Demand and Supply of Gold

CHAPTER THREE: DEMAND AND SUPPLY OF GOLD

Introduction

It is important to have a good understanding of the supply and demand dynamics of the
gold – it is the supply and demand, when at equilibrium that determines the price of gold.
Going forward, the outlook the demand for gold remains robust due to various reasons such
as, a fundamental shift in the behavior of reserve banks worldwide, from traditionally being
net sellers to net buyers of gold since 2009. Also, strong demand especially for jewelry and
investments from emerging markets such as China, and India are driving the demand for
gold forward. Further, new advances in the industrial use for gold such as in the area of
nanotechnology and medicine, are also contributing to the increasing gold demand.

On the other hand, the supply of gold remains constrained due to the persistent high cost of
production from the existing mines, as well as, long gestation period (and high capital
expenditure) needed for developing new mines. The 2008 financial crisis had thrown a
spanner into the works, as investments into new mines were temporary halted due to
prevailing global uncertainty. The impact of this delay on new supply from mines will only
be felt in the next few years, and will likely put substantial pressure on gold prices to move
up steadily from current levels.

This chapter will provide readers with an exposition of what drives supply and demand for
gold.

The supply of gold

There are essentially three main sources of supply for this precious metal, namely from
mines production, scrap or recycled gold, and from official sector i.e. government and
related organizations such as the International Monetary Fund (IMF), and European Central
Bank (ECB).

The supply for gold over the last five years can be summed up by the chart from the World
Gold Council (WGC) – see below. The major source of supply has been mine production,
which roughly constitute 60% of all supplies. This is not unusual considering that the only
way known to produce gold is to mine it; unlike paper money (or fiat currency), it is not
possible to produce real gold in the laboratory or via a printing press. The second source of
gold is what is known as recycled gold or scrap gold, which forms roughly 35% of the
supply into the market. Scrap is derived from industrial recycling such as from old mobile
phones, electronic gadget and others, and also from jewelry. The amount that is supplied is
usually dependant upon the price of gold: higher prices tend to stimulate more recycled
gold being supplied.

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 Demand and Supply of Gold
Finally, the third major source of gold supply is the official sector which is the reserve
banks and also organizations such as the IMF, which traditionally held gold to back their
respective currencies during the monetary gold standard. Further, Asian central banks such
as India and China are now more aggressive in increasing the proportion of gold held in
their currency reserves, in light of the devaluation of the US dollar and the uncertainties
surrounding Europe due to the debt crisis.

Annual supply for gold ( 5 year average)

1) Mine production
The only known way to produce gold is by mining gold ore: as such, gold produced from
below ground has been the major contributor to the supply of gold. Gold mining started as
early as 2000BC and the Egyptians were the first recorded civilizations to have mined this
shiny metal. The first gold coin ever found (Croesus) dates back to 8th century BC. Gold is
usually mined as a native metal and it is also mined as an alloy predominantly with other
metals such as silver or mercury. Native gold occurs in nuggets form or as grains embedded
in rocks. Gold is usually not found in chemical composition with other elements and it is a
very rare commodity.

The process of producing gold is divided into six different phases which is: finding the ore
body, creating access to it, removing the ore by mining or breaking the ore body,
transporting the mined mineral from the mine to the plants for treatment, processing and
refining. The basic principles apply to mining both underground and surface operations in
producing gold.
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 Demand and Supply of Gold

As outlined, the process of producing gold is quite extensive in terms of time and money
needed to extract the gold to a stage where it can be refined, and sold through a bullion
dealer to the end users. The cost of producing the gold is relatively high, and the gestation
period required for a new mine to be productive is around 10 years. It is estimated that the
cost of producing one troy ounce of gold from an existing mine currently is around $600/oz,
which basically puts a floor to the current gold prices. The global increase in prices of other
commodity has also impacted the cost of gold production. For example, an increase in
price of rubber may affect cost of the huge tires used on the trucks at the open mines, while
an increase in crude oil prices may impact the cost of transporting mined gold to the plants.

It should be acknowledged that the production of gold is well spread out geographically;
there are hundreds of gold mines, from small scale operations to major ones like the
Anglogold Ashanti’s massive Tau Tona mine in Sesotho, South Africa. Gold is mined on
virtually every continent on the planet, with the exception of Antartica where mining is
banned. South Africa used to be the largest producer of gold in the world for a very long
time: producing at its peak, 1400 tonnes of gold per annum in the 1970’s. But, it has since
ceded the mantle to China in the 2nd half of 2007. China, the third largest economy in the
world in terms of gross domestic product (GDP), now produces over 281 tonnes of gold per
annum, which are largely kept for its domestic use and for its currency reserves. South
Africa’s gold production has been steadily declining by 5.6% per annum for the last decade;
it now produces roughly 269.9 tonnes annually.

2) Recycled gold
As gold is indestructible, it can be reused in different forms. Interestingly, according to the
World Gold Council, all the gold that has ever been mined (around 166,000 tonnes) is still
in existence today, and can be found in near perfect state in one form or another, like
jewelry or gold wafers, and others. This is not a surprising as no matter how “old” your
gold ring, bracelet or necklace is, one is not likely to discard them during the annual spring
cleaning. There is an intrinsic value to gold as it can be recycled and reused, countless times
– and thus, keeps its value intact. Recycled gold (which also includes gold recycled from
industrial use) is the second largest contributor with 35% of the supply flows (over last five
years).

Scrap gold is a term coined for any gold collected from old fabricated products. Gold has
various industrial uses, and often because of the high gold prices, the “used” gold is often
recovered through various mechanical and chemical processes. Many companies around the
world have embarked on scrap gold production business as it can be highly profitable.

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 Demand and Supply of Gold
The amount of gold collected from electronic components, and other industrial use are
included in the scrap gold supply sources. This does not normally include the amount of
gold that is traded in the form of jewelry. Reselling or re-trading of jewelry in its original
form is not included in gold supply sources. Investment bars and coins when they are
recycled (not traded) also contribute to this gold supply source.

Incidentally, the highest amount of scrap gold supply was recorded in 1998 when during the
Asian financial crisis the South Korean government launched a gold collection campaign to
shore up its falling foreign exchange reserves. South Koreans contributed about 300 tonnes
of gold and in return received Won-denominated bonds. The government of Thailand also
embarked on a similar program during this difficult period, also with much success. The
gold-for-bond campaigns further amplified the role of gold as a global currency, especially
in times of turmoil and uncertainty.

iii) Official Sector

The above-ground stocks for gold (end 2009)

Source :GFMS

About one fifth of the above ground gold stocks are held by central banks and other
international organizations like the International Monetary Fund (known as official sector).
At end of 2009, the official sector accounted for 17% of stocks with the United States as the
largest holder with roughly 8,133.5 tonnes of gold in its reserves, kept at Fort Knox.
Germany is in second spot with 3,401 tonnes and IMF with 2,846 tonnes. The high level of
gold holdings is evident for U.S and many European central banks such as Germany, Italy,
France and others, as they were previously party to the classical Gold Standard in the
previous decades.

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 Demand and Supply of Gold

It is well known that most countries usually have at least 10% of their reserves in gold.
However, the actual percentage depends on the country’s reserve management and the
prevailing economic conditions. Central bankers tend to diversify their portfolio beyond the
usual major currencies such as Euro, U.S Dollar, Yen, and Pound Sterling by including
physical gold. This is given that gold has diversification benefits in that, its returns are not
correlated with any other financial assets such as stocks and bond. Further, the price of gold
is not affected by the current monetary policies of the country and is influenced only by the
variation in supply and demand. As such, gold in reserve management plays a very
important stabilizing role.

The value of gold is also unaffected by inflation or currency status of the country. It has no
counterparty risk (i.e. it is no one else’s liability but it is your asset) and it represents real
purchasing power. Unlike paper currencies, gold in a country’s reserve does not lose its
value in the long run. Gold is a highly liquid resource that can be used during crisis as
witnessed during the Asian financial crisis with Korea and Thailand calling on its citizen to
contribute gold to its coffers. This gold can then be traded with other nations for foreign
currencies, if needed. Gold offers fundamental strength to the balance sheet of banks: and
lately, China and India have been strengthening their gold holdings. It was widely reported
that the Reserve Bank of India purchased 200 tonnes of gold from the IMF in 2009, while
China had increased its gold reserves by 400 tonnes between 2003 and 2010. Finally, with
the presence of a gold lending market, it is possible for central banks to make some returns
from their gold reserves. Also during good times, and with increasing gold prices, some
central banks have also engaged in actively selling down some of their holdings as seen
with the central banks of the Philippines (between 2003 to 2009). But, most central banks
since 2009 have turned to become net buyers, adding more gold to their reserves as its
prices hit new highs.

The demand for gold

Annual demand for gold falls into three broad categories, namely jewelry demand,
industrial demand and from investments. Jewelry demand forms the largest component,
roughly about 60% of total demand, worth around $55bn in 2009, followed by investments
(31%). Prior to 1999, investment demand for gold from exchange traded funds (ETFs) was
miniscule, amounting to only 510 tonnes; but it surged to more than 1,750 tonnes in 2009.
Incidentally, investment demand also includes gold bars, coins, medals and wafers.
Industrial demand for gold (11%) is dominated by the electronics sector but it also includes
dentistry and other industrial and decorative applications.

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 Demand and Supply of Gold
Annual demand for gold (5 year average)

Source: GFMS, WGC

*Includes identifiable and non-identifiable investment

1. Jewelry demand
Globally, about two thirds of gold demand is made up of jewelry. Over the last five years,
the average demand for this sector was roughly 2,150 tonnes, and this was worth around
$55bn in 2009. India is the largest consumer market for gold with 27% share of this,
followed closely by China.

In 2009, India imported 600 tonnes of gold, worth $19bn, and accounted for 15% of the
global demand. It has 18,000 tonnes of above ground stock (around 11% of global total). In
the last 10 years, gold demand in this fast growing country averaged around 13% p.a.
according to WGC, outpacing GDP growth which averaged around 8% p.a. Indian’s tend to
regard gold, both as jewelry, as well as, a form of investment, and a store of value. Every
home in India aspires to have at least a small piece of gold to signify its wealth. It is well
regarded as a form of money and as a tradable, liquid asset in this country.

The demand for gold jewelry is often driven by social and cultural aspects of a country.
Using gold jewelry as a fashion accessory is increasingly becoming common in other parts
of the world. Outside of Asia, the Middle East also sees strong demand for gold especially
jewelry. It should also be noted that the demand for gold jewelry is highly seasonal. During
festival periods such as Diwali, a Hindu religious celebration in October, there is a
noticeable increase in the demand for gold in India. In China, during the Lunar New Year in
February, and for special occasions such as a child’s birth or wedding, gold jewelry are
often given as presents. As such, gold demand would see an increase in the fourth quarter of
the year as several festivals are celebrated in different parts of the world during this time.
The first quarter demand for gold is also considerably high due to the spillover effect of
demand from the fourth quarter.
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 Demand and Supply of Gold
Another factor that drives the strong demand for gold jewelry is the increasing amount of
disposable wealth in the developing nations such as India and China.

India has one of the highest saving rates in the world, of around 30%; interestingly enough,
10% of which is held in gold! India certainly has a high affinity to gold. However, the
intensity of gold consumption which measures the consumption of gold per capita for India
is still quite low. At around 0.4g per capita, it lags that of developed countries like U.S (1.1g
per capita) and Taiwan (1.4g per capita). This reflects the countries large population and
low incomes. Nonetheless, as its income rises, and propensity to save improves, this
intensity value is likely to shift higher towards that of developed countries and as a result,
demand and gold prices are likely to move up further.

China & India’s gold intensity consumption still low, but growing

Source: WGC estimates, GFMS, Bloomberg, IMF

China’s intensity of gold consumption (which compares consumption per capita vs. GDP)
like India’s is still relatively low (0.3g per capita) compared to that of more developed
nations like the U.S. As its intensity of gold consumption improves on the back of increased
economic prosperity, this will have a significant, positive impact on the country’s gold
demand and on prices globally.

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 Demand and Supply of Gold
Among the Middle East countries, Dubai is a major hub for gold jewelry trading. Locals,
expats, tourists and business visitors flock to the Middle East countries to buy gold jewelry
in different designs at competitive prices. Exclusive shopping festivals are held in Dubai to
improve sales of gold jewelry. Turkey experienced an increase in gold jewelry demand from
1990s as new varieties of gold jewelry that captured the essence of tradition in modern
designs became very popular. As a result, Turkey is one of the second biggest exporters of
gold jewelry in the Middle East

2. Investments
Investment demand constitute about 30% of the annual demand for gold; this is made up
largely by demand for physical gold from gold-backed exchange traded funds (ETFs), and
also from private investors in the form of wafer, bars, coins and others.

One of the key areas of strong demand is coming from ETFs; in 1999, they accounted for
only a small portion of demand, but today the amount has grown enormously, for example
the world’s largest gold ETF, the SPDR Gold Trust (GLD) now holds 1,100 tonnes of gold.
Overall, ETFs are estimated to hold close to 2,000 tonnes of gold (see chart below) – its
asset under management is roughly $71.2bn (as at 21 December 2010), and this number is
fast growing as the increasing global uncertainty drives more investors to invest in such
ETFs.
ETFs demand for gold main driver of investments

Data: www.ishares.com;www.exchangetradedgold.com; www.etfsecurities.com; Zurich

Kantonalbank; Finans Portfoy; www.Deutsche-Boerse.com;www.juliusbaer.com;London Bullion
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Market Association, HIS Global Insight. Chart: WGC, www.gold.org
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 Demand and Supply of Gold
Gold’s use as an investment dates back many centuries and it derives its role as a safe
haven, a store of value and monetary assets. Since gold does not have default risk, it does
not run the risk of being worthless through the default of the issuer. Unlike a bank that
issues paper or financial instruments, the owner of physical gold such as gold wafers or
coins like the Krugerrand is not exposed to default risk, as the investments is held by
individual.

Essentially, investors choose to own gold because:

• It is a hedge against inflation in the long-run,
• It is a hedge against any currency weakness,
• It is a safe haven asset in times of financial and geopolitical crisis,
• Gold is typically less volatile compared to stocks and other commodities,
• Gold is an effective portfolio diversifier as it lacks correlation with mainstream financial
assets. (This is perhaps the most compelling reason to own gold).

It is envisaged that demand from gold as an investment will remain robust going forward
especially from emerging countries. Gold investments demand in China have shown a
marked improvement in 2009. Although the government has not officially encouraged
private investments in gold, but the central bank has been approving gold imports,
according to the World Gold Council. Industry observers noted a big jump in delivered gold
import through the local gold exchange, and an increase in volume of gold being traded.
Gold demand in China gained in the 1H2010 as the government set measures to cool down
the over-heating property market and falling equity prices, spurring the move into gold.
About 70-80% of the gold imported in first 10 months of the year was made into mini gold
bars or wafers, which are favored by Chinese investors. China’s inflation showed a sharp
hike (Oct 2010 its CPI jumped 4.4%), the fastest pace in two years and above the
government’s target of 3%. As a result, Chinese are buying more gold to hedge against
inflation as the country’s tightening monetary policy drives money out from properties and
stocks, into gold. China imported 209 tonnes of gold in first 10 months compared to 45
tonnes for all of 2009 (an increase of five folds).

Moving forward, the demand for gold as investment will be rooted in factors such as
concerns over the continued U.S dollar devaluation, hyper inflationary expectations,
continuing high levels of geopolitical uncertainty and increased acceptance that gold can
play a vital role to diversify an investor’s portfolio.

3. Industrial demand
Gold has a long and fascinating history of use in a diverse range of industries and
applications. Demand for gold from industrial use currently accounts for around 11% of
total demand with around 400 tonnes consumed per year. In the future, we are likely to see
gold being used in many other new industries, thus driving demand further. Gold is used in
the following industries: namely electronics, medicine, nanotechnology, and space and
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Due to its high electrical and thermal conductivity, gold is used extensively in electronics. It
is the single largest industrial application for gold. It is the metal of choice for numerous
electronic applications, especially telecommunications, information technology and other
high performance and safety critical applications. Moreover gold never corrodes, making it
highly resistible to tough weather conditions and this property is essential in electronic
components. The demand for gold in electronic components has increased greatly in the last
ten years, but fluctuations in demand are also seen as manufacturers cope with rising prices.

The use of gold in medicine and dentistry dates back thousands of years. This unique
resistant metal has long been associated with gods, immortality and health. The earliest
recorded medical use of gold was by the Chinese in 2500 BC. Since then numerous cultures
have utilized gold-based medicinal preparations for the treatment of various conditions
including small pox, skin ulcers and measles, for example Ayurvedic medicines on the
Indian sub-continent, where gold is ingested with herbs to promote vitality. Millions of
Indians consider gold to be an excellent ‘rejuvenator’, and consume it regularly. A typical
daily dose of gold would include one or two milligrams in a mixture of herbs. Ayurvedic
use constitutes a significant source of demand for gold, which some commentators estimate
to reach a few tonnes of gold per year. Gold is also used in dentistry due to its bio-
compatibility malleability and resistance to corrosion. The need for biocompatibility in part
relates to corrosion resistance. When the alloy is placed in contact with the patient’s body,
there should be no detrimental health issues. Dentistry demand contributes about 2% of the
overall industrial gold demand. This demand has been considerably stable in the past
decade. Dental alloys using gold is manufactured predominantly by USA, Germany and
Japan.

For the longest time, researchers have investigated gold compounds to cure ailments. It has
been used to treat rheumatoid arthritis with the most widely used drug called Auranofin
which is taken orally, and over the years, gold has also been used as possible treatment of
cancer. Gold offers a high degree of resistance to bacteria, making it the material of choice
for implants which are at risk of infection, such as the inner ear, or in eyelids. In addition, it
is also used as stents in arteries for heart surgery.

Gold is also used in the art industry, as gold threads are used in decorating arts. Gold plating
and gold coating is given to various artistic pieces to preserve the nature of the art and
retain its beauty. The optical industry too uses gold as it reflects heat and laser. All these
other industries uses contribute to 2-5% of the total gold demand.

Recently researchers have uncovered new uses of gold in the latest technologies, for
example, gold can be used as a catalyst in various chemical processes. Industrial grade
catalysts based on gold can deliver superior performance. Nanotechnology, a rapidly
developing field is revealing several unknown uses of gold. This means that industrial gold
demand will likely continue to increase in the future.
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