May 052015

Around this time of year The Perth Mint puts together its budget for the June 2014 to July 2015 financial year. For normal companies the whole budgeting process can be a cynical exercise but for a precious metals business it is even more problematic – our sales volumes are driven by the gold price, and if anyone knew how to forecast those, well they’d be “see you later suckers, I’m off to trade gold in the Bahamas based on my computer model.”

But they have to be done. Our approach is generally to use current precious metal prices and FX rates without any real aggressive forecast one way or the other. While we have no direct exposure to metal prices themselves (our unallocated clients own the metal in our business) our profit is impacted by price changes in that it affects the amount of, and mix of, coins and bars we sell and our premium revenue (for coins priced as a percentage of metal value). The result is we focus more on “what ifs” in our budgeting – for example, if prices decline, then what is the impact to our profit from volume and revenue changes.

Following on from that, the budget write up around the outlook for precious metal prices also takes a classic economist approach: on one hand X, on the other hand Y. For those who don’t want to read a whole lot of words, I’ve summarised the current competing forces that will drive precious metal prices during this year in the diagram below.

Factors driving metal prices

Foremost on the negative side for precious metals is the outlook for the US economy, with the consensus being that an improving US economy (which is debatable I think but that is the current consensus) will give the US Federal Reserve scope to increase interest rates, although in a tentative manner due to conflicting economic data about the strength of the recovery. With continued low inflation any interest rate rise will increase real interest rates, which have a long run negative correlation to gold prices. Increasing rates will also support the already strong US dollar, putting further pressure on gold.

Weak oil prices have impacted on gulf country gold demand with some retailers in Dubai reporting drops in sales volume of up to 40%. Lower oil prices have also lowered import costs for some emerging markets, particularly India, where the resulting easing of pressure on their current account balance has allowed the Government to tolerate higher gold imports, which is a counterbalancing positive force.

Recent strong gains in the Chinese stock market in conjunction with a weak to sideways trend in gold prices has resulted in Chinese investors favouring stocks over gold recently. However, GFMS see a growing demand side response from China and India as prices approach $1,100 that will help contain any falls. Currently we are seeing Chinese demand weaken on prices above $1,200 but return once it gets below that.

Finally, there is some risk that mining companies may cap any strength in gold prices with forward selling, which has doubled over the past year, as exemplified by some Australian producers who took advantage of higher AUD gold prices on the Aussie dollar’s weakness. GFMS do not however that the hedging increases have been limited to a handful of miners.

On the positive side (for precious metals, that is) continued weakness in the Europe and uncertainty around Greece has weakened the Euro which drives up local gold prices and attracts investor interest. For those emerging markets reliant on oil revenue or European consumer demand, the resulting economic slowdown leads to a continuation or increasing of financial repression policies, increasing demand for gold within the country as well as capital flight (some of which is going into gold but from local media noise it seems to all be going into Sydney real estate, but it seems that Vancouver, New York and London property are also getting some money flow).

Continued low gold prices have put pressure on mining companies, with many below all-in production cost or at very low margins. In this environment analysts do not forecast any significant increase in gold production, which some see as support for gold (at least those focusing on annual flows and not stock, which many mainstream financial analysts do).

I think the market continues to be complacent about geopolitical risks in Eastern Europe and the Middle East (lessened somewhat with recent US-Iran negotiations), which provides the potential for surprises to the upside in precious metal prices.

Right now prices are “stuck” as there is no compelling narrative or story to get mainstream professional investors to buy gold – the longer precious metals continue in this sideways range the more traders sell the bottom of the range and buy the top of the range and it becomes self fulfilling.