Biff and all.
Very interesting read on the gold price.
Quite complex but a valued read.
Date: Wed Aug 11 1999 08:24
ORO (Is the "final" gold rally coming? Part VII - Distress - more numbers - Fed critique) ID#71231:
Copyright © 1999 ORO All rights reserved
LBMA thinning volumes:
From 35M oz per day in 97 to 27M oz in June ( 3 mo avg ) , down 20%.
Trades down from 1300 per day to 1000 ( 97 avg vs 3 mo avg in June ) , down 25%.
Rumors of thin volumes will be substantiated in the July trade statistics when they are released.
This is a sign of declining trust in deliverability on the paper portion of the trade. Since physical demand is reportedly very high ( 200% to 300% higher in some major consuming countries ) and is accelerating, while paper bids are drying up.
As this is not fully arbitraged into the spot physical market, the contango is getting distorted. The appearance of differential price changes in futures ( weaker ) and spot ( stronger ) is a further sign of the paper bid disappearing.
The lease rate situation:
Forward rates falling and remaining down are once again a sign of any or all of the following: ( a ) bid loss on futures contracts and of ( b ) unwillingness to hold treasuries and other $ debt ( the arbitrage equation contains expected profit from treasury securities and borrowing costs to determine the forward contract's value ) . ( c ) High short term lease rates are a sign of lack of leasing supply or of ( d ) higher risk premiums demanded by the lender or the ( e ) futures buyer ( see a above ) . If leasing was being done in order to put on fresh short positions then the POG should have dropped substantially rather than rising, as has been the case these last few days.
New hedging by indebted producers:
The indebted producers selling forward are also a sign of distress among the shorts ( Newmont was only one of the biggest but not the only one - e.g. micro junior Dayton has eliminated debt and preferred shares outstanding by a forward sale ) . The fact of the debt being a lever over the producer is obvious. That producer debt is being used as such has been rumored often over the past month. It is obvious that a banker exercising this leverage will eventually loose his client. The obvious conclusion would be that the future business of the client is less important to the bank than "something" that will benefit from the sale of gold. The "something" is either a bank short position or the short position of a distressed client of greater importance ( threatens bank equity ) .
Gold warehouse statistics showing that registration for delivery has pretty much eliminated the stocks. I would guess that some of the producers are using the futures market to buy back the gold they sold as they were forced to hedge against their better judgement.
Pressure on weak CBs and institutions to sell:
The squeeze on the Lebanon CB was only the last. The sale of gold by all the small distressed CBs last year and in 97, as well as the pressure on BOE and the IMF are part of the same problem - short exposures are largely short term and have to be rolled over while the supply deficit is approaching the size of another year's production.
Oil - gold contratrend:
Oil prices rising since mid 97 ( with the exceptions of the well known dip this year and in July -Aug of last year ) without gold responding corresponds in time to the decline in LBMA volumes and the appearance of enormous derivative positions in the commercial bank reports to the Fed.
What is the market discounting?
The market seems to be discounting the sale of gold from BOE, IMF ( directly or through the repatriation of the gold to members ) and Swiss sales as a result of the expectation of their obtaining Euro and others selling. The belief seems to be that these sales will limit upside POG exposure in a market that is threatening to tighten. Currently, the possibility of these not coming to market is not being considered fully. Furthermore, the high probability of these supplies not being sufficient to cover demand at this price or at $300 or even at $325 is also not being considered by this price.
A few more numbers from commercial bank reports to the fed to get a better feel for the short position in the gold market:
The data is from Federal Reserve call reports for Q1 99, Kitco and Sharefin's lease data and gold prices.
The notional value for open positions is not all a net short position. The correlation between the lease rates and the notional value and between the POG and the position size indicates that the US reporting banks are net short about 75% of their gold derivative positions. These positions are reported only by insured commercial banks and do not include all other non-insured investment banks. These are about one third the size and would probably raise the short position in proportion to their assets. Thus if say 75% of the reported notional position is short and represents 3/4 of the US positions implies a 5700 ton US short position at end Q1 99 and a 7100 ton US short currently.
Though US banks are the big players in the derivative game, they are not alone. English institutions play a disproportionately large role in the gold market, and Japanese, Swiss, French and German banks probably play an equivalent though smaller part in proportion to their size. Any kind of proportional calculation of equal positions to the US ( comes to 11000 to 14000 total ) and up to double the US position ( 17000 to 20000 ) would far exceed the numbers I have from any other source. ( 10000-11000 tons implied by Veneroso, 14000 to 16000 by my reckoning, 14000 by ANOTHER in late 97 ) , The US accounts for 1/3 of the world total derivatives position.
Another interesting point is the positions of Morgan guarantee and Chase - in particular the disproportionate short term position at Morgan. Morgan has been rumored to be pushing gold miners to hedge by threatening withdrawals of credit lines. Pretty obvious why.
Maturities
$billions 0-1 yr 1-5 yrs over 5 All Change POG change
95Q1 20.4 9.4 1.2 31 382
95Q2 22.8 9.5 1.4 33.7 9% 388 1%
95Q3 28.4 10.6 1.3 40.3 20% 383 -1%
95Q4 35.9 16.1 1.9 53.9 34% 387 1%
96Q1 38.8 16.4 2.4 57.6 7% 396 2%
96Q2 36.5 15.6 1.7 53.8 -7% 385 -3%
96Q3 46.8 15.6 1.7 64.1 19% 383 -1%
96Q4 39.4 17.4 2 58.8 -8% 369 -4%
97Q1 34.2 22.9 2.4 59.5 1% 352 -5%
97Q2 35 14.3 2.9 52.2 -12% 340 -3%
97Q3 44.1 13.6 3.1 60.8 16% 323 -5%
97Q4 42.6 15.4 4.2 62.2 2% 289 -1%
98Q1 39.7 17.7 4.9 62.3 0% 296 2%
98Q2 37 23.5 9.1 69.6 12% 291 -2%
98Q3 40.6 24.3 9.2 74.1 6% 289 -1%
98Q4 36 23.2 9.2 68.4 -8% 290 0%
99Q1 34.8 21.5 8.9 65.2 -5% 285 -2%
Converted to tons through dollar position change relative to price
Tons gold 0-1 yr 1-5 yr 5- yrs All Change Gold change Lease rate
95Q1 1,660 765 98 2,523 382 1.2%
95Q2 1,853 773 114 2,740 9% 388 1% 1.7%
95Q3 2,308 862 106 3,276 20% 383 -1% 3.0%
95Q4 2,910 1,304 154 4,368 33% 387 1% 2.7%
96Q1 3,138 1,328 193 4,658 7% 396 2% 2.0%
96Q2 2,952 1,263 137 4,351 -7% 385 -3% 1.5%
96Q3 3,788 1,263 137 5,187 19% 383 -1% 2.3%
96Q4 3,164 1,415 162 4,741 -9% 369 -4% 1.8%
97Q1 2,705 1,901 197 4,803 1% 352 -5% 1.7%
97Q2 2,778 1,114 243 4,135 -14% 340 -3% 2.5%
97Q3 3,654 1,047 262 4,963 20% 323 -5% 3.3%
97Q4 3,493 1,240 381 5,114 3% 289 -1% 1.8%
98Q1 3,188 1,482 454 5,124 0% 296 2% 2.2%
98Q2 2,899 2,102 903 5,904 15% 291 -2% 2.0%
98Q3 3,287 2,188 914 6,389 8% 289 -1% 1.7%
98Q4 2,794 2,070 914 5,777 -10% 290 0% 1.7%
99Q1 2,663 1,884 881 5,428 -6% 285 -2% 1.5%
99Q2 My Estimate correlation 7,351 35% 262 -8% 2.1%
TABLE 9 NOTIONAL AMOUNT OF OFF BALANCE SHEET DERIVATIVES CONTRACTS BY CONTRACT TYPE & MATURITY FOR THE 7
COMMERCIAL BANKS AND TRUST COMPANIES WITH THE MOST OFF BALANCE DERIVATIVE CONTRACTS
MARCH 31, 1999, $ MILLIONS
NOTE: DATA ARE PRELIMINARY
GOLD All figures in Tons at $300 gold
RANK BANK NAME & STATE
ASSETS DERIVATIVES ( $millions )
MATURITY 0-1 YR 1 - 5 YRS 5+ YRS ALL
1 CHASE MANHATTAN BANK NY
291,476 10,383,902
779 1,137 543 2,459
2 MORGAN GUARANTY TR CO NY
184,314 8,248,677
1,109 390 64 1,562
3 CITIBANK NA NY
304,316 3,384,165
307 223 224 753
4 NATIONSBANK NATIONAL ASSN NC
317,268 2,624,328
- - - -
5 BANKERS TRUST CO NY
98,919 2,516,510
304 182 80 566
6 BANK OF AMERICA NT&SA CA
250,700 1,823,487
- - - -
7 FIRST NB OF CHICAGO IL
68,940 1,329,058
7 - - 7
TOP 7 COMMERCIAL BANKS
1,515,934 30,310,127
2,505 1,931 911 5,348
OTHER 432 COMMERCIAL BANKS & TCs
2,691,361 2,161,031
1,099 294 9 1,403
TOTAL FOR ALL 439 BKS & TCs
4,207,295 32,471,157
3,605 2,226 920 6,751
Data source: Call Report, schedule RC-R
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Fed support of the gold banking system:
Fed papers such as the one I reviewed lightly here last week and the issues they address more so than their conclusions, indicate that the Fed is interested in minimizing the long term price of gold and assuring a steady long term supply of gold.
1. Though the stated goal is to assure "private market depletion uses", when viewed from the angle of the oil for gold deal, the assurance of long term supply for oil should be viewed as the actual goal.
2. The simulations come to a few conclusions that are obvious ( and wrong!! ) without the heavy math. Namely, ( a ) that to assure long term supply to trade for oil, it is necessary to close down as much of the mining as possible today so as to preserve the resource, and ( b ) make available to the market all aboveground supply that the CB controls. The sale or lease of the gold ( i.e. item b ) would depress the price and close the mines. ( c ) The leasing program is expected to provide items a and b while increasing the final gold quantity held by the central bank.
3. In any case, the gold price is expected to be much higher into the next century.
4. The gold mining industry is expected by the Fed to shut down much of its production in this and the next year.
5. Mine reopening is expected by the Fed to occur in 2008.
The simulations are wrong because of the basic misunderstandings of all issues but one - that gold price falls when supply is added. ( For which conclusion one needs not do a PhD dissertation. )
Critique of the assumptions underpinning the article are given in the re-post at the end of this text.
Comments on the expected events because of the backfiring of the program.
The gold banking and trading system has managed to finance gold mine capital investment over the last 20 years ( particularly since 1985 ) through forward selling of large portions of new and current production and financing capital below 1% ( as against 8-10% for all other industries ) . The oil for gold view is that the intention was to assure an oil supply by selling the future gold production at a lower cost to oil producers than could be obtained by bidding on the open market for current production. Therefore, oil producers agreed to forward sell their production as well, and thus kept oil prices low while raising market share.
( 1 ) The market structure interposes the banks between the buyer and the mine, thereby reducing mine's power over both supply and price. Forward selling dictates future supply, price, and the destination of the product ( oil producers ) . The paper obligations of the banks are perceived to be backed by a leasing supply at the CBs. This provides the confidence in this paper and the premium bid for it ( always above current spot price and at the arbitrage limit, until recently ) . During the process CB gold must be owned directly or indirectly by oil until the obligated future supply materializes.
( 2 ) If at any time this CB backing is deemed lacking in either commitment or ability, the premium gold bid is taken out or reduced. A crisis of confidence would also cause the bid for physical to increase at the same time. The significance of this is a shift from deferred buying to physical buying without much reduction or increase in overall demand. Parallel to this would be a halt in the selling of future oil production resulting in an oil price increase. The end result is that the bidding at the physical side of the market is imperfectly arbitraged into the much larger deferred trading. The shift of the bid causes the disappearance of the forward premium ( low to negative forward rates ) is translated into a high lease rate. At this point the miners stop rolling over their hedges. This, in turn, results in reduced colateralized CB leasing to the market and raises prices.
( 3 ) Since this deferred trading dictates the price due to its larger portion of the market ( though it seems to have fallen ) , the loss of the oil bid for deferred contracts would manifest in a temporarily low POG as long as physical supplies last. Since the low POG forces the mine closures desired by the Fed as its duration is extended, alternate supplies are coaxed into the market by whatever means possible ( political pressure, economic pressure, and threats on indebted gold holders and suppliers ) .
( 4 ) Once the CB gold has begun being tapped out ( as I have previously shown should be the case at this point ) , there would be a mad scramble to borrow the remaining available gold, even at higher lease rates. Once these are tapped out, there would be direct buying of gold from the market and from producers. At this point in the progression there would be a price spike that may be enormous if some of the CB sources decided against further lending ( as is ECB policy ) and no more gold sellers can be squeezed.
( 5 ) If there is an oil for gold deal, by this point oil would rise and the dollar would be falling, and treasury rates rising as the transfer of the oil bid into the physical market induces those who are aware of the oil for gold deal to understand that oil will no longer be bought by dollars.
As this starts there should be military threats by a US proxy against some oil producers as well as military posturing by whomever it is that takes the part of protector of oil if the US is unwilling to do so without issuing the oil settlement currency. Right now it looks like China is playing for the role.
( 6 ) The danger of a price spike in gold during the leasing period of the program can destabilize the banking system and drive some institutions into receivership. All the government gains projected in the program would be lost in a bailout of the institutions affected.
Where the program backfires is in the fact that low POG causes quicker depletion rather than slower depletion of the resources. ( 1 ) Mines typically have a main ore body of, say, 80% of reserves at a low grade 0.02 to 0.05 ounces per ton, and a small rich ore body or vein at a much higher grade of anywhere from 0.1 to 0.5 oz/ton extractable at a much lower cost of 50% to 10% of the main ore. ( 2 ) The mine can process a fixed amount of ore in any period and has an inflexible fixed cost structure - some miners have lowered this by eliminating staff, exploration, and reducing maintenance. ( 3 ) Thus total income is the price obtained for the gold production from each ore in the processed mix less the fixed costs. ( 4 ) As prices fall higher production rates are required to maintain total income. So more high grade ore is used ( high grading ) and the richer ore is depleted, raising the price at which the remaining potential mine production may be obtained by 20% to double or more and reducing mine life appreciably at any price.
Interesting items to note:
1. Gold is expected to be depleted completely by 2030 ( what hokum!! ) . - wonder what price that'l bring.
2. Returns from reinvesting capital freed by gold sales ( not leasing ) is thought to earn an interest rate providing a higher real return than the capital appreciation in the gold price ( as a result of scarcity ) . I wonder what kind of idiocy brings people to put the results of such bogus simulations in front of the bankers. The gold market dynamics will lead to a price spike of enormous proportions the moment gold is known to have mostly exited the CB vaults. The selling governments will be locked in a scandal that would make Watergate look like a minor peccadillo.
3. They believe that only 150000 tons will ever be available aboveground.
4. The "constant dollar" POG after a liquidation of CB gold is thought to slowly rise by 25% or so over the next few decades. What a joke.
Date: Tue Aug 03 1999 15:05
ORO ( @Isure - post of Fed papers - Merton Scholes Markovitz and Sharpe in action ) ID#71231:
Copyright © 1999 ORO All rights reserved
As an illustration of misapplication of a weak theory guiding the CBs I want to show the following Federal reserve paper and the intro to the analysis that underlies its findings. First a quick critique.
1. The obvious fact that gold is money - a competing currency - is being ignored in the paper. Particularly the role of money as a portable store of value is ignored i.e. the non-working asset aspect of money. This aspect has never been addressed by the "great minds" above.
2. Ignored as well, is the actual cost structure and economic dynamics of the gold mining industry.
3. The paper, by ignoring ( 1 ) above compounds the error with a reverse interpretation of the vast majority of private gold holdings, referred to as "service stocks" in the paper. The paper views the private stock as a direct financial investment that is justified by the returns achieved through capital gains on a continuous basis and a return on the lent asset. The financial "insurance" value of private gold holdings is not taken into consideration at all.
4. Furthermore, by ignoring the latter aspect ( 3 ) , the gold demand is estimated incorrectly, since they do not see that anyone with their heads outside the "asset pricing model" would happily buy "insurance" at a growing discount, and would buy the store-of-value equivalent of the Mona Lisa at a distressed price.
5. The hooey and baloney conclusions as to maximizing the private sector and CB ( government ) benefits through the lending of CB gold stocks with an eye to reducing "excess current production of a depleting resource" ignores ( 2 ) ( 3 ) and ( 1 ) . The accumulation of store-of-value gold in private hands is a one way street, only a tiny portion of it comes back into the market, and then only at exponentially higher real prices. The practice of high grading has reduced possible future production and availability of gold at any future price, thus voiding the desired results for the private depletion uses.
6. The investment return model is extremely flawed because of two flaws, first is the assumption that any substantial amount of gold at all will be returned to the lending CB; second assumption is that the selling CB will not find itself forced into buying gold in the market at the substantially higher price due to economic necessity and a much reduced future supply.
7. Ignorance of ( 1 ) and ( 3 ) leads to a further misunderstanding of gold demand dynamics whereby the demand rises at a greater than linear rate with the falling price, and rises steeply when economic or political turmoil makes the financial markets doubt CB actions would be responsible, or political unrest eliminates all value of the currency of the country at risk.
8. Market dynamics, though addressed in a light fashion, are presented incorrectly, since the purely financial aspect of artificially low gold lease rates encourages a carry trade that must end with default since supply breaks down and the investment consumption is not returned to market. Thus the impact on the private market and CBs of the damage to the banking system as a result of the inevitable default is not considered.
The leasing scheme suggested as a way of both eating most of the cake and keeping most of the cake is most likely to result in loosing all of the cake and eating none of it.
Wayne Angel's remarks of late concerning gold seem to be based on the line of thinking presented in this paper. He will be pilloried if he had a hand in putting together this disaster in the making.
-for charts and complete text view
federalreserve.gov
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