Fructivore Investments

Value investors have a preference for income producing assets and concomitantly a particular disdain for gold. Gold, even apart from other commodities, is valued not for its industrial applications or even as a consumable, but specifically because people like to incur storage and insurance costs in order to pile it in a vault and leave it there.

Even so, value investors cannot affect to be wholly unaware of gold’s existence, even in a world with TIPS, REITs, managed futures in non-gold commodities, and publicly traded companies that can pass inflation on to their consumers. And it is commonly alleged that there is a floor to the price of gold, which is the economic cost of mining it because if the price drops below that point miners will simply refuse to mine.

Furthermore, since neither gold nor gold ore spoils, there’s never really a need to sell it to an end user in any length of time, unlike more perishable commodities. Also, even if the world decides that some cryptocurrency or other alternative robs gold of its status as a fear hedge, gold does have industrial applications in electronics and gilding hardcover books and so forth, so eventually the world’s gold stocks will be drawn down to the point where gold will be profitable to mine again. Of course, any financier knows about discounting, so even if the future value of gold in that scenario will be above the cost of mining it, its present value can be well below it.

However, I was throwing around the idea that the cost of producing gold, plus a reasonable profit margin for the miner, could constitute a ceiling for the price of gold. My reasoning is that a person who actually wants gold has two options: one, buy gold; or two, buy a gold mine and exercise some patience. And if the spread between gold and gold miners becomes too great, the latter option becomes more attractive.

The Internet, of course, disagrees with me; it records an incident back in the 70s when gold spiked, but South Africa, which represented the majority of gold production and the vast majority of the First World’s gold production, decided that it would maximize its long term profits by mining lower quality ore instead of mining high quality ore to take advantage of the situation to earn massive windfall profits. Of
course, I wonder if the illustrative quality of this example is limited, considering that gold production is more globally distributed now and there is no OPEC-style cartel for gold producers.

So there is no reason in theory why a lot of gold miners shouldn’t be ramping up production to take advantage of the spike in gold prices; although the Internet informs me that most gold miners don’t fully hedge their output like they did in the bad old days. But since, as of this writing, gold is just over $4000 when it was at $2000 five years ago and at $3000 seven months ago, while the all-in cost of producing gold is hovering around $1500 or less, one can imagine at least some miners to take advantage of a windfall profit.

Even so, I would treat the demand for gold as exogenous, like most economic goods, meaning that the demand is determined by “animal spirits” and is mostly decoupled from supply. In other words, the demand of gold is subjectively determined and the various factors of production must line themselves up to meet it as best they can. So if the cost of production, profits included, serves as a ceiling on the price of gold, it is a very soft ceiling, as miners ramping up production seems like an attractive strategy in the abstract but it also takes time and effort to accomplish in practice, and of course the annual output of gold mines is actually a fairly small percentage of the world’s gold that is available for sale.

At any rate, the situation suggests a strategy that is schizophrenic at first glance but in fact is just hedged. The plan is to buy gold miners, which will be experiencing windfall profits from the spike in gold, and then to either short gold outright or buy puts on it. Ordinarily gold miners represent a leveraged long bet on the price of gold, since they have overhead that magnifies the effect of gold price movements on their profits, so what could be more natural than hedging it with a leverage short on the price of the gold? If gold miners are resistant to hedging the price of their output, let us hedge it for them. In this way we are betting on gold miners’ improved profitability without the inconvenience of the price of gold getting in the way.

And thus, for those of us who do not affect to be pridefully ignorant of gold’s price action, there is a speculative play available.

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Investing by grocca