What’s the Real Price of Gold?

What’s the price of gold?

That seems like a ridiculously easy question to answer. I’m looking at a trading screen right now, and it displays a price of $1,733.80 per ounce.

That price may change a bit by the time you read this, but it would only take a fresh glance at the screen to get the new price. Case closed.

What’s the price of silver? Again, the question seems easy to answer. My trading screen right now says $26.82 per ounce. That price also changes, but it only takes another look at the screen to fetch the new price. Nothing to it.

If only things were that simple. They’re not.

In fact, establishing prices for gold and silver is far more difficult than it sounds. Further, the different prices on offer and the reasons for those differences can tell us a lot about what’s going on right now in precious metals markets.

Paper, Not Metal

First off, the prices I quoted above are not for gold and silver in the traditional, physical sense.

They are the one-ounce prices for COMEX gold and silver futures contracts. COMEX, a division of the Chicago Mercantile Exchange, is the world’s largest futures and options trading market for metals.

A futures contract gives the holder price exposure, but it does not give you physical gold or silver. It is a paper contract governed by exchange rules. It can be subject to early termination under those rules in the event of disorderly markets or other market disruptions.

So we’re talking about paper gold and paper silver, not the actual metals.

There is a process for taking physical delivery at the expiration of a long contract position, but this is used in only a small number of expiring contracts. Most contracts are cash-settled, rolled-over or paired-off without any physical product being delivered.

If more than a small number of contract holders asked for physical delivery, the authorized vaults would quickly run out of bullion, and the exchange would intervene to cash-settle the contracts or order that holders “trade for liquidation only.”

Physical delivery would be denied. So why do traders prefer paper gold and silver over the real McCoy?

Leverage, Leverage, Leverage

Gold and silver futures contracts offer leverage. A trader is required to put down an initial margin, typically about 5% of the amount of bullion subject to the contract.

The initial margin rules mean that $100,000 of capital can control $2,000,000 worth of gold or silver. An upward price move of 5% in the actual metal would result in a 100% return on equity on the cash invested.

This is why hedge funds typically trade in futures rather than physical bullion because the cash-on-cash returns are much greater. Of course, the opposite is also true. It would only take a 5% price decline to wipe out the initial margin and leave the trader with a 100% loss.

Failure to meet a margin call results in the contract being terminated and the defaulting trader likely being barred from further exchange dealings.

It’s a highly complex trading process, but the main point is there’s no actual gold or silver involved.

What about gold or silver contracts with the big banks who are members of the London Bullion Market Association (LBMA)?

These purchases are also paper contracts for what is called “unallocated” bullion. That’s a fancy way of saying “no bullion.” An LBMA bank might have one metric tonne of gold and sell 100 metric tonnes of unallocated gold contracts based on that single tonne.

Again, if all of the contract holders gave notice that they wanted to convert to fully allocated bullion and take physical delivery, there would not be enough gold or silver to go around. As with futures, these LBMA contracts would be subject to early termination and cash settlement.

Ultimately, you would not get physical bullion when you most want it — during a buying panic.

Yes and No

What about the famous London Gold Fix? Surely that involves physical bullion and presents a fair market price to the public? Yes, and no.

This process does involve the purchase and sale of physical bullion, and it is done through an auction-style procedure.

There are 15 participating banks in the gold fix including, HSBC, Goldman Sachs, Citi, JPMorgan Chase, Bank of China, Koch Supply, Morgan Stanley and Toronto Dominion Bank.

The problems are that the fix is not open to the public, it involves large quantities only (minimum size is a 400-ounce gold bar worth about $720,000), and most of the gold never physically moves.

It just remains in a designated vault, and ownership changes hands through a warehouse receipt or ledger entry. There is also a London Silver Fix, by the way.

Fraud and Manipulation

In short, all of these trading venues — futures, LBMA forwards and the London Fix —  have unique contract features that either have no physical bullion involved or have trading limited to big banks, which do business in large volumes and therefore are not accessible to everyday investors.

Even when the gold and silver are paper and not physical, the temptation to rig markets seems irresistible.

All of the paper gold and silver markets and the London Fix have been investigated in recent years and were found to have engaged in various kinds of front-running, market manipulation and bid-rigging.

Substantial fines and penalties have been assessed, and some actions have resulted in criminal convictions.

But what if you just want to buy physical gold and silver and take delivery for storage in a safe non-bank vault? How would you go about it?

This is where things get interesting and where the true price of gold and silver is revealed.

The first hurdle is to find a dealer. This is not as easy as it sounds.

Find the Right Dealer

There are hundreds of online dealers available. Some have fine reputations and offer outstanding service. (I like Hard Assets Alliance, which, in the interest of full disclosure, my publisher owns a stake in).

Others are sleazy and try to push you into high-priced “rare coins” (not worth it unless you’re a true collector, in which case you should look to an established rare coin dealer). Otherwise, they are likely more interested in getting your IRA business than in delivering coins and bars.

Dealer commissions also vary and can be quite steep.

Right now, the UK Royal Mint website is offering a one-troy ounce gold bar with a 9.2% mark-up or commission over the COMEX price.

Commissions or mark-ups in silver are even greater. A 15% premium on silver coins is not unusual. This would move the price of a one-ounce silver coin from $26.82 (the current COMEX price) to $30.85 or higher.

Of course, this assumes availability. The U.S. Mint has periodically announced that it will not be taking new orders from dealers due to a shortage of bullion and minting capacity. The Mint remains in operation only to fill existing orders until further notice.

So, again, what’s the price of gold or silver?

The answer depends on whether you want a paper contract or physical bullion. It depends on whether you want leverage (and margin calls) or outright ownership. It depends on whether you buy new production or older, rarer coins, etc.

Sales taxes, storage costs, insurance costs, exchange rates (if you buy from a foreign mint) and shipping costs make the calculations even more complicated.

Two Key Takeaways

Despite these variables, two things are clear.

The cost of owning bullion coins or bars you can hold in your hand is materially higher than the official “prices” you see listed on the exchanges. That tells you that actual bullion is considerably more scarce than paper bullion.

The second point is that the scarcity of physical bullion relative to paper gold and silver contracts will emerge with a vengeance in a buying panic resulting from any number of catalysts, including war, a new pandemic, a stock market crash, bank failures, or social disorder.

The paper holders will try to convert to physical and find that it’s too late. The vaults will be empty.

The lesson for investors is also clear. Get your physical gold or silver now while you still can. Don’t sweat the commissions because that’s the real price. Then rest easy.

I predict gold will ultimately go to $15,000 an ounce. Commissions are nothing when you look at the big picture.

The buying panic is just a matter of time.


Jim Rickards
for The Daily Reckoning

The Daily Reckoning