The gold stock-to-flow model

Commodity markets are typically interpreted through the lens of changes in supply and demand and the impact on inventories in any particular year. This model works for most commodities that are ‘consumed’ (crude oil, wheat, etc.), but is useless to understand the value of those commodities used for investment purposes. I think this distinction is so important for investors to appreciate that I’ve shared how wealth management company Incrementum outlines it (highlights my own).

Gold Bullion, Bank, Finance, Savings

While the economic utility of a consumable good is created when it is destroyed or used up, the utility of investment assets lies in their possession and later resale. Industrial commodities therefore have low stock-to-flow ratios, this is to say, inventories usually only cover consumption demand for a few months. If there were no inventories at all, supply would have to correspond exactly to production and demand exactly to consumption. However, if there are inventories, consumption can temporarily exceed production. Since inventories of consumable commodities are as a rule very low, prices will rise quickly in anticipation of a future supply shortage and bring consumption into balance with production.

Unlike consumable commodities, gold and silver exhibit a large discrepancy between annual production and the total available supply which is a high stock-to-flow ratio. It is our premise that the high stock-to-flow ratio represents the most important characteristic of gold (and silver).

While the entire amount of gold ever mined totals approximately 190,000 tonnes (the stock), annual production is about 2,900 tonnes (the flow). If you divide the stock by the flow you get a stock-to-flow ratio of 66 years. Silver meanwhile has a stock-to-flow ratio of ~22.

Platinum and palladium have a ratio of 1.1 and 0.4 respectively. Although typically lumped together with gold and silver as precious metals, annual production is a much more significant factor. If either of these metals start being hoarded prices will rise leading to higher supply and falling prices.

Gold isn’t as valuable because it is so rare, but quite the opposite: Gold is valued so highly because annual production relative to the existing stock is so small. Putting it differently: not only scarcity, but primarily the relative constancy of the available stock is what makes gold unique. This characteristic was attained over centuries and can no longer be altered. This stability and security is a crucial precondition for creating confidence.

Apart from gold’s unique stock-to-flow ratio its high marketability is another important feature. The easier it is to exchange a commodity, the more pronounced its ‘moneyness’ is. Carl Menger developed the theory of marketability in the 19th century. According to this theory, gold has established itself in a long term evolutionary process, because its marketability was higher than that of any other good. According to Menger, the marginal utility of gold therefore declines more slowly than that of other goods. Gold and silver therefore enjoy their monetary status not due to their alleged scarcity, but rather due to their superior marketability. 

In this respect there is a crucial difference between gold and other stores of value such as expensive real estate, diamonds or art objects. A Picasso painting, an expensive Bordeaux or a unique piece of real estate are all difficult to liquidate at an acceptable price in a liquidity emergency during a crisis situation. Furthermore, the specific features of art objects or real estate are only ascertainable after extensive due diligence. The fungibility of gold is therefore a crucial differentiation. This seems to be an additional reason why central banks are hoarding gold and not real estate, art objects or commodities as their main currency reserve.

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