Physical Gold Buyers Are Forcing Futures Delivery

The precious and shiny metal that saw its 12-year bullish run end last year is now down 20% YTD, but the bear trend may be short-lived as fundamentals haven’t changed much. After rising to an all-time high near $1,900, gold traded as low as below $1,200 on June 27 (intraday), a price that puts the gold industry on a negative marginal profit as the cost to produce gold has been estimated around $1,287. Demand for physical gold has been growing steadily while supply has been relatively unchanged. Economics would tell us that this is the perfect picture for a price rise but that hasn’t been happening lately. The problem with gold is that price is set in the futures market  (at Comex), and there is a major disjoint with the physical product. Due to its characteristics relating to leverage trading and nature of many institutional traders, delivery almost never occurs. But, in a derivatives market that surpasses 100 times the physical availability of the underlying asset, someone would be under deep trouble if delivery were forced. Physical owners of gold would be in such a privileged position that they could charge almost any price for their gold.

Rather that trading on fundamentals, gold has been trading on speculation and probably on some manipulation. With the Federal Reserve expanding its balance sheet to the trillions and keeping the current pace of asset-purchases at record highs, there’s no reason for the dollar to appreciate relative to gold. In fact, gold is the best protection against this debasement.

It is true that Ben Bernanke first talked about a possible QE tapering, which would start later this year with the aim of reducing the current bond purchase program until completely extinguishing it by mid next year. Gold retreated substantially and even crashed by 13.5% during a 2-day session. In our view, such tapering wouldn’t be enough to put gold on a downtrend. FED’s balance sheet will still take a few years’ diet to return to regular levels, the risks of inflation will continue for a period after QE is ended and the tone that marks monetary policy around the world is still accommodative. Those are enough reasons to view gold with bullish eyes.

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But, as if that weren’t enough, the first tapering talks were reverted by new dovish statements coming from Ben Bernanke in an attempt to revert the sell off in equities. Sadly for Ben Bernanke, the equity market is as dependent on QE as a baby on his pacifier, which should be a kicker for gold. Since June 27 gold has been appreciating, now 10% off its lows, but we still believe the bulk of the change is still to happen in the near future.

On July 19, it was reported that JPM gold reserves were at an all-time low. In a single day during last week, the bank had to withdraw 90,311 ounces of unregistered gold from its vault, or 66% of its reserves. Total gold at the vault is now of just 436,000 ounces (14 tonnes) with 390,000 being of registered gold. This is due to delivery notices coming from Comex. If these delivery notices keep coming, JPM won’t have the necessary gold to honor contracts and will have to buy it. Can you imagine the situation? How much would you charge to a desperate buyer?

It seems that investors/speculators on futures are forcing delivery of the metal. Data shows that this year alone almost 750 tonnes of gold were withdrawn from ETFs and Comex futures. There’s someone accumulating the precious metal.

Interestingly data on China imports shows the country imported 1,500 tonnes of gold YTD. With physical gold produced during the same period held at 1,300 tonnes and even if there is some overlapping in Chinese data, there’s probably not enough gold production to fulfill the world’s demand, thus there is a huge pressure forming on prices that haven’t risen just because there is a disjoint between futures and the physical asset. But things are changing very fast and we may be assisting to a futures catch up with the physical market.

With China at the other side of the equation, we wouldn’t be sellers for gold futures, incurring in the risk of having to dig California as during the Gold Rush in 1849, seeking for gold to honor the contract.

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