What's Holding Gold Back?

Most people assume some group of interests is manipulating the price of gold to keep it artificially low. That remains to be seen, but there certainly are a number of economic reasons for gold to be priced as it is – or at least as it was until recently. Doug Casey explores…

After the price of gold spiked over $850 in January of 1980, gold production increased substantially – and it stayed up, even with the steep falloff in gold prices. Production has gone from about 1,200 tonnes per year in 1980 to its current level, over 2,500 tpy.

Where did all that new gold production come from? Aside from the dramatic increase in price incentive in 1980, new technologies have matured, such as heap leaching and satellite prospect identification. In addition, since the collapse of communism, many prospective areas of the world have opened to modern exploration.

Another economic factor keeping the price of gold down recently has been producer hedging. This is a particularly complex part of the puzzle, but in a nutshell, when gold was falling, as it was from 1980 to 2000, many big producers, starting with Barrick, "hedged" against decreasing prices by selling large portions of their future production at substantially over the then-current prices. Since gold is a "carrying charge" market, it’s usually possible to sell several years forward at a price reflecting current interest rates and storage costs. In the mid ’80s, when gold was, say, $400, that meant they could sell three years out for, say, $520. When time came to deliver, the metal might actually have traded for only $350. That was a very smart thing to do – at the time. What wasn’t so smart was failing to recognize when gold bottomed out and prices started rising again. The producers have started de-hedging in the last couple of years but they still have massive short positions. By some estimates, on the order of 1,700 tonnes of gold – almost half last year’s entire gold supply from all sources – is still sold forward.

Obviously, gold sold forward in the last 5-7 years at prices considerably below today’s is costing these companies a fortune, but the big impact on price may come from the bullion banks. Why? Because they could borrow gold from central banks for nominal interest rates (0.5 to 1.0%), sell it on the open market (believing they will be able to return it when they take delivery on futures contracts bought from hedging mines) and invest the proceeds, conservatively, to clear a 4 to 5% profit margin.

This had the effect of increasing the global supply of gold, basically adding already produced (borrowed) reserves onto the production/supply side of the scales.

The Crisis Commodity: More Factors Holding Gold Down

Another purely economic factor holding the price of gold back may simply be traders selling every time gold approaches $440. Why do I say that? In part because you can see gold retreat time and time again, as it approaches $440 – $450. As Jon Nadler, a senior executive with Kitco.com explains: traders, not being long-term-oriented folks, are not waiting for gold to go to the moon. They are perfectly happy to buy in the $417 – $430 range and sell the moment they can make $20 – $30 per ounce. This doesn’t really affect the balance of supply and demand, but since prices are fixed at the margins in general, and are particularly volatile in a relatively small but psychologically important market like gold (if supply hits 4,000 tonnes this year, that would only be $57 billion at $440 gold), even a modest amount of selling by traders can have a strongly negative short-term effect on prices.

In addition, investor fascination with real estate is drawing capital from other investments, even undervalued ones like gold. Why did investors focus on real estate, rather than gold, after the tech bubble burst, the dollar started falling, and broader equities markets started trading sideways?

I attribute it mainly to the fact that gold was in a secular bear market from 1980 to 2001. As a consequence, a whole generation of investors grew up thinking of it as an investment "dog" as well as a monetary anachronism. Largely due to the strong growth of the U.S. economy and the years of low interest rates have spawned a complacent mentality among most Americans; they expect continuous prosperity. Given the record levels of debt among individuals and the federal government, this feeling of prosperity must be a form of mass delusion.

Rising interest rates are already putting the squeeze on credit card and mortgage holders with variable interest rates. That could get very ugly, very quickly. Though we are seeing the beginnings of a change in attitude, most institutional and retail investors still think putting capital in gold and other precious metals is a little loony.

The Crisis Commodity: Influencing Gold

When the housing bubble bursts, though, I suspect things will begin to change. Stocks, bonds, and the depreciating dollar won’t provide a refuge. The herd is going to head into commodities in general, and gold in particular. Gold is, after all, the crisis commodity – and, as explained in last month’s edition of this newsletter, I am more convinced than ever that we’re heading for a financial crisis that’s going to dwarf what we saw in the ’30s.

As long-time readers know, I don’t generally subscribe to conspiracy theories. Occam’s Razor dictates that the simplest solution to a problem is likely the most correct one. And anybody who has tried to get a few friends to agree on something as simple as what movie to watch can imagine how hard it might be getting dozens of the most powerful malefactors in the world to agree on how to suppress the gold price. But I have to say that the folks at the Gold Anti-Trust Action Committee (www.gata.org) present a pretty compelling case.

Central banks may not be able to control the price of gold, as was the case before 1971, but they have the motive, means and appearance of influencing it. The U.S. in particular, since its dollar has in good measure replaced gold as a reserve asset around the world, has an interest in seeing low gold prices, and a quiet gold market. Why? Because the value of the world’s fiat currencies, particularly the dollar, rests mainly upon the confidence of the public.

Unfortunately, confidence is not a stable foundation upon which to build the world economy. Like any attitude, confidence can change over night. Governments want to maintain confidence at all costs, and the one thing most likely to destroy it and set off a full-scale monetary panic, is a runaway gold price. Therefore, it’s quite logical that they will make every effort to suppress the price of gold.

How? Remember what I said about producer hedging above? The key component of GATA’s claims is that the central banks are lending gold to bullion banks and still keeping the gold on their books as reserves. In these "swaps", each bar of gold essentially gets counted twice, exerting a negative pressure on the gold price when the borrowed gold gets sold on the open market.

There’s no question that bullion banks are selling borrowed gold – what makes this the stuff of a "conspiracy" is that GATA says the central banks are not being truthful about whether or not they are counting gold not actually in their vaults as reserves.

Specifically, GATA chairman Bill Murphy says the central banks are reporting an aggregate of about 31,000 tonnes of gold held in reserve, but only have about half as much in their vaults. The amount of gold they actually have on hand may be as little as 14,000, or even 12,000 tonnes.

Murphy says the IMF claims it "recommends" that swapped gold be excluded from reserve assets. However, some central banks report otherwise. For example, a footnote on the central bank of the Philippines web site contradicts the IMF’s claim: "Beginning January 2000, in compliance with the requirements of the IMF’s reserves and foreign currency liquidity template…gold swaps undertaken by the BSP with non-central banks shall be treated as collateralized loans. Thus, gold under the swap arrangement remains to be part of reserves…"

The European Central Bank, the Bank of Finland, the German Bundesbank and the Bank of Portugal also confirmed in writing to GATA that swapped gold remains a reserve asset as per IMF regulations. So, clearly there is a disconnect here. Summarizing the GATA argument, in their own words: "GATA believes that the implications of IMF accounting procedures for reversible gold transactions are very significant. Clearly deceptive accounting, countenanced by the IMF, has allowed official sector gold to hit the market without a corresponding drawdown on the balance sheets of central banks. This has made it impossible for analysts to ascertain the exact size of official sector gold loans, swaps and deposits. The unwillingness of central banks to provide even a minimum level of transparency suggests that total gold receivables are substantially larger than the accepted industry figure of approximately 5,000 tonnes. Macroeconomist and former World Bank consultant Frank Veneroso contends that 10,000-15,000 tonnes of gold have left central bank vaults via loans, deposits and swaps."

The Crisis Commodity: Stupid Central Bankers

Could central bankers really be stupid enough to lend out gold to people who are selling it, in return for a measly 0.5% interest? Yes. My impression of central bankers is that most are not smart enough to buy low and sell high; they’re a bunch of stumblebums from wealthy families who know how to dress well. They likely feel quite clever getting 0.5%, when before they were getting nothing. I also don’t doubt the favor to the bullion banks often gets repaid with cushy jobs or consulting contracts after the bureaucrats go out into the private sector.

What happens if production from Barrick and the other hedged producers (many of whom are taking a severe beating from rising costs and commitments to sell gold at below-market prices) falls off and J.P. Morgan and the other bullion banks can’t replace the gold they’ve sold at prices they can afford to pay? It’ll be a scandal of a scale that, by itself, could move gold much higher.

But even if that doesn’t happen, it’s easy to see that the bullion banks must feel a well-deserved and thoroughly unpleasant jolt of panic every time the price of gold heads north – especially with mine strikes in South Africa, unrest in Peru and environmental activism threatening gold production in other places. If they can’t replace the gold they’ve sold from new mine production, they’ll have to get it on the open market, and that could wipe them out. And if the bullion banks go bust, the central banks will be caught with their suspenders down; they’ll be forced to go public, admitting that they have less than half the gold they’ve been reporting in reserve. Fear of that outcome could certainly drive them to lend even more gold to the bullion banks, adding selling pressure whenever the price of gold goes up, making the hole they are digging deeper each time.

Whether or not there’s any deliberate price manipulation may be hard for GATA to prove. However, GATA’s questions of the central bankers regarding their policies on reserves, swaps, sales, etc. are valid and deserve answers. I’ve made light of GATA’s efforts to force disclosure in the past only because I’ve felt they were doomed to failure, not because I disapproved of the intent. I asked Bill Murphy how long before the bullion banks and central banks hit the wall and the whole house of cards collapses. Bill answered: "I think we’re there now. I’m not sure the central banks can lend any more gold out – the scandal could break at any moment."


Doug Casey
for The Daily Reckoning

September 07, 2005

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A friend writes from New Orleans…

"… one of the greatest tragedies in the history of our nation has been visited on my little corner of the world.

"Don’t let the shrieking headlines fool you – the vast, vast majority of the people being affected by this disaster are good-hearted, hard-working people. The salt of the earth, as they say. A small number of hoodlums have tarnished the reputation of the greater, better whole, and this has only been made possible by the treasonous inaction, utter disregard and disdain of the federal authorities.

"Imagine if you spent a harrowing day or two trapped in an attic or, if you were lucky, baking on your roof, in 95 degree heat and 95% humidity. And this after losing everything you owned. Now you¹re corralled with hundreds of others on a hot street, and told to wait because buses, boats, food and water were on the way. One day passes. Then another. And nothing comes.

"In the meantime, people are literally dying around you. Bodies are floating by. Your children’s cries are growing more faint. And, somewhere beyond your little hell, politicians are elbowing each other for face time in front of the cameras, figuratively standing on the bodies of your friends and loved ones to further their petty ambitions."

The story from N.O. is not a pretty one. Many residents of the Big Easy did not behave themselves. Instead of looking out for their neighbors, they turned on them.

But what do you expect? Everything has its time…its season.
Our mission is merely to try to understand what season we are in. Then, we can guess about what comes next.

So far, it seems to most people that the United States is enjoying a very long, very hot summer. For the last several years, there has been little change; the sun shone every day. So hot has the real estate market been that the average house has increased 50% in price since 2001. Why is a house worth 50% more this year than it was just four years ago? It is exactly the same house in exactly the same place rendering exactly the same service to its owners. There are plenty of explanations for why it is now more valuable, but almost all of them are foolish: growing population, growing wealth, shrinking availability, echo boom buyers. Nothing has really changed between 2001 and 2005 that would make houses more valuable. What has changed is that the Feds have made much more money and credit available which has found its way into the one consumer item (mistaken for a capital asset) that the Chinese couldn’t produce: houses.

In Nevada, house prices have been as hot as the desert itself. Last year, houses sizzled 28%. In Las Vegas the growth slowed down to only 26.9%. Local ‘experts’ thought this was a good thing. "They can’t keep going up at 50% a year," said one. This will give the market a time to catch its breath, he continued, so as to "avoid future problems."

It is far too late to avoid future problems…at least, that is our guess. The season if too advanced. America no longer basks in the warm sunshine of growth and progress, but in a fantasy moonshine of its own making.

In this soft and agreeable world there is no wind so ill it blows no one good – not even one of the worst natural disasters in American history. The Fed will stop raising rates. Homebuilders will begin replacing 100,000 houses. Stocks rose yesterday…as investors anticipated another wash of easy credit…another fraud…and another boom. Laissez les bons temps roulez.

But sometime the wind will shift…and the season will change. When the bons temps stop rouling, will Americans pull together with the calm spirit that marked London during the Blitz…or will they turn on one another?

More news, from our team at The Rude Awakening…


Andreas Ettl, reporting from London:

"By owning this stock, you own the world’s biggest uranium producer. We expect the share price to continue climbing as investors around the world pile in."


Bill Bonner, with more thoughts…

*** America uses too much energy, says the Economist. How they know how much the United States should use is a mystery. But they think they have found a problem that needs a solution.

"The best long-term solution – for America as well as the world economy-would be higher petrol taxes in the United States. Alas, there is little prospect of that happening. America, unlike Europe, has preferred fuel-economy regulations to petrol taxes. But even with those it has failed abysmally. These regulations have been so abused that the oil efficiency of its vehicles has fallen to a 20-year low. This week, the Bush administration announced proposals for changing the fuel-economy rules governing trucks and sport-utility vehicles, but failed to close loopholes that allow these gas guzzlers to use more petrol than normal cars, a shameful concession to carmakers."

*** This view – that central authorities know better than individual consumers and producers how much oil a person should use and how much they should pay for it – is widely shared. New Times columnist Thomas Friedman makes it a cornerstone of his earnest mittel-brow weltanshaung (check spelling).

Of course, we are just lonely scribblers. Friedman is a media star…almost a guru to the rich, the powerful, and the hollow dummies.

"He dazzles crowds. He brews conventional wisdom. He charms CEOs. And he drives some people crazy. Meet Tom Friedman, the oracle of the Global Century," says Fortune Magazine:

"With all the famous people clogging the sidewalks and mountain trails of Aspen, you might think that no one there would make a fuss over a newspaper columnist. Try making the rounds of the Colorado resort town with Thomas Friedman. Everywhere you go, people stop him to gush. They tell him they loved his Aug. 10 performance at Aspen’s Benedict Music Tent, where he wowed a crowd of 1,700 (ticket prices: $50 and $75) with his tales of the ever-troubled Middle East and the ever-changing global economy. They bring up one of his twice-weekly columns in the New York Times, or one of his four books, or one of his appearances on Charlie Rose. They just want to shake his hand. For a reporter in Friedman’s wake, the celebrity moments just keep coming: Cosmetics magnate Leonard Lauder presents a detailed analysis of Friedman’s writing style; venture capitalist John Doerr tells of his annual New Year’s Day cross-country ski outings with the writer; Queen Noor of Jordan offers up some of her French fries.

"Aspen isn’t the only place it happens. At the National Governors Association summer meeting in July in Des Moines, Friedman also outshone the stars…. At an August breakfast in New York City to unveil September’s Playboy interview – a conversation with Friedman, of course -it was more of the same. Fox News czar Roger Ailes was among the bigwigs who listened raptly while Friedman told tales of terrorism, Iraq, and Indian call centers. Finally Steven Silverstein, CEO of shopping-mall stalwart Spencer Gifts, blurted out what must have been on the minds of several around the table: "I understand from what you’ve said today that you are running for President. You have my vote.""

There, dear, dear reader…is any further proof needed? If people take Friedman seriously…is there anything at which they can still giggle and guffaw?

The Daily Reckoning