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Gold Futures' Dirty Secret (Part I)

by: Nicholas Jones September 03, 2008 | about stocks: GLD    

Nicholas Jones

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Cash markets and futures markets carry both similarities and differences. For example, both markets are a form of price discovery. Also, both markets are used by commercials and speculators alike. Given that, their differences are much more pronounced.

In a cash market, the physical product changes hands immediately. Both buyer and seller are looking for delivery of the commodity. This only happens in futures markets if you are left with an open position when the futures contract expires. In most cases, futures deliveries are intentional. If a market is more illiquid, unintentional deliveries are more common.

What I’m essentially getting at is in futures markets, the initial buyer or seller of a contract is very rarely the one who ends up with that contract on delivery date. In the meantime, the paper contract will change hands between large specs, small specs, commercials, etc., many times before it reaches its final destination. On the other hand, in the cash market, the initial exchange of goods is simply the extent of the deal.

I’m here to tell you that I’m actively involved in both markets, and the cash market and futures market are telling me two very different things.

Paper Discrepancy

In prior issues of Bourbon & Bayonets I’ve discussed my more recent dealings in the gold cash market. For those who missed it, here’s the brief recap. When I started buying physical gold in the early 2000s, I could easily receive overnight delivery. It was this way for many years, even as the price of gold multiplied.

Just over a month ago, I was on the phone with my dealer. He explained to me that it was going to be a three week delay on my bullion delivery. It turns out that the market for gold was drying up. Even the dealers were having trouble getting their hands on anything substantial.

Well, things have gotten even tighter in the physical markets. In fact, I called my dealer last week, and he simply told me that I was out of luck. He can’t get his hands on ANY gold. I’m saying that he couldn’t get me a U.S. Eagle, Toronto Maple Leaf, or South African Krugerrand.

What could cause such a freeze up of markets on such a massive scale?

Cash is Trash

My cash dealer explained a few things to me. He said it was a deadly combination of tightening supply and massive growth in demand. On the manufacturers' side, the plants that could get raw metals were working 24/7 and were still backlogged on orders.

While he was telling me this, stories like this one from Bloomberg started popping up:

Aug. 28 (Bloomberg) -- Rand Refinery Ltd., the world's largest gold refinery, ran out of South African Krugerrands after an ``unusually large'' order from a buyer in Switzerland.

This was particularly unfortunate, because the Krugerrand is my favorite of the 1 oz coins.

Here’s another article from CoinNews:

(Aug. 17, 2008) The Gold Anti-Trust Action Committee [GATA] reported Friday that the United States Mint has suspended sales of American Eagle gold coins to their network of Authorized Purchases.

So these issues that are in the cash market are beginning to leak their way into the crevasses of the media. Right now, you kind of have to do some digging and searching to find news on this sort of topic. I imagine that in a short time, this will be making headlines. Of course, it will be the speculators who are blamed.

Regardless, we still need to look into this a little deeper and find where the issues stem from and how this sort of market irregularity can exist. In doing so, we will also identify why the cash market is frozen and the futures market is still running…for now.

More Supply and Demand

The demand side of the picture is not something that requires a lot of brains to analyze. When the systematic destruction of the world’s reserve currency begins to show up in commodities prices including, copper, corn, oil, etc., people want to hedge their falling dollars with precious metals. Throw in some foreign central banks that are now net sellers of U.S. dollars and net buyers of precious metals, and you have a flood of new demand in the cash market, ranging from lack of sufficient mine production to lack of manufacturing infrastructure, and you get a tight market.

I noted the lock ups in curtain production and distribution facilities. The question now is why would distributors run out of supply now? Why would curtain producers now lose access to the raw minerals necessary to produce?

The answer to that question will require an in depth analysis on the disruption in the supply side of the futures market. My views on the supply side of the gold futures market are both controversial and revealing. It will not only helps us understand the freeze in cash markets, but it will also make clear to us how a cash market and futures market can be telling us two drastically different things. These questions will be answered in a “do not miss” issue of Bourbon & Bayonets later this week…stay tuned.

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This article has 14 comments:

  •  
    Sep 03 08:07 AM
    Maybe people would take more account of your posts if you could write coherently, Paul&Shark. But thanks for the rambling drivel anyway.
    Reply
  •  
    Sep 03 09:05 AM
    the poor olde dollar index, which according to the "negatory collective netmind" was going to 50 or 40, didn't. since last winter it's up 10-20% in the various other varieties of paper. so if the dow is down 20% you broke even,,,as the legions of purveyors of "depression now!" always said when it was headed the other way.

    needless to say gold is down that much or more. well good stuff can't just happen, so someone must be manipulating everything again after 6-9 years of inflation! it makes me laugh but you'll never get an admission from the "negatory collective netmind" that it/they was/were EVER wrong. so they have quietly dropped $1500 gold tomorrow and burn your dollars for their energy content and have moved on to science fiction and barrack h mugabe jr's coming apotheosis.

    i wish i could just accept the fact that the ability for neocommies to dilate at length on the "negatory collective netmind" is good for mental health in a general sense, but i was taught to demand responsibility from those flapping their lips and distracting me. the theory is that if they weren't hyperventilating their drivel, they'd be burning synagogs or whatever architectural symbol is hot this month amongst the neocommies.

    the alternative theory is that constant hyperventilation only encourages them to assume they must be correct and now they'll move on to even worse verbal (mental?) debauchery....not to mention the deleterious effects of "recruitment"... of other borderline minds which were managing to stay afloat until finally done in by the "negatory collective netmind".

    ever wonder how hitler got legally elected? he knew people really wanted change, and he gave it to them.
    Reply
  •  
    Sep 03 09:54 AM
    Here's what my wife asked me: Why is gold so cheap if no one can get any?
    Reply
  •  
    Sep 03 10:19 AM
    mikeyLV,,,one theory comes from 1979-81. dealers then got stuck with tonnes of gold and silver at the highs. partly this was due to their own greed and partly to the wise disgorgement by the public of their silver tableware, gold coins, and jewelry into the parabola. eventually the "precious metals" newbies were convinced by science fiction writers that prices were coming back "right away". so then the dealers who were still standing were able to distribute all the way down until 1999-2002. scads of writing hacks for dubious publishers are needed to stoke that demand. BB and his stable of hacks is at the ready as always. "shortage" may replace "manipulation&quo... on the top ten science fiction hits.

    Reply
  •  
    Sep 03 11:36 AM
    Perhaps physical buyers have a much longer time horizon and see an opportunity to pick up coins at a 25-30% discount from recent highs. I know its hard for speculators to fathom, but there are some folks who aren't looking for a quick buck (i.e. my friend who holds Standard Oil of New Jersey stock from 1948). Needless to say its been a fairly good long term holding.
    Should gold go ballistic over the next 10 years, the question of whether you paid $800 or $500 or $1030 will likely be a moot point. We must always remember that gold simply IS - it does not owe its value to any government or entity. Given the messes we are looking at across the board from Iraq to the mortgage meltdown, to the dollar disaster, owning physical gold makes eminently good sense, just as owning some Treasuries makes good sense. None of us know which way this financial situation will resolve itself so covering as many bases as you can to preserve your long term assets is a sound investment strategy.
    For whatever its worth, most of the really wealthy people I know are not short term traders so Paul&Shark and whatever, keep in mind that some investors rode the silver market all the way down from $50 and never missed a meal or a European cruise. Its all a matter of perspective.
    Reply
  •  
    Sep 03 12:12 PM
    My suggestion would be to look at the same bullion banks, or their financial friends, who are driving the spot price of gold down with their naked shorts . . . flooding the current market with 'paper gold' with no gold behind it. There are relatively few places where gold trades in enough quantity to affect the price, and my guess is that these same 'Insiders' are buying up all the real gold in those venues that weary and discouraged gold owners are selling.

    I would like to see the books of the major gold producers to see exactly who it is that is buying their gold. Do you think they would sell some to you or me? My guess is that these same 'Insiders' are buying up all that gold they can, and they are powerful enough to do it.

    The question is, 'Why?' What do they know about the dollar and the economies of the world that we don't?
    Reply
  •  
    Sep 03 12:35 PM
    Thanks for sharing this Nicholas.
    I too have experienced the same thing: the dealer that I have dealt with for the last three years is completely out of silver, and is running low on gold. And this is a MAJOR dealer in my area.

    Obviously, the recent rigged "long squeeze" has given someone a chance to unload their paper to buy the physical before the next collosal short squeeze.
    Reply
  •  
    Sep 03 01:03 PM
    Very refreshing, Bowman711, to read a valid piece about what is happening today. Of course, the SHARKS of the world are all about THEMSELVES, so they are totally UNIMPORTANT!

    On the PM issue, I suspect that when the opportunity presents itself (VERY soon) the ELITE RATS who are running the PM prices into the ground will REVERSE COURSE, and you and I and the rest who are buying as much Gold/Silver we can lay our hands on, will be SMILING!
    Reply
  •  
    Sep 03 01:19 PM
    I have been reading the articles about gold market manipulation by banks, paper gold creation, and doomsday scenario. I thought, let me test this theory out myself. Can I actually get my hands on physical gold at the current spot price of $800 per oz? Since I wasn't rich enough for taking a delivery of 1000 troy oz on the futures market, I went on Ebay to buy some gold bars. Let me tell you, the price I finally won the bidding at was $50 for 1 gram! I lost on another bidding which sold at $59!! (My bid limit was $55) I did win another bidding at $44. But at these prices, the gold price for 1oz is $1500! (not $800) Perhaps I got killed on the mark-up for buying a small amount but the mark-up sure was HUGE. Therefore my conclusion is that you can buy gold but only at such a HUGE mark-up (unless you can afford to take physical delivery on 1000oz gold future.. then again when someone actually take the delivery, the whole market will collapse??)
    Reply
  •  
    Sep 03 02:09 PM
    Gold is a valid way to diversify and reduce overall portfolio volatility. Professor Roy Jastram's seminal book, The Golden Constant (John Wiley and Sons, 1977), established that a portfolio with 5-10% gold in it was much more stable than a portfolio without any gold. 2008 has certainly proven that fact yet again even though gold is now down on the year.

    Professor Jeremy Siegel's work also establishes that gold holds its value over all types of markets and through all sorts of upheavals:
    .
    "If you had taken US$1 and invested it into the following assets in 1802, by the end of 2007 they would have grown to:

    US Stocks: $766,854
    Bonds: $1,320
    T-Bills: $302
    Gold: $2.45
    The US Dollar: $0.06"

    www.wheredoesallmymone.../

    Many people have political and philosophical agendas behind their fascination for gold, but it's just a time proven diversifier in the very long run. The history of gold is fascinating, but so is the history of interest rates and stocks. They are all necessary in optimal investment planning.
    Reply
  •  
    Sep 04 07:38 AM
    Theoretically can't one go to the futures market and buy Gold and wait till the expiry of the contract to get delivery. You'll get physical Gold at the price of Paper Gold. Can someone tell me why is that not happening for if it were then the price difference would not exist
    Reply
  •  
    Sep 05 01:21 PM
    SB. It does happen. The price difference is because of the time difference. The value of future delivery does not equal the value of immediate delivery because of what can happen in between.
    Reply
  •  
    Sep 06 04:16 AM
    Think-About-It - What I meant was the premium people are paying, which is alot more than the justifiable time-price difference. So one can buy the near month contract very close to epiry and take delivery (this will only work if there is compulsory delivery on all open positions on expiry - I don't know whether US Exchanges enforce compulsory deliveries)
    Reply
  •  
    Sep 06 09:44 PM
    Just a few thoughts:
    - Financial markers and central government are manipulating financial markets, fiat currencies and the real markets. Consequently, free-market economies do not exist any more;
    - The above artificial system [similar to the old Soviet economy] cannot continue for a long time. To extend "the run", the old Soviet system had to enforce itself using totalitarian means. But even these dictatorial means cannot continue for long. As a result, the entire system destiny to a collapse;
    - It appears that, following the upcoming elections in the USA, the entire US economy is about to have a very hard fall;
    - It is difficult to expect that Asian countries and other major commodities suppliers are about to continue this game for long.
    - The latest geopolitical events when Russia clearly stated that it does not want to play by old US and EU rules are clear indications that the entire world is moving in a direction of major military confrontations. The present events remind me the events leading to the WWI and WWII. However, this time the US political system is not in a position for major international confrontations.
    Reply
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