Fair Use, etc., [Emphasis Mine] Interesting POG projection herein, thank you very much Alex<ggg>
Apocalypse No
By John Hathaway
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% of official sector gold.
Mine Company Hedging: widespread announcements by
all of the largest hedgers suggesting 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. [Music to my ears!] The largest
hedgers have made recent statements that effectively forswear
additional hedging or have been eliminated from the game by other
circumstances. In alphabetical order:
Company Hedgebook (mm oz) Status
Anglo Gold
(inc. Acacia) 16.3 Up to 4.7mm oz decrease in ?00
Ashanti 9.0 1.5mm oz. (100% of production)
Barrick 9.8 No increase in ?00/could decline
JCI Group &
Related 4.3 Under new management; being dismantled; 2.0mm oz. (est.)
Normandy 7.7 1-2mm oz.
Placer Dome 7.3 2mm oz.[It would appear that the "throng of 6" now is a Throng of 7 as Western Area's Two Panic Buy Ins in the physical market is "missing" from Hathaway's sparse "throng enumeration" above]
These producers account for approximately 55 mm oz (about 1700
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. [that is to say, back into relic containment facilitities for decontamination aka "vaults."] Their aggregate hedge
position is roughly half of the entire industry. As a group, they
will produce 19-20mm 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 mm oz or 350
to 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. [Good, Glad you 'plained that, John. Always wondered what GFMS was good for] Instead, it is likely that
forward sales will be negative this year, a 500 to 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 1000 tons, a reduction of 21%-25% vs. 1999. The
shortfall in supply from hedging activity could be even greater if
other producers with hedge books decide to follow suit. [Be still mah beatin' heart, John...you mean there are "others" who might panic and buy like poor lil'ole Western Area's and tick off the "throng" of dominoes mentioned above????]All of this
assumes gold prices stay in the low $300?s. Higher prices will
likely lead to rollovers of hedge positions, but then again, much
higher prices would be a happy trade off 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.[As George Cole implied earlier this week, couldn't happen to a nicer bunch of bullion banks.]
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.[Now, THIS is why I read guys like Hathaway...they always let some detail out to bolster their argument that us lil'plebes don't know...c'mon, let's see a show of hands that knew ole ABX didn't have to fork over ANY margin money until POG=$800T/oz. Do I see ole "Enigma/DoubleD's" hand in the air over there in the darkened corner of the SI chatroom?...ah....] 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 6.8mm oz. for this year and next in order to
tweak its hedge book towards a positive correlation with gold.
Bullion dealers wrote or sold these calls with a strike price of $319
for ?00 and $335 for ?01 in return for a premium of $68mm, or $10 per
call. The transactions occurred mostly during the fourth quarter of
1999 when gold was trading in the low $290?s. [Well, now, didn't we ALL wonder why gold was forced down to $290 T/oz during Q499....] Without delta
hedging, the bullion dealers would be short 6.8mm oz 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. [and Foreign Exchange Stabiliztion Fund backing all 3 of those guys, plus Rothschild's taking a piece of the action over in LDMA land...]
What is interesting about these options for the dynamics of the
gold market is the delta hedging that 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 which employed his model. It is certain
that his 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 2.1m ounces.
Since those calls were written, however, the price of gold rallied
momentarily into the low $320?s, causing a considerable amount of
forced buying in a short period of 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 LBMA (London
Bullion Market Association) recently reported a 22% 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.[heh heh heh heh...like one wheel off a tricycle...look at them sparks as the axle merrily screeches along on the sidewalk or driveway...]
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 counter
parties in the same fashion as they had been undressed. They
must depend on the notoriously unreliable rating agencies. [Now, pardon me all to heck, but isn't this "rating agency machination/scam" been exposed on this thread by our own Richard Harmon??!!! Way to go, RICH!] It is
doubtful whether rating agencies have been granted access to
analyze the derivative positions of the bullion dealers or their
parent institutions. [No, TELL ME THIS AIN'T SO, John!!!! I'm Shocked!!!]
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. [You got a date on that for me, John?]
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 period
of 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 mm ounces. Ashanti?s hedge book contains
3.5mm written calls. Certain smaller producers have been known to
write calls in order to meet the payroll when gold prices were
lower. [Well, now, THERE's a compelling reason to run right out and invest in micro-crap Juniors touted by Cormier and Kaiser bottom feeders...] 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. [And herein, folks lies the reason that the "lil plebe" can act more nimbly than the battleship sized dealer in playing this game...3-5 years lock-up...LordyLORDY!!!...heh heh heh] 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 ($400mm est.), versus the less than $200mm in the
red four months ago, both figured at today?s gold price. [Remember, you heard it here folks...short this sucker...and keep an eye on the Geita birdie!] This is
despite the fact that 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%) 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% while the XAU is down
2%. 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. [Be still mah heart!!!]
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, [and remember they just adjusted higher the prices permitted on their fair continent for the second time in about 5 months...a shocking departure from historical norms for them...maybe "liberalization" is dead ahead, John????] 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%
increase in gold demand vs. 1998, which was depressed by the
Asian meltdown. More significant is the 7% 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 run up in September,
this particular 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% of world gold monetary reserves. Only a small
percentage, perhaps 15%, is available to be mobilized [newbies: read that word Mobilized as the synonym of L-E-A-S-E-D] at any given
moment to satisfy market demand. At market, the gold ?float?
approximates $150-$200billion, 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 utilized 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; 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.
[SAY, WHAT, JOHN???? I think we better all read THAT line again! ]
It will only require the inevitable unwinding of bearish producer
and dealer hedge structures amidst a change of market perceptions
on the desirability of financial assets.
John Hathaway
February 2000
¸ Tocqueville Asset Management L.P.
COMMENTARY:
Aaaaaaaaaah...was that as good for you as it was for me, goldbugs? And this is the guy credited as I recall for calling precisely the last "two" POG rallies, the one in September, and the one just past on Feb 3rd... GOJOHNGO!
GOJOHNGO!!!
O/49r |
