Paper vs Metal

March 1, 1999 – Every once in awhile there is some heated discussion and contentious debate within the Gold market about the relative impact on the price of Gold by two opposing forces. We are at one of those times.

On one side of the equation are the speculators, who generally deal in the paper aspects of the market – namely, futures, options, and other paper representations of Gold. The force on the other side of the equation is the traditional bullion houses and other market makers like the big international banks, who generally deal in the physical metals market – usually, 400 ounce London good delivery bars, and to a lesser extent, 100 ounce bars and kilobars.

Over the years, these two opposing forces in the gold market have blended to a large degree, so it is at times quite difficult to distinguish between the very different methods they employ to achieve the same objective, namely, to make a profit from their activity in the Gold market. Speculators now regularly deal with the physical metal, and many veteran observers of the Gold market – including me – believe that speculative short positions against physical metal far exceed those on the Comex.

And bullion houses now often act as speculators, regularly seeking to add ‘position profits’ to their bread-&-butter trading income, the spread they earn between the bid/ask price in their market making activities. Specifically, instead of going home every night with a ‘flat book’ – i.e., their longs and shorts are in balance – many market makers in the bullion houses now regularly carry a net long or short position, hoping to sell the long position profitably at a higher price, or to cover a short position at a lower price with that same profit objective in mind.

Right now these two opposing forces are again getting a lot of attention. It therefore makes sense to sort through some of the silliness we are hearing, and to examine which side is having the greatest impact, that is to say, causing the low Gold price.

Perhaps the most controversial statement comes from Anglogold, the big South African company that is the world’s largest Gold miner. Because of some diligent analysis by John Brimelow, a leading South African broker with Donald & Co. in New York City, Anglogold was forced to make a statement to the press about its hedging position, i.e., the weight of Gold that it had sold forward. Specifically, by pouring through some arcane reports, John concluded that Anglogold had increased its hedge position in 4Q98 by 3.7 million ounces.

To put that number into perspective, that weight of Gold represents about one-half of Anglogold’s annual production and more than 5% of the weight of Gold mined annually worldwide.

In short, it was a big number, and I find it very curious that such a dramatic jump in hedges over so short a period did not warrant a formal press release from the company to explain this change, which I consider to be material.

In any case, when confronted with this discovery by the media, Anglogold was forced to make a statement. Speaking for the company, the Finance Director explained that the increased hedge was taken in order to lock in prices as part of Anglogold’s acquisition of the Gold assets of its sister company, Minorco.

Presumably, because Anglogold increased its debt to make this acquisition, it sought to lock in future revenue to protect some of its cash-flow in case the Gold price dropped. Fair enough, but what really caught my attention were his additional comments.

Evidently aiming to downplay the significance of this new hedge on the already battered Gold price, the Finance Director, Jonathan Best, was quoted by Reuters as saying: “The market price isn’t really determined in the physical market. It’s the speculative market that determines the price.” And then to justify this bold statement, Mr. Best said that: “Speculative volume dwarfs physical volume by 20 to 30 times.“

Mr. Best did get that part right – speculative volume does dwarf physical volume, but so what? Are we to believe that volume determines the Gold price? Mr. Best would be laughed off the floor of the New York Stock Exchange or out of any Nasdaq office if he proposed that theory of price discovery to any specialist or market maker. A comparison of the discovery process of Gold prices to stock prices is logical and appropriate.

Look at it this way. Based on Friday’s closing price of $150 per share, Microsoft has a market capitalization of around $378 billion. It has 2.52 billion shares in issue, so the price of its stock is the result of the willingness of the people comprising the market (speculators, market makers, and investors) to either buy that stock, to sell that stock, to own that stock, or to short sell that stock. That’s it. There are no other alternatives, and the market is continuously discovering a price for Microsoft stock based on the changing perceptions of these different groups interacting with one another. Volume goes up and down for countless reasons, but volume is a measurement and an outcome of this process of price discovery, not the cause of it.

Now consider what happens in the Gold market. Based on Fridays closing price of $287.50, Gold has a market capitalization of $1.07 trillion. There are 3.74 billion ounces in existence (in ‘issue’, to put it in stock market terms), and just like the price of Microsoft shares, the price of each ounce of Gold is the result of speculators, market makers and investors interacting with one another to buy Gold, to sell Gold, to own Gold or to short sell Gold. Again, that’s it; there are no other alternatives.

And just like the interaction of people trading Microsoft shares determines the price of those shares, the continuous interaction in the Gold market determines the price of those ounces of Gold.

A further comparison of the Microsoft market and the Gold market is interesting and useful. Gold does not pay interest (unless loaned); Microsoft does not pay a dividend (nor do its shares earn interest unless they are loaned). Of course, Microsoft is a business enterprise, and for that reason generates value for a reason different from Gold, which has value because it is a numeraire, a useful means for measuring the price of goods and services. But the point is that both Gold ounces and Microsoft shares have value, even if that value arises for different reasons.

Last year, the ounces of Gold in existence grew by 1.9%. Microsoft shares in issue (split adjusted) increased by 3.6%, nearly double the rate of new Gold ounces mined. In other words, the aboveground stock of Microsoft shares is growing nearly twice as fast as the aboveground stock of Gold ounces.

But there is one area where Gold and Microsoft really differ. Currently, the short position in Microsoft is 15.9 million shares, about .5% of the total shares in issue. By comparison the short position in Gold is huge, and is more than 17-times larger on a relative basis. Following the reasoning used by Frank Veneroso in his estimates, I believe the short position in Gold is around 325 million ounces, about 8.7% of the total weight of the aboveground Gold stock. Where is this Gold coming from?

Insiders in Microsoft own about 800 million shares, about 32% of the total shares in issue. ‘Insiders’ in the Gold market, i.e., the central banks, own about 28% of the total aboveground stock of Gold. I seriously doubt whether one insider at Microsoft in an attempt to earn interest income has loaned even one share of stock to the short sellers. Not so with the Gold market. More than 90% of the Gold borrowed by short sellers has come from the Gold market ‘insiders’, the central banks. In contrast to Microsoft, these insiders have loaned to the short sellers and mining companies about one-third of what they own.

Despite what Mr. Best may lead you to believe, the impact on the Gold price from the forward selling by the mining companies is no different than that of the short sellers. It puts downward pressure on the Gold price, and we have seen that downward pressure at work over the past several years as the short position of speculators and the hedge position of mining companies has mushroomed.

The mining companies are ‘hedged’ – they are not ‘short’ Gold – because they hope to mine in the future the Gold they need to repay what they have borrowed. Nevertheless, the impact on the Gold price is the same from hedging as short selling; it adds downward pressure.

Incidentally, one other part of Mr. Best’s statement is incorrect. The physical market drives the Gold price, not the other way around, and the reason is simple.

In the final analysis, it is the physical Gold the matters, not the varied and numerous paper representations of Gold. The reason of course is delivery. From time to time, the longs ask the shorts – as is their right to ask – to make delivery. In other words, the longs want the physical metal, and not just some promise to pay metal, or another paper promise to pay value, what we call national currencies. In contrast to the national currencies, which can be created out of thin air by bookkeeping entries, Gold can only be created by mining. That means sweat and toil. If a short is required to make delivery, the metal he requires can only be obtained by going into the market and buying it back, exactly the same procedure that must be followed by the shorts in Microsoft.

What will happen when all the shorts in Gold seek to cover? The price will skyrocket. Let the short sellers take warning, and recall the sage advice of stock manipulator Daniel Drew, who defeated Commodore Vanderbilt’s attempts to get control of the Erie Railroad over one hundred years ago.

He who sells

What isn’t his ‘n

Buys it back

Or goes to prison.

Ah, the good old days, long before the ‘too big to fail’ doctrine was promulgated. The short sellers at Long Term Capital didn’t go to prison, their friends on Wall Street saw to that. In fact they are still there in control managing that hedge fund’s trading, somewhat poorer and hopefully a lot wiser.

Vanderbilt lost a fortune in his failed attempt to control the Erie. But that fortune pales in comparison to what will be lost by the shorts in today’s Gold market when they finally cover.