Bullion shortages

Alasdair Macleod – 21 June 2010

Gold has begun to venture into new high ground against the US dollar, and silver will surely follow. This rise in gold comes after substantial physical demand from small hoarders all round Europe, responding to the developing euro crisis. In the last month alone, gold ETFs have grown by about 240 tonnes, a rate if annualised that would more than account for all mine production. On top of this the queue for gold coins has lengthened considerably.

There is no doubt that the withdrawal of so much physical metal is having an impact on a high-volume market. The commercials (bullion banks and market makers) are short of 867 tonnes of gold and 8,364 tonnes of silver on Comex alone. These bear positions represent 35% and 38% of annual mine production respectively. At the same time, bullion banks in London are technically short of undisclosed amounts to their customers’ unallocated accounts. Every physical ounce is precious to them.

Traditionally, the big bullion banks have turned to central banks for help. They are no longer in a position to do so. The current bull market in gold follows a twenty year bear market, brought about by the determination of the Fed and other co-operating central banks to remove all monetary credibility from precious metals. Sales of gold from official reserves were easily absorbed in the market in the 1970s, but it was the interest rate peaks in 1980 and 1984 that turned the tide. From that time, outright sales of bullion by the central banks were gradually replaced by gold leasing as a vehicle for the carry trade. Gold would be leased by a bullion bank, sold into the market and the proceeds invested in government bonds. It was a profitable business, and at the end of the lease, bullion was either delivered through matched forward contracts from mining companies, or rolled over. It is suspected that many of these leases were effectively abandoned, which in falling markets could have suited all parties.

None of this activity was public, and from the central banks’ point of view, there was no reporting involved, either because a lease did not represent change of ownership, or if a lease became a sale, reporting was conveniently withheld.

The full consequences of this activity have never been revealed. It has been estimated that the central banking cartel disposed of some 10,000 to 15,000 tonnes of gold by these means[i], out of a reported total of 31,000 tonnes held by all central banks in 2006. It meant that large quantities of gold were being sold into the market at prices significantly below gold’s theoretical value[ii] for long periods of time. Much of this gold was dispersed into jewellery, and some it was presumably hoarded.

Gold has only two uses, as a store of incorruptible value and as an incorruptible medium of exchange, but silver combines these functions with many commercial applications. The result is that silver is consumed through industrial usage, with limited scrap recovery. Demand has been greater than supply for the last sixteen years, with the balance being met by draw-downs on inventories and strategic reserves – both of which now appear to be exhausted. This difference between gold and silver is illustrated by the difference in activity in the two large American ETFs, GLD and SLV.

GLD consistently grows, now holding 1,308 tonnes of gold, while SLV has had 270 tonnes withdrawn over the last three months. No explanation has been offered for this withdrawal, but the likeliest explanation is that industrial users and perhaps some bullion houses are redeeming SLV shares for silver, which is permitted under the terms of the prospectus. So SLV’s shares are a substitute for physical inventory, functioning as a silver stockpile. This would be consistent with prudent management of silver for industrial purposes at a time of acute shortage.

Both these ETFs are also regarded with considerable suspicion by gold and silver bugs. Their opaque nature and the managers’ seeming reluctance to answer critics do not help and has encouraged accusations of fraudulent behaviour. They are indeed very different from the British offshore ETF model, and would not be regarded as permissible for regulatory purposes.

Perhaps the most important accusations are that the gold and silver bars listed by these ETFs are being used by their respective custodians to cover their short positions. Given that the custodians, HSBC US London Branch for GLD and JPMorganChase Bank London Branch for SLV are running substantial short positions on Comex as principals, and given that the ETFs’ auditors have their access to the ETFs’ property restricted by the custodians, this conflict of interest has not been properly addressed.

There may be insufficient evidence of fraudulent behaviour, but if there is nothing to hide, why not come clean? Is it because the custodians have in fact leased the metals to themselves? Such an arrangement would not involve a change of ownership and would not necessarily be deemed fraudulent with the corporate structures employed; furthermore retaining leased bullion on the books is common practice in the central banks, which also regulate the banks in question.

It is against this background that gold and silver are quietly exhibiting strength. This is not so much a bull market as a bear squeeze. It is shaping up to be one of the biggest in any market in history. It threatens to feed on itself, since the physical metal is being bought by hoarders, who are quite likely to increase their appetite as prices rise. The bigger squeeze is likely to be on silver, which is relatively underpriced and has had virtually no speculative interest in it.

We tend to think of markets purely in investment terms; but this cannot be true of markets where investors are generally absent. Speculators and investors are tempted to take profits as prices rise or fall, but they are a small part of the precious metals market. Gold and silver bugs are still regarded as a lunatic fringe.

The punters are there in piffling quantities, so cannot help the bears to close their positions at any price.


[i] See the Cheuvreux sector report by Paul Mylchreest, January 2006 and the references therein.

[ii]The price of gold was below its long-term average from 1991 to 2006, and substantially so from 1997 to 2005.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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