What Is Driving Up the Price of Gold?

Emilie Rutledge

Last week, oil has been trading at historic high prices, and oil futures on NYMEX have closed at over $75 per barrel. We have passed the northern winter spell, and have yet to move into the US driving or hurricane seasons. At this time of year, oil prices usually tend to dip in line with reduced demand, but this is clearly not happening. If you factor in geopolitical concerns, such as instability in Nigeria and uncertainty over America’s intentions toward Iran, oil prices still have the capacity to rise further in coming months. China’s and India’s meteoric growth will mean that demand for oil will remain strong even if prices rise higher. On a similar trajectory, gold prices have also been rising, and have increased by over 20 percent so far this year. Gold prices touched $680 per ounce last week, their highest levels since November 1980. Gold tends to be seen as a “safe haven” for investors when they fear other monetary assets will lose value, often because of inflationary pressure or threat of war. Therefore gold prices tend to rise when the global economy is unstable and inflation is high. Presently though, and despite high oil prices, the consensus is that global inflation is under control. This view is backed up by the fact that interest rates are also low globally. It seems that central bankers do not fear imminent inflation. So what exactly is driving up the price of gold? It may be because other metals are rising, but unlike copper and aluminum, for instance, gold is not integral to industrial growth. The bull market for gold could also in part be a consequence of the weakening US dollar and America’s unenviable and widening trade deficit. The question many economists are now pondering is to what extent, if at all gold is overvalued. The US dollar has fallen by about 3 percent so far this year against a basket of six other major currencies, and it is becoming apparent that investment funds are looking to hedge themselves against a weakening US dollar. They are doing this partly by investing more capital in commodities at the expense of US Treasury bonds. A lot of demand for commodities is a result of the fact that currencies in general are “losing value.” It is not just the dollar, but also the euro, and the yen that are being debased. The price of gold rose against all major currencies last year. Analysts concur that gold prices will continue to move upward unless there is a major change in the geopolitical situation or oil prices fall sharply. Demand Is the Key Driver China’s and India’s stellar economic growth, combined with the tepid recovery of Japan and four years of continuous global growth have all helped fuel demand for commodities. In short, prices are rising because more people are consuming more goods. Global demand therefore may have outpaced supply, which itself has been hindered by a lack of investment and output disruptions. China, which has over 1.3 billion citizens, saw its economy grow by over 10 percent in the first quarter of 2006. China is now the world’s largest consumer of steel, copper, and zinc. According to research by investment bank Morgan Stanley, China accounts for between 25 and 35 percent of global aluminum, copper, iron, and steel demand. The price of oil has the potential to rise even further this year, and as it is a key ingredient for economic growth, this will cause commodities prices to rise across the board. No major oil field has been discovered for decades, and increasing output, even in Saudi Arabia, is a costly and gradual process. On the subject of metals, there is only a finite supply, and few major new mines have opened in recent years. As with oil, investment in the mining sector today will take a long time to bring more production online. It takes a long time to bring new mines onstream, and existing ones are gradually being depleted. Jim Rogers, a one-time business partner of legendary speculator George Soros, predicted last month that gold prices could go as high as $1,000 per ounce. Using history as a guide, he said that the shortest bull market for commodities in the past had a “duration of 15 years.” Rogers said that the current bull run for gold was “not a bubble.” Those that already hold large amounts of gold bullion will understandably be pleased to see prices rise even further, and may be “talking the market up.” A commodity tracker fund set up by Rogers in 1998 has now more than tripled in value. Nevertheless, the largest source of demand for gold is for the production and consumption of jewelry. The primary markets for such ‘investment jewelry’ are in the Middle East and India. India’s growing middle class and the Gulf’s oil-rich consumers are not likely to change their habits anytime soon. Saudi Arabia imported record amounts of gold in 2005. Rampant Overvaluation? To a certain extent, the demand for gold, mostly by investment funds, is feeding on itself. Some analysts have argued that the price of gold is being inflated by a “sheer wall of investment money” being attracted to it. The higher the price rises, the greater the number of investors there are who want to get a piece of the action — rather like the Gulf’s stock markets in 2005. The Goldman Sachs Commodity Index is now at record levels, and has risen by 13 percent since the start of this year. The current bull run on gold has led to the creation of various tracker funds that let anyone speculate on gold without needing to acquire a bank vault in order to safely store it. Such funds have enabled huge numbers of investors to trade in gold. UK-based metal market analysts Virtual Metals points out that gold-centric funds were nonexistent before 2002. As has already been pointed out, gold has few industrial uses, and therefore at a time of limited global inflation should not necessarily be rising in tandem with copper and oil. It was estimated that in 2005 the electronics industry (the main industrial consumer of gold) accounted for only eight percent of total gold demand. In theory, a rapidly growing gold-recycling industry and steady supplies of the precious metal should see price stabilizing somewhat. But markets do not always act rationally. In summary, it is not likely that commodity prices will significantly fall in the short term. This is because demand from rapidly growing developing economies is set to remain strong. Such economies will require large amounts of raw products, and will thus buy them even at arguably inflated prices. In a fast-transforming global economic landscape, it is not really all that surprising that supplies of some raw materials are not keeping up with demand. Similarly, investors seeking short-term profits at a time when other asset classes are comparatively underperforming are bound to put more of their money into gold. (Emilie Rutledge is economist at the Gulf Research Center, Dubai.)