Gold Physical Demand Surges on Inflation and Systemic Risk

By: Mark_OByrne

Gold was flat while silver rose yesterday ( gold closed at $ 887.70 up 90 cents while silver closed at $13.37 up 25 cents ) as gold continued to consolidate near eight week highs . The COMEX October gold contract expires later today and there are significant levels of open interest between $890 and $910 which may see bullion constrained until the contract expires whereupon we may see further moves to the upside. $950/oz remains a realistic target by the end of the month.

There are a confluence of extremely  bullish factors driving the gold marketplace. The primary one is safe haven demand due to unprecedented macroeconomic and systemic risk. Credit markets are again showing signs of considerable distress and the uncertainty over the bailout plans is causing a further flight to safety. Even assets considered secure previously such as ETFs and money market funds have seen redemptions.

There is also continuing inflation hedging buying of gold. Inflation remains elevated despite the recent falls in oil and some commodity prices (oil despite it's recent sell off is still up 35% in the last 12 months and nearly 300% in the last 5 years).

The notion that oil and gas prices are going to continue to fall sharply and inflation become benign is wishful thinking and looks increasingly erroneous.

U.S. gasoline inventories have shrunk to the lowest level since 1967 after Hurricanes Gustav and Ike shut down a huge amount of Gulf Coast oil refineries. The situation is so serious that the Bush administration said there is still no need to ask for emergency fuel supplies from European allies. The drop in fuel stocks has caused long lines at service stations in southern cities. Retail outlets, including those in Atlanta and Memphis and as far away as Ohio, have run out of fuel. There is dramatic evidence of the widespread disruption caused by the hurricanes, as a third of the US refining system has been shut down.

I nflation is not only a threat to western economies but also to economies internationally. Most economies international are suffering from surging inflation and some emerging markets are suffering double digit inflation and this is leading to huge physical demand for gold bullion in Russia, China and particularly in India and the Middle East.

The two fundamental forces and the toxic mix of debt and asset deflation and yet stubbornly high inflation are leading to increasingly stagflationary conditions but this is not the stagflation seen in the 1970's as this is happening at a time of massive systemic risk and the worst financial, systemic and economic crisis since 1929.

This is leading to record demand for physical gold and silver. There continue to be significant shortages, delays and rising premiums in the gold and particularly silver bullion markets

And all this is happening against a backdrop of constrained gold supply. Central bankers are reluctant to sell their gold monetary reserves realising their increasing importance. And some central banks are becoming buyers again. Meanwhile gold production remains flat despite the rise in gold prices in recent years. 

For example, Australian gold production has been falling. Australia which is the world's third-largest producer, saw its gold production slump 13% in the second quarter to an 18 year low. There have not been any major gold discoveries in Australia for many years and the difficulty and cost of gold mining is leading to falling supplies year on year since 2001.

South African production has been plummeting also (see http://blog.goldassets.co.uk/..) . Of the world's three biggest gold producers (China, South Africa and Australia), only China has managed to increase gold production in recent years and this Chinese gold is used in China to meet the rapidly growing demand for gold as jewellery and as an investment in China. Thus Chinese gold is not exported into the international market which remains the supply/demand balance in gold is becoming increasingly tight and is likely to lead to markedly higher prices in the coming years.

T hus, this confluence of supply and demand, macroeconomic, inflation and systemic factors is leading to extremely bullish conditions for the gold market - probably even more bullish than in the 1970's when gold rose some 3,000% from $35 to over $850 in just 9 years.

By Mark O'Byrne, Executive Director

Gold and Silver Investments Ltd. have been awarded the MoneyMate and Investor Magazine Financial Analyst of 2006.

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