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Thread: Gold pricing Theories

  1. #1
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    Default Gold pricing Theories

    A good theory of gold's price will tell you when to buy, when to sell, and how much profit you will make. It will also explain the causes of the the price movements. Since gold is the macro-economic barometer par-excellence, understanding the gold price is a major part of understanding the global economic and monetary situation.

    I'll briefly discuss several theories, and put each in a separate sub-thread, to organize the discussion. I've you have a theory I haven't covered, send me a private message. I want to organize the first level of the hieararchy. After that, it's up for grabs.

    Below is a very long term chart, don't know how accurate it is.

    I'll try to include all theories, from the astute to the wacky. It's worth discussing the wacky theories, to understand what's wrong with them, and also because they are valid for pricing other things, but not gold.
    I'll give each theory a number from 0-10, reflecting its usefullness an a guide to investment.




    Last edited by Polish_Silver; 01-14-13 at 11:01 AM.

  2. #2
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    Default Marginal Cost theory of Gold price

    The idea of "marginal cost pricing" is that the commodity price reflects the marginal cost of production. This is valid for something like oil or wheat, which is produced and then consumed.

    Krugman advanced an over-thought version of this idea for the gold price about a year ago. Another place you will see it is in the disclaimer for a gold ETF. There is a sentence like "the gold price could decline for technological reasons, for example, the discovery of a transmutation process". Transmutation means changing lead into gold by shooting a proton into the lead nucleus. I have studied physics, and transmutation can be done using nuclear reactors, particle accelerators, or a Ghost Buster Proton Pack. Transmutation crashing the gold price to crash is on my list of worries, right behind an asteroid crashing into my house.

    Marginal cost pricing is of limited value for gold, which is not consumed, but just circulates between buyers and sellers. The industrial consumption of gold only uses up a tiny bit each year, which is replaced by mining. So you can think of the total amount of gold as fixed. Gold mines do not go bankrupt because they over produce and bomb the price. The price is set by global monetary factors, and the mines are profitable or not at that price.

    However the "marginal cost" idea is correct in one important respect. The relatively small amount of gold in the world is the reason it is so expensive. If the mass of gold in the world magically increased 10X, the price per oz. would decrease 10X. So the fact that producing gold is difficult and expensive is what causes there to be a small, fixed quantity of gold, and hence its high price and usefulness as a monetary asset. Interestingly, in the "Harry Potter" series, there were about 4 things that couldn't be accomplished by Magic. One of them was creation of gold, which was used by the Wizards as a medium of exchange. Kudos to Rowling for educating the public.

    Why is gold the only physical asset held by central banks? Because it is "precious" having a very high value per gram, and the supply of gold is fixed. This is desirable for a monetary asset.

    Central banks could hoard oil, but the price fluctuates so much that the book keeping would be a nightmare. Because reserves of oil are small relative to production and consumption, the price of oil is buffeted by demand and supply shocks. The oil price reflects political, geological and technical constraints more than monetary conditions.



    Theory value rating : 3.0/10
    Last edited by Polish_Silver; 01-14-13 at 10:58 AM.

  3. #3
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    Default Re: Marginal Cost theory of Gold price

    The viewing gold by the marginal cost of production was important to my purchase decisions several years ago.

    Back in 2000 when gold was under $300/oz, the only mines that could produce gold were both managed well and sitting on the best ore. I took that as evidence the price would not go down. Today at $1667/oz it doesn't seem such a relevant factor, though others on this forum have posted that costs of production have gone up dramatically so it is still hard to make a profit mining gold at today's price.

  4. #4
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    Default Re: Marginal Cost theory of Gold price

    agree.

    graph the price of gdx with gld or with bullion. Gold miners should be rolling in money. So either they are using profits to buy large oak conference tables, or
    they must be using all their profits to buy new high tech equipment to be able to mine lower and lower quality ores. Although I thought owning gold miners
    was a diversifier over bullion, it has been a money loser over the long term. If gvts seize gold or tax the pee out of gold, I would also think they would nationalize
    mines and/or tax the mines too. Miners might be a short term leveraged play on gold if you think they are underpriced or you expect gold to pop up in price.
    Long term hold facts point to no.

  5. #5
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    Default Re: Marginal Cost theory of Gold price

    Quote Originally Posted by thriftyandboringinohio View Post
    The viewing gold by the marginal cost of production was important to my purchase decisions several years ago.

    Back in 2000 when gold was under $300/oz, the only mines that could produce gold were both managed well and sitting on the best ore. I took that as evidence the price would not go down. Today at $1667/oz it doesn't seem such a relevant factor, though others on this forum have posted that costs of production have gone up dramatically so it is still hard to make a profit mining gold at today's price.
    Thrifty,
    A very interesting point! Think of mining costs as a long term "floor".

    It would be interesting to examine this historically. The long term chart shows a big drop in gold prices starting about 1500, corresponding to the Spainish stealing all the gold from the Indians.
    This undoubtedly undercut european miners.

    However, there are no new continents to discover.
    however, If CB's would suddenly start selling gold. . .
    (again, this is asteroid collision territory)

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    Default EJ's gold newspaper articles

    EJ once posted some newspaper articles about gold, from the 1970's:

    Here they are, with some comments


    http://www.itulip.com/forums/showthr...22901#poststop

    http://www.itulip.com/forums/showthr...22987#poststop

    banking industry still reeling



    Date Event notes
    1958 First major gold run, according to (2)
    1968 US and European governments agree that only central banks will buy gold from the US, and only at $35/oz, and only for monetary transactions. See (3)
    August 1971 Nixon closes gold window.
    Dec 14, 1971 “The gold issue” Boca Raton news
    Burns & Volcker: “dollar value is more certain due to formal devaluation of 5% + wiggle room. Expect gradual devaluations rather than one large one and Global financial meltdown.
    (2)
    Amazingly vague prediction of how big the devaluation will be.
    Dec 17, 1971 Formal devaluation.
    Feb 26, 1973 “Devaluation of dollar not seen as answer”
    Burns claims it is “last devaluation”
    Yet gold at record highs, dollar sliding,
    Fed signals higher rates.
    Trade barriers discussed, monetary crisis a way of life until a new fund system is figured out. Net problem is too many dollars going offshore.
    Beaver County Times, 1973

    Market price $95,
    UST price $42.22
    Feb 26, 1973 Burns warns efforts needed to keep trade improvements.” Domestic policies must also change, not just devaluation.
    Volcker rules out further devaluation and affirms that gold will be liss important in the international monetary system.
    March 3, 1973 “why currencies appear to be returning to normal” Discount rates raised to 5.5%
    Gold price declines below $91.
    Japan buying gold. Soviet union selling gold to pay for grain imports.
    Nov 14, 1973 “US ends two-tier gold prices”
    Burns announces that the US and 6 european nations have abolished the two tier pricing system for gold.
    Still illegal for Americans to buy gold.
    (3) Montreal Gazette
    1968 agreement explained.

    Free market price now about $100, the old fixed price was $42.22.
    Dec 6, 1974 Burns calls gold sale ‘mistake’
    Gold will be legal in three weeks. Burns says that is a mistake. Treasury secretary Simon says legalization is Ok.
    Burns fears that people would liquidate stocks and cash to buy gold. That could hammer stocks, and also bank reserves, and therefore housing.
    Burns warns of a gold bubble.
    Miami News
    Dec 6, 1974 “The trouble with Gold”
    Warning that people may be cheated into buying gilded lead.
    Nobody has thought of tungsten yet.
    States that gold would have been a good inflation hedge over the last 10 years.
    Banks will sell gold to retail customers.
    Gov will sell 2million oz on jan 6. Reserves are 276million oz.
    Burns doesn’t want banks accepting gold as collateral, which is weird given his concerns of a run on cash to buy gold.

    Miami News
    Dec 23, 1974 “Gold fever” skips state.
    Stock brokers say nobody wants gold,
    But bankers say people do.
    Fraud risk highlighted—seedy characters!
    Kenturcky New Era
    Burns worried that people use gold instead of savings accounts as store of value.
    Dec 31, 1974 Americans can buy gold for the first time since 1932.
    Nov 25, 1976 Time here to curb the federal reserve.”
    Carter wants jobs, Fed (burns) wants to control inflation.
    History of conflict between banks and 99%. Criticizes fed for pro-bank anti—99% policies. Remarkably good summary of the problem.
    Ernest Cuneo
    Mistakenly thinks the problem is gold/price stability, rather than leveraged finance.
    Jan 9, 1978 Arthur Burns, chairman of the Fed, just lost his job. Pound rising because of oil.
    Gold as a hedge against falling dollar.
    Switzerland behind it all.
    Art Buchwald
    Apr 6, 1978 US may sell gold to aid dollar
    Carter considering selling gold on regular basis to prop dollar. 300,000 oz/month. Inflation and energy bill mentioned. Burns now recommending gold auctions and carter bonds.
    New york times
    Gold is $180/oz
    pJul 26, 1979 Volcker nomination helps dollar
    Dollar rises gold falls, on news of Volcker nomination as Fed chairman.


    Lakeland Ledger
    $306.25/oz
    Oct14 1979 Lakeland ledger article
    “banking industry still reeling…”
    Mentions Lacy Hunt
    Couldn’t find this article 2nd time aroundk
    Jan 19, 1980 Gold reaches $850


    Lacey hunt is still around. He has recommended banking reform, similiar to Kotlkoff's limited purpose banking: separate the lending from the depository and payment systems.

  7. #7
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    Default Re: Marginal Cost theory of Gold price

    Quote Originally Posted by charliebrown View Post
    If gvts seize gold or tax the pee out of gold, I would also think they would nationalize
    mines and/or tax the mines too.
    http://www.financialsense.com/contri...-gold-accounts

  8. #8
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    Default Gold as money

    Gold is the money that can't be printed. It is certainly useful to think of gold as a currency, competing with dollars, euros, etc.

    Gold does not pay interest like USD bonds do. But it is also much less vulnerable to depreciation.

    Here is EJ's essay "The fourth Currency".

    Well worth reading.

    Here's a recent article by James Turk, evaluating gold as an international exchange currency.
    "Why gold will go above $11,000"

    The idea is that the value of gold held by world governments should equal all the foreign exchange reserves they hold. That way, all the paper money would be (unofficially) backed by gold. EJ has also said that the gold price would reflect overseas US debts. '

    Value of this idea for thinking about gold: 7/10

  9. #9
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    Default Industrial Demand Pricing

    The idea of industrial demand pricing is that the price of a commodity is determined by what the industrial users are willing to pay for it, as opposed to what it costs to produce it. A good example is catalytic converters, which can be made from Platinum or Palladium. If either metal gets too expensive, manufacturers can switch to the other. (Or that's the gossip, anyway).

    Farmers do this all the time. If one grain gets too expensive, they stop buying it and use something else to feed the animals.



    For gold, the thinking is that gold has three sources of demand: industrial, jewelry and monetary.

    Eliminating any source of demand causes the price to fall.

    In 1971, the US treasury stopped converting dollars to gold for foreign governments. So gold was officially "demonetized". If you take away the monetary demand, then gold has only jewelry and industrial demand, so the price should fall. This idea is criticized in Turk's "The coming collapse of the dollar". I do vaguely remember some newspaper articles from the early 1970's claiming that gold would go down in price because it was demonetized. "barbarous relic".

    Of course, the opposite happened. Since the US treasury would not convert dollars to gold, central banks and individuals converted it themselves, by buying gold coins and bars. So gold was still monetary, but the UST stopped converting dollars to gold. EJ has mentioned that CB's are hedging dollar devaluation by buying gold.

    A major difference between gold and industrial commodities is that Gold mainly circulates between buyers and sellers. Very little is ever used up. It is precisely because the world's gold supply is fixed that it is a good store of value.
    Last edited by Polish_Silver; 02-23-13 at 10:59 AM. Reason: wording amiguous

  10. #10
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    Default Interest rates and Gibson's Paradox

    Interest rates are key to understanding gold prices. But it is the combination of interest rates and inflation that matters. The "Real rate" is the difference between the market interest rate and the inflation rate. The "real rate" is supposed to be positive, but can be negative at times. The higher the real rate, the cheaper gold is. The lower, or more negative the real rate, the more expensive gold gets. This is called "Gibson's Paradox"

    This is a big subject, so I'll just hit some highlights.


    Gibson under a Gold standard:

    Keynes analysis was based on gold standard money systems. What happened was, when people saved a lot of gold, interest rates became low, because the supply of savings was large relative to the demand for borrowed money. But if people had saved a lot of gold, they were not spending it. So prices of goods were low at this time, because the circulating money supply had decreased. (Gold had shifted from circulation into savings--deflation, low prices, and low rates).

    If people started liquidating savings to buy stuff, the price level would go up ,(inflation, more money in circulation). Then there was less money to lend out, and interest rates would go up.

    So the prices and interest rates would be strongly correlated. Notice that the interest rate is correlated to the price of items, not to the inflation rate, like most people would think. Hence it is a "paradox".

    Gibson' works somewhat differently under a paper money system--it is more like Gresham's law.

    Gibson vs Gresham:

    If you think of gold as a currency that depreciates less than paper currency, than it is in competition with paper currencies as a store of value. If you save paper, you can get a bond and collect interest. In that case, your loss is bond rate - inflation. So for gold to win, the real rate must be negative, or you must expect that a negative real rate will occur while you hold the gold. This was the case for the $USD during the 1970's. Rates on T-bonds were less than inflation, so you lost purchasing power by holding them. But gold kept going up because more and more people realized that cash and bonds were a losing deal.

    Gresham's law is the idea that people spend a depreciating currency and hoard (save) a stable one.

    So, if dollars are depreciating, Gresham says they should hoard gold---same as Gibson.

    Gibson vs Free market:

    Gibson was originally figured out for gold standard money systems operating on free market principals.

    When governments are controlling interest rates, Gibson doesn't always work the way you think.
    http://www.goldensextant.com/commentary18.html (mentions 1918-1939 as a time when it didn't work right)


    Gibson vs Insurance:


    Here's the really interesting part. In a separate post, we'll discuss the idea that Gold is "Insurance" against collapse of the financial system. This idea has been affirmed by EJ, Antal Fekete, Jim Rikkards.

    This is a different idea than Gibson's paradox, but it's hard to disentangle them. Take the 1970's.

    Dollars were depreciating, gold was going up. But people such as Paul Volcker were worried about an out and out US bond crisis. So the insurance idea predicts gold would become valuable as the probability of crisis increased. But the crisis probability also coincided with inflation. So Gibson's Paradox and insurance ideas were predicting the same thing, for somewhat different reasons.

    The same thing is happening now, for similar reasons. Rates are being held near zero to protect the financial system. So that indicates a risk of financial crisis. But the rates being held low also means a negative real interest rate. So both the insurance idea and Gibson indicate a rising gold price.

    So when EJ or somebody says that Gold is rising because of financial risk, not because of dollar depreciation, remember that the depreciation is a tool to manage the financial risk.



    References:

    Golden Sextant : kind of a gold bug article.

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    Default JUne 2013 articles

    june 2013 Gold articles:
    http://www.itulip.com/forums/showthr...861#post261861

    The first article is published at the mid 1970's low. The thinking doesn't appreciate that inflation and negative real rates are still going on, and that the US is importing more and more oil.


    The second article predicts huge gold prices which never happened (yet). The guy doesn't get that real interest rates
    increased the value of the dollar/bonds, decreasing the value of gold. He seems to think in terms of perpetual inflation and 6 year cycles.
    Last edited by Polish_Silver; 06-28-13 at 09:10 AM.

  12. #12
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    Default Re: JUne 2013 articles

    Quote Originally Posted by Polish_Silver View Post
    june 2013 Gold articles:
    http://www.itulip.com/forums/showthr...861#post261861

    The first article is published at the mid 1970's low. The thinking doesn't appreciate that inflation and negative real rates are still going on, and that the US is importing more and more oil.


    The second article predicts huge gold prices which never happened (yet). The guy doesn't get that real interest rates
    increased the value of the dollar/bonds, decreasing the value of gold. He seems to think in terms of perpetual inflation and 6 year cycles.
    I would say "price" not "value".

    Be kinder than necessary because everyone you meet is fighting some kind of battle.

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