All that glitters is gold

Yellow metal is back in focus as the output may fall amid soaring production costs.

George Soros has sold his gold exchange-traded funds (ETFs), but if reports are to be believed, he has entered gold mining stocks. It’s probably time to look beyond the obvious and much-flogged correlation between the dollar and gold. That’s passé. Future supply is going to be an important determinant of prices. If this is so, the gold mining stocks will command a significant premium.

Analysis shows existing gold mines across the world are ageing and output is falling. A study of 375 gold projects by Standard Chartered Research team suggests a very limited production growth profile for the next five years. A 10-year bull market in gold has done little to drive production. A lack of funding from equity markets and shortage of large gold mines makes it difficult for the industry to compensate for the depletion caused by aging mines and falling grades.

As a result, there are very few large gold mines commencing operations in the next five years. Only seven gold mines and one copper/gold mines (the Oyu Tolgoi Mine in Mongolia) are capable of adding a total of 500koz gold production over 2011-15.

Standard Chartered’s analysis of IRR (internal rate of return) for major gold projects under construction (for which the acquisition cost of gold resources has already been spent) shows the gold price would need to be $1,400/oz to generate a 20 per cent IRR, usually the minimum return requirement. It’s from this point of view that analysts have been saying gold will touch $2,000/oz, since new projects would need that price realisation to produce an IRR of 20 per cent. Till then, gold production will face delays.

What strengthens the case for gold is the change in stance of central banks towards the yellow metal. Analysts bullish on the metal believe central banks may accelerate their net buying programmes. China is way behind the curve, with only 1.8 per cent of its foreign exchange reserves in gold. In case it were to bring this proportion in line with the global average of 11 per cent, it would have to buy 6,000 tonnes of gold, equivalent to more than two years of gold production. That’s enough to move prices of the precious metal.