The world’s gold bugs are going to be sadly disappointed by the current round of economic turmoil. Instead of boosting their favorite metal’s price, the recent changes in the world’s economy are going to drive gold prices down a lot further.
How China Threatens the Gold Market
The biggest threat to gold prices comes from China, where the collapse of the Shanghai Composite and the decline in manufacturing has triggered an economic meltdown. This is bad news for gold for three reasons:
- Chinese will simply have less money to buy gold with. That’s bad because China is already one of the world’s biggest buyers of the yellow metal. Forbes contributor Frank Holmes even believes the Chinese might be buying more gold than the world is producing. Chinese buying drives much of the demand for gold; if that falls, the demand falls and so does the price.
- Chinese might start selling gold to make up for stock and real estate market losses or to use the proceeds of gold sales to buy cheaper stocks and property. If Chinese start dumping large amounts of gold on the market, the price will fall.
- The Chinese government might move to shut down the gold market or ban gold transactions in an attempt to force money into other markets if things get really bad. One reason why the People’s Republic would make that move would be to keep people from removing money from circulation by converting it to gold, a move that encourages deflation. Were that to happen, one of the world’s biggest gold markets could disappear, leading to an almost total collapse in gold prices.
Such a drastic move has a strong historical precedent; U.S. president Franklin D. Roosevelt did something similar with Executive Order 6102 on April 5, 1933, in an attempt to relieve the effects of the Great Depression. That order effectively banned the private ownership of or trade in gold bullion in the United States for nearly 40 years. Since the People’s Bank of China and the Communist Party seem to share the classical Keynesian economic philosophy as FDR, this is a strong possibility.
Oil and Gold
A more immediate threat to gold values is the price of oil, which is falling. The spot price for Brent Crude on August 24 was $41.59 a barrel, down from $59.41 as recently as June 19. Oil has actually lost 58.45% of its value in the last year; in August 2014 Brent Crude was trading for $100.09 a barrel.
The oil price collapse threatens gold because people in oil-rich countries like Saudi Arabia are major gold buyers. As oil prices fall, they will have less money to buy gold with and an even stronger incentive to dump gold onto the market to make up for oil losses.
Another problem is that countries like Russia, which is a major producer of both gold and oil, might ramp up gold production in an attempt to make up for oil losses. Something to remember is that the high markup on gold means it you can make money mining and selling it even if the price is fairly low.
Lower Gold Prices Increased Gold Production
This brings us to the final and in some ways most perplexing dilemma facing gold investors. Lower oil prices means lower fuel prices, which means mining will get cheaper. Most of the work in modern gold mines is done by diesel-burning machines such as power shovels and bulldozers.
Cheaper diesel fuel means that mining will be cheaper, which gives miners a strong incentive to dig more gold ore. That also increases the supply, which will further drive down the price. When the gold price falls, miners may need to increase production to cover costs and to make a profit, which pushes the price down even more.
This creates a vicious cycle that is hard to escape. The price falls, forcing miners to increase production in order to maintain their profits. Lower fuel prices drive the cycle because decreased costs make it easier to increase volume and profits for miners. Remember, miners make their money by selling gold; the more they sell, the more money they make.
Mining companies also have to maintain a certain level of production just to cover their costs. If the price of gold keeps falling they will be forced to dig more ore just to pay the bill. That of course can drive the price down by increasing the volume of gold in the market.
The worst case scenario here is that gold could end up on the same downward spiral as oil. Prices fall, forcing producers to drill more just to meet their costs which causes prices to fall faster and further. For gold it would mean miners raising production and flooding the market with more and cheaper metal. Mining companies would then have to keep lowering prices just to stay in business.
It looks as if falling gold prices could be a fact of life for the foreseeable future. That is going to lead to a world of hurt for gold miners, investors, and gold bugs.