Is Gold Making a Comeback?

Lior is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Gold and leading gold ETF SPDR Gold (NYSEMKT: GLD) have recently rallied, but they haven’t performed well during most of the year: During 2013, the price of gold declined by 23%; the price of the ETF fell by 22.9%. Moreover, SPDR Gold's hoard plummeted by more than 30%. Is gold making a comeback? Is it time to reconsider investing in this precious metal or gold companies?

One of the main concerns for investors who purchase an ETF that follows a certain commodity is the contango/backwardation in the future contracts that could lead to decay and thus slash the profits of investors who purchased these ETFs in case the commodity rose during the period. The chart below shows the normalized prices of gold and the ETF during the past year.

<img alt="" src="http://g.fool.com/editorial/images/58522/gold-and-gold-2013_large.jpg" />

As seen, the two data sets are closely linked and in sync during the period. This means the ETF didn’t experience roll decay. For a good explanation of ETF decay you can check out on Fool’s site.

One factor that could determine the future course of gold is the Fed’s next move.

Will the FOMC ease its asset-purchase program?

During the year (year-to-date) the Federal Reserve has been purchasing $85 billion of mortgage-backed securities and long-term Treasury bills. This program kept long-term interest rates from rising at the beginning of the year, but in recent months long-term rates have sharply increased. One reason for the sharp rise in rates is the strong hint the FOMC and Ben Bernanke provided:  Bernanke hinted that the Fed may taper its asset-purchase program in the coming months and end it by the first half of 2014. How does this relate to gold prices?

  • The asset-purchase program augments the U.S money base, which raises the concerns for inflation. Gold is still considered by many as a safe haven investment against inflation.
  • Long-term Treasury yields and gold tend to be correlated. The drop in long- term Treasury yields led to a rise in demand for gold as stipulated from the Hotelling model (Paul Krugman explains this relation on his blog.) If the Fed slows down its asset-purchase program, the long-term interest rates will continue to rise, which may pressure gold price lower. The chart below shows the developments of the long-term Treasury yields and the price of gold in the past couple of years. As seen, the price of gold tumbled in the past month while long-term Treasury yields sharply rose.
    <img alt="" src="http://g.fool.com/editorial/images/58522/gold-july-2013_large.jpg" />
  • The asset-purchase program may have pressured the US dollar against leading currencies, which could have also kept the price of gold from falling.

But the Fed continues to provide different perspectives regarding its next move. Therefore, the high uncertainty with respect to the FOMC’s monetary policy is likely to keep volatility in the price of gold high in the coming months.

Looking further into the near future, given the ongoing progress of the U.S economy and forthcoming changes in the Fed’s monetary policy, the price of gold is likely to resume its downward trend. But the U.S isn’t the only one that affects the price of gold. Let’s turn East.

China and India

Despite the recent developments in the U.S, the demand for gold (the physical metal) continues to rise:  China’s gold imports are rising; the tax hike on gold imports in India has curbed the demand for gold in this country, but so far this year India’s gold demand is much higher than it was last year. Moreover, the recent pullback in the price of gold is likely to grow the demand for gold in these countries. The strong demand for gold is likely to keep the price of gold from tumbling further.

Gold producers

The recent drop in the price of gold is likely to substantially slash the profit margins of gold companies. Gold producers such as Newmont Mining (NYSE: NEM) and Yamana Gold (NYSE: AUY) haven’t done well in the stock market during 2013 – despite their more recent rally. During the year, shares of Newmont Mining plummeted by 38%. The stock price of Yamana Gold plunged by 39%. One factor that will determine these companies’ profit margins is the cost of producing gold.

Cost of production

The direct cost of production for these companies is expected to rise in 2013 compared to 2012. Specifically, Newmont estimates that its all-in sustaining cost of production per ounce of gold will range between $1,100 and $1,200 this year. The company projects its total gold production will range between 4.8 and 5.1 million ounces, which isn’t far from the total production recorded in 2012 – slightly less than 5.0 million ounces. Moreover, at the current pace, the company’s 2013 gold production might even be below 4.8 million ounces. Since the current price of gold is roughly $1,300 per ounce, Newmont is likely to further slash its production.

Newmont has already taken measures to cut down on operational expenses: The company recently announced it will cut its workforce in Colorado by one-third.

For Yamana Gold, production costs are lower: The company estimates its all-in sustaining cost of production per ounce of gold will reach $800 in 2013. Such a low cost of production should be reflected in the company’s profit margin.

In the first quarter of 2013, Yamana’s operating profit was 30%, which was higher than Newmont’s profit margin of 26.5%. Yamana also estimates its gold production will rise by 20% in 2013 compared to 2012. This means Yamana may not suffer as much as Newmont this year.

Nonetheless, if the price of gold dwindles below $1,000, these companies might start losing money and thus might be better off not extracting gold.

Takeaway

Gold's recent rally might continue in the near future, but I still think that neither gold nor gold producers are about the make a comeback. Moreover, if the price of gold resumes its downward trend and falls below $1,000, gold companies could start losing money and might be better off leaving the precious metal underground.

For further reading:

Gold and Silver Outlook for July

Will Gold Recover from its Recent Fall?

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Lior Cohen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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