Why gold prices are so high.

Why gold prices are so high.

Why gold prices are so high.

Moneybox
Commentary about business and finance.
April 11 2006 10:30 AM

Attack of the Gold Bugs

The price of the precious metal is rising when it should be dropping. What gives?

Gold jewelry 
Click image to expand.
Gold jewelry

Lately, gold has been golden. The price of the precious metal has soared in recent years. Last week, it pierced the $600-per-ounce barrier, marking a 25-year high. In trading Monday at the New York Mercantile Exchange, the contract for an ounce of gold to be delivered in June 2006 settled at a whopping $603.

An ancient store of value, gold is a safe haven for investors worried that their other monetary assets will lose value because of inflation, war, or confiscation by a tyrannical government. You'd expect gold to soar when the world economic state is parlous and inflation is rampant. But the global economy is in quite good shape. Despite the rising price of energy, inflation is generally under control. And investors, far from behaving skittishly, are remarkably blasé, as evidenced by low interest rates and low measures of volatility in stock and bond markets.

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So, why is gold so hot? It's partly that gold is simply being swept along in the global commodity boom. The prices of metals—copper, steel, and gold—have all risen sharply, along with prices of sugar, soybeans, oil, and natural gas. The rising industrial and consumer bases in China and India, four straight years of global economic growth, and the recovery of Japan have fueled the commodity demand. Production of most of these commodities is increasing—just not rapidly enough to keep up with demand, or with perceived future demand. At root, prices are rising because people are consuming more of the stuff.

But that's not really the case with gold, whose price is skyrocketing even as there's actually less demand for it. Unlike copper or platinum, it's not particularly an industrial metal. As London-based Virtual Metals notes in its biannual Yellow Book, which is full of fascinating details and charts, in 2005 the electronics industry accounted for about 8 percent of total gold demand.

The biggest source of gold demand—about 70 percent in 2005—is for the production and consumption of jewelry. And as the price has risen in recent years, people around the world have lost their taste for gold baubles. The Yellow Book distinguishes between investment jewelry and adornment jewelry—two markets of roughly equal size but with significantly different dynamics. The primary markets for investment jewelry are in the Middle East and India, where women store wealth in gold. For women in these cultures, gold jewelry functions as "a combination of insurance, pension and ready cash," according to the Yellow Book. As might be expected, these (comparatively poorer) consumers of gold jewelry are sensitive to big swings in price. Virtual Metals believes demand for investment jewelry will fall a whopping 30 percent in 2006. That's bad news for merchants in Bahrain's Gold Souk.

Adornment jewelry's core market is the First World, particularly North America and Europe. These comparatively wealthy customers are less price-sensitive than investment-jewelry buyers, but they still respond rationally to sharp increases in price. Virtual Metals predicts that demand for adornment jewelry will fall 12 percent in 2006. That's bad news for Zales. Combined, the demand for gold used in jewelry is expected to fall by 600 metric tonnes (a metric tonne is equal to 2,204 pounds), or 21 percent, in 2006.

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In theory, sharply falling demand, a rapidly growing gold-recycling sector, and steady mine supplies of gold should stabilize the metal's price. Indeed, Virtual Metals is predicting a 422-tonne surplus in the world's gold market this year, after two successive years in which demand outweighed supply. And yet gold is trading as if demand is rising rapidly and production is falling. The contract for delivery of gold in October is trading at $614.4 an ounce—even more than the current market price.

What gives? Essentially: speculation. While consumers are reacting to expensive gold by demanding less of it and recycling more, investors are reacting by bidding up the price further. And just as has been the case with every asset class over the past decade—real estate, Brazilian stocks—strong performance attracts a tidal wave of hot money. Indeed, Virtual Metals concludes that the price of gold is "being supported by the sheer wall of investment money moving into commodities." The current bull run in gold has spurred the creation of two Exchange Traded Funds that afford individuals the opportunity to speculate on gold without having to worry about where to store it—Streettracks Gold Shares and iShares COMEX Gold Trust. Essentially, they're mutual funds that buy gold bricks instead of shares. As money flows in, they buy gold. (Streettracks alone has 350 tonnes of gold stored in London, worth about $6.7 billion.) Gold ETFs, which didn't exist in 2002, last year consumed 192 tonnes of gold and are expected to demand 173 tonnes this year, according to Virtual Metals.

Hedge funds, speculators, and investors of all stripes can invest in gold without actually buying the stuff—they buy and sell virtual futures and options on physical gold at the New York Mercantile Exchange.

In other words, the eternal and largely immobile store of value is soaring, thanks to some newfangled trends in investment. Gold used to be incredibly valuable because it couldn't easily be destroyed and it was difficult to move vast quantities of it. Today, it's incredibly valuable—at least in the short term—because some of the fastest-moving cash in the world has decided that gold is the place to be, at least for now. When that cash decides gold isn't the place to be, the price may plunge faster than it rose.