With gold prices surging in late 2008 and 2009, many gold mining companies enjoyed a banner year, with their share prices rising commensurately. However, we believe some of the demand tailwinds that bolstered pricing in 2009 may prove unsustainable in the long run, meaning that gold prices could experience substantial volatility in the coming years. As such, we advise investors interested in the gold mining space to focus on low-cost producers capable of generating economic profits even in a weak pricing environment.
We attribute the recent appreciation in gold prices to robust investment demand for gold, which has more than offset feeble industrial and jewelry gold demand in the wake of the recession. Investment demand for gold soared more than 72% in 2008 and grew by an additional 90% through the first nine months of 2009, according to the World Gold Council. We believe the factors driving this stronger investment demand include the increasing popularity of gold ETFs as well as renewed institutional purchases by hedge funds and central banks, who view gold as a hedge against inflation and a weaker dollar. In addition, several gold mining companies, including AngloGold Ashanti AU
, Barrick Gold ABX
, and Northgate Minerals NXG
, have recently closed some or all of their gold price hedges. Closing these hedge books has usually forced these gold miners to deliver physical gold from either their own production or spot market purchases, thereby further boosting gold demand.
Although robust investment demand certainly proved a boon for most gold miners in 2009, we do not necessarily expect this trend to continue. The central banks in many countries, especially India and China, have substantially increased their gold holdings in 2009, but central banks around the world have been net sellers of gold since 1989. A reversion to this trend of waning government interest could significantly dent gold prices. Furthermore, if gold ETFs were to fall out of favor with investors, then the resulting fund outflows could force these ETFs to liquidate a sizable portion of their gold holdings, thereby undermining gold prices. Finally, the elimination of gold hedge books cannot continue indefinitely, in our opinion, which means that this particular driver of higher gold prices is unsustainable over the long run.