Rarely has an emerging commodities producer been greeted with such a welcoming market outlook: an affluent regional customer base, sustained high global prices and the prospect of long-term production decline at a major rival.
No wonder Saudi Arabian Mining Company (Maaden) has felt sufficiently confident to up the pace of exploration and development of the gold sector in at least four locations in the centre and west of the kingdom, all of which are now in production.
The buoyant market conditions also create a favourable context for the foreign partners the group is seeking to attract as it moves towards partial privatisation.
However, world market conditions, while positive, are less secure than the boom prices of the past year might suggest. This means that cost and financing issues will be critical to the long-term commercial viability of development in the Saudi gold sector.
Maaden remains cautious about releasing full accounting data on the performance of its gold operations. But several factors should work strongly in its favour. Like other Saudi industrial groups, it benefits from cheap energy and the support of a government that has had the money to build modern support infrastructure such as roads.
Moreover, the cost of imported labour for lower-skilled tasks is relatively low. This is a significant contrast with South Africa – until recently the world’s top producer, but now over-taken by China – where the workforce is highly unionised and, for obvious political and historical conditions, there has been a long-term drive to push pay and conditions strongly upwards.
Moreover, Maaden is operating mainly in a barely populated desert setting where environmental challenges are less acute than for other medium-sized competitors based in more well-watered countries with a substantial local population dependent on agriculture. In western Mali, for example, there are major concerns over the damage that may have been caused to the health of villagers by alleged leaks of dangerous chemicals into the water table.
As it looks to the future, Maaden will need to make the most of its cost advantages, because of the uncertain pricing outlook for the world gold market. Prices may be about $900 an ounce ($/oz) now, but this already represents a $100 slippage on the highs of late 2007, and they could drop by a quarter or more in the near future, according to analysts.
“Gold is not a commodity that is consumed,” says Walter de Wet, analyst at Standard Bank in Johannesburg.
Once it is ‘above ground’, in the form of jewellery or ingots, it exists as part of global supply. Investment holdings can be reduced, and there is a significant market in ‘scrap’ jewellery.
Gold’s principle role is to act either as a form of decoration, which can be easily melted down for resale, or as a store of value – a ‘quasi-currency’ held by investors and central banks as part of a wider asset portfolio. There is some industrial use for gold, mainly in the electronics sector, and this is rising, but it accounts for only 12 per cent of physical gold demand.
This puts gold in a different category from most of the other commodities that have also benefited from high prices as demand surges in the booming economies of East Asia.
Iron ore, copper or oil, for example, are transformed for energy production or through industrial use into other finished products. Although trade in scrap metal is a factor in the equation, for the most part these industrial bulk commodities are consumed or used up. Continuous new supplies are therefore needed to replace them.
Soaring economic growth in China and other emerging economies has fuelled a sustained rise in the price of industrial commodities, and now food items as well. And because these supplies are being actively consumed, future demand will help to bolster prices even if the pace of economic growth eventually slows.
The unique nature of gold as a quasi-currency means that its price is also shaped by the level of global economic confidence and conditions in world financial markets.
“The main sources of gold consumption are jewellery and investment,” says De Wet.
But these can exercise conflicting influences on the price. For investors, gold’s attraction lies partly in its price, as a store of value at a time when alternative assets such as the dollar, shares or real estate may be fragile. But for jewellery buyers, excessively high gold prices can be a deterrent.
Although demand for some items, such as wedding rings, is not entirely optional and continues to be driven by fundamental social practises, jewellery is a luxury item and purchases are, to a significant degree, a matter of consumer choice. This means they are sensitive to the level of gold prices, even in affluent Arabian markets.
“Having performed well in the first half of the year, jewellery demand suffered from price volatility in the fourth quarter, particularly in traditional markets such as the Middle East and India,” says a spokesman for international mining company AnglogoldAshanti, commenting on market conditions in 2007. “Gold jewellery demand in the Gulf countries was particularly affected by this period of price volatility.”
This might seem surprising at a time of booming economic conditions in the Gulf. But local currencies are mainly tied to the dollar, which has weakened dramatically and thus reduced purchasing power. Moreover, in a climate of rising inflation and escalating house rents, many shoppers are seeing their purchasing power reduced.
AnglogoldAshanti expects that when regional sales data for the final quarter of 2007 becomes available, it will show a fall in gold jewellery sales in the Gulf, compared with the last three months of 2006. It draws a contrast with Egypt and Turkey – which are not experiencing the same sort of inflationary oil-fuelled boom – where demand for jewellery remains strong, thanks to longer-term economic buoyancy and demand from foreign tourists.
Consumption in China has remained steady, but AnglogoldAshanti reports a low level of repeat orders from retailers, who appear to be waiting to see whether prices will ease. Demand in India has also fallen.
In the US, demand outside the affluent ‘top end’ market has been depressed. While dollar weak-ness may be an issue, the biggest factor appears to be the weakness of the domestic economy.
By contrast, demand for gold among investors – driven by perceptions of global financial market and currency stability – remains strong.
“People are buying gold as a hedge against dollar weakness and uncertainty,” says De Wet.
He notes that gold’s traditional role as a value store has been enhanced by a growing tendency for investors to see commodities as a useful element in a well-diversified asset portfolio. “It is becoming more and more acceptable that you should hold 5-10 per cent of your portfolio in commodities,” he says.
The US remains the biggest centre for gold investment, despite the expanding role of investors in the economies of the Far East and the Gulf. And this remains true also for the Exchange Traded Funds (ETFs), which are an increasingly significant force in the gold investment market.
By the end of last year, total ETF holdings had reached almost 28 million ounces of gold, with a dollar value of more than $23bn. Of this, $17bn was held by US-listed ETF StreetTracks.
In tonnage terms, at 803 tonnes, total ETF holdings are now equal to three years’ output from South Africa. However, investor demand, being linked to wider levels of financial market confidence or concern, is fundamentally volatile. This has had a marked impact on prices.
Global economic uncertainty has buoyed prices over the past six months, although they have already slipped from the peak of a few months ago. Pricing levels, of course, have implications for the development of mines. “At current prices of $900/oz, most projects will be viable,” says De Wet.
But the margin for slippage before some projects are rendered uneconomic is not large. For example, production costs for 90 per cent of South African output average about $700/oz, even though some mines produce for as little as $350/oz. If prices fall substantially, some South African pits will become unviable.
As world economic confidence recovers, perhaps in a year or two, gold demand and prices will soften. The question is not whether projects can make sense in today’s conditions, but whether they are likely to be as viable when prices may be substantially lower.
“It is possible that you will see gold fall, and if it falls it should fall fairly rapidly,” warns De Wet. “There is definitely a risk. Gold is, especially now, very volatile. Demand has shifted upwards. That is why we are unlikely to see gold at $350/oz. But we are likely to see $700, or maybe even $600.”
In such a context, for emergent producers such as Maaden, and the investment partners the Saudi group hopes to attract, production costs will be a key issue.