Gold Demand – The Greatest Misunderstanding In The Gold Sector

2013 was a special year for gold (and silver). Although the year is not over yet, it has been marked by a remarkable evolution, i.e. a disconnect between the demand for physical metal and the price of the metal. Let us quickly highlight a common trend over the course of the year:

  • Gold rush in China and India; delays of one to two months for physical gold deliveries (April 2013).
  • Swiss refineries working day and night to meet gold demand (May 2013).
  • Demand for gold (and silver) coins from the US Mint on its way for best first 6 months (June 2013).
  • Gold price goes under cost of production (June 2013).
  • Gold production flat, discoveries falling (June 2013).
  • Backwardation in gold market (July 2013).
  • Gold forwards rate negative for more than one month, historic record (August 2013).
  • China on its way to surpass 1,000 tonnes of gold imports from Hong Kong (September 2013).
  • Gold forwards rate again negative pointing to tightness in physical market (October 2013).

Even with these headlines pointing to an incredible gold demand and to flat new production, the price of gold has been weak. How is that possible?

The answer is based on the dynamics within the gold market. The demand for physical gold has been driven mainly by the East; Western large investors have been selling gold signaled by the mass exodus from the GLD ETF (the largest investment vehicle for Western investors). Besides, the truth of the matter is that newly mined production only accounts for some 2% of total above-the-ground gold. That is an insignificant portion which truly does not matter in the big picture. The new production is low compared to a very high stock; the technical term for this is “stock to flow ratio.” Precious metals are unique commodities from the point of view that they have a very high stock compared to their flow.

Nobody better than Ronald Stoeferle explains the “gold stock to flow” concept in his In Gold We Trust reports (citing Robert Blumen as well). This excerpt learns why gold demand and gold production are no primary drivers of the gold price. Gold demand merely points to a shift in gold ownership from one hand (read: hemisphere ) to another. From the In Gold We Trust 2013 report:


There is a clear difference between commodities, which can be explained by a consumption model (e.g. crude oil, copper, agricultural commodities) and goods that are bought in order to be held (gold, diamonds, works of art). While the economic utility of a consumable good is created when it is destroyed or used up, the utility of investment assets lies in their possession and later resale. Industrial commodities therefore have low stock-to-flow ratios, this is to say, inventories usually only cover consumption demand for a few months. If there were no inventories at all, supply would have to correspond exactly to production and demand exactly to consumption. However, if there are inventories, consumption can temporarily exceed production. Since inventories of consumable commodities are as a rule very low, prices will rise quickly in anticipation of a future supply shortage and bring consumption into balance with production.

Unlike consumable commodities, gold and silver exhibit a large discrepancy between annual production and the total available supply which is a high stock-to-flow ratio. It is our premise that the high stock-to-flow ratio represents the most important characteristic of gold (and silver). The entire amount of gold ever mined totals approximately 172,000 tons. That is the stock. Annual production was about 2,700 tons as of 2012. That is the flow. If one divides the two amounts, one arrives at the stock-to-flow ratio of currently 64 years.

Gold isn’t as valuable because it is so rare, but quite the opposite: Gold is valued so highly because annual production relative to the existing stock is so small. Putting it differently: not only scarcity, but primarily the relative constancy of the available stock is what makes gold unique. The annual production of 2,700 tons is therefore not relevant to price determination. This characteristic was attained over centuries and can no longer be altered. This stability and security is a crucial precondition for creating confidence.

Apart from gold’s unique stock-to-flow ratio its high marketability is another important feature. The easier it is to exchange a commodity, the more pronounced its ‘moneyness’ is. Carl Menger developed the theory of marketability in the 19th century. According to this theory, gold has established itself in a long term evolutionary process, because its marketability was higher than that of any other good. According to Menger, the marginal utility of gold therefore declines more slowly than that of other goods. Gold and silver therefore enjoy their monetary status not due to their alleged scarcity, but rather due to their superior marketability.

In this respect there is a crucial difference between gold and other stores of value such as expensive real estate, diamonds or art objects. A Picasso painting, an expensive Bordeaux or a unique piece of real estate are all difficult to liquidate at an acceptable price in a liquidity emergency during a crisis situation. Furthermore, the specific features of art objects or real estate are only ascertainable after extensive due diligence. The fungibility of gold is therefore a crucial differentiation. This seems to be an additional reason why central banks are hoarding gold and not real estate, art objects or commodities as their main currency reserve.

The reason why individuals don’t spend all of their money today is their reservation demand for money and the greater utility they expect it to command in the future. Reservation demand is therefore essential for price determination. The decisive factor is who values gold more highly: the new, incremental buyer, or the existing owner. The majority of gold analysts however focuses exclusively on ‘exchange demand’ and therefore assumes that price determination in gold can be forecast with the help of a simplistic consumption model.

Closely related to this concept is the reservation price. Every gram of gold that is held for a variety of motives is for sale at a certain price. The motives for holding gold are diverse: as jewelry, as a currency reserve, in the form of objects of art, for technological applications, and so forth. Similarly diverse are therefore the associated time horizons, which range from the short term speculation of a trader to the generation-spanning insurance of an Indian bride. These decisions are not transparent, but depend on a range of competing opportunities in the course of time.

As a result, opportunity costs are essential for the gold price. How significant are the competing economic opportunities and risks that I am exposed to because I am holding gold? Real interest rates, growth rates of monetary aggregates, size and quality of debt, political risks, as well as the attraction of other investment classes are the most important determinants of opportunity costs. All market participants employ different filters, thoughts and time preferences in this context, which influence their price determination.

Everybody who owns gold is therefore part of the supply side. Gold owners and non-owners alike constitute the buy side because they are all capable of demanding additional units. There will always be a price, or a combination of price and circumstances that will induce market participants to sell their gold. For some this will be at a far higher price level, for some however also at a significantly lower price level (for instance as a consequence of a deflationary collapse). The decision not to sell gold at the prevailing price level is therefore just as important as the decision to buy gold.

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