Not Your Father's Gold Market

June 15, 2003

Gold Derivatives: Updating the Scorecard. On May 8, 2003, the Bank for International Settlements released its regular semi-annual report on global OTC derivatives, which showed continued robust growth across all major categories during both the last half and all of 2002 (http://wwww.bis.org/publ/otc_hy0305.pdf). Total notional value of gold derivatives rose from $279 billion at mid-year to $315 billion by December 31, an increase of $36 billion or almost 13% in the last half alone. On June 2, separate figures for forwards and swaps and for options were reported in table 22A of the BIS Quarterly Review (http://www.bis.org/press/p030602a.htm).

On June 9, the Office of the Comptroller of the Currency released its report on the derivatives held by U.S. commercial banks as of March 31, 2003 (http://www.occ.treas.gov/deriv/deriv.htm). Their gold derivatives, held almost entirely by J.P. Morgan Chase, Citibank and HSBC USA, fell marginally from $71.7 billion at the end of 2002 to $67.5 billion at the end of this year's first quarter.

All this new data has been summarized by Mike Bolser in chart form according to his usual practice. When reduced to tonnes, total forwards and swaps now exceed 14,000 tonnes, continuing to push toward the upper reaches of the estimated total short physical position. See http://www.goldensextant.com/commentary23.html#anchor19855
Gold Derivatives: Moving towards Checkmate; also http://www.goldensextant.com/commentary23.html#anchor77962
Gold: Cover or Cover-up? and http://www.goldensextant.com/commentary25.html#anchor522925
Long Con: Mother of Bank Runs. (Note: Because the gold derivatives of investment banks (e.g., Goldman Sachs and Morgan Stanley) and others (e.g., American International Group) are not included in the OCC reports, they do not give a complete picture of all gold derivatives held by major U.S. banks and dealers.)

De-Hedging Throws a Curve. Although estimates vary, total producer hedgebooks apparently declined by some 500 tonnes, from over 3000 tonnes to perhaps under 2500, during calendar 2002. Whatever the exact amount of the decline, it failed not only to manifest itself in total forwards and swaps reported by the BIS, but also to prevent these figures from rising sharply. This phenomenon is wholly inconsistent with the frequently stated view that producer hedgebooks are the principal driver of total gold lending.

With the totals reported by the BIS in a pronounced uptrend, the gently declining trend at the three U.S. commercial banks over the past several quarters suggests that gold derivatives must either be growing strongly at major U.S. investment banks and dealers or elsewise exploding at foreign-based institutions.

As in prior years, the 2002 annual reports from UBS (http://www.ubs.com) and Deutsche Bank (http://www.deutsche-bank.com) include detailed information on their precious metals derivatives (almost all gold). Unlike most other major bullion banks (and most central banks), these two huge international banks do not hide their gold banking operations from any intelligent scrutiny.

Deutsche Bank's OTC precious metals derivatives closed 2002 at E57.5 billion in total notional value, up from E41.6 billion the previous year and eclipsing the old 1999 high of E50.9 billion. The increases over the prior year were spread across all maturities (less than 1 year, 1-5 years, over 5 years) with larger percentage increases coming in the longer maturities (e.g., from E3.6 billion to E6.6 billion in the over 5 years category). Deutsche Bank does not break out forwards and swaps from options.

At UBS, the total notional value of OTC precious metals derivatives declined in 2002 for the fourth year in a row, to CHF56.6 billion from CHF71.1 billion at the end of 2001, and down by just over 50% from CHF112.9 billion at the end of 1999. As in the prior two years, the reductions took place entirely in options. Forwards, which had been reduced from CHF47.7 billion at the end of 1998 to CHF15.3 billion by the end of 2000, closed 2002 at CHF18.0 billion versus CHF17.0 billion the previous year. UBS reports positive and negative market values by maturity but not by notional value.

Converting the figures for Deutsche Bank and UBS to tonnes, Mike has charted them alongside total gold derivatives reported by the BIS. As the chart makes clear, UBS has cut its gold derivatives by half since 1999 while the trend at Deutsche Bank almost exactly mirrors that of the totals reported by the BIS.

The divergences in trend among UBS, Deutsche Bank and the BIS totals are striking. The reductions at UBS may have received a real tail wind from Swiss gold sales. At Deutsche Bank, on the other hand, periodic threats of future gold sales by the Bundesbank can have provided only buffeting. UBS has not been observed to act with the gold price fixing cabal. Deutsche Bank, although missing in action recently, was a charter member. See http://www.goldensextant.com/Complaint.html#anchor3130 Complaint, paragraphs 11, 42 and 45. Finally, UBS built its gold banking business over decades. Deutsche Bank built its now larger business in a just a few years beginning at roughly the same time as the gold price fixing scheme.

Newmont Plays Hardball. In a startling recent gambit, Newmont hit back hard at the bullion banks that pitched hedges to Normandy's Yandal subsidiary, which Newmont acquired last year by merger but without becoming directly liable for its obligations. Against proven and probable reserves of just over 2.1 million ounces, Yandal had sold forward (or written options on) some 3.5 million ounces. Having promised to reduce Normandy's hedgebook through "opportunistic" buy-backs, Newmont decided to play hardball in response to an attempt by one of Yandal's bullion banks to exercise right to break clauses in its hedge contracts.

Newmont threatened to let Yandal slide into insolvency unless each of its bullion banks either accepted a cash offer of 50 cents for each dollar of Yandal's net mark-to-market liability on its hedge contracts to that bank as of May 22, 2003, or, alternatively, assigned those contracts to a Newmont subsidiary and entered into new hedge contracts with Newmont equal to an undivided 40% of Yandal's existing hedge obligations to that bank. As of June 3, 2003, all but one of Yandal's bullion banks, collectively representing 94% of the hedged ounces and 76% of the negative mark-to-market liability, had accepted the cash offer for a total payment of $77 million. See Newmont, http://biz.yahoo.com/prnews/030603/latu144_1.html Press Release, PRNewswire-FirstCall (June 3, 2003).

Whether Newmont will close the deal without an acceptance by the lone holdout, rumored to be Goldman Sachs, before a deadline of June 21 has been questioned (e.g., Tim Wood, "http://www.mips1.net/MGGold.nsf/Current/4225685F0043D1B285256D3B00767EDE?OpenDocument>Yandal hedge drama - it's not over yet," Mineweb (June 4, 2003)), but Newmont appears to consider the acceptances in hand as a done deal. See "<http://biz.yahoo.com/rc/030611/minerals_newmont_hedging_2.html>Newmont says nearly out of Aussie gold hedges," Reuters (June 11, 2003). In any event, two points are clear: Newmont's management is bullish on gold prices; and gold bears are spinning the drama for their own purposes.

Witness a New York bullion trader as quoted by Alden Bentley, "<http://biz.yahoo.com/rf/030604/minerals_newmont_goldhedges_1.html>Newmont closes book on Yandal gold hedges," Reuters (June 4, 2003): "It's just a dramatic finish. That hedge book is gone with the exception of that one position. Its going to severely limit the pace of buybacks. It's definitely going to alleviate the upside pressure for gold, once the market digests what happened." Or the following from a newspaper often regarded as close to the Bank of England (John Dizard, "<http://news.ft.com/servlet/ContentServer?pagename=FT.com/StoryFT/FullStory&c=StoryFT&cid=1054416468361>Neither a borrower nor gold lender be," FT.com (June 5, 2003):

In the meantime, the gold lenders to Yandal had to balance their books and offset their newly naked short position by buying up gold over the past few months. That 2.5 million to 3.5 million ounces of gold demand has helped run the price up to its recent peak of around $390. Since the uncollectible loans have been covered, demand and the price have slumped.

Taking the high end of the range, 3.5 million ounces is equivalent to 109 tonnes worth a little over $1 billion at $300/ounce. Newmont announced its offer on May 27, less than three weeks ago. Yandal's bullion banks must have had unusual clairvoyance to cover "over the past few months." What is more, they must have done so with their own money since no cash has yet changed hands. But whether they have already covered or have yet to do so, the key issue is not when but how they cover.

Nothing about Newmont's offer requires or even implies any bullion repayments to those who loaned gold to Yandal's bankers. Unless they elect to cover by purchasing physical metal, the total short physical position of 15,000 tonnes remains unchanged and direct demand in the physical market is not affected. Yandal's bankers are far more likely to cover by purchasing options or other derivatives. In that event, as the recent figures from the BIS demonstrate, 109 tonnes is a drop in the bucket, unlikely to have any noticeable impact on gold prices unless specifically executed for that purpose, and even then having only transitory effect.

Bush League Analysis. At over 30,000 tonnes, total gold derivatives are now approximately equal to total reported official gold reserves. Yet, although the data on gold derivatives reported by the BIS represents the only publicly available information compiled on the global gold market according to a published methodology by a presumably reliable source, neither the World Gold Council nor Gold Fields Minerals Services appears to make any effort to try to reconcile their statistics on global gold flows with the BIS figures.

However, CPM Group, another mainstream provider of data to the precious metals industry, has recently taken a greater interest in the mammoth gold derivatives market. See Tim Wood, "<http://www.mips1.net/MGGold.nsf/Current/4225685F0043D1B285256D40006F2D29?OpenDocument>Physical gold trade is a dwarf - CPM Group," Mineweb (June 10, 2003). According to its managing director, Jeffrey Christian: "The physical market has been very small compared to the derivatives trading based on it. Yet, it is surprising the extent to which many gold market observers could not see this very fat, very enormous tail that was wagging the dog."

Contrary to 1999, neither the sharp rally in gold prices in 2002 nor the addition of roughly 5000 tonnes of gold derivatives boosted trading at the London Bullion Market Association, where average daily turnover of gold remained locked in the strong downward trend that began following the spike in turnover precipitated by the Washington Agreement on Gold and consequent rally in prices. See <http://www.goldensextant.com/Charts.html#anchor161737>GOLD MARKET REGRESSION CHARTS. Not surprisingly, therefore, reports from the LBMA's recent shindig in Lisbon conveyed a rather gloomy tone. Stewart Bailey reported in "<http://www.mips1.net/mgl03.nsf/UNID/TWOD-5N6QMQ?OpenDocument>Gold bears hijack LBMA 2003," Mineweb (June 3, 2003):

Of chief concern for the industry's major players is the fact that the much vaunted investment demand, which was to be the silver bullet for the market, has failed to materialize and still languishes around 12 percent of total gold offtake [3978 tonnes in 2002 according to GFMS] each year. The failure of gold as an investment to meet expectations is all the more disappointing given the near perfect conditions for its so-called safe-haven status, or its quality as 'real money' when pitted against the world's fiat currencies; ... .

"There is a feeling of, 'if it doesn't happen now then when's it going happen,'" says Gold Field Mineral Services managing director Phillip Klapwijk.

While gold's 25% price jump in 2002 may have disappointed some gold bulls, it considerably exceeded the published predictions of most if not all analysts in the LBMA fraternity. The alleged shortfall in investment demand is based on nothing more than estimates of dubious and unverifiable validity from GFMS, which put bar hoarding and implied net investment at "a rather anemic" 382 tonnes in 2002, up from 248 tonnes the prior year, according to Stewart Bailey in "<http://www.mips1.net/MGGold.nsf/Current/4225685F0043D1B285256D3F004A7BC2?OpenDocument>Gold still missing the point," Mineweb (June 8, 2003). See also GFMS, "<http://www.gfms.co.uk/>Gold Supply & Demand Report Q1 2003" (May 2003).

In contrast, CPM Group reported in its "<http://www.cpmgroup.com/>Gold Survey Press Release" (April 29, 2003):

The sharp rise in gold prices in 2002 reflected a massive rush into gold by investors worldwide. Investors bought more gold bullion in 2002 than they had in any year since 1967, the year that investors flooded the world’s central banks with their paper money in exchange for gold, leading to the collapse of the post-war gold-dollar standard for international currency markets. ...

The dynamics of the market are that investors, stimulated by international financial, economic, and political conditions, raced to buy gold last year, purchasing an estimated 26.9 million ounces [836.7 tonnes] on a global net basis. This investor buying, more than double the 10.0 million ounces [311 tonnes] purchased by investors on a net basis the year before, in 2001, squeezed jewelers and other fabricators out of the gold market, and led other people to sell their jewelry and other gold-bearing items to scrap dealers for its gold content.

These widely varying figures on investment demand apparently reflect different approaches to measurement. GFMS looks exclusively at physical demand. CPM Group also takes into account paper gold, including derivatives. Last year alone, gold derivatives accounted for twice as much tonnage as gold producers and equaled 125% of GFMS's estimate of total physical offtake. Under these circumstances, gold's performance is rather creditable. What is more, it should be quite alarming to the central banks whose vaults are slowly and steadily being emptied even while significant investment demand is being diverted into paper gold.

Big League Analysis. "<http://www.canarc.net/venerosos_corner.asp>Gold: The Investment Case, the Commodity Case" (March 21, 2003), Frank Veneroso's most recent published article on the gold market, is mandatory reading for all gold bugs and anyone else who follows gold. (Available at the same URL is an MP3 audio file of Mr. Veneroso's June 6, 2003, conference call on "Gold Bullion Flows and the Outlook for Gold.")

Most of the article is devoted to an analysis of multiple factors that are expected ultimately to result in an upsuge of investment demand for gold. In this connection, some "very rough numbers on the composition of the global balance sheet" are cited (at page 12) to show that total global gold holdings, including official reserves, amount to just $1.4 trillion, as against total global private monetary and financial assets of over $100 trillion, of which privately held bullion accounts for a mere $300 billion, leading to the conclusion (at pages 25-26): "[G]iven the small role that gold now plays in so large a global wealth portfolio, only a miniscule asset allocation toward gold could blow the lid off the gold price."

For present purposes, the key point is found on page 5:

On the internet there is still much discussion of the gold loan position [i.e., total short physical position of 10,000 to 15,000 tonnes]. Many gold bulls are eagerly awaiting the inevitable short covering explosion in gold. Well, it's time has passed. What we have instead is simply a gold market under management by an official sector that has far less ammunition to enforce its management than most people realize. For this reason we believe that the official sector will lose control within perhaps three to five years. If investment demand materializes in the global gold market, that day will come earlier. ...

The new data on gold derivatives is consistent with this view. The anticipated gold short covering rally has largely occurred, most notably after the Washington Agreement in 1999 and again in the latter part of last year. It was turned back in 1999-2000 and blunted in 2002 by massive explosions in gold derivatives. In other words, investment demand was satisfied by paper gold whenever possible rather than physical bullion, and derivatives were employed whenever necessary to transfer risk from the bullion banks to the central banks.

Some simple examples may help to illustrate these processes. When investors go long in gold through futures, options or even gold certificates, they are accepting someone's promise to pay gold in place of physical bullion. What is more, if the long position is closed out at a profit which the investor is willing to take in cash rather than metal, no physical gold need ever be involved. While the prudent seller (or writer) of the long position normally delta hedges its exposure, that hedge too could -- and frequently is -- carried out in the paper market. Given the very small size of the gold market relative to other investment and financial markets, losses that bullion banks can settle in cash rather than metal are unlikely to threaten any widespread systemic failure because they can easily be handled by the central banks.

To take another example, suppose a producer de-hedges by delivering into a forward contract. The bullion bank receives the metal, but is it then returned to the central bank lender? Not necessarily. If metal is required to meet demand in the physical market, the central bank may elect to roll over its gold loan to the bullion bank while simultaneously selling it a new hedge to replace the producer's contract. In this event, the original gold loan stays on the books of both banks. In the bullion bank's derivatives reporting, the forward contract with the producer is simply replaced by one with the central bank or an equivalent option. Indeed, if done at a higher effective price for the same weight of gold, the notional value of the new hedge will be greater than that of the one it replaces.

Father Knows Best. One of the more promising recent developments in the gold market is the creation of exchange traded funds and similar vehicles that try to make it easier for investors to acquire and hold what is effectively allocated gold, and thereby to support and augment physical demand. The premature demise of the short covering rally has postponed but not canceled the next roaring bull market for gold. It will break out when physical investment demand exhausts or overwhelms the willingness of the central banks to continue to empty their vaults, or when some other event reveals the extent to which their physical gold reserves have already been depleted.

In earlier times, when the volume of paper gold grew too large relative to physical supply, bank runs, panics, devaluations or "going off specie" followed. The last big event of this nature was the closing of the U.S. gold window in 1971, more than a generation ago. Since then, the modern mind has become accustomed to thinking of financial wealth in dollars having no fixed relationship to gold (or any other real asset). Under these conditions, abetted by modern derivatives, the supply of paper gold has mushroomed relative to physical supply.

Famous investor Warren Buffett has suggested that derivatives are a form of financial sewage. His father took a similar view of irredeemable paper money. Concluding a 1948 speech to the Conference of American Small Business Organizations, "Human Freedom Rests on Gold Redeemable Money" (The Commercial and Financial Chronicle (May 6, 1948), Nebraska Congressman Howard Buffett stated:

The paper money disease has been a pleasant habit thus far and will not be dropped voluntarily any more than a dope user will without a struggle give up narcotics. But in each case the end of the road is not a desirable prospect.

I can find no evidence to support a hope that our fiat paper money venture will fare better ultimately than such experiments in other lands. Because of our economic strength the paper money disease here may take many years to run its course.

But we can be approaching the critical stage. When that day arrives, our political rulers will probably find that a foreign war and ruthless regimentation is the cunning alternative to domestic strife. That was the way out for the paper-money economy of Hitler and others.

In these remarks I have only touched the high points of this problem. I hope that I have given you enough information to challenge you to make a serious study of it.

I warn you that politicians of both parties will oppose the restoration of gold, although they may outwardly seemingly favor it. Also those elements here and abroad who are getting rich from the continued American inflation will oppose a return to sound money. You must be prepared to meet their opposition intelligently and vigorously. They have had 15 years of unbroken victory.

But unless you are willing to surrender your children and your country to galloping inflation, war and slavery, then this cause demands your support. For if human liberty is to survive in America, we must win the battle to restore honest money.

There is no more important challenge facing us than this issue -- the restoration of your freedom to secure gold in exchange for the fruits of your labors.

Since 1948, the proponents of paper money have remained ascendant for more than half a century. Nevertheless, Americans have regained "the freedom to secure gold" in the open market. The question posed by the Buffetts -- father and son -- boils down to this: Can crap be saved with more crap? As strange as today's gold market would seem to their fathers, for today's investors the reasons to hold gold are the same as ever.

We think our fathers fools, so wise we grow; Our wiser sons, no doubt, will think us so. Alexander Pope (An Essay on Criticism, 1711)

http://www.goldensextant.com/commentary25.html