29 October 2009

Golden Avalanche

Nick from www.sharelynx.com shared some quotes with me that I'd like to pass on. They are from a book written in 1939 by Graham & Whittlesey called Golden Avalanche:

“Before leaving the subject of gold supply it is interesting to relate present gold reserves to the monetary circulation of this country and the world. The gold reserves of the United States are almost two and a half times the total of all ordinary money now in circulation in this country. We could replace at its present value every piece of paper money with a gold coin and would still have enough left over to do the same for every country in Europe. There is enough gold in the monetary reserves of the world to replace all ordinary currency of the entire world 100 per cent with gold coins. Never until the present decade was such a situation as this even approached.” p.15

"It has been estimated by a number of writers, on the basis of conditions prior to 1914, that the production of gold would have to rise by about 3 per cent a year in order to preserve approximately stable price levels. The best known of these calculations are those of the Swedish economist, Professor Cassel. This estimate tends to exaggerate the rate of expansion in the demand for basic reserve money. It is based on a period when population and production, and, therefore, the money-work to be done, were increasing at an exceptional rate, and when the non-monetary demand for gold was at its highest. During these years, moreover, the need for gold rose as rapidly as it did partly because of the extension of the international gold standard system to embrace a growing list of countries.

Even if the gold standard system were again established as it was in 1913 the need for gold could not be expected to increase as it did in the half century before the World War, simply because there would not exist the same possibility of extending the use of gold over a steadily widening area.

As was noted earlier, the monetary reserves of the world are today nearly three times as great as in 1929. If commodity prices were to return to the 1929 level, if business activity were to increase at an annual rate equal to that maintained in the sixty fat years prior to 1914, and if all the countries then on the gold standard should return to it, we should still have enough gold to meet all monetary requirements for many years to come, even though not one single ounce was produced during that time. If the gold standard is not restored on such a scale, then the world is long on gold to a corresponding degree. It is absolutely fair to say that, ignoring entirely the possibility of increasing the efficiency of our monetary and banking systems and making the most liberal assumptions as to growth in the monetary and non-monetary demand for gold, there is not the remotest prospect of the world’s needing to have another ounce of gold mined for several decades." p. 18-19

20 October 2009

The King of Currencies

A reader has asked me to comment on these two recent GATA articles www.gata.org/node/7908 and www.gata.org/node/7911, which claim that London unallocated metal is a fractional reserve system.

Adrian Douglas’ assertion is that there is at a minimum four owners for each ounce of unallocated metal held in London. His support for this is to apply the ratio of average daily share trading in GLD (11.9m) to its shares outstanding (325m), rounding to a ratio of 1:30, to an estimate of the daily trading in gold in London to derive the amount of gold London should have. This is then compared to an estimate of what London does have, resulting in the 1:4 fractional ratio.

For his estimates of the London market, Douglas relies on a report by Paul Mylchreest. I haven't had time to review Mylchreest’s numbers in detail, but his report takes a very logical approach and is fact based to estimating of the amount of gold in London. His conclusion is that there is

"an aggregate pool of gold of just over 16,866 tonnes of gold to support an average of 2,134 tonnes of daily spot gold trade. On this basis, 12.7% of the pool of available gold is being turned over every day on average. … And the entire pool is turned over every 7.9 working days. In my opinion, this level of trade relative to the estimated pool of gold liquidity is excessive and doesn’t pass the smell test."

Firstly, he makes a series of assumptions to get to his figures. For example, his 16,866t figure relies on World Gold Council/industry estimates of above ground gold and the percentage that is investment. Being a trade organisation representing miners who want a high gold price one should expect that “stock” numbers will be estimated on the downside. When estimating what the real trading volume of gold is, then he steps into a more rubbery area because he is relying on only two guesses from some industry people - we need more than that.

As a result, one must consider his 12.7% turnover figure to have a fair margin of error considering all the assumptions and estimations used to derive it. This is not to say that it should be 1%, just that it is not a “hard” number.

Secondly, even if 12.7% is correct, I don’t think it logically follows that this “doesn’t pass the smell test", a conclusion he comes to by comparing gold to equity, other commodities and fiat currencies. The last one is probably the most relevant. In this he has to again make some assumptions about currency trading turnover to come to a figure of 2.6% for Sterling, conceding that when including forwards and swaps “daily Sterling turnover is only equivalent to 8.4% of UK broad money”.

Why stop at Sterling? If one does the same calculations for the Australian dollar, you get 4.1% for spot and 13.3% including forwards and swaps. Does gold’s 12.7% (which could be lower if some of Mylchreest’s assumptions are changed) now appear as an “excessive amount of gold trading relative to the likely pool of available gold”?

Mylchreest’s final conclusion is that either 1. there is “more than one ownership claim on each gold bar” or 2. “there is far more gold bullion held in private hands than is acknowledged by current industry estimates”.

I would suggest that there is another OR that Mylchreest has not considered: the very fact that gold is no one’s liability and cannot be printed means it attracts a disproportionate amount of trading and speculation. Why is it assumed that 12.7% is excessive and unreasonable? Could not the 12.7% figure be proof of the special monetary nature of gold, proof that it is the King of Currencies?

I have spent a bit of time on Mylchreest’s report because it is the key input into Adrian Douglas’ calculations. Before I move on to his numbers, I would like to say that I have a lot of respect for Mylchreest’s report and look forward to it being improved with more accurate data.

On that, I note Mylchreest’s statement on page 25 that “I haven’t a clue what COMEX inventories were in 1997, but let’s assume 200 tonnes …” That information is available at Sharelynx.com going back to 1975. A subscription is required but would be worthwhile as Sharelynx has a lot of other data that would be very useful for Mylchreest’s analysis.

Now on to Adrian Douglas’ calculations. He is basically applying GLD's turnover of 3.66% to Mylchreest’s turnover figure of 2,134t to come to an implied stock holding that London should have of 64,000t. This is then contrasted to Mylchreest’s estimate of 15,000t of non-leased physical to derive the 1:4 fractional ratio.

This analysis assumes that the behaviour of over-the-counter (OTC) players is/must be the same as those trading GLD. Let us consider each of Douglas’ statements in support of this.

“The purpose of buying investment gold is for it to store wealth. This necessarily implies that it is held for a long time.”

This is a very broad statement and one that I don’t think can be supported. Investors have all sorts of different time horizons. Remember we are talking about trading in unallocated and whether that is backed. The fact that it is unallocated rather than allocated bars would imply, if anything, that the investors have shorter time frames rather than long.

“If gold is bought and traded quickly it would destroy wealth, not store it, because there would be a large loss due to transactional fees.”

It is actually the other way around. The quicker you can trade something the less risk you have to changes in prices. Bullion banks have a spread between their bid and ask prices – they MAKE money from quickly trading gold. For those dealing with bullion banks in the OTC market, the tightness of those spreads combined with the volatility of gold mean it is entire reasonable for them to make money day trading gold.

“Considering these limitations [minimum trade limit of 1,000 ounces] it is likely that OTC participants would turn over a lot less than 1/30th of the inventory in a day.”

I do not see how the $1 million trade size must mean a lower turnover. That is not a big figure for wholesale market participants. With bullion bank spreads of $0.50 to $1.00, a 1000oz deal only means $500 to $1000 profit. This would mean that a spot gold trader would need to do a lot of trading to make a decent return on the capital employed, which means they would trade more frequently, rather than less.

As with Mylchreest’s comparisions to currency trading, I don’t think Douglas’ comparisions to GLD make any conclusive case that London gold turnover is suspicious.

For further support, Douglas notes that

“In the last 14 years the supply of dollars has increased from $4 trillion to $15 trillion (+275 percent) while the gold price has risen from $400 in 1995 to $1,000 in 2009 (+150 percent). How could this happen? … There has to be an alternative massive supply of gold to make the price rise slower than the influx of dollars.”

How it could happen is that those extra dollars were diverted into equities and house prices, rather than gold, pushing up their price more instead.

He also says that “If the OTC market traded only gold that was in the vaults on a 100 percent reserve ratio, there could never be a lack of liquidity.”

Lack of liquidity has nothing to do with stocks, backed or not. It has to do with a depth of buyers and sellers. If you have 100% backed unallocated, but few of the holders want to sell, then you have a lack of liquidity as well.

For some closing comments, I’ll quote Lawrence Williams from Mineweb:

“The big problem, though, with much of this kind of analysis is that the analysts and observers are working with a mixture of real and assumed figures. It thus tends to rely on statistics being manipulated, perhaps subconsciously, to support pre-conceived theories.”

10 October 2009

Futures COT

Adam Hamilton of Zeal LLC is one commentator I have been following for many years. His latest one on the Commitments of Traders Report is essential reading:

"The bottom line is gold futures activity as chronicled in the CFTC’s Commitments of Traders Report is often misunderstood. A minority of analysts choose to interpret facts about week-to-week developments out of the illuminating context of bull-to-date behavior in similar situations. Thus their interpretations of this complex report are often misleading. And sadly many newer traders are swayed by this shoddy analysis.

It is critical to remember gold futures are a zero-sum game. For every short, there is an offsetting long. So if the feared commercial hedgers’ net-short position is surging and hitting records, then so too are speculators’ net-long positions."

04 October 2009

SLV and Jeff Nielson

On Sep 17 Jeff Nielson posted an article on SLV. I took issue with his belief that ETFs' management fees were unrealistically cheap and thus another indicator they were a scam. Below is the exchange between Jeff and I on the matter.

Bron: You say "custodians of the vast majority of all the world's bullion-ETFs – a service which they are providing free of charge" but SLV has an expense ratio of 0.50%, some of which if I remember the prospectus correctly, is paid to the custodian. If SLV holders pay 0.50% how can it be considered "free". By what do you mean free?

Jeff: Hi Bron. Just look at all that is SUPPOSEDLY covered by this 1/2% fee:

1) Transaction costs. Purchases must be made CONSTANTLY, all day long - in order to buy the actual silver for unit-holders at the same price they bought their units at. Given the huge volatility with silver, it's not even feasible to restrict buying to once a day - since silver has had MANY daily moves of 5% or more.
2) Insurance/delivery costs
3) Storage/security costs.

Obviously BILLIONS of dollars of silver require significant security to guard such a hoard. The U.S. government has an entire military battalion guarding Fort Knox - so no one can find out how much gold is NOT there.If you think these costs are minimal, then answer this question: why do the small number of companies who hold their own bullion need to charge MANY times that premium for their own security/storage costs?

Bron: Before I comment, just want to state upfront that I work for the Perth Mint, but I am speaking here in a personal capacity. While I’m speaking personally, obviously the ETFs are competitors to my employer’s business, both in respect of physical coins and bars as well as our own storage facility, so I’m not any apologist for the ETFs. Taking each of your points in turn.

1) Transaction costs. I note that SLV’s average Bid Ask Ratio is 0.08%. This is very tight but is not necessarily unprofitable for a market maker. You are right that the market maker must be purchasing (or selling) gold constantly as it sells (or buys) SLV shares. My experience with the Perth Mint’s ASX listed product (code: ZAUWBA) is that the market maker will simply set their stock exchange price for an ETF higher than their cost on the wholesale over-the-counter market and adjust this constantly during the trading day. This way they always make a profit on transactions, it is not a cost to them. If individuals bid prices under this than the market maker misses out on a trade. It is only where there are excessive buyers or sellers that the market maker’s prices will get hit.

2) Insurance/delivery costs. Delivery costs are effectively zero, as the metal is most likely already in the vaults as sellers of physical need to bring their metal to London to trade it. Insurance is a real cost, but are easily covered by 0.50%. Important to note that the metal is not fully insured, just the first couple of billion (I don’t think the prospectus says anything about the first loss limit of the insurance). Once you get to a certain size therefore, the insurance cost is a fixed cost, not variable.

3) Storage/security costs. These are fixed costs, once you have a vault and have secured it, every additional ounce does not result in any change in costs. Once you get to the point that you have covered these fixed costs, every ounce above that is pure profit and this is where custodianship can be highly profitable. At 280 million ounces, SLV is definitely there in my opinion. Storage business is a classic case of economies of scale, which is why smaller companies have to have higher storage charges (eg Perth Mint allocated silver is 2.5% pa).

I have been a bit brief on explaining the above, but my view is that they are making money with a 0.5% expense ratio. That is why I think the “free of charge” line of attack is not supported and you are better off focusing on your other criticisms.

Jeff: Bron, at the time that SLV was created, there was only 200 million oz's of silver in GLOBAL inventories. Now SLV and others hold close to 450 million oz's. Obviously there MUST be both delivery AND insurance charges for AT LEAST 250 million oz's of silver - which could NOT have "already been in vaults".

As for security/storage costs, I'll happily concede (for purposes of argument) that no new storage space was created. This brings me back to my point about the ludicrous idea of a BANKER (holding a massive short position) SUBSIDIZING "longs" by providing free storage/security.

Even if you subscribe to that ludicrous fantasy, there is still the issue of the "opportunity cost" to banks. Precious metals are not the ONLY items in the world for which there is a demand for high-security storage. Will ANYONE suggest that banks will provide a FREE service for precious metals longs - rather than charge someone a fee for storing other valuable assets? Try asking JP Morgan to store YOUR OWN precious metals for free - and listen to how hard they laugh at you.

Bron: "Obviously there MUST be both delivery AND insurance charges for AT LEAST 250 million oz's of silver - which could NOT have already been in vaults"

You've missed my point. Lets assume the additional 250moz is real and was bought by bullion banks to back SLV & others. In that case, the bullion banks would incur no delivery charges as the seller delivers metal to London at their cost to be able to sell it on the spot market in London. Secondly, the additional 250moz has no insurance charges - as I said, they only insure the first $1b of holdings, not the entire holdings.

"the ludicrous idea of a BANKER (holding a massive short position) SUBSIDIZING longs by providing free storage/security" & "Will ANYONE suggest that banks will provide a FREE service for precious metals longs - rather than charge someone a fee for storing other valuable assets?"

Jeff, you keep on saying they are doing it for free when SLV charges 0.5%. Some of that 0.5% goes to the custodian, they are being paid. That is not "for free" - I don't understand why you keep on saying they are providing free storage.

The question is whether the 0.5% charge is realistic, profitable assuming the volumes of metal SLV and others hold is physical. As explained in my previous reply it is. Saying this does not mean that they have physical, but nor does it mean they do not.

Jeff: Bron, your assumptions about delivery cost are only valid if you're implying that silver (and gold) goes straight from refineries into bankster vaults - rather than having to be PURCHASED by the banksters (first) on the open market, and then transferred to their vaults.

When you mention the 0.5% fee charged by SLV, my understanding is that this also (supposedly) covers their OWN administrative costs AS WELL AS all the shipping costs, transaction costs, insurance costs, and storage/security costs.

You would be hard-pressed to find any ONE bankster service (in ANY of their business activities) which they are willing to provide for a 0.5% fee. Suggesting that they are willing to REDUCE their fees (to close to ZERO) to SUBSIDIZE the entry of longs into the market is simply nonsense.

Bron: "your assumptions about delivery cost are only valid if you're implying that silver (and gold) goes straight from refineries into bankster vaults - rather than having to be PURCHASED by the banksters (first) on the open market, and then transferred to their vaults."

No it doesn't. There is no difference between purchasing from refineries or on the open market - refineries are all in different countries just like existing stocks. If market makers cannot acquire metal from investors or sellers already holding it in London, they will actually be able to acquire it at a discount to London spot (which is the usual state of the market), the discount equalling the shipment cost into London. Even if they have to pay a premium (or pay shipment costs into London), then they just factor this into their bid and ask prices quoted for SLV. This is why delivery is not a cost that comes out of the 0.5% fee.

"When you mention the 0.5% fee charged by SLV, my understanding is that this also (supposedly) covers their OWN administrative costs AS WELL AS all the shipping costs, transaction costs, insurance costs, and storage/security costs."

The 0.5% does cover their administrative and compliance costs, but as I have discussed above and in my previous replies, any shipping and transaction costs are recovered via market making activities, so these do not come out of the 0.5%. As I have also replied, insurance and storage/security are FIXED costs, not variable, whereas the revenue of 0.5% is variable. This means that once you cover you fixed costs, the 0.5% on any additional metal is pure profit.

"You would be hard-pressed to find any ONE bankster service (in ANY of their business activities) which they are willing to provide for a 0.5% fee. Suggesting that they are willing to REDUCE their fees (to close to ZERO) to SUBSIDIZE the entry of longs into the market is simply nonsense."

0.5% is not "close to zero". On 280moz, 0.5% = $24 million, that is not anywhere near zero. The fact is that in the wholesale market storage is offered for much less than 0.5%. Do you remember David Einhorn's Greenlight Capital exiting his GLD in favor of physical bullion? He did this because it was CHEAPER, in other words he could get storage for less than GLD’s 0.4%. In fact, quoting http://www.hardassetsinvestor/:

“By contrast, a $400 million player in the bullion market has substantial room to negotiate. You can be sure his [Einhorn] bullion holdings are being custodied for less than 12 basis points.”

If you believe that 0.5% is an unrealistic fee, a subsidised fee and therefore proof that SLV is a scam, then logically you must also believe that Bullion Vault, with a 0.12% storage fee, is also a scam. This puts you in a bit of a spot, because Bullion Vault is one of the most transparent operations in the market, and favoured by many goldbugs and commentators. Your stepping out on a limb here.

The post above was on Sep 21, Jeff replied to another post on Sep 22 but ignored mine. I posted the comment below on Sep 27. No response by Jeff as at Oct 4.

Bron: You have replied to someone else's comment which appear after mine, but ignored mine. Does this mean you conceed on the issue of the reasonableness of the storage fee?

01 October 2009

Canberra Trip

I have been busy preparing for two presentations I'll be doing at the Gold Standard Institute's seminar in Canberra. As a result my blogging will be infrequent.

On Sunday 1 Nov there is a free gold investor day and I will be explaining how London metal accounts are used to facilitate the flow of gold from mine to you. There is a great range of other speakers from Daily Reckoning, BullionMark, Global Speculator. If you are within driving distance of Canberra you would be crazy to miss it as it is a great opportunity to catch up with fellow precious metal investors.

2 Nov to 5 Nov is the formal seminar with Professor Fekete the key speaker. I'll have an hour session on COMEX stocks. Daily Reckoning will also be speaking and has a good explanation of what you can expect. Cost is $790 and a 4 day committment but if you have the time will be well worth it.

I have also forgottent to mention a new precious metals forum for Australians called Silver Stackers (they let gold investors in :). If you are tired of US centric discussions on forums like Kitco, it is worth a look.