Can Barrick and the price of gold outpace inflation?

A ship washed up on the shores of Northern Japan after the tsunami. Is this the sign of pending inflation?

These days, mining companies worldwide are getting hit by soaring costs. The price of raw materials, energy and labour have all experienced steep and recent increases. Barrick Gold (TSX: ABX), the world’s largest gold miner, recently increased capital expenditure estimates for two of its projects in the Dominican Republic and Chile by between 10% and 20%. Last month, TD Newcrest analyst Greg Barnes said, “cost inflation appears to have returned to the mining industry with a vengeance.”

All this should come as no surprise to Barrick shareholders. Some may have seen the writing was on the wall in 2009 when Barrick announced a bought deal public offering for gross proceeds of approximately $3.0 billion ($36.95 per share). At the time, Barrick said it intended to use $1.9 billion of the net proceeds to eliminate all of its fixed priced gold contracts (gold hedges) and another $1.0 billion to eliminate a portion of its spot price gold contracts (floating contracts). Barrick cited an increasingly positive outlook on price of gold and the risk of higher inflation. A $5.6 billion charge to earnings then hit the books.

In February, Barrick reported an excellent fourth quarter. The company earned $.95 cents a share and declared a $0.12 cent dividend while posting $2.95 billion in revenue. And although cash costs are expected to be about 10% higher next year, Barrick’s total costs when factoring in all the company’s expenses, not just those associated with production, are estimated at $750-$800 for 2011.

The key question for Barrick shareholders, and for all investors in gold equities, is “Can the price of gold outpace inflation?” Perhaps the answers lie in defining whether gold is more of an asset than a commodity.

A commodity, any economics professor will tell you, is a good that is purchased in order to be permanently removed from the market. An asset, on the other hand, is a good that is purchased in order to be held.  Because people hold on to and accumulate assets the demand exceeds the annual production volume, sometimes by a large margin. In the case of gold, the ratio of the world’s “above ground gold” to annual mine supply is about 100:1. For most other commodities that ratio is less than 1:1. In other words, there is less than one year’s total production in storage reserves for most commodities because everything that is produced is sold and everything that is purchased is consumed within the year.

For gold, the size of existing stockpiles and the large daily trading volume in bullion makes annual mine supply (est. 2,500 tonnes) more or less a non-factor in determining its price.  To quantify the impact of mine supply on the market consider the trading volume on the London Bullion Market Association (LBMA) on any given day. The LBMA can actually absorb the world’s annual mine output in about six trading days. And the LBMA is just one of several bullion markets worldwide. In fact, an entire year’s worth of global mine production turns over in the physical market in just a few days. Because gold is an asset, the real demand for gold each year is equal to the total world supply of gold,  which is about 150 million tonnes.

Over the past decade the price of gold has fared well against inflation, and gold miners have done especially well. Economic uncertainty, global crisis of various lengths and geographic origin, and an increasing money supply have served investors well who look at the shiny metal as a stable store of wealth.

Is it possible, however, that what we have experienced in the last couple of years is merely the beginning of global inflation? Some feel that the US Federal Reserve will ultimately have to work much harder than they have to date to ward off inflation. The Obama administration, over the past three years, has injected billions of dollars in stimulus into the US economy. And immediately after the devastation of the Sendai earthquake and tsunami the Bank of Japan injected $184 billion into money markets and eased monetary policy to support the economy. So the question remains, if costs of production continue to rise will the price of gold outpace inflation?

Emma Simon, in a recent editorial for the UK’s Telegraph about inflation in that part of the world, said that with “inflation now running at twice the Government’s target it is not surprising that gold hasn’t lost its lustre.” Adding “given our current economic situation, it’s not hard to see why there is increasing demand for an asset that appears to offer inflation-proofed returns.” With the removal of its hedges, investors bullish on Barrick think the company might be the equity issue set to benefit most from an increase in government spending, worldwide.

Did you enjoy this article? Check out MiningFeeds.com’s feature story 10 Gold Stocks to Watch in 2011.

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