Fool’s Gold

What is gold really worth? Not Fool’s Gold, but real gold but you would be foolish to buy gold if you didn’t understand what really drives it’s price.

You can’t eat gold, it won’t keep you warm at night, it produces no income, and it has limited industrial use. Sure it looks pretty and it’s considered precious but it has little practical use other than an alternative currency. But how useful is it even as an alternative currency if very few people have physical possession of it.

Gold is a commodity that is traded no different than oil, corn, wheat, or pork bellies and all commodity prices are driven by supply and demand. Unlike other commodities, very little gold is consumed. It may change shape and change ownership but most gold will remain on this earth forever.

It is estimated that all the gold ever mined totals 174,000 short tons and new gold mined is approximately 2,000 tons a year. Subtract the small amount of gold that is consumed and the global supply of gold increases only about 1% per year. So the supply side of the equation is very stable.

So the only true driving force in gold pricing is demand. But if it has no practical use other than the relatively small amount used in jewelry and industry what drives demand?

Fear! When risk becomes too high in other investments money moves to gold as a “safe haven”. But when risk declines money moves out of gold and back into traditional investment markets. Since we’ve already established that supply is a negligible factor and we can’t measure fear directly the only measurement remaining is the price of gold itself.

Starting in the lower left corner in the chart below you can see that gold rose from $100 in 1976 to nearly $900 in 1980. During this period we went through a double dip recession, hyperinflation, double digit unemployment, and the 1979 Energy Crisis driven by the Iranian Revolution. Fear was rampant during this time in our history. I know I was there. After 2 years of struggling to find a good job I joined the Air Force in 1981.

Click on the Chart for a Larger View.

Gold

Little did I know at the time, that fear was beginning to subside in 1981. By 1985 gold had dropped to $300 and remained in the $300 to $400 range for nearly 20 years. Anyone buying gold to hold in 1980 suffered a severe loss that lasted 25 years.

The “DOT COM” stock market crash of 2000/2002 and the Twin Towers attack in 2001 sparked a new era of fear fueled further by the Great Recession and Global Financial Crisis of 2007/2008.

Gold rose from $300 in 2002 to nearly $2,000 in 2011 but has weakened significantly since. Is the era of fear coming to a close? If so, gold could drop to a “Hibernation Range” and stay there for many years. The average cost to extract gold out of the ground is about $700 per ounce. That being said, I would expect the “Hibernation Range” to be somewhere around $1,000.

If you are a pessimist on the near future of the global economy this may prove to be a good time to buy gold. But if you are an optimist and currently own gold or gold mining stocks it may be time to re-evaluate the risks of owning gold.

Following are a few quotes on gold from billionaire investor extraordinaire Warren Buffet:

Warren Buffet

1. “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

2. “The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you….it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.”

3. “Gold is a way of going long on fear, and it has been a pretty good way of going long on fear from time to time. But you really have to hope people become more afraid in a year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money, but the gold itself doesn’t produce anything.”

4. “I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion – that’s probably about a third of the value of all the stocks in the United States…For $7 trillion…you could have all the farmland in the United States, you could have about seven Exxon Mobils (XOM) and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I’ll take the farmland and the Exxon Mobils.”

5. “The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.”

6. “What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As ‘bandwagon’ investors join any party, they create their own truth — for a while.”