by Julian Philips
October 8, 2013 (TSR) – This is a series on how and why the gold markets fail to reflect the true balance of demand and supply in gold and silver prices. Many investors expect and believe that the gold price is an accurate reflection of demand and supply, but it isn’t.
In a perfect market the exact weight of demand and supply on a daily basis would be reflected in the daily prices. In both gold and silver markets this is just not true. Many of these factors are common to all markets, but in the gold market the different factors on a broad front are wider and more complex than most. The extent of market liquidity is a key factor in the efficiency of markets so we need to know just how responsive to prices is the liquidity of the gold market.
It’s naïve to expect markets to be perfect in a very imperfect world and where large investors have a disproportionate power to influence precious metal prices –aided by the different structures of different global markets and their relationships to each other—so the most important point for both traders and investors is that they realize this and adjust their trading and investment with these factors in mind. Of course, the real skill is being able to synthesize these factors into an understanding of where gold and silver prices will go and when.
But this subject has major relevance today. We know that global demand for gold is as strong as ever right now, if not stronger, so why isn’t this being reflected in the gold price?
Will the demand eventually find its way into the open global market and impact the gold price? Or has it been knocked away from doing so?
Why does New York have such an impact on precious metal prices when, particularly in the case of gold it is a minor player in terms of demand and supply [7% of global annual demand]?
With China and India the main physical gold buyers, why isn’t the market in one of those countries and dominating it when combined they account for around 70% of global demand?
How easy is it for prices to be managed and manipulated?
We hear much talk about market manipulation by various institutional bodies, but have you thought just how the different gold markets can do this by their structure and through the institutions that provide market liquidity?
Seashore
As we start this series, it’s good to have an analogy on which to hang the picture so we have a clear idea at the end of the series. An analogy that best portrays the interaction of different market influences in the gold and silver market is the seashore. There are three influences: the current, tide and waves, with current the most dominant.
The tides, however, are the most dominant noticeable influence to us. They dominate the wave action completely. But in the increasingly short-term world of financial markets, it’s the moment to moment wave action that absorbs the media and unfortunately the traders and often investors. This wave action can be gently and placid on wind free days, but can be whipped up into a raging surf with its furious mist just as easily. But the surf and wind has barely any influence on the actions of the sea, even though they rivet our attention.
Here again we would be naïve to believe that the sea-shore of financial markets would be allowed to act and react smoothly to the underlying influences.
In a commodity market, the bulk of the product is negotiated between user and supplier by an ongoing contract for a specific amount. Anything above or below that amount is supplied to or bought from the open market or exchange. But surprisingly enough, it is the marginal amount bought and sold and the price at which this is done that determines the price that the bulk of demand and supply is priced at.
In the gold market, we will look at the most efficient part of the market where 90% of physical gold is traded, the London Gold Fix.
The Gold Fix
One market where there is close communication between the various professionals is the London gold Fix. Think of a pyramid shape with the 5 gold bullion banks in London (see www.goldFixing.com) at the top. These communicate on a twice daily basis at 10.30 in London’s morning and at 3.00 p.m. there to set the gold price at which all gold deals dealt there are priced. Each of these banks has its own clients who are buying and selling and many of these have internal clients buying and selling within their own walls. Each professional ‘nets’ out the supply and demand before he takes his ‘net’ position up the pyramid to the higher level until the overall, net position of his bullion bank in the structure is netted out and used as a basis for determining the Fix. If the price they are considering changes their net position and raises the demand or supply, another price is looked at. Once the five banks are in agreement over a particular price, then the price is set for all deals being transacted at that particular fix.
In this way, demand and supply as reflected in the banking system is smoothed out. But there are so many other factors that influence the gold market that detract from an accurate picture. It’s these that we will examine. You will then see just how easily gold prices can be deflected from giving and accurate balance of demand and supply. In some cases, such ‘deflections’ are outright price manipulations without the manipulators buying and selling physical gold. We have seen this year, in April alone, cases where buying and selling of gold has been engineered by banks and their largest clients, and very successfully so. But we will also look at other ways this can be done. It can even be done with the banks absent from the picture.
We conclude this first part by emphasizing that if the gold market were truly efficient the gold price would be much higher and with far less volatility.
Part 2:
Hedging
One of the biggest problems facing a miner, a refiner, a jewelry maker and anyone forced to hold gold for a period of time, when his business is not speculating on the gold price, is avoiding the price risk inherent in owning gold for such a time. Just the act of holding it for that time is a speculation. So what can these risk-averse gold holders do to get rid of the risk? The answer is that they hedge their gold.
If they’re going to have gold to sell gold to buy gold to refine or to make jewelry, and they know the period when they can get rid of that risk, they buy/sell that gold forward to the date when they get rid of the gold. So these professionals ensure that they either buy/sell an amount of gold (the reverse of their present position) or buy/sell an option that matures at that time. What they lose on holding the gold, they make on the futures position and vice versa.
This puts them where they should be as a business, using gold to make a product. They work for the profit margin on their product which they build into the price and eliminate the gold price risk this way. Any business of this nature that does not hedge in this way becomes a speculator on the gold price. Many businesses have gone bust doing this.
Dangers of Hedging
To highlight the problem that come with hedging we go back to the late ‘80’s then follow right through to 2005. During this period the central banks of the world and the authorities ruling the financial system wanted the world to turn to currencies as money and away from gold.
So they lent gold miners gold against the miner‘s future gold production. All knew that with central bank support and threats that they were going to sell their gold in the open market that the gold price was going to go down (it went from $850 to $272 over time). So what incentive would miners have to produce more gold?
It was existence of the futures market. By selling the gold they had borrowed from the bullion banks as far forward as possible, they would not only achieve the current market price but the interest on the proceeds of the sale until the maturity of the futures contracts. This is known as the “Contango”. By doing this they could turn a $300 gold price into above $500 and boost their profits enormously. The Directors of these mining companies were to be congratulated not only on their prudence but their ability to achieve greater profits outside of mining. This was fine so long as the gold price was falling or standing still.
But from 2005 the gold price started to rise!
As gold prices past the level of income the futures contracts were to achieve, these Directors realized that they had locked their income to a price that may well be lower than the market price. Suddenly shareholders had a sense of humor failure. The Directors of these mining companies were then quickly seen as speculators on the gold price using shareholders money to do so. Heads began to roll.
The policies of nearly all mining companies then changed dramatically as the miners realized they had to expose their companies to the spot price of gold for the benefit of their shareholders. This meant they had to ‘de-hedge’ their positions, or buy back the amounts of gold they had hedged in the futures market to uncover their positions. Around 3,500 tonnes of gold were bought back by the gold mining companies over the next few years, as the gold price roared up from $300 to $1,200. That ended the speculation on the gold price for them.
But businesses, like jewelers or refiners, still hedge their positions to eliminate risk and earn profits on the work they do. Some miners who need to finance their future production continue to hedge, but simply for the funds with which to develop a new mine. Such an exercise now is to finance, not to speculate. But the volume of hedging is extremely low.
The Speculator
But as with any system, certain evolutions take place that fall within the business of making profits. One of these was the creation of the “speculator” and with him entered the first distortion to the gold/silver price.
A speculator can buy gold on a forward (future) basis –on the physical market, usually in London—which he does not intend to accept delivery of. Let’s say he buys and arranges to accept delivery of his gold in 6 months’ time. He may put down a deposit in good faith, i.e. margin, and then hold the gold for say, 5.5 months before selling it.
While his actions take that gold off the market (on a forward basis) seemingly adding to demand he becomes a seller of the same gold adding to supply at that time. The impact is to push prices higher up front and prices lower subsequently, rather like an individual wave flowing in then ebbing out. The net effect on the gold price at the end of the exercise should be nil. But from a trader’s point of view, the move is usually sufficient to move the price enough for him to make his money. But he needs to know if the wave and the tide are flowing.
The most spectacular speculative ‘hit’ on a market came in April of 2013. This was when two U.S. banks, JP Morgan Chase and Goldman Sachs took short positions on COMEX to the extent of over 400 tonnes this is a 95% ‘paper’ market, not a physical gold market. They threw gold at the physical market to the extent of at least 100 tonnes at a time when the sales from the major U.S. gold Exchange Traded Fund, the SPDR gold ETF was selling persistently around 20 tonnes a month/week. The daily supply of physical gold to the market is around 11 tonnes a day.
At the time the market was ripe for a fall, so the gold price fell $100 in a day easily. Overall the gold price fell from $1,650 to $1,180 making overall around $8 billion in the exercise. Take away this speculation and we feel that the gold price would still have been above $1,500.
A very recent example of speculation that distorts market prices happened on the day that the U.S. gov’t shut down on October 1st 2013. The gold price was completing yet another consolidation phase, but this time was different. It was when the gold price’s downward trend met strong support at the 1,300+ level. The mood of the gold and all other financial markets reflected the risks that lay ahead and the possibility of a U.S. credit default on the 18th October perhaps precipitating a ‘credit event’ similar to the mid-2007 ‘credit crunch’.
As the U.S. market opened the price plunged over $40 as it was realized that a strong move was about to happen. This was a perfect point for speculators to hit the market hard. We wait to see if these speculators will be beaten back by physical demand or not!
So here you have seen one instance over a long period of time, when the central banks/gov’t/commercial banks, blatantly manipulated the gold market price down. In the first instance the manipulation happened over a twenty year period. Once they ceased, the gold price eventually soared to $1,900 an ounce.
In the second instance, the sheer weight of money power that the leading U.S. banks have, was used to force the gold price down in a well-engineered shorting exercise. This too is a reflection of how the fundamental demand and supply picture can be distorted by speculators of size.
But despite their size they remain weaker than the long-term current of the market and have, at best, a tidal influence. What remains constant, over time, is the fact that the world sees gold as money. We quote the head of the French central bank who said this last week,
“Gold is unique among assets, in that it is not issued by any government or central bank, which means that is value is not influenced by political decisions or the solvency of one institution or another.”
-Salvatore Rossi, Chief of the Central Bank of Italy, 30 Sept 2013.
And with that in mind, we think gold will rise in price and importance in the future, no matter what efforts are made by manipulative financially important bodies.
In the third part of this series we look at other ways that the gold market can be distorted that are happening at this moment, less visibly.
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Julian Philips‘ history in the financial world goes back to 1971 when Julian joined the London Stock Exchange, qualifying as a member. He specialized from the beginning in currencies, gold and the “Dollar Premium”, Britain’s Exchange Control system at the time. After the floating of the US$ and the Pound Sterling, the gold/currency world exploded into action. He wrote on gold and the US$ premium in Accountancy and The International Currency Review. Julian moved to South Africa, where he was appointed a Macro economist for the Electricity Supply Commission, guiding currency decisions on the multi-billion dollar, foreign Loan Portfolio. He then joined Chase Manhattan for a period, until moving to the U.K. Merchant Bank, Hill Samuel, in Johannesburg, specializing in gold and fund management. He then shifted his sights to Capetown, where he established the Fund Management department of the Board of Executors, which later became part of one of the four, big South African banks. He also contributes to Global Watch and is the founder of The Gold Forecaster and the Silver Forecaster.
