29 April 2012

Student of the physical market - demand doesn't drive the gold price

Eric Sprott and David Baker has a new article out discussing central bank buying of gold and particularly China. I agree with his conclusion that this is an important demand side shift in the market but then Sprott plays it up way too much with statements like:

"... there isn't a physical market on earth that can withstand that type of demand increase without higher prices over the long-run, and the gold market is no different. There are no sellers of physical gold that we know of who can satiate that scale of new demand ..."

"Who is going to give up their gold purchases to make room for this scale of new demand? Where is the gold going to come from? We ask because we don't actually know."

"We have written at length about the disconnect between the paper gold price and the physical gold market. If the demand changes stated above applied to any other market, the investing public would lose their minds."

"The paper market for gold can continue its charade, but demand in the physical market will soon overpower it through sheer momentum - there's only so much physical to go around, and it appears that there are some very large buyers that are eager to take it."

If Sprott and Baker "are students first and foremost of the physical market" then they surely are aware that the one thing which makes gold different from all the other physical markets on earth is its huge above ground stocks relative to new mine supply - 170,000 tonnes versus 2800 tonnes.

This, I suggest, is a quite material fact and one which may be where "the gold is going to come from". Unlike "any other market", to which conventional supply/demand analysis can be applied, one cannot understand the gold market by just looking at annual supply/demand numbers when there is such a large overhang of stock.

What drives the gold price I would therefore argue, is not so much demand, but to what extent existing holders of the 170,000t will withhold it from the market. It is actually supply - the withholding of supply - that matters most. If even a small fraction of these holders decide to sell, then that supply "will soon overpower" the physical market, China or no China. This is not a negative statement. The decade long gold bull market is a message that the existing holders are requiring higher and higher gold prices to let go of their gold and that the new holders are more likely to withhold it.

The reason you don't see this approach to analysing the gold market is because there are only sketchy numbers on the flow of gold from existing holders to new holders - say ETF volumes, futures warehouses and scrap - and therefore its difficult if not impossible to get any handle on total real supply so analysts just avoid it. It doesn't mean you should.

This unique feature of the gold market, which we can describe as "a stock overhang so large relative to new supply that in any other market would push the price to zero, but for some reason for gold it doesn't", is often referred to as monetary demand or gold as a monetary metal. When you see someone refer to gold as a commodity, it tells you they don't really understand the gold market and you need to exercise some caution with their statements.

Gold is monetary in nature, with only a small commodity component. Further proof of this is the fact that central banks hold it as they generally hold only money as reserves. A lot more can be said on this but it is 8:30 on Sunday night.

The other thing I find interesting about the Sprott piece, and what I react to negatively, is the use of emotive phrases like "on earth", "lose their minds", "charade" etc. Never a good thing when we are talking about investing and its a point Kid Dynamite has made, that Screwtape dissects, and which Erik Townsend makes quite forcefully in the Martenson/Harvey interview discussion.

Speaking of that discussion and Sprott, for those interested in Sprott's silver delivery problem, Jeff Christian has weighed in with some interesting comments at the Martenson/Harvey interview. Warren James has updated Screwtape's post on the issue with the relevant material and it is a good summary and discussion of the "problem" for those new to it (or who want a refresher).


  1. Great post.

    I can only conclude that withholding/selling gold from the market (and therefore the price), is based on "trust".

    Trust in the system, your political and financial leaders.

    Trust has to be earned, lose it in an hour but takes 20 years to regain.

    In my humble opinion you have here the reason that there is no way the gold price will go down soon, even if CB and big players would like to see (and certainly will try) otherwise.

  2. Exactly, gold is trust in itself. Its constantly debased currency that has to earn it.

  3. Bron, that perfectly parallels what "ANOTHER" said: "Gold has always been funny in that way. So many people worldwide think of it as money, it tends to dry up as the price rises."

  4. Thanks Bron. Nice to see some activity here again. Good point about the withholding of supply, something we intuitively know.

    PS: Thanks for the reference to Jeff Christian comments on Chris's blog. He is one of the smartest guys around, who knows his stuff.

  5. me again... :-) Wow, that is an informative thread. Good to see you there Bron :-) still reading, only up to page 5 :-)

  6. Bron,

    Could you comment (or provide some facts) on the alleged missing allocated gold that Egon Von Greyerz discussed on KWN?

    No lawsuit was filed?
    The bank is not named?
    Wouldn't they be able to sue for damages?

    Wouldn't the collapse of the Bullion Banking system qualify as news? :)

    -----Begin Paste from KWN---------

    "Von Greyerz also told KWN that a major Swiss bank did not have a substantial amount of allocated gold which they claimed to possess for their client: “We are stressing to investors to take their gold out of the banking system, not only because there are runs on banks that will continue, but the risk of being in the banking system is major. So you should take the additional step of not just owning physical gold, but also owning it outside of the banking system.

    We (just) had an example of a client moving a substantial amount (of gold) from a Swiss bank to our vaults, and we found out the bank didn’t have the gold. This was supposed to be allocated gold, but the bank didn’t have it. We didn’t understand why there was a delay (in our vaults receiving the gold), but eventually we found out why there was a delay (the bank didn’t have the gold). It’s absolutely amazing, but not surprising.

    This confirms what I’ve always thought. Not only should you not have gold in banks or even unallocated gold, but even allocated gold. It seems that some banks don’t even possess that. So the risk of having gold in the banking system is major.”

  7. You are asking the right questions.

    If they didn’t have his metal then we must assume this was found out because the bar numbers of the metal delivered were different from the client's original bar list.

    However if this is the case then the client should be suing them for breach of contract, at least for repayment of any storage fees for metal not being stored (metal was eventually delivered so no failure in that respect).

    I do wonder if this is really a Harvey Organ situation again, where the client thinks he has allocated but really hasn't read his agreement properly.

    If the client did not have a bar list then it wasn't allocated.

  8. thanks for your post. I particularly like your analysis of the call to emotive arguments. While I make the oddly tempered comments in my own blog its not for persuasion in the same way.

    Generally if people are making calls to emotion its for aother agenda than the stated one (http://cjeastwd.blogspot.com.au/2012/05/emotional-arguments.html)

    I think I have found another blog to follow.

  9. The current paper price per dollar is 0.0006389 ounces of gold or 0.02grams of gold. (and going down)

  10. What is it with gold? It is regarded as a traded commodity and takes so much dollars to purchase an amount of gold. Gold is not considered as money to a population as a whole but has been taught as to be treated more like a financial instrument. Gold is something that you cannot physically possess as it is dangerous to store and you need someone else to store it for you, like a bank or bullion depository or Fort Knox. Not to mention the government, no sorry the RBA can confiscate the gold in times of economic upheaval.
    Is it not better to start trading every day using gold and silver now as a currency or is it preferred to use it as an investment.
    We are paying to use dollars through inflation, a hidden tax everyday. An example is if you were to come into possession in 1966 a 50 cent silver coin and a $20 note and held onto them until now. The 50 cent coin is currently trading at $10, a 20 times increase. Therefore the $20 note of 1966 should be also worth 20 times more, i.e. $400 today.
    The whole problem is people don’t want to work but trade to make a profit. But are we making a profit when we have inflation.
    Can we ever go back to gold/silver economic system? Is there enough gold and silver for day to day transactions to occur? If 35 million ounces of silver eagles are manufactured by the US mint per year, is it enough to have an economic system working with 300 million people. That’s 1/10 ounce per US person for a year. The Perth mint produces about 500,000 ounces of silver per year. Distribute this to 20 million Australians in 1 year and it is only 1/40 of ounce per person or 1 kookaburra for 40 people per year.
    There is an estimated 7 billion ounces of gold. One ounce of gold for each person in the world. Supposedly there is 1 billion ounces of above ground silver, don’t know how they would be able to calculate it. That is 1/7 of an ounce of silver per person in the world. How can a global economic system work with such a shortage of gold and silver?
    We will probably have to continue with the electronic, paper financial system as complicated it has been made out with using financial gibberish, financial instruments, whatever smooth sounding words you want to use for itching ears that cant wait to make a quick buck.
    Problem is greed, buy cheap, sell dear.
    The general population does not know what gold and silver is, in an economic system that is. They are psychologically damaged as they would compare gold and silver to the change that they have in their pockets. Tricked by fools gold, todays one and two dollar coins, and fools silver the five to fifty cent coins.
    Gold and silver may try to make a comeback but with the lack of it and hoarding, it will probably end up as a failure. The solution will come where we will be chipped as dogs and slaves to the elite.
    What would it be like now if the 1910 money system of sovereigns and florins, etc was never interrupted to this day.