The rise in precious metals has been across the board. The price of silver bullion has moved from a low of $4.06 to today’s close of $7.628. Platinum prices as well as palladium are soaring again as well. Just look at the three-year charts below.

The rise in the price of precious metals has also been duplicated by price increases in other commodities. It doesn’t matter whether you are looking at oil, natural gas, copper, lead, zinc, corn, wheat, soybeans, or cotton. They have all risen in price, some more than others, and some in spectacular fashion.

The plain fact is that the commodities sector is in a new bull market and the precious metals are in a new super bull market. Price increases of 400-1000% are a bull market and not mere happenstance as some on Wall Street would have you believe. Like all new bull markets in their formative stage it has very few believers, Wall Street being one of them. Talk to industry executives and very few can see beyond present prices. The industry has been in the doldrums for so long it is hard for many executives to see gold or silver prices beyond where they are today. The lack of belief also applies to the gold newsletter industry where most writers have been bearish, cautious, or hesitant with doubts whether present prices can hold. This weekend’s edition of Barron’s featured an interview with the dean of Dow Theory, Richard Russell. The seasoned sage of the financial markets sees a big ugly bear market for stocks in the future. To quote Russell, “I’m afraid we are coming into one of the worst bear markets in history.” Russell advises his subscribers to hold cash, gold and gold stocks. Gold at $400 an ounce is “as cheap as dirt.” Russell sees gold prices above $1,000 an ounce. Today on cable TV one financial anchor’s response to the Barron’s Russell interview was that Russell likes gold, but “he’s getting on in age.” The wall of disbelief is still pervasive on Wall Street and within the industry.

Yet, despite the wall of worry, the metals have been relentless in their climb, first gold and now silver. This new super bull market has barely begun and at some point this year, we will begin to see the price of gold rise in all currencies around the globe. By year- end the prices of gold and silver will be far higher than where they are today. The race to own real money is just beginning and this super bull market has a long, long, long way to go. For those who want to know why gold prices are heading higher ( besides the mindless spin coming from anchors and analysts), I have listed 7 fundamental reasons why gold and silver are heading higher.

GOLD & SILVER FUNDAMENTALS

1) Producer Hedge Book Reductions and the Decline in Central Bank Gold Sales

For years the price of gold was kept suppressed throughout the 1990s by large central bank sales. As prices were kept suppressed, many mining companies sold their forward production. The combination of central bank sales with producer hedge books brought additional supplies onto the market. This kept prices low at a time demand for gold was increasing. When interest rates were high and when gold prices were falling, many companies made money by hedging their future production. It became an attractive proposition. Contangos (the implied margin between six-month LIBOR and six- month gold) lease rates were high. You could sell or borrow gold and sell at attractive borrowing rates and invest the difference in high- yielding paper instruments. Central banks made it attractive to borrow and sell gold and invest the difference in high- yielding government paper. It became known as the “gold carry trade.” Basically, you could borrow gold from a bullion bank at a very low interest rate and then invest the difference in high yielding paper. It is similar to what is going on in today’s bond markets where large investors and institutions can borrow short-term and invest long- term and pocket the spread.

In the gold market contangos have shrunk as shown in the graph below.

Since 2001 interest rates have fallen dramatically, gold prices have firmed and the production of gold itself has fallen. It is no longer profitable to borrow and sell gold short. In fact it can be financially dangerous as several mining companies have found out. In a rising gold market, a profitable gold company doesn’t short its future production. Instead they profit from future price increases since their production is leveraged to a rise in gold and silver prices. Furthermore, in a rising gold market, shareholders of gold companies have been bringing enormous pressure on management to unwind hedge book positions. In the last few months aggressive hedgers such as Barrick Gold and Cambior have announced an end to their hedging policies. Gold hedging has made Barrick Gold a major underperformer in this new super bull market. Barrick’s stock is up only 33% over the last few years compared to a gain of 450% for the Amex Gold Index of unhedged gold companies.

This low interest rate environment has reversed large spec positions on the COMEX from net short to net long. With a contango of only 1%, there is very little incentive to short gold. As shown in the chart above contangos have fallen from the range of 5-6% to today’s 1%.

A reversal of hedging policies has produced two effects. The first is that gold companies are delivering into existing hedge contracts without renewing these contracts. This results in gold being delivered back to bullion and central bank vaults. The second factor is that as prices strengthen and then pull back, companies have been aggressive repurchasers. This trend of aggressive hedge book repurchases should continue as the price of gold advances. It can make all of the difference of survival in a company. Hedged positions aren’t profitable when the price of gold is rising, or even worse, going parabolic. The drastic reduction of hedge book positions can be seen in the table below:

In addition to low interest rates, we are actually in a negative interest rate environment (interest rates below the inflation rate). In a period of higher inflation such as we are in today, negative interest rates are forecasting the destruction of the value of financial assets. This makes gold more valuable.

Finally there is the Washington Agreement which limited annual central bank gold sales to 400 tonnes of gold a year. This agreement will be extended. For more about central bank sales, I suggest the reader go to www.gata.org to find out more about central bank sales and their impact on the gold markets.

The only addition I would make it to ask the following question:  If central banks have been selling, who has been doing all of the buying?

2) Reflation

Since the stock market bubble burst in 2000, the recession and terrorist attacks of 2001, the Federal Reserve and central banks around the globe and their respective governments have been fighting deflation with massive monetary and fiscal stimulus. Global governments are running large, and in some cases as in the U.S., massive budget deficits in order to counter economic weakness. Both money and credit have expanded exponentially in the U.S. Traditional standards of money growth no longer tell the whole story of credit reflation. Credit is expanding beyond the traditional venues of bank lending. Today, credit is expanded mainly through the financial markets through asset- backed securities. Every conceivable kind of debt from home mortgages and credit cards to auto and installment loans have been securitized. As of 3rd quarter 2003, national debt increased year-over-year by $1 trillion, while personal income grew by only $298.5 billion. Nominal GDP grew by $371.2 billion and consumer debt by $969.5 billion. Total debt expanded by $1.7 trillion. [1]

America’s debt bubble has grown to be so large that there is only one way out for this country and that is to inflate its way out of its debt burdens. I happen to be one of the few who believe that the Fed will not return to a tight monetary policy. The debt burden has become too large and the country now depends heavily on asset bubbles to keep the economy from collapsing. Last year households extracted between $600-700 billion out of their homes in the refinancing boom. All of that equity extraction went to pay ordinary bills of living and into stock speculation. It wouldn’t take much in the way of interest rate hikes to collapse this debt- laden economy. The last time the Fed tried ( beginning in 1999 and in 2000), it brought about a collapse in the stock market and a recession in short order. Today the economy is far more dependent on asset inflation in real estate, stocks, bonds and mortgages. A sharp rise in rates would bring about severe asset deflation in paper assets.

The long and short of it is that credit will continue to be expanded in this country until there are no more borrowers to be found. Then, when there are no more private borrowers to be had, the government will become the borrower- of- last- resort with the Fed monetizing all of the government’s excess borrowing or budget deficits. Monetary reflation equals gold, silver and commodity inflation.

3) A Declining U.S. Dollar

The third pillar of this new super bull market in precious metals is a declining dollar. Despite a 28% decline in the U.S. currency, the United States is still running record trade deficits. America’s trade deficits are structural from energy to capital goods. Last year’s trade deficit was a record, rising to over $500 billion. In the month of January the U.S. experienced another record trade deficit of over $43 billion. At the present rate of rise it will take more than a 50% increase in exports just to balance out our trade. With budget and trade deficits that are now running at over 5% of GDP and growing, our trade and budget deficits are now at levels where a currency crisis sets in. The dollar is going much, much lower. A decline of 50% or more would be possible if not probable. It is also unlikely a decline of this magnitude would be orderly. Severe currency adjustments don’t correct themselves in an orderly fashion. A crisis is more likely. The chart below of Gold vs. US Dollar (1990 - 2004) shows the decline in the dollar since 2001 and the rise of gold. There is a reverse relationship between the two. One is a fiat currency and the other is real money. Over the course of history only real money survives a crisis, an empire or a nation. Gold and silver are enduring; paper currencies are not.

4) Increased Demand Decreasing Supply

The fundamental supply and demand picture for gold has begun to deteriorate. Demand is rising while supply can no longer keep up with demand. According to Gold Fields Mineral Services demand for gold rose 4% globally last year while supply increased by only 0.4%. The demand for gold is changing from one of industrial demand to one of investment demand. Higher prices have curtailed jewelry demand while investment demand is flourishing. What becomes obvious from the table below is this: as prices have risen, fabrication demand has fallen from 3,782 tonnes to estimated demand of 2,822 tonnes this year. Primary demand has fallen, while investment demand has accelerated; disinvestment of 358 tonnes in 2000 to estimated demand of 565 tonnes this year, a turn around in demand of 923 tonnes.

A summary of the GFMS report for last year reveals the following:

Gold demand rose 4% year over year.
Producer de-hedging fell by 27%.
Jewelry demand fell by 7%.
Mine supply increased by less than 1%. 
Investment demand has risen by 328%.
Over 50% of the industry’s 3,000 hedge position has been eliminated over the last three years.

Jim Puplava

[1] The Richebächer Letter, February 2004 p.9-11.
Chart courtesy: www.stockcharts.com, www.ino.com, The Richebächer Letter and Bloomberg

© 2004 James J. Puplava
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