Gold: Glitter or Glut?

Gold is up when oil is up because Arabs go in and out of gold the way Westerners go in and out of banks. But can they buy enough to drive gold prices back to $850 an ounce?

October 1 1990 by Harry M.Conger

The Kuwait invasion is only the most recent indication that the gold which Lord Keynes labeled a “barbarous relic” is still a vital force in economic affairs. Although no nation is on the gold standard, gold remains the de facto standard against which the value of paper currencies continues to be measured in international trade. News that the Soviet Union has been depositing gold bullion from its monetary reserves with Western central banks as collateral for foreign trade credit only confirms this truth.

Russia has also been selling new gold to increase its hard currency reserves. Since the world supply of gold is comprised of two main elements-monetary gold on reserve in central banks, and new gold being currently produced-the Russian moves raise the specter of oversupply, even though the credit swaps do provide for repurchase and most reserves will remain just that.

Gold bugs thinking glut also argue that even holders of monetary gold reserves are not indifferent to price. The Bank for International Settlement estimates that from the end of 1989 to mid-1990 the value of central bank gold holdings dropped by about $55 billion as a result of falling prices. In periods of lower prices central banks often buy gold to replace gold sold earlier at higher prices. And just to complicate matters, at the same time that the Russians are delivering bullion as collateral, they are reportedly buying gold in the forward market for future delivery.

An important supply factor to keep in mind is that, unlike other commodities, gold is not consumed. Over 90 percent of the gold ever mined is still in existence, whether in national treasuries and central banks, in jewelry or in various products.

Current production does not serve as a replacement, but simply adds to the total amount of gold in existence, estimated at about 95,000 metric tons. The economics of gold are unique and subtle.

For the past decade, gold mining has been primarily price driven. The current boom in world gold production was set in motion by very high prices beginning in 1980 when gold briefly hit a record $850 an ounce. At the same time, technological innovations made it possible to mine gold from ores where mineralization was so diffuse that they had been considered unprofitable. The resulting rise in mine production has been nothing short of spectacular. Since 1980, total world gold production-excluding Russia-has soared by 72 percent to a record 1,653 metric tons in 1989.

This steep rise in world production has some analysts musing darkly about the possibility of a prospective gold glut that will send prices into the cellar. However, most signs were pointing in the opposite direction even before the Iraqi invasion of Kuwait, which triggered economic uncertainty and rising oil prices that made investors clamor after gold, sending prices briefly soaring. Our outlook is for world gold production to stabilize and actually begin to decline by the middle of the current decade, if not sooner.

Gold mining is different from most other industries in that gold miners do not build and maintain significant inventories of their finished product. Their inventories are in the ground in the form of ore reserves. Although traders and speculators deal in contracts to buy and sell gold at some future time, in general what gold miners take out of the ground flows directly into the market. And because gold miners, however large, are virtually powerless to influence the gold prices set worldwide at daily “fixings,” 111 the only way they can increase their profit is by controlling cost of production.

When gold prices are low, miners process higher quality ore, getting the most recovery for the lowest cost. When prices are high, lower grade ore is processed. Gold mines operate at 100 percent of capacity because all

production can be sold, even though this can mean operating at a loss until the next upswing in prices. But there is a limit to this, and “pre-Kuwait,” some South African mining companies had announced significant shutdowns due to low prices. Gold will continue to glitter. The reasons are economic, political and geological. These forces will combine to raise production costs and reduce supply, especially in South Africa and Russia.

South Africa remains the largest gold producer, with 1989 production of 608 metric tons. But its share of world production fell to only 37 percent last year, down from 70 percent in 1980, and in 1990 it is expected to decline even further. From being the lowest-cost producer as recently as 1985, South Africa is now ranked as the highest. Over half of the country’s mines are currently operating at a loss, and social pressure for higher wages and better working conditions will cause costs to escalate.

While the world’s richest known gold reserves are in South Africa, the development of new mines there faces formidable obstacles. The best deposits are found at great depth, a mile or even two miles below the surface. Developing new deposits under those conditions requires large amounts of capital investment and long periods of time. It is not unrealistic to think that 10 years could pass before the first ounces are brought up to be milled. Despite massive known reserves, the outlook for new production in South Africa is highly problematical.

In the Soviet Union the prospects are equally poor, if not worse. The best estimates are that they have some 2,000 metric tons of gold in their treasury and that by mid-1990 about 250 to 300 metric tons were pledged in swap deals with British and Swiss banks. Little is known about Soviet mining methods, or costs, although the government has promised to be more forthcoming, probably under pressure from lending banks. Pending such revelations, it seems reasonable to suppose that cost per ounce must be considerably higher than in the rest of the world. Profitability may require that production be subsidized by the central government, which is exactly what the new leadership says it does not want.

The U.S. industry’s cash costs have actually decreased. With cost again the major determinant of profitability, cheaper production methods are becoming increasingly important. This has led to wider and wider use of open pit bulk mining combined with more efficient heap leach recovery techniques with gold recovery rates of up to 70-plus percent. However, with a few exceptions-notably Newmont Mining’s big Carlin mine complex in northeast Nevada-the reserves behind such mines are small. Unless new reserves are found, the smaller heap leach operations will mine out and shut down. This will likely result in a flattening out of domestic production.

Despite strict regulation, producers will suffer from growing public fears of aquifer contamination due to heap leaching, which is conducted in large outdoor pads both lined and covered to prevent cyanide leaks. Because the U.S. is the most environmentally sensitive gold-producing nation, such concerns will raise costs and limit supply.

Gold’s role as a store of value goes back to the beginnings of history. Beautiful, virtually indestructible, fungible, and relatively scarce, its value against other metals and currencies has varied according to circumstances over the centuries. But value it has always had.

Harry M. Conger is chairman and CEO of San Francisco-based Homestake Mining, whose 1989 revenues exceeded $500 million.