Round Table Interview w Philip Judge, Simon Heapes, Alex Stanczyk

Audio of our recent round table discussion after the most recent trip to Switzerland for the annual gold audits has been posted.

At the PGF website (Flashplayer only): http://bit.ly/1Fcz58L

At the AFE website (downloadable MP3): http://bit.ly/round-table-pgf-dec-2014

Topics covered:

* Summary of physical gold flow 2014
* Chinese gold demand
* Price of gold has dropped below cost of production
* Gold in Backwardation
* Negative Gold Forward Offered Rate
* LBMA will no longer report GOFO as of Jan. 30th 2015
* The refineries are the core of the industry
* Difference in market today vs 90?s
* Potential for mining companies to start shutting in production
* Structual problems with physical gold supply
* Demand by country
* Difference between the physical and paper market
* Swiss refinery running 3 shifts, 24/7
* Currently delivery delays of up to 6 weeks due to physical scarcity
* Mis-match between physical tightness and pricing will result in dramatic price change to clear
* Premiums for rapid delivery
* The mindset of the eastern versus western investor
* New generation of futures traders are unaware of the physical industry
* Focus on the physical as derivative reference indicators may no longer be accurate
* Market narrative and sentiment by demand spheres or regions driving price

There is no such thing as a “Gold Shortage”

As part of my (affliction?) area of interest, I read a great deal about the gold market daily, and one thing that I think is confusing people is this consistent dialogue of there being a gold shortage. Combined with my observations over the years in this industry and a recent insightful chat I had with Bron Suchecki of the Perth Mint, I felt compelled to pen this entry.

There can not be a gold shortage because it is one of the few things on earth still referred to as a commodity that does not get used up as part of an industrial process of some type; the majority of it is still with us. Sure, like many who write/speak/study gold, I have used that word in the past, but I am now repenting of my sins because it does not accurately describe reality.

How much gold is there, really

There is, by some estimates, as much as 175,000 tons of gold above ground, mined since antiquity going back thousands of years of human history. If you consider the tiny amount of gold used each year in electronics applications, medical, and microscopic coatings on the visors of astronauts, virtually all the gold ever mined is still in existence today.

If we subtract from that an estimated 30,000 tons known to be held by Central Banks/IMF/Etc (being generous), another approx 16,000 tons in China, another 15,000 tons in India (all rough guesstimates), there is no doubt some lost which is sitting at the bottom of the ocean in the belly of a ship, but for the most part it leaves us with more than 100,000 tons conservatively speaking that someone, somewhere owns. All of this gold is available for sale, the only question is at what price, and that depends primarily on one thing: The narrative. The narrative is the story people are telling themselves, and each other, about what gold is worth, or what it is about to be worth at some point in the future.

It is my opinion that this narrative is occurring in three major separate  demand spheres, these being

  • China and other Asian countries
  • India
  • The west, which would include primarily the United States and every country whose narrative relies on US based financial “experts” for their cues into whether the building is actually on fire and they should be running for the exits, or if the party will continue on and its ok to have another drink

Yes, there are other demand spheres besides these (such as Germany), and while they contribute to the overall picture they are not market moving from my observation as these 3 major spheres are.

There are other major (and a plethora of minor) factors which affect the price of gold as well such as

  • Geo-political events – examples include US gold confiscation in 1963, gold ownership being against the law such as it was in China until recent times, India imposing import taxes and import export ratios on gold, the recently failed Swiss Gold Initiative, the failure of Bretton Woods convertibility
  • Deflation/Inflation, expectations of inflation
  • Interest Rates
  • Basic supply and demand of physical gold availability in the “float”, or what is for sale immediately in the institutional market depending on the current price
  • Central bank purchasing/sales

Ultimately all of these factors feed back into the narrative.

I have read a lot of what seems like gold haters (or maybe just gold bug haters? I wont name any names ) who appear to like to troll the idea that China is playing any kind of major role in the market. This is clearly untrue as anyone who bothers to do any research on physical demand compared to mining / scrap / etf / central bank sales supply will find out. What this does tell me however is a great deal about their narrative.

Just as so-called “gold bugs” can adopt a narrative so strong that they are unwilling to look at the facts because it conflicts with what they wish to believe, so too does many a western minded trader construct a narrative about the markets which at times cannot be shifted with facts, because the trader in question is falling victim to his own worst enemy of confirmation bias. This my friends is how bubbles are formed, and no amount of reason/logic/facts is going to change the minds of people caught up in it.

Gold Demand Spheres

To dive a bit deeper into the narratives in play in these demand spheres:

China (and other Asian countries)

  • Gold is a long term way to store wealth
  • Have long histories of experience in failures of fiat (paper) based money
  • Desperately need additional investment vehicles to diversify their portfolios
  • Government advocates gold ownership

India

  • Gold is culturally imbedded and a deep part of the psyche
  • Gold is a trusted long term means of storing wealth
  • Gold represents prosperity, honor, and station in society
  • Gold makes an excellent gift, and holds special religious significance

West

  • Gold is a barbarous relic which earns no yield, is dug from the ground and re-buried at great cost. An excellent example of this narrative can be found in this recent segment on Bloomberg, in which one of the people being interviewed has obvious emotional disdain for gold and anyone idiotic enough to consider it valuable
  • Has no redeeming investment qualities
  • Is going to continue to fall in value
  • The world economy is getting better with the US leading the charge

Measuring the narrative

To measure the narrative occurring in each of these demand spheres, I pay attention to import/export statistics for China and India, and for the west I keep track of daily inventory tonnage in the wests flagship gold proxy GLD ETF. I also pay attention to headlines and commentary from media in all three demand spheres which gives some indication of sentiment.

So why do these three spheres in particular matter? For me, its because the portion of measurable annual gold demand that they represent.

If we start with a rough annual supply (mining, scrap, etf sales, excluding float) of 4250 tons in 2013 (updated thanks to a reader),  China by some accounts ate half of it at over 2000 tons, India another fourth with 1018 tons, roughly three fourths of our narrative demand is from the China and India demand spheres. This leaves one fourth (half if you want to use the conservative figures of Chinese gold imports) of available supply to satisfy physical demand for the rest of the world which happens to mostly align with the western narrative.

It is a pretty well accepted and understood process at this point that since gold’s price peak in 2011, a substantial amount of physical gold is being sold by western investors, converted into “four nines” kilo bars and shipped off to eastern buyers.

We can substantiate this if we choose to use the GLD inventory as a proxy for the western narrative, and observe that at its 2014 peak of 818.77 tons back in March, the physical stocks have been drawn down and are now sitting at 717.63 tons, which jives with my general western narrative above. If we look back, the record holdings for GLD came in at 1353.3 tons and has been drawn down on since then as western interest and narrative in gold shifted to negative.

From my professional experience and sources within the industry, we know that a substantial amount of gold flowing through the worlds largest refineries is coming out of the UK which is where the inventory for GLD is warehoused. How much of the GLD bars are actually shipped out versus put aside to be re-added to GLD stocks is not clear, and cannot be determined until GLD adds a large chunk back to its inventory, but I think it is safe to say that some (alot?) of this inventory of 12.5 kilo good delivery bars have been melted, re-refined and cast into kilo bars and is now sitting somewhere in or very close to China.

A Simple Equation

So here is a very basic summary of my thoughts on this:

Definitions

Annual Supply (AS) = mines, scrap, etf sales, central bank sales
Float (F) = gold that becomes available for sale from existing above ground stocks as the price rises

Simplified Equation

Gold price is primarily determined by  AS and F minus demand by the three demand spheres. If that number goes substantially negative, we are going to have a rising gold price.

There seem to be many who have been scratching their heads over how there can be such incredible physical demand from Asia (historically speaking it is off the charts), and yet have a sinking to flat gold price.

The key narrative here, if you haven’t figured it out by now, is the west. Assuming the current demand levels from each narrative remain the same, the price will likely bounce around in the same range. What will shift this up or down is contingent largely upon what western investors/traders are telling themselves (and each other) about the future for gold.

It is possible that these demand spheres can change, they certainly did when China stepped onto the scene. It would however take a really significant buyer or seller to enter the picture.

Extreme Tightness in Physical Supply

I will add, before I conclude this post that it is definitely possible for there to be extreme tightness in the physical gold market, which is measurable both by data and by anecdotal experience of myself and colleagues in the industry who have authoritative visibility into significant portions of the market. There is extreme tightness now, worse perhaps than at any time in the last 30 years or so in the physical gold market on a global level.

I am aware there are alot of traders out there who think the idea of a physical and paper price dis-connect is conspiracy theory. I also know authoritative people in the industry with more than 100 yrs of combined experience that think todays young gun futures traders have no clue what is truly happening in the physical market. If the movement of COMEX physical inventory (or I should say lack of it, compared to how GLD inventory moves based on price) is their lens on physical realities they might as well be holding a stethoscope to a corpse, IMHO.

Should anything occur which changes the general narrative of the west such as a roll over of equities or other substantial sea-changes in the markets which causes the west to adopt a negative view of economic recovery and shift the narrative on gold, the combined pressure of western buying and the other demand spheres will exacerbate the current physical supply tightness and force dramatically higher prices to clear this situation. That will only feed on itself as investors come back to GLD which will act as an accelerant on a brushfire.

Watch for the shift in the western narrative, and watch GLD inventory. These canaries in the coal mine will signal change is in the air.

 


Notes and updates:

1. Just found this regarding estimated gold in India of approx 22,000 tons: http://www.gold.org/advanced_by_gold/#!market-development-en

2. To clarify a bit, I think it makes sense to not ignore mining supply, scrap sales, and etf sales sales as a source of consistent supply. This offsets global demand to the degree of tonnage provided by these supply sources. Gold in the float tends to increase at times based on the price of gold and more-so when the price rises versus when it falls.

3. Expanded commentary on the current supply tightness in the market at our recent PGF round-table discussion: http://bit.ly/1Fcz58L

Media Spin on Swiss Referendum over Gold Reserves Getting Ridiculous

If you do not know already, the Swiss are voting on a referendum which will force its government to pass legislation to the following effect:

  • Back 20% of its reserves in gold,
  • Repatriate the gold that Switzerland owns from abroad,
  • Prevent the Swiss National Bank from selling off any more gold.

The Swiss have a very interesting form of government, where the people can vote directly to force their government to create legislation. A majority of more than 50% of the Cantons must agree.

The reason this is so important, is that if this measure passes, it will force the Swiss National Bank to purchase gold from the market, which is already stretched thin on the supply side. According to a note from the SNB, they would have to buy roughly 10% of annual mining supply each year through 2019. Some estimate this to be over 1700 tons of gold, over a 5 year period.

This is where it gets dicey. Since gold dropped below the average global cost of production in June ( http://www.cnbc.com/id/100851209 ) , the amount of gold available in the supply pipeline has been getting tighter. To make matters worse, according to the CEO of the worlds largest mining company, because the price has dropped so low mining exploration has taken a huge hit and will result in less gold production moving forward. He claims the industry will hit “Peak Gold” in 2015 ( http://bit.ly/peak-gold ).

I have read a few articles which claim that if the physical supply was tight, then the price would reflect that because as we all know, traders who deal in these markets are efficient, and above all very smart, therefore gold should be priced in a way that reflects its true market value…kind of like triple A rated mortgage backed securities….right?

Just in case anyone has forgotten what financially incentivized traders are willing to do, I present without comment the following recent articles:

1. Regulators in US and UK mete out record fines after finding a ‘free for all culture’ on currency trading floors at RBS, HSBC, Citibank, JP Morgan and UBS http://bit.ly/FX-free-for-all

2. Six Banks to Pay $4.3 Billion in First Wave of Currency-Rigging Penalties  http://bit.ly/FX3bfines

3. Swiss regulator finds “clear attempt to manipulate fixes in the precious metal markethttp://bit.ly/clear-evidence

4. UBS agrees to settle charges in gold and silver manipulation http://bit.ly/ubs-metals-manipulation-settlement

5. Reuters: EU fines JPMorgan, UBS, Credit Suisse for taking part in cartels http://reut.rs/1BN0ajC

6. SEC charges High Frequency Traders with Fraud manipulating prices http://bit.ly/SEC-charges-HFT

There are many more recent examples in this fact freight train, but I am sure you get the point.

Vote Yes Argument

The group that wants this initiative to pass says that if it is not passed, then Switzerland’s economy will be dictated by the EU, the Swiss Franc will (continue to be) tied to a weak Euro, inflation will increase dramatically, the Swiss National Bank will print hundreds of billions of Francs (to maintain the Euro/Franc 1.2  peg), the Swiss Franc will weaken, and the Swiss citizens will be stuck with hundreds of billions of devaluing Euros.

A few comments:

  • Even if the measure passes, the SNB might still print hundreds of billions of Francs to retain the Euro 1.2 peg, it will just have to buy an amount of gold equal to 20% of the Euro’s it buys. This shouldnt be that much of a problem, they do have a printing press, they could just do what my friend Jim Rickards says and print fiat / buy gold. It would of course create other problems, explained below.
  • Yes, if it doesn’t pass, the Franc will weaken, but that is the entire point of currency wars and the reason the SNB (and the government) hates this idea, aside of course from the fact that it destroys the credibility of the Central Bank (not just the SNB, but globally).
  • What will happen if this measure passes is the Swiss Franc will be reinforced as being a safe haven currency with real value, and that will cause a massive inflow into the Swiss Franc in times of fear, which does indeed create problems – the Swiss have experienced this in the 1970’s and were forced to resort to negative interest rates (charging you to hold your money instead of paying you interest) to discourage capital flow into the Franc. The amounts of Euros the Swiss would have to buy to maintain order could end up being …I have no words for it…huge…and therefore also force them to be big buyers of gold. In time, this could erode confidence in the entire system as the pressure could cause the price of gold to skyrocket which would cause people to start asking questions.

Vote No Argument

For this section, I am going to reference an article in Yahoo today which closely reflects the attitude and presentation of other articles I have read regarding this subject.

For starters it says “economists warn a ‘Yes’ vote could wreak havoc in financial markets” – but then conveniently fails to reference those economists or why they think this.

“Industry organisations have also warned that the move would tie the central bank’s hands and damage its credibility” – With the loss of credibility part I agree. After all, if the central bank itself starts buying gold to support its currency as demanded by the citizens, then it messes with their job stability doesn’t it? Are central bankers really needed if all you have to do is buy gold and call it good? This may be why the Fed has tried to convince the world that gold has no monetary use for the last 45 years. It would not, however “tie their hands”. They could still print up all the Francs they wanted and buy Euros to maintain the Euro peg, they would simply have to buy more gold when doing so, which comes back to that destroying their own credibility thing again.

Most observers expect the Swiss to snub the motion, and low global gold prices indicate investors agree – Some facts here would be nice.

According to the Swiss Central Bank Chief Thomas Jordan, if the measure passes then “The central bank’s capacity to take action would be weakened. This would also lead to higher unemployment”. – Not weakened, again it would reduce credibility because actions taken to devalue the currency intentionally by printing and buying other currencies would force them to buy gold.

He has appealed to Swiss voters to pay attention, warning that if the gold initiative passes the consequences could be disastrous. – Yes, for the credibility of the central bank.

However, “if the ‘Yes’ side wins, gold risks reacting strongly, since the market is not expecting that result,” Nannette Hechler-Fayd’herbe of Credit Suisse. - I also think the gold market will react strongly, but not because an affirmative vote is unexpected, further explanation coming up.

Strategists at Commerzbank (Xetra: CBK100 – news) said the ban on selling gold would put the very credibility of SNB at stake. – Near the end of the article, and there we have it. Economists are heralding doom, but cant seem to be found in the article after that. This whole thing about concern over a loss of credibility is pretty consistent though. If people start looking at gold as money, then that paper becomes less important, and if that happens then so does the role of the paper printer.

If SNB’s gold “reserve can no longer be sold in the event of a crisis it no longer constitutes a reserve in the stricter sense,” they said, stressing that “if the gold reserves cannot be sold they are ‘lost’ for the Swiss.” – You can always take one last swing at this issue with a straw man. This is complete non-sense. Central Banks have been using their gold reserves in a leasing capacity for decades, it serves as collateral of the highest caliber bar-none and can be put to use as such without being required to sell it.

Talking to the Swiss

Last night I was having dinner with a Swiss client and the subject of the gold initiative came up. He said that in the early part of the month it did not seem anyone was taking it seriously. Since then, there has been alot of debate, and the issue is gaining more awareness to the point that his feeling is the Swiss Government and SNB are now panicking. They are advertising in the trains to vote no, while the group that wants the measure to pass had its donation accounts frozen.

You have to know a Swiss to understand this. They are a stubborn and fiercely independent people. The idea that they are becoming lackeys to the Euro is disturbing to them. His comment to me was that if the people think the government is panicking, they will vote yes by instinct, even if they do not fully understand the underlying issues.

Gold Physical Supply

Once a year (or more often as needed) AFE travels over to Switzerland to participate in the audits of the gold in custody, as well as handle other administrative work and meet with our strategic partners. Each time we do this we are able to talk to key people within the industry.

One of the gentlemen we regularly meet with is a Director for one of the largest refineries in the world. He has perhaps one of the best views into global physical gold flows from a practical hands on perspective than any other I am aware of, and has more than 30 yrs experience under his belt. The way he puts it, paper trading in gold (on exchanges such as COMEX) is being done by young men who have no interest in the physical fundamentals, and have very little concern nor care about physical movements. My thought is he may be right, after all despite what is happening in physical flows, reservoirs of gold such as COMEX which should act as a gauge on available physical don’t seem to move much, regardless of moves in the price.

We will be doing a round table interview soon with the Board of Directors of AFE where we go into more detail about this, but I will make a few comments about the available physical gold float now.

In October, backwardation re-entered the gold market http://goldmarketmacro.wordpress.com/2014/10/28/backwardation-returns-as-the-gold-market-tightens/

The best explanation of backwardation in gold I have found is this, hat tip to Bron Suchecki of the Perth Mint (from http://goldmarketmacro.wordpress.com/2014/11/07/eastern-physical-demand-versus-western-financial-supply-who-will-win-out/ ) :

Negative gold forward rate (GOFO) is a true backwardation of gold prices.  It means participants can sell physical gold now and instantaneously buy it for delivery in 2 months time at a 0.145% discount.  Not only that, but the entrepreneurial arbitrageur can also invest the proceeds from the spot sale in risk-free securities over the period.  In two months time, they will have their gold back, have banked 14.5 basis points profit, have banked the risk free security return and will have save on 2 months storage and insurance of the physical gold.

This is why backwardation of gold is so fascinating, it just should not happen.  The arbitrageur may not be so smug if the future delivery never occurs (in trying to make 0.145% he has lost 100% of his gold), and that is the risk which backwardation effectively prices in.

It implies a very tight physical gold supply in what we call the “float”, which is gold available for sale. It is important to bear in mind that the amount of gold in the “float” changes, based on the price of gold and if owners of existing gold turn into sellers. Float gold consists of gold from mines, gold outflows from ETF’s such as GLD if they are selling, scrap, and also from an estimated 165,000 tons of gold above ground which was mined since antiquity, all of which can come available for sale if the price is high enough.

A point some of you may find interesting is that the LBMA has decided to stop reporting GOFO as of Jan. 30th 2015, claiming banks do not want to report rates dues to increased regulatory scrutiny ( http://www.ubs.wallst.com/ubs/mkt_story.asp?docKey=1329-L2N0T11GZ-1&first=0 ).

I will not say more on this topic at this time as we are reserving some important information we have to share for the upcoming round table interview, but I will say that if the current situation in the physical float continues and then this referendum passes, it will have a substantial impact on price and it will not be because “it was not expected”, but because the float is so tight right now.