Gold Markets Are Not Efficient, Don’t Reflect Fundamentals & Understate Gold’s Market Value (Part 2)

Hedging

One of the biggest problems facing a miner, a refiner, a jewelry maker and anyone forced to hold gold for a period of time, when his business is not speculating on the gold price, is avoiding the price risk inherent in owning gold for such a time. Just the act of holding it for that time is a speculation. So what can these risk-averse gold holders do to get rid of the risk? The answer is that they hedge their gold.

If they’re going to have gold to sell gold to buy gold to refine or to make jewelry, and they know the period when they can get rid of that risk, they buy/sell that gold forward to the date when they get rid of the gold. So these professionals ensure that they either buy/sell an amount of gold (the reverse of their present position) or buy/sell an option that matures at that time. What they lose on holding the gold, they make on the futures position and vice versa.

This puts them where they should be as a business, using gold to make a product. They work for the profit margin on their product which they build into the price and eliminate the gold price risk this way. Any business of this nature that does not hedge in this way becomes a speculator on the gold price. Many businesses have gone bust doing this.

Dangers of Hedging

To highlight the problem that come with hedging we go back to the late ‘80’s then follow right through to 2005. During this period the central banks of the world and the authorities ruling the financial system wanted the world to turn to currencies as money and away from gold.

So they lent gold miners gold against the miner‘s future gold production. All knew that with central bank support and threats that they were going to sell their gold in the open market that the gold price was going to go down (it went from $850 to $272 over time). So what incentive would miners have to produce more gold?

It was existence of the futures market. By selling the gold they had borrowed from the bullion banks as far forward as possible, they would not only achieve the current market price but the interest on the proceeds of the sale until the maturity of the futures contracts. This is known as the “Contango”. By doing this they could turn a $300 gold price into above $500 and boost their profits enormously.  The Directors of these mining companies were to be congratulated not only on their prudence but their ability to achieve greater profits outside of mining. This was fine so long as the gold price was falling or standing still.

But from 2005 the gold price started to rise!

As gold prices past the level of income the futures contracts were to achieve, these Directors realized that they had locked their income to a price that may well be lower than the market price. Suddenly shareholders had a sense of humor failure. The Directors of these mining companies were then quickly seen as speculators on the gold price using shareholders money to do so. Heads began to roll!

The policies of nearly all mining companies then changed dramatically as the miners realized they had to expose their companies to the spot price of gold for the benefit of their shareholders. This meant they had to ‘de-hedge’ their positions, or buy back the amounts of gold they had hedged in the futures market to uncover their positions. Around 3,500 tonnes of gold were bought back by the gold mining companies over the next few years, as the gold price roared up from $300 to $1,200.  That ended the speculation on the gold price for them.

But businesses, like jewelers or refiners, still hedge their positions to eliminate risk and earn profits on the work they do. Some miners who need to finance their future production continue to hedge, but simply for the funds with which to develop a new mine. Such an exercise now is to finance, not to speculate. But the volume of hedging is extremely low.

The Speculator

But as with any system, certain evolutions take place that fall within the business of making profits. One of these was the creation of the “speculator” and with him entered the first distortion to the gold/silver price.

A speculator can buy gold on a forward (future) basis –on the physical market, usually in London—which he does not intend to accept delivery of. Let’s say he buys and arranges to accept delivery of his gold in 6 months’ time. He may put down a deposit in good faith, i.e. margin, and then hold the gold for say, 5.5 months before selling it.

While his actions take that gold off the market (on a forward basis) seemingly adding to demand he becomes a seller of the same gold adding to supply at that time. The impact is to push prices higher up front and prices lower subsequently, rather like an individual wave flowing in then ebbing out. The net effect on the gold price at the end of the exercise should be nil. But from a trader’s point of view, the move is usually sufficient to move the price enough for him to make his money. But he needs to know if the wave and the tide are flowing.

The most spectacular speculative ‘hit’ on a market came in April of 2013. This was when two U.S. banks, JP Morgan Chase and Goldman Sachs took short positions on COMEX to the extent of over 400 tonnes this is a 95% ‘paper’ market, not a physical gold market. They threw gold at the physical market to the extent of at least 100 tonnes at a time when the sales from the major U.S. gold Exchange Traded Fund, the SPDR gold ETF was selling persistently around 20 tonnes a month/week. The daily supply of physical gold to the market is around 11 tonnes a day.

At the time the market was ripe for a fall, so the gold price fell $100 in a day easily. Overall the gold price fell from $1,650 to $1,180 making overall around $8 billion in the exercise. Take away this speculation and we feel that the gold price would still have been above $1,500.

A very recent example of speculation that distorts market prices happened on the day that the U.S. gov’t shut down on October 1^st 2013. The gold price was completing yet another consolidation phase, but this time was different. It was when the gold price’s downward trend met strong support at the 1,300+ level. The mood of the gold and all other financial markets reflected the risks that lay ahead and the possibility of a U.S. credit default on the 18^th October perhaps precipitating a ‘credit event’ similar to the mid-2007 ‘credit crunch’.

As the U.S. market opened the price plunged over $40 as it was realized that a strong move was about to happen. This was a perfect point for speculators to hit the market hard. We wait to see if these speculators will be beaten back by physical demand or not!

So here you have seen one instance over a long period of time, when the central banks/gov’t/commercial banks, blatantly manipulated the gold market price down. In the first instance the manipulation happened over a twenty year period. Once they ceased, the gold price eventually soared to $1,900 an ounce.

In the second instance, the sheer weight of money power that the leading U.S. banks have, was used to force the gold price down in a well-engineered shorting exercise. This too is a reflection of how the fundamental demand and supply picture can be distorted by speculators of size.

But despite their size they remain weaker than the long-term current of the market and have, at best, a tidal influence. What remains constant, over time, is the fact that the world sees gold as money. We quote the head of the French central bank who said this last week,

“Gold is unique among assets, in that it is not issued by any government or central bank, which means that is value is not influenced by political decisions or the solvency of one institution or another."

-Salvatore Rossi, Chief of the Central Bank of Italy, 30 Sept 2013.

And with that in mind, we think gold will rise in price and importance in the future, no matter what efforts are made by manipulative financially important bodies.

In the third part of this series we look at other ways that the gold market can be distorted that are happening at this moment, less visibly.

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