Basic Supply and Demand Factors Will Drive Gold Prices Higher

Basic Supply and Demand Factors Will Drive Gold PricesRegarding gold, there’s a daunting question going around these days: is the yellow metal worth buying? If you listen to the mainstream, you will hear them say it’s the worst investment possible for your portfolio. According to them, instead of protecting your wealth, this precious metal is doing the opposite. Some are going even further, saying the “gold trade is dead” or “the metal’s going down to $800.00.” They all have their convictions, but as the number of bears increases, I am turning more bullish towards it. Why? Basic supply and demand.

I may be one of the only few saying this, but I believe the sell-off in the gold market was hands down the best thing possible for investors who never really bought into it back in 2009, or when the bull market began back in 2002.

What’s going to drive gold prices going forward is basic demand and supply. I see the demand for the metal is robust, while the supply is looking very shaky, to say the least. This is Economics 101; the perfect recipe for higher gold prices ahead.

Increasing Demand: Central Banks and Consumers Buying

Back in 2013, when gold prices were plunging, we were told the gold buyers will run out. This hasn’t happened yet.

Consider this: in the third quarter of 2014, central banks remained buyers of the precious metal—purchasing 93 tonnes. They have been buying gold and adding it to their reserves for 15 consecutive months. Year-to-date, central banks have purchased 335 tonnes of the precious metal. In the same period a year ago, their gold bullion purchases came to 324 tonnes. To me, it seems more like central banks have become bargain hunters for the yellow metal.

Consumers are buying gold as well. I look at the numbers from India and China, since they are the biggest consumers of gold bullion. The numbers from these countries continue to impress me. For example, in the third quarter of 2014, India’s jewelry demand increased by 60% from the same period a year ago. Jewelry demand from China declined, but it’s well in-line with its five-year average. One interesting note: jewelry demand from the U.S. increased by four percent in the fourth quarter, and the U.K. showed its fifth consecutive increase in demand.(1)

Dwindling Gold Supply

From a basic economics level, for prices to go down when demand is increasing, you want to see an immense influx in supply. More supply leads to an abundance of the commodity, resulting in lower prices.

But the complete opposite is happening in the gold market. Supply is constrained. Mind you, this is something you will not hear about from advisors who say gold is a horrible investment.

Mine production in the U.S. is declining. In the first eight months of 2013, U.S. mines produced 152,000 kilograms (kg) of gold.(2) This year, mine production is down almost eight percent to 140,000 kg.(3)

This isn’t all. Look at the decline in South African gold mine production in the table below. It exhibits the percentage change from the same period a year ago. These numbers put a further dent in the supply side of the equation.

Changes in Production Volume
South Africa, 2013 vs. 2014(4)

Month Year-over-Year % Change
April -4.20%
May -2.10%
June -0.30%
July -14.50%
August -8.10%
September -0.60%

If the prices remain suppressed, don’t be surprised to see production of the yellow metal decline further. The reason behind this is simple: as prices decline or remain subdued, lower grades become unfeasible to mine, and miners don’t really have much incentive to produce more.

What’s Ahead for Gold Prices?

I don’t think there’s anyone who can tell when the prices will turn, but I have very strong convictions that it will be sooner rather than later. If prices do go higher, I would be watching mining companies. They don’t need gold prices to be at $1,900 an ounce to double; even a move of just 30% to the upside will do the job.