Investing in Gold with the Tocqueville Gold Fund (TGLDX)
Is there a Shortage of Physical Gold?
In economics, there is a saying that the cure for high prices is high prices. In other words, in a market economy, when the price of something is up, it encourages consumers to demand less and suppliers to supply more. This often results in “solving” the problem of high prices.
The best example of this is with oil. When the price of oil was over $100 per barrel, we saw massive investment in the industry, including in the United States with shale oil. Shale oil is more expensive to extract and bring to market, unlike much of the oil coming out of the Middle East.
At some price, it is worth the cost of extraction. If oil had never gone above $50, then the investment in the shale oil fields probably never would have happened. In retrospect, some of it may have been a bad investment due to the now lower oil price.
The point is, when oil was trading at $100, it encouraged consumers to reduce their use of oil and it encouraged producers to ramp up production. Therefore, the high price alone is at least partially responsible for driving the price back down.
It can also work the other way. When the price of something is low, then more is demanded and more can be consumed. In addition, it can lead to a decrease in production by suppliers.
Is this what is happening in the physical gold market now? With prices having fallen below $1,100, it has become less profitable for gold miners to extract gold out of the ground.
One of the tricky aspects of gold mining is that these projects are typically long term. Therefore, there can often be something of a lag effect. If a gold mining company starts a new project when gold is trading at $1,400, it probably isn’t going to abandon the project just because the price drops to $1,100.
The upfront and fixed costs are already paid. You can’t do much about them at this point. As long as the additional variable costs do not exceed the price of the metal, then it makes sense to continue with the project.
With that said, since gold is now around $1,100 per ounce, there are likely some projects that will never get started that otherwise would have been started with a higher gold price. But these projects probably would take at least a few years to come to fruition. In other words, the lack of investment in gold mining now, due to the lower price, will likely lead to less supply a few years down the road.
Paper Gold and Physical Gold
John Hathaway, a senior portfolio manager with the Tocqueville Gold Fund (TGLDX), recently wrote a report pointing out what he believes will be a shortage of physical gold in the years to come. He believes that there is a shortage due to the “relentless dumping of synthetic or paper gold contracts since 2011 by speculators…”
Hathaway says, “The steady selling has driven down the price of physical gold, hobbled the gold-mining industry, and drained the stores of gold held in the vaults of Western financial centers…”
Hathaway goes on to explain the exact scenario of a lower gold price leading to reduced supplies in the future. He says, “absent any significant and sustained rise in the gold price, we expect few new mines to built for many, many years to replace depleting and aging mine reserves.”
Hathaway concludes his lengthy report as follows: “We believe that the stage has been set for a significant repricing of gold in all currencies, including the US dollar. Ownership of physical gold outside of the financial system seems to make more sense than ever. Gold-mining equities, which have been severely depressed by the four-year decline in the gold price, should also participate. We believe that a trend reversal could prove explosive for the entire precious metals complex.”
Of course, Hathaway manages a gold fund. We shouldn’t ask a barber if we need a haircut or a divorce lawyer if we should get a divorce. Still, his commentary is worth paying attention to because there is logic to it.
The gold price has been on a downward trend for about 4 years now. There is no question at this point that it has discouraged gold mining, at least on the margin.
When it comes to gold and other commodities, the paper market dominates the scene. Most of the gold bought and sold every day is done in the futures and options market. Gold never actually changes hands. Even when it comes to investing in an exchange-traded fund (ETF), gold does not have to trade hands. At most, the fund may adjust its holdings based on the net transactions, but a lot of buyers and sellers cancel each other out.
Sometimes there can be some disconnect between the paper market and the physical market. But over the long term, this will not be sustained. If there truly is a shortage in the gold market that has not been realized, then this will eventually be reflected in the paper market.
Of course, there is one way we could instantly see a shortage in gold at today’s prices. If there is a sudden increase in demand for physical gold, then this will do it. It will mean prices will have to go up. Considering there are many geopolitical events and financial events that could quickly cause an increase in demand, at least on the margin, then this could happen easily and quickly.
The gold bulls are going to have their day again. Right now, an economic downturn seems more and more likely. This means that we may not have hit the bottom yet in the gold market.
When this trend does reverse, as Hathaway says, gold-mining equities should participate. Gold mining stocks have been a terrible investment over the last several years, but they will have their day in the sun again.
When you are ready to invest, the Tocqueville Gold Fund (TGLDX) that Hathaway manages is a good pick. It is one of the riskier mutual funds you will see, but the profit potential is high when mining stocks reverse their trend.
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