Previously by Robert Blumen: US To Return to
Gold Standard. Really?
Introduction
Most gold market research is based on the premise that the supply side of
the market can be characterized by the quantity supplied and demand side by
the quantity demanded. The specific cause and effect relationship between
these two variables and price is often unstated; and perhaps rightfully so:
is it not obvious that a greater quantity demanded is the cause of a higher
price, and that a greater quantity supplied is responsible for a lower price?
No.
This article will show that market forecasts based on quantities of gold
are meaningless. Widespread statements like "Gold demand was up by 15%
in 2012" are true but only if they are understood in a misleading sense.
The supply and demand sides of the market consist of supply and demand
schedules, not quantities. A price forecast based on quantities is a non sequitur
because there is no causal connection from the quantities to the price. This
error has side-tracked the majority of analysts into an obsessive focus on
quantities while ignoring the actual drivers of the price.
The first part of this article will examine the definitions of supply and
demand and discuss their relationship to price. Most analysts define supply
and demand as quantities. There are several ways to do this. If used
consistently, any of these definitions are valid but none of them are useful
for the purpose of the purpose of price estimation.
After establishing the definitions, I will show that the quantities
supplied and demanded must conform to an arithmetic relationship that is
logically true but has no causal connection with the gold price. Supply and
demand totals can be any numbers that satisfy the arithmetic relationship,
while at the same time the price can rise, fall, or stay flat.
The next section will explain the true drivers of the gold price: the
supply and demand schedules. These schedules are not scalar quantities and
cannot be measured; they can only be observed indirectly through the gold
price itself. I will show that the cause and effect relationship between
quantity and price runs in the opposite direction from what is widely
assumed. The quantities are driven by a temporary disequilibrium between the
market price and the supply and demand schedules of investors. This
disequilibrium induces market participants to supply, and to demand gold to
bring their portfolio in line with their preferences.
The final section delves into materials from the CPM Group, a prominent
and respected gold market research consultancy, showing how their research
relies on the same error.
This article does not entirely stand alone; it builds upon other articles
that I have written about the gold market, and on the marginal price theory
of the Austrian School. Some parts of this article will not make sense unless
you are familiar with some of these concepts. I chose to do this partly to
avoid repeating ideas that I have already published, and partly to control
the length. I have linked to backup material that I believe is relevant.
The Usual Explanation
First, let's look at the examples. Most published analysis of the gold
market is concerned with supply and demand numbers.
From the UK Telegraph, under the
headline, Gold
demand increases 15pc:
As the gold price increases, demand for gold and other precious metals has
continued to grow. Demand for gold has continued to grow in 2012 and is
predicted to increase further next year. Research by Source, a provider of
exchange traded products, shows that inflows into European gold ETPs have
reached $6.8bn this year to date, constituting a staggering 15.4pc growth
Almost every page of the World Gold
Council's Third Quarter 2012 Gold Demand Trends deals with either the
quantity supplied or demanded by a sector of the market. The following
sentences are selected at random for illustrative purposes:
Third quarter gold demand was up 10% on the previous quarter but 11% lower
than record year-earlier levels (p1)
Investment demand was 16% below the exceptional levels witnessed in Q3
2011. (p2)
Total demand (including OTC investment and stock flows) was 2% weaker
year-on-year … (p2)
The most significant contribution to the fall in gold demand came from a
drop in bar and coin investment.
The World Gold Council's web site contains the following:
Since 2003, investment has represented the strongest source of growth in
demand. The last five years to the end of 2011 saw an increase in value terms
of around 534%. In 2011 alone, investment attracted net inflows of
approximately US$82.9bn.
My third example cites CPM Group's 2012
Gold Yearbook Press Release:
Investment demand, the key driver for gold prices, remained at
historically high levels last year. Net additions to private investor gold
holdings declined to 34.3 million ounces in 2011, down 5.8% from 2010 levels.
Even though net additions to private investor holdings slipped lower in 2011,
a year in which prices touched a record high, the decline had followed two
years of double-digit growth from already high levels of net additions to
investor holdings. (p2)
Gold fabrication demand rose 0.6% to 72.9 million ounces in 2011, slower
than the 2.3% growth in 2010 due to higher gold prices. Despite higher
prices, many consumers sought to purchase more gold jewelry, specifically in
developing countries, as a hedge against inflation and form of savings.
Developing countries' demand for gold in the form of jewelry rose to 50.2
million ounces, up from 49.6 million ounces. (p3)
The bearish financial
planner Arthur Stein also believes
that gold demand is declining (based on the World
Gold Council's figures) which will result in a lower price:
Demand for Gold Declines, Will Prices Follow?
…Demand for gold has been declining worldwide, but prices haven't. What
does this mean for someone investing in gold?
Gold demand declined 11 percent in the third quarter of 2012 compared to
the third quarter of 2011, according to the World Gold Council
(www.gold.org). Demand fell in every sector except for purchases by central
banks.
Market Sectors and Flows
Most gold analysts divide the market into sectors. This section will
discuss how this is done and what the quantities mean in relation to the
sectors. A typical sector breakdown is: mines, industry, jewelry, investors,
and the official sector (central banks). Some writers break the investment
sector down into bars, coins, and ETFs. The choice of sectors is not critical
to the points that follow; none of the conclusions would change if, instead
of these sectors, flows between countries were used instead. Some reports combine
the two approaches, dividing the developed world market into sectors and
treating the rest of the world on a country or regional basis. Any of these
breakdowns would serve equally well.
Below is a list of the sectors, their buying, and their selling:
Sector
Buying
Selling
Mine
Not a buyer
All production sold to the market,
where it is eventually refined into investment, jewelry, or industrial
products.
Industry
For electronics, dentistry, and
other applications that use up gold.
Recovery from scrap
Jewelry
Raw material for fabrication.
Melt from scrap jewelry sold by
people who no longer want it.
Investor
Additions to portfolio holdings.
Reductions from portfolio holdings.
Central banks
Add to gold reserves
Subtract from gold reserves
Inter-sector Flows and Quantity Balance
The quantity balance between sectors is at the core of most market
analysis. The quantity balance is an equation relating all of the flows in
the market to each other. (A flow is the quantity bought and sold, while a
stock is a quantity held by someone over time). Quantity balance is the
requirement that every movement of gold must be accounted for on the buy side
and the sell side. It is similar to the way that double-entry bookkeeping
works. This section will derive the quantity balance equation. The following
section will discuss its significance.
Over a one-year period, every trade that takes place between a buyer and a
seller is counted in the following way: the quantity of gold bought (and
sold) is added the buying sector's gross quantity bought and to the selling
sector's gross quantity sold.
At the end of the year, net flows for each sector are calculated. The
definition of the net flow for a single sector is:
sector net flow = sector total buying — sector total selling
Sector net flow can be a positive number, meaning that the members of the
sector bought more than it sold; or a negative number, indicating that the
members of that sector sold, in aggregate, a greater quantity of gold than
they bought.
Assuming that mines sell all of their production, which is nearly always
true, mine sector net flow is always a negative number.
mine net flow = mine buying — mine selling = 0 – mine selling = –
quantity mined
For every trade, the quantity bought is equal to the quantity sold. This
means that the sum of all sector net flows is zero. By the rules of algebra,
this arithmetic identity can be rearranged in several ways:
- quantity mined + net industry + net jewelry + net
investor + net official = 0
- net industry + net jewelry + net investor + net
official = quantity mined
The CPM Group uses a different sector breakdown than I have used here, so
their quantity balance is a little bit different. They use the following
market sectors: total supply (mine plus scrap), fabrication demand (industry
plus jewelry), official sector and investment. Their quantity balance in
their partitioning is summarized in equation (3), below.
- quantity mined + industry sold + jewelry sold =
industry bought + jewelry bought + net official + net investor
In this breakdown, official and investor sectors have a net flow on the
right side of the equation but the jewelry and industry sectors have gross
purchases on the left of the equation and gross sales on the right.
The preceding equations are all saying the same thing: all the gold that
comes out of mines ends up as net inflow into one or more market sectors.
These identities all follow directly from the laws of arithmetic. They
contain no new information. They are only a restatement of the original
assumptions, namely, that miners sell all of their production, and that no
gold is destroyed during a trade. The mine sector net flow is always negative
but the other sector net flows could be positive, negative or zero.
Gold can be destroyed not in the physical sense, but in the economic
sense. This means that the industrial process renders some of the metal into
a form where it would be too costly to recover. The boundary where recovering
gold from industrial use is cost effective depends on many factors,
especially the price of gold, which can change over time. Gold destruction
occurs only in the industry market sector. The rate of gold production always
exceeds gold destruction. Consequently the total of gold held above ground
grows over time.
The False Logic of Quantities
I believe that the error of attributing gold price moves to quantities is
based on the following invalid thought process on the demand side (with
similar thoughts on the supply side not shown here):
- The gold price is driven by supply and demand
- Supply and demand are quantities
- Looking at the demand side, more demand implies a higher
price, less demand a lower price.
- More supply means a lower price, less supply a higher
price.
- The key to forecasting the gold price is therefore
measurement of gold supply and demand.
Arthur Stein is representative of this type of reasoning. Quoting at
length from his bearish
forecast,
Gold is unlike other commodities in many respects. For investors, one of
the significant differences is that the supply of gold (called “above-ground
gold") never decreases; it only increases. So declining demand should
cause a decline in the price of gold, not an increase.
The sources of total demand are another concern. Jewelry demand has been
declining since at least 1997. Jewelry demand in 2011 was 40 percent lower
than 1997 and demand in the first three quarters of 2012 was 9 percent lower
than the same period in 2011. … Industrial and dental demand declined in 2011
and is on track to decline another 6 percent this year. … Investment demand
(bars, coins, Exchange Traded Funds, etc.) declined 3% in the first three
quarters of 2012 compared to 2011.
The bright spot for gold demand was official sector (central bank)
purchases. Central bank activity went from net sales to net purchase in 2010,
and net purchases continued to be positive in 2011 and the first three
quarters of 2012.
The main problem with this view, as I will show in the next section, is
that there is no cause and effect relationship between the quantities and
price.
Flows not the Cause of Price
The financial media commonly reports that buying is the cause of the price
going up. Stories in the financial media usually report only one side or the
other side of the market. For example, an increasing number of small
investors buying coins is often cited as the cause of gold price strength.
However, the same story could equally well have been written as a bearish
report about the increasing number of investors willing to sell their coins.
Either story would be true, at least from a quantitative standpoint and both
would be wrong in attributing the movement in the gold price to one side of
the market only.
If the reporter accurately described a large volume of coin buying and an
equal volume of coin selling, then what conclusion about the price should the
reporter draw? Exactly none. Buying as such is not the cause of the higher
gold price, nor is selling the cause of price declines. If buying could take
place without selling or selling without buying, then one or the other could
be an independent cause of price moves. But neither can occur without the
other. Buying and selling occur always in equal quantities, and, at the same
time. For every purchase of gold by a buyer, an equal quantity is sold by the
seller. The quantity of buying, which is always the same as the quantity of
selling, is not the cause of the gold price.
While everyone agrees that the gold price is driven by supply and demand,
not everyone who voices agreement means the same thing. The correct version
is: the gold price is driven by supply schedules and demand schedules. Most
analysis of the gold market is based on an incorrect interpretation of the
statement, namely, the gold price is driven by the quantity supplied and the
quantity demanded. An increase in gold demand is the cause of a higher price
if an increase in demand, means a change in the preference rankings of coin
buyers for more gold/less cash. In that case, all other things equal,
transactions would occur at a higher price.
The quantity balance equations are logically valid at all times, but they
are accounting identities, not statements of cause and effect.1
The quantity bought and sold is not an explanation of why the price moved.
All inter-sector flows must balance, but flow is not the cause of the price;
it is a summary quantity of gold traded, at whatever price. Any combination
of positive, negative, or net inflows or outflows into any one or more
sectors could occur during a year where the gold price was higher, lower, or
unchanged.
Suppose during the last year that net investor inflow is a positive number
and net official inflow is negative. This indicates that over one year,
investors purchased gold from central banks. But this fact is an arithmetic
identity, not a cause of the gold price movements during this year. If, the
following year, central banks on net purchased gold from investors, we are
still no closer to knowing at what price the gold was purchased, and whether
that price is higher or lower than the current price.
The True Cause of the Gold Price: Marginal Preferences
The theory of equilibrium price formation is necessary to understand the
remainder of this article. I will not attempt a detailed explanation of the
theory here, but the interested reader may find it in one of the following
references: Rothbard shows in detail how supply and demand schedules are
derived from individual preference rankings in Man Economy and State, starting
with his discussion in Chapter
2 sections 4-5, and Chapter
2, section 8: Stock and the Total Demand to Hold, and then later as
applied to money in Chapter 11
(Money and its Purchasing Power) sections 2-5.
Each investor strives to maintain their desired holdings of all potential
assets, including cash (i.e. one or more national currencies such as the US
dollar or euro). As their preferences change, and as market prices change,
investors adjust their portfolio holdings, at the margin, to bring them in
line with their preferences. The price of an asset emerges as investors
balance, bid for assets they wish to hold more off and offer assets they
prefer to hold less of.
Supply and demand as they contribute to the price must be understood not
as quantities but as schedules.
Market prices balance the aggregated supply and demand schedules of the
entire market. These aggregated schedules are also known as the more widely
used supply and
demand curves. In the standard micro-economic presentation, the supply
and demand curves intersect at a point, marking the price and the quantity.
I have written about the application of supply and demand schedules to the
gold market in Does Gold Mining Matter?
There I explain that the supply schedule for gold (in dollar terms) is
dominated by the owners of the world's existing stockpile of gold, and that
mined gold during any one year period has a relatively small impact on the
supply schedule. The price is set primarily by the reservation demand
schedules of the owners of the existing gold. In the same piece, I show that
the quantity mined, which many analysts incorrectly believe is "the
supply", has little influence on the gold price.
The quantity balance constraint cannot be a cause of the gold price
because balance equations contain only quantities. The gold price is the
quantity of money exchanged for the quantity of gold. Any explanation of the
gold price must contain some reference to the quantity of money involved.
Equilibrium price theory provides a complete theory of the cause of the gold
price, taking into account the gold and money sides of the market.
If the gold price is higher now than it was at some point in the past,
that can only be due to a shift in preference schedules. One of the following
must be true: 1) either buyers valued the gold more highly and thus were
willing to pay higher price, or 2) sellers valued their gold more highly and
were only willing to part with it at a higher price. Historical net flows
provide a summary of where in the market were the buyers who valued gold the
most highly, and the sellers who valued it the least.
Up to this point I have argued that the quantities supplied and demanded
are not the cause of the gold price. The true causal relationship between
price and quantity is nearly in the opposite direction. Transactions occur in
the market because there are some investors whose mix of cash and gold
holdings is not consistent with their preferences. Trading will occur until
everyone has adjusted their portfolios, at the margin, to their preferred
holdings. If no one changed their preferences after this moment, and no new
gold were mined, then no more trading would occur.
Trading continues because people are always changing their minds about
what they want to own. Individuals who did not previously consider themselves
gold investors enter the market; others no longer consider gold a good
investment and sell out. The more individual investors that have changed
their preference rankings since the last market price, the greater the
disequilibrium in the market, and the more change in the ownership of gold
and cash is necessary in order for investors to reach their desired holdings.
The volume of trading reflects the extent that holdings of some individuals
no longer reflect their preferences.
Attributing a higher gold price to an increase in coin buying alone
ignores the equal quantity of coin selling that is necessary for more coin
buying to occur. More coin buying means more coin selling. The media story
about coin buyers driving the gold price higher could be correct, if the
buyers are the only ones whose preferences have changed. In that case they
are willing to pay up, higher into the supply side of the market. But action
in the coin shops could also result from sellers liquidating at lower prices,
or a simultaneous set of changes by some buyers and some sellers that
cancelled each other out in price action, leaving the price unchanged after a
large volume of trading.
Demand Schedules Not Measurable
So far I have argued that the gold price is an outcome of the preference
schedules of investors. A preference schedule is not a number. It is a spiky
curve representing a range of quantities and prices. Schedules are not
directly measurable in the way that quantities are, because they include
hypothetical quantities that would be supplied and demanded at prices above
and below the market. In order to have the complete supply and demand
schedules, the analyst would have to know how much gold would be sold and
purchased at every price. When gold trades, we know only that the quantity
supplied and demanded at one price.
Laura Davidson explains this point in her excellent piece The Causes of
Price Inflation and Deflation. In reading the quoted passage, it may help
to understand that reservation demand for money is another term that means
the same thing as the term that I have been using, cash holding preference,
except measured against all goods in general.
When the social reservation demand for money changes, it can neither be
measured nor observed directly. Whether market participants hoard money, or
dishoard it, the amount of money in their wallets and their bank balances in
the aggregate remains exactly the same ceteris paribus. There is no special
place from which money flows, or to which it flows, when the demand for cash
balances changes.
The same point can be made for any good that is demanded in order to be
held in stockpiles. Examples include not only gold but most financial assets
such as stocks and bonds. Reservation demand can be inferred, indirectly, by
observing the price. Davidson continues,
Nevertheless, it is possible to observe the effects of the change [in
reservation demand]. Suppose, for example, prices-in-general are falling, and
yet the supply of goods in the market has not changed. From this it can be
deduced that the exchange demand for goods must have fallen. But let us also
suppose the money stock has not changed. This leaves only the reservation
demand for money as the causative factor for the reduction in the demand for
goods and the ultimate cause of the price deflation.
While I have spent most of this article discussing demand, the supply side
of the market works the same way. Supply schedules and demand schedules
together drive the gold price. Supply schedules are immeasurable as are
demand schedules.
Conclusion
The main point that I have tried to show is that the demand numbers used
in most gold market reports do not measure the demand side of the price
formation process. The same could be said about the supply number. These two
numbers are connected through the quantity balance constraint but they are
not the cause of the gold price.
Gold market analysts have a tougher job other financial analysts. In Value Investors
Hate Gold, I argue that it is more difficult to analyze the yellow metal
than equities because quantitative measures such as yield, cash flows,
balance sheet leverage, and growth rates provide a fundamental basis for
analysis. Gold has none of those things.
The fundamentals of gold are the current purchasing power of money;
expectations about the future purchasing power of money; the growth rates of
various national money supplies; the volume of bad debts in the system;
expected growth rates of bad debts; the attractiveness of other available
investments; and the investor's preference for consumption rather than
investment. These factors do not act directly on the gold price. Instead,
they are focused through the prism of investor preferences, which are not
measurable. The price is the ultimate measurement of how investors view these
factors. The paradox of gold is that which drives the price cannot be
measured, that which can be measured does not drive the price.
Appendix: The CPM Group
Introduction
I have devoted an entire section to The
CPM Group's gold research because, of all of the major research firms,
they have has the most information available about how they think. While I
chose to focus on the CPM Group, as far as I have been able to determine from
published reports, GFMS agrees on the
basic framework of the quantity model, if not on all of the particulars. The
other major research firm, the WGC, uses
the numbers compiled by GFMS. From those aspects of the CPM Group's thinking
that are available to the public, I have tried to reverse engineer how they
see the gold price from what is available.
In the next section I will explain my interpretation of their thinking.
And then, in the following section I will provide my critique of the CPM
Group. I have found several problems in their model: the first, that they
consider market data on a year-by-year segregated basis; the second, the
belief that gold holdings are not part of the market; and third, the premise
that net flows drive the gold price. I will discuss each of these points in
more detail below.
The CPM Group's Model
My sources consist of the CPM
Gold Yearbook 2012 (cited below as Yearbook) and a 1996 presentation to
the Australian Gold Conference by the CPM Group's founder Jeffrey Christian, Gold:
Supply, Demand, Price and Research (below, AGC Presentation). After
reading the sources, I have synthesized what I believe to be the CPM Group's
model of supply, demand, and price into the following propositions:
Gold Supply: The gold supply consists of mine production plus
"secondary sales". The latter consists of melted gold sold in the
form of scrap by the jewelry sector and the fabrication sector. See the
Yearbook, p. 105: Gold supply, which includes gold output from mines in
market economies, gold exports from transitional economies into market
economies, and old gold scrap that has been refined, is estimated to have
totaled 119.9 million ounces in 2011….
Gold Demand: Gold demand is the sum of the following: industrial
use (electronics, dental, medical, other), gold use to make new jewelry,
official sector net flow (IMF, US, Canada, other) and investor sector net
flow (coins, bullion, bars, Indian). See the Yearbook, pages 6-7. Investment
demand is defined by CPM in some places as the net flow of the investor
sector and in other places as the net flow of the investor and official
sectors combined. My citations in support of this are:
- Yearbook, p. 4, labels on the chart titled Gold Supply
and Demand shows investor demand as the difference between supply
(defined as mine + secondary) and fabrication demand. From the quantity
balance equation (3, above), total supply less fabrication demand must
equal net investor and official sector flows.
- Yearbook, p 11: Net purchases of gold by central banks
have complemented healthy gold investment demand…. If net central bank
purchases have complemented investor demand, they cannot be the same
thing.
- See the Yearbook, p. 29, Investment demand (subtitle),
followed by: Net additions to private investor gold holdings declined to
34.3 million ounces in 2011
Quantity Balance: Demand equals supply. See the Yearbook, pages
6-7. The total supply consists of 31.0Moz mined, 4.5Moz secondary, and
13.2Moz from transitional economies for a total of 50.0Mz. Total demand
consists of 43.9Moz fabrication, -8.7Moz official sector reserve sales, and
14.8 net investor portfolio additions, for a total of 50.0Moz.
Quantities Drive the Gold Price:Each of the terms in the quantity
balance equation is a contributing cause of the gold price, with net
investment demand being the most important cause. If the net investor sector
flow is a large positive number, this is deemed a cause of a higher gold
price, while a small positive or a negative number is deemed a cause of a
lower gold price. My reason for thinking this is the following citations:
- Yearbook, p. 8: (chart) Net Investment Demand is plotted
on the left scale of the chart with the gold price on the right scale.
The chart's title is Investment Demand's Effect [sic] on Gold Prices.
- Yearbook, p. 9: Gold investment demand is one of the
strongest influences on gold prices.
- Yearbook, p. 10: …it is projected that net additions to
private investor gold holdings will remain at extremely high levels,
which is expected to help keep prices at elevated levels during 2012.
- Yearbook, p. 69: "Central banks were net buyers of
gold for the fourth consecutive year in 2011". (i.e. net flow into
the central bank sector was a positive number).
- Yearbook, p. 233: Strong investment demand for gold,
particularly during the first three quarters of the year, pushed prices
higher.
- AGC Presentation, p. 4: my next slide [not shown in PDF
-- rb] illustrates the weightings of each supply and demand sector in
CPM Group's amin gold price model. Central bank activity and investment
demand trends … exert much more powerful influences in determining the
gold price.
- AGC Presentation p. 8: SLIDE SEVEN: Investment Demand's
Effect on Prices. My next chart compares levels of investment demand for
gold to changes in gold prices. We call it our most important chart.
Herein lies the key to accurate gold price forecasts: Investment demand
is the most important influence on gold prices. Markets are made at the
margin, and in the gold market investors are the marginal market
participants.
- AGC Presentation, p. 8: Over the past few years, investors
have not been buying a great deal of gold. As a consequence, gold prices
have languished. Investment demand reached a low of 184 mt (5.9 million
ounces) in 1994. Investor demand increased 11.7% in 1995, but the level,
at 205 mt (6.6 million ounces), remained low. A further increase, to
around 239 mt (7.7 million ounces), is projected for this year. The
steady increase is being reflected in the slow upward march in gold
prices; the low levels overall are being reflected in the fact that
prices are not rising sharply.
Forecasting the Gold Price: Knowing the cause of an event does not
necessarily help to forecast the event. A cause can only be used to forecast
an effect if the cause occurs far enough in time before the effect that the
cause can be identified and acted on.
Mr. Christian states that net investor flows can be used to forecast the
gold price. I am not clear from the following whether Christian is saying
that the net investor flows in one year can be used to forecast the following
year's gold price, or whether he means that a correct forecast of next year's
net investor flows is the key to forecasting the next year's price. Below is
a relevant passage:
AGC Presentation p. 8: SLIDE SEVEN: Investment Demand's Effect on Prices.
My next chart compares levels of investment demand for gold to changes in
gold prices. We call it our most important chart. Herein lies the key to
accurate gold price forecasts: Investment demand is the most important
influence on gold prices. Markets are made at the margin, and in the gold
market investors are the marginal market participants.
Summary: Based on the above, it appears the CPM Group posits the
following logic regarding the gold market, though I cannot say for certain
because their quantitative model is proprietary.
- Supply is defined as mine plus secondary
- Demand is the sum of the various components.
- The price on any market is set by supply and demand. If
the number that CPM has defined as "demand" increases, the
price will be higher.
Critique of CPM Group's Model
Consumption versus Asset
My first criticism of the CPM Group's model is that conceive the of the
price formation process only in the context of annual data. In fact, annual
production and consumption quantities are quite unimportant in the overall
picture of gold price formation. The error of looking at gold as an annual
market is widespread and follows from a failure to understand the difference
between a consumption commodity and an asset.
Most commodities are produced primarily for consumption. Consumption
permanently destroys the economic value of the commodity (or in some cases,
makes the commodity costly to recover back to a form where it has economic
value). The market demonstrates that a commodity is produced mainly for
consumption by the lack of large above-ground stockpiles. A small stockpile
measured in terms of production output would be several days, weeks or a
small number of months at most. All commodities other than gold have
stockpiles that are small by this definition.
In consumption commodity markets, production and consumption must remain
very nearly in balance because on the one hand, reserves will be depleted
quickly if consumption exceeds production and, on the other hand, production
can only exceed consumption if stockpiles increase. Stockpiles generally will
not increase much beyond a few weeks or months of production flow because
users and speculators have historically demonstrated that they are not
willing to hoard larger supplies. For a consumption type commodity, the
supply that is produced during a given year, plus small stockpiles, is the
only supply available for consumption during that year.
An asset is a good that people buy in order to hold, rather than consume.
Some examples of assets are land, property, money, stocks, bonds, and gold.
Nearly all of the gold ever mined still exists either as bars, coins, or
jewelry. The total quantity of gold stockpiles grows by about 1-2% per year,
implying a ratio of stockpiles to one year production in the 50 to 100 x
range. Only a small amount of gold is truly consumed. Even jewelry
fabrication is not consumption because its bullion value is retained and can
be reclaimed at the relatively low cost of melting. Gold is held in a
continuum of products which can be transformed from one to the other, such as
bars, coins, and jewelry.
Price formation in an asset market works differently than in a consumption
market. Because consumption goods are bought in order to be permanently
destroyed, buyers must bid for newly mined product. The reservation demand to
and from stockpiles does not play much of a role in the pricing process. All
possible supply (regardless of price) is from recent production, and any
possible demand (regardless of price) is demand for current consumption. In a
consumption good market, the lack of stockpiles ensures that:
quantity supplied = quantity produced
quantity demanded = quantity consumed
In an asset market production and consumption (destruction) do not
significantly impact the supply or the demand because they both are small
compared to the above-ground supply. In a consumption market, the trade is
mostly from producers to consumers, while the majority of gold trading
consists of movement of gold from one stockpile to another stockpile. The
supply schedules are dominated by the offers of existing stockpiles at a
range of prices. The demand schedules are dominated by reservation demand to
hold existing stockpiles. Selling by producers and buying by (destructive)
consumers is small in comparison.
As I have explained here, the
gold market is a single integrated market where all sellers compete against
all buyers. It is not an annual market for the current year's supply. Buyers
compete to buy any gold, not only for gold mined in the last year. All
sellers compete to find buyers. The reservation demand for existing stocks,
because it is so large, is the major player in the price formation process.
While I have argued above that the quantities traded do not drive the
price, my point here is a different one. Consider a gold market without
producers or (destructive) consumers. The market would clear at a price and
quantity where the supply and demand schedules come into balance. Adding a
relatively small quantity to either side of the market would not move the
price much, even if the buyer (seller) were totally price-insensitive because
of the large depth of the supply and demand schedule on either side of it.
Recent Activity Sets the Price
In the AGC Presentation (p. 100), Mr. Christian explains that he does not
consider gold holdings to be part of the market if those holdings have not
changed hands recently. This is consistent with the view discussed in the
previous section, that the market price clears only the current year's supply
against the current year's demand. If I understand the reasoning behind this,
Mr. Christian believes that only transactions participate in price formation.
After a particular gold ounce has not been traded for a long enough time, he
no longer considers that ounce to be part of the market. At that point, in
Mr. Christian's view, that ounce has no impact on the market price. This view
is consistent with the CPM's mistaken focus on quantities traded as the keys
to the gold market:
Gold also has a multiplier. For the Australian dollar, as with the U.S.
dollar, I believe the multiplier is around 3 or 4. For gold, our estimate is
that the multiplier is around 9 at present. That is, an ounce of gold
entering the bullion market, from mine output, scrap recovery, central bank
sales, or wherever, will be involved in 9 transactions before it exits the
bullion market, either being used in a fabricated product or being dumped
into an investor’s inventories somewhere.
Mr. Christian's view is entirely mistaken. As I have explained, the supply
side of the market is formed by all of the owners of existing gold, who offer
it at a range of reservation prices. The price is an emergent property of the
decisions of all of the owners of gold stockpiles to not to sell below their
reservation prices, and the decisions of gold bidders not to offer above
their reservation prices. The reservation demand of the sellers of existing
gold, no matter how long ago it last traded, is the primary reason for the gold
price being where it is.
Net Sector Flows
My second criticism of the CPM Group's model is over-emphasis on net
sector flows. In the preceding section, I discussed Mr. Christian's incorrect
view that gold holdings are not part of the market. Removing holdings (the
primary locus of price formation) from consideration leaves only quantities
recently traded as a possible object of investigation. The CPM Group goes to
the far regions of the earth to measure quantities. The effort expended to
get the numbers is impressive. While these numbers contribute to our
understanding of what is going on in the market, they are largely irrelevant
to an understanding of the price.
As explained above, net sector flows are caused by preference changes, and
are not a cause of the gold price. Quantity balance rules require that
"total supply" as the CPM Group defines it be equal to the sum of
gross fabrication demand and net investment flows (private and official).
This identity is logically valid and true at all times, but it contains no
information about the cause of the price, for the reasons given above: a net
flow into, or out of, one sector of buyers is not the cause of the price
being higher, or lower. For every inflow into one market sector, there are
equal and opposite outflows from other market sectors.
As discussed above, I believe that the CPM Group's model attributes
causality to net flows based on the mistaken belief that the market's price
equilibration process only balances net flows during a year. As explained, flows
are not a cause or driver of the price; they are a reflection of changes in
preferences that have occurred since the last trading activity. These changes
in preferences determine where the gold flows.
CPM Group: Conclusion
The CPM Group's approach to the gold market is consistent with common
practices in the industry. Their approach is not any more mistaken than that
of the other analysts who do things the same way. I have chosen CPM as the
subject of this appendix because the clarity and detail of their reports has
made it easier for me to follow their thinking. I do not take issue with the
entire contents of the yearbook, only with their misuse of quantities.
I cannot rule out the possibility that the CPM Group has found statistical
correlations between net flows into or out of one of the sectors, and the
gold price and that these correlations are employed in their proprietary
model. This could occur if it were generally true over many years that actors
in one sector (or country) tended to be more price sensitive, or those in
other sectors less price sensitive. If that were the case, then buying by the
traditionally price-insensitive buyers would be correlated with a higher gold
price and selling by price-sensitive buyers would be coincident with a lower
gold price.
I should also give CPM Group credit for their
study of macro-economic factors that do impact the gold price. These factors
influence the price through their effect on investor preferences. I agree
with the 2012
Gold Yearbook Press Release that "a host of economic, financial and
political problems" are driving investor interest in gold. The Yearbook
covers in detail macro-economic factors such as monetary policy, the business
cycle, currency exchange rates, debt, and political uncertainty.
Notes
- For another illustration of the confusion of accounting
identities with causal relationships see Robert Murphy, Krugman Falls
Into the Keynesian Accounting Trap.
- I had hoped to use only free sources but I found that
the yearbook, which is priced at $150, contained invaluable information
in my understanding of the CPM Group's model. The CPM Group originally
provided me with a free copy of the yearbook, but prior to writing this
article, I purchased a copy at the normal retail price.
Robert Blumen [send him mail] is
an independent software developer based in San Francisco. Robert wishes to
thank James Hickling of GoldMoney for assistance in copy editing the final
version.
Robert
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