Commodities One on One (part III)

Commodities differ from stocks or bonds in the fact that, usually they have significant importance for some industry. For example, silver is used in the production of electrical conductors and oil is used as fuel for various kinds of machines. The main difference from a financial point of view is that, other than bonds and stocks, commodities do not give you cash flows in the like of dividends, coupons or the principal. The only way in which commodities generate returns (excluding industrial applications) is when their price changes in the direction you bet on. This article is a continuation of Commodities One on One (part II).

GOLD
Influencing factors

Today, like most commodities, the price of gold is driven by supply and demand as well as speculation. However unlike most other commodities, saving and disposal plays a larger role in affecting its price than its consumption. Most of the gold ever mined still exists in accessible form, such as bullion and mass-produced jewelry, with little value over its fine weight — and is thus potentially able to come back onto the gold market for the right price. At the end of 2006, it was estimated that all the gold ever mined totaled 158,000 tonnes (156,000 long tons; 174,000 short tons). The investor Warren Buffett has said that the total amount of gold in the world that is above-ground, could fit into a cube with sides of just 20 metres (66 ft). However estimates for the amount of gold that exists today vary significantly and some have suggested the cube could be a lot smaller or larger.

Given the huge quantity of gold stored above-ground compared to the annual production, the price of gold is mainly affected by changes in sentiment (demand), rather than changes in annual production (supply). According to the World Gold Council, annual mine production of gold over the last few years has been close to 2,500 tonnes. About 2,000 tonnes goes into jewelry or industrial/dental production, and around 500 tonnes goes to retail investors and exchange traded gold funds.

Central banks

Central banks and the International Monetary Fund play an important role in the gold price. At the end of 2004 central banks and official organizations held 19 percent of all above-ground gold as official gold reserves. The ten-year Washington Agreement on Gold (WAG), which dates from September 1999, limits gold sales by its members (Europe, United States, Japan, Australia, Bank for International Settlements and the International Monetary Fund) to less than 500 tonnes a year. European central banks, such as the Bank of England and Swiss National Bank, were key sellers of gold over this period. In 2009, this agreement was extended for a further five years, but with a smaller annual sales limit of 400 tonnes.

Although central banks do not generally announce gold purchases in advance, some, such as Russia, have expressed interest in growing their gold reserves again as of late 2005. In early 2006, China, which only holds 1.3% of its reserves in gold, announced that it was looking for ways to improve the returns on its official reserves. Some bulls hope that this signals that China might reposition more of its holdings into gold in line with other Central Banks. India has recently purchased over 200 tons of gold which has led to a surge in prices. It is generally accepted that interest rates are closely related to the price of gold.