest assured the bullion bankers are going to fight hard to keep it that way. This is all about tight-fisted supply and control versus unstoppable demand and a return to personal reliance. I’m betting on demand and I’m betting on the folks.

Reason: We all know that during the last few months the global economy has been brought to its knees. Yet in North America, demand for physical gold continues to soar. An interesting fact – before it abruptly suspended production of gold coins, the US Mint’s figures show that it had hammered out 2.5 as many gold coins (and over three times as many silver coins) in 2008 compared to the year before. At the same time, in bullion shops across Canada and the United States, gold and silver was flying off the shelves. In other words, even in a down market…with people hurting financially, enough people were paying record prices and exhausting the supply of physical gold and silver.

These related actions indicate that North Americans have not only embraced the concept of holding gold – they have come to realize why holding gold is so important. Gold is their only safe haven. Gold and silver may very well become part of the new currency system once fiat currency collapses. In the months to follow, the fallout from these realizations will result in gold prices reaching levels that will take your breath away.

Continuing to invest in gold

More than a few readers have suggested that I have turned into an “economic survivalist” by (constantly) beating the drum for physical gold ownership. In response, I point out that we are going through the toughest – and for many, the scariest – economic downturn in living memory. So you will excuse me if I go right back to the basics. With the American government completely out of control when it comes to printing trillions of new dollars, it is only prudent to set aside a personal ‘reserve of true wealth’ in the form of gold and silver bars or coin.

Once your ‘reserve’ is at a level that brings you comfort in the night, there are other options available:

Gold Certificates: Gold cert’s offer a method of holding gold without having to take physical delivery. They are issued by banks in countries such as Switzerland and Germany. The bank holds the gold on the investor’s behalf.

Gold Accounts: Bullion banks offer allocated or unallocated accounts. An allocated account is not unlike keeping gold in a safety deposit box. The gold is stored in a vault that is under the control of a recognized gold depository or bullion dealer. In an unallocated account, clients do have specific bars allotted to them. Not as secure as allocated accounts because the bank reserves the right to ‘lease’ out your gold, there are advantages such as the absence of insurance or storage charges.

Exchange Traded Funds (ETF’s): Currently the ‘go to’ choice for many investors. ETF’s are technically not funds because they follow a single security. Traded on the London Stock Exchange, they essentially track the gold price and can be traded daily.

Gold and Silver Stocks: Cheap to the point of ridiculous. I consider owning shares in the right gold company as the ultimate leverage when it comes to near and long term prosperity. When the market rebounds gold shares in select companies will appreciate and outpace everything else, including the ounce price for gold (and silver). Here are a few points when thinking about buying gold stocks:

· Management: A team with experience that has been there before is crucial. Mines are built, not discovered. The right team for the job at hand will make all the difference. I respect a management team smart enough to suss out an ore body – and smart enough to peel the project off to a team that can actually take it to production.

· Working Capital: Exploring for gold and silver is expensive – bringing same to production, even more expensive. Ask the company how much they have in the bank, what their burn rate is, and the cost of advancing their project to the next level.

· Property: Where is it (country), how far along (grassroots, drill-ready, advanced, production-ready), and when will work commence, how much will it cost to get the work done.

The big piece of cheese is ‘product in the ground’. With gold prices soaring, gold production and supply on the wane, a junior with assets in the ground would be worthy of time spent on due diligence and our investment capital.

I will continue to seek out junior gold companies in safe and mining friendly environments, while at the same time keeping my eye on the bullion spot price. Thus far, the companies I had listed in my November, 2008 report as prime examples of undervalued opportunities continue to meet my expectations. They were described as investment bargains, and that description has thus far proven accurate: Moto Goldmines (MGL), Nova Gold (NG), Azteca Gold (AZG), Central Sun Mining (CSM) and La Mancha Resources (LMA). Last I looked, NG has turned into a six-bagger...but that was pretty much a given.

Worth a look at this point is a Canadian company working in Manitoba: San Gold Corp. (TSX.V: SGR). Enterprising group, serious and all about the business of gold. At $1.56 a share and a wealth of experience, funding and product in the ground, San Gold appears poised to move to higher levels. A Canadian narrative in a mining-friendly province of a country that still looks kindly on producing real wealth.

I will continue to seek out junior gold companies in safe and mining friendly environments, while at the same time keeping my eye on the bullion spot price. Accumulating gold and silver during weakness is a solid strategy as there is no doubt this bull market will be of historic proportion. Again...remember when buying bullion - buy on the dips!

Accumulating gold and silver during weakness is a solid strategy as there is no doubt this bull market will be of historic proportion.

Larry Myles
604-408-7600
1-877-405-7600
http://www.larrymylesreports.com

"As fewer and fewer people have confidence in paper as a store of value, the price of gold will continue to rise."