29 June 2010

In gold we trust

In gold we trust is a special report by Ronald-Peter Stöferle of Erste Group Bank. It is very comprehensive and well worth a read because it covers across its 65 pages all key factors influencing gold prices, leading to their conclusion that:

"The risk/return profile of gold investments remains excellent. ... Our next 12-month target is USD 1,600. We expect the parabolic trend phase to still be ahead of us. At the end of this cycle the price should reach our target of USD 2,300."

In the section "Paper gold vs. physical gold" (pages 36-37) however I would debate the following statements:

"At the moment physical gold commands a premium of up to 20%."

In the wholesale physical market the Perth Mint is not seeing anything abnormal. Even in the retail market premiums are back to normal (subscribers to Sharelynx can see this for themselves at the CoinPremiums page). I have asked Ronald-Peter where he is getting this number from but no response as yet.

"According to Paul Mylchreest the London OTC market trades 2,134 tonnes of gold every day. This is 346 times the daily production and close to the global annual production."

This point is presented as proof of a discrepancy between the physical market and paper gold market. As discussed in this blog post, I don't see any problem with this rate of turnover. In his report Mylchreest concluded that gold's 12.7% turnover "is excessive and doesn’t pass the smell test." My alternatively conclusion is that "the very fact that gold is no one’s liability and cannot be printed means it attracts a disproportionate amount of trading and speculation. ... Could not the 12.7% figure be proof of the special monetary nature of gold, proof that it is the King of Currencies?"

"According to Jeff Christian, founder of CPM Group, the trade on the LBMA is based on a leverage factor of 100:1"

Mr Christian has stated that he was talking about COMEX paper trading versus physical COMEX deliveries. There are some who think he is trying to retrospectively cover up his admission. My view is that a 100:1 fractional is ridiculous considering the crucial role London plays in the physical market. London unallocated simply could not function on a 100:1 ratio in my view. Those who accept this number do not appreciate to amount of physical delivery made ex-unallocated accounts by the trade. In any case, Mr Christian actually confirmed the fractional/leverage ratio of bullion banks at around 10:1. See this blog post.

"The volume of gold derivatives is worrisome as well. According to the Bank for International Settlements, the nominal value of all gold derivatives at the end of 2009 amounted to USD 423bn."

I have often seen the nominal value referred to and while it produces an impressive number the way it is presented is often misleading on two fronts:

1. Common interpretation of these numbers is that the market is short $432bn worth of gold. In fact the nominal value is the summation of both long and short positions, it is not a net figure. If one looks at the BIS figures it can be seen that bought and sold options somewhat net out (although it is not that simple because of differences in dates and strikes).

2. Nominal does not equate to actual value at risk. As per the BIS report: "Nominal or notional amounts outstanding provide a measure of market size and a reference from which contractual payments are determined in derivatives markets. However, such amounts are generally not those truly at risk. The amounts at risk in derivatives contracts are a function of the price level and/or volatility of the financial reference index used in the determination of contract payments, the duration and liquidity of contracts, and the creditworthiness of counterparties."

They note that "Gross market values provide a more accurate measure of the scale of financial risk transfer taking place in derivatives markets" and if one looks to page six of the report it states that the gross market value of the $432bn nominal figure is actually $48bn.

There is also the issue of what is the actual delta-adjusted position (see page 10 of GMFS Hedge Book for an explanation) of the $432bn nominal gold derivatives and its real (past) impact on the spot market, but that is getting a bit technical. The point is don't get over excited by the $423bn figure and assume it means the market is short 10,000 tonnes of gold.


  1. so is it best to buy into bullion or gold mine stocks

  2. The answer is dependant on the situation. In normal situations, a gold mine is expected to be a riskier / higher return investment. In times of currency crisis, the situation inverts, and gold picks up value representing the perceived sovereign risk to currency value. Gold resumes its historical role as money. Mines remain subject to a portion of the risk involved in a caurrency crisis and as such do not garner value at the same rate, despite their leverage on the gold price.

  3. Good answer Chris. Coconut peat - consider the case of Sons of Gwalia, it blew up because of its hedge book.

    If you want to look at miners, I would strongly recommend http://goldnerds.com.au/ as an essential resource.

  4. I thint that the physical gold is much safer that paper gold. But where this gold is stored? For example this gold http://www.gbullion.com/?