The gold market is sitting on a time bomb
Contrary to the opinion of most published commentaries; the drastic, unrelenting decline of the value of gold bullion isn't a product of the selling by Central Banks. With few exceptions, the selling by official holders of bullion has been totally professional. Their activities result in large offerings of metal purchased at singular prices relative to the prevailing market price, but not in the market place. Neither is the unrelenting rally-less tumbling bullion wholly a product of an economic environment. Yet, even when gold-positive economic influences surface, gold cannot hold a price rally for more than a few days.
Some observers propose the existence of some conspiracy to depress the price of gold for political reasons. There is no conspiracy.
Yes, the Exchange Stabilization Fund under total control of the US Administration can trade in gold whenever it pleases, in any form it pleases. Yes, there is no public accounting for this body. Yes, it does act in secrecy. However, if the gold market was not under pressure from some powerful Bearish Cartel, the exchange stabilization fund could not influence bullion's price except in the very short term. Therefore, the conspiracy theory is not the substance of what this Gold Bear market is about.
I have participated in the gold market every day for the last forty years. Some believe that I was a major price influence from time to time. When the Hunt Brothers were granted a one billion dollar loan to bail out major US trading houses holding their account, Federal Reserve Chairman at the time Paul Volker required as a criteria for the loan that I take the position of advisor on their silver position liquidation.
In my forty-year career, I have successfully managed a Chicago commodity clearing house, an international precious metals arbitrage company, a primary market maker in gold and industrial metals plus a significant over the counter trading department of a member firm. I have written four books on gold, industrial metals currencies and markets. I have been the chairman of a successful public exploration and development company. Now I have a private exploration and development company having just completed a 32,000-line kilometer geophysics and radiometric survey in East Africa. We have identified 24 gold target and 198-diamond target now being advanced. I have studied the metals markets from almost every angle. The Wall Street Journal has dubbed me "Mr. Gold."
My observations lead me to the conclusion that the reason for gold's continual decline and possible terminal demoralization is the most unusual and unthinkable source - the AU-PEC CARTEL. Without intention or formal organization the producing gold companies, through their utilization of similar transactions, without organization or intention, formed a Bearish Price Demoralizing Cartel of common interest.
They have inadvertently placed the market for their final product (gold), their stockholders and themselves in a precarious and potentially terminal position.
There is a possibility that the gold industry is headed for the same place as the Edsel, the Buggy Whip and the Danbury Hatter's industries executed as it were by their own hand.
What industry experiencing a 21-year bear market for its product can survive the following financial strategy?
First, lease your final product from an official state holder. Then sell the leased product into a critically weak market · After this, sell deferred final product or enter derivative packages, which are structured in anticipation of a lower price for the final product. Call these transactions "hedges" when in most cases they are at risk to the market short spreads, not hedges by the traditional or dictionary definition. Then publicize the gold bear market anticipatory positions, thereby stating their conclusions looking for significantly lower gold prices to the only gold Bulls left in the universe, their stockholders.
The Central Banks have handled themselves professionally while the producers have pounded the gold market relentlessly for years. Recent publication of the supply and demand figures by the Mining Journal indicate, I believe, that if the producers had not hedged they would most likely not have had to hedge at all from the $400 level down. On a supply and demand basis, I believe, gold would have had a moderate up trend over the past three years without the extra supply generated by the producer's constant bear spread and leased gold selling.
Why have the producers continually hammered the gold market? The answer is to raise money at less than 2% cost, off balance sheet, for the purpose of developing new lower priced supply. That strategy is laudable in one sense and market debilitating in another. What good is more supply when we are slipping under the average cost of world production? More supply usually means lower prices if demand is constant. How low can the price of gold go? Back to $35? Is the so-called hedge of any value when it is done at a price that will result in a loss in operations regardless?
To recap, the gold producing industry has serious problems.
These problems are products of the Gold Leasing & Product Hedging Financial Strategy which places unrelenting pressure on the price of gold bullion.· The Accounting Standards of both the US and Great Britain allow the use of deferred gold sold derived profits unrealized quarterly mark-to-market generated to be used by gold producers as credits to the cost of operation in determining the cost of product. Many major gold producers utilize this accounting method. Therefore, the publicly stated cost of gold produced for many major gold producers does not necessarily represent pure operating costs. They represent operating costs less credits from profitable but still open bear market spread positions.
Gold prices below $270 are dangerously close to the real average world cost of operation level for the industry as a whole. The major beneficiary in terms of incremental income to economy size where the producing gold industry operates is the developing nations. Therefore any significant injury to the financial stability of the gold producing industry must seriously impact the developing nation representing the world's poorest.
The key element in the gold pricing picture is not the Central Banks, it is the hedging producers constant selling of specie bullion, deferred gold forward as well as their activities in the second forward to exotic derivative private treaty arrangements. The Central Banks with little exception, one middle east central bank heavily involved in granting derivatives arrangements and the ill conceived British sales mechanism, have performed most professionally. The Central Bank long history in gold selling has resulted in their activities being handled with care for the market.
The hedgers on the other hand are motivated by the capital-intensive characteristic of new production and less knowledgeable or interested in market execution professionalism of price as a focal point of the transactions. In practice, they generally deal in arranged packages of BEAR Spreads. For the past three years any profitable hedge position is not a pure hedge but rather a BEAR SPREAD POSITION at risk to the market place or it would not have been profitable in the manner reported by public companies.
What would happen if an exogenous event propelled the gold bullion market higher? To answer that we need only look at the Ashanti situation. Ashanti had significant so-called hedge positions. When the gold market moved from $252 to $262 margin calls were, I believe, generated on the positions. As a result of this the gold market moved into the $340 range. If little Ashanti can smoke nearly one billion dollars from credit to debit what do you think could happen to an unprepared major producer's position?
If a failure of the hedge market derivatives in gold took place the result could be equally bad for bullion. After a drastic rise in price, possibly to new high levels, as bankrupt hedgers fell into the hands of judges, attorneys and accountants who would buy gold. Certainly few at the high levels it would go to. After the covers were made the price of gold would fall as drastically as it rose.
Why do I fear a potential collapse of the Derivative market for gold if an exogenous event occurs to boost the price of gold?
I am concerned about the stability of the gold derivative market for the following reasons:
Gold, unlike other major markets, has not grown in bullion trading to keep up with the volume of gold derivative paper created in the last ten years. Gold bullion is the underling asset, which supports the derivative standing upon it. It is a poor pillar because, unlike securities, government bonds and currencies, demand and supply create erratic movements from inception due to low volume trading.
The market for derivatives is generally a private treaty market, not open outcry or listed on a major exchange. It is a market without transparency. It is a non-regulated market in general. A majority of gold-based derivatives are granted by the subsidiary of the good name investment bank, bank or brokerage house. In many cases these subsidiaries are not located in the same country as the parent. There is no automatic mechanism by which these subsidiaries can rely on their parents to cover trade debts in the case of a failure. Even though some of these subsidiaries do publish large balance sheets they do not publish their potential total obligations.
In my opinion, present disclosure requirements of public companies lack requirements that would give a clear picture of the real risk. This was apparent in the risk disclosure statements of the major companies that recently had problems · FASB, the accounting standard number 137 and 138 which are being provided to tighten up the disclosure of derivative risk inherent still consider market risk as what occurs to a derivative if the specific factors affecting the market change. That is items such as volatility and interest costs. The real market risk is that there is no market when a fast trading situation occurs.
The underlying assumption for derivatives to function is that the mathematical relationships inherent in markets if disturbed will return to normal in time. The problem is what happens during until the return to "normal". The answer is possible bankruptcy and liquidation.
Most contracts between the producers and their derivative grantors lack two important items. First the producer must be able to transfer the derivatives to any other dealer the producers selects. Second, the producer must have a right of offset in their contract with the derivative dealer. This will allow for a real market to develop and will protect the producer if the risk of a position is offset with the dealer who granted it in the first place.
What can be done?
Stop hedging and cover the risks in simple second derivatives.
An example is the excellent judgment of Barrick in covering all of its short deferred gold positions with call options. As long as its contracts provide the right offset it has its cake to eat. Congratulations are due to those companies who have restrained themselves from large participation in the hedge market, including Newmont Mining and Homestake Mining. To those that have apparently handled their hedge book with a stroke of genius such as Barrick, respect must be shown.
To the many that really have no place at all in this arena yet are participating we wish them well. I do not hold out much hope that the producing companies will make any change in their hedging practices. Neither stockholders nor management of many of the gold producing hedging companies have the transactional orientated understanding that reveals the critical weaknesses of this financially engineered strategy.
More than likely the final chapter of this story will be told in the courts. That is where Ashanti is now doing battle with it's stockholders in the United States District Court Eastern District of New York Class Action suit filed by attorneys for Jayne Furman, on behalf of herself and all other similarly situated vs Ashanti Goldfields.
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