Houston, We Have A Problem
The well-known Hollywood movie Apollo 13 tells the story of the 3rd American Moon landing mission. As many of you will remember, the mission was going smoothly until a routine “tank stir” (whatever that is) caused an explosion.
The explosion immediately set off a barrage of warning lights, alarm sounds, and extreme gauge readings, while the spacecraft shook violently. The deeply concerned astronauts, overwhelmed by instrument chaos, couldn’t figure out what was wrong, when one of them uttered the famous phrase, “Houston, we have a problem.”
Along with the chaos unfolding on the spaceship, back on Earth the NASA computers also started flashing and beeping incessantly in front of an equally alarmed and befuddled flight team. No one was initially sure of what went wrong or what was happening. I mean, “…it couldn’t be a QUADRUPLE FAILURE, that can’t happen!”
The situation took everyone involved by surprise and completely transformed the nature of their mission. The cascading system failures depicted in this scene represent an intriguing and useful parallel to current events in today’s gold market.
History in the Making – The 2013 Gold Market
From our perspective, the current gold market is undergoing an historic transformation.
The laundry list of unprecedented events taking place is simply remarkable. A survey of them suggests tectonic shifts are taking place, which are altering the gold market landscape to a degree that will render it changed and unrecognizable in comparison to its former structure.
Backwardation in the Futures Market
Let’s begin our survey with the exceedingly rare situation of gold backwardation in the futures market. Backwardation simply means that the physical spot price for gold is higher than the nearest futures contract price. This implies that there is a high demand for physical delivery today as opposed to a future paper promise of delivery later.
If this was not the case, market participants would happily sell their gold for a higher price today in order to buy it right back at a cheaper price, but for future delivery. Thus, it is reasonable to conclude that backwardation suggests a concern about the paper promise of future delivery.
Gold has been in significant backwardation only twice in recent history, in 1999 and 2008. However, each occurrence lasted only a few days because of the quick profit presented by the arbitrage opportunity inherent with backwardation.
According to James Turk, a well-respected gold market authority, gold slipped into backwardation on July 8th. This means that gold has been in this rare market condition for an extraordinary 35 days, and that market participants currently prefer to hold physical gold today over a paper promise tomorrow.
Associated with backwardation is the Gold Forward Offered Rate (GOFO), which is the rate of profit that will induce bullion banks to swap gold for US dollars.
GOFO are usually positive. This is because there is typically greater demand for paper currencies in comparison to gold. In contrast, a negative GOFO implies that market participants are showing a stronger preference for physical gold than US dollars; a market state that is uncommon.
The GOFO rate has only been negative on two prior occasions since 1998. The first instance occurred in 1999 and the second in 2008 and both only lasted a short time. In dramatic comparison, the current GOFO has been negative for an unprecedented 29 trading days.
In past instances, negative GOFO have marked a turnaround in the gold price. See the chart above. Are backwardation and a negative GOFO the proverbial canary in a coal gold mine? Only time will tell for the current episode, but since James Turk’s July 8th backwardation call, gold has rallied over 14% or US$170.
Declining COMEX Inventories & Musical Chairs
In a King World News interview, Grant Williams and Eric King discussed a situation where there are currently 42.5 paper claims for each ounce of physical gold. With this alarming 42.5:1 ratio, it is no wonder an individual would want to take delivery of physical before the other 41.5 claimants show up!
Speaking of taking delivery, take a look at the graph below showing an alarming decline in the total ounces of gold held in COMEX warehouses.
There are two types of accounts associated with the COMEX gold inventories; registered and eligible. A registered account means that the gold is available for settlement of futures contracts. An eligible account is more like a storage account. The gold is in the warehouse but it is not available to settle contracts unless the owner designates it so.
As of last week, roughly 7 million total ounces of gold were held in COMEX inventory. This is a low not seen since 2005. Of this total, only 812K ounces were available to settle contracts. The rest was held as eligible stocks, suggesting a preference by the owners for physical gold rather than making it available to settle futures contracts.
As a result, the COMEX exchange participants have a problem. They do not have enough gold to cover the 42.5 paper claims per 1 ounce of physical gold they have sold. As you can see from the waterfall in the above graph, others are well aware of that problem and are trying to get their chair before the music stops!
When the music does stop, it is looking increasingly like JP Morgan will be without a seat.
As of last week, the firm had a relatively small and dwindling balance of 462,762 ounces stored with the COMEX. Of this total, 326,362 ounces were registered for delivery leaving only 136,434 in its eligible account. It’s a fair bet that some of those holding claims to this gold will stand for delivery and collect their gold before it is too late!
As a result, JP Morgan has shown signs of desperation. This week, Zero Hedge presented transactional evidence that they have tried to source gold from two fellow bullion banks on the COMEX; HSBC and ScotiaMocatta. Both chipped in with a paltry 26,000 ounces combined.
As unprecedented gold backwardation and negative GOFO signal strong physical demand, there’s a decent chance that COMEX inventories are headed even lower.
Mom … Chavez and Merkel Started It!
In July, Grant Williams, a highly respected fund manager, made an astute observation and offered his thoughts as to why the gold price has fallen precipitously.
Take a look at his chart below. Vertical line #1 shows when, in early 2011, Chavez asked the Bank of England, Federal Reserve and various bullion banks to please return all of Venezuela’s gold holdings.
Vertical line #2 shows when Germany recently submitted a similar request to the Federal Reserve to have their gold holdings returned from vaults in New York.
Grant Williams submits that both these repatriation requests set off alarm bells.
Summarizing his speculation, he feels that the two gold repatriation requests prompted western central banks to sell enough gold futures contracts to knock the gold price down in an effort to recover physical gold at lower prices.
This was necessary because Venezuelan and German gold had been previously leased out and sold into the market. Therefore it was not on hand to honor the requests. In the German case they ultimately settled for delivery over the next 7 years, adding substance to William’s argument.
The important point here is not whether the gold is there or not. It is however just one more powerful indicator of the preference, by the largest market participants in this case, for physical gold held in their possession.
ETF Outflows Indicate The Gold Bull Run Is Over
The above title is an example of a recent Bloomberg title… which states exactly the opposite of facts reported in the article!
For those who don’t get the reference, last week Bloomberg wrote a story titled “China’s Gold Imports From Hong Kong Decline as Demand Slows.”
The article emphasized that a 5% drop in imports over a one-month period (May – June) was THE CAUSE for slowing gold demand. However, the article failed to mention that, even with that 5% decline, the month of June was still the 4th highest import figure ever at 101 tonnes and May’s figure was 40% higher than April’s.
I can’t speak for Bloomberg but I would not describe a net increase of 35% in two months on top of already record import numbers, slowing gold demand. Maybe their crack editorial staff missed it. Then again, maybe they didn’t.
Anyways, the recent ETF redemptions are not signaling the end of the gold bull market. It is actually the exact opposite.
ETF’s are a source of physical gold. Due to the recent steep declines in gold price, reasons for that aside, retail ETF investors in the west have stampeded for the exits to the tune of 650 tonnes or $31B over the past year.
The authorized participants (i.e. bullion banks) of the ETF’s are buying up these shares in an effort to accumulate enough to redeem physical gold from the ETF inventories. Therefore, ETF liquidation is serving as a large source of gold to feed unprecedented demand coming from Asia.
Let’s Get Ready To Ruuuuummmble!
The most significant historical story in the gold market today is arguably the fight between India and China for the gold buying title.
In this corner, in the Orange, White, and Green trunks…India
In spite of a record import duty on gold of 10%, a total ban on the importation of gold coins, and tying imports to export volumes, India remains the number one consumer of gold in the world.
In fact, even after all the government has done to try and suppress demand, gold imports have risen 87% when comparing April through June of this year with the same period last year. And, let’s not forget that the smuggling of gold into India (an amount that can’t be quantified) is also suspected to be at an all-time high.
And in this corner, wearing the red trunks…China
The amount of physical gold flowing into China is simply eye-watering. Even as the traditional leader in gold consumption (India) increases their purchases, China is on track to overtake them and become the largest gold consumer in the world this year.
On the Shanghai Gold Exchange alone, 1,098 tonnes was delivered to buyers in the first six months of this year. Annualized, that is 2,196 tonnes. Take note, annual mine supply after subtracting China’s production of roughly 400 tonnes, which China keeps, is 2,400 tonnes.
In further support of this enormous amount of physical gold flowing into the east are the gold export numbers from Hong Kong. Below is a graph which emphasizes the increase of gold exports into China from Hong Kong over the last two years, already reaching 1,160 tonnes for the year.
The Historical Conclusion
Taking into consideration all of the events highlighted above, we can also add the following to the market madness; a surge in precious metal vaults coming online around the world, the 1,300 tonnes of someone’s gold the Bank of England is rumored to have mobilized, and the record speculative short positions held by hedge funds.
The point of today’s exercise is simply to demonstrate that historic events are underway which are transforming the nature of the gold market. Warning lights and alarm bells are going off everywhere, signaling the change!
From our perspective, given the nature of these events, it is unlikely that tomorrow’s gold market will emerge with the same ownership, supply and demand characteristics as yesterdays. Gold is flowing, in unprecedented volume, into strong eastern hands and it is not likely to return anytime soon.
That’s it for this week.
As always, we include our Comparative Analysis Table for your review. It tracks many important metrics critical to evaluating gold mining companies.
Also, check out the News Corner on our website where we compile and summarize each day’s best news stories related to the gold market, gold mining, and the share markets.