Why Betting On the Gold Industry Might Be Risky Now

Though the market for gold will remain strong for years to come given the demand for jewelry, bars and coins as well as its safe-haven appeal, it has a number of threats lurking. Below, we have discussed some of the key challenges and what investors in the sector should be wary of in the coming months and years.

Production Will Eventually Dwindle

Even though a small number of major projects came online by the end of 2017, the project pipeline remains weak. And while major miners have improved cash flow and reduced debt over the last few years, production development expenditures remain at multi-year lows. Though production is expected to pick up this year and next, global mine production levels are expected to decline eventually.

Previously, incremental production from newer mines led to continued growth in overall gold production. However, newer mines are now at or near full potential, leading to slowing down in growth rates. This has made production gains increasingly difficult.

This is the aftermath of sharp cuts in capital expenditure in recent years as well as the lack of significant discoveries. Though there have been signs of renewed interest in brownfield development and extending the life of existing mines, these are not adequate to mitigate the slashed project development spending. As existing reserves are depleted, the current project pipeline will be inadequate to replace them completely and ultimately leading to a supply crunch.

Gold Substitutes In Technology

Demand for gold in technological applications has been affected by cheaper substitutes. Despite inferior durability, copper and palladium-coated copper have made vast inroads into the share of gold in the bonding wire sector. The decade-long decline in the dental sector shows no sign of abatement as gold continues to lose ground to ceramic alternatives, which have improved steadily in quality, strength and durability.

Impact Af A Stronger Greenback, Rate Hike

There is an inverse relationship between the trade-weighted U.S. dollar and the price of gold. If the dollar gains strength against major currencies on the back of positive macroeconomic data, like an improving job market and growing industrial activity, it will again put gold prices under pressure.

The Federal Reserve hiked interest rate by 25 basis points to a range of 1.50-1.70%. It was the sixth rate increase since late-2015 and projects two more hikes in 2018. Higher rates normally translate into a stronger dollar which results in lower gold prices. Further, higher U.S. rates raise the opportunity cost of holding non-yielding bullion and normally weigh on gold.

U.S. April retail sales rose by 0.3% month over month to $497.6 billion, matching expectations. On a year-over-year basis, retail trade grew 4.7% in April, compared with a rise of 4.9% in March. These results add to the expectation that consumer spending, which is the single largest component of U.S. gross domestic product and considered as a gauge of the economy, has rebounded after a weak showing in the first quarter.

A strong job market and higher take-home pay due to tax cuts has improved people's spending power. This also acted as a shield against the pressure from costlier fuel that leaves people with less money to buy other goods and services.

The improvement in retail sales growth signals a strengthening economy and gives the Federal Reserve more reason to raise interest rates. Higher U.S. rates make gold a less attractive investment, as bullion does not offer interest. Consequently, an interest rate hike, possibly in June at the Fed's next meeting is likely to weigh on gold.

Inherent Risks

Gold exploration and mining are time consuming and expensive tasks. Given its scarcity and remote location of deposits, exploration for new gold deposits is difficult. Once an economically viable deposit is identified, bringing a mine on line can take a decade or more, and it requires substantial capital investment.

Moreover, the mining industry is subject to several risks such as political conflicts, environmental hazards, industrial accidents, unexpected geological conditions, labor force disruptions, unavailability of materials and equipment, weather conditions, pit wall failures, rock bursts, cave-ins, flooding, seismic activity and water conditions. However, once a mine is successfully developed, its returns can be enormously high. This is likely to more than neutralize the risks inherent in development and the capital invested for the project.

Related Links:

Four Reasons Why Natural Gas Prices Could Touch $3 Shortly

How Losing Control Of The World's Biggest Gold Mine Could Pay Off For Freeport