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Global Outlook

Commodities Will Rise From Their Slumber

December 20, 2013, Friday, 17:35 GMT | 12:35 EST | 22:05 IST | 00:35 SGT
Contributed by eResearch

Gold may be slumbering but, when it awakens, watch out. Ignoring the case for a virtually certain massive surge in the metal, although the timing is uncertain, would be akin to overlooking the kind of move I like to call a “mate-in-one” (see Leeb Market Forecast, Nov. 11, 2013). If you are an investor, do not make that tragic mistake.

A big reason we remain so confident that gold will head dramatically higher hails from China. Today, it is no secret, China is the world’s No. 1 gold buyer. In October, that nation bought a near-record 130 tons, bringing its total 2013 gold purchases, through October, to more than 950 tons. For the year, 1,150 tons is a likely figure, which will far exceed past gold-buying records for any single country, including gold-crazy India. Moreover, these numbers cover only the readily trackable gold that passes through Hong Kong. China almost certainly imports additional large amounts through other conduits.

Probably the most important, and overlooked, aspect of China’s gold activities is its huge amount of gold mining. According to the latest data (from the U.S. Geological Survey), China is not only the largest gold producer, mining about 400 tons a year, but also mines roughly 20% of its in-ground reserves a year. That is far and away the largest portion of any mineral or commodity reserves mined by any country worldwide. Even 10% would be exceptionally high.

The implications are astonishing and suggest that, over the long term, gold prices will head many times higher than current levels. It does not matter if gold bottoms out around here or first moves 10% lower, the calculus does not change. The clock is ticking on what could prove to be the mother of all bull markets. Moreover, it will likely be accompanied by the resumption in bull markets in most other commodities as well. And, sadly, it could mark the effective death of the dollar.

Before parsing the above mining numbers, it is important to understand how the Chinese think. Compared to Westerners, they tend to think along much larger time horizons, leading them to see the big picture. Fascinating psychological studies show this to be literally true. These works compare what Asians and Westerners see when they look at a painting. Westerners tend to focus on the center of the painting, the main theme. The Chinese and other Asians give just as much attention to what goes on outside the center, striving for a broad understanding of the artist’s perspective.

To express it another way, the attitudes differ sharply, one being “let’s get to the point” and the other, “let’s make sure we get to the right point.”

Now to why these mining numbers look so significant to us. One of the first formulas learned in any introductory finance course calculates net present value. For example, if a company invests $1 million in a new factory, the formula helps determine the value of that investment considering total profits to be contributed by the factory over its lifetime. Such calculations help determine which projects a company will pursue.

Investors can find the exact calculations and formulas on the Internet. The calculations all consider a stream of earnings from a project in which, the sooner it earns money, the more the money counts. In other words, getting $100 today should be worth more than a promise of getting, say, $120 in 10 years.

Intuitively, that might sound right, but is it always true? What would happen, for instance, if the future profits of a project were greatly enhanced by undertaking a particular effort today? As we noted, for a country to mine 10% of its gold reserves is a lot (according to the U.S.G.S., the world mines around 5% of its gold reserves annually). One reason not to mine more is that per-ounce costs rise as companies dig deeper or develop new sites with less dense, lower grades of ore. Indeed, the value of any commodity or mineral reserves relate directly to the price of the mineral in question.

U.S. miners typically use a three-year moving price average to decide whether to proceed with a mine. By comparing the three-year average of a mineral’s price with its cost of production, they can estimate initial returns. Going forward, they generally make some simplistic projections of the mineral’s future price.

To forecast future prices, Western miners seldom, if ever, deviate much from the three-year moving average. If prices have climbed dramatically, Western miners generally assume they will deflate. They further assume that the price of the mineral mined will fairly closely correlate with the costs to expand the mine. So the critical piece of information is the initial comparison between costs and the price of the mineral.

While Western miners look to the immediate past to make long-term projections, China approaches things differently. That nation considers many commodities and minerals “strategic”, i.e., necessary building blocks to ensure future national prosperity. If mining costs for these strategic minerals rise, regardless of their total cost, China views the minerals as scarce and, therefore, worth mining, and the sooner the better.

Suppose, for example, that copper prices are falling, along with costs of most inputs it takes to mine copper, but copper mining costs are rising. The only reasonable explanation is that the copper in the ground is growing more scarce, making it necessary to mine increasing amounts of ore-containing earth to obtain the same volume of copper. In mining terms, this means that the grade of copper is declining.

The McKinsey consulting firm recently published a report suggesting that grades of many critical commodities and minerals are continuing to decline. This implies that the decline in commodity prices since 2011 notwithstanding, the bull market in commodities is far from over.

This helps explain why China is mining so much of its copper, coal, and other commodity reserves as quickly as possible. Clearly, it would avidly accumulate as much of the commodities as possible today, even at substantial losses, to be assured of an ability to proceed in countless future projects essential to the country’s long-term well being.

This does not explain, though, China’s strong emphasis on gold. After all, only about 15% or so of the world’s gold goes into industrial use, and substitutes are available for that 15%. Yet as indicated by the percentage of the Chinese gold reserves it mines, the country almost certainly suffers huge current losses.

Indeed, many companies lose money when mining only about 5% of their reserves. Gold is a commodity rapidly getting more scarce. Though precise estimates are unavailable, no one would think it crazy to assume China spends well over $2,000 an ounce to mine 20% of its gold reserves, and possibly far more for some reserves.

Either the Chinese have lost their minds, or they are mining gold, despite its paucity of industrial uses, due to its value as a strategic metal. That would be true only if one considered gold to be a monetary metal.

From China’s perspective, this makes perfect sense. If so many other commodities and minerals are destined to grow increasingly scarce, one needs a plan to buy them. Down the road, no-one will exchange a scarce commodity for paper money. They will insist on payment with some other scarce commodity. The Chinese clearly believe some form of gold standard is in our future.

In 1944, Bretton Woods set the stage for the last gold standard. It established a postwar monetary system in which the dollar was convertible into gold, and other currencies convertible into dollars. One reason the U.S.A. got the long straw was that we had the most gold, about 8,000 tons. With inflation rising, President Nixon ended the gold standard in 1971.

Next time around, China will want to take America’s place, and by having the largest hoard of gold, it can most likely call the shots. Also likely, if gold plays an active role in the exchange of scarce commodities, its price will rise dramatically from current levels, and we do mean dramatically. In the commodities bull market that began to take a breather in 2011, gold outperformed other commodities by a considerable margin. That 11-year period likely gives just a hint of what lies ahead.

Our only caveat: the underlying premise assumes that China will continue to grow. For those convinced that China’s so-called “overbuilding” signals a coming slowdown or crash in its economy, please note, at least a significant portion of this putative overbuilding involves construction of infrastructure to create and expand mines.

Any assumption that the dollar will lose part, or all, of its reserve currency status, and gold reassert itself as a monetary metal, provides a strong argument for major economic changes in the U.S.A., with virtually all commodities surging and gold at the head of the line.

Thus, it is essential for investors to treat even the fairly sharp and admittedly frightening dip in gold prices as an exceptional buying opportunity. Ditto for other commodities that have held up much better than gold.

Commodity exchange traded funds (ETFs) including SPDR Gold Shares (GLD) and iShares Silver Trust (SLV).