Gold Boom or Bust? (Or Both?)

Everyone in our business has been aware of the rise in precious metals prices. In 2007, gold prices opened 50 percent higher than they were two years ago and 130 percent higher than just five years ago. While gold is particularly important in the jewelry business, all precious metals have seen serious increases. Even palladium, which became a new alternative white metal in the last couple of years, has seen sharp increases for two years after a long period of decline. (See Chart A, below.)

It would be easy, and wrong, to make comparisons with 1980, when last we had an explosive increase in gold prices. Serious inflationary pressures back then caused a rush to buy hard assets—art, real estate, antiques, diamonds, and especially gold. Speculative gold buying sparked a rapid escalation in prices through late 1979, peaking at $850 on Jan. 21, 1980. The next day, gold was at $737, and it finished January at $653. We’re not seeing any heavy speculation now, nor is inflation even remotely comparable. Gold prices are responding to a number of factors that suggest the jewelry industry faces some potentially disruptive changes.

Mine production was down slightly last year, partly because of problems at some mines. The outlook for new mines is weak, and older mines are beginning to play out. New restraints on environmental impact and rising costs of supplying mines will tend to limit new ventures. Even so, the London-based consultancy GFMS expects a low single-digit increase in mining output in 2007, in kilos.

Two other supplies of gold to the market—official sales from government stockpiles and recycling of old gold—are expected to drop significantly. The two together will represent about 34 percent of total supply. The public and the wholesale sector both took advantage of last year’s spike in prices to recycle old or dead stocks.

Jewelry manufacturing worldwide used 16 percent less gold, in weight, in 2006 than in 2005. GFMS expects usage to decline only slightly more this year. (At this writing, gold has climbed back to nearly $700, and if the trend continues, as some expect, the decline in usage this year could be deeper than GFMS predicts.) This was the worst demand for new bullion in 18 years. Part of the decline was offset by growth in use in electronics and coins. More than half the decline is attributed to India, Italy, and Turkey.

More dramatic and revealing is the precipitous drop in hedging, by some 68 percent. Hedging by miners has been used heavily for years to defend against a drop in gold prices and to finance mine development and expansion. It assures the mining company of a fixed return. The largest hedger, Barrick Gold Corp., one of the largest producers, has totally de-hedged. Apparently, insiders feel that the price of gold has only one way to go—up.

The dollar has remained relatively weak, and economists predict further weakness, which is likely to drive investors into gold as a safe haven. Most economists have been predicting a recession as the United States deals with its national debt and growing spending on entitlements. That presumably would soften demand for oil, and that would bring gold down somewhat. But with readily available ETFs (exchange-traded funds) that specialize in gold, small investors can now easily invest in gold without needing to take possession. This market is steadily growing and is far from its potential. In the opinion of some, private investment will more than offset any decline in gold prices that might come with economic recession.

The Central Bank Gold Agreement, implemented in 1999 and re-signed in March 2004 by 15 major central banks, limits sales of gold by these banks to not more than 500 tons per year for five years. That target has not been met, and will likely not be met. Central banks have historically been important suppliers to the open market.

Indicative of what may lie ahead was last year’s spike in the gold price. It hit $725 in May, at a time when there was concern about rising rates. The reaction in some markets was quick—business dropped off, and there was a surge of jewelry being scrapped. We should assume that this will be the reaction if gold spikes again, as it might if there are increased geopolitical problems (especially in oil-producing regions) or further dollar weakness. Again, there is a marked difference with 1980. Gold prices had a short recovery in the middle of that year, were down to under $590 by the end of 1981, and then went into a long decline. Early on, people were buying gold jewelry thinking it was a good investment. Then investment scams took a toll, and the commodity failed to track even inflation rates. Today we see a combination of stalling supply, concern over the economic outlook, and geopolitical uncertainty that may be with us for years.

What might mitigate steadily higher gold prices?

Jewelry fabrication now accounts for about 58 percent of gold consumption. Though it used to be higher (by about 10 points), it still has great leverage on supply/demand balance, and therefore on prices. If last year’s dramatic drop in consumption is indicative of consumers’ appetite for the metal when prices rise, then we could see demand in weight fall if prices continue to rise. Also, the public’s scrapping of gold declined quickly when prices declined last year by about $200 off the peak. That could be the result of people believing that gold prices will rise again. If so, a continuing price rise will stimulate scrapping, and that also will temper the price increases.

Higher prices will make expensive mining viable, thereby bringing more supply to the market. Of course, miners would have to feel that higher prices will continue, so we can expect this to have a tempered effect.

Recycling of gold could become a new industry, especially if gold prices climb slowly. Publicly held stocks are huge and could fill shortfalls in supply. At the same time, growth in alternative uses for gold—especially coins and electronics—could offset this factor.

Finally, jewelry manufacturers will look to respond to price rises by finding a way to give the public time to adjust to new levels. We may see more of a shift to lower-price colored stones to bring prices down. We will see alternative metals—silver, steel, palladium, titanium—take a larger piece of the market. In some products, 10k and 14k jewelry will make something of a recovery. Synthetic stones will clearly have a larger opportunity to capture market share, as they could easily make up for any increased prices in gold.

Still, gold is essential for the core of the jewelry business. GFMS expects $700 gold by next year, and others are saying we will see it this year. Some analysts predict $1,000 gold in the next couple of years, and one says $3,000 within five years.

For our industry, these could be daunting numbers, but not impossible. We have just seen platinum prices rise by 250 percent in five years, and rhodium prices increased more than tenfold since 2003 (after declining by 75 percent in the four prior years). Platinum is still very important to many manufacturers and retailers. And rhodium is still used regularly in plating.

But what will booming gold prices mean in popular-price jewelry and in expensive jewelry?

Let’s compare the effect in four cases: Two 14k pieces—a ring with 0.25 cts. of diamonds and earrings with 1.00 ct. of diamonds plus colored stones—and two 18k pieces—a bracelet with 4.00 cts. of diamonds and a necklace with 6.00 cts. of diamonds plus colored stones. We set typical pennyweights for each case. (See Key Chart, p. 131.)

The purpose is to see what would happen as the overall retail scales up. Let’s look at the value of gold in each case, first at scrap value. (See Chart B, p. 130.)

Then we mark up the gold to retail using low wholesale markups on the 14k items (we used 25 percent) and a higher for 18k (60 percent), then retail at straight keystone. (See Chart C, p. 130.)

Then we estimate the value of the other components in each case. We used diamonds ranging from $500 to $1,000 per carat, as we moved up, and did a rough estimate of labor. (See Chart D, above right.)

Finally, we added it all up. (See Chart E, above right.)

Clearly, the impact of the price of gold is less the higher the total price of the item. The total retail changes as a percentage at much less than the change in the gold price alone. Of course, this also assumes that there are no changes in stone prices and labor. Viewed as percentages, it looks like Chart F, above right.

Viewed as dollars, which will be the consumer’s perspective, we will question how readily average consumers will increase their budgets. If we look at Chart E again, we can see what increases we might see for a gold-only piece. Can you sell a $1,500 bracelet for $2,500 (which would be the case if gold went to $1,000)? For that matter, can a consumer handle the price of a 0.25 ct. t.w. ring that sold for $499 at the beginning of this year that might be $799 by the end of the year? Answer that question in the context of growth in wages, which essentially have not moved in seven years.

It’s hard to say what consumers will do. Somehow, we have been able to go from $300 gold to almost $700 gold, and the consumer has adjusted. Should we have a gradual increase in gold prices, the public may adjust again. There seems little doubt at this point that unit sales have suffered, even as we see sales in dollars go up. Declining unit sales means trouble for an industry that has too much capacity in manufacturing and a shrinking number of retail operators.

If we see much sharper declines in unit sales as gold climbs, and especially if increases are sharp, manufacturers and retailers may have to institute sliding-scale markups on gold to try and hold important price points.

Some suppliers are already looking at bottom-line dollars rather than margin. They think that it is unworkable to use the same markups on gold at $700 that they used at $400. They may be right.

In late February, the stock market took a big hit, and gold dropped $20, a token reaction to recessionary fears. But even if gold remains volatile, everyone in the industry needs to do some serious scenario planning for the coming year or more.

[Chart A] London Fixed Metal Prices ($/oz), 2000–07

Year* Gold ±%† Silver ±% Platinum ±% Palladium ±%
*Taken at the start of January †Year-over-year percentage change
2007 639.75 20.7 13.01 43.9 1,135.00 15.6 334.00 26.0
2006 530.00 23.9 9.04 41.5 982.00 16.4 265.00 47.2
2005 427.75 3.0 6.39 6.8 844.00 3.5 180.0 –6.3
2004 415.25 20.8 5.99 28.3 815.50 34.1 192.0 –19.0
2003 343.80 23.5 4.67 1.6 608.00 26.4 237.0 –45.4
2002 278.35 2.7 4.59 0.0 481.00 –20.9 4,434.0 –55.0
2001 $271.10 –3.7 4.59 –13.4 608.00 40.4 965.00 117.8
2000 $281.50 $5.30 $433.00 $443.00

[Chart B] Raw Value of Gold Content
Hypothetical Gold Prices, Per Oz

Item* $600 $800 $1,000 $1,500 $2,000
*See Key Chart, p. 131
1 $105.12 $140.16 $175.20 $262.80 $350.40
2 $175.20 $233.60 $292.00 $438.00 $584.00
3 $450.00 $600.00 $750.00 $1,125.00 $1,500.00
4 $900.00 $1,200.00 $1,500.00 $2,250.00 $3,000.00

[Chart C] Gold Prices at Retail, Using Average Markups
Hypothetical Gold Prices, Per Oz

Item $600 $800 $1,000 $1,500 $2,000
*Markup of 25% used for 14k items †Markup of 60% used for 18k items
1* $262.80 $350.40 $438.00 $657.00 $876.00
2 $438.00 $584.00 $730.00 $1,095.00 $1,460.00
3† $1,440.00 $1,920.00 $2,400.00 $3,600.00 $4,800.00
4 $2,880.00 $3,840.00 $4,800.00 $7,200.00 $9,600.00

[Chart D] Other Costs
Estimated Labor Stones*

Item Wholesale Retail at Keystone
*Diamonds ranging from $500 to $1,000 per carat
1 $175 $350
2 $775 $1,550
3 $3,450 $6,900
4 $7,600 $15,200

[Chart E] Total Retail Prices, Including Cost of Gold + Other Costs*
Hypothetical Gold Prices per Oz

Item $600 $800 $1,000 $1,500 $2,000
*Chart C + Chart D
1 $612.80 $700.40 $788.00 $1,007.00 $1,226.00
2 $1,988.00 $2,134.00 $2,280.00 $2,645.00 $3,010.00
3 $8,340.00 $8,820.00 $9,300.00 $10,500.00 $11,700.00
4 $18,080.00 $19,040.00 $20,000.00 $22,400.00 $24,800.00

[Chart F] Percentage Changes From $600 Retail Price*
Hypothetical Gold Prices per Oz

Item $800 $1,000 $1,500 $2,000
*See Chart E
1 14.3% 28.6% 64.3% 100.1%
2 7.3% 14.7% 33.0% 51.4%
3 5.8% 11.5% 25.9% 40.3%
4 5.3% 10.6% 23.9% 37.2%