Gold Has Now Hit Marginal Cost of Production

In this post I will try to explain how important it is to watch the total marginal cash cost of gold mining to predict where the gold price (GLD) will be headed to. This marginal cost can be divided in two parts: cash cost of production and other costs (exploration, construction, maintenance, etc...) and stands at around $1300/ounce. With the recent decline in the price of gold, I believe we have finally hit the bottom.

The gold price has always followed the marginal cost of suppliers throughout history (Figure 1). The correlation between gold prices and gold mining cash costs between 1980 and 2010 stood at 0.85, which is pretty highly correlated (Source: CPM Gold Yearbook 2011).

With the price of gold at $1400/ounce today I'm pretty sure we can't go much lower if this correlation proves to be correct.

The following chart is the most important chart every gold investor needs to be aware of. As I mentioned before, there is a high correlation between the all in cash costs of gold mining and the gold price (Chart 4). So investors need to monitor the total cash cost of gold mining in order to predict the trend in the gold price itself.

(click to enlarge)

Chart 4: All in Costs Vs. Gold Price

Continue reading here.

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The Marginal Cost of Gold Production

UBS recently put out a number for the cost of producing an extra ounce of gold. As you can see on chart 1, the cost has skyrocketed from 2008 onwards to today. Costs almost doubled in 2 years time.

It shows us that if the gold price were to go to $1500/ounce, nobody would go out and search for gold as it would be unprofitable.

Chart 1: All-in Cost of Gold Mining

Chart 2 gives an operating cost of $700/ounce for gold, but it's important to notice that the large bulk of the costs go to construction, maintenance, exploration and taxes. Also note that the lowest gold went in 2008 is exactly at $712/ounce in October 2008, which was 10% below marginal cost of production at that time. That low in today's terms would be $1350/ounce.

Chart 2: Replacement cost for an ounce of gold

With all of this in mind, I believe gold will never go below $1350/ounce. This will be the ultimate floor. If it does, it will quickly rebound.

And for people who are interested in the marginal cost of production in silver, it is around $30/ounce as suggested in this article. So I expect silver to rebound soon.

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Correlation between Industrial Production Vs. CRB Metals Index

Thanks to Bob Garino, who commented on this article, I found out about the correlation between Industrial Production (manufacturing) and the CRB metals index.

Let's see if this correlation is correct.

I immediately see that from 1990 till 2000 the correlation doesn't fit. That period was a period where miners were in a bear market as metals prices declined and mining companies were getting worse and worse conditions for mining. Bonds were doing ok in that period.

So I'm a bit sceptical about this correlation. But I'll still add it to my list of correlations.

Chart 0: Industrial Production: Manufacturing

Chart 1: Industrial Production Index

Chart 2: CRB Metals Sub-Index

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China Electricity Production Inches Up

If you recall my article about China and its real growth rate. Well, there is light at the end of the tunnel.

China finally has an upward move in electricity production, which is basically good for commodities. Let's see if this trend keeps going up.

Chart 1: China Electricity Production

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The Marginal Production Cost of Oil

There is a theorem about the marginal production cost of oil. The price of the commodity in question should always be slightly higher than the marginal production cost of oil. If not, then many companies that produce the commodity will start going bankrupt.

Wikipedia has this definition for marginal cost of production:
The change in total cost that comes from making or producing one additional item. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale. The calculation is most often used among manufacturers as a means of isolating an optimum production level.

In the case of oil, it would take over $100 now to produce an additional barrel of crude oil. The oil production cost was only $85/barrel in 2009. So, if we see a crude oil price of $85/barrel today at a marginal cost of production around $100/barrel, a light should spark in every investor's mind. Especially when we hear news that Iran is threatening to stop exporting crude oil.

I'm going to bet on this by buying stocks like USO and UCO.

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Another Correlation: What is China's Real Growth Rate?

In the last week of August, Marc Faber gave a signal that all is not well in China. He points out that the Chinese statistics of 7% growth are inflated to the upside. There is a big chance for a hard landing to come in China because many statistics point to a significant slowing of the Chinese economy. For example, in July, industrial production declined sharply (Chart 1).

Chart 1: China Industrial Production (yoy)

It is very important to know that commodity prices are completely dependent on the growth of China as China is the biggest consumer of commodities in the world. If for example, the U.S. slows down 10%, it would be completely meaningless and wouldn't have any influence on the price of commodities. The reason is that the U.S. GDP consists for 80% of services, which don't use any commodities (Figure 1), while China's GDP consists only for 44% of services (Figure 2). So all eyes should be on China for the commodity investor.

Figure 1: Composition of U.S. GDP

Figure 2: Composition of GDP

So what is the best way to find the real growth of China?

Find out in the full version of this article.

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An Analysis on the Oil Price

Since May, the price of crude oil (OIL) has fallen from $US 106/barrel to $US 78/barrel (Chart 1). It is very likely that the price of crude oil will continue to decline because for the first time in a decade, supply is exceeding demand.

In this article I will give advice to investors on how to play the oil price and I will give critical information on when to buy the dip in crude oil based on a fundamental analysis of crude oil production costs.

Chart 1: Crude Oil Price

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