So why do I think the demand for precious metals is set to soar?

The demand for precious metals falls under two broad categories: the monetary demand, and the commodity demand. This article is going to be about the commodity demand but let's touch on the monetary demand first just to establish what the two demands are.

Monetary Demand

Monetary demand is the use that we are generally most familiar with when we talk about precious metals. Gold, for example, is used by governments and individuals as a medium of exchange. Governments historically have paid off their outstanding debts to each other in gold and have historically amassed large stockpiles for this reason (in the US this stockpile has been at Fort Knox). Silver is the other monetary metal. As one example, until 1965 US silver coins were made of 90% pure silver. If the dollar continues to weaken (which we see as almost a certainty and will discuss in a future issue) then precious metals will continue to rise as more people seek a safe refuge for their money. In future articles we will delve into this realm at great depth but first I want to take a look at the other side of precious metals. A side that most people don't immediately think of; and a side that will also play an ever increasing role in the price of precious metals.

The Commodity Demand

The commodity demand deals with the fact that in addition to being used as money, precious metals are used in industry. Examples include the use of gold for high quality connections in electronic equipment, palladium and platinum in automotive catalytic converters and silver in electronics and reflective coatings. In almost all cases the precious metals that are used for these applications are currently used because there is no other acceptable substitute. If copper could be substituted for silver they would have done it already and not be incurring the extra cost in their products. So as the demand for commodities increase, so will the demand for precious metals (in many cases at a rate much higher than other commodities). Now let's take a look at what history tells us we can expect.

The Commodity Cycle

Chart Courtesy of Marc Faber Ltd.

A look back at history shows a very interesting pattern. There have been 5 commodity bull markets in the past 200 years, with almost rhythmic frequency. The longest has been about 40 years with the shortest at 15 years.

1st boom-1823 to 1838 (15 years)
2nd boom-1848 to 1865 (17 years)
3rd boom-1878 to 1918 (40 years)
4th boom-1929 to 1950 (21 years)
5th boom-1963 to 1980 (17 years)

During each up-cycle the prices of commodities increase so more producers come on line to supply more product. However, during the down-cycle the prices of commodities decrease, squeezing the profits of the producers, eventually pushing many out of business. As the next up-cycle begins (many years later) there is a lag time involved as the producers still remember the pain of the last down-cycle and how every expansion they tried was met by the headwinds of declining prices. Not until they have seen the new trend firmly in place do they typically spend the money to increase production. Once they have decided to increase production then there is another time lag. New production can not happen immediately for certain commodities. In the case of agricultural commodities a shift from one product to another can happen relatively quickly. The farmer just plants a different crop in his field, or brings land out of the government fallow program that it has been in and plants it in the new crop. However, in the case of metals it is a far more time consuming process. New mines take years to refurbish (or find) and millions of dollars of equipment to get them back to being productive and pass the new environmental standards. Meanwhile the demand for the metal continues to increase causing the price to increase.

This Cycle

In addition to the fact that it is historically time for another up-cycle and in addition to the fact that it is already happening I am expecting a doozy of a commodity cycle. Why?

Just like the Confucius saying that a butterfly flapping its wings in one part of the world can cause a hurricane in another part of the world if that small breeze just happens to line up with another small breeze that happens to be strengthened by another small breeze. The sum of all the seemingly inconsequential events add together to form a storm.

Everything that I am seeing makes me believe that this commodity cycle will be one for the history books.

India and China

We have all heard a lot about the strength of these developing nations so I am not going to spend a lot of time here, but let me just add that these countries consistently beat their growth projections. That is saying a lot. Think about other bull markets you have experienced - when companies consistently beat their earnings, that usually indicates there is more upside to the stock left. In other words, people don't yet appreciate the true growth that is happening and the company exceeds the expectations to the upside. I would submit a similar dynamic applies here and the countries have a long road of growth ahead.

As these citizens become wealthier they will desire the same material benefits that we enjoy in the west (bigger houses, more electronics, better diets, more cars etc). This requires more commodities to make these products and puts the developing world in direct competition for the same resources with the western countries. By contrast, during the last commodity bull market (1963-1980) the increased demand came almost exclusively from the western civilizations. Even more interestingly, the people in these eastern countries have an affinity for precious metals. In India, for example, a woman is given "bangles" (golden bracelets) as a wedding present by her family. I am told that this is considered her personal wealth and she will keep it her entire life. As Indian families become wealthier it can be presumed that they will give more bangles to their daughters. Gold is considered very much a part of their culture and as the Indians become more affluent they will desire more. In fact look at almost any Asian culture. They use gold as often as they can, temples are plated in gold and it is the preferred medium of exchange.

Limited Resources

Modern Geologists have an incredible set of tools available to them to help them find new deposits. Not the least of these is the aerial magnetometer. This is an instrument that is towed behind or put on board an aircraft that measures the earth's magnetic field strength. A large deposit of metal ore underneath the ground will distort the magnetic field of the earth and register on the equipment. Geologists then explore this further to determine exactly what the deposit might be and if it is economically viable to extract it. Even with these incredible tools there have not been any new silver discoveries recently that are large enough to have a marked effect on the silver market. While I am not saying that we are close to "running out" of minerals on our planet, geologist are finding fewer "mother lodes" of minerals (specifically silver) ripe for the taking. As the easy pickings are used it will become more expensive to get the smaller and deeper deposits. This increased scarcity will put yet another upward pressure on prices.

So where are we in this commodity bull market?

As commodity prices have started to rise from the ashes of the last 20 year bear market the press has been using phrases like "Commodity prices approaching all time highs". While in nominal terms (not corrected for inflation) this is technically correct, it is misleading. A U.S. Dollar in 1981 would buy you a whole lot more "stuff" than it will today, in other words it was worth more than a 2005 dollar. To get a grasp of where commodity prices really are today you simply have to consider inflation. Look at the chart below. When inflation is taken out of the picture we get a realistic view of the prices of commodities. Take a look at the following chart. The red line indicates the real CRB which is the Commodity Research Bureau Index (an index of 17 commodities) corrected for inflation. It has recently bottomed out and is no where near its top in 1980 (the end of the last commodities bull market).

Chart Courtesy of Zeal LLC

Also, a bull market tends to climb even higher than the one previously. So the last top should be considered as a reference but not necessarily a top.

Summary

All the data that we have indicates that we have entered a new "mega-cycle bull market" for commodities. History would suggest that this bull market should run for at least 15 years from when it started. In addition, this time, there are some very unique global monetary problems that could accelerate the climb of the precious metals, in particular, and cause an exaggerated market. We will discuss these in a future issue.

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