Saturday, April 28, 2012

Explainer: Why gold is still precious for investors

Richard Heaney
Winthrop Professor at University of Western Australia
Reshared from
20 July 2011

The price of gold reached a record high of $US1607.01 an ounce on Tuesday as investors turn to the precious metal amid uncertain global economic conditions.

University of Western Australian Professor of Accounting and Finance Richard Heaney explains this trend.

Why has the gold price hit a record high?

There are a number of factors. The key one that you read about in the newspapers is the flight to safety. People tend to invest in precious metals because they are concerned about uncertainty.

Certainly the present price levels, which are pushing up around US$1600 per ounce, surprised me. The gold prices are very high and they’ve stayed up around US$1500 for some time.

To a large extent these prices just reflect the general feeling of unease in the world economy.

I do not think the US political problems in addressing their deficit is helping things. I think that is of deep concern to most people in the world.

If the US fails to reach some sort of political resolution then, at the very least, there is going to be a very severe shock to the US economy if Federal Government employees are not paid.

If the situation gets worse and the US Government does the unthinkable, and defaults on their debt, then there will be some fairly powerful shocks that will adversely affect the world economy.

I doubt that is going to happen, in fact it’s highly unlikely, but people will factor this possibility into their assessment gold prices. A very small probability of a huge event like US debt default will have an impact on the price of commodities like gold.

My best guess is that the jump in price to around US$1600 is being driven by gold trader expectations associated with a very unlikely event of the failure of the US Government to reach agreement on increasing its debt ceiling.

Why is gold seen as a safe investment in times of crisis?

It’s a rare metal, and it has been held by governments and individuals for investment purposes for quite a long time. There is a certain level of gold production each year, and this gold is either used in the production of goods or stored.

People find value in putting their wealth into gold during times of uncertainty. It has been suggested that the majority of gold that has been mined is presently stored and so it is clear that gold is used as a store of wealth.

For example, Germany just after World War I went through a period of very high inflation. The country’s paper money was basically worthless.

Yet, Germany’s gold reserve maintained value in terms of its ability to be used to pay for goods and services that the Government required.

How does the gold market actually operate? If somebody wanted to invest in gold, would they physically buy a piece of gold?

It depends on where you are as to whether you can actually buy gold, but Australian investors can buy gold and sell gold.

Once purchased it is possible to store the gold with a bank where it is looked after in a secure manner until you want to sell it. It’s not the sort of thing you would generally store at home as gold can be easily stolen and is often difficult to trace once stolen.

Storage costs are important. When prices are either stable or falling, the storage costs associated with gold holdings tend to exacerbate the poor return earned from holding the metal during these periods.

Gold and oil price have often followed each other in terms of prices but they have recently diverged. Why is this the case?

There is a fundamental difference between gold and oil. Oil is rarely used as a store of wealth. It is generally extracted, processed and sold for consumption.

The only exception to this is the Strategic Petroleum Reserve that is presently held in the US. This is a very large store of oil held in the US to hedge against times of restricted supply.

People are buying gold because they’re concerned with what’s happening in the world and so they are relying on gold as a store of wealth. Global demand for oil is falling in line with falling consumer demand around the world, resulting in falling oil prices.

Is the rise in the price of silver connected to the price of gold going up?

Silver and gold tend to track each other as they both provide a store of wealth. While both silver and gold are used in electrical circuits and in jewellery their use as a store of wealth has considerable impact on their price. People often invest in precious metals as a store of wealth during periods of uncertainty. You could hold paper money, you could place a deposit with a bank, or you could buy gold, or some other precious metal as a store of wealth. The nice thing about gold is that its supply is limited and its price is a little more stable than some of the alternative investments available at present.


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