By: Grant Williams
Gold has been money for thousands of years. Despite what several misguided Wall Street analysts might think, I believe the gold market is a long way from being over. We will see the proof of that once the conditions surrounding gold will get normalized (whenever it will be in the future), and the debt mountain causing these outside interferences (which are distorting markets) has been dealt with through either inflation or default. Both inflation or default will be positive for gold. Lately, however, gold has been under serious and mathematically inexplicable pressure. Before we get to the recent action the gold market let’s get a better understanding of the difference between the gold price and the price of gold.
The gold price is essentially the price of a future paper conveying upon the buyer of that piece of paper the right to take delivery from the seller of a stipulated amount of gold in the contract, in this case a 100 troy ounces in good delivery form. All the gold that has physically settled as a result of the futures transaction must conform the good delivery standards in terms of purity, and it must be an approved hallmark.
The price of gold on the other hand is whatever you have to pay to actually get your hands on an ounce of physical metal, and it is very different: it differs from day to day, it differs from city to city, even within those cities it differs from dealer to dealer, but it is nearly always higher than the gold price. Traditionally physical gold traded at a premium to the futures price, and that premium fluctuates depending on the level of demand for the physical mental. The subtle difference between the two has always been uppermost in the minds of people who are called gold bugs, but developments in the gold market over the last nine years primarily since the listing of the GLD ETF in 2004 have meant that more money has been casually diverted into paper gold. The ease of doing this (no storage, no transportation, no insurance cost) has meant money that finds their way easily into gold has a similarly trouble-free return journey. This is one of the main causes of the increased volatility in gold. By way of an example, at September 27th 2012 the gold price stood at $1,777. The average premium at that time was 9.49% which means that the price of gold was $1,945. In the case of 1/10oz American Gold Eagle the price of gold was even $2,041.
Let’s take a look at the gold price, and in particular in April of this year where it challenged the mathematical probability that has ever been written. Recently the gold price has broken down from its corrective pattern, but the nature of that breakdown is where we find some really strange things going on.
- On Friday April 15th alone, 400 tons of gold have been sold in the futures market which is15% of total yearly global production. It has a notional value of future sales of $20 billion.
- Combined with the even more exaggerated decline on Monday April 18th , the price of gold fell $213, and this is where the maths become astounding.
- The two day move in the gold price was an 8 standard deviation event. A 7 standard deviation event happens once every 1 billion years.
So far the gold price action. What about the price of gold? In the aftermath, as a reaction to the decline in the gold price the public did not rush to sell like they did with their equities in the crash of 1987 or 2000. In fact, they did the exact opposite. The public stampeded to buy the physical metal at a 20% discount. Of course, the price of gold was definitely not the same as the gold price. Premiums have been quoted as much as 25% above the spot price which completely negated the entire downward move of the price of gold in the futures market. That didn’t matter because the headlines were all about the supposed crash in the gold price. Gold demand over this period in India jumped to 138% to $7.5 billion, and premiums there increased five-fold. Dubai gold imports in April were 50 tons which is as high as over the twelve months of 2012. Even the Perth Mint gold sales doubled.
It was not only Hong Kong and Beijing, but all other cities over the world where the physical demand was huge: Toronto, Zurich, Sydney, London, New York, … an extraordinary list of cities which all saw a stampede to buy physical gold. This is the disconnect between the paper and physical gold: the the huge downward move in gold has resulted in a massive acceleration of buying of physical metal.
It is not only the public taking advantage of the weakness in the gold price. 2012 saw central bank gold buying at a top not seen in 50 years. Central banks have purchased 534.6 tons. The World Gold Council counts a further 450 tons increase in gold demand by central banks in 2013. It adds to the clamour of physical metal. Once central banks take the physical metal away, unlike the holders of the GLD ETF, it tends to stay there for a very long time.
In closing, the most interesting figure of them all, is the potential demand for physical gold. The following chart shows the central bank reserves with the upper part the Western economies and the lower part the emerging economies, or put it another way the upper part represents the holders and the lower part represents the buyers. Western central banks are no longer sellers after 20 years of continuous sale. Western central banks hold on average 58% of their reserves in gold bullion. The buyers hold only 2.6% on average. Here it gets interesting. If the buyers will increase their holdings from the current 2.6% to a hardly extravagant 15% it will create demand for 17,359 tons (indicated in red in the chart below). That is about 15 to 20 years of global gold production.
Source : Bullion Bulletin