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The Hard Assets Alliance Blog

The Looming Catalyst That Ensures Higher Gold Prices

I bet your interest in gold is due to the money-printing policies of most developed countries and the effect those policies will have on your future purchasing power. It’s probably also because you don’t see a viable way to escape the consequences from all the debt that’s piled up. And maybe because you don’t trust politicians to formulate a realistic strategy to avoid any number of monetary, fiscal, and/or economic crises going forward.

These are valid, core reasons to hold gold in a portfolio at this point in time. But a new trend is under way, and someday soon it will become a major driving force for gold prices…

A good old-fashioned supply crunch.

A few metals analysts have discussed it, but it escapes many and certainly is off the radar of the mainstream financial media. But unless several critical factors reverse course, a supply shortage is on the way. And I bet you can guess what that would mean for prices.

The following four factors are conspiring to diminish gold supply, creating a perfect storm that will, sooner or later, impact the gold market in several powerful ways. As these forces gather steam, you’ll want to make sure you already own as much bullion as you’ll need…

1. Production pullbacks, development delays, exploration cancelations

A gold producer doesn’t operate in a vacuum. If the price of its product falls by 30% over a two-year period, it’s got to make some adjustments. In more cases than not, those adjustments center on expense reductions and subsequently result in lower production, delayed mine development plans, and cuts in exploration budgets. The response is industry-wide, and even the lower-cost producers are not immune.

The precipitous drop in metals prices means that some mines can’t operate profitably—and no management team is going to keep a mine open if it loses money. As operations come offline, global output falls.

The impact on development and exploration projects is even greater: it’s easy to postpone construction on tomorrow’s new mine when you’re worried about cash flow today. As a result, many companies have cut drilling projects and laid off geologists. As one example, check out the decline in the number of drilling projects around the world.

The number of drill projects this year has clearly fallen off. Through the first nine months of 2013, there are 52% fewer drills turning compared to the same period last year.

It’s not just fewer holes being poked in the ground. Ore grades are also declining.

As of last year, ore grades of the ten largest gold operations are less than a third of what they were just five years earlier, and less than a quarter of 14 years ago.

The troubling aspect to all this is that it can’t be easily reversed. Long lead times are required to bring new projects on line. Even shuttered mines can’t return to commercial levels easily or quickly. Once the market turns around, new mine supply will take years to rebuild. Many companies will find themselves without readily available ore, and the market with fewer ounces.

Lower metals prices are clearly having an impact on how much metal gets dug up. This alone is bad enough for supply, but unfortunately it’s not the only factor…

2. Now you see ’em, now you don’t

Many mining projects have both low-grade and high-grade zones. When prices fall, a company can mine the richer ore and still make money. It may sound shortsighted, but it can be the right thing to do to stay profitable and be able to survive and advance in a temporarily weak price environment.

But high-grading, as it’s called, can make low-grade ore part of a disappearing act. Here’s how…

When metals prices are low and companies focus on high-grade ore, the low-grade material is temporarily bypassed. It’s still physically there, so one might assume the company will come back at a later time to mine it. But not only is it not economic at lower metals prices, it may never get mined at all.

That’s because some low-grade ore only “works” when it’s mixed with high-grade ore. Even when gold moves back up to the price that the low-grade ore needed to be economic when mixed with the higher-grade material, it doesn’t matter, because the high-grade ore is gone. So it’s not just gone legally, as per regulatory definitions of mining reserves—it may be economically gone for good.

Miners could return to some of these zones in a very high gold-price environment (something north of $2,000), but that’s a concern for another day. The point for now is that many of today’s low-grade zones won’t be mined anytime soon, and maybe never.

High-grading can initially lead to a small bounce in global output, since more ounces are coming out of the ground from these zones. But that can’t last, and the medium- to long-term picture for supply will be significantly impacted by this practice.

3. Greed is good—says the politician

It’s become increasingly difficult for mining companies to navigate the political minefield in many gold-mining countries. Many politicians have become so rapacious that supply is actually suffering.

Take a look at how governments and NGOs (nongovernment organizations) put an effective halt to some of the biggest precious metals discoveries seen this cycle…

Pebble Project in Alaska. Anglo American (AAUKY) spent $540 million on one of the biggest copper/gold discoveries ever, but recently announced that it will walk away from it. The company said it wants to focus on lower-risk projects and is undoubtedly tired of putting up with ongoing environmental scares and regulatory delays.

Fruta del Norte in Ecuador. Kinross Gold (KGC) bought Aurelian shortly after what many called the discovery of the decade, but the politicos demanded such a big slice of the pie that Kinross stopped developing the project.

New Prosperity Mine in British Columbia. Taseko Mines (TGB) has been relentlessly challenged by environmental activists at the world’s tenth-largest undeveloped gold/copper deposit and pushed politicians to continually delay permitting.

Pascua-Lama in Argentina and Chile. This giant deposit has been postponed for several years, largely due to environmental issues and unmet regulatory requirements. Some analysts think it may never enter production.

Navidad in Argentina. Pan American Silver (PAAS) was forced to admit that the Navidad silver deposit—one of the world’s biggest pure silver deposits—was “uneconomic at any reasonable estimate of long-term silver prices” when the local governor announced he wanted “greater state ownership” and increased royalties from 3% to 8%.

Minas Conga in Peru. Newmont'’ (NEM) multibillion-dollar project was put on the back burner last year when the government gave the company two years to develop a way to guarantee water supplies for residents of the Cajamarca region.

Certainly bigger projects attract greater attention and scrutiny, but as it stands now, none of the above projects is in operation.

This list is by no means exhaustive; large numbers of smaller projects all around the world face similar challenges.

The bottom line is that the ability to find economic gold deposits in pro-mining jurisdictions is increasingly difficult. The result? The metal stays in the ground.

4. Implosion explosion

In South Africa, the gold industry is imploding.

  • Labor strife: Strikes are common, and layoffs have numbered in the thousands this year.

  • Rising costs: Labor and power costs have doubled since 2009. Some projects have been taken offline due to the one-two punch of higher costs and lower metals prices.

  • Maturing assets: Many mines here are past their heyday and have forced companies to dig deeper. The deepest mine is now 2.4 miles below surface; it takes workers a full hour to reach the bottom.

  • Power inefficiencies: Electricity shortages are at their worst in five years. Poor power supply has led to blackouts and mining stoppages and has made expansion difficult.

  • Political interference: The industry has faced frequent calls for nationalization. Miners were told earlier this year they can stay private, though in exchange they were forced to pay higher taxes.

The breakdown in South Africa is important because as recently as 2006, it was the world’s top producing country. It’s now fifth. Unfortunately, there’s every reason to expect this trend to continue.

The result is—you guessed it—fewer ounces coming to market.

What’s important to be aware of is that these four trends are already affecting gold supply. As one example, gold production in the US is already 8% lower in the first half of the year vs. the first half of 2012. Through June of each year, output dropped from 655,875 ounces last year to 623,724 in 2013.

The net result is that we should expect gold supply to decline. The shortfall will become increasingly evident in 2014, and reach fractious levels by 2015.

As it becomes increasingly difficult for supply to meet demand—especially in an environment where the fallout from currency depreciation could gain steam and pull in ever-growing numbers of investors—gold and silver prices will be forced up.

But that’s not the only ramification. Investors will be required to pay higher premiums on bullion. Further, we can expect a lack of available product, most likely resulting in delivery delays or even rationing.

But if you already own bullion and you need to sell a little to maintain your standard of living, the effects on you are all positive. The product you sell will…

  • Fetch much higher prices

  • Return the premium you paid—perhaps more than you paid

  • Have a steady stream of ready customers.

All it takes to capitalize on this opportunity is that one recognize the looming supply shortage and act accordingly.

 

Jeff Clark is editor of BIG GOLD, and a regular contributor to the Hard Assets Alliance.


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