The Gold Market is Broken Which Means a Rally Could Be Near

Demand for physical gold continues to exceed supply but the gold price keeps falling.

Apr 11, 2014 at 12:41PM

Gold has had an interesting year to date. Thanks to the Russian crisis and subsequent geopolitical tensions, the price of the yellow metal rallied 17% to a high of around $1,400 per ounce after entering the year at around $1,200.

However, now that the Russia crisis has deescalated, the price of gold has fallen back to the $1,300. Looking at it further, these price movements tell a completely different story to physical gold sales.

Indeed, although the price of gold continues to slide, demand for physical gold continues to rise and supply keeps falling. With this being the case, it would seem that the gold market is heading for a reversal, making industry-leading miners such as Barrick Gold (NYSE:ABX) and Newmont Mining (NYSE:NEM) as well as industry leader by market capitalization Goldcorp (NYSE:GG) look attractive.

Demand exceeds supply
Currently, I'm not much of a gold bull. However, developments in the gold market are starting to make me think otherwise.

First of all, at the end of last year, volume of gold flowing into China reached record highs; there was also a 500-tonne gap in China's gold-consumption data -- that's right, 500 tonnes of gold went missing. In dollar terms, that translates into about $23 billion worth of gold. At the time, there was speculation that the Chinese central bank swelled excess demand, panic buying, and stockpiling.

Aside from this stockpiling speculation, China's reported gold imports hit a new high of 109.2 tonnes in February, a month-on-month rise of 30%; year-on-year, gold imports have surged 79%!

Iraq has also been stockpiling the precious metal, buying 36 tons during March -- a dollar value of around $1.5 billion. 

India's gold imports have also surged, rising by more than 100 tonnes during full-year 2013. On top of this, despite stringent import and trading restrictions, "unofficial imports" almost doubled according to some estimates. 

Taking these factors into account, I'm looking to invest in the gold mining sector as demand for the yellow metal continues to rise. However, to limit my risk, I'm only looking for industry-leading, low-cost producers boasting high quality assets.

Working hard but progress is slow
Barrick Gold has been the poster child of gold industry excesses that have occurred during the past few years. In particular, rising debt, disproportionate levels of executive pay and bloated capital spending budgets ultimately resulted in a collapse in company profits.

However, the company has actually made some really great progress trying to restructure its operations during the space of the last year.

For example, during the past year Barrick has reduced capital spending and operating costs by about $2 billion and announced agreements to divest six high-cost, non-core mines and other assets for a total consideration of almost $1 billion. The most recent move by Barrick to streamline operations and reduce costs was the divestment of the company's 33.3% interest in the high-cost Marigold mine, which is jointly owned with Goldcorp.

Management currently predicts that Barrick's all-in sustaining cost of production, or AISC, per ounce of gold produced is expected to be in the region of $950 during 2014. The company is expected to produce 6.5 million ounces of gold at the high end during 2014, 10% below 2013 production of 7.2 million ounces. 

Good progress
Meanwhile, Newmont is also working hard to reconfigure its operations.

Newmont divested $600 million of non-core assets throughout 2013 and has bumped up gold production estimates for 2014. Specifically, Newmont's management believes that the company will produce 5 million to 5.3 million ounces of gold during the year, compared to 5.1 million ounces produced during 2013.

Further, Newmont is targeting an AISC per gold ounce of $1,075 to $1,175, below the $1,100 to $1,200 figure reported for 2013. Cost cuts are also set to continue throughout 2014 as the company plans to reduce operating expenses by 20%.

Still, Newmont is facing some tax issues in Indonesia, where the government has decided that it will place a 25% tax on any unprocessed materials leaving the country, this tax rate rises to 60% by year end 2016. It is rumored that the government is reconsidering this tax, but in the meantime, Newmont has curtailed output. This might have an effect on the company's 2014 output forecasts which should be revealed within first quarter results. 

Best of breed
One company that has been behaving itself during the past few years is Goldcorp. Indeed, Goldcorp has kept its spending and expansion plans under control during the past few years, and as a result, the company is much more efficient than its larger peer Barrick Gold.

Goldcorp is predicting that its AISC will drop to less than $1,000 per ounce during 2014; gold production is also expected to increase around 13% to 18% for 2014.

That said, the company is having some operational issues around the world, notably its hostile takeover of Osisko mining, which now seems unlikely to go ahead. Additionally, Goldcorp has suspended operations at the Los Filos mine in Mexico, pending renewal of a land occupancy agreement. Goldcorp's first quarter results are worth keeping an eye on for any outlook adjustments. 

Foolish summary
So all in all, it would appear that as physical gold demand continues to rise, the yellow metals price is set for a move higher. The best way to play this would be with Goldcorp, easily the most efficient of the companies above.

That said, investors should keep an eye of Goldcorp's first quarter results to see what effects the company's global setbacks are likely to have on output and profits for the year. 

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Rupert Hargreaves 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.

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