An Expert’s Opinion On The Value Of Gold

September 13, 2011

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The topic of gold investing is a divisive one. One group of people say that gold is a great way to hedge against inflation and that it is a much better than currency. Others, such as myself, feel that the gold investors are simply replacing a de jure currency with a de facto currency. Are people investing in gold because of an underlying value in the product, or because they feel it will be a valuable trading chip in the case of an economic meltdown? If it’s the latter, then gold has become a de facto currency. If both are currencies, should we ridicule the dollar while at the same time praising gold?

Who knows more about precious metals than the people who go deep into the crust of the earth to extract them? Today, we sit down with Engineer Joe, a metallurgical engineer currently working at a mine in Peru.

Kosmo: First of all, why invest in metals at all? Why not put your money into other raw materials, such as rock, paper, chemicals, or water? What makes metal special?

Engineer Joe: You can buy rock (minerals), natural resources (paper, wood, whathaveyou), and most of the chemicals needed to make plastics are metals or derivatives of metals on the market. Water is not considered a tradable thing because of its abundance, but the metals and chemicals to treat water can be bought.

But none of those things retain their value like metals. Metals are easier to reuse (thus why they pay you to recycle aluminum and other scrap, but you have to pay to recycle paper and plastics), easier to extract, and easier in general to work with.

Kosmo: OK, gold is pretty, and it conducts electricity really well, but if you’re starving, you can’t eat it. It seems ridiculous to pay $1900 per ounce for something with fairly limited uses.

Engineer Joe: Gold is the flubber of metals. It can do some weird shit, along with looking cool. It’s extremely malleable (a single gram can be beaten into a sheet of 1 square meter, or an ounce into 300 square feet), one of the most chemically resistant solid elements (for complete dissolution, you need to use a teflon coated beaker), more dense than most metals (almost twice as dense as lead), and it’s pretty rare (as of 2009, only 165,000 metric tonnes have ever been mined in human history, whereas most of the larger metal mines produce over half a million tonnes a year of common metals). Take all that, and find that it has a relatively low melting point and conducts electricity. It has all the most desirable characteristics of metals, rolled into one.

Kosmo: OK, gold is flubber. Very versatile and great for a lot of things. However, is there a point at which you go to a substitute? If gold goes to $1 million per ounce, obviously you’d need to use substitutes for a lot of uses. Not optimal, but acceptable. $1 million is an extreme example, but where is that line in the sand? $2500? $10K?

Engineer Joe: Yep, one of the best substitutes for gold is silver, which may be in part why its value has grown so much over the last two years. Certain applications can use other metals, which drives their value up as gold rises. But there are certain things that only gold may be used for, such as thin film deposits as on circuit boards. Only gold can be applied so thin and precise, and not corrode over millions of uses in many environments.

Kosmo: There are a lot of mines currently extracting metals from the earth. Is there any way I can keep track of the status of mines?

Engineer Joe: The USGS maintains a list of total inferred reserves (inferred by initial exploration), total proven reserves (final prep before mining), and total available reserves (in mines currently operating). As a company starts to reopen a mine, it moves the reserves from proven to available, which usually causes speculation that more supply will be available, and thus a price drop.

Most people are looking at the total reserves available for mining right now and the demand on the market. London Metal Exchange (LME) keeps track of all available raw metals available for trading on the market, and, for a price, you can see how many tonnes of any metal or significant mineral are available. You can also track the demand with their system. They also act as a middle man for buying large quantities.

Kosmo: One of the factors that keep the price of gold and other precious metals so high is the perception of scarcity. In theory, a mining company could strike a rich vein of gold tomorrow, right?

Engineer Joe: Actually, there is a mine in Alaska near Bristol Bay (Pebble Mine) working on obtaining necessary permits. If they can get things rolling in the next couple of years, you will see a drop in Gold, Silver, Copper, and other metals. It is the largest polymetallic deposit in the world, and their initial estimated production numbers show that it will dwarf all other mines currently in production. But they still have a long way to go.

Kosmo: When oil prices began to skyrocket, I heard about oil companies re-opening wells that had been capped years before. Oil wells that were unprofitable when crude was selling for $50 per barrel were profitable when oil was selling for $90 per barrel. It makes sense that there would be a similar situation in the mining industry – mines where the cost of extraction was high enough to make them unprofitable when gold was selling for $500 per ounce could be a cash cow with gold selling for $1900 per ounce.

Engineer Joe: Yes, this is the case of many mines. Most large mining companies will expand and buy these old properties, or just the mineral rights to them. They will do an assessment, determine the cost of remediation and reopening, and set a minimum price needed for reopening.

The Climax Mine in Leadville, Colorado is a good example. It was shut down in the early 90’s (as well as many times before), but Phelps Dodge (now owned by Freeport McMoran) announced in 2005 that it would refurbish the processing mill and reopen the mine. In 2008 Molybdenum prices dropped below where they though it was profitable to continue with reopening, so they idled the project. They resumed in early 2010 when both their stock price and Moly prices rose. It still has yet to be opened. Many presume that they just want to get the property “ready to operate” but not actually produce anything because it deters other companies from trying to develop a new mine or would be a good property to sell to a company looking to expand. It can take over 5 years to develop a new metal mine in the US right now. The EPA actually gives precedence to issuing permits if a company wants to reopen a mine because it includes clean-up of any problems that may exist and that the government is currently funding. So the process is faster than obtaining new permits from the EPA.

The problem that Freeport and many other companies see with reopening is the price of environmental remediation, and the fact that after buying the property, entering into environmental contracts with the government, the prices may drop due to the increase in proven reserves available for mining. That is why it is good for large mining companies to own the mineral rights, but not develop the old mines until the price gets so high that even with a drop it will be profitable to operate the mines.

Kosmo: In the oil market, OPEC has the power to set prices. They act as a cartel, working in concert to fix prices in a manner that maximizes their profit over the long term. This does not violate U.S. anti-trust laws because as a foreign entity, OPEC is not subject to these laws.

Does a similar situation exist in the metals market? Is there a cartel setting prices, or does the price fluctuate simply based on supply and demand?

Engineer Joe: I’m not aware of any cartels in the mining industry, other than diamonds. The most accessible diamonds are in Africa, and those mining companies did a good job over the years of protecting their investment. Things are changing now, as many jewelers won’t buy diamonds from Africa. There aren’t really any other companies or countries that have the most of a particular metal.

There is, however, an entity that plays a major role in the market.

There is this country in the Far East, with over a billion people. Maybe you’ve heard of it? For the last decade, they have been buying and stockpiling metals of all sorts, based on what they think they will need for the development of their country. This is probably the single reason why metals skipped a downturn in the mid-2000’s. Right now, they are still buying metals used for alloying steel, along with copper and other critical metals, and just stockpiling them. They’re still in raw form, so when processing prices drop, they can take advantage and have as much as they need. And if the prices rise, well then, they’re in a good spot to sell at a rate that wouldn’t flood the market.

Within the country, there are many natural occurring rare earth elements not found in abundance in many other places. They won’t sell those on the open market, and many speculate it’s because most rare earth elements are used in missile guidance systems and smart weapons. They really aren’t breaking any rules, but many speculate if there was a war, China (oops, just said their name) would be the most powerful country because of the amount of resources they have stockpiled. That is kind of scary, but the truth. And who knows how many oil reserves they have.

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