Ever since the beginning of gold’s bull market, this metal’s economic balance has come under intense scrutiny. Demand has been on the rise as more and more investors have embraced gold as a store of wealth. And the supply chain has done its best to meet this growing demand.
However considering gold’s sharply rising price over the last decade, it is clear that this market has been experiencing a major structural imbalance. And the supply side of the equation has proven to be a fascinatingly volatile realm, making it quite difficult to set the scale.
Interestingly this supply volatility is somewhat of a new phenomenon, as the major supply sources of mine production, recycling, and central-bank sales had been relatively consistent and reliable in feeding demand for many years. But for a variety of reasons, this just isn’t the case anymore.
One big factor that has radically altered supply’s cadence is an actual loss of one of its major sources. Just in the last couple years gold supply from central-bank sales has completely dried up. In fact, the CBs have since become substantial net buyers of the metal. According to metals-research consultancy GFMS, in 2011 CBs loaded their coffers with 440 metric tons of gold (~10% of total annual supply).
It is no doubt entertaining watching the CBs implement radical changes in their fiscal strategies. And while it is wise of them to buy gold rather than foolishly sell it like they had been doing for so many years, this shift has resulted in a big impact on the global supply chain. For nearly 20 years leading to 2007 CB sales averaged between 400mt to 500mt per year, a consist and reliable supply source that was the equivalent of up to 20% of global gold supply. This source is now gone!
Gold’s second-largest source of supply, recycling, has also seen its fair share of volatility over the course of this bull. For many years recycling was consistently good for about a quarter of global supply. But thanks to higher gold prices coinciding with a brutal global recession, this supply source has seen a huge boost over the last four years.
In 2009 recycling exceeded 1500mt (nearly 40% of global supply) for the first time ever, and it has been above this level for three years running. But though this surge has partly counteracted the loss of CB supply, recycling volume has been trending down over the last couple years. Interestingly this downward trend has many folks scratching their heads considering gold’s record highs, but it does make sense considering the timing of the big 2008 and 2009 recycling surges that brought us to these levels.
Sadly much of the recycling during these surges was desperation retail selling, the hawking of gold jewellery in order to keep food on the table during hard economic times. And since it doesn’t take very long for this type of recycling to reach a point of exhaustion, as most people who needed to sell in this fashion have done so by now, these 1500mt+ levels are likely short lived. In 2011 recycling was down by 2%, and I would expect it to keep trending down towards normal levels in the years to come.
So with central-bank sales now extinct, recycling in a downtrend, and gold demand still at record levels, gold’s final source of supply has a lot of weight on its shoulders. And with mine production typically accounting for about two-thirds of total global supply, thankfully it is used to bearing such a burden. But as you can see in the chart below, even this primary supply source comes with its fair share of volatility. 
TIn the several years preceding and in the early years of gold’s bull, mine production was consistently generating annual output of at least 2500mt. But by the time 2004 rolled around, this supply source started taking a dive. And over a span of five years global mine production had fallen by a staggering 12.7%. At 2008’s low point of 2260mt, the world’s mines were producing 10.6m ounces less than they were in 2003.
For the casual observer this downtrend just didn’t make any sense, especially considering that during this time the average price of gold had more than doubled. Why wouldn’t the miners want to ramp up production in order to take advantage of these higher gold prices? Well the simple answer is, they couldn’t.
Since gold is a finite natural resource, it cannot be manufactured. And with the process of producing it involving painstaking extraction from rocks, naturally it doesn’t grow back. Gold miners can’t just turn a spigot or dial to increase the production flow whenever they want. They are bound by the physical constraints of the geology and engineering of their operations.
When economical reserves are depleted, the miners must then move on to a new deposit in order to replace production. And since there is only so much gold on the planet, the next generation of deposits are usually harder to find and tend to be more geologically complex. And to complicate matters even further, the process of replacing reserves and production is not linear and sequential.
In order to maintain production levels and secure future pipeline, the miners must be exploring and developing in parallel with existing operations. For a decent-sized mine it typically takes about 10 years to get from discovery to commercial production. So if a miner only has 5 years of mining life remaining and has yet to discover its next deposit, it is already well behind the curve.
What we are seeing in the first part of this chart is the lagging effect of an industry that fell way behind the curve in production and reserve replacement. And the culprit responsible for this production decline was the brutal secular bear that preceded our current bull.
With the price of gold spiralling downward in the late 1980s and 1990s, most gold miners struggled just to survive. During this time many miners saw their margins vanish. This of course severely depressed cash flow, and thus didn’t allow for much non-operational spending. And to make matters worse, investors didn’t want anything to do with the gold companies, which made raising capital nearly impossible.
So with the existing miners not spending nearly what they needed to on exploration and development, along with hardly any new entries into the space, the global gold-mining infrastructure greatly suffered. The big production decline to 2008 was an aftereffect of many years of neglect. Mines were depleting at a faster pace than their replacements were coming online. Needless to say, this sharp production decline was quite alarming during a time in which gold demand was skyrocketing.
Thankfully beginning in 2009 we finally started to see the effects of this bull’s exploration and development cycle. Global gold production had jumped to exceed 2400mt for the first time in three years. And it has been on the rise ever since.
It is important to realise that 2009’s growth is the product of efforts that were kicked off eight years prior. Newfound capital from rising gold prices and investor interest kicked off a major increase in exploration spending beginning in 2001. This spending led to new discoveries. And it took many years of developing these discoveries to finally generate enough production to outpace depletion.
Several years and tens of billions of dollars in capex later, the once dilapidated gold-mining industry finally started to get its colour back. And the miners have been doing their best to make up for lost time. 2009’s production increase was followed by a 2500mt+ year, the first since 2003. And in 2011 the miners achieved record-high gold production of 2700mt (87m ounces) according to the latest figures compiled by the US Geological Survey. In just three years global mine production is up an incredible 19.5%, which translates to 14.1m more ounces extracted from the earth in 2011 than in 2008.
But while this 2011 tally is quite an accomplishment, the miners can hardly afford to sit on their laurels as they look ahead to the future. Their challenge now is to not only sustain production, but ideally to continue down this path of growth. The miners still have some making up to do for their shortcomings in the beginning part of this bull, and they’ll likely need to answer the call of continually rising demand.
Interestingly even with 2011’s all-time high, bull-to-date average annual gold production comes in at only 2493mt. This happens to be the exact same average of the final four years of gold’s bear, meaning that in aggregate there’s been no production growth over a period of 15 years! This is pretty sobering considering the rising gold demand over this time.
And speaking of rising demand, the supply chain needs to be ready for what is expected to be massive investment-demand growth in the coming years. Investment demand is typically what drives the second and most important stage of a secular gold bull. Even though measurable investment demand has already increased over four-fold from 2001 to 2011 according to GFMS data, we haven’t likely seen anything yet.
Not only will central banks continue to diversify away from fiat currencies that are inflating into oblivion, more and more investors will find their way to gold. We’ve already seen demand for both in-possession physical and asset-backed ETFs greatly increase. But measured by dollars, this increase is miniscule in the grand scheme of global investment capital.
Still today the majority of institutional and retail investors don’t own gold in their portfolios. And for those that do it is usually only a very small fraction of their capital. Thankfully gold’s appeal as part of a diversified portfolio is starting to gain traction. And it won’t take much widespread interest in gold, even if it remains a small portion of a portfolio, to trigger demand many multiples higher than where it is today.
In this scenario mined supply will continue to be heavily relied upon to meet demand. Not only will the miners need to continue to pump out volume, they’ll need to continue to put significant capex into securing production and reserve renewal. Many more deposits will need to be discovered, and many more mines will need to be built.
In order for this to happen gold prices will need to remain high, and investors will need to stay interested in the mining companies. Higher gold prices will allow for higher margins for the producers, which ought to give them higher cash flow and thus more capital for exploration and development. And investor interest will supplement producers’ cash-flow shortfalls as well as fund the work of non-revenue-generating explorers that are in the trenches scouring the planet for more gold.
While the gold price will take care of itself, unfortunately things aren’t as simple as they seem on the investor front. In theory it is natural to assume that higher gold prices would lead to investor interest in gold stocks. But this hasn’t been the case lately as anybody currently invested in this sector will tell you. And this could end up being a major problem if it carries on for a prolonged period of time. Without investors, capex will naturally fade. And this would restart a nasty chain reaction that would eventually lead to a decline in production volume.
Though it is no doubt a contrarian view these days, we don’t believe the gold stocks will remain out of favour for much longer. It is just too early in gold’s bull for a sustained loss of investor interest to effect a sector failure. And if we are indeed at the tail end of the sentiment storm that has hammered these stocks, then legendary gains can be won for investors who are properly positioned in the elite companies laying the groundwork for the mining industry to continue its success.
The bottom line is growing gold demand has really tested the mettle of the global supply chain. And accordingly this chain has experienced wild volatility and radical transformations over the last 10+ years. But of all the ebbing and flowing in the major sources of supply, one constant is that mine production will continue to shoulder the majority of the burden of meeting this demand.
Though production had lagged early on as the miners fought to rebuild an infrastructure that had been woefully neglected, we are finally starting to see the fruits of 10+ years of labor via a banner 2011. And so long as higher gold prices and investors support the miners, they should be able to successfully supply what is expected to be continued demand growth.
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