Does The ‘Shadow Price’ Of Gold Hold The Key To Its True Value?

“Oh Gold! I still prefer thee unto paper, which makes bank-credit like a bark of vapour,”
Byron, Don Juan, Canto XII

Shadow Price: Shadow pricing is used to refer to the assignment of a dollar value to an abstract commodity that is not ordinarily quantifiable as having a market price, but needs to be assigned a valuation to conduct a cost-benefit analysis.

• For non-cash generating assets such as gold, traditional valuation models have little to offer when estimating fair values
   
• We use a shadow price methodology which relates the monetary base to gold reserves to derive an implied or shadow price of gold
   
• Using data on the US monetary base and gold reserves, and assuming 100% backing of the monetary base we derive a shadow price of gold of $14,119 per troy ounce
   
• Using the more conservative assumption of only 25% monetary backing we estimate the shadow price of gold to be $3,530 per troy ounce
   
• Comparing the differential between the actual and shadow price of gold over discrete ten- year periods we find a relatively close relationship between the average inflation rate and the average actual/shadow gold price ratio
   
• On the basis of the actual-to-shadow gold price ratio, we estimate that a relatively limited increase in the medium-term inflation rate could have a significant impact on the price of gold
   
• Using the shadow price methodology in conjunction with the historic gold-sliver price ratio we calculate a shadow price of silver to be $249
   
• Using our analysis on shadow prices, we conclude that there is significant upside potential for both gold and silver prices

Jumping at shadows

Written off with Keynesian disdain by many financial markets commentators as a “barbarous relic”, global central banks have, post the global financial crisis (GFC) shown a keen interest in adding to their reserve allocations of gold. As shown in figure 2, prior to the financial crisis central banks had been net sellers in every year from 2004 to 2008, reducing official reserves by over 2,000 tonnes over the period. Since 2010, this trend has sharply reversed with net additions of just over 3,000 tonnes between 2010 and 2017.