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This piece is written on the base provided by GFMS, as always, a most competent gold survey of what happened in the gold market last year. Their conclusions highlight the evolution of the gold market over the last 7 years, since the Washington Agreement was signed in 1999.

At that time in an environment of a gold market clouded by the constant threat of Central Bank sales, the treatment of the metal as a commodity and the accelerated gold production fuelled by the hedging of future production at prices persistently higher than those achieved when a new mine came into production.

The path of gold since then has been remarkably slow. At first a key change was the announcing of Central Bank sales of gold ahead of the event, which limited sales to 'ceilings'. This removed the fear of unexpected sales.

Then the gold price was at the mercy of hedge and speculative fund dominance making the gold price rise then fall 30% each way.

Jewelry demand, along with other uses for gold grew steadily, while absorbing price rises until it became apparent that the gold price was going far higher, then demand stabilized from this source. This was most noticeable in the West, in particular and in times of volatility in India.

Jewelry decline
But as gold prices rose it moved out of the reach of the small consumer, through the buying of lower caratage gold, so reducing tonnage demand. After all, they wanted something they could afford and looked like gold, so price was very important to them. Jewelry making is a key source of demand for gold even now. Offtake in the sector fell sharply in 2006 by 428 tonnes to 2,280 tonnes, marking a 15-year low. Gold imports into the Middle East, which were cut by half last year, could be reduced again this year if price volatility remains in place. Turkey, Saudi Arabia and Egypt accounted for 80% of the decline in imports, which were affected by increased scrap supplies and less jewelry production. Scrap jewelry volumes leapt 34% or 112 tonnes. The outlook for this year is not much brighter if prices continue to rise, which would mean jewelry demand could contract even further, but the pull back is unlikely to be as steep as in 2006. The lost jewelry demand has to be replaced with investment demand or prices will fall to a level where jewelry demand returns.

But in the Indian sub continent gold demand grew as it held true to it's promise of financial security and reliability in a country where the 'alternative gold world' provided a money out of the sight of a corrupt officialdom, satisfying privacy requirements as well as fulfilling their religious and social requirements.

The shift to Investment
But as the gold price rose, there had to be a falling away of the price conscious buyer, eventually bringing in the wealthy individual and institutions who looked to gold for long-term investment. 2005 & 6 in particular saw a gear-shift in the attitude to gold as an investment rather than as a commodity or even simply jewelry. But investment dropped in 2006 compared to the previous year, as the market adjusted to a more active buy and sell activity, rather than just buying. Implied net investment fell 20% in 2006 to just under 400 tonnes. But GFMS stated, "Continued weakness in the U.S.$, ongoing geopolitical tensions and strong commodity prices, coupled with fundamental support appearing on price dips, continue to make the investment case for gold strong". We agree completely, but would like to add that it will be increasingly be on the back of falling global confidence in paper money and uncertainty over the stability and prospects for the global economy.

Central Bank's changing attitudes
It also coincided with a change in attitude of the Central Banks towards gold, fully aware of the dangers facing the $ as well as other paper currencies. We saw the transition from the gold overhang of 1999 to some Central Banks buying the metal, wanting to lower their exposure to the $. But the most important move by the Central Banks like Germany and Italy was the refusal to sell their gold, saying that gold was a "useful counter to the $". This stated its monetary value as an integral art of their reserves. Central bank gold sales slowed sharply in 2006, declining 51% to 328 tonnes as signatories to the Central Bank Gold Agreement (CBGA) recorded lower sales and some other banks starting to buy gold.

On the one hand, Agreement signatories seems set to continue to sell below their annual quota, and on the other, the appetite for certain central banks to diversify away from U.S. $ and into gold is likely to generate further purchases, although the volumes of the latter are expected to be constrained, at least for the short to medium term. There is even a possibility that the announced gold sales of the Central Bank Gold Agreement will be virtually exhausted by the 26th of September, the end of the C.B.G.A. year.

Central Banks are faced with a gold market in which a Central Bank finds it difficult to buy gold in volume, without setting the gold price shooting up, and the need for them to propagate their own national currencies, but unhappy with holding huge amounts of those currencies, now set to fall in value.

The effect of higher prices
The gold market will continue to evolve, we believe, into an investment market for Central Banks, institutions and wealthy individuals with gold prices rising to a level that makes gold most gold jewelry just too expensive. Indeed we expect the commodity side of gold to diminish, where replacement metals are an alternative. At some point in the future we would expect, because gold prices will be high enough, for institutional demand to provide sufficient liquidity for major Central Bank transactions as in the past. Sound too rich? Just take a look at the weekly of the E.C.B. for the week before last, in which the sales of gold from their members was, yet again, overshadowed by the quarterly revaluation of their reserves. The revaluation of total gold reserves, after the sales of the week, was the equivalent of buying nearly 250 tonnes of gold. However, this point seems to be lost on those still fearful of more Central Bank sales and on those Central Banks still selling gold.

Is it any wonder that wealthy individuals and institutions want to follow Germany and Italy holding gold?

De-hedging confirms rising prices
The very act of de-hedging is a statement by gold producers that they believe in a rising gold price and don't want to lose profits by selling their gold ahead of production. So last year continued the strong trend of producer de-hedging, buying back 373 tonnes last year. The de-hedging will continue in 2007, with a total of between 210 tonnes and 300 tonnes for the full year.

The total outstanding forward sales, loans and the delta hedge against option positions stood at 1,364 tonnes at the end of 2006 giving producers an ongoing nightmare. Every time a producer reports that he sold for between $350 and $430, when he could have got $675 if he had waited, he does so with head hung low. Isn't it better to take that lost opportunity by buying back the hedge now and get the continuing price rises from now on, rather than watch the position steadily worsen?

Mining production to rise
On the supply side, the picture looks brighter for 2007 after global mine output fell by 79 tonnes last year to a 10-year low, led by Asia, Africa and North America. Cash costs rose by $45/oz, double the increase in 2005. New mines, ramp ups and less of a swing at some of the world's larger operations that dampened the impact of new production in 2006 should support production level to above 2,500 tonnes. But don't expect that to rise to the point where the present levels of demand will be satisfied.

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