After the Bell: The astounding new discipline of gold companies

20 Feb 2023

A really incredible thing happened: Gold producers became irrational and started cooperating. Or perhaps they weren’t actually cooperating so much as they became very conscious of the consequences of overproduction. Whatever. They found discipline.

Discipline. That’s the stuff you learn in the army. There is apparently a true story about a visiting major who went for a meal in the officer’s club, and asked the chef, “What’s good here, soldier?” The chef snapped to attention and said, “Discipline, Sir!”

Discipline is also associated with some businesses. But there is one industry not particularly known for its discipline: the gold industry.

The reason is simple. Commodity producers are typically price-takers because the price of their product, their only product, is publicly set on an ongoing basis by the market. There is no such thing as “good gold” and “bad gold”, there is just gold. The ability to differentiate is non-existent. So the ability of gold companies to grow their companies is determined really by a single variable: how much gold they can pull out of the ground.

But then over time, gold companies got to realise that if they all pulled as much gold as they could out of the ground, the price of gold would decline, nullifying the advantage. Amazing! The trick was to somehow convince everyone else to stop producing so much gold, while at the same time, producing more yourself.

Pessimism

But there is a contradiction here too. What gold producers are selling is essentially pessimism. Gold’s one great advantage is its history as a store of value outside of the global monetary system. I remember having a long lunch with a gold producer a long time ago who was convinced that this new-fangled dotcom stuff, otherwise known as the internet, was bound to end in disaster. In a way, he was right! The dotcom bubble did in fact burst. But then it went on to change the world. And that is gold producers for you; disasters, potential and actual, are everywhere.

But if you are arguing in favour of pessimism, there is an underlying contradiction if you go nuts pulling more gold out of the ground, which sounds like the kind of thing an optimist would do. I suppose you could be optimistic about the likelihood of increasing pessimism.

In any event, gold mining does involve something of the prisoner’s dilemma. This is the famous thought experiment where two prisoners are caught committing a crime and subsequently cannot communicate. Either could get off entirely by one ratting on the other, in which case the rat goes free and the loyal one gets the highest sentence. If they both rat on each other, they both get a medium sentence. Or they could both remain silent and get the lightest sentence.

What the prisoner’s dilemma shows us is that loyalty to your partner is irrational, and the reason is simple: people tend to gravitate toward certainty. The consequences of betrayal could be serious, but they are certain, whereas trusting your partner is uncertain even if the consequences could be the lightest on offer.

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You get the drift: it would pay gold companies to cooperate and not produce more gold than the world wants. But historically, they never did that. In 1980, the world’s gold miners produced around 1,250 metric tons of gold. After that point, the line points sharply up and right, and by the year 2000, the world was producing about 2,500 metric tons a year. The price of gold, during that period — and this will shock you — went down.

So far, so good. The market works; more production means a lower price. But there were some anomalies here. The price went down, but not by huge amounts, or at least not in proportion to the increase in production. The price in 1980 was about $400/ounce (with big variations, year by year); that decreased to about $280/oz by the early 2000s.

But from 2000 onwards, things started to go in a very unusual direction: gold production increased, but so did its price. The production increases were not huge, but the gold price increases were pretty substantial. By 2010, gold was flying and hit a peak of just under $2,000/oz. Over the next five years, it came down again by a quarter.

But then a really incredible thing happened: gold producers became irrational, in prisoner’s-dilemma terms, and started cooperating. Or perhaps they weren’t actually cooperating so much as they became very conscious of the consequences of overproduction. Whatever. They found discipline. The result is that gold production since 2015 has more or less flattened at 3,100 metric tons a year. In fact, production last year, and in 2015 was exactly that. The result has been a more or less stable gold price — to the extent that it’s ever really “stable” — of around $1,800/oz.

Now that is a pretty high number. Historically, it’s massively high, and it’s particularly high for SA combined with the stronger dollar. The rand gold price is really eye-poppingly high and is now very close to an all-time record. And that’s keeping what remains of SA’s creaking industry alive for the time being.

All the big gold miners are now sitting with trivial amounts of debt on their books, and the gold miners outside of SA are sitting on moderately high price/earnings ratios. And that’s not because the market is pricing them high, it’s because their margins are pretty good. Over the past five years, share prices have been pretty stable, but it’s worth noting the majors have been floating down gently over the past few years.

The really crazy thing is how little the big calamities of our times, Covid-19 and the global inflation outbreak, have affected gold companies, and gold production for that matter. High inflation is supposed to be a boon for the industry, but it hasn’t worked out that way. Dollar strength, the other traditional dynamic which tends to push down the price of gold, is similarly not operating according to the script. And gold has also seen off that other claimant to the “store of value” crown, crypto.

Why are these big changes taking place? I confess I’m not sure. If you have a theory, please let me know. My off-pat thesis is that gold is really becoming quite difficult to find and mine because if it weren’t, miners would be mining more. But what these changes do show is that the plate tectonics of the gold industry are changing fundamentally in ways we don’t quite understand. DM/BM

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