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(May 25, 2001) Spot prices ran as high as $294 Monday May 21st, after Friday’s $14 rally. The rest of this week was spent in retrenchment, but overall the price action is convincingly positive. With demand for gold up again in first quarter 2001, and rising energy prices pushing up mining costs, how much longer can gold prices remain immune to inflation?
First-quarter gold demand was reported up some 5% over last year’s first quarter, with jewelry demand being the largest component, and investment demand actually declining. 2001’s first quarter use of 826 tons translates into 3300 tons a year, which once again greatly exceeds expected mine production of some 2500 tons annually.

Paul Burton, writing in the London Bullion Market Association’s publication The Alchemist in an article entitled “Facing Facts,” reports:

“When final figures for 2000 are available they are expected to show that aggregate gold mining production has leveled off over the past year.”

“Although many producers were able to grow production, the continuing flat US dollar gold price took its toll, leading to a number of mine closures in 2000.”

“The predicted levelling off in production is almost certainly a symptom of a fall-off in global exploration spending over the past few years. The 7% decrease in 2000, the third consecutive annual fall, was more modest than the previous year’s 29%.”

Burton goes on to discuss a number of prospective mining ventures which were halted because of low gold prices, and the general consolidation in the industry going on due to depressed gold prices.

We often use the phrase “sitting on a gold mine” in a figurative sense as a positive state of being, but in fact many large corporations around the world are sitting on gold mines – and sitting, and sitting, and sitting, and wondering when gold prices will rise sufficiently so that they can quit sitting and start working these mines.

As has been discussed here and in every gold forum recently, many gold mining concerns have ‘hedged’ many years of their future gold production in the forward markets. This ensures the price that they will receive for their gold despite market fluctuations in the spot price. In a flat or falling gold market, this makes good business sense - if you are certain of your production costs.

But with energy prices skyrocketing, these mining companies are finding themselves bringing gold out of the ground at an unexpectedly higher cost. For instance, there are mines in Nevada that have been able to extract 3/100 of an ounce of pure gold from a ton of ore, and do it profitably. How do you process a ton of dirt to get $8 worth of gold out of it, and make money doing it? Only cheap electricity made it possible, and the days of cheap electricity, particularly in a state next door to California, are probably over for some time.

Extracting gold from the Earth takes a lot of energy: oil, gas, electricity, or manpower. Unfortunately for the big mines that have hedged the price that they’re going to receive for their future production, they had no way to hedge their costs. And there’s the rub. With energy prices rising worldwide, gold mines face the potential of runaway production costs.

The hedges that allowed them to profit in a falling gold market could now come back to bite them. And bankruptcy could loom for companies whose gold production costs start to exceed the price at which they've sold gold forward.

Gold has traditionally been thought of as an inflation hedge. Yet today gold prices are actually trailing the potential increases in the overall inflation rate, a rate which will no doubt increase as higher energy costs work their way through the world economy.

Amazingly, gold prices today don't even reflect the increased costs of simply getting this element out of the ground, much less the higher overall inflation rate which increasing energy costs portend.

We can’t help but think that gold prices have quite a ways to go from this modest beginning.


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