Two Down, Two To Go

June 7, 1997

The stunning ongoing developments in the precious metal world, centered on platinum and palladium, in the past week have left participants and observers awe struck. Amid dramatic price increases, a tense crisis atmosphere has enveloped the precious metal community rife with concerns of counter party risk and delivery uncertainties. The obvious cause is the lack of metal coming out of Russia, which is the premier producer of palladium and an important supplier of platinum. What is obvious, it is written, is obviously wrong. Not to underestimate Russia's importance to these markets, something more basic is responsible for the sudden upheaval in trading circles and sharp price changes. After all, the Russian situation is, and has been well documented by even the most casual observer, so it's hard to believe that that is the main cause, especially since not a single news account fails to explain in detail the latest update on the Russian-Japanese negotiations and the intricacies of the export license procedures of the Kremlin bureaucracy.

Interest rates of 300% were quoted on palladium one month leases (60% on platinum), before the lease market just shut down (I think forever).

No, something else is responsible for the sudden unprecedented breakdown of the actual trading mechanism of the market itself. Think of it, so soon into a market move (palladium for a few months, platinum for a few weeks), emergency discussions were held in London last week to work out the "problem". Interest rates of 300% were quoted on palladium one month leases (60% on platinum), before the lease market just shut down (I think forever). Market makers abandoned the forward market and cash deals were unilaterally extended to 30 days from the normal two day settlement. Dresdner Bank called upon the United States to release its stockpiles of platinum and palladium from the strategic reserve, even though the largest U.S. consumer, General Motors, said they had no unmanageable difficulties. Officials were quick and frequent in announcing there were no defaults (although the entire market had failed). And all this from a delay in export negotiations? I don't think so.

The palladium and platinum markets are in such a predicament because of the very structure of the market. If you define the failure of a market as a sudden lurch into disorderly pricing with wholesale abandonment of contractual considerations and demands for governmental bailout, then the platinum and palladium markets have failed. In fact, they had to fail. Just like the gold and silver markets have to fail. It's unavoidable. And it's all because of the idiotic mutant of a derivative known as the metal loan. Metal loans are the sole cause of the current and guaranteed future failures in the precious metals. If you allow your mind to think this through objectively, you will understand just what the real "problem" is. You will understand why the German Dresdner Bank is pleading for the U.S. Government to bail it out. And you'll be prepared for the coming doublespeak and convoluted explanations as trading officials try to assure the world that everything is fine.

Everything is not fine. Metal loans have first depressed prices uneconomically for years and then they have or will cause the markets to fail amid soaring prices. It's really simple. Because all the tradable precious metals slipped into deficit consumption patterns years ago (meaning current production fell short of current consumption), prices could only rise (to encourage additional production or ration demand) or additional above ground supply had to be provided to the market to balance a supply/demand equation that must be balanced. Because precious metals have been mined and accumulated for years (in the case of gold and silver for thousands of years), even before industrial uses for them were discovered, there existed large above ground inventories. But those above ground inventories were only available at various prices determined by their owners, as it would be in any owned item. Therefore, it would still require rising prices to bid those inventories away from the owners in order to balance the deficit. This is the very essence of the law of supply and demand. If this would have happened, or been allowed to occur, we would have no precious metal problem today. As prices rose to induce owners to sell inventory, mine production would have been stimulated and consumption would have been curtailed, and inventories would stabilize as the rising price served as the fulcrum to balance supply and demand.

Metal loans have first depressed prices uneconomically for years and then they have or will cause the markets to fail amid soaring prices.

But that's not what happened. What happened instead, through a confluence of narrow minded personal motives, was the advent of the metal loan. What this misguided and anti-free market concoction did was to render inoperative the law of supply and demand by substituting an interest rate for a price to get the owners of inventory to release their metal. The owners were told don't sell your silver, just loan it - this way you can have your cake and eat it, too. You'll get a return (small but better than nothing), and you can have your silver back whenever you want. But the lease arrangers overlooked one small detail. And it is that detail that has upended the precious metal world today. The owners who leased out their metal can't have their cake and eat it, because someone else has already eaten it. All the loaned metal has found its way into the world market and has been consumed in the balancing of the supply demand deficit. Where do you think the loaned metal went after it left the real owners? Do you think it just sat in some warehouse waiting to go back to its original owner? No, most of the metal was consumed straight off, or sold and then consumed. In a very real and practical sense there is no metal left to be returned to owners. That's why there are emergency meetings in London and cash transactions are extended to one month transactions and foreign banks beg for material from U.S. taxpayers.

The owners who leased out their metal can't have their cake and eat it, because someone else has already eaten it. All the loaned metal has found its way into the world market and has been consumed in the balancing of the supply demand deficit.

Metal loans allowed inventories to be depleted by deceiving the original owners into believing they could get their metal back any time. Events of the past week have exposed that lie in platinum and palladium. Never again will owners of platinum and palladium be so naïve as to loan their metal out for a paper promise of return, no matter how high the rate or how important the name behind the promise (not even for the Dresdner Bank). Two down.

As bad as things have gotten in platinum and palladium (some would argue this is as bad as it gets), you must remember that leases and futures and options in these markets were quite small in relation to world production and consumption. The paper obligations compared to actual annual production and consumption in platinum and palladium were relatively modest and normal when compared to other traded commodities. But that is not the case for gold and, particularly, silver. Here, lease and total derivative exposure (exchange and OTC) dwarf annual production and consumption. Now we are left with the bitter consequences of the metal loan fiasco - artificially low gold and silver prices, huge imbalances between real supply and demand, and massive obligations in place of squandered inventory.

What this means is that when the certain failure of the lease market in gold and silver occurs, it will make the platinum and palladium experience look like a tea party.

When will this take place? The instant the lenders of gold and silver move to call in their metal, just like what happened this past week in platinum and palladium. They know now that only the first few through this narrow door stand a chance of getting back their metal. The rest will face delays and paper workout compromises - but no metal. Two to go.

The term “carat” comes from “carob seed,” which was standard for weighing small quantities in the Middle East.