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Gold rally likely to continue

By Neville Bennett

Friday 28th November 2003

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Gold has reached its seven-year high of $US400 an ounce in response to a possible decline in value of other assets because of the impact of war, terror, inflation or devaluations.

But the 55% rise in three years (see chart) is still short of its 1980 peak of $US850. Most economists underrate the power of gold to preserve the value of portfolios. This is particularly the case for lesser currencies. When these seem likely to lose value, a shift of resources into gold makes sense.

Using the 1997 Asian crisis as an example, imagine an investor in country X. At the beginning of the year, X's currency exchanges 20 units per US dollar. In a crisis, it falls to 40. If the investor has all his assets in X denominations, his international buying power has been halved. But if the investor had bought gold, and its international price was stable, the investor would not have missed out. Indeed, if the investor then sold gold to buy X, he would double his investment in X terms.

Thus for investors living in some smaller economies ­ such as Thailand or New Zealand ­ there is a case for the wealthy increasing their exposure to gold. The case becomes more valid in times of gold appreciation.

US investors have seen their gold increase from $US300 to $US400 this year ­ a 33% rise. Holders of gold, in economies with depreciating currencies, would have made higher returns.

But beware the free lunch. Gold investors forfeit interest payments. There is an opportunity cost for holding gold rather than an interest-bearing security such as bonds. If gold prices decline, gold investors become conscious of these opportunity costs and some selling occurs. But if gold appreciates, there are few reasons to sell, so gold prices rise dramatically in a bull market of few sellers and clamouring buyers.

The gold market also responds to supply and demand. Increases in supply can depress prices. Supply has been quite low for several years as the price incentive to produce was low. The recent bull market has greatly stimulated exploration and production.

In New Zealand, interest in exploration has been low since the 1980 boom. Production has focused on rich fields operated by Newmont in Waihi and GRD Macraes in Otago. The rise in prices has stimulated exploration by HPD NZ, Auzex Resources, Aurora Minerals, Australasian Gold, CanAlaska Minerals and Glass Earth.

Obviously the boom will eventually reach a point of correction. Gold production increases at times of high prices as former marginal deposits become worthwhile. If the market becomes over-supplied, prices will slide and the correction will increase in pace as successive waves of sellers try to limit their losses.

There is an over-hang. Some years ago the European central banks began to sell their reserves. This drove the price down too far. The banks formed a cartel and agreed to suspend sales until September next year. Sales could resume, presumably in an orderly fashion.

Where is gold headed? My guess is that gold will continue a bull run until about September.

It will be sustained by a rising volume of contracts (see chart) but it is vulnerable to the over-hang and a flush of production.

It is driven up in price by anxieties about the value of various currencies but gold producers buying back supply they had earlier sold forward in hedges are also driving it. Speculation is also a factor, with about a year's supply being hoarded. Hedge funds are also involved. I expect a cautious rise followed by a correction.

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