Print 
PDF
BookmarkIn an age when computer trading programs seem to take over the show at times, it is natural to call foul in the event of an unexpected and severe market sell-off.
Only some time after the event does a plausible explanation come to light, which most often turns out to be just normal trading activity, its effect amplified by today’s growing trading volumes and ever-increasing automation.
But what if that severe sell-off hits a market as liquid and heavily-traded as gold? And what if that gold price remains depressed for weeks or months, despite a scarce supply that by all reports is clearly unable to fill a clamoring demand? Is there a strong hand holding it down?
The Paper Sell-Off
The physical gold market is easy enough to understand. You simply walk into a bullion shop, buy some coins or bars, and store them in a safety box.
The paper gold market, though, can be pretty complex. It started with the futures market, where gold producers have been selling the resource for over a hundred years. Futures contracts have made it easy for large volumes of gold to change hands multiple times from suppliers through speculators to end users, trading across the country and around the world without a single ounce of physical gold ever being moved until final delivery.
So convenient it was that investment funds and trusts started buying gold and issuing their own paper gold contracts, which can be called anything from stocks to notes to receipts and more. By reducing the sizes of their shares to just 1 ounce equivalent, or even fractions of an ounce, these funds were instrumental in making gold available to ordinary, everyday investors.
Thus, the paper gold market exploded, contributing to gold’s stellar price performance since 2001 by taking large volumes of physical gold off the market and storing it vaults. The largest gold ETF – the SPDR Gold Trust (NYSE: GLD) – still holds some 32.5 million ounces, or 1,013 tons. Even after the abundant redemptions of GLD shares as of late, out of 109 countries with gold reserves, the trust’s stockpile still ranks in 8th place – just ahead of Russia’s.
It should not take anyone by surprise, then, that paper trading should have a considerable impact on the gold price. Bloomberg reported last week that “investors sold 467 metric tons [of gold] valued at about $20.9 billion from exchange-traded products this year.”
To where did all these investments get redirected? “Some lost faith in gold as a store of value amid an improving U.S. economy and rally in equities,” Bloomberg answers. Investment fund managers are paid to get the greatest return for the money entrusted to them. They saw gold moving sideways for over a year, with equities ripping upward since the middle of 2012 and understandably jumped the fence.
Despite Strong Physical Buying
What is not so understandable in many investors’, traders’, and analysts’ eyes is why the gold price should remain depressed despite the heavy physical buying that has been snapping up all the gold that these paper redemptions have released into the marketplace.
“Asian markets will see record quarterly totals of gold demand in the second quarter of 2013,” World Gold Council Managing Director Marcus Grubb informed Reuters. “Even if ETF outflows continue in the United States, it is quite likely that the gold previously held in ETFs will find a ready market among Indian, Chinese and Middle Eastern consumers who are taking a long-term view on the prospects for gold.”
Grubb indicated that China’s gold imports reached 160-170 tons in April alone, with total offtake this year expected to reach 880 tons. Right there, just one country by itself has in one month already absorbed 35% of the physical gold released by all paper redemptions in 2013 to date. And it is on track to absorb twice the redeemed paper amount in total physical purchases by the end of the year.
But there’s another country even hungrier for gold than that. “We now definitely expect Indian demand to come in at the upper end of the 865 tonnes to 965 tonnes range that we had previously forecast for 2013 because of the effect of what happened in April,” Grubb added.
In fact, India may have already soaked up all 2013 paper gold sales to date all by itself. Its gold imports for 1Q were 256 tons, while 2Q is on track to reach 350-400 tons, the World Gold Council reports.
The WGC also expects central bank purchases of gold to range between 450 and 550 tons this year. Add it all up – just Chinese and Indian imports plus central bank purchases, nothing else – and we already have at the very least 1,000 tons of purchases in 1H 2013, well over 210% of the paper gold sold over the same period.
ETF liquidations were quickly absorbed with a further substantial chunk taken out of stockpiled inventory. And yet the gold price is still stumbling along the $1,400 line? To have all this gold taken off the market without a proportionate recovery in the gold price is leading some to ask some serious questions.
Insiders Wonder
Those scratching their heads are not just your typical ill-informed investors looking for someone to blame for the losses they have sustained over the past few months. They also include industry insiders at one of the world’s largest government mints.
Since 1908, the Royal Canadian Mint has been the Canadian government’s coin stamper, manufacturing currency coins for a number of countries besides, plus collector coins of both precious and base metals.
Two executives at the Royal Canadian Mint have recently voiced their concern over a “disconnect” between the physical gold and paper gold markets. While the demand for the RCM’s gold coins and bars are skyrocketing, their paper gold exchange traded receipts (ETRs) are trading at a discount below the gold price.
“We’ve seen this massive physical demand,” Steve Higgins, senior manager of ETR compliance, revealed to the Canadian paper The Financial Post. “There’s a disconnect between that and the trading price of the securities.”
Even Randy Smallwood, CEO of the world’s largest silver streamer Silver Wheaton (NYSE:SLW), joked in an interview with The Slant, “I almost wonder if it’s time for two different commodity prices out there — one for the paper trade and one for the real trade.”
Possible Causes
So what could be causing this apparent “disconnect” between the paper and physical markets? Unfortunately, that is something we may never know.
Timing could be a factor. Paper is traded so much more quickly than the physical. Billions of dollars’ worth of product can trade in a minute on an exchange, while transacting an equivalent amount in material bullion would understandably take longer.
Reporting is another factor. While electronic exchange transactions are tallied and made known almost instantly, physical purchases of a size large enough to move the market would take days if not weeks to compile and disseminate through the press.
Randy Smallwood gives yet another probable reason why all this physical buying has not reinflated the gold price: the strength of the USD. “What’s happening and what I see around the world,” he hones, “is that the U.S. dollar is becoming the dominant reserve currency … The U.S. dollar isn’t devaluing as fast as the other currencies in the world.”
When asked if the strong USD might not depress precious metals further, Smallwood insisted that given mining costs, there isn’t much more air that can be squeezed out of prices.
“The silver price out there is probably $20-plus, for an all-in capital burden cost. The gold price, I would say it’s probably $1,200 all-in capital burden, sustaining exploration, expenses, costs. There’s not a lot of margins in commodity prices right now. That tells me we are at or near the bottom in the commodity price cycle,” Smallwood encourages.
Given that metals prices are not far from their production costs is a reassuring sign to metals investors. Any further drops would force production cuts and mine closures, which would reduce the supply and reinflate prices.
Sooner Or Later
We may never get to the bottom of this disconnect between the paper market and the physical market or why the astounding physical buying of released ETF bullion has not yet worked itself into the gold price.
If governments are forcibly holding gold underwater just long enough to buy as much as they can to beef up their reserves before sending it skyrocketing upward again, they will never tell. Some believe that makes perfect sense, considering almost every country’s financial problems.
At some point, though, fundamentals will once again dictate the trade. According to Smallwood, “Without exploration dollars being spent, there won’t be new [mining] successes coming on … Without expansion projects … to replace some of the depleted mines out there, there will be supply-side pressures.”
Add to that the physical demand pressures noted above, and the only logical conclusion to reach is that at some point the precious metals trade will once again run uphill.
Remember too that during much of the run up in the gold price from 2001 to about 2007, central banks as a group were net sellers of physical gold. And yet prices rose for the most part due to paper buying. Currently, central banks are net buyers of physical gold, while paper selling has driven prices down.
Love it or hate it, the paper trade has become the dominant market mover in not just the metals market but in just about every other investment market out there. Fret not. The bandwagon made of paper is just taking a 15 minute break. It’ll play its music for us yet again.
