Gold Price Discovery Shifting to Physical Shanghai Gold Exchange as Prices Diverge vs LBMA

The launch of the Shanghai Gold Exchange (SGE) was a promising event for gold investors. The exchange provides a new benchmark price for gold bullion with a much higher backing of contracts by actual physical metal. Many hope this new price benchmark will challenge or one day replace the Western price benchmarks that are widely believed to be manipulated.

To underscore the importance of this new pricing center, Craig Hemke of the TF Metals Report said:

This is one of the biggest developments that we’ve seen in the physical market in maybe a hundred years in that for the past 97 years total pricing, let’s call it pricing ability, on the wholesale market has been controlled in London through the twice daily fixes. 

It’s actually priced in the local currency, the yuan. It’s a very big development. It is a natural occurrence in that all of the gold is migrating to the East so therefore the pricing power should be migrating to the East as well. 

Shanghai, instead though, is a physical market and where this gets very interesting at some point in the future is that the Shanghai Exchange, which is really just an extension of the Chinese government if you will, has the ability to control a significant level of arbitrage between the East and the West and arbitrage between paper in the West and physical in the East. And they can kick off that arbitrage any time they want in how they set their benchmark, where they set this yuan denominated fix. They will most certainly affect that arbitrage and rapidly increase the drain of physical gold from London and exponentially increase the level of pain that the bullion banks feel trying to meet all of their obligations.

So this is a game changer.

The new Shanghai Gold Benchmark auction “concentrates” supply and demand twice every working day, aiming to find the one single price at each event that matches the most business from buyers and sellers. While physical demand has always provided underlying support to gold prices, speculative paper trading has been the main driver of prices. With China’s push for an international physical exchange, physical demand could begin to have a stronger influence over the gold price.

As the importance of physical exchange of gold vs. paper increases influence over prices, many believe there will be upward pressure on the gold price or an outright upward revision to much higher price points. The hope is that true free market pricing for gold may come from the Shanghai Gold Exchange and that the Western paper price mechanisms will lose legitimacy.

To this end, we are starting to see some wide divergences in the gold price in Shanghai vs London. We should point out that a small discount in London is to be expected, given a slightly lower purity, trust and history in the LBMA, etc. China is also seeing a spike in demand during this time of year. But what had been single digit differences between prices in London and Shanghai have quickly ballooned into double digit price differences over the past several weeks.

(Data sourced from kitco.com and complied by lawrieongold.com)

It is still too early to tell if the growing price divergence is a short-term phenomenon or sign of things to come. If arbitrage forces pricing on the LBMA and COMEX to catch up to pricing on the Shanghai Gold Exchange, this could bring an end to gold price manipulation (to whatever extend it is occurring).

To those that doubt the manipulation, consider that just today it was reported that Deutsche Bank has agreed to pay $60 million to settle U.S litigation by traders and other investors who accused the German bank of conspiring to manipulate gold prices. Details of the preliminary settlement were filed on Friday with the U.S. District Court in Manhattan. In October, Deutsche Bank agreed to pay $38 million to settle similar claims related to silver prices.

Such a development would be very bullish for gold investors as the price is allowed to finally climb to meet true free market demand. A more steady rise in the price would likely follow, rewarding long-term investors rather than short-term paper speculators.

This is all occurring against the backdrop of multiple bullish developments for gold, yet the price has corrected sharply in the past month. We firmly believe that the current pullback is offering investors an excellent buying opportunity. Once the uncertainty over the FED rate hike is gone, we expect to see another major rally in the gold market. This is precisely what occurred the last time the FED raised interest rates in December of 2015.

We want to be buying when sentiment is negative and there is blood in the streets. We want to run head first into the crowd that is panicking out of their gold and silver positions, adding to our positions on the cheap. A few of our favorite mining stocks are down 40% or more in the past few months, despite posting record quarterly production results and strong revenue growth. In our view, the upside potential is enormous compared to the downside risk at this juncture.

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