30 May 2013

Hedging against price changes

Slow Loris Larry asked a few questions around who loses when prices decline and how do industry participants protect themselves against price declines.

SLL: I understand that the Perth Mint does not, as it owns no precious metal. It stores allocated metal for account holders, and it backs its unallocated accounts with metal that is being refined, or fabricated, or is for sale. Being a Mint account holder, both allocated and unallocated, I know full well who is exposed to changes in the prices, both up and down. However, the Perth Mint’s ‘business model’ is apparently unique in that it doesn’t involve hedges. How about other refiners, fabricators, and purveyors of precious metal products, particularly at the wholesale level?

The Perth Mint's business model is unusual, but certainly not unique. It can also be considered a "hedge" similar to the other two common hedging methods, being futures or forwards. The reason it is unusual is because leasing (or renting) gold outright requires the person lending to you to trust you. Futures and forwards involve initial margin deposits and margin calls as the way the lender can manage their risk that you won't honor your side of the hedge.

SLL: I know, from past experience, that Local Coin Shops always know what the current going wholesale prices are, and will still phone a wholesaler when a large transaction is in the offing in order to lock in a guaranteed price that they can make a profit on. Fair enough, or they couldn’t stay in business.

That sort of back-to-back buy then sell is also a form of hedge. However, some smaller dealers do not do this and are prepared to take some risk to the price. That probably seemed a good idea while the gold price was mostly rising. However, consider this Bloomberg article:

The prospect of losses has made retailers who buy used gold and the middlemen who sell to refiners unwilling to part with metal purchased at higher costs. “Nobody is selling right now, and it’s survival of the fittest,” said Dan Nektal of 46th Street Buyers in New York, which has been in the jewelry business for three decades. “If you bought at $1,700, how can you sell at the moment? Everybody’s presuming it’s going to go back up.”

I would guess this happens because their transaction sizes are too small to hedge on futures markets. However, dealers could use FX trading or contracts for difference websites to hedge small quantities, but that does require some financial knowledge to know what you're doing.

SLL: But how about the larger operations? How do they hedge their stock against price movements, particularly to the downside, as they will profit from price increases on stock they hold but cannot let themselves be unprotected from downside risks if they want to remain in business.

I would be surprised if any larger organisation did not hedge themselves, both from price movements down and up. These businesses buy their inventory and then short it; they are hedging their stock. Consider that most of the gold sitting around in the inventories of refiners, mints, coin dealers etc is hedged and ultimately shows up in COMEX and OTC markets as a base amount of short positions.

Now some of the larger organisations may not fully hedge their inventory, say only hedging 90% of their inventory if they thought that the price would rise. This to my mind is speculation and should not be related to, or accounted for, as part of the profitability of the underlying business.

SLL: I know that spreads tend to increase when ‘spot’ prices go down, but only temporarily and sooner or later adjust to lower prevailing prices. I also understand that, eventually at least, miners will only be able to sell the partially refined metal that they produce at the lower prevailing prices. But there are lags at all stages from mine output to retail sales.

To the extent that a small operation doesn't have the volume to fully hedge every transaction, then increasing spreads are one way to manage the risk of having bought at higher prices. That would create some friction in the flow of gold through the value chain, but I don't think it would be an issue at the bigger end of the chain, as they would have much better hedging processes.

SLL: If one looks at the COMEX, which is not really intended to be a major vehicle for delivery of large amounts of physical metal, it is basically a ‘zero sum game’, or speculators’ market , with clear winners and losers on every contract. Do large bullion buyers and sellers hedge their holdings of physical metal there with paper contracts? Or is most of the necessary hedging done on the LBM Over-the-Counter unallocated market, where there are presumably also clear winners and losers, at least over time?

Futures markets don't need to physically receive or deliver metal to perform their hedging function for the industry properly. A supplier and customer can independently sell and buy futures contracts with speculators on the other side of their contracts. When the gold is ready the supplier can sell to the customer at current spot prices and physically ship the gold to the customer, nothing going through COMEX warehouses. The supplier and customer then independently close out their futures contracts. From this viewpoint, COMEX warehouse changes would only occur when there are changes in the amount of gold in the entire value chain or when there are timing differences between participants in the value chain.

Which market is used depends on the country. In the case of the US or Japan, then most hedging probably goes on in their futures markets. For countries without a futures market, possibly bullion bank OTC transactions are more prevalent.

SLL: But the main players on the LBM are the Bullion Banks, are they not? Do they hedge against price declines with short forward contracts? If so, who are their counter parties, other Bullion Banks? Or Central Banks? Or just big speculators, like hedge funds? Dumb money, in other words? Again, someone has to loose when prices go down. So who are the losers when the evil manipulators crash the COMEX derived ‘spot’ price? Or alternatively, do efficient markets just naturally balance excess supply and declining demand with lower prices?

My view is that bullion banks, like all the other participants, are mostly hedged, that they act primarily as brokers or intermediaries between speculators, small or large. Sure, they have their own speculative positions, but it would be minor compared to the entire industry's hedging requirements. It is not like they just sit there and take whatever net position the industry has on to their own books. It is a process of the bullion banks taking on a client's position and then finding another market participant to hedge that position against that makes the price move.

In respect of the inventory of gold sitting in the value chain, the futures, fowards, and leasing markets are just mechanisms by which investors effectively "own" that inventory and take the risk of changes in the gold price away from the businesses in the value chain. While the financial markets may have become a casino and dominated by speculators betting against each other, it doesn't mean in there somewhere is legitimate inventory hedging going on.


  1. Bron:

    I sent the same email about 'Who Loses' to Nick Laird. He replied along similar lines to your post, to wit: 'The big players are all hedged'.

    But if they are hedged to the downside, they have counter parties that loose when the price goes down, meaning that those counter parties were long.

    But, how can everyone be hedged to the downside? Someone must take the other side, and they will loose when they have to pay off when the price goes down.

    Who is big enough to take on the Bullion Banks' hedges that protect them on the downside?

    Is there enough spec dumb money to buy all the shorts they sell?

    What they appear to be doing now, according to the COT analysts I follow, is to be balancing their pre-existing shorts by buying approximately the same numbers of long contracts.

    I suppose that those might create spreads or other complex positions that I don't understand all that well, which might balance the upside risks that their shorts represent, but who is holding the bag if prices then drop and their longs are all losers.

    Just seems to me that in what are essentially zero sum games, not everybody can be hedged against downside risks. I suppose that there could me net gains for all when prices rise, but that would mean that there would have to be net losses when prices go down.

    So, who loses then?


  2. Bron:

    Thanks so much for taking the time to go over my questions so thoroughly. Much to think about, at least for me.

    One little query: the last sentence in your post would make more sense to me if it contained a double negative, and read as follows:

    "While the financial markets may have become a casino and dominated by speculators betting against each other, it doesn't mean in there somewhere legitimate inventory hedging isn't going on.

    With that little change, it all seems to come down to what you told me privately before, which is that it is the longs who lose when prices fall, which should have been obvious, even to me. My problem was in figuring out who the longs and shorts actually are in such a complex, and less than transparent, set of ‘markets’.

  3. SLL, I can answer your question by reframing it. Who is big enough to own all of the 172,000 tonnes of gold above ground?

    There isn't anyone big enough, but enought largish and small investors, speculators etc to make up a deep market of people willing to go long or go short. Given the negative mainstream press towards gold, we shouldn't be surprised that there is a deep pool of people willing to go short (ie be the ones "behind" the BBs short positions).