Gold: Market Broken or Something More Sinister?
I can tell you a few stories from my days at a derivatives firm.
For starters, I was the first female to join the team. In the days leading up to it, they put a swear jar in place to try to ‘clean it up a bit’.
Apparently — so the story goes — after my first 15 minutes in the office, my colourful language lead to the manager shoving the swear jar in a draw. Never to be spoken of again.
Then, there was the day another female joined the firm. Oh no, it had nothing to do with celebrating another female in a room full of blokes.
She was trying to get her head around the futures market.
My boss at the time — who had spent many years in the depths of various futures markets around the world — was walking her through how it all worked.
But she kept getting stuck on ‘Exchange for Physical (EFP)’ when it came to the futures market.
That is when a futures contract is ‘settled’ with the underlying item being delivered to your door, instead of settling for cash.
She was trying to work out, what she would do if 10,000 pork bellies showed up on her doorstep if some settled in pork bellies, not cash. ‘How would I store them?’ she asked.
My boss explained that no one in their right mind would settle for the physical.
They’d take the cash.
That’s what the futures market is for after all…
Northern Hemisphere refineries shut shop
Another day, another massive volume of news to get through.
I was explaining to my subscribers over at Rock Stock Insider last week, that a week in the markets feels like a month.
Markets are moving quickly. And information even more so.
Not only that, but the speed at which everything moves and the lack of information at the time means everything is surrounded by conspiracy theories.
And much is stirring in the gold market at the moment.
Why all the troubles?
Simply put, people can’t get gold. And depending on the web hole you fall down, some reckon something nefarious is up.
However, the truth is much stranger than fiction.
Australia for the moment, is fairly immune to the problem.
The Northern Hemisphere on the other hand has a bunch of problems when it comes to gold.
There is a real ‘squeeze’ in the gold market.
Since the start of the year, gold has been in high demand. Yet demand has really increased in the last couple of weeks…
…just as three major Swiss refineries were shut down.
This time last week, PAMP Valcambi and Argor-Heraeus were all forced to tun off the machines and close the refineries on government orders. Like many parts of the world reacting to the coronavirus, all non-essential industries must shut.
These three refineries produced 1,500 tonnes of gold per year. Roughly one third of the world’s supply.
This has never happened before.1
And this shut down of major global refineries comes right as gold demand is higher than ever…
There ain’t no planes
So, how does a refinery closing in Europe affect the markets across the pond in the US?
Well, markets are more linked than ever before.
And we are witnessing this play out in the futures market right now.
On Tuesday last week ‘open interest’ — the number of outstanding futures contracts — over at Comex for April delivery was 19.6 million troy ounces.
Yet the total deliverable stock in the Comex warehouses was only 8.7 million troy ounces.
In other words, the amount of gold being traded for one particular contract was more than double the amount of total gold that could be delivered. Of course, this is very normal that there’s more paper gold then physical gold for delivery.
As my old boss will tell you, no one trades the futures market for delivery.
That might have been true in a pre-COVID-19 world.
Today it turns out punters in the futures market are opting for EFP. And that itself is causing a whole bunch of problems.
Not only is the paper gold market many multiples higher than the gold available, there is a size difference for the contracts.
Over in the deep dark vaults of the London Bullion Market Association (LBMA), rest 12.4 kilo bars.
These 400 ounce bars are the majority that are bought and traded between central banks and exchange traded funds, for example.
However over at COMEX the contracts are based on 100 ounce bars (3.1 kilos).
Normally, delivering the physical wouldn’t be a problem.
The LBMA 400-ounce gold bar would be flown to a refinery in Switzerland. There it would be melted down into the 100-ounce bar needed to settle a COMEX contract. Which would be then flown to the US, and driven out COMEX or the place of delivery.
Except…plane traffic is down 90% around the world.
Oh, and the refineries that would do this are shut.
So not only is there no way of getting the gold to multiple destinations, the folks who reshape the metal aren’t there to do the job…
Because of this size disparity between the LBMA and Comex, we’re currently seeing the rules change.
By the close of business last Tuesday, CME Group were in the process of re-writing the size of bullion for delivery for Comex contracts. Chapter 113 has been amended to allow delivery of 400 troy ounces, 100 troy ounces, and 1 kilo gold bars.
Ditch paper gold and hold the real stuff
Of course, this ability to settle gold futures contracts for the real stuff has begun causing problems in markets.
There’s been conspiracy theories abound that the world has run out of gold.
While gold is a finite resource and eventually we will run out of stuff to mine, we are not facing a shortage of gold.
Rather, I believe we are witnessing the realisation of how distorted the gold paper market is to the physical gold market.
The futures market was created to hedge a potential price of gold in the future. The intention to settle — while an option — was never really its purpose. It was about minimising risk for producers and buyers.
Not only are we witnessing some settling in cash, we are seeing the fragility of the system in trying to get it to where it needs to be.
That like every single other derivative, the system works as long as people only want fiat dollars, not the goods.
What’s happening with gold right now isn’t a conspiracy theory. It’s a flaw in using the futures market for price discovery.
With the gold paper market being so much bigger than the physical market, I always advocate owning the real deal.
The only gold that counts is the physical stuff you own in your name.
The rest is merely a piece of paper that says you have a claim to gold.
Until next time,
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