The Other Side of Leasing

May 5, 1999

I have written extensively over the past two years about precious metals leasing and its manipulative effect on the markets. My theme is simple - silver and gold have been physically released on the markets as a result of leasing to the effect of satisfying a major supply/demand deficit in each, thus depressing the price. Further, since there is no possible way for the loans to be collectively paid back with metal, as called for (since there is a deficit), the continuation and new issuance of these loans is fraudulent (to say nothing of stupid). The lease rate has replaced the price per ounce as the price determinant at the margin.

My main argument has been that leasing is the ultimate short sale. While some might have trouble accepting this, selling what you have borrowed and promised to return is a short sale, pure and simple. Every loan, every forward sale, every carry trade sale is a short sale. No exceptions. Somebody is selling something that he doesn't own. If there are 400 million ounces of gold loans, then there are 400 million ounces of gold sold short. If there is a billion ounce silver loan position, there is a billion ounce short sale from this source alone. Leasing is short selling, period. Once you accept this simple fact, and view the past ten years or so with that fact in mind, you will see clearly that since the price of gold and silver have been depressed in price, participants in leasing have done really well. It's not even required to accept my premise that leasing has caused the decline to accept this. I'm just stating that since leasing is just a disguised short sale, and the price has basically gone down over the past decade, those in the leasing game have been on the right side of the market. Short selling in a declining market is profitable, buying isn't - I'm not trying to trick anyone with this.

After so many words on the past and current effects of leasing on the precious metals market, I thought it might be constructive to look at the future of leasing., or more precisely, what happens when leasing starts to unwind. What will the precious metals landscape look like once no new supplies are forthcoming ala leasing? Needless to say, with no supplies from leasing, the price environment will look much different than the last 10-15 years. Not just higher prices, but violently higher prices. And, even if leasing ended tomorrow, its effects would be felt for many years.

There are a number of possibilities that could spell the end of leasing. While the most obvious is that Central Banks will exhaust lendible supplies or decide to no longer lend as a policy decision, this is by no means the only possibility. There are other parties involved in a metal lease, bullion banks and the parties on the end of lease chain, mining companies, users and speculators. Distinctly apart from the Central Banks, if any of these decide to no longer participate, leasing stops. It would matter not that the Central Banks were ready, willing and able to lease gold and silver, if the other parties to the transaction would shun the game. So why not ask yourself how likely or not it would be for a non-Central Bank leasing participant to quit leasing.

Once you accept the simple fact that leasing is short selling, and that a declining price rewards leasing participants, you arrive at the corollary - rising prices hurt lease participants. It's simple to see that a sustained price rise would drive the more speculative inclined leasing participants to exit the game. There's nothing complicated about the profit motive here - you do what makes money and stop that which doesn't. But what about the mining companies - how would they behave in a sustained price rise? After all, they claim to be hedging, so they say they are protected in any event with their forward sales. And the market has rewarded those companies most aggressive in their forward sale book. Is this justified? I don't think so.

I know I'll likely take some flak for what I'm about to present, so you should know up front that I have no position of any type, long or short, in any mining company. If you accept that leasing/forward sales are pure short sales (they are), what the mining companies have been doing is dangerous to their financial health. Mining companies, and the people around them, claim to be hedging with their forward sales. Nothing could be further from the truth. Any resemblance to hedging by using forward sales is coincidental. Hedging is a time honored legitimate practice, whereby a commercial producer or user locks in as favorable a price on an item that is expected to fluctuate. It is the very economic basis upon which the futures market is allowed to exist. It is the cornerstone of legitimacy in the futures markets. It is not what the mining companies are practicing.

A legitimate hedge attempts to lock in a profit or a known cost. Gold mining companies may think they are hedging by engaging in (multi year) forward sales with leased metal, but that is not what they are doing in reality. All they are doing is massively selling short Central Bank gold and silver. Please think about this for a moment. If a mining company wanted to lock in a favorable price, they could go to the listed futures or options market, or OTC, and effect a paper transaction, like a farmer or other producer. What is made or lost on the paper transaction is offset by the loss or gain on the real production (notwithstanding any 'basis' loss or gain). There exists a broad and deep paper market in precious metals. There is no need to physically sell short gold or silver to effect a hedge. No other commodity producer would or could effect such a transaction - just precious metal mining companies. This is at the heart of the leasing scam - mining companies saying one thing (they are hedging) and doing something else completely (selling short). I don't even think they realize what they are doing, the situation is that out of control.

Let's take a real world example - Barrick Gold Corporation. I'm not singling out Barrick for any reason other than they are so vocal and brazen about their forward gold sales. The first thing you should do in analyzing what I am saying is study Barrick's description of what they claim to be doing by visiting www.barrick.com and click on Financial Data and then on Premium Gold Sales and the Q and A section. What you'll find is basically this: Barrick considers its forward selling an integral part of their corporate strategy. It's been a big money maker and a main reason for their success and they plan to continue forward selling. They even go so far as flatly stating that regardless of what the price of gold does, it's good for them. If it goes up, it's good and if it goes down it's good.

This is patently absurd. There has never been, nor will there ever be, a financial vehicle that makes money no matter what happens. Your common sense should tell you that. It is simply amazing that Barrick could make such a misleading statement, or characterize what they are really doing (short selling massive amounts of gold) in such a grade school primer fashion. One of the things they always claim is the high price they get for their forward sales. If the price of gold is 300, somehow they get $50 or $100 more. I've heard people ask out loud (well not too loudly) who is on the other side of that transaction, paying that price. The answer is no one is paying that price - all Barrick is doing is extrapolating what they'll make on the proceeds of their short sale at the end of so many years, and saying that's what they are getting (now).

What I would ask you to do, is to study the Barrick description of what they are doing and compare it to what I say they are doing. If all they are doing is short selling gold borrowed from Central Banks, with a few wrinkles concerning repayment, then they are up to their eyeballs in this leasing scam. Barrick has made money by selling short gold for years. The gold market has declined and they made money - good for them. If the market has a sustained rise, it won't be good for them. Which is ironic considering this is a big gold mining company and I would imagine some shareholders are rooting for a gold price increase.

Barrick says it is protected against rising prices because it holds "spot deferred" contracts. (Who thinks up these meaningless financial terms?). They claim that if prices rise above their (short) sale price, they have the option to postpone the settlement of their forward sale for up to ten years. This gives them the opportunity to wait out a gold price rise, until the price settles down. What happens if the price doesn't settle down? More to the point is what happens in the interim. What happens if lease rates don't cooperate? Barrick's claim to fame is the financial management of the spreads between lease rates and money market rates. What happens if they invert? I know it has never happened in gold, but it has in the three other precious metals where lending is practiced. Does that make it more or less likely that it might happen in gold? What's the lease rate likely to be when people try to exit the market? I question whether Barrick and others could cover gracefully even if they wanted to.

While some will consider this an attack on Barrick, that is not my intention. As I said, I've singled them out because they are so insistent about what they are doing. What I am attacking is this misconceived notion that all the mining companies are doing is hedging. They are not hedging. Hedging means locking in a favorable price. Considering how close the price of gold and silver is to the cost of production, a true hedge would be unwound here, not initiated or allowed to run. If the mining companies are truly concerned about prolonged (years) of price weakness, why mine and deplete assets? Close down and await higher prices. While it has been profitable to short sell physical metal, any student of the market knows it premature to brag about an open transaction. And all these leasing short sales are most definitely open and growing. When we see higher prices, the short sellers in the lease scam will suffer just as they prospered with lower prices. Let's see how it plays out on the other side of leasing.

Gold is found in nature in quartz veins