For everyone in the financial sector, September will probably be the most watched month of 2015. Clue: a four-letter abbreviation -- FOMC. But won't the Federal Open Market Committee meeting from Sept 16-17 be just another business-as-usual affair? Don't count on it. The market consensus is there is more than a 50% chance the Fed will raise its benchmark interest rate for the first time in almost 10 years.
The impact of such a decision will ripple across the globe. In fact, we're already feeling the chill. The US dollar has appreciated almost 6.5% against the Thai currency over the past year and is trading above 35 baht compared with 32.90 in January.
A strong dollar is always bad for gold since it makes the precious metal more expensive for holders of other currencies. In the past couple of months, gold has plunged 9%, from about US$1,200 an ounce to $1,090 now. If you bought gold in 2011, when the price was about $1,800, you're looking at a loss of almost 40%.
With the dollar continuing to appreciate, how low could gold go? Many analysts estimate the cost of gold production is about $1,000 an ounce. Therefore, the price could not fall below that threshold; otherwise, producers would face losses and cease production. Makes sense, right? We beg to differ.
To see why, you need some background information, starting with what people in the gold industry call "all-in sustainable cost", which is roughly comparable with total cost. It includes the cost of ore processing, administrative expenses and money spent to find new mine locations. In other words, it is the cost that allows gold mining companies to sustain operations over a long period of time.
According to the GFMS Gold Survey 2015 by Reuters, the average all-in sustainable cost for gold production is $1,314 an ounce. Thanks to economies of scale, large mining companies have lower total costs. Barrick, the world's biggest gold miner, reports a total cost of $927 an ounce. Note that this is below the "rock bottom" total cost of $1,000 that media commentators tend to use.
However, things are more complicated than that. Total cost could be separated into fixed and variable costs. Fixed cost is the expense that does not vary with production levels such as machinery and mine development expenses. Variable cost fluctuates with production levels -- for example, mining and ore processing expenses. The more gold is produced, the more the variable cost.
"Cash costs" -- another fancy gold industry term -- is probably the closest indicator of variable cost. Reuters puts the average cash cost at $749 an ounce and Barrick at $879.
Economics 101 and loss minimisation: Now what if the gold price drops to $950? Should mining companies that have higher total costs but lower variable costs cease operations immediately? From an economic point of view, the answer is no.
Notice that at $950, mining companies could still earn a gross profit margin (price minus variable cost) of $200 an ounce on average. Sure, this gross profit would not be enough to cover fixed costs, but it could still partially compensate for them. In other words, even though miners may suffer overall losses regardless of whether they decide to continue producing or not, the loss is less when they decide to carry on.
Therefore, the miners should keep producing as long as the price remains higher than the variable cost -- $749 an ounce, as noted above. That means the assertion that companies will stop production once the price falls below $1,000 may not be true -- at least in the short run.
And in the long run? Things are more complicated.
Admittedly, if the gold price stays below the total cost for an extended period of time, companies will have no incentive to develop new gold mines. As a result, supply will gradually decline to zero. But there is always demand for gold. With excess demand, the gold price should be pushed up, right? Yes, at least in theory, and if the supply comes solely from gold mining companies.
Unlike with oil, there is a second source of gold supply -- gold owners. Unlike the supply from mining companies, there is no obvious reason why we should expect the supply from gold owners to suddenly disappear once the price drops below the total cost of production.
Given that the total supply of gold comes from these two independent sources, there should still be a supply available even if the price drops below the total cost and the supply curve does not disappear below the total cost of mining. Hence, market equilibrium with a price below the total cost of production is possible even in the long run. Demand will dictate how low it can go.
To sum up, let us be clear about our message. We are simply arguing the practical equilibrium gold price could fall below the total cost -- say $1,000. Though we did not argue it would, "could" is already a grim possibility. So don't be too surprised if gold does dip below the analysts' threshold of $1,000.
TMB Analytics is the economic analysis unit of TMB Bank. Behind the Numbers is co-authored by Benjarong Suwankiri and Peerawat Samranchit. They can be reached at tmbanalytics@tmbbank.com