Investing in Precious Metals

The best-known precious metals are gold and silver. Other precious metals include palladium, platinum and other metals in the platinum group, but are not recognized an investment vehicle as widely as gold and silver. Historically, gold and silver were important as currency, but are now regarded mainly as investment and industrial commodities. Throughout history silver has served mankind as the primary monetary metal. In U.S. gold stardard was first introduced after the Civil War, and it still wasn't the primary monetary metal. Today, gold is regarded as the primary investment metal, and silver is both - investment and industrial metal. None is used for backing of the currency.

Since 1968, when the price of gold and silver ceased to be set by the government, at least in theory it depends on the market forces of supply and demand. It should be mentioned here, that metals, just like all other economic goods can be divided into two groups:

1. Industrial metals - those for which the entire annual supply is destroyed in the process of consumption.
2. Precious metals - those for which new supply is hoarded for investment.

Gold: Out of 5.5 billion Troy oz. of gold mined throughout history, about 5.2 billion (95%) is in bars, coins and jewelry. Thus, gold is primarily an investment metal.

Silver: Out of 46.0 billion Troy oz of silver mined throughout history, about 1.0 billion (only 2%) is above the ground. The remainder of silver supply has been used up in industries like photography, chemicals, dentistry, etc. Silver should be considered primarily as an industrial metal, but because the above-ground silver stocks exceed the total annual demand (about 895 million oz in 2007), silver can still be categorized as an investment metal.

Investors, depending on their sentiment, may be buying or selling gold, thus they may be on the supply side or on the demand side of the market. If the majority of investors buy (or sell) gold, they may push the market price much higher (or lower) than it would go, if gold was purely an industrial metal. This makes the gold market a place prone to price bubbles.

Despite that nowadays silver is an industrial metal, investors still hold more silver than the annual industrial demand. That silver may enter the market anytime depending on investor's sentiment, and it may depress the price well below production cost. The silver price may be more influenced by the demand for and the production of metals of which silver is a by-product.

Gold and silver supply

There are three major sources of gold supply: mining, scrap and bank holdings. According to data published by World Gold Council in 2008, the total mine production accounted for about 58% of gold supply. Recycled gold scrap generated a further 34% and central bank sales the remaining 6%.

About 70% of the annual silver supply consists of newly mined production and most of the remainder from recycled above-ground stocks (20%) and net central banks sales (10%). Around three quarters of silver is mined as a co-product of copper, lead, zinc, gold, or poly-metallic deposits, which is why changes in those industries have a significant impact on silver production.

Gold and silver demand

The demand for precious metals is driven not only by their practical use, but also by their role as investments and a store of value.

In 2008, the demand for gold accounts for about 58% from jewelry industry (68% in 2007), 31% from investors (19% in 2007) and the remaining 11% from industrial buyers (13% in 2007). It should be remembered, that gold used for jewelry production is not destroyed and can come back into the market as scrap anytime. It should be noted, that since 2008 the industrial and jewelry demand is falling while the demand from retail investment is rising.

The status of silver is gradually changing from a precious to an industrial metal. In 2007, about 54% of silver demand was used in industrial applications, 15% in photography, 26% jewelry and silverware, and the remaining 5% used for production of medals or sold to investors in bars and coins.

Gold and silver price

London is the largest market in the world for gold and silver trading. Most gold and silver transactions, particularly those of central banks and mining companies, are conducted through the London Bullion Market. A procedure known as the Gold Fixing was designed to fix a price for settling contracts between members of the London bullion market, but it is used worldwide as a benchmark for pricing the majority of gold products and derivatives.

Gold Fixing is conducted twice a day by telephone, at 10:30 GMT and 15:00 GMT. Currently, there are only five members of the Gold Fixing. They are Market Making members of London Bullion Market Association (LBMA): the Bank of Nova Scotia-ScotiaMocatta, Barclays Bank Plc, Deutsche Bank AG, HSBC Bank USA and Societe Generale. Each representative keeps an open phone line to their firm's trading room which has orders from other bullion banks and customers from all over the world.

The fixing of the silver price is conducted once a day at 12:00 GMT by three members of LBMA: The Bank of Nova Scotia-ScotiaMocatta, Deutsche Bank AG and HSBC Bank USA.

Because the trading volume cleared by LBMA far exceeds the mining output, there is a huge possibility that gold and silver price is manipulated by trading banks. For example, in November 2008, the annual gold mine production was cleared at the LBMA every 4.4 days, and the annual silver production every 6.2 days (source: www.ifsl.org.uk). If the real annual supply and the real annual demand amounts for less than 5% of the market volume, then in can easily be concluded that the real market forces of supply and demand don't work in gold and silver markets.

It's worth to mention here about the Gold Agreement. In 1998 most of European Union central banks agreed to sell no more than 400 metric tonnes of gold annually. The first Gold Agreement expired in 2004, but was renewed for another 5-year period with an annual limit of 500 tonnes. The second Agreement expires on September 15, 2009. Up until 1973 (the end of the gold standard in U.S.), central banks were the major buyers of gold. Since 1973, central banks are one of the major sellers of gold. Because banks became suppliers of gold competing with gold mining industry, several times since the seventies the gold market price fell below the mining costs for many mining companies. The purpose of the Gold Agreement was to protect mining companies. As of 2008 central banks were still a major holders (and sellers) of gold. Out of an approximate 163 thousand metric tonnes of gold ever mined in human history, the central banks are still holding about 25 thousand metric tonnes.

In late nineties, the government of China allowed the Chinese citizens to buy and own gold, thus creating a demand for gold of about 500-600 metric tonnes a year. In just several years, the Chinese gold mining industry output increased to about 500-600 metric tonnes of gold a year (in 2007) - the gold supply in China approximately equals the demand.

There was also a huge demand for gold from other developing countries - in most cases from jewelry industry. In 2008 alone, India imported abut 2,500 metric tonnes of gold, but with the global recession in 2009 demand from India almost vanished - India imported only several tonnes of gold in the first quarter of 2009. The demand from jewelry industry in all countries all over ther world is falling since 2008, due to recession and drop in consumer spending. Only the rising demand from investors driven by fear of inflation is keeping the price of gold on the current level. Once the current global recession and inflation fears are over, the gold price may fall again. The future is unknown.

In summary, the recent run up in gold price was caused by restriction of supply (Gold Agreement) and increased demand (China, India and other developing countries). All such increase in demand for gold has been filled with supply from increased mining. However, the gold price seem to stay inflated. The silver price fell together with most commodities, but it did significantly rebound because of increased demand from investors and decreased production as a co-product of other metals.

Aluminum lesson

Aluminium used to be more valuable than gold. But after the Hall-Héroult process was discovered, the price of aluminium dropped significantly. The current price of aluminium is below $1 per pound.

The world's oceans hold a vast amount of gold, but in very low concentrations (about 1-2 parts per 10 billion). In comparison, the typical ore grades in open-pit mines are 1-5 g/1000 kg (1-5 parts per million). Thus extraction of gold from salt water is not economically viable. However, one day some lucky scientist may discover by accident a way to extract gold from seawater at a very low cost, using for example gold-accumulating microbes. The history of aluminium price can repeat.

Precious metals are only as much valuable, as they are perceived to be by investors.

When to invest in gold or silver?

The primary purpose of investing is to protect one's wealth against inflation. It is to keep money in as liquid assets as possible, for any planned or unplanned future expenditures. When the time comes to use the money, the value of such investment should not be lower than the inflation-adjusted purchase price. At least not for long. But the price of gold or silver can fall and stay down for a very long period of time. Because the price of precious metals, and gold price in particular, depends very heavily on investor sentiment, the future price is very unpredictable. Investing in precious metals should be avoided by most investors.

Gold Price history 1793-2009. Nominal and Real (inflation-adjusted) gold price (data sources: Gold price from GoldInfo.net. Inflation data from MeasuringWorth.org).

There are times however, when the prices of precious metals fall so low, that it's very unlikely that it could stay that low for long. The best time to buy precious metals is when their market price falls below the production cost. It doesn't do so too often, but it may produce an opportunity of a lifetime. The production cost is not a fixed price. It is different for each mine and for each mining company, but the range is quite narrow. If the market price falls below the average production price, the supply will shrink due to mining companies closing their operations. The price will be low until there's any excess inventory. The prices will rebound due to the supply deficit, when the excess inventory dries out. When the new production due to raised prices fills out that deficit, then it's time to sell.

Warren Buffet purchased 130 million troy ounces of silver in 1997 at $4.41, when the market price of silver fell in the range of mining costs. He sold that silver in the first quarter of 2006 ($9.15-$12.62). That's about 100% gain in 9 years - compound annual growth rate of 8-12%. Not so bad. However, the iflation-adjusted market value of that silver was about 10-20% below the purchase price for about three years (2001-2003).

The current mining costs of gold are somewhere between $300 and $350 per Troy oz. The current market price $900-$950 (August 2009) is almost three times higher. The gold price seems to be artificially kept high by some speculators or central banks. That's why investing in gold is not recommended at this time.

The mining costs of silver are between $2 and $6 per Troy oz. The current market price is above $14 (August 2009). That's why investing in silver is also very speculative.

If you're still thinking about investing in gold, then just go for a trip to Nevada Desert with a metal detector. Most likely you'll get your gold for much cheaper than buying it on the market while improving your health hiking in the desert.

Links:

1. Gold supply and demand numbers: Gold.org
2. Gold and silver price fixings: London Bullion Market Association
3. Silver statistics: USGS - U.S. Geological Survey
4. Silver and Gold:Silver ratio: The Gold/Silver ratio strategy