The price of gold is a unique and volatile beast. As an extremely rare precious metal, its lack of availability is a major factor in its high value. It makes sense that more readily available commodities such as silver can be purchased at lower prices. Perhaps due to its coverage in the press and infamy throughout history, the average person doesn’t realise quite how rare gold is. It is estimated that all the gold ever mined throughout the entire history of existence, would only fill a cube the size of the Eiffel Tower’s footprint. Our infographic Where in the world is the gold provides some insight into where exactly gold is mined around the globe.

So it’s interesting that so many gold investors and commentators focus primarily on demand, while completely neglecting to consider the impact of a supply squeeze on the value of gold.

Gold mine closures
While gold has entered a period of consolidation with its price falling to 4 year lows, it seems that many gold funds and ETFs have experienced sell offs. Meanwhile demand for physical gold bars and coins remains robust. However, the dramatic price drop has significant consequences for gold mines – the major providers ingold’s supply chain.

The cost of production differs across the various gold mines, with some being less efficient than others. For the higher-cost producers, the current gold price has meant losses on every ounce mined, they are literally having to sell the gold lower than their cost of production. Presently 5 of the 19 major mining companies fall into this category with several others on the brink. Fixed costs are nearly impossible to reduce and many mines are paying the price for letting costs spiral during gold’s bull run.

For those holding direct shares in gold mining companies, complete losses are possible if mines close. Your hope would be that you own shares in the more resilient lower-cost mines to ride out the storm. Either way, the precarious position demonstrates how much riskier gold mining share investment is compared to physical gold investment, where the tangible metal will always provide an intrinsic value.

Eventually mines will close, probably in the not too distant future, as no business can justify producing a product at a loss. Obviously this will immediately cut the supply of gold coming into the market, providing support for the gold price. For those mines who survive, this price increase will in turn release the mounting cost pressures. For those holding physical gold, it seems that the medium term looks promising due to this dynamic.

Physical selling and recycling
The second form of gold supply is in the secondary market through recycling and physical holders selling their positions. The World Gold Council released their latest Investment Commentary last week, siting record low gold recycling as a factor to consider when thinking of gold over the medium term. Less gold being scrapped and recycled puts a major dent in the overall pool of gold available.

Despite the price falls, we’ve actually seen very few clients coming back to sell their holding. There is always a small percentage who panic or simply need cash, but overall the physical gold market has not sold off like the paper gold market. With few second hand sellers, many gold coins remain in very short supply. While availability of gold bars seems unaffected, the premium of a Victorian gold Sovereign for example has increased. If physical holders can remain calm during the current sell-off, this supply squeeze will provide a catalyst for a quick bounce back upwards.

Central bank hoarding
In addition to retail customers holding gold, central banks also impact the supply/demand ratio. There’s no more significant player on the global stage today than China, so any rumour relating to their possible hoarding of gold should also be considered. Alan Greenspan, the former head of the Federal Reserve, recently suggested that if China converted only a small part of its $4 trillion reserves into gold, their currency would assume huge strength in the current fragile international financial system – possibly toppling the US Dollar. While China has not disclosed its gold reserves for years, it is believed they are aggressively stockpiling the metal to diversify its holdings away from the vulnerable Dollar. While official figures claim its gold holding is 1,051.1 tonnes, many analysts believe the true figure to be 2-3,000 tonnes.

Any significant move to topple the Dollar by hoarding more gold would dramatically reduce the world’s supply of the precious metal.

So while the gold price consolidation is unsettling, especially for those holding mining stocks, the upcoming supply squeeze could yet save the day.

This piece was originally published on the Physical Gold blog here.