Gold Market Update

June 12, 2002

Many market watchers, ourselves included, have been anticipating a correction or consolidation for gold and especially for gold shares. The $330 level has been touted as a major technical barrier on the upside, and so far has lived up to its billing. Gold touched $330 intraday on June 4th, then fell precipitously as large sell orders swamped the thinly traded after-hours Access system of Nymex. The selling continued in Asian trading on June 5th. Gold closed Friday at $324.60. While the fundamentals that brought gold to its current level - low interest rates, weakening dollar, anemic stock market, political unrest - remain in place, we consider some profit-taking at this point to be quite healthy for the market.

I am periodically asked to do interviews in the mainstream press on gold. I recently realized that no matter how much I explain the gold lease market and its profound impact on market fundamentals, reporters neglect to mention it in their articles. The conspiracy cynics would say this is the hand of big brother keeping quiet what it does not want revealed - keep it contained to the chat rooms of the gold bug web sites. My explanation is a little more mundane - the lease market is mildly complex and somewhat opaque, so most reporters lack the time or energy to reach an understanding that they can articulate for publication. Nonetheless, it is a major force in the market and it is worth speculating on how long it might last.

The gold lease market was borne out of Central Bankers' desire to earn a return on an asset that otherwise costs money to store. Thus, they decided to lease their gold at relatively low rates, thinking that a little income is better than a little expense. This created a carry trade in bullion, where gold lease rates are lower than prevailing London Interbank rates (or Libor). The difference between Libor and the gold lease rate is termed the contango, or forward price premium. Producers, fabricators, and speculators can borrow gold, sell it into the market, invest the proceeds, and pocket the difference between their Libor (or other) investment and the gold lease rate. When it comes time to close the lease (or hedge) contract, producers can deliver from their mine production, whereas fabricators and speculators have to buy bullion on the market to deliver back to the banks. This is a winning proposition so long as the price of gold either falls or rises at a rate that is less than the contango. When the gold price rises at a faster rate than the contango, the transaction can be a money loser for the fabricator and speculator. Similarly, it is an opportunity cost for the producer when the hedge contract must be closed out at a price that is below the spot price.

Now let's look at the state of the gold lease market today. On Friday, 12-month U.S. Libor rates stood at 2.55% and the 12 month gold lease rate at 0.93%, which gives a 12 month gold contango of 1.62%. This translates to a one-year forward price premium of about $5.25 per ounce. Historically, the contango has ranged between 3% and 6%. The aggressive Fed rate cuts in 2001 worked to drive the contango to its current low levels. This, combined with the steadily rising gold price has all but wiped out the lease market. In addition, higher gold prices have made many existing lease contracts unprofitable. Hedged producers have been delivering gold into existing contracts, while refraining from replacing them with new contracts. The net effect of this is that gold which normally would have found its way to the market, is now being returned to Central Bank vaults, thereby restricting supply. Many producers are also accelerating delivery into their contracts in order to avoid additional opportunity costs should the gold price rise further. This involves either buying ounces in the spot market to deliver back to the bank, or delivering more from production than planned. We suspect that speculators and fabricators are under the same pressure to return leased gold to the banks, however, they do not have the luxury of drawing from newly mined production and must buy on the spot market to close a contract.

Assuming current market dynamics persist, how much of this leased gold could potentially be withheld from the market as it is returned to Central Bank vaults? An independent report prepared by Virtual Metals Research & Consulting Ltd. for the World Gold Council estimated that as of December 1999 the total amount of gold that had been leased amounted to 5,230 tonnes. This is what is commonly called the short position in gold. Roughly half of that amount, or 2,600 tonnes, had been leased to gold producers who hedge and half to other market participants. To put this into perspective, global mine production in 2001 totaled 2,604 tonnes. This massive short position is a feature that was absent in past gold bull markets. According to Gold Fields Minerals Services Ltd., in 2000, producers reduced their hedging by 15 tonnes, the first such decrease in over 12 years. In 2001 hedging was reduced by a further 147 tonnes, and in the first quarter of 2002 by another estimated 100 tonnes. This means that, so far, about 262 tonnes has been returned to bank vaults by producers, which reduces the amount of gold leased to producers to 2300 tonnes. Assuming the current coverage rate of roughly 400 tonnes per year, it will take nearly six years to unwind the total producer hedge position. These 400 tonnes potentially represent 10% of annual supply that will be missing from the market. Additionally, it is likely that specs and fabricators will also impact the market, however, a lack of information makes this aspect difficult to quantify. Whether this activity lasts depends mainly on interest rates and the gold price trend. The gold contango will remain low so long as the Fed refrains from raising interest rates, and a rate rise of at least 2% would be needed before the contango would be considered attractive. The investor mood towards producer hedging is decidedly negative, while there is currently a broad expectation for higher prices amongst the producers. Nearly all of the majors have said publicly that they intend to continue to accelerate delivery into their hedge contracts for the remainder of the year.

The covering of the gold short position has thus far been an orderly affair, as the gold price has advanced along a gradual slope for over a year now. Given the large amount of leased gold in the market, the potential for short covering on a grand scale is a possibility that some market watchers salivate over. A sharp sustained rise in the gold price might set off such action. We would much prefer the environment of the past year, whereby an orderly unwinding creates solid support for gold, as investors are now slowly returning to gold as a portfolio diversifier and alternative to other poorly performing assets.

In the Aztec language the name for gold is teocuitlatl which means "excrement of the gods."

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