Goldman On Gold: $1,450/Oz
And forthwith, the oracle speaks. The much awaited 2010 Commodity Outlook is out. Here is the 2010 summary breakdown:
As we start a new decade with the global economy emerging from the worst recession of the post-war era, we expect the commodity supply-side constraints of the past decade to once again reemerge, reinforcing the sustainability of higher long-term commodity prices – a theme we first began discussing at the turn of the current decade. However, the inability to grow supply after a decade of sharply higher prices turns the question of the sustainability of higher long-term commodity prices into one of the sustainability of higher long-term growth. Anemic supply growth of energy and basic materials runs head-on into the ongoing revolution in emerging markets generated by more than a billion people rising into the ranks of the middle class over the next decade.
We maintain that this undesirable outcome is not the inevitable result of dismal Malthusian logic, but rather the result of deliberate choices as expressed through policy. At the beginning of the current decade, we argued that decades of inadequate investment in commodity productive infrastructure were leading to a "Revenge of the Old Economy", where a constrained supply base would sustain higher commodity prices. Toward the end of the current decade we argued that the "Revenge of the Old Economy" had turned into the "Revenge of the Old 'Political' Economy" where significant policy constraints on the free flow of capital, labor and technology were substantially constraining supply growth for many commodities, regardless of price or expected return. Furthermore, these protectionist policies caused capital not to flow to the most efficient commodity investment but rather to the most freely accessible one that was usually inefficient, extremely high cost/tax with poor rates of return, which put more upward pressure on prices, or in some cases the capital did not flow at all, creating outright physical shortages.
But not all commodity markets finished the decade supply constrained. Impressive supply growth in several key commodities in recent years proves that many of these supply-side problems can be alleviated through well aimed policy that motivates investment in resource constrained sectors. For example, the ability to freely invest in US domestic natural gas production has led to the technological breakthrough of unconventional shale gas plays, which has created a global glut of natural gas. In addition, investment in petroleum refineries and ferronickel pig iron technologies has led to sharp declines in petroleum product cracks and substantially lower nickel prices.
Moreover, in many of these cases, policy served to encourage rather than to discourage investment. For instance, while the United States and Europe opposed petroleum refinery investments owing to environmental concerns, India incentivized this investment through tax breaks, but maintained strict environmental standards, creating a "nearly zero-emission refinery" that uses state of the art technologies with a cost basis that has even driven some less sophisticated western refineries into closure.
Overall, these developments suggest three emerging themes that are likely to continue to dominate in 2010 and beyond:
- Differentiation between commodities driven by the extent of supply constraints that will likely drive greater price dispersion across the commodity complex;
- Resource realignment as emerging markets are forced to bid away scarce commodities from the developed economies, especially when supply constraints are more restrictive, which shifts the focus away from the sustainability of higher prices and towards the sustainability of higher growth;
- Increasing macroeconomic correlations as resource realignment will likely increase the relevance of commodity prices and supply to the broader macroeconomic environment.
Differentiation between commodities driven by the extent of supply constraints will likely drive greater price dispersionOver the past decade a substantial amount of investment and technological innovation has taken place across the commodities complex with widely varying degrees of success. As we emphasized at the beginning of this decade, it was precisely this uncertainty in the success of different technologies that generated a premium in commodity prices above the observed marginal cost of production.
During the first part of this decade, almost all technological advances in commodity production failed. In energy, oil sands failed to deliver owing to energy and water constraints, gas- and coal-to-liquids proved too costly, biofuels used too much land and drove up agriculture prices, solar parks proved too expensive and wind used up too much real estate. All of these problems made scaling up these technologies too difficult. In metals, environmental impacts restricted the widespread use of otherwise productive technologies, while in agriculture GMO was simply additive to Borland and hybrid technologies.
By the end of this decade, however, some of these failures started to turn into successes, such as the technological breakthroughs that occurred in natural gas and nickel, which started to create differentiation in commodity pricing, especially when the ability (or inability) to grow supply was matched against emerging market demand growth.
Overall, the more binding the constraints on investment and supply growth and the more leverage to emerging market demand, the stronger the commodity price recovery has been this past year and the stronger the outlook is into 2010 and beyond. In particular, natural gas, refined petroleum products, nickel, wheat and aluminum have all seen significant growth in production capacity and with the exception of aluminum all have limited exposure to emerging market demand growth. Accordingly, these commodities have experienced far more modest price recoveries and have a much weaker forward price outlook. In sharp contrast, crude oil, copper, zinc, platinum, corn and soybeans all have binding supply constraints with far greater leverage to emerging market demand.
In the past, these types of shortages were largely dealt with by intra-commodity substitution. This behavior generated fundamental tightness across the commodities and drove the commodity price convergence that has been a key feature of the markets over the last five years, making the consumer indifferent to the specific commodity. For example, corn could be used for transportation like oil, for power generation like gas and for material like aluminum, so if the prices of these commodities were the same on a Btu basis, we were indifferent to the commodity.
However, the nature of the current shortages limits the ability to substitute, suggesting the likelihood of increased price divergence in coming years. For example, we expect that the substantial disconnect between oil and natural gas prices will likely be sustained over the medium term. When natural gas was in tight supply, oil could be used as a substitute to natural gas in the generation of electricity. However, substitution in the other direction does not work given current installed technologies and infrastructure. In other words, oil can substitute for natural gas in power generation where it is predominantly used by combined cycle units that can burn both fuels, but natural gas cannot substitute for oil in transportation where oil is predominantly used without massive investment in infrastructure. The avenues to convert natural gas into an oil substitute are wide ranging but all very expensive – gas-to-liquids to turn natural gas into diesel, compressed natural gas (CNG) as a direct automotive fuel and electric cars. Until these investments are made or the gas glut is resolved, which is unlikely in the next three to five years, natural gas is likely to trade at a steep discount to oil.
And while you can read the oil propaganda on your own (maybe just pull the summer 2008 report: same shit, different day), here is what Goldman had to say on Gold.
With the US Federal Reserve expected to keep its short-term nominal interest rate target near zero through 2011, we expect the low US real interest rate environment will continue to provide strong support for gold price in 2010 and 2011. However, as we also expect US inflation to remain subdued, we expect that gold prices will come under significant downward pressure once the US economic recovery strengthens and the US Federal Reserve begins to raise interest rates. Consequently, an earlier than expected tightening of US monetary policy is the primary downside risk to gold prices in 2010 and 2011, in our view. In the interim, however, we expect the low US real interest rate environment, continued gold-ETF buying and reduced Central Bank gold sales will allow gold prices to continue to move higher. Consequently, we raise our gold price forecasts to $1200/toz, $1260/toz and $1350/toz on a 3-, 6- and 12-month horizon, respectively, with a 2010 average price forecast of $1265/toz and a 2011 average price forecast of $1425/toz. While an earlier than expected tightening of US monetary policy presents a substantial downside risk to gold prices in 2010 and 2011, we believe the near-term risk to our gold price forecast is skewed to the upside.
While gold prices denominated in US dollars continue to march steadily high, looking at the price denominated in other currencies is a healthy reminder that gold prices remain creatures of their financial environment. For example, Australian dollar denominated gold prices peaked on February 20 of this year at 1563 AUD/toz and are currently 17.5% off of their highs. Meanwhile euro-denominated gold prices have only recently returned to their February 20 high of 789 E
While Exhibit 32 highlights the view of gold as a currency, we continue to believe that the impact of the financial environment on gold prices can best be understood by viewing gold as a commodity. As discussed in detail in our March 25, 2009 Commodities:
Frameworks: Forecasting gold as a commodity, US dollar-denominated gold prices are driven by different market fundamentals over long, medium and short horizons.
- Long-horizon: Over long horizons (often more than a decade), the price of gold keeps pace with inflation. In 2008 US dollars, the long-run price of gold is near $420/toz.
- Medium-horizon: Over medium horizons, the real price of gold fluctuates around its long-run price: pricing higher in low US real interest rate environments and lower in high US real interest rate environments.
- Short-horizon: Over short horizons, fluctuations in the monetary demand for gold, notably gold-ETF buying and government central bank selling drive the price of gold relative to its medium-term real interest rate equilibrium.
This implies that the outlook for US inflation and interest rates is the key determinant of gold prices in the medium to long term. Our US Economics team expects that a slow US economic recovery will keep inflation rates low in 2010 and 2011 and lead the US Federal Reserve to maintain it short-term nominal interest rate target near zero. In our view, this has two important implications for gold prices in 2010 and 2011.
- A continuing low US real interest rate environment will likely allow gold prices to continue to rise higher in 2010 and 2011.
- The widening gap between current gold prices and their long-run inflation-adjusted average price of $420/toz combined with a benign US inflation outlook suggests that when the US economy strengthens and the US Federal Reserve tightens its monetary policy, the convergence of inflation-adjusted gold prices to their long-run average in a rising real interest rate environment will likely come through falling nominal US dollar denominated gold prices, not inflation.
This suggests that for the gold investor, US dollar-denominated gold will likely continue to rise in the expected low real US interest rate environment of 2010 and 2011. However, the widening gap between current gold prices and their long-run inflation-adjusted average price of $420/toz combined with a benign US inflation outlook suggest that an earlier than expected tightening of US monetary policy is the primary downside risk to gold. In short, we expect that the gold price-real interest rate cycle will turn when the US Federal Reserve begins to raise interest rates, but do not expect that to happen this year or next.
A continuing low US real interest rate environment will likely allow gold prices to continue to rise higher in 2010 and 2011
Gold prices have continued to drift higher since a surge in net speculative long positions first pushed prices through the $1000/toz mark in September (Exhibit 33). This surge in net speculative length preceded a decline in US real interest rates, with the yield on 10-year US Treasury Inflation-Protected Securities (TIPS) falling more than 50 basis points to 1.20%, highlighting the strong relationship between US real interest rates, speculative positions and gold prices (Exhibit 34).
The ongoing decline in the 10-year TIPS yield has been suggesting ongoing upside risk to our gold price forecasts, which were based on the view that yields would move back closer to 2.00% as the economy emerged from recession. However, with the US Federal Reserve expected to keep its short-term interest rate target near zero through 2011, with US inflation expected to remain low and with 10-year nominal US Treasury bond-yields expected to range from 3.00%-3.25% in 2010 and only reach 4.00% in 4Q2011, we now expect that US real interest rates will remain near current levels at least through the first half of 2010 (Exhibit 35). With current US 10-year TIPS yields near 1.10%, this would imply a medium-term gold price of $1350/toz, if Central Bank sales were strong enough to offset investment demand (Exhibit 36). However, we expect that the buying from the gold-ETFs will continue to outweigh Central Bank selling over the next two years, leading us to expect gold prices to move even higher.
An earlier than expected tightening of US monetary policy presents a substantial downside risk to gold prices in 2010 and 2011
While movements in US real interest rates have dominated US dollar-denominated gold price movements in recent months, the increasing gap between current gold prices and the long-run average inflation-adjusted price of gold requires one to think about how the price of gold will converge to its long-horizon equilibrium when the US real interest rate environment begins to normalize. More specifically, the long-run inflation-adjusted price of gold is roughly 420 USD/toz in today’s prices (Exhibit 37). To return to this equilibrium, either US inflation must rise dramatically – a three-fold increase in US consumer prices – or we must expect a sharp decline in nominal gold prices when US real interest rates rise back toward more normal levels. Given our US Economics teams view that US inflation will likely remain subdued, falling to a rate of only 0.3% in 2011, this convergence must come from falling nominal gold prices.
Consequently, the key question for the gold investor becomes when will US real interest rates rise, pushing gold prices back towards their long-run average levels? In our view, US real interest rates will rise when US economic recovery strengthens and the US Federal Reserve begins to tighten US monetary policy, raising its short-term nominal interest rate target. The last gold price spike in the early 1980s ended as the dramatic tightening of US monetary policy under Chairman Paul Volcker drove US real interest rates dramatically higher and drove gold prices down substantially (Exhibit 38).
In the interim, the balance between investor buying and central bank sales suggests that the balance of gold price risk remains skewed to the upside
Buying by the gold-ETFs surged during the first four months of 2009 by 13 million toz, far outpacing the total 2008 total of 8 million toz (Exhibit 39). Since this initial surge, ETFs inventories have remained stable and we expect ETF buying to revert to its long-term pace of 6 million toz per year. However, we see upside risk to this assumption. Over the past decade total overall gold investment demand, including bar hoarding, coins and gold-ETFs, has averaged 11 million toz per year. Given the growing size and popularity of gold ETFs, they now represent a larger portion of this total investment demand suggesting a potential shift higher in investment flows. Should the buying from gold-ETFs continue at this faster pace of 11 million toz per year, we would expect gold prices to rise to $1,400 /toz by the end of 2010 and over $1,550/toz by the end of 2011.
Although central banks have historically been net sellers of gold, we have witnessed a significant slowdown in the pace of sales since 2008 with the latest data suggesting an outright halt in aggregate sales. Compared to the late 1990s when many central banks viewed gold as a low-yielding asset and their gold sales put downward pressure on gold prices, the more recent movement among central banks is to view gold reserves as an important source of diversification away from the US dollar in their reserve holdings.
Furthermore, emerging market central banks have explicitly stated their intentions to gradually diversify reserves into gold as well as currency reserve assets other than the US dollar. From a positioning point of view, Asian nations as a group hold only a small percentage of their reserves in gold vs. the major European nations holding more than half their assets in gold (56% as of October). China, for example, holds only about 1.49% of its reserve assets in gold and surprised earlier this year when it announced that it had increased its gold holdings by 76% since 2003 to 1,054 tons, mostly from buying from their domestic mine production. Similarly, only 4.7% of Russia’s reserves are in gold and it has stated its intention to increase its gold holdings and has done so by 19% this year alone. Furthermore, the recent announcement that India was to purchase 200 tons of the 403 tons of gold the IMF plans to sell has substantially reduced the outlook for central bank sales in 2010 and 2011. Net, we expect selling by central banks and other official sector institutions to remain near subdued, less than 100 tonnes per year on net (0.25 million toz per month, Exhibit 40). Should Central Banks continue to be net buyers of gold in the next two years, the upside risk to gold prices would be considerable.
With gold-ETF expected to buy 0.25 million toz per month more than the central banks sell on net and with US real interest rates expected to remain depressed near current levels at least through the first half of 2010, we raise our gold price forecasts to $1200/toz, $1260/toz, and $1350/toz on a 3-, 6-, and 12-month horizon, respectively, with a 2010 average price forecast of $1265/toz and a 2011 average price forecast of $1425/toz (Exhibit 41). While this represents a 12% move to the upside in the next 12 months and a 20% move to the upside in the next 24 months, the last time US real interest rates declined to these low levels on a sustained basis was in the late 1970s, gold prices spiked to $1870/toz in today’s US dollars in January of 1980. While we view an earlier than expected tightening of monetary policy by the US Federal Reserve as the primary downside risk to gold prices in 2010 and 2011, we see the balance of risks as remaining skewed to the upside.