assume that I will be the only speaker to use a
four letter word today, GOLD. Actually,
this four letter word is less welcome in polite
society than its more commonly used counterparts.
I have found that when I talk about gold, some
people walk out, some take out their newspapers,
others wonder about what is for lunch.
In short, it is not politically
correct to have anything good to say about gold.
We live in a world where
everything is just about right and gold seems to
have the power to speak up and say, "wait a
minute, if I'm still around, maybe there is some
risk out there". So gold must be denigrated,
denounced, discarded, disowned and at the very
least disliked. We also live in a world of new
era and revisionist thinking to insure that there
can be no negative thoughts.
- The Holocaust did not
- The Japanese were
victimized in WorId War II by U.S.
- Bear markets are over
- Traditional share
valuation methods are obsolete.
- Inflation is dead and
- There can be no
systemic banking crisis.
- Foreigners will
continue to buy, or at least hold, U.S.
- EMU is a certainty.
To make the fantasy
complete we need only add that gold, the
traditional store of value which people have used
as currency since civilization began and to buy
their way out of danger, is now obsolete,
demonetized and a relic. It has been replaced by
paper, and if you are such a heretic as to
believe that paper may have a slight risk to it,
all risk can be eliminated through derivatives,
which are, of course, more paper. The paper asset
mania requires that the principal alternative,
gold, be thoroughly discredited. Whether you call
it greed, irrational exuberance or whatever,
there have been few times in history where at
least the temporary accumulation of wealth has
been this easy and where risk has been so
disregarded. These few times are well chronicled
in the book "Extraordinary Popular Delusions
and the Madness of Crowds".
I only mention the wonders
of paper to offer an explanation as to why gold
is in the doghouse.
The "sirens" call
to the financial markets are irresistible until
fear sets in and then things change rapidly as we
all know that fear generates behavioral change
faster than greed.
ActualIy, the gold story is
compelling even without the catalyst of fear.
|"This is the shabby
secret of the welfare statists
tirades against gold. Deficit spending is
simply a scheme for the
hidden confiscation of
wealth. Gold stands in the way of this
insidious process. It stands as a
protector of property rights. If one
grasps this, one has no difficulty in
understanding the statists
antagonism toward the gold
Alan Greenspan (1966)
"You have to choose
[as a voter] between trusting to the
natural stability of gold and the natural
stability and intelligence of the members
of the government. And with due respect
to these gentlemen, I advise you, as long
as the capitalist system lasts, to vote
George Bernard Shaw (1856-1950)
interested in gold about five or six years ago
when I looked at the basic supply/demand
equation, that is jewelry and industrial demand
versus mine supply.
It was evident then, as it
is now, that billions of Asians with rapidly
rising discretionary incomes and a history of
purchasing gold and gold jewelry as a form of
savings would accelerate the demand for gold. It
was also obvious that mine supply, due to
environmental constraints, capital intensiveness
and long lead times between finding a deposit and
actually producing gold, would grow at a much
slower rate than demand. This has proven to be
true and a substantial deficit exists in the
The basic supply/demand
equation is extremely bullish with a gap between
supply and demand of around 800 or 900 tonnes per
year last year and much larger this year.
(tonnes) in Gold Market
cannot replace their reserves in line with
production. The industry needs to find 100
million ounces per year which is about equal to
the total reserves of Barrick, Newmont and
Homestake. The only chance of doing this, even
once, was through Bre-X whose 100 million ounces
turned out to be a complete fraud. Mine supply is
growing slowly without considering any impact
from the depressed price of gold. At current
prices many projects have been delayed,
especially in view of the difficulty in obtaining
the necessary financing at the current gold
price. In addition, there have been a significant
number of mine closures announced with Barrick
recently announcing the closing of five mines.
Finally, in South Africa, where the average full
cost of producing gold is now above the spot
price, the mining industry is in crisis.
Gold Price Will Lead to
- At $320/oz.,
50% of the western world's gold
production is unprofitable on a
full cost basis.
- At $320/oz.,
25% of the western world's gold
production is unprofitable on a
cash cost basis.
- At $320/oz.,
only 5 of 19 of South Africa's
major mines could show a profit.
As you can
see, at the current gold price 25% of the western
world's gold production is unprofitable on a cash
basis. On a full cost basis, 50% are
The demand side continues
to be extremely robust with fabrication, i.e.
jewelry demand, growing at 13% in the latest
quarter. For the six months ended June 30,
Goldfields Mineral Services reports gold demand
up 18%, with fabrication demand up 15% and bar
hoarding up 67%. On the supply side, mine output
rose just 1.4% and gold scrap declined 27%.
Goldfields Mineral Services supply/demand numbers
show a large deficit of about 600 tonnes for just
the first six months of 1997. This was with gold
at an average price of $347, about a $40 drop
from the beginning of the year. With gold now at
$325 price elasticity plus seasonality should
result in an even larger deficit in the second
half. The deficit will also expand in the second
half due to mine closures. Thus a deficit
estimate for 1997 of a record 1,200-1,500 tonnes
is reasonable. With producers heavily hedged and
shorts having large positions which have already
pushed up lease rates, that is the cost of
borrowing the gold they sell short, it is likely
that neither of these groups will have a
significant impact on filling the deficit going
forward. That means that gross central bank sales
of probably 1,500 tonnes or more are needed to
keep gold at the current low level. This is
highly unlikely especially since central bank net
sales for the past decade only averaged 250
tonnes per year, and even if it were to occur it
would quickly bring us to the end of central bank
Actually the market may be
able to absorb even more than 1,500 tonnes of
central bank sales since the deficit does not
fully reflect Chinese purchases. In China there
is huge latent demand which goes unsatisfied
because of the extremely limited number of
jewelry outlets and also due to the significant
premium above the spot price which the government
charges the public. Nevertheless, surveys in
China show that the wish list among Chinese is
first a refrigerator, second a television set and
third, gold jewelry. We believe that the official
gold consumption numbers used for China may be
much too low as they are out of line with other
countries having comparable GDP per capita. It is
likely that the high state markup and limited
distribution system results in
"unofficial" sales. This could mean
that the overall deficit is actually 200 or 300
Nevertheless, while the
basic market structure is in a record deficit,
gold differs from other commodities in the
magnitude of the above ground supplies and in the
ability of short sellers to borrow the gold they
need to deliver against their short.
The basic question then is
to what degree above ground sellers will be able
to fill the deficit. Let's look first at the
central banks. While potential gold investors are
paralyzed by the fear of the central banks
aggressively selling their holdings, the reality
is quite different.
In fact in 1996, 19 central
banks bought gold while 16 sold and of the 16 who
sold, only 5 sold 10 tonnes or more. Furthermore,
over the past decade, over 70% of all central
bank sales came from just three central banks:
Belgium, Netherlands and Canada. That means that
all the other central banks combined sold only a
minor amount of gold each year. Nevertheless,
there is a perception and some reality to the
concept that many central banks are
"mobilizing" their reserves.
Over the past year there
has been much discussion about sales and
"mobilization" of Western central bank
gold reserves. Mobilization is the lending of
reserves to enable producers to sell future
production into the market today, effectively a
short sale, and to provide actual short sellers
with the bullion to deliver to the purchaser of
their short sales. I should also mention that we
suspect that dealers and others are using this
mechanism as a form of financing, i.e. borrow
gold at a low rate, sell it and use the proceeds
for whatever. We are also told that there is a
"carry trade" in gold where gold is
borrowed, sold and the proceeds invested in
government bonds. The currency risk of borrowing
in yen and buying U.S. bonds has been partially
replaced by the obviously less risky program of
being short gold, which according to most
observers, can only go down. For the risk of
lending out their gold these central banks
typically receive about 1.5% interest per annum.
As I have mentioned, a
large and growing deficit exists between the
supply of gold from mines and demand, which in
the absence of central bank sales and lending
would result in a much higher gold price, perhaps
over $500 per ounce. In an attempt to earn a
small return on a portion of their gold, central
banks have, in fact, lost hundreds of billions of
dollars in the reduced value of their gold
holdings and have caused losses far in excess of
that amount to gold investors worldwide.
Just as an example, which
is probably not far from the actual figures,
assume that Western central banks last year sold
500 tonnes of gold, loaned 500 tonnes to
facilitate producer forward sales and loaned 500
tonnes through dealers to short sellers. Assuming
that they earned 6% on the proceeds of the gold
sold and 1.5% on the gold loaned, the centraI
banks would have earned about $500 million on
their gold sales and loans.
But central banks and
official agencies own 33,000 tonnes of gold, the
price of which has declined 20% from its recent
highs entirely due to central bank activity. This
has resulted in a decline of approximately $80
billion in the value of their gold
holdings. In addition, if one believes that
without these sales and loans of gold, the price
of gold would be over $500/ounce due to the
imbalance of basic supply and demand, then the
central banks have given up an additional $90
billion. In sum, they have earned $500
million and lost $170 billion in
the process. How's that for shooting yourself in
Furthermore, as the central
banks lend out more and more of their gold, they
are effectively allowing a reserve asset, which
is the only asset that is no one else's
liability, to be replaced by a note from a
dealer. In addition, the loaned gold ends
up being sold into the marketplace by the dealer
on behalf of short sellers, producers, etc. and
much of it is fabricated into jewelry. The loaned
gold has, in large part, permanently disappeared.
If one central bank wants its gold back, the
dealer can borrow gold from another central bank.
But if many or most of the central banks want
their gold back, for whatever reason, then lease
rates would skyrocket, there would probably be a
default and gold would go into backwardation
where the spot price was higher than the future.
This would wreak havoc with producers who sold
forward, short sellers and dealers, all of whom
could suffer huge losses. There is increasing
evidence that the amount of gold on loan is much
greater than generalIy thought and thus the risks
in the market are increasing. Nevertheless,
certain bullion dealers with their "chicken
little" story of the sky is falling have
been successful in spreading the fear story that
the central banks will sell all their gold. This
has brought them the producer and short seller
business since the declining gold price is enough
verification of the story and the facts are
ignored. The producers and short sellers selling
at today's prices are probably the weakest and
most gullible of the lot. This will enable the
brokers to fulfill the old axiom which says,
"client's money and broker's experience soon
becomes broker's money and client's
As a result of all this
borrowed gold the risks in the gold market are
very real. No one anticipated the palladium
market going into backwardation as the Russians
were expected to continuously supply metal to the
market. This key assumption failed which could
happen in the gold market where the key
assumptions are that central banks will continue
to lend their gold, and in such amounts that
lending rates remain at low enough levels to keep
the market in contango. If lending central banks
withdrew from this activity or if physical demand
for gold is substantially increased by other
central banks or investors becoming aggressive
buyers then lease rates would become so high that
the market would go into backwardation and the
spot price would rise dramatically as in the case
of palladium. Lease rates have recently soared,
perhaps indicating that the limits of gold
lending are being reached.
We have not touched on yet
another form of central bank gold mobilization
which is the sale of calls. These calls are sold
by central banks, primarily to dealers who then
delta hedge the call with short sales. This is
unmeasurable but probably a significant factor.
Since the decision to selI calls is probably made
by a trader at a central bank, it is unlikely
that the same trader would have the authority to
deliver the national gold reserves in case the
gold price rose and the call was exercised. Most
likely the call would be repurchased adding fuel
to a rising market.
On the positive side,
however, are the central banks who have been
buying gold and the huge underweighting of gold
among Asian central banks due to the enormous
increase in their holdings of U.S. dollars.
With only 5 or 6% of their
reserves in gold Asian central banks need to buy
$6 billion worth of gold for each 1% increase in
gold reserves. Thus, even a small increase of a
few percent would overwhelm the gold market. In
discussing central bank purchases of gold during
the first half, Gold Fields comments: "But a
larger element appears to reflect several
institutions diversifying their reserves away
from what they perceive to be an excessive
reliance on the dollar, an asset which under
certain circumstances could conceivably be open
to political interference from the U.S.
The chart on shows that
central bank net sales and producer net forward
sales are really not so great relative to the
market deficit. The additional gold needed to
fill the deficit and keep gold from rising comes
from short sellers. There are estimates of
producer forward sales being in the 2,000 tonne
range and outright shorts possibly equal to that.
These figures are in line with estimates of
borrowed gold in the 3,000-5,000 tonne range. The
key point, of course, is that with the market in
deficit, above ground sales must continue at
these high levels to prevent gold from rising
since without above ground sales the deficit
would result in a much higher price for gold.
Now I run through a little
recent history of the gold market to show how we
got to the current point and a possible future
scenario. An acceleration in producer hedging was
followed by some central bank sales. The weakness
created by these two selling groups encouraged
outright shorting of gold.
of a Gold Cycle
- 1. ABX starts hedging
- 2. Other producers
join in hedging.
- 3. Physical demand
absorbs increased hedging.
- 4. Hedging
accelerates, but physical demand
still supports gold price.
- 5. Central banks join
in by making sales.
- 6. Gold looks shaky
and starts to decline.
- 7. Producers sell more
as price declines.
- 8. Short sellers join
in and break market.
- 9. Sentiment at lowest
levels, shares collapse.
- Central banks
have sold much of what they want
- Producers are
heavily hedged and have huge
- Shorts are in
record short position.
- Sentiment at
- Evidence of
central bank buying.
- Evidence of
producer hedge reversals.
- Evidence of
CATALYSTS FOR INVESTMENT DEMAND:
- EMU problems.
- Paper markets
- Removal of
theoretical central bank
- Evidence of
significant Asian central bank
State of the Gold Market
- 1. Large and expanding
2. Producer forward
sales, speculator shorts and some
central bank sales fill the
bearish sentiment promoted by
bullion dealers in an attempt to
capture flow from producers,
short sellers and central banks.
Their "bear" story:
A. Central banks 'will sell
all their gold.
B. Producers should sell forward
at any level as the gold price is
4. In fact:
A. In 1996, 19 central banks
bought gold versus 16 that sold.
Of the 16, only 5 sold more than
B. Mines are closing and many
projects are being deferred at
the current gold price, further
expanding the deficit.
producers have large gains on their forward
position. Barrick has a $600 million unrealized
gain and Normandy, the largest gold company in
Australia, has an $800 million unrealized gain.
It is now much more likely that forward positions
will be bought back rather than additional shorts
initiated by producers since hedging at current
levels for many producers would just lock in a
loss. By the way, while these producer hedges in
retrospect seem wise as industry hedge gains are
probably $2-3 billion, the market capitalization
of the gold companies was reduced by $15-20
billion in part due to the effect of their
forward sales on the gold price. Producers are
also good at shooting themselves in the foot.
When gold looks as if it
has made a solid bottom, it is likely that a
flurry of acquisitions will take place as
virtually all the majors must make acquisitions
to replace reserves since exploration will not
find the reserves fast enough, if at all. An
important asset in these acquisitions would be
the unrealized gains many companies have on their
hedge positions. For example, Barrick could
acquire Normandy for cash, raising all the needed
money from the reversal of both company's hedges.
In the process they would have to buy back 13
million ounces which would initiate a breakout to
the upside in the gold price.
We believe that in addition
to producer hedge reversals we will soon see
evidence of significant central bank buying. If
borrowed gold is 5,000 tonnes or more, someone
has been buying all this gold and rumors of Asian
central bank purchases will probably be verified.
Finally, we expect
investment demand to pick up as paper markets
falter, the Asian currency crisis spreads, EMU
has problems or there is a "clean up"
of any central bank overhang.