Despite the Greek crisis, some fundamental factors may still drive gold prices up in coming months

All that glitters is GOLD

EVY HAMBRO

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In the first six months of this year, against the backdrop of very volatile global equities markets, gold bullion has gained over 13 per cent to finish at US$1,242 per ounce at the end of last month on the back of continued investor concerns over the Greek debt crisis and the prospect of contagion.

With gold hitting all-time highs in several currencies in recent weeks including the euro, we thought it would be worthwhile to remind investors of the fundamental factors which may drive the gold price in coming months and years.

ver the past nine years, gold has managed to post successive increases in its annual average price, navigating the choppiest of waters.Demand Side

We continue to see strong investment demand for gold, with investors viewing gold, a real asset, as a hedge against medium-term inflationary pressures and potential US dollar weakness, while also providing important diversification benefits as investors continue to look to gold as a safe haven asset and an alternative currency in the face of volatile currency markets.

These issues, in our view, may take some time to resolve.

Jewellery demand, which has in the past made up the largest component of total consumption, has been weak during the credit crisis.

It was down by around 20 per cent last year but has remained strong in emerging markets and is likely to grow in the future.

Indian gold imports were 30 tonnes in March, an 84 per cent increase compared to last year.

It is believed that this may have been driven by restocking by Indian jewellers in advance of the Indian wedding season.

An estimated one million weddings were believed to have taken place in India between April and May alone.

The World Gold Council announced that they expected the demand for gold in China to double over the forthcoming decade.

They forecast this coming from both jewellery and investment demand, as the world’s fastest growing consumer of the yellow metal has more than doubled its share of global demand in the past seven years — from 5 per cent to 11 per cent.

Supply Side

Since mine supply peaked in 2001, the gold mining industry has been struggling to grow production.

Despite an increase of 6 per cent (by 144 tonnes) last year, which was mainly driven by the Grasberg Mine in the province of Papua in Indonesia, there is little material sign of growth during the coming few years.

In fact, there are few operations next year and in 2012 of notable size and others are exhausted so the growth in supply we saw last year may be offset by declines elsewhere.

We estimate that the allin cost for a new ounce of production is between US$850 to US$900 per ounce once exploration, capital expenditure and operating costs are taken into account.

In addition, those areas where gold mineralisation is being discovered tend to be in regions of higher political risk.

At the current price there is not sufficient incentive for gold mining companies to bring on significant amounts of new supply.

Cen tral Banks

We have seen developing countries (most notably, China and India) increasing their gold reserves as they seek to diversify their Foreign Exchange Reserves, in particular to reduce their exposure to the US dollar.

It is also notable that recently there has been a distinct lack of gold supply into the market from European Central Bank and the only known vendor has been the International Monetary Fund (IMF).

Over the past few years, around 400 tonnes of gold has typically been sold into the market by both Central Banks and the IMF.

In this year so far, the IMF sold limited volumes, indicating that central banks are increasingly reluctant to sell down their gold holdings.

The conclusion that can be drawn from this is that gold is now seriously considered by Central Banks as a monetary asset and a useful source of diversification in a way that has not been seen for at least the last two decades.

Whilst the immediate impact of this strategic shift on the gold price may be limited to possible supply curtailments, the long-term implications are extremely supportive as looking back over the last fifty years.

Central Banks have tended to be a good indicator of broader investor appetite for gold.A key recent development is the strategic shift in the attitude of the world’s Central Banks towards gold.

Still a safe haven asset

Whilst uncertainty remains in financial markets and concerns shift from corporate debt to sovereign debt, investors may continue to look to gold as a safe haven asset and an alternative currency as gold reaches all time highs in euro and sterling terms.

Also, investors are increasingly looking to gold as a hedge against inflation and potential US dollar weakness.

In terms of supply, long term fundamentals remain tight with little sign of any material increases in mine production, and central bank supply is also at reduced levels which for many years was a notable source of supply. Market fundamentals suggest that gold prices are well supported.

The writer is managing director and joint chief investment officer of the natural resources team at BlackRock.