No Way Out

September 15, 1999

Many people, like myself, consider the Internet one of mankind's greatest technological marvels. In terms of the medium's impact on present and future commerce and business success and failure, we are truly witnessing a unique time in world history. My own awe of the Internet revolves around how efficient it is to reach heretofore-untold numbers of people around the world who share a common and specific interest. Regardless of your opinion on what I write, for instance, you should remind yourself that without the Internet, you would not be reading it, nor would I have an audience. I mention this to try and point out that we are all blessed with this great gift of enhanced communication and empowerment for the average world citizen.

That this enabler of discussion and hopefully, understanding, has appeared at this particular point in history is timely, in my opinion, because simultaneously, it seems that the forces of controlled news and spin have attained art form status. The inevitable clash between the raw and uncensored and that of managed news makes this one of the most exciting and interesting eras in world history. In our specific world of precious metals, especially gold and silver, the clash of competing analysis, offered by those in both forms, is particularly sharp and rich.

To display my obvious prejudice, I recommend a re-reading of John Hathaway's brilliant essay, "The Golden Pyramid". Mr. Hathaway has done all of us a favor and has demonstrated the power of the Internet in disseminating analysis and thought process that would generally not be available to the vast majority who were exposed to his piece. He explains the fallacy of leasing/forward sales in compelling terms. Ask yourself - without the Internet, how would we even be aware of the practice of leasing of gold and silver? We would all wait a long time indeed, if we waited for someone inside the leasing daisy chain (bullion banks, central banks, miners and speculators) and the press they control, to proclaim their own actions as fraudulent and manipulative. Like I said, we're blessed to have such a thing as the Internet.

In this essay, I attempt to explain why the ill fated experiment in the leasing of gold and silver will end soon and why the demise will be violent and have an impact on price well beyond conventional reasoning. We have set the stage for an unavoidable major market event. For those well versed in market history, the most comparable example would be the impact that portfolio insurance had on the Stock market in 1987, when the practice caused prices to decline 23% in one day. While they might be comparable, leasing is about to impact the price of gold and silver in a more profound way.

I've written extensively about how the law of supply and demand has been compromised in gold and silver for many years because the supply at the margin, provided by leasing, has circumvented the price per ounce, by substituting an interest rate instead. Since the central banks involved in leasing refuse to recognize that their gold and silver that is sold as a necessary first step of the leasing process is actually a sale and not a loan, they can ignore the price per ounce and focus on an interest rate. Supply flows at the margin controlled by an interest rate. This is the explanation, and the only explanation, for how a market could be in a physical deficit for years with prices declining.

Let me try and explain this by using an analogy involving a water faucet. In the normal equation for a physical commodity, the price is the fulcrum that balances demand versus supply and vice versa. Demand up or supply down = price up, demand down or supply up = price down. This is the cornerstone of the free market and the rule of law that supports it. In spite of record demand for gold and silver, and an actual deficit measured against the free market sources of supply unable to keep pace with that demand, the price of each fails to respond because of the leasing water faucet. A faucet regulates the flow of water with a simple twist or turn of the handle to the desired rate of flow. Similarly, leasing supplies of gold and silver are regulated by the leasing rate handle. The leasing faucet is a remarkably efficient allocater of the flow of gold and silver. That's because the parties involved in the leasing supply flow are sophisticated, efficient organizations - namely, the leading investment and financial firms of our day. These are can do companies, staffed by the brightest minds, and aided with the latest technological wares. They can secure and deliver gold and silver with a precision never before witnessed and are highly suited to our just-in-time world. The central banks that provide the material are certainly indispensable, but it is the bullion banks that have fine-tuned the leasing faucet so effectively, that there is never an interruption to the flow of gold and silver to the market. Instead of the price moving up and down, reflecting the interaction between supply and demand flows, the price goes down or stays down, because the leasing faucet provides just the right amount of supply at the margin, plus a little extra.

Were there to be an infinite supply of a material like water (droughts notwithstanding), the leasing faucet could control prices forever. That, however, is not the case. The amount of gold and silver owned by the central banks is definitely finite, which dictates an end to the leasing game someday. But I said it would end soon, not someday. Here's why - the faucet is wide open and we're in a drought and many are converging to sate their thirst.

While the leasing faucet has distorted the supply/demand equation in gold and silver, it has not eliminated the equation altogether. In other words, the fall to twenty-year lows in gold, for instance, has resulted in rapidly growing record demand and escalation in the deficit. I've read that Frank Veneroso, has estimated that the current gold monthly deficit at 5 million ounces per month, or over 60 million ounces a year (this against scrap and mine supply around 100 million ounces). In silver, my estimate runs over 12 million ounces per month. This is what I mean by saying the leasing faucet is wide open. With prices per ounce holding to current low levels, it is reasonable to assume that demand will remain strong or increase, while conventional supply (mine production and scrap) will stagnate. This is the essence of the supply/demand equation. For the price of gold and silver to remain stagnant, the leasing faucet must stay wide open. Any restriction to the leasing faucet flow of gold and silver, at this critical point in the game, will prove violent to the price. Forget about restriction in the flow, I think the leasing faucet is about to be turned off permanently, and we will all be awe-struck with what is about to happen.

Let's see if I can back up my contention that leasing is about to end and we are about to witness unprecedented price violence. When metal leasing first started around 15 years ago, like most new concepts, it started with a trickle. As time went on, the trickle grew, because all the players - central banks, bullion banks, miners and speculators - benefited by leasing. No one noticed or was concerned about what impact the practice had on the price of gold and silver and any resultant supply/demand distortions. As success begets excess, the trickle has now turned into a flood, an unsustainable flood. This flood in turn has increased the overall reliance by the market on the continued flow of lease supplies at current flood rates. Any diminution in the flow at this point would be a first - the lease market has always been able to supply material at the margin for the life of this experiment. The gold and silver market has never known, in the past 15 years, a time when leasing supplies were insufficient to create balance at the margin, keeping a resultant anvil-like weight on the price. But we have reached the point where leasing has become too successful at providing material to the market, thereby ensuring its own certain destruction. The reason is because leasing finally created the end game by driving the price of gold below the legitimate average real cost of production.

The price of gold below the average cost of production is incompatible with leasing as a continuing process. Not just because gold below its production cost is an extremely rare event in history, but because it invalidates any reason for leasing beyond pure intended manipulation. Would any producer of any commodity hedge its production at a guaranteed loss? In fact the more difficult question to answer would be why would the gold producing community hold its collective short hedge of years and years of total world production when the price fell below the most logical of all covering price points - the cost of production? The short answer, of course, is that forward sales aren't real hedges, but that discussion is for another time. The continued release of material on the market by the leasing faucet can't be legitimately justified below the cost of production, if you think it out. That the rate of forward selling by miners in the future must slow should be obvious if prices stay below production costs. What may not be so obvious is that forward selling will slow even if prices rise, due to guaranteed stagnating future world production because of slashed exploration and development budgets. And it is becoming blatantly obvious to the dealers and central banks that future borrowers and short sellers can't be exclusively the speculative community which has no apparent method of repaying metal loans, save buying on the open market.

But the drying up of the legitimate borrowing pool is not what's going to cause the cessation of leasing in the normal sense (although it certainly could). No, what's going to cause the blow-up is the triumph of the supply/demand equation. With gold at a multi-decade low, real world demand will kill leasing. Look at the numbers. Central banks hold about 30,000 tons of gold. 10,000 to 15,000 are out on loan (sold to unknown and unrelated third parties). Of the 30,000 tons of CB gold, the US holds 8,000. Everyone says that the US doesn't lease, but I'm not so sure. (One of the hallmarks of leasing is that no reporting is generally the rule, as the leased gold is kept on the books - a "gold receivable" according to Hathaway) I mean, if the US doesn't lease, then the resultant remaining stockpiles of gold of the leasing CB's are really low. Even if you assume the US does lease a proportionate share, we could be down to the 50% remaining mark. At a current rate of 2000 tons a year being demanded by the market from the leasing faucet, some could argue that leaves 7 years of central bank stocks left for leasing. But I think that thinking is somewhat linear. It doesn't take into account that central banks are becoming concerned about the leasing game for the first time in the grand experiment and that some alarm must be registering at prospect of growing continuous physical withdrawals on a weekly, if not daily, basis. I mean, it's hard for them not to notice that the vaults are getting emptied. Already there are widespread reports that a number of central banks are abandoning the leasing game, leaving a fewer number to sate increased demand. This is what the prolonged rise in gold lease rates reflects. Remember, even though the bullion banks' ability to provide delivery of gold and silver is state of the art, if central banks don't or can't provide the raw materials, the bullion banks can't continue to provide timely delivery. With the price of gold still below the cost of production, rising lease rates will only be effective in continuing to provide supply at the margin a short while longer. Why? Because of the demand component of the equation.

Demand is the lease killer and prime reason for my contention that the end game is at hand. There is more and more discussion on leasing/forward sales than ever before. I guarantee this will continue. Three years ago I was very alone in discussing leasing and its manipulative effect on the market. No longer am I alone. Too many people are noticing the low price of gold and silver relative to their fundamentals and other relative objective comparisons. When the dawn of recognition hits you about leasing, you know immediately the ending. There is certainly no shortage of investment buying power throughout the world. As intelligent people realize the gift that the leasing faucet is bestowing on them, the buying will intensify. The CB's and bullion banks have created the buying opportunity of many lifetimes. It is inconceivable that the hedge fund community, for instance, will not recognize the give away price levels and precarious position of the central and bullion banks and the vulnerable status of the massive short position and press that advantage. That the central banks are being drained at the alarming rate of 5 million ounces a month only equates to less than $1.5 billion at current prices. (That's on a full cash basis - there is no law against using credit to buy gold - yet). With stresses showing in the gigantic derivatives arena, and Y2K fears rising, it is not unreasonable to imagine a spike in dollar flow many times current record levels. What would happen, for instance, if at current prices, a monthly demand of 10 or 20 or 50 million ounces of gold were demanded by the market? Would the decreasing number of leasing central banks willingly, or even be able to, provide the supply at the margin, especially when there are developing so few legitimate borrowers below the cost of production? Clearly, I'm suggesting that breaking point is about to be reached.

What would happen if, for the first time in the grand leasing experiment, leasing couldn't provide the supply at the margin? It would mean only one thing - that the non-leasing component of the supply side of the equation would have to satisfy demand. And since we are in a clear and growing deficit, the only possible source of supply would come from the owners of unencumbered physical gold and silver. While that might seem rather unremarkable for a commodity that had been operating in a free market, in a manipulated market like gold or silver, that prospect would literally be a shock to the system. Think how long it has been since gold and silver owners have had to even think about selling because the price is too high for them to continue holding their inventory. Because it has been such a long time since gold and silver have been in bona fide bull markets, that means most long term holders have a much higher cost basis than current prices. It may take much higher prices to persuade those holders to relinquish ownership, especially if the price spikes quickly with the violence I have mentioned.

I compared the current situation in gold and silver leasing to portfolio insurance in 1987. They are similar in that leasing and portfolio insurance were based on a defective premise. In leasing, that defective premise is that you can call a sale a loan even if there is no prospect of repayment because the collateral is destroyed. In portfolio insurance, the faulty premise was that you could create a gigantic stop-loss order for the entire market with no thought given as to who would take the other side of the transaction and at what price. I remember clearly that there was sufficient commentary weeks and months before the day of the melt down that the mathematics of suddenly selling amounts of futures greater than had ever traded before would be disastrous. Similarly, there is developing sufficient commentary about leasing pointing to the market disaster in the making due to a short position that dwarfs anything seen in history. Because of this, physical positions seem the safest route, paper and derivative gold and silver must contend with counter-party risk.

But there is a major difference between portfolio insurance and leasing. That difference is that after the severe adjustment to stock prices that portfolio insurance caused, the problem was basically over. The solution was simple - no more portfolio insurance (at least in the form it was in). With leasing, no such quick solution is possible. That's because even if a violent short covering rally propels the price of gold and silver a hundred (or hundreds in the case of silver) per cent, the market will still have a major problem. That problem will be closing the structural deficit that leasing has created. It's not enough for the shorts to cover and leasing to end., the market must find a long term solution (the right price) to balancing supply and demand without leasing. Unlike a failed currency intervention or devaluation, whereby the adjustment to the new price level is immediate - you don't quickly adjust mine production or manufacturing lines. Don't look at the coming demise of leasing and the certain short covering rally as the terminus - it is just the beginning. It is only after leasing ends that the sacred law of supply and demand will begin to fully function.

The extraordinary circumstance of a precious metal selling below the cost of production is sounding the death knoll for leasing and manipulative shorting. The world investment community has been presented with a rare and timely offer that won't be refused. The leasing scam presents a very big positive to those who can read between the lines - gold and silver are being offered in volume at prices that won't be witnessed again in a normal life time. But there is a catch or time limit. The offer is only valid while leasing is functioning and the central banks and bullion banks are able to defend a soon to be indefensible practice. When the remaining leasing central banks say "no más" to throwing away good material after bad, it is game over. That will happen in a heart beat. If you are going to buy gold and silver do it now. There is no possible easy way out of this mess. Of course, this is an Internet delivered, highly independent analysis. The alternative is to rely on the conventional press and analytical community who say leasing is just business as usual and metal prices will be subdued for as far as the eye can see. One of us will obviously be wrong.

The purity of gold is measured in carat weight.

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