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Simple Math & Common Sense: A $66 Billion Problem

CFA, Senior Managing Director, Co-Portfolio Manager
October 9, 1999

Don't be confused by self-serving outcries from various parties trapped in the gold short squeeze. I am amazed to hear reports that so-and-so has restructured their hedge book or that this or that group has covered its short position in gold. Such statements are misleading, if not false. What is happening is that the self-made victims of the growing gold short squeeze are passing the hot potato back and forth among themselves in a desperate attempt to wriggle free. This activity amounts to little more than frenetic paper shuffling. The gold market is in the throes of a spreading credit crisis.

The short squeeze will be over when, and only when, there has been a full repayment of the bullion deposits owed by dealers to the central banks. These deposits are the foundation of the Golden Pyramid described in our recent Themes Express article. Ex repayment of central bank gold, the massive short squeeze we forecast when gold was trading around $250/oz a few weeks ago will continue even if distribution of risk among various players changes slightly with their desperate maneuvers.

Let's do the simple math. At 6000 tons, a conservative estimate based on the usual reputable sources, the mark to market value of the short interest in gold at $330/oz is approximately $66 billion. That doesn't sound like a very big number in today's financial markets with flows several multiples of this amount, until you consider how concentrated the exposure is relative to the thin financial resources of the participants.

For example, a 1% increase in the cost of carry equals $660mm. When most of this business was put on the books, the cost of carry was around 1% per year. Based on current lease rates, there has been a negative swing of $2.6 billion. By the way, as the price of gold moves higher, so does the interest burden. A $10/oz increase in gold equals $1.9 billion. In the last two weeks since the ECB announcement that lending would be capped, the $60 adverse swing has added over $11 billion to the shorts' obligation to repay. Who's paying the price?

What is the equity of the gold mining industry, hedge funds and bullion desks involved in this position? The world gold mining industry's equity on a very rough basis is only $20 to $25 billion. The equity of the ten or so major bullion traders is very likely less than $1 billion, even though the resources of the institutions that stand behind them is far larger. The depleted equity of the hedge fund community may stand at $30-$50 billion. Only the bullion desks are committed to trading gold. Hedge funds of course have no generic interest other than to make a profit. Even the mining companies have other things to do with their capital than trade bullion.

For example, Chase Manhattan reports gold derivative notes outstanding of $20 billion. These are "structured" notes where the obligation of the issuer varies, possibly quite dramatically, with the spot price of gold. Chase was among the most aggressive of the bullion banks, doubling its gold derivative position over the last 18 months, at the same time gold prices were plummeting. The book value of Chase was $23 billion as of 6/30/99. One of their clients, Ashanti Goldfields, is suffering severe margin calls on their gold hedge, which stands at 10mm ounces. Each $10 increase in the gold price costs Ashanti and/or its bankers an additional $100mm of pain. Ashanti's stock has declined by more than 50% in recent trading, despite the sharp run up in gold prices. Ashanti seems likely to disappear as a freestanding entity, and their shareholder equity could easily vaporize despite valuable, world-class assets.

Ashanti is not alone. Several other companies suffer from hedge book troubles at current prices. A further $100 run up in the gold price would raise questions on even more. Since the liquidity and financial resources of the gold mining industry are limited, the financial exposure to higher gold prices will inevitably pass through to the bullion dealers that were so eager to put this business on the books in the first place.

In a conference call, Ashanti management characterized the relationship with their 17 bullion banks as "orderly and stable," yet another misleading statement emanating from the current mess. In reality, the only step that will spare Ashanti and its bankers further misery is a 10mm oz buyback and delivery of physical gold to satisfy the credit. Of course, a $3.2 billion purchase order for physical gold cannot be filled for the time being. More likely, Ashanti will be carved up and its credit subsumed by that of Barrick, Anglo, the government of Ghana, or some other better balance sheet. The price of a rescue will be high both to the existing Ashanti shareholders and the bullion dealers. The risk profile of the bullion desks will then deteriorate in return for the appearance of "business as usual," awaiting the next disaster. As the gold price rises, the credit position of the bullion dealers and producer hedge books will deteriorate further. The process could well accelerate, and possibly culminate in a divine intervention by the central banks in yet another spectacle of "too big to fail." By then, the good name of gold should be restored.

Expect to see a retreat of capital from gold hedging and short selling in the coming months. Within the gold mining industry, a witch-hunt mentality towards hedge book risks is certain to commence. Pressure for buybacks will grow. The speculative blood lust for shorting gold among the hedge funds is a thing of the past. If anything, hedge funds are likely to line up on the buy side to attack the short position. We doubt whether risk managers of financial institutions will favor additional allocations of capital to the trading of paper claims based on gold in the bullion trade. Essentially, credit has seized up in the paper gold market.

Once the initial shock has been absorbed, the paper gold market should enter a protracted workout mode in which producers buy back hedges and speculators steer clear of the short side. Issuance of equity shares to fund hedge book buybacks, in other words, outright purchases of gold, would not be surprising. There is just one problem. If the gold producers all act simultaneously, as they did in herd-like fashion on the way down, the gold price will skyrocket. Reason: there is no physical gold to buy, other than from the central banks, and the only if they choose to sell or lend additional quantities.

This short squeeze has the potential to send gold hundreds of dollars higher. It took years of stupid collective actions by many very clever people to set this trap. A miscalculation of this magnitude is unlikely to be rectified in a few short weeks or with just a proportionally small change in the gold price. We have a long way to go before the market is correctly balanced. In the meantime, the squeeze has the potential to threaten the health of some major financial institutions. It certainly has the potential to disrupt the earnings and finances of mining companies who have hedged excessively or foolishly. The degree of "excessive" hedging will rise with the gold price. Even those companies that will soon be proudly proclaiming their "hedge lite" position stand to be shocked at the degree of risk they have undertaken. Officers and directors should understand the potential for shareholder suits from investors who bought shares as a play on higher gold prices. Without hedging and short selling over the last several years, the gold price would be several hundred dollars higher based on the short fall of mine production relative to consumer demand. Panic short covering could drive the gold price well above any theoretical equilibrium.

The existing and potential exposure of this massive trade gone wrong must be frightening to those trapped in it. Still many others have no grasp of what is happening and regard themselves as secure. Time will tell who's holding the bag on basis risk and lease rate exposure. For now, it is safe to say that nobody knows or is telling the truth.

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.  

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