Determinants of precious metal price development

Influence of depleting underground resources

Between 2001 and 2008, gold production declined in every year and in 2011 was only slightly above the 2001 level. The question therefore arises as to whether the global gold production peak has already been reached, the so-called " peak gold ".

Forecasting a global gold production maximum requires estimating the remaining underground gold and production over time. What is not clear is how reliable the resource data are. Gold production is also influenced by geological, technological, economic, and political factors that are difficult to predict. Fluctuations in annual gold production should therefore not be overestimated. However, the development of gold production in some important producing countries supports the peak gold thesis. This applies in particular to South Africa, once the most important producing country, where the depletion of the legendary Witwatersrand gold veins is imminent. The average gold content per ton of rock is now only 4 grams (in 1966 it was around 16 grams), since the deposits currently being mined are less productive than those already exploited.[2] The development of gold production in South Africa - representative of other important gold-producing countries such as the USA or Australia - corresponds almost textbook-like to the bell-shaped course of the production rate of finite raw materials assumed by Hubbert. In the chart, such a development was simulated for the worldwide gold mine production. Until the gold deposits are exhausted, the total gold production can still rise to about a quarter of a million tons (gold mined so far as well as the still extractable resources in the earth's crust; see black curve). Annual production volumes, on the other hand, will decline continuously according to this projection.

Simulation of future gold mine production

Source:  Own presentation based on data from U.S. Geological Survey (2010), Gold Statistics (internet retrieved 01.10.2012); from 2010: own projection.

The peak gold thesis is also supported by the fact that the peak of discoveries of new gold deposits dates back to the 1980s. in 2008, new gold discoveries were 13% of gold production, a decade earlier they had exceeded gold production; at the same time, the average grade of mineralization was cut in three from 2.2 to 0.8 grams of gold per ton of rock (in 1950 it was 8 grams and in 1920 22 grams).[3] This is due to the depletion of higher-grade deposits and the mining of lower-grade deposits made possible by higher prices and new technologies. New discoveries tend to be less productive, have lower grades of mineralization, and are located in politically unstable regions with inadequate infrastructure, leading to increased investment, exploration, and cash costs[4].

 Gold price, production, exploration, new discoveries, mineralization and cash costs (2001=100)

Source: Illustration based on data from Stöferle, R.-P. (2010), In Gold we trust (Internet retrieved 01.10.2012): P. 50f.; Markt-Daten.de (Internet retrieval of 01.10.2012); U.S. Geological Survey (2010), Gold Statistics (Internet retrieval of 01.10.2012).

However, variable mining costs per ounce(cash costs) increased not only because mineralization grades steadily decreased due to increasing depletion of deposits, but also because of the commissioning of mines that were previously not profitable due to lower precious metal prices. From 2003 to 2010, cash costs increased from US$180 to just under US$560 per troy ounce of gold, and other costs - capital costs, exploration, administration and royalty costs - were about the same.[5]

Thus, the all-in cost is now more than US$1,100, up from US$300 in 2003. In the medium to long term, the price of gold must always be above these all-in costs, otherwise mining will be uneconomic.

The stagnation of gold production is remarkable in that over the past decade the price of gold has increased about six-fold and at the same time global exploration spending has increased six-fold (from US$0.55 billion to US$3.25 billion).

In the case of silver, a development comparable with peak gold to peak silver is not yet immediately recognizable, but to deduce from this that the situation here would be less tense would be a fatal fallacy. Silver is (still) in a somewhat different situation for the following reasons:

(1)       about two-thirds of the silver mined annually is a byproduct of the mining of other metals such as lead, zinc, copper or gold, whose production is independent of the silver price,

(2)       due to the low silver prices in the 1990s, relatively little exploration was carried out and many of the pure silver mines were closed, which is why the output of the primary silver mines is increasing for the time being,

(3)       due to the predominance of near-surface silver deposits compared to gold, low-cost minable deposits have not yet been depleted to the same extent,

(4)       new discoveries are less likely with silver, since most deposits have already been discovered due to the proximity to the surface; in addition, enriched deposits are rarer with silver than with gold in relation to the precious metal content of the earth's crust.

Why the current price ratio between gold and silver is far too high and what criteria can be used to determine a price ratio that can be considered fair is the subject of the gold-silver ratio page.

Supply Deficits or Supply Surpluses

The next chart combines supply and demand developments on the silver market, the resulting supply deficits or surpluses and the corresponding development of the silver price. Supply and demand (upper part of the chart) do not include disinvestment/investment, government sales/government purchases and hedging/de-hedging. Accordingly, the supply side includes only mine production, which increases the above-ground quantity of physical silver - at the expense of underground resources - and recycling, which is fed by silver recovery from industry and photography, as well as the mining of old silver stocks (melting down of jewelry, silverware, bars, coins or medals). On the demand side, only what requires fabrication, i.e. is consumed by industry or photography or is processed into a store of value or a non-material object of value, is taken into account.

A supply deficit (middle part of the chart) is a market situation in which the fabrication demand for silver cannot be met by mine production and recycling alone. It must be offset by a reduction in stocks (disinvestments, government sales) that were invested in times of supply surpluses, or by hedging, i.e., the forward sale of silver that has not yet been mined at all. Conversely, a supply sur plus - as in 2009 to 2011 - is absorbed through investments, government purchases or de-hedging. From the end of the 1980s until 2007, the silver market was characterized by supply deficits of up to 5 thousand tons per year. Overall, the cumulative supply deficit during this period was 46 thousand tons of silver (1.5 billion ounces), or just under two mines' production in 2011. Supply and demand initially increased in parallel, so supply deficits remained at relatively high levels until the silver price increased, demand leveled off somewhat, and supply expanded.

Individual supply and demand segments develop differently, but the silver market must be in equilibrium at all times, which is brought about by the price mechanism and the futures markets. Aggregate supply and aggregate demand follow the cycles described earlier, with a correlation between the development of supply deficits/surpluses and the silver price. To determine the direction and magnitude of this relationship, a Correlation analysis analysis is carried out.

Supply deficit or surplus

Source:  Own calculations and presentation based on data from the World Silver Survey (internet retrieved 01.10.2012).

Silver price in the context of the correlation analysis

The correlation coefficient for the relationship between supply deficits/surpluses and silver price is 0.83. Accordingly, when supply deficits decrease or supply surpluses increase, silver price tends to increase (and vice versa).

The next chart adds the investment sector to the previous observation. In the 1990s, disinvestment took place on balance, offsetting part of the supply deficits. At some point, however, the possibilities for this were exhausted. Shortly after the turn of the millennium, precious metal prices therefore began to rise. Investments exceeded disinvestments on balance, so that the net position was no longer a supply component, but now a demand component.[6] The share of investment demand in physical silver demand rose from -9% in 2000 (net disinvestments) to +16% in 2011 (net investments).[7] The correlation coefficient for the relationship between investment demand and the silver price shows a value of 0.72. The two variables are thus also closely related. Accordingly, these two variables are also closely positively correlated.

Investment demand and silver price

Source:  Own calculations and presentation based on data from the World Silver Survey (internet retrieved 01.10.2012).

Supply and demand elasticities for gold and silver

The price elasticities of supply and demand influence the cycles of price and quantity developments on the precious metals markets already mentioned in the theoretical part of this chapter. Mine production of gold has hardly increased since 2001, despite the annual double-digit percentage increase in the price of gold. The price elasticity of supply is thus low. However, the price elasticity is at least arguably positive, since if the gold price had remained unchanged, gold production would presumably have declined significantly due to the depletion of deposits that can be mined at low cost.

Mine production of silver is also price inelastic, as most of it is not produced by primary silver mines but as a byproduct of mines whose main product is other metals, some of which are cyclically sensitive: 28% of global silver production in 2008 was from primary silver mines, 37% was a byproduct of lead and zinc production, 23% from copper, 11% from gold.[8] Prices of industrial metals tend to rise when their production cannot be increased accordingly in the short term as demand picks up. Only if metal prices remain high will silver production, which is a byproduct, increase in the medium term, but the influencing factors behind this will at the same time lead to an increase in demand for silver, as it is a sought-after industrial raw material. In addition, higher economic growth and rising commodity prices increase the risk of inflation, which has a positive effect on investment demand, as silver is regarded as an inflation-proof store of value and investment. In the event of economic downturns, mines that produce silver as a by-product will in turn cut back their production irrespective of the silver price.[9] The frequently assumed cyclical dependence of the silver price is therefore less than assumed. The correlation between mine production and silver price is nevertheless quite close: the correlation coefficient is 0.76 for the period from 1900 to 2010, 0.4 for 1970 to 2010 and 0.81 for 1990 to 2010.

The price elasticity of recycling is also usually overestimated. It is not rational to have jewelry or coins melted down. If they are to be gold-plated or silver-plated, they can be sold at a premium to the material value. In this respect, only the owner would change here, which would not be relevant from a recycling point of view. In the case of industrial applications, the economic incentive to use recovery processes increases as precious metal prices rise, but due to the often very low unit consumption, they are usually uneconomical as things stand, even at higher precious metal prices.

Government and central bank sales, as the third area of supply, are now of little significance. Precious metal prices play no role in the level of official gold and silver inventories, such as those on the COMEX commodity futures exchange, as they serve as a reserve to compensate for short-term imbalances in the market for physical precious metals. Central banks, which in the past tried to depress the price of gold by selling gold (or announcing their intention to do so), are now net buyers of gold. Like the investment sector, they thus appear on the demand side.

Industrial demand for precious metals is relatively price inelastic, since silver in particular is indispensable in many applications and can hardly be replaced, which sometimes causes large price jumps in tight market situations.[10] Precious metals are only used in trace amounts in many mass applications, so they do not represent a significant cost factor. A car, for example, contains around one ounce of silver, a cell phone 250 mg.[11] Even sharp increases in silver prices therefore have relatively little impact: if the price of silver increases from US$20 to US$50, for example, the additional costs per car are only US$30, those per cell phone US$0.25.

Physical jewelry demand is developing differently: while there has been a sharp decline in gold, it is comparatively stable for silver. Budget constraints apparently require switching from the more expensive gold to silver. The declines in silverware are not a result of high silver prices, but of changing consumer preferences and new materials to substitute for silverware, nor is the collapse in silver demand from photography due to the technological displacement of analog by digital photography.

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Influence of inflation, interest rates, money supply and US dollar

Inflation already occurred when gold and silver coins were the only means of payment. Major precious metal discoveries could cause inflation (but this was rare before industrialization due to the underdeveloped exploration and mining methods), but inflation-triggering manipulations also occurred as coins were ground off at their edges (this was only curtailed by so-called knurling, which fluted the edges of coins). More significant was the government-imposed lowering of the precious metal content of coins.[12] But all this was nothing compared to the creation of money in the age of unbacked paper money. Freed from the shackles of a precious metal standard, the money supply has been growing considerably faster than nominal economic growth for four decades. Since the 1970s, the U.S. has been financing its economic growth by issuing government bonds from abroad, which translates into gigantic budget and current account deficits, and inflating its foreign debt through dollar devaluations.

Inflation rates were extremely high in the 1970s. In the following three decades, this was no longer the case to the same extent. On the one hand, this was related to the price-dampening effects of globalization, increasing competition and pressure from financial markets, which caused interest rates to fall and, at the same time, increased money creation and indebtedness.[13] On the other hand, this was due to manipulations of the inflation rate, which meant that actual inflation was not fully reflected in official inflation rates. There was also so-called asset inflation, as part of the excess money supply sought attractive investment opportunities, which found expression in rising asset prices (stocks, real estate, etc.). This leads to the formation of speculative bubbles that erupt, as in 2000 with the bursting of the New Economy bubble or in 2008 with the real estate bubble and the resulting financial market crisis of 2008/2009.[14] The measures taken to deal with the financial market crisis have been very effective

However, the measures taken to deal with the financial market crisis did not serve to solve the problem; on the contrary, there was an additional increase in the money supply and a massive inflation of debt through (1) government purchases of bad loans or structured securities that had become largely worthless, (2) the launch of large-scale bank rescue and economic stimulus programs and (3) further interest rate cuts. Ultimately, this also set the stage for the 2011/2012 sovereign debt crisis. A similar procedure is repeated again and again: people try to cast out the devil with the Beelzebub by trying to solve crises with the means that triggered them in the first place. The distortions in the financial sector and future crises are becoming more and more pronounced as a result of this vicious circle. In the process, monetary expansion, debt orgies and currency turbulence have resulted in an increasing loss of confidence in the financial and monetary system, which is growing with each passing day.

The three following suggest that there seem to be correlations between the inflation rate or interest rate, money supply and currency developments and the silver price.

Inflation and silver price since 1970

Source:  Own calculations and presentation based on data from Markt-Daten.de (internet retrieval from 01.10.2012).

Interest rates, money supply and silver price since 1970

Source: Own calculations and presentation according to data from Markt-Daten.de and Shadow Government Statistics (Internet retrieval of 01.10.2012).

US-$ and silver price since 1980

Source: Own calculations and presentation based on data from Markt-Daten.de (Internet retrieval dated 01.10.2012).

Based on the past four decades (1970 to 2010), the correlation coefficient for the relationship between inflation and silver price development is 0.41, based on the period 1990 to 2010 even 0.85 (for inflation and gold: 0.72 and 0.77, respectively), for interest rate and silver price development 0.05 and -0.52 (interest rates and gold: -0.31 and -0.58, respectively), for money supply and silver price development at 0.52 and 0.88 (for money supply and gold: 0.79 and 0.82, respectively), and for the development of the U.S. dollar/euro ratio and silver price development for 1980 to 2010 at 0.44 and for 1990 to 2010 at 0.53 (dollar and gold: 0.52 and 0.59, respectively). The overall conclusion is that rising gold and silver prices are good indicators of an increasing loss of confidence in the paper money system. There is therefore a growing need to grant gold and silver a stronger monetary function again. This is favored above all by the fact that precious metals do not - like paper money - emerge from the indebtedness of another, but rather a service has already been rendered by mining them.[15]

Since high rates of inflation lead to a reduction in real monetary assets, investments in precious metals of intrinsic value are intended to protect precisely against such asset losses. Precious metal prices then generally rise faster than the rate of inflation, so that they more than compensate for the inflationary effect and generate a real return despite inflation. Rising precious metal prices as a result of inflation do not even necessarily require an increase in physical investment demand; in many cases, increasing inflation expectations are already sufficient to cause precious metal prices to rise. Due to this circumstance, precious metal price increases can thus be seen as a good seismograph for emerging inflation threats, which underpins the correlation analysis especially for gold, but also for silver. In this respect, precious metals are a more reliable indicator than official, government-manipulated inflation indicators, as they react sensitively to market developments that are causal for the evocation of inflationary dangers and anticipate corresponding information. In this respect, it is not surprising that governments fear rising precious metal prices, as they reveal the failure of their central banks to rein in inflation and declining confidence in the stability of the unbacked paper money system.

When inflationary threats rise, central banks should actually raise interest rates to tighten the money supply, reduce inflationary pressures and increase the external value of the currency. Since the turn of the millennium, however, they have been doing the opposite. After the financial market crisis subsided in 2008/2009, economic growth picked up, but interest rates remained as low as the external value of the dollar. Official inflation rates also continued to be moderate, and real interest rates were even negative at times.[16] Gold and silver benefit from low real interest rates to the extent that this results in lower opportunity costs for precious metal investments.[17] Accordingly, the correlation between interest rates and precious metal prices is negative. The correlation analysis had confirmed this for gold, for silver for the period from 1990 to 2010, but not for 1970 to 2010. This was related to the low variance of interest rates as well as the sometimes in the same direction, sometimes in the opposite direction. However, interest rate effects are also reflected in their impact on inflation, money supply and currency developments, which in turn are closely correlated with the price of gold and silver.

The excursus "Blessing and Curse of the Compound Interest Effect" illustrates, against the background of the complex of topics discussed earlier, where an economic system based primarily on interest rates and growth must inevitably lead sooner or later.[18]

Influence of stock market and economic developments

According to a widespread view, the development of precious metal prices is negatively correlated with the stock market development. According to this view, precious metal prices are said to rise especially when the stock markets are in a weak phase and to fall when the stocks are rising. However, the long-term statistical correlation between the development of silver prices and the S&P 500 Index is lower than assumed and, moreover, positive (Chart 8.11; the correlation coefficient for the period from 1970 to 2010 is 0.27, for gold 0.49). Silver returns and the return of the S&P 500 index - an indicator of economic growth expected a few months later - also develop independently of each other (correlation coefficient for the period from 1951 to 2002: 0.02), as do silver returns and actual U.S. economic growth (correlation coefficient for the period from 1955 to 2003: 0.01[19]). The reason for this is that while economic growth increases industrial demand for silver, it also increases silver supply, as production of industrial metals is ramped up, the extraction of which produces silver as a byproduct.

S&P 500 Index and silver price since 1970

Source: Own calculations and presentation based on data from Markt-Daten.de (internet retrieval from 01.10.2012).

Precious metals, since they do not correlate with the economy or stock market performance, are thus well suited for diversifying investments.[20] On the 20% weakest days of the S&P 500, they proved to be a safe haven, up +2% against the broad-based stock indices (whose performance on these days was -6 to -8%), but also against oil (-6%), industrial metals (-2.5%), agricultural products (-1%), and commodities as a whole (-0.25%).[21] The S&P 500's performance on these days was +2%

Influence of the prices of other metals and commodities on gold and silver

Commodity and precious metal prices go through a similar cycle and therefore sometimes move almost in unison. The next chart illustrates the close correlation between oil and silver prices: the correlation coefficient is 0.81 for the period from 1970 to 2010, and 0.91 for 1990 to 2010 (oil and gold: 0.87 and 0.86, respectively). Similar results can be shown for other commodities: The relationship between the performance of the broader commodity index CRB and the price of silver is even somewhat closer, with correlation coefficients of 0.83 and 0.97, respectively (CRB and gold: 0.93 and 0.94, respectively). This close correlation is related to the fact that rising commodity prices signal high demand as measured by mining companies' production capacities. Increasing economic growth also implies inflationary risks, with rising commodity prices in turn having a trend-reinforcing effect. In this respect, there is a positive effect of economic development on the silver price, even if this cannot be shown by looking at the relationship between economic growth and the silver price in isolation.

Finally, the correlation between the gold and silver prices is also very close: The correlation coefficient for the period from 1900 to 2010 is 0.94 for the nominal annual average prices and 0.85 for the period from 1970 to 2010, and 0.82 and 0.97 for the real prices. The price correlation between the two precious metals will be discussed in more detail in the section on gold-silver ratios.

Crude oil and silver prices since 1970

Source: Own calculations and presentation based on data from Markt-Daten.de (internet retrieval from 01.10.2012).

CRB commodity index and silver price since 1970

Source: Own calculations and presentation according to information from Markt-Daten.de (Internet retrieval of 01.10.2012).

Nominal gold and silver price since 1970

Source: Own calculations and presentation according to information from Markt-Daten.de (Internet retrieval of 01.10.2012).

Retrieval: Current gold price and silver price

Real gold and silver price since 1970

Source: Own calculations and presentation according to information from Markt-Daten.de (Internet retrieval of 01.10.2012).

Overview of the results of the correlation analysis

In the concluding table, the results of the correlation analyses are once again presented in overview.

Table 8.2:   Correlation between the gold or silver price and price-influencing variables

Correlation between gold or silver price and ..	Period	Gold price	Silver price
	from ... to ..	Correlation coefficient
Silver price	1900-2010	0,94	1,00
	1970-2010	0,85	1,00
	1990-2010	0,97	1,00
Oil price	1970-2010	0,87	0,81
	1990-2010	0,86	0,91
Commodity index CRB	1970-2010	0,93	0,83
	1990-2010	0,94	0,97
US interest rates (Fed Funds)	1970-2010	-0,31	0,05
	1990-2010	-0,58	-0,52
Inflation trend	1970-2010	0,72	0,41
	1990-2010	0,77	0,85
US money supply M3	1970-2010	0,79	0,52
	1990-2010	0,82	0,88
US-$-€ ratio	1980-2010	0,52	0,44
	1990-2010	0,59	0,53
S&P 500 Index	1970-2010	0,49	0,27
	1990-2010	0,27	0,45
Mine production of silver	1900-2010	-	0,76
	1970-2010	-	0,40
	1990-2010	-	0,81
Investment demand for silver	1985-2011	-	0,72
Supply Deficits/Surpluses (Silver)	1990-2011	-	0,83

 

For the period from 1970 to 2010, the identified correlations are predominantly weaker than is the case for the period from 1990 to 2010. This is due to the special circumstances before and after the end of the last upswing in precious metal prices in the early 1980s, which was characterized by very high volatility in precious metal prices, caused, among other things, by the shortage of physical silver due to market speculation as well as oil and commodity crises and the associated high inflation rates - as well as the sharp increase in money supply. The existence of such correlations is strongly confirmed by the correlation analyses, in particular the close correlation between precious metal prices and investments in precious metals on the one hand, and on the other hand the positive correlation between precious metal prices and the prices of other commodities, inflation, money supply and the U.S. dollar, or the negative correlation in relation to interest rates. In this context, it is irrelevant which causal interrelationships between the individual influencing variables actually exist; ultimately, the more decisive factor is the present mixed situation, which in some respects is reminiscent of that at the end of the 1970s, although the current situation is probably far more dramatic.