What next for gold?
Following the worst sell off in gold for 30 years many investors are scratching their heads.
A fall in the gold price of around 13% over two days (last Friday and Monday) is exceptional and seems at odds with an environment of low interest rates and quantitative easing. In theory, gold, whose supply is finite, should appreciate as more paper currency is printed.
Even more confusingly, various reasons put forward to explain the price fall do not seem to account for it. For instance, cash-strapped Cyprus' plan to sell its bullion is insignificant in the context of the global gold market. At around 12 tonnes it is dwarfed by the 400 tonnes of gold sold during last Friday's trading alone.
It all serves to highlight the complexity of the gold market. Although sometimes seen as a safe haven asset, it is not always the case. Investors flocked to buy gold in the summer of 2011 during the eurozone debt crisis, yet during periods of more extreme market stress the price has fallen, the credit crunch being a prime example. With the advent of exchange traded products gold has become easily tradable, which adds to its volatility - it is not a substitute for cash and for some investors the recent sharp fall is a wake-up call. It is also worth noting the extent of gold's bull market since an all-time high of $1,921 was reached in September 2011. The price appreciated from around $250 an ounce in 2001, so it has travelled a long way. The recent sell off has taken us back to where we were in March 2011 at around $1,400.
Where gold goes from here is a difficult question. The inherent problem with gold is how to value it. The value of a share can be estimated based on company earnings or net assets. Whilst there is a certain level of demand for gold in jewellery and in industry, for investors it is harder to denote an ‘intrinsic' value.
Examining the cost of production can give us some idea. Evy Hambro, manager of the BlackRock Gold & General Fund, explains the present average cost of gold production is between $1,100 and $1,300 an ounce. Following gold's recent fall below $1,400 some companies are operating at a significant loss and many others are barely breaking even. For this reason Evy Hambro is confident we are towards the bottom end of gold's price range. If these (or lower) prices persist higher cost producers would go out of business, and projects operating at or above these costs would be abandoned, thereby constraining supply.
However, it is important to note that the average cost of production is variable. To what extent companies can reduce costs or focus on more profitable projects must be assessed on a case by case basis. Some miners have been criticised for mining expensive ore whilst easier to reach gold lies idle in the ground. Many investors would prefer to see more profitable gold extracted first and cash returned to shareholders via dividends. According to Mr Hambro, gold miners are gradually becoming more sympathetic to shareholder's views.
For Mr Hambro's portfolio it has been a case of damage limitation. A focus on larger gold miners with relatively little debt and a lower cost of production has helped the fund hold up better than its peers recently. The fund's holdings in other areas such as iron ore have fared better, though the mining sector as a whole has disappointed and investors have still seen significant losses.
Despite this I believe there is still a place for a small quantity of gold exposure in a portfolio. Central banks seem intent on keeping interest rates low and printing more currency, a positive backdrop for gold over the longer term. Exposure to a physically-backed gold Exchange Traded Commodity is a convenient way to take a position, though it should still be seen as a speculative investment.
Alternatively, if Mr Hambro is right that gold miners are becoming more shareholder friendly there is potential for the sector to become more attractive to a wider pool of investors. For those tempted to scavenge amongst the wreckage for gold mining bargains, BlackRock Gold & General is a consideration - though remember any sector-specific fund such as this is higher risk and susceptible to significant price movements.
By Rob Morgan at Charles Stanley Direct