Gold Demand: The Great Disconnect Between Paper and Bullion

So have we found a bottom in gold? Following last week’s plunge to around US$1320/oz, the gold price is now up to around US$1,470/oz, for a gain of US$150/oz. And the gold miners rallied strongly in the US on Wednesday night (as they are in Australia today), suggesting we may have seen an end to the capitulation selling.

And there was plenty of capitulating going on. On Tuesday, we asked a friend who works for a fund manager about a certain gold stock – mid pummelling. There were huge trading volumes going through the stock…the selling looked like pure capitulation. He responded that they were selling that day too. The reason? There is only so much pain you can take.

We could be wrong, but Tuesday and Wednesday seemed like the point of maximum pain for many gold stock owners. When you see the price fall day after day, it conditions you to think that it will keep falling. You think everyone must know something you don’t. No one wants to be the patsy at the table. You think that maybe your stocks will go bust and you’ll lose everything. So you sell, just for the psychological relief and to ease the pain. Fundamentals don’t really come into it.

What makes matters so acute for Australian gold miners is that they are amongst the highest cost producers in the world. When the price tanked last week, it rendered quite a few gold producers uneconomic. At such low gold prices, they were unprofitable. So if you thought low prices were here to stay, it made sense to dump the stocks.

But the recent rally could signal that the low price of recent weeks is an aberration. The high cost gold producers may just hang on and begin to generate profits as the price rebounds. For all the selling of these stocks in the past few weeks there was a whole lot of buying…the buyers clearly think low prices ARE an aberration.

The big meme in the gold market lately has been the apparent ‘disconnect’ between the paper price of gold and the physical price. All around the world we’ve heard reports of huge demand for physical gold brought about by the price collapse as determined in the gold futures market (aka, the paper gold price).

We consider this a very bullish development, but don’t be caught out by some of the extreme commentary that seems to suggest there’s little physical gold left in the world. For example, we’ve heard stories of huge premiums on certain coins as evidence of physical scarcity. But it’s just a function of the limited production capacity of mints around the world.

When you have demand over a couple of days that you normally see in a few months, of course mints and coin dealers will run out of inventory. So don’t be fooled into buying physical at a huge premium. Or as the Perth mint’s Bron Sucheki writes over at his Goldchat Blog, ‘Chill Out Dudes’.

Of far more interest to us is what’s happening at the big end of the gold market. This is where gold moves IN SIZE…and the moves are certainly mysterious.

For example, in just the past four days, COMEX gold inventory declined by 10%. Since the start of February inventories are down by more than 25%. That’s interesting news to say the least.

There are two types of gold inventory, ‘registered’ and ‘eligible’. Registered gold is available for delivery to the owner of a futures contract. Eligible gold is gold held by the bullions banks on behalf of clients for safekeeping.

Both levels are in decline. As of 24 April, there were 2.174 million ounces of registered gold and 5.817 million ounces of eligible gold. But eligible gold inventories have taken the brunt of the falls, suggesting clients no longer see the western bullions banks as safe guardians of their gold. Notably, JP Morgan’s vault of eligible gold is nearly empty, with just 141,500 ounces left.

Meanwhile, over at GLD, the world’s largest gold ETF, you’re seeing inventories fall too. Since the start of April, the trust has offloaded 127 tonnes of gold. The consensus view is that as the price falls, investors sell and gold leaves the trust.

But that’s not how it works. Investors sell shares in the trust, not the gold itself. Only ‘Authorised Participants’ (the bullion banks) can take gold from the trust, by redeeming baskets of shares.

Given the huge demand for physical gold recently, it is perhaps not surprising that bullion banks are using GLD inventory to augment supply. 127 tonnes of physical in a few weeks is huge. Where is it all going?

There’s a stark difference between the gold ETF, GLD, and the major silver ETF, SLV. Even though the silver price has crashed harder than gold, the SLV has actually ADDED tonnes to its inventory. So no selling at all, despite the price plunge.

You can twist this story any way you want. It could be bullish for silver because no one is selling physical (even though the ETF does not give you legal ownership of physical) or it could be bullish for gold because it’s a sign of strong physical demand for gold, not paper claims to it via a western bank run ETF.

Either way, it’s all an intriguing mystery. This precious metals story still has a long way to run. But last week’s price action was telling in that we think a few major global players showed their hand. It’s a stretch, and against historical precedence, but we think the patsy in all this could be the western bullion banks. When you hold a lot of paper and a dwindling supply of the real stuff, you’re certainly not coming from a position of strength.

Greg Canavan
for Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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