The Driving Force

People sometimes wonder whether supply and demand fundamentals have anything to do with precious metals prices, given that price moves often seem unrelated to such fundamental trends. Supply and demand fundamentals determine the price of commodities in the long run, but the relationship is complex.

Furthermore, analysts often ignore one key fundamental aspect of demand: investment demand. Investment demand is driving the market prices of precious metals today. That should not be surprising to anyone. Investment demand, in fact, has been one of the major factors determining precious metals prices since at least the 1960s. It is a basic fundamental of these markets.

Investment demand for precious metals varies across gold, silver, platinum and palladium, but currently investor buying of these metals is the most significant factor driving the prices of all four commodities.

Producers and consumers tend to be price-takers: They generally agree to buy or to sell a given commodity at prices at or near the market price at the time of the transaction. They tend not to wait for lower prices before buying or higher prices before selling. As a result, production and fabrication demand tend to follow prices, not lead them. This is not to say that the actions of producers and consumers do not exert direct influence over precious metals prices. They do; but, their influence tends to be less dynamic than those of investors. Additionally, the actions of producers and consumers, or perceptions of what these actions may be, heavily influence the sentiment of investors.

Investors, in contrast, are free to open or close positions in the market entirely at their discretion. They always have been important to determining the future prices of precious metals. This is truer for gold and silver but perhaps less so for the industrially oriented platinum and palladium.

THE ECONOMIC ENVIRONMENT. Periods of intense investor interest in gold and silver tend to coincide with periods of severe economic, financial and political unrest. The reality presently is that global economic conditions are relatively positive overall, considering the major economic developments and expansion taking place in China, India, the former Soviet Union, the Middle East, Latin America and Africa. This is not to belittle the economic growth underway in the industrialized nations of North America, Europe and Asia, all of which continue to register overall healthy economic growth rates. Healthy economic growth continues in the United States and across Europe, while Japan is experiencing its first consistent economic expansion since the 1980s.

The world presently appears to be in a period of relatively low inflation as well. Although rising inflation is a concern, interest rates have been increased in several major economies as pre-emptive measures that seem to be yielding the desired results: Inflationary pressures are being quelled, while economic growth is being maintained. The strength of the world economy indicates that it is unlikely that the United States or world will enter a recession in the near term.

As with the risks or potential for recessions, other economic conditions similarly are in good shape in most parts of the world, but investor concerns about them remain key to market behavior. Inflation has risen somewhat in the United States in recent years but remains under control. Monetary policies have been put in place to contain inflation and appear to be working. Even so, some investors remain worried about inflation and are buying precious metals as a result.

The same is true regarding equity markets. The U.S. stock market has reached record levels. Corporate profits once more are above market expectations, helping stimulate demand for shares. However, as the market grows more nervous, the better its performance. Investors know that no run-up in prices is permanent, and equity market participants have looked to diversify their portfolios by increasing allocation to alternative investments such as commodities. If stock prices rise, they buy more precious metals to hedge the increased value of their equity holdings. If stock prices fall, they buy more precious metals to protect against the seemingly inevitable sell-off.

INVESTMENT DEMAND. In standard commodities research, the supply-demand balance, depending on the commodity, is measured as total supply, including primary production, secondary recovery and other sources of material relative to fabrication demand. In classical commodities market analysis, investment demand is an off-balance-sheet item.

Investment demand often is not well understood or easily measurable, so it is simply left out. As a result, many market observers have overlooked its importance. In one specific example, a market observer suggested that fabrication demand for palladium had been decreasing and that prices would respond by dropping. Instead, palladium prices increased, because investment demand, not fabrication demand, was then driving the palladium market.

It is important to segregate investment demand from fabrication demand for several reasons. One is that investors are not consumers; they do not transform a commodity into another product that cannot be re-sold instantaneously as the original commodity. They also have total discretion as to whether they want to be buyers, sellers or leave the market entirely.

In the silver market, trading volume at the exchanges along with LBMA (London Bullion Market Association) clearing volume has been increasing since 2002. In the gold market in 2006 there was a substantial increase in the exchange volume for futures and options as well as the LBMA clearing volume. Combined trading volumes for platinum on the Nymex and Tocom were up 25 percent in 2006 and up palladium was up 15.6 percent.

The increase in volume is a result of greater market participation from individual investors, major banks and investment funds.

Between 1968 and 2001, investors purchased anywhere from virtually nothing up to 26.2 million ounces of gold per year. Since 1965, investors have only been net sellers of gold on a global basis in three years: 1970, 1972 and 1995. Only in 1970 were investors net sellers of more than a million ounces. When investors are bearish on gold, they continue to be net purchasers, but to a lesser extent than during bullish periods.

This all changed throughout the past few years, as the gold market moved into a sustained period of unprecedented historically high levels of annual investor demand. Investors purchased 37.2 million ounces of gold in 2002, 50.4 million ounces in 2003, 41.3 million ounces in 2004, 46.7 million ounces in 2005 and 43.5 million ounces in 2006. From 2001 through 2006, investors bought a total of 241.5 million ounces of gold. In 2005, investor holdings of gold surpassed those of central banks for the first time.

From 1990 to 2005, investors were net sellers of silver. In 2006 they shifted to net buyers of silver. The last shift of this kind occurred in 1979. Silver prices jumped from $5.79 in early 1979 to $50 per ounce in January 1980.

The most significant issue for the platinum group metals markets is the large and sharply widening surplus of platinum and the declining, yet still large surplus of palladium in the marketplace since 2003. Yet, platinum prices have risen from $600 per ounce to more than $1,300 during that same time. Platinum prices were strong during this period because of a combination of strong investor demand, scooping up those surpluses in platinum, and strong automotive industry demand. Investors have filled the gap and are holding inventory, anticipating the price will rise.

THE ROAD AHEAD. Since the middle of the 1960s, when gold prices were freed to float, the price of gold has generally risen when net investment demand has exceeded 20 million ounces per year. Throughout the past four decades, periods of such intense investor demand have lasted one or two years. The current period has lasted a full six years and has seen investors add 30.1 percent to their collective total holdings in gold. Investor demand for gold will continue to be at a historically high level in 2007, but the amount demanded will depend on investor sentiment and expectations of economic, political and financial uncertainty.

The price level at which investors have considered gold to be cheap has continually increased during the current bull market, and the price at which gold has met with resistance from investors has increased as well. Prices should continue to be pushed higher by strong investment demand for as long as political and economic worries that have been fueling this demand remain.

In the silver market, many investors bought billions of ounces of silver from the 1950s through the 1990s. They have continued to sell silver and were satisfied doing so at current prices, since silver had spent the past 20 years well below current price levels. Even as these sales continued, other investors were buying, so that investors as a group were net buyers of silver in 2006. By the end of 2006, the iShares Silver Trust exchange traded fund launched last April had amassed 121.1 million ounces of silver.

CPM Group projects that net investor demand will continue to rise in 2007. In a world where the printer of the world’s reserve currency is running budget deficits of historic proportion, in which there is great political uncertainty and in which the U.S. dollar has fallen sharply since 2002 and continues to decline, it is highly unlikely that investors will not continue to mitigate their exposure to these risks by continuing to allocate capital toward the purchase of gold and silver.

Demand for platinum group metals from fabricators will continue, but the market will be driven by investors. Naturally, a market driven by investor demand will have increased volatility, since investors chase rising markets and pull back in declining markets. If investors begin to sell their positions in platinum or palladium, the decline in prices will exceed that experienced in 2006, when platinum rose to $1,347 in May and then declined within one month to $1,095 and when palladium declined from $409 to $267.

One factor driving current bullishness in the platinum group metals market is the launch of exchange-traded funds (ETF) by ETF Securities on the London Stock Exchange and the Deutsche Börse as well the launch of exchange traded funds by Zurich Cantonal Bank on the Swiss Exchange, SWX. The ETFs will not be the major impetus affecting investor buying of precious metals, but they will add upward pressure.