How $2,250 Gold Comes Into Clearer View

Although gold knocked on the door briefly during 2011, I am waiting until my long-standing price target of $2,000 per ounce is finally breached before I revise my conservative long-term price objective. In the meantime, my uninterrupted gaze across the gold market's fundamental landscape sees a steady trend toward de-risking of the $2,250 mark as a very conservative basis for a follow-on target.

I have discussed on countless occasions the key macroeconomic trends supporting sustained appreciation in the gold price, and I am well aware of just how contentious a topic it can be. But the fact is that investment demand for gold continues to expand, particularly in the East, where China is poised to surpass India as the world's foremost source of gold demand. Global mine supply, meanwhile, is struggling to keep up in an atmosphere of rising production costs, escalating mine-construction costs, and diminishing frequency and scale of new world-class discoveries.

Although the gold-price outlook can never be divorced from prevailing macroeconomic trends, I spot $2,250 gold coming into clearer view through a comprehensive examination of mining-industry fundamentals. The world's largest gold miner -- Barrick Gold (NYSE: ABX  ) -- released its quarterly and annual results this week. Although I am not a shareholder, I continue to track Barrick very carefully as an effective harbinger of emerging industry dynamics. Barrick delivered another solid year in 2011, growing adjusted net earnings by 33% despite essentially flat production volume year over year. And by replacing the year's production of 7.7 million gold ounces to stand with nearly 140 million ounces of gold in reserves, the company reminds observers that meaningful volumes of gold can still be found ... but at what cost? For those interested on forecasting the gold price trend, that is the question to ask.

Observable cost inflation
Barrick's total production cost for 2011, which accounts for depreciation and other items, rose 14% year over year from $552 to $630 per ounce. The less inclusive total cash cost of production came in at $460 per ounce, or 12.5% higher than the year before. For 2012, Barrick is targeting a further increase of between 13% and 22% for a targeted cost range of $520 to $560 per ounce. And this is from the producer with a massive edge in terms of economies of scale over its smaller competitors. To make a long story short, the industry is experiencing significant upward pressure on operational cost structures.

At the same time, capital costs for mine construction are going through the roof. The conceived price tag for construction of NovaGold Resources' Galore Creek joint venture with Teck Resources (NYSE: TCK  ) has increased by 373% since 2006 to reach a whopping $5.2 billion. The estimated cost to construct Barrick's 75%-owned Cerro Casale project in Chile has tripled since 2007 from $2 billion to $6 billion. Kinross Gold recently opted to reassess its entire growth pipeline in response to severe rates of cost inflation. In my recent interview, Thompson Creek Metals (NYSE: TC  ) CEO Kevin Loughrey lamented, "We are living in a world where mining projects are expensive to build and getting more expensive."

The rising long-term floor beneath gold prices
The all-in cost of gold production is a crucial metric for establishing just where the floor beneath long-term gold prices stands. As the long-term breakeven price for the mining industry, it represents a price level below which new mine supply to replenish existing production will tend not to come online. Fools may recall that discussions of industrywide all-in costs in the range of $700 to $800 per ounce back in 2008 proved very instructional in forecasting the range in which the cascading gold price would ultimately recover its footing.

Taking into account the substantial trailing cost inflation, would you believe that the industrywide all-in cost of gold production today is already trending closer to $1,200 per ounce? In a recent interview with Mineweb's Geoff Candy, AngloGold Ashanti (NYSE: AU  ) CEO Mark Cutifani corroborated another recent estimate by IAMGOLD (NYSE: IAG  ) CEO Stephen Letwin that places the all-in cost of production for the industry at about the $1,200 mark. Cutifani states: "The average cost to produce an ounce of gold, all up, everything loaded, is about $1,200 to $1,250." However, reminding observers that the industry cost of capital belongs in the equation, he adds: "$1,650 is only just returning the weighted average cost of capital for the industry. So for the industry to keep its nose above water and even hold the current production base, I think $1,650 is a minimum gold number that we need to work from on a real basis."

For the millions of gold skeptics out there who perceive the current gold price as a wildly inflated speculative bubble perched above a cavernous lack of fundamental footing, Cutifani's well-informed perspective must give one a moment's pause to consider that the price is barely sufficient to maintain existing production volume. Cutifani goes on to forecast an annual gold-price increase of "about $150 a year over the next four or five years." From the baseline of $1,650, this perspective results in an outlook for $2,250 gold within about a four-year timeframe. When gold does finally surpass the $2,000 mark, I look forward to issuing a new target at that time, and certainly Cutifani's view from inside the gold-mining industry will inform that deliberation process.

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Fool contributor Christopher Barker can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets. He owns shares of IAMGOLD, Kinross Gold, Teck Resources, and Thompson Creek Metals. We Fools don't 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.


Read/Post Comments (9) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 18, 2012, at 11:49 PM, talan123 wrote:

    Isn't gold supposed to be a safe-haven investment? Meaning that you invest in it so that when everything else goes wrong, you can still draw down on it? Placing bets on it kind of defeats the purpose of "safe haven."

    ETF gold demand dropped 58% in 2011 from 2010 which means people are starting to smart up to the fact that gold is overpriced. Paulson & co just dumped $600 million worth of gold. Production meanwhile is at around 2,700 Tons a year.

    I like how buffet put it using an example of taking the world's gold supply at current prices: "Let's now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?"

    A gold price of 28% increase like the author is suggesting, you would have $12.29T. You are starting to approach the GDP of the United States in that figure.

    Gold is also showing the classic signs of a bubble:

    Greater fool theory where people are following each other off a cliff in order to get a better price, Extrapolation is taking a hold of people (gold has done x in 5 years and you are a fool to do so!), Herd behavior is also there with the sheer amount of gold scams and gold investment commercials (Glenn Beck anybody?).

    Gold is meant to be a boring asset that is supposed to keep up with inflation if nothing else. The fact that there is so much talk about Gold and where it is going should be a gigantic clue (think about housing and the internet stocks) about what is going on in the market.

  • Report this Comment On February 19, 2012, at 12:02 AM, ath002 wrote:

    Hi Talan,

    There are a number of ways of looking at it, regarding the bubble. About 2 months ago I, together with 19 other owners of companies was invited to lunch with our bank CE.

    At the table I asked for a show of hands from anyone that owned gold or gold investments. No one did. so far from the situation where even the shoe shine chap owns gold, these supposedly clued up and well off individuals are not considering gold. This in a country, South Africa, where gold is a inextricably linked with our history.

    Just a thought, best to you. L

  • Report this Comment On February 19, 2012, at 12:34 AM, talan123 wrote:

    A couple of my thoughts (which that and $4.50 will get you a cup of Starbucks coffee...)

    Scrap recycling of gold has gone up almost 70% from 2007 and it was going up every year until recently. The producers are expecting prices to go down.

    Jewelry fabrication, Computer manufacturing gold consumption are down from last year. Jewelry is approaching a 20 year low because it is so expensive.

    All of this is pointing to the fact that the price of gold is too high.

  • Report this Comment On February 19, 2012, at 12:39 PM, JakeJT wrote:

    talan123,

    Funny how you do not understand the gold market at all. I honestly don't feel like teaching you. Anyways. By the way, what you are saying is exactly what people have been saying for 10 years. Haha. And gold bubble ? HAHA. You probably have ZERO education in economics nor investment for such a comment.

  • Report this Comment On February 19, 2012, at 1:32 PM, talan123 wrote:

    "Anyways. By the way, what you are saying is exactly what people have been saying for 10 years. Haha. And gold bubble ? HAHA. "

    Yeah, this comment is pretty much the entire problem with investing right here.

    Every single time a market starts to bubble up, like housing, you see all kinds of people saying that this time it is different. "Housing has not gone down on national level since the great depression!"

  • Report this Comment On February 19, 2012, at 4:47 PM, JakeJT wrote:

    talan,

    Do your homeworks and read more about the last assets bubbles. Read the criteria for asset bubbles. Read, read, read. After we can talk.

    And what I meant with my comment about what people have been saying for 10 years is that people, like you, didn't understand gold 10 years ago, and those same people still don't. But that is changing, slowly.

    By the way, I'm not a gold bug. I just happen to invest in gold amongst other things because I understand the gold market.

    Good luck.

  • Report this Comment On February 20, 2012, at 12:54 PM, MoneyWorksforMe wrote:

    @ talan,

    What do you make of these charts? lol

    http://www.ritholtz.com/blog/2012/01/living-in-a-qe-world/

    Jake, you can't do anything but pity these people...I've been hearing bubble talk since I got in a few years ago at silver $18/oz. and gold around $1000/oz.

    I heard the same arguments from the same types of people i hear now. And what do all these skeptics focus on? Price. That's all they know and the only argument they think they need to be able to accurately diagnose a bubble.

  • Report this Comment On February 20, 2012, at 1:53 PM, XMFSinchiruna wrote:

    MWM,

    That's not accurate in this case. While I do vehemently disagree with his conclusions, Talan is to be credited for at least taking the time to look up the World Gold Council's latest report on supply and demand. That's a better effort than I've seen from the majority of the gold bears out there. Holders of diverse perspectives and opinions are welcome here, which is one of the greatest features of The Motley Fool's community.

    Talan,

    Thanks for sharing your thoughts. I do disagree entirely with your conclusions, but I appreciate the discussion.

    I find Buffet's analogy very strained indeed. Pointing out the tremendous portfolio of assets one could purchase with the global supply of gold does not challenge its efficacy as a competing global currency, an enduring store of value, or a strategic hedge against paper currency devaluation or systemic risk in the global economy. To the contrary, the meaningful purchasing power of gold as the world's primary hard currency speaks to its enduring relevance despite all manner of official efforts to leave it behind.

    Also, given that Buffet once cornered 37% of the world's above-ground supply of silver, his oft-cited remarks on gold are strangely at odds with his precious metals investment history. And besides, I'm still waiting for his pal Mr. Munger to apologize for this unacceptable character assassination directed at gold investors.

    http://www.fool.com/investing/general/2010/09/29/take-it-bac...

    Gold is money. To reveal the weakness of the analogy, one need only replace gold with dollars to illustrate the underlying illogic. But for those who fail to understand that gold is still money, as corroborated by former Fed chair Alan Greenspan, I can see how Buffet's analogy might offer comfort to those still eschewing exposure to the metal.

    http://www.fool.com/investing/general/2009/09/23/biggest-mar...

    I would like to address other portions of your comments, as time allows.

  • Report this Comment On February 21, 2012, at 11:12 AM, DJDynamicNC wrote:

    Well, consider me grudgingly convinced.

    I've avioded gold and I'll probably continue to avoid gold, but these are good points.

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