IT was the gold rush all over again. In a matter of seven years, the price of gold nearly tripled from US$250 an ounce in September 1999 to a high of US$730 an ounce in May this year. Gold is currently trading around US$620 an ounce. The extremely bullish sentiment on gold seen at the end of 2005 and the start of 2006 has since abated and investors are currently divided as to where the price of gold will head next.

Investors' choice: While the old-fashioned hoarding of gold has a certain romantic appeal, a preferred alternative by many investors is to invest in gold equities

As with any commodity, the price of gold depends on demand and supply. The principal demand for gold is jewellery, which accounts for 80 per cent of total demand. The key areas of gold jewellery demand are from East Asia, Europe, the Indian sub-continent and the Middle East. Jewellery demand peaked in 1997 and then declined until 2003.

Demand has since improved. Recovery in the Indian sub-continent and the Middle East has been especially strong. Indians have a cultural affinity towards the metal and demand has grown in line with the booming Indian economy. In the Middle East, also traditionally a centre of strong demand, high oil prices are once again leading to surplus petrodollars, some of which are finding their way into gold. Jewellery demand declined earlier this year as gold prices rose towards US$700 an ounce but picked up again with the start of the wedding and festive season in India.

Jewellery demand underpins gold prices but it is investment and speculative demand which has really provided the lift to prices in recent years. This demand was particularly strong between the third quarter of 2005 and the second quarter of 2006 when gold prices surged 49 per cent, rising from US$490 to US$730 an ounce.

Investment demand takes many forms, from the simple hoarding of gold bars to exchange traded funds (ETFs). ETFs are exchange-listed investment products in gold. They grew spectacularly from zero in 2002 to an estimated 30 per cent of investment demand in 2005.

Flight to safety

Investors seek gold for a number of reasons. These reasons are diverse but typically include a concern about the value of currencies, especially the US dollar; a fear of inflation and worries about traditional asset classes. Gold as an asset class is considered a safe haven and typically benefits when there is a flight to safety. This negative correlation with other asset classes makes gold an attractive addition in investment portfolios.

Currently, gold not only attracts investors but also speculators, mostly in the form of hedge funds. Speculators, by nature, have a very short-term horizon, and following the parabolic run-up in prices up to May, the market was vulnerable to profit-taking. Following the liquidation of long positions, the price of gold has tumbled by about 20 per cent since its high in May. The impact of speculation on gold prices can be seen in Chart 1.

Some longer-term investors have, however, also turned lukewarm towards gold, and are questioning the sustainability of continued institutional (eg, pension funds) diversification into commodities following the recent period of weak returns.

The gold bulls, however, believe that inflows into gold ETFs will resume and that gold prices will continue to rise. One possible near-term driver is the US dollar. The greenback is likely to be entering a period of cyclical weakness as the US economy is slowing and the US Federal Reserve has already paused in its tightening campaign.

The market is currently expecting interest rate cuts in the first half of 2007. The European Central Bank and the Bank of Japan, in contrast, are still in tightening mode. The currency markets have not focused on the record US trade deficit for a while but this structural issue may re-emerge at some point.

Another consideration is that gold still offers value relative to other commodities. Over the long run, commodities tend to maintain their relative prices. If there is a price shift in one commodity, the prices of other commodities tend to adjust in the same direction. In comparison to gold, the rallies in the prices of crude oil and other commodities in the past few years have been tremendous and this has pushed relative prices to historically very low levels. Chart 2 shows the ratio of gold-to-oil prices.

The bullish camp of investors also points to the problems of supply. At the Denver gold forum in September, many leading gold companies highlighted the replacement of reserves as the key issue facing gold companies today. Although the price of gold has more than tripled since 1999, there have been no new world class gold mines discovered in recent years.

As was the case with other commodities, exploration in gold mining was severely cut back in the late 1990s due to the weakness in prices. This not only meant there was less incentive to explore but it also has an impact on the capital-raising abilities of junior mining companies which are normally very important in the field of gold exploration.

In addition, a number of regions which are geologically very attractive, (such as Central America or parts of South Asia) are currently out of bounds for exploration because of political instability or nationalistic sentiment.

Although exploration has now increased again, the lead time from initial investment to production is long in gold mining - from three to 15 years - depending on location, depth and environmental legislation. Environmentalists' protests against the mining industry have intensified in recent years and these tend to extend the already long lead times for gold projects.

Gold exploration projects have also become much more expensive as there is a shortage of mining machinery and skilled labour. According to estimates by Brook Hunt, the Mining and Metal Industry Consultants, the typical capital expenditure per ounce of production has increased by 134 per cent between 1999 and 2004.

Mergers and acquisitions

As finding new reserves is difficult, the alternative way for gold mining companies to increase their reserves is through mergers and acquisitions. M&As in the gold sector have been gaining momentum and recent deals included the takeover by Barrick of Placer Dome, the Goldcorp/Glamis combination and IAMGOLD's acquisition of Cambior and Yamana of Viceroy.

Gold is, however, unusual among the commodities because central banks hold gold as part of their official reserves and any decision made by central banks to buy more or to sell their gold holdings affects the supply of gold. Central banks hold about 30,000 tonnes of gold in official sector reserves, equivalent to 10 years of supply.

The main sellers of gold are the European central banks, as gold makes up a large portion of their external reserves. They are, however, signatories to the European Central Bank Gold Agreement, which limits their sale of gold to 500 tonnes per year. This agreement runs out in 2010. The holdings by Asian central banks are, in contrast, small compared to the European central banks, with most of them holding below 5 per cent of their foreign reserves in gold. Asian central banks are, however, known to have been increasing their gold purchases in recent years and their demand could become meaningful.

Investors who believe that the gold rally is still intact have several investment options. The straightforward way is to buy physical gold itself, holding it in the form of gold bars or coins. A paper form of this would be through a gold savings account, which is more prosaic but requires no special arrangements for safe-keeping.

While the old-fashioned hoarding of gold has a certain romantic appeal, a preferred alternative by many investors is to invest in gold equities, ie, gold mining companies. Gold equities typically offer investors leverage. Historically, there has been a one to three times beta to the spot price of gold. This means that if the spot price rises 10 per cent, the price of gold equities can potentially rise by 10-30 per cent.

The caveat is that this equity-beta relationship is not always a steady one. The prices of gold equities often do not move in tandem with the price of gold, as has been the case this year. Gold equities reflect the medium to long-term fundamentals and equity investors are usually sceptical of price rises which appear to be driven by speculative money.

But all said, if the medium-term bull case for gold is intact, the proposition for gold mining stocks remains an attractive one.

The writer is assistant director, equities, UOB Asset Management.He is fund manager of the United Gold & General Fund and the United Global Resources Fund.

» Understanding your options
» Putting money in warrants
» When ill health strikes
» Investors still taking a shine to gold
» The alternative view
» Holistic approach to investing
» Diversifying into foreign currencies
» Greater accessibility for smaller investors
» Cashing in on en bloc fever
» A closer look at structured deposits
» Retirement dreams
» The lowdown on home loans
» Opportunity for greater gains