first majestic silver

Apocalypse No

CFA, Senior Managing Director, Co-Portfolio Manager
February 19, 2000

The rapid pace of developments in the gold market prompts this summary of key milestones and their status:

Central Bank/Official Sector Selling: no longer a threat. Washington Agreement limits amounts to manageable numbers over next five years.

Central Bank Lending: Washington Agreement caps lending for 85% of official sector gold.

Mine Company Hedging: widespread announcements by all of the largest hedgers suggesting this source of supply will dry up this year.

Positive Swing in investor sentiment: very early stages

Contraction of bullion bank /producer hedges: in process.

Financial asset bear market: sooner or later.

Apocalypse: Not Yet

Implications of Producer Announcements

There has been rapid and substantial progress in gold market fundamentals since September 1999. The oversupply issue that has plagued the gold price for years has been dispatched.The supply/demand equation in the gold market is far brighter than the gold share or bullion markets have recognized. The largest hedgers have made recent statements that effectively forswear additional hedging or have been eliminated from the game by other circumstances. In alphabetical order:

Company Hedgebook (mm oz) Status
Anglo Gold
(inc. Acacia)
16.3 Up to 4.7mm oz decrease in ’00
Ashanti 9.0 1.5mm oz. (100% of production)
Barrick 9.8 No increase in ’00/could decline
JCI Group & Related 4.3 Under new management; being dismantled; 2.0mm oz. (est.)
Normandy 7.7 1-2mm oz.
Placer Dome 7.3 2mm oz.

These producers account for approximately 55 mm oz (about 1700 tons) of forward sales (net of puts) and, for the most part, represent the most active hedge programs that bullion banks could rely on for their flow of physical metal. Their aggregate hedge position is roughly half of the entire industry. As a group, they will produce 19-20mm oz in 2000. Based on recent management statements and on the assumption that Ashanti will be forced to deliver into its hedge book, it appears that 11.2 to 16.7 mm oz or 350 to 500 tons could come out of mine supply this year. Compare this to the Goldfields Mineral Services (GFMS) forecast of an additional 150 tons of forward sales in 2000. The GFMS forecast forms the basis for the much of the expectations of the bullion dealing community, which is why it is pertinent. Instead, it is likely that forward sales will be negative this year, a 500 to 650 ton variance from the GFMS expectation. Last year, according to GFMS, producer hedging represented 445 tons of gold supply. The potential shrinkage of gold supply due to this single factor is about 850 to 1000 tons, a reduction of 21%-25% vs. 1999. The shortfall in supply from hedging activity could be even greater if other producers with hedge books decide to follow suit. All of this assumes gold prices stay in the low $300’s. Higher prices will likely lead to rollovers of hedge positions, but then again, much higher prices would be a happy trade off for diminished hedge book reductions. A significant shrinkage of new physical gold for hedging strikes me as big news and a reason to expect considerable distress among bullion dealers this year.

The Coming Short Squeeze

Bullion dealers are short gold but may not be aware of the extent to which they, as a group, are short. Their basic transaction is to borrow gold from a central bank and to cover that short position with a contract from a gold producer to deliver the same amount of gold at some time in the future. A significant percentage of these contracts have maturities in excess of one year. Most of the contracts between dealers and their mine suppliers do not have tight margin positions. For example, Barrick Gold is not required to provide margin unless gold exceeds $800. The dealers appear to believe that ounces of gold in the ground to be delivered at a future date constitute a reasonable substitute for physical gold that could be delivered immediately should the central banks ask for their gold. Their reasoning in all likelihood did not contemplate a situation in which gold prices spiked $100 or more, with little promise of retracing. However, most of this business was booked when central banks were viewed as non-stop sellers/lenders and mining executives could easily be panicked into hedging to save their companies and jobs. Oops!

Bullion dealers make their living by intermediating the physical gold and paper gold markets. For example, Barrick Gold recently purchased calls on 6.8mm oz. for this year and next in order to tweak its hedge book towards a positive correlation with gold. Bullion dealers wrote or sold these calls with a strike price of $319 for ’00 and $335 for ’01 in return for a premium of $68mm, or $10 per call. The transactions occurred mostly during the fourth quarter of 1999 when gold was trading in the low $290’s. Without delta hedging, the bullion dealers would be short 6.8mm oz of gold once the price exceeds the strike levels during the next two years. However, once Barrick bought bullion dealer paper; the dealers bought gold (delta hedged) according to a mathematical formula. This position represents a liability of more than $2 billion for the bullion dealers. There is a very short list of names, most likely Goldman Sachs (J. Aron), Deutsche Bank, and J.P. Morgan, that would have the necessary credit standing to do this trade.

What is interesting about these options for the dynamics of the gold market is the delta hedging that they require. A delta hedge is simply a mathematical formula that dictates how much physical gold must be bought or sold relative to the paper option. In general, the closer in time or price to the strike price/expiration date of the call or put, and the greater the volatility of the metal, the greater the amount of physical gold the dealer must buy (call) or sell (put). The actual amounts to be bought or sold are dictated by a mathematical formula known as the Black Scholes model. The dominance of computer generated orders in an essentially illiquid market is the reason that the out of balance, bearish market posture of the bullion dealers will lead to a series of major spikes in the gold price. Aside from their contributions to option theory, one of these gentlemen, Myron Scholes, is also well known as a prominent partner in Long Term Capital Management, a high profile hedge fund disaster which employed his model. It is certain that his model has nothing to say about the proper ratio of option paper outstanding to the liquidity of the underlying commodity for which it dictates buys and sells. Therefore, look for brief periods when the physical markets cannot accommodate computer generated buy orders at any price.

In Barrick’s case, the initial delta hedge was about 2.1mm ounces. Since those calls were written, however, the price of gold rallied momentarily into the low $320’s, causing a considerable amount of forced buying in a short period of time. As the price has backed off, there has been forced selling. The day-to-day behavior of the gold price is very often exaggerated by this kind of dealer hedging activity. While the supply of paper gold has stayed constant or increased, the flow of physical gold available for delta hedging activities is declining sharply. The two sources of liquidity in the physical gold market have been (1) central bank selling or lending and (2) forward selling by mining companies. Official sector supply has been capped, perhaps imperfectly, by the Washington Agreement. Mine hedging will be a big negative factor for supply this year. In light of these considerations, the ability of the physical market to accommodate the buying or selling mandated by the delta hedge formula is questionable. The LBMA (London Bullion Market Association) recently reported a 22% decline in physical trading activity for the first month of this year. The average value of gold transfers fell to $6.3 billion from $8.1 billion in December. If this acute decline in physical trading volume continues, it is not hard to imagine the wheels coming off of the bullion dealer’s machine.

Bullion dealers conduct extensive due diligence before committing to hedge contracts with mining companies. Mine company fundamentals are carefully scrutinized in order to assure all involved that the transactions seem responsible and conservative from a risk/ reward perspective. Why shouldn’t the reverse be true? However, in choosing to conduct business with a particular dealer, mining executives are not permitted to examine their counter parties in the same fashion as they had been undressed. They must depend on the notoriously unreliable rating agencies. It is doubtful whether rating agencies have been granted access to analyze the derivative positions of the bullion dealers or their parent institutions.

Despite the opacity, surely all risks are being conservatively hedged. Wasn’t this the case for portfolio insurance in 1987 or Long Term Capital Management in 1998? The rationale for the credit and confidence necessary to conduct the bullion trade, especially in the highly leveraged versions that prevail at the moment, no longer makes sense. The attraction of leveraged financial structures based on the borrowing of physical gold seems increasingly dubious. The reliable aphorism among bullion dealers, that the safest hedge against one option is another option, is ready to be scrapped.

Capital and credit are on the verge of evacuating the gold derivatives arena. In the last five years, this trade has augmented the supply of physical gold to such an extent that it has driven gold prices well below their equilibrium levels by $100 to $200. Prior to 1996, when the supply of paper gold via bullion dealers became a torrent, gold traded regularly in a high $300 to low $400 range. The subsequent explosion of gold derivatives was an aberrant credit excess that exaggerated the downswing in gold. Should a shrinkage of the bullion trade coincide with an improved macro economic outlook, gold could rise far more in a short period of time than anyone positioned as a short could possibly contemplate.

The recent call purchase by Barrick is not the whole story by any means. For example, at last count, the Australian gold industry had written calls on 7 mm ounces. Ashanti’s hedge book contains 3.5mm written calls. Certain smaller producers have been known to write calls in order to meet the payroll when gold prices were lower. Other than the calls written for Barrick, it is impossible to get a picture of the dealer hedge book option structures. Our conjecture is that the bias of the aggregate dealer hedge book is still bearish. Should the dealers who wrote the Barrick call options wish to insure themselves by themselves purchasing calls with higher strike prices, it is safe to say that the credit rating of the dealers writing the new options would be no match for their own. The dealer hedge position was built over three to five years. It cannot be reconfigured easily. For example, the problem ridden Ashanti hedge book is in worse condition today than when it was initially understood to be a problem four months ago. If it were easy to fix, it would have been done by now. Instead, it is more in the red today ($400mm est.), versus the less than $200mm in the red four months ago, both figured at today’s gold price. This is despite the fact that the book has been under the supervision of a syndicate of bullion dealers who have much to lose if the price of gold moves sharply higher.

The bullion and the gold share markets have yet to recognize these changes. Gold prices have barely risen over the last year. The $50 (25%) rise from the August lows is no more than a weak snap back from a severely oversold position. Gold shares have fared more poorly. In the past year, gold is up 7% while the XAU is down 2%. Skepticism tends to peak well after a major low, which in gold’s case was established in August 1999. The laggard behavior of the shares relative to the metal is classic bull market action.

Investment Demand And Apocalyptic Considerations

A short squeeze caused by a contraction of credit among and for the gold intermediaries, the bullion dealers, is on the horizon. Demand far greater and longer lasting than a short squeeze will come from investors seeking inflation protection or diversification from financial asset exposure. In addition, further liberalization of Asian and other emerging market economies will broaden and deepen demand. On their recent conference call to discuss quarterly results, Anglogold management discussed the positive role played by market liberalization in stimulating gold demand. If mainland China’s bullion market is liberalized, a possibility this year, incremental demand could be 600 tons in the estimation of management, which is working with Chinese authorities towards this goal. The World Gold Council has just announced a 21% increase in gold demand vs. 1998, which was depressed by the Asian meltdown. More significant is the 7% gain over the previous peak in 1997.

In a recent conversation, a bullion dealer mentioned to me that investment psychology was beginning to change in the Indian and other important Asian markets. Following the run up in September, this particular dealer stated that three or four weeks went by without selling “even a kilogram” of gold compared to his normal volume of 1 ton per day. Buyers stepped away expecting to see the price fall back to the old lows. Three months later, expectations have changed. There is greater confidence that the gold price is no longer a purely downside proposition. Physical buyers in Asia are now willing to step up to gold prices in excess of $300. Still, each new rise in the price of gold is being greeted with cries from the bearish camp that physical demand is falling away. But the bullish case for gold calls for the crowding out of physical buyers by short covering and investment buyers.

GFMS once estimated the entire stock of gold to be 130,000 tons. This includes central bank gold, private holdings, jewelry, and museum exhibits. The total includes King Tut’s mask, the crown jewels of England and similar artifacts. Also included are the bullion holdings of parties to the Washington agreement which account for 85% of world gold monetary reserves. Only a small percentage, perhaps 15%, is available to be mobilized at any given moment to satisfy market demand. At market, the gold “float” approximates $150-$200billion, less than the market capitalization for many equities. Gold is a currency, a monetary reserve asset and a credit instrument in the way it has been utilized by bullion dealers. Once investors come to realize that the secular low was put into place last August, and that a new uptrend has been established, a rising price in itself will cause demand to increase and supply (the willingness of holders or producers to sell) to decrease.

Macro economic factors, which could liberate investment demand for gold, can be loosely grouped under the banners: inflation in the pipeline; synchronized world economic strength; impotent Fed. These incipient speculations could transform non-existent investment demand into a powerful force. The traditional positive case for gold has been characterized as laden with irrational cataclysmic forecasts. It would be a mistake to make the same assessment at this juncture. Apocalyptic expectations are unnecessary to project a dollar gold price that includes four digits. It will only require the inevitable unwinding of bearish producer and dealer hedge structures amidst a change of market perceptions on the desirability of financial assets.

John Hathaway, CFA, Senior Managing Director, Co-Portfolio Manager

Mr. Hathaway is a co-portfolio manager of the Tocqueville Gold Fund, as well as other investment vehicles in the Gold Equity Strategy. Mr. Hathaway also manages separately managed accounts for individual and institutional clients.  He is a member of the Investment Committee and a limited partner of Tocqueville Asset Management ( Mr. Hathaway began his career in 1970 as an Equity Analyst with Spencer Trask & Co. In 1976, he joined investment advisory firm David J. Greene & Co., where he became a partner. In 1986, he founded Hudson Capital Advisors and in 1988 became Chief Investment Officer of Oak Hall Advisors. He joined Tocqueville as a Senior Partner in 1998. Mr. Hathaway has a BA degree from Harvard College and an MBA from the University of Virginia.  

The naturally occurring gold-silver alloy is called electrum.
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