It seems very important but analysts tend to ignore gold’s voluminous above-ground stocks. I’ve always thought this was a mistake, but I’m still not quite sure the best way to approach it. This is an idea I’ve had but it’s still very much a work-in-progress.

People throughout history have preferred to hold – store or wear – gold rather than consume it, and with very little deterioration very large stockpiles have steadily accumulated, rising by between 1-2% a year (see chart). GFMS ¹, the research group, estimate this “above-ground stock” to be around 194,000t, some 55x annual mine supply ².

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This enormous stockpile gives (and is also a consequence of) gold’s financial-asset-like characteristics. But I’ve always thought something hasn’t quite added up about the “above-ground stocks” story. While the gold price is not very volatile compared to many other commodity prices, it seems to react far more to short-term shifts in supply & demand than you would expect of a true financial asset and given such a large inventory. To give an example, imagine all the world’s mines and wells are forced to shut 1/3rd of production for a year. The oil price would go stratospheric; gold would be far more restrained. But I think it would still go up more than a shortfall of 1,000t in a market of 194,000t would suggest ³.

How can we explain this?

One possibility is the stockpile is far smaller than most estimates. I think we can discount this. It is true the calculation is relatively unsophisticated, being essentially the sum of all historical mine production less a small assumption of gold lost forever. And it could overstate stocks if a) historical mine production has been overestimated, or b) losses have been understated, both perfectly plausible. But while over the years there have been lower calculations (see for example here), they are still many tens of times higher than current mine production; similarly even if GFMS’s ceiling of around 3,600t “unaccounted/lost” is too low ⁴, it is unlikely to be significantly too low.

Another explanation is that gold and gold investors are a special breed. This was suggested by Professor Anthony Neuberger in this 2001 WGC study.

Most private and institutional investors hold little or no gold. Investors who hold gold do so at least in part because gold has certain properties which make it peculiarly attractive in the event of acute political or financial instability. For these investors, gold is not readily substitutable by other assets.

In other words those who hold gold like gold as gold, not as just another financial asset, whereas most other investors don’t like gold as gold, and never the twain shall meet. Take, for example, a central bank. This argument says that hold gold as it is a unique asset of last resort, and so are unlikely to either sell it, even when the price goes a lot higher, or add more, even if it goes a lot lower. In general this means the effective potential ownership of gold is much smaller than for other financial assets, and as such the market is more internalised and hence susceptible to short-term flows.

A third, and the one I want to explore, is related to both of these – that not all gold is the same. Of course we know it is held in different forms – of the 191,000t of stocks not lost or unaccounted for, GFMS estimate ⁵ 91,600t is held as jewellery, 23,800t other fabricated products (but not coins) ⁶, 42,400t as private sector investment (ETFs, bars & coins) and 32,500t by central banks. My argument would be that some of this, such as ETF gold, is far more liquid than others, say certain jewellery or fabricated products and as such is likely to play a more important role in price formation.

One way to deal with this would be to exclude some of the stocks. Neil Meader, in a 2015 presentation, explored some of these issues here and offered a somewhat lower total. You could be more radical, for example, by look at the investment stocks (bars, coins and ETFs). This would reduce global above-ground stocks to 42,400t. If you added in central banks and OTC investment you would be nearer to 80,000t.

The risk here is in excluding too much. Jewellery does come back to the market and in response to price signals – especially high-carat jewellery in places like India. My alternative suggestion is that you weight each category of gold stocks in terms of how liquid they are. The idea would be that if, say, gold jewellery is being melted down and turned into bars, the global gold stock is becoming more liquid. If gold bars are being melted down and turned into jewellery, it is becoming more liquid.

Something similar happens to measures of the money supply, where the difficulty historically has been whether you should look at cash, or cash and current account, or those and savings accounts and so on (M0, M1 etc). The Divisia measure deals with this by aggregating them according to how much they provide transaction services, and its proxy for this is the relative interest rates on each type.

Unfortunately in gold we don’t have an interest rate to do that. And this is where it gets tricky. The question is how easily such gold can return to market. One measure could therefore be the cost of transforming the product into London Good Delivery metal. For ETFs this is almost zero. For bars and coins it is relatively small. For jewellery it is higher. But it doesn’t quite measure what we want. After all the cost of transforming low caratage western jewellery presumably isn’t much higher than high-carat jewellery, but it is less likely to happen as the western jewellery has higher value-added elsewhere. So possibly a better measure is gold as a % of the items value – near 100% for investment gold, quite low for western jewellery and industrial gold.

Calculating neither of these will be easy. And so I’m just going to give some guesses. I’m going to weight ETF and institutional gold holdings at 1, retail investment at 0.7, high-carat investment jewellery at 0.5, western-style jewellery at 0.3 (note I’ve made some assumptions about the split between these) and other fabricated products at 0.1. Central banks is a tricky one – they hold mostly London Good Delivery Gold, so highly liquid, but there is a lot institutional stasis preventing both buying and selling. I think the former wins out – so I’ll go for 0.8 – but I could see good reasons for a much lower figure.

Applying these weights to the current 191,000t of actual above-ground stocks gives a a weighted figure of 91,000t (which I’ll call, slightly inaccurately, the liquidity-weighted gold stock, LWGS), made up of 2,400t of other fabricated stocks, 16,500t of adornment jewellery, 14,700t of high carat investment jewellery, 25,400t of bars/coins, 26,000t of central bank gold and finally 6,100t of ETFs and other institutional stocks.

Does this aid analysis? Obviously it means for a given size of gold move the market will have a harder time absorbing it. New mine supply every year represents about 3-4% of this weighted gold stock compared to 1.5-2% of the total gold stock.

Of course while new mine supply needs to be absorbed, it is no longer an indication of how much the gold stock is growing by. That which is diverted into technological uses, for instance, doesn’t add at all much on my measure.

The annual increase in the liquidity-weighted gold stock looks like this.

We can see that in the 1990s the global LWGS grew less slowly than the total gold stock (or put another way the total gold stock was becoming less liquid), a function largely of liquid central bank gold being sold and converted into less liquid Asian jewellery. But starting in 2001, and gradually building up to 2009, the annual increase in this liquidity-weighted gold stock accelerated as this process reversed, with a splurge of investor buying. Since the the liquidity-weighted gold stock has continued to grow proportionally faster than the total gold stock, with the exception of 2013, when a wave of ETF selling saw liquid gold melted down and converted into less-liquid jewellery into China.