PM Bug forum comments on backwardation

Those who are not bored to death with the backwardation/gold bank run narrative may find my comments on this PM Bug forum thread of interest, which was in response to this post of mine. I've cut and past some of them below for the lazy readers, but to get the correct context of Mr/Ms Unbeatable's probing questions you need to read the thread. I'm working on some posts on GOFO/backwardation to further expand on my comments in this post.

Originally Posted by Unbeatable:

Hmm.... When he sees 400oz bars attracting a 'special premium' he will let us know?The two biggest gold consumers India & China are paying a $30+ premium an ounce over spot, a 600%+ increase over what they paid in previous years!?

The premium in India and China is not for 400oz bars, but for smaller forms and particularly in India there are import duties and other taxes that go into the premium. The demand in India and China is high, but it is not translating into premiums for the raw wholesale form (400oz bars).

Originally Posted by Unbeatable:

Hmm... When he sees bullion banks desperately bidding on Perth Mint's refining output he'll let us know?

My statement was about bullion banks and 400oz bars. Your quote is referring to demand for coins, two different markets. You are missing the whole point of my comment, which is that retail level demand, premiums do not reflect a shortage of gold at the wholesale level and a run on the fractional reserve bullion banking system.

Originally Posted by Unbeatable:

Hmm.. When he sees restrictions on how much gold can be bough he will let us know? 'the Reserve Bank of India banned import of gold by domestic consumers through bank credit' ' Gold coin and bar sales stopped in India' 'Pakistan temporarily bans gold imports'

You are misquoting again. The restrictions I was talking about was restrictions by GoldMoney and Bullion Vault, not any restriction in any market. I picked GM and BV because they buy 400oz bars for their pooled storage products. If there was a shortage/run on the wholesale gold banking system then GM and BV would have problems sourcing 400oz bars. They are not.

Originally Posted by Unbeatable:

But to be blunt (And as I think you know full well yourself), the idea that you'll see the overt stress indicators that you suggest coming from the bullion banks actions themselves is quite frankly absurd because the day they show provable supply side issues is the day they default.

Nope, it is not a sudden event, it will build up over time and signals will be given, see http://www.goldchat.blogspot.com/201...strust.html‎ (that does need some refinement but the basic idea is there). Bullion banks, just like any bank, will do everything they can to drag out and avoid a run, they aren't just going to throw their hands up at the first sign of trouble. Those "do everything" will be gradual at first and will be visible to us in the wholesale market who know what to look for.

Originally Posted by Unbeatable:

Which is why I showed how each of the indicators are already clearly manifesting themselves in the gold market. (& though you repeatedly try to pretend that there is this massive separation between stresses in demand in the retail and wholesale market, they are in fact completely interlinked.)

There is separation between retail and wholesale. Most of the retail problems/premiums are driven by production capacity shortages rather than shortages of raw gold or silver. For example, during the 2008 financial crisis the blogosphere was going crazy about shortages of silvers, particularly, yet the Perth Mint was shipping in 20 tonnes of silver each week from London for about 20 weeks on end. Go and have a look at my blog around that time.

The indicators you mention are just indicators of strong end user demand, not a run on the bullion banks nor any stress at that end. India premiums reflect the restrictions the Govt has put on, something they have been ratching up for a long time well before this talk of a run/stress and driven by a CAD problem. It hasn't affect demand much at all - instead of the shipments of gold we sell going to India they have suddenly started going (demand coming from) dubai and thailand, funny that.

Originally Posted by Unbeatable:

1. In times of demand stress the bullion banks are the ones supplying many mints with additional refining input never mind bidding on the output?

Nope, got that wrong. US Mint, yes needs to get metal from the market but the two other big ones - Canadian Mint and Perth Mint - are refineries so they source their own metal and in fact have excess left over after coining needs. Perth Mint refines around 6 tonnes a week and we use 10%, maybe up to 20% if lucky, for coin production. The rest we turn mostly into kilo bars and then sell it to the highest bullion bank bidder - it is that premium on kilo bars that tells us how desperate they are, in addition to where it is going and what form, gives a lot of info.

Originally Posted by Unbeatable:

2. I'd imagine the bullion banks have preferential contracts in place and ones that prohibit you, a Perth Mint employee from disclosing market sensitive information, so I take your 'I will let you know' with a pinch of salt.

We work with a range of bullion banks and have no exclusive supply arrangements. While we have customer privacy requirements, that does not stop us from making general statements about what we are seeing. And there is no such thing as market sensitive information in bullion - it isn't an equity.

Originally Posted by Unbeatable:

3. If the bullion banks were having issues, instead of people like Perth Mint employees letting the public know about it, I'd expect them to go out and try to convince people of the opposite - 'Don't worry there are not wholesale supply issues' & shi*, look, here you are...

Actually, it would be more logical for us to hype up shortages so that we could increase coin and kilo bar premiums and make more profit. I've rarely seen any market comment coming out of the major refiners talking about how crap demand is. Shortage hype is used by coin dealers to 1. get people to buy now 2. pay excessive premiums. Perth Mint has a bit more integrity and we stick to the facts. Why do you think Perth Mint and I get so much crap on the gold blogosphere - because we are wrecking their sales patter.

Originally Posted by Unbeatable:

So rather if I was looking for supply problems in the 400oz wholesale market, I'd look for signs of additional central bank leasing, particularly the Bank of England who are a key source of supply in times of stress. & shi* look a story just in the last two weeks that the BOE may have leased up to 1300 tons in the 400oz wholesale market in the first half of the year

You are on the right track here, a run is about liquidity, so the first action of a bullion bank experiencing a run will be to lease/borrow gold (not buy), which should show up in increasing lease rates (which has the effect of decreasing GOFO) - although lease rates are still quite low compared to stress periods in the past but trending up.

The 1300t story is another beat up, see here http://www.screwtapefiles.blogspot.c...or-layout.html the BoE said that the figure that Alasdair relies on for his whole thesis cannot be relied upon.

Originally Posted by Unbeatable:

Or I'd look for signs that Bullion Banks are running short of supply and/or are being forced to help one another out. & shi* look at how much of JPM's inventory has been removed this year and also this story from just yesterday

Those sort of inter-bank transfers are standard part of market clearing http://lpmcl.com/

Originally Posted by Unbeatable:

But as these don't constitute hard evidence, & people like Potemkin would say 'Rumours, words, stories...' I chose to bring up provable supply side shortages &/or unprecedented demand in the gold market which is of course what creates the wholesale market problems you are witnessing above.

Signs of increased demand and just signs of demand, not a bank run and does not cause a bank run as the bullion banks just act as a broker between buyer and seller and let price manage it. It is only unallocated holders taking delivery that creates a run and possibility of default. That shows up in lease rates and the futures/forward market first.

Originally Posted by Unbeatable:

Really!? How many hours do you think it will take from the time they announce purchasing restrictions to Gold Money to the time they default? I think you know that this is the very last thing they will do, if they don't actually just default first.

First sign will be premium increases, that is the key signal. And it won't be explicit purchase restrictions, more like delays due to "transport issues" etc.

Originally Posted by Unbeatable:

If there are demand stresses for gold, I think it's (painfully) obvious that they would rather do their best to try cut demand from the biggest gold consumer, India. (EDIT: Which is obviously why I brought up the restrictions in India and outright temporary import ban in Pakistan as being very indicative of shortages in the wholesale market.) As this would ideally (For the bullion banks) have the effect of decreasing demand for their good delivery bars in that market and also freeing up mint output sourced from the mines & scrap, so that it could then be used to refine new 400oz delivery bars for the bullion banks as opposed to coins and smaller bars for retail.

See my earlier comment on India. The Indian restrictions aren't doing anything to stop demand, it is just being smuggled. The Indian Govt actions are just about making their CAD figure look better to financial markets.

Originally Posted by PMBug:

Bronsucheki, are you able to confirm or deny this claim (at least as it pertains to the Perth Mint) from Bill Haynes?

No can't confirm it directly as we aren't being given any 100oz (ex Comex) or 400oz (ex London ETFs) bars by bullion banks to melt and recast into kilo bars. However, we are seeing good demand for our refining output into kilo bars for shipment into China, Dubai and Thailand, so the Bill and Tekoa reports fit in with that.

Originally Posted by Unbeatable:

Hi Bronsucheki, thanks for taking the time to give such a detailed response and for doing it in a pretty reasonable tone despite how confrontational mine was. Also especially considering that you work & have considerable knowledge in that area vs. me who doesn't.

No problem, don't mind being challenged. This time is different to 2008 and certainly more stress, I'm just not sure there is a run on yet, but it is finely balanced I think. We are seeing very high premiums on kilo bars, premiums we haven't seen for a very long time.

In addition, we did hear that 99.99% purity 400oz bars were attracting a premium in London (but the normal 99.5% purity wasn't). Mostly likely explanation for that was that 99.99% purity 400oz bars could just be melted and recast into kilo bars (which are generally preferred to be 99.99% purity in Asia/India) without needing refining. Screwtapefiles blog did some good analysis on the number of 99.99% vs 99.50% purity and what was being withdrawn from GLD, but nothing conclusive yet.

So certainly this is all very unusual and you're right to be cautious.

Originally Posted by Unbeatable:

So I'm surprised during the period of unprecedented demand this year that you didn't have to source any additional supply from the LBMA in London again?

Perth Mint is primarily a gold refiner and we get silver as a by-product of that gold refining. Normally the silver was enough for our coining needs but in 2008 the demand was so high we had to source silver externally. Since then we have picked up some more silver refining so have enough silver now, even with higher demand.

Originally Posted by Unbeatable:

You also say the majority of your non coin production is being made into Kilo bars for the highest bullion bank bidder. But I was under the impression that the bullion banks dealt in the larger 100 & 400oz bars & that the 1 kilo bars would be more for the retail investment market?

1kg = $40,000, not exactly "retail" by most definitions! Bullion banks deal in any size - they cover all markets. 100oz gold bars are primarily a US market size. 400oz bars are usually used for investment, bulk long term storage, they are not really convenient for use in industry/jewellery/mint as you need a big caster to melt 400oz, plus 400oz is 99.5%. So, particularly in Asia, the smaller 1kg in 99.99% purity is preferred by jewellers. Plus when I talk about kilo bars wholesale, that is selling in half or one tonne lots, eg $20m to $40m deal size.

Originally Posted by Unbeatable:

But the import taxes/duties in India are 8% that would be $104 an ounce, far higher than the $30 premium the media is using. Doesn't this mean that the $30 premium is the premium they're paying prior to import duties/taxes being applied?

Yes correct, the $30 would not include that import tax, but I believe there are some other duties/fees and often bullion banks selling into distributors in India include shipment and finance deals in the price, so I'm not sure the $30 is the full premium. However there is still a large premium in that market reflecting the restrictions and driving the smuggling, so I probably pushed my point too hard there. The premium is also highly volatile as the Indians are very price sensitive.

Originally Posted by Unbeatable:

this is perhaps the first time we have seen this happen laterally between two vaults

Has ZH been following these comex reports for the past ten years? I doubt it. I am sure if I had the time and went through all the reports I would be able to find this happening many times. One also needs to consider that if a BB is doing other movements/transfers as well as to another BB's vault, that is not going to be visible as the aggregate number would combine both. So one cannot say this is unusual.

Originally Posted by Unbeatable:

Today I see another negligible 4k ounces went from Scotia to JPM and JPM converted a massive 70k ounces from there 360k registered total and moved it onto their 100k eligible total.

The transfer from registered to eligible is why one needs to add both stocks together and compare that to open interest, which is what I did in this post. The current coverage ratio for gold is 17.7% and silver 24.5%. Looks like plenty of metal for redemptions.

Originally Posted by Unbeatable:

Personally I think at the very least a Bullion Bank run is in progress at JPM and I think even though the writing is on the wall, the others are just trying to help JPM make it to some pre-determined end date.

How long do you think banks runs last for? I note no commentator is really putting a date out there, except Jim Sinclair "because of the continued fall in gold inventory that within in 90 days or sooner the Comex must change its delivery mechanism". Personally I think by mid-Oct Comex will still be going on as per normal and the BBs will still be around.

Originally Posted by Unbeatable:

My question to you is, having seen how these unusual transfers have continued since my original post do you still think

As noted above about ZH, I question whether there is any proof these are "unusual transfers".

Originally Posted by Unbeatable:

My question to you is would you agree that the banning of buying gold on consignment did have the effect of considerably decreasing India's overall physical gold demand for 1-2 months (incl. smuggling)?

Yes, as India had a relatively open gold import system the sudden rule changes crimped legitimate imports but the smuggling network was not in place to take up the slack so that would have had the net impact of restricting demand. We have recently seen a pick up in demand from other countries which tells us smuggling has started back up.

I disagree with Eric Sprott that western central bankers "called up" India and asked/told them to do these import restrictions to help them out. I agree more with Jim Rogers on this "Indian politicians who suddenly blamed their problems on gold. The three largest imports to India are crude oil, gold and cooking oil. Since they can’t do anything about crude and vegetable oil, the politicians said India’s problems were because of gold, which, in my view, is totally outrageous. But like all politicians across the world, the Indians too needed a scapegoat."

Norcini: Gold is not in backwardation

In my last post I was not saying that what we see now on COMEX and with GOFO is not important – remember the mugger in Crocodile Dundee still had a knife – just that his switchblade is small compared to Dundee’s much larger “full” backwardation knife.

There is a lot of confusion about the definition of backwardation. Here is a quote from the Dummies series of books:

"When a market is experiencing backwardation, the contracts for future months are decreasing in value relative to the current and most recent months. The spot price is thus greater than the front month, which is greater than future delivery months."

Note their use of plural – "contracts" and "futures months" - as these other links also do, from the first page of a google search on "definition backwardation":

Wikipedia - "The resulting futures or forward curve would typically be downward sloping (i.e. "inverted"), since contracts for further dates would typically trade at even lower prices."

McClellan Oscillator - "Backwardation means that forward contracts are priced lower than nearer term contracts, or spot"

Investopedia - "Backwardation is the same as inverted when futures prices are lower than spot prices."

This is what I understand by backwardation when one uses that word in a general sense about a futures market. Having said that, I think it is valid to talk of a specific month being “in backwardation” even if that is not exactly a precise use of the term. What I have a problem with is describing what we are currently seeing in gold as a general backwardation and playing this up as a sign of the failure of the fractional reserve bullion banking system. It is not.

Last word on this I'll give to Dan Norcini:

"gold is not in backwardation and has not been at any time whatsoever on the Comex during the entire time this backwardation talk commenced and picked up some gullible followers"

The post is worth reading in full because he explains the need to look at current bid/ask rather than last price for the further out contracts due to lack of liquidity and the difference between backwardation and the basis (or strong basis as he calls it when spot is above futures). He also makes the following statement:

"When we do however see a STRONG BASIS PLUS a BACKWARDATION STRUCTURE ON THE FUTURES BOARD, then we have the real deal."

I covered similar ground this in 2010 post, saying that that occasional "backwardation" in the shorter months is just the start, or first sign, of a breakdown in the system. Calling what we see now in gold as backwardation proper overstates the phase we are in.

I think the other issue with backwardation is that it is a concept that comes from commodity markets. In this post I question whether such a commodity type interpretation of backwardation is appropriate for gold. Aren't we told that gold is a monetary asset with high stocks to flow, unlike commodities? If so, should we apply a commodity futures market interpretation to gold? As I say in that post "Then you see that gold hasn't went into backwardation, but that USD has went into contango."

If gold is mostly monetary with only a little commodity-like nature, it is therefore best analysed as a currency and in that respect, no one talks of currencies going into backwardation or contango, they just have different interest rates and that differential might drive a carry trade if the difference is big enough. FT Alphaville has done a whole series on this more "financialised" view of gold.

Regarding negative GOFO (which reflects the interest rate differential between USD and XAU), my current view is that it is reflecting the shift by speculators to the short side - more shorting results in more demand to lease gold, which drives up the lease rate (thus GOFO goes down). I have read that liquidation by specs out of long positions has also restricted supply of gold to lease (as the gold has been sold to those unable or unwilling to lease their gold out) and seen comments that increased physical demand has resulted in more metal being tied up in the value chain, so that results in more demand for leasing (or inventory to hedge).

So I think there is a case to say that negative GOFO as more driven by tightness in the gold leasing market. Note that shortage in the borrowing and lending market does not have to coincide with a shortage in the buying and selling market. Holders of gold may be willing to sell it (so price is low), but at the same time those continuing holding it (or the new people buying it) may not willing to lend it (so lease rate is high).

 

This is why it is logical for Dan Norcini to say that the structure of the futures market is not exhibiting "a true supply shortage" while at the same time we have negative GOFO and some futures contracts below spot.

So this development in leasing is probably what has driven GOFO negative, which, as Keith Weiner notes in this post, is then synced/transmitted to the futures markets by arbitrage (and has a very compelling combined chart of GOFO and the basis to prove his point). Therefore I think we are currently seeing is more a liquidity squeeze on the bullion banks, rather than a full blown distrust in them by holders of unallocated or shortages of physical (a price squeeze).

 

A real gold bank run will manifest itself in the wholesale markets for 400oz bars. When I see them attracting a premium and/or being difficult to source, or bullion banks desperately bidding on the Perth Mint's refining output, then we "have the real deal" as Dan says. I will let you know.

 

Alternatively, just watch Bullion Vault and Gold Money - which are backed by 400oz bars and which deal in that market every day - for reports of difficultlies in getting 400oz bars and restrictions on how much gold can be bought, and/or if they start to add on a "special" premium to their spot price.

Don't be complacent however. What I'm talking about above is the end of the line and things can unravel quickly - a liquidity squeeze can turn into a price squeeze - so keep your gold close or stored with non-banks, like the Perth Mint, who don't engage in fractional reserve and maturity transformation activities.

Shortodile Golddee: That's not backwardation

Shortodile Golddee is threatened by a goldbug with backwardation

Sue Shortton: Shortodile Golddee, give him your short positions.
Shortodile Golddee: What for?
Sue Shortton: He's got backwardation.
Shortodile Golddee: [chuckling] That's not backwardation. [draws a oil chart] That's backwardation.

(apologies to the screenwriters and thanks to Nick for the charts)

Gold is a pure Epsilon/Narrative asset

I came across this gem of a blog from a reader sending me Mauldin Economics' latest.

I think I could argue the case that gold is almost all Epsilon and little Alpha or Beta, because it is a Monetary asset, because of its massive stocks to flow ratio. As I said here "It is actually supply - the withholding of supply - that matters most." What those holders think matters, and that "think" is what the blogger calls a Narrative.

What we see going on in the goldbug internet is an attempt to construct a Narrative around gold. However, as the blogger says, it is not necessary for the Narrative to be true, "it is only important for a Narrative to sound truthful." Truth is not relevant because the point of the Narrative is to serve the interests of the powerful/those who are communicating it. How true - truth doesn't matter as long as it generates clicks and sells newsletters and coins.

It seems my, at times, crusade for truth in the blogosphere is in vain because what matters is "the more Common Knowledge in play at any given time, the more that market behaviors will be driven by the rules and logic of the Common Knowledge Game than by fundamentals or traditional factors."

Certainly I would have to concede that the current goldbug Narrative (a group of various memes) is all pervading in the gold blogosphere and I'm not really making a dent. There is a catch however. What the goldbugs don't realise is that their Narrative is not the Narrative that the rest of the world is using. Indeed in this post the blogger says that gold doesn't have a Narrative:

"In some periods of history gold is money. In other periods of history gold is not. But gold is always something, and that something is defined by the Common Knowledge of the day. To be an efficient gold investor in any period, I believe it’s crucial to identify and measure the relevant Narrative that is driving the Common Knowledge regarding gold. Only then can one construct an informational surface that predicts how the equilibrium price of gold will respond to new information ... There is no stand-alone Narrative regarding gold today, as there was in 1895. Today gold is understood from a Common Knowledge perspective only as a shadow or reflection of a powerful stand-alone Narrative regarding central banks, particularly the Fed … what I will call the Narrative of Central Banker Omnipotence. Like all effective Narratives it’s simple: central bank policy WILL determine market outcomes."

The result is that those who operate under the blogosphere Narrative will make the wrong decisions:

"You may privately believe that J.P. Morgan is still right, that gold has meaning as a store of value. But if you participate in the market on the basis of that belief, then you will buy and sell gold in an incredibly inefficient manner. You would be a smart gold investor in 1895, but a poor gold investor today."

This is a challenging statement for goldbugs - it doesn't matter if you think gold is a store of value, or if it should be one, what matters is what most people think gold is. I first came across this idea when reading The Social Construction of Reality (see this blog post of mine for background on this idea). When making investment decision what matters is what is, not what ought to be. I think most blogosphere Narratives are about the Ought, not the Is. That's fine, just don't buy and sell on that basis.

Gold and silver market status update

An update to my previous posts here and here on the state of the gold and silver markets as the Perth Mint sees them. Coin demand (retail and wholesale) has also eased but still good. Our retail outlet in Perth is quiet.

On the gold kilobar market, premiums have come off a bit but are still way above normal levels. This market action is confirmed by Warren "the ETF bar list guru" James at Screwtape Files who has observed a clear preference by bullion banks to choose 99.99% 400oz bars rather than 99.5% bars when redeeming physical from the ETFs as investors sell up, as the 99.99% bars can just be melted down and recast into kilobars (no refining required) and sold at a premium. Warren will have a post on his blog showing this graphically when he gets time.

On the Depository front, over the past few weeks we are now seeing net selling. It seems a bit of that is clients selling up part of their holdings and switching into equities. This may reflect what Financial Sense Newshour said in this podcast where they have clients who originally had a modest allocation percentage into precious metals but after the bull market (and no rebalancing) they are now sitting on excessive allocations of say 75%. Clients may have been induced into rebalancing with gold not showing any signs (yet) that a rapid rise is coming combined with the stock market showing gains.

 

We have also seen some physical collections of metal in Depository, mostly silver but minor quantities overall. The net loss in Depository is modest an similar to the percentage losses Bullion Vault, GoldMoney and BMG Bullion are also showing, according to Sharelynx's Transparent Holdings page (you'll need to subscribe if you want to see the data). The ETFs have been showing a lot more percentage losses than PM, BV, GM and BMG have, which reflects I think our more retail (strong hand) client base.

I don't know how to read this market behaviour. Weak investor sentiment like this could portend a bottom, but it could also make the market suseptible to a sell off if the April price smash entity decides to test the market's strength again as it need not worry about position limits and the CFTC catching them out.

Gene Arensberg at Got Gold Report also sees the market as “very imbalanced” and “dangerous for both sides of the battlefield.” with the largest hedgers of gold are positioned as though they see very little downside left, while on the other the Funds, while still net long gold, have put on their largest gross short position since the disaggregated data begins in 2006. 

Further confusing messages comes from the contrast between James Turk and the Royal Canadian Mint. James Turk reports some stress in the wholesale markets (although I think when he says that "some of the larger orders to buy bars have been moving out to as long as T+5, which is extraordinary" he is referring to kilobar, not 400oz bars, as GoldMoney isn't showing premiums or delays for their 400oz bar backed product) and that "the buyer or buyers who pushed the gold price up during the London PM fix yesterday were obviously desperate to get their hands on physical metal and were prepared to pay whatever price it took to obtain it".

 

Then we have this Globe and Mail article which notes that the Royal Canadian Mint's gold and silver exchange-traded receipts were trading at a 1.7% and 1% discount on Wednesday. The fact that "major investors holding at least 10,000 of the gold ETRs or 5,000 of the silver ones could also redeem them for metal and acquire holdings at a below-market price" certainly isn't reflective of a shortage in the wholesale markets.

At this time I think I agree with Gene: "We have to admire the courage of those willing to sell gold short in this, very imbalanced environment, knowing that a reversal could occur any moment and that it could be epic in its violence. Rest assured we have neither the courage nor the inclination to do so ourselves."

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.

Delusions so obvious

Time to catch up on some articles that caught my eye this week. First up is Charles Hugh Smith who picked up a quote that really resonated with me:

The obvious can be dangerous. The deluded man frequently finds his delusions so obvious that he can hardly credit the good faith of those who do not share them.

because I've often been on the receiving end of this. The problem with much of the precious metal commentary is that it seeks to explain market action in terms of obviousness, black and white, single reasons. I understand why this is, because many people are confused and afraid and simple comic book explanations are easy to understand, emphatic, and give a sense of control as you know the "real" (sole) reason why things are as they are. People don't want a multi-factor explanation where which factor is driving behaviour changes over time and the factors influence each other. It is too complex.

A good example of obviousness in action is this Alasdair piece (my bolding):

My reason for writing to the FSA was to establish if allegations were true that bullion owned by these two trusts was being used in contravention of custody agreements. If they had any foundation there would be an important regulatory risk for the FSA which should be drawn to their attention, and in any event needed clarification to prevent a false market. Suspicions that this was the case were fuelled by obvious conflicts of interest in the firms concerned. The sensible course for the FSA would have been to investigate the matter with the custodians and give them a clean bill of health, or alternatively take appropriate action in the event of a breach. Instead, they ducked the issue, leaving the impression that there was indeed a problem.

I couldn't have found a better example as Alasdair actually uses the word "obvious". When I see similar certain words like "will", "is", "clearly" I get cautious because it generally doesn't suggest an open mind. In this case the obvious conflict of interest is that the bullion banks are massively naked short while acting as custodian. You can read the letter Alasdair sent here where he states that "it is common knowledge they are running large short positions in those markets. The perceived conflicts of interest have led to widespread public allegations that the assets of these ETFs are being used to satisfy market deliveries in bullion markets ..."

Now whether or not this is true is beside the point I will be making, but if you want the other side then consider Kid Dynamite's comments/debate on my last post. A little more confusing is the statement by Alasdair in this post that bullion banks are now net long, so does that mean there is no longer a conflict of interest?

Anyway, my point is that Alasdair does not credit the FSA with any good faith or that that maybe the situation is not as obvious as he thinks. Here is an alternative viewpoint. Financial firms for a long time have had potential conflicts of interest between their custodial and trading arms. This is not news to regulators and they and the market have developed mechanisms to manage this. What they are interested in is evidence that these Chinese walls are not working. A conflict of interest can exist if a proprietary trading desk is short OR long. Simply quoting "allegations" based on an inference that a bank may be short would not represent anything obvious to the FSA. In addition, consider that the FSA can maybe entertain the possibility that the short position is hedged and is just market making, as Kid Dynamite asserts. Is it then ducking the issue when from their viewpoint what the FSA sees is just a non-evidence/fact based circumstantial allegation? They will expend their limited resources into investigating this when they have many other breaches to look at?

It may be entirely possible that the bullion banks are using ETF metal illegally. Certainly in most jurisdictions precious metals often fall outside financial regulations as they are real property and often not classified as a financial product, creating loopholes as discussed in my CFTC post. The problem with the "obvious mindset" is that it prevents those who hold it from developing an appropriate strategy to resolving it. They are unable to put themselves in the shoes of the people they seek to convince and rather than trying to find that person's hot button concern, they resort to "its obvious" and "you can't trust them" arguments. When these arguments are rejected because they are not obvious to the other person, the "obvious mindset" person sees it as another example of corruption/stupidity, which feeds their distrust even more, rather than "crediting good faith" to the other person.

Having said that, Alasdair's letter to the FSA is cleverly worded to appeal to the FSA's hot button concern, I just think the letter was ineffectual because the evidence presented was not convincing enough nor were the allegations "widespread" or "public" from the FSA's point of view - precious metal bloggers don't constitute "widespread public", as much as we'd like to think us blogger/commentators are that important.

On to Dan Norcini, talking about copper:

Drawdowns in copper stocks are notoriously unreliable signals however as some less-than-scrupulous players have in the past, simply bought copper, moved it out of the official warehouses and stuck it elsewhere all to give the idea that demand is robust. That allowed them to play the market from the long side claiming that supply was insufficient for current levels of demand.

Of course this would never happen in the gold or silver market. Just a thought for those who claim all of the COMEX and ETF metal has gone to China, never to return. Again, there are often multiple factors behind market behviour, it is not black and white. Maybe some of that metal is sitting in other off-market vault, helping to paint the tape?

Regarding the ETF holdings reductions, Dan calculates from recent 13F filings that "if you take the largest institutional investors combined, their selling accounted for nearly 75% of the shares being dumped in GLD", which is interesting as institutional investors hold around 50% of GLD. I think Dan sums up the recent market behaviour well:

"This is where the pressure keeps coming on the paper markets over here in the West. Institutions see no reason whatsoever to own the metal when they can better put that client money to work achieving historic gains in the US equity market bubble. As mentioned many times here - trying to fight the tape is a fool's errand. Traders have to go with the money flow. Investors had better be damned careful is all that I can say. There is a vast difference between trading and investing."

I really liked this article on hyperinflation in Diablo 3. This is a great piece of research and writing with the amusing conclusion that "if a small, straightforward economy generating detailed, timely economic data for its managers can careen so completely aslant in a matter of months, should anyone be surprised when the performance of central banks consistently breeds results which are either ineffective or destabilizing."

The author does wonder that "considering the level of planning that goes into designing and maintaining virtual gaming environments, that some measure of statistical monitoring and/or econometric modeling must have been applied to Diablo 3’s game world." My guess is they did, using the same mainstream economic thinking that informs public policy, that is why it was such a stuff up!

On to a phase space chart from The World Complex of the gold-oil ratio and silver-barley ratio. It results in a very interesting scatterplot chart in which:

the direction of the orbit is the opposite to what I had supposed it would be when I first graphed the scatterplot. I had assumed we would see higher silver (industrial activity) followed by higher oil price, leading to higher food prices, which I thought would scare people into gold. But what we observe since 1984 is the opposite--higher silver prices leads to higher gold prices leading to higher food prices (anticipating inflation?) followed by higher oil.

The peak in the Au/oil ratio in 1988 is a reflection of low oil price rather than high gold. Perhaps the high silver/barley ratio is a reflection of low food prices, which allows more savings in India and China which translate into gold demand, raising the price of gold first, and food prices secondly due to increased demand.

I'm not sure what to make of the increased noise since 1990. It may have to do with the increasing amounts of easy money in the system encouraging more participants in the commodities markets.

Well worth a click through to have a look at his chart and consider where next in the cycle we will move.

To finish some classic Jim Willie delusions:

I can guarantee you in the next several months, or a year or more, there will be NO COMEX GOLD PRICE. ... It’s all coming to a climax where gold is going to be central with a gold-trade central bank and gold priced at $7,000 per ounce.

What is encouraging is the comments to the article, with many less than impressed, so maybe people are tiring of the same old script which never seems to come true. This comment to the article sums it up:

This is classic Jim Willie gibberish. He is saying he “guarantees” there will be no COMEX gold price in the next few months, or maybe a few years. Basically, he has no clue. But hey, it sounds SO GOOD to hear if you are long the metals. Please. This kind of vague, unsubstantiated opinion, offered as a guarantee, well it really is wordless no isn’t it?

Time to give up on the CFTC

Gene Arensberg has an article out on the COMEX price smash where he concludes that:

 

"in order for the initial 124 tonne sale to have occurred “legally” it would have had to have been 14 traders, all with zero orders open, all acting simultaneously, all acting independently, in their own self-interest, without colluding with each other to “sell-for-effect” or conspiring to foment a price smash.

In actuality, the chances that there were 14 traders who held zero open orders all acting independently, all throwing their full allowable 3,000 contracts into the gold market within a few minutes of each other are infinitesimally small."

Gene notes that hedge members have a bona fide hedger exemption "to sell more than the limit, but not without filing paperwork with the exchange" which means that "whoever blew out the gold market on April 12 is already known to the CFTC (and what documentation they used to back up their trade)."

Now I would have thought that position limits would still apply to the person whom the hedger was executing for. A quick google search brought up this 20 page client update document from a law firm. Reading through the first few pages I was confronted by stuff like this:

"To qualify as a bona fide hedging transaction under the Final Rule, a transaction or position must (1) represent a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel, (2) be economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, and (3) either (a) qualify as one of the eight enumerated bona fide hedging transactions under the Final Rule and arise from the potential change in the value of (x) assets a person owns, produces, manufactures, processes or merchandises or anticipates owning, producing, manufacturing, processing or merchandising, (y) liabilities a person owes or anticipates incurring or (z) services a person provides, purchases or anticipates providing or purchasing, or (b) qualify as a “passthrough swap.”"

Eyes glazing over? Same here, so I then proceeded to the scroll/skim through reading method. My lay person summary: plenty of loopholes for someone to do what they want and have the CFTC running around in circles.

Now you know why the CFTC investigation into silver has been going on for years without any result.

As I said in response to this question: Do you think Bart Chilton of the CFTC is imagining things when he says its happening, or maybe he wants to be loved by the Goldbug crowd?:

"Consider that the CFTC has to deal/manage/politic two types of market participants – producers, who want prices to be high and consumers, who want prices to be low. I have seen the theory that Bart’s role is to play to or appease the consumers, which in the case of PMs means they want high prices. I really don’t know if this is the case or he is just straight up. Either way he is often very careful in what he says, and keep in mind the difference between manipulation and suppression. Bart talks of manipulation, not suppression."

To that I'd add the CFTC has to deal with a complex set of rules and regulations. When regulations get this complex market fairness and transparency is actually harmed, and the only ones who benefit are those big enough to have lawyers able to work out the loopholes.

What the market needs is straightforward commonsense rules that everyone knows in advance, just like Kid Dynamite points out in this post on cancelling trades. Or just drop the pretence and go free-for-all law of the jungle.

 

Having interest rates this low doesn't help, as speculators have minimal cost in holding a position for a long time (until it blows up) or taking on large positions. This just adds to the volatility.

 

Time to give up on the CFTC being able to control this, just like Ted Butler did.

BTW, Perth Mint once had a new hire in our Treasury department suggest we should trade on COMEX. That got laughed at (and that was before MF Global). We will take our chances in the OTC market, where at least we can pick our counterparties, do due dilligence on them, and trade on our terms.

The Andrew Maguire Challenge

I love a challenge/bet and Dan at The Fundamental View obliges with a challenge to Andrew Maguire to provide his CV to justify the title given to him as a whistleblower. Dan spices it up by making it one-sided, in that Dan will "promise to never write another word about you again. In fact, I will even provide you with a free banner advertisement spot on my blog for your “trading service” for a full year."

 

My view/best guess on why Andrew will not provide his CV can be found here. I can't think of any reason why he would not want to supply it. Jeff Christian said he couldn't find anyone who knew of Andrew so the question I have is why would Andrew pass up the opportunity to make Jeff eat humble pie and supply his CV for verification? I have seen arguments made that Andrew is under physical threat (as per the car crash) but if so then why is Andrew going to GATA conferences, has his image on the internet, does all these podcasts and runs a business?

The comments Dan got to 24hGOLD's republishing of his article tell you a lot about Andrew's supporters. Completely missing the point and going on about issues unrealated to the point, saying Dan does not believe in manipulation of gold (what has that got to do with whether Andrew is a whistleblower), or thinking he is asking for Andrew's personal details or trading/financial details. I find it surprising that his supporters don't think any is funny about Andrew's refusal to provide even limited previous employment details.
 

PS -  I have to give a hat tip to Faeces Ferguson for eating his hat.

Precious metal memes

I'm having a debate with The Daily Bell over their assertion that "physical gold and its delivery will cost you up toward US$2,000" in the comments to this article of theirs. Readers of this blog I think will find it interesting, as well as the diversion into questions about the Germany repatriation and central bank transparency. I also questioned their view that the London Fix was not a free market in the comments to this article.

The thing about The Daily Bell is that they track and look behind memes. Their reaction to my questioning made me ask this question in my latest comment:

You, DB, should know more about memes and their propagation than anyone else. Your willingness to look behind dominant social themes and ask who benefits is one reason why I was first attracted to, and continue to read, this site. I would suggest that you consider the possibility that memes also exist in the precious metals world. Many, like the Willie $2,000 story, don't have any malicious creator and come about from misunderstandings of how the market operates or exaggeration of a fact, mostly with the intent to just sell newsletters or product.

However, I would also suggest you consider that some may originate from the monetary or power elite you watch. The objective? To divert attention away from how the gold market really works and avoid probing questions by creating dumbed down comic book-style stories, that has the bonus of making gold investors look like nutters to the mainstream and which dissuade the mainstream from thinking about investing in gold.

I'm interested in your views on the above idea as well as from any The Daily Bell readers as to whether you think they have a blind spot in respect of precious metal memes.