Gold bubble burst, pricked by inflation and mining costs

It has been the most violent fall in prices in three decades. Since hitting $US1900 an ounce in September last year, the gold price has fallen below $US1400 an ounce, a fall of 26 per cent in just six months.

It has been the most violent fall in prices in three decades. Since hitting $US1900 an ounce in September last year, the gold price has fallen below $US1400 an ounce, a fall of 26 per cent in just six months.

Predictable proclamations followed. The investment banks, despite being bulls last year, have slashed their price "forecasts".

The Reserve Bank has all but called gold a bubble, despite holding over $4 billion worth of the stuff in its vaults. Critics long silent reappeared with earnest smugness to agree on one thing: the gold bubble has burst.

But why? And was it really a bubble?

Inflation, or the lack of it, is the immediate explanation. Despite unprecedented quantitative easing, inflation remains stable. For many, that's enough to explain plunging prices. Yet inflation was in check last year when gold reached $1900 an ounce.

Europe, according to the critics' choir, is another explanation. In addition to its economic sins, Cyprus has threatened to sell its gold holding to accommodate a bailout - all 10 tonnes of the stuff.

Although a tiny hoard, the argument goes that this may encourage other central banks to flood the market with glitter. But central banks have been net buyers of gold for years. The explanation can't be found here either.

There is a more obvious reason: that gold has risen for 12 consecutive years and was due for a fall.

When it came, exchange-traded funds (ETFs), the second-largest holders of gold, faced redemptions and were forced to sell physical metal into a falling market.

Lower prices thus forced more gold sales and lower prices creating a negative feedback loop, which magnified the scale of the decline. A healthy correction thus morphed into a panic-inducing plunge.

Gold, it's claimed, is a hedge against inflation. But this is a by-product of its true calling: gold is not a guard against inflation but a shield against monetary debasement. Often that is inflationary, sometimes it isn't.

There's a strong argument the steep rise in the price of gold isn't down to a bubble but the increase in the money supply since the GFC. In the US, monetary debasement has occurred on a colossal scale.

The change in the gold price is a reflection of the change in the money supply. Gold's rise has been neither irrational nor exuberant. It has behaved the way one might expect.

But there's another factor, from the supply side. The marginal cost of gold production has risen from about $300 an ounce 10 years ago to about $1200 an ounce today. Higher gold prices reflect the higher cost of mining it.

The conspicuous lack of super profits among gold miners confirms higher prices have been driven by costs.

Bubbles, when they occur, are marked by tremendous leaps in profitability. BHP Billiton's return on equity, for example, rose from 10 per cent in 2002 to 50 per cent at the height of the great iron ore boom.

No gold miner has a return on equity larger than 10 per cent. In fact, profits of any magnitude are hard to find.

Miners are partly to blame but this fact also suggests the marginal cost of mining gold has kept pace with the increase in the gold price. By this definition there has been no bubble.

The steep fall in the gold price may not be rational and lasting, but that doesn't necessarily make falls in mining equities irrational or tempting. Once gold prices fall, even for silly reasons, so do profits.

Consider a miner producing gold at $1200 an ounce. A fall in the gold price from $1900 to $1300 - a 30 per cent decline - reduces the miner's profit margin from $700 an ounce to $100, a fall of 85 per cent.

So a 30 per cent fall in gold prices translates to an 85 per cent fall in profits. The higher the cost base, the more damage falling prices do. If the miner has debt or hedge contracts to meet, even a temporary fall in prices is life-threatening.

High-cost miners will provide maximum returns if gold prices rebound but the risks are huge. We'd recommend your search for miners should be for those with low costs and little or no debt.

Nathan Bell is research director at Intelligent Investor Share Advisor, which is currently recommending two gold companies as speculative buys. To find out what they are, register for a free trial at shares.intelligentinvestor.com.au.