Perhaps the most important comments you will recieve as an indirect Barrick shareholder and as a direct Junior Gold participant.
By James E. Sinclair, Chairman & CEO
Tan Range Exploration TNX
jes108@aol.com
As we follow the yellow brick road of gold derivatives we seem to entering the financial land Oz. We need to examine comparisons between what occurred in the Derivative market for electricity and what might occur in the Derivative market for gold.
A Derivative is defined as a trading item derived from an underling asset. The first gold derivatives are futures. That means the first financial entity derived from gold. There is inherent financial strength in the first derivative, the listed futures markets, because they are reasonably guaranteed by the existence of a clearing house function, known statistics of price and volume plus regulations. As we move into second and third derivatives the air of the exotic mathematician enters the equation. So does the feeling that we are in financial land of Oz.
We have already described these advanced derivatives as financial creations to you characterized by their nature of;
Unregulated,
Non Transparent,
Without a clearinghouse,
Dependent entirely on the balance sheet of the grantor as to performance
Without rights of offset,
only to mention a few of their less than desirable characteristics.
The primary similarity between the derivative market for electricity and the derivative market for gold is the fact that the underling volume of trade in the basic asset electricity and basic asset gold is the smallest of all popular trading items upon which has been constructed a large modern derivative market.
You can simplify your understanding of the strength of a derivative vehicle by accepting the axiom that the more volume that is traded in the underling asset the stronger will the derivative in that item be. Therefore the least likely derivatives to fail would be those on interest sensitive items, currencies and equities. The most likely to fail are those on electricity or gold.
Now we come to two interesting facts concerning Enron. You can track the beginning of Enron's end to the end of the Bull Market in electricity. The second and most important fact is that it has been reported that Enron hedged with itself. However no one so far has outlined why Enron hedged with itself. Finally we know that Enron set up a maze of partnerships that appeared independent but were not.
We are working our way toward the relationship between Enron on one hand and the Gold Derivative/Gold Banks on the other hand. It should be kept in mind that the derivative market for gold is a phenomenon of the 90s. That in the 80s this market was practically non-existent.
Now let us paint a scenario that only an arbitrageur could. If someone less then ethical or legal wanted to start a market in electricity in a derivative form they would need to establish what we shall call foundational transactions.
In order to do this they would;
1/ Organize a group of partnerships which would be given different names, different partners, different capitalization and addresses. These partnerships would appear independent but would in fact be controlled.
2/ Then organize a number of people to act as members of the independent partnerships parceling them out one at a time to appear to manage each of the independent appearing partnerships.
3/ Then one master trader with a singular derivative program would create many trades of different kinds and varieties of derivatives handing them out to say 12 partnerships.
4/ Each partnership would be given transactions that represented different views. Some would be bull, some neutral and other would be bears.
5/ If you examined any one of these partnerships you would see real risk giving the appearance of a real market. However if you looked at all the partnerships on one singular spread sheet the entire group of partnerships are totally even without any risk.
Could the gold derivative market's foundational transactions have been created by the same procedure? We shall see.
After you have done the above, any partnership can trade with a non conspiratorial dealer. All that needs to be done at night is that the conspiratorial group's master trader writes trades and distributes to the entire inside group transactions that return the conspiratorial group to even. The commissions that the group receives are enormous and hidden in the spread. That means the prices paid for derivative instruments includes points for the partnership. All this will stand up until one thing happens. A significant change in trend results in a need to close and reverse position which is by definition impossible.
Therefore, if Enron did this, they would have been making a fortune in trading derivatives in electricity until the bull market in electricity failed, thereby giving birth and acceleration to the bear market. Enron started its collapse when the electricity market changed trend and reversed direction. This could be the real Enron story. In such a situation the foundational derivative position would then failed to function financially because it was a paper construct. Thus the entire market melts down. Bankruptcy occurs but those in conspiracy have made huge commissions and taken profits out the back door of the failed entity in salaries, expenses and bonuses.
The entire mess is so huge, complex and confusing that the conspiracy is never defined. The conspirators laugh all the way to the bank. No one will know what really happened unless all of partnership and their transaction are audited as one spread sheet.
Is it possible that the end of the bear market in gold, which we have certainly feel has occurred, is the beginning of the demise of the financial integrity of the gold derivative and therefore many of the gold banks. We shall see but there is a great deal of reason to suspect the financial integrity of the instruments.
Thanks to Reginald Howe all the information you require to keep yourself abreast of the size of the total commercial bank position in the gold derivative market is available on his web page www.goldensextantcom. Mr. Howe has even provided the hyperlink required for direct access to the facts and figures.
Dr. Schultz (www.hsletter.com) has outlined for you the exact position of all the producing gold companies short spread position. This will be continually monitored for you in the Harry Schultz Letter.
All these figures are as of the latest reporting period with new figures due shortly.
Total Gold Producers Short Gold Spreads as reported in HSL are 97,446,190 ounces which is today worth USD$30,344,743,566.00. This represents two years full production of all producing gold mines. However this figures represents only 13% of the value of the total Gold Derivative market according to the Bank for International Settlements Yes, the total size of the G 10 commercial banks derivative positions is valued by the BIS at a lower gold price than today at $218,000,000,000.00. Harry Schultz & I will pains takingly examine the figures in order to offset longs against shorts to render a better figure for you.
The commercial bank net short spread position will, in our opinion, represent a net position of 100,000,000 to 200,000,000 ounces in short gold spreads. Regardless, it should bring the total short spread position to net short of an at least a total of 3 to 4 years production. We hope that will be the final number but stay tuned as we diligently work to provide you with the real gold picture.
The notional value is the value that a derivative such as a call is determined if you multiplied the price at which call is written times the ounces for which the call was written. For instance if you had a call on 100 ounces of gold at $325, the notional value is $32,500 but the call may have cost you only $2000. Our calculations indicate to us that at $354 every derivative on gold will reach its notional value. Therefore you can say that notional value will become real value because the call is exercisable by the bull interest in this case. For those that argue this $354 price, please remember that if gold for delivery one year out rises the price of gold every year out also rises but to a larger degree.
Therefore we conclude that;
1/Notional value becomes real value at the average price of gold over the past five years plus the average catango (a condition that exists when cash gold sells at a lower price than forward gold is called a catango) when it becomes the market price. In the most practical sense, knowing the inside of this market, the price of gold at which notional value of all present gold derivative becomes real value at $354 gold.
2/All derivative dealers maintain software programs for risk control. When I ran an arb, I & my partners determined what risk percentage of nominal value we would permit as we pursued our arb business on any given item such as gold, silver etc. I was never interested as the proprietor in each trader's position. What I watched was the entire house position. Risk control programs vary from gold bank to gold bank but the computer mathematical logic is the same. All gold hedges are short gold spreads (a spread is a long position against a short position). For the gold producers it takes many different forms but is basically the same logic. A producer could simply sell deffered delivery gold against gold in the ground as an example.
By our calculation as gold closed over $305 the risk control programs began to call for increased longs to offset the short in the short gold spread. This explains the strong action in gold over the last two weeks. It also explains the absence of the gold cartel right now. If they were in to sell now they would be buying from themselves on their risk control programs. This maintains the risk exposure fixed at a predetermined level for the arbitrage dealer gold bank. At $354 gold, the risk control programs will call for one ounce long for every ounce of gold short. The gold producer hedges at 97,466,190 ounces industry wide.
These producer positions have been laid off (a term meaning trade to) to the subsidiaries commercial/investment banks called gold banks that in turn lay off the long side by selling into the various paper gold items from Comex and London deferred to derivative of third and fourth forms. The skinny is someone will be buying 97,466,190 ounces or going quite broke at gold $354.
As a professional trader in the gold market for a total of 43 years experience, allow me to assure you the gold market is in the hands of the bull today. It appears to me as if Hung Fat and Dr. No have the producers and what I call "Wise Guys" by the neck. Anyone who thinks there is a public in this market knows nothing about gold. Gold never leads the commodity market, it follows it.
I would like to call your attention to what I see as the real risk to the gold producers:
The present vehicles used by the gold producers has produced a total short spread position of 97,466,190 ounces worth today USD$30,344,743,566.00 are:
1/ Unregulated.
2/ Non transparent.
3/ Traded in private treaty.
4/ Without reporting of trading statistics.
5/ Without the ability for the gold producer to lift legs of the spreads independently
6/ With a requirement that changes or closures must be made only at the gold bank that granted the short gold spread.
7/ Without a right of offset between the gold producer and the gold bank.
8/Priced by computer modeling, not market forces of supply and demand.
9/Without a clearing house facility to give a reasonable guarantee to financial performance.
10/Granted generally by subsidiaries of the well known investment or commercial bank.
11/ These subsidiaries generally do not publish balance sheets. It appears that for SEC purposes all which is required for a subsidiary is reporting if or not they comply with capital requirements in area of their domiciled if there is any.
12/Those that do publish financial figures usually do not give figures for total derivatives to which they are obligated to.
13/These subsidiaries have no automatic guarantee for their trade debts in case of bankruptcy
14/These subsidiaries are generally not domiciled in the USA.
To the short spread positions of the gold producers of 97,466,190 ounces, you must add at least a short gold spread position of that same amount or larger for what I call the "Wise Guys." The "Wise Guys" are traders in the market without a commodity hedging reason to be there.
They are the gold lease boys that use the funds for other than mining purposes and the carry trade gang who seek to profit as gold bears while capturing the difference between cash gold and forward gold in unlisted markets.
In my opinion, at $354 gold the foundational transactions of the gold derivative market could be tested. The melt down could then in full swing. We shall see as the gold market is no longer in the hands of the bears. The bears have lost their death grip on gold, if or not they know it. Be prepared for the arrival of central bank selling. The Cartel is neutralized by the risk control programs as buyers. I suspect that the next arrival of large cartel selling in gold will be hours before some central bank announces a large sale of gold. Expect the market to pull back but not as much as expected. Then Hung Fat and Dr. No will oversubscribe the auction and away we go on the upside for the price of gold. This will mirror the events of 1978, 1979 & 1980.
Both the junior exploration and development company plus all producers from modest to major who have hedge position will be placed in dire to uncomfortable conditions. Junior exploration and development companies with percentage deals with the majors are in as much and more danger than a major gold producer with a war chest of money.
Every junior exploration and development company subordinates their percentage of the property to the means of creating the loan which included full recourse to the derivative position taken by the major to produce the non recourse development loan. I believe when the cash call comes because of the derivative melt down the juniors will have to hand over their percentage property position to the major. This is why Harry advised and I have taken TNX towards the royalty route which has no exposure to the derivative of the major.
The non gold related people in gold derivatives, "Wise Guys", will be pulled down in whatever entities they are dealing if the melt down occurs. Balanced positions or even bull positions are no protection for the gold producer dealing in the gold derivative market today. If a melt down occurs gold producers who have no rights of offset in their contracts with the gold bank will be in serious difficulties regardless of their position. They will in the ensuing bankruptcy lose their credits and have to pay up on debits.
The gold producers should certainly ask themselves why they remain in gold derivative positions even if those positions are balanced when major traditional dealers exit the marketplace. If Credit Suisse First Boston and Rothschild's as example are expunging derivative contracts from their book, why does a gold producer take comfort holding such items? We are in a gold bull market and the gold equity or convertible bond financing window is open. The gold producers should either replace the non recourse gold loan with traditional financing or take recourse to the company on all development loans in order to expunge all derivative contracts now. |
