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
- 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
- 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
- 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:
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
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