The Two Sides of the Gold Market

August 30, 1999 – There are two sides to the Gold market. One is the paper side, which encompasses all transactions denominated in terms of Gold for which the metal never changes hands. The other is the physical side, meaning that a transaction actually involves a change in ownership of Gold bullion, i.e., physical metal.

These two sides are fundamentally very different. Most notably, the number of paper transactions each and every day always totally overwhelms the number of transactions in which physical metal is traded.

Paper contracts for Gold are traded throughout the world, both on and off organized exchanges. One of the largest and best recognized Gold exchanges is the Comex in New York City.

Each day thousands of futures contracts for Gold are bought and sold on the floor of the Comex. Each Comex contract is a commitment to buy or sell 100 ounces of Gold at some future date, but each trade is only a paperrepresentation of the underlying metal in which the transaction is denominated. Little metal actually changes hands.

For example, typical Comex volume is often around 40,000 futures and option contracts per day, which represents a total weight of 4 million ounces of Gold being traded. However, little physical metal actually changes hands. In fact, on some days no physical metal is involved. Traders merely buy and sell weights of Gold in paper representations based on their promise to their counterparty, with a small cash margin placed as a good faith deposit.

Another major Gold market, which is even bigger than the Comex, operates in London. The market is not an organized exchange like the Comex, but rather, an association of bullion dealers that trade with one another on their own behalf as well as to execute trades as brokers for their customers. The London Bullion Market Association (LBMA) reports the trading activity of its members.

On a typical day, 1,000 metric tonnes (over 30 million ounces) is traded, 7½-times the volume of the Comex. This huge volume though, usually involves only 1,000 or so individual transactions. Thus, given the relatively large size of an average transaction, it is clear that London is much more a market for institutional players, compared to Comex, which is geared primarily toward individual traders. Nevertheless, like Comex, little physical metal actually changes hands in London.

The exact amount of physical metal changing hands is not reported by the LBMA, but it is probably less than 1% of total turnover, or 10 tonnes per day. My estimate is based on the fact that about 2,500 tonnes of Gold is mined each year, which is about 10 tonnes per working day. However, much of this newly mined metal goes to Zurich and other major centers, with London I estimate capturing about one-third, or three tonnes per day. The other seven tonnes in my 10-tonne estimate that is traded in London arises from Gold already in the aboveground stock.

While the preponderance of paper traded Gold compared to the exchange of physical metal is staggering, don’t draw the wrong conclusion about their relative importance. It is easy to assume that paper is far more important than physical metal, but in fact, the opposite is the case. The physical market is by far the more important of the two, and the reason is simple.

Paper transactions are based on physical metal. Whether futures contracts, forward contracts, options or any other form, paper contracts are derived from physical metal, and are traded as substitutes for physical metal. Consequently, as a derivative of a physical, tangible commodity, a paper trade can always be turned into physical metal.

In other words, the longs can always force the shorts to make delivery, or vice versa. It rarely happens that way, as evidenced by the relatively small amount of physical metal traded compared to paper. But the potential is always there, and sometimes it does happen. Every once in awhile, the physical market takes center stage. And more often than not, it is the longs who are the main actors in this drama.

In effect, the longs can, if they choose to do so, dominate the market. Again, the reason is very simple. The aggregate promise of everyone holding paper derivative contracts to deliver Gold far exceeds the capacity of these shorts to make good on their promise to deliver. Consider these numbers.

The total open interest on the Comex for futures and call options, net of put options, is 56.5 million ounces, which is the size of the short position. If we assume that the open interest in London is 7½-times greater than Comex, based on the volume comparison of these two markets, the London short position is 424 million ounces. Then there is the Zurich market, reputed to be as large as London, Tokyo, Australia, and a dozen other markets around the world, so when taken together, it is not at all inconceivable that there are commitments by the shorts of one billion ounces of Gold, or perhaps even more. It is a staggering number, particularly when the size of this commitment to deliver is compared to the total weight of Gold that actually exists.

The total aboveground stock of Gold fabricated into bullion, i.e., bars, coins and high-karat jewelry, is only about 2¾ billion ounces. This total represents about 70% of the total aboveground Gold stock. In other words, of the 120,000 tonne total aboveground Gold stock, about 85,000 tonnes of Gold exists as bullion. The balance of 35,000 tonnes of Gold is readily inaccessible and illiquid, because it has been fabricated into low-karat jewelry, electronics, works of art, and other uses.

Of this 2¾ billion ounce total aboveground stock of bullion, nearly 1 billion ounces is in central bank vaults, with the balance fairly broadly dispersed in private, individually owned hoards. So again a comparison to the 1 billion ounce short position is useful to show the true vulnerability of the shorts.

Short positions are established in two ways. The most common way is the paper short. If, for example, I sell a Comex contract short, all I have to do is find someone to take the other side of the trade. The other type of short is the so-called ‘carry trade’, nearly all of which has been financed by central banks. In carry trades, the short is established by borrowing physical Gold, which is then sold in exchange for some national currency. At least one-third of the total short position is carry trade oriented, financed almost entirely by the central banks. The rest of the total short position is paper oriented.

Given the above, we can begin to visualize the predicament of the shorts. They are short 1 billion ounces. The total aboveground stock of bullion is only 2¾ billion ounces, so the shorts owe nearly 40% of it.

Imagine if the shorts owed 40% of some equity. How could the shorts possibly buy back enough of the stock to cover their position without driving the price sky-high? And similarly in the case of Gold, where can the shorts ever get enough metal to deliver, if a short squeeze were to begin?

The answer is that they can’t, not at least at current prices because most of that 2¾ billion ounces is in strong hands. Consequently, the only thing lacking from a big short covering rally is a trigger. And I thought that we would see that trigger this month on the Comex.

We now know that the longs on Comex have this month taken delivery of 846,400 ounces of Gold, even more than I expected. To meet this commitment to deliver to the longs, the shorts had to bring new metal into the Comex warehouse, and the stock increased to 1.2 million ounces. So this month 70% of the Comex inventory changed hands, a truly extraordinary event. But rather than shooting higher as I expected, and as Gold had begun to do in mid-month, the price of Gold was stopped dead in its tracks. What happened?

The simple answer is that the paper market dominated the physical market, an extraordinary event in its own right because of the importance of physical metal in the market equation. The real answer though is that, much like the Bank of England sale and the curious way in which they made their announcement, whoever has been manipulating the Gold price continues to manipulate it. This month’s events on the Comex are more evidence of it.

Readers know that for months I have been contending there was an ongoing price manipulation of Gold, and I have laid out over these months many pieces of evidence that this price manipulation was occurring. Besides the Bank of England sale, this evidence included Alan Greenspan’s testimony last year before Congress, and other pieces of information.

So whoever has been manipulating the Gold price – and I believe that it is an unholy alliance of the big American and British commercial banks, with the assistance of the Bank of England and the US Treasury – is still successful in keeping the Gold price quiet. Notwithstanding in recent months a doubling of crude oil prices, firming base metal prices, signs of growing inflation in the US government’s own statistics, a record US trade deficit, and on and on, someone is still successfully sitting on the price of Gold. How much longer can this intolerable situation go on?

It has already gone on longer than I expected. So I guess it can go on awhile longer. No one really knows? But I do know one thing.

If the freemarket process is not destroyed first, eventually and inevitably the Gold price is set to sky-rocket. Eventually and inevitably the shorts will lose control of their price manipulation because the longs can demand and are demanding physical bullion. In the end, physical metal always means more than someone’s promise to deliver metal, which brings us back to the Comex. The story there is not yet finished.

While the shorts have so far managed to find the inventory to deliver, the next step is in the hands of the longs. Will they take their 846,400 ounces out of the Comex warehouse? Will they take delivery for another big amount in September or October? If so, will the shorts once again find the metal to deliver?

There are more questions than answers for the moment, but stay tuned. I think that the shorts are just beginning to feel the heat, which means that the price manipulators are very close indeed to losing control of the Gold price.