Precious Metals Update

March 9, 1998 – Last month Warren Buffett lit the fuse of a precious metals firecracker with the stunning announcement that his investment company, Berkshire Hathaway, had purchased 130 million ounces of Silver. Initially Silver soared on the announcement, and Gold bounced higher in sympathy.

But since that initial flurry of activity and the brief rally in prices, both precious metals have settled back, with Silver now down more than 20% from its recent high. Was the firecracker a dud? Or is the fuse still lit, but just difficult to see it burning? I think the latter.

This precious metals update provides several reasons why the outlook remains positive for Gold and Silver, even though their price has been lackluster over the past few weeks. Let’s look first at the cost of borrowing Gold.

Short-term interest rates for Gold recently jumped to more than 3% from the low 2% range they had been holding. It is a remarkable jump because of its size, and because it occurred so suddenly in just a couple of days. However, the real story is not so much this latest fluctuation, but the fact that Gold’s interest rate is so high in the first place.

If you look back at the history of Gold, its short-term interest rate (1 month up to 3 months) has normally ranged from .25% up to .75%. Rarely would it ever get as high a 1%, but it has ranged well above that level for two years now. The bears say that this higher rate is one result proving that Gold’s role has changed, and that it no longer is money. I disagree.

Gold’s monetary role hasn’t changed one whit. What has changed is market perceptions about Gold’s usefulness. Because confidence reigns supreme, Gold is given little value. While it remains money of substance (a tangible asset), this characteristic is not highly valued in the present climate because everyone’s credit worthiness is accepted without question. Therefore, as confidence in the monetary and banking system rises, national currencies (all of which are based on credit) are valued increasingly higher, which is another way of saying that the Gold price has been falling. But I think it has fallen way too far, which explains why Gold’s interest rate is so high.

There is too little Gold available at current prices to enable its interest rate to be anywhere near historical levels. In other words, there is a shortage of precious metal. Gold’s normal interest rate will again be achieved, but only when Gold gets back to a normal price level, which would be somewhere north of $400 per ounce. This higher price will increase the available supply of Gold, which will result in more Gold for lending and lower interest rates. Until then, however, we know that Gold is undervalued. In fact, it should continue to be accumulated because it represents exceptional value, notwithstanding all the concerns and hand-wringing about central bank dishoarding. It has been my contention – which was well stated in these letters in the ending months of last year – that central banks dishoarded some 500-800 tonnes of Gold in 1997. This weight of Gold equals about 25%-40% of annual production, so it would be a considerable amount of Gold for the market to absorb.

The existence of this dishoarding is important. I believe that last year’s drop in the Gold price can be explained by this dishoarding. My conclusion has been that the low Gold price is an aberration resulting from one-off central bank transactions which are now complete, and that higher prices will return this year as the market recognizes that further European dishoarding is unlikely.

Earlier this year, a 500 tonne dishoarding estimate was reported by Gold Fields Mineral Services and others for 1997, thus confirming from their own independent sources my estimate of the weight of central bank dishoarding. The likely culprits in my view are the Dutch and/or the Belgians, as the central bank of both these countries has dishoarded Gold in the past, and both banks have made plain their view that they hold too large a weight of Gold when its value is viewed as a percentage of their country’s total foreign reserves.

I had expected in January or February an announcement from these banks about last year’s dishoarding, but none was made. In fact, recently the Belgians even suggested that they had dishoarded none of their remaining Gold reserve, but the announcement was vague enough that it should not carry too much weight, particularly because they have made similar announcements in years past when they had in fact actually dishoarded Gold.

In any case, the question remains. Was the drop in the Gold price last year due to central bank dishoarding?

Recently, some evidence has emerged confirming that a central bank did dishoard Gold last year. Gold borrowing rates (Gold’s so-called ‘lease rate’) have jumped considerably over the past few weeks.

This jump in cost to borrow Gold was not the result of new borrowing. Rather, it was the result of a drop in the supply of Gold available for lending. It appears that one central bank (I suspect the Dutch) sold Gold last year on a forward basis for delivery in March of this year. While they retained the Gold during the period of the forward sales, they continued to lend it into the market. But those forward sales are now coming due.

Consequently, they had to withdraw their Gold from the lending market in preparation for its delivery into their forward sales.

If this course of events is accurate, then we can expect an announcement from this central bank in April or early May about their dishoarding. This announcement may coincide with the statement by the proposed European central bank advising what its Gold policy will be once this new central bank is formed and operational. And here there is also reason to be positive.

Votes in the proposed European central bank are based on the relative size of the economy of its various members, and these votes of its member countries acting in the Governing Council will set the policies of the new European central bank. While eleven of the fifteen countries in the European Union are likely to join the single currency at its formation, the reality is that only three countries – Germany, France and Italy – will for all practical purposes determine the policies of the new central bank. Their votes total 71%, an effective majority that outweighs the 29% of the other eight potential members combined. Therefore, it is the views of these three countries which should be given the most weight, and here there is encouraging news.

Germany, France and Italy together own 73.6% of the total Gold reserve of the eleven members of the proposed European monetary union. Recently it has become increasingly clear that these three countries want and expect Gold to play an important role within the new European central bank. France in particular has been outspoken in this regard through its central bank governor Jean-Claude Trichet, who himself is one of two potential candidates being considered to assume the responsibilities of Chief Executive of the new European central bank.

The consensus view now is that there will be little Gold in the new European central bank. Therefore the market I believe is setting itself up for a surprise. If the ‘big three’ member countries are indeed serious about Gold playing an important role as one type of reserve for the new European single currency to be issued by the proposed European central bank, then the market will be caught wrong-footed when the Gold policy is announced in May. My expectation is that when the eleven countries are chosen in May and their currency exchange rates are fixed, the Gold in the coffers at that time will remain in the coffers of the new European central bank and/or its subsidiary bank in each of the member countries (which is those countries’ current central bank).

The important point is that the uncertainty of potential European central bank dishoarding will end. There will be no more dishoarding if the Germans, French and Italians have their way, which it seems clear they will do because they control the voting majority of the proposed European central bank. This development will in time prove to be positive for market sentiment and prices.

Finally, why has Silver dropped back down to $6 per ounce? Isn’t that slide in price a bearish omen indicating that the Buffett-effect has ended?

On March 14th Mr. Buffett will no doubt have more to say about his Silver purchase when Berkshire Hathaway publishes its annual report, which will be posted that day to its website www.berkshirehathaway.com. In the meantime, we can only speculate as to what is taking place in the Silver market, but the recent drop is still tied to Mr. Buffett’s actions. Here’s how.

As I understand it, Mr. Buffett was very surprised by all of the media attention he received when his Silver purchase was announced, and he quickly became very alarmed by some of this attention. Given the huge drawdown in Silver inventories, the big jump in price, and the frequent mention of the attempted squeeze of the market by the Hunt brothers in 1980, Mr. Buffett became very uncomfortable with all of the media coverage given to his Silver purchase. Therefore, to take the pressure off himself and his company, he took some of the pressure off the Silver market.

He deferred delivery on some of his Silver purchases (I hear an estimated 30 million ounces will now be delivered in the June/July period instead of March). Rumor has it he also loaned some of his Silver back into the market to take advantage of the high prevailing interest rate. The result was swift.

There were big drops both in Silver borrowing costs and the price of Silver, and less media attention for Mr. Buffett.

However, I also hear that these actions in no way changed his long-term view on Silver, which is an asset that remains undervalued – which is after all Mr. Buffett’s favorite kind of asset.

So in summary, a lot has changed over the past few weeks for the precious metals, but much of this change is inconsequential to the big picture and long-term outlook for the precious metals. The most important factor has not changed.

Both Gold and Silver remain good value, and both should continue to be accumulated by long-term investors seeking exceptional value.

Moreover, this accumulation will now be taking place in an environment turning increasingly favorable toward the precious metals. Much of the uncertainty surrounding the European central bank policy on Gold is ending.

As the market begins to recognize the importance of the pro-Gold view of the ‘big-three’ central banks, higher Gold prices will likely be the result. And Silver will also move higher in that environment. I still expect 1998 will prove to be a good year for the precious metals.