Hello,
FWIW.....
this might help put things into better focus :-)
9:40p EST Friday, February 18, 2000
Dear Friend of GATA and Gold:
Here's another important essay by John Hathaway of
Tocqueville Asset Management, who, you may recall,
has called exactly the turns in the gold market since
last September. Hathaway writes that the gold market
has turned strongly bullish and that a four-digit price
of gold is quite possible as a result of forces already
in place, without any world financial catastrophe.
The essay as posted at the Tocqueville web site --
tocqueville.com
-- contains a chart that I can't reproduce here, so you
may want to check it out directly on the Internet.
In any case, please post this as seems useful.
CHRIS POWELL, Secretary/Treasurer
Gold Anti-Trust Action Committee Inc.
-----------------------------------------------------
APOCALYPSE NO
By John Hathaway
www.Tocqueville.com
February 18, 2000
The rapid pace of developments in the gold market
prompts this summary of key milestones and their
status:
Central Bank/Official Sector Selling: no longer a
threat. Washington Agreement limits amounts to
manageable numbers over next five years.
Central Bank Lending: Washington Agreement caps lending
for 85 percent of official sector gold.
Mine Company Hedging: Widespread announcements by all
of the largest hedgers suggesting that this source of
supply will dry up this year.
Positive Swing in investor sentiment: Very early stages.
Contraction of bullion bank/producer hedges: In process.
Financial asset bear market: Sooner or later.
Apocalypse: Not yet.
Implications of Producer Announcements
There has been rapid and substantial progress in gold
market fundamentals since September 1999. The
oversupply issue that has plagued the gold price for
years has been dispatched. The supply/demand equation
in the gold market is far brighter than the gold share
or bullion markets have recognized. The largest hedgers
have made recent statements that effectively forswear
additional hedging or have been eliminated from the
game by other circumstances.
(CHART HERE)
These producers account for approximately 55 million
ounces (about 1,700 tons) of forward sales (net of
puts) and, for the most part, represent the most active
hedge programs that bullion banks could rely on for their
flow of physical metal. Their aggregate hedge position
is roughly half of the entire industry. As a group,
they will produce 19-20 million oz in 2000. Based on
recent management statements and on the assumption that
Ashanti will be forced to deliver into its hedge book,
it appears that 11.2 to 16.7 million ounces or 350-500 tons
could come out of mine supply this year. Compare this
to the Goldfields Mineral Services (GFMS) forecast of
an additional 150 tons of forward sales in 2000. The
GFMS forecast forms the basis for the much of the
expectations of the bullion dealing community, which is
why it is pertinent.
Instead, it is likely that forward sales will be negative this
year, a 500-650-ton variance from the GFMS expectation.
Last year, according to GFMS, producer hedging
represented 445 tons of gold supply. The potential
shrinkage of gold supply due to this single factor is about
850 to 1,000 tons, a reduction of 21-25 percent vs. 1999.
The shortfall in supply from hedging activity could be even
greater if other producers with hedge books decide to
follow suit.
All of this assumes gold prices stay in the low $300s.
Higher prices will likely lead to rollovers of hedge
positions, but then again, much higher prices would be
a happy tradeoff for diminished hedge book reductions.
A significant shrinkage of new physical gold for
hedging strikes me as big news and a reason to expect
considerable distress among bullion dealers this year.
The Coming Short Squeeze
Bullion dealers are short gold but may not be aware of
the extent to which they, as a group, are short. Their
basic transaction is to borrow gold from a central bank
and to cover that short position with a contract from a
gold producer to deliver the same amount of gold at
some time in the future.
A significant percentage of these contracts have maturities
in excess of one year. Most of the contracts between
dealers and their mine suppliers do not have tight margin
positions. For example, Barrick Gold is not required to
provide margin unless gold exceeds $800. The dealers
appear to believe that ounces of gold in the ground to be
delivered at a future date constitute a reasonable
substitute for physical gold that could be delivered
immediately should the central banks ask for their
gold. Their reasoning in all likelihood did not
contemplate a situation in which gold prices spiked
$100 or more, with little promise of retracing.
However, most of this business was booked when central
banks were viewed as non-stop sellers/lenders and
mining executives could easily be panicked into hedging
to save their companies and jobs. Oops!
Bullion dealers make their living by intermediating the
physical gold and paper gold markets. For example,
Barrick Gold recently purchased calls on 6.8 million
ounces for this year and next in order to tweak its
hedge book toward a positive correlation with gold.
Bullion dealers wrote or sold these calls with a strike
price of $319 for 2000 and $335 for 2001 in return for a
premium of $68 million, or $10 per call. The transactions
occurred mostly during the fourth quarter of 1999 when
gold was trading in the low $290s. Without delta
hedging, the bullion dealers would be short 6.8 million
ounces of gold once the price exceeds the strike levels
during the next two years.
However, once Barrick bought bullion dealer paper, the
dealers bought gold (delta hedged) according to a
mathematical formula. This position represents a liability
of more than $2 billion for the bullion dealers. There is a
very short list of names, most likely Goldman Sachs (J.
Aron), Deutsche Bank, and J.P. Morgan, that would have
the necessary credit standing to do this trade.
What is interesting about these options for the dynamics
of the gold market is the delta hedging they require. A
delta hedge is simply a mathematical formula that dictates how
much physical gold must be bought or sold relative to the paper
option. In general, the closer in time or price to the strike
price/expiration date of the call or put, and the greater the
volatility of the metal, the greater the amount of physical gold
the dealer must buy (call) or sell (put). The actual amounts to
be bought or sold are dictated by a mathematical formula
known as the Black Scholes model. The dominance of
computer-generated orders in an essentially illiquid market
is the reason that the out-of-balance, bearish market posture
of the bullion dealers will lead to a series of major spikes
in the gold price. Aside from their contributions to option
theory, one of these gentlemen, Myron Scholes, is also
well known as a prominent partner in Long-Term Capital
Management, a high-profile hedge fund disaster that employed
his model. It is certain that Scholes' model has nothing to
say about the proper ratio of option paper outstanding to the
liquidity of the underlying commodity for which it dictates
buys and sells. Therefore, look for brief periods when the
physical markets cannot accommodate computer-generated buy
orders at any price.
In Barrick's case, the initial delta hedge was about
2.1 million ounces. But since those calls were written,
the price of gold rallied momentarily into the low
$320s, causing a considerable amount of forced buying
in a short time. As the price has backed off, there has
been forced selling. The day-to-day behavior of the
gold price is very often exaggerated by this kind of
dealer hedging activity. While the supply of paper
gold has stayed constant or increased, the flow of
physical gold available for delta hedging activities is
declining sharply. The two sources of liquidity in the
physical gold market have been 1) central bank selling
or lending and 2) forward selling by mining companies.
Official sector supply has been capped, perhaps
imperfectly, by the Washington Agreement. Mine
hedging will be a big negative factor for supply this year.
In light of these considerations, the ability of the
physical market to accommodate the buying or selling
mandated by the delta hedge formula is questionable. The
London Bullion Market Association recently reported a 22
percent decline in physical trading activity for the first
month of this year.The average value of gold transfers fell
to $6.3 billion from $8.1 billion in December. If this acute
decline in physical trading volume continues, it is not
hard to imagine the wheels coming off of the bullion
dealer's machine.
Bullion dealers conduct extensive due diligence before
committing to hedge contracts with mining companies.
Mine company fundamentals are carefully scrutinized in
order to assure all involved that the transactions seem
responsible and conservative from a risk/ reward
perspective. Why shouldn't the reverse be true?
However, in choosing to conduct business with a
particular dealer, mining executives are not permitted
to examine their counterparties in the same fashion as
they had been undressed. They must depend on the
notoriously unreliable rating agencies. It is doubtful
whether rating agencies have been granted access to
analyze the derivative positions of the bullion dealers
or their parent institutions.
Despite the opacity, surely all risks are being
conservatively hedged. Wasn't this the case for
portfolio insurance in 1987 or Long-Term Capital
Management in 1998? The rationale for the credit and
confidence necessary to conduct the bullion trade,
especially in the highly leveraged versions that
prevail at the moment, no longer makes sense. The
attraction of leveraged financial structures based on
the borrowing of physical gold seems increasingly
dubious. The reliable aphorism among bullion dealers,
that the safest hedge against one option is another
option, is ready to be scrapped.
Capital and credit are on the verge of evacuating the
gold derivatives arena. In the last five years this
trade has augmented the supply of physical gold to such
an extent that it has driven gold prices well below
their equilibrium levels by $100 to $200. Prior to
1996, when the supply of paper gold via bullion dealers
became a torrent, gold traded regularly in a high $300
to low $400 range. The subsequent explosion of gold
derivatives was an aberrant credit excess that
exaggerated the downswing in gold. Should a shrinkage
of the bullion trade coincide with an improved macro
economic outlook, gold could rise far more in a short
time than anyone positioned as a short could possibly
contemplate.
The recent call purchase by Barrick is not the whole
story by any means. For example, at last count, the
Australian gold industry had written calls on 7 million
ounces. Ashanti's hedge book contains 3.5 million
written calls. Certain smaller producers have been
known to write calls in order to meet the payroll when
gold prices were lower. Other than the calls written for
Barrick, it is impossible to get a picture of the
dealer hedge book option structures. Our conjecture is
that the bias of the aggregate dealer hedge book is
still bearish. Should the dealers who wrote the
Barrick call options wish to insure themselves by
themselves purchasing calls with higher strike prices,
it is safe to say that the credit rating of the dealers
writing the new options would be no match for their
own.
The dealer hedge position was built over three to
five years. It cannot be reconfigured easily. For
example, the problem-ridden Ashanti hedge book is in
worse condition today than when it was initially
understood to be a problem four months ago. If it were
easy to fix, it would have been done by now. Instead,
it is more in the red today, $400 million estimated,
versus the less than $200 million in the red four months
ago, both figured at today's gold price. This is even
though the book has been under the supervision of a
syndicate of bullion dealers who have much to lose if
the price of gold moves sharply higher.
The bullion and the gold share markets have yet to
recognize these changes. Gold prices have barely risen
over the last year. The $50 (25 percent) rise from the
August lows is no more than a weak snap back from a
severely oversold position. Gold shares have fared
more poorly. In the past year, gold is up 7 percent while
the XAU is down 2 percent. Skepticism tends to peak
well after a major low, which in gold's case was established
in August 1999. The laggard behavior of the shares
relative to the metal is classic bull-market action.
Investment Demand And Apocalyptic Considerations
A short squeeze caused by a contraction of credit among
and for the gold intermediaries, the bullion dealers, is on
the horizon. Demand far greater and longer-lasting than a
short squeeze will come from investors seeking inflation
protection or diversification from financial asset exposure.
In addition, further liberalization of Asian and other
emerging market economies will broaden and deepen demand.
On their recent conference call to discuss quarterly
results, Anglogold management discussed the positive role
played by market liberalization in stimulating gold demand.
If mainland China's bullion market is liberalized, a
possibility this year, incremental demand could be 600
tons in the estimation of management, which is working
with Chinese authorities towards this goal. The World
Gold Council has just announced a 21 percent increase
in gold demand vs. 1998, which was depressed by the
Asian meltdown. More significant is the 7 percent gain
over the previous peak in 1997.
In a recent conversation, a bullion dealer mentioned to
me that investment psychology was beginning to change
in the Indian and other important Asian markets.
Following the runup in September, this dealer stated that
three or four weeks went by without selling "even a
kilogram" of gold compared to his normal volume of 1
ton per day. Buyers stepped away expecting to see the
price fall back to the old lows.
Three months later, expectations have changed. There
is greater confidence that the gold price is no longer
a purely downside proposition. Physical buyers in Asia
are now willing to step up to gold prices in excess of
$300. Still, each new rise in the price of gold is
being greeted with cries from the bearish camp that
physical demand is falling away. But the bullish case
for gold calls for the crowding out of physical buyers
by short covering and investment buyers.
GFMS once estimated the entire stock of gold to be
130,000 tons. This includes central bank gold, private
holdings, jewelry, and museum exhibits. The total
includes King Tut's mask, the crown jewels of England,
and similar artifacts. Also included are the bullion
holdings of parties to the Washington Agreement, which
account for 85 percent of world gold monetary reserves.
Only a small percentage, perhaps 15 percent, is available
to be mobilized at any given moment to satisfy market demand.
At market, the gold "float" approximates $150-$200 billion,
less than the market capitalization for many equities. Gold is
a currency, a monetary reserve, asset and a credit instrument
in the way it has been used by bullion dealers. Once investors
come to realize that the secular low was put into place last
August and that a new uptrend has been established, a
rising price in itself will cause demand to increase and supply
(the willingness of holders or producers to sell) to decrease.
Macro-economic factors, which could liberate investment
demand for gold, can be loosely grouped under the
banners: inflation in the pipeline; synchronized world
economic strength; and an impotent Fed. These incipient
speculations could transform non-existent investment
demand into a powerful force. The traditional positive
case for gold has been characterized as laden with
irrational cataclysmic forecasts. It would be a
mistake to make the same assessment at this juncture.
Apocalyptic expectations are unnecessary to project a
dollar gold price that includes four digits. It will
require only the inevitable unwinding of bearish
producer and dealer hedge structures amidst a change
of market perceptions on the desirability of financial
assets.
-END-
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